Finance operations. CFC is headquartered in St. Paul, Minnesota in a CFC-owned building (110,000 square feet of which is occupied by CFC). CFC leases additional space in downtown St. Paul (185,000 square feet), which is used by its mortgage services, manufactured housing and private credit card divisions. CFC owns a building in Rapid City, South Dakota (137,000 square feet), which is used by its manufactured housing, private label credit card and retail bank servicing units. CFC also leases buildings in Tempe, Arizona (200,000 square feet) and Atlanta, Georgia (48,000 square feet) which serve as collection and service centers. CFC had previously leased an additional 75,000 square feet in Rapid City, South Dakota, and 48,000 square feet in Atlanta, Georgia, however CFC rejected these leases in its bankruptcy proceedings in January 2003. CFC leases 31 regional manufactured housing division offices and 88 mortgage services branch offices across the United States; the lease terms generally range from one to five years.
Our evaluation of investments for impairment requires significant judgments to be made including: (i) the identification of potentially impaired securities; (ii) the determination of their estimated fair value; and (iii) assessment of whether any decline in estimated fair value is other than temporary. Our periodic assessment of whether unrealized losses are "other than temporary" also requires significant judgment. Factors considered include: (i) the extent to which market value is less than the cost basis; (ii) the length of time that the market value has been less than cost; (iii) whether the unrealized loss is event driven, credit-driven or a result of changes in market interest rates; (iv) the near-term prospects for improvement in the issuer and/or its industry; (v) whether the investment is investment-grade and our security analyst's view of the investment's rating and whether the investment has been downgraded since its purchase; (vi) whether the issuer is current on all payments in accordance with the contractual terms of the investment and is expected to meet all of its obligations under the terms of the investment; (vii) our ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery; and (viii) the underlying asset and enterprise values of the issuer. If new information becomes available or the financial condition of the investee changes, our judgments may change resulting in the recognition of an investment loss at that time. At December 31, 2002, our net accumulated other comprehensive income included gross unrealized losses on investments of $508.9 million; we consider all such declines in estimated fair value to be temporary. Our assessments of the potential other-than-temporary losses related to investments in our portfolio at December 31, 2002 are described in the note to our consolidated financial statements entitled "Investments".
Below investment grade securities have different characteristics than investment grade corporate debt securities. Risk of loss upon default by the borrower is significantly greater with respect to below investment grade securities than with other corporate debt securities. Below investment grade securities are generally unsecured and are often subordinated to other creditors of the issuer. Also, issuers of below investment grade securities usually have higher levels of debt and are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than are investment grade issuers. The Company attempts to reduce the overall risk in the below investment grade portfolio, as in all investments, through careful credit analysis, strict investment policy guidelines, and diversification by issuer and/or guarantor and by industry.
We seek to closely match the estimated duration of our invested assets to the expected duration of our insurance liabilities. When the estimated durations of assets and liabilities are similar, exposure to interest rate risk is minimized because a change in the value of assets should be largely offset by a change in the value of liabilities. A mismatch of the durations of invested assets and insurance liabilities could have a significant impact on our results of operations and financial position.
The cost of policies purchased are the costs assigned to the right to receive future cash flows from contracts existing at the date of an acquisition. The cost of policies produced are those costs that vary with, and are primarily related to, producing new insurance business. These amounts are amortized using the interest rate credited to the underlying policy: (i) in relation to the estimated gross profits for universal life-type products; or (ii) in relation to future anticipated premium revenue for other products.
At December 31, 2002, the combined balance of our cost of policies purchased and cost of policies produced was $3.2 billion. The recovery of these costs is dependent on the future profitability of the related business.
Goodwill is the excess of the amount we paid to acquire a company over the fair value of its net assets. As more fully described in the note to our consolidated financial statements entitled "Summary of Significant Accounting Policies", the Company recorded the cumulative effect of the accounting change for goodwill impairment of $2,949.2 million in 2002. In addition, we recognized an impairment charge of $500 million in 2002, due to changes in the value of our insurance businesses resulting from events occurring during 2002.
The significant factors used to determine the amount of the impairments included analyses of industry market valuations, historical and projected performance of our insurance segment, discounted cash flow analyses and the market value of our capital. The valuations utilized the best available information, including assumptions and projections we considered reasonable and supportable. The assumptions we used to determine the discounted cash flows involved significant judgments regarding the best estimate of future premiums, expected mortality and morbidity, interest earned and credited rates, persistency and expenses. The discount rates used were based on analyses of the weighted average cost of capital for other insurance companies and considered the specific risk factors related to Conseco. Pursuant to the guidance in Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142"), quoted market prices in active markets are the best evidence of fair value and shall be used as the basis for measurement, if available. Management believes that the assumptions and estimates used are reasonable given all available facts and circumstances. However, if projected cash flows are not realized in the future, we may be required to recognize additional impairments. Subsequent impairment tests will be performed on an annual basis, or more frequently if circumstances indicate a possible impairment. Subsequent impairments, if any, would be classified as an operating expense.
At December 31, 2002, Conseco had federal income tax loss carryforwards of $1,757.4 million available (subject to various statutory restrictions) for use on future tax returns (including $552.4 million of federal income tax carryforwards attributable to discontinued operations). These carryforwards will expire as follows: $2.3 million in 2003; $11.2 million in 2004; $4.9 million in 2005; $.6 million in 2006; $7.9 million in 2007; $7.5 million in 2008; $14.7 million in 2009; $30.7 million in 2010; $6.2 million in 2011; $10.1 million in 2012; $43.9 million in 2013; $6.9 million in 2014; $60.5 million in 2016; $90.0 million in 2017; $244.6 million in 2018; $159.1 million in 2019; $594.3 million in 2020; and $462.0 million in 2022.
At December 31, 2002, the total balance of our liabilities for insurance and asset accumulation products was $22.8 billion. These liabilities are often payable over an extended period of time and the profitability of the related products is dependent on the pricing of the products and other factors. Differences between what we expected when we sold these products and actual experience could result in future losses.
We calculate and maintain reserves for the estimated future payment of claims to our policyholders based on actuarial assumptions. For our health insurance business, we establish an active life reserve plus a liability for due and unpaid claims, claims in the course of settlement and incurred but not reported claims, as well as 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, the reserves and liabilities we establish are necessarily based on extensive estimates, assumptions and 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. 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, negatively affecting our operating results.
Liabilities for insurance products are calculated using management's best judgments of mortality, morbidity, lapse rates, investment experience and expense levels that are based on the Company's past experience and standard actuarial tables.
We also establish a liability for potential losses related to our guarantees of bank loans and the related interest loans to approximately 155 current and former directors, officers and key employees for the purchase of Conseco common stock. This liability is based on an assessment of the value of collateral held for the loans, the personal wealth of the participants in the stock purchase plan, and other factors (such as current and expected future earnings of the participants) which could affect the participants' ability to repay the loans. As of December 31, 2002, we had guaranteed loans totaling $481.3 million. In addition, Conseco has provided loans to participants for interest on the bank loans totaling $179.2 million. During 2002, Conseco purchased $55.5 million of loans from the banks utilizing cash held in a segregated cash account as collateral for our guarantee of the bank loans (including accrued interest, the balance on these loans was $56.7 million at December 31, 2002). At December 31, 2002, we had recognized a reserve liability of $660.0 million based on our estimate. A change in the ability of participants to meet their obligations related to the bank loans and related interest loans would have an effect on our results of operations and financial position.
Retained Interests in Securitization Trusts and Guarantee Liability Related to Interests in Securitization Trusts Held by Others
The estimation of the value of CFC's retained interests in securitization trusts requires significant judgment. CFC has recognized significant impairment charges when the retained interests did not perform as well as anticipated based on the assumptions and expectations of CFC management.
CFC's current valuation of retained interests in securitization trusts may prove inaccurate in future periods. In the securitizations to which these retained interests relate, CFC has retained certain contingent risks in the form of guarantees of certain lower-rated securities issued by the securitization trusts. As of December 31, 2002, the total nominal amount of these guarantees was $1.4 billion. The net present value of expected future guarantee payments are recognized as a liability by CFC and totaled $326.7 million at December 31, 2002. Management of CFC valued the guarantee liability using the same assumptions used in valuing its retained interests in securitization trusts. If CFC has to make more payments on these guarantees than anticipated, or CFC experiences higher than anticipated rates of loan prepayments, including those due to foreclosures or charge-offs, or any adverse changes in CFC's other assumptions used for such valuation (such as interest rates and loss mitigation policies), CFC could be required to recognize additional impairment charges (including potential payments related to $1.4 billion of guarantees) which could have a material adverse effect on CFC's financial condition or results of operations. CFC considers any estimated payments related to these guarantees in the projected cash flows used to determine the value of its retained interests in securitization transactions.
During 2002, CFC recognized an impairment charge related to the value of its retained interests in securitization trusts of $1,077.2 million. CFC also recognized a $336.5 million increase in the valuation allowance related to servicing rights as a result of changes in assumptions in 2002. See "Finance Operations - Impairment Charge" included in this "Management's Discussion and Analysis of Financial Condition" for additional discussion.
At December 31, 2002, the balance of CFC's finance receivables was $14.5 billion. This value is significantly affected by CFC's assessment of the collectibility of the receivables, servicing actions and the provision for credit losses that CFC establishes.
The provision for credit losses charged to expense is based upon an assessment of current and historical loss experience, loan portfolio trends, the value of collateral, prevailing economic and business conditions, and other relevant factors. CFC reduces the carrying value of finance receivables to net realizable value at the earlier of: (i) six months of contractual delinquency; or (ii) when CFC takes possession of the property securing the finance receivable. Estimates of the provision are revised each period, and changes are recorded in the period they become known. A significant change in the level of collectible finance receivables would have a significant adverse effect on CFC's results of operations and financial position in future periods.
Conseco and its businesses are subject to a number of risks including: (i) bankruptcy related risk factors; and (ii) general business and financial risk factors. Any or all of such factors, which are enumerated below, could have a material adverse effect on the business, financial condition or results of operations of Conseco. Also see "Cautionary Statement Regarding Forward-Looking Statements" above. For additional risk factors specific to the Chapter 11 cases, readers of this report should refer to the Plan and the Disclosure Statement, which were filed with the SEC on March 21, 2003 as exhibits to CNC's Current Report on Form 8-K dated March 18, 2003.
The Bankruptcy Filing May Further Disrupt Our Operations and the Operations of Our Subsidiaries.
The impact that the Chapter 11 Cases may have on our operations and the operations of our subsidiaries cannot be accurately predicted or quantified. Since the announcement of our intention to seek a restructuring of our capital in August 2002 and the filing of the Chapter 11 Cases, we have suffered significant disruptions in our operations. Our leveraged condition and liquidity difficulties have eliminated CFC's access to the securitization markets, which have historically served as CFC's main source of funding. As a result, CFC has had to terminate the origination of loans which it is unable to sell profitably in the whole-loan market. In addition, insurance regulators in each of the states in which our insurance subsidiaries are domiciled have been monitoring the Company's activities associated with its financial restructuring. Bankers National Life Insurance Company and Conseco Life Insurance Company of Texas, our insurance subsidiaries domiciled in Texas, each entered into consent orders with the Commissioner of Insurance for the State of Texas, which, among other things, has limited their ability to pay dividends without regulatory approval and to make disbursements other than in the ordinary course of business. Conseco Life Insurance Company of Texas is the parent of all of the Company's insurance subsidiaries, except for Bankers National Life Insurance Company. In August 2002, A.M. Best further downgraded the financial strength ratings of our primary insurance subsidiaries to "B (fair)." These ratings downgrades and other adverse publicity concerning the Company's financial condition have caused sales of our insurance products to decline and
The continuation of the Chapter 11 Cases, particularly if the Plan is not approved or confirmed in the time frame currently contemplated, could further adversely affect our operations and relationship with our customers, employees, regulators, distributors and agents. If confirmation and consummation of the Plan do not occur expeditiously, the Chapter 11 Cases could result in, among other things, increased costs for professional fees and similar expenses. In addition, prolonged Chapter 11 Cases may make it more difficult to retain and attract management and other key personnel and would require senior management to spend a significant amount of time and effort dealing with our financial reorganization instead of focusing on the operation of our business.
We May Not Be Able to Obtain Confirmation of the Plan.
We cannot assure you that we will receive the requisite acceptances to confirm the Plan. Even if we receive the requisite acceptances, we cannot assure you that the Bankruptcy Court will confirm the Plan. The Bankruptcy Court could also decline to confirm the Plan if it found that any of the statutory requirements for confirmation had not been met, including that the terms of the Plan are fair and equitable to non-accepting holders of claims. Section 1129 of the Bankruptcy Code sets forth the requirements for confirmation and requires, among other things, (i) a finding by the Bankruptcy Court that the Plan "does not unfairly discriminate" and is "fair and equitable" with respect to any non-accepting holders of claims, (ii) confirmation of the Plan is not likely to be followed by a liquidation or a need for further financial reorganization and (iii) the value of distributions to non-accepting holders of claims and interests within a particular class under the Plan will not be less than the value of distributions such holders would receive if the Company were liquidated under Chapter 7 of the Bankruptcy Code. While there can be no assurance that these requirements will be met, we believe that the Plan will not be followed by a need for further financial reorganization and that non-accepting holders within each class under the Plan will receive distributions at least as great as would be received following a liquidation under Chapter 7 of the Bankruptcy Code when taking into consideration all administrative claims and costs associated with any such Chapter 7 case. We believe that holders of equity interests in Conseco would receive no distribution under either a liquidation pursuant to Chapter 7 or Chapter 11.
The confirmation and consummation of the Plan are also subject to various conditions. One condition is the cancellation of the guarantee CIHC has given Lehman for up to $125 million of obligations CFC owes to Lehman. The CFC unsecured creditors have indicated that they intend to bring a lawsuit in the Chapter 11 Cases to prevent Lehman from getting paid in full from the proceeds of the sale of CFC's assets. If such suit were successful, the guarantee provided by CIHC may not be cancelled resulting in the plan condition not being satisfied. We can not predict the outcome of the threatened lawsuit by the CFC unsecured creditors or the delay to consummation of the Plan that may result from any such lawsuit against Lehman. If the Plan is not confirmed, it is unclear whether a restructuring of Conseco could be implemented and what distributions holders of claims or equity interests ultimately would receive with respect to their claims or equity interests. If an alternative reorganization could not be agreed to, it is possible that we would have to liquidate our assets, in which case it is likely that holders of claims and equity interests would receive substantially less favorable treatment than they would receive under the Plan.
The Finance Company Debtors May be Unable to Close the Sale of CFC Assets
Our Degree of Leverage May Limit Our Financial and Operating Activities.
A Failure to Improve and Maintain the Financial Strength Ratings of Our Insurance Subsidiaries Could Negatively Impact Our Operations and Financial Results.
An important competitive factor for our insurance subsidiaries is the ratings they receive from nationally recognized rating organizations as discussed in Item 1. "Competition." In July 2002, A.M. Best downgraded the financial strength ratings of Conseco's primary insurance subsidiaries to "B++ (Very Good)" and placed the ratings "under review with negative implications." On August 14, 2002, A.M. Best further lowered the financial strength ratings of our primary insurance subsidiaries from "B++ (very good)" to "B (fair)". The A.M. Best downgrades caused sales of our insurance products to decline and policyholder redemptions and lapses to increase. In some cases, the downgrades also caused defections among our independent agent sales force and increases in the commissions we must pay. These events have had a material adverse effect on our operations, financial results and liquidity.
Although our Plan contemplates that our insurance subsidiaries will achieve a category "A" rating by the end of 2004, we cannot assure you that we will be able to achieve or maintain this rating. If we fail to achieve and maintain a category "A" rating, sales of our insurance products could continue to fall and additional existing policyholders may redeem or lapse their policies, adversely affecting our future operations, financial results and liquidity.
The Covenants in the New Credit Facility Restrict Our Activities and Require Us to Meet or Maintain Various Financial Ratios and Minimum Insurance Ratings.
CNC and CIHC 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. The cash CNC and CIHC receive from insurance subsidiaries consists of fees for services, tax sharing payments, dividends and distributions, and from our non-insurance subsidiaries, loans and advances. A deterioration in the financial condition, earnings or cash flow of the material subsidiaries of CNC or CIHC for any reason could limit such subsidiaries' ability to pay cash dividends or other disbursements to CNC and/or CIHC, which, in turn, would limit CNC's and/or CIHC's ability to meet debt service requirements and satisfy other financial obligations.
Our results for future periods are subject to numerous uncertainties. We may encounter liquidity problems, which could affect our ability to meet our obligations while attempting to meet competitive pressures or adverse economic conditions following the confirmation of the Plan.
Because our operations are conducted through subsidiaries, claims of the creditors of those subsidiaries (including policyholders) will rank senior to claims to distributions from the subsidiaries, which we depend on to make payments on our obligations. CIHC's subsidiaries excluding CFC had indebtedness for borrowed money (including capitalized lease obligations but excluding indebtedness to affiliates), policy reserves and other liabilities of approximately $24.1 billion at December 31, 2002. The obligations of CNC and CIHC, as parent holding companies, will rank effectively junior to these liabilities.
Several of our principal insurance businesses have experienced substantial recent losses in their investment portfolio, declining sales and expense levels that do not match product pricing. We have adopted several initiatives designed to improve these operations, including focusing sales efforts on higher margin products; reducing operating expenses by eliminating or reducing the costs of marketing certain products; personnel reductions and streamlined administrative procedures; stabilizing the profitability of inforce business, particularly long-term care policies; combining certain legal insurance entities to reduce burdens associated with statutory capital requirements; and improving the performance of investments by reducing exposure to credit events and certain types of higher risk assets. We have only recently adopted these initiatives and we cannot assure you that they will be successfully implemented.
Our Reserves for Future Insurance Policy Benefits and Claims May Prove To Be Inadequate, Requiring Us To Increase Liabilities and Resulting In Reduced Net Income and Shareholders' Equity.
Our Insurance Subsidiaries May be Required to Pay Assessments to Fund Policyholder Losses or Liabilities; This May Have a Material Adverse Effect on Our Results of Operations.
In Certain Circumstances, Regulatory Authorities May Place Our Insurance Subsidiaries Under Regulatory Control.
