The Company cautions readers regarding certain forward-looking statements contained in the following discussion and elsewhere in this report and in any other statements made by, or on behalf of, the Company, whether or not in future filings with the Securities and Exchange Commission ("SEC"). Forward-looking statements are statements not based on historical information. They relate to future operations, strategies, financial results or other developments. In particular, statements using verbs such as "expect," "anticipate," "believe" or similar words generally involve forward-looking statements. Forward-looking statements include statements that represent the Company's beliefs concerning future or projected levels of sales of the Company's products, investment spreads or yields, or the earnings or profitability of the Company's activities.
Forward-looking statements are based upon estimates and assumptions that are subject to significant business, economic and competitive uncertainties, many of which are beyond the Company's control and are subject to change. These uncertainties can affect actual results and could cause actual results to differ materially from those expressed in any forward-looking statements made by, or on behalf of, the Company. Whether or not actual results differ materially from forward-looking statements may depend on numerous foreseeable and unforeseeable events or developments, some of which may be national in scope, such as general economic conditions and interest rates. Some of these events may be related to the insurance industry generally, such as pricing competition, regulatory developments and industry consolidation. Others may relate to Conseco specifically, such as credit, volatility and other risks associated with the Company's investment portfolio, and other factors. Investors are also directed to consider other risks and uncertainties discussed in documents filed with the SEC. Conseco disclaims any obligation to update forward-looking information.
Conseco's 1996 operating earnings were $267.7 million, or $1.89 per fully diluted share, up 104 percent and 50 percent, respectively, over 1995. Operating earnings increased as a result of the LPG Merger, the ALH Stock Purchase, the full-year effect of the CCP Merger, the effect of increased ownership of BLH as a result of purchases of BLH common stock during 1995 and 1996, and profit improvements in each of the Company's segments. Operating earnings for 1996 were not affected by the ATC Merger, the THI Merger or the BLH Merger, all of which were recorded as of December 31, 1996. The percentage increase in operating earnings was greater than the increase in operating earnings per fully diluted share primarily because of the additional common shares or equivalents outstanding in 1996 resulting from: (i) the LPG Merger; and (ii) the Company's January 1996 offering of PRIDES, which are mandatorily convertible into shares of Conseco common stock.
(a) Revenues exclude net investment gains (losses); benefits and expenses exclude amortization related to net investment gains (losses).
General: This segment includes SPDAs, FPDAs, SPIAs and variable annuities sold through both career agents and professional independent producers. For periods prior to September 30, 1994, this segment consists solely of the annuity operations of: (i) BLH, whose products are primarily marketed to seniors; and (ii) various Conseco subsidiaries whose products are not currently being actively marketed. The segment's operations were significantly affected by: (i) the acquisition of ALH by Partnership II on September 30, 1994; (ii) the consolidation of the CCP subsidiaries effective January 1, 1995, as a result of the CCP Merger; and (iii) the LPG Merger,
Premiums collected by this segment in 1996 were $1,542.4 million, down 7.1 percent from 1995. Increased competition from products such as mutual funds, traditional bank investments, variable annuities and other investment and retirement funding alternatives was a significant factor in the decrease. Premiums collected in 1995 were $1,659.5 million, up 190 percent over 1994, due to the acquisition transactions described above under "General."
Net investment income on general account invested assets (excluding income on separate account assets related to variable annuities) increased 4.7 percent in 1996, to $891.2 million, and increased 286 percent in 1995, to $851.2 million. The yield earned on average invested assets declined to 7.9 percent in 1996 from 8.4 percent in 1995. Cash flows received during 1995 and 1996 (including cash flows from the sales of investments) were invested in lower yielding securities due to a general decline in interest rates.
Amortization related to operations increased 19 percent in 1996 and 484 percent in 1995. Such increases reflect a larger balance subject to amortization as a result of the acquisition transactions described above under "General."
Net investment gains (losses), net of related costs and amortization often fluctuate from period to period. In 1995, this segment's level of sales of securities (principally fixed maturities) in a recently acquired subsidiary increased to accomplish planned changes in that subsidiary's fixed maturity investment portfolio in order to reduce its duration and exposure to more volatile CMO investments. Net investment gains (net of related costs and amortization) were $72.0 million in 1995.
(a) Revenues exclude net investment gains; benefits and expenses exclude amortization related to net investment gains.
Premiums collected by this segment in 1996 were $825.1 million, up 9.2 percent over 1995. Premiums collected in 1995 were $755.8 million, up 4.4 percent over 1994.
Medicare supplement policies have accounted for more than 75 percent of this segment's collected premiums in each of the last three years. Collected premiums on Medicare supplement policies increased 5.7 percent in 1996, to $630.9 million, and increased .9 percent in 1995, to $597.0 million. Such increases primarily reflect a larger base of premiums due to rate increases. The number of new Medicare supplement policies sold in 1996, 1995 and 1994 were 43,800, 62,800 and 89,700, respectively, and annualized new business premiums were $43.2 million, $56.3 million and $76.3 million, respectively. New policy sales have been affected by steps taken to improve profitability by increasing premium rates and changing the commission structure and underwriting criteria for these policies and by increased competition from alternative providers, including HMOs.
Insurance policy income is comprised of premiums earned on the segment's policies, and has increased over the last three years consistent with the explanations provided above for premiums collected.
Amortization related to operations includes amortization of: (i) the cost of policies produced; (ii) the cost of policies purchased; and (iii) goodwill related to this segment's business. The amount of amortization was primarily affected by: (i) the increase in the amount of business in force on which amortization is recognized; and (ii) the effects of Conseco's purchases of additional shares of BLH common stock in September 1993 and in 1995 and 1996.
The cost of policies produced represents the cost of producing new business. This cost varies with, and is primarily related to, the production of new business. Costs deferred may represent amounts paid in the period new business is written (such as underwriting costs and first year commissions) or in periods after the business is written (such as commissions paid in subsequent years in excess of ultimate commissions paid).
Conseco's purchase of BLH is described in the notes to the consolidated financial statements. The cost of policies purchased represents the portion of Conseco's cost to acquire BLH that is attributable to the right to receive cash flows from insurance contracts in force at the acquisition dates. Some costs incurred after the purchases on policies issued prior to such dates, which otherwise would have been deferred had it not been for the purchases (because they vary with and are primarily related to the acquired interests in the policies), were expensed. Such costs consist primarily of certain commissions paid in excess of ultimate commissions that have been expensed as operating expense. Such amounts, however, were considered in determining the amount and amortization of cost of policies purchased. The amortization of goodwill increased in 1996 and 1995 as a result of additional goodwill related to Conseco's purchases of additional shares of BLH common stock. Such increased amortization partially offset the effect of the aforementioned expenses on the amortization of cost of policies purchased.
Other operating costs and expenses were affected by costs incurred subsequent to Conseco's purchases of additional shares of BLH common stock (on September 30, 1993 and in 1995 and 1996) on policies issued prior to such dates, which otherwise would have been deferred had it not been for the purchases as described above under amortization related to operations.
Net investment gains, net of related costs and amortization often fluctuate from period to period. Net investment gains affect the timing of the amortization of costs of policies purchased and the cost of policies produced. As a result of net investment gains from the sales of fixed maturity investments, amortization of cost of policies purchased and cost of policies produced increased by $.6 million in 1996, $2.3 million in 1995 and $.2 million in 1994.
General: This segment includes traditional life and universal life products sold through both career agents and professional independent producers. The segment's operations were significantly affected by: (i) the acquisition of ALH by Partnership II on September 30, 1994; (ii) the consolidation of the CCP subsidiaries effective January 1, 1995, as a result of the CCP Merger; and (iii) the LPG Merger, effective July 1, 1996. The profitability of this segment largely depends on the investment spread earned for universal life and other investment products, persistency of inforce business, claim experience and expense control.
