The following table presents certain consolidated financial data for the periods indicated and should be read in conjunction with the consolidated financial statements and notes thereto and Management's Discussion and Analysis of Financial Condition and Results of Operations appearing elsewhere in this Form 10-K. The comparison of consolidated financial data set forth below is significantly affected by: (i) the Acquisition on September 29, 1994; and (ii) the ALH Stock Purchase effective September 30, 1996. The Acquisition was accounted for using the purchase method of accounting. Under purchase accounting, the total purchase cost was allocated to the assets and liabilities acquired based on their fair values, with the excess of the total purchase cost over the fair value of the net assets acquired recorded as goodwill (the "prior basis"). The consolidated balance sheet at December 31, 1994 and 1995, and the consolidated statements of operations, shareholder's equity and cash flows for the three months ended December 31, 1994, the year ended December 31, 1995, and the nine months ended September 30, 1996, are reported based on such purchase values. As a result of the ALH Stock Purchase, a new basis of accounting under the "push down" method was adopted effective September 30, 1996. Under this method, the assets and liabilities of the Company were revalued to reflect Conseco's cost basis, which is based on the fair values of such assets and liabilities on the dates Conseco's ownership interests were acquired. The new accounting basis was reflected in the consolidated balance sheet at September 30, 1996, and is reflected in the statements of operations, shareholder's equity and cash flows for periods subsequent to September 30, 1996. As a result, the assets and liabilities of the Company included in the December 31, 1996, consolidated balance sheet reflect the following combination of values: (i) the portion of the Company's net assets acquired by Conseco in the Acquisition of the Company made by Partnership II is valued as of September 29, 1994; and (ii) the portion of the Company's net assets acquired in the ALH Stock Purchase is valued as of September 30, 1996. For periods prior to the Acquisition, financial data presented are the historical financial data of the Company ("predecessor basis").
Insurance policy income, which consists of premiums received on traditional life insurance products and policy fund and surrender charges assessed against investment type products, decreased 24 percent to $44.2 million in the 1996 periods from $58.1 million in 1995. This decrease was primarily the result of a reduction in life insurance premiums related to group life insurance business coinsured to an unaffiliated company, partially offset by an increase in surrender charges earned on annuity policy withdrawals. Surrender charges assessed against universal life-type and investment-type contracts for the 1996 periods were $18.3 million compared to $15.4 million for 1995 while withdrawals from such contracts were $756.4 million and $766.2 million for the same periods, respectively. The Company has experienced increases in withdrawals during 1996 due to: (i) the increased size of the Company's annuity portfolio; and (ii) competition from other investment products, which caused some policyholders to surrender policies and incur a surrender charge to invest funds in alternative investments.
Net investment gains (losses) were $20.3 million in the 1996 periods and $149.3 million in 1995 and often fluctuate from period to period. The Company sold approximately $2.5 billion of investments (principally fixed maturities) in the 1996 periods compared to $2.8 billion in 1995.
Selling securities at a gain and reinvesting the proceeds at lower yields may, absent other management action, tend to decrease future investment yields. The Company believes, however, that certain factors would mitigate the adverse effect of such decreases as follows: (i) additional amortization of the cost of policies purchased and the cost of policies produced is recognized in the same period as the gain in order to reflect reduced future yields thereby reducing such amortization in future periods (see amortization related to investment gains below); (ii) interest rates credited to some products can be reduced thereby diminishing the effect of the yield decrease on the investment spread; and (iii) the investment portfolio grows as a result of reinvesting the investment gains.
Insurance policy benefits and change in future policy benefits decreased 27 percent to $24.1 million in the 1996 periods from $33.1 million in 1995 primarily as a result of the reinsuring of the group life insurance business.
Interest expense on annuities and financial products decreased 4.9 percent to $246.2 million in the 1996 periods from $258.8 million in 1995 primarily due to: (i) lower crediting rates; and (ii) the expensing of the first year interest rate bonuses of approximately $5.9 million in 1995 on policies issued prior to the Acquisition date as a result of the application of purchase accounting on the Acquisition date. Such amounts were considered in determining the cost of policies purchased and its amortization. Prior to the Acquisition date, such first year interest rate bonuses (related to policies issued prior to the Acquisition date) were capitalized as a cost of policies produced. At December 31, 1996 and 1995, the weighted average crediting rate for the Company's annuity liabilities excluding interest bonuses guaranteed for the first year of the annuity contract was 5.1 percent and 5.3 percent, respectively.
Interest expense on notes payable decreased to $24.7 million in the 1996 periods from $32.6 million in 1995 due to reductions in outstanding indebtedness and from lower interest rates on the borrowings.
Amortization related to operations increased 6.9 percent to $45.2 million in the 1996 periods from $42.3 million in 1995. Such increase is affected by: (i) the adoption of a new basis of accounting as discussed above; and (ii) the increased amount of business in force on which acquisition costs are capitalized.
