Management's discussion and analysis reviews the consolidated financial condition of Conseco at December 31, 1997 and 1996, the consolidated results of operations for the three years ended December 31, 1997, and where appropriate, factors that may affect future financial performance. This discussion should be read in conjunction with the accompanying consolidated financial statements, notes thereto and selected consolidated financial data.
All statements, trend analyses and other information contained in this report and elsewhere (such as in other filings by the Company with the Securities and Exchange Commission, press releases, presentations by the Company or its management or oral statements) relative to markets for the Company's products and trends in the Company's operations or financial results, as well as other statements including words such as "anticipate," "believe," "plan," "estimate," "expect," "intend," and other similar expressions, constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to known and unknown risks, uncertainties and other factors that may cause actual results to be materially different from those contemplated by the forward-looking statements. Such factors include, among other things: (i) general economic conditions and other factors, including prevailing interest rate levels, stock market performance and health care inflation, which may affect the ability of the Company to sell its products, the market value of the Company's investments and the lapse rate and profitability of the Company's policies; (ii) the Company's ability to achieve anticipated levels of operational efficiencies at recently acquired companies, as well as through other cost-saving initiatives; (iii) customer response to new products, distribution channels and marketing initiatives; (iv) mortality, morbidity, use of health care services and other factors that may affect the profitability of the Company's insurance products; (v) changes in the federal income tax laws and regulations that may affect the relative tax advantages of some of the Company's products; (vi) increasing competition in the sale of the Company's products; (vii) regulatory changes or actions, including those relating to regulation of financial services affecting (among other things) bank sales and underwriting of insurance products, regulation of the sale, underwriting and pricing of insurance products, and health care regulation affecting the Company's health insurance products; (viii)
the availability and terms of future acquisitions; and (ix) the risk factors or uncertainties listed from time to time in the Company's other filings with the Securities and Exchange Commission.
Our 1997 operating earnings were $574.9 million, or $2.74 per diluted share, up 115 percent and 42 percent, respectively, over 1996. Operating earnings increased as a result of the LPG Merger (completed effective July 1, 1996), the ALH Stock Purchase (September 30, 1996), the ATC Merger (December 31, 1996), the THI Merger (December 31, 1996), the BLH Merger (December 31, 1996), the CAF Merger (January 1, 1997), the PFS Merger (April 1, 1997), the Colonial Penn Purchase (September 30, 1997) and the WNIC Merger (December 1, 1997) and as a result of the increased business in force of these acquired companies and companies previously owned. The percentage increase in operating earnings was greater than the percentage increase in operating earnings per diluted share primarily because of the 51 percent increase in weighted average diluted common shares or equivalents outstanding during 1997. The increase in weighted average diluted shares resulted from shares issued in certain 1997 and 1996 acquisitions (the LPG Merger, the ATC Merger, the THI Merger, the BLH Merger, the CAF Merger and the PFS Merger), partially offset by repurchases of Conseco common stock.
Net income of $567.3 million in 1997, or $2.64 per diluted share, included: (i) net investment gains (net of related costs, amortization and taxes) of $44.1 million, or 21 cents per diluted share; (ii) an extraordinary charge of $6.9 million, or 3 cents per share, related to early retirement of debt; (iii) a charge of 7 cents per share related to the induced conversion of preferred stock (treated as a preferred stock dividend); and (iv) nonrecurring charges totaling $44.8 million, or 21 cents per share. Nonrecurring charges include: (i) $40.5 million related to our Medicare supplement business in Massachusetts; and (ii) $4.3 million related to the death of an executive officer. Regulators in Massachusetts have not allowed premium increases for Medicare supplement products necessary to avoid losses on the business. We are currently seeking rate increases. We are no longer writing new Medicare supplement business in Massachusetts. We have written off the cost of policies purchased and produced and accrued additional claim reserves related to our in-force Massachusetts Medicare supplement business due to the estimated premium deficiencies.