Universal life product collected premiums increased 169 percent to $271.5 million, in 1996, and increased 82 percent to $101.1 million, in 1995. Such premiums collected in 1996 include $177.0 million collected by LPG after the LPG Merger. Such premiums collected in 1995 include $30.7 million collected by CCP after its consolidation and $19.8 million collected by ALH. As a result of the LPG Merger, Conseco expects that universal life product premiums will account for an increasing percentage of this segment's collected premiums.
Traditional life product collected premiums increased 4.1 percent to $182.2 million, in 1996, and increased 37 percent to $175.1 million, in 1995. Such premiums collected in 1996 include $19.3 million collected by LPG after the LPG Merger. Such premiums collected in 1995 include $26.7 million collected by CCP after its consolidation, and $24.9 million collected by ALH. Conseco does not currently emphasize new product sales of traditional life products, although such inforce business continues to be profitable.
Insurance policy income has increased over the last three years primarily as a result of the acquisition transactions described above under "General."
Insurance policy benefits and change in future policy benefits increased in 1996 and 1995 as a result of the larger amount of business inforce on which benefits are incurred as a result of the acquisition transactions described above under "General." There were no material fluctuations in claim experience during the periods.
Interest expense on investment borrowings is affected by changes in investment borrowing activities during the last three years and the higher interest rates paid on such borrowings during 1996 and 1995.
Other operating costs and expenses increased 71 percent in 1996 and 86 percent in 1995. Such increases correspond to the increases in the total insurance liabilities related to this segment's business.
Net investment losses, net of related costs and amortization often fluctuate from period to period. Net investment gains (losses) affect the timing of the amortization of costs of policies purchased and the cost of policies produced. As a result of net investment gains (losses) from the sales of fixed maturity investments, amortization of cost of policies purchased and cost of policies produced increased $4.4 million in 1996, increased $9.3 million in 1995 and decreased $2.6 million in 1994.
Group accident and health premiums decreased .8 percent in 1996 and increased 1.7 percent in 1995. Such fluctuations reflect premium increases as a result of rate increases, net of premium decreases from policy lapses.
Insurance policy income is comprised of premiums earned on the segment's policies, and has fluctuated over the last three years consistent with the explanations provided above for premiums collected.
Net investment income decreased 13 percent in 1996 and increased 34 percent in 1995. Such investment income fluctuated primarily in relationship to the amount of average invested assets supporting this segment's insurance liabilities.
Fee revenue and other income include: (i) fees for investment management and mortgage origination and servicing; and (ii) commissions earned for insurance and investment product marketing and distribution. Such amounts exclude the fees for services provided to Conseco's consolidated subsidiaries. Fee revenue and other income in 1996 were $49.8 million, up 14 percent from 1995, primarily as a result of the acquisition of certain property and casualty insurance brokerage businesses. Fee revenue and other income in 1995 were $43.6 million, down 42 percent from 1994, primarily as a result of: (i) the exclusion of fees for services provided to CCP in 1995 after its consolidation with Conseco on January 1, 1995; (ii) a reduction in rates charged to certain clients for investment management services; and (iii) a decrease in commissions generated from marketing agreements with certain banks.
Insurance policy benefits and change in future policy benefits fluctuate in relationship to the amount of segment business inforce and the incidence of claims. In 1996, the ratio of policy benefits to insurance policy income fell by 3 percentage points, to 78 percent, reflecting the premium rate increases implemented in 1995 and 1996. The ratio of policy benefits to insurance policy income was 81 percent in both 1995 and 1994.
Interest expense on investment borrowings was affected by changes in investment borrowing activities during the last three years.
Other operating costs and expenses have fluctuated during the last three years, primarily as a result of fluctuations in the expenses of Conseco's subsidiaries providing fee-based services.
In addition to the income of the four operating segments, income before income taxes, minority interest and extraordinary charge is affected by: (i) interest and other corporate expenses; (ii) income from restructuring activities; and (iii) in 1994, equity in earnings of CCP and WNC.
Interest and other corporate expenses were $112.4 million in 1996, $140.5 million in 1995 and $88.0 million in 1994. Fluctuations are primarily due to the interest expense component of these expenses. Interest expense was $108.1 million in 1996, $119.4 million in 1995 and $59.3 million in 1994. Such expense fluctuates in relationship to the average debt outstanding during each period.
Equity in earnings of CCP and WNC was $64.9 million in 1994. Such amount relates solely to 1994 because Conseco: (i) began to consolidate the operations of CCP on January 1, 1995, as a result of the CCP Merger; and (ii) Conseco sold its remaining interest in WNC on December 23, 1994. After January 1, 1995, the operations of CCP are included in the operating segments of Conseco.
Total premiums collected by Conseco's business segments during the last three years were as follows:
The Company's investment strategy is to: (i) maintain a predominately investment grade fixed income portfolio; (ii) provide adequate liquidity to meet the cash flow requirements of policyholders and other obligations; and (iii) maximize current income and total investment return through active investment management. Consistent with this strategy, investments in fixed maturity securities, mortgage loans, credit-tenant loans, policy loans and short-term investments comprised 96 percent of the Company's $19.6 billion investment portfolio at December 31, 1996. The remainder of the invested assets were equity securities and other investments.
Although investment income is a significant component of total revenues, the profitability of Conseco's annuity business is determined primarily by spreads between interest rates earned and rates credited on annuity contracts. At December 31, 1996, the average yield, computed on the cost basis of the Company's investment portfolio, was 7.8 percent and the average interest rate credited on the Company's total liability portfolio was 5.1 percent, excluding interest bonuses guaranteed only for the first year of the contract.
Conseco's actively managed fixed maturity portfolio at December 31, 1996, was comprised primarily of 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.
Conseco periodically evaluates the creditworthiness of each issuer whose securities it holds. Special attention is paid to those securities whose market values have declined materially for reasons other than changes in interest rates or other general market conditions. The Company considers available information to evaluate the realizable value of the investment, the specific condition of the issuer, and the issuer's ability to comply with the material terms of the security. Information reviewed may include the recent operational results and financial position of the issuer, information about its industry, recent press releases and other information. Conseco employs a staff of experienced securities analysts in a variety of specialty areas. Among other responsibilities, this staff compiles and reviews such evidence. If evidence does not exist to support a realizable value equal to or greater than the carrying value of the investment and such decline in market value is determined to be other than temporary, Conseco reduces the carrying amount to its net realizable value, which becomes the new cost basis; the amount of the reduction is reported as a realized loss. Conseco recognizes any recovery of such reductions in the cost basis of an investment only upon the sale, repayment or other disposition of the investment. Conseco recorded writedowns of fixed maturity investments and other invested assets totaling $8.9 million in 1996, primarily as a result of: (i) changes in the financial condition of a private company in which the Company had an indirect equity investment; and (ii) changes in the value of the underlying collateral associated with certain notes. These changes caused the Company to conclude that the decline in fair value of such investments was other than temporary. The Company's investment portfolio is subject to the risks of further declines in realizable value. The Company, however, attempts to mitigate this risk through the diversification and active management of its portfolio.
As of December 31, 1996, fixed maturity investments in substantive default (i.e., in default due to nonpayment of interest or principal) had an amortized cost of $.4 million and had no carrying value. The Company had no fixed maturity investments in technical (but not substantive) default (i.e., in default, but not as to the payment of interest or principal). There were no other fixed maturity investments about which management had serious doubts as to the ability of the issuer to comply on a timely basis with the material terms of the instruments.
The Company's policy is to discontinue the accrual of interest and eliminate all previous interest accruals for defaulted securities, if it is determined that such amounts will not be ultimately realized in full. Investment income forgone due to defaulted securities was $3.8 million in 1996, $1.6 million in 1995 and $3.9 million in 1994.
In general, prepayments on the underlying mortgage loans, and the securities backed by these loans, increase when the level of prevailing interest rates declines significantly relative to the interest rates on such loans. Mortgage-backed securities purchased at a discount to par will experience an increase in yield when the underlying mortgages prepay faster than expected. Those securities purchased at a premium that prepay faster than expected will incur a reduction in yield. When interest rates decline, the proceeds from the prepayment of mortgage-backed securities are likely to be reinvested at lower rates than the Company was 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 annual amortization of the premium.