Our insurance subsidiaries are subject to risk-based capital requirements. These requirements were designed to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks associated with: asset quality; mortality and morbidity; asset and liability matching; and other business factors. The requirements are used by states as an early warning tool to discover potential weakly-capitalized companies for the purpose of initiating regulatory action. Generally, if an insurer's ACLRBC falls below specified levels, the insurer would be subject to different degrees of regulatory action depending upon the magnitude of the deficiency. Possible regulatory actions range from requiring the insurer to propose actions to correct the ACLRBC deficiency to placing the insurer under regulatory control. The 2002 statutory annual statements filed with the state insurance regulators of each of our insurance subsidiaries reflected total adjusted capital in excess of levels subjecting the subsidiary to any regulatory action. However, our ACLRBC ratios have declined significantly over the last year and some of our subsidiary's capital levels are near the level which would require them to submit a comprehensive plan aimed at improving their capital position to the regulatory authority.
Recently Enacted and Pending or Future Legislation Could Also Affect the Financial Performance of Our Insurance Operations.
During recent years, the health insurance industry has experienced substantial changes, including those caused by healthcare legislation. Recent federal and state legislation and legislative proposals relating to healthcare reform contain features that could severely limit or eliminate our ability to vary our pricing terms or apply medical underwriting standards with respect to individuals which could have the effect of increasing our loss ratios and have an adverse effect on our financial results. In particular, Medicare reform and legislation concerning prescription drugs could affect our ability to price or sell our products.
Proposals currently pending in Congress and some state legislatures may also affect our financial results. These proposals include the implementation of minimum consumer protection standards for inclusion in all long-term care policies, including: guaranteed premium rates; protection against inflation; limitations on waiting periods for pre-existing conditions; setting standards for sales practices for long-term care insurance; and guaranteed consumer access to information about insurers (including lapse and
replacement rates for policies and the percentage of claims denied). Enactment of any of these proposals could adversely affect our financial results.
In addition, the federal government may seek to regulate the insurance industry, and recent government regulation may increase competition in the insurance industry and may affect our insurance subsidiaries' current sales methods. Although the federal government generally does not directly regulate the insurance industry, federal initiatives often have a direct impact on the insurance business. Current and proposed measures that may significantly affect the insurance business generally include limitations on antitrust immunity and minimum solvency requirements.
Our profitability may be directly affected by the level of and fluctuations in interest rates. While we monitor the interest rate environment and have previously employed hedging strategies designed to mitigate the impact of changes in interest rates, our financial results could be adversely affected by changes in interest rates. Our spread-based insurance and annuity business is subject to several inherent risks arising from movements in interest rates, especially if we fail to anticipate or respond to such movements. First, interest rate changes can cause compression of our net spread between interest earned on investments and interest credited on customer deposits, thereby adversely affecting our results. Second, if interest rate changes produce an unanticipated increase in surrenders of our spread-based products, we may be forced to sell investment assets at a loss in order to fund such surrenders. At December 31, 2002, approximately 20 percent of our total insurance liabilities (or approximately $4.5 billion) could be surrendered by the policyholder without penalty. Finally, changes in interest rates can have significant effects on the performance of our mortgage-backed securities portfolio, including collateralized mortgage obligations, as a result of changes in the prepayment rate of the loans underlying such securities. We follow asset/liability strategies that are designed to mitigate the effect of interest rate changes on our profitability. However, there can be no assurance that management will be successful in implementing such strategies and achieving adequate investment spreads.
Litigation and Regulatory Investigations May Harm Our Financial Strength and Reduce Our Profitability.
A Delay or an Unfavorable Outcome in the Dispute Surrounding Our Interest in the GM Building May Adversely Affect Our Financial Condition and Our Ability to Fund Our Business Plan.
Each of the markets in which we operate is highly competitive. Competitors include other life insurers, commercial banks, thrifts, mutual funds and broker-dealers. Many of our competitors in different segments and regions are larger companies that have greater capital, technological and marketing resources, and have access to capital at a lower cost. Because the actual cost of products is unknown when they are sold, we are subject to competitors who may sell a product at a price that does not cover its actual cost. Agents placing insurance business with our insurance subsidiaries generally are compensated on a commission basis. There are many life and health insurance companies in the U.S. Some of these companies may pay higher commissions and charge lower premium rates, and many companies have more substantial resources than we do. Publicity about our recent financial difficulties may cause agents to place business with other insurers.
financial services companies for efficient sales representatives. We compete with other financial services companies for sales representatives primarily on the basis of our financial position, support services and compensation and product features. Our competitiveness for such agents also depends upon the relationships we develop with these agents. If we are unable to attract and retain sufficient numbers of sales representatives to sell our products, our ability to compete and our revenues would suffer.
Tax Law Changes Could Adversely Affect Our Insurance Product Sales and Profitability.
The following tables and narratives summarize our operating results for the three years ended December 31, 2002. Please read this discussion in conjunction with the accompanying consolidated financial statements and notes.
Average liabilities for insurance and asset accumulation products, net of reinsurance receivables, were $22.6 billion in 2002, down 3.2 percent from 2001, and $23.3 billion in 2001, down 1.7 percent from 2000. The decrease in such liabilities is primarily due
to ceding approximately $870 million of insurance liabilities pursuant to reinsurance agreements entered into during the first quarter of 2002. In addition, policyholder redemptions and lapses have increased following the downgrade of our A.M. Best financial strength rating to "B (fair)". See the note to our consolidated financial statements entitled "Summary of Significant Accounting Policies" for additional discussion of the reinsurance transactions. See "Liquidity for insurance and fee-based operations" within "Management's Discussion and Analysis of Financial Condition and Results of Operations" for additional discussion of the A.M. Best ratings downgrade. Such decrease in 2001 primarily reflects the decreased sales of interest-sensitive products. Surrenders exceeded sales in both 2002 and 2001.
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. In 2002, this amount includes $16.7 million of affiliated fee revenue earned by our subsidiary in India compared to $5.4 million in 2001 and nil in 2000. Such revenue is eliminated in consolidation. Excluding such affiliated income, fee revenue and other income decreased in 2002 and 2001 primarily as a result of a decrease in the market value of investments managed for others, upon which these fees are based. The Company sold its India subsidiary in the fourth quarter of 2002 and has significantly reduced the customer service and backroom operations conducted there.
Insurance policy benefits fluctuated in 2002 and 2001 as a result of the factors summarized in the explanations for loss ratios related to specific products which follow. Loss ratios are calculated by taking the related insurance product's: (i) policy benefits; divided by (ii) policy income.
The loss ratio for Medicare supplement products has been within the range we expected it to be in during 2002 and 2001. Such ratio was higher in 2000, for the following reasons: (i) our estimate of 1999 year end reserves proved to be less than necessary to cover pre-2000 claims; (ii) the mix of our Medicare supplement business in 2000 included a higher percentage of less profitable standard Medicare supplement policies than the prior year (and a lower percentage of more profitable nonstandard policies that we are no longer able to offer to new policyholders); and (iii) a larger portion of certain older blocks of our Medicare supplement business had remained inforce longer than we expected. While the Company benefited from the additional profits earned on the larger blocks of business, the loss ratio will generally increase since the older policies have higher claim costs. Governmental regulations generally require us to attain and maintain a loss ratio, after three years, of not less than 65 percent.
The loss ratios for long-term care products also increased in 2002 due to the higher level of benefits paid out on these products as the policies age. The net cash flows from our long-term care products generally result in the accumulation of amounts in the early years of a policy (accounted for as reserve increases) which will be paid out as benefits in later policy years (accounted for as reserve decreases). Accordingly, as the policies age, the loss ratio will typically increase, but the increase in the change in reserve will be partially offset by investment income earned on the assets which have accumulated. The interest-adjusted loss ratio for long-term care products is calculated by taking the insurance product's (i) policy benefits less interest income on the accumulated assets which back the insurance liabilities; divided by (ii) policy income.
The loss ratios for long-term care products increased in 2001 and 2000, reflecting the effects of the asset accumulation phase of these products. In addition, the estimated liabilities for claims at December 31, 2001 were deficient by approximately $19 million based on subsequent payments through December 31, 2002. Such claims at December 31, 2000 were deficient by approximately $14 million based on subsequent claim payments through December 31, 2001.
Amounts added to policyholder account balances for annuity products decreased by 5.3 percent, to $501.7 million, in 2002, and 5.5 percent, to $530.0 million, in 2001. The decrease in 2002 as compared to 2001 is primarily due to the decrease in the weighted average crediting rates as the average liabilities for this block of business were approximately $11.7 billion for both 2002 and 2001. The weighted average crediting rates for these products was 4.3 percent and 4.5 percent in 2002 and 2001, respectively. The decrease in 2001 as compared to 2000 is primarily due to a smaller block of this type of business inforce. Average liabilities for these products were $11.7 billion in 2001, down 7.1 percent from 2000. The weighted average crediting rates for these products was 4.5 percent in both 2001 and 2000.
Amounts added to equity indexed products and separate account liabilities correspond to the related investment income accounts described above.
Amortization related to operations includes amortization of the cost of policies produced and the cost of policies purchased. Amortization generally fluctuates in relationship to the total account balances subject to amortization.
Policyholder redemptions of annuity and, to a lesser extent, life products have increased in recent periods. We have experienced additional redemptions following the downgrade of our A.M. Best financial strength rating to "B (fair)". When redemptions are greater than our previous assumptions, we are required to accelerate the amortization of our cost of policies produced and cost of policies purchased to write off the balance associated with the redeemed policies. Accordingly, amortization expense has increased. We have changed the lapse assumptions used to determine the amortization of the cost of policies produced and the cost of policies purchased related to certain universal life products and our annuities to reflect our current estimates of future lapses. For certain universal life products, we changed the ultimate lapse assumption from: (i) a range of 6 percent to 7 percent; to (ii) a tiered assumption based on the level of funding of the policy of a range of 2 percent to 10 percent. Policyholder withdrawals in recent periods have exceeded our estimates. Such withdrawals were $3,708.3 million in 2002 and $2,528.3 million in 2001. Accordingly,
we increased the expected future lapse rates on these products to reflect our current belief that lapses on these policies will continue to be higher than previously expected for the next several quarters. We recorded additional amortization of $203.2 million in 2002 related to higher redemptions and changes to our lapse assumptions.
As a result of economic developments, actual experience of our products and changes in our expectations, we changed our investment yield assumptions used in calculating the estimated gross profits to be earned on our annuity products in 2001 and 2000. Such changes resulted in additional amortization of the cost of policies produced and cost of policies purchased of $27.8 million and $25.6 million in 2001 and 2000, respectively.
Other items include general corporate expenses, net of amounts charged to subsidiaries for services provided by the corporate operations. Such amount in 2002 includes the establishment of a $40.0 million allowance for a claim receivable as further discussed in the note to our consolidated financial statements entitled "Other Disclosures - Securities Litigation".
The major medical business in run-off includes individual major medical health insurance products. These lines of business had losses of $130.3 million and $51.3 million in 2001 and 2000, respectively. These lines of business, which have substantially run-off,
did not incur additional losses in 2002. The amount in 2001 includes $77.4 million of amortization, which represented the unrecoverable cost of policies produced and cost of policies purchased related to the major medical business in run-off.
Gain on sale of interest in riverboat represents the gain recognized in the first quarter of 2001 as a result of our sale of our 29 percent ownership interest in the riverboat casino in Lawrenceberg, Indiana, for $260 million.
Special charges in corporate operations for 2002 include: (i) a loss of $20.0 million associated with the sale of our India subsidiary; (ii) $17.7 million related to debt modification and refinancing transactions; (iii) other items totaling $22.0 million; partially offset by (iv) net gains of $7.5 million related to the sale of certain non-core assets. Special charges in corporate operations for 2001 include: (i) litigation accrual and expenses of $23.8 million; (ii) severance benefits of $2.9 million; (iii) losses related to office closings and the sale of artwork totaling $6.8 million; (iv) losses related to disputed reinsurance balances totaling $8.5 million; and (v) other losses totaling $16.9 million. Special charges in 2000 include: (i) advisory and professional fees related to debt restructuring of $9.9 million; (ii) a portion of the loss on the sale of asset-backed loans (excluding loss related to loans held by the finance segment) of $15.2 million; (iii) advisory fees paid to investment banks of $44.0 million; (iv) the loss related to our exit from the subprime automobile business of $71.6 million; (v) the amount paid to a terminated executive pursuant to his employment agreement of $72.5 million; (vi) the amount paid to the newly hired Chief Executive Officer of $45.0 million; (vii) the value of warrants issued to release the newly hired Chief Executive Officer from a noncompete provision of a prior agreement of $21.0 million; and (viii) other charges of $25.8 million. These charges are described in greater detail in the note to our consolidated financial statements entitled "Special Charges".
We set the premium rates on our health insurance policies based on facts and circumstances known at the time we issue the policies and on assumptions about numerous variables, including the actuarial probability of a policyholder incurring a claim, the
severity, and the interest rate earned on our investment of premiums. In setting premium rates, we consider historical claims information, industry statistics, premiums charged by competitors and other factors. If our actual claims experience proves to be less favorable than we assumed and we are unable to raise our premium rates, our financial results will be adversely affected. We generally cannot raise our premiums in any state unless we first obtain the approval of the insurance regulator in that state. We review the adequacy of our premium rates regularly and file requests for rate increases on our products when we believe existing premium rates are too low. It is possible that we will not be able to obtain approval for premium rate increases from currently pending requests or requests filed in the future. If we are unable to raise our premium rates because we fail to obtain approval for a rate increase in one or more states, our financial results will be adversely affected. If we are successful in obtaining regulatory approval to raise premium rates due to unfavorable actual claims experience, the increased premium rates may reduce the volume of our new sales and cause existing policyholders to allow their policies to lapse. This would reduce our premium income in future periods. Increased lapse rates also could require us to expense all or a portion of the cost of policies produced or the cost of policies purchased relating to lapsed policies in the period in which those policies lapse, adversely affecting our financial results in that period.
Other fixed rate annuity products include SPDAs, FPDAs and SPIAs, which are credited with a declared rate. The demand for traditional fixed-rate annuity contracts has increased in 2002 as such products became more attractive than equity-indexed or variable annuity products due to the general stock market performance. SPDA and FPDA policies typically have an interest rate that is
guaranteed for the first policy year, after which we have the discretionary ability to change the crediting rate to any rate not below a guaranteed rate. The interest rate credited on SPIAs is based on market conditions existing when a policy is issued and remains unchanged over the life of the SPIA. Annuity premiums on these products increased by 3.5 percent, to $872.7 million, in 2002 and by 44 percent, to $842.8 million, in 2001.
Other health products include disability income, dental and various other health insurance products. The disability income and dental products are marketed to school systems located in nearly all states. The other health insurance products are generally not being actively marketed. Premiums collected in 2002 were $104.3 million, down 4.6 percent from 2001. Premiums collected in 2001 were $109.3 million, down 13 percent from 2000. The inforce business continues to be profitable.
Major medical in run-off includes major medical health insurance products sold to individuals. In the second half of 2001, we stopped renewing a large portion of our major medical lines of business. In early 2002, we decided to stop renewing all inforce individual and small group business and discontinue new sales. Individual health premiums collected in 2002 decreased by 74 percent, to $93.9 million, and by 10 percent, to $366.2 million in 2001. These premiums will continue to decrease in future periods.
Although investment income is a significant component of total revenues, the profitability of certain of our insurance products is determined primarily by the spreads between the interest rates we earn and the rates we credit or accrue to our insurance liabilities. At December 31, 2002, the average yield, computed on the cost basis of our actively managed fixed maturity portfolio, was 6.7 percent, and the average interest rate credited or accruing to our total insurance liabilities (excluding interest rate bonuses for the first policy year only and excluding the effect of credited rates attributable to variable or equity-indexed products) was 5.1 percent.
Our actively managed fixed maturity portfolio at December 31, 2002, included primarily debt securities of the United States government, public utilities and other corporations, and mortgage-backed securities. Mortgage-backed securities included collateralized mortgage obligations ("CMOs") and mortgage-backed pass-through securities.
As of December 31, 2002, our fixed maturity investments in substantive default (i.e., in default due to nonpayment of interest or principal) or technical default (i.e., in default, but not as to the payment of interest or principal) had an amortized cost of $203.9 million and a carrying value of $174.8 million. Conseco employs a staff of experienced professionals to manage non-performing and impaired investments. There were no other fixed maturity investments about which we had serious doubts as to the ability of the issuer to comply with the material terms of the instrument on a timely basis.
At December 31, 2002, fixed maturity investments included $6.4 billion of mortgage-backed securities (or 33 percent of all fixed maturity securities). CMOs are backed by pools of mortgages that are segregated into sections or "tranches" that provide for reprioritizing of retirement of principal. Pass-through securities receive principal and interest payments through their regular pro rata share of the payments on the underlying mortgages backing the securities. The yield characteristics of mortgage-backed securities differ from those of traditional fixed-income securities. Interest and principal payments for mortgage-backed securities occur more frequently, often monthly. Mortgage-backed securities are subject to risks associated with variable prepayments because borrowers are generally allowed to pre-pay their mortgages without penalty. Prepayment rates are influenced by a number of factors that cannot be predicted with certainty, including: the relative sensitivity of the underlying mortgages backing the assets to changes in interest rates; a variety of economic, geographic and other factors; and the repayment priority of the securities in the overall securitization structures.
In general, prepayments on the underlying mortgage loans and the securities backed by these loans increase when prevailing interest rates decline significantly relative to the interest rates on such loans. The yields on mortgage-backed securities purchased at a discount to par will increase when the underlying mortgages prepay faster than expected. The yields on mortgage-backed securities purchased at a premium will decrease when they prepay faster than expected. When interest rates decline, the proceeds from the prepayment of mortgage-backed securities are likely to be reinvested at lower rates than we were earning on the prepaid securities. When interest rates increase, prepayments on mortgage-backed securities decrease, as fewer underlying mortgages are refinanced. When this occurs, the average maturity and duration of the mortgage-backed securities increase, which decreases the yield on mortgage-backed securities purchased at a discount, because the discount is realized as income at a slower rate, and increases the yield on those purchased at a premium as a result of a decrease in the annual amortization of the premium.
