Our Bankers Life segment is primarily administered from a facility in downtown Chicago, Illinois. Bankers Life has approximately 222,000 square feet leased under an agreement which expires in 2018. In addition, Bankers Life leases approximately 114,000 square feet of space in its former location, the Merchandise Mart. Approximately 98 percent of that space is subleased through November 2013, the early termination date of the lease. We also lease 247 sales offices in various states totaling approximately 736,000 square feet. These leases generally are short-term in length, with remaining lease terms expiring between 2011 and 2017.
Selected amounts have been restated to reflect the retrospective application of the adoption of authoritative guidance that specifies that issuers of convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) 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. The guidance has been applied retrospectively to the years ended December 31, 2008, 2007 and 2006.
We have derived the statutory data from statements filed by our insurance subsidiaries with regulatory authorities which are prepared in accordance with statutory accounting principles, which vary in certain respects from GAAP, and include amounts related to our discontinued operations in 2007 and 2006.
In this section, we review the consolidated financial condition of CNO and its consolidated results of operations for the years ended December 31, 2010, 2009 and 2008 and, where appropriate, factors that may affect future financial performance. Please read this discussion in conjunction with the consolidated financial statements and notes included in this Form 10-K.
changes in or sustained low interest rates causing a reduction in investment income, the margins of our fixed annuity and life insurance business and demand for our products;
our ability to make changes to certain non-guaranteed elements of our life insurance products;
changes in the Federal income tax laws and regulations which may affect or eliminate the relative tax advantages of some of our products.
Generating targeted levels of investment income in a low interest rate environment within acceptable risk tolerance levels.
Improving profitability of existing lines of business or disposing of underperforming blocks of business.
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 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
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.
Our fixed maturity investments are generally purchased in the context of a long-term strategy to fund insurance liabilities, so we do not generally seek to purchase and sell such securities to generate short-term realized gains. In certain circumstances, including those in which securities are selling at prices which exceed our view of their current fair value, and it is possible to reinvest the proceeds to better meet our long-term asset-liability management objectives, we may sell certain securities. During 2010, we sold $1.4 billion of fixed maturity investments which resulted in gross investment losses (before income taxes) of $147.7 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 fair 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.
for the impact of unrealized gains (losses) in the same manner as the deferred acquisition costs described below. We expect to amortize approximately 13 percent of the December 31, 2010 balance of the present value of future profits inforce in 2011, 11 percent in 2012, 10 percent in 2013, 8 percent in 2014 and 7 percent in 2015.
summarized below would occur equally among policy types, ages and durations within each product classification. Any actual adjustment would be dependent on the specific policies affected and, therefore, may differ from the estimates summarized below. In addition, the impact of actual adjustments would reflect the net effect of all changes in assumptions during the period.
A significant portion of our universal life-type products inforce are valued in a loss recognition status. A favorable change in experience on such blocks may slow down future amortization; however, the current period adjustment to insurance acquisition costs would be small. This causes the downside sensitivities above to be lower in magnitude than the upside results.
The Medicare supplement block of Bankers Life reflected higher lapse activity which was expected due to conversions to new Medicare Modernization plans.
We have noted an increase in persistency rates since 2008 for other annuity products (consisting primarily of fixed rate annuity policies). We believe this increase is related to the lack of competing investment products which would offer higher returns for consumers.
This block of business experienced higher than anticipated surrenders during 2009. The annuities which experienced higher surrenders have a MVA feature, which effectively reduced (or in some cases eliminated) the charges paid upon the surrender of these policies as the 10-year treasury rate dropped to historic lows. The impact of both the historical experience and projected increased surrender activity and higher MVA benefits has reduced our expectations on the profitability of the annuity block of Other CNO Business to approximately break-even. Refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Other CNO Business - Amortization Related to Operations” for additional information.
The following summarizes the pre-tax income (loss) of the PDP business (dollars in millions):
The following summarizes the pre-tax income (loss) of the PFFS business (dollars in millions):
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 any changes to the deferred tax valuation allowance recognizes that as of December 31, 2010, we have incurred a cumulative loss over the evaluation period, resulting from the substantial loss during 2008 primarily related to the Transfer of the stock of Senior Health to the Independent Trust for the exclusive benefit of Senior Health’s long-term care policyholders 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 valuation allowance for deferred tax assets was primarily based on our historical taxable earnings. However, because a substantial portion of the cumulative losses for the three-year period ended December 31, 2010, 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”. We consider this to be non-recurring and have reflected our best estimates of when temporary differences will reverse over the carryforward periods.
In order to support the utilization of the tax benefits of NOLs that do not have an offsetting valuation allowance, we project future taxable income based on our historical earnings adjusted for the items described in the previous paragraph. Based on these projections, we must generate approximately $225 million for each year through 2018 in order to utilize the tax benefits of our NOLs which expire through that date. The taxable income requirements are substantially comprised of life insurance income, as the potential tax benefits related to our non-life NOLs are substantially offset by a valuation allowance. Our taxable income excluding realized gains for 2010 was $235 million and we expect our future taxable income to be adequate to utilize the remaining NOLs. The projections of future taxable income used to support the recovery of our NOLs do not anticipate the use of any tax planning strategies that we would consider to avoid a tax benefit from expiring.
The $856.2 million increase to our valuation allowance during 2008 included increases of: (i) $452 million of deferred tax assets related to Senior Health, which was transferred to an independent trust during 2008; (ii) $298 million related to our reassessment of the recovery of our deferred tax assets in accordance with GAAP, following the additional losses incurred as a result of the transaction to transfer Senior Health to an independent trust; (iii) $60 million related to the recognition of additional realized investment losses for which we are unlikely to receive any tax benefit; and (iv) $45 million related to the estimated additional future expense following the modifications to our Second Amended and Restated Credit Agreement dated as of October 10, 2006, as subsequently amended (the “Previous Senior Credit Agreement”) as described in the note to these consolidated financial statements entitled “Notes Payable - Direct Corporate Obligations.”
Section 382 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 7.0% Debentures), or acquisitions or sales of shares of CNO 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 additional 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 CNO’s equity at the time of such ownership change, multiplied by a federal long-term tax exempt rate (3.67 percent at December 31, 2010), 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 December 31, 2010, we were below the 50 percent ownership change level that would trigger further impairment of our ability to utilize our NOLs.
Tax years 2007 through 2009 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 2007 through 2009 based on the individual state statutes of limitation.
We calculate and maintain reserves for the future payment of claims to our policyholders based on actuarial assumptions. For all our insurance products, we establish an active life reserve, a liability for due and unpaid claims, claims in the course of settlement and incurred but not reported claims. In addition, for our health insurance business, we establish a reserve for the present value of amounts not yet due on claims. Many factors can affect these reserves and liabilities, such as economic and social conditions, inflation, hospital and pharmaceutical costs, changes in doctrines of legal liability and extra-contractual damage awards. Therefore, our reserves and liabilities are necessarily based on numerous estimates and assumptions as well as historical experience. Establishing reserves is an uncertain process, and it is possible that actual claims will materially exceed our reserves and have a material adverse effect on our results of operations and financial condition. We have incurred significant losses beyond our estimates as a result of actual claim costs and persistency of our long-term care business of Senior Health and Washington National. Our financial results depend significantly upon the extent to which our actual claims experience is consistent with the assumptions we used in determining our reserves and pricing our products. If our assumptions with respect to future claims are incorrect, and our reserves are insufficient to cover our actual losses and expenses, we would be required to increase our liabilities, which would negatively affect our operating results.
Florida Order - In 2004, the Florida Office of Insurance Regulation issued an order to Washington National regarding its home health care business in Florida. The order required Washington National to offer a choice of three alternatives to holders of home health care policies in Florida subject to premium rate increases as follows:
retention of their current policy with a rate increase of 50 percent in the first year and actuarially justified increases in subsequent years;
Reserves for all three groups of policies under the order were prospectively adjusted using the prospective revision methodology described above, as these alternatives were required by the Florida Office of Insurance Regulation. These policies had no insurance acquisition costs established at the Effective Date.
In conjunction with our bankruptcy reorganization in 2003, $481.3 million principal amount of bank loans made to certain former directors and employees to enable them to purchase common stock of our Predecessor were transferred to the Company. These loans had been guaranteed by our Predecessor. We received all rights to collect the balances due pursuant to the original terms of these loans. In addition, we held loans to participants for interest on the loans. The loans and the interest loans are collectively referred to as the “D&O loans.” As of December 31, 2010, we had reached settlements with the former directors and employees and had collected the remaining amounts outstanding related to the D&O loan settlements.
Pursuant to the settlement that was reached with the Official Committee of the Trust Originated Preferred Securities (“TOPrS”) Holders and the Official Committee of Unsecured Creditors in connection with our bankruptcy reorganization in 2003, the former holders of TOPrS (issued by our Predecessor’s subsidiary trusts and eliminated in our reorganization) who did not opt out of the bankruptcy settlement were entitled to receive 45 percent of any proceeds from the collection of certain D&O loans in an aggregate amount not to exceed $30 million. As of December 31, 2010, we had paid $20.5 million to the former holders of TOPrS and we have established a liability of $2.0 million (which is included in other liabilities), representing the final amount which will be paid to the former holders of TOPrS pursuant to the settlement.
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 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.
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 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 $238.8 million, $225.1 million and $210.1 million in 2010, 2009 and 2008, respectively.
Average liabilities for insurance products, net of reinsurance ceded were $12.1 billion in 2010, up 5.5 percent from 2009, and $11.5 billion in 2009, up 8.9 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.
Net investment income on general account invested assets (which excludes income on policyholder accounts) increased 12 percent, to $719.3 million, in 2010 and 4.3 percent, to $643.6 million, in 2009. The average balance of general account invested assets was $12.3 billion, $11.4 billion and $10.6 billion in 2010, 2009 and 2008, respectively. The average yield on these assets was 5.84 percent in 2010, 5.64 percent in 2009 and 5.83 percent in 2008. The increase in general account invested assets is primarily due to: (i) sales of our annuity and health products in recent periods; and (ii) the proceeds from collateralized borrowings from the FHLB pursuant to an investment borrowing program that commenced in September 2010. The increase in net investment income in 2010 reflects: (i) an increase in the average yield due to our reinvestment of short-term investments held in 2009 into longer-term securities; and (ii) the growth in general account invested assets.
Net investment income on other special-purpose portfolios includes: (i) 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; and (ii) the change in fair value of a trading securities portfolio. 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 $5.0 million, $7.1 million and $(9.5) million in 2010, 2009 and 2008, respectively. We also recognized a death benefit of $2.9 million in 2009. The trading securities are carried at estimated fair value with changes in such value recognized as trading income. We recognized trading income of $2.0 million in 2010. There was no such trading income in 2009 or 2008.
