Our headquarters and the administrative operations of our Conseco Insurance Group segment are located on a Company-owned 142-acre corporate campus in Carmel, Indiana, immediately north of Indianapolis. The ten buildings on the campus contain approximately 854,500 square feet of space and house Conseco's executive offices and certain administrative operations of its subsidiaries. In May 2005, we entered into a listing agreement for the sale/lease of 105,535 square feet of unused office space. In July 2005, we entered into a listing agreement for either the sale of 121,762 square feet or the lease of 115,988 square feet of unused office space, and we also entered into a listing agreement for the sale of approximately 36 acres of undeveloped land. Management believes that our remaining office space is adequate for our needs.
o our ability to achieve anticipated expense reductions and levels of operational efficiencies;
o general economic conditions and other factors, including prevailing interest rate levels, stock and credit market performance and health care inflation, which may affect (among other things) our ability to sell products and access capital on acceptable terms, the returns on and the market value of our investments, and the lapse rate and profitability of policies;
o changes in the Federal income tax laws and regulations which may affect or eliminate the relative tax advantages of some of our products; and
bank sales and underwriting of insurance products, regulation of the sale, underwriting and pricing of products, and health care regulation affecting health insurance products.
We conduct our business operations through two operating segments, which are defined on the basis of product distribution, and a third segment comprised of business in run-off. Prior to September 30, 2003, we conducted our insurance operations through one segment. In the fourth quarter of 2003, we implemented changes contemplated in our restructuring plan to conduct our business through the following segments:
o Bankers Life, which consists of the businesses of Bankers Life and Casualty and Colonial Penn. Bankers Life and Casualty markets and distributes Medicare supplement insurance, life insurance, long-term care insurance and certain annuity products to the senior market through approximately 4,800 exclusive career agents and sales managers. Colonial Penn markets graded benefit and simplified issue life insurance directly to consumers through television advertising, direct mail, the internet and telemarketing. Both Bankers Life and Casualty and Colonial Penn market their products under their own brand names.
o Other Business in Run-off, which includes blocks of business that we no longer market or underwrite and are managed separately from our other businesses. This segment consists of long-term care insurance sold in prior years through independent agents and major medical insurance.
For the year ended December 31, 2005, net income after dividends on our preferred stock totaled $286.9 million, or $1.76 per diluted share.
We continue to focus on the factors that we believe are most important to achieving improved financial strength ratings for our insurance subsidiaries. Our major goals for 2006 are to continue to strengthen our balance sheet and improve our execution on the basics of our business by:
At December 31, 2005, the carrying value of our investment portfolio was $25.0 billion. The accounting risks associated with investments relate to the recognition of income, our determination of other-than-temporary impairments and our estimation of fair values.
anticipated recovery; and (viii) the underlying current and prospective asset and enterprise values of the issuer and the extent to which our investment may be affected by changes in such values. At December 31, 2005, our net accumulated other comprehensive income included gross unrealized losses on investments of $238.2 million, which we consider to be temporary declines in estimated fair value.
When the cost basis of a security is written down to fair value due to an other than temporary decline, we review the circumstances of that particular investment in relation to other investments in our portfolio. If such circumstances exist with respect to other investments, those investments are also written down to fair value. Future events may occur, or additional or updated information may become available, which may necessitate future realized losses of securities in our portfolio. Significant realized losses on our investments could have a material adverse effect on our earnings in future periods.
The cost of policies produced are those costs that vary with, and are primarily related to, producing new insurance
When we realize a gain or loss on investments backing our universal life or investment-type products, we adjust the amortization to reflect the change in estimated gross profits from the products due to the gain or loss realized and the effect on future investment yields. We also adjust the value of policies inforce at the Effective Date for the change in amortization that would have been recorded if actively managed fixed maturity securities had been sold at their stated aggregate fair value and the proceeds reinvested at current yields. We include the impact of this adjustment in accumulated other comprehensive income within shareholders' equity.
The assumptions we use to amortize and evaluate the recoverability of the value of policies inforce and the cost of policies produced both involve significant judgment. A revision to these assumptions could have a significant adverse effect on our results of operations and financial position.
above) or to the non-life companies. If the IRS approves the tentative settlement agreement but disagrees with the tax position we plan to take with respect to the allocation of cancellation of indebtedness income, and their position prevails, $631 million of the NOLs expiring in 2018 would be characterized as non-life NOLs.
The following paragraphs describe some of the open matters related to the classification of our NOLs.
Due to the current interest rate environment and the requirement to mark the value of the investment portfolio to market, we changed our assumptions related to future investment earnings. The weighted average expected yield on our investment portfolio decreased to approximately 5.6 percent at the Effective Date from 6.7 percent at December 31, 2002. Approximately $.9 billion of the fresh-start increase to insurance liabilities was the result of changes in future expected investment earnings.
The performance of our long-term care business (especially the acquired block originally sold through independent agents) has generally been unfavorable relative to the Predecessor's assumptions established when these blocks of business were acquired. For example, variances in actual morbidity, lapses and expenses have been unfavorable compared to original estimates. Approximately $1.4 billion of the increase to insurance liabilities was the result of changes in non-interest assumptions for our long-term care policies. Our assumption changes for the long-term care business included: (i) changes in morbidity assumptions from estimates made when the business was acquired to recent Company experience; (ii) changes in mortality assumptions related to certain blocks of this business from the 1958 and 1980 Commissioners Standard Ordinary Mortality table to the 1983 Group Annuity Mortality table; and (iii) changes in ultimate lapse ratios from a range of approximately 3 percent to 5.5 percent prior to the adoption of fresh start accounting to a range of 2 percent to 3.5 percent.
In conjunction with the Plan, $481.3 million principal amount of bank loans made to certain former directors and employees to enable them to purchase common stock of Old Conseco were transferred to the Company. These loans had been guaranteed by Old Conseco. We received all rights to collect the balances due pursuant to the original terms of these loans. In addition, we hold loans to participants for interest on the loans which exceed $230 million. The former bank loans and the interest loans are collectively referred to as the "D&O loans." We regularly evaluate the collectibility of these loans in light of the collateral we hold, the credit worthiness of the participants and the current status of various legal actions we
Total premium collections were $2,415.8 million in 2005; $2,319.9 million in 2004; $720.3 million in the four months ended December 31, 2003; and $1,560.7 million in the eight months ended August 31, 2003. See "Premium Collections" for further analysis of Bankers Life's premium collections.
Net investment income related to equity-indexed products based on the change in value of options represents the change in the estimated fair value of options which are purchased in an effort to hedge certain potential benefits accruing to the policyholders of our equity-indexed products. Our equity-indexed products are designed so that the investment income spread earned on the related insurance liabilities is more than adequate to cover the cost of the options and other costs related to these policies. Option costs attributable to benefits provided were $7.8 million in 2005; $7.1 million in 2004; $2.9 million in the four months ended December 31, 2003; and $7.7 million in the eight months ended August 31, 2003. These costs are reflected in net investment income. Investment income related to equity-indexed products before these costs was $5.2 million in 2005; $9.7 million in 2004; $9.5 million in the four months ended December 31, 2003; and $12.5 million in the eight months ended August 31, 2003. Such amounts are generally offset by the corresponding charge (credit) to amounts added to policyholder account balances for equity-indexed products based on the change in value of the indices. Such income and related charges fluctuate based on the value of options embedded in the segment's equity-indexed annuity policyholder account balances subject to this benefit and to the performance of the index to which the returns on such products are linked.
The Medicare supplement business consists of both individual and group policies. Government regulations generally require us to attain and maintain a ratio of total benefits incurred to total premiums earned (as calculated based on amounts reported for statutory accounting purposes, which differ from the amounts reported for GAAP purposes), after three years, of not less than 65 percent on individual products and not less than 75 percent on group products. The benefit ratio experienced in 2005 reflected a $2.0 million claim reserve deficiency resulting from the ultimate development of reserves at December 31, 2004, as well as a higher level of paid claims compared to 2004. In 2004, we recognized $1.5 million of positive developments from reserves established in prior periods. Our loss experience in the four months ended December 31, 2003 was favorably impacted by positive developments of $5.8 million from insurance liabilities established in prior periods.
Other operating costs and expenses in our Bankers Life segment were $155.2 million in 2005; $160.1 million in 2004; $51.8 million in the four months ended December 31, 2003; and $85.3 million in the eight months ended August 31, 2003. The decrease in 2005, as compared to 2004, was due primarily to: (i) lower policy maintenance expenses reflecting our cost reduction initiatives, partially offset by; (ii) higher advertising expenses in our direct response marketing channel and higher commission expense. These expenses were higher in 2004 compared to the 2003 periods due primarily to higher sales and career agency infrastructure costs and lower reinsurance expense allowances. Other operating costs and expenses, excluding commission expenses, for this segment were $135.4 million in 2005; $144.4 million in 2004; $45.4 million in the four months ended December 31, 2003; and $75.9 million in the eight months ended August 31, 2003.
Amortization related to net realized investment gains (losses) is the increase or decrease in the amortization of insurance acquisition costs which results from realized investment gains or losses. When we sell securities at a gain (loss) and reinvest the proceeds at a different yield, we increase (reduce) the amortization of insurance acquisition costs in order to reflect the change in future expected yields. Sales of fixed maturity investments resulted in an increase (decrease) in the amortization of insurance acquisition costs of $(1.0) million in 2005; $4.7 million in 2004; nil in the four months ended December 31, 2003; and $.5 million in the eight months ended August 31, 2003.
Collections on insurance products were $1,158.2 million in 2005; $1,165.6 million in 2004; $421.6 million in the four months ended December 31, 2003; and $880.0 million in the eight months ended August 31, 2003. Decreases in premium collections have been significantly impacted by decreases in collected premiums on Medicare supplement policies in this segment, which were $288.8 million in 2005; $351.7 million in 2004; $134.2 million in the four months ended December 31, 2003; and $250.4 million in the eight months ended August 31, 2003. We implemented increases in premium rates in both 2005 and 2004. These rate increases resulted in higher than expected lapses which reduced premiums collected for this segment. In addition, we believe premium collections in this segment have been impacted by our A.M. Best financial strength rating. See "Premium Collections" for further analysis of fluctuations in premiums collected by product. The premiums collected by this segment have decreased in each of the last two years. We expect further decreases in 2006.
Average liabilities for insurance products, net of reinsurance ceded were $12.0 billion in 2005; $12.6 billion in 2004; $13.0 billion in the four months ended December 31, 2003; and $13.3 billion in the eight months ended August 31, 2003. The decrease in such liabilities was due primarily to policyholder redemptions and lapses exceeding new sales due in part to our A.M. Best financial strength rating. The liabilities for insurance products in this segment were not significantly affected by the adoption of fresh start accounting.
Net investment income on general account invested assets (which excludes income on policyholder and reinsurer accounts) was $718.6 million in 2005; $702.3 million in 2004; $242.2 million in the four months ended December 31, 2003; and $557.3 million in the eight months ended August 31, 2003. The average balance of general account invested assets was $12.1 billion in 2005; $12.5 billion in 2004; $12.7 billion in the four months ended December 31, 2003; and $13.7 billion in the eight months ended August 31, 2003. The average yield on these assets was 5.9 percent in 2005; 5.6 percent in 2004; 5.7 percent in the four months ended December 31, 2003; and 6.1 percent in the eight months ended August 31, 2003. This segment's investment income included income related to prepayments of securities (including prepayment penalties on mortgages, call premiums on fixed maturities and acceleration of discount amortization, net of premium amortization) of $22.8 million and $5.0 million in 2005 and 2004, respectively. This additional investment income in 2005 resulted in additional amortization expense of $9.4 million to reflect the higher gross profits for universal life and investment-type products. The decreases in yields in 2004 and for the four months ended December 31, 2003, reflected the adoption of fresh start accounting which effectively reset the yields to market rates at August 31, 2003.