Subordinated and mezzanine tranches are classes that provide credit enhancement to the senior tranches. The rating agencies require that this credit enhancement not deteriorate due to prepayments for a period of time, usually five years of complete lockout followed by another period of time where prepayments are shared pro rata with senior tranches. The credit risk of subordinated and mezzanine tranches is derived from owning a small percentage of the mortgage collateral, while bearing a majority of the risk of loss due to property owner defaults. Subordinated bonds can be rated "AA" or lower; we typically do not invest in such securities rated lower than "BB".
Other invested assets also include: (i) S&P 500 Call Options; and (ii) certain nontraditional investments, including investments in limited partnerships and promissory notes.
Changes in the Consolidated Balance Sheet of 2002 Compared with 2001
In accordance with GAAP, we record our actively managed fixed maturity investments, equity securities and certain other invested assets at estimated fair value with any unrealized gain or loss (excluding impairment losses which are recognized through earnings), net of tax and related adjustments, recorded as a component of shareholders' equity. At December 31, 2002, we increased the carrying value of such investments by $448.1 million as a result of this fair value adjustment. The fair value adjustment resulted in a $816.0 million decrease in carrying value at year-end 2001.
Book value (deficit) per common share outstanding decreased to $(7.38) at December 31, 2002, from $12.34 a year earlier. Such change was primarily attributable to our net loss for 2002. Excluding accumulated other comprehensive income (loss), book value (deficit) per common share outstanding was $(9.05) at December 31, 2002, and $13.61 at December 31, 2001.
Goodwill (representing the excess of the amounts we paid to acquire companies over the fair value of net assets acquired in transactions accounted for as purchases) was $100.0 million and $3,695.4 million at December 31, 2002 and 2001, respectively. Amortization of goodwill totaled $109.6 million and $112.5 million during 2001 and 2000, respectively.
The FASB issued SFAS 142, in June 2001. Under the new rule, intangible assets with an indefinite life are no longer amortized in periods subsequent to December 31, 2001, but are subject to annual impairment tests (or more frequent under certain circumstances), effective January 1, 2002. The Company has determined that all of its goodwill has an indefinite life and is therefore subject to the new rules.
Pursuant to the transitional rules of SFAS 142, we completed the two-step impairment test during 2002 and, as a result of that test, we recorded the cumulative effect of the accounting change for the goodwill impairment charge of $2,949.2 million. The
The significant factors used to determine the amount of the initial impairment included analyses of industry market valuations, historical and projected performance of our insurance segment, discounted cash flow analyses and the market value of our capital. The valuation utilized the best available information, including assumptions and projections we considered reasonable and supportable. The assumptions we used to determine the discounted cash flows involve significant judgments regarding the best estimate of future premiums, expected mortality and morbidity, interest earned and credited rates, persistency and expenses. The discount rate used was based on an analysis of the weighted average cost of capital for several insurance companies and considered the specific risk factors related to Conseco. Pursuant to the guidance in SFAS 142, quoted market prices in active markets are the best evidence of fair value and shall be used as the basis for measurement, if available.
On August 14, 2002, our insurance subsidiaries' financial strength ratings were downgraded by A.M. Best to "B (fair)" and on September 8, 2002, the Company defaulted on its public debt. These developments caused sales of our insurance products to fall and policyholder redemptions and lapses to increase. The adverse impact on our insurance subsidiaries resulting from the ratings downgrade and parent company default required that additional impairment tests be performed as of September 30, 2002 in accordance with SFAS 142.
Only a small portion of our insurance liabilities have a time for contractual payment; the majority of such liabilities are payable upon occurrence of the insured event or upon surrender. Of our total insurance liabilities at December 31, 2002, approximately 20 percent could be surrendered by the policyholder without a penalty. Approximately 62 percent could be surrendered by the policyholder subject to penalty or the release of an insurance liability in excess of surrender benefits paid. The remaining 18 percent do not provide a surrender benefit.
Approximately 46 percent of insurance liabilities were subject to interest rates that may be reset annually; 36 percent have a fixed explicit interest rate for the duration of the contract; 12 percent have credited rates which approximate the income earned by the Company; and the remainder have no explicit interest rate.
Insurance liabilities for interest-sensitive products by credited rate (excluding interest rate bonuses for the first policy year only) at December 31, 2002 were as follows (dollars in millions):
On August 14, 2002, A.M. Best lowered the financial strength ratings of our primary insurance subsidiaries from "B++ (very good)" to "B (fair)". A.M. Best ratings for the industry currently range from "A++ (Superior)" to "F (In Liquidation)" and some companies are not rated. An "A++" ranking indicates superior overall performance and a strong ability to meet obligations to policyholders over a long period of time. The "B" rating is assigned to companies which have, on balance, fair balance sheet strength, operating performance and business profile, when compared to the standards established by A.M. Best, and have an ability in A.M. Best's opinion to meet their current obligations to policyholders, but their financial strength is vulnerable to adverse changes in underwriting and economic conditions. The rating reflects A.M. Best's view of the uncertainty surrounding our restructuring initiatives and the potential adverse financial impact on the subsidiaries if negotiations are protracted and execution of the restructuring plan is delayed. S&P has given our insurance subsidiaries a financial strength rating of "B+". Rating categories from "BB" to "CCC" are classified as "vulnerable", and pluses and minuses show the relative standing within a category. In S&P's view an insurer rated "B" currently has the capacity to meet its financial commitments but adverse business conditions could lead to insufficient ability to meet financial commitments.
During 2002, our insurance subsidiaries paid dividends to Conseco totaling $240 million. As more fully described in the note to our consolidated financial statements entitled "Statutory Information", our two insurance subsidiaries domiciled in Texas entered into consent orders with the Texas Department of Insurance. The consent orders apply to all of our insurance subsidiaries and, among other things, restrict the ability of our insurance subsidiaries to pay dividends and other amounts to the parent company. State laws generally provide state insurance regulatory agencies with broad authority to protect policyholders in their jurisdictions. Accordingly, there can be no assurance that the regulators will not seek to assert greater supervision and control over our insurance subsidiaries' businesses and financial affairs.
Our insurance subsidiaries experienced increased lapse rates on annuity policies during 2002. We believe that the diversity of the investment portfolios of our insurance subsidiaries and the concentration of investments in high-quality, liquid securities provide sufficient liquidity to meet foreseeable cash requirements of our insurance subsidiaries. At December 31, 2002, we held $1.1 billion of cash and cash equivalents and $15.8 billion of publicly traded investment grade bonds. Our insurance subsidiaries could readily liquidate portions of their investments, if lapses continue at current levels. In addition, investments could be used to facilitate borrowings under reverse-repurchase agreements or dollar-roll transactions. Such borrowings have been used by the insurance subsidiaries from time to time to increase their return on investments and to improve liquidity. The availability of reverse-repurchase agreements and dollar-roll transactions is dependent on counter parties' willingness to enter into the transactions, and, consequently, no assurance can be given that such transactions will be available in the future.
The continuation of the Chapter 11 Cases, particularly if the Plan is not approved or confirmed in the time frame currently contemplated, could further adversely affect our operations and relationship with our customers, employees, regulators, distributors and agents. If confirmation and consummation of the Plan do not occur expeditiously, the Chapter 11 Cases could result in, among other things, increased costs for professional fees and similar expenses. In addition, prolonged Chapter 11 Cases may make it more difficult to retain and attract management and other key personnel and would require senior management to spend a significant amount of time and effort dealing with our financial reorganization instead of focusing on the operation of our business. However, we currently expect that our current cash resources and additional cash flows from the operations of our non-life subsidiaries will be adequate to complete our financial reorganization if the Plan is approved in the time frame currently contemplated.
Our cash flow may be affected by a variety of factors, many of which are outside of our control, including insurance and banking regulatory issues, competition, financial markets and other general business conditions. We cannot assure you that we will possess sufficient income and liquidity to meet all of our liquidity requirements and other obligations. Although we believe that
Because our operations are conducted through subsidiaries, claims of the creditors of those subsidiaries (including policyholders) will rank senior to claims to distributions from the subsidiaries, which we depend on to make payments on our obligations. CIHC's subsidiaries, excluding CFC, had indebtedness for borrowed money (including capitalized lease obligations but excluding indebtedness to affiliates), policy reserves and other liabilities of approximately $24.1 billion at December 31, 2002. The obligations of CNC and CIHC, as parent holding companies, will rank effectively junior to these liabilities.
Our spread-based insurance business is subject to several inherent risks arising from movements in interest rates, especially if we fail to anticipate or respond to such movements. First, interest rate changes can cause compression of our net spread between interest earned on investments and interest credited on customer deposits, thereby adversely affecting our results. Second, if interest rate changes produce an unanticipated increase in surrenders of our spread-based products, we may be forced to sell investment assets at a loss in order to fund such surrenders. At December 31, 2002, approximately 20 percent of our total insurance liabilities (or approximately $4.5 billion) could be surrendered by the policyholder without penalty. Finally, changes in interest rates can have significant effects on the performance of our mortgage-backed securities portfolio, including collateralized mortgage obligations, as a
The profitability of many of our products depends on the spreads between the interest yield we earn on investments and the rates we credit on our insurance liabilities. In addition, changes in competition and other factors, including the impact of the level of surrenders and withdrawals, may limit our ability to adjust or to maintain crediting rates at levels necessary to avoid narrowing of spreads under certain market conditions. Approximately 46 percent of our insurance liabilities were subject to interest rates that may be reset annually; 36 percent have a fixed explicit interest rate for the duration of the contract; 12 percent have credited rates which approximate the income earned by the Company; and the remainder have no explicit interest rates. As of December 31, 2002, the average yield, computed on the cost basis of our investment portfolio, was 6.7 percent, and the average interest rate credited or accruing to our total insurance liabilities (excluding interest rate bonuses for the first policy year only and excluding the effect of credited rates attributable to variable or equity-indexed products) was 5.1 percent.
finance business and the filing of petitions under the Bankruptcy Code by the Finance Company Debtors, the finance business is being accounted for as a discontinued business in Conseco's consolidated financial statements. See the note to our consolidated financial statements entitled "Discontinued Finance Business - Planned Sale of CFC" for additional information. CFC's finance products include both fixed-term and revolving loans and leases. CFC also markets physical damage and other credit protection relating to the loans it services.
CFC's remaining liquidity sources (excluding its bank subsidiaries) are a warehouse and a residual facility with Lehman and a postpetition financing facility. CFC's diminished access to the securitization markets and the constrained liquidity under its other funding sources have had a material adverse effect on CFC's business and results of operations, resulting in CFC's petition for relief under the Bankruptcy Code. On December 19, 2002, shortly after the filing of the Chapter 11 Cases, CFC obtained debtor-in-possession ("DIP") financing provided by U.S. Bank and FPS DIP LLC, an affiliate of Fortress Investment Group LLC ("Fortress"), J.C. Flowers & Co. LLC. ("Flowers") and Cerberus Capital Management, L.P. ("Cerberus"). The DIP financing motion was granted by the Bankruptcy Court on January 14, 2003. On April 14, 2003, the Bankruptcy Court approved an amendment to the DIP Facility to increase the maximum permitted borrowings thereunder, from $125 million to $150 million.
CFC is currently in violation of several financial covenants required by its warehouse and residual facilities. CFC has entered into a forbearance agreement with Lehman pursuant to which Lehman has agreed to temporarily refrain from exercising any rights arising from events of default that occurred under the warehouse and residual facilities as of the date of such forbearance agreement, including certain events of default triggered by CFC not being in compliance with certain financial covenants. This forbearance agreement expires on June 1, 2003 and is subject to various conditions.
CFC's residual facility is collateralized by retained interests in securitizations. CFC is required to maintain collateral based on current estimated fair values in accordance with the terms of such facility. Due to the decrease in the estimated fair value of its retained interests, CFC's collateral was deficient at December 31, 2002 (as calculated in accordance with the relevant transaction documents). Under the terms of the forbearance agreement, Lehman has agreed not to cause accelerated repayment of the residual facility based on the collateral deficiency through June 1, 2003. However, Lehman is retaining certain cash flows from CFC's retained interests pledged to this facility and applying these cash flows to the margin deficit. CFC is currently unable to provide sufficient additional collateral or repay this residual facility.
During 2000 and 2001, management completed several actions with respect to CFC, including: (i) the sale, closing or runoff of several units (including asset-based lending, vendor leasing, bankcards, transportation and park construction, which are collectively referred to as the "other lines"); (ii) monetization of certain on-balance sheet financial assets through sales or as collateral for additional borrowings; and (iii) cost savings and restructuring of ongoing businesses such as streamlining of loan origination operations in the manufactured housing and home equity divisions. The transactions CFC completed to raise cash during 2001 and 2000 included: (i) the sale of a $568.4 million portfolio of high-loan-to-value loans (which generated $80 million of cash after repayment of debt collateralized by the loans); (ii) the sale of a $802.3 million portfolio of vendor services loans (which generated $180 million of cash after repayment of debt collateralized by the loans); (iii) the sale of a 15 percent interest in the interest-only securities and new borrowing agreements collateralized by the interest-only securities (which generated cash of $100 million); (iv) the sale of substantially all of the bankcard (Visa and Mastercard) portfolio (which generated $154 million of cash); (v) the sale of $216.1 million of asset-backed loans (which generated $43 million of cash after repayment of debt collateralized by the loans); (vi) the sale of a $566.0 million portfolio of loans which finance the purchase of trucks (which generated $30 million of cash after repayment of debt collateralized by the loans); and (vii) new or revised borrowing agreements which provided financing for loans not previously pledged under other borrowing agreements (which generated over $300 million of cash). The cash generated from these transactions was primarily used toward the reduction of debt due to CNC of $674.1 million in 2000 and $537.2 million in 2001. These courses of action have caused significant fluctuations in account balances.
The risks associated with the finance business become more acute in any economic slowdown or recession. Periods of economic slowdown or recession may be accompanied by decreased demand for consumer credit and declining asset values. In the home equity mortgage and manufactured housing businesses, any material decline in real estate values reduces the ability of borrowers to use home equity to support borrowing and increases the loan-to-value ratios of loans previously made, thereby weakening collateral coverage and increasing the size of losses in the event of a default. Delinquencies, foreclosures and losses generally increase during economic slowdowns or recessions. For CFC's finance customers, loss of employment, increases in cost-of-living or other adverse economic conditions impair their ability to meet their payment obligations. Higher industry inventory levels of repossessed manufactured homes have affected recovery rates and may result in future impairment charges and provision for losses. In addition, in an economic slowdown or recession, CFC's servicing and litigation costs increase. Any sustained period of increased delinquencies, foreclosures, losses or increased costs would have a material adverse effect on CFC's financial condition and results of operations.
Managed receivables include finance receivables recorded on CFC's consolidated balance sheet and those managed by CFC but held by trusts applicable to holders of asset-backed securities sold in securitizations structured in a manner that resulted in gain-on-sale revenue. Average managed receivables decreased to $39.8 billion in 2002, down 10 percent from 2001, and decreased to $44.4 billion in 2001, down 6.4 percent from 2000.
Net investment income on finance receivables and other consists of: (i) interest earned on finance receivables; and (ii) interest income on short-term and other investments. Such income decreased by 4.4 percent, to $2,074.2 million, in 2002 and increased by 17 percent, to $2,169.7 million, in 2001, consistent with the changes in average on-balance sheet finance receivables. The weighted average yields earned on finance receivables and other investments were 11.5 percent, 12.6 percent and 12.9 percent during 2002, 2001 and 2000, respectively. The average yields decreased due to the declining interest rate environment, change in product mix of the portfolio and rising delinquencies primarily in CFC's manufactured housing business.
Net investment income on retained interests is the income recognized on the retained interests in securitizations CFC retains after it sells finance receivables. Such income decreased by 40 percent, to $75.0 million, in 2002 and by 31 percent, to $125.3 million, in 2001. The decrease is consistent with the change in the average balance of retained interests. The weighted average yields earned on retained interests were 12.3 percent, 14.4 percent and 13.6 percent during 2002, 2001 and 2000, respectively. As a result of the change in the structure of CFC's securitizations, securitization transactions are accounted for as secured borrowings and CFC does not recognize gain-on-sale revenue or additions to retained interests from such transactions. Accordingly, future investment income accreted on the retained interests will decrease, as cash remittances from the prior gain-on-sale securitizations reduce the retained interests balances. In addition, the balance of the retained interests was reduced by $1,077.2 million in 2002, $264.8 million in 2001 and $504.3 million in 2000 (including $70.2 million due to the accounting change described in the note to Conseco's consolidated financial statements entitled "Summary of Significant Accounting Policies") due to impairment charges. Impairment charges are further explained below. The weighted average yield was also adversely affected by the decline in guarantee payments received on certain lower-rated securities in the fourth quarter of 2002.
Gain (loss) on sales of finance receivables resulted from various loan sale transactions in 2002, 2001 and 2000. During 2002, CFC sold $2.1 billion of finance receivables which generated net losses of $17.1 million. In 2002, CFC also recognized $32.4 million loss to reduce the value of unsecuritized finance receivables, which are being held for eventual sale and have market values below their cost basis. During 2001, CFC sold $1.6 billion of finance receivables which included: (i) $802.3 million vendor services loan portfolio (the value of which was reduced in the fourth quarter of 2000 since the market value of these loans exceeded their cost basis, and no additional gain or loss was recognized in 2001); (ii) $568.4 million of high-loan-to-value mortgage loans; and (iii) $269.0 million of other loans. These sales resulted in net gains of $26.9 million. In 2000, CFC sold approximately $147.1 million of finance receivables in whole-loan sales resulting in net gains of $7.5 million. Gain on sales of finance receivables in 2000 excludes the gain realized on the sale of CFC's bankcard portfolio which is included in special charges.
Fee revenue and other income includes servicing income, commissions earned on insurance policies written in conjunction with financing transactions and other income from late fees. Such income decreased by 18 percent, to $273.8 million, in 2002 and by 8.2 percent, to $335.8 million, in 2001. Such decreases are primarily due to decreases in commission income as a result of reduced origination activities and the termination of sales of single premium credit life insurance. In addition, as a result of the change in the structure of CFC's securitizations, CFC no longer records an asset for servicing rights at the time of its securitizations, nor does CFC record servicing fee revenue; instead, the entire amount of interest income is recorded as investment income. The amount of servicing income (which is net of the amortization of servicing assets and liabilities) was $83.9 million in 2002, $115.3 million in 2001 and $108.2 million in 2000. Servicing income will continue to decline in future periods as the managed receivables in these securitizations are paid down. In 2000, the decrease in servicing income was partially offset by higher commissions and late fee income.
