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. Management believes that Conseco's offices are adequate for its current needs.
Our Bankers Life segment is primarily administered from two facilities in Chicago. Bankers Life has 149,000 square feet in downtown Chicago, Illinois, leased under an agreement whereby 114,000 square feet are leased until 2018 and 35,000 square feet are leased until 2008. We leased approximately 130,000 square feet of space in a second Chicago facility. This lease expired in October 2004, at which time the operations of this facility were moved to a new location (with approximately 222,000 square feet) in downtown Chicago under a lease that expires in 2013. We own an office building in Philadelphia, Pennsylvania (127,000 square feet), which serves as the administrative center for the direct marketing operation of our Bankers Life segment. We occupy approximately 60 percent of this space, with the remainder leased to tenants. We also lease 210 sales offices in various states totaling approximately 570,000 square feet. These leases are short-term in length, with remaining lease terms expiring between 2005 and 2010.
In this section, we review the consolidated financial condition of Conseco at December 31, 2004, and the consolidated results of operations for: (i) the year ended December 31, 2004; (ii) the four months ended December 31, 2003; (iii) the eight months ended August 31, 2003; and (iv) the year ended December 31, 2002 and, where appropriate, factors that may affect future financial performance. Please read this discussion in conjunction with the consolidated financial statements and notes included in this Form 10-K.
o our ability to improve the financial strength ratings of our insurance company subsidiaries and the impact of prior rating downgrades on our business;
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 450 IMOs that represent over 6,200 producing independent agents. This segment markets its products under the "Conseco" brand.
For the year ended December 31, 2004, net income after dividends on our preferred stock totaled $229.3 million, or
We continue to focus on the factors that we believe are most important to achieving our number one business objective - improved ratings for our insurance subsidiaries. Our major goals for 2005 are to strengthen our balance sheet and improve our execution on the basics of our business by:
o Consolidating and streamlining our back-office systems to reduce complexity, lower our costs and improve customer service.
The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Management has made estimates in the past that we believed to be appropriate but were subsequently revised to reflect actual experience. If our future experience differs materially from these estimates and assumptions, our results of operations and financial condition could be affected.
At December 31, 2004, the carrying value of our investment portfolio was $24.3 billion. The accounting risks associated with these assets relate to the recognition of income, our determination of other-than-temporary impairments and our estimation of fair values.
We defer any fees received or costs incurred when we originate investments. We amortize fees, costs, discounts and premiums as yield adjustments over the contractual lives of the investments. We consider anticipated prepayments on structured securities in determining estimated yields on such securities. Adjustments to yields as a result of actual prepayments being different than anticipated are recognized as investment income (loss).
We regularly evaluate all of our investments for possible impairment based on current economic conditions, credit loss experience and other investee-specific developments. If there is a decline in a security's net realizable value that is other than temporary, the decline is recognized as a realized loss and the cost basis of the security is reduced to its estimated fair value. During the year ended December 31, 2004, we recorded $18.1 million of writedowns of fixed maturities, equity securities and other invested assets as a result of conditions that caused us to conclude a decline in the fair value of the investments was other than temporary.
Our evaluation of investments for impairment requires significant judgments to be made including: (i) the identification of potentially impaired securities; (ii) the determination of their estimated fair value; and (iii) assessment of whether any decline in estimated fair value is other than temporary. If new information becomes available or the financial condition of the investee changes, our judgments may change resulting in the recognition of a realized investment loss at that time.
Our periodic assessment of whether unrealized losses are "other than temporary" requires significant judgment.
Factors considered include: (i) the extent to which market value is less than the cost basis; (ii) the length of time that the market value has been less than cost; (iii) whether the unrealized loss is event-driven, credit-driven or a result of changes in market interest rates; (iv) the near-term prospects for improvement in the issuer and/or its industry; (v) whether the investment is investment-grade and our view of the investment's rating and whether the investment has been downgraded since its purchase; (vi) whether the issuer is current on all payments in accordance with the contractual terms of the investment and is expected to meet all of its obligations under the terms of the investment; (vii) our ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery; and (viii) the underlying current and prospective asset and enterprise values of the issuer and the extent to which our investment may be affected by changes in values. At December 31, 2004, our net accumulated other comprehensive income included gross unrealized losses on investments of $39.4 million; we consider all such declines in estimated fair value to be temporary.