CMOs are securities backed by pools of pass-through securities and/or mortgages that are segregated into sections or "tranches" that provide for sequential retirement of principal, rather than the pro rata share of principal return that occurs through regular monthly principal payments on pass-through securities.
The degree to which a mortgage-backed security is susceptible to income fluctuations is influenced by: (i) the difference between its cost and par; (ii) the relative sensitivity of the underlying mortgages backing the security to prepayment in a changing interest rate environment; and (iii) the repayment priority of the security in the overall securitization structure. The Company seeks to limit the extent of these risks by: (i) purchasing securities that are backed by collateral with lower prepayment sensitivity (such as mortgages priced at a discount to par value and mortgages that are extremely seasoned); (ii) avoiding securities whose values are heavily influenced by changes in prepayments (such as interest-only and principal-only securities); and (iii) investing in securities structured to reduce prepayment risk (such as planned amortization class ("PAC") and targeted amortization class ("TAC") CMOs). PAC and TAC instruments represented approximately 22 percent of the Company's mortgage-backed securities at December 31, 1996. The call- adjusted modified duration of the Company's mortgage-backed securities at December 31, 1996, was 5.9 years.
The following table sets forth the par value, amortized cost and estimated fair value of mortgage-backed securities including CMOs at December 31, 1996, summarized by interest rates on the underlying collateral:
Accrual bonds are CMOs structured such that the payment of coupon interest is deferred until principal payments begin. On each accrual date, the principal balance is increased by the amount of the interest (based upon the stated coupon rate) that otherwise would have been payable. As such, these securities act much the same as zero coupon bonds until cash payments begin. Cash payments typically do not commence until earlier classes in the CMO structure have been retired, which can be significantly influenced by the prepayment experience of the underlying mortgage loan collateral in the CMO structure. Because of the zero coupon element of these securities and the potential uncertainty as to the timing of cash payments, their market values and yields are more sensitive to changing interest rates than are other CMOs, pass-through securities and coupon bonds.
During 1996, fixed maturity investments with par values totaling $267.8 million were redeemed prior to their scheduled maturity dates. As a result of such redemptions, Conseco recognized approximately $5.6 million of additional investment income.
At December 31, 1996, Conseco held mortgage loan investments with a carrying value of $356.0 million (or 1.8 percent of total invested assets) and a fair value of $356.1 million. Substantially all of the mortgage loan investments were commercial loans. Approximately 2 percent of the Company's mortgage loan balance consisted of investments in junior and residual interests of CMOs. These instruments entitle the Company to the excess cash flows arising from the difference between: (i) the cash flows required to make principal and interest payments on the related senior interests in the CMOs; and (ii) the actual cash flows received on the mortgage loan
Non-current mortgage loans were insignificant at December 31, 1996. The Company had $.4 million in realized losses on mortgage loans for the year ended December 31, 1996. At December 31, 1996, the Company had a loan loss reserve of $2.4 million. Approximately 30 percent of the mortgage loans were on properties located in California, 12 percent in Texas and 6 percent in Mississippi. No other state comprised greater than 5 percent of the mortgage loan balance.
At December 31, 1996, the Company held no trading account securities. Trading account securities are investments that are purchased with the intent to be traded prior to their maturity, or are believed likely to be disposed of in the foreseeable future as a result of market or issuer developments. Trading account securities are carried at estimated fair value, with the changes in fair value reflected in the statement of operations.
Other invested assets include certain non-traditional investments, including investments in venture capital funds, limited partnerships, mineral rights and promissory notes.
As part of its investment strategy, the Company enters into reverse repurchase agreements and dollar-roll transactions to increase its return on investments and improve its liquidity. Reverse repurchase agreements involve a sale of securities and an agreement to repurchase the same securities at a later date at an agreed upon price. Dollar rolls are similar to reverse repurchase agreements except that the repurchase involves securities that are only substantially the same as the securities sold. The Company enhances its investment yield by investing the proceeds from the sales in short-term securities pending the contractual repurchase of the securities at discounted prices in the forward market. The Company is able to engage in such transactions due to the market demand for mortgage-backed securities to form CMOs. Such investment borrowings averaged $424.7 million during 1996 and were collateralized by investment securities with fair values approximately equal to the loan value. The weighted average interest rate on short-term collateralized borrowings was 5.2 percent in 1996. The primary risk associated with short-term collateralized borrowings is that the counterparty will be unable to perform under the terms of the contract. The Company's exposure is limited to the excess of the net replacement cost of the securities over the value of the short-term investments (which was not material at December 31, 1996). The Company believes that the counterparties to its reverse repurchase and dollar roll agreements are financially responsible and that the counterparty risk is minimal.
Changes in the consolidated balance sheet of 1996 compared to 1995
Conseco's consolidated balance sheet at December 31, 1996, compared to 1995 was materially affected by the following acquisition transactions which occurred during 1996: (i) the LPG Merger; (ii) the ALH Stock Purchase; (iii) the ATC Merger; (iv) the THI Merger; and (v) the BLH Merger.
Notes payable decreased during 1996 as a result of the repayment of debt using the proceeds from the issuance of Preferred Redeemable Increased Dividend Equity Securities, 7% Convertible Preferred Stock ("PRIDES") and the Company-obligated mandatorily redeemable preferred securities. Such repayments included the repayment of debt acquired with LPG and THI.
Shareholders' equity increased by $2.0 billion in 1996, to $3.1 billion. Significant components of the increase included: (i) the issuance of shares of common stock with a value of $1.6 billion related to the LPG Merger, the ATC Merger, the THI Merger and the BLH Merger; (ii) the issuance of PRIDES with a value of $267.1 million; (iii) net income of $252.4 million; and (iv) amounts related to stock options and employee benefit plans (including the tax benefit related to issuance of shares under employee benefit plans) totaling $45.4 million. These increases were partially offset by: (i) dividends paid on preferred stock of $27.4 million; (ii) dividends paid on common stock of $10.7 million; and (iii) the decline in unrealized appreciation of $73.8 million.
In accordance with SFAS 115, Conseco records its actively managed fixed maturity investments at estimated fair value. At December 31, 1996 and 1995, such investments were increased by $103.8 million and $608.2 million, respectively, as a result of the SFAS 115 adjustment.
(b) Statutory earnings represent: (i) gain from operations of Conseco's consolidated life insurance companies before interest (including, for purposes of the "as reported" ratio, interest on annuities and financial products) and income tax as reported for statutory accounting purposes; plus (ii) income before interest and income tax of all non-life companies. Cash interest includes interest (including, for purposes of the "as reported" ratio, interest on annuities and financial products) of Conseco's consolidated subsidiaries.
(c) For periods prior to 1996, debt includes obligations for which Conseco was not directly liable.
Approximately 20 percent of insurance liabilities were contracts subject to a fixed interest rate for the life of the contract. The remaining liabilities generally were subject to interest rates that could be reset at least annually.
Conseco believes that the diversity of its investment portfolio and the concentration of investments in high quality liquid securities provide sufficient liquidity to meet foreseeable cash requirements. The Company's investment portfolio at December 31, 1996, included $.3 billion of short-term investments, $.6 billion of United States government and agency securities, $5.5 billion of mortgage-backed securities, and $10.6 billion of publicly traded investment grade bonds. Although there is no present need or intent to dispose of such investments, the life companies could readily liquidate portions of their investments, if such a need arose. In addition, investments could be used to facilitate borrowings under reverse repurchase agreements or dollar-roll transactions. Such borrowings have been used by the life companies from time to time to increase their return on investments and to improve liquidity. At December 31, 1996, the Company's portfolio of bonds and redeemable preferred stocks had an aggregate unrealized gain of $103.8 million.