Fee revenue and other income was $12.8 million in 2010, compared to $10.2 million in 2009 and $11.0 million in 2008. We recognized fee income of $11.4 million, $9.2 million and $9.9 million in 2010, 2009 and 2008, respectively, pursuant to the agreements described above under “Accounting for marketing and reinsurance agreements with Coventry”.
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 our long-term care business in the Bankers Life segment was 113.7 percent, 105.2 percent and 107.6 percent in 2010, 2009 and 2008, respectively. The interest-adjusted benefit ratio on this business was 73.0 percent, 67.9 percent and 74.0 percent in 2010, 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 redundancies (deficiencies) from prior years of $26.3 million, $10.0 million and $(6.0) million in 2010, 2009 and 2008, respectively. Excluding the effects of prior year claim reserve redundancies (deficiencies), our benefit ratios would have been 118.2 percent, 106.9 percent and 106.7 percent in 2010, 2009 and 2008, respectively. The benefit ratio for 2009 reflected a reduction in liabilities for insurance products of approximately $41.9 million due to our estimates of: (i) the reduction in liabilities for policyholders choosing to lapse their policies rather than paying higher rates; (ii) the reduction in liabilities for policyholders choosing to reduce their coverages to achieve a lower cost; offset by (iii) the 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 acquisition costs of $4.7 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). The benefit ratio in 2010 increased due to lower re-rate activity.
Amounts added to fixed index products based on change in value of the indices will generally fluctuate with the corresponding related investment income accounts described above. Such corresponding relationship did not exist in 2008 due to a number of factors including variations in option costs and changes in the value of the trading account securities which did not correspond to the changes in the value of the embedded derivatives related to these products.
these costs is not recoverable from future profits. Bankers Life’s amortization expense was $290.5 million, $267.9 million and $234.8 million in 2010, 2009 and 2008, respectively. Amortization expense related to our annuity block of business increased $46.9 million in 2009, as compared to 2008, partially due to changes in our lapse assumptions. Amortization expense related to our annuity block continued to increase in 2010 due to higher gross profits on this business. 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 2009, amortization expense related to annuities decreased by $5.9 million due to this limitation. During the first six 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 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 $185.0 million in 2010, down 5.9 percent from 2009 and were $196.6 million in 2009, up 7.8 percent from 2008. Other operating costs and expenses include the following (dollars in millions):
Net realized investment losses fluctuated each period. During 2010, net realized investment gains in this segment included $116.8 million of net gains from the sales of investments (primarily fixed maturities) and $54.7 million of writedowns of investments for other than temporary declines in fair value recognized through net income ($50.7 million, prior to the $(4.0) million of impairment losses recognized through accumulated other comprehensive income (loss)). During 2009, net realized investment losses in this segment included $65.0 million of net gains from the sales of investments (primarily fixed maturities) and $96.4 million of writedowns of investments for other than temporary declines in fair value recognized through net income ($182.2 million, prior to the $85.8 million of impairment losses recognized through accumulated other comprehensive income (loss)). During 2008, net realized investment losses in this segment included $31.1 million of net losses from the sales of investments (primarily fixed maturities) and $85.6 million of writedowns of investments resulting from declines in fair value that we concluded were other than temporary.
Average liabilities for insurance products, net of reinsurance ceded were $2.7 billion in 2010, down 7.5 percent from 2009, and $2.9 billion in 2009, down 3.6 percent from 2008. The decrease in such liabilities in 2010 and 2009 was primarily due to the coinsurance transaction with Wilton Re completed in September 2009, as further discussed in the note to the consolidated financial statements entitled “Summary of Significant Accounting Policies - Reinsurance”, and policyholder redemptions and lapses exceeding new sales.
Net investment income on general account invested assets (which excludes income on policyholder and reinsurer accounts) decreased 3.7 percent, to $184.2 million, in 2010 and 3.1 percent, to $191.2 million, in 2009. The average balance of general account invested assets was $3.1 billion, $3.3 billion and $3.4 billion in 2010, 2009 and 2008, respectively. The average yield on these assets was 5.90 percent in 2010, 5.71 percent in 2009 and 5.87 percent in 2008. The increase in yield in 2010 primarily resulted from shifts among asset classes to increase income. The reduction in average yield in 2009 reflects lower new money rates due to tighter credit spreads for many investments.
Change in value of embedded derivatives related to modified coinsurance agreements is described in the note to our consolidated financial statements entitled “Summary of Significant Accounting Policies - 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.
The benefit ratios on Washington National’s Medicare supplement products have been impacted by increases 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 $4.2 million, $4.6 million and $2.5 million in 2010, 2009 and 2008, respectively. Excluding the effects of prior year claim reserve redundancies, our benefit ratios for the Medicare supplement block would have been 69.9 percent, 70.8 percent and 69.6 percent in 2010, 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 $51.8 million, $57.6 million and $64.6 million in 2010, 2009 and 2008, respectively. Such decreases are primarily due to lower sales, partially offset by favorable claim experience.
The benefit ratios on Washington National’s other products are subject to fluctuations due to the smaller size of these blocks of business.
Average liabilities for insurance products, net of reinsurance ceded, did not fluctuate significantly during the three years ended December 31, 2010.
million final distribution and commutation amount following the termination of a group insurance pool that Colonial Penn previously participated in. Insurance policy income in the 2010 and 2009 periods also reflects the growth in this segment.
Other operating costs and expenses in our Colonial Penn segment did not fluctuate significantly during the three years ended December 31, 2010.
Net realized investment gains (losses) fluctuated each period. During 2010, net realized investment gains in this segment included $9.0 million of net gains from the sales of investments (primarily fixed maturities) and $2.4 million of writedowns of investments for other than temporary declines in fair value recognized through net income ($2.7 million, prior to the $.3 million of impairment losses recognized through accumulated other comprehensive income (loss)). During 2009, net realized investment gains in this segment included $8.7 million of net gains from the sales of investments (primarily fixed maturities) and $4.2 million of writedowns of investments for other than temporary declines in fair value recognized through net income ($4.6 million, prior to the $.4 million of impairment losses recognized through accumulated other comprehensive income (loss)). During 2008, net realized investment losses in this segment included $.1 million of net gains from the sales of investments (primarily fixed maturities) and $1.7 million of writedowns of investments resulting from declines in fair value that we concluded were other than temporary.
We calculate the interest-adjusted benefit ratio (a non-GAAP measure) for long-term care products in our Other CNO Business segment 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.
Total premium collections were $239.7 million in 2010, down 26 percent from 2009, and $322.7 million in 2009, down 19 percent from 2008. The decrease in collected premiums was primarily due to policyholder redemptions and lapses and lower life insurance premiums subsequent to the completion of the coinsurance transaction with Wilton Re in 2009. See “Premium Collections” for further analysis of fluctuations in premiums collected by product.
Average liabilities for insurance products, net of reinsurance ceded were $5.5 billion in 2010, down 5.0 percent from 2009, and $5.8 billion in 2009, down 6.7 percent from 2008. The decreases in such liabilities were primarily due to: (i) the coinsurance transaction with Wilton Re completed in September 2009, as further discussed in the note to the consolidated financial statements entitled “Summary of Significant Accounting Policies - Reinsurance”; and (ii) policyholder redemptions and lapses.
primarily due to lower policyholder charges and premiums from our life insurance block including the impact of the completion of the coinsurance transaction with Wilton Re in 2009. See “Premium Collections” for further analysis.
The net cash flows from long-term care products generally cause an accumulation of amounts in the early years of a policy (reflected in our earnings as reserve increases) which will be paid out as benefits in later policy years (reflected in our earnings as reserve decreases which offset the recording of benefit payments). 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 123.8 percent, 107.9 percent and 93.5 percent in 2010, 2009 and 2008, respectively. Excluding the effects of prior year claim reserve redundancies (deficiencies), our interest-adjusted benefit ratios would have been 111.1 percent, 101.5 percent and 96.7 percent in 2010, 2009 and 2008, respectively.
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.
During the last three years, we were required to accelerate the amortization of insurance acquisition costs due to the experience of a block of fixed index annuities. This block of business has experienced higher than anticipated surrenders and
Interest expense on investment borrowings includes $19.8 million, $20.3 million and $21.9 million of interest expense on collateralized borrowings in 2010, 2009 and 2008, respectively, as further described in the note to the consolidated financial statements entitled “Summary of Significant Accounting Policies - Investment Borrowings”.
Other operating costs and expenses were $81.4 million, $102.1 million and $97.2 million in 2010, 2009 and 2008, respectively. Other operating costs and expenses include commission expense of $6.2 million, $8.0 million and $11.7 million in 2010, 2009 and 2008, respectively. These amounts fluctuate as a result of consulting and legal costs which often vary from period to period.
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 an increase (decrease) in the amortization of insurance acquisition costs of $1.3 million, $(4.2) million and $(5.7) million in 2010, 2009 and 2008, respectively.
Interest expense on corporate debt has been impacted by: (i) an amendment to our Previous Senior Credit Agreement in 2009; (ii) repayments of our Previous Senior Credit Agreement; (iii) the issuance in 2008 of the Senior Health Note; (iv) repurchases of 3.5% Convertible Debentures due September 30, 2035 (the “3.5% Debentures”); (v) completion of a cash tender offer (the “Tender Offer”) for $176.5 million aggregate principal amount of the 3.5% Debentures; (vi) the issuances of 7.0% Debentures; and (vii) the issuance of 9.0% Senior Secured Notes. Such transactions are further discussed in the note to the consolidated financial statements entitled “Notes Payable - Direct Corporate Obligations”. Our average corporate debt outstanding was $1,036.5 million, $1,275.8 million and $1,219.3 million in 2010, 2009 and 2008, respectively. The average interest rate on our debt was 7.3 percent, 5.7 percent and 4.6 percent in 2010, 2009 and 2008, respectively.
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 has decreased primarily as a result of a decrease in investments managed for others.
Gain (loss) on extinguishment or modification of debt of $6.8 million in 2010 resulted from the write-off of unamortized discount and issuance costs related to: (i) the repurchases of 3.5% Debentures; and (ii) the repayment of our Previous Senior Credit Agreement. The loss on extinguishment or modification of debt in 2009 consisted of expenses incurred and the write-off of unamortized discount or issuance costs totaling $22.2 million related to the following transactions: (i) the Tender Offer; (ii) repayment of principal amounts on the Previous Senior Credit Agreement from the proceeds from the issuance of common stock; and (iii) modifications to our Previous Senior Credit Agreement in March 2009 and December 2009. The gain on extinguishment of debt of $21.2 million in 2008 resulted from the repurchase of $37.0 million par value of 3.5% Debentures for $15.3 million plus accrued interest. These transactions are further discussed in the note to the consolidated financial statements entitled “Notes Payable - Direct Corporate Obligations”.