Total revenues include net investment gains of $266.5 million in 1997, $60.8 million in 1996 and $204.1 million in 1995. Excluding net investment gains, total revenues were $5.3 billion in 1997, up 76 percent from $3.0 billion in 1996. Total revenues in 1997 include a full year of activity for acquisitions completed in 1996 and the revenues of CAF, PFS, Colonial Penn and WNIC in the periods subsequent to their acquisitions. Total revenues in 1996 include LPG revenues after July 1, 1996. Total revenues, excluding net investment gains, were up 13 percent in 1996 from $2.7 billion in 1995.
Results of operations by segment for the three years ended December 31, 1997:
Premiums collected on long-term care policies increased 244 percent in 1997, to $663.9 million, and 36 percent in 1996, to $192.9 million. First-year collected premiums in 1997, 1996 and 1995 were $143.4 million, $51.6 million and $44.4 million, respectively. The increase in long-term care premiums collected primarily reflects the acquisition of recently acquired companies.
Changes in the ratio of policy benefits to insurance policy income for long-term care policies reflect different characteristics of such policies in recently acquired companies as well as fluctuations in claim experience and reserve development. In 1997, the long-term care loss ratio increased by 4.9 percentage points, to 63.6 percent. In 1996, the long-term care loss ratio fell by 1.8 percentage points, to 58.7 percent.
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 increased primarily because of the increase in balances subject to amortization as a result of recent acquisitions.
Other operating costs and expenses increased in 1997 from the increased business of recently acquired companies. Such expenses did not change materially in 1996 compared with 1995.
Traditional fixed rate annuity products include SPDAs, FPDAs and SPIAs, which are credited with a guaranteed rate. SPDA and FPDA policies (which make up 78 percent, 84 percent and 90 percent of traditional fixed rate annuity premiums collected in 1997, 1996 and 1995, respectively) typically have an interest rate that is guaranteed for the first policy year, after which we have the discretionary ability to change the crediting rate to any rate not below a guaranteed minimum rate. The interest rate credited on SPIAs is based on market conditions existing when a policy is issued and remains unchanged over the life of the SPIA. The demand for traditional fixed rate annuity contracts has decreased in recent years, as relatively low interest rates have made other investment products more attractive. Annuity premiums on these products decreased 24 percent in 1997, to $937.2 million, and decreased 22 percent in 1996, to $1,241.3 million.
Insurance policy income includes: (i) premiums received on SPIA policies that incorporate significant mortality features; (ii) cost of insurance and expenses charged to annuity policies; and (iii) surrender charges earned on annuity policy withdrawals. In accordance with GAAP, premiums on annuity contracts without mortality features are not reported as revenues, but rather are reported as deposits to insurance liabilities. Insurance policy income increased in 1997 and 1996 primarily because of increased surrender charges collected (changes in premiums received on policies with mortality features and cost of insurance and expenses charged to annuity policies were not significant). Surrender charges were $64.0 million in 1997, $41.2 million in 1996 and $28.6 million in 1995. Annuity policy withdrawals were $1.8 billion in 1997, compared with $1.7 billion in 1996 and $1.5 billion in 1995. The increase in policy withdrawals and surrender charges generally corresponds to the aging and the growth of our annuity business in force. In addition, policyholders are using the systematic withdrawal features available in several of our annuity policies, and more policyholders are surrendering in order to invest in alternative investments. Total withdrawals and surrenders were 15 percent, 16 percent and 16 percent of insurance liabilities related to surrenderable policies in 1997, 1996 and 1995, respectively.
Insurance policy benefits and change in future policy benefits relate solely to annuity policies that incorporate significant mortality features. The increase corresponds to the increase in the in-force block of such policies.
Amounts added to policyholder account balances for interest expense on annuity products increased 3.6 percent in 1997 and 3.6 percent in 1996, primarily due to a larger block of annuity business in force in 1997, partially offset by a reduction in crediting rates. The weighted average crediting rates for these annuity liabilities were 4.8 percent in 1997, 5.0 percent in 1996 and 5.3 percent in 1995.
Other operating costs and expenses decreased 12 percent in 1997 and increased 18 percent in 1996. Other operating costs and expenses were favorably affected in 1997 by the consolidation of all annuity operations in Conseco's Carmel, Indiana facilities. The increase in 1996 corresponds to the increases in the total business in force primarily related to acquisition transactions described above under "General."