Trading account income related to policyholder and reinsurer accounts represents the income on trading securities which are designed to act as hedges for embedded derivatives related to certain modified coinsurance agreements. In addition, such income includes the income on investments backing the market strategies of certain annuity products which provide for different rates of cash value growth based on the experience of a particular market strategy. The income on our trading account securities is designed to substantially offset: (i) the change in value of embedded derivatives related to modified coinsurance agreements described below; and (ii) certain amounts included in insurance policy benefits.
Insurance policy benefits fluctuated as a result of the factors summarized below for benefit ratios and, in the eight months ended August 31, 2003, as a result of a change in estimate of future losses on certain policies, as discussed below. Benefit ratios are calculated by dividing the related insurance product's insurance policy benefits by insurance policy income.
The benefit ratios on Conseco Insurance Group's Medicare supplement products in 2005 and 2004 were impacted by rate increases. The higher rates caused an increase in policyholder lapses. The release of the policy benefit reserve related to the lapsed business contributed to the lower benefit ratios in 2005 and 2004. Government regulations generally require us to attain and maintain a ratio of total benefits incurred to total premiums earned (as calculated based on amounts reported for statutory accounting purposes, which differ from the amounts reported for GAAP purposes), after three years, of not less than 65 percent on these products. On a statutory accounting basis, such benefit ratios exceeded the minimum requirement in 2005 and 2004.
Conseco Insurance Group's specified disease products generally provide fixed or limited benefits. For example, payments under cancer insurance policies are generally made directly to, or at the direction of, the policyholder following
From time-to-time, we experience higher (or lower) than expected death claims in the life business of the Conseco Insurance Group segment. For example, during the first quarter of 2004, we experienced adverse life mortality of approximately $4.4 million. Since the first quarter of 2004, our life mortality experience generally returned to levels comparable to previous periods.
In August 2003, we decided to change a non-guaranteed element of certain Conseco Insurance Group policies that was not required by the policy. This change eliminated the former practice of reducing the cost of insurance charges below the levels permitted under the policies. As a result, our estimates of future expected gross profits on these products, which is used as a basis for amortizing insurance acquisition costs, and our estimate of insurance liabilities changed. We adjusted the total amortization and reserve charges which we had recorded since the acquisition of these policies as a result of these changes in earlier estimates in accordance with SFAS 97. The changes in these estimates resulted in a $220.2 million reduction to insurance policy benefits and a $39.8 million reduction to amortization recorded in the eight months ended August 31, 2003.
Amounts added to policyholder account balances for annuity products and interest-sensitive life products were $254.5 million in 2005; $260.9 million in 2004; $94.9 million in the four months ended December 31, 2003; and $218.4 million in the eight months ended August 31, 2003. The fluctuations are primarily due to a smaller block of annuity business inforce. The weighted average crediting rates for these products were 4.0 percent in 2005; 3.8 percent in 2004; 4.0 percent for the four months ended December 31, 2003; and 4.4 percent for the eight months ended August 31, 2003.
Amortization related to operations includes amortization of insurance acquisition costs. Insurance acquisition costs are amortized either: (i) in relation to the estimated gross profits for universal life and investment-type products; or (ii) in relation to actual and expected premium revenue for other products. In addition, for universal life and investment-type products, we are required to adjust the total amortization recorded to date through the statement of operations if actual experience or other evidence suggests that earlier estimates of future gross profits should be revised. Accordingly, amortization for universal life and investment-type products is dependent on the profits realized during the period and on our expectation of future profits. For other products, we amortize insurance acquisition costs in relation to actual and expected premium revenue, and amortization is only adjusted if expected premium revenue changes or if we determine the balance of
these costs is not recoverable from future profits. The rate increases implemented in early 2005 and in 2004 on our Medicare supplement products resulted in higher lapses than we anticipated. These lapses reduced our estimates of future expected premium income and, accordingly, we recognized additional amortization expense in 2005 and 2004. The assumptions we use to estimate our future gross profits and premiums involve significant judgment. A revision to our current assumptions could result in increases or decreases to amortization expense in future periods.
Conseco Insurance Group's amortization recorded in the eight months ended August 31, 2003, was affected by the change in estimates of future losses on certain policies described above under "insurance policy benefits."
Interest expense on investment borrowings fluctuated with Conseco Insurance Group's investment borrowing activities and the interest rates thereon.
Amortization related to net realized investment gains (losses) is the increase or decrease in the amortization of insurance acquisition costs which results from realized investment gains or losses. When we sell securities at a gain (loss) and reinvest the proceeds at a different yield, we increase (reduce) the amortization of insurance acquisition costs in order to reflect the change in future expected yields. Sales of fixed maturity investments resulted in an increase (decrease) in the amortization of insurance acquisition costs of $(1.8) million in 2005; $8.7 million in 2004; $1.1 million in the four months ended December 31, 2003; and $(.9) million in the eight months ended August 31, 2003.
Total premium collections were $351.9 million in 2005; $395.9 million in 2004; $173.9 million in the four months ended December 31, 2003; and $424.4 million in the eight months ended August 31, 2003. We have ceased marketing the long-term care business and major medical business of this segment. Accordingly, collected premiums will decrease over time as policies lapse, partially offset by premium rate increases. See "Premium Collections" for further analysis.
Average liabilities for insurance products, net of reinsurance ceded were $3.3 billion in 2005; $3.4 billion in 2004; $3.4 billion in the four months ended December 31, 2003; and $2.1 billion in the eight months ended August 31, 2003. The increase in 2003 reflected the adoption of fresh start accounting as further discussed under "Critical Accounting Policies -- Liabilities for Insurance Products."
o retention of their current policy with a rate increase of 50 percent in the first year and actuarially justified increases in subsequent years (which is also the default election for policyholders who fail to make an election by the deadline) ("option one");
o receipt of a replacement policy with reduced benefits and a rate increase in the first year of 25 percent and no more than 15 percent in subsequent years ("option two"); or
The orders also require Conseco Senior and Washington National to pursue a similar course of action with respect to approximately 24,000 home health care policies in other states, subject to consideration and approval by the other state insurance departments. If we are unsuccessful in obtaining rate increases or other forms of relief in those states, or if the policy changes approved by the Florida Office of Insurance Regulation prove inadequate, our future results of operations could be adversely affected.
The benefits we have experienced since August 31, 2003 have generally been consistent with the revised assumptions resulting from the actuarial studies completed in 2003. However, as described below, estimating benefits on long-term care products involves significant judgment and our prior estimates have not always been accurate.
During the first eight months of 2003, we conducted various actuarial studies to evaluate this segment's long-term care reserves given our recent adverse experience and claim reserve deficiencies. We engaged an actuarial consulting firm to assist us with the examination. The performance of this business had been generally unfavorable relative to the assumptions established when these blocks of business were acquired. Although we considered historical claim experience and recent trends in establishing our reserves, we had relatively limited historical claim experience. In addition, these products tend to have fewer claims than other products such as Medicare supplement, but when claims are incurred, they tend to be much higher in dollar amount. Also, long-term care product claims are incurred much later in the life of the policy than most other supplemental health products. These factors make it more difficult to estimate claim reserves for this product. The change in estimates resulting from the actuarial studies increased our claim reserves by $85 million and our benefit ratio by 20 percent in the eight months ended August 31, 2003.
The net cash flows from long-term care products generally cause an accumulation of amounts in the early years of a policy (accounted for as reserve increases) which will be paid out as benefits in later policy years (accounted for as reserve decreases). Accordingly, as the policies age, the benefit ratio will typically increase, but the increase in the change in reserve will be partially offset by investment income earned on the assets which have accumulated. The interest-adjusted benefit ratio for long-term care products is calculated by dividing the insurance product's insurance policy benefits less interest income on the accumulated assets backing the insurance liabilities by insurance policy income.
Amortization related to operations includes amortization of insurance acquisition costs. The decrease in amortization expense subsequent to August 31, 2003, reflected the adoption of fresh start accounting, and also reflected the relatively small amount of value of policies inforce associated with the business comprising this segment.
Net realized investment gains (losses) fluctuated each period. During 2005, net realized investment gains included $6.8 million of net gains from the sales of investments (primarily fixed maturities), net of $6.3 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary. During 2004, net realized investment gains in this segment included $5.1 million of net gains from the sales of investments (primarily fixed maturities), net of $.6 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary. During the four months ended December 31, 2003, net realized investment losses in this segment included $.2 million of net losses from the sales of investments and $.5 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary. During the first eight months of 2003, net realized investment gains included $8.7 million of net gains from the sales of investments (primarily fixed maturities), net of $2.4 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary.
Provision for losses and expense related to stock purchase plan represents the non-cash provision for our Predecessor's guarantees of the bank loans of approximately 155 former directors and employees and the related loans for interest. The funds from the bank loans were used by the participants to purchase approximately 18.0 million shares of our Predecessor's common stock. In the first eight months of 2003, our Predecessor established a provision of $55.6 million in connection with these guarantees and loans. Our Predecessor determined the reserve based upon the value of the collateral held by the banks. The outstanding principal balance on the bank loans was $481.3 million. In addition, our Predecessor
In conjunction with the Plan, the principal amount of the bank loans of $481.3 million was transferred to the Company. We received all rights to collect the balances due pursuant to the original terms of these loans. In addition, we hold loans to participants for interest on the bank loans which exceeded $230 million at December 31, 2005. We regularly evaluate the collectibility of these loans in light of the collateral we hold, the credit worthiness of the participants and the current status of various legal actions we have taken to collect the D&O loans. At December 31, 2005, we have established a liability of $17.5 million (which is included in other liabilities), representing our estimate of the amount which will be paid to the former holders of TOPrS pursuant to the settlement.
Fee revenue and other income includes: (i) revenues we receive for managing investments for other companies; and (ii) fees received for marketing insurance products of other companies. In 2005, our wholly owned investment management subsidiary recognized a performance-based fee of $8.1 million earned in conjunction with its management of a $510 million portfolio of loans for an issuer of structured securities. This portfolio was liquidated and the related securities were redeemed on September 1, 2005, resulting in the receipt of this fee which was largely based on the market value of the managed loan portfolio at the redemption date. Excluding such performance-based fee, fee revenue and other income decreased primarily as a result of a decrease in the market value of investments managed for others, upon which these fees are based. Fee revenue and other income in the four months ended December 31, 2003, included $5.6 million of interest received on a Federal income tax refund.
Other operating costs and expenses include general corporate expenses, net of amounts charged to subsidiaries for services provided by the corporate operations. These amounts fluctuate as a result of expenses such as consulting, legal and severance costs which often vary from period to period. In 2005, other operating costs and expenses are net of a $3.2 million recovery related to our evaluation of the collectibility of the D&O loans. In 2004, we incurred expenses of $13.2 million related to our executive transition as further discussed in the notes to consolidated financial statements entitled "Other Disclosures" under the captions "Executive Termination" and "Executive Hiring". General corporate expenses included other severance expense of $2.4 million and $8.3 million in 2005 and 2004, respectively. During the first eight months of 2003, disputes with our insurance carriers were resolved and a liability of $40 million previously established in 2002 was released. This was substantially offset by increases to various litigation reserves of $30 million.