Net realized investment losses often fluctuate each period. During 2010, net realized investment losses in this segment included $.2 million of net losses from the sales of investments (of which $.4 million were losses recognized by VIEs) and $3.3 million of writedowns of investments (all of which were recognized by VIEs) due to other-than-temporary declines in value. During 2009, net realized investment losses in this segment included $6.1 million of net gains from the sales of investments (of which $.7 million were losses recognized by a VIE) and $13.5 million of writedowns of investments (all of which were recognized by a VIE) due to other-than-temporary declines in value. During 2008, net realized investment losses included $36.1 million from the sale of investments ($14.1 million of such losses were recognized by a VIE) and $14.7 million of writedowns ($10.8 million of such writedowns were recognized by a VIE) of investments resulting from declines in fair value that we concluded were other than temporary due to declines in value on certain securities.
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.
Annuities in this segment include fixed index and other fixed annuities sold to the senior market. Annuity collections in this segment decreased 5.2 percent, to $1,005.5 million, in 2010 and 13 percent, to $1,060.4 million, in 2009. The change in mix of premium collections between our fixed index products and our fixed annuity products has fluctuated due to volatility in the financial markets in recent periods. In addition, premium collections from Bankers Life’s fixed annuity products decreased in 2010 as low new money interest rates negatively impacted our sales and the overall sales in the fixed annuity market. A new product, which provides more flexibility in setting the bonus interest rates, was launched in early 2010.
Health products include Medicare supplement, Medicare Part D contracts, long-term care and other insurance products. Our profits on health policies depend on the overall level of sales, the length of time the business remains inforce, investment yields, claims experience and expense management.
Life products in this segment are sold primarily to the senior market through our career agents. Life premiums collected in this segment decreased 8.4 percent, to $209.6 million, in 2010 and increased 9.3 percent, to $228.8 million, in 2009. Collected premiums have been impacted by the reinsurance agreement with Wilton Re completed in the fourth quarter of 2009.
Premiums collected on supplemental health products (including specified disease, accident and hospital indemnity insurance products) increased 5.8 percent, to $405.5 million, in 2010 and 2.3 percent, to $383.3 million, in 2009. Such increases are due to higher new sales in each year and an improvement in persistency.
Life products in the Washington National segment are primarily traditional life products. Life premiums collected decreased 46 percent, to $16.2 million, in 2010 and 16 percent, to $30.1 million, in 2009, reflecting the completion of the coinsurance transaction with Wilton Re in the third quarter of 2009.
Our fixed index 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 these products decreased 81 percent, to $14.9 million, in 2010 and 38 percent, to $76.6 million, in 2009.
Health products in the Other CNO Business segment include long-term care and other health insurance products. Our profits on health policies depend on the overall level of sales, the length of time the business remains inforce, investment yields, claim experience and expense management.
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 Other CNO Business segment include primarily universal life products. Life premiums collected decreased 8.8 percent, to $191.6 million, in 2010 and 10 percent, to $210.2 million, in 2009, reflecting the completion of the coinsurance transaction with Wilton Re in the third quarter of 2009.
The following table summarizes the composition of our investment portfolio as of December 31, 2010 (dollars in millions):
The following table summarizes the carrying value of our fixed maturity securities, available for sale, by category as of December 31, 2010 (dollars in millions):
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 16 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.
Privately placed securities comprise approximately 66 percent of our fixed maturities, available for sale, classified as Level 3. Privately placed securities are classified as Level 3 when their valuation is based on internal valuation models which rely on significant inputs that are not observable in the market. Our model applies spreads above the risk-free rate
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.
Amounts represent adjustments to investments related to a variable interest entity that was required to be consolidated effective January 1, 2010, as well as the reclassification of investments of a variable interest entity which was consolidated at December 31, 2009.
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 accumulated other comprehensive income (loss) within shareholders’ equity based on the appropriate accounting treatment for the instrument.
Our fixed maturity portfolio at December 31, 2010, included primarily debt securities of the United States government, various corporations, and structured securities. Asset-backed securities, collateralized debt obligations, commercial mortgage-backed securities, mortgage pass-through securities and collateralized mortgage obligations are collectively referred to as “structured securities”.
recovery of such reductions as investment income over the remaining life of the investment (but only to the extent our current valuations indicate such amounts will ultimately be collected), or upon the repayment of the investment. During 2010, we recognized net realized investment gains of $30.2 million, which were comprised of $180.0 million of net gains from the sales of investments (primarily fixed maturities) with proceeds of $8.6 billion and $149.8 million of writedowns of investments for other than temporary declines in fair value recognized through net income ($146.8 million, prior to the $(3.0) million of impairment losses recognized through accumulated other comprehensive income (loss)). Our investment portfolio is subject to the risks of further declines in realizable value. However, we attempt to mitigate this risk through the diversification and active management of our portfolio.
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.
At December 31, 2010, fixed maturity investments included structured securities with an estimated fair value of $4.2 billion (or 20 percent of all fixed maturity securities). The yield characteristics of structured securities can differ in some respects from those of traditional fixed-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, in many cases, partial 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; the timing and pace of liquidations of defaulted collateral; the amount of loan maturities; and various security-specific structural considerations (for example, the repayment priority of a given security in a securitization structure). In addition, the total amount of payments for non-government structured securities may be affected by changes to cumulative default rates or loss severities of the related collateral.
During 2010, we sold $1.4 billion of fixed maturity investments which resulted in gross investment losses (before income taxes) of $147.7 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 fair value could deteriorate further; (iii) desire to reduce our exposure to an asset class, an issuer or an industry; (iv) changes in credit quality; or (v) changes in expected liability cash flows. As discussed in the notes to our consolidated financial statements, the realization of gains and losses affects the timing of the amortization of insurance acquisition costs related to universal life and investment products.
The following table shows our commercial mortgage loan portfolio by loan size as of December 31, 2010 (dollars in millions):
At December 31, 2010, we held investments with an amortized cost of $428.0 million and an estimated fair value of $420.9 million related to variable interest entities that we are required to consolidate. The investment portfolio held by the variable interest entities is primarily comprised of corporate fixed maturity securities which are almost entirely rated as below-investment grade securities. Refer to the note to the consolidated financial statements entitled “Investments in Variable Interest Entities” for additional information on these investments.
The Company participated in a securities lending program whereby certain fixed maturity securities from our investment portfolio were loaned to third parties via a lending agent for a short period of time. We maintained ownership of the loaned securities. We required collateral equal to 102 percent of the fair value of the loaned securities. The collateral was invested by the lending agent in accordance with our guidelines. The fair value of the loaned securities was monitored on a daily basis with additional collateral obtained as necessary. In the third quarter of 2010, the Company discontinued its securities lending program. As of December 31, 2009, the fair value of the loaned securities was $178.5 million. As of December 31, 2009, the Company had received collateral of $185.7 million. Income generated from the program, net of expenses is recorded as net investment income and totaled $.2 million, $1.2 million and $2.4 million in 2010, 2009 and 2008, respectively.
In accordance with GAAP, we record our fixed maturity securities, available for sale, equity securities and certain other invested assets at estimated fair value with any unrealized gain or loss (excluding impairment losses, which are recognized through earnings), net of tax and related adjustments, recorded as a component of shareholders’ equity. At December 31, 2010, we increased the carrying value of such investments by $.5 billion as a result of this fair value adjustment.
The following table summarizes certain financial ratios as of and for the years ended December 31, 2010 and 2009:
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.
These cash flows represent our estimates of the payments we expect to make to our policyholders, without consideration of future premiums or reinsurance recoveries. These estimates are based on numerous assumptions (depending on the product type) related to mortality, morbidity, lapses, withdrawals, future premiums, future deposits, interest rates on investments, credited rates, expenses and other factors which affect our future payments. The cash flows presented are undiscounted for interest. As a result, total outflows for all years exceed the corresponding liabilities of $24.5 billion included in our consolidated balance sheet as of December 31, 2010. As such payments are based on numerous assumptions, the actual payments may vary significantly from the amounts shown.
For products such as universal life, ordinary life, long-term care, supplemental health and fixed rate annuities, the future payments are not due until the occurrence of an insurable event (such as death or disability) or a triggering event (such as a surrender or partial withdrawal). We estimated these payments using actuarial models based on historical experience and our expectation of the future payment patterns.
Includes benefits expected to be paid pursuant to our deferred compensation plan and postretirement plans based on numerous actuarial assumptions and interest credited at 5.50 percent.
Refer to the notes to the consolidated financial statements entitled “Commitments and Contingencies” for additional information on operating leases and certain other contractual commitments.
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.
On November 30, 2010, Moody’s affirmed the financial strength rating of “Ba1” of our primary insurance subsidiaries with a stable outlook. On May 26, 2010, Moody’s upgraded the financial strength ratings of our primary insurance subsidiaries to “Ba1” from “Ba2”. Moody’s also revised the outlook for the ratings of our primary insurance subsidiaries to stable from positive. A “stable” designation means that a rating is not likely to change. 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 “Ba1” 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 ten ratings above our “Ba1” rating and ten ratings that are below our rating.
At December 31, 2010, CNO, CDOC (our wholly owned subsidiary and a guarantor under the New Senior Credit Agreement) and our other non-insurance subsidiaries held unrestricted cash of $161 million. 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, which receives fees from the insurance subsidiaries for investment services, and CNO Services, LLC which receives fees from the insurance subsidiaries for providing administrative services. The agreements between our insurance subsidiaries and CNO 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.
CDOC holds surplus debentures from Conseco Life of Texas with an aggregate principal amount of $749.6 million. Interest payments on surplus debentures from Conseco Life of Texas do not require additional approval provided the RBC ratio of Conseco Life of Texas exceeds 100 percent (but do require prior written notice to the Texas state insurance department). The RBC ratio of Conseco Life of Texas was 262% at December 31, 2010. Dividends and other payments from our non-insurance subsidiaries, including 40|86 Advisors and CNO 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 interest rate applicable to the New Senior Secured Credit Agreement is, at our option (in most instances), a Eurodollar rate of Libor plus 6.00 percent (subject to a Libor “floor” of 1.5 percent) or a Base Rate plus 5.00 percent (subject to a Base Rate “floor” of 2.5 percent). The pricing terms for the New Senior Secured Credit Agreement included upfront fees of 1.25 percent paid to the lenders. At December 31, 2010, the interest rate on our New Senior Secured Credit Agreement was 7.5 percent. The New Senior Secured Credit Agreement is guaranteed by the Subsidiary Guarantors and secured by substantially all of our and the Subsidiary Guarantors’ assets.
In addition, the New Senior Secured Credit Agreement requires the Company to maintain: (i) a debt to total capitalization ratio of not more than 30 percent (such ratio was 19.99 percent at December 31, 2010); (ii) an interest coverage ratio of not less than 2.00 to 1.00 for each rolling four quarters (or, if less, the number of full fiscal quarters commencing after the effective date of the New Senior Secured Credit Agreement) (such ratio was not applicable for the period ended December 31, 2010); (iii) an aggregate ratio of total adjusted capital to company action level risk-based capital for the Company’s insurance subsidiaries of not less than 225 percent on or prior to December 31, 2011 and 250 percent thereafter (such ratio was 332 percent at December 31, 2010); and (iv) a combined statutory capital and surplus for the Company’s insurance subsidiaries of at least $1,200.0 million (combined statutory capital and surplus at December 31, 2010, was $1,596.4 million).