General: This segment includes traditional life and universal life products sold through career agents, professional independent producers and direct response distribution channels. This segment's operations were significantly affected by recent acquisitions (LPG effective July 1, 1996; PFS effective April 1, 1997; Colonial Penn effective September 30, 1997; and WNIC effective December 1, 1997). The profitability of this segment largely depends on the investment spread earned (for universal life), the persistency of in-force business, claim experience and expense management.
Premiums collected by this segment were up 76 percent in 1997, to $709.0 million. Premiums collected in 1996 were up 59 percent in 1996, to $403.6 million. Such increases relate primarily to premiums collected by recently acquired companies in periods after their acquisition.
All three components of insurance policy income have increased over the last three years primarily as a result of the acquisition transactions described above under "General."
Net investment income increased 60 percent in 1997, to $448.2 million, and 58 percent in 1996, to $279.7 million. Investment income fluctuates with changes in: (i) the amount of average invested assets supporting insurance liabilities; and (ii) the yield earned on invested assets. During 1997, the segment's average invested assets increased 71 percent, to $6.0 billion, and the net yield on invested assets decreased from 7.9 percent to 7.5 percent. During 1996, the segment's average invested assets increased 66 percent, to $3.5 billion, and the net yield on invested assets decreased from 8.4 percent to 7.9 percent. Invested assets grew primarily as a result of the growth in insurance liabilities from the acquisition transactions described above under "General."
Insurance policy benefits and change in future policy benefits increased in 1997 and 1996, reflecting the larger amount of business in force on which benefits are incurred as a result of the acquisition transactions described above under "General." There were no unusual fluctuations in claim experience during the periods.
Amortization related to operations increased 27 percent in 1997, to $61.3 million, and 44 percent in 1996, to $48.1 million. 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 the increases in balances subject to amortization as a result of the recent acquisitions, net of the effect of reductions in the balances of the cost of policies purchased and cost of policies produced resulting from net investment gains recognized during 1997 and 1996 (see "Net investment gains (losses)" below).
Net investment gains (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 $49.2 million in 1997, $4.4 million in 1996 and $9.3 million in 1995.
Net investment income increased 97 percent in 1997, to $17.3 million, and decreased 7.4 percent in 1996, to $8.8 million. Investment income fluctuates when changes occur in: (i) the amount of average invested assets supporting insurance liabilities; and (ii) the yield earned on invested assets. During 1997, the segment's average invested assets increased approximately 111 percent, to $244.0 million, and the net yield on invested assets decreased from 7.6 percent to 7.1 percent. During 1996, the segment's average
Insurance policy benefits and change in future policy benefits increased in 1997, primarily as a result of the larger amount of segment business in force. In 1997, the ratio of policy benefits to insurance policy income decreased 7.7 percentage points, to 78.0 percent. In 1996, the ratio of policy benefits to insurance policy income increased from 85.4 percent to 85.7 percent. The lower benefit ratio in 1997 reflects: (i) the lower incidence of claims experienced on business written by the acquired companies compared with the business of other Conseco subsidiaries; and (ii) favorable claim developments.
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. Amortization expense increased 33 percent in 1997, to $21.2 million, and 18 percent in 1996, to $16.0 million. The amount of amortization was primarily affected by the increase in balances subject to amortization as a result of the recent acquisitions.
Other operating costs and expenses increased 674 percent in 1997, to $133.9 million, and 47 percent in 1996, to $17.3 million. Such increases correspond to the increases in the total business in force related primarily to the recently acquired companies.
Net investment gains, net of related costs, realized by this segment were not material in 1997, 1996 or 1995.
General: This segment includes: (i) various other health insurance products that are not currently being actively marketed; and (ii) beginning December 1, 1997, the specialty health insurance products of WNIC marketed to educators through career agents. The segment's operations were significantly affected by recent acquisitions (THI, effective January 1, 1997, and WNIC, effective December 1, 1997). The profitability of this business depends largely on the overall persistency of the business in force, claim experience and expense management.
This segment also includes the fee revenue generated by our non-life subsidiaries, including the investment advisory fees earned by CCM and commissions earned for insurance and investment product marketing and distribution. Such amounts exclude the fees and commissions we charge to our consolidated subsidiaries. The profitability of the fee-based business depends on the total fees generated and on expense management.