The following table shows the cash flow activity of the parent company and its wholly owned non-life subsidiaries:
Statutory operating results and statutory surplus are determined according to statutes adopted by each state in which the subsidiaries do business. Statutory surplus bears no direct relationship to equity as determined under GAAP. With respect to new business, statutory accounting practices require that: (i) acquisition costs and (ii) reserves for future guaranteed principal payments and interest in excess of statutory rates, be expensed as the new business is written. These items cause a statutory loss ("surplus strain") on many insurance products in the year in which they are issued. Conseco manages the effect of such statutory surplus strain by designing its products to minimize such first-year losses, and by controlling the amount of new premiums written.
Note 13 to the consolidated financial statements shows the difference between pretax income reported using statutory accounting practices (before deduction of expenses paid to affiliates and transfers to and from and amortization of the interest maintenance reserve ("IMR")) and GAAP.
As indicated throughout this report, Conseco intends to continue to grow its life and health insurance operations.
Conseco's operations in 1997 and in future years will be significantly affected by several planned and recently completed acquisitions. Operating earnings for 1996 were not affected by the ATC Merger, the THI Merger or the BLH Merger, all of which were recorded as of December 31, 1996. On March 4, 1997, Conseco completed the CAF Merger. On December 15, 1996, Conseco and PFS entered into the PFS Merger Agreement pursuant to which PFS would become a wholly owned subsidiary of Conseco. The PFS Merger is expected to be completed in the second quarter of 1997. After an acquisition is completed, Conseco minimizes operating expenses by centralizing, standardizing and more efficiently performing many functions common to most life insurance companies.
The Company believes a number of life insurance companies will become available for acquisition in the next 10 years as a result of strategic restructuring and consolidation within the life insurance industry. The Company may participate in such acquisitions (such as the LPG Merger, the ATC Merger, the THI Merger and the CAF Merger), when the acquisition fits Conseco's strategic growth plan and can be achieved with a capital structure that results in: (i) increased earnings per share and value to Conseco's shareholders; (ii) favorable rating agency actions; and (iii) an expansion of profitable marketing activities by all Conseco companies. Conseco's ability to complete acquisitions that achieve those objectives depends on a number of external factors, including: (i) the attitudes of rating agencies toward Conseco's strategic plan and capital structure; (ii) the availability and cost of both debt and equity capital; (iii) pressures that motivate companies to seek to be acquired at a reasonable cost; and (iv) competition from other acquirers, which affects the cost of acquisitions.
The pro forma consolidated statement of operations information for the year ended December 31, 1996, in the column headed "Pro forma for completed transactions" reflects the following transactions, all of which have already occurred, as if such transactions had occurred on January 1, 1996: (i) the issuance of 4.37 million shares of PRIDES in January 1996; (ii) the BLH offer for and repurchase of its 13 percent senior subordinated notes due 2002 and related financing transactions completed in March 1996; (iii) the LPG Merger; (iv) the call for redemption of Conseco's Series D Convertible Preferred Stock completed on September 26, 1996; (v) the ALH Stock Purchase; (vi) the issuance of $600 million of Company-obligated mandatorily redeemable preferred securities of subsidiary trusts; (vii) the ATC Merger; (viii) the THI Merger; (ix) the BLH Merger; and (x) the CAF Merger. The pro forma consolidated statement of operations information for the year ended December 31, 1996, in the column headed "Pro forma for completed transactions and the PFS Merger" reflects further adjustments to the consolidated operating results of Conseco as if the PFS Merger had occurred on January 1, 1996.
(a) All share and per-share amounts have been restated to reflect the two-for-one stock splits paid on April 1, 1996, and February 11, 1997.
(d) Represents income before extraordinary charge, excluding net investment gains (losses) (less amortization of cost of policies purchased and cost of policies produced and income taxes relating to such gains) and restructuring activities (net of income taxes).
We have audited the accompanying consolidated balance sheet of Conseco, Inc. and Subsidiaries as of December 31, 1996 and 1995, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
Conseco, Inc. ("We," "Conseco" or "the Company") is a financial services holding company engaged primarily in the development, marketing and administration of annuity, supplemental health and individual life products. Conseco's operating strategy is to grow the insurance business within its subsidiaries by focusing its resources on the development and expansion of profitable products and strong distribution channels. Conseco supplements such growth by acquiring companies that have profitable niche products, strong distribution systems and progressive management teams who can work with Conseco to implement Conseco's operating and growth strategies. Once a company is acquired, our operating strategy is to consolidate and streamline management and administrative functions, to realize superior investment returns through active asset management, to eliminate unprofitable products and distribution channels, and to expand and develop the profitable distribution channels and products.
Consolidation issues. Conseco Capital Partners, L.P. ("Partnership I"), an investment partnership formed by Conseco with other investors, was the Company's vehicle for acquiring four insurance companies: Great American Reserve in June 1990, Jefferson National Life Insurance Company in November 1990 (it was merged with Great American Reserve in 1994), Beneficial Standard in March 1991 and Bankers Life in November 1992. We accounted for all of these acquisitions as purchases, reflecting the acquired operations in our financial statements beginning with the acquisition dates. As sole general partner, Conseco exercised unilateral control over Partnership I even though our ownership interest was less than 50 percent. We were therefore required to include the accounts of Partnership I and its majority-owned subsidiaries in our consolidated financial statements until Partnership I was liquidated on March 31, 1993.
We were required to use step-basis accounting when we acquired the shares of CCP common stock in various transactions. As a result, the assets and liabilities of CCP included in our consolidated balance sheet represent the following combination of values: (i) the portion of CCP's net assets acquired by Conseco in the initial acquisitions of CCP's subsidiaries made by Partnership I is valued as of those respective acquisition dates; and (ii) the portion of CCP's net assets acquired in the CCP Merger is valued as of August 31, 1995.
The assets and liabilities of BLH included in Conseco's 1996 consolidated balance sheet represent the following combination of values: (i) the portion of BLH's net assets acquired by Conseco in the November 1992 acquisition made by Partnership I is valued as of that acquisition date; (ii) the portion of BLH's net assets acquired in 1993, 1995 and the first quarter of 1996 is valued as of the dates of their purchase; and (iii) the portion of BLH's net assets acquired in the BLH Merger is valued as of December 31, 1996.
On September 30, 1996, we purchased all of the common shares of ALH we did not previously own from Partnership II for $165.0 million in cash (the "ALH Stock Purchase") and Partnership II was terminated. We were required to use step-basis accounting when we acquired the shares of ALH common stock in the ALH Stock Purchase and for our previous acquisitions. As a result, the assets and liabilities of ALH included in the December 31, 1996, consolidated balance sheet represent the following combination of values: (i) the portion of ALH's net assets acquired by Conseco in the initial acquisition of ALH made by Partnership II is valued as of September 29, 1994; (ii) the portion of ALH's net assets acquired on November 30, 1995 is valued as of that date; and (iii) the portion of ALH's net assets acquired in the ALH Stock Purchase is valued as of September 30, 1996.
Neither "consolidation" nor "non-consolidation" methods of accounting for partially owned subsidiaries affect our reported net income or shareholders' equity. Our consolidated financial statements do not include the results of material transactions between us and our consolidated affiliates, or among our consolidated affiliates. We reclassified some figures in our 1995 and 1994 consolidated financial statements and notes to conform with the 1996 presentation.
Fixed maturities are securities that mature more than one year after issuance. They include bonds, notes receivable and preferred stocks with mandatory redemption features and are classified as follows:
Held to maturity - (all other fixed maturities) securities which we have the ability and positive intent to hold to maturity. When we own such securities, we carry them at amortized cost. We may dispose of these securities if the credit quality of the issuer deteriorates, if regulatory requirements change or under other unforeseen circumstances. We have not held any held to maturity securities since implementing SFAS 115 in 1993.
We consider the anticipated returns from investing policyholder balances, including investment gains and losses, in determining the amortization of the cost of policies purchased and the cost of policies produced. When we state actively managed fixed maturities at fair value, we also adjust the cost of policies purchased and the cost of policies produced to reflect the change in cumulative amortization that we would have recorded if we had sold these securities at their fair value and reinvested the proceeds at current yields. If future yields on such securities decline, it may be necessary to increase certain of our insurance liabilities. We are required to adjust such liabilities when their balances and future net cash flows (including investment income) are insufficient to cover future benefits and expenses.