The 9.0% Senior Secured Notes were issued pursuant to an indenture governing the 9.0% Senior Secured Notes dated as of December 21, 2010 (the “Indenture”), by and among the Company, the Subsidiary Guarantors and Wilmington Trust FSB, as trustee and collateral agent (the “Trustee”).
consolidate or merge with or into other companies or transfer all or substantially all of the Company’s assets; and
Under the Intercreditor Agreement, any actions that may be taken with respect to the collateral that secures the 9.0% Senior Secured Notes and the New Senior Secured Credit Agreement, including the ability to cause the commencement of enforcement proceedings against such collateral, to control such proceedings and to approve amendments to releases of such collateral from the lien of, and waive past defaults under, such documents relating to such collateral, will be at the direction of the authorized representative of the lenders under the New Senior Secured Credit Agreement until the earlier of: (i) the Company’s obligations under the New Senior Secured Credit Agreement (or refinancings thereof) are discharged; (ii) the date on which the outstanding principal amount of loans and commitments under the New Senior Secured Credit Agreement is less than $25.0 million; and (iii) 180 days after the occurrence of both an event of default under the Indenture and the authorized representative of the holders of the 9.0% Senior Secured Notes making certain representations as described in the Intercreditor Agreement, unless the authorized representative of the lenders under the New Senior Secured Credit Agreement has commenced and is diligently pursuing enforcement action with respect to the collateral or the grantor of the security interest in that collateral (whether the Company or the applicable Subsidiary Guarantor) is then a debtor under or with respect to (or otherwise subject to) any insolvency or liquidation proceeding.
In December 2010, we repaid the $652.1 million outstanding principal balance under our Previous Credit Agreement using: (i) the proceeds from the New Senior Secured Credit Agreement and the issuance of the 9.0% Senior Secured Notes; and (ii) available cash.
In February 2010, we repurchased $64.0 million aggregate principal amount of our 3.5% Debentures in a privately-negotiated transaction. In connection with the repurchase of the 3.5% Debentures, we completed a second closing of $64 million aggregate principal amount of our 7.0% Debentures. The net proceeds from the issuance of the 7.0% Debentures were used to fund a substantial portion of the consideration payable in connection with the repurchase of the 3.5% Debentures. The purchase price for the $64.0 million of 3.5% Debentures was equal to 100 percent of the aggregate principal amount plus accrued and unpaid interest.
In May 2010, we repurchased $52.5 million aggregate principal amount of our 3.5% Debentures in a privately-negotiated transaction. In connection with the repurchase of the 3.5% Debentures, we completed a third closing of $52.5 million aggregate principal amount of our 7.0% Debentures. The net proceeds from the issuance of the 7.0% Debentures were used to fund a substantial portion of the consideration payable in connection with the repurchase of the 3.5% Debentures. The purchase price for the $52.5 million of 3.5% Debentures was equal to 100 percent of the aggregate principal amount plus accrued and unpaid interest.
At December 31, 2010, as a result of the transactions described above, we had an aggregate $293.0 million principal amount of the 7.0% Debentures outstanding and none of the 3.5% Debentures. See the note to the consolidated financial statements entitled “Notes Payable - Direct Corporate Obligations” for further information on the 3.5% Debentures and 7.0% Debentures.
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, our entire portfolio of fixed maturity securities is available to be sold in response to: (i) changes in market interest rates; (ii) changes in relative values of individual securities and asset sectors; (iii) changes in prepayment risks; (iv) changes in credit quality outlook for certain securities; (v) liquidity needs; and (vi) other factors. From time to time, we invest in securities for trading purposes, although such investments are a relatively small portion of our total portfolio.
We use computer models to simulate the cash flows expected from our existing insurance business under various interest rate scenarios. These simulations help us to measure the potential gain or loss in fair value of our interest rate-sensitive investments and to manage the relationship between the interest sensitivity of our assets and liabilities. When the estimated durations of assets and liabilities are similar, a change in the value of assets should be largely offset by a change in the value of liabilities. At December 31, 2010, the adjusted modified duration of our fixed income securities (as modified to reflect payments and potential calls) was approximately 8.8 years and the duration of our insurance liabilities was approximately 8.7 years. We estimate that our fixed maturity securities and short-term investments (net of corresponding changes in insurance acquisition costs) would decline in fair value by approximately $405 million if interest rates were to increase by 10 percent from their levels at December 31, 2010. This compares to a decline in fair value of $455 million based on amounts and rates at December 31, 2009. Our computer simulated calculations include numerous assumptions, require significant estimates and assume an immediate change in interest rates without any management of the investment portfolio in reaction to such change. Consequently, potential changes in value of our financial instruments indicated by the simulations will likely be different from the actual changes experienced under given interest rate scenarios, and the differences may be material. Because we actively manage our investments and liabilities, our net exposure to interest rates can vary over time.
We are subject to the risk that our investments will decline in value. This has occurred in the past and may occur again. During 2010, we recognized net realized investment gains of $30.2 million, which were comprised of $180.0 million of net gains from the sales of investments (primarily fixed maturities) and $149.8 million of writedowns of investments for other than temporary declines in fair value recognized through net income ($146.8 million, prior to the $(3.0) million of impairment losses recognized through accumulated other comprehensive income (loss)). During 2009, we recognized net realized investment losses of $60.5 million, which were comprised of $134.9 million of net gains from the sales of investments (primarily fixed maturities) and $195.4 million of writedowns of investments for other than temporary declines in fair value recognized through net income ($385.0 million, prior to the $189.6 million of impairment losses recognized through accumulated other comprehensive loss). During 2008, we recognized net realized investment losses of $262.4 million, which were comprised of: (i) $100.1 million of net losses from the sales of investments (primarily fixed maturities) and; (ii) $162.3 million of writedowns of investments for other than temporary declines in fair value.
Average liabilities for insurance products, net of reinsurance ceded were approximately $2.9 billion in 2008.
Net investment income on general account invested assets was $156.9 million in 2008. The average balance of general account invested assets was $2.5 billion in 2008. The average yield on these assets was 6.22 percent in 2008. The yield in 2008 reflects the decrease in the cost basis of investments as a result of the recognition of other-than-temporary impairments as further discussed below under net realized investment gains (losses).
The benefit ratio on this block of business was 136.6 percent in 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 deficiencies from prior years of $21.8 million in 2008. Excluding the effects of prior year claim reserve deficiencies, our benefit ratios would have been 127.0 percent in 2008. These ratios reflect the significantly higher level of incurred claims experienced in 2007 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 67.7 percent in 2008. Excluding the effects of prior year claim reserve deficiencies, our interest-adjusted benefit ratios would have been 58.1 percent in 2008.
We had been aggressively seeking actuarially justified rate increases and pursuing other actions on our long-term care policies. During the third quarter of 2006, we began a new program to file requests for rate increases on various long-term care products of Senior Health as we believed the existing rates were too low to fund expected future benefits. These filings were expected to be the first of three rounds of rate increase filings for many of the same policies, and in some cases we requested three years of successive rate increases. We chose to request a series of smaller rate increases, rather than a single large increase, to limit the impact on a policyholder’s premiums in any single year. The effects of the first round of rate filings were partially realized in our premium revenue. In the second quarter of 2007, we began filing requests for the second round of rate increases on many of the same policies. The full effect of all three rounds of rate increases was not expected to be fully realized until 2011.
Gain on reinsurance recapture resulted from the recapture of a block of previously reinsured long-term care business in the third quarter of 2008. Such business was included in the Transfer.
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of CNO Financial Group, Inc. and its subsidiaries at December 31, 2010 and 2009, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2010 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The Company's management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in Management's Report on Internal Control Over Financial Reporting appearing under Item 9A. Our responsibility is to express opinions on these financial statements and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
CNO Financial Group, Inc., a Delaware corporation (“CNO”), (formerly known as Conseco, Inc. prior to its name change in May 2010) is a holding company for a group of insurance companies operating throughout the United States that develop, market and administer 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 “CNO Financial Group, Inc.”, the “Company”, “we”, “us”, and “our” as used in these financial statements 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, underserved, high growth markets. We sell our products through three distribution channels: career agents, independent producers (some of whom sell one or more of our product lines exclusively) and direct marketing.
Bankers Life, which markets and distributes Medicare supplement insurance, interest-sensitive life insurance, traditional life insurance, fixed annuities and long-term care insurance products to the middle-income senior market through a dedicated field force of career agents and sales managers supported by a network of community-based branch offices. The Bankers Life segment includes primarily the business of Bankers Life and Casualty Company (“Bankers Life”). Bankers Life also markets and distributes Medicare Advantage plans primarily through a distribution arrangement with Humana, Inc. (“Humana”) and Medicare Part D prescription drug plans through a distribution and reinsurance arrangement with Coventry Health Care (“Coventry”).
Washington National, which markets and distributes supplemental health (including specified disease, accident and hospital indemnity insurance products) and life insurance to middle-income consumers at home and at the worksite. These products are marketed through Performance Matters Associates, Inc., a wholly owned subsidiary, and through independent marketing organizations and insurance agencies, including worksite marketing. The products being marketed are underwritten by Washington National Insurance Company (“Washington National”).
We prepare our financial statements in accordance with accounting principles generally accepted in the United States of America (“GAAP”). We follow the accounting standards established by the Financial Accounting Standards Board (“FASB”) and the Securities and Exchange Commission (the “SEC”).
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 deferred acquisition costs, the present value of future profits, 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.
On November 12, 2008, CNO and CDOC, Inc. (“CDOC”), a wholly owned subsidiary of CNO, completed the transfer (the “Transfer”) of the stock of Senior Health Insurance Company of Pennsylvania (“Senior Health”) to Senior Health Care Oversight Trust, an independent trust (the “Independent Trust”) for the exclusive benefit of Senior Health’s long-term care policyholders. The Transfer was approved by the Pennsylvania Insurance Department.
In connection with the Transfer, the Company entered into a $125.0 million Senior Note due November 12, 2013 (the “Senior Health Note”), payable to Senior Health. The note has a five-year maturity date; a 6 percent interest rate; and requires annual principal payments of $25.0 million. As a condition of the order from the Pennsylvania Insurance Department approving the Transfer, CNO agreed that it would not pay cash dividends on its common stock while any portion of the $125.0 million note remained outstanding.
CNO recorded accounting charges totaling $1.0 billion related to the transaction, comprised of Senior Health’s equity (as calculated in accordance with generally accepted accounting principles), an additional valuation allowance for deferred tax assets, the capital contribution to Senior Health and the Independent Trust and transaction expenses. The accounting charges are summarized as follows (dollars in millions):
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 fixed index annuity products and certain modified coinsurance agreements. See the sections of this note entitled “Accounting for Derivatives” and “Investment Borrowings” 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 fair 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 $372.6 million and $293.3 million at December 31, 2010 and 2009, respectively.