Net realized investment losses often fluctuate each period. During 2005, net realized investment losses in this segment included $.1 million of net losses from the sale of investments (primarily fixed maturities), and $1.3 million of writedowns due to other-than-temporary declines in value on certain securities. During 2004, we recognized writedowns of $2.9 million due to other-than-temporary declines in value on certain securities.
In accordance with GAAP, insurance policy income in our consolidated statement of operations consists of premiums earned 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 as deposits to insurance liabilities. We recognize revenues for these products over time in the form of investment income and surrender or other charges.
Our insurance segments sell products through three primary distribution channels -- career agents and direct marketing (our Bankers Life segment) and independent producers (our Conseco Insurance Group segment). Our career agency force in the Bankers Life segment sells primarily Medicare supplement and long-term care insurance policies, life insurance and annuities. These agents visit the customer's home, which permits one-on-one contact with potential policyholders and promotes strong personal relationships with existing policyholders. Bankers Life's direct marketing distribution channel is engaged primarily in the sale of "graded benefit life" and simplified issue life insurance policies which are sold directly to the policyholder. Our independent producer distribution channel in the Conseco Insurance Group segment consists of a general agency and insurance brokerage distribution system comprised of independent licensed agents doing business in all fifty states, the District of Columbia, and certain protectorates of the United States. Independent producers are a diverse network of independent agents, insurance brokers and marketing organizations. Our independent producer distribution channel sells primarily specified disease and Medicare supplement insurance policies, universal life insurance and annuities.
Agents, insurance brokers and marketing companies who market our products and prospective purchasers of our products use the financial strength ratings of our insurance subsidiaries as an important factor in determining whether to market or purchase. Ratings have the most impact on our annuity, interest-sensitive life insurance and long-term care products. Our insurance companies' financial strength ratings were downgraded by all of the major rating agencies beginning in July 2002, in connection with the financial distress that ultimately led to our Predecessor's bankruptcy. In the second quarter of 2004, such ratings of our primary insurance subsidiaries (except Conseco Senior) were upgraded by A.M. Best, S&P and Moody's. Moody's again upgraded the ratings of our primary insurance subsidiaries (except Conseco Senior) in the third quarter of 2004 and the first quarter of 2006. The current financial strength ratings of our primary insurance subsidiaries (except Conseco Senior) from A.M. Best, S&P and Moody's are "B++ (Very Good)", "BB+" and "Baa3", respectively. The current financial strength ratings of Conseco Senior from A.M. Best, S&P and Moody's are "B (Fair)", "CCC" and "Caa1", respectively. For a description of these ratings and additional information on our ratings, see "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity for Insurance Operations."
Supplemental health products include Medicare supplement, long-term care and other insurance products distributed through our career agents. Our profits on supplemental health policies depend on the overall level of sales, the length of time
Collected premiums on Medicare supplement policies in the Bankers Life segment totaled $651.2 million in 2005; $640.0 million in 2004; $225.6 million in the four months ended December 31, 2003; and $419.1 million in the eight months ended August 31, 2003.
Life products in this segment are sold primarily to the senior market through our career agents and our direct response distribution channel. Life premiums collected in this segment totaled $237.2 million in 2005; $180.9 million in 2004; $58.6 million in the four months ended December 31, 2003; and $102.7 million in the eight months ended August 31, 2003. Collected premiums have been impacted by an increased focus on life products, including the introduction in the first quarter of 2005 of a new single premium whole life product and increased advertising in our direct response marketing channel. During 2005, the new single premium whole life products accounted for $32.2 million of our collected premiums. Graded benefit life products sold through our direct response marketing channel accounted for $81.2 million of our total collected premiums in 2005, compared to $72.3 million in 2004.
Annuities in this segment include equity-indexed and other fixed annuities sold through professional independent producers. Total annuity collected premiums in this segment were $161.7 million in 2005; $63.7 million in 2004; $18.1 million in the four months ended December 31, 2003; and $74.0 million in the eight months ended August 31, 2003. Total annuity premiums collected in 2005 increased due to sales efforts in this segment, expanded product offerings and attractive crediting rates on certain products. In 2004 and 2003, we took actions to reduce our marketing of these products and focus instead on selling products that were less ratings sensitive (such as specified disease and Medicare supplement products).
in the eight months ended August 31, 2003. Collected premiums for this product increased in 2005 due to the introduction of four new products. In addition, these products have become relatively attractive due to general stock market conditions in recent periods.
Supplemental health products in the Conseco Insurance Group segment include Medicare supplement, specified disease and other insurance products distributed through professional independent producers. Our profits on supplemental health policies depend on the overall level of sales, the length of time the business remains inforce, investment yields, claim experience and expense management.
Collected premiums on Medicare supplement policies in the Conseco Insurance Group segment were $288.8 million in 2005; $351.7 million in 2004; $134.2 million in the four months ended December 31, 2003; and $250.4 million in the eight months ended August 31, 2003. We implemented increases in premium rates in both 2005 and 2004. These rate increases resulted in higher than expected lapses which reduced the premiums collected for these products in this segment. In 2005, we began selling Medicare supplement policies which are more competitively priced in another subsidiary.
Our investment strategy is to: (i) maintain a predominately investment-grade fixed income portfolio; (ii) provide adequate liquidity to meet our cash obligations to policyholders and others; and (iii) generate stable and predictable investment income and total investment return through active investment management. Consistent with this strategy, investments in fixed maturity securities, mortgage loans and policy loans made up 97 percent of our $25.0 billion investment portfolio at December 31, 2005. The remainder of the invested assets were trading securities, equity securities and other invested assets.
The following table summarizes the composition of our investment portfolio as of December 31, 2005 (dollars in millions):
Insurance statutes regulate the types of investments that our insurance subsidiaries are permitted to make and limit the amount of funds that may be used for any one type of investment. In light of these statutes and regulations and our business and investment strategy, we generally seek to invest in United States government and government-agency securities and corporate securities rated investment grade by established nationally recognized rating organizations or in securities of comparable investment quality, if not rated.
The following table summarizes the carrying values of our fixed maturity securities by category as of December 31, 2005 (dollars in millions):
Our fixed maturity securities consist predominantly of publicly traded securities. We classify securities issued in the Rule 144A market as publicly traded. Our privately traded securities comprise less than four percent of our total fixed maturity securities portfolio.
We continually evaluate the credit worthiness of each issuer whose securities we hold. We pay special attention to those securities whose market values have declined materially for reasons other than changes in interest rates or other general market conditions. We 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. We review the recent operational results and financial position of the issuer, information about its industry, information about factors affecting the issuer's performance and other information. 40|86 Advisors employs a staff of experienced securities analysts in a variety of specialty areas who compile and review such data. 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, we reduce the carrying amount to its fair value, which becomes the new cost basis. We report the amount of the reduction as a realized loss. We recognize any recovery of such reductions as investment income over the remaining life of the investment (but only to the extent our current valuations indicate such amounts will ultimately be collected), or upon the sale, repayment or other disposition of the investment. We recorded writedowns of fixed maturity investments, equity securities and other invested assets totaling $14.7 million in 2005. Our investment portfolio is subject to the risks of further declines in realizable value. However, we attempt to mitigate this risk through the diversification and active management of our portfolio.
Our investment strategy is to maximize, over a sustained period and within acceptable parameters of risk, investment income and total investment return through active investment management. Accordingly, we may sell securities at a gain or a loss to enhance the total return of the portfolio as market opportunities change or to better match certain characteristics of our investment portfolio with the corresponding characteristics of our insurance liabilities. While we have both the ability and intent to hold securities with unrealized losses until they mature or recover in value, we may sell securities at a loss in the future because of actual or expected changes in our view of the particular investment, its industry, its type or the general investment environment.
Pass-through securities and sequential and targeted amortization class securities have different prepayment variability characteristics. Pass-through securities typically return principal to the holders based on cash payments from the underlying mortgage obligations. Sequential classes return principal to tranche holders in a detailed hierarchy. Targeted amortization classes, planned amortization classes and accretion-directed bonds adhere to fixed schedules of principal payments as long as the underlying mortgage loans experience prepayments within certain estimated ranges. Changes in prepayment rates are first absorbed by support or companion classes. This insulates the timing of receipt of cash flows from the consequences of both faster prepayments (average life shortening) and slower prepayments (average life extension).
Our venture capital investment in AWE was made by our subsidiary which engaged in venture capital investment activity. AWE is a company in the wireless communication business. In December 2003, we sold our remaining 4.1 million shares of AWE common stock. We recognized venture capital investment income (losses) related to this investment of $(5.5) million in the four months ended December 31, 2003; and $10.5 million in the eight months ended August 31, 2003.
The following table summarizes the distribution of maturities of our mortgage loans (dollars in millions):
Our capital structure as of December 31, 2005 and 2004, was as follows (dollars in millions):
o For products such as universal life, ordinary life, long-term care, specified disease and fixed rate annuities, the future payments are not due until the occurrence of an insurable event (such as death or disability) or a triggering event (such as a surrender or partial withdrawal). We estimated these payments using actuarial models based on historical experience and our expectation of the future payment patterns.
o The average interest rate we assumed would be credited to our total insurance liabilities (excluding interest rate bonuses for the first policy year only and excluding the effect of credited rates attributable to variable or equity-indexed products) over the term of the contracts was 4.6 percent.
Our insurance operating companies generally receive adequate cash flows from premium collections and investment income to meet their obligations. Life insurance and annuity liabilities are generally long-term in nature. Policyholders may,
On August 3, 2005, A.M. Best revised its outlook on our primary insurance subsidiaries to positive from stable, except Conseco Senior (the issuer of most of our long-term care business in our Other Business in Run-off segment), for which the outlook remains stable. On June 25, 2004, A.M. Best upgraded the financial strength ratings of our primary insurance subsidiaries from "B (Fair)" to "B++ (Very Good)", except Conseco Senior, whose "B (Fair)" rating was affirmed by A.M. Best. According to A.M. Best, these rating actions reflected the substantial recapitalization of our balance sheet, improved absolute and risk-adjusted capital on a statutory basis and improving operating fundamentals. The "B++" rating is assigned to companies that have a good ability, in A.M. Best's opinion, to meet their ongoing obligations to policyholders. The "B" rating is assigned to companies which have a fair ability in A.M. Best's opinion to meet their current obligations to policyholders, but are financially vulnerable to adverse changes in underwriting and economic conditions. A.M. Best ratings for the industry currently range from "A++ (Superior)" to "F (In Liquidation)" and some companies are not rated. An "A++" rating indicates a superior ability to meet ongoing obligations to policyholders. The "B++" rating and the "B" rating from A.M. Best are the fifth and seventh highest, respectively, of sixteen possible ratings.
On August 2, 2005, S&P revised its outlook on our primary insurance subsidiaries to positive from stable, except Conseco Senior, for which the outlook remains stable. On May 27, 2004, S&P upgraded the financial strength ratings of our primary insurance companies from "BB-" to "BB+", except Conseco Senior, which was assigned a "CCC" rating. S&P financial strength ratings range from "AAA" to "R" and some companies are not rated. Rating categories from "BB" to "CCC" are classified as "vulnerable", and pluses and minuses show the relative standing within a category. In S&P's view, an insurer rated "BB" has marginal financial security characteristics and although positive attributes exist, adverse business conditions could lead to an insufficient ability to meet financial commitments. In S&P's view, an insurer rated "CCC" has very weak financial security characteristics and is dependent on favorable business conditions to meet financial commitments. The "BB+" rating and the "CCC" rating from S&P are the eleventh and eighteenth highest, respectively, of twenty-one possible ratings.
