Conseco includes life insurance companies in its financial statements on a consolidated basis if Conseco unilaterally controls their operations - either by owning more than 50 percent of their stock or by being the sole general partner of a partnership that owns more than 50 percent of their stock. Conseco includes significant investments in life insurance companies in its financial statements on an equity basis if Conseco does not unilaterally control their operations. Refer to notes 1 and 2 of the consolidated financial statements for a description of changes during the last three years in the companies included in Conseco's consolidated financial statements.
Earnings in this segment increase when Conseco: (i) acquires new companies; (ii) increases its ownership interest in the partially owned companies; or (iii) improves the profitability of owned companies by increasing their sales, investment income or product profitability, or by reducing their expenses.
Since commencing operations in 1982, Conseco has acquired 12 life insurance companies -- the first seven as wholly owned subsidiaries, the next four through Partnership I and the last one through Partnership II. Recent acquisition activity is described in notes 1 and 2 to the consolidated financial statements. All acquisitions have been accounted for as purchases. Therefore, activities of the acquired companies have been included in Conseco's results of operations beginning with the date of purchase.
Conseco plans to accomplish future acquisitions of life insurance businesses through Partnership II, of which a subsidiary of Conseco is the sole managing general partner. Partnership II was formed in early 1994 with commitments from investors for $624 million of capital. The purpose of Partnership II is to complete acquisitions of insurance companies, build value within the acquired companies and, ultimately, realize increased value for the investing partners. The remaining capital commitments of Partnership II (after deducting commitments used in the most recent acquisition) totaled $576.4 million. Such commitments to Partnership II include $92.4 million from Conseco, $23.1 million from BLH, $23.1 million from CCP and $29.9 million from executive officers and directors of Conseco and its affiliates.
Conseco records the activities of acquired companies in its insurance operations segment. Conseco also provides services to acquired companies, thereby generating income in the fee for service segment. Incentive compensation earned by exceeding prescribed returns to the partners and restructuring gains realized from the sale of portions of the acquired entities are reflected in the acquisition and restructuring segment.
General. Conseco's 1994 earnings reflect its ownership interest in Statesman from September 29, 1994, the date Statesman was acquired by Partnership II. Immediately after the acquisition of Statesman, Conseco, through its direct investment and through its equity interests in the investments made by BLH, CCP and WNC, had approximately a 27 percent ownership interest in Statesman. At December 31, 1994, Conseco's ownership interest in Statesman decreased to 25 percent as a result of (i) the sale of Conseco's 40 percent equity interest in WNC on December 23, 1994, and (ii) the sale by a subsidiary of CCP of a portion of its investment in Statesman, partially offset by Conseco's increased ownership percentage in BLH and CCP due to stock repurchases made by BLH and CCP. While all activities of Statesman are required to be included in Conseco's financial statements on a consolidated basis for all periods after September 29, 1994, the minority interest adjustment removes from Conseco's net income the portion applicable to other owners so that net income reflects only Conseco's applicable ownership interest. To enhance comparability, the amounts for the year ended December 31, 1993, and for the nine months ended September 29, 1994, (which were prior to Partnership II's acquisition of Statesman) are presented separately.
Insurance policy income relates primarily to premiums from products with mortality and morbidity features and to surrender charges on annuity products. Total 1994 insurance policy income increased primarily from increased surrender charges earned on annuity policy withdrawals, offset in part by a slight decrease in life insurance premiums and policy fund charges. The increase in surrender charges earned on annuity policy surrenders resulted from an increase in the gross policy withdrawal and surrender payments. The increase in withdrawal and surrender activity was due the increased size of Statesman's annuity portfolio and, as the general level of interest rates increased during 1994, to decisions by policyholders to surrender policies and incur a surrender charge in order to invest funds in higher-yielding alternative investments.
Net investment income for the three months ended December 31, 1994, reflects increased yields on invested assets resulting from the application of purchase accounting. Net investment income in 1994 also reflects an increase in Statesman's average invested assets, primarily from increased premium collections.
Interest expense on annuities and financial products increased in 1994 compared with 1993 as a result of increased annuity deposits and increases in the interest rates credited on new annuity fund deposits. The average rate credited on all insurance liabilities was 5.8 percent and 5.6 percent at December 1994 and 1993, respectively.
Interest expense on long-term debt for the three months ended December 31, 1994, reflects: (i) interest on debt incurred to finance the acquisition of Statesman by Partnership II; and (ii) interest incurred on the $69.0 million of 6-1/4 percent convertible subordinated debentures issued in April 1993 ($44.8 million of which were redeemed on or subsequent to the date of acquisition).
Acquisition and merger expenses incurred by Statesman related to its acquisition by Partnership II include, among other things, compensation expense recognized upon the cash redemption of certain unexercised stock options and stock appreciation rights upon consummation of the acquisition.