Other invested assets include: (i) certain call options purchased in an effort to hedge the effects of certain policyholder benefits related to our fixed index annuity and life insurance products; and (ii) certain non-traditional investments. We carry the call options at estimated fair value as further described in the section of this note entitled “Accounting for Derivatives”. Non-traditional investments include investments in certain limited partnerships, which are accounted for using the equity method, and promissory notes, which are accounted for using the cost method.
We regularly evaluate our investments for possible impairment as further described in the note to the consolidated financial statements entitled “Investments”.
The investment environment during the fourth quarter of 2008 resulted in significant net unrealized losses in our fixed maturity investment portfolio. The total adjustment to accumulated other comprehensive income (loss) related to the change in deferred acquisition costs for the negative amortization that would have been recorded if the fixed maturity securities had been sold at their stated aggregate fair value would have resulted in the balance of deferred acquisition costs exceeding the total of
costs capitalized plus interest for annuity blocks of business issued in certain years. Accordingly, the adjustment made to deferred acquisition costs and accumulated other comprehensive income (loss) was reduced by $206 million.
The discount rate we used to determine the present value of future profits was 12 percent.
The Company expects to amortize the balance of the present value of future profits as of December 31, 2010 as follows: 13 percent in 2011, 11 percent in 2012, 10 percent in 2013, 8 percent in 2014 and 7 percent in 2015.
using mortality tables in general use in the United States, which are modified to reflect the Company’s actual experience when appropriate. We establish liabilities for accident and health insurance products using morbidity tables based on the Company’s actual or expected experience. These reserves are computed at amounts that, with additions from estimated future premiums received and with interest on such reserves at estimated future rates, are expected to be sufficient to meet our obligations under the terms of the policy. Liabilities for future policy benefits are computed on a net-level premium method based upon assumptions as to future claim costs, investment yields, mortality, morbidity, withdrawals, policy dividends and maintenance expenses determined when the policies were issued (or with respect to policies inforce at August 31, 2003, the Company’s best estimate of such assumptions on the Effective Date). We make an additional provision to allow for potential adverse deviation for some of our assumptions. Once established, assumptions on these products are generally not changed unless a premium deficiency exists. In that case, a premium deficiency reserve is recognized and the future pattern of reserve changes are modified to reflect the relationship of premiums to benefits based on the current best estimate of future claim costs, investment yields, mortality, morbidity, withdrawals, policy dividends and maintenance expenses, determined without an additional provision for potential adverse deviation.
Reserves for all three groups of policies under the order were prospectively adjusted using a prospective revision methodology, as these alternatives were required by the Florida Office of Insurance Regulation. These policies had
The Medicare Prescription Drug, Improvement and Modernization Act of 2003 provided for the introduction of a prescription drug benefit (“PDP”). In order to offer this product to our current and potential future policyholders without investing in management and infrastructure, we entered into a national distribution agreement with Coventry to use our career and independent agents to distribute Coventry’s prescription drug plan, Advantra Rx. We receive a fee based on the premiums collected on plans sold through our distribution channels. In addition, CNO has a quota-share reinsurance agreement with Coventry for CNO enrollees that provides CNO with 50 percent of net premiums and related policy benefits subject to a risk corridor. The Part D program was effective January 1, 2006.
We recognize risk-share premium adjustments consistent with Coventry’s risk-share agreement with the Centers for Medicare and Medicaid Services.
We also paid commissions to our agents who sell the plans on behalf of Coventry and other parties. These payments were deferred and amortized over the remaining term of the initial enrollment period (the one-year life of the initial policy).
The cost of reinsurance on life and health coverages is recognized over the life of the reinsured policies using assumptions consistent with those used to account for the underlying policy. The cost of reinsurance ceded totaled $258.6 million, $179.4 million and $164.0 million in 2010, 2009 and 2008, respectively. We deduct this cost from insurance policy income. Reinsurance recoveries netted against insurance policy benefits totaled $471.6 million, $477.2 million and $536.3 million in 2010, 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 deferred acquisition costs described above. Reinsurance premiums assumed totaled $92.6 million, $475.5 million and $641.0 million in 2010, 2009 and 2008, respectively. Reinsurance premiums included amounts assumed pursuant to marketing and quota-share agreements with Coventry of $67.2 million, $444.3 million and $609.5 million in 2010, 2009 and 2008, respectively. Such premiums assumed included group policy quota-share agreements whereby we assumed: (i) a specified percentage of the PFFS business written by Coventry under a large group policy effective July 1, 2007 (which was 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). Coventry decided to cease selling PFFS plans effective January 1, 2010. In July 2009, Bankers Life entered into an agreement with Humana under which it offers Humana’s Medicare Advantage/PFFS plans to its policyholders and consumers nationwide through its career agency force and receives marketing fees based on sales. Effective January 1, 2010, the Company no longer assumes the underwriting risk related to PFFS business.
In 2008, Bankers Life entered into a reinsurance agreement, as amended, pursuant to which it ceded 70 percent of its new 2008 and 2009 long-term care business, excluding certain business sold in the state of Florida. The amount reinsured decreased to 50 percent in the first quarter of 2010 and to 25 percent thereafter. The pre-tax impact of this reinsurance agreement was not significant in 2008.
At December 31, 2010, our valuation allowance for our net deferred tax assets was $1.1 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.
Two of the Company’s insurance subsidiaries (Conseco Life and Bankers Life) are members of the Federal Home Loan Bank (“FHLB”). As members of the FHLB, Conseco Life and Bankers Life have the ability to borrow on a collateralized basis from FHLB. Conseco Life and Bankers Life are required to hold certain minimum amounts of FHLB
The variable rate borrowings are pre-payable on each interest reset date without penalty. The fixed rate borrowings are pre-payable subject to payment of a yield maintenance fee based on current market interest rates. At December 31, 2010, the aggregate fee to prepay all fixed rate borrowings was $61.2 million.
At December 31, 2009, investment borrowings consisted of: (i) collateralized borrowings from the FHLB of $450.0 million; (ii) $229.1 million of securities issued to other entities by a variable interest entity (“VIE”) which is consolidated in our financial statements as further discussed in the note to the consolidated financial statements entitled “Investments in Variable Interest Entities”; and (iii) other borrowings of $4.8 million.
Our fixed index annuity products provide a guaranteed minimum 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, on 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 (including 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 policy’s return is linked. We reflect changes in the estimated fair value of these options in net investment income (classified as investment income from policyholder and reinsurer accounts and other special-purpose portfolios). Net investment gains (losses) related to fixed index products were $28.2 million, $50.7 million and $(104.3) million in 2010, 2009 and 2008, respectively. These amounts were substantially offset by a corresponding change to insurance policy benefits. The estimated fair value of these options was $89.4 million and $114.9 million at December 31, 2010 and 2009, respectively. We classify these instruments as other invested assets.
If the counterparties for the call options 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 December 31, 2010, all of our counterparties were rated “BBB+” or higher by Standard & Poor’s Corporation (“S&P”).
The Company’s multibucket annuity is an annuity product that credits interest based on the experience of a particular market strategy. Policyholders allocate their annuity premium payments to several different market strategies based on different asset classes within the Company’s investment portfolio. Interest is credited to this product based on the market return of the given strategy, less management fees, and funds may be moved between different strategies. The Company guarantees a minimum return of premium plus approximately 3 percent per annum over the life of the contract. The investments backing the market strategies of these products are designated by the Company as trading securities. The change in the fair value of these securities is recognized as investment income (classified as income from policyholder and reinsurer accounts and other special-purpose portfolios), which is substantially offset by the change in insurance policy benefits for these products. As of December 31, 2010, we hold insurance liabilities of $63.7 million related to multibucket annuity products.
Effective January 1, 2008, we adopted authoritative guidance 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. The guidance is intended to increase consistency and comparability among fair value estimates used in financial reporting and the disclosure requirements 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 the guidance 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 fixed index annuity products. The change resulted from the incorporation of risk margins into the estimated fair value calculation for this liability.
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 fixed index annuity products and to a modified coinsurance arrangement) are classified in Level 3 since their values include significant unobservable inputs including actuarial assumptions.
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.
Privately placed securities comprise approximately 66 percent of our fixed maturities, available for sale, classified as Level 3. Privately placed securities are classified as Level 3 when their valuation is based on internal valuation models which rely on significant inputs that are not observable in the market. Our model applies spreads above the risk-free rate which are determined based on comparison to securities with similar ratings, maturities and industries that are rated by independent third party rating agencies. Our process also considers the ratings assigned by the National Association of Insurance Commissioners (the “NAIC”) to the Level 3 securities on an annual basis. Each quarter, a review is performed to determine the reasonableness of the initial valuations from the model. If an initial valuation appears unreasonable based on our knowledge of a security and current market conditions, we make appropriate adjustments to our valuation inputs. The remaining securities classified as Level 3 are primarily valued based on internally developed models using estimated future cash flows. We recognized other-than-temporary impairments on securities classified as Level 3 investments of $75.9 million during 2010 ($72.0 million, prior to the $(3.9) million of impairment losses recognized through accumulated other comprehensive income (loss)).
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, 2010 is as follows (dollars in millions):
Includes $494.4 million of embedded derivatives associated with our fixed index annuity products and $1.6 million of embedded derivatives associated with a modified coinsurance agreement.
Included in the transfers out of Level 3 is approximately $282 million of privately issued securities that were priced using observable market data at December 31, 2010 and were, therefore, transferred to Level 2.
Realized and unrealized investment gains and losses presented in the preceding tables 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 accumulated comprehensive income (loss) within shareholders’ equity based on the appropriate accounting treatment for the instrument.
We review the fair value hierarchy classifications each reporting period. Transfers in and/or (out) of Level 3 in 2010 and 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. There were no significant transfers between Level 1 and Level 2 in 2010.
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 in accordance with GAAP. Such amounts are deferred and amortized in the same manner as deferred acquisition costs. Sales inducements deferred totaled $20.0 million, $28.4 million and $47.1 million in 2010, 2009 and 2008, respectively. Amounts amortized totaled $31.2 million, $30.2 million and $16.7 million in 2010, 2009 and 2008, respectively. The unamortized balance of deferred sales inducements was $166.4 million and $177.6 million at December 31, 2010 and 2009, respectively. The balance of insurance liabilities for persistency bonus benefits was $85.3 million and $136.2 million at December 31, 2010 and 2009, respectively.
We recorded the net effects of certain out-of-period adjustments which decreased our net income by $5.5 million (or two cents per diluted share) in 2010. We evaluated these errors taking into account both qualitative and quantitative factors and considered the impact of these errors in relation to 2010, as well as the materiality to the periods in which they originated. Management believes these errors are immaterial to the consolidated annual financial statements.