State laws generally give state insurance regulatory agencies broad authority to protect policyholders in their jurisdictions. Regulators have used this authority in the past to restrict the ability of our insurance subsidiaries to pay any dividends or other amounts to any non-insurance company parent without prior approval. We cannot be assured that the regulators will not seek to assert greater supervision and control over our insurance subsidiaries' businesses and financial affairs.
In August 2005, we completed the private offering of $330.0 million of Debentures. The net proceeds from the offering of approximately $320 million were used to repay amounts outstanding under the Company's Credit Facility.
At December 31, 2005, Conseco Inc. and CDOC held unrestricted cash of $89.5 million. Conseco Inc. and CDOC are holding companies with no business operations of their own; they depend on their operating subsidiaries for cash to make principal and interest payments on debt, and to pay administrative expenses and income taxes. Conseco and CDOC receive cash from insurance subsidiaries, consisting of dividends and distributions, principal and interest payments on surplus debentures and tax-sharing payments, as well as cash from non-insurance subsidiaries consisting of dividends, distributions, loans and advances. The principal non-insurance subsidiaries that provide cash to Conseco and CDOC are 40|86 Advisors, which receives fees from the insurance subsidiaries for investment services, and Conseco Services, LLC which receives fees from the insurance subsidiaries for providing administrative services. A deterioration in the financial condition, earnings or cash flow of the material subsidiaries of Conseco or CDOC for any reason could hinder such subsidiaries' ability to pay cash dividends or other disbursements to Conseco and/or CDOC, which, in turn, would limit Conseco's and/or CDOC's ability to meet debt service requirements and satisfy other financial obligations. In addition, we may need to contribute additional capital to certain insurance subsidiaries to strengthen their surplus and this could affect the ability of our top tier insurance subsidiary to pay dividends.
The ability of our insurance subsidiaries to pay dividends is subject to state insurance department regulations and is
We use computer models to simulate the cash flows expected from our existing insurance business under various interest rate scenarios. These simulations help us to measure the potential gain or loss in fair value of our interest rate-sensitive financial instruments and to manage the relationship between the duration of our assets and the expected 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, 2005, the adjusted modified duration of our fixed maturity investments (as modified to reflect payments and potential calls) was approximately 6.6 years and the duration of our insurance liabilities was approximately 7.3 years. We estimate that our fixed maturity securities and short-term investments (net of corresponding changes in insurance acquisition costs) would decline in fair value by approximately $685 million if interest rates were to increase by 10 percent from their levels at December 31, 2005. This compares to a decline in fair value of $630 million based on amounts and rates at December 31, 2004. Our computer simulated calculations include numerous assumptions, require significant estimates and assume an immediate change in interest rates without any management of the investment portfolio in reaction to such change. Consequently, potential changes in value of our financial instruments indicated by the simulations will likely be different from the actual changes experienced under given interest rate scenarios, and the differences may be material. Because we actively manage our investments and liabilities, our net exposure to interest rates can vary over time.
Our investment in options backing our equity-linked products is closely matched with our obligation to equity-indexed annuity holders. Market value changes associated with that investment are substantially offset by an increase or decrease in the amounts added to policyholder account balances for equity-indexed products.
Also, in our opinion, management's assessment, included in Management's Report on Internal Control Over Financial Reporting appearing under Item 9A, that the Company maintained effective internal control over financial reporting as of December 31, 2005 based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), is fairly stated, in all material respects, based on those criteria. Furthermore, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on criteria established in Internal Control - Integrated Framework issued by the COSO. The Company's management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express opinions on management's assessment and on the effectiveness of the Company's internal control over financial reporting based on our audit. We conducted our audit of internal control over financial reporting in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. An audit of internal control over financial reporting includes obtaining an understanding of internal control over financial reporting, evaluating management's assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we consider necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
In our opinion, the accompanying consolidated statements of operations, shareholders' equity (deficit) and cash flows present fairly, in all material respects, the results of their operations and their cash flows of Conseco, Inc. and subsidiaries (Predecessor Company) for the period from January 1, 2003 through August 31, 2003 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
o Conseco Insurance Group, which markets and distributes specified disease insurance, Medicare supplement insurance, and certain life and annuity products to the senior and middle-income markets through over 500 independent marketing organizations that represent over 6,000 producing independent agents. This segment markets its products under the "Conseco" brand.
On December 17, 2002, Old Conseco and certain of its non-insurance company subsidiaries filed voluntary petitions for relief under Chapter 11 of Title 11 of the United States Bankruptcy Code in the United States Bankruptcy Court for the Northern District of Illinois, Eastern Division (the "Bankruptcy Court"). We emerged from bankruptcy protection under the Sixth Amended Joint Plan of Reorganization (the "Plan"), which was confirmed pursuant to an order of the Bankruptcy Court on September 9, 2003 (the "Confirmation Date"), and became effective on September 10, 2003 (the "Effective Date"). Upon confirmation of the Plan, we implemented fresh start accounting in accordance with Statement of Position 90-7 "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7"). References in these consolidated financial statements to "Predecessor" refer to Old Conseco prior to August 31, 2003. References to "Successor" refer to the Company on and after August 31, 2003, after the effects of fresh start reporting. Our accounting and actuarial systems and procedures are designed to produce financial information as of the end of a month. Accordingly, for accounting convenience purposes, we applied the effects of fresh start accounting on August 31, 2003. The activity of the Company for the period from September 1, 2003 through September 10, 2003 was therefore included in the Successor's statement of operations and excluded from the Predecessor's statement of operations. We believe the net income impact of the use of a convenience date is immaterial.
The Plan generally provided for the full payment or reinstatement of allowed administrative claims, priority claims, fully secured claims and certain intercompany claims, and the distribution of new equity securities (including warrants) to partially secured and unsecured creditors of our Predecessor. Holders of claims arising under our Predecessor's $1.5 billion senior bank credit facility also received a pro rata interest in a $1.3 billion credit agreement. Holders of our Predecessor's common stock and preferred stock did not receive any distribution under the Plan, and these securities, together with all other
o a $1.3 billion credit agreement, (the "Previous Credit Facility", which has been subsequently repaid as further discussed in the note to the consolidated financial statements entitled "Notes Payable - Direct Corporate Obligations");
The distribution of our common stock represented approximately 98 percent of all of the shares of common stock to be distributed under the Plan. As of December 31, 2003, approximately 1.8 million of our outstanding shares of common stock were reserved for distribution under the Plan for unresolved disputed claims. During 2004 and 2005, a total of .6 million of these reserved shares were distributed upon the resolution of certain disputed claims. If reserved shares remain after resolution of pending disputed claims, such shares will be reallocated to other general unsecured creditors of our Predecessor as provided for under the Plan.
The accompanying financial statements include the accounts of the Company and its subsidiaries. Our consolidated financial statements exclude the results of material transactions between us and our consolidated affiliates, or among our consolidated affiliates. We have reclassified certain amounts in our 2004 and 2003 consolidated financial statements and notes to conform with the 2005 presentation. These reclassifications have no effect on net income or shareholders' equity.
When we prepare financial statements in conformity with GAAP, we are required to make estimates and assumptions that significantly affect reported amounts of various assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting periods. For example, we use significant estimates and assumptions to calculate values for the cost of policies produced, the value of policies inforce at the Effective Date, certain investments, assets and liabilities related to income taxes, liabilities for insurance products, liabilities related to litigation, guaranty fund assessment accruals and amounts recoverable from loans to certain former directors and former employees. If our future experience differs from these estimates and assumptions, our financial statements would be materially affected.
(b) These adjustments reflected the reorganization value of Conseco of $3,800.0 million. After deducting from Conseco's reorganization value the long-term indebtedness of Conseco at the Effective Date, consisting of $1,300.0 million under the senior secured bank credit facility, the total equity of Conseco was $2,500.0 million. After deducting from Conseco's total equity the value of the new preferred stock of $859.7 million, the value of the new common stock was $1,640.3 million. These adjustments also reflected the gain on the discharge of prepetition liabilities.
(c) In accordance with a new accounting pronouncement, the Company was required to consolidate the assets and liabilities of a partnership which owned the General Motors building. As a result of the consolidation and the adoption of fresh start accounting, we increased our investment in the General Motors building by $1,043.5 million and recognized the following other assets and liabilities held by the partnership which owned the General Motors building: (i) cash of $28.4 million; (ii) other liabilities of $30.8 million; and (iii) a note payable of $700 million. We sold the General Motors building in September 2003 at a value that was approximately equal to the fresh start value. The note payable of the partnership was paid in full and the net proceeds from the sale were distributed to the partners.
(d) The values of our mortgage loans, policy loans and other invested assets were adjusted to market value at the Effective Date. In addition, the cost basis of our actively managed fixed maturities was increased to the market value at the Effective Date.
o The magnitude of the risks associated with each of the actuarial assumptions used in determining the expected cash flows;
We classify our fixed maturity securities into one of three categories: (i) "actively managed" (which we carry at estimated fair value with any unrealized gain or loss, net of tax and related adjustments, recorded as a component of shareholders' equity); (ii) "trading" (which we carry at estimated fair value with changes in such value recognized as trading income); or (iii) "held to maturity" (which we carry at amortized cost). We had no fixed maturity securities classified as held to maturity during the periods presented in these financial statements.
Our trading securities are designed to act as hedges for embedded derivatives related to our equity-indexed annuity products and certain modified coinsurance agreements. See the note entitled "Accounting for Derivatives" for further discussion regarding embedded derivatives and the trading accounts. In addition, the trading account includes investments backing the market strategies of our multibucket annuity products. The change in market value of these securities, which is recognized currently in income from policyholder and reinsurer accounts (a component of investment income), is substantially offset by the change in insurance policy benefits for these products. Our trading securities totaled $716.3 million and $902.3 million at December 31, 2005 and 2004, respectively.
Other invested assets include: (i) certain call options purchased in an effort to hedge the effects of certain policyholder benefits; and (ii) certain non-traditional investments. We carry the call options at estimated fair value as further described below under "Accounting for Derivatives". Non-traditional investments include investments in certain limited partnerships, which are accounted for using the equity method, and promissory notes, which are accounted for using the cost method.
Upon the implementation of fresh start accounting, we eliminated the historical balance of Old Conseco's cost of policies produced as of September 10, 2003 (the effective date of the reorganization of our Predecessor), and replaced it with the value of policies inforce at the Effective Date.
When we realize a gain or loss on investments backing our universal life or investment-type products, we adjust the amortization to reflect the change in estimated gross profits from the products due to the gain or loss realized and the effect on future investment yields. We also adjust the cost of policies produced for the change in amortization that would have been recorded if actively managed fixed maturity securities had been sold at their stated aggregate fair value and the proceeds reinvested at current yields. We include the impact of this adjustment in accumulated other comprehensive income within shareholders' equity.
See note entitled "Fresh Start Reporting", for further explanation of this rate.
The Company expects to amortize the balance of the value of policies inforce at the Effective Date as of December 31, 2005 as follows: 12 percent in 2006, 11 percent in 2007, 10 percent in 2008, 8 percent in 2009 and 8 percent in 2010.
The goodwill recognized upon our emergence from bankruptcy resulted from the revaluation of our balance sheet accounts. We revalued our assets and liabilities to current estimated fair value and established our capital accounts at the reorganization value determined in connection with the Plan. We recorded goodwill of $1,141.6 million representing the excess of the reorganization value over specific tangible or identified intangible assets. In accordance with GAAP, the goodwill balance was not amortized.
Pursuant to SOP 90-7, the reduction of the deferred income tax valuation allowance established at the emergence date is first accounted for as a reduction of goodwill, and second as a reduction of other intangible assets. As further described in the note entitled "Income Taxes", the reduction of a portion of our deferred income tax valuation allowance resulted in the elimination of our other intangible assets in 2004.