Minority interest for periods prior to September 30, 1994, represents dividends on preferred stock of a subsidiary of Statesman. Subsequent to that date, minority interest includes such dividends and the portion of earnings applicable to other owners of Statesman.
Prior to July 1, 1992, Conseco, as the sole general partner of Partnership I, exercised unilateral control over CCP. Conseco, therefore, was required to include the accounts of CCP in its consolidated financial statements. After CCP's IPO, Conseco no longer had unilateral control over CCP. Conseco, therefore, includes CCP's results since the IPO in its financial statements on the equity method.
CCP's operating earnings for 1994 were adversely affected by: (i) a reduction of $9.5 million in prepayment income included in net investment income; and (ii) a charge of $4.2 million, net of income tax of $2.2 million, for current and future guaranty fund assessments on known insolvencies of life insurance companies; and (iii) an increase in morbidity and mortality costs compared to 1993 of approximately $1.1 million, net of tax of $.6 million. CCP's operating earnings in 1993 were affected by: (i) wider spreads between investment yields and policy crediting rates on an increasing base of invested assets; (ii) lower interest expense resulting from the reduction in CCP's long-term debt through scheduled and unscheduled principal payments and lower interest rates; and (iii) the investment of the net proceeds (after prepayment of certain debt) from CCP's IPO and from its secondary public offering in September 1993. CCP's net investment included prepayment income of $.8 million in 1994 and $10.3 million in 1993. Total investment spread excluding prepayment income (the difference between what CCP earns on its investments and what it credits to policyholders) did not change materially between 1994 and 1993.
Insurance policy income relates primarily to premiums from products with mortality and morbidity features. Recent declines have resulted from decreased emphasis on generating new premiums from such products.
Insurance policy benefits (including change in future policy benefits) relate solely to policies with mortality and morbidity features. These benefits have decreased over the last three years due to the decreased emphasis on generating new premiums from such products.
Amortization related to operations decreased in 1993 as a result of the reinsurance recapture previously discussed.
Other operating costs and expenses decreased over the last three years primarily due to the reinsurance recapture by WNC.
Conseco sold its ownership interest in Life Re in November 1992, thereby terminating this source of income.
Conseco's fee revenues include: (i) fees for investment management and mortgage origination and servicing; (ii) commissions earned for insurance and investment product marketing and distribution; (iii) administrative fees for policy administration, data processing, product marketing and executive management services; and (iv) fees for financing services provided to Partnership II. Fees earned from services provided to consolidated entities are eliminated.
Medicare supplement policies accounted for approximately 39 percent of total collected premiums in the last three years. Premiums from Medicare supplement policies increased in 1994 primarily due to a larger base of renewal premiums, improved persistency and rate increases on renewal policies. During 1992, BLH implemented a new strategy of pricing Medicare supplement policies on an attained-age basis. This strategy, which produces lower first-year premiums, along with an increase in the proportion of policies sold with lower benefit levels, caused annualized new business premiums from such new sales to decrease to $76.3 million in 1994 compared with $80.5 million in 1993 and $83.0 million in 1992.
Long-term care plans accounted for 8.6 percent, 7.8 percent and 7.6 percent of total collected premiums in 1994, 1993 and 1992, respectively. The increase was due to growth in new business and a larger base of renewal premiums. Annualized new business premiums were $27.9 million, $21.6 million and $18.1 million in 1994, 1993 and 1992, respectively.
Annuity premiums collected increased by 22 percent in 1994 following a 28 percent increase in 1993. BLH sold more single premium deferred annuities because of an increased marketing emphasis placed on annuity sales.
Premiums collected by Conseco's wholly owned subsidiaries were $88.5 million, $142.2 million and $82.6 million in 1994, 1993 and 1992, respectively. These subsidiaries are no longer writing new business, except that during 1994 and 1993, they collected $5.6 million and $61.8 million, respectively, of premiums from guaranteed investment contracts and deposit funds for qualified retirement plans maintained by the Company.
The Company's investment strategy is to: (i) maintain a predominately investment-grade fixed-income portfolio; (ii) provide adequate liquidity for expected liability durations and other requirements; and (iii) maximize total return through active investment management. At December 31, 1994, the Company had invested assets of approximately $8.2 billion. These assets were primarily actively managed fixed maturities, as well as mortgage loans, credit-tenant loans, policy loans, trading account securities, investment in CCP, and short-term investments.
The following table summarizes investment yields earned over the past three years and includes subsidiaries from the date of their acquisition, and CCP and WNC until the date of their deconsolidation.
Conseco's actively managed fixed maturity portfolio at December 31, 1994, was comprised primarily of debt securities of the U.S. 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 discussed in the notes to the consolidated financial statements, when the carrying values of actively managed fixed maturity investments are adjusted for changes in fair value, Conseco also adjusts the cost of policies purchased, cost of policies produced and insurance liabilities. These adjustments reflect the change in amortization that would be needed if those fixed maturity investments had actually been sold at their fair values and the proceeds reinvested at current interest rates.