Many consumer lenders have stopped or significantly scaled back their consumer finance operations in the manufactured housing sector. These lenders began to foreclose on collateral pledged to secure loans at a more aggressive rate. CFC has faced increased competition from such lenders in disposing of collateral pledged to secure its loans. Often collateral is in similar forms. There is a limited number of collateral buyers and the exiting consumer lenders have been willing to sell their foreclosed collateral at prices significantly below fair market value. As a result, collateral recovery rates for CFC have fallen significantly and could fall further, which could have a further material adverse effect on the financial position and results of CFC's operations.
CFC believes that its historical loss experience has been favorably affected by various loss mitigation policies. Under one such policy, CFC works with the defaulting obligor and its dealer network to find a new buyer who meets CFC's underwriting standards and is willing to assume the defaulting obligor's loan. Under other loss mitigation policies, CFC may permit qualifying obligors (obligors who are currently unable to meet the obligations under their loans, but are expected to be able to meet them in the future under modified terms) to defer scheduled payments or CFC may reduce the interest rate on the loan, in an effort to avoid loan defaults.
Due to the prevailing economic conditions in 2002 and 2001, CFC increased the use of the aforementioned mitigation policies. Based on past experience, CFC believes these policies will reduce the ultimate losses it recognizes. If CFC applies loss mitigation policies, CFC generally reflects the customer's delinquency status as not being past due. Accordingly, the loss mitigation policies favorably impact CFC's delinquency ratios. CFC attempts to appropriately reserve for the effects of these loss mitigation policies when establishing loan loss reserves. These policies are also considered when CFC determines the value of its retained interests in securitization trusts. Loss mitigation policies were applied to 10.7 percent of average managed accounts in 2002 compared to 8.8 percent in 2001. Such loss mitigation policies were applied to 3.0 percent, 2.7 percent, 2.8 percent and 2.2 percent of average managed accounts during the first, second, third and fourth quarters of 2002, respectively. Due to CFC's liquidity limitations, many loss mitigation policies were curtailed in the fourth quarter of 2002.
Reorganization items are professional fees associated with CFC's bankruptcy proceedings which are expensed as incurred in accordance with SOP 90-7.
The determination of the value of CFC's retained interests in securitization trusts requires significant judgment. CFC has recognized significant charges when the retained interests did not perform as well as anticipated based on CFC's assumptions and expectations. CFC's current valuation of retained interests may prove inaccurate in future periods. In securitizations to which these retained interests relate, CFC has retained certain contingent risks in the form of guarantees of certain lower-rated securities issued by the securitization trusts. As of December 31, 2002, the total amount of these guarantees was approximately $1.4 billion. CFC considers any potential payments related to these guarantees in the projected cash flows used to determine the value of its retained interests. See the note to Conseco's consolidated financial statements entitled "Financial Information Regarding CFC."
Approximately 9 percent, 8 percent, 7 percent and 6 percent of the loans that CFC serviced were in Texas, North Carolina, Florida and Georgia, respectively. No other state comprised more than 5 percent of the loans serviced. In addition, no single contractor, dealer or vendor accounted for more than 1 percent of the total contracts CFC originated.
The interest-only securities and subordinated securities are carried at estimated fair value. On a quarterly basis, CFC estimates the fair value of these securities by discounting the projected future cash flows using current assumptions. If CFC determines that the differences between the estimated fair value and the book value of these securities is a temporary difference, CFC adjusts shareholders' equity. At December 31, 2002, this adjustment increased the carrying value of the retained interests by $63.5 million to $252.6 million.
The assumptions CFC uses to determine new values are based on its internal evaluations. Although CFC's management believes its methodology is reasonable, many of the assumptions and expectations underlying CFC's determinations are not possible to predict with certainty and may change adversely in the future for reasons beyond CFC's control. Largely as a result of adverse changes in the underlying assumptions (as discussed above in the section entitled "Operating Results of the Discontinued Finance Operations"), CFC recognized impairment charges of $1,077.2 million in 2002, $386.9 million ($250.4 million after tax) in 2001 and $515.7 million ($324.9 million after tax) in 2000 to reduce the book value of interest-only securities and servicing rights as described above under "Operating Results of the Discontinued Finance Operations."
Based on CFC's current assumptions and expectations as to future events related to the loans underlying its retained interests, management has projected that the adverse loss experience in 2002 will continue into 2003 and then improve over time. As a result of these assumptions, CFC projects that payments related to the guarantees (including the guarantee payments described in the preceding paragraph and guarantee payments related to the subordinated securities we hold) will exceed the gross undiscounted cash flows from the interest-only securities by approximately $225 million in 2003, $100 million in 2004, $60 million in 2005 and $10 million in 2006. CFC projects that the gross cash flows from the interest-only securities will exceed the payments related to guarantees issued in conjunction with the sales of certain finance receivables by approximately $175 million in all years thereafter.
Effective September 30, 2001, CFC transferred substantially all of its interest-only securities into a securitization trust. The transaction provided a means to finance a portion of the value of its interest-only securities by selling some of the cash flows to Lehman. The transfer was accounted for as a sale in accordance with SFAS 140. However, no gain or loss was recognized because the aggregate fair value of the interest retained by CFC and the cash received from the sale were equal to the carrying value of the interest-only securities prior to their transfer to the trust. The trust is a qualifying special purpose entity and is not consolidated pursuant to SFAS 140. CFC received a trust security representing an interest in the trust equal to 85 percent of the estimated future cash flows of the interest-only securities held in the trust. Lehman purchased the remaining 15 percent interest. The value of the interest purchased by Lehman was $20.4 million at December 31, 2002. CFC continues to be the servicer of the finance receivables underlying the interest-only securities transferred to the trust. Lehman has the ability to accelerate the principal payments related to their interest after a stated period. Until such time, Lehman is required to maintain a 15 percent interest in the estimated future cash flows of the trust. By aggregating the interest-only securities into one structure, the impairment tests for these securities are conducted on a single set of cash flows representing CFC's 85 percent interest in the trust. Accordingly, adverse changes in cash flows from one interest-only security may be offset by positive changes in another. The new structure does not avoid an impairment charge if sufficient positive cash flows in the aggregate are not available (such as was the case at December 31, 2002).
CFC requires cash to originate finance receivables. CFC's primary sources of cash have historically been: (i) the collection of receivable balances; (ii) proceeds from the issuance of debt, certificates of deposit, bank credit facility, securitizations, warehouse and residual lines, and sales of loans; and (iii) cash provided by operations. CFC's lenders have severely restricted its access to liquidity. The liquidity needs of CFC could increase in the event of an extended economic slowdown or recession. Loss of employment, increases in cost-of-living or other adverse economic conditions impair the ability of CFC's customers to meet their payment obligations. Higher industry levels of repossessed manufactured homes have affected recovery rates and resulted in decreased cash flows. In addition, in an economic slowdown or recession, CFC's servicing and litigation costs generally increase. Any sustained period of increased delinquencies, foreclosures, losses or increased costs would have an adverse effect on its liquidity. See "Operating Results of the Discontinued Finance Operations" above for additional discussion.
CFC is currently in violation of several of its financial covenants required by its warehouse and residual facilities. CFC has entered into a forbearance agreement with Lehman pursuant to which Lehman has agreed to temporarily refrain from exercising any rights arising from events of default that occurred under the facilities as of the date of such forbearance agreement, including certain events of default triggered by CFC not being in compliance with certain financial covenants. This forbearance agreement expires on June 1, 2003. The forbearance agreement with Lehman contains additional provisions which: (i) prohibit CFC from making any dividend or other payments to CNC or any affiliates; (ii) during the forbearance period, grant Lehman rights over cash proceeds resulting from the sale of assets in excess of $25 million; (iii) provide Lehman with the right to consent to amendments to the documents governing certain of CFC's securitization facilities; and (iv) provide Lehman with additional security interests in CFC's otherwise unencumbered assets (including, but not limited to, rights on servicing fees received by CFC). In connection with the execution of the forbearance agreement, CFC and Lehman amended the warehouse and residual facilities. These amendments provide for a level of increased liquidity during the forbearance period and provide Lehman with a security interest in cash flows received by CFC from its securitization facilities.
CFC's residual facility is collateralized by retained interests in securitizations. CFC is required to maintain collateral based on current estimated fair values in accordance with the terms of such facility. Due to the decrease in estimated fair value of its retained interests, CFC's collateral was deficient at December 31, 2002 (as calculated in accordance with the relevant transaction documents). CFC has executed a forbearance agreement with Lehman in which, among other things, Lehman has agreed not to require additional collateral with respect to the residual facility through June 1, 2003. Under the terms of the forbearance agreement, Lehman is retaining certain cash flows from CFC's retained interests pledged to this facility and applying these cash flows to the margin deficit. CFC is currently unable to provide sufficient additional collateral or to repay this credit facility. The value of the retained interests in the manufactured housing portfolio may also decrease based on CFC's inability to continue to effectuate its historical loss mitigation strategy with respect to the sale of repossessed manufactured housing units resulting in a reduction of collateral pledged on its residual facility. CFC had historically provided financing to retail buyers of repossessed units and funded that financing through the securitization of those refinancing loans. Without access to the securitization market, CFC's ability to provide financing to purchasers of repossessed manufactured housing units has ceased. On November 25, 2002, CFC announced it was suspending originations of loans for manufactured housing, which required CFC to sell repossessed manufactured housing units in the wholesale market at significantly reduced prices, thereby reducing cash flow available to the retained interests. Additionally, the uncertainty with respect to CFC's liquidity position and its ability to continue to provide servicing for the securitized portfolios has reduced and may further reduce the value of its retained interests pledged as collateral on the residual facility.
During 2002, CFC repurchased $46.9 million par value of its senior subordinated notes and medium term notes resulting in an extraordinary gain of $3.9 million (net of income taxes). In March 2002, CFC completed a tender offer pursuant to which it purchased $75.8 million par value of its senior subordinated notes due June 2002. The purchase price was equal to 100 percent of the principal amount of the notes plus accrued interest. The remaining principal amount outstanding of $34.8 million of the senior subordinated notes after the tender offer and other debt repurchases completed prior to the tender offer was retired at maturity on June 3, 2002.
CFC has historically reduced interest rate risk of its finance operations by funding most of the loans it makes through securitization transactions. The finance receivables transferred in these transactions and the asset-backed securities purchased by investors generally both have fixed rates. Principal payments on the assets are passed through to investors in the securities as received, thereby reducing interest rate exposure in these transactions that might otherwise arise from maturity mismatches between debt instruments and assets.
Prior to September 8, 1999, CFC retained interests in the finance receivables sold through investments in interest-only securities that are subordinated to the rights of other investors. Interest-only securities do not have a stated maturity or amortization period. The expected amount of the cash flow as well as the timing depends on the performance of the underlying collateral supporting each securitization. The actual cash flow of these instruments could vary substantially if performance is different from CFC's assumptions. CFC develops assumptions to value these investments by analyzing past portfolio performance, current loan characteristics, current and expected market conditions and the expected effect of its actions to mitigate adverse performance.
CFC uses computer models to simulate the cash flows (including any potential payments related to the guarantees of certain lower-rated securities issued by the securitization trusts) expected from its retained interests in securitization trusts (including interest-only securities) under various interest rate scenarios. These simulations help CFC to measure the potential gain or loss in fair value of these financial instruments, including the effects of changes in interest rates on prepayments. CFC estimates that its retained interests would decline in fair value by approximately $10 million if interest rates were to decrease by 10 percent from their December 31, 2002 levels. This compares to a decline in fair value of approximately $60 million based on amounts and rates at December 31, 2001. The calculations involved in CFC's computer simulations incorporate numerous assumptions, require significant estimates and assume an immediate change in interest rates without any management of the interest-only securities in reaction to such change. Consequently, potential changes in value of its retained interests indicated by the simulations will likely be different from the actual changes experienced under given interest rate scenarios, and the differences may be material. See the note to Conseco's consolidated financial statements entitled "Financial Information Regarding CFC" for a summary of the key economic assumptions used to determine the estimated fair value of all of its retained interests in securitizations and the sensitivity of the current fair value of cash flows to immediate 10 percent and 20 percent changes in those assumptions.
We estimate that CFC's finance receivables (including both "finance receivables" and "finance receivables-securitized") would decline in fair value by approximately $240 million if interest rates were to increase by 10 percent from their December 31, 2002
The accompanying consolidated financial statements have been prepared assuming that Conseco, Inc. will continue as a going concern, which contemplates continuity of Conseco's operations and realization of its assets and payments of its liabilities in the ordinary course of business. As more fully described in the notes to the consolidated financial statements, on December 17, 2002, Conseco, Inc. and several of its wholly-owned subsidiaries filed voluntary petitions for reorganization under Chapter 11 of the United States Bankruptcy Code. The uncertainties inherent in the bankruptcy process and Conseco's recurring losses from operations raise substantial doubt about Conseco's ability to continue as a going concern. Conseco, Inc. is currently operating its business as a Debtor-in-Possession under the jurisdiction of the Bankruptcy Court, and continuation of Conseco as a going concern is contingent upon, among other things, the confirmation of Conseco's Plan of Reorganization and Conseco's ability to generate sufficient cash from operations and obtain financing sources to meet its future obligations. If no reorganization plan is approved, it is possible that Conseco's assets may be liquidated. The consolidated financial statements do not include any adjustments to reflect the possible future effects on the recoverability and classification of assets or the amount and classification of liabilities that may result from the outcome of these uncertainties.
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002) CONSOLIDATED STATEMENT OF OPERATIONS (Continued) for the years ended December 31, 2002, 2001 and 2000 (Dollars in millions, except per share data)
Conseco, Inc. ("CNC") is the top tier holding company for our two operating businesses: insurance and finance. Our insurance business is operated through subsidiaries owned directly and indirectly by CIHC, Incorporated ("CIHC"), an intermediate holding company that is controlled by CNC. Our finance business has been historically operated through Conseco Finance Corp. ("CFC"), a wholly-owned subsidiary of CIHC, and its subsidiaries. Effective December 17, 2002 (the date CFC filed a petition for relief under the Bankruptcy Code as further described below), we began to account for our finance business as a discontinued operation. Our subsidiaries operate throughout the United States. We sometimes collectively refer to CNC, together with its consolidated subsidiaries, as "we," "Conseco" or the "Company."
CFC and Conseco Finance Servicing Corp. also filed petitions under the Bankruptcy Code with the Bankruptcy Court on the Petition Date. In addition, on February 3, 2003, the following subsidiaries of CFC filed petitions under the Bankruptcy Code with the Bankruptcy Court: Conseco Finance Corp. - Alabama, Conseco Finance Credit Corp., Conseco Finance Consumer Discount Company, Conseco Finance Canada Holding Company, Conseco Finance Canada Company, Conseco Finance Loan Company, Rice Park Properties Corporation, Landmark Manufactured Housing, Inc., Conseco Finance Net Interest Margin Finance Corp. I, Conseco Finance Net Interest Margin Finance Corp. II, Green Tree Finance Corp. - Two, Green Tree Floorplan Funding Corp., Conseco Agency of Nevada, Inc., Conseco Agency of New York, Inc., Conseco Agency, Inc., Conseco Agency of Alabama, Inc., Conseco Agency of Kentucky, Inc., Crum-Reed General Agency, Inc. The foregoing entities are referred to as the "Finance Company Debtors." The Finance Company Debtors filed a separate plan in connection with their bankruptcy proceedings. The bankruptcy proceedings of the Debtors and the Finance Company Debtors are referred to as the "Chapter 11 Cases".
As a result of these developments, on August 9, 2002, we announced that we would seek to fundamentally restructure the Company's capital, and announced that we had retained legal and financial advisors to assist us in these efforts. We ultimately decided to seek to reorganize under Chapter 11 of the Bankruptcy Code.
Under the Bankruptcy Code, actions to collect prepetition indebtedness, as well as most pending litigation, are stayed and other contractual obligations against the Debtors generally may not be enforced. Absent an order of the Bankruptcy Court, substantially all prepetition liabilities are subject to settlement under a plan of reorganization to be voted upon by creditors and other stakeholders and approved by the Bankruptcy Court. On March 18, 2003, the Bankruptcy Court approved the Debtors' Plan, as summarized in the Disclosure Statement, as containing adequate information, as such term is defined in Section 1125 of the Bankruptcy Code, to permit the solicitation of votes from creditors on whether or not to accept the Plan. The Debtors commenced solicitation on April 4, 2003. The voting record date has been set as March 19, 2003 and the deadline for returning completed ballots is May 14, 2003. A hearing to consider confirmation of the Plan is scheduled to begin on May 28, 2003. The Debtors will emerge from bankruptcy if and when
the Plan receives the requisite stakeholder approval and is approved by the Bankruptcy Court, and all conditions to the consummation of the Plan, have been satisfied or waived.
The United States Trustee has appointed a creditors committee representing the unsecured creditors of the Debtors and a TOPrS committee representing the claims of the holders of the Company-obligated mandatorily redeemable preferred securities of subsidiary trusts ("Trust Preferred Securities"). Before the Petition Date, the Company met with and provided materials to certain prepetition committees and entered into extensive arms-length negotiations with committees representing the holders of bank debt and publicly held notes of CNC. Shortly before the Petition Date, the Company reached a non-binding agreement in principle with respect to the general terms of a restructuring with certain prepetition committees. However, there can be no assurance that the appointed committees will support the Debtors' positions in the bankruptcy proceedings or approve the Plan. The TOPrS committee has raised certain objections to the Plan which are summarized in the Disclosure Statement. Disagreements between the Debtors and the appointed committees could protract the bankruptcy proceedings, could negatively impact the Company's ability to operate and the results of those operations during bankruptcy, and could delay the Debtors' emergence from bankruptcy.