The other intangible assets identified at the emergence date were valued with assistance from a consulting valuation firm. In accordance with Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets", other intangible assets with indefinite lives were not amortized and other intangible assets with finite useful lives were amortized over their estimated useful lives. We amortized the value of our career agency force and our independent agency force over their estimated useful lives of 15 years using the straight line method.
Our income tax expense includes deferred income taxes arising from temporary differences between the financial reporting and tax bases of assets and liabilities, capital loss carryforwards and net operating loss carryforwards ("NOLs"). The net deferred tax assets before valuation allowance totaled $2.5 billion at December 31, 2005. In evaluating our deferred income tax assets, we consider whether it is more likely than not that the deferred income tax assets will be realized. The ultimate realization of our deferred income tax assets depends upon generating sufficient future taxable income during the periods in which our temporary differences become deductible and before our capital loss carryforwards and NOLs expire. In addition, the use of the Company's NOLs is dependent, in part, on whether: (i) the IRS affirms the tentative settlement agreement related to the allocation of the tax loss on our predecessor's investment in CFC (the "CFC loss"); and (ii) the IRS does not take an adverse position in the future regarding the tax position we plan to take in our tax returns with respect to the allocation of cancellation of indebtedness income. These matters are further described in the note entitled "Income Taxes".
Based upon information existing at the time of our emergence from bankruptcy, we established a valuation allowance against our entire balance of net deferred income tax assets as we believed that the realization of such net deferred income tax assets in future periods was uncertain. During 2004 and 2005, we concluded that it was no longer necessary to hold certain portions of the previously established valuation allowance. Accordingly, we reduced our valuation allowance by $947.0 million in 2004 and $585.8 million in 2005. However, we are required to continue to hold a valuation allowance of $1,043.8 million because we have determined that it is more likely than not that a portion of our deferred tax assets will not be realized. This determination was made by evaluating each component of the deferred tax asset and assessing the effects of limitations or interpretations on the value of such component to be fully recognized in the future.
As part of our investment strategy, we may enter into repurchase agreements and dollar-roll transactions to increase our investment return or to improve our liquidity. We account for these transactions as collateralized borrowings, where the amount borrowed is equal to the sales price of the underlying securities. 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 repurchase agreements except that, with dollar rolls, the repurchase involves securities that are substantially the same as the securities sold (rather than being the same security). Such borrowings averaged $234.2 million during 2005 and $522.6 million during 2004. These borrowings were collateralized by investment securities with fair values approximately equal to the loan value. The weighted average interest rates on such borrowings were 2.9 percent during 2005 and 1.5 percent during 2004. The primary risk associated with short-term collateralized borrowings is that a counterparty will be unable to perform under the terms of the contract. Exposure is limited to the excess of the net replacement cost of the securities over the value of the short-term investments. During the third quarter of 2005, the market spread on these transactions declined to a level at which our continued participation in these transactions was not profitable. As a result, these transactions were terminated.
value of these options in net investment income (classified as investment income from policyholder and reinsurer accounts). Option costs that are attributable to benefits provided were $42.0 million during 2005; $44.8 million during 2004; $19.1 million during the four months ended December 31, 2003; and $53.5 million during the eight months ended August 31, 2003, and were included in investment income. Net investment income (loss) related to equity-indexed products before these option costs were $27.4 million in 2005; $58.5 million in 2004; $61.3 million in the four months ended December 31, 2003; and $83.6 million in the eight months ended August 31, 2003. These amounts were substantially offset by the corresponding charge to insurance policy benefits. The estimated fair value of these options was $44.5 million and $50.4 million at December 31, 2005 and 2004, respectively. We classify these instruments as other invested assets.
If the counterparties for the derivatives we hold fail to meet their obligations, we may have to recognize a loss. We limit our exposure to such a loss by diversifying among several counterparties believed to be strong and creditworthy. At December 31, 2005, all of our counterparties were rated "A" or higher by Standard & Poor's Corporation ("S&P").
The FASB's Derivative Implementation Group issued SFAS No. 133 Implementation Issue No. B36, "Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments that Incorporate Credit Risk Exposures that are Unrelated or Only Partially Related to the Creditworthiness of the Obligor of Those Instruments" ("DIG B36") in April 2003. DIG B36 addresses specific circumstances under which bifurcation of an instrument into a host contract and an embedded derivative is required. DIG B36 requires the bifurcation of a derivative from the receivable or payable related to a modified coinsurance agreement, where the yield on the receivable and payable is based on a return of a specified block of assets rather than the creditworthiness of the ceding company. We implemented this guidance on August 31, 2003, in conjunction with our adoption of fresh start accounting. We have determined that certain of our reinsurance payable balances contain embedded derivatives. Such derivatives had an estimated fair value of $17.4 million and $32.1 million at December 31, 2005 and 2004, respectively. We record the change in the fair value of these derivatives as a component of investment income (classified as investment income from policyholder and reinsurer accounts). We maintain a specific block of investments related to these agreements in our trading securities account, which we carry at estimated fair value with changes in such value recognized as investment income (also classified as investment income from policyholder and reinsurer accounts). The change in value of these trading securities should largely offset the change in value of the embedded derivatives.
Certain of our annuity products offer sales inducements to contract holders in the form of enhanced crediting rates or bonus payments in the initial period of the contract. Certain of our life insurance products offer persistency bonuses credited to the contract holders balance after the policy has been outstanding for a specified period of time. These enhanced rates and persistency bonuses are considered sales inducements under Statement of Position 03-01 "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts" ("SOP 03-01"). Such amounts are deferred and amortized in the same manner as the cost of policies produced. Sales inducements deferred totaled $62.8 million in 2005, $14.3 million in 2004 and $4.8 million in the four months ended December 31, 2003. Amounts amortized totaled $8.5 million in 2005, $2.9 million in 2004 and $.4 million in the four months ended December 31, 2003. The unamortized balance of deferred sales inducements was $70.1 million and $15.8 million at December 31, 2005 and 2004, respectively. The balance of insurance liabilities for persistency bonus benefits was $320.7 million and $313.2 million at December 31, 2005 and 2004, respectively.
In February 2006, the FASB issued SFAS No. 155, "Accounting for Certain Hybrid Financial Instruments - an amendment of FASB Statements No. 133 and 140" ("SFAS 155"). SFAS 155 amends SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), and SFAS 140, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities" and resolves issues addressed in SFAS 133 Implementation Issue No. D1, "Application of Statement 133 to Beneficial Interest in Securitized Financial Assets". SFAS 155: (a) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; (b) clarifies which interest-only strips and principal-only strips are not subject to the requirements of SFAS 133; (c) establishes a requirement to evaluate beneficial interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; (d) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and, (e) eliminates restrictions on a qualifying special-purpose entity's ability to hold passive derivative financial instruments that pertain to beneficial interests that are or contain a derivative financial instrument. The standard also requires presentation within the financial statements that identifies those hybrid financial instruments for which the fair value election has been applied and information on the income statement impact of the changes in fair value of those instruments. SFAS 155 is effective for all financial instruments acquired or issued in a fiscal year that begins after September 15, 2006. Given its recent issuance, management is still assessing the impact SFAS 155 will have on our results of operations or financial position.
In September 2005, the Accounting Standards Executive Committee issued Statement of Position 05-1, "Accounting by Insurance Enterprises for Deferred Acquisition Costs in Connection With Modifications or Exchanges of Insurance Contracts" ("SOP 05-1"). This statement provides guidance on accounting for deferred acquisition costs on an internal replacement which is defined broadly as a modification in product benefits, features, rights, or coverages that occurs by the exchange of an existing contract for a new contract, or by amendment, endorsement, or rider to an existing contract, or by the election of a benefit, feature, right, or coverage within an existing contract. An internal replacement that is determined to result in a replacement contract that is substantially unchanged from the replaced contract should be accounted for as a continuation of the replaced contract. Contract modifications resulting in a replacement contract that is substantially changed from the replaced contract should be accounted for as an extinguishment of the replaced contract and any unamortized deferred acquisition costs, unearned revenue liabilities, and deferred sales inducement assets from the replaced contract should not be deferred in connection with the replacement contract. The provisions of SOP 05-1 are effective for internal replacements occurring in fiscal years beginning after December 15, 2006. We are currently assessing the impact of SOP 05-1, however we do not expect the pronouncement to have a material impact on our results of operations or financial position.
The FASB issued SFAS 123R in December 2004. SFAS 123R revises SFAS 123 and supersedes APB 25. SFAS 123R provides additional guidance on accounting for share-based payments and will require all such awards to be measured at fair value with the related compensation cost recognized in the statement of operations over the related service period. SFAS 123R is effective for all awards granted, modified, repurchased or cancelled and requires the recognition of compensation cost over the remaining requisite service period for the portion of outstanding awards that are not vested as of January 1, 2006 and were not previously expensed on a pro forma basis in the disclosure included under the caption entitled "Accounting for Stock Options". SFAS 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow rather than as an operating cash flow, as currently required. We currently measure compensation expense for our stock option plans using the intrinsic value method. Effective January 1, 2006, we will be required to recognize expense related to our stock option plans consistent with the requirements of SFAS 123R described above. We will implement this requirement using the modified prospective method. See "Accounting for Stock Options" above for further information on this method. The Company's net income would have been reduced by $3.1 million and $4.1 million in 2005 and 2004, respectively, if we had recognized stock-based employee compensation as determined under the fair value method, net of income taxes.
The FASB issued Statement of Financial Accounting Standards No. 150, "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity" ("SFAS 150") in May 2003. SFAS 150 established standards for classifying and measuring certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. For example, mandatorily redeemable preferred stock is required to be classified as a liability pursuant to SFAS 150. SFAS 150 was effective immediately for financial instruments entered into or modified after May 31, 2003, and for all other financial instruments beginning with the third quarter of 2003. Effective July 1, 2003, Old Conseco's Company-obligated mandatorily redeemable preferred securities of subsidiary trusts, with an aggregate carrying value of $1,921.5 million, were reclassified to liabilities pursuant to the provisions of SFAS 150. Such securities were not outstanding after the Effective Date. We followed the guidance of SFAS 150 to properly classify the Class B mandatorily convertible preferred stock issued in the second quarter of 2004 as a component of shareholders' equity.
The FASB issued Statement of Financial Accounting Standards No. 149 "Amendment of SFAS No. 133 on Derivative Instruments and Hedging Activities" ("SFAS 149") in April 2003. SFAS 149 amended and clarified accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities." Except for certain implementation guidance included in SFAS 149 which was already effective, the new guidance was effective for: (i) contracts entered into or modified after June 30, 2003; and (ii) hedging relationships designated after June 30, 2003. The adoption of SFAS 149 did not have a material impact on the Company's consolidated financial statements.
The FASB issued Statement of Financial Accounting Standards No. 146, "Accounting for Exit or Disposal Activities" ("SFAS 146") in June 2002. SFAS 146 addressed financial accounting and reporting for costs that are associated with exit and disposal activities and supersedes Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)". SFAS 146 is required to be used to account for exit or disposal activities that are initiated after December 31, 2002. SFAS 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of commitment to an exit or disposal plan. The Company adopted the provisions of SFAS 146 on January 1, 2003, and its initial adoption did not have an impact on the Company's consolidated financial statements.