Cost of policies purchased represents the portion of the cost to acquire the Company that is attributable to the right to receive cash flows from insurance contracts in force at the acquisition dates. Some costs incurred subsequent to the acquisition dates on policies issued prior to such dates, which otherwise would have been deferred had it not been for the Acquisition or change in accounting basis (because they vary with and are primarily related to the production of the acquired policies), are expensed. Examples include commissions paid in excess of ultimate commissions and bonus interest. However, such amounts were considered in determining the cost of policies purchased and its amortization.
Amortization related to investment gains decreased to $16.8 million in the 1996 periods from $83.3 million in 1995 as a result of the decrease in investment gains.
Income tax expense decreased to $33.3 million in the 1996 periods from $51.9 million in 1995. This decrease is primarily due to the decrease in pretax income to $84.7 million in the 1996 periods from $139.4 million in 1995. The effective tax rate of 39 percent in 1996 and 37 percent in 1995 exceeded the statutory corporate federal income tax rate (35 percent) primarily because goodwill amortization is not deductible for federal income tax purposes.
Operating data for 1994 are presented in two periods: the three months ended December 31, 1994, and the nine months ended September 30, 1994 (the period preceding the Acquisition). As explained above, under Item 6 - Selected Consolidated Financial Data, the purchase accounting adjustments resulting from the Acquisition materially affect the comparability of operating data for the periods before and after the Acquisition.
Insurance policy income, which consists of premiums received on traditional life insurance products and policy fund and surrender charges assessed against investment type products, increased 8 percent to $58.1 million in 1995 from $53.8 million in the 1994 periods, primarily because increased annuity policy withdrawals resulted in higher surrender charges. Surrender charges assessed against universal life-type and investment-type contracts for 1995 were $15.4 million compared to $10.2 million for the 1994 periods while withdrawals from such contracts were $766.2 million and $539.2 million for the same periods, respectively. The Company has experienced increases in withdrawals during 1995 due to: (i) the increased size of the Company's annuity portfolio; and
(ii) competition from other investment products, which caused some policyholders to surrender policies and incur a surrender charge to invest funds in alternative investments.
Net investment gains (losses) were $149.3 million in 1995 and $(15.8) million in the 1994 periods and often fluctuate from period to period. The Company sold approximately $2.8 billion of investments (principally fixed maturities) in 1995 compared to $1.1 billion in the 1994 periods. Net investment gains from sales of investments in the 1994 periods were offset by a loss on certain interest rate swap contracts that no longer effectively hedged interest rate risks in the second quarter of 1994 and were therefore recorded at fair value, resulting in a net realized loss of $21.3 million. Substantially all of the Company's interest rate swap contracts were terminated subsequent to the Acquisition with no additional loss. The increased level of investment activity in 1995 is the result of planned changes in the fixed maturity investment portfolio to reduce the portfolio's duration and exposure to more volatile CMO investments.
Interest expense on annuities and financial products increased 18 percent to $258.8 million in 1995 from $220.1 million in the 1994 periods primarily due to: (i) a larger block of annuity business in force in 1995; and (ii) the expensing of the first year interest rate bonuses of approximately $5.9 million in 1995 on policies issued prior to the Acquisition date as a result of the application of purchase accounting on the Acquisition date. At December 31, 1995 and 1994, the weighted average crediting rate for the Company's annuity liabilities excluding interest bonuses guaranteed for the first year of the annuity contract was 5.3 percent.
Income tax expense increased to $51.9 million in 1995 from $14.7 million in the 1994 periods. This increase is primarily due to the increase in pretax income to $139.4 million in 1995 from $41.7 million in the 1994 periods. The effective tax rate of 37 percent in 1995 exceeded the statutory corporate federal income tax rate (35 percent) because goodwill amortization is not deductible for federal income tax purposes. The effective tax rate approximated the statutory rate of 35 percent in 1994.
Dividends on preferred stock decreased to $8.7 million in 1995 from $9.4 million in the 1994 periods primarily due to the elimination of the dividends on the issues of preferred stock held by ALH which were redeemed at the Acquisition date.
The Company's investment portfolio has been managed by CCM since the Acquisition. Prior to the Acquisition, the Company maintained a predominantly investment grade fixed maturity investment portfolio with the primary goal of avoiding credit risk. As a result, fixed maturity investments on the Acquisition date included approximately $2.0 billion of mortgage-backed securities which comprised 50 percent of the Company's fixed maturity investments. While these securities had minimal credit risk they were subject to greater interest rate risk (as discussed hereafter) than traditional fixed income securities. Since the Acquisition, the Company has reduced its overall exposure to interest rate risk by, in part, selling mortgage-backed security investments with high interest rate risk and investing proceeds and new cash flows in intermediate term investment grade corporate securities.
Below investment grade securities generally have greater risks than other corporate debt investments, including risk of loss upon default by the borrower, and are often unsecured and subordinated to other creditors. Below investment grade issuers usually have high levels of indebtedness and are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than are investment grade issuers. The Company is aware of these risks and monitors its below investment grade securities closely. At December 31, 1996, the Company's below investment grade corporate fixed maturities had an amortized cost of $187.8 million and an estimated fair value of $191.7 million.
The Company had no fixed maturity investments in technical or substantive default as of December 31, 1996. There were no fixed maturity investments about which the Company had serious doubts as to the ability of the issuers to comply with the contractual terms of their obligations on a timely basis.