The unrealized gains and losses and the related adjustments described above have no effect on our earnings. We record them, net of tax, to shareholders' equity. The following table summarizes the effect of these adjustments on the related balance sheet accounts as of December 31, 1996:
Credit-tenant loans ("CTLs") are loans for commercial properties. When we make these loans: (i) the lease of the principal tenant must be assigned to Conseco; (ii) the lease must produce adequate cash flow to fund substantially all the requirements of the loan; and (iii) the principal tenant or the guarantor of such tenant's obligations must have an investment-grade credit rating when the loan is made. These loans also must be collateralized by the value of the related property. Our underwriting guidelines take into account such factors as: (i) the lease term of the property; (ii) the borrower's management ability, including business experience, property management capabilities and financial soundness; and (iii) such economic, demographic or other factors that may affect the income generated by the property, or its value. The underwriting guidelines generally require a loan-to-value ratio of 75 percent or less. We carry both CTLs and traditional mortgage loans at amortized cost.
As part of our investment strategy, we may enter into reverse repurchase agreements and dollar-roll transactions to increase our investment return or to improve our liquidity. We account for these transactions as collateral borrowings, where the amount borrowed is equal to the sales price of the underlying securities.
We defer any fees received or costs incurred when we originate investments--principally CTLs and mortgages. We amortize fees, costs, discounts and premiums as yield adjustments over the contractual lives of the investments. We consider anticipated prepayments on mortgage-backed securities in determining estimated future yields on such securities.
We record the cost of each individual investment security. When we sell a security, we report the difference between our sale proceeds and its carrying value (before unrealized adjustment) as a realized gain or loss on investments. If the proceeds result from prepayments by the issuer prior to maturity, we record those differences as an adjustment to investment income.
- The cost of our capital required to fund the acquisition.
- The acquired company's compatibility with other Conseco activities that may favorably affect future cash flows.
Each year, we evaluate the recoverability of the cost of policies purchased to the unamortized asset balance by line of business within each block of purchased insurance business. If our current estimate indicates that the existing insurance liabilities, together with the present value of future net cash flows from the blocks of business purchased, will be insufficient to recover the cost of policies purchased, we charge the difference to expense. We adjust amortization consistent with the methods used with the cost of policies produced (as described below).
Each year, we evaluate the recoverability of the unamortized balance of the cost of policies produced. For universal life-type contracts and investment-type contracts, we increase or decrease the accumulated amortization whenever there is a material change in the estimated gross profits expected over the life of a block of business. We do this in order to maintain a constant relationship between the cumulative amortization and the present value (discounted at the rate of interest that accrues to the policies) of expected gross profits. For most other contracts, we reduce the unamortized asset balance (by a charge to income) only when the present value of future cash flows, net of the policy liabilities, is insufficient to recover the asset balance.
Goodwill is the excess of the amount we paid to acquire a company over the fair value of its net assets. We amortize goodwill on the straight-line basis over a 40-year period. We continually monitor the value of our goodwill based on our estimates of future earnings. We determine whether goodwill is fully recoverable from projected undiscounted net cash flows from earnings of the subsidiaries over the remaining amortization period. If we were to determine that changes in such projected cash flows no longer supported the recoverability of goodwill over the remaining amortization period, we would reduce its carrying value with a corresponding charge to expense or shorten the amortization period (no such changes have occurred).
We carry property and equipment at depreciated cost. We depreciate property and equipment on a straight-line basis over the estimated useful lives of the assets, which average approximately 13 years. Our depreciation expense was $11.9 million in 1996, $9.3 million in 1995 and $8.3 million in 1994.
We calculate our reserves for traditional and limited-payment life contracts generally using the net-level-premium method, based on assumptions as to investment yields, mortality, withdrawals and dividends. We make these assumptions at the time we issue the contract, or in the case of contracts acquired by purchase, at the purchase date. We base these assumptions on projections from past experience, modified as necessary to reflect anticipated trends and making allowance for possible unfavorable deviation.
For contracts with mortality risk, but with premiums paid for only a limited period (such as single-premium immediate annuities with benefits paid for the life of the annuitant), we use an accounting treatment similar to that used for traditional contracts. An exception is that we defer the excess of the gross premium over the net premium and recognize it in relation to the present value of expected future benefit payments (when accounting for annuity contracts) or in relation to insurance in force (when accounting for life insurance contracts).
The liability for future policy benefits for accident and health policies consists of active life reserves and the estimated present value of the remaining ultimate net cost of incurred claims. Active life reserves include unearned premiums and additional reserves. The additional reserves are computed on the net level premium method using assumptions for future investment yield, mortality and morbidity experience. Our assumptions are based on projections of past experience and include provisions for possible adverse deviation.
In the normal course of business, Conseco seeks to limit its exposure to loss on any single insured and to recover a portion of the benefits paid over such limits. We do this by ceding reinsurance to other insurance enterprises or reinsurers under excess coverage and coinsurance contracts. We limit how much risk per policy we will retain. We currently retain no more than $.8 million of risk on any one policy.
Our consolidated financial statements include all of the assets, liabilities, revenues and expenses of BLH, ALH (since its acquisition by Partnership II on September 29, 1994), and CCP (since January 1, 1995, as a result of the CCP Merger) even though we did not own all of the common and preferred stock of these subsidiaries during all periods. We make a charge against consolidated income for the share of earnings allocable to minority interests, for dividends on preferred stock of subsidiaries and for distributions on the Company-obligated mandatorily redeemable preferred securities of subsidiary trusts. We show the shareholders' equity of such entities allocable to the minority interests separately on our consolidated balance sheet.
We report Company-obligated mandatorily redeemable preferred securities of subsidiary trusts at their liquidation value under minority interest. We charge the distributions on these securities against consolidated income.
Other invested assets. We use quoted market prices, where available. For other invested assets, which are not material, we have assumed a market value equal to carrying value.
Other liabilities. The portion of other liabilities representing the value attributable to the conversion feature of subordinated convertible debentures acquired in conjunction with the ATC Merger is valued at estimated fair value.
At January 1, 1994, we owned 40 percent of the common stock of CCP, which was acquired through several separate transactions beginning in 1992. During 1994, CCP acquired 3.5 million shares of its common stock under a stock repurchase program which increased our ownership interest in CCP to 45 percent at December 31, 1994. In early 1995, CCP repurchased an additional 2.2 million shares under this program increasing our ownership interest to 49 percent.
In August 1995, we completed the purchase of all of the shares of common stock of CCP that we did not previously own. A total of 11.8 million shares were purchased for $281.8 million (including transaction costs and the cost to settle outstanding stock options of CCP) in a transaction pursuant to which CCP was merged with Conseco, with Conseco being the surviving corporation. Income tax expense was reduced by $8.4 million in the third quarter of 1995 as a result of the release of deferred income taxes previously accrued on income related to CCP. Such deferred tax is no longer required because the CCP Merger was completed without incurring additional tax. We funded the CCP Merger with available cash and borrowings from our credit facility.
Effective November 1, 1992, Partnership I formed BLH to acquire Bankers Life from I.C.H. Corporation ("ICH"). Immediately after the acquisition, Conseco owned approximately 44 percent of the common equity interest in BLH through direct investments and investments in Partnership I. On March 25, 1993, BLH completed an IPO of 19.6 million shares of its common stock at $22 per share. After the IPO, Conseco owned 31 percent of the shares of BLH common stock. On September 30, 1993, Conseco acquired 13.3 million shares of BLH common stock from ICH for $287.6 million. The shares purchased represented 25 percent of BLH's outstanding shares. Conseco paid for these shares by surrendering for redemption $50.0 million stated value of ICH preferred stock, and by paying $237.6 million in cash. The transaction with ICH increased Conseco's ownership of BLH to 56 percent.