We do not emphasize the sale of many of the products in this segment, andcollected premiums are expected to decrease in future years. However, the in-force business continues to be profitable.
Fee revenue and other income includes: (i) fees for investment management and for mortgage origination and servicing; and (ii) commissions earned for insurance and investment product marketing and distribution. Such amounts exclude the fees and commissions we charge our consolidated subsidiaries. Fee revenue and other income increased 32 percent in 1997, to $65.8 million, primarily due to increased investment management fees. Fee revenue and other income increased 14 percent in 1996, to $49.8 million, primarily as a result of the acquisition of certain property and casualty insurance brokerage businesses.
Insurance policy benefits and change in future policy benefits fluctuate in relationship to the amount of segment business in force and the incidence of claims.
Amortization related to operations decreased 16 percent in 1997, to $9.4 million, and increased 11 percent in 1996, to $11.2 million. 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 decrease in amortization in 1997 is consistent with the declining balance of cost of policies purchased and cost of policies produced associated with the business included in this segment. The increase in 1996 was primarily due to the increases in such balances as a result of our purchase of additional shares of BLH common stock in 1995 and 1996. The acquisitions of THI and WNIC did not materially increase the balance of goodwill and cost of policies purchased of this segment (valuations of the acquired blocks indicated that such amounts were insignificant).
Other components of income before income taxes, minority interest and extraordinary charge:
Net investment gains, net of related costs, of $15.2 million in 1995 primarily arose from the gain realized on the sale of Conseco's investment in Eagle Credit (a finance subsidiary of Harley-Davidson).
In accordance with GAAP, insurance policy income shown in our consolidated statement of operations consists of premiums received for policies that have life contingencies or morbidity features. For annuity and universal life contracts without such features, premiums collected are not reported as revenues, but rather are reported as deposits to insurance liabilities. Revenues for these products are recognized over time in the form of investment income and surrender or other charges assessed to the policy.
At December 31, 1997, our fixed maturity portfolio had net unrealized gains of $484.4 million (equal to approximately 2.1 percent of the portfolio's carrying value), consisting of $611.5 million of unrealized gains and $127.1 million of unrealized losses. Estimated fair values for fixed maturity investments were determined based on: (i) estimates from nationally recognized pricing services (82 percent of the portfolio); (ii) broker-dealer market makers (8 percent of the portfolio); and (iii) internally developed methods (10 percent of the portfolio).
As discussed in the notes to the consolidated financial statements, when we adjust carrying values of actively managed fixed maturity securities for changes in fair value, we also adjust the cost of policies purchased, cost of policies produced and liabilities. These adjustments are made in order to reflect the change in amortization and liability accruals 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.
At December 31, 1997, approximately 5.5 percent of our invested assets and 6.6 percent of fixed maturity investments were rated below-investment grade by nationally recognized statistical rating organizations (or, if not rated by such firms, with ratings below Class 2 assigned by the NAIC). We plan to maintain approximately the present level of below-investment-grade fixed maturities. These securities generally have greater risks than other corporate debt investments, including risk of loss upon default by the borrower, and are often unsecured and subordinated to other creditors. Below-investment-grade issuers usually have high levels of indebtedness and are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than are investment grade issuers. We are aware of these risks and monitor our below-investment-grade securities closely. At December 31, 1997, our below- investment-grade fixed maturity investments had an amortized cost of $1,525.1 million and an estimated fair value of $1,496.2 million.
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. These 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 we were earning on the prepaid securities. When interest rates increase, prepayments on mortgage-backed securities decrease, because 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.
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 cost greater than par are backed by mortgages that prepay faster than expected, we record a charge to investment income. When securities having a cost less than par prepay faster than expected, we record investment income.
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); (iii) investing in securities structured to reduce prepayment risk (such as planned amortization class ("PAC") and targeted amortization class ("TAC") CMOs); and (iv) actively managing the entire portfolio of mortgage-backed securities to dispose of those which are deemed more likely to be prepaid. PAC and TAC instruments represented approximately 24 percent of our mortgage-backed securities at December 31, 1997. The call-adjusted modified duration of our mortgage-backed securities at December 31, 1997, was 5.2 years.