Conseco periodically evaluates the creditworthiness of each issuer whose securities are held in the portfolio. Conseco pays special attention 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 evidence 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. Evidence 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: (i) reduces the carrying amount to its net realizable value, which becomes the new cost basis; and (ii) reports the amount of the reduction as a realized loss. Conseco recognizes any recovery of such reductions in the cost basis of an investment as a realized gain only upon the sale, repayment or other disposition of the investment. Conseco recorded writedowns of investments of $1.0 million in 1994 as a result of conditions which caused the Company to conclude that it would not be able to collect all amounts due according to the terms of the securities.
As of December 31, 1994, the amortized cost and estimated fair value of fixed maturity investments in substantive default (i.e.,in default due to nonpayment of interest or principal) were $9.8 million and $10.1 million, respectively. The Company had no fixed maturity investment 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.
All mortgage-backed securities are subject to risks associated with variable prepayments. As a result, these securities may have a different actual maturity than planned at the time of purchase. When securities having a carrying value greater than par are backed by mortgages that prepay faster than expected, Conseco records a charge to investment income. When securities having a carrying value less than par prepay faster than expected, Conseco records investment income.
If the Company determines that it will dispose of an investment held in the actively managed fixed maturity category, the security will be either sold or transferred to the trading account at its fair value and the gain or loss will be recognized. There were no such transfers in 1994. During 1994, the Company sold actively managed fixed maturity securities with a $1.9 billion book value, resulting in $9.3 million of investment losses (before related expenses, amortization and taxes). Such securities were sold in response to changes in the investment environment which created opportunities to enhance the total return of the investment portfolio without adversely affecting the quality of the portfolio or the matching of expected maturities of assets and liabilities. The realization of gains and losses affects the timing of the amortization of the cost of policies produced and the cost of policies purchased, as explained in note 11 to the consolidated financial statements.
Credit-tenant loans are loans on commercial properties where the lease of the principal tenant is assigned to the lender and the principal tenant, or any guarantor of such tenant's obligations, has a credit rating at the time of origination of the loan of at least BBB- or its equivalent. The underwriting guidelines consider such factors as: (i) the lease term of the property; (ii) the mortgagee'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 also generally require a loan-to-value ratio of 75 percent or less. Credit-tenant loans are carried at amortized cost and were $69.0 million at December 31, 1994, or .8 percent of total invested assets. The total estimated fair value of credit-tenant loans was $61.3 million at December 31, 1994.
As part of its investment strategy, the Company enters into reverse repurchase agreements and dollar-roll transactions (specialized forms of collateralized lending involving mortgage-backed securities) to increase its return on investments and improve liquidity. These transactions are accounted for as short-term collateralized borrowings and are collateralized by pledged securities with fair values approximately equal to the loan value. Conseco had no investment borrowings at December 31, 1994, compared with investment borrowings of $427.7 million at December 31, 1993. The average amount of investment borrowings during 1994 was approximately $208.0 million, compared to $431.0 million during 1993.
Conseco's investment in CCP represents its share of the equity of CCP. Such investment decreased during 1994 as a result of the unrealized loss adjustment to fixed maturity investments recognized by CCP in accordance with SFAS 115, offset by Conseco's equity in the earnings of CCP.
Reinsurance receivables, which primarily represent liabilities ceded under reinsurance agreements, decreased as a result of the recapture of annuity business by BLH that had previously been ceded to nonaffiliated companies as described in note 6 to the consolidated financial statements.
Goodwill increased in 1994 as a result of the acquisition of Statesman by Partnership II, as further described in note 2 to the consolidated financial statements.
Insurance liabilities decreased primarily as a result of the sale of WNC, partially offset by: (i) the acquisition of Statesman by Partnership II; and (ii) the recapture of annuity business by BLH that had previously been ceded.
Common stock and additional paid-in-capital increased by $63.0 million. This was a result of 3.9 million shares of common stock issued pursuant to the Company's stock option and deferred compensation programs for net proceeds and tax benefits of $16.9 million and $69.2 million, respectively. Additionally, $2.4 million was added to common stock and additional paid-in capital relating to employee benefit plans. These increases were partially offset by share repurchases, which reduced common stock and additional paid-in capital by $25.5 million. As a result of changes in common stock accounts, the number of common shares outstanding decreased by 3.1 million shares.
Of the companies' total insurance liabilities at December 31, 1994, approximately 83 percent could be surrendered by the policyholder, of which 78 percent were subject to penalty if surrendered. Payment characteristics of the insurance liabilities at December 31, 1994, were as follows (dollars in millions):
Approximately 20 percent of insurance liabilities were subject to interest rates, ranging from 2 percent to 10 percent, fixed for the life of the contract. The remaining liabilities generally were subject to interest rates that could be reset at least annually.