During 1994, BLH acquired 1.8 million shares of its common stock under a stock repurchase program at a cost of $35.7 million. BLH's repurchases increased Conseco's ownership interest in BLH to 58 percent. During 1995, we acquired 12.8 million shares of BLH common stock for $262.4 million in open market and negotiated transactions, increasing our ownership of BLH to 85 percent. Income tax expense was reduced by $66.5 million in the second quarter of 1995 as a result of the release of deferred income taxes previously accrued on income related to BLH. Such deferred tax is no longer required since we are permitted to file a consolidated tax return with BLH. In addition, BLH repurchased 2.2 million shares of its common stock during 1995 at a cost of $42.1 million, increasing our ownership interest in BLH to 88 percent as of December 31, 1995. During the first three months of 1996, BLH repurchased 1.3 million shares of its common stock at a cost of $27.7 million. As a result of such repurchases, Conseco's ownership interest in BLH increased to 90.4 percent.
On December 31, 1996, we completed the BLH Merger. Each outstanding share of BLH common stock not already owned by Conseco was exchanged for 0.7966 shares of Conseco common stock. We issued 3.9 million shares of common stock (including .1 million common equivalent shares in exchange for BLH's outstanding options) with a value of $123.0 million.
(i) In the event of a determination of the ALH Litigation that is unfavorable to ALH, $30.1 million would be paid to the holders of ALH's 1988 Series I and II Preferred Stock $1 Par (the "ALH 1988 Series Preferred Stock"). This stock is currently held by the U.S. Government. In the event of a favorable determination of this litigation, the same amount, representing a portion of the Contingent Consideration, would be paid to the other former stockholders of ALH. On August 30, 1995, the United States Court of Appeals of the Federal Circuit, in banc, affirmed the summary judgment of the Court of Federal Claims in favor of ALH by a decision of nine to two. On July 1, 1996, the Supreme Court affirmed the summary judgment of the Court of Federal Claims in ALH's favor by a decision of seven to two. A trial has been scheduled in May 1997, in the Court of Federal Claims to determine damages related to the breach of contract by the United States of America. Since the timing of a final determination of the litigation is uncertain, we are unable to predict when such $30.1 million amount will become payable.
(ii) This amount assumes conversion for redemption of all of ALH's outstanding 6-1/4% Convertible Subordinated Debentures due 2003 (the "Convertible Debentures"). These debentures were convertible into an aggregate of 4,528,125 shares of ALH common stock. At December 31, 1996, $13.0 million of the Convertible Debentures remained outstanding.
(iii) A subsidiary of ALH was the borrower under a credit facility having an outstanding balance (including accrued interest and fees) of $55.5 million at the Acquisition date. This facility was repaid with a portion of the proceeds from the financing.
On November 30, 1995, ALH issued 2,142,857 shares of its common stock for $30.0 million (including $13.2 million paid by Conseco and its subsidiaries) in a private placement transaction. Eighty percent of the shares were purchased by Partnership II and the remainder were purchased by the other holders of ALH common stock. The proceeds from the sale were used to reduce the amount of ALH's outstanding debt. In accordance with the Partnership II agreement, Conseco earned fees of $.2 million (net of taxes of $.1 million) for services in connection with such transaction. On September 30, 1996, we repurchased all of the common shares of ALH we did not already own for $165.0 million in cash in the ALH Stock Purchase.
The Partnership II agreement provided that an additional ownership interest in ALH would be allocated to Conseco if returns to the limited partners were in excess of prescribed targets. Upon termination of Partnership II, such targets were exceeded and the additional ownership interest allocated to Conseco was recognized as follows: (i) $10.2 million, which represents Conseco's increased ownership interest in the previously reported net income of Partnership II, was recorded as a reduction of amounts that would otherwise be charged to the minority interest; and (ii) $16.6 million was recorded as restructuring income. Such restructuring income of Conseco was offset by $16.2 million of expenses incurred in connection with the realization of the restructuring income.
Effective July 1, 1996, we completed the LPG Merger. Each of the issued and outstanding shares of LPG common stock was converted into 1.1666 shares of Conseco common stock. We issued 32.6 million shares of common stock (including .4 million common equivalent shares issued in exchange for LPG's outstanding options) with a value of $586.8 million. In connection with the LPG Merger, we also assumed notes payable of $253.1 million.
On December 17, 1996, we completed the ATC Merger. Each outstanding share of ATC common stock was exchanged for 1.1672 shares of Conseco common stock. We issued 21.0 million shares of common stock (including .9 million common equivalent shares issued in exchange for ATC's outstanding options) with a value of $630.9 million. We also assumed ATC's convertible subordinated debentures, which are convertible into 7.9 million shares of Conseco common stock with a value of $248.3 million (of which $102.8 million, representing the principal amount outstanding, is included in notes payable and $145.5 million, representing the additional value attributable to the conversion feature, is included in other liabilities).
On December 23, 1996, we completed the THI Merger. Each outstanding share of THI common stock was exchanged for 2.8 shares of Conseco common stock. We issued 4.9 million shares of common stock (including .4 million common equivalent shares issued in exchange for THI's outstanding options and warrants) with a value of $121.7 million. In addition, pursuant to an exchange offer, all of THI's Convertible Notes were exchanged for 4.2 million shares of Conseco common stock with a value of $106.2 million plus a cash premium of $11.9 million.
We accounted for the THI Merger under the purchase method of accounting effective December 31, 1996. Under this method, we allocated the cost to acquire THI to the assets and liabilities acquired based on fair values as of the date of the THI Merger. There was no goodwill acquired with the THI Merger. The THI Merger did not qualify to be accounted for under the pooling of interests method in accordance with APB No. 16 because THI was a subsidiary of another corporation within two years of the transaction.
The Company intends to minimize the operating expenses of the companies acquired during 1996 by centralizing many operations with those of its other companies. At the dates of the mergers, we began to assess and formulate plans to involuntarily terminate or relocate employees of the acquired companies. At December 31, 1996, all aspects of such plans have not yet been completed. We anticipate completion and communication of the plans of termination (relocation) (including the number of employees of the acquired companies to be terminated (relocated), their job classifications or functions, and their locations) prior to June 30, 1997. The following estimated liabilities related to these plans were included in the allocation of the costs to acquire these companies: $8.2 million, with respect to LPG; $3.3 million, with respect to ALH; $5.2 million, with respect to ATC; and $7.8 million, with respect to THI. During 1996, the following amounts were paid and charged against the estimated liabilities: $6.0 million, with respect to LPG and $3.3 million, with respect to ALH. If the ultimate costs to complete these plans are less than the estimated liability, the excess liability will be reflected as an adjustment to the liabilities assumed (with a corresponding adjustment to goodwill). If the ultimate costs to complete these plans are more than the estimated liability, an adjustment to the liability will be made (with a corresponding adjustment to goodwill), if such adjustment is determined within one year of the date of each of the mergers. Thereafter, any additional amounts will be included in the determination of the Company's net income.
The following summarizes the effects of the transactions described above on the consolidated statement of cash flows and consolidated balance sheet as of the dates of the respective transactions:
The following unaudited pro forma results of operations of the Company are presented as if the following had occurred as of January 1, 1995: (i) the LPG Merger; (ii) the call for redemption of Conseco's Series D Convertible Preferred Stock (the "Series D Call") completed on September 26, 1996; (iii) the ALH Stock Purchase; (iv) the issuance of $600.0 million of Company - obligated mandatorily redeemable preferred securities of subsidiary trusts (see note 9); (v) the ATC Merger; (vi) the THI Merger; (vii) the BLH Merger; (viii) the CCP Merger; (ix) the increase of Conseco's ownership in BLH to 90.4 percent, as a result of purchases of BLH common shares in 1995 and 1996; (x) the issuance of 4.37 million shares of Preferred Redeemable Increased Dividend Equity Securities Convertible Preferred Stock ("PRIDES") in January 1996; (xi) the BLH tender offer for and repurchase of its 13 percent senior subordinated notes due 2002 and related financing transactions completed in March 1996; and (xii) the debt restructuring of ALH in the fourth quarter of 1995.
The following unaudited pro forma results of operations of the Company are presented as if the following had occurred as of January 1, 1994: (i) the CCP Merger; (ii) the acquisition of additional shares of BLH common stock in 1995; (iii) the acquisition of ALH by Partnership II; (iv) the IPO of WNC; and (v) the sale by Conseco of its remaining 40 percent equity interest in WNC.
The following table sets forth fixed maturity investments at December 31, 1996, classified by rating categories. The category assigned is the highest rating by a nationally recognized statistical rating organization or, as to $482.0 million fair value of fixed maturities not rated by such firms, the rating assigned by the National Association of Insurance Commissioners ("NAIC"). For purposes of the table, NAIC Class 1 is included in the "A" rating; Class 2, "BBB-"; Class 3, "BB-"; and Classes 4-6, "B+ and below."
The following table sets forth below investment grade fixed maturity investments as of December 31, 1996, summarized by the amount their amortized cost exceeds fair value:
The following table sets forth the amortized cost and estimated fair value of actively managed fixed maturities at December 31, 1996, 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 and because most mortgage-backed securities provide for periodic payments throughout their lives.
The carrying value of fixed maturity investments and mortgage loans not accruing investment income totaled $2.1 million, $1.5 million and $11.2 million at December 31, 1996, 1995 and 1994, respectively.
At December 31, 1996, fixed maturity investments in default as to the payment of principal or interest were insignificant. Conseco recorded writedowns of fixed maturity investments and other invested assets of $8.9 million in 1996, $24.9 million in 1995 and $1.0 million in 1994. These writedowns were the result of changes in conditions that caused the Company to conclude that the decline in fair value of the investment was other than temporary. Investment income forgone due to defaulted securities was $3.8 million in 1996, $1.6 million in 1995 and $3.9 million in 1994.
Life insurance companies are required to maintain certain investments on deposit with state regulatory authorities. Such assets had an aggregate carrying value of $141.3 million at December 31, 1996.
Conseco had no investments in any single entity in excess of 10 percent of shareholders' equity at December 31, 1996, other than investments issued or guaranteed by the United States government or a United States government agency.
Participating policies represented approximately 2 percent, 12 percent and 8 percent of total life insurance in force at December 31, 1996, 1995 and 1994, respectively. Participating policies represented approximately 1 percent, 1 percent and 2 percent of premium income for 1996, 1995 and 1994, respectively. Dividends on participating policies amounted to $13.4 million, $12.3 million and $12.0 million in 1996, 1995 and 1994, respectively.
The Company has ceded certain policy liabilities under assumption reinsurance agreements. Since all of Conseco's obligations under these insurance contracts have been ceded to another company, insurance liabilities related to such policies were not reported in the balance sheet. We believe the assuming companies are able to honor all contractual commitments under the assumption reinsurance agreements, based on our periodic reviews of financial statements, insurance industry reports and reports filed with state insurance departments.
The Company's reinsurance receivable at December 31, 1996, relates to approximately 175 reinsurers. Three major United States insurance companies rated "A- (Excellent)" or better by A.M. Best Company, a recognized insurance rating agency, account for approximately 26 percent, 9 percent and 5 percent, respectively, of such balance. Other than these companies, no single reinsurer accounts for more than 4 percent.
At December 31, 1996, Conseco had federal income tax loss carryforwards of $441.1 million available (subject to various statutory restrictions) for use on future tax returns. Portions of these carryforwards begin expiring in 1999. Of the loss carryforwards: (i) $24.5 million may be used to offset income only from the non-life insurance companies; and (ii) $67.3 million are attributable to acquired companies and may be used only to offset the income from those companies. None of the carryforwards are available to
We recognized an extraordinary loss of $12.9 million during 1996 (net of a $7.0 million tax benefit) as a result of prepaying our prior bank credit agreements and the bank credit agreements of BLH and ALH.
11.25% senior subordinated notes due 2004 were issued to the public by ALH in conjunction with its acquisition by Partnership II. Such notes are unsecured and will be subordinated in the right of payment to the prior payment in full of all senior indebtedness. The notes are redeemable at the Company's option, in whole or in part, at any time on or after September 15, 1999, initially at 105.625 percent of their principal amount, plus accrued interest, declining to 100 percent of their principal amount, plus accrued interest, on and after September 15, 2001. We recognized an extraordinary charge of $4.2 million (net of a $2.3 million tax benefit) during 1996 as a result of repurchasing $51.9 million par value of these notes.
6.5% convertible subordinated debentures due 2005 were acquired in conjunction with the ATC Merger and are convertible into Conseco common stock at any time prior to maturity, at a conversion ratio of 76.96 shares of Conseco common stock for each $1,000 principal amount of debentures. The convertible debentures may be redeemed at Conseco's option at a price equal to 103.25 percent after October 1998, declining to 100 percent after October 2001. The value of the convertible debentures in excess of the principal balance at the ATC Merger date (the value attributable to the conversion feature) of $145.5 million is included in other liabilities.
In conjunction with the LPG Merger and the THI Merger, Conseco repaid acquired debt of $214.5 million and $78.5 million, respectively. Conseco also repurchased other debt of $65.8 million during 1996. Conseco recognized an extraordinary charge of $.4 million (net of $.2 million tax benefit) related to such repurchases.
The Company rents office space, equipment and computer software under noncancellable operating leases. Rental expense was $21.3 million in 1996, $20.8 million in 1995 and $18.8 million in 1994. Future required minimum rental payments as of December 31, 1996, were as follows (dollars in millions):
Some officers of the Company are employed under long-term employment agreements. One of these agreements provides for a base salary plus an annual bonus equal to 3 percent of the Company's consolidated defined pretax profits. This agreement renews annually for a five-year period unless either party notifies the other, in which case the agreement expires five years from the last renewal date. Additionally, a $1.9 million interest-free loan has been granted to the officer. Repayment is due two years after termination of the officer's employment contract.
The Company also has a stock bonus and deferred compensation program for certain officers and directors. Company contributions vary based on the profitability of the Company. Each year's contribution, which is fully funded in the form of Conseco common stock, vests five years later or upon certain other events. The cost of the program is charged to expense over the vesting period and amounted to $3.9 million in 1996, $3.7 million in 1995 and $1.4 million in 1994. The market value of Conseco common stock held under the program (included in other assets and other liabilities) was $101.7 million and $46.0 million at December 31, 1996 and 1995, respectively.
From time to time, the Company and its subsidiaries are involved in lawsuits related to their operations. In most cases, such lawsuits involve claims under insurance policies or other contracts of the Company. Even though the Company may be contesting the validity or extent of its liability in response to such lawsuits, the Company has established reserves in its consolidated financial statements that approximate its estimated potential liability. Accordingly, none of the lawsuits currently pending, either individually or in the aggregate, is expected to have a material effect on the Company's consolidated financial condition, cash flows or results of operations.
Minority interest represents the interest of investors other than Conseco in its subsidiaries. Minority interest at December 31, 1996, included: (i) $600.0 million par value of Company-obligated mandatorily redeemable preferred securities of subsidiary trusts; (ii) $97.0 million interest in the redeemable preferred stock of a subsidiary of ALH; and (iii) $.7 million interest in the common stock of a subsidiary of ALH.
Company-obligated mandatorily redeemable preferred securities of subsidiary trusts at December 31, 1996, were as follows (dollars in millions):
On November 19, 1996, Conseco issued 11 million of the TOPrS of Conseco Financing Trust ("Trust I") at $25 per security. Each TOPrS security will pay cumulative cash distributions at the annual rate of 9.16 percent of the stated liquidation amount per security, payable quarterly commencing December 31, 1996. The TOPrS are fully and unconditionally guaranteed by Conseco. Proceeds from the offering of approximately $266.1 million (after underwriting and associated costs) were used to repay bank debt. Conseco has the right to redeem the securities at any time, in whole or in part, on or after November 19, 2001, at the principal amount plus accrued and unpaid interest. The securities are subordinated to all senior indebtedness of Conseco and mature on November 30, 2026. Conseco may extend the maturity date by one or more periods, but in no event later than November 30, 2045. The terms of the TOPrS parallel the terms of Conseco's debentures held by Trust I, which debentures comprise substantially all of the assets of Trust I.