Pass-throughs and sequential and targeted amortization classes have similar prepayment variability. Pass-throughs historically provide the best liquidity in the mortgage-backed securities market and provide the best price/performance ratio in a highly volatile interest rate environment. This type of security is also frequently used as collateral in the dollar-roll market. Sequential classes pay in a strict sequence; all principal payments received by the CMO are paid to the sequential tranches in order of priority. Targeted amortization classes provide a modest amount of prepayment protection when prepayments on the underlying collateral increase from those assumed at pricing. Thus, they offer slightly better call protection than sequential classes and pass-throughs.
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 on 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.
Subordinated CMO classes have both prepayment and credit risk. The subordinated classes are used to enhance the credit quality of the senior securities, and as such, rating agencies require that this support not deteriorate due to the prepayment of the subordinated securities. The credit risk of subordinated classes is derived from the negative leverage of owning a small percentage of the underlying mortgage loan collateral while bearing a majority of the risk of loss due to homeowner defaults.
Noncurrent mortgage loans were insignificant at December 31, 1997. We recognized realized losses of $.8 million on mortgage loans for the year ended December 31, 1997. At December 31, 1997, we had a loan loss reserve of $9.0 million. Approximately 20 percent of the mortgage loans were on properties located in California, 11 percent in Texas and 9 percent in Florida. No other state accounted for more than 7 percent of the mortgage loan balance.
At December 31, 1997, we held $64.8 million of trading securities that are included in other invested assets. Trading securities are investments that are held 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 securities are carried at estimated fair value, with the changes in fair value reflected in the statement of operations.
Other invested assets include: (i) trading securities; (ii) S&P 500 Call Options; and (iii) certain nontraditional investments, including investments in venture capital funds, limited partnerships, mineral rights and promissory notes.
Short-term investments totaled $990.5 million, or 3.7 percent of invested assets at December 31, 1997, and consisted primarily of commercial paper and repurchase agreements relating to government securities.
As part of our investment strategy, we enter into reverse repurchase agreements and dollar-roll transactions to increase our return on investments and improve our 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. We enhance our 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. We are able to engage in such transactions due to the market demand for mortgage-backed securities to form CMOs. Such investment borrowings averaged $719.3 million during 1997 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 5.8 percent in 1997. The primary risk associated with short-term collateralized borrowings is that the counterparty will be unable to perform under the terms of the contract. Our 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, 1997). We believe that the counterparties to our reverse repurchase and dollar-roll agreements are financially responsible and that the counterparty risk is minimal.
Notes payable increased during 1997 primarily as a result of: (i) debt issued or assumed in connection with the acquisitions of CAF, PFS, Colonial Penn and WNIC; (ii) debt used to finance common stock repurchases; and (iii) the redemption of mandatorily redeemable preferred stock of a subsidiary of ALH. The increase in notes payable was partially offset by the repayment of debt using the proceeds from the issuance of Company-obligated mandatorily redeemable preferred securities.
Company-obligated mandatorily redeemable preferred securities of subsidiary trusts are classified as minority interest in accordance with GAAP. During 1997, we issued $300 million of Capital Securities and $500 million of FELINE PRIDES. See note 8 to the consolidated financial statements for a description of these securities.
During 1997, we repurchased all of the mandatorily redeemable preferred stock of a subsidiary of ALH formerly held by minority interests. As a result, gains of $3.7 million were realized from the sale of securities having an amortized cost of $47.7 million; such securities had been held in a segregated account to ensure the redemption of such preferred stock.
Shareholders' equity increased by $804.8 million in 1997, to $3.9 billion. Significant components of the increase included: (i) Conseco common stock issued in the CAF Merger with a value of $117.4 million; (ii) Conseco common stock issued in the PFS Merger with a value of $354.1 million; (iii) net income of $567.3 million; (iv) the conversion of convertible debentures into Conseco common stock with a value of $150.0 million; (v) the issuance of common stock related to stock options and employee benefit plans (including the tax benefit thereon) of $276.1 million; and (vi) the increase in net unrealized appreciation of $143.1 million. These increases were partially offset by: (i) repurchases of common stock for $711.7 million; and (ii) common and preferred stock dividends totaling $80.6 million.
Book value per common share outstanding increased to $20.22 at December 31, 1997, from $16.86 at December 31, 1996. Such increase was primarily attributable to the factors discussed in the previous paragraph. Excluding unrealized appreciation of fixed maturity securities in accordance with SFAS 115, book value per common share outstanding was $19.27 at December 31, 1997, compared with $16.62 at December 31, 1996.
We believe that the diversity of our investment portfolio and the concentration of investments in high quality liquid securities provide sufficient liquidity to meet foreseeable cash requirements. Our investment portfolio at December 31, 1997, included $1.0 billion of short-term investments and $19.2 billion of publicly traded investment grade bonds, including $.6 billion of United States government and agency securities. Although there is no present need or intent to dispose of such investments, our life insurance subsidiaries 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, 1997, our portfolio of bonds and redeemable preferred stocks had an aggregate unrealized gain of $484.4 million.
The parent company is a legal entity, separate and distinct from its subsidiaries, and has no business operations. The parent company needs cash for: (i) principal and interest on debt; (ii) dividends on preferred and common stock; (iii) distributions on the Company-obligated mandatorily redeemable preferred stock of subsidiary trusts; (iv) holding company administrative expenses; (v) income taxes; and (vi) investments in subsidiaries. The primary sources of cash to meet these obligations include statutorily permitted payments from our life insurance subsidiaries, including: (i) dividend payments; (ii) surplus debenture interest and principal payments; (iii) tax sharing payments; and (iv) fees for services provided. The parent company may also obtain cash by: (i) issuing debt or equity securities; (ii) borrowing additional amounts under its revolving credit agreement, as described in note 7 to the consolidated financial statements; or (iii) selling all or a portion of its subsidiaries. These sources have historically provided adequate cash flow to fund: (i) the needs of the parent company's normal operations; (ii) internal expansion, acquisitions and investment opportunities; and (iii) the retirement of debt and equity. In 1997, we also issued new shares of Conseco common stock for a portion of the cost to acquire CAF and the entire cost to acquire PFS.
At December 31, 1997, the parent company and its non-life subsidiaries had short-term investments of $50.1 million, of which $28.7 million was expended in January 1998 for accrued interest and dividends. The parent company and its non-life subsidiaries had additional investments in fixed maturities, equity securities and other invested assets of $155.0 million at December 31, 1997, which, if needed, could be liquidated or contributed to the insurance subsidiaries.
Insurance departments in the states where our life insurance subsidiaries are domiciled or do business require insurance companies to make annual and quarterly filings. The interest maintenance reserve ("IMR") and the asset valuation reserve ("AVR") are required to be appropriated and reported as liabilities. The IMR captures all investment gains and losses resulting from changes in interest rates and provides for such amounts to be amortized into statutory net income on a basis reflecting the remaining lives of the assets sold. The AVR captures investment gains and losses related to changes in creditworthiness; it is also adjusted each year based on a formula related to the quality and loss experience of the Company's investment portfolio. These reserves affect the ability of our insurance subsidiaries to reflect investment gains and losses in statutory earnings and surplus.
Our debt agreements require the Company to maintain minimum working capital and RBC ratios and limit the Company's ability to incur additional indebtedness. They also restrict the amount of retained earnings that is available for dividends and require Conseco to maintain certain minimum ratings at its insurance subsidiaries.
We have initiated a corporate-wide program designed to ensure that our computer systems will function properly in the year 2000. For some of our operations, the most effective solution will be to ensure timely completion of the previously planned conversions of their older systems to more modern, year 2000 - compliant systems used in other areas of the Company. In some cases, our most effective solution will be to purchase new, more modern systems; these costs will be capitalized as assets and amortized over their expected useful lives. In other cases, we will modify existing systems, thereby incurring costs that will be charged to operating expense. To date, we have incurred $11.6 million in costs related to year 2000 projects. We expect to spend approximately an additional $35 million on these projects over the next two years. We began to incur expenses related to this program several years ago. We expect our year 2000 program to be completed on a timely basis.
We seek to invest our available funds in a manner that will maximize shareholder value and fund future obligations to policyholders and debtors, subject to appropriate risk considerations. We seek to meet this objective through investments that: (i) have similar characteristics to the liabilities they support; (ii) are diversified among industries, issuers and geographic locations; and (iii) make up a predominantly investment-grade fixed maturity securities portfolio. Many of our products incorporate surrender charges, market interest rate adjustments or other features to encourage persistency. Approximately 59 percent of our total insurance liabilities at December 31, 1997, had surrender penalties or other restrictions and approximately 24 percent are not subject to surrender.
Profitability of many of our products is significantly affected by the spreads between interest yields on investments and rates credited on insurance liabilities. Although substantially all credited rates on our annuity products may be changed annually (subject to minimum guaranteed rates), changes in competition and other factors, including the impact of the level of surrenders and withdrawals, may limit our ability to adjust or to maintain crediting rates at levels necessary to avoid narrowing of spreads under certain market conditions. As of December 31, 1997, the average yield, computed on the cost basis of our investment portfolio, was 7.5 percent, and the average interest rate credited or accruing to our total insurance liabilities was 5.2 percent, excluding interest bonuses guaranteed for the first year of the annuity contract only.
We use computer models to perform simulations of the cash flows generated from our existing business under various interest rate scenarios. These simulations enable us to measure the potential gain or loss in fair value of our interest rate-sensitive financial instruments. With such estimates, we seek to closely match the duration of our assets to the duration of our liabilities. When the estimated durations of assets and liabilities are similar, exposure to interest rate risk is minimized because a change in the value of assets should be largely offset by a change in the value of liabilities. At December 31, 1997, the adjusted modified duration of our fixed maturity securities and short-term investments was approximately 5.8 years and the duration of our insurance liabilities was approximately 6.7 years.
We manage the composition of our borrowed capital by considering factors such as the ratio of borrowed capital to total capital, the portion of our outstanding capital subject to fixed and variable rates, the current interest rate environment and other market conditions. Our borrowed capital at December 31, 1997, includes commercial paper, notes payable and Company-obligated mandatorily redeemable preferred securities of subsidiary trusts totaling $3.7 billion ($1.8 billion of which is at floating rates and $1.9 billion of which is at fixed rates). Based on the interest rate exposure and prevalent rates at December 31, 1997, a relative 10 percent decrease in interest rates would increase the fair value of our fixed-rate borrowed capital by approximately $75 million. Our interest expense on floating-rate debt will fluctuate as prevailing interest rates change.
We periodically use options and interest rate swaps to hedge interest rate risk associated with our investments and borrowed capital. Although we had no such agreements outstanding at December 31, 1997, we entered into four interest rate swap agreements in March 1998. The Company entered into such agreements to create a hedge that effectively converts a portion of its fixed-rate borrowed capital into floating-rate instruments for the period during which the agreements are outstanding. Such interest rate swap agreements have an aggregate notional principal amount of $1.0 billion, mature in various years through 2008, and have an average remaining life of seven years. If the counterparties of these interest rate swaps do not meet their obligations, Conseco could have a loss. Conseco limits its exposure to such a loss by diversifying among several counterparties believed to be financially sound and creditworthy. At March 13, 1998, all of the counterparties were rated "A" or higher by Standard & Poor's Corporation. These swap agreements, if in existence when the assumed 10 percent decrease in interest rates occurred (see
preceding paragraph), would cause the increase in the fair value of our borrowed capital to be $55.0 million, or $20.0 million less than indicated in the preceding paragraph.
As indicated in this report, Conseco intends to continue to grow its life and health insurance operations.
Conseco continually reviews its capital structure, including the need and desirability of restructuring the existing debt and equity of the Company.
As a result of its recent acquisitions, Conseco has significant in-force business and marketing activity in multiple segments of the life insurance industry, including universal life, whole life, term life, single-premium and flexible-premium deferred and immediate annuities (including variable, indexed and fixed), Medicare supplement insurance, long-term care coverage, specified- disease coverage, and individual and group health insurance. Conseco will continue to concentrate on opportunities to improve the effectiveness of its distribution systems in marketing these products.