At December 31, 2004, the amortized cost and estimated fair value of actively managed fixed maturities and equity securities were as follows (dollars in millions):
Accumulated other comprehensive income is comprised of the net effect of unrealized appreciation on our investments. These amounts, included in shareholders' equity as of December 31, 2005 and 2004, were as follows (dollars in millions):
At December 31, 2005, the amortized cost of the Company's below-investment grade fixed maturity securities was $986.9 million, or 4.4 percent of the Company's fixed maturity portfolio. The estimated fair value of the below-investment grade portfolio was $994.4 million, or 101 percent of the amortized cost. The value of these securities varies based on the economic terms of the securities, structural considerations and the creditworthiness of the issuer of the securities.
The following table sets forth the amortized cost and estimated fair value of actively managed fixed maturities at December 31, 2005, by contractual maturity. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Most of the structured securities shown below provide for periodic payments throughout their lives (dollars in millions).
The carrying value of fixed maturity investments and mortgage loans not accruing investment income totaled $12.7
million and $7.2 million at December 31, 2005 and 2004, respectively.
During 2005, we recognized net realized investment losses of $2.9 million, which were comprised of $11.8 million of net gains from the sales of investments (primarily fixed maturities) with proceeds of $11.5 billion, net of $14.7 million of writedowns of investments for other than temporary declines in fair value. During 2004, we recognized net realized investment gains of $40.6 million, which were comprised of $58.7 million of net gains from the sales of investments (primarily fixed maturities) with proceeds of $12.7 billion, net of $18.1 million of writedowns of investments for other than temporary declines in fair value. During the four months ended December 31, 2003, we recognized net realized investment gains of $11.8 million, which were comprised of $21.4 million of net gains from the sales of investments (primarily fixed maturities) with proceeds of $4.7 billion, net of $9.6 million of writedowns of investments for other than temporary declines in fair value. During the first eight months of 2003, we recognized net realized investment losses of $5.4 million, which were comprised of $45.9 million of net gains from the sales of investments (primarily fixed maturities) with proceeds of $5.4 billion, net of $51.3 million of writedowns of investments for other than temporary declines in fair value. At December 31, 2005, investments in default as to the payment of principal or interest had an aggregate amortized cost of $26.6 million and a carrying value of $27.7 million.
During 2005, we sold $3.7 billion of fixed maturity investments which resulted in gross investment losses (before income taxes) of $82.3 million. We sell securities at a loss for a number of reasons including, but not limited to; (i) changes in the investment environment; (ii) expectation that the market value could deteriorate further; (iii) desire to reduce our exposure to an issuer or an industry; (iv) changes in credit quality; (v) identification of a superior investment alternative; or (vi) changes in expected liability cash flows. During 2005, we sold no investments at a loss which had been continuously in an unrealized loss position exceeding 20 percent of the amortized cost basis for over a month.
Our assessment of whether unrealized losses are "other than temporary" requires significant judgment. Factors considered include: (i) the extent to which market value is less than the cost basis; (ii) the length of time that the market
value has been less than cost; (iii) whether the unrealized loss is event driven, credit-driven or a result of changes in market interest rates; (iv) the near-term prospects for improvement in the issuer and/or its industry; (v) our view of the investment's rating and whether the investment is investment-grade and/or has been downgraded since its purchase; (vi) whether the issuer is current on all payments in accordance with the contractual terms of the investment and is expected to meet all of its obligations under the terms of the investment; (vii) our ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery; and (viii) the underlying current and prospective asset and enterprise values of the issuer and the extent to which our investment may be affected by changes in such values.
When a decline in value is determined to be other than temporary and the cost basis of the security is written down to fair value, we review the circumstances of that particular investment in relation to other investments in our portfolio. If such circumstances exist with respect to other investments, those investments are also written down to fair value. Future events may occur, or additional information may become available, which may necessitate future realized losses of securities in our portfolio. Significant losses in the carrying values of our investments could have a material adverse effect on our earnings in future periods.
During 2005, we recorded writedowns of actively managed fixed maturities totaling $4.5 million as a result of analysis that led us to conclude that their declines in value were other than temporary. Of this total writedown, $3.8 million related to bonds, secured by an apartment complex, which were issued as part of the USDA Section 538 program for rural housing development. This complex has significant construction cost overruns as well as lower rents than were projected which make the viability of the USDA guarantee unclear. The remaining $.7 million of writedowns related to various other actively managed fixed maturities.
At December 31, 2005, we held two investments in our fixed maturity portfolio which were rated below-investment grade and had unrealized loss positions exceeding 20 percent of their cost bases. At December 31, 2005, such investments had an amortized cost and estimated fair value of $1.7 million and $1.3 million, respectively.
During the summer of 2003, we successfully enforced our contractual right to buy out our 50 percent equity partner in the GM building, a landmark 50-story office tower in New York City. After obtaining an award in arbitration, and confirming that award in the New York court system, we settled our differences with our equity partner, thus permitting us to put the building up for sale. On September 26, 2003, we sold our investment in the GM building. We received cash of $636.8 million, which was approximately equal to the value established upon the adoption of fresh start accounting.
The following table sets forth the par value, amortized cost and estimated fair value of structured securities, summarized by interest rates on the underlying collateral, at December 31, 2005 (dollars in millions):
The amortized cost and estimated fair value of structured securities at December 31, 2005, summarized by type of security, were as follows (dollars in millions):
Pass-through securities and sequential and targeted amortization class securities have different prepayment variability characteristics. Pass-through securities typically return principal to the holders based on cash payments from the underlying mortgage obligations. Sequential classes return principal to tranche holders in a detailed hierarchy. Targeted amortization classes, planned amortization classes and accretion-directed bonds adhere to fixed schedules of principal payments as long as
the underlying mortgage loans experience prepayments within certain estimated ranges. Changes in prepayment rates are first absorbed by support or companion classes. This insulates the timing of receipt of cash flows from the consequences of both faster prepayments (average life shortening) and slower prepayments (average life extension).
Conseco had two fixed maturity investments in excess of 10 percent of shareholders' equity at December 31, 2005 and one fixed maturity investment in excess of 10 percent of shareholders' equity at December 31, 2004 (other than investments issued or guaranteed by the United States government or a United States government agency), which are summarized below (dollars in millions):
The performance of our long-term care business (especially the acquired block originally sold through independent agents) has generally been unfavorable relative to the Predecessor's assumptions established when these blocks of business were acquired. For example, variances in actual morbidity, lapses and expenses have been unfavorable compared to original estimates. Approximately $1.4 billion of the increase to insurance liabilities was the result of changes in non-interest assumptions for our long-term care policies. Our assumption changes for long-term care business included: (i) changes in morbidity assumptions from estimates made when the business was acquired to recent Company experience; (ii) changes in mortality assumptions related to certain blocks of this business from the 1958 and 1980 Commissioners Standard Ordinary Mortality table to the 1983 Group Annuity Mortality table; and (iii) changes in ultimate lapse ratios from a range of approximately 3 percent to 5.5 percent prior to the adoption of fresh start accounting to a range of 2 percent to 3.5 percent.
The insurance liability for asset accumulation products (such as deferred annuities and universal life products) is generally equal to current policyholder account balances. These balances generally do not change as a result of the adoption of fresh start accounting. The fresh-start adjustment to insurance liabilities for interest-sensitive products primarily resulted from: (i) the adoption of SOP 03-01 as of the Effective Date; and (ii) certain Predecessor insurance liabilities that were different from the present value of estimated future benefits as of August 31, 2003.
The components of income tax expense (benefit) were as follows (dollars in millions):
million because we have determined that it is more likely than not that a portion of our deferred tax assets will not be realized. This determination was made by evaluating each component of the deferred tax asset and assessing the effects of limitations or interpretations on the value of such component to be fully recognized in the future.
The Code limits the extent to which losses realized by a non-life entity (or entities) may offset income from a life insurance company (or companies) to the lesser of: (i) 35 percent of the income of the life insurance company; or (ii) 35 percent of the total loss of the non-life entities (including NOLs of the non-life entities). There is no limitation on the ability to utilize NOLs generated by a life insurance company.
In addition, the timing and manner in which the Company will be able to utilize some of its NOLs is limited by Section 382 of the Code. Section 382 imposes limitations on a corporation's ability to use its NOLs when the company undergoes an ownership change. Because the Company underwent an ownership change pursuant to its reorganization, this limitation applies to the Company. Any losses that are subject to the Section 382 limitation will only be utilized by the Company up to approximately $140 million per year with any unused amounts carried forward to the following year.
We have also evaluated the likelihood that we will have sufficient taxable income to offset the available deferred tax assets. This assessment required significant judgment. Based upon our current projections of future income that we completed at December 31, 2005, we believe that we will more likely than not recover $1,504.4 million of our deferred tax assets through reductions of our tax liabilities in future periods. However, recovery is dependent on achieving such projections and failure to do so would result in an increase in the valuation allowance in a future period. Any future increase in the valuation allowance would result in additional income tax expense and reduce shareholders' equity, and such an increase could have a significant impact upon our earnings in the future.
At the fresh-start date, we were required to estimate our tax basis in CFC in order to determine the tax loss carryforward related to the worthlessness of CFC. The determination of this amount and how the loss was recognized were subject to interpretation of various tax laws and regulations. During the third quarter of 2004, the Company and the IRS entered into a closing agreement which determined that the tax loss on the worthlessness of CFC was $6.7 billion, instead of our original estimate of $5.4 billion. This determination resulted in $500.1 million of additional deferred tax assets. We also recognized a $500.1 million valuation allowance, as we had deemed it more likely than not that such deferred tax asset would not be realized. As this increase related to the period prior to the Effective Date, a reduction of any portion of the deferred income tax valuation allowance will be accounted for as additions to paid-in capital pursuant to SOP 90-7. The closing agreement with the IRS also determined that the loss recognized on the worthlessness of CFC was an ordinary loss for tax purposes and not a capital loss.
Conseco and its affiliates are currently under examination by the IRS for the tax year ending December 31, 2003. During the 2003 audit, the IRS questioned the Company's tax position on the CFC loss, and requested Technical Advice from the National Office of the IRS. The Technical Advise Memorandum ("TAM") issued by the National Office confirmed the Company's position that the CFC loss would be treated as a post-emergence loss and therefore would not be subject to the Section 382 limitation. However, the TAM was adverse to the Company's position that the CFC loss was incurred by a life insurance company. The Company then requested, pursuant to its appeal rights, that the issue be resolved through the IRS's Fast-Track resolution process, and a settlement was reached. The settlement was incorporated as an adjustment in the audit. The tentative settlement characterized $2.1 billion of the CFC loss as life insurance company losses and the remaining amount as non-life losses prior to application of the cancellation of indebtedness attribute reductions described below. Due to the carryback of capital losses during the audit period resulting in a refund in excess of $2 million, the audit is not final until the Joint Committee on Taxation (the "Joint Committee"), which is a committee composed of 10 members (five of whom are members of the Committee on Finance of the United States Senate and five of whom are members of the Committee on Ways and Means of the United States House of Representatives), has approved it. Generally, the IRS must audit and the Joint Committee must approve any tax years in which there is a refund in excess of $2 million, as required by Internal Revenue Code Section 6405. The IRS has proposed to the Joint Committee, in a special report as mandated by IRC ss.6405(b), that the audited tax years for 2002-2003 be accepted as adjusted. This special report was sent to the Joint Committee in February of 2006. If the Joint Committee does not approve the audit, the Committee will explain its objections to the IRS and the IRS must then address those objections in the audit and resubmit the audit for approval. Review by the Joint Committee can take as long as nine months to complete.