Below-investment grade securities have different characteristics than investment grade corporate debt securities. Risk of loss upon default by the borrower is significantly greater with respect to below-investment grade securities than with other corporate debt securities. Below-investment grade securities are generally unsecured and are often subordinated to other creditors of the issuer. Also, issuers of below-investment grade securities usually have higher levels of debt and are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than are investment grade issuers. The Company attempts to reduce the overall risk related to its investment in below-investment grade securities, as in all investments, through careful credit analysis, strict investment policy guidelines, and diversification by issuer and/or guarantor and by industry.
the cost of policies inforce at the Effective Date. We also defer renewal commissions paid in excess of ultimate commission levels related to the existing policies in this account. The balance of this account is amortized, evaluated for recovery, and adjusted for the impact of unrealized gains (losses) in the same manner as the cost of policies produced described below. We expect to amortize approximately 11 percent of the December 31, 2004 balance of value of policies inforce in 2005, 10 percent in 2006, 9 percent in 2007, 8 percent in 2008 and 7 percent in 2009.
The cost of policies produced are those costs that vary with, and are primarily related to, producing new insurance business in the period after August 31, 2003. We amortized these costs (using the interest rate credited to the underlying policy for universal life or investment-type products and the projected investment earnings rate for other products): (i) in relation to the estimated gross profits for universal life-type and investment-type products; or (ii) in relation to future anticipated premium revenue for other products.
At December 31, 2004, the combined balance of the value of policies inforce and cost of policies produced was $3.0 billion. The recovery of these costs is dependent on the future profitability of the related business.
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. In assessing the realization of deferred income tax assets, we consider whether it is more likely than not that the deferred income tax assets will be realized. The ultimate realization of our deferred income tax assets depends upon generating future taxable income during the periods in which our temporary differences become deductible and before our capital loss carryforwards and net operating loss carryforwards expire. In addition, the use of the Company's net operating loss carryforwards is dependent, in part, on whether the IRS ultimately agrees with the tax position we have taken and plan to take in our current and future tax returns. With respect to the deferred income tax assets, we assess the need for a valuation allowance on an ongoing basis.
The following paragraphs summarize some of the unresolved limitations and contingencies which exist with respect to the future utilization of the net operating loss carryforwards which will cause a reassessment of the need for a major portion of the valuation allowance when resolved.
The timing and manner in which the Company will be able to utilize some or all of its net operating loss carryforward may be limited by Section 382 of the Code. Section 382 imposes limitations on a corporation's ability to use its net operating losses if the company undergoes an ownership change. Because the Company underwent an ownership change pursuant to its reorganization, we have determined that this limitation applies to the Company. In order to determine the amount of this limitation we must determine how much of our net operating loss carryforward relates to the period prior to our emergence from bankruptcy (such amount will be subject to the 382 limitation) and how much relates to the period after emergence (such amount will not be subject to the 382 limitation). When the Company filed its 2003 federal income tax return, it elected to specifically identify transactions in each period and record it in the period it actually occurred. We believe this election will result in the loss related to CFC being treated as post emergence and therefore not subject to the Section 382 limitation. 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. The IRS has informed the Company that it will address this matter during its examination of our tax returns for calendar years 2002-2003.
Liabilities for insurance products are calculated using management's best judgments of mortality, morbidity, lapse rates, investment experience and expense levels that are based on our past experience and standard actuarial tables.
At the Effective Date, the Successor established insurance liabilities at the present value of future benefits and expenses less future premiums associated with the policies, by using current best-estimate assumptions with provisions for
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, variance in actual versus estimated morbidity, lapses and expenses have been unfavorable to original assumptions. Approximately $1.4 billion of the increase to insurance liabilities is 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.
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 $265 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 creditworthiness of the participants and the current status of various legal actions we have taken to collect the D&O loans. At December 31, 2004, we have estimated that approximately $46 million of the D&O balance (which is included in other assets) is collectible (net of the cost of collection). An allowance has been established to reduce the recorded balance of the D&O loans to this balance.