The Debtors previously filed with the Bankruptcy Court schedules of assets and liabilities of the Debtors as reflected on our books and records. Subject to certain limited exceptions, the Bankruptcy Court established a bar date of February 21, 2003, for all prepetition claims against the Debtors. A bar date is the date by which claims against the Debtors must be filed if the claimants wish to receive any distribution in the bankruptcy proceedings. The Debtors notified all known or potential claimants subject to the February 21, 2003 bar date of their need to file a proof of claim with the Bankruptcy Court. Approximately 9,000 proofs of claim were filed on or before the February 21, 2003 bar date and the Company has begun objecting to claims and otherwise reconciling claims that differ from the Debtors' records. Any differences that cannot be resolved through negotiations between the Debtors and the claimant will be resolved by the Bankruptcy Court. Certain creditors have filed claims substantially in excess of amounts reflected in the Debtors' records. Accordingly, the ultimate number and amount of allowed claims is not presently known. Similarly, the ultimate distribution with respect to allowed claims is not presently known.
We have filed several motions in the Chapter 11 Cases pursuant to which the Bankruptcy Court has granted us authority or approval with respect to various items required by the Bankruptcy Code and/or necessary for our reorganization efforts. We have obtained orders providing for, among other things: (i) payment of prepetition and postpetition employee compensation and benefits; (ii) continuing a key-employee retention plan; (iii) obtaining debtor-in-possession financing for the Finance Company Debtors; and (iv) increasing the amount of the servicing fee paid to the Finance Company Debtors as servicers of various manufactured housing securitization trusts.
At this time, it is not possible to predict with certainty the effect of the Chapter 11 cases on our business or various creditors, or when we will emerge from Chapter 11. Our future results depend upon our confirming and successfully implementing, on a timely basis, a plan of reorganization.
In October 2002, we announced that we had engaged financial advisors to pursue various alternatives with respect to our finance business and that CNC's board of directors had approved a plan to sell or seek new investors for our finance business. On December 19, 2002, CFC entered into an Asset Purchase Agreement (the "Asset Purchase Agreement") with CFN Investment Holdings LLC ("CFN"), an affiliate of Fortress Investment Group LLC, J.C. Flowers & Co. LLC and Cerberus Capital Management, L.P., pursuant to which CFC would, subject to the satisfaction of certain conditions, sell all or substantially all of its assets (the "CFC Assets") in a sale pursuant to Section 363 of the Bankruptcy Code as part of CFC's Chapter 11 proceedings, subject to the right of CFN to exclude certain assets from its purchase. In accordance with Section 363 of the Bankruptcy Code and the terms of the Asset Purchase Agreement, CFC continued to seek alternative transactions that would provide greater value to CFC and its creditors than the
As a result of the formalization of the plans to sell the finance business and the filing of petitions under the Bankruptcy Code by CFC and certain of its subsidiaries, the finance business is being accounted for as a discontinued operation. See the note to the consolidated financial statements entitled "Financial Information Regarding CFC" for information regarding this discontinued operation.
As part of CFC's efforts to seek alternative transactions that would provide greater value to CFC, and in accordance with the bidding procedures order approved by the Bankruptcy Court, CFC conducted an auction for the sale of its businesses and assets. Potential bidders that submitted bids for the purchase of the CFC Assets that, by their own terms or aggregated with other bids, were for more than the purchase price payable under the Asset Purchase Agreement, plus the amount of the break-up fee of $30 million, plus $5 million in expense reimbursements, plus the profit sharing rights relating to the manufactured housing business, were allowed to participate in the auction. The auction, which commenced on February 28, 2003, promptly adjourned, and was continued to March 4, 2003, ultimately concluding the morning of March 5, 2003.
At the auction, CFC, with the assistance of its advisors, analyzed each of the bids presented and determined that CFN's bid of $970 million in cash, plus the assumption of certain liabilities, represented the highest and best bid. The terms of the sale included an option for CFC to sell the assets of Mill Creek Bank, Inc. ("Mill Creek Bank", formerly known as Conseco Bank, Inc.) to General Electric Capital Corporation ("GE") for approximately $310 million in cash, plus certain assumed liabilities, which option, if exercised, would provide CFN with a credit of $270 million to its $970 million bid.
On March 6, 2003, CFC received an offer from Berkadia Equity Holdings, L.L.C. ("Berkadia") that purported to be a bid in the recently concluded auction. Concurrently therewith, Berkadia filed an objection to the sale that the Bankruptcy Court heard, and summarily dismissed, on March 7, 2003. After further negotiations during the March 7-14, 2003 period, CFN and GE significantly increased the amount of cash to be paid for the CFC Assets. Ultimately, each of the major constituencies, including the CFC Committee, the Ad Hoc Securitization Holders' Committee, U.S. Bank as securitization trustee for the certificate holders of certain lower-rated securities that are senior in payment priority to the interest-only securities (the "B-2 securities"), and Federal National Mortgage Association, as a major B-2 securities certificate holder, agreed to support the sale of CFC Assets to CFN and GE. The total value to be received as part of the transactions with CFN and GE upon closing is expected to be approximately $1.3 billion, representing approximately $1.1 billion in cash and approximately $200 million in assumed liabilities, subject to certain purchase price adjustments. On March 14, 2003, the Bankruptcy Court entered orders approving the terms of the sale of the CFC Assets free and clear of all liens to each of CFN and GE. The closing of the sale of the CFC Assets is subject to various closing conditions, but is currently expected to occur in the second quarter of 2003.
Pursuant to SOP 90-7, professional fees associated with the Chapter 11 Cases are expensed as incurred and reported as reorganizational items. Interest expense is reported only to the extent that it will be paid during the Chapter 11 Cases or when it is probable that it will be an allowed claim. During 2002, the Company recognized a charge of $14.4 million associated with the Chapter 11 Cases for fees payable to professionals to assist with the filing of the Chapter 11 Cases.
As described in the note entitled "Discontinued Finance Business - Planned Sale of CFC", CFC is being accounted for as a discontinued operation.
During 2001, we stopped renewing a large portion of our major medical lines of business. These lines of business are referred to herein as the "major medical business in run-off". These actions had a significant effect on the Company's operating results during 2001 and 2000. These lines had pre-tax losses of $130.3 million in 2001 (including a write off of $77.4 million of the cost of policies produced and the cost of policies purchased related to this business that is not recoverable) and $51.3 million in 2000.
Statement of Financial Accounting Standards No. 141, "Business Combinations" ("SFAS 141") eliminated the pooling-of-interests method of accounting for business combinations initiated after July 1, 2001 and also changed the criteria used to recognize intangible assets apart from goodwill. We were required to apply these rules in accounting for the Exl acquisition. Pursuant to these rules, in the Exl acquisition Conseco acquired: (i) goodwill with a value of $38.6 million, which had an indeterminate life; and (ii) other intangible assets with a value of $7.5 million, which were expected to have an average life of approximately 5 years. Pursuant to SFAS 141 and Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142") described below under "Recently Issued Accounting Standards", this goodwill was not amortized but was subject to annual impairment tests, effective January 1, 2002.
The accompanying financial statements include the accounts of the Company and all of its wholly owned insurance subsidiaries. Our consolidated financial statements exclude the results of material transactions between us and our consolidated affiliates, or among our consolidated affiliates. We reclassified certain amounts in our 2001 and 2000 consolidated financial statements and notes to conform with the 2002 presentation. These reclassifications have no effect on net income (loss) or shareholders' equity (deficit).
For certain other special purpose entities related to our investment portfolio, we consider the requirements of Emerging Issues Task Force Issue Topic D-14, "Transactions Involving Special-Purpose Entities" ("EITF D-14") in determining whether to consolidate such entities. We consolidate such entities if: (i) an independent third party has not made a substantial capital investment in the entity; (ii) such independent third party does not control the activities of the entity; and (iii) the independent party does not retain substantial risks and rewards of the special purpose entity's assets. See the note to the consolidated financial statements entitled "Investments in Variable Interest Entities" for additional information.
Fixed maturities are securities that mature more than one year after issuance and include bonds, certain notes receivable and redeemable preferred stock. Fixed maturities that we may sell prior to maturity are classified as actively managed and are carried at estimated fair value, with any unrealized gain or loss, net of tax and related adjustments, recorded as a component of shareholders' equity (deficit). Fixed maturity securities that we intend to sell in the near term are classified as trading and included in other invested assets. We include any unrealized gain or loss on trading securities in net realized investment losses.
Finance receivables relate to the business of CFC and include manufactured housing, home equity, home improvement, retail credit and floor plan loans. CFC carries finance receivables at amortized cost, net of an allowance for credit losses.
CFC defers fees received and costs incurred when it originates finance receivables. CFC amortizes deferred fees, costs, discounts and premiums over the estimated lives of the receivables. CFC includes such deferred fees or costs in the amortized cost of finance receivables.
CFC generally stops accruing investment income on finance receivables after three consecutive months of contractual delinquency.
Finance receivables transferred to securitization trusts in transactions structured as securitized borrowings are classified as finance receivables - securitized. These receivables are held as collateral for the notes issued to investors in the securitization trusts. Finance receivables held by CFC that have not been securitized are classified as finance receivables.
The provision for credit losses charged to expense is related to the business of CFC. This expense is based upon an assessment of current and historical loss experience, loan portfolio trends, prevailing economic and business conditions, and other relevant factors. In management's opinion, the provision is sufficient to maintain the allowance for credit losses at a level that adequately provides for losses inherent in the portfolio.
CFC reduces the carrying value of finance receivables to net realizable value at the earlier of: (i) six months of contractual delinquency; or (ii) when it takes possession of the property securing the finance receivable.
In addition, during 2002, 2001 and 2000, we established additional provisions for losses related to our guarantees of bank loans and the related interest loans to approximately 155 current and former directors, officers and key employees for the purchase of Conseco common stock (see the note to the consolidated financial statements entitled "Other Disclosures" for additional information on this provision).
When we realize a gain or loss on investments backing our universal life or investment-type products, we adjust the amortization to reflect the change in estimated gross profits from the products due to the gain or loss realized and the effect of the event on future investment yields. We also adjust the cost of policies produced for the change in amortization that would have been recorded if actively managed fixed maturity securities had been sold at their stated aggregate fair value and the proceeds reinvested at current yields. We include the impact of this adjustment in accumulated other comprehensive income (loss) within shareholders' equity.
Goodwill is the excess of the amount we paid to acquire a company over the fair value of its net assets. We adopted SFAS 142 effective January 1, 2002, as further described under the caption "Cumulative Effect of Accounting Change and Goodwill Impairment". Prior to the adoption of SFAS 142, our analysis of acquired businesses indicated that the anticipated ongoing cash flows from the earnings of the purchased businesses extended beyond the maximum 40-year period allowed for goodwill amortization. Accordingly, for periods prior to 2002, we amortized goodwill on a straight-line basis generally over a 40-year period. Pursuant to GAAP in effect at December 31, 2001, we had determined that goodwill was fully recoverable from projected undiscounted net cash flows from earnings of the subsidiaries over the remaining amortization period. If we had determined that the undiscounted projected cash flows no longer supported the recoverability of goodwill over the remaining amortization period, we would have reduced its carrying value with a corresponding charge to expense or shortened the amortization period. Cash flows considered in such an analysis were those of the business acquired, if separately identifiable, or the product line that acquired the business, if such earnings were not separately identifiable.
In addition, we hold investments in a trust for the benefit of the purchasers of certain products of our asset management subsidiary; this amount is offset by a corresponding liability account, the value of which fluctuates in relation to changes in the values of these investments. Because we hold the residual interests in the cash flows from the trust and actively manage its investments, we are required to include the accounts of the trust in our consolidated financial statements. We record the fees earned for investment management and other services provided to the trust as fee revenue. See the caption "Brickyard Trust" in the note to the consolidated financial statements entitled "Investments in Variable Interest Entities" for further information on these investments.
From time-to-time, we assume insurance from other companies. Any costs associated with the assumption of insurance are amortized consistent with the method used to amortize the cost of policies produced described above. Reinsurance premiums assumed totaled $78.7 million, $146.0 million and $300.5 million in 2002, 2001 and 2000, respectively.
Our income tax expense includes deferred income taxes arising from temporary differences between the tax and financial reporting bases of assets and liabilities and net operating loss carryforwards. In assessing the realization of deferred income tax assets, we consider whether it is more likely than not that the deferred income tax assets will be realized. The ultimate realization of deferred income tax assets depends upon generating future taxable income during the periods in which temporary differences become deductible and net operating loss carryforwards expire. As of December 31, 2002, a valuation reserve of $1.7 billion has been provided as the realization of the net deferred tax asset is uncertain.
Under the Bankruptcy Code, actions by creditors to collect indebtedness we owe prior to the Petition Date are stayed and certain other prepetition contractual obligations may not be enforced against the Debtors. We have received approval from the Court to pay certain prepetition liabilities including employee salaries and wages, benefits and other employee obligations. All other prepetition liabilities have been classified as "liabilities subject to compromise" in the December 31, 2002 consolidated balance sheet.
The following table summarizes condensed consolidating financial information segregating such information between the Debtors and non-Debtor subsidiaries.
Condensed Consolidating Balance Sheet as of December 31, 2002 (Dollars in millions)
Subject to certain limited exceptions, the Bankruptcy Court established a bar date of February 21, 2003, for all prepetition claims against the Debtors. A bar date is the date by which claims against the Debtors must be filed if the claimants wish to receive any distribution in the Chapter 11 Cases. The Debtors have notified all known or potential claimants subject to the February 21, 2003, bar date of their need to file a proof of claim with the Bankruptcy Court.
When we prepare financial statements in conformity with GAAP, we are required to make estimates and assumptions that significantly affect various reported amounts of 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 in calculating values for the cost of policies produced, the cost of policies purchased, retained interest in securitization trusts (including interest-only securities and B-2 securities), certain investments, servicing rights, assets and liabilities related to income taxes, goodwill, liabilities for insurance and asset accumulation products, the guarantee liability related to interests in securitizations, liabilities related to litigation, guaranty fund assessment accruals, liabilities related to guarantees of securitized debt issued in conjunction with certain sales of finance receivables and liabilities related to guarantees of bank loans and the related interest loans to certain current and former directors, officers and key employees, gain on sale of finance receivables and allowance for credit losses on finance receivables. If our future experience differs from these estimates and assumptions, our financial statements would be materially affected.
Our equity-indexed annuity products provide a guaranteed base rate of return and a higher potential return linked to the performance of the Standard & Poor's 500 Index ("S&P 500 Index") based on a percentage (the participation rate) over an annual period. At the beginning of each policy year, a new index period begins. The Company is able to change the participation rate at the beginning of each index period, subject to contractual minimums. We buy S&P 500 Call Options in an effort to hedge potential increases to policyholder benefits resulting from increases in the S&P 500 Index to which the product's return is linked. We include the cost of the S&P 500 Call Options in the pricing of these products. Policyholder account balances for these annuities fluctuate in relation to changes in the values of these options. We reflect changes in the estimated market value of these options in net investment income. Option costs that are attributable to benefits provided were $97.5 million, $119.0 million and $123.9 million during 2002, 2001 and 2000, respectively. These costs are reflected in the change in market value of the S&P 500 Call Options included in investment income. Net investment income (loss) related to equity-indexed products before this expense was $(3.0) million, $4.8 million and $12.9 million in 2002, 2001 and 2000, respectively. Such amounts were substantially offset by the corresponding charge to insurance policy benefits. The estimated fair value of the S&P 500 Call Options was $32.8 million and $49.8 million at December 31, 2002 and 2001, respectively. We classify such instruments as other invested assets. The Company accounts for the options attributed to the policyholder for the estimated life of the annuity contract as embedded derivatives as defined by Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities", as amended by Statement of Financial Accounting Standards No. 137, "Deferral of the Effective Date of FASB Statement No. 133" and Statement of Financial Accounting Standards No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities" (collectively referred to as "SFAS 138"). The Company records the change in the fair values of the embedded derivatives in current earnings as a component of policyholder benefits. The fair value of these derivatives, which are classified as "liabilities for interest-sensitive products" was $274.0 million and $491.2 million at December 31, 2002 and 2001, respectively.
If the counterparties for the derivatives we hold fail to meet their obligations, Conseco may have to recognize a loss. Conseco limits its exposure to such a loss by diversifying among several counterparties believed to be strong and creditworthy. At December 31, 2002, all of the counterparties were rated "A" or higher by Standard & Poor's Corporation ("S&P").
earnings. If CFC determines, upon subsequent measurement of the fair value of these servicing rights, that the fair value equals or exceeds the amortized cost, any previously recorded valuation allowance would be deemed unnecessary and restored to earnings.
Retained interests in securitization trusts. These assets relate to the business of CFC. Management of CFC discounts future expected cash flows over the expected life of the receivables sold using current estimates of future prepayment, default, loss severity and interest rates. They consider any potential payments related to the guarantees of certain lower-rated securities issued by the securitization trusts in the projected cash flows used to determine the value of CFC's retained interests in securitization trusts.
Finance receivables. These assets relate to the business of CFC. The estimated fair value of finance receivables, including those that have been securitized, is determined based on general market transactions which establish values for similar loans.
The FASB issued SFAS 142, in June 2001. Under the new rule, intangible assets with an indefinite life are no longer amortized in periods subsequent to December 31, 2001, but are subject to annual impairment tests (or more frequently under certain circumstances), effective January 1, 2002. The Company has determined that all of its goodwill has an indefinite life and is therefore subject to the new rules.
Prior to the adoption of SFAS 142, we determined whether goodwill was recoverable from projected undiscounted net cash flows for the earnings of our subsidiaries over the remaining amortization period. If we determined that undiscounted projected cash flows were not sufficient to recover the goodwill balance, we would reduce its carrying value with a corresponding charge to expense or shorten the amortization period. Cash flows considered in such an analysis were those of the business acquired, if separately identifiable, or the product line that acquired the business, if such earnings were not separately identifiable.
Changes in the carrying amount of goodwill for the years ended December 31, 2002 and 2001, are as follows:
During the third quarter of 2000, the Emerging Issues Task Force of the Financial Accounting Standards Board issued EITF 99-20, "Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets" ("EITF 99-20").
Under the prior accounting rule, declines in the value of our interest-only securities and other retained beneficial interests in securitized financial assets were recognized in the statement of operations when the present value of estimated cash flows discounted at a risk-free rate using current assumptions was less than the carrying value of the interest-only security.