In January 2010, the FASB issued authoritative guidance which requires additional disclosures related to purchases, sales, issuances and settlements in the rollforward of Level 3 fair value measurements. This guidance is effective for reporting periods beginning after December 15, 2010. We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.
In March 2010, the FASB issued authoritative guidance clarifying the scope exception for embedded credit derivatives and when those features would be bifurcated from the host contract. Under the new guidance, only embedded credit derivative features that are in the form of subordination of one financial instrument to another would not be subject to the bifurcation requirements. Accordingly, entities will be required to bifurcate any embedded credit derivative features that no longer qualify under the amended scope exception, or, for certain investments, an entity can elect the fair value option and record the entire investment at fair value. This guidance is effective for fiscal quarters beginning after June 15, 2010. The adoption of this guidance did not have a material impact on our consolidated financial statements.
On April 9, 2009, the FASB issued authoritative guidance regarding the recognition and presentation of an other-than-temporary impairment and requires additional disclosures. The recognition provision within this guidance 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 accumulated other comprehensive income (loss), net of taxes and related amortization. The guidance requires a cumulative effect adjustment to accumulated deficit and a corresponding adjustment to accumulated other comprehensive income (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. We adopted the guidance 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 income (loss).
On April 9, 2009, the FASB issued authoritative guidance which provided 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. The guidance also discusses 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 guidance requires additional disclosures about fair value measurement in annual and interim reporting periods. The guidance is effective for interim and annual reporting periods ending after June 15, 2009 with early adoption permitted. We adopted the guidance effective for the period ending March 31,
In May 2008, the FASB issued authoritative guidance that specifies that issuers of convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) 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. The guidance is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. The guidance was applied retrospectively to all periods presented unless instruments were not outstanding during any period included in the financial statements. In October 2009, the Company reissued its financial statements as December 31, 2008 and 2007, and for the three years ended December 31, 2008, to reflect the adoption of this authoritative guidance on a retrospective basis. The adoption of the guidance affected the accounting for our 3.5% Convertible Debentures due September 30, 2035 (the “3.5% Debentures”). Upon adoption of the guidance, the effective interest rate on our 3.5% 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. Such discount is amortized as interest expense over the remaining life of the 3.5% Debentures.
2008, and interim periods within those years and requires retrospective application. Our adoption of the guidance 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 authoritative guidance which required enhanced disclosures about an entity’s derivative and hedging activities. The guidance is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008. The adoption of the guidance did not have a material effect on our consolidated financial statements.
In December 2007, the FASB issued authoritative guidance which 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, the guidance 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. The guidance also provides for a substantial number of new disclosure requirements. The guidance is effective for business combinations initiated on or after the first annual reporting period beginning after December 15, 2008. We expect that the guidance will have an effect on our accounting for business combinations, if any, that are made in the future. In addition, the guidance 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 the guidance.
In December 2008, the FASB issued authoritative guidance which required public entities to provide additional disclosures about transferors’ continuing involvements with transferred financial assets and to provide additional disclosures about their involvement with VIEs. The guidance was effective for financial statements issued for fiscal years and interim periods ending after December 15, 2008. We adopted the guidance on December 31, 2008 and it did not have a material effect on our consolidated financial statements.
In April 2007, FASB issued authoritative guidance which allows 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. The guidance also requires an entity to disclose the accounting policy decision to offset, or not to offset, fair value amounts. 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 December 31, 2008, $11.4 million of derivative liabilities had been offset against derivative assets executed with the same counterparty under master netting arrangements. There were no such derivative liabilities offset against derivative assets at December 31, 2010 or 2009. We adopted the guidance on January 1, 2008, and it did not have a material effect on our consolidated financial statements.
At December 31, 2010, the amortized cost and estimated fair value of fixed maturities, available for sale, and equity securities were as follows (dollars in millions):
Investment ratings - Investment ratings are assigned the second lowest rating by a nationally recognized statistical rating organization (Moody’s Investor Services, Inc. (“Moody’s”), S&P or Fitch Ratings (“Fitch”)), or if not rated by such firms, the rating assigned by the NAIC. 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). 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). References to investment grade or below investment grade throughout our consolidated financial statements are determined as described above.
At December 31, 2009, the amortized cost and estimated fair value of fixed maturities, available for sale, and equity securities were as follows (dollars in millions):
Accumulated other comprehensive income (loss) is primarily comprised of the net effect of unrealized appreciation (depreciation) on our investments. These amounts, included in shareholders’ equity as of December 31, 2010 and 2009 were as follows (dollars in millions):
At December 31, 2010, the amortized cost of the Company’s below-investment grade fixed maturity securities was $1,805.2 million, or 9.0 percent of the Company’s fixed maturity portfolio. The estimated fair value of the below-investment grade portfolio was $1,791.5 million, or 99 percent of the amortized cost.
The estimated fair value of fixed maturity investments and mortgage loans not accruing investment income totaled $7.9 million and $39.8 million at December 31, 2010 and 2009, respectively.
During 2010, we recognized net realized investment gains of $30.2 million, which were comprised of $180.0 million of net gains from the sales of investments (primarily fixed maturities) with proceeds of $8.6 billion and $149.8 million of writedowns of investments for other than temporary declines in fair value recognized through net income ($146.8 million, prior to the $(3.0) million of impairment losses recognized through accumulated other comprehensive income (loss)).
During 2009, the $233.9 million of realized losses on sales of $1.3 billion of fixed maturity securities, available for sale, included: (i) $178.3 million of losses related to the sales of mortgage-backed securities and asset-backed securities; (ii) $11.3 million of losses related to the sale of securities issued by providers of financial guarantees and mortgage insurance; and (iii) $44.3 million of additional losses primarily related to various corporate securities.
The following summarizes the investments (including investments held by the VIEs) sold at a loss during 2010 which had been continuously in an unrealized loss position exceeding 20 percent of the amortized cost basis prior to the sale for the period indicated (dollars in millions):
require us to sell the investment before recovery occurs; (viii) 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; (ix) projections of, and unfavorable changes in, cash flows on structured securities including mortgage-backed and asset-backed securities; and (x) other objective and subjective factors.
Impairment losses on equity securities are recognized in net income. The manner in which impairment losses on fixed maturity securities, available for sale, 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 accumulated other comprehensive income (loss). Prior to 2009, such other-than-temporary impairments were recognized in their entirety through earnings and the amount recognized was the difference between amortized cost and estimated fair value.
The remaining non-credit impairment, which is recorded in accumulated other comprehensive income (loss), is the difference between the security’s estimated fair value and our best estimate of future cash flows discounted at the effective interest rate prior to impairment. The remaining non-credit impairment typically represents changes in the market interest rates, current market liquidity and risk premiums. As of December 31, 2010, other-than-temporary impairments included in accumulated other comprehensive income (loss) of $23.4 million (before taxes and related amortization) relate to structured securities.
The following table sets forth the amortized cost and estimated fair value of those fixed maturities, available for sale, with unrealized losses at December 31, 2010, by contractual maturity. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without penalties. Structured securities frequently permit periodic unscheduled payments throughout their lives (dollars in millions):
and it increases the yield on those purchased at a premium because of a decrease in the annual amortization of the premium.
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 December 31, 2010 (dollars in millions):
The amortized cost and estimated fair value of structured securities at December 31, 2010, summarized by type of security, were as follows (dollars in millions):
At December 31, 2010, the mortgage loan balance was primarily comprised of commercial loans. Approximately 7 percent, 7 percent, 6 percent, 6 percent, 5 percent and 5 percent of the mortgage loan balance were on properties located in Minnesota, California, Arizona, Florida, North Carolina and Indiana, respectively. No other state comprised greater than five percent of the mortgage loan balance. None of the commercial mortgage loan balance was noncurrent at December 31, 2010. We had no allowance for losses on mortgage loans at both December 31, 2010 and 2009.
During 2010, we reduced the valuation allowance established in prior periods by $95 million. The decrease was primarily attributable to: revisions to projected future taxable income supported by our increased profitability in the past two years ($47 million); utilization of capital loss carryforwards with current capital gains ($30 million); and utilization of NOL carryforwards with higher taxable income than projected in our previous analysis of the valuation allowance ($18 million).
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 a portion of the cancellation of indebtedness income resulting from the bankruptcy of our Predecessor and the classification of the loss we recognized as a result of the transfer of Senior Health to an Independent Trust (as further described below).
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).
On January 20, 2009, the Company’s Board of Directors adopted a Section 382 Rights Agreement which is designed to protect shareholder value by preserving the value of our tax assets primarily associated with tax NOLs under Section 382. The Section 382 Rights Agreement 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.
The Section 382 Rights Agreement 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 Section 382 Rights Agreement based on its review. The Section 382 Rights Agreement was approved by a vote at the annual meeting of shareholders on May 12, 2009.
In July 2006, the Joint Committee of Taxation accepted the audit and the settlement which characterized $2.1 billion of the tax losses on our Predecessor’s investment in Conseco Finance Corp. as life company losses and the remaining $3.8 billion as non-life losses prior to the application of the cancellation of indebtedness attribute reductions described below.
In accordance with GAAP, we are precluded from recognizing the tax benefits of any tax windfall upon the exercise of a stock option or the vesting of restricted stock unless such deduction resulted in actual cash savings to the Company. Because of the Company’s NOLs, no cash savings have occurred. NOL carryforwards of $.6 million related to deductions for stock options and restricted stock will be reflected in additional paid-in capital if realized.
In August 2005, we completed the private offering of $330 million of 3.5% Debentures. During 2008, we repurchased $37.0 million par value of such 3.5% Debentures for $15.3 million plus accrued interest. On November 13, 2009, we completed a cash tender offer (the “Tender Offer”) for $176.5 million aggregate principal amount of the 3.5% Debentures. The aggregate consideration for the 3.5% Debentures accepted by us in the Tender Offer, plus accrued and unpaid interest thereon, was $177.2 million. This amount was funded primarily from the net proceeds from the issuance of 7.0% Debentures as described below.
On November 13, 2009, we issued $176.5 million aggregate principal amount of our 7.0% Debentures in the initial closing of our private offering of 7.0% Debentures to Morgan Stanley & Co. Incorporated, as the initial purchaser of the 7.0% Debentures. The net proceeds from the initial closing of the offering of our 7.0% Debentures, after deducting the initial purchaser’s discounts and commissions and before other offering expenses, totaled $172.0 million. The Company used the net proceeds to fund a substantial portion of the consideration payable in connection with the Tender Offer for the 3.5% Debentures.
offering price less the initial purchaser’s discounts and commissions, but before expenses) of: (i) $61.4 million in the second closing of the 7.0% Debentures; and (ii) $49.4 million in the third closing of the 7.0% Debentures. At December 31, 2010 and 2009, unamortized issuance costs (classified as other assets) related to the 7.0% Debentures were $1.9 million and $2.1 million, respectively, and are amortized as an increase to interest expense over the term of the 7.0% Debentures.