The Company's policy is to discontinue the accrual of interest and eliminate all previous interest accruals for defaulted securities, if based on the Company's assessment such amounts will not be ultimately realized in full. Investment income forgone due to defaulted securities was $.2 million, $.7 million and $.5 million for the three months ended December 31, 1996, the nine months ended September 30, 1996, and the year ended December 31, 1995, respectively. There was no forgone investment income in the 1994 periods.
Such sales resulted in net investment gains of $.9 million. Proceeds from sales of fixed maturity securities during the first nine months of 1994 were $604 million, of which $596 million were from sales of securities classified as actively managed and $8 million were from the sale of securities classified as held-to-maturity as of January 1, 1994. These sales resulted in net investment gains of $5.8 million. The securities classified as held-to-maturity were sold subsequent to a debtor being placed on credit watch by a major independent rating agency. A loss of $1.6 million was recognized on such sale. The issuer's credit ratings were subsequently downgraded.
The following table sets forth the par value, amortized cost and estimated fair value of mortgage-backed securities including CMOs at December 31, 1996, summarized by interest rates on the underlying collateral at December 31, 1996:
The amortized cost and estimated fair value of mortgage-backed securities including CMOs at December 31, 1996, summarized by type of security, were as follows:
Planned amortization classes and accretion directed bonds are some of the most stable and liquid instruments in the mortgage-backed securities market. Planned amortization class bonds adhere to a fixed schedule of principal payments provided that the underlying mortgage collateral experiences prepayments within a certain range. Changes in prepayment rates are first absorbed by support classes which insulate the planned amortization classes from the consequences of both faster prepayments (average life shortening) and slower prepayments (average life extension).
Accrual bonds are CMOs structured such that the payment of coupon interest is deferred until principal payments begin on these bonds. On each accrual date, the principal balance is increased by the amount of the interest (based upon the stated coupon rate) that otherwise would have been payable. As such, these securities act much the same as zero coupon bonds until cash payments begin. Cash payments typically do not commence until earlier classes in the CMO structure have been retired, which can be significantly influenced by the prepayment experience of the underlying mortgage loan collateral in the CMO structure. Because of the zero coupon element of these securities and the potential uncertainty as to the timing of cash payments, their market values and yields are more sensitive to changing interest rates than other CMOs, pass-through securities and coupon bonds.
Subordinated CMO classes have both prepayment and credit risk. The subordinated classes are used to lend credit enhancement to the senior securities and as such, rating agencies require that this support not deteriorate due to the prepayment of the subordinated securities. The credit risk of subordinated classes is derived from the negative leverage of owning a small percentage of the underlying mortgage loan collateral while bearing a majority of the risk of loss due to homeowner defaults.
Short-term investments totaled $15.4 million, or .3 percent of invested assets at December 31, 1996, and consisted primarily of commercial paper and repurchase agreements relating to government securities.
The Company's annuity and life insurance business generally provides the Company's insurance subsidiaries with positive cash flows from premium collections and investment income. Cash flows from insurance subsidiary financing activities principally result from the excess of premium collections from annuities and interest-sensitive insurance contracts over related benefit payments, including withdrawal and surrender payments. Changes in the account balances for insurance liabilities accounted for as universal life-type and investment-type contracts (primarily deferred annuities) (see note 1 in the consolidated financial statements) for the three years ended December 31, 1996 are summarized as follows:
Growth in annuity deposits began to slow in 1994 and declined in 1995 and 1996 as a result of several factors. The demand for individual fixed annuity products offered by all insurance companies decreased during 1995 and 1996. Such decrease is believed to be attributable to increased competition from products such as mutual funds, traditional bank investments, variable annuities and other investment and retirement funding alternatives as a result of a flattened yield curve and rising equity markets.
The trend of significant increases in withdrawals and surrenders subsided in 1996 as policy withdrawal and surrender payments decreased moderately to $756.4 million compared to $766.2 million in 1995. Withdrawal and surrender payments accelerated in recent years primarily due to a certain policy form principally issued during 1988 through 1990 whose surrender charge declined from 4 percent at the fifth policy anniversary date to 0 percent at the sixth policy anniversary date. Surrenders have occurred after these policies have reached their sixth anniversary. The Company expects the trend of accelerated withdrawals and surrenders of this product to subside since sales of this product peaked in the second quarter of 1989 and were effectively discontinued after June 30, 1990. At December 31, 1996, the aggregate account balances still in force for this product were $469.2 million.
Substantially all of the Company's annuity products have a surrender charge feature designed to reduce early withdrawal or surrender of the policies and to partially compensate the Company for its costs if policies are withdrawn early. Surrender charge periods on annuity policies currently being issued generally range from five years to 12 years. Most of the Company's annuities that were issued during 1995 and 1996 have a surrender charge period of eight years or more. The initial surrender charge on annuity policies ranges from 6 percent to 12 percent of the accumulation value and generally decreases by approximately 1 to 2 percentage points per year during the surrender charge period.
