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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2009
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
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Commission File Number 001-31792
Conseco, Inc.
Delaware 75-3108137
---------------------- -------------------------------
State of Incorporation IRS Employer Identification No.
11825 N. Pennsylvania Street
Carmel, Indiana 46032 (317) 817-6100
----------------------------------- --------------
Address of principal executive offices Telephone
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days: Yes [ X ] No [ ]
Indicate by check mark whether the registrant has submitted electronically
and posted on its corporate Web site, if any, every Interactive Data File
required to be submitted and posted pursuant to Rule 405 of Regulation S-T
during the preceding 12 months (or for such shorter period that the registrant
was required to submit and post such files). Yes [ ] No [ ]
Indicate by check mark whether the Registrant is a large accelerated filer,
an accelerated filer, a non-accelerated filer or a smaller reporting company.
See the definitions of "large accelerated filer", "accelerated filer" and
"smaller reporting company" in Rule 12b-2 of the Exchange Act. Large accelerated
filer [ X ] Accelerated filer [ ] Non-accelerated filer [ ] Smaller reporting
company [ ]
Indicate by check mark whether the registrant is a shell company (as defined
in Rule 12b-2 of the Exchange Act): Yes [ ] No [ X ]
Indicate by check mark whether the registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court: Yes [ X ] No [ ]
Shares of common stock outstanding as of April 27, 2009: 184,758,758
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TABLE OF CONTENTS
PART I - FINANCIAL INFORMATION Page
----
Item 1. Financial Statements
Consolidated Balance Sheet as of March 31, 2009 and December 31, 2008.................................. 3
Consolidated Statement of Operations for the three months ended March 31, 2009 and 2008................ 5
Consolidated Statement of Shareholders' Equity for the three months ended
March 31, 2009 and 2008............................................................................. 6
Consolidated Statement of Cash Flows for the three months ended March 31, 2009 and 2008................ 7
Notes to Consolidated Financial Statements............................................................. 8
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
Cautionary Statement Regarding Forward-Looking Statements.............................................. 47
Overview............................................................................................... 48
Critical Accounting Policies........................................................................... 49
Results of Operations.................................................................................. 49
Premium Collections.................................................................................... 64
Liquidity and Capital Resources........................................................................ 68
Investments............................................................................................ 81
Investment in Variable Interest Entity................................................................. 89
Results of Discontinued Operations..................................................................... 91
New Accounting Standards............................................................................... 93
Item 3. Quantitative and Qualitative Disclosures About Market Risk ............................................ 93
Item 4. Controls and Procedures................................................................................ 93
PART II - OTHER INFORMATION
Item 1. Legal Proceedings...................................................................................... 95
Item 1A. Risk Factors........................................................................................... 95
Item 5. Other Information...................................................................................... 95
Item 6. Exhibits............................................................................................... 95
2
PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS.
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars in millions)
(unaudited)
ASSETS
March 31, December 31,
2009 2008
---- ----
(as adjusted)
Investments:
Actively managed fixed maturities at fair value (amortized cost:
March 31, 2009 - $18,538.0; December 31, 2008 - $18,276.3)........................... $15,396.8 $15,277.0
Equity securities at fair value (cost: March 31, 2009 - $30.7;
December 31, 2008 - $31.0)........................................................... 32.5 32.4
Mortgage loans......................................................................... 2,140.5 2,159.4
Policy loans........................................................................... 361.3 363.5
Trading securities..................................................................... 280.3 326.5
Securities lending collateral.......................................................... 243.9 393.7
Other invested assets ................................................................. 101.6 95.0
--------- ---------
Total investments.................................................................. 18,556.9 18,647.5
Cash and cash equivalents - unrestricted.................................................. 769.6 894.5
Cash and cash equivalents - restricted.................................................... 4.5 4.8
Accrued investment income................................................................. 312.5 298.7
Value of policies inforce at the Effective Date........................................... 1,425.5 1,477.8
Cost of policies produced................................................................. 1,874.5 1,812.6
Reinsurance receivables................................................................... 3,155.3 3,284.8
Income tax assets, net.................................................................... 2,068.6 2,047.7
Assets held in separate accounts.......................................................... 17.0 18.2
Other assets.......................................................................... 322.9 276.7
--------- ---------
Total assets....................................................................... $28,507.3 $28,763.3
========= =========
(continued on next page)
The accompanying notes are an integral part
of the consolidated financial statements.
3
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET, continued
(Dollars in millions)
(unaudited)
LIABILITIES AND SHAREHOLDERS' EQUITY
March 31, December 31,
2009 2008
---- ----
(as adjusted)
Liabilities:
Liabilities for insurance products:
Interest-sensitive products............................................................ $13,215.3 $13,332.8
Traditional products................................................................... 9,864.3 9,828.7
Claims payable and other policyholder funds............................................ 987.8 1,008.4
Liabilities related to separate accounts............................................... 17.0 18.2
Other liabilities........................................................................ 506.5 457.4
Investment borrowings.................................................................... 758.3 767.5
Securities lending payable............................................................... 256.4 408.8
Notes payable - direct corporate obligations............................................. 1,310.5 1,311.5
--------- ---------
Total liabilities.................................................................. 26,916.1 27,133.3
--------- ---------
Commitments and Contingencies
Shareholders' equity:
Common stock ($0.01 par value, 8,000,000,000 shares authorized, shares issued
and outstanding: March 31, 2009 - 184,758,758; December 31, 2008 - 184,753,758)........ 1.9 1.9
Additional paid-in capital............................................................... 4,105.6 4,104.0
Accumulated other comprehensive loss..................................................... (1,840.5) (1,770.7)
Accumulated deficit...................................................................... (675.8) (705.2)
--------- ---------
Total shareholders' equity......................................................... 1,591.2 1,630.0
--------- ---------
Total liabilities and shareholders' equity......................................... $28,507.3 $28,763.3
========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
4
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(Dollars in millions, except per share data)
(unaudited)
Three months ended
March 31,
------------------
2009 2008
---- ----
(as adjusted)
Revenues:
Insurance policy income................................................................... $ 782.8 $ 785.1
Net investment income (loss):
General account assets.................................................................. 308.6 310.0
Policyholder and reinsurer accounts and other
special-purpose portfolios............................................................ (18.0) (26.0)
Realized investment gains (losses):
Net realized investment gains (losses), excluding impairment losses..................... 85.1 (4.3)
Other-than-temporary impairment losses:
Total other-than-temporary impairment losses.......................................... (108.1) (41.3)
Other-than-temporary impairment losses recognized in other comprehensive loss......... 16.1 -
-------- --------
Net impairment losses recognized........................................................ (92.0) (41.3)
-------- --------
Total realized gains (losses)............................................................. (6.9) (45.6)
-------- --------
Fee revenue and other income.............................................................. 3.0 4.0
-------- --------
Total revenues........................................................................ 1,069.5 1,027.5
-------- --------
Benefits and expenses:
Insurance policy benefits................................................................. 753.5 767.7
Interest expense.......................................................................... 23.2 30.8
Amortization.............................................................................. 120.8 109.8
Expenses related to debt modification..................................................... 9.5 -
Other operating costs and expenses........................................................ 120.3 131.1
-------- --------
Total benefits and expenses........................................................... 1,027.3 1,039.4
-------- --------
Income (loss) before income taxes and discontinued operations......................... 42.2 (11.9)
Income tax expense (benefit):
Tax expense (benefit) on period income.................................................... 15.3 (4.2)
Valuation allowance for deferred tax assets............................................... 2.4 -
-------- --------
Income (loss) before discontinued operations.......................................... 24.5 (7.7)
Discontinued operations, net of income taxes................................................. - .5
-------- --------
Net income (loss)..................................................................... $ 24.5 $ (7.2)
======== ========
Earnings (loss) per common share:
Basic:
Weighted average shares outstanding................................................... 184,754,000 184,653,000
=========== ===========
Income (loss) before discontinued operations.......................................... $.13 $(.04)
Discontinued operations............................................................... - -
---- ----
Net income (loss)................................................................... $.13 $(.04)
==== =====
Diluted:
Weighted average shares outstanding................................................... 184,756,000 184,653,000
=========== ===========
Income (loss) before discontinued operations.......................................... $.13 $(.04)
Discontinued operations............................................................... - -
---- -----
Net income (loss)................................................................... $.13 $(.04)
==== =====
The accompanying notes are an integral part
of the consolidated financial statements.
5
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(Dollars in millions)
(unaudited)
Retained
Common stock Accumulated other earnings
and additional comprehensive (accumulated
paid-in capital loss deficit) Total
--------------- ---- -------- -----
Balance, December 31, 2007 (as originally reported)........... $4,070.5 $ (273.3) $ 438.7 $4,235.9
Cumulative effect of accounting change (adoption of
FSP APB 14-1)............................................ 28.0 - (11.6) 16.4
-------- --------- ------- --------
Balance, December 31, 2007 (as adjusted)...................... 4,098.5 (273.3) 427.1 4,252.3
Comprehensive loss, net of tax:
Net loss................................................. - - (7.2) (7.2)
Change in unrealized appreciation (depreciation)
of investments (net of applicable income tax
benefit of $163.5)..................................... - (292.3) - (292.3)
--------
Total comprehensive loss............................. (299.5)
Stock option and restricted stock plans.................... 1.9 - - 1.9
-------- --------- ------- --------
Balance, March 31, 2008 (as adjusted)......................... $4,100.4 $ (565.6) $ 419.9 $3,954.7
======== ========= ======= ========
Balance, December 31, 2008 (as originally reported)........... $4,077.9 $(1,770.7) $(688.0) $1,619.2
Cumulative effect of accounting change (adoption of
FSP APB 14-1)............................................ 28.0 - (17.2) 10.8
-------- --------- ------- --------
Balance, December 31, 2008 (as adjusted)...................... 4,105.9 (1,770.7) (705.2) 1,630.0
Comprehensive loss, net of tax:
Net income............................................... - - 24.5 24.5
Change in unrealized appreciation (depreciation)
of investments (net of applicable income tax
benefit of $31.6)...................................... - (56.2) - (56.2)
Noncredit component of impairment losses on actively
managed fixed maturities (net of applicable income tax
benefit of $4.7)....................................... - (8.7) - (8.7)
--------
Total comprehensive loss............................. (40.4)
Stock option and restricted stock plans.................... 1.6 - - 1.6
Effect of reclassifying noncredit component of previously
recognized impairment losses on actively managed
fixed maturities (net of applicable income tax benefit
of $2.6)................................................. - (4.9) 4.9 -
-------- --------- ------- --------
Balance, March 31, 2009....................................... $4,107.5 $(1,840.5) $(675.8) $1,591.2
======== ========= ======= ========
The accompanying notes are an integral part
of the consolidated financial statements.
6
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(Dollars in millions)
(unaudited)
Three months ended
March 31,
----------------------
2009 2008
---- ----
Cash flows from operating activities:
Insurance policy income............................................................... $ 688.1 $ 764.4
Net investment income................................................................. 279.1 331.7
Fee revenue and other income.......................................................... 3.0 4.0
Net sales of trading securities....................................................... 40.8 306.3
Insurance policy benefits............................................................. (617.2) (652.6)
Interest expense...................................................................... (22.4) (31.4)
Policy acquisition costs.............................................................. (105.8) (123.3)
Other operating costs................................................................. (99.9) (140.3)
Expenses related to debt modification................................................. (9.2) -
Taxes................................................................................. (2.3) (.1)
--------- ---------
Net cash provided by operating activities........................................... 154.2 458.7
--------- ---------
Cash flows from investing activities:
Sales of investments.................................................................. 2,615.2 1,866.6
Maturities and redemptions of investments............................................. 117.4 411.2
Purchases of investments.............................................................. (2,964.1) (2,515.8)
Change in restricted cash............................................................. .3 (15.4)
Change in cash held by discontinued operations........................................ - 1.2
Other................................................................................. (8.1) (7.9)
--------- ---------
Net cash used by investing activities .............................................. (239.3) (260.1)
--------- ---------
Cash flows from financing activities:
Payments on notes payable............................................................. (3.4) (2.1)
Amounts received for deposit products................................................. 454.1 402.5
Withdrawals from deposit products..................................................... (481.3) (390.8)
Investment borrowings................................................................. (9.2) (64.7)
--------- ---------
Net cash used by financing activities............................................. (39.8) (55.1)
--------- ---------
Net increase (decrease) in cash and cash equivalents.............................. (124.9) 143.5
Cash and cash equivalents, beginning of period........................................... 894.5 361.9
--------- ---------
Cash and cash equivalents, end of period................................................. $ 769.6 $ 505.4
========= =========
The accompanying notes are an integral part
of the consolidated financial statements.
7
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
The following notes should be read together with the notes to the
consolidated financial statements included in the 2008 Form 10-K of Conseco,
Inc.
Conseco, Inc., a Delaware corporation ("CNO"), is a holding company for a
group of insurance companies operating throughout the United States that
develop, market and administer supplemental health insurance, annuity,
individual life insurance and other insurance products. CNO became the successor
to Conseco, Inc., an Indiana corporation (our "Predecessor"), in connection with
our bankruptcy reorganization which became effective on September 10, 2003 (the
"Effective Date"). The terms "Conseco", the "Company", "we", "us", and "our" as
used in this report refer to CNO and its subsidiaries or, when the context
requires otherwise, our Predecessor and its subsidiaries. We focus on serving
the senior and middle-income markets, which we believe are attractive, high
growth markets. We sell our products through three distribution channels: career
agents, professional independent producers (some of whom sell one or more of our
product lines exclusively) and direct marketing.
TRANSFER OF SENIOR HEALTH INSURANCE COMPANY OF PENNSYLVANIA TO AN
INDEPENDENT TRUST
On November 12, 2008, Conseco and CDOC, Inc. ("CDOC"), a wholly owned
subsidiary of Conseco (and together with Conseco, the "Conseco Parties"),
completed the transfer (the "Transfer") of the stock of Senior Health Insurance
Company of Pennsylvania ("Senior Health", formerly known as Conseco Senior
Health Insurance Company prior to its name change in October 2008) to Senior
Health Care Oversight Trust, an independent trust (the "Independent Trust") for
the exclusive benefit of Senior Health's long-term care policyholders.
Consummation of the transaction was subject to the approval of the Pennsylvania
Insurance Department.
As a result of the Transfer, Senior Health's long-term care business is
presented as a discontinued operation in prior periods. The operating results
from the discontinued operations are as follows (dollars in millions):
Three months ended
March 31, 2008
--------------
Revenues:
Insurance policy income......................................................... $ 66.1
Net investment income........................................................... 43.7
Net realized investment gains................................................... 2.0
------
Total revenues............................................................... 111.8
------
Benefits and expenses:
Insurance policy benefits....................................................... 90.1
Amortization.................................................................... 5.3
Other operating costs and expenses.............................................. 15.7
------
Total benefits and expenses.................................................. 111.1
------
Income before income taxes................................................... .7
Income tax expense on period income................................................ .2
------
Net income from discontinued operations...................................... $ .5
======
8
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
BASIS OF PRESENTATION
Our unaudited consolidated financial statements reflect normal recurring
adjustments that are necessary for a fair statement of our financial position
and results of operations on a basis consistent with that of our prior audited
consolidated financial statements. As permitted by rules and regulations of the
Securities and Exchange Commission (the "SEC") applicable to quarterly reports
on Form 10-Q, we have condensed or omitted certain information and disclosures
normally included in financial statements prepared in accordance with accounting
principles generally accepted in the United States of America ("GAAP"). We have
reclassified certain amounts from the prior periods to conform to the 2009
presentation. These reclassifications have no effect on net income or
shareholders' equity. Results for interim periods are not necessarily indicative
of the results that may be expected for a full year.
The balance sheet at December 31, 2008, presented herein, has been derived
from the audited financial statements at that date but does not include all of
the information and footnotes required by GAAP in the United States for complete
financial statements.
When we prepare financial statements in conformity with GAAP, we are
required to make estimates and assumptions that significantly affect reported
amounts of various assets and liabilities and the disclosure of contingent
assets and liabilities at the date of the financial statements and revenues and
expenses during the reporting periods. For example, we use significant estimates
and assumptions to calculate values for the cost of policies produced, the value
of policies inforce at the Effective Date, certain investments (including
derivatives), assets and liabilities related to income taxes, liabilities for
insurance products, liabilities related to litigation, guaranty fund assessment
accruals and amounts recoverable from loans to certain former directors and
former employees. If our future experience differs from these estimates and
assumptions, our financial statements would be materially affected.
Our consolidated financial statements exclude the results of material
transactions between us and our consolidated affiliates, or among our
consolidated affiliates.
OUT-OF-PERIOD ADJUSTMENTS
During the first quarter of 2009, we corrected calculations affecting
insurance policy income for certain life products and insurance policy benefits
for certain annuity products for errors discovered during the quarter which
decreased net income by $2.1 million in the first quarter of 2009. The impact of
correcting these errors in prior years was not significant to any individual
period. We evaluated these errors taking into account both qualitative and
quantitative factors and considered the impact of these errors in relation to
the current period, which is when they were corrected, as well as the periods in
which they originated. Management believes these errors are immaterial to both
the consolidated quarterly and annual financial statements.
ACCOUNTING FOR INVESTMENTS
We classify our fixed maturity securities into one of three categories: (i)
"actively managed" (which we carry at estimated fair value with any unrealized
gain or loss, net of tax and related adjustments, recorded as a component of
shareholders' equity); (ii) "trading" (which we carry at estimated fair value
with changes in such value recognized as trading income); or (iii) "held to
maturity" (which we carry at amortized cost). We had no fixed maturity
securities classified as held to maturity during the periods presented in these
financial statements.
Certain of our trading securities are held in an effort to offset the
portion of the income statement volatility caused by the effect of interest rate
fluctuations on the value of certain embedded derivatives related to our
equity-indexed annuity products and certain modified coinsurance agreements. See
the note entitled "Accounting for Derivatives" for further discussion regarding
embedded derivatives and the trading accounts. In addition, the trading account
includes investments backing the market strategies of our multibucket annuity
products. The change in market value of these securities, which is recognized
currently in income from policyholder and reinsurer accounts and other
special-purpose portfolios (a component of investment income), is substantially
offset by the change in insurance policy benefits for these products. Our
trading securities totaled $280.3 million and $326.5 million at March 31, 2009
and December 31, 2008, respectively.
9
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
Accumulated other comprehensive loss is primarily comprised of the net
effect of unrealized appreciation (depreciation) on our investments. These
amounts, included in shareholders' equity as of March 31, 2009 and December 31,
2008, were as follows (dollars in millions):
March 31, December 31,
2009 2008
---- ----
Net unrealized depreciation on actively managed fixed maturity securities
on which an other-than-temporary impairment loss has been recognized............. $ (25.3) $ -
Net unrealized losses on all other investments...................................... (3,124.0) (3,015.9)
Adjustment to value of policies inforce at the Effective Date....................... 110.5 111.0
Adjustment to cost of policies produced............................................. 179.9 154.8
Unrecognized net loss related to deferred compensation plan......................... (7.9) (8.0)
Deferred income tax asset........................................................... 1,026.3 987.4
--------- ---------
Accumulated other comprehensive loss........................................... $(1,840.5) $(1,770.7)
========= =========
EARNINGS PER SHARE
A reconciliation of net income (loss) and shares used to calculate basic
and diluted earnings (loss) per share is as follows (dollars in millions and
shares in thousands):
Three months ended
March 31,
-----------------------
2009 2008
---- ----
Income (loss) before discontinued operations............................................. $24.5 $(7.7)
Discontinued operations.................................................................. - .5
----- -----
Net income (loss) for basic and diluted earnings per share.......................... $24.5 $(7.2)
===== =====
Shares:
Weighted average shares outstanding for basic
earnings per share................................................................ 184,754 184,653
------- -------
Effect of dilutive securities on weighted
average shares:
Stock option and restricted stock plans........................................... 2 -
------- -------
Dilutive potential common shares.................................................. 2 -
------- -------
Weighted average shares outstanding for diluted
earnings per share.............................................................. 184,756 184,653
======= =======
There were no dilutive common stock equivalents during the first three
months of 2008 because of the net loss recognized by the Company during such
period. Therefore, all potentially dilutive shares are excluded in the weighted
average shares outstanding for diluted earnings per share.
10
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
The following summarizes the equivalent common shares for securities that
were not included in the computation of diluted earnings per share, because
doing so would have been antidilutive in such period (shares in thousands):
Three months ended
March 31, 2008
------------------
Equivalent common shares that were antidilutive during the period:
Stock option and restricted stock plans............................................ 26
==
As further discussed in the note to the consolidated financial statements
entitled "Recently Issued Accounting Standards", the Financial Accounting
Standards Board (the "FASB") issued FSP EITF 03-6-1 in May 2008 which is
effective for fiscal years beginning after December 15, 2008. FSP EITF 03-6-1
requires unvested share based payment awards that contain non-forfeitable rights
to dividends or dividend equivalents (whether paid or unpaid) to be treated as
participating securities prior to vesting and, therefore, must be included in
the earnings allocation in calculating earnings per share under the two-class
method. Our adoption of FSP EITF 03-6-1 did not have a significant impact on our
earnings per share calculations due to the immateriality of unvested restricted
stock that are considered to be participating securities.
In August 2005, we completed the private offering of $330.0 million of
3.50% Convertible Debentures due September 30, 2035 (the "Debentures"). In
future periods, our diluted shares outstanding may include incremental shares
issuable upon conversion of all or part of such Debentures. Since the remaining
$293.0 million principal amount of outstanding Debentures can only be redeemed
for cash, it has no impact on the diluted earnings per share calculation. In
accordance with the conversion feature of these Debentures, we may be required
to pay a stock premium along with redeeming the accreted principal amount for
cash, if our common stock reaches a certain market price. In accordance with the
consensus from EITF No. 04-8, "The Effect of Contingently Convertible
Instruments on Diluted Earnings per Share", we will include the dilutive effect
of our Debentures in the calculation of diluted earnings per share when the
impact is dilutive. During the three months ended March 31, 2009 and 2008, the
conversion feature of these Debentures did not have a dilutive effect because
the weighted average market price of our common stock did not exceed the initial
conversion price of $26.66. Therefore, the Debentures had no effect on our
diluted shares outstanding or our diluted earnings (loss) per share for the
three months ended March 31, 2009 and 2008.
Basic earnings (loss) per common share is computed by dividing net income
(loss) applicable to common stock by the weighted average number of common
shares outstanding for the period. Restricted shares (including our performance
shares) are not included in basic earnings (loss) per share until vested.
Diluted earnings (loss) per share reflect the potential dilution that could
occur if outstanding stock options were exercised and restricted stock was
vested. The dilution from options and restricted shares is calculated using the
treasury stock method. Under this method, we assume the proceeds from the
exercise of the options (or the unrecognized compensation expense with respect
to restricted stock) will be used to purchase shares of our common stock at the
average market price during the period, reducing the dilutive effect of the
exercise of the options (or the vesting of the restricted stock).
BUSINESS SEGMENTS
We manage our business through the following: three primary operating
segments, Bankers Life, Colonial Penn and Conseco Insurance Group, which are
defined on the basis of product distribution; and corporate operations, which
consists of holding company activities and certain noninsurance businesses.
Prior to the fourth quarter of 2008, we had a fourth operating segment comprised
of other business in run-off. The other business in run-off segment had included
blocks of business that we no longer market or underwrite and were managed
separately from our other businesses. Such segment had consisted of: (i)
long-term care insurance sold in prior years through independent agents; and
(ii) major medical insurance. As a result of the Transfer, as further discussed
in the note entitled "Transfer of Senior Health Insurance Company of
Pennsylvania to an Independent Trust", a substantial portion of the long-term
care business in the other business in run-off segment is presented as
discontinued operations in our consolidated financial statements. Accordingly,
we have restated prior period segment disclosures to conform to management's
current view of the Company's operating segments.
11
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
We measure segment performance for purposes of Financial Accounting
Standards No. 131, "Disclosures about Segments of an Enterprise and Related
Information", excluding realized investment gains (losses) because we believe
that this performance measure is a better indicator of the ongoing business and
trends in our business. Our primary investment focus is on investment income to
support our liabilities for insurance products as opposed to the generation of
realized investment gains (losses), and a long-term focus is necessary to
maintain profitability over the life of the business. Realized investment gains
(losses) depend on market conditions and do not necessarily relate to decisions
regarding the underlying business of our segments. We may experience realized
investment gains (losses), which will affect future earnings levels since our
underlying business is long-term in nature and we need to earn the assumed
interest rates on the investments backing our liabilities for insurance products
to maintain the profitability of our business.
12
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
Operating information by segment was as follows (dollars in millions):
Three months ended
March 31,
-------------------
2009 2008
---- ----
Revenues:
Bankers Life:
Insurance policy income:
Annuities......................................................................... $ 10.6 $ 17.0
Supplemental health............................................................... 410.9 412.4
Life.............................................................................. 42.2 43.6
Other............................................................................. 27.8 24.0
Net investment income (a).............................................................. 142.2 129.3
Fee revenue and other income (a)....................................................... 1.4 1.6
-------- --------
Total Bankers Life revenues................................................... 635.1 627.9
-------- --------
Colonial Penn:
Insurance policy income:
Supplemental health............................................................... 1.9 2.2
Life.............................................................................. 45.0 41.9
Other............................................................................. .2 .3
Net investment income (a).............................................................. 9.8 9.2
Fee revenue and other income (a)....................................................... .2 .3
-------- --------
Total Colonial Penn revenues.................................................. 57.1 53.9
-------- --------
Conseco Insurance Group:
Insurance policy income:
Annuities......................................................................... 12.9 2.7
Supplemental health............................................................... 149.4 153.9
Life.............................................................................. 79.8 83.8
Other............................................................................. 2.1 3.3
Net investment income (a).............................................................. 134.3 136.1
Fee revenue and other income (a)....................................................... .7 .8
-------- --------
Total Conseco Insurance Group revenues........................................ 379.2 380.6
-------- --------
Corporate:
Net investment income.................................................................. 4.3 9.4
Fee and other income................................................................... .7 1.3
--------- --------
Total corporate revenues...................................................... 5.0 10.7
-------- --------
Total revenues................................................................ 1,076.4 1,073.1
-------- --------
(continued on next page)
13
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
(continued from previous page)
Three months ended
March 31,
----------------------
2009 2008
---- ----
Expenses:
Bankers Life:
Insurance policy benefits............................................................. $ 467.2 $ 479.7
Amortization.......................................................................... 75.6 75.0
Other operating costs and expenses.................................................... 47.6 44.1
-------- --------
Total Bankers Life expenses...................................................... 590.4 598.8
-------- --------
Colonial Penn:
Insurance policy benefits............................................................. 36.4 35.3
Amortization.......................................................................... 8.4 7.4
Other operating costs and expenses.................................................... 7.2 7.5
-------- --------
Total Colonial Penn expenses..................................................... 52.0 50.2
-------- --------
Conseco Insurance Group:
Insurance policy benefits............................................................. 249.9 252.7
Amortization.......................................................................... 36.8 30.2
Interest expense on investment borrowings............................................. 5.2 5.8
Other operating costs and expenses.................................................... 56.1 68.6
-------- --------
Total Conseco Insurance Group expenses........................................... 348.0 357.3
-------- --------
Corporate:
Interest expense on corporate debt.................................................... 13.7 18.5
Interest expense on variable interest entity.......................................... 4.3 6.5
Expenses related to debt modification................................................. 9.5 -
Other operating costs and expenses.................................................... 9.4 10.9
-------- --------
Total corporate expenses......................................................... 36.9 35.9
-------- --------
Total expenses................................................................... 1,027.3 1,042.2
-------- --------
Income (loss) before net realized investment losses (net of related
amortization), income taxes and discontinued operations:
Bankers Life..................................................................... 44.7 29.1
Colonial Penn.................................................................... 5.1 3.7
Conseco Insurance Group.......................................................... 31.2 23.3
Corporate operations............................................................. (31.9) (25.2)
-------- --------
Income (loss) before net realized investment losses (net of related
amortization), income taxes and discontinued operations...................... $ 49.1 $ 30.9
======== ========
<FN>
- -------------------
(a) It is not practicable to provide additional components of revenue by
product or services.
</FN>
14
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
A reconciliation of segment revenues and expenses to consolidated revenues
and expenses is as follows (dollars in millions):
Three months ended
March 31,
---------------------
2009 2008
---- ----
Total segment revenues...................................................................... $1,076.4 $1,073.1
Net realized investment losses.............................................................. (6.9) (45.6)
-------- --------
Consolidated revenues................................................................... $1,069.5 $1,027.5
======== ========
Total segment expenses...................................................................... $1,027.3 $1,042.2
Amortization related to net realized investment losses...................................... - (2.8)
-------- --------
Consolidated expenses................................................................... $1,027.3 $1,039.4
======== ========
ACCOUNTING FOR DERIVATIVES
Our equity-indexed annuity products provide a guaranteed base rate of
return and a higher potential return that is based on a percentage (the
"participation rate") of the amount of increase in the value of a particular
index, such as the Standard & Poor's 500 Index, over a specified period.
Typically, at the beginning of each policy anniversary date, a new index period
begins. We are generally able to change the participation rate at the beginning
of each index period during a policy year, subject to contractual minimums. We
typically buy call options or call spreads referenced to the applicable indices
in an effort to hedge potential increases to policyholder benefits resulting
from increases in the particular index to which the product's return is linked.
We reflect changes in the estimated market value of these options in net
investment income (classified as investment income from policyholder and
reinsurer accounts and other special-purpose portfolios). Net investment losses
related to equity-indexed products were $15.7 million and $34.4 million in the
three months ended March 31, 2009 and 2008, respectively. These amounts were
substantially offset by a corresponding release of insurance policy benefits.
The estimated fair value of these options was $16.5 million and $17.6 million at
March 31, 2009 and December 31, 2008, respectively. We classify these
instruments as other invested assets.
The Company accounts for the options attributed to the policyholder for the
estimated life of the annuity contract as embedded derivatives as defined by
Statement of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities", as amended by Statement of Financial
Accounting Standards No. 137, "Deferral of the Effective Date of FASB Statement
No. 133" and Statement of Financial Accounting Standards No. 138, "Accounting
for Certain Derivative Instruments and Certain Hedging Activities" (collectively
referred to as "SFAS 138"). In accordance with these requirements, the expected
future cost of options on equity-indexed annuity products is used to determine
the value of embedded derivatives. The Company does not purchase options to
hedge liabilities which may arise after the next policy anniversary date. The
Company must value both the options and the related forward embedded options in
the policies at fair value. These accounting requirements often create
volatility in the earnings from these products. We record the changes in the
fair values of the embedded derivatives in current earnings as a component of
policyholder benefits. Effective January 1, 2008, we adopted Statement of
Financial Accounting Standards No. 157 "Fair Value Measurements" ("SFAS 157")
which required us to value the embedded derivatives reflecting a hypothetical
market perspective for fair value measurement. We recorded a charge of $1.8
million to net income (after the effects of the amortization of the value of
policies inforce at the Effective Date and the cost of policies produced
(collectively referred to as "amortization of insurance acquisition costs") and
income taxes), attributable to changes in the fair value of the embedded
derivatives as a result of adopting SFAS 157. The fair value of these
derivatives, which are classified as "liabilities for interest-sensitive
products", was $396.3 million at March 31, 2009 and $430.6 million at December
31, 2008. We maintain a specific block of investments in our trading securities
account, which we carry at estimated fair value with changes in such value
recognized as investment income (classified as investment income from
policyholder and reinsurer accounts and other special-purpose portfolios). The
change in value of these trading securities attributable to interest
fluctuations is intended to offset a portion of the change in the value of the
embedded derivative.
15
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
If the counterparties for the derivatives we hold fail to meet their
obligations, we may have to recognize a loss. We limit our exposure to such a
loss by diversifying among several counterparties believed to be strong and
creditworthy. At March 31, 2009, substantially all of our counterparties were
rated "A" or higher by Standard & Poor's Corporation ("S&P").
Certain of our reinsurance payable balances contain embedded derivatives as
defined in SFAS No. 133 Implementation Issue No. B36, "Embedded Derivatives:
Modified Coinsurance Arrangements and Debt Instruments that Incorporate Credit
Risk Exposures that are Unrelated or Only Partially Related to the
Creditworthiness of the Obligor of Those Instruments". Such derivatives had an
estimated fair value of $7.7 million and $6.6 million at March 31, 2009 and
December 31, 2008, respectively. The adoption of SFAS 157 had no impact on the
valuation of these embedded derivatives. We record the change in the fair value
of these derivatives as a component of investment income (classified as
investment income from policyholder and reinsurer accounts and other
special-purpose portfolios). We maintain a specific block of investments related
to these agreements in our trading securities account, which we carry at
estimated fair value with changes in such value recognized as investment income
(also classified as investment income from policyholder and reinsurer accounts
and other special-purpose portfolios). The change in value of these trading
securities attributable to interest fluctuations is intended to offset the
change in value of the embedded derivatives. However, differences will occur as
corporate spreads change.
REINSURANCE
The cost of reinsurance ceded totaled $43.7 million and $37.6 million in
the first three months of 2009 and 2008, respectively. We deduct this cost from
insurance policy income. In each case, the ceding Conseco subsidiary is directly
liable for claims reinsured in the event the assuming company is unable to pay.
Reinsurance recoveries netted against insurance policy benefits totaled $126.7
million and $93.5 million in the first three months of 2009 and 2008,
respectively.
From time-to-time, we assume insurance from other companies. Any costs
associated with the assumption of insurance are amortized consistent with the
method used to amortize the cost of policies produced. Reinsurance premiums
assumed totaled $131.1 million and $127.4 million in the first three months of
2009 and 2008, respectively. Reinsurance premiums included amounts assumed
pursuant to marketing and quota-share agreements with Coventry Health Care
("Coventry") of $122.6 million and $118.7 million in the first three months of
2009 and 2008, respectively. The increase in premiums assumed under these
agreements in 2008 resulted from agreements whereby we are assuming: (i) a
specified percentage of the Private-Fee-For-Service ("PFFS") business written by
Coventry under a large group policy effective July 1, 2007 (which will be
terminated on June 30, 2009); and (ii) a specified percentage of the PFFS
business written by Coventry under another large group policy effective May 1,
2008 (which was terminated on December 31, 2008).
See the note entitled "Accounting for Derivatives" for a discussion of the
derivative embedded in the payable related to certain modified coinsurance
agreements.