The 7.0% Debenture provides for customary events of default (subject in certain cases to customary grace and cure periods), which include nonpayment, breach of covenants in the 7.0% Debenture, failure to pay at maturity or acceleration of other indebtedness and certain events of bankruptcy and insolvency. Generally, if an event of default occurs, Mellon or holders of at least 50% in principal amount of the then outstanding 7.0% Debentures may declare the principal of, and accrued but unpaid interest on all of the 7.0% Debentures to be immediately due and payable.
We may prepay, in whole or in part, the New Senior Secured Credit Agreement, together with any accrued and unpaid interest, with prior notice but without premium or penalty in minimum amounts of $1.0 million or any multiple thereof.
Notwithstanding the foregoing, no mandatory prepayments pursuant to items (i) or (iii) in the preceding paragraph shall be required if: (x) the debt to total capitalization ratio is equal or less than 20 percent; and (y) either (A) the financial strength rating of certain insurance subsidiaries is equal or better than A- (stable) from A.M. Best Company or (B) the New Senior Secured Credit Agreement is rated equal or better than BBB- (stable) from S&P and Baa3 (stable) by Moody’s.
In connection with the execution of the New Senior Secured Credit Agreement, the Company and the Subsidiary Guarantors entered into a guarantee and security agreement, dated as of December 21, 2010 (the “Guarantee and Security Agreement”), by and among the Company, the Subsidiary Guarantors and the Agent, pursuant to which the Subsidiary Guarantors guaranteed all of the obligations of the Company under the New Senior Secured Credit Agreement and the Company and the Subsidiary Guarantors pledged substantially all of their assets to secure the New Senior Secured Credit Agreement, subject to certain exceptions as set forth in the Guarantee and Security Agreement.
In connection with the issuance of the 9.0% Senior Secured Notes and execution of the Indenture, the Company and the Subsidiary Guarantors entered into a security agreement, dated as of December 21, 2010 (the “Security Agreement”), by and among the Company, the Subsidiary Guarantors and Wilmington Trust FSB, as collateral agent, pursuant to which the Company and the Subsidiary Guarantors pledged substantially all of their assets to secure their obligations under the Indenture, subject to certain exceptions as set forth in the Security Agreement.
In connection with the issuance of the 9.0% Senior Secured Notes and entry into the New Senior Secured Credit Agreement, the Agent and Wilmington, as collateral agent and authorized representative with respect to the 9.0% Senior Secured Notes, entered into an Intercreditor Agreement, dated as of December 21, 2010 (the “Intercreditor Agreement”), which sets forth agreements with respect to the first-priority liens granted by the Company and the Subsidiary Guarantors pursuant to the Indenture and the New Senior Secured Credit Agreement.
Pursuant to its amended terms, the applicable interest rate on the Previous Senior Credit Agreement (based on either a Eurodollar or base rate) was increased. The Eurodollar rate was 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 was 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 required the Company to pay a fee equal to 1 percent of the outstanding principal balance under the Senior Credit Agreement, which fee was added to the principal balance outstanding and was payable at the maturity of the facility. This 1 percent fee was reported as non-cash interest expense.
the minimum risk-based capital ratio requirement was 200% through December 31, 2010 and was to increase to 225% for 2011 and 250% for 2012 (the risk-based capital requirement was previously scheduled to return to 250% after June 30, 2010);
the interest coverage ratio requirement was 1.50 through December 31, 2010 and was to increase to 1.75 for 2011 and 2.00 for 2012 (the interest coverage ratio requirement was previously scheduled to return to 2.00 after June 30, 2010); and
the Company repaid $161.4 million of outstanding principal on the Previous Senior Credit Agreement from proceeds of an equity offering. Such transactions are further discussed in the note to the consolidated financial statements entitled “Shareholders’ Equity.”
The Previous Senior Credit Agreement included an $80.0 million revolving credit facility that could be used for general corporate purposes. In October 2008, the Company borrowed $75.0 million under the revolving credit facility to assure the future availability of this additional liquidity given our concerns with the ability of certain financial institutions to be able to provide funding in the future. 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. In April 2009, we repaid the remaining $55.0 million that was outstanding under the revolving facility portion of our Previous Senior Credit Agreement. The Company paid a commitment fee equal to .50 percent of the unused portion of the revolving credit facility on an annualized basis.
In connection with the Transfer, the Company issued the Senior Health Note payable to Senior Health. The Senior Health Note is unsecured and bears interest at a rate of 6.0 percent per year payable quarterly, beginning on March 15, 2009. We are required to make annual principal payments of $25.0 million beginning on November 12, 2009. The Company made a $25.0 million scheduled payment on the Senior Health Note in both 2010 and 2009. The Company may redeem the Senior Health Note, in whole or in part, at any time by giving the holder 30 days notice (unless a shorter notice is satisfactory to the holder). The redemption amount is equal to the principal amount redeemed plus any accrued and unpaid interest thereon. Any outstanding amount under the Senior Health Note will be due and payable immediately if an event of default (as defined in the Senior Health Note) occurs and continues without remedy. As a condition of the order from the Pennsylvania Insurance Department approving the Transfer, we agreed that we would not pay cash dividends on our common stock while any portion of the Senior Health Note remained outstanding.
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. When assessing reasonably possible and probable outcomes, the Company bases its assessment on the expected ultimate outcome following all appeals.
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. The parties to this case have reached a settlement, which was approved by the court. The Company did not incur any additional liability in connection with the settlement.
On August 6, 2009, a purported class action complaint was filed in the United States District Court for the Southern District of New York, Plumbers and Pipefitters Local Union No. 719 Pension Trust Fund, on behalf of itself and all others similarly situated v. Conseco, Inc., et al., Case No. 09-CIV-6966, on behalf of purchasers of our common stock during the period from August 4, 2005 to March 17, 2008 (the “Class Period”). The complaint charges CNO and certain of its officers and directors with violations of the Securities Exchange Act of 1934. On June 2, 2010, the plaintiff filed a second amended complaint. The amended complaint alleges that, during the Class Period, the defendants issued numerous statements regarding the Company’s financial performance. As alleged in the complaint, these statements were materially false and misleading because the defendants misrepresented and/or failed to disclose the following adverse facts, among others: (i) that the Company was reporting materially inaccurate revenue figures; (ii) that the Company’s reported financial results were materially misstated and did not present the true operating performance of the Company; (iii) that the Company’s shareholders’ equity was materially overstated during the Class Period, including the overstatement of shareholders’ equity by $20.6 million at December 31, 2006; and (iv) as a result of the foregoing, the defendants lacked a reasonable basis for their positive statements about the Company, its corporate governance practices, its prospects and earnings growth. On August 2, 2010, we filed a motion to dismiss the amended complaint. 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 2, 2010, a purported shareholder derivative complaint was filed in the Marion County Circuit/Superior Court, Indiana, William T. Carter, derivatively on behalf of CNO Financial Group, Inc. v. R. Glenn Hilliard, Donna A. James, R. Keith Long, Debra J. Perry, C. James Prieur, Neal C. Schneider, Michael T. Tokarz, John G. Turner, William Kirsch, Eugene Bullis, Michael Dubes, James Hohmann, Edward Bonach, Ali Inanilan, and John Wells, and CNO Financial Group, Inc., Cause No. 49D10 10 06 PL 024523, on behalf of nominal defendant CNO Financial Group, Inc. against certain current and/or former members of its Board of Directors and executive officers seeking to remedy defendant’s alleged breaches of fiduciary duties and unjust enrichment from August 2005 to the present. On November 1, 2010, the plaintiffs filed an amended complaint. The allegations in the complaint are similar to those described in the preceding paragraph. On December 17, 2010, we filed a motion to dismiss the amended complaint. We believe the action is without merit, and intend to defend it vigorously. The ultimate outcome of the action cannot be predicted with certainty.
Two lawsuits are pending 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 and Clifford S. Arakaki et al. v. Conseco Life Insurance Company, Doe Defendants 1-100, Case No. CV05-00026 (United States District Court, District of Hawaii). These suits involve an aggregate of approximately 700 plaintiffs all of whom purport to have opted out of the previously settled In Re Conseco Life Insurance Co. Cost of Insurance Litigation multi-district action. The complaints allege 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. A settlement in principle has been reached. The ultimate outcome of these lawsuits cannot be predicted with certainty and an adverse outcome could exceed the amount we have accrued and could have a material adverse impact on the Company’s consolidated financial condition, cash flows or results of operations.
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 settlement in principle has been reached in this case, and the hearing for preliminary approval of the settlement is set for March 25, 2011.
On July 2, 2009, a purported class action was filed in the U.S. District Court for the Middle District of Florida, Bill W. McFarland, and all those similarly situated v. Conseco Life Insurance Company, Case No. 3:09-cv-598-J-32MCR. The plaintiff alleges that Conseco Life committed breach of contract and has been unjustly enriched in the administration, including changes to certain non-guaranteed elements, of various interest sensitive whole life products sold primarily under the name “Lifetrend.” The plaintiff seeks declaratory and injunctive relief, compensatory damages, punitive damages and attorney fees. As described in the preceding paragraph, on February 3, 2010, the Judicial Panel on MDL ordered this case be consolidated with the Brady case for pretrial proceedings in the Northern District of California Federal Court. On July 7, 2010, plaintiffs filed an amended motion for class certification of a nationwide class and a California state class. The Company filed its motion in opposition on July 21, 2010. On October 6, 2010, the court granted the motion for certification of a nationwide class and denied the motion for certification of a California state class. Trial is set for May 7, 2012. 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.
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.
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.
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. Several states initiated regulatory actions and inquiries after the notices were sent by Conseco Life, and Conseco Life agreed to take no further actions with respect to those policies during the pendency of a market conduct examination.
After working with various state insurance regulators to review the terms of the Lifetrend and CIUL3+ policies, Conseco Life reached a settlement in principle with the regulators regarding issues involving these policies. During this regulatory review process, Conseco Life had been allowed to move forward with implementing the NGE changes in its CIUL3+ policies while the regulators continued their review. Conseco Life had also resumed the administration of its Lifetrend policies with administrative changes in place but did not implement the NGE changes pending execution of the final settlement agreement with the regulators. On June 30, 2010, we announced that Conseco Life had finalized a regulatory settlement agreement that requires the establishment of a $10 million fund for certain owners of its Lifetrend life insurance products and the payment of a $1 million assessment to participating jurisdictions. Over 45 jurisdictions, representing almost 98 percent of the Lifetrend policyholders, have signed the settlement agreement. Conseco Life is in the process of notifying consumers of the settlement and the increase in their non-guaranteed elements. As previously disclosed, we accrued for the financial impact of the settlement in our consolidated financial statements for year-end 2009.