At December 31, 1996, the Company had $150 million of senior subordinated notes outstanding. The Company and its subsidiaries may incur additional indebtedness in the future, subject to the limitations contained in the indenture for the senior subordinated notes. In addition, the indenture contains limitations on the ability of the Company to pay dividends on its capital stock other than the two series of its redeemable preferred stock discussed in the following paragraph. Under the most restrictive covenants of the indenture, the Company is limited to paying dividends of $28.3 million per year to ALH.
The Company has two series of redeemable preferred stock outstanding. Principal and interest payments on the Company's senior subordinated notes have priority over dividend payments on these issues of preferred stock, however the rights of the holders of such preferred stock with respect to the securities segregated in escrow accounts for the future redemption of that stock are unaffected by the incurrence of the new indebtedness.
The payment of dividends and other distributions, including surplus note payments, by American Life and Casualty are subject to regulation by the Iowa Insurance Division. Currently, American Life and Casualty may pay dividends or make other distributions without the prior approval of the Iowa Insurance Division, unless such payments, together with all other such payments within the preceding 12 months, exceed the greater of (1) American Life and Casualty's net gain from operations (excluding net investment gains or losses) for the preceding calendar year or (2) 10 percent of its statutory surplus at the preceding December 31. For 1997, up to $28.3 million can be distributed as dividends or surplus note payments without prior approval of the Iowa Insurance Division. In addition, dividends and surplus note payments may be made only out of earned surplus, and all surplus note payments are subject to prior approval by regulatory authorities. Vulcan Life, which is subject to similar regulatory limitations on its ability to pay dividends, has not paid a dividend during the entire period of time it has been a subsidiary of the Company and no future dividend payments by Vulcan Life are currently contemplated.
The maximum distribution permitted by law is not necessarily indicative of an insurer's actual ability to pay such distribution, which may be constrained by business and regulatory considerations, such as the impact of such distributions on surplus, which could affect an insurer's ratings or competitive position, the amount of premiums that can be written and the ability to pay future dividends or make other distributions. Further, the Iowa insurance laws and regulations require that the statutory surplus of American Life and Casualty following any dividend or distribution be reasonable in relation to its outstanding liabilities and adequate for its financial needs. The Iowa Insurance Division may bring an action to enjoin or rescind the payment of a dividend or distribution by American Life and Casualty that would, in its judgment, cause American Life and Casualty's statutory surplus to be unreasonable or inadequate under this standard.
The Company's cash flow also includes dividends and tax sharing payments derived from American Life and Casualty Marketing Division Co.'s ("ALMD") income, if any. ALMD functions as a general agent for American Life and Casualty, and its primary purpose is to pay commissions to American Life and Casualty's agents on annuity and life insurance policies issued by American Life and Casualty pursuant to a general agency commission and servicing agreement between ALMD and American Life and Casualty. This agreement initially benefits the statutory surplus of American Life and Casualty by extending the payment of first year commissions by American Life and Casualty to ALMD on certain deferred annuity policies over a longer period of time. In subsequent periods, American Life and Casualty's statutory surplus is reduced through the payment of renewal commissions to ALMD equal to a specified percentage of the accumulated policyholder account values of certain deferred annuity policies in force issued by American Life and Casualty since July 1990 remaining in force. These renewal commissions and capital contributions and/or advances from the Company are the sources of funds for ALMD's payment of the first year commissions to agents on the deferred annuity policies issued by American Life and Casualty.
ALH has no direct ownership interest in the Company's insurance subsidiaries and must rely on dividends from the Company and payments under the tax sharing agreement with its subsidiaries to fund its operating expenses and any dividends or interest expense it may seek or be obligated to pay. ALH remains obligated to pay interest on the remaining $13.0 million principal balance of its convertible Subordinated Debentures ("Convertible Debentures") as long as such amounts remain outstanding.
Disclosures related to the financial effect of inflation generally focus on the items most often affected by inflation - inventories and property, plant and equipment. For a life insurance organization these items are insignificant or nonexistent. Most of the Company's assets are investments, repayable in the future in dollars that, assuming that inflation continues, will have less purchasing power than the dollars originally invested. Similarly, most of the Company's reserves and liabilities would be payable in the future with dollars with less purchasing power. An effect of inflation is a decline in purchasing power when monetary assets exceed monetary liabilities.
Stephen C. Hilbert Rollin M. Dick Chief Executive Officer Executive Vice President and Chief Financial Officer
We have audited the accompanying consolidated balance sheet of American Life Holding Company and subsidiaries as of December 31, 1996, and the related consolidated statements of operations, shareholder's equity, and cash flows for the three months ended December 31, 1996. We have also audited the accompanying consolidated balance sheet of American Life Holding Company as of December 31, 1995, and the related consolidated statements of operations, shareholder's equity, and cash flows for the nine months ended September 30, 1996, the year ended December 31, 1995, and the three months ended December 31, 1994 based on the prior basis of accounting prior to Conseco, Inc.'s purchase of all of the common stock of the Holding Company's parent. (See note 1 to the notes to consolidated financial statements regarding the September 30, 1996 stock purchase). We have also audited the accompanying consolidated statements of operations, shareholder's equity and cash flows of American Life Holding Company and subsidiaries for the nine months ended September 30, 1994 based on the historical predecessor basis applicable to periods prior to the acquisition of the Company (see note 1 of the notes to consolidated financial statements regarding the September 29, 1994 acquisition). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
American Life Holding Company (the "Company") is a wholly owned subsidiary of American Life Holdings, Inc. ("ALH"). In 1996, ALH changed its name from American Life Group, Inc. (formerly The Statesman Group, Inc. prior to its name change in 1995). Effective September 30, 1996, ALH became a wholly owned subsidiary of Conseco, Inc. ("Conseco"). Conseco is a financial services holding company engaged primarily in the development, marketing and administration of annuity, supplemental health and individual life products.