16
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
INCOME TAXES
The components of income tax expense (benefit) were as follows (dollars in
millions):
Three months ended
March 31,
--------------------
2009 2008
---- ----
Current tax expense....................................................................... $ 2.0 $ .6
Deferred tax provision.................................................................... 13.3 (4.8)
----- -----
Income tax expense (benefit) on period income......................................... 15.3 (4.2)
Valuation allowance....................................................................... 2.4 -
----- -----
Total income tax expense (benefit).................................................... $17.7 $(4.2)
===== =====
A reconciliation of the U.S. statutory corporate tax rate to the effective
rate reflected in the consolidated statement of operations is as follows:
Three months ended
March 31,
--------------------
2009 2008
---- ----
U.S. statutory corporate rate............................................................ 35.0% (35.0)%
Valuation allowance...................................................................... 5.7 -
Other nondeductible expense (benefit).................................................... - 11.7
State taxes.............................................................................. 1.2 (13.9)
Provision for tax issues, tax credits and other.......................................... - 1.9
---- -----
Effective tax rate.............................................................. 41.9% (35.3)%
==== =====
17
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
The components of the Company's income tax assets and liabilities were as
follows (dollars in millions):
March 31, December 31,
2009 2008
---- ----
Deferred tax assets:
Net operating loss carryforwards attributable to:
Life insurance subsidiaries.................................................... $ 826.8 $ 840.7
Non-life companies............................................................. 829.2 835.4
Net state operating loss carryforwards............................................ 19.9 20.3
Tax credits....................................................................... 13.7 13.7
Capital loss carryforwards........................................................ 388.0 406.0
Deductible temporary differences:
Actively managed fixed maturities.............................................. 4.2 -
Insurance liabilities.......................................................... 772.2 789.9
Unrealized depreciation of investments......................................... 1,026.3 987.4
Reserve for loss on loan guarantees............................................ 68.1 68.2
Other.......................................................................... 34.2 25.1
--------- ---------
Gross deferred tax assets.................................................... 3,982.6 3,986.7
--------- ---------
Deferred tax liabilities:
Actively managed fixed maturities.............................................. - (17.7)
Value of policies inforce at the Effective Date and cost of policies produced.. (729.7) (739.1)
--------- ---------
Gross deferred tax liabilities............................................... (729.7) (756.8)
--------- ---------
Net deferred tax assets before valuation allowance........................... 3,252.9 3,229.9
Valuation allowance................................................................... (1,183.1) (1,180.7)
--------- ---------
Net deferred tax assets...................................................... 2,069.8 2,049.2
Current income taxes prepaid (accrued)................................................ (1.2) (1.5)
--------- ---------
Income tax assets, net....................................................... $ 2,068.6 $ 2,047.7
========= =========
We account for income taxes in accordance with Statement of Financial
Accounting Standards No. 109, "Accounting for Income Taxes", ("SFAS 109"). Our
income tax expense includes deferred income taxes arising from temporary
differences between the financial reporting and tax bases of assets and
liabilities, capital loss carryforwards and net operating loss carryforwards
("NOLs"). Deferred tax assets and liabilities are measured using enacted tax
rates expected to apply in the years in which temporary differences are expected
to be recovered or paid. The effect of a change in tax rates on deferred tax
assets and liabilities is recognized in earnings in the period when the changes
are enacted.
SFAS 109 requires a reduction of the carrying amount of deferred tax assets
by establishing a valuation allowance if, based on the available evidence, it is
more likely than not that such assets will not be realized. We evaluate the need
to establish a valuation allowance for our deferred income tax assets on an
ongoing basis. In evaluating our deferred income tax assets, we consider whether
the deferred income tax assets will be realized, based on the SFAS 109
more-likely-than-not realization threshold criterion. The ultimate realization
of our deferred income tax assets depends upon generating sufficient future
taxable income during the periods in which our temporary differences become
deductible and before our capital loss carryforwards and NOLs expire. This
assessment requires significant judgment. In assessing the need for a valuation
allowance, appropriate consideration is given to all positive and negative
evidence related to the realization of the deferred tax assets. This assessment
considers, among other matters, the nature, frequency and severity of current
and cumulative losses, forecasts of future profitability, excess appreciated
asset value over the tax basis of net assets, the duration of carryforward
periods, our experience with operating loss and tax credit carryforwards
expiring unused, and tax planning alternatives.
18
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
Pursuant to SFAS 109, concluding that a valuation allowance is not required
is difficult when there has been significant negative evidence, such as
cumulative losses in recent years. We utilize a three year rolling calculation
of actual income before income taxes as our primary measure of cumulative losses
in recent years. Our analysis of whether there needs to be further increases to
the deferred tax valuation allowance recognizes that as of March 31, 2009, we
have incurred a cumulative loss over the evaluation period, resulting from the
substantial loss during the year ended December 31, 2008 primarily related to
the transfer of Senior Health to an independent trust as described in the note
to these consolidated financial statements entitled "Transfer of Senior Health
Insurance Company of Pennsylvania to an Independent Trust". As a result of the
cumulative losses recognized in recent years, our evaluation of the need to
increase the valuation allowance for deferred tax assets was primarily based on
our historical earnings. However, because a substantial portion of the
cumulative losses for the three-year period ended March 31, 2009, relates to
transactions to dispose of blocks of businesses, we have adjusted the three-year
cumulative results for the income and losses from the blocks of business
disposed of in the past and the business transferred as further described in the
note to these financial statements entitled "Transfer of Senior Health Insurance
Company of Pennsylvania to an Independent Trust". In addition, we have adjusted
the three-year cumulative results for a significant litigation settlement, which
we consider to be a non-recurring matter and have reflected our best estimates
of how temporary differences will reverse over the carryforward periods.
At March 31, 2009, our valuation allowance for our net deferred tax assets
was $1.2 billion, as we have determined that it is more likely than not that a
portion of our deferred tax assets will not be realized. This determination was
made by evaluating each component of the deferred tax asset and assessing the
effects of limitations and/or interpretations on the value of such component to
be fully recognized in the future. We have also evaluated the likelihood that we
will have sufficient taxable income to offset the available deferred tax assets
based on evidence which we consider to be objective and verifiable. Based upon
our analysis completed at March 31, 2009, we believe that we will, more likely
than not, recover $2.1 billion of our deferred tax assets through reductions of
our tax liabilities in future periods.
Recovery of our deferred tax assets is dependent on achieving the
projections of future taxable income embedded in our analysis and failure to do
so would result in an increase in the valuation allowance in a future period.
Any future increase in the valuation allowance may result in additional income
tax expense and reduce shareholders' equity, and such an increase could have a
significant impact upon our earnings in the future. In addition, the use of the
Company's NOLs is dependent, in part, on whether the Internal Revenue Service
(the "IRS") does not take an adverse position in the future regarding the tax
position we have taken in our tax returns with respect to the allocation of
cancellation of indebtedness income.
The Internal Revenue Code (the "Code") limits the extent to which losses
realized by a non-life entity (or entities) may offset income from a life
insurance company (or companies) to the lesser of: (i) 35 percent of the income
of the life insurance company; or (ii) 35 percent of the total loss of the
non-life entities (including NOLs of the non-life entities). There is no similar
limitation on the extent to which losses realized by a life insurance entity (or
entities) may offset income from a non-life entity (or entities).
Section 382 of the Code imposes limitations on a corporation's ability to
use its NOLs when the company undergoes an ownership change. Future transactions
and the timing of such transactions could cause an ownership change for Section
382 income tax purposes. Such transactions may include, but are not limited to,
additional repurchases or issuances of common stock (including upon conversion
of our outstanding Debentures), or acquisitions or sales of shares of Conseco
stock by certain holders of our shares, including persons who have held,
currently hold or may accumulate in the future five percent or more of our
outstanding common stock for their own account. Many of these transactions are
beyond our control. If an ownership change were to occur for purposes of Section
382, we would be required to calculate an annual restriction on the use of our
NOLs to offset future taxable income. The annual restriction would be calculated
based upon the value of Conseco's equity at the time of such ownership change,
multiplied by a federal long-term tax exempt rate (currently approximately 5.5
percent), and the annual restriction could effectively eliminate our ability to
use a substantial portion of our NOLs to offset future taxable income. We
regularly monitor ownership change (as calculated for purposes of Section 382)
and, as of March 31, 2009, we were below the 50 percent ownership change level
that would trigger further impairment of our ability to utilize our NOLs.
On January 20, 2009, the Company's Board of Directors adopted a Section 382
Rights Plan (the "Rights Plan") which is designed to protect shareholder value
by preserving the value of our tax assets primarily associated with tax NOLs
under
19
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
Section 382. The Rights Plan was adopted to reduce the likelihood of this
occurring by deterring the acquisition of stock that would create "5 percent
shareholders" as defined in Section 382.
Under the Rights Plan, one right was distributed for each share of our
common stock outstanding as of the close of business on January 30, 2009.
Effective January 20, 2009, if any person or group (subject to certain
exemptions) becomes a "5 percent shareholder" of Conseco without the approval of
the Board of Directors, there would be a triggering event causing significant
dilution in the voting power and economic ownership of that person or group.
Existing shareholders who currently are "5 percent shareholders" will trigger a
dilutive event only if they acquire additional shares exceeding one percent of
our outstanding shares without prior approval from the Board of Directors.
The Rights Plan will continue in effect until January 20, 2012, unless
earlier terminated or redeemed by the Board of Directors. The Company's Audit
Committee will review our NOLs on an annual basis and will recommend amending or
terminating the Rights Plan based on its review. Additionally, the continuation
of the Rights Plan is subject to a vote at the annual meeting of the
shareholders in May 2009. If the shareholders do not approve the Rights Plan, it
will be terminated.
Changes in our valuation allowance are summarized as follows (dollars in
millions):
Balance at December 31, 2008....................... $1,180.7
Increase related to tax benefits associated with
capital loss carryforwards recognized in the
current period.................................. 2.4
--------
Balance at March 31, 2009.......................... $1,183.1
========
20
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
As of March 31, 2009, we had $4.7 billion of NOLs and $1.1 billion of
capital loss carryforwards, which expire as follows (dollars in millions):
Net operating
loss carryforwards(a)
--------------------- Capital loss Total loss
Year of expiration Life Non-life carryforwards carryforwards
------------------ ---- -------- ------------- -------------
2009................................. $ - $ - $ 34.9 $ 34.9
2010................................. - .1 - .1
2011................................. - .1 - .1
2012................................. - - 63.6 63.6
2013................................. - - 1,010.1 1,010.1
2017................................. - - - -
2018................................. 2,125.0 (a) - - 2,125.0
2021................................. 29.6 - - 29.6
2022................................. 207.8 - - 207.8
2023................................. - 2,055.9 (a) - 2,055.9
2024................................. - 3.2 - 3.2
2025................................. - 118.8 - 118.8
2026................................. - 1.6 - 1.6
2027................................. - 188.4 - 188.4
2028................................. - .9 - .9
-------- -------- -------- --------
Total................................ $2,362.4 $2,369.0 $1,108.6 $5,840.0
======== ======== ======== ========
<FN>
- --------------------
(a) The allocation of the NOLs summarized above assumes the IRS does not
take an adverse position in the future regarding the tax position we
plan to take in our tax returns with respect to the allocation of
cancellation of indebtedness income. If the IRS disagrees with the tax
position we plan to take with respect to the allocation of
cancellation of indebtedness income, and their position prevails,
approximately $631 million of the NOLs expiring in 2018 would be
characterized as non-life NOLs.
</FN>
We had deferred tax assets related to NOLs for state income taxes of $19.9
million and $20.3 million at March 31, 2009 and December 31, 2008, respectively.
The related state NOLs are available to offset future state taxable income in
certain states through 2015.
Tax years 2005 through 2007 are open to examination by the IRS, and tax
year 2002 remains open only for potential adjustments related to certain
partnership investments. The Company does not anticipate any material
adjustments related to these partnership investments. The Company's various
state income tax returns are generally open for tax years 2005 through 2007
based on the individual state statutes of limitation.
NOTES PAYABLE - DIRECT CORPORATE OBLIGATIONS
The following notes payable were direct corporate obligations of the
Company as of March 31, 2009 and December 31, 2008 (dollars in millions):
March 31, December 31,
2009 2008
---- ----
3.50% convertible debentures............................................................ $ 293.0 $ 293.0
Secured credit agreement................................................................ 908.4 911.8
6% Senior Note.......................................................................... 125.0 125.0
Unamortized discount on convertible debentures.......................................... (15.9) (18.3)
-------- --------
Direct corporate obligations....................................................... $1,310.5 $1,311.5
======== ========
21
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
During the first three months of 2009, we made a scheduled principal
payment totaling $2.2 million on our secured credit agreement ("Second Amended
Credit Facility"). Also, during the first three months of 2009, we made a
mandatory prepayment of $1.2 million based on the Company's excess cash flows at
December 31, 2008 as defined in the Second Amended Credit Facility. There were
$5.5 million and $5.8 million of unamortized issuance costs (classified as other
assets) related to our Second Amended Credit Facility at March 31, 2009 and
December 31, 2008, respectively.
On March 30, 2009, we completed an amendment to our Second Amended Credit
Facility, which provides for, among other things: (i) additional margins between
our current financial status and certain financial covenant requirements through
June 30, 2010; (ii) higher interest rates and the payment of a fee; (iii) new
restrictions on the ability of the Company to incur additional indebtedness; and
(iv) the ability of the lender to appoint a financial advisor at the Company's
expense.
The following summarizes the changes to the financial covenant
requirements:
Covenant under the
Second Amended Margin for
Credit Facility as Balance or adverse development from
amended on ratio as of March 31, 2009
March 30, 2009 March 31, 2009 levels
-------------- -------------- ------
Aggregate risk-based
capital ratio........... Greater than or equal to 230% Reduction to statutory capital
200% from March 31, 2009 and surplus of approximately
through June 30, 2010 and $169 million, or an increase
thereafter, greater than 250% to the risk-based capital of
(the same ratio required by approximately $85 million.
the facility prior to the
amendment).
Combined statutory
capital and surplus..... Greater than $1,100 million $1,301 Reduction to combined
from March 31, 2009 through statutory capital and surplus
June 30, 2010 and thereafter, of approximately $201 million.
$1,270 million (the same amount
required by the facility prior
to the amendment).
Debt to total capitalization
ratio................... Not more than 32.5% from 27.9% Reduction to shareholders'
March 31, 2009 through equity of approximately $672
June 30, 2010 and thereafter, million or additional debt of
not more than 30% (the same $324 million.
ratio required by the facility
prior to the amendment).
Interest coverage ratio..... Greater than or equal to 1.50 3.07 to 1 Reduction in cash flows to
to 1 for rolling four quarters the holding company of
from March 31, 2009 through approximately $80 million.
June 30, 2010 and thereafter,
2.00 to 1 (the same ratio
required by the facility prior
to the amendment).
22
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
Pursuant to its amended terms, the applicable interest rate on the Second
Amended Credit Facility (based on either a Eurodollar or base rate) has
increased. The Eurodollar rate is now equal to LIBOR plus 4 percent with a
minimum LIBOR rate of 2.5 percent (such rate was previously LIBOR plus 2 percent
with no minimum rate). The base rate is now equal to 2.5 percent plus the
greater of: (i) the Federal funds rate plus .50 percent; or (ii) Bank of
America's prime rate. In addition, the amended agreement requires the Company to
pay a fee equal to 1 percent of the outstanding principal balance under the
Second Amended Credit Facility, which fee will be added to the principal balance
outstanding and will be payable at the maturity of the facility. This 1 percent
fee is reported as non-cash interest expense.
The modifications to the Second Amended Credit Facility also place new
restrictions on the ability of the Company to incur additional indebtedness. The
amendment: (i) deleted the provision that allowed the Company to borrow up to an
additional $330 million under the Second Amended Credit Facility (the lenders
under the facility having had no obligation to lend any amount under that
provision); (ii) reduced the amount of secured indebtedness that the Company can
incur from $75 million to $2.5 million; and (iii) limited the ability of the
Company to incur additional unsecured indebtedness, except as provided below, to
$25 million, and eliminated the provision that would have allowed the Company to
incur additional unsecured indebtedness to the extent that principal payments
were made on existing unsecured indebtedness.
The Company is permitted to issue unsecured indebtedness that is used
solely to pay the holders of the Debentures, provided that such indebtedness
shall: (i) have a maturity date that is no earlier than October 10, 2014; (ii)
contain covenants and events of default that are no more restrictive than those
in the Second Amended Credit Facility; (iii) not contain any covenants or events
of default based on maintenance of the Company's financial condition; (iv) not
amortize; and (v) not have a put date or otherwise be callable prior to April
10, 2014, and provided that the amount of such unsecured indebtedness incurred
under this provision shall not exceed the $293 million of Debentures outstanding
on March 30, 2009; and provided further that the amount of cash interest payable
annually on any new issuance of such indebtedness, together with the cash
interest payable on the outstanding Debentures, shall not exceed twice the
amount of cash interest currently payable on the outstanding Debentures.
The amendment prohibits the Company from redeeming or purchasing the
Debentures with cash from sources other than those described in the previous
paragraph. The amendment permits the Company to amend, modify or refinance the
Convertible Indebtedness so long as such new indebtedness complies with the
restrictions set forth in the previous paragraph.
In addition, pursuant to the terms of the amended debt agreement, the
lenders have the right to appoint a steering committee which has the right to
appoint a financial advisor at the Company's expense to, among other things,
review financial projections and other financial information prepared by or on
behalf of the Company, perform valuations of the assets of the Company and take
other actions as are customary or reasonable for an advisor acting in such
capacity.
Pursuant to GAAP, the amendment to the Second Amended Credit Facility is
required to be accounted for in accordance with Statement of Financial
Accounting Standards No. 15, "Accounting by Debtors and Creditors for Troubled
Debt Restructurings" ("SFAS 15"). Accordingly, the effects of the modifications
will be accounted for prospectively from March 31, 2009, and we will not change
the carrying amount of the Second Amended Credit Facility as a result of the
modifications. However, the $9.5 million of fees incurred in conjunction with
the modifications of the facility were expensed in the first quarter of 2009.
23
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
The scheduled repayment of our direct corporate obligations is as follows
(dollars in millions):
Remainder of 2009............................. $ 86.6 (a)
2010.......................................... 326.8 (b)
2011.......................................... 33.7
2012.......................................... 33.8
2013.......................................... 845.5
--------
$1,326.4
========
<FN>
- --------------
(a) This amount includes $55.0 million which was outstanding at March 31,
2009, under the revolving facility portion of our Second Amended
Credit Facility. Such amount was repaid in full in April 2009.
(b) Holders of our Debentures have the right to require the Company to
repurchase their Debentures for cash on September 30, 2010. This
amount assumes that all holders of our Debentures exercise that right.
</FN>
INVESTMENT BORROWINGS
One of the Company's insurance subsidiaries (Conseco Life Insurance
Company, "Conseco Life") is a member of the Federal Home Loan Bank of
Indianapolis ("FHLBI"). As a member of the FHLBI, Conseco Life has the ability
to borrow on a collateralized basis from FHLBI. Conseco Life is required to hold
a certain minimum amount of FHLBI common stock as a requirement of membership in
the FHLBI, and additional amounts based on the amount of the borrowings. At
March 31, 2009, the carrying value of the FHLBI common stock was $22.5 million.
Collateralized borrowings from the FHLBI totaled $450.0 million as of March 31,
2009, and the proceeds were used to purchase fixed maturity securities. The
borrowings are classified as investment borrowings in the accompanying
consolidated balance sheet. The borrowings are collateralized by investments
with an estimated fair value of $535.5 million at March 31, 2009, which are
maintained in a custodial account for the benefit of the FHLBI. Such investments
are classified as actively managed fixed maturities in our consolidated balance
sheet. Conseco Life recognized interest expense of $5.1 million and $5.7 million
in the first three months of 2009 and 2008, respectively, related to the
borrowings.
The following summarizes the terms of the borrowings (dollars in millions):
Amount Maturity Interest rate
borrowed date at March 31, 2009
-------- ---- -----------------
$ 54.0 May 2012 Variable rate - 1.251%
37.0 July 2012 Fixed rate - 5.540%
13.0 July 2012 Variable rate - 1.414%
146.0 November 2015 Fixed rate - 5.300%
100.0 November 2015 Fixed rate - 4.890%
100.0 December 2015 Fixed rate - 4.710%
At March 31, 2009, investment borrowings consisted of: (i) collateralized
borrowings from the FHLBI of $450.0 million; (ii) $302.8 million of securities
issued to other entities by a variable interest entity ("VIE") which is
consolidated in our financial statements; and (iii) other borrowings of $5.5
million.
At December 31, 2008, investment borrowings consisted of: (i)
collateralized borrowings of $450.0 million; (ii) $311.7 million of securities
issued to other entities by a VIE which is consolidated in our financial
statements; and (iii) other borrowings of $5.8 million.
24
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
CHANGES IN COMMON STOCK
Changes in the number of shares of common stock outstanding were as follows
(shares in thousands):
Balance at December 31, 2008................................................. 184,754
Shares issued under employee benefit compensation plans.................. 5
-------
Balance at March 31, 2009.................................................... 184,759
=======
SALES INDUCEMENTS
Certain of our annuity products offer sales inducements to contract holders
in the form of enhanced crediting rates or bonus payments in the initial period
of the contract. Certain of our life insurance products offer persistency
bonuses credited to the contract holders balance after the policy has been
outstanding for a specified period of time. These enhanced rates and persistency
bonuses are considered sales inducements under Statement of Position 03-01
"Accounting and Reporting by Insurance Enterprises for Certain Nontraditional
Long-Duration Contracts and for Separate Accounts". Such amounts are deferred
and amortized in the same manner as the cost of policies produced. Sales
inducements deferred totaled $6.0 million and $11.0 million during the three
months ended March 31, 2009 and 2008, respectively. Amounts amortized totaled
$8.7 million and $4.0 million during the three months ended March 31, 2009 and
2008, respectively. The unamortized balance of deferred sales inducements at
March 31, 2009 and December 31, 2008 was $176.7 million and $179.4 million,
respectively. The balance of insurance liabilities for persistency bonus
benefits was $182.8 million and $195.9 million at March 31, 2009 and December
31, 2008, respectively.
RECENTLY ISSUED ACCOUNTING STANDARDS
Adopted Accounting Standards
On April 9, 2009, the FASB issued FSP No. FAS 115-2 and FAS 124-2,
"Recognition and Presentation of Other-Than-Temporary Impairments" ("FSP FAS
115-2"). FSP FAS 115-2 provides new guidance on the recognition and presentation
of an other-than-temporary impairment and requires additional disclosures. The
recognition provision within FSP FAS 115-2 applies only to fixed maturity
investments that are subject to the other-than-temporary impairments. If an
entity intends to sell or if it is more likely than not that it will be required
to sell an impaired security prior to recovery of its cost basis, the security
is other-than-temporarily impaired and the full amount of the impairment is
recognized as a loss through earnings. Otherwise, losses on securities which are
other-than-temporarily impaired are separated into: (i) the portion of loss
which represents the credit loss; and (ii) the portion which is due to other
factors. The credit loss portion is recognized as a loss through earnings while
the loss due to other factors is recognized in other comprehensive loss, net of
taxes and related amortization. FSP FAS 115-2 requires a cumulative effect
adjustment to accumulated deficit and a corresponding adjustment to accumulated
other comprehensive loss to reclassify the non-credit portion of previously
other-than-temporarily impaired securities which were held at the beginning of
the period of adoption and for which we do not intend to sell and it is more
likely than not that we will not be required to sell such securities before
recovery of the amortized cost basis. FSP FAS 115-2 is effective for interim and
annual periods ending after June 15, 2009, with early adoption permitted for
periods ending after March 15, 2009. We adopted FSP FAS 115-2 effective January
1, 2009. The cumulative effect of adopting this guidance was a $4.9 million net
decrease to accumulated deficit and a corresponding increase to accumulated
other comprehensive loss. Adoption also resulted in an increase to net income
(after tax) of $8.7 million in the first quarter of 2009, because the portion of
other-than-temporary impairment loss related to factors other than credit was
recorded in other comprehensive loss instead of being reflected in net income.
On April 9, 2009, the FASB issued FSP No. FAS 157-4, "Determining Fair
Value When Volume and Level of Activity for the Asset or Liability Have
Significantly Decreased and Identifying Transactions that Are Not Orderly" ("FSP
FAS 157-4"). FSP FAS 157-4 amends SFAS 157 to provide additional guidance on
estimating fair value when the volume and level of activity for an asset or
liability have significantly decreased in relation to normal market activity for
the asset or liability and clarifies that the use of multiple valuation
techniques may be appropriate. FSP FAS 157-4 also provides additional guidance
on
25
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
circumstances that may indicate a transaction is not orderly. The guidance
re-emphasizes that fair value continues to be the exit price in an orderly
market. Further, this FSP requires additional disclosures about fair value
measurement in annual and interim reporting periods. FSP 157-4 is effective for
interim and annual reporting periods ending after June 15, 2009 with early
adoption permitted. We adopted FSP FAS 157-4 effective for the period ending
March 31, 2009, and this guidance did not have a material effect on our
consolidated financial statements.
In May 2008, the FASB issued FSP No. APB 14-1, "Accounting for Convertible
Debt Instruments That May Be Settled In Cash Upon Conversion (Including Partial
Cash Settlement)" ("FSP APB 14-1"). FSP APB 14-1 specifies that issuers of such
instruments should separately account for the liability and equity components in
a manner that will reflect the entity's nonconvertible debt borrowing rate when
interest cost is recognized in subsequent periods. FSP APB 14-1 is effective for
financial statements issued for fiscal years beginning after December 15, 2008,
and interim periods within those fiscal years. Early adoption was not permitted.
FSP APB 14-1 shall be applied retrospectively to all periods presented unless
instruments were not outstanding during any period included in the financial
statements. The adoption of FSP APB 14-1 affected the accounting for our 3.5
percent Debentures. Upon adoption of FSP APB 14-1, the effective interest rate
on our 3.5 percent Debentures increased to 7.4 percent, which resulted in the
recognition of a $45 million discount to these notes with the offsetting after
tax amount recorded to paid-in capital.
Amounts related to the Debentures are reflected in our consolidated balance
sheet as follows (dollars in millions):
March 31, December 31,
2009 2008
---- ----
Increase to additional paid-in capital............... $ 28.0 $ 28.0
====== ======
Par value of Debentures.............................. $293.0 $293.0
Unamortized discount................................. (15.9) (18.3)
------ ------
Carrying value of Debentures.................... $277.1 $274.7
====== ======
Interest expense related to the Debentures includes the following (dollars
in millions):
Three months ended
March 31,
---------------------
2009 2008
---- ----
Contractual interest expense............................... $2.5 $2.9
Amortization of discount................................... 2.5 2.3
Amortization of debt issuance costs........................ .3 .3
---- ----
Total interest expense.................................. $5.3 $5.5
==== ====
26
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
The adoption of FSP APB 14-1 affected prior period information as follows
(dollars in millions):
Three months ended
March 31, 2008
----------------------------------------------------------
As originally Effect of adoption of As
reported FSP APB 14-1 adjusted
-------- ------------ --------
Interest expense....................... $28.7 $2.1 $30.8
Income tax benefit..................... (3.5) (.7) (4.2)
Loss before discontinued
operations.......................... (6.3) (1.4) (7.7)
Net loss............................... (5.8) (1.4) (7.2)
Loss per common share:
Basic:
Loss before discontinued
operations.................... (.03) (.01) (.04)
Net loss......................... (.03) (.01) (.04)
Diluted:
Loss before discontinued
operations.................... (.03) (.01) (.04)
Net loss......................... (.03) (.01) (.04)
December 31, 2008
----------------------------------------------------------
As originally Effect of adoption of As
reported FSP APB 14-1 adjusted
-------- ------------ --------
Income tax assets, net................. $ 2,053.7 $ (6.0) $ 2,047.7
Other assets........................... 277.1 (.4) 276.7
Total assets........................... 28,769.7 (6.4) 28,763.3
Notes payable - direct corporate
obligations......................... 1,328.7 (17.2) 1,311.5
Additional paid-in capital............. 4,076.0 28.0 4,104.0
Accumulated deficit.................... (688.0) (17.2) (705.2)
27
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
In January 2009, the FASB issued FASB Staff Position No. EITF 99-20-1,
"Amendments to the Impairment Guidance of EITF Issue No. 99-20," ("FSP EITF
99-20-1"). FSP EITF 99-20-1 amends the impairment guidance of Emerging Issues
Task Force Issue No. 99-20, "Recognition of Interest Income and Impairment of
Purchased Beneficial Interest and Beneficial Interest that Continue to Be Held
by a Transferor in Securitized Financial Assets," by removing the exclusive
reliance upon market participant assumptions about future cash flows when
evaluating impairment of securities within its scope. FSP EITF 99-20-1 requires
companies to follow the impairment guidance in Statement of Financial Accounting
Standards No. 115, "Accounting for Certain Investments in Debt and Equity
Securities" ("SFAS 115"), which permits the use of reasonable management
judgment of the probability that the holder will be unable to collect all
amounts due. FSP EITF 99-20-1 is effective prospectively for interim and annual
reporting periods ending after December 15, 2008. The Company adopted FSP EITF
99-20-1 on December 31, 2008 and the adoption did not have a material effect on
our consolidated financial statements.
In May 2008, the FASB issued Statement of Financial Accounting Standards
No. 162, "The Hierarchy of Generally Accepted Accounting Principles" ("SFAS
162"). Under SFAS 162, the GAAP hierarchy will now reside in the accounting
literature established by the FASB. SFAS 162 identifies the sources of
accounting principles and the framework for selecting the principles used in the
preparation of financial statements in conformity with GAAP. SFAS 162 became
effective in November 2008. The adoption of SFAS 162 did not have a material
effect on our consolidated financial statements.
In March 2008, the FASB issued FASB Staff Position Emerging Issues Task
Force 03-6-1, "Determining Whether Instruments Granted in Share Based Payment
Transactions Are Participating Securities" ("FSP EITF 03-6-1"). Under FSP EITF
03-6-1, unvested share based payment awards that contain non-forfeitable rights
to dividends or dividend equivalents (whether paid or unpaid) are to be treated
as participating securities prior to vesting and, therefore, must be included in
the earnings allocation in calculating earnings per share under the two-class
method. FSP EITF 03-6-1 is effective for financial statements issued for fiscal
years beginning after December 15, 2008, and interim periods within those years
and requires retrospective application. Our adoption of FSP EITF 03-6-1 did not
have a material effect on our earnings per share calculations due to the
immateriality of unvested restricted shares that are considered to be
participating securities.
In March 2008, the FASB issued Statement of Financial Accounting Standards
No. 161, "Disclosure about Derivative Instruments and Hedging Activities, an
Amendment of FASB Statement No. 133" ("SFAS 161"). SFAS 161 requires enhanced
disclosures about an entity's derivative and hedging activities. SFAS 161 is
effective for financial statements issued for fiscal years and interim periods
beginning after November 15, 2008. The adoption of SFAS 161 did not have a
material effect on our consolidated financial statements.
In February 2008, the FASB issued FASB Staff Position FAS 157-2, "Effective
Date of FASB Statement No. 157" ("FSP FAS 157-2"). FSP FAS 157-2 delays the
effective date (to fiscal years beginning after November 15, 2008) of SFAS 157
for nonfinancial assets and nonfinancial liabilities, except for items that are
recognized or disclosed at fair value in the financial statements on a recurring
basis (at least annually). The adoption of FSP FAS 157-2 did not have a material
effect on our consolidated financial statements.
In December 2007, the FASB issued Statement of Financial Accounting
Standards No. 160, "Noncontrolling Interests in Consolidated Financial
Statements, an amendment of ARB No. 51" ("SFAS 160"), which establishes new
standards governing the accounting for and reporting of noncontrolling interests
(previously referred to as minority interests). SFAS 160 establishes reporting
requirements which include, among other things, that noncontrolling interests be
reflected as a separate component of equity, not as a liability. It also
requires that the interests of the parent and the noncontrolling interest be
clearly identifiable. Additionally, increases and decreases in a parent's
ownership interest that leave control intact shall be reflected as equity
transactions, rather than step acquisitions or dilution gains or losses. SFAS
160 is effective for fiscal years beginning on or after December 15, 2008 and
early adoption is prohibited. The initial adoption of SFAS 160 had no effect on
our consolidated financial statements.
In December 2007, the FASB issued Statement of Financial Accounting
Standards No. 141 (revised 2007), "Business Combinations" ("SFAS 141R"). SFAS
141R requires the acquiring entity in a business combination to recognize all
assets acquired and liabilities assumed in a transaction at the acquisition date
fair value, with certain exceptions. Additionally, SFAS 141R requires changes to
the accounting treatment of acquisition related items, including, among other
items, transaction costs, contingent consideration, restructuring costs,
indemnification assets and tax benefits. SFAS 141R also provides for a
substantial
28
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
number of new disclosure requirements. SFAS 141R is effective for business
combinations initiated on or after the first annual reporting period beginning
after December 15, 2008 and early adoption is prohibited. We expect that SFAS
141R will have an effect on our accounting for business combinations, if any,
that are made in the future. In addition, SFAS 141R changes the previous
requirement that reductions in a valuation allowance for deferred tax assets
established in conjunction with the implementation of fresh-start accounting be
recognized as a direct increase to additional paid-in capital. Instead, the
revised standard requires that any such reduction be reported as a decrease to
income tax expense through the consolidated statement of operations.
Accordingly, any reductions to our valuation allowance for deferred tax assets
will be reported as a decrease to income tax expense, after the effective date
of SFAS 141R.
In December 2008, the FASB issued FASB Staff Position FAS 140-4 and FIN 46
(R) - 8, "Disclosures by Public Entities (Enterprises) about Transfers of
Financial Assets and Interests in Variable Interest Entities" ("FSP FAS 140-4
and FIN 46 (R)-8"). The purpose of FSP FAS 140-4 and FIN 46 (R)-8 is to promptly
improve disclosures by public entities and enterprises until pending amendments
to SFAS No. 140, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishment of Liabilities" ("SFAS 140") and FASB Interpretation No. 46 (R),
"Consolidation of Variable Interest Entities" ("FIN 46 (R)"), are finalized and
approved by the FASB. The FSP amends SFAS 140 to require public entities to
provide additional disclosures about transferors' continuing involvements with
transferred financial assets. It also amends FIN 46 (R) to require public
enterprises to provide additional disclosures about their involvement with
variable interest entities. FSP FAS 140-4 and FIN 46 (R)-8 were effective for
financial statements issued for fiscal years and interim periods ending after
December 15, 2008. We adopted FSP FAS 140-4 and FIN 46 (R)-8 on December 31,
2008.