The Company believes that it has adequate short-term investments and readily marketable investment grade securities to cover the payments under contracts containing fixed payment dates plus any likely cash needs for all other contracts. The Company's investment portfolio at December 31, 1994, included $.3 billion of short-term investments, $2.9 billion of U.S. Government/agency and mortgage-backed securities and $3.6 billion of publicly traded investment grade bonds. The Company believes that such investments could be readily sold at or near carrying value or used to facilitate borrowings under reverse repurchase agreements. At December 31, 1994, the Company's portfolio of bonds, notes and redeemable preferred stocks had an aggregate unrealized loss of $373.4 million.
BLH provided BLI with funds to acquire Bankers Life. In exchange, BLH received a $500 million surplus debenture from BLI. he surplus debenture was approved by the Illinois Department of Insurance ("DOI"). During 1994 and 1993, BLI repaid principal of $25.0 million and $15.0 million, respectively, plus accrued interest on the surplus debenture. BLI may repay principal and interest on the surplus debenture only when the DOI is satisfied that the financial condition of BLI warrants that action; such approval may not be withheld if BLI submits satisfactory evidence of surplus of at least the amount stipulated in the surplus debenture.
At December 31, 1994, BLH's debt service obligations included a $99.0 million principal amount senior term loan payable in annual installments and $180 million principal amount of senior subordinated notes due in 2002. Future annual debt service requirements are discussed in note 8 to the consolidated financial statements.
At December 31, 1994, BLH had short-term investments of $88.7 million. Conseco believes that BLH could generate additional liquidity, if needed in the future, by issuing equity on debt securities or by converting existing assets to cash (such as the sale or transfer of existing blocks of insurance through reinsurance arrangements).
Of the proceeds from its IPO, BLH contributed $114 million to the capital of its subsidiaries. BLH believes its life subsidiaries are adequately capitalized and will not require additional investment to maintain their current operations.
Dividends on ALHC's common stock are limited by: (i) the rights of holders of its preferred stock to receive cumulative dividends in full before any dividends may be paid on common stock; and (ii) the covenants of the senior term loan. ALHC currently has redeemable preferred stock outstanding, on which aggregate dividends of $8.8 million are payable annually. The two series of redeemable preferred stock outstanding must be redeemed in 2007 and 2008 at their respective par values of $69.0 million and $30.0 million. ALHC holds zero coupon U.S. Treasury securities in escrow which will provide adequate funds for the redemption of the preferred shares on the mandatory redemption date of each issue.
At December 31, 1994, the parent company and its non-life subsidiaries had short-term investments of $132.5 million, of which $8.1 million was expended in January 1995 for accrued interest and dividends. The life subsidiaries are permitted to distribute an additional $48.4 million to the parent company in 1995. The parent company and its non-life subsidiaries had additional investments in nonaffiliates of $40.4 million at December 31, 1994, which, if needed, could be liquidated or contributed to the insurance subsidiaries. Conseco believes that it could generate additional liquidity, if needed in the future, through equity offerings, debt issuance, or the conversion of existing assets to cash, including the sale of a partial or entire interest in its affiliates.
On February 27, 1995, Conseco announced that its board of directors had approved proposals to acquire, in separate transactions, the outstanding shares of CCP and BLH that it does not already own. Under the proposal, CCP and BLH would merge into Conseco, with Conseco being the surviving corporation. Each holder of CCP shares other than Conseco would receive $22.50 per share in cash. Each holder of BLH shares other than Conseco would receive $22.00 per share in cash. Each proposed merger transaction requires the approval of holders of a majority of outstanding shares of the company being acquired (other than shares held by Conseco) voting at a special stockholders' meeting.
CCP has: (i) a sizable and profitable block of in-force business; and (ii) a distribution system that has the potential to generate growth in the SPDA and 403(b) tax sheltered annuity markets.
BLH's strategy is to continue to grow profitably its individual health and other insurance business while maintaining appropriate levels of capital and surplus. A primary area of focus is expanding and enhancing the productivity of the career agency force, which is BLH's main distribution system. During 1994, BLH's agent force grew by 3 percent. BLH's growth strategy also emphasizes increased cross-selling to existing policyholder households and developing products tailored to meet specific consumer needs. As a result of cross-selling, 1994 annualized new business premiums increased 29 percent for long-term products and 23 percent for annuities.
The U.S. Congress and state legislatures are currently considering various proposals relating to the country's health care delivery system. BLH is unable to predict what changes to the country's health care system will be enacted and, if enacted, their scope and effects on its business. However, BLH continues to believe that opportunities for its products will grow under any realistic and affordable health care reform scenario.
Conseco believes that the statutory surplus of its insurance subsidiaries and investees is adequate. Conseco expects that statutory earnings in 1995 will exceed amounts needed by the holding companies for debt service and other requirements. Such excesses will be available to increase statutory capital of the life insurance subsidiaries and investees so that their internal growth can continue.