Prior to January 1, 1984, certain life insurance subsidiaries of the Company were entitled to exclude certain amounts from taxable income and accumulate such amounts in a "Policyholders Surplus Account". Pursuant to the American Jobs Creation Act of 2004 (the "2004 Act"), the affected subsidiaries can reduce the Policyholders Surplus Account in 2006 without incurring any tax liability. The aggregate balance in this account at December 31, 2005 was $150.7 million, which prior to the 2004 Act would have resulted in federal income taxes payable of $52.7 million if such amounts had been distributed or deemed distributed from the Policyholders Surplus Account. No provision for taxes has ever been made for this item since the affected subsidiaries had no intention of distributing such amounts. The affected subsidiaries expect to utilize this provision, thereby eliminating or substantially reducing this potential tax liability.
If an event of default occurs and is continuing with respect to the Debentures, either the trustee or the holders of at least 25 percent of the aggregate accreted principal amount of the Debentures then outstanding may declare the accreted principal amount, plus accrued and unpaid interest, including additional interest and contingent interest, if any, on the Debentures to be due and payable immediately. If an event of default relating to certain events of bankruptcy, insolvency or reorganization occurs, the accreted principal amount plus accrued and unpaid interest, including additional interest and contingent interest, if any, on the Debentures will become immediately due and payable. The following are events of default
o default for 30 days in payment of any interest, contingent interest or additional interest due and payable on the Debentures;
In connection with the sale of the Debentures, the Company also entered into a Registration Rights Agreement (the "Registration Rights Agreement") with the initial purchasers. Pursuant to that agreement, the Company agreed to file with the SEC within 90 days, and to use its reasonable best efforts to cause to become effective on or before March 13, 2006, a shelf registration statement with respect to the resale of the Debentures and the sale of our shares of common stock issuable upon conversion of the Debentures. If the Company fails to comply with certain of its obligations under the Registration Rights Agreement, additional interest will be payable on the Debentures. The Company filed the shelf registration statement on November 8, 2005, but it has not yet become effective.
In the second quarter of 2004, our Previous Credit Facility was repaid as follows: (i) $620.0 million from the proceeds from our issuance of common and preferred stock as further discussed in the note entitled "Shareholders' Equity"; (ii) $674.3 million from amounts borrowed under our Credit Facility as further described below; and (iii) a $5.7 million required prepayment made pursuant to a provision in the Previous Credit Facility. The repayment of the Previous Credit Facility resulted in a gain from the extinguishment of debt totaling $2.8 million. The gain resulted from the release of a $6.3 million accrual for a fee that would have been required to be paid under the Previous Credit Facility, partially offset by the write-off of unamortized amendment fees.
On June 22, 2004, we entered into the Credit Facility with a principal balance of $800.0 million. The Credit Facility was a six-year term loan, the proceeds of which were used: (i) to refinance in full all indebtedness, including accrued interest, under the Previous Credit Facility; (ii) to repurchase $106.6 million of certain affiliated preferred stock; and (iii) for other general corporate purposes.
In August 2005, we entered into a $447.0 million secured credit agreement (the "Amended Credit Facility"). The proceeds of the Amended Credit Facility were used to repay the remaining principal amount of the Credit Facility. The Company recognized a $3.7 million loss on the extinguishment of debt during 2005 for the write-off of certain debt issuance costs related to the reduction of the principal amount borrowed under the Amended Credit Facility. The Amended Credit Facility provided for a one-time increase in the facility or the addition of a new facility of up to $325.0 million. In December 2005, we borrowed an additional $80.0 million pursuant to this provision. The proceeds from the additional borrowing were used to increase the capital and surplus of our insurance subsidiaries. During 2005, we made principal payments totaling $2.4 million on our Amended Credit Facility as well as a mandatory prepayment of $.9 million on the Credit Facility (after consideration of a $28.0 million prepayment made in December 2004) based on the Company's excess cash flows at December 31, 2004, as defined in the Credit Facility. There were $5.6 million and $9.1 million of unamortized issuance
costs (classified as other assets) related to our senior secured credit facilities at December 31, 2005 and 2004, respectively.
Under the terms of the Amended Credit Facility, we are required to make quarterly principal payments of .25 percent (approximately $1.3 million) of the initial principal amount through March 31, 2010. The remaining principal balance is due on June 22, 2010. The amount outstanding under the Amended Credit Facility bears interest, payable at least quarterly, based on either a Eurodollar rate or a base rate. The Eurodollar rate on the Amended Credit Facility is equal to LIBOR plus 2 percent, compared to LIBOR plus 3.5 percent under the Credit Facility. The base rate on the Amended Credit Facility is equal to 1 percent (2.5 percent under the Credit Facility) plus the greater of: (i) the Federal funds rate plus .50 percent; or (ii) Bank of America's prime rate. If the Company's senior secured long-term debt is rated at least Ba3 by Moody's Investors Service, Inc. ("Moody's") and BB- by S&P, in each case with a stable outlook, the margins on the Eurodollar rate or the base rate would each be reduced by .25 percent. In March 2006, Moody's upgraded our senior secured debt rating to "Ba3" from "B2". At December 31, 2005, the interest rate on our Amended Credit Facility was 6.4 percent.
Pursuant to the Amended Credit Facility, as long as the debt to total capitalization ratio (as defined in the Amended Credit Facility) is greater than 20 percent and certain insurance subsidiaries (as defined in the Amended Credit Facility) have financial strength ratings of less than A- from A.M. Best, the Company is required to make mandatory prepayments with all or a portion of the proceeds from the following transactions or events including: (i) the issuance of certain indebtedness; (ii) equity issuances; (iii) certain asset sales or casualty events; and (iv) excess cash flows as defined in the Amended Credit Facility. The Company may make optional prepayments at any time in minimum amounts of $3.0 million or any multiple of $1.0 million in excess thereof.
The Amended Credit Facility includes an $80.0 million revolving credit facility that can be used for general corporate purposes and that would mature on June 22, 2009. There were no amounts outstanding under the revolving credit facility at December 31, 2005. The Company pays a commitment fee equal to .50 percent of the unused portion of the revolving credit facility on an annualized basis. The revolving credit facility bears interest based on either a Eurodollar rate or a base rate in the same manner as described above for the Amended Credit Facility.
The Amended Credit Facility prohibits or restricts, among other things: (i) the payment of cash dividends on our common stock; (ii) the repurchase of our common stock; (iii) the issuance of additional debt or capital stock; (iv) liens; (v) certain asset dispositions; (vi) affiliate transactions; (vii) certain investment activities; (viii) change in business; and (ix) prepayment of indebtedness (other than the Amended Credit Facility). The obligations under our Amended Credit Facility are guaranteed by Conseco's current and future domestic subsidiaries, other than: (i) its insurance companies; (ii) subsidiaries of the insurance companies; or (iii) certain immaterial subsidiaries as defined in the Amended Credit Facility. This guarantee was secured by granting liens on substantially all the assets of the guarantors, including the capital stock of our top tier insurance company, Conseco Life Insurance Company of Texas.
On December 1, 2000, the Company's former subsidiary, Manhattan National Life Insurance Company, was named in a purported nationwide class action seeking unspecified damages in the First Judicial District Court of Santa Fe, New Mexico, Robert Atencio and Theresa Atencio, for themselves and all other similarly situated v. Manhattan National Life Insurance Company, an Ohio corporation, Cause No. D-0101-CV-2000-2817, alleging among other things fraud by non-disclosure of additional charges for those policyholders paying via premium modes other than annual. We retained liability for this litigation in connection with the sale of Manhattan National Life in June 2002. We believe this lawsuit is without merit and intend to defend it vigorously. Given the uncertainties regarding the outcome of these proceedings, we are unable to estimate the possible range of loss that may result from this pending litigation.
On March 24, 2004, a complaint was filed in the United States District Court for Western District of North Carolina, Statesville Division, StockCar Stocks Advisors, LLC v. 40/86 Advisors, Inc. f/k/a Conseco Capital Management, Inc.; Maxwell E. Bublitz; Gregory J. Hahn; and D. Bruce Johnson, Cause No. 5:04-04 CV 31. Plaintiff is a limited liability company formed to sponsor, operate, and manage a mutual fund company known as StockCar Stocks Mutual Fund, Inc. Plaintiff alleges in its complaint that it was damaged by 40|86's conduct related to its purchase of the StockCar Stocks Mutual Fund from Plaintiff. Plaintiff demanded damages in an unnamed amount based on their claims of breach of contract,
fraud, fraudulent concealment, negligent and innocent misrepresentation, unfair and deceptive trade practices, conversion, negligence and wantonness. The case has been settled and dismissed.
On December 10, 2004, a complaint was filed in the United States District Court for the Northern District of Oklahoma, Robin C. Willig, as Executrix of the Estate of Rhodes K. Scherer vs. Conseco Senior Health Insurance Company and Conseco, Inc., Case No. 04 CV 923E (M). The plaintiff alleges that the failure to pay long term care insurance policy proceeds has been a breach of contract and in violation of the duty to act in good faith, and seeks actual damages in a sum in excess of $75,000, punitive damages in a sum in excess of $75,000, her costs, attorneys' fees, and such other and further relief as the Court and jury determine to be just, equitable, and fair. On or about September 27, 2005, the plaintiff dismissed Conseco, Inc. as a defendant. Discovery is ongoing. Jury trial is currently set for September 18, 2006. We believe the action is without merit, and intend to defend it vigorously. The ultimate outcome of the action cannot be predicted with certainty.
On October 8, 2003, a complaint was filed in the United States District Court for South Carolina, Greenville Division, Consolidated Insured Benefits, Inc. and Ronald F. English v. Conseco Medical Insurance Company, Cause No. 6:03-3211-20. Plaintiffs are a former Conseco Medical Insurance Company ("CMIC") field marketing organization and its president and chief executive officer, and they allege in the complaint that they were damaged by CMIC's exit from the individual medical insurance market claiming damages in an unnamed amount for fraud, negligent misrepresentation and breach of fiduciary duty. CMIC has filed a motion for summary judgment, and the court has enlarged the time for discovery to July 2006. The case is expected to be set for trial in 2007. We believe the action is without merit, and intend to defend it vigorously. The ultimate outcome of the action cannot be predicted with certainty.
On January 31, 2003, a complaint was filed in the Circuit Court of Rock County, Wisconsin, School District of Beloit v. Conseco Life Insurance Company f/k/a Philadelphia Life Insurance Company, Daniel Boutelle, Combined Insurance Group, Inc., H.E.P. Administrators, Inc., and Beloit Memorial Hospital, Inc., Case No. 03-CV-134. A first amended complaint was filed on or about October 1, 2003, adding Sympson & Associates, Inc. and Reinsurance Consultants, LTD. The lawsuit involves two stop loss policies under which coverage was provided by Conseco Life to the School District of Beloit with respect to its employees' group health plan. The matter has been settled. The case is to be dismissed.
On October 20, 2004, in Conseco Services v. Hilbert, Conseco Services was granted partial final summary judgment in the amount of $62.7 million plus interest. Mr. Hilbert has appealed that ruling. The Court of Appeals ruled in our favor on November 8, 2005. Mr. Hilbert has now filed a petition to transfer with the Indiana Supreme Court. Ms. Cuneo recently settled all outstanding litigation with us and the cases were dismissed in February, 2006.
The balance sheet at December 31, 2005, included: (i) accruals of $10.8 million, representing our estimate of all known assessments that will be levied against the Company's insurance subsidiaries by various state guaranty associations based on premiums written through December 31, 2005; and (ii) receivables of $7.5 million that we estimate will be recovered through a reduction in future premium taxes as a result of such assessments. At December 31, 2004, such guaranty fund assessment accruals were $10.3 million and such receivables were $7.8 million. These estimates are subject to change when the associations determine more precisely the losses that have occurred and how such losses will be allocated among the insurance companies. We recognized expense (benefit) for such assessments of $4.0 million in 2005; $(.6) million in 2004; $1.2 million in the four months ended December 31, 2003; and $4.1 million in the eight months ended August 31, 2003.