We adopted the new accounting rule on July 1, 2000. The cumulative effect of the accounting change for periods prior to July 1, 2000 was a charge to the statement of operations of $55.3 million (net of an income tax benefit of $29.9 million), or $.17 per diluted share. The cumulative effect of the accounting change includes: (i) $45.5 million (net of an income tax benefit of $24.7 million) related to interest-only securities held by CFC; and (ii) $9.8 million (net of an income tax benefit of $5.2 million) related to other retained beneficial interests in securitized financial assets held by our insurance segment.
In January 2003, the FASB issued Interpretation No. 46, "Consolidation of Variable Interest Entities" ("FIN 46"), which requires expanded disclosures for and, in some cases, consolidation of significant investments in variable interest entities ("VIE"). A VIE is an entity in which the equity investors do not have the characteristics of a controlling financial interest, or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. Under FIN 46, a company is required to consolidate a VIE if it is the primary beneficiary of the VIE. FIN 46 defines primary beneficiary as the party which will absorb a majority of the VIE's expected losses or receive a majority of the VIE's expected residual returns, or both. FIN 46 is effective immediately for VIEs created after January 31, 2003. For VIEs acquired before February 1, 2003, the additional disclosure requirements are effective for financial statements issued after January 31, 2003 and the consolidation requirements must be applied not later than the fiscal year or interim period beginning after June 15, 2003.
The Company has investments in various types of VIEs, some of which require additional disclosure under FIN 46, and several of which that will require consolidation under FIN 46. As further discussed in the note to the consolidated financial statements entitled "Investments in Variable Interest Entities", certain of our investments in VIEs are already consolidated in our financial statements. We have identified one additional VIE investment in which we are the primary beneficiary and, accordingly, will require consolidation in our financial statements beginning with our September 30, 2003 financial statements. The additional liabilities, which will be recognized as a result of consolidating the VIE, do not represent claims on the general assets of the Company. Likewise, the additional assets, which will be recognized upon consolidation, are collateral for the additional recognized liabilities. Consequently, the adoption of the consolidation requirements of FIN 46 is not expected to have a material impact on our financial condition or results of operations. The note entitled "Investments in Variable Interest Entities" includes the expanded disclosures required by FIN 46.
SFAS 138 requires all derivative instruments to be recorded on the balance sheet at estimated fair value. Changes in the fair value of derivative instruments are to be recorded each period either in current earnings or other comprehensive income (loss), depending on whether a derivative is designated as part of a hedge transaction and, if it is, on the type of hedge transaction. We adopted SFAS 138 on January 1, 2001. The initial adoption of the new standard did not have a material impact on the Company's financial position or results of operations and there was no cumulative effect of an accounting change related to its adoption.
At December 31, 2001, the amortized cost and estimated fair value of actively managed fixed maturities and equity securities were as follows:
Accumulated other comprehensive income (loss) is primarily comprised of unrealized gains (losses) on actively managed fixed maturity investments. Such amounts, included in shareholders' equity (deficit) as of December 31, 2002 and 2001, were as follows:
At December 31, 2002, the amortized cost of the Company's fixed maturity securities in below-investment grade securities was $1,435.1 million, or 7.6 percent of the Company's fixed maturity portfolio. The estimated fair value of the below-investment grade portfolio was $1,261.2 million, or 88 percent of the amortized cost. The value of these securities varies based on the economic terms of the securities, structural considerations and the credit worthiness of the issuer of the securities. Recently a number of large highly leveraged issuers have experienced significant financial difficulties, which resulted in our recognition of other-than-temporary impairments. These impairments have had a material adverse effect on us.
The following table sets forth the amortized cost and estimated fair value of actively managed fixed maturities at December 31, 2002, 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. Most of the mortgage-backed securities shown below provide for periodic payments throughout their lives.
During 2002, we sold $11.3 billion of fixed maturity investments which resulted in gross investment losses (before income taxes) of $251.8 million. Securities sold at a loss are sold for a number of reasons including: (i) changes in the investment environment; (ii) expectation that the market value could deteriorate further; (iii) desire to reduce our exposure to an issuer or an industry; (iv) changes in credit quality; and (v) our analysis indicating there is a high probability that the security is other-than-temporarily impaired.
During 2002, we recorded writedowns totaling $73.7 million related to fixed maturity investments issued by a merchant energy company rated B3/B-. The issuer's operating results and liquidity have deteriorated due to lower energy prices, diminished energy trading profits and higher working capital demands. Although the issuer has successfully executed certain cash raising activities and has remained in compliance with the terms of all of its debt securities, its earnings have significantly declined and its debt service requirements are significant. We concluded the decline in fair value was other than temporary.
During 2002, we recorded writedowns totaling $67.8 million on certain lower-rated securities issued by the non-consolidated securitization trusts which hold loans to purchase manufactured housing originated and managed by CFC. These securities were acquired by our insurance subsidiaries prior to our acquisition of CFC. Due to the performance of the underlying portfolios, the payments on lower-priority securities are dependent on the guarantees of CFC. Given the current financial condition of CFC, there can be no assurance it will be able to honor its commitments with respect to such guarantees. Accordingly, we wrote these investments down to estimated fair value.
During 2002, we recorded writedowns totaling $9.4 million of fixed maturity investments issued by a global energy services company. The issuer is suffering from reduced profitability due to declining energy prices in key markets plus the effect of above market purchase contracts. Due to very high financial leverage related to several acquisitions at high prices and diminished cash flows, we believe that the decline in fair value is other than temporary.
During 2002, in addition to the specific securities discussed above, we recorded $105.3 million of writedowns related to various other investments. In accordance with GAAP, we are required to recognize an impairment charge when we no longer have an intent to hold an investment with unrealized loss for a period of time sufficient to allow for any anticipated recovery. In early 2003, we sold certain securities at a loss in conjunction with decisions made in 2003 to restructure our portfolio by reducing our exposure to certain credits. We recorded $32.0 million of investment writedowns in 2002 related to such sales. No other writedowns of a single issuer exceeded $7.0 million.
Our periodic assessment of whether unrealized losses are "other than temporary" requires significant judgment. Factors considered include: (i) the extent to which market value is less than the cost basis; (ii) the length of time that the market value has been less than cost; (iii) whether the unrealized loss is event driven, credit-driven or a result of changes in market interest rates; (iv) the near-term prospects for improvement in the issuer and/or its industry; (v) whether the investment is investment-grade and our security analyst's view of the investment's rating and whether the investment has been downgraded since its purchase; (vi) whether the issuer is current on all payments in accordance with the contractual terms of the investment and is expected to meet all of its obligations under the terms of the investment; (vii) our ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery; and (viii) the underlying asset and enterprise values of the issuer.
At December 31, 2002, we held fixed maturity investments issued by a telecommunications company with ratings of Ba3/B- and Caa1/C with an amortized cost basis of $54.1 million and an estimated fair value of $32.6 million. The issuer reduced total debt in the fourth quarter of 2002 by $4.6 billion due to the closing of a sales transaction and a debt exchange offer. The issuer also expects to receive regulatory approval to close a $4.3 billion transaction in mid-2003, the proceeds of which will be used to further reduce debt. We believe that the issuer has sufficient liquidity and the underlying value of the issuer's customer base provides sufficient value to cover the existing debt. Therefore, we concluded that the unrealized loss at December 31, 2002 is temporary.
At December 31, 2002, we held fixed maturity investments issued by a commercial property and casualty insurance company rated Ba2/BB+ with an amortized cost basis of $32.1 million and an estimated fair value of $24.5 million. We believe this issuer currently has sufficient liquidity to cover its debt service through 2005. They believe the underwriting cycle will improve before then (consistent with prior cycles), allowing the issuer to continue to service its debt beyond 2005. In addition, this issuer recently completed the public issuance of equity securities, which further improves its liquidity and demonstrates the ability to access the capital market, if needed, to service its future debt obligations. Therefore, we concluded that the unrealized loss at December 31, 2002 is temporary.
At December 31, 2002, we held fixed maturity investments issued by a regional retail chain rated B2/B+ with an amortized cost basis of $28.8 million, a par amount of $24.2 million and an estimated fair value of $20.1 million. We have observed that this issuer has improving fundamentals including its liquidity position, leverage and operating performance. This fixed maturity has a long duration and was purchased at a price in excess of par as an investment grade credit. The market value of this security has increased significantly during 2002 (from 70 percent of par at December 31, 2001 to 83 percent of par at December 31, 2002). We believe that
we will recover full value from this investment and we intend to hold the security to maturity. Therefore, we concluded that the unrealized loss at December 31, 2002 is temporary.
At December 31, 2002 we held fixed maturity investments in a reinsurance company rated Ba2/BB+ with an amortized cost of $23.1 million and an estimated fair value of $16.0 million. The reinsurance on the books of the issuer is high quality, with counter parties rated AA or better. The issuer recently received a capital infusion and is seeing strong price increases across most product lines. The issuer appears to have sufficient cash flow to retire existing debt. We concluded that the unrealized loss at December 31, 2002 is temporary.
At December 31, 2002, Conseco holds $292.9 million of investments related to a 50 story office building in New York City known as the General Motors Building. Such investments are primarily held in our fixed maturity investment portfolio. In January 2002, Conseco exercised its right to purchase the interest of the other investor in the building.
Pursuant to GAAP, Conseco's future earnings on these investments are limited to amounts which are based on the actual earnings related to the operation of the building (including adjustments to reflect Conseco's actual cost basis). These earnings were not material in 2002 and are not expected to be material in 2003; accordingly, our income from these investments will be less than the stated return on the investment of 12.7 percent.
At December 31, 2002, fixed maturity investments included $6.4 billion of mortgage-backed securities (or 33 percent of all fixed maturity securities). The yield characteristics of mortgage-backed securities differ from those of traditional fixed-income securities. Interest and principal payments for mortgage-backed securities occur more frequently, often monthly. Mortgage-backed securities are subject to risks associated with variable prepayments. Prepayment rates are influenced by a number of factors that cannot be predicted with certainty, including: the relative sensitivity of the underlying mortgages backing the assets to changes in interest rates; a variety of economic, geographic and other factors; and the repayment priority of the securities in the overall securitization structures.
In general, prepayments on the underlying mortgage loans and the securities backed by these loans increase when prevailing interest rates decline significantly relative to the interest rates on such loans. The yields on mortgage-backed securities purchased at a discount to par will increase when the underlying mortgages prepay faster than expected. The yields on mortgage-backed securities purchased at a premium will decrease when they prepay faster than expected. When interest rates decline, the proceeds from the prepayment of mortgage-backed securities are likely to be reinvested at lower rates than we were earning on the prepaid securities. When interest rates increase, prepayments on mortgage-backed securities decrease as fewer underlying mortgages are refinanced. When this occurs, the average maturity and duration of the mortgage-backed securities increase, which decreases the yield on mortgage-backed securities purchased at a discount, because the discount is realized as income at a slower rate, and increases the yield on those purchased at a premium as a result of a decrease in the annual amortization of the premium.
The amortized cost and estimated fair value of mortgage-backed securities at December 31, 2002, summarized by type of security, were as follows:
At December 31, 2002, the mortgage loan balance was primarily comprised of commercial loans. Approximately 9 percent, 8 percent, 7 percent, 6 percent, 6 percent and 6 percent of the mortgage loan balance were on properties located in New York, Massachusetts, Florida, California, Ohio and Pennsylvania, respectively. No other state comprised greater than 5 percent of the mortgage loan balance. Less than one percent of the mortgage loan balance was noncurrent at December 31, 2002. Our allowance for loss on mortgage loans was $3.5 million and $3.8 million at December 31, 2002 and 2001, respectively.
Conseco had two investments in excess of 10 percent of the absolute dollar amount of shareholders' deficit at December 31, 2002, (other than investments issued or guaranteed by the United States government or a United States government agency) which are summarized below:
This note contains information regarding notes payable that were direct corporate obligations of CNC as of December 31, 2002 and 2001. As a result of the filing of the Chapter 11 Cases previously described, no payments have been made by CNC on these prepetition notes payable:
CNC has not made any interest or principal payments on any of its direct corporate obligations since its August 9, 2002 announcement that it intends to effectuate a fundamental restructuring of the Company's capital structure. As a result of its failure to make such payments and the filing of the Chapter 11 Cases, CNC has defaulted on its debt obligations, $481.3 million of principal amount of the guaranteed D&O loans and approximately $1.9 billion of trust preferred securities through cross-default provisions contained in the governing instruments. CNC is also not in compliance with certain covenants under its bank credit agreement and the guarantees of the D&O loans. During the reorganization proceedings the Debtors are not subject to the restrictions contained in the bank credit agreement and the guarantees of the D&O loans.
CNC has a $1.5 billion credit facility (the "Senior Credit Facility") with Bank of America, N.A., as administrative agent, and various other lending institutions. The Senior Credit Facility was scheduled to mature on December 31, 2003. Approximately $38 million of accrued and unpaid interest was added to the outstanding principal amount of the Senior Credit Facility pursuant to a waiver dated September 8, 2002.
In 1993, CNC issued $200 million of 8.125% senior notes due February 15, 2003 (the "93 Notes"). In 1994, CCP Insurance, Inc. ("CCP") issued $200 million of 10.5% senior notes due December 15, 2004 (the "94 Notes"). CNC acquired CCP by merger on
August 31, 1995 and assumed CCP's obligations under the 94 Notes in connection with the merger.
Between 1998 and 2001, CNC issued the following series of senior notes: (i) $450,000,000 of 8.5% senior notes due October 15, 2002 (the "8.5% Original Notes"); (ii) $250,000,000 of 6.4% senior notes due February 10, 2003 (the "6.4% Original Notes"); (iii) $800,000,000 of 8.75% senior notes due February 9, 2004 (the "8.75% Original Notes"); (iv) $250,000,000 of 6.8% senior notes due June 15, 2005 (the "6.8% Original Notes"); (v) $550,000,000 of 9.0% senior notes due October 15, 2006 (the "9.0% Original Notes"); and (vi) $400,000,000 of 10.75% senior notes due June 15, 2008 (the "10.75% Original Notes").
In connection with the exchange offer CNC issued: (i) $991,000 of 8.5% senior notes due October 15, 2003, in exchange for an equal amount of 8.5% Original Notes due October 15, 2002 (the "8.5% Exchange Notes"); (ii) $14,936,000 of 6.4% senior notes due February 10, 2004 in exchange for an equal amount of 6.4% Original Notes due February 10, 2003 (the "6.4% Exchange Notes"); (iii) $364,294,000 of 8.75% senior notes due August 9, 2006 in exchange for an equal amount of 8.75% Original Notes due February 9, 2004 (the "8.75% Exchange Notes"); (iv) $150,783,000 of 6.8% senior notes due June 15, 2007 in exchange for an equal amount of 6.8% Original Notes due June 15, 2005 (the "6.8% Exchange Notes"); (v) $399,200,000 of 9.0% senior notes due April 15, 2008 in exchange for an equal amount of 9.0% Original Notes due October 15, 2006 (the "9.0% Exchange Notes"); and (vi) $362,433,000 of 10.75% senior notes due June 15, 2009 in exchange for an equal amount of 10.75% Original Notes due June 15, 2008 (the "10.75% Exchange Notes").
Effective March 20, 2002, CNC reached agreement with the participating banks in its bank credit facility to modify certain terms and conditions within the $1.5 billion Senior Credit Facility. The most significant changes in the amended facility include (i) a change in financial covenant requirements; (ii) a change in the distribution of proceeds on asset sales; (iii) a reduction in the minimum liquidity requirement at the holding company necessary to pay trust preferred dividends; and (iv) a provision permitting the Company to exchange up to $2.54 billion aggregate principal amount of newly issued notes guaranteed by CIHC. As noted above, the new notes are structurally senior to the existing notes, but subordinated to the CIHC guarantee of the Senior Credit Facility. Absent the default described above, the amended facility would have been due on December 31, 2003, and could have been extended to March
31, 2005, subject to the satisfaction of a number of conditions.
During 2002, we repurchased: (i) $76.4 million par value of the 8.5% Original Notes (resulting in an extraordinary gain of $1.7 million); and (ii) $1.0 million of the 6.4% Original Notes (resulting in an extraordinary gain of $.2 million).
During 2001, we repurchased: (i) $64.6 million par value of the 7.6% senior notes due June 2001 (resulting in an extraordinary gain of $.3 million, net of income taxes of $.2 million); and (ii) $147.7 million par value of the 8.5% Original Notes (resulting in an
extraordinary gain of $15.8 million, net of income taxes of $8.5 million).
During 2000, we repurchased: (i) $18.5 million par value of the 7.875 percent notes due 2000 for $16.7 million; and (ii) $12 million par value of the 8.75% Original Notes for $8.7 million. We recognized an extraordinary gain of $3.2 million (net of income taxes of $1.7 million) related to these repurchases. In addition, during 2000, the Company repurchased $250 million of notes payable due 2003. We recognized an extraordinary loss of $4.9 million (net of an income tax benefit of $2.6 million) related to this repurchase.
The Company rents office space, equipment and computer software under noncancellable operating leases. Rental expense was $41.5 million in 2002, $45.3 million in 2001 and $42.4 million in 2000. Future required minimum rental payments as of December 31, 2002, were as follows (dollars in millions):
One of our insurance subsidiaries has a noncontributory, unfunded deferred compensation plan for qualifying members of its career agency force. Benefits are based on years of service and career earnings. The liability recognized in the consolidated balance sheet for the agents' deferred compensation plan was $54.2 million and $48.4 million at December 31, 2002 and 2001, respectively. Included as an adjustment to accumulated other comprehensive income (loss) is a $9.1 million adjustment representing the additional minimum liability associated with this plan. Substantially all of this liability represents vested benefits. Costs incurred on this plan, primarily representing interest on unfunded benefit costs, were $5.1 million, $4.9 million and $4.4 million during 2002, 2001 and 2000, respectively.