The Company believes that a number of life insurance companies will be available to be acquired in the next 10 years as a result of strategic restructuring and consolidation within the life industry. The Company expects to participate in such acquisitions through Partnership II, using the capital provided by: (i) the partnership; (ii) mezzanine capital that may be provided by the individual partners of Partnership II and others; and (iii) debt capital from various sources.
At the current time Conseco believes that some sources of capital (primarily bank financing) are more available to life insurance companies than in some prior periods. As a result: (i) more restructuring and financing alternatives are available to owners and managers of insurance companies so that fewer companies are currently seeking buyers, such as Conseco; and (ii) more buyers have access to such capital and are creating more competition to purchase those companies that are available. Consequently, Conseco believes it may be able to complete fewer acquisitions in the near future while these conditions exist.
The Company believes there will be a period in the future when it will be more difficult to obtain financing for acquisitions because of conditions in the capital markets, causing a greater dependence on equity capital financing, such as that obtained through Partnership II. Conseco will actively seek alternative capital sources, if needed, to finance acquisitions. If those conditions in the capital markets continue, it may also affect the availability of appropriate acquisition targets, if sellers of insurance companies decide to wait for more favorable conditions. In addition, Conseco's increased size and evolving strategies will eliminate a number of potential acquisition candidates who are either too small or are inappropriate strategic targets. However, Conseco believes it has the resources and capabilities to continue its strategy of acquiring and restructuring life insurance companies. It also believes that its past record of successfully acquiring, financing and operating life insurance companies will be an advantage compared to others who may attempt to acquire available candidates.
When there are changes in conditions that cause us to transfer a fixed maturity investment to a different category (i.e., actively managed, trading or held to maturity), we transfer it to the new category at its fair value on the date of the transfer. We account for the security's unrealized gain or loss (such amounts were immaterial in 1994) as follows:
Short-term investments include commercial paper, invested cash and other investments purchased with maturities of less than three months. We carry them at amortized cost, which approximates their estimated fair value. We consider all short-term investments to be cash equivalents.
We defer any fees received or costs incurred when we originate investments--principally credit-tenant loans 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, we report the difference between our sale proceeds and our carrying value of the individual security as a realized gain or loss on investments. If the proceeds result from prepayments by the issuer prior to maturity, then those differences are recorded as an adjustment to investment income.
- The magnitude of the risks associated with each of the actuarial assumptions used in determining expected future cash flows (as described above).
- The likelihood of changes in projected future cash flows that might occur if there are changes in insurance regulations and tax laws.
After we determine the cost of policies purchased, we amortize that amount based on the incidence of the expected cash flows. For acquisitions we made on or before November 19, 1992, we amortize the asset with interest at the same rate used to determine the discounted value of the asset. For acquisitions after November 19, 1992, including the acquisition of Statesman on September 29, 1994, and the acquisition of additional shares of BLH on September 30, 1993, we amortize this asset using the interest rate credited to the underlying policies.
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. If we determine that our goodwill has been impaired, we reduce its carrying value with a corresponding charge to expense (no such charges have been made).
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 range from three to 50 years. Our depreciation expense was $8.3 million in 1994, $6.0 million in 1993 and $3.7 million in 1992.
Our reserves for universal life-type and investment-type contracts are based either on the contract account balance (if future benefit payments in excess of the account balance are not guaranteed) or on the present value of future benefit payments (if such payments are guaranteed). We make additions to insurance liabilities if we determine that future cash flows (including investment income) are insufficient to cover future benefits and expenses.
Our reserves for traditional and limited-payment life contracts are generally calculated using the net level premium method, based on assumptions as to investment yields, mortality, withdrawals and dividends. We make these assumptions at the time the contract is issued or, in the case of contracts acquired by purchase, at the purchase date. We base these assumptions on projections from past experience, making allowance for possible unfavorable deviation.
We establish reserves for the estimated present value of the remaining net cost of all reported and unreported claims. We base our estimates on past experience and on published tables for disabled lives. We believe that the reserves we have established are adequate. Final claim payments, however, may differ from the established reserves, particularly when those payments may not occur for several years. Any adjustments we make to reserves are reflected in the results for the year during which the adjustments are made.
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. The 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. The assumptions are based on projections of past experience and include provisions for possible adverse deviation.
Our income tax expense includes deferred taxes arising from temporary differences between the tax and financial reporting basis of assets and liabilities. This liability method of accounting for income taxes also requires us to reflect the effect of a tax rate change on accumulated deferred income taxes in income in the period in which the change is enacted.
Interest rate swaps. We use fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the credit standing of the counterparties.
In September 1993, CCP completed a public offering in which CCP sold 3.0 million shares of its common stock and certain shareholders sold 6.5 million shares of CCP common stock. Proceeds of approximately $80.9 million from the offering of common shares by CCP (after underwriting and issuance costs) were added to CCP's funds for general corporate purposes. CCP received no proceeds from the sale of shares by the selling shareholders. In a separate transaction, Conseco purchased 2.0 million shares of CCP common stock from the selling shareholders for $53.6 million. In addition, Conseco purchased .3 million shares of CCP common stock in open market transactions for $5.9 million during 1993. After these transactions, Conseco owned 40 percent of the common stock of CCP.
The closing price of CCP's shares on the New York Stock Exchange on December 31, 1994, was $20.375 per share, indicating a total fair value of Conseco's investment in CCP of $235.4 million. Conseco's cost of these shares was $102.8 million. The CCP shares held by Conseco are not freely tradable, and sale of such shares may require a registration statement with the Securities and Exchange Commission.
On September 30, 1993, Conseco acquired 13.3 million shares of BLH common stock from Southwestern Life 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 Southwestern Life preferred stock, and by paying $237.6 million in cash. Conseco funded the cash payment using available cash and the net proceeds from a $200.0 million senior unsecured loan. As described below, the loan was repaid in February 1994, using the proceeds from the IPO of WNC. The transaction with Southwestern Life increased Conseco's ownership of BLH to 56 percent.
The closing price of BLH's shares on the New York Stock Exchange on December 31, 1994, was $19.00 per share, indicating a total fair value of Conseco's investment in BLH of $576.9 million. Conseco's cost of these shares was $313.1 million; net equity included in these consolidated financial statements is $477.9 million. Shares held by Conseco are not freely tradable, and sale of such shares may require a registration statement with the Securities and Exchange Commission.
On February 15, 1994, WNC completed the IPO of 37.2 million shares of common stock. Of these shares, 2.3 million were sold by WNC and 34.9 million were sold by Conseco. In addition, Conseco sold .2 million shares to the president of WNC at the IPO price, less underwriting discounts and commissions. In connection with the organization of WNC and the transfer of the stock of Western National to WNC by Conseco, WNC issued 60 million shares of its common stock and a $150.0 million, 6.75 percent senior note due March 31, 1996 (the "Conseco Note") to Conseco. On February 22, 1994, WNC completed a public offering of $150.0 million aggregate principal amount of 7.125 percent senior notes due February 15, 2004. The net proceeds from the offering of $147.5 million (after original issue discount, underwriting discount and offering expenses) together with some of the proceeds from WNC's IPO of common stock, were used to repay the Conseco Note.
The following table sets forth the amortized cost and estimated fair value of actively managed fixed maturities as of December 31, 1994, based upon the pricing source used to determine estimated fair value:
The proceeds from sales of fixed maturity investments were $1.9 billion, $6.5 billion and $4.2 billion in 1994, 1993 and 1992, respectively. Proceeds from the sales of trading account securities were $.9 billion, $10.0 billion and $6.7 billion in 1994, 1993 and 1992, respectively.
At December 31, 1994, net depreciation of equity securities (before income tax) was $3.4 million, consisting of $.3 million of appreciation and $3.7 million of depreciation.
At December 31, 1994, mortgage loans were comprised of 91 percent commercial loans and 7 percent junior and residual interests in collateralized mortgage obligations. Approximately 11 percent, 10 percent and 10 percent of the mortgage loans were on properties located in Texas, New York, and Florida, respectively. No other state comprised greater than 8 percent of the mortgage loan balance. At December 31, 1994, the Company had an allowance for loss on mortgage loans of $1.9 million. The Company had no realized losses on mortgage loans during 1994.
Life insurance companies are required to maintain certain investments on deposit with state regulatory authorities. Such assets had an aggregate carrying value of $45.0 million at December 31, 1994.
Conseco had no investments in any single entity in excess of 10 percent of shareholders' equity at December 31, 1994, other than investments in affiliates and investments issued or guaranteed by the U.S. Government.
Conseco's investment in 45 percent of the common stock of CCP was carried on the equity basis at $195.4 million at December 31, 1994. This amount represents the effect of the transactions described in note 2 and Conseco's equity in CCP's earnings. See note 2 for a further description of Conseco's ownership of CCP.
Conseco amortizes the difference of $22.8 million between the carrying value of its investment in CCP and the amount of its underlying equity in net assets on the straight-line basis over a 40-year period. The following tables summarize financial information of CCP for the periods during which CCP and its subsidiaries have been included in Conseco's financial statements on the equity basis:
See note 2 for a description of transactions affecting Conseco's ownership of WNC. The following summarizes selected account balances of WNC. All 1993 and 1992 amounts were consolidated with the Company's accounts and 1994 was included on the equity basis.