The balance sheet at December 31, 2010, included: (i) accruals of $21.8 million, representing our estimate of all known assessments that will be levied against the Company’s insurance subsidiaries by various state guaranty associations based on premiums written through December 31, 2010; and (ii) receivables of $16.2 million that we estimate will be recovered through a reduction in future premium taxes as a result of such assessments. At December 31, 2009, such guaranty fund assessment accruals were $22.1 million and such receivables were $16.9 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 for such assessments of $2.4 million, $.3 million and $3.1 million in 2010, 2009 and 2008, respectively.
We held bank loans made to certain former directors and employees that enabled them to purchase common stock of our Predecessor. These loans, with a principal amount of $481.3 million, had been guaranteed by our Predecessor. We received all rights to collect the balances due pursuant to the original terms of these loans. In addition, we held loans to participants for interest on the loans. The loans and the interest loans are collectively referred to as the “D&O loans.” At December 31, 2010, we had reached settlements with the former directors and employees and had collected the remaining amounts outstanding related to the D&O loan settlements.
Pursuant to the settlement that was reached with the Official Committee of the Trust Originated Preferred Securities (“TOPrS”) Holders and the Official Committee of Unsecured Creditors in the Plan, the former holders of TOPrS (issued by our Predecessor’s subsidiary trusts and eliminated in our reorganization) who did not opt out of the bankruptcy settlement, were entitled to receive 45 percent of any net proceeds from the collection of certain D&O loans in an aggregate amount not to exceed $30 million. As of December 31, 2010, we had paid $20.5 million to the former holders of TOPrS and we have established a liability of $2.0 million (which is included in other liabilities), representing the final amount which will be paid to the former holders of TOPrS pursuant to the settlement.
respectively, and is included in the caption “Other liabilities” in the consolidated balance sheet.
The Company rents office space, equipment and computer software under noncancellable operating lease agreements. In addition, the Company has entered into certain sponsorship agreements which require future payments. Total expense pursuant to these lease and sponsorship agreements was $42.8 million, $42.3 million and $44.1 million in 2010, 2009 and 2008, respectively. Future required minimum payments as of December 31, 2010, were as follows (dollars in millions):
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 December 31, 2010, 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).
The benefits expected to be paid pursuant to our agent deferred compensation plan as of December 31, 2010 were as follows (dollars in millions):
The warrants have an exercise price of $6.50 per share of common stock, subject to customary anti-dilution adjustments. Prior to June 30, 2013, the warrants are not exercisable, except under limited circumstances. Commencing on June 30, 2013, the warrants will be exercisable for shares of our common stock at the option of the holder at any time, subject to certain exceptions. The warrants expire on December 30, 2016.
In 2010 and 2008, such amount was reduced by 74 thousand shares and 16 thousand shares, respectively, which were tendered for the payment of federal and state taxes owed on the issuance of restricted stock.
The Company has a long-term incentive plan which permits the grant of CNO incentive or non-qualified stock options, restricted stock awards, stock appreciation rights, performance shares or units and certain other equity-based awards to certain directors, officers and employees of the Company and certain other individuals who perform services for the Company. In April 2009, the shareholders of the Company approved an increase in the number of shares authorized to be issued under the plan to a maximum of 25.8 million shares from 10 million shares. As of December 31, 2010, 9.3 million shares remained available for issuance under the plan. Our stock option awards are generally granted with an exercise price equal to the market price of the Company’s stock on the date of grant. For options granted in 2006 and prior years, our stock option awards generally vest on a graded basis over a four year service term and expire ten years from the date of grant. Our stock option awards granted in 2007 through 2009 generally vest on a graded basis over a three year service term and expire five years from the date of grant. Our stock options granted in 2010 vest on a graded basis over a three year service term and expire seven years from the date of grant. The vesting periods for our restricted stock awards range from immediate vesting to a period of four years.
A summary of the Company’s stock option activity and related information for 2010 is presented below (shares in thousands; dollars in millions, except per share amounts):
The exercise price was equal to the market price of our stock for all options granted in 2010, 2009 and 2008.
The following table summarizes information about stock options outstanding at December 31, 2010 (shares in thousands):
During 2010, 2009 and 2008, the Company granted 1.0 million, .8 million and .1 million restricted shares, respectively, of CNO common stock to certain directors, officers and employees of the Company at a weighted average fair value of $6.28 per share, $1.67 per share and $9.75 per share, respectively. The fair value of such grants totaled $6.2 million, $1.4 million and $.8 million in 2010, 2009 and 2008, respectively. Such amounts are recognized as compensation expense over the vesting period of the restricted stock. A summary of the Company’s non-vested restricted stock activity for 2010 is presented below (shares in thousands):
At December 31, 2010, the unrecognized compensation expense for non-vested restricted stock totaled $4.4 million which is expected to be recognized over a weighted average period of 2.0 years. At December 31, 2009, the unrecognized compensation expense for non-vested restricted stock totaled $1.1 million. We recognized compensation expense related to
As further discussed in the footnote to the consolidated financial statements entitled “Income Taxes”, the Company’s Board of Directors adopted the Section 382 Rights Agreement on January 20, 2009, which is designed to protect shareholder value by preserving the value of our tax assets primarily associated with NOLs. As a result, the Company declared a dividend of one preferred share purchase right (a “Right”) for each outstanding share of common stock. The dividend was payable on January 30, 2009, to the shareholders of record as of the close of business on that date. Each Right entitles the shareholder to purchase from the Company one one-thousandth of a share of Series A Junior Participating Preferred Stock, par value $.01 per share (the “Junior Preferred Stock”) of the Company at a price of $20.00 per one one-thousandth of a share of Junior Preferred Stock. The description and terms of the Rights are set forth in the Section 382 Rights Agreement. The Rights would become exercisable in the event any person or group (subject to certain exemptions) becomes a “5 percent shareholder” of CNO without the approval of the Board of Directors or an existing shareholder who is currently a “5 percent shareholder” acquires additional shares exceeding one percent of our outstanding shares without prior approval from the Board of Directors.
In August 2005, we completed the private offering of the 3.5% Debentures. For periods in which the 3.5% Debentures were outstanding, the conversion feature of the 3.5% 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 3.5% Debentures had no effect on our diluted shares outstanding or our diluted earnings per share in 2010, 2009 or 2008.
A summary of the Company’s performance shares is presented below (shares in thousands):
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, 2010 balance of the present value of future profits in 2011, 11 percent in 2012, 10 percent in 2013, 8 percent in 2014 and 7 percent in 2015. The discount rate used to determine the amortization of the present value of future profits averaged approximately 5 percent in the years ended December 31, 2010, 2009 and 2008.
Non-cash items not reflected in the investing and financing activities sections of the consolidated statement of cash flows (dollars in millions):
In accordance with an order from the Florida Office of Insurance Regulation, Washington National may not distribute funds to any affiliate or shareholder without prior notice to the Florida Office of Insurance Regulation. In addition, the RBC and other capital requirements described below can also limit, in certain circumstances, the ability of our insurance subsidiaries to pay dividends.
RBC requirements provide a tool for insurance regulators to determine the levels of statutory capital and surplus an insurer must maintain in relation to its insurance and investment risks and the need for possible regulatory attention. The RBC requirements provide four levels of regulatory attention, varying with the ratio of the insurance company’s total adjusted capital (defined as the total of its statutory capital and surplus, AVR and certain other adjustments) to its RBC (as measured on December 31 of each year) as follows: (i) if a company’s total adjusted capital is less than 100 percent but greater than or equal to 75 percent of its RBC, the company must submit a comprehensive plan to the regulatory authority proposing corrective actions aimed at improving its capital position (the “Company Action Level”); (ii) if a company’s total adjusted capital is less than 75 percent but greater than or equal to 50 percent of its RBC, the regulatory authority will perform a special examination of the company and issue an order specifying the corrective actions that must be taken; (iii) if a company’s total adjusted capital is less than 50 percent but greater than or equal to 35 percent of its RBC, the regulatory authority may take any action it deems necessary, including placing the company under regulatory control; and (iv) if a company’s total adjusted capital is less than 35 percent of its RBC, the regulatory authority must place the company under its control. In addition, the RBC requirements provide for a trend test if a company’s total adjusted capital is between 100 percent and 125 percent of its RBC at the end of the year. The trend test calculates the greater of the decrease in the margin of total adjusted capital over RBC: (i) between the current year and the prior year; and (ii) for the average of the last 3 years. It assumes that such decrease could occur again in the coming year. Any company whose trended total adjusted capital is less than 95 percent of its RBC would trigger a requirement to submit a comprehensive plan as described above for the Company Action Level.
Beginning July 1, 2010, management changed the manner in which it disaggregates the Company’s operations for making operating decisions and assessing performance. As a result, the Company manages its business through the following operating segments: Bankers Life, Colonial Penn and Washington National, which are defined on the basis of product distribution; Other CNO Business, comprised primarily of products we no longer sell actively; and corporate operations, comprised of holding company activities and certain noninsurance company businesses.
Effective January 1, 2010, the Company adopted authoritative guidance that requires an entity to perform a qualitative analysis to determine whether a primary beneficiary interest is held in a VIE. The guidance also requires ongoing reassessments to determine whether a primary beneficiary interest is held. Based on our assessment, we concluded that we were the primary beneficiary with respect to two VIEs which are consolidated in our financial statements. One of the VIEs was consolidated prior to 2010. The following is a description of our significant investments in VIEs:
The following table provides supplemental information about the revenues and expenses of Fall Creek and Eagle Creek which have been consolidated in accordance with authoritative guidance, after giving effect to the elimination of our investment in Fall Creek and Eagle Creek and investment management fees earned by a subsidiary of the Company (dollars in millions):
The investment portfolio held by the VIEs is primarily comprised of corporate fixed maturity securities which are almost entirely rated as below-investment grade securities. At December 31, 2010, such securities had an amortized cost of $428.0 million; gross unrealized gains of $3.7 million; gross unrealized losses of $10.8 million; and an estimated fair value of $420.9 million.
The following table sets forth the amortized cost and estimated fair value of the investments held by the VIEs at December 31, 2010, 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.
The following summarizes the investments in our portfolio held by the VIEs 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 December 31, 2010 (dollars in millions):
During 2010, $36.1 million of investments held by the VIEs were sold which resulted in gross investment losses (before income taxes) of $4.2 million. The following summarizes the investments sold at a loss during 2010 which had been continuously in an unrealized loss position exceeding 20 percent of the amortized cost basis prior to the sale for the period indicated (dollars in millions):
The investments held by the VIEs are evaluated for other-than-temporary declines in fair value in a manner that is consistent with the Company’s fixed maturities, available for sale.
At December 31, 2010, we hold investments in various limited partnerships, in which we are not the primary beneficiary, totaling $20.7 million (classified as other invested assets). At December 31, 2010, we had unfunded commitments to these partnerships of $14.7 million. Our maximum exposure to loss on these investments is limited to the amount of our investment.