On November 27, 1996, Conseco issued 325,000 of the TruPS of Conseco Financing Trust II ("Trust II") at $1,000 per security. Each TruPS security will pay cumulative cash distributions at the annual rate of 8.70 percent of the stated $1,000 liquidation amount per security payable semi-annually commencing May 15, 1997. The TruPS are fully and unconditionally guaranteed as to distributions and other payments by Conseco. Proceeds from the offering of approximately $321.6 million (after underwriting and associated costs) were used to repay bank debt. Conseco has the right to redeem the securities at the principal amount plus a premium equal to the excess, if any, of the sum of the discounted present values of the remaining scheduled payments of principal and interest over the principal amount of securities to be redeemed. The securities are subordinated to all senior indebtedness of Conseco and mature on November 15, 2026. The terms of the TruPS parallel the terms of Conseco's debentures held by Trust II, which debentures comprise substantially all of the assets of Trust II.
The $2.16 Preferred Shares are entitled to cash dividends of $2.16 per share per annum payable quarterly and may be redeemed, in whole or in part, at any time after August 25, 1997, at $26.25 per share declining to $25.00 per share on or after September 30, 2000, plus cumulative unpaid dividends. The $2.16 Preferred Shares are mandatorily redeemable on September 30, 2007.
At December 31, 1996, minority interest in common stock of Conseco's subsidiaries includes only the $.7 million interest in the common stock of Vulcan. At December 31, 1995, such minority interest also included the interests of the non-Conseco shareholders in ALH and BLH. Conseco acquired such ownership interests from the minority interest in the ALH Stock Purchase and the BLH Merger.
Changes in minority interest in common and preferred stock of consolidated subsidiaries during 1996 and 1995 are summarized below:
Changes in the number of shares of common stock outstanding for the years 1996, 1995 and 1994 were as follows:
The Company was authorized under its 1983 employee stock option plan to grant options to purchase up to 48 million shares of Conseco common stock at a price not less than its market value on the date the option was granted. The 1983 stock option plan continues to govern options granted thereunder, but expired in all other respects in December 1993. A new plan was adopted in 1994 that authorizes the granting of options to employees and directors of the Company to purchase up to 24 million shares of Conseco common stock at a price not less than its market value on the date the option is granted. The options may become exercisable immediately or over a period of time. The plan also permits granting of stock appreciation rights and certain other awards.
participants for interest payments under the bank loans. A total of 22 directors and officers of Conseco elected to participate in the plan and purchased all 4 million shares of Conseco common stock offered under the Plan. At December 31, 1996, the bank loans guaranteed by Conseco totaled $83.4 million and the loans provided by Conseco totaled $2.2 million. The common stock that collateralizes the loans had a fair value of $144.5 million on February 6, 1997. On February 18, 1997, the program was expanded, to permit the purchase of an additional 4 million shares.
The fair value of each option grant used for purposes of estimating the pro forma amounts summarized above is estimated on the date of grant using the Black-Scholes option-price model with the following weighted-average assumptions for 1996 and 1995:
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferrable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because our employee stock options have characteristics significantly different from those of traded options, and because changes in subjective assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not provide a reliable single measure of the fair value of its employee stock options. Because SFAS 123 is effective only for awards granted after January 1, 1995, the pro forma disclosures provided above may not be representative of the effects on reported net income for future years.
The following table summarizes information about fixed stock options outstanding at December 31, 1996:
In connection with the THI Merger, the outstanding warrants to purchase shares of THI common stock were converted into warrants to purchase the same number of shares of Conseco common stock that the holders would have been entitled to receive if such warrants were exercised immediately prior to the THI Merger. Such warrants may be exercised to buy 700,000 shares of Conseco common stock for $13.8 million at anytime through September 29, 2005. The value of the warrants on the THI Merger date of $3.8 million is included in the total cost to acquire THI (see note 2).
Conseco considers anticipated returns from the investment of policyholder balances in determining the amortization of the cost of policies purchased and cost of policies produced. Sales of fixed maturity investments change the incidence of profits on such policies because gains (losses) are recognized currently and, if the sale proceeds are reinvested at the current market yields, the expected future yields on the investment of policyholder balances are reduced (increased). Accordingly, amortization of the cost of policies purchased was increased (decreased) by $31.1 million, $106.4 million and $(3.9) million in the years ended December 31, 1996, 1995 and 1994, respectively, and amortization of the cost of policies produced was increased (decreased) by $4.9 million, $20.2 million and $(1.4) million in the years ended December 31, 1996, 1995 and 1994, respectively.
Cash flows from operations included interest paid on debt of $111.3 million, $112.0 million and $54.3 million in 1996, 1995 and 1994, respectively. Income taxes paid were $122.5 million, $90.3 million and $99.8 million in 1996, 1995 and 1994, respectively.
The statutory capital and surplus of the insurance subsidiaries include surplus debentures of the parent holding companies totaling $855.8 million. Payments of interest and principal on such debentures are generally subject to the approval of the insurance department of the subsidiary's state of domicile.
Certain subsidiaries follow permitted accounting practices, which have been approved by the insurance department of the subsidiary's state of domicile, but have not been specifically prescribed in state laws, regulations, general administration rules and various NAIC publications. Such permitted accounting practices do not affect statutory surplus.
Most states have adopted risk-based capital ("RBC") rules to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks. The RBC formula is designed as an early warning tool to help state regulators identify possible weakly capitalized companies for the purpose of initiating regulatory action. At December 31, 1996, the ratios of total adjusted capital to RBC, as defined by the rules, for the primary insurance subsidiaries of Conseco were greater than twice the level at which regulatory attention is triggered.
Conseco conducts and manages its business through four segments, reflecting the Company's major lines of insurance business and target markets: (i) annuities; (ii) supplemental health; (iii) life insurance; and (iv) other. In addition, from time to time Conseco's earnings also include restructuring income representing the gains realized upon the sale of: (i) portions of acquired companies; and (ii) certain special capital investments. Summarized data for the Company's business segments follow (dollars in millions):
After the LPG Merger, the ALH Stock Purchase and the BLH Merger, LPG, ALH and BLH ceased filing periodic reports with the Securities and Exchange Commission. At December 31, 1996, the following notes remain outstanding: (i) $23.5 million of LPG's senior subordinated notes; (ii) $13.0 million of ALH 6.25% convertible subordinated debentures; and (iii)) $3.2 million of BLH's subordinated notes. These notes are fully guaranteed by Conseco. Because the notes remain outstanding, summarized financial information of LPG, ALH and BLH is presented as follows:
On March 4, 1997, Conseco acquired (the "CAF Merger") Capitol American Financial Corporation ("CAF"). CAF was merged with and became a wholly owned subsidiary of Conseco. In the CAF Merger, each of the approximately 17.7 million shares of CAF common stock and common stock equivalents was converted into the right to receive $30.75 in cash plus 0.1647 of a share of Conseco common stock. Conseco paid $545 million in cash and issued 2.9 million shares of Conseco common stock with a value of approximately $115.7 million to acquire the CAF common stock. In addition, Conseco assumed a note payable of CAF of $31.0 million. CAF, through its insurance subsidiaries, underwrites, markets and distributes individual and group supplemental health and accident insurance. CAF's principal insurance subsidiary is Capitol American Life Insurance Company ("CALI"), an Arizona domiciled insurance company, which accounted for more than 97 percent of CAF's earned premiums over the last five years. CALI is licensed to sell its products in 47 states, the District of Columbia, Puerto Rico and the U.S. Virgin Islands, and markets its products through a sales force consisting of independent agents, agent organizations and brokers. CAF had total assets of $1.1 billion at December 31, 1996.
PFS, through its insurance subsidiaries, underwrites life insurance, annuities and health insurance in selected niche markets throughout the United States. PFS had total assets of approximately $1.8 billion at December 31, 1996. PFS's life, annuity and health insurance premiums collected were $794.2 million in 1996.