At December 31, 1991, Conseco owned a 31 percent equity interest (after exercise of warrants held by others) in the common stock and $30.0 million of 12 percent junior preferred stock of Life Re Corporation ("Life Re"), a company engaged in the life reinsurance business. In November 1992, Life Re completed an initial public offering of its common stock and redeemed all of the common and preferred stock held by the Company. As a result, Conseco recorded a gain of $15.2 million (net of tax of $21.2 million) in 1992. The following amounts related to Life Re were recorded in Conseco's financial statements:
The sale of fixed maturity investments during 1993 reduced the expected future yields on the investment of policyholder balances to the extent that projected future cash flows on certain products were insufficient to cover future benefits and expenses. Accordingly, Conseco established additional estimated insurance liabilities of $37.1 million by a charge to expense.
Effective April 1, 1994, BLH recaptured certain annuity business previously ceded to an unaffiliated company and retroceded to an affiliate of Southwestern Life. The excess of liabilities assumed of $390.2 million over assets acquired of $371.0 million was capitalized as a component of cost of policies purchased. Reserves related to these policies totaling $398.5 million were included in reinsurance receivables at December 31, 1993.
On June 30, 1993, Western National recaptured certain annuity business with insurance liabilities of $156.5 million that had previously been reinsured with an unaffiliated company. Assets with a fair value approximating the insurance liabilities were transferred to the Company.
Notes payable that are direct obligations of the Company at December 31, 1994 and 1993, were as follows:
In February 1993, the Company completed a public offering of $200 million of 8-1/8% senior notes due in 2003. Interest on the senior notes is payable semi-annually on February 15 and August 15. The notes are unsecured and rank pari passu with all other unsecured and unsubordinated indebtedness of the Company. The notes are not redeemable prior to maturity. Proceeds from the offering of approximately $195.6 million (after original issue discount and other associated costs) were used to repurchase in open market transactions or redeem the remaining outstanding 12.75 percent senior subordinated notes issued in July 1987, and for general corporate purposes. The repurchase and redemption of the senior subordinated notes resulted in an extraordinary charge of $8.4 million, net of a $4.3 million tax benefit, in 1993.
During 1992, the Company purchased in the market or called $20.0 million par value of senior subordinated notes. These redemptions resulted in an extraordinary charge of $1.4 million, net of a $.7 million tax benefit.
At December 31, 1994, notes payable of Partnership II entities, which are not direct obligations of Conseco, were as follows:
On September 29, 1994, American Life Holding Company ("ALHC") executed a $200 million senior term loan with a group of banks as partial financing for the acquisition of Statesman by Partnership II. The loan has two tranches. One tranche has an aggregate principal amount of $160.0 million ("Tranche A") and the other tranche has an aggregate principal amount of $40.0 million ("Tranche B"). On the Acquisition date, $130.0 million and $40.0 million were borrowed under Tranche A and Tranche B, respectively. The remaining $30.0 million is to be borrowed at a later date when needed either to redeem the Statesman 1988 Series Preferred Stock or to pay the Contingent Consideration, depending on the outcome of the Government Litigation as further described in note 2.
Tranche A and Tranche B bear interest at a rate of either: (i) the Bank's Alternate Reference Rate plus an applicable margin payable monthly; or (ii) the Interbank Offered Rate ("IBOR") plus an applicable margin for periods of one, two, three or six months as selected from time to time. Such rate selected at December 31, 1994, was 8.3 percent for Tranche A and 8.8 percent for Tranche B. The applicable margin for the rate based on the Alternate Reference Rate will vary from .25 percent to 1.0 percent for Tranche A and from .75 to 1.5 percent for Tranche B, depending on the principal amount plus unused commitments. The applicable margin for the rate based on IBOR will vary from 1.5 percent to 2.25 percent for Tranche A and from 2.0 percent to 2.75 percent for Tranche B, depending on the principal amount plus unused commitments.
Mandatory prepayments will be required: (i) from 50 percent of excess cash flow (as defined in the loan agreement); (ii) upon the sale or disposition of any significant assets other than in the ordinary course of business; and (iii) upon the sale or issuance of debt or equity securities of Statesman or any of its subsidiaries. Under the provisions of the senior term loan, ALHC must comply with various covenants, including the maintenance of specific financial ratios and restrictions on the payment of dividends. The senior term loan has as collateral, among other things, pledges of the capital stock of ALHC's subsidiaries (American Life and Casualty Insurance Company ("American Life," Statesman's primary operating subsidiary) and American Life and Casualty Marketing Division Co. ("AMCO")) and the surplus notes of American Life held by ALHC. The senior term loan is unconditionally guaranteed by Statesman and AMCO. In addition, Partnership II has pledged to the lenders the Statesman common stock owned by Partnership II.
Certain notes payable, not direct obligations of Conseco, were issued by subsidiaries of Partnership I to finance portions of the purchase prices of Great American Reserve, Jefferson National and Beneficial Standard. In connection with the IPO and recapitalization of CCP, a significant portion of CCP's debt was retired, resulting in an extraordinary charge for CCP of $8.8 million, net of a $4.8 million tax benefit, in 1992. Conseco's share of this charge ($3.9 million) was included as an extraordinary charge in 1992 consolidated financial statements. The remaining outstanding debt was no longer consolidated in the consolidated financial statements, as described in note 1.