We hold bank loans made to certain former directors and employees to enable them to purchase common stock of Old Conseco. These loans, with a principal amount of $481.3 million, had been guaranteed by our Predecessor. We received all rights to collect the balances due pursuant to the original terms of these loans. In addition, we hold loans to participants for interest on the bank loans which exceed $230 million. The former bank loans and the interest loans are collectively referred to as the "D&O loans." We regularly evaluate the collectibility of these loans in light of the collateral we hold, the credit worthiness of the participants and the current status of various legal actions we have taken to collect the D&O loans. At December 31, 2005, we have estimated that approximately $34.4 million of the D&O loan balance (which is included in other assets) is collectible (net of the costs of collection). An allowance has been established to reduce the total D&O loan balance to the amount we estimated was recoverable. In 2005, other operating costs and expenses are net of a $3.2 million recovery related to our evaluation of the collectibility of the D&O loans.
Pursuant to the settlement that was reached with the Official Committee of the Trust Originated Preferred Securities ("TOPrS") Holders and the Official Committee of Unsecured Creditors in the Plan, the former holders of TOPrS (issued by Old Conseco's subsidiary trusts and eliminated in our reorganization) who did not opt out of the bankruptcy settlement, will be entitled to receive 45 percent of any net proceeds from the collection of certain D&O loans in an aggregate amount not to exceed $30 million. We have established a liability of $17.5 million (which is included in other liabilities), representing our estimate of the amount which will be paid to the former holders of TOPrS pursuant to the settlement.
In accordance with the terms of the employment agreements of two of the Company's former chief executive officers, certain wholly-owned subsidiaries of the Company are the guarantors of the former executives' nonqualified supplemental retirement benefits. The liability for such benefits at December 31, 2005 and 2004, was $23.2 million and $22.0 million, respectively, and is included in the caption "Other liabilities" in the consolidated balance sheet.
The Company rents office space, equipment and computer software under noncancellable operating leases. In addition, the Company has entered into certain sponsorship agreements which require future payments. Total expense pursuant to these agreements was $41.3 million in 2005; $44.1 million in 2004; $20.3 million in the four months ended December 31, 2003; and $29.0 million in the eight months ended August 31, 2003. Future required minimum payments as of December 31, 2005, were as follows (dollars in millions):
For our deferred compensation plan and postretirement plans, in periods subsequent to the Effective Date, it is our policy to immediately recognize changes in the actuarial benefit obligation resulting from either actual experience being different than expected or from changes in actuarial assumptions (which differs from the method used by our Predecessor, whereby, such gains (losses) were recognized over the expected service lives of the participants).
Effective December 31, 2005, the Company terminated certain postretirement benefit plans. Prior to the termination of such plans, we provided certain health care and life insurance benefits for certain eligible retired employees under partially funded and unfunded plans in existence at the date on which certain subsidiaries were acquired. Certain postretirement benefit plans were contributory, with participants' contributions adjusted annually. Actuarial measurement dates of September 30 and December 31 were used for our postretirement benefit plans. In 2005, we recognized gains of $13.2 million on the termination of these plans. The costs incurred on these plans during 2004 were reduced by $7.9 million related to the recognition of changes in the actuarial benefit obligation resulting either from actual experience being different than expected or from changes in actuarial assumptions. The remaining liability at December 31, 2005, relates to benefits to be paid in 2006. Amounts related to the postretirement benefit plans were as follows (dollars in millions):
Components of the cost we recognized related to postretirement plans were as follows (dollars in millions):
The benefits expected to be paid pursuant to our deferred compensation plan and postretirement benefit plans as of December 31, 2005 were as follows (dollars in millions):
The Company has qualified defined contribution plans for which substantially all employees are eligible. Company contributions, which match certain voluntary employee contributions to the plan, totaled $4.0 million in 2005 and $4.1 million in 2004. No employer contributions were made during the 2003 periods. Employer matching contributions are discretionary.
The changes in unrealized appreciation (depreciation) included in comprehensive income are net of reclassification adjustments for after-tax net gains (losses) from the sale of investments included in net income (loss) of approximately $165 million and $75 million for the years ended December 31, 2005 and 2004, respectively. Such changes for the 2003 periods were not significant.
(iv) Certain supplemental retirement, insurance and other benefits for which we recognized expenses of $2.4 million in 2004.
The Preferred Stock has a par value of $.01 per share and a liquidation preference of $25 per share. Dividends are payable in cash at a rate of 5.5 percent of the liquidation preference per share, payable quarterly on February 15, May 15, August 15 and November 15.
The Preferred Stock is mandatorily convertible into common stock of Conseco on May 15, 2007. The conversion rate for each share of Preferred Stock will range from 1.1228 to 1.3699 shares of Conseco common stock, depending on the applicable market value of our common stock, as defined in the certificate of designations, on the mandatory conversion date. As of December 31, 2005, the Preferred Stock would have been convertible into 31.0 million shares of Conseco common stock. At any time prior to May 15, 2007, the holders of the Preferred Stock may convert such shares at the minimum conversion rate of 1.1228 shares of our common stock for each share of Preferred Stock. If at any time prior to May 15, 2007, the closing price of our common stock exceeds 150 percent of the threshold appreciation price of $22.27, subject to adjustment under certain circumstances, the Company, at its option for a certain period of time, may elect to convert all outstanding Preferred Stock at the minimum conversion rate of 1.1228 shares of our common stock for each share of Preferred Stock. In addition, if the Company elects such conversion, it must pay the holders of the Preferred Stock, in cash, an amount equal to the present value of all remaining unpaid dividends on the Preferred Stock through and including May 15, 2007.
Holders of the Preferred Stock are only entitled to voting rights in limited circumstances as further described in the
All outstanding stock options of the Predecessor were cancelled pursuant to the Plan.
The following table summarizes information about stock options outstanding at December 31, 2005 (shares in thousands):
During 2004, equivalent common shares of 19.9 million related to the assumed conversion of convertible exchangeable preferred stock (which was redeemed in the second quarter of 2004) were not included in the computation of diluted earnings per share because doing so would have been antidilutive.
In August 2005, as further discussed in the note to the consolidated financial statements entitled "Notes Payable - Direct Corporate Obligations", we completed the private offering of $330.0 million of 3.50% Convertible Debentures due September 30, 2035. In future periods, our diluted shares outstanding may include incremental shares issuable upon conversion of all or part of such Debentures. Since the $330.0 million principal amount can only be redeemed for cash, it has no impact on the diluted earnings per share calculation. In accordance with the conversion feature of these debentures, we may be required to pay a stock premium along with redeeming the accreted principal amount for cash, if our common stock reaches a certain market price. In accordance with the consensus from EITF No. 04-8, "The Effect of Contingently Convertible Instruments on Diluted Earnings per Share", we will include the dilutive effect of our Debentures in the calculation of diluted earnings per share when the impact is dilutive. As of December 31, 2005, the conversion feature of these Debentures did not have a dilutive effect because the weighted average market price of our common stock did not
exceed the initial conversion price of $26.66. Therefore, the Debentures had no effect on our diluted shares outstanding or our diluted earnings per share for 2005.
Basic earnings per common share is computed by dividing net income applicable to common stock by the weighted average number of common shares outstanding for the period. Restricted shares are not included in basic earnings per share until vested. Diluted earnings per share reflects the potential dilution that could occur if outstanding stock options were exercised and restricted stock was vested. The dilution from options and restricted shares is calculated using the treasury stock method. Under this method we assume the proceeds from the exercise of the options (or the unrecognized compensation expense with respect to restricted stock) will be used to purchase shares of our common stock at the average market price during the period, reducing the dilutive effect of the exercise of the options (or the vesting of the restricted stock).
Based on current conditions and assumptions as to future events on all policies inforce, the Company expects to amortize approximately 12 percent of the December 31, 2005 balance of the value of policies inforce at the Effective Date in 2006, 11 percent in 2007, 10 percent in 2008, 8 percent in 2009 and 8 percent in 2010. The discount rate used to determine the amortization of the value of policies inforce at the Effective Date averaged 5 percent in the years ended December 31, 2005 and 2004, and the four months ended December 31, 2003.
The discount rates used to determine the amortization of the cost of policies purchased averaged 7 percent in the eight months ended August 31, 2003.
The following disclosures supplement our consolidated statement of cash flows (dollars in millions):
At December 31, 2005, restricted cash and cash equivalents consisted of: (i) $33.3 million held by a variable interest entity; and (ii) $1.9 million of segregated cash held for the benefit of the former holders of TOPrS.
At December 31, 2004, restricted cash and cash equivalents consisted of: (i) $15.1 million held in an escrow account pursuant to a settlement with the Securities and Exchange Commission and the New York Attorney General concerning their joint investigation into market timing in variable annuities issued by a former subsidiary of Old Conseco; (ii) $3.6 million held
in trust for the payment of bankruptcy-related professional fees; and (iii) $.2 million of segregated cash held for the benefit of the former holders of TOPrS.
Statutory earnings build the capital required by ratings agencies and regulators. Statutory earnings, fees and interest paid by the insurance companies to the parent company create the "cash flow capacity" the parent company needs to meet its obligations, including debt service. The consolidated statutory net income (loss) (a non-GAAP measure) of our insurance subsidiaries was $65.8 million, $(3.3) million and $286.1 million in 2005, 2004 and 2003, respectively. Included in such net income (loss) were net realized capital gains (losses), net of income taxes, of $7.8 million, $(17.7) million and $32.8 million in 2005, 2004 and 2003, respectively. In addition, such net income (loss) included pre-tax amounts for fees and interest to Conseco or its non-life subsidiaries totaling $145.6 million, $283.1 million (including $148 million related to prior years) and $85.8 million in 2005, 2004 and 2003, respectively.
Insurance regulators may prohibit the payment of dividends or other payments by our insurance subsidiaries to parent companies if they determine that such payment could be adverse to our policyholders or contract holders. Otherwise, the ability of our insurance subsidiaries to pay dividends is subject to state insurance department regulations. Insurance regulations generally permit dividends to be paid from statutory earned surplus of the insurance company without regulatory approval for any 12-month period in amounts equal to the greater of (or in a few states, the lesser of): (i) statutory net gain from operations or statutory net income for the prior year; or (ii) 10 percent of statutory capital and surplus as of the end of the preceding year. Any dividends in excess of these levels require the approval of the director or commissioner of the applicable state insurance department. All of the dividends we plan to have our insurance subsidiaries pay in 2006 will require regulatory approval.
In accordance with an order from the Florida Office of Insurance Regulation, Conseco Senior may not distribute funds to any affiliate or shareholder unless such distributions have been approved by the Florida Office of Insurance Regulation. In addition, the risk-based capital and other capital requirements described below can also limit, in certain circumstances, the ability of our insurance subsidiaries to pay dividends.
The 2005 statutory annual statements filed with the state insurance regulators of each of our insurance subsidiaries reflected total adjusted capital in excess of the levels subjecting the subsidiaries to any regulatory action. However, as a result of losses on the long-term care business, we made a capital contribution to Conseco Senior of $24.9 million in order to avoid triggering the trend test with respect to Conseco Senior.
The Company has investments in various types of special purpose entities and other entities, some of which are VIEs under FIN 46R, as described in the note to the consolidated financial statements entitled "Summary of Significant Accounting Policies". The following are descriptions of our significant investments in VIEs: