o our ability to achieve an upgrade of the financial strength ratings of our insurance company subsidiaries as well as the potential impact of rating downgrades on our business;
o Further reducing operating expenses and improving the efficiency of our operations.
We regularly evaluate our investments for possible impairment based on current economic conditions, credit loss experience and other investee-specific developments. When we conclude that a decline in a security's net realizable value is other than temporary, the decline is recognized as a realized loss and the cost basis of the security is reduced to its estimated fair value. During the year ended December 31, 2006, we recorded $22.4 million of such writedowns of investments.
Below-investment grade securities have different characteristics than investment grade corporate debt securities. 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 creditors of the issuer. Also, issuers of below-investment grade securities usually have higher levels of debt and may be 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-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.
When we realize a gain or loss on investments backing our universal life or investment-type products, we adjust the amortization of insurance acquisition costs to reflect the change in estimated gross profits from the products due to the gain or loss realized and the effect on future investment yields. We increased (decreased) amortization expense for such changes by $(10.1) million, $(2.8) million and $13.4 million during the years ended December 31, 2006, 2005 and 2004, respectively. We also adjust insurance acquisition costs for the change in amortization that would have been recorded if actively managed fixed maturity securities had been sold at their stated aggregate fair value and the proceeds reinvested at current yields. We include the impact of this adjustment in accumulated other comprehensive income (loss) within shareholders' equity. The total pre-tax impact of such adjustments on accumulated other comprehensive income (loss) was an increase of $32.4 million at December 31, 2006.
Trading account income related to policyholder and reinsurer accounts represents the income on trading securities which are designed 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) amounts included in insurance policy benefits related to the aforementioned annuity products.
(primarily fixed maturities), net of $10.6 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary.
Trading account income related to reinsurer accounts represents the income on trading securities, which are designed to act as hedges for embedded derivatives related to certain modified coinsurance agreements. The income on our trading account securities is designed to be substantially offset by the change in value of embedded derivatives related to modified coinsurance agreements described below.
o Certain claims in this segment are being paid pursuant to non-forfeiture benefits, which are provided in certain cases when the policyholder elects this option and ceases paying premiums. Liabilities for these claims are provided for as they are incurred, until an aggregate maximum (or "pool of money") is exhausted. During the fourth quarter of 2006, we discovered that some claim liabilities for non-forfeiture benefits had been estimated based on the original pool of money benefit, rather than pool amounts reduced by benefits previously paid. We changed our estimates to properly reflect the benefits available for these policies.
The following table summarizes the composition of our investment portfolio as of December 31, 2006 (dollars in millions):
At December 31, 2006, our fixed maturity portfolio had $198.3 million of unrealized gains and $342.3 million of unrealized losses, for a net unrealized loss of $144.0 million. Estimated fair values of fixed maturity investments were determined based on estimates from: (i) nationally recognized pricing services (91 percent of the portfolio); (ii) broker-dealer market makers (3 percent of the portfolio); and (iii) internally developed methods (6 percent of the portfolio).
- -------------------- (a) Includes below-investment grade structured securities with an amortized cost and estimated fair value of $18.2 million and $18.4 million, respectively.
At December 31, 2006, we held mortgage loan investments with a carrying value of $1,642.2 million (or 6.4 percent of total invested assets) and a fair value of $1,684.7 million. The mortgage loan balance was primarily comprised of commercial loans. Noncurrent mortgage loans were insignificant at December 31, 2006. Realized losses on mortgage loans were not significant in any of the past three years. Our allowance for loss on mortgage loans was $2.4 million at both December 31, 2006 and 2005. Approximately 8 percent, 7 percent, 6 percent and 6 percent of the mortgage loan balance were on properties located in Minnesota, Ohio, New York and California, respectively. No other state comprised greater than 6 percent of the mortgage loan balance.
(d) Includes benefits expected to be paid pursuant to our deferred compensation plan and postretirement plans based on numerous actuarial assumptions and interest credited at 5.75 percent.
Under the Second Amended Credit Facility, we may pay cash dividends on our common stock or repurchase our common stock in an aggregate amount of up to $150.0 million over the term of the facility (compared to a limitation of $50.0 million under the Amended Credit Facility). As further discussed in the note to the consolidated financial statements entitled "Shareholders Equity", we repurchased 1.2 million shares of our common stock for $25.0 million in January 2007.
Our spread-based insurance business is subject to several inherent risks arising from movements in interest rates, especially if we fail to anticipate or respond to such movements. First, interest rate changes can cause compression of our net spread between interest earned on investments and interest credited on customer deposits, thereby adversely affecting our results. Second, if interest rate changes produce an unanticipated increase in surrenders of our spread-based products, we may be forced to sell investment assets at a loss in order to fund such surrenders. Many of our products include surrender charges, market interest rate adjustments or other features to encourage persistency; however at December 31, 2006, approximately 18 percent of our total insurance liabilities, or approximately $4.7 billion, could be surrendered by the policyholder without penalty. Finally, changes in interest rates can have significant effects on the performance of our structured securities portfolio as a result of changes in the prepayment rate of the loans underlying such securities. We follow asset/liability strategies that are designed to mitigate the effect of interest rate changes on our profitability. However, there can be no assurance that management will be successful in implementing such strategies and achieving adequate investment spreads.
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 $64.0 million, $62.8 million and $14.3 million in 2006, 2005 and 2004, respectively. Amounts amortized totaled $19.1 million, $8.5 million and $2.9 million in 2006, 2005 and 2004, respectively. The unamortized balance of deferred sales inducements was $115.0 million and $70.1 million at December 31, 2006 and 2005, respectively. The balance of insurance liabilities for
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.
1-100, Case No. CV05-00594 (United States District Court, District of Hawaii). This suit involves 724 plaintiffs all of who 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. Additionally, a lawsuit was filed on December 22, 2005 in Pennsylvania captioned Lisa M. Jordan v. Allen R. Shank and Conseco Life Insurance Company, Case No. 05-10204 (Court of Common Pleas, Chester County, Pennsylvania).
On December 10, 2004, a complaint was filed in the United States District Court for the Northern District of Oklahoma, Robin C. Willig, as Executrix of the Estate of Rhodes K. Scherer vs. Conseco Senior Health Insurance Company and Conseco, Inc., Case No. 04 CV 923E (M). The plaintiff alleged that the failure to pay long term care insurance policy proceeds has been a breach of contract and in violation of the duty to act in good faith. On January 9, 2007, the case was settled.
Beneficial Standard Life Insurance Company, a predecessor company to Conseco Insurance Company, filed suit for declaratory judgment against J.C. Penney Life Insurance Company a/k/a Stonebridge Life Insurance Company ("Stonebridge") in a case captioned, Beneficial Standard Life Insurance Company v. J.C. Penney Life Insurance Company and J.C. Penney Company, Inc., United States District Court for the Central District of California, Case no. CV-98-02792-SVW. This litigation arises from the 1967 sale of Beneficial Fire & Casualty ("BF&C") by Beneficial Standard Life Insurance Company to J.C. Penney Company, Inc. The subject of the case is whether Conseco Insurance Company must indemnify Stonebridge for losses and expenses incurred as a result of claims arising under presale BF&C insurance policies. Conseco Insurance Company filed suit in April 1998 seeking a judicial declaration that: (1) it is not generally obligated to indemnify Stonebridge under the terms of the agreement governing the 1967 sale; and (2) that it is not obligated to indemnify Stonebridge for losses or expenses incurred in connection with specific known claims. Penney counterclaimed for breach of contract and declaratory relief. The counterclaim did not specify the damages sought by Penney on the breach of contract claims. After a bench trial in 2002, certain rulings of the trial court were appealed to the United States Court of Appeals for the Ninth Circuit. In June 2005, the Ninth Circuit issued an opinion upholding a trial-court determination that the terms of the 1967 sale generally require Conseco Insurance Company to indemnify Stonebridge for net losses arising from pre-sale BF&C policies, but only after Stonebridge pursues and exhausts available reinsurance. The Ninth Circuit remanded the case to the trial court for further proceedings. The trial court had previously found against Stonebridge on its breach of contract claims, ruling that Stonebridge could not assert such claims until it pursued and exhausted available reinsurance. Stonebridge did not appeal that specific ruling. The remaining issue before the trial court is whether Conseco Insurance Company's
In 2006, certain insurance subsidiaries (Conseco Insurance Company, Conseco Life Insurance Company, Washington National Insurance Company, Conseco Health Insurance Company and Conseco Senior Health Insurance Company) agreed to settle matters resulting from a market conduct examination by the Minnesota Commerce Department. A fine of $2.5 million was paid in April 2006.
premiums written through December 31, 2006; and (ii) receivables of $3.4 million that we estimate will be recovered through a reduction in future premium taxes as a result of such assessments. At December 31, 2005, such guaranty fund assessment accruals were $10.8 million and such receivables were $7.5 million. These estimates are subject to change when the associations determine more precisely the losses that have occurred and how such losses will be allocated among the insurance companies. We recognized expense (benefit) for such assessments of $2.5 million, $4.0 million and $(.6) million in 2006, 2005 and 2004, respectively.
The discount rate is based on the yield of a hypothetical portfolio of high quality debt instruments which could effectively settle plan benefits on a present value basis as of the measurement date. At both December 31, 2006 and 2005, for our deferred compensation plan for qualifying members of our career agency force, we assumed a 5 percent annual increase in compensation until the participant's normal retirement date (age 65 and completion of five years of service).
We recognized compensation expense related to stock options totaling $6.5 million ($4.2 million after income taxes) in 2006. Compensation expense related to stock options reduced both basic and diluted earnings per share by less than 3 cents in 2006. At December 31, 2006, the unrecognized compensation expense for non-vested stock options totaled $13.4 million which is expected to be recognized over a weighted average period of 2.7 years. Cash received from the exercise of stock options was $1.0 million, $.5 million and nil during 2006, 2005 and 2004, respectively.
The following table summarizes information about stock options outstanding at December 31, 2006 (shares in thousands):
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 periods.
Based on current conditions and assumptions as to future events on all policies inforce, the Company expects to amortize approximately 13 percent of the December 31, 2006 balance of the value of policies inforce at the Effective Date in 2007, 11 percent in 2008, 10 percent in 2009, 9 percent in 2010 and 7 percent in 2011. The discount rate used to determine the amortization of the value of policies inforce at the Effective Date averaged 5 percent in the years ended December 31, 2006, 2005 and 2004.
Statutory earnings build the capital required by ratings agencies and regulators. Statutory earnings, fees and interest paid by the insurance companies to the parent company create the "cash flow capacity" the parent company needs to meet its obligations, including debt service. The consolidated statutory net income (loss) (a non-GAAP measure) of our insurance subsidiaries was $(232.4) million, $97.3 million and $(3.3) million in 2006, 2005 and 2004, respectively. Included in such net income (loss) were net realized capital gains (losses), net of income taxes, of $(1.8) million, $7.8 million and $(17.7) million in 2006, 2005 and 2004, respectively. In addition, such net income (loss) included pre-tax amounts for fees and interest to Conseco or its non-life subsidiaries totaling $157.6 million, $145.6 million and $283.1 million (including $148 million related to prior years) in 2006, 2005 and 2004, respectively.