In February 2007, the FASB issued Statement of Financial Accounting
Standards No. 159, "The Fair Value Option for Financial Assets and Financial
Liabilities - Including an Amendment of FASB Statement No. 115" ("SFAS 159").
SFAS 159 allows entities to choose to measure many financial instruments and
certain other items, including insurance contracts, at fair value (on an
instrument-by-instrument basis) that are not currently required to be measured
at fair value. The objective is to improve financial reporting by providing
entities with the opportunity to mitigate volatility in reported earnings caused
by measuring related assets and liabilities differently without having to apply
complex hedge accounting provisions. We adopted SFAS 159 on January 1, 2008. We
did not elect the fair value option for any of our financial assets or
liabilities.
In April 2007, FASB issued Interpretation 39-1 "Amendment of FASB
Interpretation No. 39" ("FIN 39-1"). FIN 39-1 amends FIN 39, "Offsetting of
Amounts Related to Certain Contracts", to allow fair value amounts recognized
for collateral to be offset against fair value amounts recognized for derivative
instruments that are executed with the same counterparty under certain
circumstances. FIN 39-1 also requires an entity to disclose the accounting
policy decision to offset, or not to offset, fair value amounts in accordance
with FIN 39-1, as amended. We do not, and have not previously, offset the fair
value amounts recognized for derivatives with the amounts recognized as
collateral. All collateral is maintained in a tri-party custodial account. At
March 31, 2009 and December 31, 2008, $8.7 million and $11.4 million,
respectively, of derivative liabilities have been offset against derivative
assets executed with the same counterparty under master netting arrangements. We
adopted FIN 39-1 on January 1, 2008.
Pending Accounting Standards
On April 9, 2009, the FASB issued FSP No. FAS 107-1 and APB 28-1, "Interim
Disclosures About Fair Value of Financial Instruments" ("FSP FAS 107-1"). FSP
FAS 107-1 requires that the fair value of financial instruments be disclosed in
an entity's financial statements in both interim and annual periods. The FSP
also requires disclosure of methods and assumptions used to estimate fair
values. FSP FAS 107-1 is effective for interim reporting periods ending after
June 15, 2009, with early adoption permitted for periods ending after March 15,
2009. We will adopt FSP FAS 107-1 for the quarter ended June 30, 2009, which is
not expected to have a material effect on our consolidated balance sheet or
statement of operations, but will affect our interim disclosures.
LITIGATION AND OTHER LEGAL PROCEEDINGS
Legal Proceedings
The Company and its subsidiaries are involved in various legal actions in
the normal course of business, in which claims for compensatory and punitive
damages are asserted, some for substantial amounts. Some of the pending matters
have
29
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
been filed as purported class actions and some actions have been filed in
certain jurisdictions that permit punitive damage awards that are
disproportionate to the actual damages incurred. Although there can be no
assurances, at the present time the Company does not anticipate that the
ultimate liability from either pending or threatened legal actions, after
consideration of existing loss provisions, will have a material adverse effect
on the financial condition, operating results or cash flows of the Company. The
amounts sought in certain of these actions are often large or indeterminate and
the ultimate outcome of certain actions is difficult to predict. In the event of
an adverse outcome in one or more of these matters, the ultimate liability may
be in excess of the liabilities we have established and could have a material
adverse effect on our business, financial condition, results of operations and
cash flows. In addition, the resolution of pending or future litigation may
involve modifications to the terms of outstanding insurance policies, which
could adversely affect the future profitability of the related insurance
policies.
In the cases described below, we have disclosed any specific dollar amounts
sought in the complaints. In our experience, monetary demands in complaints bear
little relation to the ultimate loss, if any, to the Company. However, for the
reasons stated above, it is not possible to make meaningful estimates of the
amount or range of loss that could result from some of these matters at this
time. The Company reviews these matters on an ongoing basis and follows the
provisions of Statement of Financial Accounting Standards No. 5, "Accounting for
Contingencies", when making accrual and disclosure decisions. When assessing
reasonably possible and probable outcomes, the Company bases its decisions on
its assessment of the ultimate outcome following all appeals.
Securities Litigation
After our Predecessor announced its intention to restructure on August 9,
2002, eight purported securities fraud class action lawsuits were filed in the
United States District Court for the Southern District of Indiana. The
complaints named us as a defendant, along with certain of our former officers.
These lawsuits were filed on behalf of persons or entities who purchased our
Predecessor's common stock on various dates between October 24, 2001 and August
9, 2002. The plaintiffs allege claims under Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934, as amended, and allege material omissions and
dissemination of materially misleading statements regarding, among other things,
the liquidity of our Predecessor and alleged problems in Conseco Finance Corp.'s
manufactured housing division, allegedly resulting in the artificial inflation
of our Predecessor's stock price. These cases were consolidated into one case in
the United States District Court for the Southern District of Indiana, captioned
Franz Schleicher, et al. v. Conseco, Inc., Gary Wendt, William Shea, Charles
Chokel and James Adams, et al., Case No. 02-CV-1332 DFH-TAB. The complaint seeks
an unspecified amount of damages. The plaintiffs filed an amended consolidated
class action complaint with respect to the individual defendants on December 8,
2003. Our liability with respect to this lawsuit was discharged in our
Predecessor's plan of reorganization and our obligation to indemnify individual
defendants who were not serving as an officer or director on the Effective Date
is limited to $3 million in the aggregate under such plan. Our liability to
indemnify individual defendants who were serving as an officer or director on
the Effective Date, of which there is one such defendant, is not limited by such
plan. Our current estimate of the maximum loss that we could reasonably incur on
this case is approximately $2.0 million. A motion to dismiss was filed on behalf
of defendants Shea, Wendt and Chokel and on July 14, 2005, this matter was
dismissed. Plaintiffs filed a second amended complaint on August 24, 2005. We
filed a motion to dismiss the second amended complaint on November 7, 2005. This
motion was denied on September 12, 2007. Plaintiffs filed their motion for class
certification on May 2, 2008, and on March 20, 2009 the court granted that
motion. On April 24, 2009, certain of the defendants initiated a request to
appeal the class certification ruling to the U.S. Circuit Court of Appeals for
the 7th Circuit. The matter is scheduled for a jury trial on May 10, 2010. We
believe this lawsuit is without merit and intend to defend it vigorously;
however, the ultimate outcome cannot be predicted with certainty. We do not
believe that our potential loss related to the individual defendant who served
as an officer on the Effective Date is material.
Cost of Insurance Litigation
The Company and certain subsidiaries, including principally Conseco Life,
have been named in numerous purported class action and individual lawsuits
alleging, among other things, breach of contract, fraud and misrepresentation
with regard to a change made in 2003 and 2004 in the way cost of insurance
charges are calculated for life insurance policies sold primarily under the
names "Lifestyle" and "Lifetime". Approximately 86,500 of these policies were
subject to the change, which resulted in increased monthly charges to the
policyholders' accounts. Many of the purported class action lawsuits were filed
in Federal courts across the United States. In June 2004, the Judicial Panel on
Multidistrict Litigation consolidated these
30
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
lawsuits into the action now referred to as In Re Conseco Life Insurance Co.
Cost of Insurance Litigation, Cause No. MDL 1610 (Central District, California).
In September 2004, plaintiffs in the multi-district action filed an amended
consolidated complaint and, at that time, added Conseco, Inc. as a defendant.
The amended complaint sought unspecified compensatory, punitive and exemplary
damages as well as an injunction that would require the Company to reinstate the
prior method of calculating cost of insurance charges and refund any increased
charges that resulted from the change. On April 26, 2005, the Judge in the
multi-district action certified a nationwide class on the claims for breach of
contract and injunctive relief. On April 27, 2005, the Judge issued an order
certifying a statewide California class for injunctive and restitutionary relief
pursuant to California Business and Professions Code Section 17200 and breach of
the duty of good faith and fair dealing, but denied certification on the claims
for fraud and intentional misrepresentation and fraudulent concealment. The
Company announced on August 1, 2006, that it had reached a proposed settlement
of this case. Under the proposed settlement, inforce policyholders were given an
option to choose a form of policy benefit enhancement and certain former
policyholders will share in a settlement fund by either receiving cash or
electing to reinstate their policies with enhanced benefits. The settlement was
subject to court review and approval, a fairness hearing, notice to all class
members, election of options by the class members, implementation of the
settlement and other conditions. The Court entered final judgment in the case on
July 5, 2007. We began implementing the settlement with the inforce and certain
former policyholders in the last half of 2007. We previously recognized costs
related to this litigation totaling $267.2 million (none of which was recognized
in 2009 or 2008).
A lawsuit was filed on September 14, 2005 in Hawaii captioned AE Ventures
for Archie Murakami, et al. v. Conseco, Inc., Conseco Life Insurance Company;
And Doe Defendants 1-100, Case No. CV05-00594 (United States District Court,
District of Hawaii). This suit involves approximately 800 plaintiffs all of whom
purport to have opted out of the In Re Conseco Life Insurance Co. Cost of
Insurance Litigation multi-district action. The complaint alleges nondisclosure,
breach of fiduciary duty, violations of HRS 480 (unfair and/or deceptive
business practices), declaratory and injunctive relief, insurance bad faith,
punitive damages, and seeks to impose alter ego liability. The ultimate outcome
of this lawsuit cannot be predicted with certainty and an adverse outcome could
exceed the amount we have accrued and could have a material impact on the
Company's consolidated financial condition, cash flows or results of operations.
Agent Litigation
On December 17, 2003, a complaint was filed in the 19th Judicial District
Court, Parish of East Baton Rouge, Louisiana, Southern Capitol Enterprises, Inc.
and F. David Tutt v. Conseco Services, LLC and Conseco Health Insurance Company,
Case No. 515105. Plaintiffs are a former Conseco Health Insurance Company agency
and its principal that allege in the complaint that they were damaged by Conseco
Health Insurance Company's termination of their Executive Marketing Agreement
("EMA") and Business Continuation Plan ("BCP"). Plaintiffs sought a declaratory
judgment declaring the parties' rights and obligations under plaintiffs' EMA and
BCP including definitions of terms within those contracts. Plaintiffs also
demanded a full accounting of all commissions allegedly due and a preliminary
injunction stopping Conseco from reducing or stopping commission payments during
the pendency of this action. At Conseco Health Insurance Company's request, the
case was removed to the United States District Court for the Middle District of
Louisiana, Case No. 04CV40-D-M1. On September 30, 2004, Mr. Tutt filed a
separate complaint for breach of contract and damages against defendants in
federal court which includes claims for: (1) breach of the EMA and BCP; (2)
tortuous interference with the EMA and BCP; (3) unjust enrichment related to the
EMA and BCP; and (4) requests an accounting of back commissions under the EMA
and BCP. The court consolidated the two cases on October 20, 2004. Plaintiff
later filed an amended and restated complaint for damages on March 15, 2006,
which added our subsidiary, Performance Matters Associates, Inc., as a
defendant. Mr. Tutt moved for partial summary judgment in July 2004, asking the
court to invalidate the non-competition and non-solicitation provisions in the
EMA and the non-competition provision of the BCP. Defendants opposed this
motion, but plaintiffs' motion was granted by the court on December 15, 2004.
The court did not decide the issue of the BCP's continued validity. After
discovery, defendants filed a partial motion for summary judgment on January 1,
2006, reasserting that the entire BCP was invalidated because the
non-competition provision had been stricken from the agreement. Plaintiff filed
a cross-motion for partial summary judgment regarding the validity of the BCP on
May 31, 2006. Both motions were denied by the court, and the court set that
issue for a bench trial. After that issue was tried in April 2007, the court
ruled that the BCP was valid and enforceable. The court further ruled that the
issues of breach of contract relating to plaintiffs' exclusive rights and due to
improper commission payments, breach of the duty of good faith and fair dealing
as to the EMA and plaintiffs' Single Business Enterprise theory remain to be
tried to a jury. We believe the action is without merit, and intend to defend it
vigorously. The ultimate outcome of the action cannot be predicted with
certainty.
31
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
On January 16, 2008, a purported class action was filed in the Superior
Court of the State of California for the County of Alameda, Robin Fletcher
individually, and on behalf of all others similarly situated vs. Bankers Life
and Casualty Company, and Does 1 through 100, Case No. RG08366328. In her
original complaint, plaintiff alleged nonpayment by Bankers Life and Casualty
Company of overtime wages, failure to provide meal and rest periods, failure to
reimburse expenses, and failure to provide accurate wage statements to its sales
representatives in the State of California for the time period January 16, 2004
to present. Additionally, the complaint alleges failure to pay wages on
termination and unfair business practices. On October 7, 2008, the plaintiff
filed a first amended complaint which changes the proposed scope of the putative
class from all agents in California for the subject time period to all agents at
a single branch office in Alameda, California. This would reduce the putative
class from hundreds of members to approximately 100 members. We believe the
action is without merit and we intend to defend the case vigorously. The
ultimate outcome of the action cannot be predicted with certainty.
Other Litigation
On November 17, 2005, a complaint was filed in the United States District
Court for the Northern District of California, Robert H. Hansen, an individual,
and on behalf of all others similarly situated v. Conseco Insurance Company, an
Illinois corporation f/k/a Conseco Annuity Assurance Company, Cause No.
C0504726. Plaintiff in this putative class action purchased an annuity in 2000
and is claiming relief on behalf of the proposed national class for alleged
violations of the Racketeer Influenced and Corrupt Organizations Act; elder
abuse; unlawful, deceptive and unfair business practices; unlawful, deceptive
and misleading advertising; breach of fiduciary duty; aiding and abetting of
breach of fiduciary duty; and unjust enrichment and imposition of constructive
trust. On January 27, 2006, a similar complaint was filed in the same court
entitled Friou P. Jones, on Behalf of Himself and All Others Similarly Situated
v. Conseco Insurance Company, an Illinois company f/k/a Conseco Annuity
Assurance Company, Cause No. C06-00537. Mr. Jones had purchased an annuity in
2003. Each case alleged that the annuity sold was inappropriate and that the
annuity products in question are inherently unsuitable for seniors age 65 and
older. On March 3, 2006 a first amended complaint was filed in the Hansen case
adding causes of action for fraudulent concealment and breach of the duty of
good faith and fair dealing. In an order dated April 14, 2006, the court
consolidated the two cases under the original Hansen cause number and retitled
the consolidated action: In re Conseco Insurance Co. Annuity Marketing & Sales
Practices Litig. A motion to dismiss the amended complaint was granted in part
and denied in part, and the plaintiffs filed a second amended complaint on April
27, 2007, which has added as defendants Conseco Services, LLC and Conseco
Marketing, LLC. The court has not yet made a determination whether the case
should go forward as a class action, and we intend to oppose any form of class
action treatment of these claims. We believe the action is without merit, and
intend to defend it vigorously. The ultimate outcome of the action cannot be
predicted with certainty.
On September 24, 2004, a purported statewide class action was filed in the
18th Judicial District Court, Parish of Iberville, Louisiana, Diana Doiron,
Individually And On Behalf of All Others Similarly Situated v. Conseco Health
Insurance Company, Case No. 61,534. In her complaint, plaintiff claims that she
was damaged due to Conseco Health Insurance Company's failure to pay claims made
under her cancer policy, and seeks compensatory and statutory damages in an
unspecified amount along with declaratory and injunctive relief. Conseco Health
Insurance Company caused the case to be removed to the United States District
Court for the Middle District of Louisiana on November 3, 2004, and it was
assigned Case No. 04-784-D-M2. An order was issued on February 15, 2007 granting
plaintiff's motion for class certification. The order specifically certifies two
sub-classes identifying them as the radiation treatment sub-class and the
chemotherapy treatment sub-class. We appealed the certification order to the 5th
Circuit Court of Appeals, and by order entered May 28, 2008, the 5th Circuit
Court of Appeals affirmed class certification but made modifications to the
class definitions. Our subsequent petition for rehearing was denied by order
dated June 27, 2008. Briefing in the district court on remand, to determine the
appropriate revised class definition, concluded in March 2009 and on April 7,
2009, the District Court entered an order denying recertification of the
proposed classes. We believe the action is without merit, and we intend to
defend the case vigorously. The ultimate outcome of the action cannot be
predicted with certainty.
On August 7, 2006, an action was filed in the United States District Court
for the Southern District of New York, Sheldon H. Solow v. Conseco, Inc. and
Carmel Fifth, LLC, Case No. 06-CV-5988 (BSJ). The plaintiff alleges breach of
duty to hold a fair auction, fraud, promissory estoppel, unjust enrichment and a
declaratory judgment with respect to the sale by defendants of the GM Building
in New York City in 2003. Plaintiff was a losing bidder on the building. In the
complaint,
32
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
plaintiff seeks damages of $35 million on the unjust enrichment count and
damages in an amount to be determined at trial on the remaining counts.
Defendants filed a motion to dismiss the complaint on September 18, 2006. On
January 11, 2008, the court ruled on the motion to dismiss, granting the motion
with respect to the unjust enrichment and declaratory judgment counts, and
denying the motion with respect to the remaining three counts. The plaintiff
filed a motion for summary judgment on July 16, 2008, to which the Company
responded with a cross-motion for summary judgment on August 29, 2008. The
Company believes the action is without merit and intends to defend it
vigorously. The ultimate outcome of the action cannot be predicted with
certainty.
On March 4, 2008, a Complaint was filed in the United States District Court
for the Central District of California, Celedonia X. Yue, M. D. on behalf of the
class of all others similarly situated, and on behalf of the General Public v.
Conseco Life Insurance Company, successor to Philadelphia Life Insurance Company
and formerly known as Massachusetts General Life Insurance Company, Cause No.
CV08-01506 CAS. Plaintiff in this putative class action owns a Valulife
universal life policy insuring the life of Ruth S. Yue originally issued by
Massachusetts General Life Insurance Company on September 26, 1995. Plaintiff is
claiming breach of contract on behalf of the proposed national class and seeks
injunctive and restitutionary relief pursuant to Business & Professions Code
Section 17200 and Declaratory Relief. The putative class consists of all owners
of Valulife and Valuterm `universal life' insurance policies issued by either
Massachusetts General or Philadelphia Life and that were later acquired and
serviced by Conseco Life. Plaintiff alleges that members of the class will be
damaged by increases in the cost of insurance that are set to take place in the
twenty first policy year of Valulife and Valuterm policies. No such increases
have yet been applied to the subject policies, and none is scheduled to take
effect until around 2011. We filed a motion to dismiss the complaint on June 25,
2008, which was denied by the court. Plaintiff has not yet filed a motion for
certification of the class, and we intend to oppose any form of class treatment
of these claims. We believe the action is without merit, and intend to defend it
vigorously. The ultimate outcome of the action cannot be predicted with
certainty.
On June 4, 2008, a purported class action complaint was filed in the Cook
County Illinois Circuit Court Chancery Division, Sheldon Langendorf, et. al.
individually and on behalf of themselves and all others similarly situated v.
Conseco Senior Health Insurance Company, and Conseco, Inc., et. al. Case No.
08CH20571. Plaintiff is claiming breach of contract and consumer fraud and seeks
a declaratory judgment, claiming that Senior Health (formerly Conseco Senior
Health Insurance Company prior to its name change in October 2008) and other
affiliated companies routinely and improperly refuse to accept Medicare
explanations of benefits as documentation in support of proofs of claim on
individual hospital indemnity and other policies of health insurance. Senior
Health subsequently removed the action to the U.S. District Court for the
Northern District of Illinois, where it is now pending as Case No. 08-CV-3914.
By stipulation of the parties, Conseco, Inc. was dismissed as a party on
September 29, 2008. Senior Health filed a motion to dismiss and/or for summary
judgment on August 22, 2008, which the court granted in part and denied in part
by entry dated December 18, 2008, dismissing the claim for Illinois statutory
consumer fraud. We agreed to assume liability for this litigation in connection
with the separation of Senior Health. The parties have agreed to settle this
case, subject to court approval. The settlement of this case will not have a
significant impact on our business, financial condition, results of operations
or cash flows.
On December 8, 2008, a purported class action was filed in the U.S.
District Court for the Southern District of Florida, Sydelle Ruderman
individually and on behalf of all other similarly situated v. Washington
National Insurance Company, Case No. 08-23401-CIV-Cohn/Selzer. In the complaint,
plaintiff alleges that the inflation escalation rider on her policy of long-term
care insurance operates to increase the policy's lifetime maximum benefit, and
breached the contract by stopping her benefits when they reached the lifetime
maximum. The Company takes the position that the inflation escalator only
affects the per day maximum benefit. The court has scheduled a jury trial on
November 2, 2009. We believe the action is without merit, and intend to defend
it vigorously. The ultimate outcome of the action cannot be predicted with
certainty.
On December 24, 2008, a purported class action was filed in the U.S.
District Court for the Northern District of California, Cedric Brady, et. al.
individually and on behalf of all other similarly situated v. Conseco, Inc. and
Conseco Life Insurance Company Case No. 3:08-cv-05746. In their complaint,
plaintiffs allege that the Company committed breach of contract and insurance
bad faith and violated various consumer protection statutes in the
administration of various interest sensitive whole life products sold primarily
under the name "Lifetrend" by requiring the payment of additional cash amounts
to maintain the policies in force. On April 23, 2009, the plaintiffs filed an
amended complaint adding the additional counts of breach of fiduciary duty,
fraud, negligent misrepresentation, conversion and declaratory relief. The
Company believes the
33
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
action is without merit and intends to defend it vigorously. The ultimate
outcome of the action cannot be predicted with certainty.
On January 26, 2009, a purported class action complaint was filed in the
United States District Court for the Northern District of Illinois, Samuel Rowe
and Estella Rowe, individually and on behalf of themselves and all others
similarly situated v. Bankers Life & Casualty Company and Bankers Life Insurance
Company of Illinois, Case No. 09CV491. The plaintiffs are alleging violation of
California Business and Professions Code Sections 17200 et seq. and 17500 et
seq., breach of common law fiduciary duty, breach of implied covenant of good
faith and fair dealing, negligent misrepresentation and violation of California
Welfare and Institutions Code Section 15600 on behalf of the proposed national
class and seek injunctive relief, compensatory damages, punitive damages and
attorney fees. The plaintiff alleges that the defendants used an improper and
misleading sales and marketing approach to Seniors that fails to disclose all
facts, misuses consumers' confidential financial information, uses misleading
sales and marketing materials, promotes deferred annuities that are
fundamentally inferior and less valuable than readily available alternative
investment products and fails to adequately disclose other principal risks
including maturity dates, surrender penalties and other restrictions which limit
access to annuity proceeds to a date beyond the applicants actuarial life
expectancy. We believe the action is without merit, and intend to defend it
vigorously. The ultimate outcome of the action cannot be predicted with
certainty.
In addition, the Company and its subsidiaries are involved on an ongoing
basis in other lawsuits, including purported class actions, related to their
operations. The ultimate outcome of all of these other legal matters pending
against the Company or its subsidiaries cannot be predicted, and, although such
lawsuits are not expected individually to have a material adverse effect on the
Company, such lawsuits could have, in the aggregate, a material adverse effect
on the Company's consolidated financial condition, cash flows or results of
operations.
Director and Officer Loan Program Litigation
Collection efforts by the Company and Conseco Services related to the
1996-1999 director and officer loan programs are ongoing against two past board
members of our Predecessor with outstanding loan balances, James D. Massey and
Dennis E. Murray, Sr. In addition, these directors have sued the companies for
declaratory relief concerning their liability for the loans. The specific
lawsuits now pending include: Murray and Massey v. Conseco, Case No.
1:03-CV-1701-LJM-VSS (Southern District, Indiana); Conseco Services v. Murray,
Case No. 29D02-0404-CC-381 (Superior Court, Hamilton County, Indiana); Conseco
Services v. Massey, Case No. 29D01-0406-CC-477 (Superior Court, Hamilton County,
Indiana); Conseco, Inc. v. Massey, Case No. 2005-L-011316 (Circuit Court, Cook
County, Illinois) and Conseco and Conseco Services v. J. David Massey et al.,
Case No. 29D02-0611-PL-1169 (Superior Court, Hamilton County, Indiana). On June
21, 2006, in the Hamilton County case, the Company obtained a partial summary
judgment against Mr. Massey in the sum of $4.4 million plus interest at 11.5
percent from June 30, 2002. The trial court stayed execution of the judgment
pending appeal. On January 22, 2008, the Indiana Court of Appeals, in Massey v.
Conseco Services, LLC Case No. 29A05-0610-CV-565, affirmed the judgment entered
in the Hamilton County case in favor of the Company and the dismissal of
Massey's counterclaims. Mr. Massey filed a petition for rehearing with the Court
of Appeals, which was denied by entry dated May 15, 2008. Mr. Massey filed for
bankruptcy on October 10, 2008. A bench trial on the Company's motion to set
aside certain transfers to Mr. Massey's family members was held in the Hamilton
County, Indiana, Superior Court in January 2009 but no decision has been made by
the court. The Murray U.S. District Court case is currently set for trial on
September 14, 2009. On January 23, 2009, the U.S. District Court issued a
summary judgment ruling dismissing all claims by Murray against the Company, and
entering judgment against Murray on Conseco's contract claims against him. The
trial will be about whether Murray's wife is liable for the debts and whether
certain transfers of assets by Murray should be set aside as fraudulent.
The Company and Conseco Services believe that all amounts due under the
director and officer loan programs, including all applicable interest, are valid
obligations owed to the companies. As part of our Predecessor's plan of
reorganization, we have agreed to pay 45 percent of any net proceeds recovered
in connection with these lawsuits, in an aggregate amount not to exceed $30
million, to former holders of our Predecessor's trust preferred securities that
did not opt out of a settlement reached with the committee representing holders
of these securities. As of March 31, 2009, we have paid $19.3 million to the
former holders of trust preferred securities under this arrangement. We intend
to prosecute these claims to obtain the maximum recovery possible. Further, with
regard to the various claims brought against the Company and Conseco Services by
certain former directors and officers, we believe that these claims are without
merit and intend to defend them vigorously. The ultimate outcome of the lawsuits
cannot be predicted with certainty. At March 31, 2009, we estimated that
34
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
approximately $9.3 million, net of collection costs, of the remaining amounts
due under the loan program will be collected (including amounts that remain to
be collected from borrowers with whom we have settled) and that $4.0 million
will be paid to the former holders of our Predecessor's trust preferred
securities.
Regulatory Examinations and Fines
Insurance companies face significant risks related to regulatory
investigations and actions. Regulatory investigations generally result from
matters related to sales or underwriting practices, payment of contingent or
other sales commissions, claim payments and procedures, product design, product
disclosure, additional premium charges for premiums paid on a periodic basis,
denial or delay of benefits, charging excessive or impermissible fees on
products, changing the way cost of insurance charges are calculated for certain
life insurance products or recommending unsuitable products to customers. We
are, in the ordinary course of our business, subject to various examinations,
inquiries and information requests from state, federal and other authorities.
The ultimate outcome of these regulatory actions cannot be predicted with
certainty. In the event of an unfavorable outcome in one or more of these
matters, the ultimate liability may be in excess of liabilities we have
established and we could suffer significant reputational harm as a result of
these matters, which could also have a material adverse effect on our business,
financial condition, results of operations or cash flows.
The states of Pennsylvania, Illinois, Texas, Florida and Indiana led a
multistate examination of the long-term care claims administration and complaint
handling practices of Senior Health and Bankers Life and Casualty Company, as
well as the sales and marketing practices of Bankers Life and Casualty Company.
This examination commenced in July 2007 and on May 7, 2008, Conseco announced a
settlement among the state insurance regulators and Senior Health and Bankers
Life and Casualty Company. This examination covered the years 2005, 2006 and
2007. More than 40 states are parties to the settlement, which included a Senior
Health fine of up to $2.3 million, with up to an additional $10 million payable
in the event the process improvements and benchmarks, on the part of either
Senior Health and/or Bankers Life and Casualty, are not met over an 18 month
period for Bankers Life and Casualty or a two-and-a-half year period for Senior
Health, which time started with the settlement. The process improvement plan
will be monitored by the lead states.
In late October 2008, Conseco Life mailed notice to approximately 12,000
holders of its "Lifetrend" life insurance products to inform them of: (i)
changes to certain "non-guaranteed elements" ("NGEs") of their policies; and
(ii) the fact that certain policyholders who were not paying premiums may have
failed to receive a notice that their policy was underfunded and that additional
premiums were required in order for the policyholders to maintain their
guaranteed cash values. In December 2008, Conseco Life mailed notice to
approximately 16,000 holders of its CIUL3+ universal life policies to inform
them of an increase in certain NGEs with respect to their policies. Prior to or
around the time that the notices were sent, Conseco Life had informed the
insurance regulators in a number of states, including among others Indiana, Iowa
and Florida, of these matters and the planned communication with the impacted
policyholders. Conseco Life received a cease and desist order from the Iowa
Department of Insurance dated December 9, 2008, directing that it cease any
further activity with respect to the matters that had been communicated in the
notice to the Lifetrend policyholders. In December 2008, in response to
communications received from certain regulators and policyholders, Conseco Life
unilaterally agreed to enter into a nationwide temporary moratorium through
March 31, 2009 with regard to the proposed Lifetrend changes. Conseco has agreed
to extend that moratorium to June 30, 2009. In addition, Conseco Life entered
into a stipulation and standstill with the Iowa Department of Insurance pursuant
to which Conseco Life also agreed to take no further action with respect to the
Lifetrend and CIUL3+ policyholders in Iowa.
On December 22, 2008, Conseco Life also received an order to show cause
relating to the Lifetrend changes from the Florida Office of Insurance
Regulation ("OIR"), and Conseco Life entered into an agreement in January 2009
with the Florida OIR preserving Conseco Life's right to a hearing while Conseco
Life and the Florida OIR engaged in settlement discussions regarding the
Lifetrend and CIUL3+ policies. In January 2009, the Florida OIR commenced a
market conduct examination involving Conseco Life. Conseco continues to work
with various state insurance regulators to review the terms of the Lifetrend
policies, the administrative changes and the adjustment of certain NGEs. The
ultimate outcome of these regulatory proceedings involving the Lifetrend
policies cannot be predicted with certainty.
35
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
CONSOLIDATED STATEMENT OF CASH FLOWS
The following disclosures supplement our consolidated statement of cash
flows (dollars in millions):
Three months ended
March 31,
------------------
2009 2008
---- ----
(as adjusted)
Cash flows from operating activities:
Net income (loss).................................................................... $ 24.5 $ (7.2)
Adjustments to reconcile the net loss to net cash provided
by operating activities:
Amortization and depreciation.................................................... 129.9 124.0
Income taxes..................................................................... 15.4 (4.1)
Insurance liabilities............................................................ 41.6 118.4
Accrual and amortization of investment income.................................... (11.5) 4.0
Deferral of policy acquisition costs............................................. (105.8) (123.3)
Net realized investment losses................................................... 6.9 43.6
Net sales (purchases) of trading securities...................................... 40.8 306.3
Other............................................................................ 12.4 (3.0)
------- -------
Net cash provided by operating activities...................................... $ 154.2 $ 458.7
======= =======
Non-cash items not reflected in the investing and financing activities sections
of the consolidated statement of cash flows:
Stock option and restricted stock plans............................................ $ 1.6 $ 1.9
Change in securities lending collateral............................................ 152.4 25.2
Change in securities lending payable............................................... (152.4) (25.2)
Our consolidated statement of cash flows for the three months ended March
31, 2008, combines the cash flows from discontinued operations with the cash
flows from continuing operations within each major category (operating,
investing and financing) of the cash flow statement.
At March 31, 2009 and December 31, 2008, restricted cash and cash
equivalents consisted of $4.5 million and $4.8 million, respectively, held by a
VIE.
36
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
INVESTMENTS
At March 31, 2009, the amortized cost, gross unrealized gains and losses,
other-than-temporary impairments in other comprehensive loss and estimated fair
value of actively managed fixed maturities were as follows (dollars in
millions):
Gross unrealized losses
-----------------------------------
Related to Other-than-temporary
Gross changes in impairments Estimated
Amortized unrealized estimated included in other fair
cost gains fair value comprehensive loss value
---- ----- ---------- ------------------ -----
Corporate securities.......................... $13,954.1 $30.0 $(2,329.9) $ - $11,654.2
United States Treasury securities
and obligations of United States government
corporations and agencies................... 398.3 8.6 (1.1) - 405.8
States and political subdivisions............. 453.8 1.5 (59.9) - 395.4
Debt securities issued by foreign
governments................................. 9.0 .1 (1.9) - 7.2
Asset-backed securities....................... 301.7 - (98.3) - 203.4
Collateralized debt obligations............... 132.2 - (26.8) (3.4) 102.0
Commercial mortgage-backed securities......... 871.1 - (279.7) - 591.4
Mortgage pass-through securities.............. 71.3 2.2 (.1) - 73.4
Collateralized mortgage obligations........... 2,346.5 35.5 (396.1) (21.9) 1,964.0
--------- ----- --------- ------ ---------
Total actively managed fixed maturities....... $18,538.0 $77.9 $(3,193.8) $(25.3) $15,396.8
========= ===== ========= ====== =========
The following table sets forth the amortized cost and estimated fair
value of those actively managed fixed maturities with unrealized losses at March
31, 2009, by contractual maturity. Actual maturities will differ from
contractual maturities because borrowers may have the right to call or prepay
obligations with or without call or prepayment penalties. Asset-backed
securities, collateralized debt obligations, commercial mortgage-backed
securities, mortgage pass-through securities and collateralized mortgage
obligations are collectively referenced to as "structured securities". Many of
the structured securities shown below provide for periodic payments throughout
their lives (dollars in millions):
Estimated
Amortized fair
cost value
--------- ---------
Due in one year or less................................................................. $ 41.7 $ 40.4
Due after one year through five years................................................... 1,501.9 1,284.1
Due after five years through ten years.................................................. 4,355.8 3,594.3
Due after ten years..................................................................... 7,308.5 5,896.3
--------- ---------
Subtotal............................................................................. 13,207.9 10,815.1
Structured securities................................................................... 2,872.4 2,046.1
--------- ---------
Total................................................................................ $16,080.3 $12,861.2
========= =========
37
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
NET REALIZED INVESTMENT GAINS (LOSSES)
During the first three months of 2009, we recognized net realized
investment losses of $6.9 million, which were comprised of $85.1 million of net
gains from the sales of investments (primarily fixed maturities) with proceeds
of $2.6 billion, net of $92.0 million of writedowns of investments for other
than temporary declines in fair value recognized through net income ($108.1
million, prior to the $16.1 million of impairment losses recognized through
other comprehensive loss). During the first three months of 2008, we recognized
net realized investment losses of $4.3 million from the sales of investments
(primarily fixed maturities) with proceeds of $1.9 billion, and $41.3 million of
writedowns of investments for other than temporary declines in fair value. At
March 31, 2009, fixed maturity securities in default as to the payment of
principal or interest had an aggregate amortized cost of $3.4 million and a
carrying value of $.9 million. At March 31, 2009, we had mortgage loans with an
aggregate carrying value of $7.6 million that were 90 days or more past due as
to the payment of principal or interest.
During the three months ended March 31, 2009, we sold $93.6 million of
fixed maturity investments which resulted in gross investment losses (before
income taxes) of $4.3 million. We sell securities at a loss for a number of
reasons including, but not limited to: (i) changes in the investment
environment; (ii) expectation that the market value could deteriorate further;
(iii) desire to reduce our exposure to an issuer or an industry; (iv) changes in
credit quality; or (v) changes in expected liability cash flows. During the
first three months of 2009, we sold two investments at a loss which had been
continuously in an unrealized loss position exceeding 20 percent of the
amortized cost basis. Such investments were continuously in an unrealized loss
position for less than six months prior to sale and had an amortized cost and
estimated fair value of $.8 million and $.4 million, respectively.
We regularly evaluate our investments for possible impairment. Our
assessment of whether unrealized losses are "other than temporary" requires
significant judgment. Factors considered include: (i) the extent to which market
value is less than the cost basis; (ii) the length of time that the market value
has been less than cost; (iii) whether the unrealized loss is event driven,
credit-driven or a result of changes in market interest rates or risk premium;
(iv) the near-term prospects for fundamental improvement in specific
circumstances likely to affect the value of the investment; (v) the investment's
rating and whether the investment is investment-grade and/or has been downgraded
since its purchase; (vi) whether the issuer is current on all payments in
accordance with the contractual terms of the investment and is expected to meet
all of its obligations under the terms of the investment; (vii) our intent not
to sell an impaired investment before its recovery occurs; (viii) whether it is
more likely than not that we will be required to sell the investment before
recovery occurs; (ix) the underlying current and prospective asset and
enterprise values of the issuer and the extent to which the recoverability of
the carrying value of our investment may be affected by changes in such values;
(x) unfavorable changes in cash flows on structured securities including
mortgage-backed and asset-backed securities; and (xi) other subjective factors.
Future events may occur, or additional information may become available,
which may necessitate future realized losses of securities in our portfolio.
Significant losses in the estimated fair values of our investments could have a
material adverse effect on our earnings in future periods.
During the first quarter of 2009, we adopted FSP FAS 115-2, which changes
the recognition and presentation of other-than-temporary impairments. Refer to
the note to the consolidated financial statements entitled "Recently Issued
Accounting Standards - Adopted Accounting Standards" for additional information.
The recognition provisions within FSP FAS 115-2 apply only to our actively
managed fixed maturity investments.
Impairment losses on equity securities are recognized in net income. The
manner in which impairment losses on actively managed fixed maturity securities
are recognized in the financial statements is dependent on the facts and
circumstances related to the specific security. If we intend to sell a security
or it is more likely than not that we would be required to sell a security
before the recovery of its amortized cost, the security is
other-than-temporarily impaired and the full amount of the impairment is
recognized as a loss through earnings. If we do not expect to recover the
amortized cost basis, we do not plan to sell the security and if it is not more
likely than not that we would be required to sell a security before the recovery
of its amortized cost, less any current period credit loss, the recognition of
the other-than-temporary impairment is bifurcated. We recognize the credit loss
portion in net income and the noncredit loss portion in other comprehensive
loss.
38
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
We estimate the amount of the credit loss component of a fixed maturity
security impairment as the difference between amortized cost and the present
value of the expected cash flows of the security. The present value is
determined using the best estimate of future cash flows discounted at the
implicit interest rate to accrete the security to par at the date of purchase.
The methodology and assumptions for establishing the best estimate of future
cash flows vary depending on the type of security. The asset-backed securities
cash flow estimates are based on bond specific facts and circumstances that may
include collateral characteristics, expectations of delinquency and default
rates, loss severity, prepayment speeds and structural support, including
subordination and guarantees. The corporate bond cash flow estimates are derived
from scenario-based outcomes of expected corporate restructurings or the
disposition of assets using bond specific facts and circumstances including
timing, secured interest and loss severity. As of March 31, 2009,
other-than-temporary impairments included in other comprehensive loss of $25.3
million (before taxes and related amortization) relate only to asset-backed
securities (including collateralized debt obligations and collateralized
mortgage obligations).
The following table summarizes the amount of credit losses recognized in
earnings on actively managed fixed maturity securities held at the beginning of
the period, for which a portion of the other-than-temporary impairment was also
recognized in other comprehensive loss for the three months ended March 31, 2009
(dollars in millions):
Credit losses recognized in earnings on actively managed fixed maturities:
Credit losses on actively managed fixed maturity securities, beginning of period......... $ (.6)
Add: credit losses on other-than-temporary impairments not previously recognized.. (6.9)
Less: credit losses on securities sold............................................. -
Less: credit losses on securities impaired due to intent to sell................... -
Add: credit losses on previously impaired securities.............................. -
Less: increases in cash flows expected on previously impaired securities........... -
-----
Credit losses on actively managed fixed maturity securities, end of period............... $(7.5)
=====
39
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
GROSS UNREALIZED INVESTMENT LOSSES
Our investment strategy is to maximize, over a sustained period and within
acceptable parameters of risk, investment income and total investment return
through active investment management. Accordingly, we may sell securities at a
gain or a loss to enhance the total return of the portfolio as market
opportunities change or to better match certain characteristics of our
investment portfolio with the corresponding characteristics of our insurance
liabilities. While we do not have the intent to sell securities with unrealized
losses and it is not more likely than not that we will be required to sell
securities with unrealized losses prior to their anticipated recovery, we may
sell securities at a loss in the future because of actual or expected changes in
our view of the particular investment, its industry, its type or the general
investment environment.
The following table summarizes the gross unrealized losses and fair values
of our investments with unrealized losses that are not deemed to be
other-than-temporarily impaired, aggregated by investment category and length of
time that such securities have been in a continuous unrealized loss position, at
March 31, 2009 (dollars in millions):
Less than 12 months 12 months or greater Total
----------------------- ---------------------- ----------------------
Estimated Estimated Estimated
fair Unrealized fair Unrealized fair Unrealized
Description of securities value losses value losses value losses
------------------------- ----- ------ ----- ------ ----- ------
United States Treasury securities
and obligations of United
States government
corporations and agencies...... $ 11.7 $ (.9) $ 1.6 $ (.2) $ 13.3 $ (1.1)
States and political subdivisions. 106.4 (14.4) 230.0 (45.5) 336.4 (59.9)
Debt securities issued by
foreign governments............ - - 6.2 (1.9) 6.2 (1.9)
Corporate securities.............. 4,366.2 (469.7) 6,093.0 (1,860.2) 10,459.2 (2,329.9)
Asset-backed securities........... 55.5 (9.1) 147.0 (89.2) 202.5 (98.3)
Collateralized debt obligations... 50.1 (16.7) 39.4 (13.5) 89.5 (30.2)
Commercial mortgage-backed
securities..................... 137.7 (18.0) 452.1 (261.7) 589.8 (279.7)
Mortgage pass-through securities.. 5.5 (.1) .1 - 5.6 (.1)
Collateralized mortgage
obligations.................... 199.4 (10.2) 959.3 (407.8) 1,158.7 (418.0)
-------- ------- -------- --------- --------- ---------
Total actively managed
fixed maturities............... $4,932.5 $(539.1) $7,928.7 $(2,680.0) $12,861.2 $(3,219.1)
======== ======= ======== ========= ========= =========
Equity securities................. $7.2 $(1.0) $ - $ - $7.2 $(1.0)
==== ===== ===== ====== ==== =====
Based on management's current assessment of investments with unrealized
losses at March 31, 2009, the Company believes the issuers of the securities
will continue to meet their obligations (or with respect to equity-type
securities, the investment value will recover to its cost basis). While we do
not have the intent to sell securities with unrealized losses and it is not more
likely than not that we will be required to sell securities with unrealized
losses prior to their anticipated recovery, our intent on an individual security
may change, based upon market or other unforeseen developments. In such
instances, we may sell securities in the ordinary course of managing our
portfolio to meet diversification, credit quality, yield, duration and liquidity
requirements. If a loss is recognized from a sale subsequent to a balance sheet
date due to these unexpected developments, the loss is recognized in the period
in which we had the intent to sell the securities before their anticipated
recovery.
40
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
INVESTMENT IN A VARIABLE INTEREST ENTITY
The Company has an investment in a special purpose entity that is a VIE
under Financial Accounting Standards Board Interpretation No. 46 "Consolidation
of Variable Interest Entities, revised December 2003" ("FIN 46R"). The following
is description of our significant investment in a VIE:
Fall Creek CLO Ltd. ("Fall Creek") is a collateralized loan trust that was
established to issue securities and use the proceeds to invest in loans and
other permitted investments. The assets held by the trust are legally isolated
and are not available to the Company. The liabilities of Fall Creek will be
satisfied from the cash flows generated by the underlying loans, not from the
assets of the Company. Repayment of the remaining principal balance of the
investment borrowings of Fall Creek is based on available cash flows from the
assets and such borrowings mature in 2017. The Company has no further
commitments to Fall Creek. The carrying value of our investment in Fall Creek
was $77.7 million and $83.5 million at March 31, 2009 and December 31, 2008,
respectively.
FAIR VALUE MEASUREMENTS
Effective January 1, 2008, we adopted SFAS 157 which clarifies a number of
considerations with respect to fair value measurement objectives for financial
reporting and expands disclosures about the use of fair value measurements. SFAS
157 is intended to increase consistency and comparability among fair value
estimates used in financial reporting. The disclosure requirements of SFAS 157
are intended to provide users of financial statements with the ability to assess
the reliability of an entity's fair value measurements. The initial adoption of
SFAS 157 resulted in a charge of $1.8 million to net income (after the effects
of the amortization of insurance acquisition costs and income taxes) in the
first quarter of 2008, attributable to changes in the liability for the embedded
derivatives associated with our equity-indexed annuity products. The change
resulted from the incorporation of risk margins into the estimated fair value
calculation for this liability.
Definition of Fair Value
As defined in SFAS 157, fair value is the price that would be received to
sell an asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date and, therefore, represents an exit
price, not an entry price. We hold fixed maturities, equity securities,
derivatives, separate account assets and embedded derivatives, which are carried
at fair value.
The degree of judgment utilized in measuring the fair value of financial
instruments is largely dependent on the level to which pricing is based on
observable inputs. Observable inputs reflect market data obtained from
independent sources, while unobservable inputs reflect our view of market
assumptions in the absence of observable market information. Financial
instruments with readily available active quoted prices would be considered to
have fair values based on the highest level of observable inputs, and little
judgment would be utilized in measuring fair value. Financial instruments that
rarely trade would be considered to have fair value based on a lower level of
observable inputs, and more judgment would be utilized in measuring fair value.
Valuation Hierarchy
SFAS 157 establishes a three-level hierarchy for valuing assets or
liabilities at fair value based on whether inputs are observable or
unobservable.
o Level 1 - includes assets and liabilities valued using inputs that are
quoted prices in active markets for identical assets or liabilities.
Our Level 1 assets include exchange traded securities and U.S.
Treasury securities.
o Level 2 - includes assets and liabilities valued using inputs that are
quoted prices for similar assets in an active market, quoted prices
for identical or similar assets in a market that is not active,
observable inputs, or observable inputs that can be corroborated by
market data. Level 2 assets and liabilities include those financial
instruments that are valued by independent pricing services using
models or other valuation methodologies. These models are primarily
industry-standard models that consider various inputs such as interest
rate, credit spread, reported trades, broker/dealer quotes, issuer
spreads and other inputs that are observable or derived from
observable information in
41
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
the marketplace or are supported by observable levels at which
transactions are executed in the marketplace. Financial instruments in
this category primarily include: certain public and private corporate
fixed maturity securities; certain government or agency securities;
certain mortgage and asset-backed securities; and non-exchange-traded
derivatives such as call options to hedge liabilities related to our
equity-indexed annuity products.
o Level 3 - includes assets and liabilities valued using unobservable
inputs that are used in model-based valuations that contain management
assumptions. Level 3 assets and liabilities include those financial
instruments whose fair value is estimated based on non-binding broker
prices or internally developed models or methodologies utilizing
significant inputs not based on, or corroborated by, readily available
market information. Financial instruments in this category include
certain corporate securities (primarily private placements), certain
mortgage and asset-backed securities, and other less liquid
securities. Additionally, the Company's liabilities for embedded
derivatives (including embedded derivatives related to our
equity-indexed annuity products and to a modified coinsurance
arrangement) are classified in Level 3 since their values include
significant unobservable inputs including actuarial assumptions.
At each reporting date, we classify assets and liabilities into the three
input levels based on the lowest level of input that is significant to the
measurement of fair value for each asset and liability reported at fair value.
This classification is impacted by a number of factors, including the type of
financial instrument, whether the financial instrument is new to the market and
not yet established, the characteristics specific to the transaction and overall
market conditions. Our assessment of the significance of a particular input to
the fair value measurement and the ultimate classification of each asset and
liability requires judgment.
The vast majority of our fixed maturity securities and separate account
assets use Level 2 inputs for the determination of fair value. These fair values
are obtained primarily from independent pricing services, which use Level 2
inputs for the determination of fair value. Substantially all of our Level 2
fixed maturity securities and separate account assets were valued from
independent pricing services. Third party pricing services normally derive the
security prices through recently reported trades for identical or similar
securities making adjustments through the reporting date based upon available
market observable information. If there are no recently reported trades, the
third party pricing services may use matrix or model processes to develop a
security price where future cash flow expectations are developed and discounted
at an estimated risk-adjusted market rate. The number of prices obtained is
dependent on the Company's analysis of such prices as further described below.
For securities that are not priced by pricing services and may not be
reliably priced using pricing models, we obtain broker quotes. These broker
quotes are non-binding and represent an exit price, but assumptions used to
establish the fair value may not be observable and therefore represent Level 3
inputs. Approximately 6 percent and 1 percent of our Level 3 fixed maturity
securities were valued using broker quotes or independent pricing services,
respectively. The remaining Level 3 fixed maturity investments do not have
readily determinable market prices and/or observable inputs. For these
securities, we use internally developed valuations. Key assumptions used to
determine fair value for these securities may include risk-free rates, risk
premiums, performance of underlying collateral and other factors involving
significant assumptions which may not be reflective of an active market. For
certain investments, we use a matrix or model process to develop a security
price where future cash flow expectations are developed and discounted at an
estimated market rate. The pricing matrix utilizes a spread level to determine
the market price for a security. The credit spread generally incorporates the
issuer's credit rating and other factors relating to the issuer's industry and
the security's maturity. In some instances issuer-specific spread adjustments,
which can be positive or negative, are made based upon internal analysis of
security specifics such as liquidity, deal size, and time to maturity.
As the Company is responsible for the determination of fair value, we
perform monthly quantitative and qualitative analysis on the prices received
from third parties to determine whether the prices are reasonable estimates of
fair value. The Company's analysis includes: (i) a review of the methodology
used by third party pricing services; (ii) a comparison of pricing services'
valuation to other pricing services' valuations for the same security; (iii) a
review of month to month price fluctuations; (iv) a review to ensure valuations
are not unreasonably stale; and (v) back testing to compare actual purchase and
sale transactions with valuations received from third parties. As a result of
such procedures, the Company may conclude the prices received from third parties
are not reflective of current market conditions. In those instances, we may
request additional pricing quotes or apply internally developed valuations.
However, the number of instances is insignificant and the aggregate change in
value of such investments is not materially different from the original prices
received.
42
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
The categorization of the fair value measurements of our investments priced
by independent pricing services was based upon the Company's judgment of the
inputs or methodologies used by the independent pricing services to value
different asset classes. Such inputs include: benchmark yields, reported trades,
broker dealer quotes, issuer spreads, benchmark securities, bids, offers and
reference data. The Company categorizes such fair value measurements based upon
asset classes and the underlying observable or unobservable inputs used to value
such investments.
The classification of fair value measurements for derivative instruments,
including embedded derivatives requiring bifurcation, is determined based on the
consideration of several inputs including closing exchange or over-the-counter
market price quotations; time value and volatility factors underlying options;
market interest rates; and non-performance risk. For certain embedded
derivatives, we may use actuarial assumptions in the determination of fair
value.
The categorization of fair value measurements, by input level, for our
fixed maturity securities, equity securities, trading securities, certain other
invested assets, assets held in separate accounts and embedded derivative
instruments included in liabilities for insurance products at March 31, 2009 is
as follows (dollars in millions):
Quoted prices
in active markets Significant other Significant
for identical assets observable unobservable
or liabilities inputs inputs
(Level 1) (Level 2) (Level 3) Total
--------- --------- --------- -----
Assets:
Actively managed fixed maturities........ $323.7 $13,121.4 $1,951.7 $15,396.8
Equity securities........................ - - 32.5 32.5
Trading securities....................... 7.1 270.5 2.7 280.3
Securities lending collateral............ - 173.3 35.5 208.8
Other invested assets.................... - 58.1 (a) 2.8 (b) 60.9
Assets held in separate accounts......... - 17.0 - 17.0
Liabilities:
Liabilities for insurance products:
Embedded derivative instruments........ - - 404.0 (c) 404.0
<FN>
- -------------
(a) Includes corporate-owned life insurance and derivatives.
(b) Includes equity-like holdings in special-purpose entities.
(c) Includes $396.3 million of embedded derivatives associated with our
equity-indexed annuity products and $7.7 million of embedded
derivatives associated with a modified coinsurance agreement.
</FN>
43
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
The categorization of fair value measurements, by input level, for our
fixed maturity securities, equity securities, trading securities, certain other
invested assets, assets held in separate accounts and embedded derivative
instruments included in liabilities for insurance products at December 31, 2008
is as follows (dollars in millions):
Quoted prices
in active markets Significant other Significant
for identical assets observable unobservable
or liabilities inputs inputs
(Level 1) (Level 2) (Level 3) Total
--------- --------- --------- -----
Assets:
Actively managed fixed maturities........ $74.9 $13,326.0 $1,876.1 $15,277.0
Equity securities........................ - - 32.4 32.4
Trading securities....................... 8.8 315.0 2.7 326.5
Securities lending collateral............ - 170.3 48.1 218.4
Other invested assets.................... - 55.9 (a) 2.3 (b) 58.2
Assets held in separate accounts......... - 18.2 - 18.2
Liabilities:
Liabilities for insurance products:
Embedded derivative instruments........ - - 437.2 (c) 437.2
<FN>
- -------------
(a) Includes corporate-owned life insurance and derivatives.
(b) Includes equity-like holdings in special-purpose entities.
(c) Includes $430.6 million of embedded derivatives associated with our
equity-indexed annuity products and $6.6 million of embedded
derivatives associated with a modified coinsurance agreement.
</FN>
44
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
The following table presents additional information about assets and
liabilities measured at fair value on a recurring basis and for which we have
utilized significant unobservable (Level 3) inputs to determine fair value for
the three months ended March 31, 2009 (dollars in millions):
Embedded derivative
Actively Securities Other instruments included
managed fixed Equity Trading lending invested in liabilities for
maturities securities securities collateral assets insurance products
---------- ---------- ---------- ---------- ------ ------------------
Assets:
Beginning balance as of
December 31, 2008.................. $1,876.1 $32.4 $2.7 $48.1 $ 2.3 $(437.2)
Purchases, sales, issuances and
settlements, net..................... 39.2 (.3) - (7.0) - 35.1
Total realized and unrealized
gains (losses):
Included in net loss............... (5.7) - - - (3.4) (1.9)
Included in other comprehensive
income (loss).................... 50.7 .4 (.4) (2.3) 3.9 -
Transfers in and/or (out) of Level 3 (a) (8.6) - .4 (3.3) - -
-------- ----- ---- ----- ----- -------
Ending balance as of March 31, 2009...... $1,951.7 $32.5 $2.7 $35.5 $ 2.8 $(404.0)
======== ===== ==== ===== ===== =======
Amount of total gains (losses) for the three
months ended March 31, 2009
included in our net loss relating to assets
and liabilities still held as of the
reporting date......................... $(5.7) $ - $ - $ - $(3.4) $(1.9)
===== ===== ==== ======= ===== =====
<FN>
- -----------
(a) Net transfers out of Level 3 are reported as having occurred at the
beginning of the period.
</FN>
45
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
-------------------
The following table presents additional information about assets and
liabilities measured at fair value on a recurring basis and for which we have
utilized significant unobservable (Level 3) inputs to determine fair value for
the three months ended March 31, 2008 (dollars in millions):
Embedded derivative
Actively Other instruments included
managed fixed Equity Trading invested in liabilities for
maturities securities securities assets insurance products
---------- ---------- ---------- ------ ------------------
Assets:
Beginning balance as of
December 31, 2007.................... $1,924.3 $34.5 $11.8 $4.3 $(354.6)
Purchases, sales, issuances and
settlements, net..................... 189.2 - (1.6) - 14.0
Total realized and unrealized gains (losses):
Included in net loss................. (13.7) - (.8) - (25.3)
Included in other comprehensive
income (loss)...................... 6.3 (.1) - - -
Transfers in and/or (out) of Level 3... - - - - -
-------- ----- ---- ---- -------
Ending balance as of March 31, 2008...... $2,106.1 $34.4 $ 9.4 $4.3 $(365.9)
======== ===== ===== ==== =======
Amount of total gains (losses) for the period
included in our net loss relating to assets
and liabilities still held as of the
reporting date......................... $(14.7) $ - $(.6) $ - $(25.3)
====== ======= ==== ====== ======
At March 31, 2009, 83 percent of our Level 3 actively managed fixed
maturities were investment grade and 76 percent of our Level 3 actively managed
fixed maturities consisted of corporate securities.
Realized and unrealized investment gains and losses presented in the
preceding table represent gains and losses during the time the applicable
financial instruments were classified as Level 3.
Realized and unrealized gains (losses) on Level 3 assets are primarily
reported in either net investment income for policyholder and reinsurer accounts
and other special purpose portfolios, net realized investment gains (losses) or
insurance policy benefits within the consolidated statement of operations or
other comprehensive income (loss) within shareholders' equity based on the
appropriate accounting treatment for the instrument.
Purchases, sales, issuances and settlements, net, represent the activity
that occurred during the period that results in a change of the asset or
liability but does not represent changes in fair value for the instruments held
at the beginning of the period. Such activity primarily consists of purchases
and sales of fixed maturity, equity and trading securities, purchases and
settlements of derivative instruments, and changes to embedded derivative
instruments related to insurance products resulting from the issuance of new
contracts, or changes to existing contracts.
We review the fair value hierarchy classifications each reporting period.
Transfers in and/or (out) of Level 3 in the first three months of 2009 were
primarily due to changes in the observability of the valuation attributes
resulting in a reclassification of certain financial assets or liabilities. Such
reclassifications are reported as transfers in and out of Level 3 at the
beginning fair value for the reporting period in which the changes occur.
The amount presented for gains (losses) included in our net loss for assets
and liabilities still held as of the reporting date primarily represents
impairments for actively managed fixed maturities, changes in fair value of
trading securities and certain derivatives and changes in fair value of embedded
derivative instruments included in liabilities for insurance products that exist
as of the reporting date.
46
CONSECO, INC. AND SUBSIDIARIES
-------------------
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
In this section, we review the consolidated financial condition of Conseco
at March 31, 2009, and the consolidated results of operations for the three
months ended March 31, 2009 and 2008, and, where appropriate, factors that may
affect future financial performance. Please read this discussion in conjunction
with the accompanying consolidated financial statements and notes.
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
Our statements, trend analyses and other information contained in this
report and elsewhere (such as in filings by Conseco with the SEC, press
releases, presentations by Conseco or its management or oral statements)
relative to markets for Conseco's products and trends in Conseco's operations or
financial results, as well as other statements, contain forward-looking
statements within the meaning of the federal securities laws and the Private
Securities Litigation Reform Act of 1995. Forward-looking statements typically
are identified by the use of terms such as "anticipate," "believe," "plan,"
"estimate," "expect," "project," "intend," "may," "will," "would,"
"contemplate," "possible," "attempt," "seek," "should," "could," "goal,"
"target," "on track," "comfortable with," "optimistic" and similar words,
although some forward-looking statements are expressed differently. You should
consider statements that contain these words carefully because they describe our
expectations, plans, strategies and goals and our beliefs concerning future
business conditions, our results of operations, financial position, and our
business outlook or they state other "forward-looking" information based on
currently available information. The "Risk Factors" section of our 2008 Annual
Report on Form 10-K provides examples of risks, uncertainties and events that
could cause our actual results to differ materially from the expectations
expressed in our forward-looking statements. Assumptions and other important
factors that could cause our actual results to differ materially from those
anticipated in our forward-looking statements include, among other things:
o general economic, market and political conditions, including the
performance and fluctuations of the financial markets which may affect
our ability to raise capital or refinance our existing indebtedness
and the cost of doing so;
o our ability to continue to satisfy the financial ratio and balance
requirements and other covenants of our debt agreements;
o our ability to generate sufficient liquidity to meet our debt service
obligations and other cash needs;
o our ability to obtain adequate and timely rate increases on our
supplemental health products, including our long-term care business;
o the receipt of required regulatory approvals for dividend and surplus
debenture interest payments from our insurance subsidiaries;
o mortality, morbidity, the increased cost and usage of health care
services, persistency, the adequacy of our previous reserve estimates
and other factors which may affect the profitability of our insurance
products;
o changes in our assumptions related to the cost of policies produced or
the value of policies inforce at the Effective Date;
o the recoverability of our deferred tax assets and the effect of
potential tax rate changes on its value;
o changes in accounting principles and the interpretation thereof;
o our ability to achieve anticipated expense reductions and levels of
operational efficiencies including improvements in claims adjudication
and continued automation and rationalization of operating systems;
o performance and valuation of our investments, including the impact of
realized losses (including other-than-temporary impairment charges);
47
CONSECO, INC. AND SUBSIDIARIES
-------------------
o our ability to identify products and markets in which we can compete
effectively against competitors with greater market share, higher
ratings, greater financial resources and stronger brand recognition;
o the ultimate outcome of lawsuits filed against us and other legal and
regulatory proceedings to which we are subject;
o our ability to complete the remediation of the material weakness in
internal controls over our actuarial reporting process and to maintain
effective controls over financial reporting;
o our ability to continue to recruit and retain productive agents and
distribution partners and customer response to new products,
distribution channels and marketing initiatives;
o our ability to achieve eventual upgrades of the financial strength
ratings of Conseco and our insurance company subsidiaries as well as
the potential impact of rating downgrades on our business;
o the risk factors or uncertainties listed from time to time in our
filings with the SEC;
o regulatory changes or actions, including those relating to regulation
of the financial affairs of our insurance companies, such as the
payment of dividends and surplus debenture interest to us, regulation
of financial services affecting (among other things) bank sales and
underwriting of insurance products, regulation of the sale,
underwriting and pricing of products, and health care regulation
affecting health insurance products; and
o changes in the Federal income tax laws and regulations which may
affect or eliminate the relative tax advantages of some of our
products.
Other factors and assumptions not identified above are also relevant to the
forward-looking statements, and if they prove incorrect, could also cause actual
results to differ materially from those projected.
All written or oral forward-looking statements attributable to us are
expressly qualified in their entirety by the foregoing cautionary statement. Our
forward-looking statements speak only as of the date made. We assume no
obligation to update or to publicly announce the results of any revisions to any
of the forward-looking statements to reflect actual results, future events or
developments, changes in assumptions or changes in other factors affecting the
forward-looking statements.
OVERVIEW
We are a holding company for a group of insurance companies operating
throughout the United States that develop, market and administer supplemental
health insurance, annuity, individual life insurance and other insurance
products. We focus on serving the senior and middle-income markets, which we
believe are attractive, underserved, high growth markets. We sell our products
through three distribution channels: career agents, professional independent
producers (some of whom sell one or more of our product lines exclusively) and
direct marketing.
We manage our business through the following: three primary operating
segments, Bankers Life, Colonial Penn and Conseco Insurance Group, which are
defined on the basis of product distribution; and corporate operations, which
consists of holding company activities and certain noninsurance company
businesses that are not part of our other segments. Prior to the fourth quarter
of 2008, we had a fourth operating segment comprised of other business in
run-off. The other business in run-off segment had included blocks of business
that we no longer market or underwrite and were managed separately from our
other businesses. Such segment had consisted of: (i) long-term care insurance
sold in prior years through independent agents; and (ii) major medical
insurance. As a result of the Transfer, as further discussed in the note
entitled "Transfer of Senior Health Insurance Company of Pennsylvania to an
Independent Trust", a substantial portion of the long-term care business in the
former other business in run-off segment is presented as discontinued operations
in our consolidated financial statements for the three months ended March 31,
2008. Accordingly, we have restated all prior year segment disclosures to
conform to management's current view of the Company's operating segments. Our
segments are described below:
o Bankers Life, which consists of the business of Bankers Life and
Casualty Company, markets and distributes Medicare supplement
insurance, life insurance, long-term care insurance, Medicare Part D
prescription drug
48
CONSECO, INC. AND SUBSIDIARIES
-------------------
program, Medicare Advantage products and certain annuity products to
the senior market through career agents and sales managers. Bankers
Life and Casualty Company markets its products under its own brand
name and Medicare Part D and Medicare Advantage products primarily
through marketing agreements with Coventry.
o Colonial Penn, which consists of the business of Colonial Penn Life
Insurance Company ("Colonial Penn"), markets primarily graded benefit
and simplified issue life insurance directly to customers through
television advertising, direct mail, the internet and telemarketing.
Colonial Penn markets its products under its own brand name.
o Conseco Insurance Group, which markets and distributes specified
disease insurance, Medicare supplement insurance, and certain life and
annuity products to the senior and middle-income markets through
independent marketing organizations that represent independent agents.
This segment markets its products under the "Conseco" and "Washington
National" brand names. Conseco Insurance Group includes the business
of Conseco Health Insurance Company ("Conseco Health"), Conseco Life,
Conseco Insurance Company and Washington National Insurance Company
("Washington National"). This segment also includes blocks of
long-term care and other health business of these companies that we no
longer market or underwrite.
CRITICAL ACCOUNTING POLICIES
Refer to "Critical Accounting Policies" in Conseco's 2008 Annual Report on
Form 10-K for information on our accounting policies that we consider critical
in preparing our consolidated financial statements.
RESULTS OF OPERATIONS
The following tables and narratives summarize the operating results of our
segments for the periods presented (dollars in millions):
Three months ended
March 31,
-----------------------
2009 2008
---- ----
Income (loss) before net realized investment gains (losses), net of related
amortization and income taxes (a non-GAAP measure) (a):
Bankers Life............................................................................. $ 44.7 $ 29.1
Colonial Penn............................................................................ 5.1 3.7
Conseco Insurance Group.................................................................. 31.2 23.3
Corporate operations..................................................................... (31.9) (25.2)
------ ------
49.1 30.9
------ ------
Net realized investment gains (losses), net of related amortization:
Bankers Life............................................................................. (2.4) (16.8)
Colonial Penn............................................................................ .1 (.6)
Conseco Insurance Group.................................................................. 3.2 (8.8)
Corporate operations..................................................................... (7.8) (16.6)
------ ------
(6.9) (42.8)
------ ------
Income (loss) before income taxes:
Bankers Life............................................................................. 42.3 12.3
Colonial Penn............................................................................ 5.2 3.1
Conseco Insurance Group.................................................................. 34.4 14.5
Corporate operations..................................................................... (39.7) (41.8)
------ ------
Income (loss) before income taxes..................................................... $ 42.2 $(11.9)
====== ======
49
<FN>
- --------------------
(a) These non-GAAP measures as presented in the above table and in the
following segment financial data and discussions of segment results
exclude net realized investment gains (losses), net of related
amortization and before income taxes. These are considered non-GAAP
financial measures. A non-GAAP measure is a numerical measure of a
company's performance, financial position, or cash flows that excludes
or includes amounts that are normally excluded or included in the most
directly comparable measure calculated and presented in accordance
with GAAP.
These non-GAAP financial measures of "income (loss) before net
realized investment gains (losses), net of related amortization, and
before income taxes" differ from "income (loss) before income taxes"
as presented in our consolidated statement of operations prepared in
accordance with GAAP due to the exclusion of before tax realized
investment gains (losses), net of related amortization. We measure
segment performance for purposes of SFAS 131, excluding realized
investment gains (losses) because we believe that this performance
measure is a better indicator of the ongoing businesses and trends in
our business. Our primary investment focus is on investment income to
support our liabilities for insurance products as opposed to the
generation of realized investment gains (losses), and a long-term
focus is necessary to maintain profitability over the life of the
business. Realized investment gains (losses) depend on market
conditions and do not necessarily relate to decisions regarding the
underlying business of our segments. However, "income (loss) before
net realized investment gains (losses), net of related amortization,
and before income taxes" does not replace "income (loss) before income
taxes" as a measure of overall profitability. We may experience
realized investment gains (losses), which will affect future earnings
levels since our underlying business is long-term in nature and we
need to earn the assumed interest rates on the investments backing our
liabilities for insurance products to maintain the profitability of
our business. In addition, management uses this non-GAAP financial
measure in its budgeting process, financial analysis of segment
performance and in assessing the allocation of resources. We believe
these non-GAAP financial measures enhance an investor's understanding
of our financial performance and allows them to make more informed
judgments about the Company as a whole. These measures also highlight
operating trends that might not otherwise be transparent. The table
above reconciles the non-GAAP measure to the corresponding GAAP
measure.
</FN>
General: Conseco is the top tier holding company for a group of insurance
companies operating throughout the United States that develop, market and
administer supplemental health insurance, annuity, individual life insurance and
other insurance products. We distribute these products through our Bankers Life
segment, which utilizes a career agency force, through our Colonial Penn
segment, which utilizes direct response marketing and through our Conseco
Insurance Group segment, which utilizes professional independent producers.
50
CONSECO, INC. AND SUBSIDIARIES
-------------------
Bankers Life (dollars in millions):
Three months ended
March 31,
---------------------
2009 2008
---- ----
Premium collections:
Annuities............................................................................ $ 302.1 $ 228.7
Supplemental health.................................................................. 423.8 435.5
Life................................................................................. 48.9 48.0
--------- ---------
Total collections.................................................................. $ 774.8 $ 712.2
========= =========
Average liabilities for insurance products:
Annuities:
Mortality based.................................................................. $ 252.9 $ 250.3
Equity-indexed................................................................... 1,426.4 1,043.6
Deposit based.................................................................... 4,678.2 4,445.9
Health............................................................................... 4,050.4 3,768.1
Life:
Interest sensitive............................................................... 397.6 380.1
Non-interest sensitive........................................................... 396.5 335.9
--------- ---------
Total average liabilities for insurance
products, net of reinsurance ceded............................................. $11,202.0 $10,223.9
========= =========
Revenues:
Insurance policy income.............................................................. $ 491.5 $ 497.0
Net investment income:
General account invested assets.................................................... 155.4 149.4
Equity-indexed products............................................................ (13.5) (17.3)
Other special-purpose portfolios................................................... .3 (2.8)
Fee revenue and other income......................................................... 1.4 1.6
------- -------
Total revenues................................................................... 635.1 627.9
------- -------
Expenses:
Insurance policy benefits............................................................ 429.6 434.9
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than equity-indexed products............................................... 45.9 44.2
Equity-indexed products............................................................ (8.3) .6
Amortization related to operations................................................... 75.6 75.0
Other operating costs and expenses................................................... 47.6 44.1
------- -------
Total expenses................................................................... 590.4 598.8
------- -------
Income before net realized investment losses, net of related
amortization and income taxes.......................................................... 44.7 29.1
------- -------
Net realized investment losses....................................................... (1.9) (19.3)
Amortization related to net realized investment losses............................... (.5) 2.5
------- -------
Net realized investment losses, net of related
amortization .................................................................. (2.4) (16.8)
------- -------
Income before income taxes................................................................ $ 42.3 $ 12.3
======= =======
(continued)
51
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Three months ended
March 31,
---------------------
2009 2008
---- ----
Health benefit ratios:
All health lines:
Insurance policy benefits............................................................ $390.1 $390.1
Benefit ratio (a).................................................................... 88.9% 89.4%
Medicare supplement:
Insurance policy benefits............................................................ $116.0 $104.3
Benefit ratio (a).................................................................... 70.2% 64.6%
PDP and PFFS:
Insurance policy benefits............................................................ $115.7 $111.5
Benefit ratio (a).................................................................... 94.4% 93.9%
Long-term care:
Insurance policy benefits............................................................ $158.4 $174.3
Benefit ratio (a).................................................................... 105.1% 111.6%
Interest-adjusted benefit ratio (b).................................................. 68.6% 79.0%
<FN>
--------------------
(a) We calculate benefit ratios by dividing the related product's insurance
policy benefits by insurance policy income.
(b) We calculate the interest-adjusted benefit ratio (a non-GAAP measure)
for Bankers Life's long-term care products by dividing such product's
insurance policy benefits less interest income on the accumulated assets
backing the insurance liabilities by policy income. These are considered
non-GAAP financial measures. A non-GAAP measure is a numerical measure
of a company's performance, financial position, or cash flows that
excludes or includes amounts that are normally excluded or included in
the most directly comparable measure calculated and presented in
accordance with GAAP.
These non-GAAP financial measures of "interest-adjusted benefit ratios"
differ from "benefit ratios" due to the deduction of interest income on
the accumulated assets backing the insurance liabilities from the
product's insurance policy benefits used to determine the ratio.
Interest income is an important factor in measuring the performance of
health products that are expected to be inforce for a longer duration of
time, are not subject to unilateral changes in provisions (such as
non-cancelable or guaranteed renewable contracts) and require the
performance of various functions and services (including insurance
protection) for an extended period of time. The net cash flows from
long-term care products generally cause an accumulation of amounts in
the early years of a policy (accounted for as reserve increases) that
will be paid out as benefits in later policy years (accounted for as
reserve decreases). Accordingly, as the policies age, the benefit ratio
will typically increase, but the increase in benefits will be partially
offset by interest income earned on the accumulated assets. The
interest-adjusted benefit ratio reflects the effects of the interest
income offset. Since interest income is an important factor in measuring
the performance of this product, management believes a benefit ratio
that includes the effect of interest income is useful in analyzing
product performance. We utilize the interest-adjusted benefit ratio in
measuring segment performance for purposes of SFAS 131 because we
believe that this performance measure is a better indicator of the
ongoing businesses and trends in the business. However, the
"interest-adjusted benefit ratio" does not replace the "benefit ratio"
as a measure of current period benefits to current period insurance
policy income. Accordingly, management reviews both "benefit ratios" and
"interest-adjusted benefit ratios" when analyzing the financial results
attributable to these products. The investment income earned on the
accumulated assets backing Bankers Life's long-term care reserves was
$55.0 million and $50.9 million in the three months ended March 31, 2009
and 2008, respectively.
</FN>
Total premium collections were $774.8 million in the first quarter of 2009,
up 8.8 percent from 2008. Premium collections include $119.2 million and $116.4
million in the first quarters of 2009 and 2008, respectively, of premiums
collected pursuant to the quota-share agreements with Coventry. See "Premium
Collections" for further analysis of Bankers Life's premium collections.
52
CONSECO, INC. AND SUBSIDIARIES
-------------------
Average liabilities for insurance products, net of reinsurance ceded were
$11.2 billion in the first quarter of 2009, up 9.6 percent from 2008. The
increase in such liabilities was primarily due to increases in annuity and
health reserves resulting from new sales of these products.
Insurance policy income is comprised of premiums earned on policies which
provide mortality or morbidity coverage and fees and other charges assessed on
other policies. Insurance policy income includes $122.6 million and $118.7
million in the first quarters of 2009 and 2008, respectively, of premium income
from the quota-share agreements with Coventry.
Net investment income on general account invested assets (which excludes
income on policyholder accounts) was $155.4 million in the first quarter of
2009, up 4.0 percent from 2008. The average balance of general account invested
assets was $11.1 billion and $10.4 billion in the first quarters of 2009 and
2008, respectively. The average yield on these assets was 5.59 percent and 5.76
percent in the third quarters of 2009 and 2008, respectively. The increase in
general account invested assets is primarily due to sales of our annuity and
health products in recent periods. The reduction in average yield reflects a
higher amount of investments in shorter-term investments with lower yields in
the first quarter of 2009.
Net investment income related to equity-indexed products represents the
change in the estimated fair value of options which are purchased in an effort
to hedge certain potential benefits accruing to the policyholders of our
equity-indexed products. Our equity-indexed products are designed so that the
investment income spread earned on the related insurance liabilities is expected
to be more than adequate to cover the cost of the options and other costs
related to these policies. Net investment losses related to equity-indexed
products were $10.9 million and $21.1 million in the first quarters of 2009 and
2008, respectively. Net investment income related to equity-indexed products
also includes income (loss) on trading securities which are held to act as
hedges for embedded derivatives related to equity-indexed products. Such trading
account income (loss) was $(2.6) million and $3.8 million in the first quarters
of 2009 and 2008, respectively. Such amounts are generally offset by the
corresponding charge (credit) to amounts added to policyholder account balances
for equity-indexed products based on the change in value of the indices. Such
income and related charges fluctuate based on the value of options embedded in
the segment's equity-indexed annuity policyholder account balances subject to
this benefit and to the performance of the index to which the returns on such
products are linked.
Our results in the first three months of 2009 and 2008, were affected by a
reduction to earnings of $7 million and $12 million, respectively, related to
equity-indexed annuity products (such variance primarily resulted from the
change in the value of the embedded derivative related to future indexed
benefits reported at estimated fair value in accordance with accounting
requirements, including a $2.0 million charge in the first quarter of 2008
related to the adoption of SFAS 157).
Net investment income on other special-purpose portfolios includes the
income related to Company-owned life insurance ("COLI") which was purchased as
an investment vehicle to fund the deferred compensation plan for certain agents.
The COLI assets are not assets of the deferred compensation plan, and as a
result, are accounted for outside the plan and are recorded in the consolidated
balance sheet as other invested assets. Changes in the cash surrender value
(which approximates net realizable value) of the COLI assets are recorded as net
investment income (loss) and totaled $.3 million and $(2.8) million in the first
quarters of 2009 and 2008, respectively.
Insurance policy benefits fluctuated as a result of the factors summarized
below for benefit ratios. Benefit ratios are calculated by dividing the related
insurance product's insurance policy benefits by insurance policy income.
The Medicare supplement business consists of both individual and group
policies. Governmental regulations generally require us to attain and maintain a
ratio of total benefits incurred to total premiums earned (excluding changes in
policy benefit reserves), after three years from the original issuance of the
policy and over the lifetime of the policy, of not less than 65 percent on
individual products and not less than 75 percent on group products, as
determined in accordance with statutory accounting principles. Since the
insurance product liabilities we establish for Medicare supplement business are
subject to significant estimates, the ultimate claim liability we incur for a
particular period is likely to be different than our initial estimate. Our
insurance policy benefits reflected reserve redundancies (deficiencies) from
prior years of $(1.3) million and $3.9 million in the first three months of 2009
and 2008, respectively. Excluding the effects of prior period claim reserve
redundancies, our benefit ratios would have been 69.4 percent and 67.1 percent
in the first three months of 2009 and 2008, respectively.
53
CONSECO, INC. AND SUBSIDIARIES
-------------------
The insurance policy benefits on our prescription drug plan ("PDP") and
PFFS business result from our quota-share reinsurance agreements with Coventry.
We began assuming the PDP business on January 1, 2006 and the PFFS business on
January 1, 2007. During 2007 and 2008, we entered into new PFFS quota-share
reinsurance agreements to assume a specified percentage of the business written
by Coventry under three group policies. In order to reduce the required
statutory capital associated with the assumption of this business, Conseco
terminated two group policy quota-share agreements as of December 31, 2008 and
will terminate the last agreement on June 30, 2009. Our benefit ratio on this
block has increased in the first quarter of 2009 due to declining margins on
this block. Although our first quarter of 2009 results reflected redundancies of
$7.3 million in the insurance liability for incurred but not reported claims
established at December 31, 2008, this favorable variance was more than offset
by unfavorable experience in the first quarter of 2009.
The net cash flows from our long-term care products generally cause an
accumulation of amounts in the early years of a policy (accounted for as reserve
increases) which will be paid out as benefits in later policy years (accounted
for as reserve decreases). Accordingly, as the policies age, the benefit ratio
typically increases, but the increase in reserves is partially offset by
investment income earned on the accumulated assets. The benefit ratio on this
business has increased over the last year, consistent with the aging of this
block. In addition, the older policies have not lapsed at the rate we assumed in
our pricing. The benefit ratio on our entire block of long-term care business in
the Bankers Life segment was 105.1 percent and 111.6 percent in the first
quarters of 2009 and 2008, respectively. The interest-adjusted benefit ratio on
this business was 68.6 percent and 79.0 percent in the first quarters of 2009
and 2008, respectively. Since the insurance product liabilities we establish for
long-term care business are subject to significant estimates, the ultimate claim
liability we incur for a particular period is likely to be different than our
initial estimate. Our insurance policy benefits reflected reserve deficiencies
from prior years of $1.6 million and $2.7 million in the first three months of
2009 and 2008, respectively. Excluding the effects of prior year claim reserve
deficiencies, our benefit ratios would have been 104.0 percent and 109.9 percent
in the first three months of 2009 and 2008, respectively. The benefit ratio for
the first three months of 2009 reflected a reduction in liabilities for
insurance products of approximately $14.5 million due to: (i) a reduction in
liabilities for policyholders choosing to lapse their policies rather than
paying higher rates; (ii) a reduction in liabilities for policyholders choosing
to reduce their coverages to achieve a lower cost; offset by (iii) an increase
in the reserves related to waiver of premium benefits to reflect the higher
premiums after the rate increase. The aforementioned reduction in liabilities
was partially offset by increased amortization of insurance intangibles of $4.1
million resulting from the increase in lapses. When policies lapse, active life
reserves for such lapsed policies are released, resulting in decreased insurance
policy benefits (although such decrease is somewhat offset by additional
amortization expense).
As a result of higher persistency in our long-term care block in the
Bankers Life segment than assumed in the original pricing, our premium rates
were too low. Accordingly, we began a program in 2006 to seek approval from
regulatory authorities for rate increases on approximately 65 percent of this
block. As an alternative to the rate increase, policyholders were offered the
option: (i) to reduce their benefits to maintain their previous premium rates;
or (ii) to choose a nonforfeiture benefit equal to the sum of accumulated
premiums paid less claims received. We have received all expected regulatory
approvals and have implemented these rate increases. In addition, another round
of increases was filed during the second and third quarters of 2007 on newer
long-term care, home health care, and short-term care policies not included in
the first round of rate increases. The policies in this round represent
approximately 25 percent of the inforce block. As of March 31, 2009, all such
filings had been submitted for regulatory approval, and approximately 65 percent
of the rate increases had been approved by regulators and implemented. Remaining
approvals and implementations are expected to occur over the next six months.
Finally, an additional rate increase on the 65 percent of the block that
received an increase in 2006 was filed in the third quarter of 2008. As of March
31, 2009, approximately 94 percent of the rate increases had been approved by
regulators and implemented. The remaining approvals and implementations of this
rate increase are expected to occur by the end of 2009.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $45.9 million in the first quarter of
2009, up 3.8 percent from 2008. The weighted average crediting rate for these
products was 3.6 percent in both the first quarters of 2009 and 2008.
Amounts added to equity-indexed products based on change in value of the
indices fluctuated with the corresponding related investment income accounts
described above.
Amortization related to operations includes amortization of insurance
acquisition costs. Insurance acquisition costs are generally amortized either:
(i) in relation to the estimated gross profits for universal life and
investment-type products; or (ii) in relation to actual and expected premium
revenue for other products. In addition, for universal life and investment-type
54
CONSECO, INC. AND SUBSIDIARIES
-------------------
products, we are required to adjust the total amortization recorded to date
through the statement of operations if actual experience or other evidence
suggests that earlier estimates of future gross profits should be revised.
Accordingly, amortization for universal life and investment-type products is
dependent on the profits realized during the period and on our expectation of
future profits. For other products, we amortize insurance acquisition costs in
relation to actual and expected premium revenue, and amortization is only
adjusted if expected premium revenue changes or if we determine the balance of
these costs is not recoverable from future profits. Bankers Life's amortization
expense was $75.6 million and $75.0 million in the first quarters of 2009 and
2008, respectively. We limit the total amortization adjustments resulting from
losses on a block of business issued in a particular year to an amount which
would not result in the balance of insurance acquisition costs exceeding the
total of costs capitalized plus interest. During the first three months of 2009,
amortization expense related to annuities issued in 2008 decreased by $5.2
million due to a reduction in such limitation. During the first three months of
2008, we experienced higher lapses than we anticipated on our Medicare
supplement products. These lapses reduced our estimates of future expected
premium income and, accordingly, we recognized additional amortization expense
of $12.2 million in the first three months of 2008. We believe such increases
were partially related to competition from Medicare Advantage products.
Other operating costs and expenses in our Bankers Life segment were $47.6
million in the first quarter of 2009, up 7.9 percent from 2008. Other operating
costs and expenses include the following (dollars in millions):
Three months ended
March 31,
-----------------------
2009 2008
---- ----
Expenses related to the marketing and quota-share
agreements with Coventry........................................................ $ 8.0 $ 8.4
Commission expense................................................................. 4.0 4.9
Other operating expenses........................................................... 35.6 30.8
----- -----
Total........................................................................... $47.6 $44.1
===== =====
Net realized investment losses fluctuate each period. During the first
three months of 2009, net realized investment losses in this segment included
$43.8 million of net gains from the sales of investments (primarily fixed
maturities), net of $45.7 million of writedowns of investments resulting from
declines in fair values that we concluded were other than temporary. During the
first three months of 2008, net realized investment losses in this segment
included $1.9 million of net gains from the sales of investments (primarily
fixed maturities), net of $21.2 million of writedowns of investments resulting
from declines in fair value that we concluded were other than temporary.
Amortization related to net realized investment losses is the increase or
decrease in the amortization of insurance acquisition costs which results from
realized investment gains or losses. When we sell securities which back our
universal life and investment-type products at a gain (loss) and reinvest the
proceeds at a different yield, we increase (reduce) the amortization of
insurance acquisition costs in order to reflect the change in estimated gross
profits due to the gains (losses) realized and the resulting effect on estimated
future yields. Sales of fixed maturity investments resulted in an increase
(decrease) in the amortization of insurance acquisition costs of $.5 million and
$(2.5) million in the first quarters of 2009 and 2008, respectively.
55
CONSECO, INC. AND SUBSIDIARIES
-------------------
Colonial Penn (dollars in millions)
Three months ended
March 31,
---------------------
2009 2008
---- ----
Premium collections:
Life................................................................................. $ 47.0 $ 42.9
Supplemental health.................................................................. 1.9 2.3
------- ------
Total collections.................................................................. $ 48.9 $ 45.2
====== ======
Average liabilities for insurance products:
Annuities-mortality based............................................................ $ 83.4 $ 87.2
Health............................................................................... 19.7 21.5
Life:
Interest sensitive............................................................... 24.1 25.0
Non-interest sensitive........................................................... 568.6 561.4
------ ------
Total average liabilities for insurance
products, net of reinsurance ceded.......................................... $695.8 $695.1
====== ======
Revenues:
Insurance policy income.............................................................. $ 47.1 $ 44.4
Net investment income:
General account invested assets.................................................... 9.8 9.7
Trading account income related to reinsurer
accounts......................................................................... - (.5)
Fee revenue and other income......................................................... .2 .3
------ ------
Total revenues................................................................... 57.1 53.9
------ ------
Expenses:
Insurance policy benefits............................................................ 36.1 35.0
Amounts added to annuity and interest-sensitive life
product account balances......................................................... .3 .3
Amortization related to operations................................................... 8.4 7.4
Other operating costs and expenses................................................... 7.2 7.5
------ ------
Total expenses................................................................... 52.0 50.2
------ ------
Income before net realized investment gains (losses) and
income taxes........................................................................... 5.1 3.7
Net realized investment gains (losses)............................................. .1 (.6)
------ ------
Income before income taxes................................................................ $ 5.2 $ 3.1
====== ======
Total premium collections were $48.9 million in the first quarter of 2009,
up 8.2 percent from 2008. See "Premium Collections" for further analysis of
Colonial Penn's premium collections.
Insurance policy income is comprised of premiums earned on policies which
provide mortality or morbidity coverage and fees and other charges assessed on
other policies. The increase in the 2009 period reflects the growth in this
segment. See "Premium Collections" for further analysis.
56
CONSECO, INC. AND SUBSIDIARIES
-------------------
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) was $9.8 million in the first
quarter of 2009, up 1.0 percent from 2008. The average balance of general
account invested assets was $660.4 million and $678.9 million in the first
quarters of 2009 and 2008, respectively. The average yield on these assets was
5.93 percent and 5.75 percent in the first quarters of 2009 and 2008,
respectively.
Trading account income related to reinsurer accounts represents the income
on trading securities, which were designed to act as hedges for embedded
derivatives related to a modified coinsurance agreement. The income on our
trading account securities was designed to be substantially offset by the change
in value of embedded derivatives related to a modified coinsurance agreement. As
a result of the recapture of a modified coinsurance agreement in the fourth
quarter of 2007, such trading account securities were sold in the first quarter
of 2008.
Insurance policy benefits fluctuated as a result of the growth in this
segment in recent periods.
Amortization related to operations includes amortization of insurance
acquisition costs. Insurance acquisition costs in the Colonial Penn segment are
amortized in relation to actual and expected premium revenue, and amortization
is only adjusted if expected premium revenue changes or if we determine the
balance of these costs is not recoverable from future profits. Such amounts were
generally consistent with the related premium revenue and gross profits for such
periods and the assumptions we made when we established the value of policies
inforce as of the Effective Date. A revision to our current assumptions could
result in increases or decreases to amortization expense in future periods.
Other operating costs and expenses in our Colonial Penn segment decreased
by 4.0 percent, to $7.2 million, in the first quarter of 2009 as compared to the
same period in 2008.
Net realized investment gains (losses) fluctuate each period. During the
first three months of 2009, net realized investment gains (losses) in this
segment included $3.2 million of net gains from the sales of investments
(primarily fixed maturities), net of $3.1 million of writedowns of investments
resulting from declines in fair values that we concluded were other than
temporary. During the first three months of 2008, net realized investment losses
in this segment included $.3 million of net gains from the sales of investments
(primarily fixed maturities), net of $.9 million of writedowns of investments
resulting from declines in fair values that we concluded were other than
temporary.
57
CONSECO, INC. AND SUBSIDIARIES
-------------------
Conseco Insurance Group (dollars in millions):
Three months ended
March 31,
-----------------------
2009 2008
---- ----
Premium collections:
Annuities............................................................................ $ 19.5 $ 41.6
Supplemental health.................................................................. 146.2 158.5
Life................................................................................. 64.4 71.9
-------- --------
Total collections.................................................................. $ 230.1 $ 272.0
======== ========
Average liabilities for insurance products:
Annuities:
Mortality based.................................................................... $ 217.2 $ 223.5
Equity-indexed..................................................................... 836.5 889.9
Deposit based...................................................................... 688.8 788.4
Separate accounts.................................................................. 17.6 26.2
Health............................................................................... 2,991.9 2,978.0
Life:
Interest sensitive................................................................. 2,906.2 2,963.0
Non-interest sensitive............................................................. 1,360.2 1,420.7
-------- --------
Total average liabilities for insurance products,
net of reinsurance ceded....................................................... $9,018.4 $9,289.7
======== ========
Revenues:
Insurance policy income................................................................ $ 244.2 $ 243.7
Net investment income:
General account invested assets...................................................... 143.4 149.4
Equity-indexed products.............................................................. (7.0) (10.5)
Trading account income related to policyholder and
reinsurer accounts................................................................. (2.3) (4.2)
Change in value of embedded derivatives related to
modified coinsurance agreements.................................................... .2 1.4
Fee revenue and other income........................................................... .7 .8
-------- --------
Total revenues..................................................................... 379.2 380.6
-------- --------
Expenses:
Insurance policy benefits.............................................................. 214.1 209.1
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life products
other than equity-indexed products................................................. 36.0 40.5
Equity-indexed products.............................................................. (.2) 3.1
Amortization related to operations..................................................... 36.8 30.2
Interest expense on investment borrowings.............................................. 5.2 5.8
Other operating costs and expenses..................................................... 56.1 68.6
-------- --------
Total expenses..................................................................... 348.0 357.3
-------- --------
Income before net realized investment gains (losses), net of
related amortization and income taxes.................................................. 31.2 23.3
-------- --------
Net realized investment gains (losses)................................................. 2.7 (9.1)
Amortization related to net realized investment gains (losses)......................... .5 .3
-------- --------
Net realized investment gains (losses), net of related
amortization..................................................................... 3.2 (8.8)
-------- --------
Income before income taxes................................................................ $ 34.4 $ 14.5
======== ========
(continued)
58
CONSECO, INC. AND SUBSIDIARIES
-------------------
(continued from previous page)
Three months ended
March 31,
-----------------------
2009 2008
---- ----
Health benefit ratios:
All health lines:
Insurance policy benefits......................................................... $122.7 $124.9
Benefit ratio (a)................................................................. 81.0% 79.5%
Medicare supplement:
Insurance policy benefits......................................................... $31.9 $35.3
Benefit ratio (a)................................................................. 67.3% 65.8%
Specified disease:
Insurance policy benefits......................................................... $71.3 $75.2
Benefit ratio (a)................................................................. 76.0% 81.7%
Interest-adjusted benefit ratio (b)............................................... 42.2% 48.1%
Long-term care:
Insurance policy benefits......................................................... $17.4 $12.1
Benefit ratio (a)................................................................. 210.1% 136.4%
Interest-adjusted benefit ratio (b)............................................... 132.0% 66.4%
Other:
Insurance policy benefits......................................................... $2.1 $2.3
Benefit ratio(a).................................................................. 98.8% 87.5%
<FN>
- --------------------
(a) We calculate benefit ratios by dividing the related product's insurance
policy benefits by insurance policy income.
(b) We calculate the interest-adjusted benefit ratio (a non-GAAP measure)
for Conseco Insurance Group's specified disease and long-term care
products by dividing such product's insurance policy benefits less
interest income on the accumulated assets backing the insurance
liabilities by policy income. These are considered non-GAAP financial
measures. A non-GAAP measure is a numerical measure of a company's
performance, financial position, or cash flows that excludes or includes
amounts that are normally excluded or included in the most directly
comparable measure calculated and presented in accordance with GAAP.
These non-GAAP financial measures of "interest-adjusted benefit ratios"
differ from "benefit ratios" due to the deduction of interest income on
the accumulated assets backing the insurance liabilities from the
product's insurance policy benefits used to determine the ratio.
Interest income is an important factor in measuring the performance of
health products that are expected to be inforce for a longer duration of
time, are not subject to unilateral changes in provisions (such as
non-cancelable or guaranteed renewable contracts) and require the
performance of various functions and services (including insurance
protection) for an extended period of time. The net cash flows from
specified disease and long-term care products generally cause an
accumulation of amounts in the early years of a policy (accounted for as
reserve increases) that will be paid out as benefits in later policy
years (accounted for as reserve decreases). Accordingly, as the policies
age, the benefit ratio will typically increase, but the increase in
benefits will be partially offset by interest income earned on the
accumulated assets. The interest-adjusted benefit ratio reflects the
effects of the interest income offset. Since interest income is an
important factor in measuring the performance of these products,
management believes a benefit ratio that includes the effect of interest
income is useful in analyzing product performance. We utilize the
interest-adjusted benefit ratio in measuring segment performance for
purposes of SFAS 131 because we believe that this performance measure is
a better indicator of the ongoing businesses and trends in the business.
However, the "interest-adjusted benefit ratio" does not replace the
"benefit ratio" as a measure of current period benefits to current
period insurance policy income. Accordingly, management reviews both
"benefit ratios" and "interest-adjusted benefit ratios" when analyzing
the financial results attributable to these products. The investment
income earned on the accumulated
59
CONSECO, INC. AND SUBSIDIARIES
-------------------
assets backing the specified disease reserves was $31.7 million and
$30.9 million in the three months ended March 31, 2009 and 2008,
respectively. The investment income earned on the accumulated assets
backing the long-term care reserves was $6.4 million and $6.2 million in
the three months ended March 31, 2009 and 2008, respectively.
</FN>
Total premium collections were $230.1 million in the first quarter of 2009,
down 15 percent from 2008. The decrease in collected premiums was primarily due
to lower equity-indexed annuity sales as we changed the pricing of specific
products and no longer emphasized the sale of certain products since the second
half of 2007. See "Premium Collections" for further analysis.
Average liabilities for insurance products, net of reinsurance ceded were
$9.0 billion in the first quarter of 2009, down 2.9 percent from 2008. The
decrease in such liabilities was primarily due to a coinsurance transaction and
policyholder redemptions and lapses exceeding new sales.
Insurance policy income is comprised of premiums earned on traditional
insurance policies which provide mortality or morbidity coverage and fees and
other charges assessed on other policies. The decrease in insurance policy
income is primarily due to lower income from Medicare supplement products due to
lapses exceeding new sales and lower premiums from our life insurance block. See
"Premium Collections" for further analysis.
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) was $143.4 million in the first
quarter of 2009, down 4.0 percent from 2008. The average balance of general
account invested assets was $9.8 billion and $10.1 billion in the first quarters
of 2009 and 2008, respectively. The average yield on these assets was 5.83
percent and 5.90 percent in the first quarters of 2009 and 2008, respectively.
Net investment income related to equity-indexed products represents the
change in the estimated fair value of options which are purchased in an effort
to hedge certain potential benefits accruing to the policyholders of our
equity-indexed products. Our equity-indexed products are designed so that the
investment income spread earned on the related insurance liabilities is expected
to be more than adequate to cover the cost of the options and other costs
related to these policies. Net investment losses related to equity-indexed
products were $4.8 million and $13.3 million in the first quarters of 2009 and
2008, respectively. Net investment income related to equity-indexed products
also includes income (loss) on trading securities which are held to act as
hedges for embedded derivatives related to equity-indexed products. Such trading
account income (loss) was $(2.2) million and $2.8 million in the first quarters
of 2009 and 2008, respectively. Such amounts were mostly offset by the
corresponding charge (credit) to amounts added to policyholder account balances
for equity-indexed products. Such income and related charges fluctuate based on
the value of options embedded in the segment's equity-indexed annuity
policyholder account balances subject to this benefit and to the performance of
the indices to which the returns on such products are linked.
Our results for the first quarters of 2009 and 2008 were affected by a
reduction to earnings of $1.0 million and $2.0 million, respectively, related to
equity-indexed annuity products (such variance primarily resulted from the
change in the value of the embedded derivative related to future indexed
benefits reported at estimated fair value in accordance with accounting
requirements, including a $.8 million charge in the first quarter of 2008
related to the adoption of SFAS 157).
Trading account income related to policyholder and reinsurer accounts
represents the income on trading securities which are held to act as hedges for
embedded derivatives related to certain modified coinsurance agreements. In
addition, such income includes the income on investments backing the market
strategies of certain annuity products which provide for different rates of cash
value growth based on the experience of a particular market strategy. The income
on our trading account securities is designed to substantially offset: (i) the
change in value of embedded derivatives related to modified coinsurance
agreements described below; and (ii) certain amounts included in insurance
policy benefits related to the aforementioned annuity products.
Change in value of embedded derivatives related to modified coinsurance
agreements is described in the note to our consolidated financial statements
entitled "Accounting for Derivatives." We have transferred the specific block of
investments related to these agreements to our trading securities account, which
we carry at estimated fair value with changes in such value recognized as
trading account income. The change in the value of the embedded derivatives has
largely been offset by the change in value of the trading securities.
60
CONSECO, INC. AND SUBSIDIARIES
-------------------
Insurance policy benefits were affected by a number of items as summarized
below.
Insurance margins (insurance policy income less insurance policy benefits)
related to life products were $(4.2) million and $.3 million in the first three
months of 2009 and 2008, respectively. Such fluctuations are primarily due to
changes in mortality. Earnings on our universal life products, which comprise a
significant part of this block, are subject to volatility since our insurance
acquisition costs are equal to the value of future estimated gross profits.
Accordingly, the entire difference between our assumptions and actual experience
is generally reflected in earnings in the period such differences occur. The
margin in the first quarter of 2009 also reflected the release of liabilities
for insurance products of $2.5 million in the first quarter of 2009 due to
refinements in the calculation of such liabilities for a block of policies.
Insurance policy benefits also fluctuated as a result of the factors
summarized below for benefit ratios. Benefit ratios are calculated by dividing
the related insurance product's insurance policy benefits by insurance policy
income.
The benefit ratios on Conseco Insurance Group's Medicare supplement
products were impacted by an increase in policyholder lapses following our
premium rate increase actions and competition from companies offering Medicare
Advantage products. We establish active life reserves for these policies, which
are in addition to amounts required for incurred claims. When policies lapse,
active life reserves for such lapsed policies are released, resulting in
decreased insurance policy benefits (although such decrease is substantially
offset by additional amortization expense). In addition, the insurance product
liabilities we establish for our Medicare supplement business are subject to
significant estimates and the ultimate claim liability we incur for a particular
period is likely to be different than our initial estimate. Our insurance policy
benefits reflected claim reserve redundancies from prior years of $2.9 million
and $2.0 million in the first three months of 2009 and 2008, respectively.
Excluding the effects of prior year claim reserve redundancies, our benefit
ratios for the Medicare supplement block would have been 73.5 percent and 69.6
percent in the first three months of 2009 and 2008, respectively. Governmental
regulations generally require us to attain and maintain a ratio of total
benefits incurred to total premiums earned (excluding changes in policy benefit
reserves), after three years from the original issuance of the policy and over
the lifetime of the policy, of not less than 65 percent on these products, as
determined in accordance with statutory accounting principles. Insurance margins
(insurance policy income less insurance policy benefits) on these products were
$15.4 million and $18.3 million in the first quarters of 2009 and 2008,
respectively. Such decrease is primarily due to lower sales and higher incurred
claims.
Conseco Insurance Group's specified disease products generally provide
fixed or limited benefits. For example, payments under cancer insurance policies
are generally made directly to, or at the direction of, the policyholder
following diagnosis of, or treatment for, a covered type of cancer.
Approximately three-fourths of our specified disease policies inforce (based on
policy count) are sold with return of premium or cash value riders. The return
of premium rider generally provides that after a policy has been inforce for a
specified number of years or upon the policyholder reaching a specified age, we
will pay to the policyholder, or a beneficiary under the policy, the aggregate
amount of all premiums paid under the policy, without interest, less the
aggregate amount of all claims incurred under the policy. The cash value rider
is similar to the return of premium rider, but also provides for payment of a
graded portion of the return of premium benefit if the policy terminates before
the return of premium benefit is earned. Accordingly, the net cash flows from
these products generally result in the accumulation of amounts in the early
years of a policy (accounted for as reserve increases) which will be paid out as
benefits in later policy years (accounted for as reserve decreases). As the
policies age, the benefit ratio will typically increase, but the increase in
benefits will be partially offset by investment income earned on the accumulated
assets. The benefit ratio will fluctuate depending on the claim experience
during the year. Insurance margins (insurance policy income less insurance
policy benefits) on these products were $22.5 million and $16.8 million in the
first quarters of 2009 and 2008, respectively. The increase in margins in the
2009 period is primarily due to lower incurred claims.
The long-term care policies in this segment generally provide for indemnity
and non-indemnity benefits on a guaranteed renewable or non-cancellable basis.
The benefit ratio on our long-term care policies was 210.1 percent and 136.4
percent in the first quarters of 2009 and 2008, respectively. Benefit ratios are
calculated by dividing the product's insurance policy benefits by insurance
policy income. Since the insurance product liabilities we establish for
long-term care business are subject to significant estimates, the ultimate claim
liability we incur for a particular period is likely to be different than our
initial estimate. Our insurance policy benefits reflected reserve redundancies
(deficiencies) from prior years of $(3.9) million and $3.0 million in the first
quarters of 2009 and 2008, respectively. Excluding the effects of prior year
claim reserve redundancies (deficiencies), our benefit ratios would have been
163.0 percent and 170.3 percent in 2009 and 2008, respectively. These ratios
reflect the level of incurred claims experienced in recent periods, adverse
development on claims
61
CONSECO, INC. AND SUBSIDIARIES
-------------------
incurred in prior periods and decreases in policy income. The prior period
deficiencies have resulted from the impact of paid claim experience being
different than prior estimates, changes in actuarial assumptions and refinements
to claimant data used to determine claim reserves.
The net cash flows from long-term care products generally cause an
accumulation of amounts in the early years of a policy (accounted for as reserve
increases) which will be paid out as benefits in later policy years (accounted
for as reserve decreases). Accordingly, as the policies age, the benefit ratio
will typically increase, but the increase in benefits will be partially offset
by investment income earned on the assets which have accumulated. The
interest-adjusted benefit ratio for long-term care products is calculated by
dividing the insurance product's insurance policy benefits less interest income
on the accumulated assets backing the insurance liabilities by insurance policy
income. The interest-adjusted benefit ratio on this business was 132.0 percent
and 66.4 percent in the first three months of 2009 and 2008, respectively.
Excluding the effects of prior year claim reserve redundancies (deficiencies),
our interest-adjusted benefit ratios would have been 84.8 percent and 100.4
percent in the first three months of 2009 and 2008, respectively.
In each quarterly period, we calculate our best estimate of claim reserves
based on all of the information available to us at that time, which necessarily
takes into account new experience emerging during the period. Our actuaries
estimate these claim reserves using various generally recognized actuarial
methodologies which are based on informed estimates and judgments that are
believed to be appropriate. As additional experience emerges and other data
become available, these estimates and judgments are reviewed and may be revised.
Significant assumptions made in estimating claim reserves for long-term care
policies include expectations about the: (i) future duration of existing claims;
(ii) cost of care and benefit utilization; (iii) interest rate utilized to
discount claim reserves; (iv) claims that have been incurred but not yet
reported; (v) claim status on the reporting date; (vi) claims that have been
closed but are expected to reopen; and (vii) correspondence that has been
received that will ultimately become claims that have payments associated with
them.
The benefit ratios on Conseco Insurance Group's other products are subject
to fluctuations due to the smaller size of these blocks of business.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $36.0 million in the first quarter of
2009, down 11 percent from 2008. The decrease was primarily due to a smaller
block of annuity business inforce due to lapses exceeding new sales in recent
periods. The weighted average crediting rate for these products was 4.1 percent
in both the first three months of 2009 and 2008. In addition, amounts added to
policyholder account balances for annuity products in the first quarter of 2008
includes a $3.0 million out-of-period expense to reflect previously unrecognized
benefits on certain annuity policies.
Amounts added to equity-indexed products generally fluctuate with the
corresponding related investment income accounts described above.
Amortization related to operations includes amortization of insurance
acquisition costs. Insurance acquisition costs are generally amortized either:
(i) in relation to the estimated gross profits for universal life and
investment-type products; or (ii) in relation to actual and expected premium
revenue for other products. In addition, for universal life and investment-type
products, we are required to adjust the total amortization recorded to date
through the statement of operations if actual experience or other evidence
suggests that earlier estimates of future gross profits should be revised.
Accordingly, amortization for universal life and investment-type products is
dependent on the profits realized during the period and on our expectation of
future profits. For other products, we amortize insurance acquisition costs in
relation to actual and expected premium revenue, and amortization is only
adjusted if expected premium revenue changes or if we determine the balance of
these costs is not recoverable from future profits. The assumptions we use to
estimate our future gross profits and premiums involve significant judgment. A
revision to our current assumptions could result in increases or decreases to
amortization expense in future periods.
During the first quarter of 2009, we were required to accelerate the
amortization of insurance acquisition costs due to the experience of a block of
equity-indexed annuities. This block of business experienced higher than
anticipated surrenders during the first quarter of 2009 and we have increased
our expected surrender assumptions in future periods. These annuities also have
a MVA feature, which effectively reduced (or in some cases, eliminated) the
charges paid upon the surrender of these policies in the recent periods as the
10-year treasury rate dropped to historic lows. The impact of both the
historical experience and the projected increased surrender activity and higher
MVA benefits has reduced our expectations on the profitability of the annuity
block of Conseco Insurance Group to approximately break-even. We recognized
additional
62
CONSECO, INC. AND SUBSIDIARIES
-------------------
amortization of approximately $3.1 million in the first quarter of 2009, related
to the actual and expected future changes in the experience of this block. We
continue to hold insurance acquisition costs of approximately $140 million
related to these products, which we determined are recoverable. Results for this
block are expected to exhibit increased volatility in the future, because almost
all of the difference between our assumptions and actual experience will be
reflected in earnings in the period such differences occur.
Interest expense on investment borrowings includes $5.1 million and $5.7
million of interest expense on collateralized borrowings in the first quarters
of 2009 and 2008, respectively, as further described in the note to the
consolidated financial statements entitled "Investment Borrowings".
Other operating costs and expenses were $56.1 million in the first quarter
of 2009, down 18 percent from 2008. Other operating costs and expenses include
commission expense of $18.4 million and $20.0 million in the first quarters of
2009 and 2008, respectively. The decrease in expenses is due to lower litigation
expenses and lower sales and marketing costs.
Net realized investment gains (losses) fluctuate each period. During the
first three months of 2009, net realized investment gains included $37.6 million
of net gains from the sales of investments (primarily fixed maturities), net of
$34.9 million of writedowns of investments resulting from declines in fair
values that we concluded were other than temporary. During the first three
months of 2008, net realized investment losses included $4.7 million of net
gains from the sales of investments (primarily fixed maturities), net of $13.8
million of writedowns of investments resulting from declines in fair values that
we concluded were other than temporary.
Amortization related to net realized investment losses is the increase or
decrease in the amortization of insurance acquisition costs which results from
realized investment gains or losses. When we sell securities which back our
universal life and investment-type products at a gain (loss) and reinvest the
proceeds at a different yield (or when we have the intent to sell the impaired
investments before an anticipated recovery in value occurs), we increase
(reduce) the amortization of insurance acquisition costs in order to reflect the
change in estimated gross profits due to the gains (losses) realized and the
resulting effect on estimated future yields. Sales of fixed maturity investments
resulted in a decrease in the amortization of insurance acquisition costs of $.5
million and $.3 million in the first quarters of 2009 and 2008, respectively.
Corporate Operations (dollars in millions):
Three months ended
March 31,
-----------------------
2009 2008
---- ----
Corporate operations:
Interest expense on corporate debt...................................................... $(13.7) $(18.5)
Net investment income .................................................................. - 1.5
Fee revenue and other income............................................................ .6 1.1
Net operating results of variable interest entity....................................... - 1.5
Expenses related to debt modification................................................... (9.5) -
Other operating costs and expenses...................................................... (9.3) (10.8)
------ ------
Loss before net realized investment losses and
income taxes........................................................................ (31.9) (25.2)
Net realized investment losses.......................................................... (7.8) (16.6)
------ ------
Loss before income taxes.............................................................. $(39.7) $(41.8)
====== ======
Interest expense on corporate debt was impacted by: (i) lower interest
rates on our Second Amended Credit Facility; and (ii) the issuance in November
2008 of the $125 million Senior Note due November 12, 2013 (the "Senior Note").
Our average corporate debt outstanding was $1,329.7 million and $1,195.5 million
during the first three months of 2009 and 2008, respectively. The average
interest rate on our debt was 3.2 percent and 5.2 percent during the first three
months of 2009 and 2008, respectively.
63
CONSECO, INC. AND SUBSIDIARIES
-------------------
Net investment income primarily included income earned on short-term
investments held by the Corporate segment and miscellaneous other income and
fluctuated along with the change in the amount of invested assets in this
segment.
Fee revenue and other income includes: (i) revenues we receive for managing
investments for other companies; and (ii) fees received for marketing insurance
products of other companies. Fee revenue and other income decreased primarily as
a result of a decrease in the market value of investments managed for others,
upon which these fees are based.
Net operating results of variable interest entity represent the operating
results of a VIE. The VIE is consolidated in accordance with FIN 46R. Although
we do not control this entity, we consolidate it because we are the primary
beneficiary. This entity was established to issue securities and use the
proceeds to invest in loans and other permitted assets.
Expenses related to debt modification reflect fees incurred in conjunction
with modifications to our Second Amended Credit Facility as further described in
the note to the consolidated financial statements entitled "Notes Payable -
Direct Corporate Obligations."
Other operating costs and expenses include general corporate expenses, net
of amounts charged to subsidiaries for services provided by the corporate
operations. These amounts fluctuate as a result of expenses such as consulting,
legal and severance costs which often vary from period to period.
Net realized investment losses often fluctuate each period. During the
first three months of 2009, net realized investment losses recognized by a VIE
included: (i) $.5 million of net gains from the sale of investments; net of (ii)
$8.3 million of writedowns due to other-than-temporary declines in value on
certain securities. During the first three months of 2008, net realized
investment losses in this segment included $11.2 million from the sale of
investments (primarily fixed maturities) and $5.4 million of writedowns due to
other-than-temporary declines in value of certain securities. All such realized
investment losses and writedowns in the first quarter of 2008 related to
investments held by a VIE.
PREMIUM COLLECTIONS
In accordance with GAAP, insurance policy income in our consolidated
statement of operations consists of premiums earned for traditional insurance
policies that have life contingencies or morbidity features. For annuity and
universal life contracts, premiums collected are not reported as revenues, but
as deposits to insurance liabilities. We recognize revenues for these products
over time in the form of investment income and surrender or other charges.
Our insurance segments sell products through three primary distribution
channels -- career agents (our Bankers Life segment), direct marketing (our
Colonial Penn segment) and independent producers (our Conseco Insurance Group
segment). Our career agency force in the Bankers Life segment sells primarily
Medicare supplement and long-term care insurance policies, Medicare Part D
contracts, PFFS contracts, life insurance and annuities. These agents visit the
customer's home, which permits one-on-one contact with potential policyholders
and promotes strong personal relationships with existing policyholders. Our
direct marketing distribution channel in the Colonial Penn segment is engaged
primarily in the sale of "graded benefit life" and simplified issue life
insurance policies which are sold directly to the policyholder. Our independent
producer distribution channel in the Conseco Insurance Group segment consists of
a general agency and insurance brokerage distribution system comprised of
independent licensed agents doing business in all fifty states, the District of
Columbia, and certain protectorates of the United States. Independent producers
are a diverse network of independent agents, insurance brokers and marketing
organizations. Our independent producer distribution channel sells primarily
specified disease and Medicare supplement insurance policies, universal life
insurance and annuities.
Agents, insurance brokers and marketing companies who market our products
and prospective purchasers of our products use the financial strength ratings of
our insurance subsidiaries as an important factor in determining whether to
market or purchase. Ratings have the most impact on our annuity,
interest-sensitive life insurance and long-term care products. The current
financial strength ratings of our primary insurance subsidiaries from A.M. Best
Company ("A. M. Best"), S&P and Moody's Investor Services, Inc. ("Moody's") are
"B (Fair)", "BB-" and "Ba2", respectively. For a description of these ratings
and additional information on our ratings, see "Liquidity for Insurance
Operations."
We set premium rates on our health insurance policies based on facts and
circumstances known at the time we issue the policies using assumptions about
numerous variables, including the actuarial probability of a policyholder
incurring a claim, the probable size of the claim, and the interest rate earned
on our investment of premiums. We also consider historical claims
64
CONSECO, INC. AND SUBSIDIARIES
-------------------
information, industry statistics, the rates of our competitors and other
factors. If our actual claims experience is less favorable than we anticipated
and we are unable to raise our premium rates, our financial results may be
adversely affected. We generally cannot raise our health insurance premiums in
any state until we obtain the approval of the state insurance regulator. We
review the adequacy of our premium rates regularly and file rate increases on
our products when we believe such rates are too low. It is likely that we will
not be able to obtain approval for all requested premium rate increases. If such
requests are denied in one or more states, our net income may decrease. If such
requests are approved, increased premium rates may reduce the volume of our new
sales and may cause existing policyholders to lapse their policies. If the
healthier policyholders allow their policies to lapse, this would reduce our
premium income and profitability in the future.
Total premium collections by segment were as follows:
Bankers Life (dollars in millions):
Three months ended
March 31,
---------------------
2009 2008
---- ----
Premiums collected by product:
Annuities:
Equity-indexed (first-year)............................................................ $ 73.1 $132.3
------ ------
Other fixed (first-year)............................................................... 228.0 95.3
Other fixed (renewal).................................................................. 1.0 1.1
------ ------
Subtotal - other fixed annuities..................................................... 229.0 96.4
------ ------
Total annuities...................................................................... 302.1 228.7
------ ------
Supplemental health:
Medicare supplement (first-year)....................................................... 19.7 19.1
Medicare supplement (renewal).......................................................... 136.1 140.8
------ ------
Subtotal - Medicare supplement....................................................... 155.8 159.9
------ ------
Long-term care (first-year)............................................................ 4.2 11.0
Long-term care (renewal)............................................................... 141.7 145.6
------ ------
Subtotal - long-term care............................................................ 145.9 156.6
------ ------
PDP and PFFS (first year).............................................................. 16.2 70.4
PDP and PFFS (renewal)................................................................. 103.0 46.0
------ ------
Subtotal - PDP and PFFS.............................................................. 119.2 116.4
------ ------
Other health (first-year).............................................................. .6 .4
Other health (renewal)................................................................. 2.3 2.2
------ ------
Subtotal - other health.............................................................. 2.9 2.6
------ ------
Total supplemental health............................................................ 423.8 435.5
------ ------
Life insurance:
First-year............................................................................. 16.8 18.5
Renewal................................................................................ 32.1 29.5
------ ------
Total life insurance................................................................. 48.9 48.0
------ ------
Collections on insurance products:
Total first-year premium collections on insurance
products............................................................................. 358.6 347.0
Total renewal premium collections on insurance
products............................................................................. 416.2 365.2
------ ------
Total collections on insurance products.............................................. $774.8 $712.2
====== ======
65
CONSECO, INC. AND SUBSIDIARIES
-------------------
Annuities in this segment include equity-indexed and other fixed annuities
sold to the senior market through our career agents. Annuity collections in this
segment increased 32 percent, to $302.1 million, in the first quarter of 2009,
as compared to the same period in 2008. Premium collections from our
equity-indexed products declined due to declines in the stock market. Premium
collections from our fixed annuity products increased due to volatility in the
financial markets which made these products more attractive to customers.
Supplemental health products include Medicare supplement, Medicare Part D
contracts, PFFS contracts, long-term care and other insurance products
distributed through our career agents. Our profits on supplemental health
policies depend on the overall level of sales, the length of time the business
remains inforce, investment yields, claims experience and expense management.
Collected premiums on Medicare supplement policies in the Bankers Life
segment decreased 2.6 percent, to $155.8 million, in the first quarter of 2009,
as compared to the same period in 2008.
Premiums collected on Bankers Life's long-term care policies decreased 6.8
percent, to $145.9 million, in the first quarter of 2009, as compared to the
same period in 2008. Such decrease was attributable to: (i) a long-term care
reinsurance agreement entered into in 2008; and (ii) higher lapses due to rate
increases in recent periods.
Premiums collected on PDP and PFFS business relate to various quota-share
reinsurance agreements with Coventry. Effective May 1, 2008 and July 1, 2007, we
entered into new PFFS quota-share reinsurance agreements with Coventry. In order
to reduce the required statutory capital associated with the assumption of group
PFFS business, we terminated two group policy quota-share agreements as of
December 31, 2008 and will terminate the last agreement on June 30, 2009.
Fluctuations in first-year and renewal premiums are generally due to the timing
of the contracts we entered into with Coventry.
Life products in this segment are sold primarily to the senior market
through our career agents. Life premiums collected in this segment in the 2009
period was comparable to the same period in 2008.
Colonial Penn (dollars in millions)
Three months ended
March 31,
-----------------------
2009 2008
---- ----
Premiums collected by product:
Life insurance:
First-year.............................................................................. $ 9.2 $ 8.4
Renewal................................................................................. 37.8 34.5
----- -----
Total life insurance.................................................................. 47.0 42.9
----- -----
Supplemental health (all of which are renewal premiums):
Medicare supplement..................................................................... 1.7 2.1
Other health............................................................................ .2 .2
----- -----
Total supplemental health............................................................. 1.9 2.3
----- -----
Collections on insurance products:
Total first-year premium collections on insurance
products.............................................................................. 9.2 8.4
Total renewal premium collections on insurance
products.............................................................................. 39.7 36.8
----- -----
Total collections on insurance products............................................... $48.9 $45.2
===== =====
66
CONSECO, INC. AND SUBSIDIARIES
-------------------
Life products in this segment are sold primarily to the senior market. Life
premiums collected in this segment increased 9.6 percent, to $47.0 million, in
the first quarter of 2009, compared to the same period in 2008. Graded benefit
life products sold through our direct response marketing channel accounted for
$44.7 million and $41.5 million of our total collected premiums in the first
quarters of 2009 and 2008, respectively.
Supplemental health products include Medicare supplement and other
insurance products. Our profits on supplemental health policies depend on the
overall level of sales, the length of time the business remains inforce,
investment yields, claims experience and expense management. Premiums collected
on these products have decreased as we do not currently market these products
through this segment.
Conseco Insurance Group (dollars in millions):
Three months ended
March 31,
-----------------------
2009 2008
---- ----
Premiums collected by product:
Annuities:
Equity-indexed (first-year).......................................................... $ 17.7 $ 38.2
Equity-indexed (renewal)............................................................. 1.4 1.8
------ ------
Subtotal - equity-indexed annuities................................................ 19.1 40.0
------ ------
Other fixed (first-year)............................................................. .1 1.0
Other fixed (renewal)................................................................ .3 .6
------ ------
Subtotal - other fixed annuities................................................... .4 1.6
------ ------
Total annuities.................................................................... 19.5 41.6
------ ------
Supplemental health:
Medicare supplement (first-year)..................................................... 1.5 2.8
Medicare supplement (renewal)........................................................ 41.3 50.3
------ ------
Subtotal - Medicare supplement..................................................... 42.8 53.1
------ ------
Specified disease (first-year)....................................................... 10.2 9.4
Specified disease (renewal).......................................................... 82.8 84.8
------ ------
Subtotal - specified disease....................................................... 93.0 94.2
------ ------
Long-term care (all of which is renewal)............................................. 8.4 8.8
------ ------
Other health (all of which is renewal)............................................... 2.0 2.4
------ ------
Total supplemental health.......................................................... 146.2 158.5
------ ------
Life insurance:
First-year........................................................................... .5 .7
Renewal.............................................................................. 63.9 71.2
------ ------
Total life insurance............................................................... 64.4 71.9
------ ------
Collections on insurance products:
Total first-year premium collections on insurance
products........................................................................... 30.0 52.1
Total renewal premium collections on insurance
products........................................................................... 200.1 219.9
------ ------
Total collections on insurance products............................................ $230.1 $272.0
====== ======
67
CONSECO, INC. AND SUBSIDIARIES
-------------------
Annuities in this segment include equity-indexed and other fixed annuities
sold through professional independent producers. Total annuity premiums
collected in this segment totaled $19.5 million in the first quarter of 2009,
compared to $41.6 million in the same period of 2008.
Our equity-indexed annuities have guaranteed minimum cash surrender values,
but have potentially higher returns based on a percentage of the change in one
of several equity market indices during each year of their term. We purchase
options in an effort to hedge increases to policyholder benefits resulting from
increases in the indices. Collected premiums for this product totaled $19.1
million in the first quarter of 2009, compared to $40.0 million in the same
period of 2008. Premium collections from our equity-indexed products have
declined due to general declines in the stock market.
Supplemental health products in the Conseco Insurance Group segment include
Medicare supplement, specified disease, long-term care and other insurance
products distributed through professional independent producers. Our profits on
supplemental health policies depend on the overall level of sales, the length of
time the business remains inforce, investment yields, claim experience and
expense management.
Collected premiums on Medicare supplement policies in the Conseco Insurance
Group segment decreased 19 percent, to $42.8 million, in the first quarter of
2009, as compared to the same period in 2008. We have experienced lower sales
and higher lapses of these products due to premium rate increases implemented in
recent periods and competition from companies offering Medicare Advantage
products.
Premiums collected on specified disease products in the first quarter of
2009 were comparable to the same period in 2008.
The long-term care premiums in this segment relate to blocks of business
that we no longer market or underwrite. As a result, we expect this segment's
long-term care premiums to continue to decline, reflecting additional policy
lapses in the future, partially offset by premium rate increases.
Life products in the Conseco Insurance Group segment are sold through
professional independent producers. Life premiums collected decreased 10
percent, to $64.4 million, in the first quarter of 2009, compared to the same
period in 2008.
LIQUIDITY AND CAPITAL RESOURCES
Changes in our consolidated balance sheet between March 31, 2009 and
December 31, 2008, primarily reflect: (i) our net income for the three months
ended March 31, 2009; and (ii) changes in the fair value of actively managed
fixed maturity securities.
In accordance with GAAP, we record our actively managed fixed maturity
investments, equity securities and certain other invested assets at estimated
fair value with any unrealized gain or loss (excluding impairment losses
recognized through earnings), net of tax and related adjustments, recorded as a
component of shareholders' equity. At March 31, 2009, we decreased the carrying
value of such investments by $3.1 billion as a result of this fair value
adjustment.
68
CONSECO, INC. AND SUBSIDIARIES
-------------------
Our capital structure as of March 31, 2009, and December 31, 2008, was as
follows (dollars in millions):
March 31, December 31,
2009 2008
---- ----
Total capital:
Corporate notes payable................................................ $ 1,310.5 $ 1,311.5
Shareholders' equity:
Common stock........................................................ 1.9 1.9
Additional paid-in capital.......................................... 4,105.6 4,104.0
Accumulated other comprehensive loss................................ (1,840.5) (1,770.7)
Accumulated deficit................................................. (675.8) (705.2)
--------- ---------
Total shareholders' equity....................................... 1,591.2 1,630.0
--------- ---------
Total capital.................................................... $ 2,901.7 $ 2,941.5
========= =========
The following table summarizes certain financial ratios as of and for the
three months ended March 31, 2009, and as of and for the year ended December 31,
2008:
March 31, December 31,
2009 2008
---- ----
Book value per common share................................................................... $ 8.61 $ 8.82
Book value per common share, excluding accumulated other comprehensive
income (loss) (a).......................................................................... 18.57 18.41
Ratio of earnings to fixed charges............................................................ 1.39X 1.01X
Debt to total capital ratios:
Corporate debt to total capital (b)........................................................ 45% 45%
Corporate debt to total capital, excluding accumulated other comprehensive
income (loss) (a)........................................................................ 28% 28%
<FN>
- --------------------
(a) This non-GAAP measure differs from the corresponding GAAP measure
presented immediately above, because accumulated other comprehensive
income (loss) has been excluded from the value of capital used to
determine this measure. Management believes this non-GAAP measure is
useful because it removes the volatility that arises from changes in
accumulated other comprehensive income (loss). Such volatility is often
caused by changes in the estimated fair value of our investment
portfolio resulting from changes in general market interest rates rather
than the business decisions made by management. However, this measure
does not replace the corresponding GAAP measure.
(b) Such ratio differs from the debt to total capitalization ratio required
by our Second Amended Credit Facility, primarily because the credit
agreement ratio excludes accumulated other comprehensive income (loss)
from total capital.
</FN>
69
CONSECO, INC. AND SUBSIDIARIES
-------------------
Liquidity for insurance operations
Our insurance companies generally receive adequate cash flows from premium
collections and investment income to meet their obligations. Life insurance and
annuity liabilities are generally long-term in nature. Policyholders may,
however, withdraw funds or surrender their policies, subject to any applicable
penalty provisions. We seek to balance the duration of our invested assets with
the estimated duration of benefit payments arising from contract liabilities.
One of the Company's insurance subsidiaries (Conseco Life) is a member of
the FHLBI. As a member of the FHLBI, Conseco Life has the ability to borrow on a
collateralized basis from FHLBI. Conseco Life is required to hold a certain
minimum amount of FHLBI common stock as a requirement of membership in the
FHLBI, and additional amounts based on the amount of collateralized borrowings.
At March 31, 2009, the carrying value of the FHLBI common stock was $22.5
million. Collateralized borrowings totaled $450.0 million as of March 31, 2009,
and the proceeds were used to purchase fixed maturity securities. The borrowings
are classified as investment borrowings in the accompanying consolidated balance
sheet. The borrowings are collateralized by investments with an estimated fair
value of $535.5 million at March 31, 2009, which are maintained in a custodial
account for the benefit of the FHLBI. The following summarizes the terms of the
borrowings (dollars in millions):
Amount Maturity Interest rate
borrowed date at March 31, 2009
-------- ---- -----------------
$ 54.0 May 2012 Variable rate - 1.251%
37.0 July 2012 Fixed rate - 5.540%
13.0 July 2012 Variable rate - 1.414%
146.0 November 2015 Fixed rate - 5.300%
100.0 November 2015 Fixed rate - 4.890%
100.0 December 2015 Fixed rate - 4.710%
State laws generally give state insurance regulatory agencies broad
authority to protect policyholders in their jurisdictions. Regulators have used
this authority in the past to restrict the ability of our insurance subsidiaries
to pay any dividends or other amounts without prior approval. We cannot be
assured that the regulators will not seek to assert greater supervision and
control over our insurance subsidiaries' businesses and financial affairs.
Financial Strength Ratings of our Insurance Subsidiaries
Financial strength ratings provided by A.M. Best, S&P and Moody's are the
rating agency's opinions of the ability of our insurance subsidiaries to repay
policyholder claims and obligations when due.
On March 4, 2009, A.M. Best downgraded the financial strength ratings of
our primary insurance subsidiaries to "B" from "B+" and such ratings have been
placed under review with negative implications. The "B" rating is assigned to
companies that have a fair ability, in A.M. Best's opinion, to meet their
current obligations to policyholders, but are financially vulnerable to adverse
changes in underwriting and economic conditions. A.M. Best ratings for the
industry currently range from "A++ (Superior)" to "F (In Liquidation)" and some
companies are not rated. An "A++" rating indicates a superior ability to meet
ongoing obligations to policyholders. A.M. Best has sixteen possible ratings.
There are six ratings above our "B" rating and nine ratings that are below our
rating.
On February 26, 2009, S&P downgraded the financial strength ratings of our
primary insurance subsidiaries to "BB-" from "BB+" and the outlook remained
negative for our primary insurance subsidiaries. On March 2, 2009, S&P placed
the financial strength ratings of our primary insurance subsidiaries on credit
watch with negative implications. A rating on credit watch with negative
implications highlights the potential direction of a rating focusing on
identifiable events and short-term trends that cause ratings to be placed under
special surveillance by S&P. A "negative" designation means that a rating may be
lowered. S&P financial strength ratings range from "AAA" to "R" and some
companies are not rated. Rating categories from "BB" to "CCC" are classified as
"vulnerable", and pluses and minuses show the relative standing within a
category. In S&P's view, an insurer rated "BB" has marginal financial security
characteristics and although positive attributes exist, adverse business
conditions could lead to an insufficient ability to meet financial commitments.
S&P has twenty-one possible ratings. There are twelve ratings above our "BB-"
rating and eight ratings that are below our rating.
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CONSECO, INC. AND SUBSIDIARIES
-------------------
On March 3, 2009, Moody's downgraded the financial strength ratings of our
primary insurance subsidiaries to "Ba2" from "Ba1" and the outlook remained
negative for our primary insurance subsidiaries. Moody's financial strength
ratings range from "Aaa" to "C". Rating categories from "Aaa" to "Baa" are
classified as "Secure" by Moody's and rating categories from "Ba" to "C" are
considered "vulnerable" and these ratings may be supplemented with numbers "1",
"2", or "3" to show relative standing within a category. In Moody's view, an
insurer rated "Ba2" offers questionable financial security and, often, the
ability of these companies to meet policyholders obligations may be very
moderate and thereby not well safeguarded in the future. Moody's has twenty-one
possible ratings. There are eleven ratings above our "Ba2" rating and nine
ratings that are below our rating.
Liquidity of the Holding Companies
We have significant indebtedness which will require over $165 million in
cash to service in the next twelve months (including the additional interest
expense required after the modification to our Second Amended Credit Facility
described in the note to the consolidated financial statements entitled "Notes
Payable - Direct Corporate Obligations"). Pursuant to our Second Amended Credit
Facility, we must maintain certain financial ratios. The levels of margin
between the financial covenant requirements and our financial status, both at
March 31, 2009, and the projected levels for the next twelve months, are
relatively small and a failure to satisfy any of our financial covenants at the
end of a fiscal quarter would trigger a default under our Second Amended Credit
Facility. Achievement of our operating plans is a critical factor in having
sufficient income and liquidity to meet our debt service requirements for the
next twelve months and other holding company obligations and failure to do so
would have material adverse consequences for the Company. These items are
discussed further below.
As described below, we completed an amendment to our Second Amended Credit
Facility, which provides for, among other things: (i) additional margins between
our current financial status and certain financial covenant requirements through
June 30, 2010; (ii) higher interest rates and the payment of a fee; (iii) new
restrictions on the ability of the Company to incur additional indebtedness; and
(iv) the ability of the lender to appoint a financial advisor at the Company's
expense.
At March 31, 2009, CNO, CDOC (our wholly owned subsidiary and a guarantor
under the Second Amended Credit Facility) and our other non-insurance
subsidiaries held unrestricted cash of $104.3 million. Subsequent to March 31,
2009, we repaid $55 million borrowed under the revolving credit facility
maturing on June 22, 2009. CNO and CDOC are holding companies with no business
operations of their own; they depend on their operating subsidiaries for cash to
make principal and interest payments on debt, and to pay administrative expenses
and income taxes. CNO and CDOC receive cash from insurance subsidiaries,
consisting of dividends and distributions, interest payments on surplus
debentures and tax-sharing payments, as well as cash from non-insurance
subsidiaries consisting of dividends, distributions, loans and advances. The
principal non-insurance subsidiaries that provide cash to CNO and CDOC are 40|86
Advisors, Inc. ("40|86 Advisors"), which receives fees from the insurance
subsidiaries for investment services, and Conseco Services, LLC which receives
fees from the insurance subsidiaries for providing administrative services. The
agreements between our insurance subsidiaries and Conseco Services, LLC and
40|86 Advisors, respectively, were previously approved by the domestic insurance
regulator for each insurance company, and any payments thereunder do not require
further regulatory approval.
A deterioration in the financial condition, earnings or cash flow of the
material subsidiaries of CNO or CDOC for any reason could hinder such
subsidiaries' ability to pay cash dividends or other disbursements to CNO and/or
CDOC, which, in turn, would limit Conseco's ability to meet debt service
requirements and satisfy other financial obligations. In addition, we may choose
to retain capital in our insurance subsidiaries or to contribute additional
capital to our insurance subsidiaries to strengthen their surplus, and these
decisions could limit the amount available at our top tier insurance
subsidiaries to pay dividends to the holding companies. In the past, we have
made capital contributions to our insurance subsidiaries to meet debt covenants
and minimum capital levels required by certain regulators and it is possible we
will be required to do so in the future. We currently do not expect that
contributions to our insurance subsidiaries will be required in 2009. If
contributions were required, our holding companies would have limited available
capital for such contributions.
71
CONSECO, INC. AND SUBSIDIARIES
-------------------
The following summarizes the legal ownership structure of Conseco's primary
subsidiaries at March 31, 2009:
[OBJECT OMITTED] [GRAPHIC OMITTED]
The ability of our insurance subsidiaries to pay dividends is subject to
state insurance department regulations and is based on the financial statements
of our insurance subsidiaries prepared in accordance with statutory accounting
practices prescribed or permitted by regulatory authorities, which differ from
GAAP. These regulations generally permit dividends to be paid from statutory
earned surplus of the insurance company for any 12-month period in amounts equal
to the greater of (or in a few states, the lesser of): (i) statutory net gain
from operations or net income for the prior year; or (ii) 10 percent of
statutory capital and surplus as of the end of the preceding year (excluded from
this calculation would be the $61.9 million of additional surplus recognized due
to the approval of a permitted practice by insurance regulators related to
certain deferred tax assets as further described below in this section
discussing actions we have taken to improve our capitalization and ratios).
These types of dividends are referred to as "ordinary dividends". Any dividends
in excess of these levels require the approval of the director or commissioner
of the applicable state insurance department. These types of dividends are
referred to as "extraordinary dividends". Each of the direct insurance
subsidiaries of CDOC has negative earned surplus at March 31, 2009 as summarized
below (dollars in millions):
Earned
surplus
Subsidiary of CDOC (deficit)(a) Additional information
------------------ ------------ ----------------------
Conseco Life of Texas $(1,238.1) (b)
Washington National (1,112.0) (c)
Conseco Health (15.6) (d)
<FN>
- -------------
(a) As calculated pursuant to the state insurance department of each
company's domiciliary state.
(b) During 2008, Conseco Life of Texas transferred the ownership of Senior
Health, Washington National and Conseco Health to CDOC. As a result of
this transaction, the $1,574.7 million of accumulated unrealized losses
of Conseco Life of Texas' former subsidiaries were realized by Conseco
Life of Texas, reducing its earned surplus to $(1,206.4) million at
December 31, 2008, pursuant to the manner earned surplus is calculated
under the regulations of the Texas Department of Insurance.
(c) Pursuant to the regulations of the Illinois Division of Insurance, the
accumulated earnings and losses of Washington National's subsidiaries
are reflected in the earned surplus of Washington National. Conseco
Life, a subsidiary of Washington National, incurred aggregate costs in
excess of $265 million during the three years ended December 31, 2007
related to litigation regarding a change made in 2003 and 2004 in the
manner cost of insurance charges are calculated for certain life
insurance policies. In addition, significant dividend payments have been
made from Washington National and its subsidiaries in the past which
have increased its earned deficit, including payments made following
significant reductions in the business of Washington National and its
subsidiaries pursuant to a reinsurance transaction completed in 2007.
(d) Based on our business plan, Conseco Health is not expected to pay any
ordinary dividends.
</FN>
72
CONSECO, INC. AND SUBSIDIARIES
-------------------
As described above, any current dividend payments from the subsidiaries of
CDOC would be considered extraordinary dividends and therefore require the
approval of the director or commissioner of the applicable state insurance
department. During the next twelve months, we are expecting our insurance
subsidiaries to pay approximately $80.0 million of extraordinary dividends to
CDOC ($25.0 million of which has been approved by the Texas Department of
Insurance and paid in April 2009 and $55.0 million of which is expected to be
approved by the Texas Department of Insurance and paid later in 2009 and in the
first quarter of 2010). In addition, we are expecting Conseco Life of Texas to
pay interest on surplus debentures of $46.1 million ($10.7 million of which has
been approved by the Texas Department of Insurance and $35.4 million of which is
expected to be approved by the Texas Department of Insurance and paid later in
2009 and in the first quarter of 2010). Although we believe the dividends and
surplus debenture interest payments we are expecting to pay during 2009 and in
the first quarter of 2010 are consistent with payments that have been approved
by insurance regulators in prior years, there can be no assurance that such
payments will be approved or that the financial condition of our insurance
subsidiaries will not change, making future approvals less likely. Dividends and
other payments from our non-insurance subsidiaries, including 40|86 Advisors and
Conseco Services, LLC, to CNO or CDOC do not require approval by any regulatory
authority or other third party. However, insurance regulators may prohibit
payments by our insurance subsidiaries to parent companies if they determine
that such payments could be adverse to our policyholders or contractholders.
The insurance subsidiaries of CDOC receive funds to pay dividends from: (i)
the earnings of their direct businesses; (ii) tax sharing payments received from
subsidiaries (if applicable); and (iii) dividends received from subsidiaries (if
applicable). At March 31, 2009, these subsidiaries had negative earned surplus
as summarized below (dollars in millions):
Earned
surplus
Subsidiary of CDOC (deficit)(a) Additional information
------------------ ------------ ----------------------
Subsidiaries of Conseco Life of Texas:
Bankers Life and Casualty Company $ (33.1) (b)
Colonial Penn (218.5) (c)
Subsidiaries of Washington National:
Conseco Insurance Company (.1) (d)
Conseco Life (348.6) (e)
<FN>
- -------------
(a) As calculated pursuant to the state insurance department of each
company's domiciliary state.
(b) Based on our 2009 business plan, Bankers Life and Casualty Company's
earnings during 2009 are expected to result in a positive earned surplus
later in the year, enabling it to pay ordinary dividends. Such ordinary
dividend payments would be limited to the lesser of $57.8 million (10
percent of Bankers Life and Casualty Company's statutory capital and
surplus balance at December 31, 2008) or its positive earned surplus
balance.
(c) For tax planning purposes, Colonial Penn paid dividends to its parent of
$150 million during 2006. In addition, Colonial Penn issued a surplus
debenture to CDOC in exchange for $160 million of cash. The 2006
dividend payment reduced Colonial Penn's earned surplus by $150 million
(even though total capital and surplus increased by $10 million after
the issuance of the surplus debenture). In 2007, Colonial Penn
recaptured a block of traditional life business previously ceded to an
unaffiliated insurer in 2002. The Company's earned surplus was reduced
by $63 million as a result of the fee paid to recapture this business.
(d) Based on our 2009 business plan, Conseco Insurance Company's 2009
earnings are expected to increase later in the year enabling it to pay
ordinary dividends. Such ordinary dividend payments would be limited to
the lesser of $18.7 million (Conseco Insurance Company's statutory net
income for the year ended December 31, 2008) or its positive earned
surplus balance.
(e) We have no plans for Conseco Life to pay dividends to Washington
National at any time in the foreseeable future.
</FN>
In assessing Conseco's current financial position and operating plans for
the future, management made significant judgments and estimates with respect to
the potential financial and liquidity effects of Conseco's risks and
uncertainties, including but not limited to:
o the approval of dividend payments and surplus debenture interest
payments from our insurance subsidiaries by the director or commissioner
of the applicable state insurance departments;
73
CONSECO, INC. AND SUBSIDIARIES
-------------------
o the potential adverse effects on Conseco's businesses from recent
downgrades or further downgrades by rating agencies;
o our ability to achieve our operating plan;
o the potential for continued declines in the bond, commercial mortgage
loan and equity markets and the potential for further significant
recognition of other-than-temporary impairments;
o the potential need to provide additional capital to our insurance
subsidiaries;
o our ability to continue to achieve compliance with our loan covenants
and the financial ratios we are required to maintain;
o the potential loss of key personnel that could impair our ability to
achieve our operating plan;
o the potential impact of an ownership change or a decrease in our
operating earnings on the valuation allowance related to our deferred
tax assets; and
o the potential impact on certain of Conseco's insurance subsidiaries if
regulators do not allow us to continue to recognize certain deferred tax
assets pursuant to permitted statutory accounting practices.
74
CONSECO, INC. AND SUBSIDIARIES
-------------------
The following summarizes the projected sources and uses of cash of CDOC and
CNO during the twelve months ended March 31, 2010 (dollars in millions):
From our operations From surplus From
or approved dividends debenture interest extraordinary
and surplus debenture payments requiring dividends
interest payments future approval requiring approval Total
----------------- --------------- ------------------ -----
Sources of holding company cash:
Dividends from our insurance subsidiaries:
Conseco Life of Texas........................ $ 25.0 $ - $40.0 $ 65.0
Washington National.......................... - - 5.0 5.0
Conseco Health............................... - - 10.0 10.0
Surplus debenture interest..................... 10.7 35.4 - 46.1
Administrative services and investment
management fees.............................. 57.5 - - 57.5
Investment recovery............................ 5.9 - - 5.9
------ ------ ----- ------
Total sources of cash expected to be available
to service our debt and other obligations.. 99.1 35.4 55.0 189.5
------ ------ ----- ------
Uses of holding company cash:
Debt service obligations of CNO and CDOC:
Estimated interest payments (b)................ 73.3 - - 73.3
Scheduled principal payments under
our secured credit agreement................. 8.8 - - 8.8
Repayment of amounts borrowed under
revolving credit facility maturing
on June 22, 2009............................. 55.0 - - 55.0
Repayment of intercompany loan................. 3.5 - - 3.5
Fees and expenses to amend the Credit Facility. .3 - - .3
Scheduled principal payment under the
Senior Note payable to Senior Health......... 25.0 - - 25.0
Corporate expense and other.................... 31.4 - - 31.4
------ ------ ----- ------
Total expected uses of cash.................. 197.3 - - 197.3
------ ------ ----- ------
Net expected increase (decrease) in cash....... (98.2) $ 35.4 $55.0 (7.8)
====== =====
Cash balance, beginning of period (a).......... 104.3 104.3
------ ------
Expected cash balance, end of period (a)....... $ 6.1 $ 96.5
====== ======
<FN>
- -------------
(a) Includes cash balances of our other non-insurance subsidiaries, which
are available to CDOC or CNO.
(b) Includes additional interest expense required after the modification to
our Second Amended Credit Facility on March 30, 2009, as further
described below.
</FN>
If an insurance company subsidiary were to be liquidated, that liquidation
would be conducted following the insurance law of its state of domicile with
such state's insurance regulator as the receiver for such insurer's property and
business. In the event of a default on our debt or our insolvency, liquidation
or other reorganization, our creditors and stockholders would have no right to
proceed against the assets of our insurance subsidiaries or to cause their
liquidation under federal and state bankruptcy laws.
In connection with the Transfer further discussed in the note to the
consolidated financial statements entitled "Transfer of Senior Health Insurance
Company of Pennsylvania to an Independent Trust", the Company issued a $125.0
million Senior Note due November 12, 2013 payable to Senior Health. The Senior
Note has a 6 percent interest rate; and requires annual principal payments of
$25.0 million. Such amounts are expected to be funded by the Company's operating
activities.
75
CONSECO, INC. AND SUBSIDIARIES
-------------------
Conseco agreed that it would not pay cash dividends on its common stock while
any portion of the Senior Note remained outstanding.
The Second Amended Credit Facility includes an $80.0 million revolving
credit facility that can be used for general corporate purposes and that will
mature on June 22, 2009. In October 2008, the Company borrowed $75.0 million
under the revolving credit facility. The Company also requested borrowings of
$5.0 million which were not funded. In December 2008, we repaid $20.0 million of
the revolving facility and reduced the maximum amount available under the
revolving facility to $60.0 million. At March 31, 2009, there was $55.0 million
outstanding under the revolving facility (which was repaid in full in April
2009). The Company pays a commitment fee equal to .50 percent of the unused
portion of the revolving credit facility on an annualized basis. The revolving
credit facility bears interest based on either a Eurodollar rate or a base rate
in the same manner as the balance of the Second Amended Credit Facility.
During the first three months of 2009, we made a scheduled principal
payment totaling $2.2 million on our Second Amended Credit Facility. Also,
during the first three months of 2009, we made a mandatory prepayment of $1.2
million based on the Company's excess cash flows at December 31, 2008, as
defined in the Second Amended Credit Facility. The scheduled repayment of our
direct corporate obligations (including payments required under the Second
Amended Credit Facility, (including the revolving credit facility), the Senior
Note and the Debentures) is as follows (dollars in millions):
Remainder of 2009.............................. $ 86.6 (a)
2010........................................... 326.8 (b)
2011........................................... 33.7
2012........................................... 33.8
2013........................................... 845.5
--------
$1,326.4
========
<FN>
- --------------
(a) This amount includes $55.0 million which was outstanding at March 31,
2009, under the revolving facility portion of our Second Amended Credit
Facility. Such amount was repaid in full in April 2009.
(b) Holders of our Debentures have the right to require the Company to
repurchase their Debentures for cash on September 30, 2010. This amount
assumes that all holders of our Debentures exercise that right.
</FN>
Pursuant to our Second Amended Credit Facility, we agreed to a number of
covenants and other provisions that restrict our ability to borrow money and
pursue some operating activities without the prior consent of the lenders. We
also agreed to meet or maintain various financial ratios and balances. Our
ability to meet these financial tests and maintain ratings may be affected by
events beyond our control. The Second Amended Credit Facility prohibits or
restricts, among other things: (i) the payment of cash dividends on our common
stock; (ii) the repurchase of our common stock; (iii) the issuance of additional
debt or capital stock; (iv) liens; (v) certain asset dispositions; (vi)
affiliate transactions; (vii) certain investment activities; (viii) change in
business; and (ix) prepayment of indebtedness (other than the Second Amended
Credit Facility). The Second Amended Credit Facility also requires that the
Company's annual audited consolidated financial statements be accompanied by an
opinion, from a nationally-recognized independent public accounting firm,
stating that such audited consolidated financial statements present fairly, in
all material respects, the financial position and results of operations of the
Company in conformity with GAAP for the periods indicated. Such opinion shall
not include an explanatory paragraph regarding the Company's ability to continue
as a going concern or similar qualification. Although we were in compliance with
the provisions of the Second Amended Credit Facility as of March 31, 2009, these
provisions represent significant restrictions on the manner in which we may
operate our business. If we default under any of these provisions, the lenders
could declare all outstanding borrowings, accrued interest and fees to be due
and payable. If that were to occur, no assurance can be given that we would have
sufficient liquidity to repay our bank indebtedness in full or any of our other
debts.
Pursuant to the Second Amended Credit Facility, as long as the debt to
total capitalization ratio (as defined in the Second Amended Credit Facility) is
greater than 20 percent or certain insurance subsidiaries (as defined in the
Second Amended Credit Facility) have financial strength ratings of less than A-
from A.M. Best, the Company is required to make mandatory prepayments with all
or a portion of the proceeds from the following transactions or events
including: (i) the issuance of certain indebtedness; (ii) certain equity
issuances; (iii) certain asset sales or casualty events; and (iv) excess cash
flows as defined in the Second Amended Credit Facility (the first such payment,
of $1.2 million, was paid in March 2009). The Company may make optional
prepayments at any time in minimum amounts of $3.0 million or any multiple of
$1.0 million in excess thereof.
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CONSECO, INC. AND SUBSIDIARIES
-------------------
Under our Second Amended Credit Facility, we have agreed to a number of
covenants and other provisions that restrict our ability to engage in various
financing transactions and pursue certain operating activities without the prior
consent of the lenders.
The following summarizes the financial ratios and amounts that we are
required to meet or maintain under our Second Amended Credit Facility as of
March 31, 2009:
Covenant under the
Second Amended Margin for
Credit Facility as Balance or adverse development from
amended on ratio as of March 31, 2009
March 30, 2009 March 31, 2009 levels
-------------- -------------- ------
Aggregate risk-based
capital ratio........... Greater than or equal to 230% Reduction to statutory capital
200% from March 31, 2009 and surplus of approximately
through June 30, 2010 and $169 million, or an increase
thereafter, greater than 250% to the risk-based capital of
(the same ratio required by approximately $85 million.
the facility prior to the
amendment).
Combined statutory
capital and surplus..... Greater than $1,100 million $1,301 Reduction to combined
from March 31, 2009 through statutory capital and surplus
June 30, 2010 and thereafter, of approximately $201 million.
$1,270 million (the same amount
required by the facility prior
to the amendment).
Debt to total capitalization
ratio................... Not more than 32.5% from 27.9% Reduction to shareholders'
March 31, 2009 through equity of approximately $672
June 30, 2010 and thereafter, million or additional debt of
not more than 30% (the same $324 million.
ratio required by the facility
prior to the amendment).
Interest coverage ratio..... Greater than or equal to 1.50 3.07 to 1 Reduction in cash flows to
to 1 for rolling four quarters the holding company of
from March 31, 2009 through approximately $80 million.
June 30, 2010 and thereafter,
2.00 to 1 (the same ratio
required by the facility prior
to the amendment).
These covenants place significant restrictions on the manner in which we may
operate our business and our ability to meet these financial covenants may be
affected by events beyond our control. If we default under any of these
covenants, the lenders could declare all outstanding borrowings, accrued
interest and fees to be immediately due and payable. If the lenders under our
Second Amended Credit Facility would elect to accelerate the amounts due, the
holders of our Debentures and Senior Note could elect to take similar action
with respect to those debts. If that were to occur, we would not have sufficient
liquidity to repay our indebtedness.
77
CONSECO, INC. AND SUBSIDIARIES
-------------------
Pursuant to its amended terms, the applicable interest rate on the Second
Amended Credit Facility (based on either a Eurodollar or base rate) has
increased. The Eurodollar rate is now equal to LIBOR plus 4 percent with a
minimum LIBOR rate of 2.5 percent (such rate was previously LIBOR plus 2 percent
with no minimum rate). The base rate is now equal to 2.5 percent plus the
greater of: (i) the Federal funds rate plus .50 percent; or (ii) Bank of
America's prime rate. In addition, the amended agreement requires the Company to
pay a fee equal to 1 percent of the outstanding principal balance under the
Second Amended Credit Facility, which fee will be added to the principal balance
outstanding and will be payable at the maturity of the facility. This 1 percent
fee will be reported as non-cash interest expense.
The modifications to the Second Amended Credit Facility also place new
restrictions on the ability of the Company to incur additional indebtedness. The
amendment: (i) deleted the provision that allowed the Company to borrow up to an
additional $330 million under the Second Amended Credit Facility (the lenders
under the facility having had no obligation to lend any amount under that
provision); (ii) reduced the amount of secured indebtedness that the Company can
incur from $75 million to $2.5 million; and (iii) limited the ability of the
Company to incur additional unsecured indebtedness, except as provided below, to
$25 million, and eliminated the provision that would have allowed the Company to
incur additional unsecured indebtedness to the extent that principal payments
were made on existing unsecured indebtedness.
The Company is permitted to issue unsecured indebtedness that is used
solely to pay the holders of the Debentures, provided that such indebtedness
shall: (i) have a maturity date that is no earlier than October 10, 2014; (ii)
contain covenants and events of default that are no more restrictive than those
in the Second Amended Credit Facility; (iii) not amortize; and (iv) not have a
put date or otherwise be callable prior to April 10, 2014, and provided further
that the amount of cash interest payable annually on any new issuance of such
indebtedness, together with the cash interest payable on the outstanding
Debentures, shall not exceed twice the amount of cash interest currently payable
on the outstanding Debentures.
The amendment prohibits the Company from redeeming or purchasing the
Debentures with cash from sources other than those described in the previous
paragraph. As a result, without a further amendment of the Second Amended Credit
Facility or a waiver from the lenders, the Company will not be able to make any
payments to the holders of the Debentures on September 30, 2010 (assuming the
holders of the Debentures elect to exercise their right to require the Company
to repurchase their Debentures for cash on that date). The amendment permits the
Company to amend, modify or refinance the Debentures so long as such new
indebtedness complies with the restrictions set forth in the previous paragraph.
In addition, pursuant to the terms of the amended debt agreement, the agent
(acting on behalf of the lenders) has the right to appoint a financial advisor
at the Company's expense to, among other things, review financial projections
and other financial information prepared by or on behalf of the Company, perform
valuations of the assets of the Company and take other actions as are customary
or reasonable for an advisor acting in such capacity. The agent has recently
informed us that they have appointed a financial advisor.
Pursuant to GAAP, the amendment to the Second Amended Credit Facility is
required to be accounted for in accordance with SFAS 15. Accordingly, the
effects of the modifications will be accounted for prospectively from March 31,
2009, and we will not change the carrying amount of the Second Amended Credit
Facility as a result of the modifications. However, the $9.5 million of fees
incurred in conjunction with the modifications of the facility were expensed in
the first quarter of 2009.
Our life insurance subsidiaries are subject to risk-based capital
requirements. As described above, our Second Amended Credit Facility contains
certain financial covenants which are based on our aggregate risk-based capital.
The recent unprecedented economic and market conditions have both reduced the
statutory capital of our insurance subsidiaries and increased the risk-based
capital requirements of our insurance subsidiaries as further discussed below:
o We have incurred realized investment losses and investment valuation
adjustments that reduced capital and surplus. For example, during the
first quarter of 2009, we incurred net capital losses and recognized
changes in unrealized losses in statutory capital pursuant to statutory
accounting practices of approximately $81 million. These losses resulted
in a reduction to our aggregate risk-based capital ratio of 14
percentage points.
o We have had adverse experience related to certain commercial mortgage
loans which has resulted in an increase to our aggregate required
risk-based capital. In the second quarter of 2008, we began foreclosure
proceedings on two delinquent commercial mortgage loans. Pursuant to
statutory rules and regulations which are followed to
78
CONSECO, INC. AND SUBSIDIARIES
-------------------
determine the amount of required risk-based capital, our insurance
subsidiaries are required to apply a "mortgage experience adjustment
factor" to the entire portfolio of commercial mortgage loans based, in
large part, on a comparison of our default and loss experience to the
aggregate industry default and loss experience. The calculation is
extremely sensitive to slight variations in our experience. For example,
during the first quarter of 2009, our minimum aggregate required
risk-based capital increased by approximately $17 million due to these
requirements. The establishment of additional required risk-based
capital related to the mortgage experience adjustment factor resulted in
a reduction to the aggregate risk-based capital ratio of 6 percentage
points in the first quarter of 2009.
o Certain of our fixed maturity investments have been subject to
downgrades by nationally recognized statistical rating organizations,
which have resulted in an increase to our aggregate required risk-based
capital. Pursuant to statutory rules and regulations which are followed
to determine the amount of required risk-based capital, our insurance
subsidiaries are required to apply factors to the carrying value of
their fixed maturity investments which increase required risk-based
capital based on current ratings of nationally recognized statistical
rating organizations. Significant ratings downgrades increase these
capital requirements. For example, during the first quarter of 2009 our
required aggregate risk-based capital increased by approximately $21
million as a result of downgrades of certain of our fixed maturity
investments. These downgrades resulted in a reduction to the aggregate
risk-based capital ratio of 7 percentage points.
We continue to take capital management actions to improve our
capitalization and ratios and/or to improve our liquidity. In addition, our
insurance subsidiaries have generated statutory operating income, excluding
capital losses. During the first quarter of 2009, our insurance subsidiaries
recognized a net operating gain of $39.9 million (excluding capital losses).
This gain resulted in an increase to our aggregated risk-based capital ratio of
7 percentage points.
The Company's management believes there are additional actions that may be
taken in 2009 to improve the capitalization and aggregate risked-based capital
ratio including, but not limited to the sale of certain securities in our
portfolio and entry into additional reinsurance arrangements. Such additional
actions that may be taken in the future are not reflected in our current 2009
operating plan or the projected sources and uses of cash summarized above. There
can be no assurance that such actions can be completed on acceptable terms or
that the completion of any such actions would not result in other adverse
effects such as the reduction of future profitability of the Company.
Our financial condition and ratings, the degree of our leverage, the
current credit market conditions and the restrictions in our Second Amended
Credit Facility present issues which could have material adverse consequences to
us, including the following: (i) the Second Amended Credit Facility places
severe limitations on our ability to make principal payments to the holders of
the Debentures and without an amendment of our Second Amended Credit Facility
(or the consent of the lenders) or a modification of our obligations under the
Debentures, we would be in default of our obligations to the holders of the
Debentures should they exercise their right to require the Company to repurchase
their Debentures for cash on September 30, 2010, (ii) our ability to obtain
additional financing is limited; (iii) all of our projected cash flow from the
operations of our holding companies will be required to be used for the payment
of interest expense and principal repayment obligations; (iv) the ability of our
holding companies to receive cash dividends and surplus debenture interest
payments from our insurance subsidiaries is subject to regulatory approval; (v)
any new financing or any refinancing or modifications of our current
indebtedness will likely be available only at interest rates that are
significantly higher than we are currently paying; and (vi) our ability to
compete in certain markets and to sell certain products is severely limited by
our current financial condition and ratings.
The current uncertainty or volatility in the financial markets has reduced
our ability to obtain new financing on favorable terms, and eliminated our
ability to access certain markets at all. As a result, we do not believe we will
be able to replace our current revolving credit facility when it matures on June
22, 2009, or if a replacement is available it would likely have unattractive
terms. In addition, if we would violate any loan covenants or financial ratios
under our Second Amended Credit Facility, the cost of a waiver or modification
would likely be unattractive, or may not be possible at all.
On March 4, 2009, A.M. Best downgraded the financial strength ratings of
our primary insurance subsidiaries to "B" from "B+" and such ratings have been
placed under review with negative implications. On March 3, 2009, Moody's
downgraded the financial strength ratings of our primary insurance subsidiaries
to "Ba2" from "Ba1" and the outlook remained negative for our primary insurance
subsidiaries. On February 26, 2009, S&P downgraded the financial strength
ratings of our primary insurance subsidiaries to "BB-" from "BB+" and the
outlook remained negative for our primary insurance subsidiaries.
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CONSECO, INC. AND SUBSIDIARIES
-------------------
In light of the difficulties experienced recently by many financial
institutions, including insurance companies, rating agencies have increased the
frequency and scope of their credit reviews and requested additional information
from the companies that they rate, including us. They may also adjust upward the
capital and other requirements employed in the rating agency models for
maintenance of certain ratings levels. We cannot predict what actions rating
agencies may take, or what actions we may take in response.
Accordingly, further downgrades and outlook revisions related to us or the
life insurance industry may occur in the future at any time and without notice
by any rating agency. These could increase policy surrenders and withdrawals,
adversely affect relationships with our distribution channels, reduce new sales,
reduce our ability to borrow and increase our future borrowing costs.
We believe that the existing cash available to CNO, the cash flows to be
generated from operations and the other transactions summarized above will be
sufficient to allow us to meet our debt obligations through the next twelve
months. Our cash flow may be affected by a variety of factors, many of which are
outside of our control, including insurance regulatory issues, competition,
financial markets and other general business conditions. We cannot provide
assurance that we will possess sufficient income and liquidity to meet all of
our debt service requirements and other holding company obligations.
Our principal repayments and other debt service requirements in 2010
currently exceed the cash flows expected to be available from our subsidiaries.
We have the following debt repayment obligations in 2010 (dollars in millions):
3.50% convertible debentures.................. $293.0
Secured credit agreement...................... 8.8
6% Senior Note................................ 25.0
------
$326.8
======
We are continuing to explore various alternatives to address our 2010 debt
service requirements, including, without limitation, financing transactions,
reinsurance transactions, asset sales, transactions to improve statutory capital
and debt modification. Failure to generate sufficient cash to meet our debt
obligations in 2010 could have material adverse consequences on the Company.
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CONSECO, INC. AND SUBSIDIARIES
-------------------
INVESTMENTS
At March 31, 2009, the amortized cost, gross unrealized gains and losses
and estimated fair value of actively managed fixed maturities and equity
securities were as follows (dollars in millions):
Gross Gross Estimated
Amortized unrealized unrealized fair
cost gains losses value
---- ----- ------ -----
Investment grade (a):
Corporate securities........................................... $12,271.5 $29.9 $(1,925.7) $10,375.7
United States Treasury securities and obligations of
United States government corporations and agencies........... 398.3 8.6 (1.1) 405.8
States and political subdivisions.............................. 449.0 1.5 (58.3) 392.2
Debt securities issued by foreign governments.................. 4.8 .1 (.6) 4.3
Asset-backed securities........................................ 263.6 - (73.7) 189.9
Collateralized debt obligations................................ 120.4 - (23.3) 97.1
Commercial mortgage-backed securities.......................... 835.4 - (262.6) 572.8
Mortgage pass-through securities............................... 71.3 2.2 (.1) 73.4
Collateralized mortgage obligations............................ 1,927.6 35.5 (233.3) 1,729.8
--------- ----- --------- ---------
Total investment grade actively managed fixed
maturities............................................... 16,341.9 77.8 (2,578.7) 13,841.0
--------- ----- --------- ---------
Below-investment grade:
Corporate securities........................................... 1,682.6 .1 (404.2) 1,278.5
States and political subdivisions.............................. 4.8 - (1.6) 3.2
Debt securities issued by foreign governments.................. 4.2 - (1.3) 2.9
Asset-backed securities........................................ 38.1 - (24.6) 13.5
Collateralized debt obligations................................ 11.8 - (6.9) 4.9
Commercial mortgage-backed securities.......................... 35.7 - (17.1) 18.6
Collateralized mortgage obligations............................ 418.9 - (184.7) 234.2
--------- ----- --------- ---------
Total below-investment grade actively
managed fixed maturities................................ 2,196.1 .1 (640.4) 1,555.8
--------- ----- --------- ---------
Total actively managed fixed maturities........................ $18,538.0 $77.9 $(3,219.1) $15,396.8
========= ===== ========= =========
Equity securities................................................. $30.7 $2.8 $(1.0) $32.5
===== ==== ===== =====
<FN>
- ---------------
(a) Investment ratings - The Securities Valuation Office ("SVO") of the
National Association of Insurance Commissioners (the "NAIC") evaluates
fixed maturity investments for regulatory reporting purposes and assigns
securities to one of six investment categories called "NAIC
Designations". The NAIC ratings are similar to the rating agency
descriptions of the Nationally Recognized Statistical Rating
Organization ("NRSROs"). NAIC designations of "1" or "2" include fixed
maturities generally rated investment grade (rated "Baa3" or higher by
Moody's or rated "BBB-" or higher by S&P and Fitch Ratings ("Fitch")).
NAIC Designations of "3" through "6" are referred to as below investment
grade (which generally are rated "Ba1" or lower by Moody's or rated
"BB+" or lower by S&P and Fitch). As a result of time lags between the
funding of investments, the finalization of legal documents and the
completion of the SVO filing process, our fixed maturities generally
include securities that have not yet been rated by the SVO as of each
balance sheet date. Pending receipt of the SVO ratings, the
classification of these securities by NAIC Designation is based on the
expected ratings as determined by the Company. References to investment
grade or below investment grade throughout our consolidated financial
statements are based on NAIC Designations.
</FN>
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CONSECO, INC. AND SUBSIDIARIES
-------------------
Concentration of Actively Managed Fixed Maturity Securities
The following table summarizes the carrying values of our actively managed
fixed maturity securities by category as of March 31, 2009 (dollars in
millions):
Percent of
Gross gross
Percent of unrealized unrealized
Carrying value fixed maturities losses losses
-------------- ---------------- ------ ------
Collateralized mortgage obligations............... $ 1,964.0 12.8% $ (418.0) 13.0%
Energy/pipelines.................................. 1,562.4 10.2 (256.4) 8.0
Utilities......................................... 1,495.7 9.7 (193.0) 6.0
Food/beverage..................................... 1,051.4 6.8 (97.1) 3.0
Healthcare/pharmaceuticals........................ 895.9 5.8 (77.9) 2.4
Banks............................................. 685.0 4.4 (330.7) 10.3
Insurance......................................... 636.6 4.1 (297.2) 9.2
Cable/media....................................... 594.0 3.9 (132.9) 4.1
Commercial mortgage-backed securities............. 591.4 3.8 (279.7) 8.7
Real estate/REITs................................. 485.8 3.2 (170.5) 5.3
Telecom........................................... 453.2 2.9 (65.6) 2.0
Capital goods..................................... 435.1 2.8 (82.7) 2.6
Aerospace/defense................................. 408.6 2.7 (21.1) .7
United States Treasury securities and obligations
of United States government corporations and
agencies........................................ 405.8 2.6 (1.1) -
Brokerage......................................... 397.4 2.6 (106.1) 3.3
States and political subdivisions................. 395.4 2.6 (59.9) 1.9
Transportation.................................... 374.4 2.4 (41.8) 1.3
Building materials................................ 291.6 1.9 (90.0) 2.8
Technology........................................ 222.0 1.5 (29.5) .9
Asset-backed securities........................... 203.4 1.3 (98.3) 3.0
Consumer products................................. 173.8 1.1 (28.7) .9
Other............................................. 1,673.9 10.9 (340.9) 10.6
--------- ----- --------- -----
Total actively managed fixed maturities........ $15,396.8 100.0% $(3,219.1) 100.0%
========= ===== ========= =====
Below-Investment Grade Securities
At March 31, 2009, the amortized cost of the Company's below-investment
grade fixed maturity securities was $2,196.1 million, or 12 percent of the
Company's fixed maturity portfolio. The estimated fair value of the
below-investment grade portfolio was $1,555.8 million, or 71 percent of the
amortized cost.
Below-investment grade fixed maturity securities with an amortized cost of
$364.8 million and an estimated fair value of $269.5 million are held by a VIE
that we are required to consolidate. These fixed maturity securities are legally
isolated and are not available to the Company. The liabilities of such VIE will
be satisfied from the cash flows generated by these securities and are not
obligations of the Company. See "Investment in Variable Interest Entity"
concerning the Company's investment in the VIE.
Below-investment grade securities have different characteristics than
investment grade corporate debt securities. Based on historical performance,
risk of default by the borrower is significantly greater for below-investment
grade securities and in many cases, severity of loss is relatively greater as
such securities are generally unsecured and often subordinated to other
indebtedness of the issuer. Also, issuers of below-investment grade securities
usually have higher levels of debt and may be more financially leveraged, hence,
all other things being equal, more sensitive to adverse economic conditions,
such as recession or increasing interest rates. The Company attempts to reduce
the overall risk related to its investment in below-
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CONSECO, INC. AND SUBSIDIARIES
-------------------
investment grade securities, as in all investments, through careful credit
analysis, strict investment policy guidelines, and diversification by issuer
and/or guarantor and by industry.
Net Realized Investment Gains (Losses)
During the first three months of 2009, we recognized net realized
investment losses of $6.9 million, which were comprised of $85.1 million of net
gains from the sales of investments (primarily fixed maturities) with proceeds
of $2.6 billion, net of $92.0 million of writedowns of investments for other
than temporary declines in fair value recognized through net income ($108.1
million, prior to the $16.1 million of impairment losses recognized through
other comprehensive loss). During the first three months of 2008, we recognized
net realized investment losses of $4.3 million from the sales of investments
(primarily fixed maturities) with proceeds of $1.9 billion, and $41.3 million of
writedowns of investments for other than temporary declines in fair value. At
March 31, 2009, fixed maturity securities in default as to the payment of
principal or interest had an aggregate amortized cost of $3.4 million and a
carrying value of $.9 million. At March 31, 2009, we had mortgage loans with an
aggregate carrying value of $7.6 million that were 90 days or more past due as
to the payment of principal or interest.
During the three months ended March 31, 2009, we sold $93.6 million of
fixed maturity investments which resulted in gross investment losses (before
income taxes) of $4.3 million. We sell securities at a loss for a number of
reasons including, but not limited to: (i) changes in the investment
environment; (ii) expectation that the market value could deteriorate further;
(iii) desire to reduce our exposure to an issuer or an industry; (iv) changes in
credit quality; or (v) changes in expected liability cash flows. During the
first three months of 2009, we sold two investments at a loss which had been
continuously in an unrealized loss position exceeding 20 percent of the
amortized cost basis. Such investments were continuously in an unrealized loss
position for less than six months prior to sale and had an amortized cost and
estimated fair value of $.8 million and $.4 million, respectively.
We regularly evaluate our investments for possible impairment. Our
assessment of whether unrealized losses are "other than temporary" requires
significant judgment. Factors considered include: (i) the extent to which market
value is less than the cost basis; (ii) the length of time that the market value
has been less than cost; (iii) whether the unrealized loss is event driven,
credit-driven or a result of changes in market interest rates or risk premium;
(iv) the near-term prospects for fundamental improvement in specific
circumstances likely to affect the value of the investment; (v) the investment's
rating and whether the investment is investment-grade and/or has been downgraded
since its purchase; (vi) whether the issuer is current on all payments in
accordance with the contractual terms of the investment and is expected to meet
all of its obligations under the terms of the investment; (vii) our intent not
to sell an impaired investment before its recovery occurs; (viii) whether it is
more likely than not that we will be required to sell the investment before
recovery occurs; (ix) the underlying current and prospective asset and
enterprise values of the issuer and the extent to which the recoverability of
the carrying value of our investment may be affected by changes in such values;
(x) unfavorable changes in cash flows on structured securities including
mortgage-backed and asset-backed securities; and (xi) other subjective factors.
Future events may occur, or additional information may become available,
which may necessitate future realized losses of securities in our portfolio.
Significant losses in the estimated fair values of our investments could have a
material adverse effect on our earnings in future periods.
During the first quarter of 2009, we adopted FSP FAS 115-2, which changes
the recognition and presentation of other-than-temporary impairments. Refer to
the note to the consolidated financial statements entitled "Recently Issued
Accounting Standards - Adopted Accounting Standards" for additional information.
The recognition provisions within FSP FAS 115-2 apply only to our actively
managed fixed maturity investments.
Impairment losses on equity securities are recognized in net income. The
manner in which impairment losses on actively managed fixed maturity securities
are recognized in the financial statements is dependent on the facts and
circumstances related to the specific security. If we intend to sell a security
or it is more likely than not that we would be required to sell a security
before the recovery of its amortized cost, the security is
other-than-temporarily impaired and the full amount of the impairment is
recognized as a loss through earnings. If we do not expect to recover the
amortized cost basis, we do not plan to sell the security and if it is not more
likely than not that we would be required to sell a security before the recovery
of its amortized cost, less any current period credit loss, the recognition of
the other-than-temporary impairment is bifurcated. We recognize the credit loss
portion in net income and the noncredit loss portion in other comprehensive
loss.
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CONSECO, INC. AND SUBSIDIARIES
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We estimate the amount of the credit loss component of a fixed maturity
security impairment as the difference between amortized cost and the present
value of the expected cash flows of the security. The present value is
determined using the best estimate of future cash flows discounted at the
effective interest rate implicit to the security at the date of purchase or the
current yield to accrete an asset-backed or floating rate security. The
methodology and assumptions for establishing the best estimate of future cash
flows vary depending on the type of security. The asset-backed securities cash
flow estimates are based on bond specific facts and circumstances that may
include collateral characteristics, expectations of delinquency and default
rates, loss severity, prepayment speeds and structural support, including
subordination and guarantees. The corporate bond cash flow estimates are derived
from scenario-based outcomes of expected corporate restructurings or the
disposition of assets using bond specific facts and circumstances including
timing, secured interest and loss severity. As of March 31, 2009,
other-than-temporary impairments included in other comprehensive loss of $25.3
million (before taxes and related amortization) relate only to asset-backed
securities (including collateralized debt obligations and collateralized
mortgage obligations).
The following table sets forth the amortized cost and estimated fair value
of those actively managed fixed maturities with unrealized losses at March 31,
2009, by contractual maturity. Actual maturities will differ from contractual
maturities because borrowers may have the right to call or prepay obligations
with or without call or prepayment penalties. Asset-backed securities,
collateralized debt obligations, commercial mortgage-backed securities, mortgage
pass-through securities and collateralized mortgage obligations are collectively
referenced to as "structured securities". Many of the structured securities
shown below provide for periodic payments throughout their lives (dollars in
millions):
Estimated
Amortized fair
cost value
--------- ---------
Due in one year or less................................................................. $ 41.7 $ 40.4
Due after one year through five years................................................... 1,501.9 1,284.1
Due after five years through ten years.................................................. 4,355.8 3,594.3
Due after ten years..................................................................... 7,308.5 5,896.3
--------- ---------
Subtotal............................................................................. 13,207.9 10,815.1
Structured securities................................................................... 2,872.4 2,046.1
--------- ---------
Total................................................................................ $16,080.3 $12,861.2
========= =========
The following summarizes the investments in our portfolio rated
below-investment grade which have been continuously in an unrealized loss
position exceeding 20 percent of the cost basis for the period indicated as of
March 31, 2009 (dollars in millions):
Number Cost Unrealized Estimated
Period of issuers basis loss fair value
------ ---------- ----- ---- ----------
Less than 6 months................. 155 $365.3 $(134.9) $230.4
Greater than or equal to
6 months and less
than 12 months................... 121 854.4 (384.6) 469.8
Greater than 12 months............. 26 69.6 (49.1) 20.5
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CONSECO, INC. AND SUBSIDIARIES
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The following table summarizes the gross unrealized losses of our actively
managed fixed maturity securities by category and ratings category as of March
31, 2009 (dollars in millions):
Below -
Investment grade investment grade Total gross
-------------------- -------------------------- unrealized
NAIC 1 NAIC 2 NAIC 3 NAIC 4 and below losses
------ ------ ------ ---------------- ------
Collateralized mortgage obligations.. $ 215.7 $ 17.6 $117.5 $ 67.2 $ 418.0
Banks................................ 239.6 46.1 39.3 5.7 330.7
Insurance............................ 163.1 125.7 - 8.4 297.2
Commercial mortgage-backed
securities......................... 168.6 94.0 9.6 7.5 279.7
Energy/pipelines..................... 40.1 200.1 10.4 5.9 256.5
Utilities............................ 46.3 133.6 4.9 8.2 193.0
Real estate/REITs.................... 15.3 144.0 8.1 3.1 170.5
Cable/media.......................... 17.4 77.1 8.9 29.4 132.8
Brokerage............................ 72.2 32.7 - 1.2 106.1
Food/beverage........................ 25.0 60.9 4.2 7.0 97.1
Asset-backed securities.............. 45.3 28.4 5.1 19.5 98.3
Building materials................... .1 38.8 43.8 7.3 90.0
Capital goods........................ 37.1 33.9 6.2 5.5 82.7
Healthcare/pharmaceuticals........... 34.4 29.9 4.0 9.6 77.9
Telecom.............................. 23.9 23.6 16.9 1.2 65.6
States and political subdivisions.... 21.8 36.5 1.6 - 59.9
Transportation....................... 2.9 37.7 - 1.2 41.8
Entertainment/hotels................. - 21.8 13.4 6.2 41.4
Retail............................... 4.9 19.9 6.0 10.1 40.9
Collateralized debt obligations...... 13.4 9.9 - 6.9 30.2
Technology........................... 8.4 8.5 6.7 5.8 29.4
Consumer products.................... 5.1 14.8 - 8.8 28.7
Chemicals............................ 1.5 12.7 4.3 9.3 27.8
Paper................................ - 9.6 11.8 5.2 26.6
Metals and mining.................... 3.6 15.1 4.8 .4 23.9
Gaming............................... - - - 22.8 22.8
Aerospace/defense.................... 5.7 10.2 4.2 1.0 21.1
Autos................................ 3.3 - .7 14.2 18.2
Textiles............................. 7.6 .2 .3 2.4 10.5
Foreign governments.................. .6 - 1.3 - 1.9
U.S. Treasury and Obligations........ 1.1 - - - 1.1
Mortgage pass-through securities..... .1 - - - .1
Other................................ 9.4 61.9 13.5 11.9 96.7
-------- -------- ------ ------ --------
Total actively managed fixed
maturities....................... $1,233.5 $1,345.2 $347.5 $292.9 $3,219.1
======== ======== ====== ====== ========
At March 31, 2009, we held seven individual non-investment grade
collateralized mortgage-backed securities that had a cost basis of $332.9
million, an estimated fair value of $165.1 million and unrealized losses of
$167.8 million. As of March 31, 2009, these securities had been in an unrealized
loss position exceeding 20 percent of cost for three to eight months. We also
held one asset-backed security that had a cost basis of $27.5 million, an
estimated fair value of $8.0 million and an unrealized loss of $19.5 million at
March 31, 2009. This security had been in an unrealized loss position exceeding
20 percent of cost for over one year. These securities are senior tranches in
their respective securitization structures which hold standard and Alt-A
residential mortgages originating in 2006 and 2007. These securities were rated
NAIC 3 and NAIC 4 at March 31, 2009. Given current market conditions, limited
trading of these securities and recent rating actions, the estimated fair value
of these securities has declined. We believe the decline is largely due to
widening credit spreads and high premium for liquidity that existed at March 31,
2009. We have examined the performance of the underlying collateral and expect
that our investments will continue to perform in accordance with the contractual
terms.
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CONSECO, INC. AND SUBSIDIARIES
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Our investment strategy is to maximize, over a sustained period and within
acceptable parameters of risk, investment income and total investment return
through active investment management. Accordingly, we may sell securities at a
gain or a loss to enhance the total return of the portfolio as market
opportunities change or to better match certain characteristics of our
investment portfolio with the corresponding characteristics of our insurance
liabilities. While we do not have the intent to sell securities with unrealized
losses and it is not more likely than not that we will be required to sell
securities with unrealized losses prior to their anticipated recovery, we may
sell securities at a loss in the future because of actual or expected changes in
our view of the particular investment, its industry, its type or the general
investment environment.
The following table summarizes the gross unrealized losses and fair values
of our investments with unrealized losses that are not deemed to be
other-than-temporarily impaired, aggregated by investment category and length of
time that such securities have been in a continuous unrealized loss position, at
March 31, 2009 (dollars in millions):
Less than 12 months 12 months or greater Total
--------------------- --------------------- ---------------------
Estimated Estimated Estimated
fair Unrealized fair Unrealized fair Unrealized
Description of securities value losses value losses value losses
------------------------- ----- ------ ----- ------ ----- ------
United States Treasury securities
and obligations of United
States government
corporations and agencies...... $ 11.7 $ (.9) $ 1.6 $ (.2) $ 13.3 $ (1.1)
States and political subdivisions. 106.4 (14.4) 230.0 (45.5) 336.4 (59.9)
Debt securities issued by
foreign governments............ - - 6.2 (1.9) 6.2 (1.9)
Corporate securities.............. 4,366.2 (469.7) 6,093.0 (1,860.2) 10,459.2 (2,329.9)
Asset-backed securities........... 55.5 (9.1) 147.0 (89.2) 202.5 (98.3)
Collateralized debt obligations... 50.1 (16.7) 39.4 (13.5) 89.5 (30.2)
Commercial mortgage-backed
securities..................... 137.7 (18.0) 452.1 (261.7) 589.8 (279.7)
Mortgage pass-through securities.. 5.5 (.1) .1 - 5.6 (.1)
Collateralized mortgage
obligations.................... 199.4 (10.2) 959.3 (407.8) 1,158.7 (418.0)
-------- ------- -------- --------- --------- ---------
Total actively managed
fixed maturities............... $4,932.5 $(539.1) $7,928.7 $(2,680.0) $12,861.2 $(3,219.1)
======== ======= ======== ========= ========= =========
Equity securities................. $7.2 $(1.0) $ - $ - $7.2 $(1.0)
==== ===== ====== ====== ==== =====
Based on management's current assessment of investments with unrealized
losses at March 31, 2009, the Company believes the issuers of the securities
will continue to meet their obligations (or with respect to equity-type
securities, the investment value will recover to its cost basis). While we do
not have the intent to sell securities with unrealized losses and it is not more
likely than not that we will be required to sell securities with unrealized
losses prior to their anticipated recovery, our intent on an individual security
may change, based upon market or other unforeseen developments. In such
instances, we sell securities in the ordinary course of managing our portfolio
to meet diversification, credit quality, yield, duration and liquidity
requirements. If a loss is recognized from a sale subsequent to a balance sheet
date due to these unexpected developments, the loss is recognized in the period
in which we had the intent to sell the securities before their anticipated
recovery.
Structured Securities
At March 31, 2009, fixed maturity investments included $2.9 billion of
structured securities (or 19 percent of all fixed maturity securities). The
yield characteristics of structured securities differ in some respects from
those of traditional fixed-
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CONSECO, INC. AND SUBSIDIARIES
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income securities. For example, interest and principal payments on structured
securities may occur more frequently, often monthly. In many instances, we are
subject to the risk that the amount and timing of principal and interest
payments may vary from expectations. For example, prepayments may occur at the
option of the issuer and prepayment rates are influenced by a number of factors
that cannot be predicted with certainty, including: the relative sensitivity of
the underlying assets backing the security to changes in interest rates; a
variety of economic, geographic and other factors; and various security-specific
structural considerations (for example, the repayment priority of a given
security in a securitization structure).
In general, the rate of prepayments on structured securities increases when
prevailing interest rates decline significantly in absolute terms and also
relative to the interest rates on the underlying assets. The yields recognized
on structured securities purchased at a discount to par will increase (relative
to the stated rate) when the underlying assets prepay faster than expected. The
yields recognized on structured securities purchased at a premium will decrease
(relative to the stated rate) when the underlying assets prepay faster than
expected. When interest rates decline, the proceeds from prepayments may be
reinvested at lower rates than we were earning on the prepaid securities. When
interest rates increase, prepayments may decrease. When this occurs, the average
maturity and duration of the structured securities increase, which decreases the
yield on structured securities purchased at a discount because the discount is
realized as income at a slower rate, and it increases the yield on those
purchased at a premium because of a decrease in the annual amortization of the
premium.
For structured securities included in actively managed fixed maturities
that were purchased at a discount or premium, we recognize investment income
using an effective yield based on anticipated future prepayments and the
estimated final maturity of the securities. Actual prepayment experience is
periodically reviewed and effective yields are recalculated when differences
arise between the prepayments originally anticipated and the actual prepayments
received and currently anticipated. For credit sensitive mortgage-backed and
asset-backed securities, and for securities that can be prepaid or settled in a
way that we would not recover substantially all of our investment, the effective
yield is recalculated on a prospective basis. Under this method, the amortized
cost basis in the security is not immediately adjusted and a new yield is
applied prospectively. For all other structured and asset-backed securities, the
effective yield is recalculated when changes in assumptions are made, and
reflected in our income on a retrospective basis. Under this method, the
amortized cost basis of the investment in the securities is adjusted to the
amount that would have existed had the new effective yield been applied since
the acquisition of the securities. Such adjustments were not significant in the
first three months of 2009.
The following table sets forth the par value, amortized cost and estimated
fair value of structured securities, summarized by interest rates on the
underlying collateral, at March 31, 2009 (dollars in millions):
Par Amortized Estimated
value cost fair value
----- ---- ----------
Below 4 percent..................................................................... $ 98.9 $ 77.8 $ 62.0
4 percent - 5 percent............................................................... 348.9 345.8 353.6
5 percent - 6 percent............................................................... 2,310.7 2,270.1 1,801.2
6 percent - 7 percent............................................................... 828.9 764.0 536.4
7 percent - 8 percent............................................................... 193.1 188.5 125.5
8 percent and above................................................................. 77.2 76.6 55.5
-------- -------- --------
Total structured securities.................................................. $3,857.7 $3,722.8 $2,934.2
======== ======== ========
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CONSECO, INC. AND SUBSIDIARIES
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The amortized cost and estimated fair value of structured securities at
March 31, 2009, summarized by type of security, were as follows (dollars in
millions):
Estimated fair value
-----------------------
Percent
Amortized of fixed
Type cost Amount maturities
- ---- ---- ------ ----------
Pass-throughs, sequential and equivalent securities....................... $1,318.3 $1,228.6 8.0%
Planned amortization class, target amortization class and
accretion-directed bonds............................................... 993.6 729.1 4.7
Commercial mortgage-backed securities..................................... 871.1 591.4 3.9
Asset-backed securities................................................... 301.7 203.4 1.3
Collateralized debt obligations........................................... 132.2 102.0 .7
Other..................................................................... 105.9 79.7 .5
-------- -------- ----
Total structured securities........................................ $3,722.8 $2,934.2 19.1%
======== ======== ====
Pass-throughs, sequentials and equivalent securities have unique prepayment
variability characteristics. Pass-through securities typically return principal
to the holders based on cash payments from the underlying mortgage obligations.
Sequential securities return principal to tranche holders in a detailed
hierarchy. Planned amortization classes, targeted amortization classes and
accretion-directed bonds adhere to fixed schedules of principal payments as long
as the underlying mortgage loans experience prepayments within certain estimated
ranges. Changes in prepayment rates are first absorbed by support or companion
classes insulating the timing of receipt of cash flows from the consequences of
both faster prepayments (average life shortening) and slower prepayments
(average life extension).
Commercial mortgage-backed securities ("CMBS") are secured by commercial
real estate mortgages, generally income producing properties that are managed
for profit. Property types include multi-family dwellings including apartments,
retail centers, hotels, restaurants, hospitals, nursing homes, warehouses, and
office buildings. Most CMBS have call protection features whereby underlying
borrowers may not prepay their mortgages for stated periods of time without
incurring prepayment penalties.
Structured Securities Collateralized by Sub Prime Residential Loans
Our investment portfolio includes structured securities collateralized by
sub prime residential loans with a market value of $43.7 million and a book
value of $79.2 million at March 31, 2009. These securities represent .2 percent
of our consolidated investment portfolio. Of these securities, $32.1 million (73
percent) were rated NAIC 1, $6.1 million (14 percent) were rated NAIC 2, $5.4
million (12 percent) were rated NAIC 3 and $.1 million (1 percent) were rated
NAIC 5. Sub prime structured securities issued in 2006 and 2007 have experienced
higher delinquency and foreclosure rates than originally expected. The Company's
investment portfolio includes sub prime structured securities collateralized by
residential loans extended over several years, primarily from 2003 to 2007. At
March 31, 2009, we held no sub prime securities collateralized by residential
loans extended in 2006 and we held $4.9 million extended in 2007.
Securities Lending
The Company participates in a securities lending program whereby certain
fixed maturity securities from our investment portfolio are loaned to third
parties via a lending agent for a short period of time. We maintain ownership of
the loaned securities. We require collateral equal to 102 percent of the market
value of the loaned securities. The collateral is invested by the lending agent
in accordance with our guidelines. The fair value of the loaned securities is
monitored on a daily basis with additional collateral obtained as necessary.
Under the terms of the securities lending program, the lending agent indemnifies
the Company against borrower defaults. As of March 31, 2009 and December 31,
2008, the fair value of the loaned securities was $244.7 million and $389.3
million, respectively. As of March 31, 2009 and December 31, 2008, the Company
had received collateral of $256.4 million and $408.8 million, respectively.
Income generated from the program, net of expenses is recorded as net investment
income and totaled $.4 million and $.7 million in the first three months of 2009
and 2008, respectively.
88
CONSECO, INC. AND SUBSIDIARIES
-------------------
INVESTMENT IN VARIABLE INTEREST ENTITY
Fall Creek is a collateralized loan trust that was established to issue
securities and use the proceeds to invest in loans and other permitted
investments. The assets held by the trust are legally isolated and are not
available to the Company. The liabilities of Fall Creek will be satisfied from
the cash flows generated by the underlying loans, not from the assets of the
Company. The investment borrowings were issued pursuant to an indenture between
Fall Creek and a trustee. The investment borrowings of Fall Creek may become due
and payable if certain threshold ratios (based on the entity's leverage and the
market value of its assets) are not met for a specified period of time. During
the first quarter of 2008, such threshold ratio was not met and the indenture
was amended. As a result of the amendment, Fall Creek sold assets of $90 million
(which resulted in net realized investment losses of $11.2 million), and paid
down investment borrowings of $88.0 million. Pursuant to the amendment, we
committed to provide additional capital to Fall Creek for up to $25 million
(under defined circumstances) all of which was contributed in 2008. In addition,
the indenture was amended and restated in November 2008, to change certain terms
related to the investment borrowings, cease future reinvesting activities of
Fall Creek, provide for an additional investment in Fall Creek and remove the
provision related to threshold ratios. In conjunction with the amendment and
restatement of the indenture, Fall Creek repaid $17.5 million of investment
borrowings and the Company purchased: (i) $25.2 million of borrowings previously
held by others; and (ii) $9.7 million of newly issued borrowings of Fall Creek.
Repayment of the remaining principal balance of the investment borrowings of
Fall Creek is based on available cash flows from the assets and such borrowings
mature in 2017. An $8.9 million repayment was made in the first quarter of 2009
based on such excess cash flows. The Company has no further commitments to Fall
Creek. The carrying value of our investment in Fall Creek was $77.7 million and
$83.5 million at March 31, 2009 and December 31, 2008, respectively. The
following tables provide supplemental information about the assets, liabilities,
revenues and expenses of Fall Creek which have been consolidated in accordance
with FIN 46 (R), after giving effect to the elimination of our investment in
Fall Creek and investment management fees earned by a subsidiary of the Company
(dollars in millions):
March 31, December 31,
2009 2008
---- ----
Assets:
Actively managed fixed maturities.................................................. $277.8 $ 269.7
Cash and cash equivalents - restricted............................................. 4.4 4.8
Accrued investment income.......................................................... 1.6 2.8
Other assets....................................................................... 6.1 7.2
------- -------
Total assets................................................................... $289.9 $ 284.5
====== =======
Liabilities:
Other liabilities.................................................................. $ 9.2 $ 7.8
Investment borrowings due to others................................................ 297.6 306.5
Investment borrowings due to the Company........................................... 81.9 81.9
------ -------
Total liabilities.............................................................. 388.7 396.2
------ -------
Equity (deficit):
Capital provided by the Company.................................................... 16.6 16.6
Capital provided by others......................................................... 3.8 3.8
Accumulated other comprehensive loss............................................... (95.8) (118.4)
Accumulated deficit................................................................ (23.4) (13.7)
------ -------
Total deficit.................................................................. (98.8) (111.7)
------ -------
Total liabilities and deficit.................................................. $289.9 $ 284.5
====== =======
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CONSECO, INC. AND SUBSIDIARIES
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Three months ended
March 31,
-----------------------
2009 2008
---- ----
Revenues:
Net investment income - deposit accounts.......................................... $ 4.3 $ 7.9
Fee revenue and other income...................................................... .1 .2
----- ------
Total revenues................................................................ 4.4 8.1
----- ------
Expenses:
Interest expense.................................................................. 4.3 6.5
Other operating expenses.......................................................... .1 .1
----- ------
Total expenses................................................................ 4.4 6.6
----- ------
Income before net realized investment
losses and income taxes..................................................... - 1.5
Net realized investment losses....................................................... (7.8) (16.6)
----- ------
Loss before income taxes...................................................... $(7.8) $(15.1)
===== ======
During the first three months of 2009, net realized investment losses
included: (i) $.5 million of net gains from the sales of investments; net of
(ii) $8.3 million of writedowns of investments resulting from declines in fair
values that we concluded were other than temporary. During the first three
months of 2008, net realized investment losses included: (i) $11.2 million of
net losses from the sales of investments; and (ii) $5.4 million of writedowns of
investments resulting from declines in fair values that we concluded were other
than temporary.
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CONSECO, INC. AND SUBSIDIARIES
-------------------
RESULTS OF DISCONTINUED OPERATIONS
As further discussed in the note to the consolidated financial statements
entitled "Transfer of Senior Health Insurance Company of Pennsylvania to an
Independent Trust", the long-term care business of Senior Health is reflected as
a discontinued operation in all periods presented. The following summarizes the
operating results of our discontinued operations (dollars in millions):
Three months ended
March 31, 2008
------------------
Premium collections (all of which are renewal premiums):
Long-term care..................................................................... $ 67.0
========
Average liabilities for insurance products, net of reinsurance ceded:
Long-term care..................................................................... $2,929.4
========
Revenues:
Insurance policy income............................................................ $ 66.1
Net investment income on general account invested assets........................... 43.7
--------
Total revenues................................................................. 109.8
--------
Expenses:
Insurance policy benefits.......................................................... 90.1
Amortization related to operations................................................. 5.3
Other operating costs and expenses................................................. 15.7
--------
Total benefits and expenses.................................................... 111.1
--------
Loss before net realized investment gains and income taxes........................... (1.3)
Net realized investment gains...................................................... 2.0
--------
Income before income taxes........................................................... $ .7
========
Health benefit ratios:
Insurance policy benefits........................................................ $90.1
Benefit ratio (a)................................................................ 136.3%
Interest-adjusted benefit ratio (b).............................................. 70.2%
<FN>
- --------------------
(a) We calculate benefit ratios by dividing the related product's insurance
policy benefits by insurance policy income.
(b) We calculate the interest-adjusted benefit ratio (a non-GAAP measure)
for long-term care products by dividing such product's insurance policy
benefits less interest income on the accumulated assets backing the
insurance liabilities by policy income. These are considered non-GAAP
financial measures. A non-GAAP measure is a numerical measure of a
company's performance, financial position, or cash flows that excludes
or includes amounts that are normally excluded or included in the most
directly comparable measure calculated and presented in accordance with
GAAP.
These non-GAAP financial measures of "interest-adjusted benefit ratios"
differ from "benefit ratios" due to the deduction of interest income on
the accumulated assets backing the insurance liabilities from the
product's insurance policy benefits used to determine the ratio.
Interest income is an important factor in measuring the performance of
health products that are expected to be inforce for a longer duration of
time, are not subject to unilateral changes in provisions (such as
non-cancelable or guaranteed renewable contracts) and require the
performance of various functions and services (including insurance
protection) for an extended period of time. The net cash flows from
long-term care products generally cause an accumulation of amounts in
the early years of a policy (accounted for as reserve increases) that
will be paid out as benefits in later policy years (accounted for as
reserve decreases). Accordingly, as
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CONSECO, INC. AND SUBSIDIARIES
-------------------
the policies age, the benefit ratio will typically increase, but the
increase in benefits will be partially offset by interest income earned
on the accumulated assets. The interest-adjusted benefit ratio reflects
the effects of the interest income offset. Since interest income is an
important factor in measuring the performance of this product,
management believes a benefit ratio that includes the effect of interest
income is useful in analyzing product performance. We utilize the
interest-adjusted benefit ratio in measuring segment performance for
purposes of SFAS 131 because we believe that this performance measure is
a better indicator of the ongoing businesses and trends in the business.
However, the "interest-adjusted benefit ratio" does not replace the
"benefit ratio" as a measure of current period benefits to current
period insurance policy income. Accordingly, management reviews both
"benefit ratios" and "interest-adjusted benefit ratios" when analyzing
the financial results attributable to these products. The investment
income earned on the accumulated assets backing long-term care reserves
in our discontinued operations was $43.7 million in the first three
months of 2008.
</FN>
Total premium collections were $67.0 million in the first three months of
2008. We ceased marketing this long-term care business in 2003.
Average liabilities for insurance products, net of reinsurance ceded were
approximately $2.9 billion the first three months of 2008.
Insurance policy income is comprised of premiums earned on these long-term
care policies.
Net investment income on general account invested assets was $43.7 million
the first three months of 2008. The average balance of general account invested
assets was $3.0 billion in the first three months of 2008. The average yield on
these assets was 5.86 percent the first three months of 2008.
Insurance policy benefits fluctuated primarily as a result of the factors
summarized below.
Insurance policy benefits were $90.1 million the first three months of
2008.
The benefit ratio on this block of business was 136.3 percent the first
three months of 2008. Benefit ratios are calculated by dividing the product's
insurance policy benefits by insurance policy income. Since the insurance
product liabilities we establish for long-term care business are subject to
significant estimates, the ultimate claim liability we incur for a particular
period is likely to be different than our initial estimate. Our insurance policy
benefits reflected reserve redundancies from prior years of $10.2 million in the
first three months of 2008. Excluding the effects of prior year claim reserve
redundancies, our benefit ratios would have been 151.7 percent in the first
three months of 2008. These ratios reflect the significantly higher level of
incurred claims experienced in 2007 and 2006 resulting in increases in reserves
for future benefits as discussed below, adverse development on claims incurred
in prior periods as discussed below, and decreases in policy income. The prior
period deficiencies have resulted from the impact of paid claim experience being
different than prior estimates, changes in actuarial assumptions and refinements
to claimant data used to determine claim reserves.
The net cash flows from long-term care products generally cause an
accumulation of amounts in the early years of a policy (accounted for as reserve
increases) which will be paid out as benefits in later policy years (accounted
for as reserve decreases). Accordingly, as the policies age, the benefit ratio
will typically increase, but the increase in benefits will be partially offset
by investment income earned on the assets which have accumulated. The
interest-adjusted benefit ratio for long-term care products is calculated by
dividing the insurance product's insurance policy benefits less interest income
on the accumulated assets backing the insurance liabilities by insurance policy
income. The interest-adjusted benefit ratio on this business was 70.2 percent in
the first three months of 2008. Excluding the effects of prior year claim
reserve redundancies, our interest-adjusted benefit ratios would have been 85.6
percent in the first three months of 2008.
This long-term care business was issued by Senior Health prior to its
acquisition by our Predecessor in 1996. The loss experience on these products
has been worse than we originally expected. Although we anticipated a higher
level of benefits to be paid on these products as the policies aged, the paid
claims have exceeded our expectations. In addition, there has been an increase
in the incidence and duration of claims in recent periods. This adverse
experience is reflected in the higher insurance policy benefits experienced in
recent periods.
In each quarterly period, we calculated our best estimate of claim reserves
based on all of the information available to us at that time, which necessarily
takes into account new experience emerging during the period. Our actuaries
estimated
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CONSECO, INC. AND SUBSIDIARIES
-------------------
these claim reserves using various generally recognized actuarial methodologies
which are based on informed estimates and judgments that are believed to be
appropriate. Additionally, an external actuarial firm provided consulting
services which involved a review of the Company's judgments and estimates for
claim reserves on this long-term care block of business on a periodic basis.
Significant assumptions made in estimating claim reserves for long-term care
policies include expectations about the: (i) future duration of existing claims;
(ii) cost of care and benefit utilization; (iii) interest rate utilized to
discount claim reserves; (iv) claims that have been incurred but not yet
reported; (v) claim status on the reporting date; (vi) claims that have been
closed but are expected to reopen; and (vii) correspondence that has been
received that will ultimately become claims that have payments associated with
them.
Amortization related to operations includes amortization of insurance
acquisition costs. Amortization of insurance acquisition costs generally
corresponds with changes in lapse experience.
Other operating costs and expenses were $15.7 million in the first three
months of 2008. Other operating costs and expenses, excluding commission
expenses, for this segment were $8.7 million in the first three months of 2008.
Net realized investment gains (losses) fluctuated each period. During the
first three months of 2008, net realized investment losses included $2.0 million
of net gains from the sales of investments (primarily fixed maturities).
NEW ACCOUNTING STANDARDS
See "Recently Issued Accounting Standards" in the notes to consolidated
financial statements for a discussion of recently issued accounting standards.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Our market risks, and the ways we manage them, are summarized in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations", included in Conseco's Annual Report on Form 10-K for the year ended
December 31, 2008. There have been no material changes in the first three months
of 2009 to such risks or our management of such risks.
ITEM 4. CONTROLS AND PROCEDURES.
Evaluation of Disclosure Controls and Procedures. Conseco's management,
under the supervision and with the participation of the Chief Executive Officer
and the Chief Financial Officer, evaluated the effectiveness of Conseco's
disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e)
under the Securities Exchange Act of 1934, as amended). Based on its evaluation,
and in light of the material weakness in internal control over financial
reporting identified as existing as of December 31, 2007, which is described in
our Annual Report on Form 10-K, Item 9A, the Chief Executive Officer and Chief
Financial Officer concluded that, as of March 31, 2009, Conseco's disclosure
controls and procedures were not effective.
As disclosed in our 2008 Annual Report on Form 10-K, we did not maintain
effective controls over the accounting and disclosure of insurance policy
benefits, amortization expense, the liabilities for insurance products and the
value of policies inforce at the Effective Date. Specifically, the design of
controls over the actuarial reporting process to ensure the completeness and
accuracy of certain inforce policies in our Conseco Insurance Group segment was
not effective. These control deficiencies resulted in an audit adjustment to
Conseco's consolidated financial statements during the fourth quarter of 2008.
Additionally, these control deficiencies could result in a material misstatement
of the aforementioned accounts and disclosures in our annual or interim
consolidated financial statements that would not be prevented or detected on a
timely basis. Accordingly, Conseco's management has determined that these
control deficiencies constitute a material weakness. Because of this material
weakness, management concluded that Conseco did not maintain effective internal
controls over financial reporting as of December 31, 2008 based on criteria in
the Internal Control - Integrated Framework - issued by COSO.
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A material weakness is a deficiency, or a combination of deficiencies in
internal control over financial reporting, such that there is a reasonable
possibility that a material misstatement of our annual or interim financial
statements would not be prevented or detected on a timely basis.
Conseco has devoted significant efforts and resources towards remediation
of the material weakness relating to the actuarial reporting process.
Significant improvements have been made to the actuarial reporting internal
control environment and the control deficiencies in our Bankers Life and our
former Other Business in Run-off segment were remediated in 2008. Nonetheless,
the material weakness related to the design of controls to ensure the
completeness and accuracy of certain inforce policies in our Conseco Insurance
Group continued to exist as of March 31, 2009. Conseco's management continues to
assign the highest priority to Conseco's remediation efforts, with the goal of
remediating the material weakness by the end of 2009. However, due to the nature
of the remediation process and the need to allow adequate time after
implementation to evaluate and test the effectiveness of the revised controls,
no assurance can be given as to the timing of achievement of remediation.
Conseco recognizes that further improvement in its internal control over the
actuarial reporting process is essential. The most significant remaining
weaknesses to be addressed by our remediation efforts relates to the flow of
information from the administrative systems to the actuarial processes for
specified disease policies in our Conseco Insurance Group segment. Correcting
these weaknesses will allow Conseco to reduce its reliance on manual controls
and procedures. Conseco intends to continue to develop improved systems and
processes which will allow it to rely on front-end preventative controls which
will be more sustainable over the long term. Conseco recognizes that further
investment is needed to improve the actuarial reporting processes and is
committed to making the investments for these improvements.
Changes to Internal Control Over Financial Reporting. There were no changes
in the Company's internal control over financial reporting (as defined in Rule
13a-15(f) under the Securities Exchange Act of 1934) during the three months
ended March 31, 2009, that have materially affected, or are reasonably likely to
materially affect, Conseco's internal control over financial reporting.
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PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
Information required for Part II, Item 1 is incorporated by reference to
the discussion under the heading "Litigation and Other Legal Proceedings" in the
footnotes to our consolidated financial statements included in Part I, Item 1 of
this Form 10-Q.
ITEM 1A. RISK FACTORS.
Conseco and its businesses are subject to a number of risks including
general business and financial risk factors. Any or all of such factors could
have a material adverse effect on the business, financial condition or results
of operations of Conseco. Refer to "Risk Factors" in Conseco's Annual Report on
Form 10-K for the year ended December 31, 2008, for further discussion of such
risk factors. There have been no material changes from such previously disclosed
risk factors.
ITEM 5. OTHER INFORMATION.
None.
ITEM 6. EXHIBITS.
3.2 Amended and Restated By-Laws of Conseco, Inc. dated as of
April 28, 2009.
12.1 Computation of Ratio of Earnings to Fixed Charges.
31.1 Certification Pursuant to the Securities Exchange Act Rule
13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification Pursuant to the Securities Exchange Act Rule
13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted
Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
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SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
CONSECO, INC.
Dated: May 12, 2009 By: /s/ Edward J. Bonach
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Edward J. Bonach
Executive Vice President and
Chief Financial Officer
(authorized officer and
principal financial officer)
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