The Company has qualified defined contribution plans in which substantially all employees of the Company's wholly owned subsidiaries, BLH and Statesman are eligible to participate. Company contributions, which match certain voluntary employee contributions to the plan, totaled $1.7 million, $1.4 million and $1.0 million in the years ended December 31, 1994, 1993 and 1992, respectively, and may be made in cash or stock of Conseco or BLH.
BLH 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 $29.5 million and $28.5 million at December 31, 1994, and 1993, respectively, substantially all of which represents vested benefits. Costs incurred on this plan, primarily representing interest on unfunded benefit costs, were $2.7 million and $2.8 million during 1994 and 1993, respectively. Costs for 1992 were not significant.
BLH also provides certain health care and life insurance benefits for eligible retired employees. Benefits are provided under a contributory unfunded plan which includes cost-sharing features determined at the discretion of management. During 1994 and 1993, several modifications were made to postretirement benefit plans that: (i) established cost-sharing for certain future retirees; (ii) established maximum annual costs and benefits; and (iii) revised certain other benefits. Such changes made in 1993 resulted in a $45.0 million decrease in the accumulated post retirement benefit obligation ("APBO"). As a result, the APBO was reduced $27.6 million, goodwill was reduced by $17.9 million and deferred income tax liability was increased by $9.7 million. The remaining 1993 changes resulted in an unrecognized net reduction in prior service costs of $11.9 million and an unrecognized gain of $2.0 million. Such changes made in 1994 resulted in a $9.2 million amendment gain and $5.2 million curtailment gain. The amendment gain is amortized over the remaining service period of active plan participants. The curtailment gain is included in other income. Amounts related to the postretirement benefit plan consisted of the following:
The net cost of providing these benefits, included in other operating expenses, was comprised of the following:
The discount rates used in determining the accumulated postretirement benefit obligation were 8 percent and 7 percent at December 31, 1994 and 1993, respectively. Future increases in salaries and the assumed health care cost trend rates produce no change in the accumulated postretirement benefit obligation at December 31, 1994, because of the employer's maximum cost sharing provisions discussed above. When computing the obligation at December 31, 1993, the assumed annual increase in salary levels was 5.2 percent and the assumed annual increase in the per capita cost of covered benefits was 12 percent in 1994 decreasing gradually to 5 percent in 2006 and remaining at that level thereafter.
From time to time, the Company and its subsidiaries are involved in lawsuits which are 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 which 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 or results of operations.
In June 1994, Conseco entered into a merger agreement with Kemper Corporation ("Kemper"). The merger agreement was terminated in November 1994. In connection with the proposed merger with Kemper, Conseco incurred pre-tax expenses totaling approximately $35.8 million including: (i) $15.1 million of fees to banks for financing commitments; (ii) $9.8 million loss on the decline in fair value of Kemper common stock held by Conseco; and (iii) $10.9 million of legal, accounting and actuarial fees and other expenses.
Another director of the Company is the chairman of the board and chief executive officer of a company that received a total of approximately $.6 million from the company during the three years ended December 31, 1994 for microfiche and related supplies.
In addition to 8,611,156 shares of common stock reserved for issuance under the 1983 and 1994 employee stock option plans, 694,759 shares of common stock are reserved for issuance under stock bonus and deferred compensation plans. The common stock and additional paid-in capital account was reduced by $6.8 million at December 31, 1994, for the unearned portion of the incentive deferred compensation program.
The five states with the largest shares of premiums collected in 1994 were Illinois (13 percent), Florida (9.4 percent), Michigan (7.2 percent), Texas (6.2 percent) and California (3.9 percent). No other state accounted for more than 3 percent of total collected premiums.
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 $(3.9) million, $46.0 million and $63.3 million in the years ended December 31, 1994, 1993 and 1992, respectively, and amortization of the cost of policies produced was increased (decreased) by $(1.4) million, $43.2 million and $30.1 million in the years ended December 31, 1994, 1993 and 1992, respectively.
Based on current conditions and assumptions as to future events on all policies in force, the Company expects to amortize approximately 10 percent of the December 31, 1994, balance of cost of policies purchased in 1995, 10 percent in 1996, 9 percent in 1997, 8 percent in 1998, and 7 percent in 1999. The discount rates used to determine the amortization of the cost of policies purchased prior to November 19, 1992, ranged from 15 percent to 20 percent during the three-year period ended December 31, 1994. The discount rates used to determine the amortization of the cost of policies purchased thereafter ranged from 5 percent to 7.5 percent.
Financial information related to these activities as included in the consolidated financial statements is as follows:
The condensed financial information should be read in conjunction with the consolidated financial statements of Conseco, Inc. The condensed financial information includes the accounts and activity of the Parent Company and its non-insurance subsidiaries which act as the holding companies for the Company's life insurance subsidiaries and investees.