On September 29, 1994, Conseco Capital Partners II, L.P. ("Partnership II"), a Delaware limited partnership, completed the acquisition (the "Acquisition") of ALH. ALH's former shareholders received $15.25 in cash per common equivalent share plus a contingent payment right (the "Contingent Payment Right") to receive up to another $2.00 in cash per common equivalent share (the "Contingent Consideration"), based on the outcome of ALH's and American Life and Casualty's pending litigation against the U.S. Government concerning their former savings bank subsidiary (the "Savings Bank Litigation") (see note 8). The sole general partner of Partnership II is a wholly owned subsidiary of Conseco. As a result of the Acquisition and related financing transactions, Partnership II owned 80 percent of ALH's outstanding common stock. Conseco, through its direct investment and interests in certain of its subsidiaries had a 38 percent ownership interest in ALH and the Company prior to the transactions described in the following paragraphs. The Acquisition was accounted for using the purchase method of accounting effective September 29, 1994. Under this method, the total cost to acquire the Company was allocated to the assets and liabilities acquired based on their fair values, with the excess of the total purchase cost over the fair value of the net assets acquired recorded as goodwill.
Effective September 30, 1996, Conseco: (i) purchased all of the outstanding common stock of ALH not previously owned by Conseco for $165.0 million in cash (the "ALH Stock Purchase"); (ii) purchased 5,434,783 newly issued shares of ALH common stock for $125.0 million; and (iii) terminated Partnership II.
The consolidated balance sheet as of December 31, 1996, and the consolidated statement of operations, shareholder's equity and cash flows for the three months ended December 31, 1996, are reported under the new basis of accounting described in the previous paragraph. The consolidated balance sheets as of December 31, 1995 and 1994, and the consolidated statements of
operations, shareholder's equity and cash flows for the nine months ended September 30, 1996, the year ended December 31, 1995 and the three months ended December 31, 1994 are reported based on such purchase values ("prior basis"). Financial data for the nine months ended September 30, 1994, are the historical financial data of the Company ("predecessor basis").
The consolidated financial statements include the accounts of the Company and its subsidiaries after elimination of all significant intercompany accounts and transactions. Certain amounts from prior periods were reclassified to conform to the 1996 presentation.
Fixed maturity investments are securities that mature more than one year after they are issued and include bonds, notes receivable and preferred stocks with mandatory redemption features and are classified as follows:
When there are changes in conditions that cause a fixed maturity investment to be transferred to a different category (e.g., actively managed, held to maturity or trading), the security is transferred to the new category at its fair value at the date of the transfer. At the date of transfer, the security's unrealized gain or loss (which was immaterial in 1996) is accounted for as follows:
For transfers to held to maturity from actively managed - the unrealized gain or loss at the date of transfer continues to be reported in shareholder's equity, but is amortized over the remaining life of the security as an adjustment of yield.
The Company manages its investments to limit credit risk by diversifying its portfolio among various security types and industry sectors. The Company regularly evaluates investment securities, credit-tenant loans and mortgage loans based on current economic conditions, past credit loss experience and other circumstances of the investee. A decline in a security's net realizable value that is other than temporary is treated as a realized loss and the cost basis of the security is reduced to its estimated fair value. Impaired loans are revalued at the present value of expected cash flows discounted at the loan's effective interest rate when it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the agreement. The Company accrues interest on the net carrying amount of impaired loans.
The discount rates used to determine the value of the cost of policies purchased is the rate of return required by Partnership II and Conseco to invest in the business being acquired. The following factors have been considered in determining this rate:
o Recent purchase prices (i.e., discount rates used in determining valuations) on similar blocks of business.
Recoverability of the cost of policies purchased is evaluated regularly by comparing the current estimate of expected future cash flows (discounted at the rate of interest earned on invested assets) to the unamortized asset balance by line of insurance business. If such current estimate indicates that the existing insurance liabilities, together with the present value of future net cash flows from the blocks of business purchased, will not be sufficient to recover the cost of policies purchased, the difference would be charged to expense.
Insurance Liabilities, Recognition of Insurance Policy Income and Related Benefits and Expenses
For investment contracts without mortality risk (such as deferred annuities and immediate annuities with benefits paid for a period certain) and for contracts that permit the Company or the insured to make changes in the contract terms (such as universal life), premium deposits and benefit payments are recorded as increases or decreases in a liability account rather than as revenue and expense. Amounts charged against the liability account for the cost of insurance, policy administration fees, surrender penalties and amortization of policy initiation fees are recorded as revenues. Interest credited to the liability account and benefit payments made in excess of the contract liability account balance are charged to expense.
For traditional insurance contracts, premiums are recognized as income when due or, for short duration contracts, over the period to which the premiums relate. Benefits and expenses are recognized as a level percentage of earned premiums. Such recognition is accomplished through the provision for future policy benefits and the amortization of the cost of policies produced. Participating business is immaterial and dividends related to such business are included as part of the policy reserves.
In the normal course of business, the Company seeks to limit its exposure to loss on any single insured and to recover a portion of the benefits paid by ceding reinsurance to other insurance enterprises or reinsurers under agreements of indemnity reinsurance. The Company has set its retention limit on life insurance policies at $.1 million.
The Company's use of derivative financial instruments is primarily limited to S&P 500 Index Options. The Company buys these options in order to offset changes in policyholder liabilities resulting from certain policy benefits tied to the S&P 500 Index. The Company buys these options at the time it issues the related annuity contracts, with similar maturity dates and benefit features which fluctuate as the value of the options change. Accordingly, changes in the value of the options are offset by changes to policyholder liabilities; such changes are reflected in the consolidated statement of operations. The credit risk associated with these options is considered low because such options are purchased from strong creditworthy parties. Both the carrying value and fair value of these contracts were $7.2 million at December 31, 1996. Such instruments are classified as other invested assets.
The estimated fair values of the Company's financial instruments are as follows:
At December 31, 1996, the amortized cost and estimated fair value of actively managed fixed maturity investments were as follows:
At December 31, 1996, the Company's below investment grade corporate fixed maturities had an amortized cost of $187.8 million and an estimated fair value of $191.7 million. For substantially all of these securities, the amortized cost exceeded the fair value by less than 5 percent or the fair value of the securities exceeded amortized cost. During the three months ended December 31, 1996, the year ended December 31, 1995 and the nine months ended September 30, 1994, the Company recorded realized losses for investment writedowns of $1.5 million, $7.1 million and $1.2 million, respectively, as a result of changes in the financial condition of an issuer and changes in the value of underlying collateral, which caused the Company to conclude that a decline in fair value of such investments was other than temporary. There were no such realized losses in the nine months ended September 30, 1996, or the three months ended December 31, 1994. The Company had no fixed maturity investments in technical or substantive default as of December 31, 1996. As of December 31, 1996, there were no fixed maturity investments about which the Company had serious doubts as to the ability of the issuer to comply with the contractual terms of their obligations on a timely basis. Investment income forgone due to defaulted securities was $.2 million, $.7 million and $.5 million for the three months ended December 31, 1996, the nine months ended September 30, 1996, and the year ended December 31, 1995, respectively. There was no forgone investment income in the 1994 periods.
Proceeds from sales of fixed maturity investments were $1,449.2 million, $1,038.6 million, $2,822.1 million, $502.0 million and $603.8 million for the three months ended December 31, 1996, the nine months ended September 30, 1996, the year ended December 31, 1995, the three months ended December 31, 1994, and the nine months ended September 30, 1994, respectively.
At December 31, 1996, approximately 83 percent of the estimated fair value of the Company's mortgage-backed securities was determined by nationally recognized pricing services, 14 percent was determined by broker-dealer market makers and 3 percent was determined by internally developed methods.
As part of its investment strategy, the Company enters into reverse repurchase agreements and dollar roll transactions to increase its return on investments and improve its liquidity. Reverse repurchase agreements involve a sale of securities and an agreement to repurchase the same securities at a later date at an agreed upon price. Dollar rolls are similar to reverse repurchase agreements except that the repurchase involves securities that are only substantially the same as the securities sold. These transactions are accounted for as short-term collateralized borrowings. Such borrowings averaged approximately $81.4 million during 1996 and were collateralized by investment securities with fair values approximately equal to the loan value. The weighted average interest rate on short-term collateralized borrowings was 5.6 percent in 1996. The primary risk associated with short-term collateralized borrowings is that the counterparty will be unable to perform under the terms of the contract. The Company's exposure is limited to the excess of the net replacement cost of the securities over the value of the short-term invesments (which was not material at December 31, 1996). The Company believes that the counterparties to its reverse repurchase and dollar roll agreements are financially responsible and that the counterparty risk is minimal.
Life insurance companies are required to maintain certain amounts of assets on deposit with state regulatory authorities. Such assets had an aggregate carrying value of $11.4 million at December 31, 1996.
The Company had no investments in any single entity in excess of 10 percent of shareholder's equity at December 31, 1996, other than investments issued or guaranteed by the United States government or a United States government agency.
The $2.9 million deferred income tax asset at December 31, 1996, is net of $21.6 million which is attributed to the effect of the fair value adjustment to actively managed fixed maturities pursuant to SFAS 115.
Federal income tax expense differed from that computed at the applicable federal statutory income tax rate (35 percent for all periods) for the following reasons:
The Company files a consolidated federal income tax return with ALH and all subsidiaries of ALH. The Company reports income tax expense as allocated under a consolidated tax allocation agreement. Generally this allocation results in profitable companies recognizing an income tax provision as if the individual company filed a separate income tax return and loss companies recognizing benefits to the extent their losses contributed to reduce consolidated income taxes. At December 31, 1996, the Company has net operating loss carryforwards of $29.6 million which expire in 1999 through 2010. These loss carryforwards relate to the operations of the parent company and the Company's marketing subsidiary, American Life and Casualty Marketing Division Co. ("ALMD"). Utilization of the operating loss carryforwards to offset taxable income of the life insurance subsidiaries is limited under existing federal income tax rules and regulations.
In connection with the financing of the Acquisition, the Company issued $150 million of senior subordinated notes in a public offering. The senior subordinated notes bear interest at 11.25 percent, payable semiannually and will mature on September 15, 2004. Such notes are unsecured and are subordinated in right of payment to the prior payment in full of all senior indebtedness (as defined in the indenture for the subordinated notes). The notes are redeemable at the Company's option, in whole or in part, at any time on or after September 15, 1999, initially at 105.625 percent of their principal amount, plus accrued interest, declining to 100 percent of their principal amount, plus accrued interest, on or after September 15, 2001. At the date of Acquisition, the senior subordinated notes were recorded net of $6.6 million of debt issuance costs. In connection with the ALH Stock Purchase, Conseco guaranteed the Company's obligations under its senior subordinated notes due in 2004. At December 31, 1996, senior subordinated notes with a principal balance and carrying value of $51.9 million and $54.7 million, respectively, were held by subsidiaries of Conseco. In the first three months of 1997, subsidiaries of Conseco purchased $76.1 million par value of the Company's senior subordinated notes for approximately $87.1 million.
The Board of Directors has authorized the Company to issue 4,160,000 shares of Series Preferred Stock, par value $.01, from time to time in one or more series and to fix the number of shares, designations, voting powers (if any), and other terms of each series. Each series shall be distinctly designated and, except as otherwise stated, shall rank equally and be identical in all respects.
The $2.16 preferred shares rank on parity with the other Series Preferred Stock shares with respect to dividends and distributions except that in the event of liquidation, they rank senior to all other preferred stock of the Company now or hereafter existing with respect to the distribution of assets held in the escrow account for the future redemption of the $2.16 preferred shares and on parity with the $2.32 preferred shares (as defined herein) and senior to all other preferred stock of the Company now or hereafter existing with respect to the distribution of assets held in the separate escrow account for the future redemption of the $2.32 preferred shares.
In February 1993, the Company issued 1.2 million shares of $2.32 Redeemable Cumulative Preferred Stock (the "$2.32 preferred shares") at an issue price of $25 per share (aggregate $30.0 million) in exchange for all of the Company's then outstanding 11.5 percent subordinated debentures which were retired. At that time, the Company purchased $30.0 million face amount of zero coupon United States Treasury securities maturing in February 2008. These securities have been placed in an escrow account to be used for the future redemption of the $2.32 preferred shares on or before their mandatory redemption date in 2008.
The $2.32 preferred shares are entitled to annual cumulative cash dividends of $2.32 per share, payable quarterly. The Company may, at its option, redeem the $2.32 preferred shares in whole or in part, at any time after five years from date of issue initially at $26.25 per share and declining to $25.00 per share on or after February 1, 2001, plus cumulative unpaid dividends. The $2.32 preferred shares are mandatorily redeemable by the Company on February 15, 2008 at a redemption price of $25 per share, plus cumulative unpaid dividends. In liquidation, the $2.32 preferred stockholders are entitled to $25 per share (aggregate $30.0 million) plus cumulative unpaid dividends before any distributions shall be made to common shareholders.
On July 24, 1992, the Court of Federal Claims granted the plaintiffs' motion for summary judgment as to the defendant's liability for breach of contract in the Savings Bank Litigation. The court also consolidated this case with two others and certified these cases for interlocutory appeal to the United States Court of Appeals for the Federal Circuit (the "Court of Appeals"). Subsequently, the Court of Appeals entered a judgment reversing the order of the Court of Federal Claims by a decision of two to one and the plaintiffs filed a Petition for Rehearing with Suggestion for Rehearing in Banc (the "Rehearing Petition") with the Court of Appeals. On August 18, 1993, the Court of Appeals accepted the Rehearing Petition, vacated the judgment which was entered in favor of the defendant and withdrew its opinion accompanying the judgment. On August 30, 1995, the Court of Appeals, in banc, affirmed the summary judgment of the Court of Federal Claims in the plaintiffs' favor by a decision of nine to two. On July 1, 1996, the Supreme Court affirmed the summary judgment of the Court of Federal Claims in the plaintiffs' favor by a decision of seven to two. A trial has been scheduled for May 1997, in the Court of Federal Claims to determine damages related to the breach of contract by the United States of America.
In conjunction with the Acquisition, each common or equivalent share of ALH outstanding immediately prior to the Acquisition received a Contingent Payment Right, designed to provide holders with certain financial benefits that the plaintiffs may receive from a favorable determination of the Savings Bank Litigation. If the rights of the holder of the 1988 Series Preferred Stock were not an issue in the Savings Bank Litigation, the 1988 Series Preferred Stock was convertible into approximately $30.1 million in conjunction with the Acquisition.
If the Savings Bank Litigation results in the return of the 1988 Series Preferred Stock to ALH, the $30.1 million amount referred to above will be payable to the holders of the Contingent Payment Rights, together with any money damages recovered by the plaintiffs, subject to certain adjustments and limitations. If, however, the plaintiffs are unsuccessful in the Savings Bank Litigation, the $30.1 million amount will instead become payable to the holder of the 1988 Series Preferred Stock upon the conversion thereof or as otherwise directed by the court. Since the timing of a final determination of the Savings Bank Litigation is uncertain, the plaintiffs are unable to predict when such $30.1 million amount will become payable.
A liability to ALH of $30.1 million was established at the Acquisition date representing the consideration that would be payable by ALH to either the holder of the 1988 Series Preferred Stock or to ALH's other former shareholders.
In the fourth quarter of 1995, the Company received a $30.0 million capital contribution from ALH. Also, in connection with the ALH Stock Purchase, the Company received a $125.0 million capital contribution from ALH effective September 30, 1996. The proceeds were used to repay amounts outstanding under the Senior Credit Facility as discussed in note 6.
In 1994, the Company paid $4.0 million to a subsidiary of Conseco for services provided in connection with the financings related to the Acquisition.
Since the Acquisition, the Company and certain of its subsidiaries have received services from or shared expenses with subsidiaries of Conseco under written agreements or based on cost allocation principles in accordance with GAAP, including investment advisory agreements which provide investment management and related accounting and reporting services. Fees charged under all such arrangements totaled $7.7 million, $11.2 million, $14.1 million and $2.5 million for the three months ended December 31, 1996, the nine months ended September 30, 1996, the year ended December 31, 1995, and the three months ended December 31, 1994, respectively.
From time to time, mandatory assessments are levied on the Company's insurance subsidiaries by life and health guaranty associations of most states in which these subsidiaries are licensed to cover losses to policyholders of insolvent or rehabilitated insurance companies. The associations levy assessments (up to prescribed limits) on all insurers in a particular state in order to pay claims on the basis of the proportionate share of premiums written by insurers in the lines of business in which the insolvent or rehabilitated insurer are engaged. These assessments may be deferred or forgiven in certain states if they would threaten an insurer's financial strength and, in some states, these assessments can be partially recovered through a reduction in future premium taxes. Assessments levied against the Company's insurance subsidiaries and charged to expense were $.5 million in 1996, $.2 million in 1995 and $2.0 million in 1994. The balance sheet at December 31, 1996, includes a liability of $4.9 million representing the Company's estimate of all known assessments that will be levied against the Company's insurance subsidiaries by various state
There were no material non-cash transactions during 1996, 1995 or 1994.
Combined statutory net income of the Company's life insurance subsidiaries was $26.9 million, $27.1 million and $39.7 million in 1996, 1995 and 1994, respectively, after appropriate eliminations of intercompany accounts between such subsidiaries. The Company's insurance subsidiaries follow certain permitted accounting practices which are not specifically prescribed in state laws, regulations, general administrative rules and various NAIC publications. Such permitted accounting practices do not enhance statutory surplus.
American Life and Casualty's surplus includes a surplus note held by the Company with a balance of $50.0 million at December 31, 1996. Each payment of interest or principal on the surplus note requires the prior approval of the Iowa Insurance Division. The Iowa insurance law provides that payments of dividends on capital stock and interest and principal on surplus notes may be made only out of an insurer's earned surplus. At December 31, 1996, American Life and Casualty had earned surplus of $111.8 million.
ALMD functions as a general agent for American Life and Casualty and its primary purpose is to pay commissions to American Life and Casualty's agents on annuity policies issued by American Life and Casualty pursuant to a general agency commission and servicing agreement between ALMD and American Life and Casualty. This agreement initially benefits the statutory surplus of American Life and Casualty by extending the payment of first year commissions to ALMD on certain deferred annuity policies over a longer period of time. In subsequent periods, American Life and Casualty's statutory surplus is reduced through the payment of renewal commissions to ALMD equal to a specified percentage of the accumulated policyholder account values of certain deferred annuity policies issued by American Life and Casualty since 1990 remaining in force.
Included in statutory capital and surplus at December 31, 1996, is $6.3 million related to 463,649 shares of ALH's common stock held by Vulcan Life. Such amount is eliminated in the consolidated financial statements.
Most states have adopted risk-based capital ("RBC") rules, to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks. The RBC formula is designed as an early warning tool to help state regulators identify possible weakly capitalized companies for the purpose of initiating regulatory action. At December 31, 1996, the ratios of total adjusted capital to RBC, as defined by the rules, for the Company's insurance subsidiaries were approximately twice the level at which regulatory attention is triggered.
The results of operations for the fourth quarter of 1996 are based on a new basis of accounting under the "push down" method adopted on September 30, 1996, as discussed in note 1. The results of operations for 1995 and the first nine months of 1996 represent results reported based on the purchase method of accounting as discussed in note 1.