We used the following weighted average assumptions to calculate benefit obligations for our 2002 and 2001 valuations: discount rate of approximately 6.5 percent and 7.0 percent, respectively; an expected return on plan assets of approximately 4.6 percent and 4.6 percent, respectively. Beginning in 2000, as a result of plan amendments, no assumption for compensation increases was required. For measurement purposes, we assumed an 11.5 percent annual rate of increase in the per capita cost of covered health care benefits for 2003, decreasing gradually to 5 percent in 2015 and remaining level thereafter.
contributions were made in cash. In September 2002, the plans were amended to make future employer matching contributions discretionary. Subsequently, the Company determined that no additional employer matching contributions will be made until the Plan of Reorganization has been confirmed.
We and our subsidiaries are involved on an ongoing basis in lawsuits (including purported class actions) relating to our operations, including with respect to sales practices, and we and current and former officers and directors are defendants in pending class action lawsuits asserting claims under the securities laws and derivative lawsuits. The ultimate outcome of these lawsuits cannot be predicted with certainty.
CFC was served with various related lawsuits filed in the United States District Court for the District of Minnesota. These lawsuits were generally filed as purported class actions on behalf of persons or entities who purchased common stock or options to purchase common stock of CFC during alleged class periods that generally run from July 1995 to January 1998. One action (Florida State Board of Admin. v. Green Tree Financial Corp., et. al, Case No. 98-1162) was brought not on behalf of a class, but by the Florida State Board of Administration, which invests and reinvests retirement funds for the benefit of state employees. In addition to CFC, certain former officers and directors of CFC are named as defendants in one or more of the lawsuits. CFC and other defendants obtained an order consolidating the lawsuits seeking class action status into two actions, one of which pertains to a purported class of common stockholders (In re Green Tree Financial Corp. Stock Litig., Case No. 97-2666) and the other of which pertains to a purported class of stock option traders (In re Green Tree Financial Corp. Options Litig., Case No. 97-2679). Plaintiffs in the lawsuits assert claims under Sections 10(b) (and Rule 10b-5 promulgated thereunder) and 20(a) of the Securities Exchange Act of 1934. In each case, plaintiffs allege that CFC and the other defendants violated federal securities laws by, among other things, making false and misleading statements about the current state and future prospects of CFC (particularly with respect to prepayment assumptions and performance of certain loan portfolios of CFC), which allegedly rendered CFC's financial statements false and misleading. On August 24, 1999, the United States District Court for the District of Minnesota issued an order dismissing with prejudice all claims alleged in the lawsuits. The plaintiffs subsequently appealed the decision to the U.S. Court of Appeals for the 8th Circuit. A three judge panel issued an opinion on October 25, 2001, reversing the United States District Court's dismissal order and remanding the actions to the United States District Court. The parties to these lawsuits have entered into a stipulation of settlement, which is subject only to review and approval by the court.
CFC is a defendant in two arbitration proceedings in South Carolina (Lackey v. Green Tree Financial Corporation, n/k/a Conseco Finance Corp. and Bazzle v. Green Tree Financial Corporation, n/k/a Conseco Finance Corp.) where the arbitrator, over CFC's objection, allowed the plaintiffs to pursue purported class action claims in arbitration. The two purported arbitration classes consist of South Carolina residents who obtained real estate secured credit from CFC's Manufactured Housing Division (Lackey) and Home Improvement Division (Bazzle) in the early and mid 1990s, and did not receive a South Carolina specific disclosure form relating to selection of attorneys and insurance agents in connection with the credit transactions. The arbitrator, in separate awards issued on July 24, 2000, awarded a total of $26.8 million in penalties and attorneys' fees. The awards were confirmed as judgments in both Lackey and Bazzle. These cases were consolidated into one case, and CFC appealed them to the South Carolina Supreme Court. Oral argument was heard on March 21, 2002. On August 26, 2002 the South Carolina Supreme Court affirmed the arbitration judgments, and CFC filed a petition for writ of certiorari with the U.S. Supreme Court on October 23, 2002. CFC's petition was granted in January 2003, and the U.S. Supreme Court will hear oral argument on April 22, 2003. CFC has posted appellate bonds, including $23 million of cash, for these cases. CFC intends to challenge the awards vigorously and believes that the arbitrator erred by, among other things, conducting class action arbitrations without the authority to do so. The ultimate outcome of this proceeding
Eleven of the cases in the United States District Court for the Southern District of Indiana were filed as purported class actions on behalf of persons or entities that purchased preferred securities issued by various Conseco Financing Trusts, including Conseco Financing Trust V, Conseco Financing Trust VI, and Conseco Financing Trust VII. Each of these complaints named as defendants CNC, the relevant trust (with two exceptions), two former officers/directors of CNC, and underwriters for the particular issuance (with one exception). One complaint also named an officer and all of CNC's directors at the time of issuance of the preferred securities by Conseco Financing Trust VII. In each case, plaintiffs asserted claims under Section 11 and Section 15 of the Securities Act of 1933, and eight complaints also asserted claims under Section 12(a)(2) of that Act. Two complaints also asserted claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and one complaint also asserted a claim under Section 10(b) of that Act. In each case, plaintiffs alleged that the defendants violated the federal securities laws by, among other things, making false and misleading statements in Prospectuses and/or Registration Statements related to the issuance of preferred securities by the Trust involved regarding the current state and future prospects of CFC (particularly with respect to performance of certain loan portfolios of CFC) which allegedly rendered the disclosure documents false and misleading.
Since we announced our intention to restructure our capital on August 9, 2002, a total of eight purported securities fraud class action lawsuits have been filed in the United States District Court for the Southern District of Indiana. The complaints name CNC as a defendant, along with certain current and former officers of CNC. These lawsuits were filed on behalf of persons or entities who purchased CNC's common stock on various dates between October 24, 2001 and August 9, 2002. In each case Plaintiffs allege claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and allege material omissions and dissemination of materially misleading statements regarding, among other things, the liquidity of CNC and alleged problems in CFC's manufactured housing division, allegedly resulting in the artificial inflation of CNC's stock price. Plaintiffs in one of these lawsuits have filed an uncontested consolidation and lead plaintiff motion, which, if granted, would result in the consolidation of these eight cases into one. On March 13, 2003, all of 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., et al.," File No. 02-CV-1332 DFH-TAB. CNC believes these lawsuits are without merit and intends to defend them vigorously. The ultimate outcome of these lawsuits cannot be predicted with certainty. CNC has filed an adversary proceeding to extend the automatic stay provided for by the Bankruptcy Code to this litigation as it pertains to current and former officers and directors of CNC.
In October 2002, Roderick Russell, on behalf of himself and a class of persons similarly situated, and on behalf of the ConsecoSave Plan filed an action in the United States District Court for the Southern District of Indiana against CNC, Conseco Services LLC and certain current and former officers of CNC (Roderick Russell, et al. v Conseco, Inc., et al., Case No. 1:02-CV-1639 LJM). The purported class action consists of all individuals whose 401(k) accounts held common stock of CNC at any time from April 28, 1999 through the present. The complaint alleges, among other things, breaches of fiduciary duties under ERISA by continuing to permit employees to invest in CNC's common stock without full disclosure of the Company's true financial condition. CNC believes
the lawsuit is without merit and intends to defend it vigorously. The ultimate outcome of the lawsuit cannot be predicted with certainty. CNC has filed an adversary proceeding to extend the automatic stay provided for by the Bankruptcy Code to this litigation as it pertains to current and former officers and directors of CNC.
On June 24, 2002, the heirs of a former officer, Lawrence Inlow, commenced an action against CNC, Conseco Services, LLC, and two former officers in the Boone Circuit Court (Inlow et al. v. Conseco, Inc., et al., Cause No. 06C01-0206-CT-244). The heirs assert that unvested options to purchase 756,248 shares of CNC common stock should have been vested at Mr. Inlow's death. The heirs further claim that if such options had been vested, they would have been exercised, and that the resulting shares of common stock would have been sold for a gain of approximately $30 million based upon a stock price of $58.125 per share, the highest stock price during the alleged exercise period of the options. CNC believes the heirs' claims are without merit and will defend the action vigorously. The maximum exposure to the Company for this lawsuit is estimated to be $33 million. The ultimate outcome cannot be predicted with certainty.
CIHC is the guarantor of an aggregate principal amount of $125 million with respect to CFC's residual and warehouse lines of credit with Lehman Brothers, Inc. and its affiliates ("Lehman"). Such facilities are collectively referred to as the "CFC Lehman Facilities". In addition, CIHC is the guarantor of: (i) the term portion of the Secured Super-Priority Debtor in Possession Credit Agreement, dated as of December 19, 2002, among CFC, various subsidiaries of CFC, CIHC and FPS DIP, LLC (the "FPS DIP"); and (ii) a cash management facility with U.S. Bank National Association (the "U.S. Bank Facility"). The term portion of the FPS DIP provides for funding in a maximum aggregate amount of $60 million and is fully drawn. The guarantee obligations of CIHC under the FPS DIP and the U.S. Bank Facility are limited to an aggregate of $125 million. The December 31, 2002 balances outstanding on the CFC Lehman Facilities and CFC's debtor-in-possession facility are included in the caption "Liabilities of discontinued operations" in the liability section of the consolidated balance sheet. Also, see the note to the consolidated financial statement entitled "Financial Information Regarding CFC." Assuming the sale of CFC's assets is completed and CFC receives the proceeds from the sale of such assets as contemplated by the CFN and GE transactions, Conseco believes the proceeds will be sufficient to satisfy CFC's obligations pursuant to the Lehman and CFC's debtor-in-possession facility and all claims senior to such facilities. CFC's unsecured creditors have indicated that they intend to challenge Lehman's security position and otherwise attempt to prevent Lehman from being paid in full out of the proceeds from the sale of CFC's assets. If Lehman were not paid in full from the proceeds, Lehman would likely pursue its claim on the CIHC guarantee which, if successful, could impact the ability of the Debtors to complete their proposed Plan.
and the common securities purchased by Conseco from the subsidiary trusts are eliminated in the consolidated financial statements.
So long as no event of default under the debentures has occurred and is continuing, Conseco has the right to defer interest payments on the subordinated debentures for up to 20 consecutive quarters, but not beyond the maturity date of the subordinated debentures. If Conseco defers interest payments on the subordinated debentures, the trust will also defer distributions on the Trust Preferred Securities. During the deferral period, distributions continue to accumulate on the par amount plus any unpaid distributions at the stated distribution rate. Since the third quarter of 2002, Conseco has not paid certain interest and principal payments on its notes payable which resulted in defaults with respect to the Trust Preferred Securities through cross-default provisions.
The changes in unrealized appreciation (depreciation) included in comprehensive income are net of reclassification adjustments for after-tax net gains (losses) from the sale of investments included in net income (loss) of approximately $545 million, $240 million and $220 million for the years ended December 31, 2002, 2001 and 2000, respectively.
In conjunction with the various modifications to borrowing arrangements (including the debt exchange offer completed in April 2002), we incurred costs of $17.7 million in 2002 which are not permitted to be deferred pursuant to GAAP.
Other items include expenses incurred: (i) as a result of the termination of our chief financial officer; (ii) in conjunction with the transfer of certain customer service and backroom operations to our India subsidiary; (iii) for severance benefits; and (iv) for other items which are not individually significant. The Company sold its India subsidiary in the fourth quarter of 2002 and has significantly reduced the customer service and backroom operations conducted there.
In conjunction with our restructuring activities, we closed certain offices, which resulted in the abandonment of certain leasehold improvements. Further, certain antiques and artwork, formerly displayed in the Company's executive offices were sold. We recognized losses of $7.9 million related to these actions in 2001.
On April 28, 2000, Conseco and Rollin M. Dick, the Company's former Chief Financial Officer, entered into an agreement pursuant to which Mr. Dick's employment was terminated. As contemplated by the terms of his employment agreement, Conseco agreed to pay Mr. Dick his salary of $250,000 per year through December 31, 2001, and he also received the bonus of $187,500 payable under his employment agreement for the first quarter of 2000. Conseco also agreed to continue to treat Mr. Dick as though he were an employee/participant for purposes of the guaranteed bank loans and the loans for interest on such loans pursuant to the stock purchase program. Conseco also entered into a consulting agreement with Mr. Dick pursuant to which Mr. Dick agreed to provide consulting services up to an average of 25 hours per month for a period of three years. Mr. Dick also agreed not to compete with Conseco during the term of the consulting agreement. On April 27, 2000, Mr. Dick was granted options to purchase an aggregate of 600,000 shares of Conseco common stock at a price of $5.75 per share. The options expire on April 26, 2003.
On June 28, 2000, the Company hired Gary C. Wendt as its Chief Executive Officer. Pursuant to the terms of his employment agreement, Mr. Wendt received a payment of $45 million (prior to required withholdings for taxes) and was granted options to purchase an aggregate of 10,000,000 shares of Conseco common stock at a price of $5.875 per share (the average of the high and low sales price on the New York Stock Exchange on the date on which the substantial terms of Mr. Wendt's employment were agreed to). The options vest over five years and expire on June 28, 2010. The Company also issued 3,200,000 shares of restricted stock to Mr. Wendt. The restrictions on the stock lapse if Mr. Wendt remains employed by Conseco through June 30, 2002, or upon a "change in control" of the Company. The value of the restricted shares ($18.8 million) was recognized as an expense to the Company over the two year period ending June 30, 2002. In 2002, Mr. Wendt's restricted stock agreement was amended to extend the date that the restrictions on the stock would lapse. Prior to the date that the restrictions would lapse, Mr. Wendt resigned his position of Chief Executive Officer (although he remains Chairman of the Board of Conseco) and the shares were canceled. Mr. Wendt is also being provided certain supplemental retirement, insurance and other benefits under the terms of his employment agreement.
In February 2001, the Company issued 11.4 million shares of Conseco common stock pursuant to stock purchase contracts related to the FELINE PRIDES. This transaction is discussed in further detail in the note to the consolidated financial statements entitled "Other Disclosures".
During 1999, we sold 3.6 million shares of our common stock to an unaffiliated party (the "Buyer"). Simultaneous with the issuance of the common stock, we entered into a forward transaction with the Buyer to be settled at $29.0625 per share in a method of our choosing (i.e., cash settlement, transfer of net shares to or from the Buyer, or transfer of net cash to or from the Buyer). We settled the contract in March 2000 by repurchasing 3.6 million shares held by the Buyer.
A summary of the Company's stock option activity and related information for the years ended December 31, 2002, 2001 and 2000, is presented below (shares in thousands):
At December 31, 2002, a total of 115 million shares of common stock were reserved for issuance under stock options, stock bonus and deferred compensation plans, Series F Preferred Stock, warrants to buy 700,000 shares of Conseco common stock for $19.71 per share at anytime through September 29, 2006 and warrants to buy 5,250,000 shares of Conseco common stock for $5.75 at any time through June 2005.
At December 31, 2002, a total of 50,000 shares of restricted common shares issued pursuant to employment agreements were outstanding. The restrictions on such shares will expire in September 2004.
There were no dilutive common stock equivalents during 2002, 2001 and 2000 because of the net loss realized by the Company.
The following summarizes the equivalent common shares for securities that were not included in the computation of diluted earnings per share during 2002, 2001 and 2000 because doing so would have been antidilutive in the periods presented:
The cost of policies produced and the cost of policies purchased are amortized in relation to the estimated gross profits to be earned
The statutory net loss of our life insurance subsidiaries was $466.0 million, $137.8 million and $70.8 million in 2002, 2001 and 2000, respectively. Included in such net loss are net realized capital losses, net of income taxes, of $514.7 million, $188.0 million and $200.8 million in 2002, 2001 and 2000, respectively. In addition, the insurance subsidiaries incur fees and interest to Conseco or its non-life subsidiaries; such amounts totaled $194.8 million, $279.2 million and $264.4 million in 2002, 2001 and 2000, respectively.
The ability of our insurance subsidiaries to pay dividends is subject to state insurance department regulations. These regulations generally permit dividends to be paid from earned surplus of the insurance company for any 12-month period in amounts equal to the greater of (or in a few states, the lesser of): (i) net gain from operations or net income for the prior year; or (ii) 10 percent of capital and surplus as of the end of the preceding year. Any dividends in excess of these levels require the approval of the director or commissioner of the applicable state insurance department. During 2002, our insurance subsidiaries paid dividends to Conseco totaling $240.0 million.
to and during Conseco's restructuring; and (vi) to continue to permit the Texas Insurance Commissioner to examine its books, papers, accounts, records and affairs. Conseco Life Insurance Company of Texas is the parent of all of the Company's insurance subsidiaries, except for Bankers National Life Insurance Company. The consent orders do not prohibit the payment of fees in the ordinary course of business pursuant to existing administrative, investment management and marketing agreements with our non-insurance subsidiaries.
The 2002 statutory annual statements filed with the state insurance regulators of each of our insurance subsidiaries reflected total adjusted capital in excess of the levels subjecting the subsidiary to any regulatory action. However, our ACLRBC ratios have declined significantly over the last year and some of our subsidiaries are near the level which would require them to submit a comprehensive plan aimed at improving their capital position.
Our internal actuaries must annually render opinions concerning the adequacy of our insurance reserves. Our actuaries
rendered unqualified opinions at December 31, 2002. Such opinions reference the Chapter 11 Cases and recent downgrades of our insurance company ratings as being outside the scope of the actuarial opinion, meaning that the actuaries did not believe it was appropriate to calculate what impact, if any, such events would have on the life insurance reserves. Regulators have raised the question as to whether or not such references result in the actuarial opinions becoming qualified opinions. We continue to believe the actuarial opinions are unqualified opinions. If the actuarial opinions were qualified opinions, more stringent rules would apply for calculating ACLRBC which we believe would result in the ACLRBC for several of our insurance subsidiaries falling below the trend test level.
Insurance and fee-based segment. Our insurance and fee-based segment provides supplemental health, annuity and life insurance products to a broad spectrum of customers through multiple distribution channels, each focused on a specific market segment. These products are primarily marketed through career agents, professional independent producers and direct marketing. Fee-based activities include services performed for other companies, including investment management and insurance product marketing.
As previously described, CFC filed a petition for relief under the Bankruptcy Code in the United States Bankruptcy Court on December 17, 2002. On March 14, 2003, the Bankruptcy Court entered orders approving the terms of the sale of substantially all of CFC's assets. The closing of the sale of the CFC assets is subject to various closing conditions, but is currently expected to occur in the second quarter of 2003. As a result of the formalization of the plan to sell the finance business and the filing of petitions for relief under the Bankruptcy Code by the Finance Company Debtors, the finance business is being accounted for as a discontinued business in our consolidated financial statements. The consolidated statement of operations reflects the operations of the discontinued finance business in the caption "Discontinued operations" for all periods. Our December 31, 2002 consolidated balance sheet includes the total assets of the finance segment in the caption "Assets of discontinued operations" and the total liabilities of the finance segment in the caption "Liabilities of discontinued operations". We currently believe that it is unlikely that the Company will receive any net proceeds from the ultimate disposition of CFC beyond the extinguishment of CFC's liabilities and the release of related Company guarantees on CFC's debt. Accordingly, we wrote off our entire remaining investment in CFC of $64.5 million on December 31, 2002.
The following summarizes selected balance sheet information of CFC as of December 31, 2002 and 2001:
CFC CONSOLIDATED STATEMENT OF OPERATIONS INFORMATION (a) for the years ended December 31, 2002, 2001 and 2000 (Dollars in millions)
Refer to the note to the consolidated financial statements entitled "Summary of Significant Accounting Policies" for disclosures related to the accounting policies of CFC. Disclosures related to the significant accounts of CFC are summarized below:
Under the Bankruptcy Code, actions by creditors to collect indebtedness CFC owes prior to the Petition Date are stayed and certain other prepetition contractual obligations may not be enforced against the Finance Company Debtors. CFC has received approval from the Bankruptcy Court to pay certain prepetition liabilities including employee salaries and wages, benefits, and other employee obligations. All other prepetition liabilities have been classified as "liabilities subject to compromise" in CFC's December 31, 2002 consolidated balance sheet.
CFC classifies the finance receivables transferred to the securitization trusts and held as collateral for the notes issued to investors as "finance receivables-securitized". The average interest rate on these receivables was approximately 12.4 percent and 12.5 percent at December 31, 2002 and 2001, respectively. We classify the notes issued to investors in the securitization trusts as "notes payable related to securitized finance receivables structured as collateralized borrowings".
Conseco's leveraged condition and liquidity difficulties eliminated CFC's ability to access the securitization markets. This has required CFC to pursue whole loan sales to maintain availability under its warehouse facilities for new originations. Accordingly, CFC has classified its unsecuritized finance receivables as held for sale which requires the assets to be carried at the lower of cost or market. At December 31, 2002, CFC has an allowance of $47.1 million for certain finance receivables with current estimated market values below cost.
The following table summarizes CFC's other finance receivables by business line and categorized as either a part of CFC's primary lines or a part of other lines (discontinued in previous periods):
The securitizations structured prior to September 8, 1999, met the applicable criteria to be accounted for as sales. At the time the loans were securitized and sold, CFC recognized a gain and recorded its retained interest represented by the interest-only security and servicing rights. The interest-only security represents the right to receive, over the life of the pool of receivables: (i) the excess of the principal and interest received on the receivables transferred to the special purpose entity over the principal and interest paid to the holders of other interests in the securitization; and (ii) contractual servicing fees. In some of those securitizations, CFC also retained B-2 securities. CFC's net retained interests in securitization trusts at December 31, 2002 and 2001 are summarized below:
During 2002, CFC's ability to access the securitization markets was eliminated. The securitization markets are CFC's main source of funding for loans made to purchasers of repossessed manufactured homes. CFC believes that its loss severity rates were
As described in the note to the consolidated financial statements entitled "Summary of Significant Accounting Policies", the Company adopted the requirements of EITF 99-20 effective July 1, 2000. Under EITF 99-20, declines in the value of CFC's retained interests in securitization trusts are recognized when: (i) the fair value of the retained beneficial interests are less than their carrying value; and (ii) the timing and/or amount of cash expected to be received from the retained beneficial interests have changed adversely from the previous valuation which determined the carrying value of the retained beneficial interests. When both occur, the retained beneficial interests are written down to fair value as an other-than-temporary impairment.
CFC recognized impairment charges of $386.9 million and $515.7 million in 2001 and 2000, respectively, for the interest-only securities that were not performing as well as expected based on its previous valuation estimates.
During the third quarter and again in the fourth quarter of 2002, CFC changed the assumptions used to estimate the value of its retained interests to: (i) project higher severity losses related to the defaults, reflecting CFC's inability to finance the sale of repossessed manufactured homes resulting in reliance on the wholesale disposition channel for repossessed manufactured homes; and (ii) project higher rates of default in the future, based on its current expectations. As a result of these assumptions, CFC projects that payments related to guarantees issued in conjunction with the sales of certain finance receivables will exceed the gross cash flows from the retained interests by approximately $225 million in 2003, $100 million in 2004, $60 million in 2005 and $10 million in 2006. These projected payments are considered in the projected cash flows CFC used to value its retained interests. Without additional liquidity in the near future, CFC will be unable to make these projected guarantee payments when such payments are required to be made. CFC projects the gross cash flows from the retained interests will exceed the payments related to guarantees issued in conjunction with the sales of certain finance receivables by approximately $175 million in all years thereafter.
Effective September 30, 2001, CFC transferred substantially all of its interest-only securities into a securitization trust. The transaction provided a means to finance a portion of the value of its interest-only securities by selling some of the cash flows to Lehman. The transfer was accounted for as a sale in accordance with SFAS 140. However, no gain or loss was recognized because the aggregate fair value of the interest retained by CFC and the cash received from the sale were equal to the carrying value of the interest-only securities prior to their transfer to the trust. The trust is a qualifying special purpose entity and is not consolidated pursuant to SFAS 140. CFC received a trust security representing an interest in the trust equal to 85 percent of the estimated future
cash flows of the interest-only securities held in the trust. Lehman purchased the remaining 15 percent interest. The value of the interest purchased by Lehman was $20.4 million at December 31, 2002. CFC continues to be the servicer of the finance receivables underlying the interest-only securities transferred to the trust. Lehman has the ability to accelerate the principal payments related to their interest after a stated period. Until such time, Lehman is required to maintain a 15 percent interest in the estimated future cash flows of the trust. By aggregating the interest-only securities into one structure, the impairment tests for these securities are conducted on a single set of cash flows representing CFC's 85 percent interest in the trust. Accordingly, adverse changes in cash flows from one interest-only security are offset by positive changes in another. The new structure does not avoid an impairment charge if sufficient positive cash flows in the aggregate are not available (such as was the case at December 31, 2002).
On December 2, 2002, Conseco Finance elected not to make approximately $4.7 million in guarantee payments of which $.6 million was owed to outside third parties. Upon filing for protection under Chapter 11 of the United States Bankruptcy Code on December 17, 2002, Conseco Finance has not made any additional guarantee payments. The continued payment of guarantee payments depends on the restructuring results of Conseco Finance Corp. as approved by the Bankruptcy Court. There can be no guarantee that the Court will uphold the continuation of the required guarantee fees (refer to the caption entitled "Subsequent events related to CFC" for further discussion regarding the guarantee payments).
At December 31, 2002, key economic assumptions used to determine the estimated fair value of CFC's retained interests in securitizations and the sensitivity of the current fair value of residual cash flows to immediate 10 percent and 20 percent changes in those assumptions are as follows:
(a) The valuation of retained interests in securitization trusts is affected not only by the projected level of prepayments of principal and net credit losses, but also by the projected timing of such prepayments and net credit losses. Should such timing differ materially from CFC's projections, it could have a material effect on the valuation of its retained interests. Additionally, such valuation is determined by discounting cash flows over the entire expected life of the receivables sold.
The income tax benefit differed from that computed at the applicable federal statutory rate (35 percent) for the following reasons:
The above deferred income tax assets are scheduled assuming a continuation of business. The actual realization of CFC's deferred items may be materially different as the result of the conclusion of bankruptcy proceedings and the disposition of certain businesses.
Notes payable (excluding notes payable related to securitized finance receivables structured as collateralized borrowings) of CFC at December 31, 2002 and 2001, were as follows (interest rates as of December 31, 2002):
The Residual Facility is collateralized by retained interests in securitizations. CFC is required to maintain collateral based on current estimated fair values in accordance with the terms of such facility. Due to the decrease in the estimated fair value of its retained interests, CFC's collateral was deficient at December 31, 2002 (as calculated in accordance with the relevant transaction documents, which provide that Lehman calculates the value of CFC's collateral within its sole discretion). Pursuant to the forbearance agreement entered into with Lehman on December 20, 2002, Lehman agreed not to accelerate the repayment of the Residual Facility based on the collateral deficiency through June 1, 2003. Under the terms of this forbearance agreement, Lehman retains the cash flows from CFC's retained interests pledged under this facility and applies those cash flows to the margin deficit. As mentioned above, this forbearance agreement is subject to a number of conditions that may cause it to terminate prior to June 1, 2003. The filing by CNC, CIHC and CFC of a Chapter 11 petition triggered additional defaults under the CFC Facilities.
From time to time, CFC has failed to comply with certain covenants regarding the maximum permissible variance of the budgets provided to the FPS DIP lenders in connection with the FPS DIP. In each instance, CFC has obtained appropriate waivers. The occurrence of events of default under the FPS DIP, may cause events of default under the Lehman December 20 Agreements (as defined below).
During 2002, CFC repurchased $46.9 million par value of its senior subordinated notes and medium term notes resulting in an extraordinary gain of $3.9 million (net of income taxes). In March 2002, CFC completed a tender offer pursuant to which it purchased $75.8 million par value of its senior subordinated notes due June 2002. The purchase price was equal to 100 percent of the principal amount of the notes plus accrued interest. The remaining principal amount outstanding of $58.5 million (including $23.7 million held by Conseco) of the senior subordinated notes was retired at maturity on June 3, 2002.
Notes payable related to securitized finance receivables structured as collateralized borrowings were $13,069.7 million and $14,484.5 million at December 31, 2002 and 2001, respectively. The principal and interest on these notes are paid using the cash flows from the underlying finance receivables which serve as collateral for the notes. Accordingly, the timing of the principal payments on these notes is dependent on the payments received on the underlying finance receivables which back the notes. In some instances, CFC is required to advance principal and interest payments even though the payments on the underlying finance receivables which back the notes have not yet been received. The average interest rate on these notes was 6.7 percent and 6.4 percent at December 31, 2002 and 2001, respectively. The notes payable balance also includes amounts related to financing transactions securitized by: (i) capitalized expenses related to the refurbishment of repossessed assets; and (ii) principal and interest advances. The outstanding liability on these facilities at December 31, 2002 was $85 million.
As partial consideration for a financing transaction, Conseco Finance issued a warrant to Lehman which permits the holder to purchase 5 percent of Conseco Finance at a nominal price. The holder of the warrant or Conseco Finance may cause the warrant and any stock issued upon its exercise to be purchased for cash at an appraised value in May 2003. Additionally, until May 2003, the holder has the right (subject to certain terms and conditions) to convert the warrant into convertible preferred stock of Conseco. Since the warrant permits cash settlement at fair value at the option of the holder of the warrant, it has been included in other liabilities and is measured at fair value, with changes in its value reported in earnings. The estimated fair value of the warrant at December 31, 2002 was nil based on current valuations of Conseco Finance. Accordingly, CFC recorded a $38.1 million reduction in the value of the warrant during 2002.
During the fourth quarter of 2000, CFC sold transportation loans with a carrying value of $566.0 million (after the market adjustment described above) in whole loan sale transactions. CFC recognized an additional loss of $30.7 million on the sale. During 2000, CFC recognized a special charge and reduced goodwill by $20.3 million, representing the difference between: (i) the carrying value of the net assets of the vendor services financing business; and (ii) the anticipated proceeds from the sale of such business, which was completed in the first quarter of 2001.
During the third quarter of 2000, CFC sold asset-based loans with a carrying value of $152.2 million in whole loan sale transactions. CFC recognized a loss of $53.0 million on these sales.
CFC's restructuring activities included the closing of several branch offices and streamlining its businesses. These activities included a reduction in the work force of approximately 1,700 employees. CFC incurred a charge of $6.9 million related to severance costs paid to terminated employees in 2000. CFC also incurred lease termination and direct closing costs of $12.3 million associated with the branch offices closed in conjunction with the restructuring activities. In addition, fixed assets and leasehold improvements of $10.3 million were abandoned when the branch offices were closed.
CFC recorded a $35.8 million charge in 2000 to write off the carrying value of capitalized computer software costs for projects that have been abandoned in conjunction with its restructuring. These costs are primarily associated with: (i) computer processing systems under development that would require significant additional expenditures to complete and that were inconsistent with its business plan; and (ii) computer systems related to the lines of business discontinued by CFC and therefore were no longer required.
CFC also paid Lehman $5.3 million in advisory fees related to the business and debt restructuring.
During 2000, CFC recognized $5.0 million of other costs related to its restructuring.
In October 2002, Conseco Life Insurance Company of Texas (a wholly-owned subsidiary of the Company) completed the sale of CVIC to Inviva, Inc. ("Inviva"), a holding company that owns The American Life Insurance Company of New York. CVIC marketed tax qualified annuities and certain employee benefit-related insurance products through professional independent agents. Pursuant to SFAS 144, CVIC is accounted for as a discontinued operation. Our consolidated statement of operations reflects the operations of CVIC in the caption "Discontinued operations" for all periods. The consideration received from Inviva at closing (subject to adjustment based upon the adjusted statutory balance sheet of CVIC at September 30, 2002) totaled $83.7 million, of which $35.0 million was in the form of Series D Preferred Shares (the "Preferred Shares") issued by Inviva and the remainder was in cash. Under the terms of the purchase agreement, if the adjusted statutory book value of CVIC at September 30, 2002, is less than a specified value, the purchase price shall be reduced by the amount that such specified value exceeds the adjusted statutory book value. In addition, Conseco Life Insurance Company of Texas received a dividend of approximately $75 million from CVIC immediately prior to the closing. We recognized a loss on the sale of $93.1 million. There was no income tax benefit recognized on the transaction.
The Preferred Shares accrue dividends (in-kind) at an annual rate of 19 percent. On or after December 31, 2002, our insurance subsidiary that holds these shares may elect to exchange the Preferred Shares for non-voting common stock of JNF Holding Company, Inc., a wholly-owned subsidiary of Inviva, ("JNF") that now owns all of the stock of CVIC. If not previously exchanged, on October 15, 2003, the Preferred Shares will be mandatorily exchanged into the common stock of JNF and our insurance subsidiary that holds the Preferred Shares will be entitled to receive a $1.67 million cash fee upon the occurrence of such exchange. After the exchange has occurred, such JNF common stock may be repurchased by JNF at any time at 115 percent of the stated value of the Preferred Shares plus accrued and unpaid dividends thereon immediately prior to the exchange.
In connection with the sale of CVIC, we agreed to provide, for a fee, various administrative and technical services in order to allow CVIC to continue to operate and to facilitate the transition of CVIC to Inviva. Such services are being provided pursuant to an Administrative and Transition Services Agreement (the "Transition Agreement"). The term of the Transition Agreement is nine months subject to extension or early termination. As part of the CVIC sale, Conseco agreed that it would not engage in the variable annuity or variable insurance business for a period of three years after the closing.
In 1998, the Company invested in an investment trust known as the Brickyard Loan Trust ("Brickyard"). Brickyard is a collateralized debt obligation trust which participates in an underlying pool of commercial loans. The initial capital structure of Brickyard consisted of $575 million of senior financing provided by unrelated third party investors and $127 million of notes and certificates owned by the Company and others. As a result of our 85 percent ownership interest in the subordinated certificates, we are the primary beneficiary of Brickyard. In accordance with ARB 51 "Consolidated Financial Statements", Brickyard is consolidated in our financial statements, because of: (i) our investment management subsidiary, Conseco Capital Management, Inc. was the investment manager; and (ii) our significant ownership of the subordinated certificates. Included in "Assets held in separate accounts and investment trust" were $410.2 million and $481.1 million at December 31, 2002 and 2001, respectively, of assets which serve as collateral for Brickyard's obligations. These amounts are offset by a corresponding liability account, the value of which fluctuates in relation to changes in the values of the investments. At December 31, 2002 the net carrying value of our investment was $66.7 million, which is also the maximum loss we could recognize if the loans held in the trust experiences significant defaults. The senior note obligations have no recourse to the general credit of the Company.
The three investment trusts are VIEs under FIN 46 because the trusts' equity represents significantly less than 10 percent of total capital and the subordinated junior notes were intended to absorb expected losses and receive virtually all expected residual returns. Based on our 100 percent ownership of the subordinated junior notes, we are the primary beneficiary of the investment trusts. All three trusts are consolidated in our financial statements at December 31, 2002. The carrying value of the total invested assets in the three trusts were approximately $382 million at December 31, 2002, which also represents Conseco's maximum exposure to loss as a result of our ownership interests in the trusts. The trusts have no obligations or debt to outside parties.
In 1998, Conseco invested in a partnership which was formed to acquire and own the 50 story office building in New York City known as the General Motors Building (the "GM Building"). The partnership acquired the GM Building for approximately $878 million. The initial capital structure of the partnership consisted of: (i) a $700 million senior mortgage; (ii) $200 million of subordinated debt with a stated fixed return of 12.7 percent payable-in-kind, and the opportunity to earn an additional residual return; and (iii) $30 million of partnership equity, owned 50 percent by Conseco and 50 percent by an affiliate of Donald Trump. A Trump affiliate also served as general manager of the acquired building. We own 100 percent of the subordinated debt. The partnership is a VIE under FIN 46 because the $30 million of equity represents significantly less than 10 percent of total partnership capital and the subordinated debt was intended to absorb virtually all expected losses and receive a significant portion of expected residual returns. Based on our 100 percent ownership of the subordinated debt, we are the primary beneficiary of the GM Building partnership. Accordingly, the partnership will be consolidated in our financial statements beginning in the third quarter 2003. We do not expect the consolidation of the GM Building partnership to have a material impact on our financial condition or results of operations. The real estate asset, which will be added to our balance sheet as a result of consolidation, collateralizes the partnership's senior mortgage obligation. The existing senior mortgage obligation, which would also be added to our balance sheet as a result of consolidation, is not guaranteed by Conseco and does not have recourse against Conseco's general credit. The existing senior mortgage obligation matures