Our 2002 bankruptcy disrupted our operations and damaged the "Conseco" brand. As a result, we may continue to experience lower sales, increased agent attrition and policyholder lapses and redemptions.
We also experienced increased agent attrition, which, in some cases, led us to increase agents' commissions or sales incentives in order to retain agents. For example, the number of producing agents selling products through the Conseco Insurance Group segment decreased by approximately 29 percent to 6,200 at December 31, 2004, compared to December 31,
An important competitive factor for our insurance subsidiaries is the ratings they receive from nationally recognized rating organizations. Agents, insurance brokers and marketing companies who market our products, and prospective policyholders view ratings as an important factor in evaluating an insurers' products. This is especially true for 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. This ratings decline was a primary factor in the decreased sales of our insurance products and the increased policyholder redemptions and lapses beginning in 2002. We also experienced increased agent attrition, which, in some cases, led us to increase commissions or sales incentives in an effort to retain them. These events have hindered our ability to market our products and to recruit and retain agents, which, in turn, has negatively impacted our financial results. The financial strength ratings of our primary insurance subsidiaries (other than Conseco Senior) were upgraded in the second quarter of 2004 by A.M. Best, S&P and Moody's and again in the third quarter of 2004 by Moody's. The current financial strength ratings of our primary insurance subsidiaries (other than Conseco Senior) from A.M. Best, S&P and Moody's are "B++ (Very Good)," "BB+" and "Bal", respectively. The ratings of Conseco Senior from A.M. Best, S&P and Moody's are "B (Fair)," "CCC" and "Caa1," respectively. The "B++" rating and the "B" rating from A.M. Best are the fifth and seventh highest, respectively, of sixteen possible ratings. The "BB+" rating and the "CCC" rating from S&P are the eleventh and eighteenth highest, respectively, of twenty-one possible ratings. The "Ba1" rating and the "Caa1" rating from Moody's are the eleventh and seventeenth highest of twenty-one possible ratings. Most of our competitors have higher financial strength ratings and we believe it is critical for us to continue to improve our ratings to be competitive.
Based on recent discussions with A.M. Best, they will review our insurance subsidiaries no sooner than June 2005. The decision to upgrade is subjective and will only be made when A.M. Best believes it is warranted. If we fail to achieve and maintain an "A" category rating from A.M. Best, we may continue to experience declining sales of our insurance products, additional defections of our independent and career sales force, and increased policies being redeemed or allowed to lapse. These events would adversely affect our financial results, which could then lead to further downgrades.
Our results of operations may be negatively impacted if we are unable to achieve the goals of our initiatives to restructure our principal insurance businesses.
Our Conseco Insurance Group segment has experienced declining sales as well as expense levels that exceed product pricing. We have implemented several initiatives to improve operating results, including: (i) focusing sales efforts on higher margin products, such as our specified disease products; (ii) reducing operating expenses by eliminating or reducing marketing costs of certain products; (iii) streamlining administrative procedures and reducing personnel; (iv) increasing retention rates on our more profitable blocks of inforce business; and (v) stabilizing the profitability of the long-term care block of business in run-off sold through independent agents through premium rate increases, improved claim adjudication procedures and other actions. Many of our initiatives address issues resulting from the substantial number of acquisitions of our Predecessor. Between 1982 and 1997, our Predecessor completed 19 transactions involving the acquisitions of 44 separate insurance companies. Our efforts involve improvements to our policy administration procedures and significant systems conversions, such as the elimination of duplicate processing systems for similar business. These initiatives may result in unforeseen expenses, complications or delays, and may be inadequate to address all issues. Conversions to new processing systems can result in valuation differences between the prior system and the new system. These differences have not been material to the Company in the past. Our planned conversions could result in such valuation adjustments, and there can be no assurance that the adjustments would not be material to future earnings. Further, some of these initiatives have only recently begun to be executed, and may not ultimately be successfully accomplished. We expect to spend over $15 million on capital expenditures in 2005 (including amounts related to these initiatives). While our future operating performance depends greatly on the success of these efforts, even if we successfully implement these measures, they alone may not sufficiently improve our results of operations.
The results of operations of our insurance business will decline if our premium rates are not adequate or if we are unable to obtain regulatory approval to increase rates.
If, however, we were successful in obtaining regulatory approval to raise premium rates, the increased premium rates may reduce the volume of our new sales and cause existing policyholders to allow their policies to lapse. This could result in a significantly higher ratio of claim costs to premiums if healthier policyholders who get coverage elsewhere allow their policies to lapse, while policies of less healthy policyholders continue in force. This would reduce our premium income and profitability in future periods.
We are also aggressively seeking rate increases on other long-term care policies in our other business in run-off segment. If we are unable to obtain these rate increases, the profitability of these policies and the performance of this block of business could be adversely affected.
The limited historical claims experience on our long-term care products could negatively impact our operations if our estimates prove wrong and we have not adequately set premium rates.
The blocks of long-term care insurance included in the other business in run-off segment were acquired through acquisitions completed in 1996 and 1997. The majority of such business was written between 1990 and 1997. The experience on these acquired blocks has generally been worse than the acquired companies' original pricing expectations. We have received necessary regulatory approvals for numerous premium rate increases in recent years pertaining to these blocks. Even with these rate increases, these blocks experienced loss ratios of 103 percent in the year ended December 31, 2004, 103 percent in the four months ended December 31, 2003, 170 percent in the eight months ended August 31, 2003, and 139 percent in 2002. If future claims experience proves to be worse than anticipated as our long-term care blocks continue to age, our financial results could be adversely affected.
We calculate and maintain reserves for the estimated future payment of claims to our policyholders primarily based on assumptions made by our actuaries. For our life insurance business, our limit of risk retention for each policy is generally $.8 million or less because amounts above $.8 million are ceded to reinsurers. For our health insurance business, we establish an active life reserve, a liability for due and unpaid claims, claims in the course of settlement, and incurred but not reported claims, and a reserve for the present value of amounts on claims not yet due. We establish reserves based on assumptions and estimates of factors either established at the fresh-start date for business inforce then or considered when we set premium rates for business written after that date.
Our ability to meet our obligations may be constrained by our subsidiaries' ability to distribute cash to us.
In 2005, our insurance subsidiaries may pay dividends to us of $150.8 million without prior regulatory approval.
Our Credit Facility contains various restrictive covenants and required financial ratios that limit our operating flexibility.
Surrenders of our annuities and life insurance products can result in losses and decreased revenues if surrender levels differ significantly from assumed levels. At December 31, 2004, approximately 18 percent of our total insurance liabilities, or approximately $4.4 billion, could be surrendered by the policyholder without penalty. The surrender charges that are imposed on our fixed rate annuities typically decline during a penalty period, which ranges from five to twelve years after the date the policy is issued. Surrenders and redemptions could require us to dispose of assets earlier than we had planned, possibly at a loss. Moreover, surrenders and redemptions require faster amortization of either the acquisition costs or the commissions associated with the original sale of a product, thus reducing our net income. We believe policyholders are generally more likely to surrender their policies if they believe the issuer is having financial difficulties, or if they are able to reinvest the policy's value at a higher rate of return in an alternative insurance or investment product.
For example, policyholder redemptions of annuity and, to a lesser extent, life products increased after the downgrade of our A.M. Best financial strength rating to "B (Fair)" in August of 2002. When redemptions exceed our previous assumptions, we are required to accelerate the amortization of the value of policies inforce at the Effective Date, and the cost of policies produced (such amortization is collectively referred to as "amortization of insurance acquisition costs") to write off the balance associated with the redeemed policies. We recorded additional amortization related to higher redemptions and changes to our lapse assumptions of $203.2 million in 2002. Such additional amortization was not significant in 2003 or 2004.
Recently enacted and future legislation could adversely affect the financial performance of our insurance operations.
Proposals currently pending in Congress and some state legislatures may also affect our financial results. These proposals include the implementation of minimum consumer protection standards in all long-term care policies, including: guaranteed premium rates; protection against inflation; limitations on waiting periods for pre-existing conditions; setting standards for sales practices for long-term care insurance; and guaranteed consumer access to information about insurers, including information regarding lapse and replacement rates for policies and the percentage of claims denied. Enactment of any proposal that would limit the amount we can charge for our products, such as guaranteed premium rates, or that would increase the benefits we must pay, such as limitations on waiting periods, or that would otherwise increase the costs of our business, could adversely affect our financial results.
Our investment portfolio is subject to several risks that may diminish the value of our invested assets and negatively impact our profitability.
The value of our investment portfolio is subject to numerous factors, which are difficult to predict, and are, in many instances, beyond our control. These factors include, but are not limited to, the following:
o Changes in interest rates can reduce the value of our investments. Actively managed fixed maturity investments comprised 89 percent of our total investments as of December 31, 2004. An increase in interest rates of 10 percent could reduce the value of our actively managed fixed maturity investments and short-term investments, net of corresponding changes in insurance acquisition costs, by approximately $630 million, in the absence of other factors.
o implementing conservative portfolio compliance guidelines which generally limit our exposure to single issuer risks; and
o expanding our portfolio reporting procedures to proactively identify changes in value related to credit risk in a more timely manner.
Our profitability is directly affected by fluctuating interest rates. While we monitor the interest rate environment and have previously employed hedging strategies to mitigate such impact, our financial results could be adversely affected by changes in interest rates. Our spread-based insurance and annuity business is subject to several inherent risks arising from movements in interest rates, especially if we fail to anticipate or respond to such movements. First, interest rate changes can cause compression of our net spread between interest earned on investments and interest credited to customer deposits. Our ability to adjust for such a compression is limited by the guaranteed minimum rates that we must credit to policyholders on
certain products, as well as the terms on most of our other products that limit reductions in the crediting rates to pre-established intervals. As of December 31, 2004, approximately 41 percent of our insurance liabilities were subject to interest rates that may be reset annually; 46 percent had a fixed explicit interest rate for the duration of the contract; 9 percent had credited rates that approximate the income we earn; and the remainder had no explicit interest rates. Second, if interest rate changes produce an unanticipated increase in surrenders of our spread-based products, we may be forced to sell invested assets at a loss in order to fund such surrenders. Thirdly, the profits from many non-spread-based insurance products, such as long-term care policies, are also adversely affected when interest rates decline because we may be unable to reinvest the cash from premiums received at the interest rates anticipated when we sold the policies. Finally, changes in interest rates can have significant effects on the performance of our structured securities portfolio, including collateralized mortgage obligations, as a result of changes in the prepayment rate of the loans underlying such securities. We follow asset/liability strategies that are designed to mitigate the effects of interest rate changes on our profitability but do not currently employ derivative instruments for this purpose. We may not be successful in implementing these strategies and achieving adequate investment spreads.
We use computer models to simulate our cash flows expected from existing business under various interest rate scenarios. These simulations help us measure the potential gain or loss in fair value of our interest-sensitive financial instruments. With such estimates, we seek 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, 2004, the duration of our fixed maturity securities and short-term investments was approximately 6.4 years, and the duration of our insurance liabilities was approximately 7.0 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 $630 million if interest rates were to increase by 10 percent from rates as of December 31, 2004. This compares to a decline in fair value of $625 million based on amounts and rates at December 31, 2003. The calculations involved in our computer simulations incorporate numerous assumptions, require significant estimates and assume an immediate change in interest rates without any management reaction to such change. Consequently, potential changes in the values 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.
Fluctuations in the securities markets and other economic factors may adversely affect sales and/or policy surrenders of our annuities and life insurance policies. For example, volatility in the equity markets may deter potential purchasers from investing in equity-indexed annuities and may cause current policyholders to surrender their policies for the cash value or to reduce their investments. For example, our sales of these products decreased significantly in 2001 and 2002 during periods of significant declines in the equity markets. Sales of equity-indexed annuities totaled $220.1 million in 2002 as compared to $380.9 million in 2001. In addition, significant or unusual volatility in the general level of interest rates could negatively impact sales and/or lapse rates on certain types of insurance products.
Our business is subject to extensive regulation, which limits our operating flexibility and could result in our insurance subsidiaries being placed under regulatory control or otherwise negatively impact our financial results.
Litigation and regulatory investigations are inherent in our business and may harm our financial strength and reduce our profitability.
Insurance companies historically have been subject to substantial litigation resulting from claims, disputes and other matters. In addition to the traditional policy claims associated with their businesses, insurance companies typically face policyholder suits and class action suits. The class action and policyholder suits are often in connection with insurance sales practices, policy and claims administration practices and other market conduct issues. State insurance departments focus on sales practices and product issues in their market conduct examinations. Negotiated settlements of class action and other lawsuits have had a material adverse effect on the business, financial condition and results of operations of insurance companies. We are, in the ordinary course of our business, a plaintiff or defendant in actions arising out of our insurance business, including class actions and reinsurance disputes, and, from time to time, we are also involved in various governmental and administrative proceedings and investigations. The ultimate outcome of these lawsuits, however, cannot be predicted with certainty, and although we do not presently believe that any of these lawsuits, individually, are material, they could, in the aggregate, have a material adverse effect on our financial condition. Because our insurance subsidiaries were not part of our bankruptcy proceedings, the bankruptcy proceedings did not result in the discharge of any claims, including claims asserted in litigation, against our insurance subsidiaries.
The supplemental health insurance, annuity and individual life insurance markets are highly competitive. Competitors include other life and accident and health insurers, commercial banks, thrifts, mutual funds and broker-dealers.
In some of our product lines, such as life insurance and fixed annuities, we have a relatively small market share. Even in some of the lines in which we are one of the top five writers, our market share is relatively small. For example, while our Bankers Life segment ranked fourth in annualized premiums of individual long-term care insurance in 2004 with a market share of approximately 9 percent, the top three writers of individual long-term care insurance had annualized premiums with a combined market share of approximately 51 percent during the period. In addition, while our Bankers Life segment was ranked third in annualized premiums of individual Medicare supplement insurance in 2004 with a market share of approximately 14 percent, the top two writers of individual Medicare supplement insurance had annualized premiums with a combined market share of approximately 68 percent during the period.
Virtually all of our major competitors have higher financial strength ratings than we do. Many of our competitors are larger companies that have greater capital, technological and marketing resources and have access to capital at a lower cost. Recent industry consolidation, including business combinations among insurance and other financial services companies, has resulted in larger competitors with even greater financial resources. Furthermore, changes in federal law have narrowed the historical separation between banks and insurance companies, enabling traditional banking institutions to enter the insurance and annuity markets and further increase competition. This increased competition may harm our ability to maintain or improve our profitability.
In addition, because the actual cost of products is unknown when they are sold, we are subject to competitors who may sell a product at a price that does not cover its actual cost. Accordingly, if we do not also lower our prices for similar products, we may lose market share to these competitors. If we lower our prices to maintain market share, our profitability will decline.
We must attract and retain sales representatives to sell our insurance and annuity products. Strong competition exists among insurance and financial services companies for sales representatives. We compete for sales representatives primarily on the basis of our financial position, financial strength ratings, support services, compensation and product features. Our competitiveness for such agents also depends upon the relationships we develop with these agents. If we are unable to attract and retain sufficient numbers of sales representatives to sell our products, our ability to compete and our revenues and profitability would suffer.
Net investment income related to equity-indexed products based on the change in value of the S&P 500 Call Options represents the change in the estimated fair value of Bankers Life's S&P 500 Index Call Options which are purchased in an effort to cover certain 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 S&P 500 Call Options and other costs related to these policies. Option costs attributable to benefits provided were $7.1 million in 2004; $2.9 million in the four months ended December 31, 2003; $7.7 million in the eight months ended August 31, 2003; and $15.2 million in 2002. These costs are reflected in net investment income. Investment income related to equity-indexed products before those costs was $9.7 million in 2004; $9.5 million in the four months ended December 31, 2003; $12.5 million in the eight months ended August 31, 2003; and $.4 million in 2002. Such amounts are generally offset by the corresponding charge (credit) to amounts added to policyholder account balances for equity-indexed products based on S&P 500 Index. 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 S&P 500 Index to which the returns on such products are linked.
The net cash flows from our 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 loss ratio typically increases, but the increase in the change in reserve is partially offset by investment income earned on the accumulated assets. The loss ratio on this business increased in 2004, consistent with the aging of this block. We have recently been experiencing lower than expected lapses on this business, which has also caused the loss ratio to increase. The interest-adjusted loss 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. The decrease in the interest-adjusted loss ratio for the four months ended December 31, 2003, was primarily due to the adoption of fresh start accounting which increased the assets backing such insurance liabilities.
The loss ratios on our other products are subject to fluctuations due to the smaller size of these blocks of business. However, the loss ratios during 2004 and the four months ended December 31, 2003, have been relatively stable despite the fluctuations experienced in the prior periods.
Amounts added to policyholder account balances for annuity products and interest-sensitive life products were $149.5 million in 2004; $50.6 million in the four months ended December 31, 2003; $89.5 million in the eight months ended August 31, 2003; and $116.9 million in 2002. The increases were primarily due to increases in annuity reserves partially offset by decreases in average crediting rates. The weighted average crediting rates for these products were 3.9 percent in 2004; 4.4 percent for the four months ended December 31, 2003; 4.2 percent for the eight months ended August 31, 2003; and 4.6 percent in 2002.
Amortization related to operations includes amortization of insurance acquisition costs. Insurance acquisition costs are amortized either: (i) in relation to the estimated gross profits of universal life-type and investment-type products; or (ii) in relation to future anticipated premium revenue of other products. Bankers Life's amortization expense in 2004 was not comparable to prior periods due to the application of fresh start accounting effective August 31, 2003. Bankers Life's amortization expense in 2004 and the four months ended December 31, 2003 was generally consistent with the related premium revenue and gross profits for such periods and the assumptions we made when we established our insurance acquisition costs as of August 31, 2003.
Other operating costs and expenses in our Bankers Life segment were $160.1 million in 2004; $51.8 million in the four months ended December 31, 2003; $85.3 million in the eight months ended August 31, 2003; and $94.4 million in 2002. These expenses increased in 2004 due primarily to higher sales and career agency infrastructure costs and lower reinsurance expense allowances. Expenses in 2003 included increases in policy acquisition costs which were non-deferrable.
Average liabilities for insurance and asset accumulation products, net of reinsurance ceded were $12.6 billion in 2004; $13.0 billion in the four months ended December 31, 2003; $13.3 billion in the eight months ended August 31, 2003; and $15.3 billion in 2002. The decrease in such liabilities was due primarily to increases in policyholder redemptions and lapses following the downgrade of our A.M. Best financial strength rating to "B (Fair)" in August 2002. The liabilities for insurance and asset accumulation products in this segment were not significantly affected by the adoption of fresh start accounting. See "Liquidity for insurance operations" for additional discussion of the A.M. Best rating downgrade.
eight months ended August 31, 2003; and $982.0 million in 2002. The average balance of general account invested assets was $12.5 billion in 2004; $12.7 billion in the four months ended December 31, 2003; $13.7 billion in the eight months ended August 31, 2003; and $15.0 billion in 2002. The yield on these assets was 5.6 percent in 2004; 5.7 percent in the four months ended December 31, 2003; 6.1 percent in the eight months ended August 31, 2003; and 6.5 percent in 2002. 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. In addition, this segment's net investment income in 2004 included $5.0 million of income related to prepayments of securities (including prepayment penalties on mortgages, call premiums on fixed maturities and accelerated amortization of discount, net of premium) and income from non-traditional investments (including securities that were previously in default). The decrease in yield in the eight months ended August 31, 2003, reflected the lower prevailing interest rate environment and the resulting lower rates earned on invested assets.
Net investment income related to equity-indexed products based on the change in value of the S&P 500 Call Options represents the change in the estimated fair value of Conseco Insurance Group's S&P 500 Index Call Options which are purchased in an effort to cover certain 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 S&P 500 Call Options and other costs related to these policies. Option costs that are attributable to benefits provided were $37.7 million in 2004; $16.2 million in the four months ended December 31, 2003; $45.8 million in the eight months ended August 31, 2003; and $82.3 million in 2002. These costs are reflected in net investment income. Net investment income (loss) related to equity-indexed products before these costs was $48.8 million in 2004; $51.8 million in the four months ended December 31, 2003; $71.1 million in the eight months ended August 31, 2003; and $(3.4) million in 2002. Such amounts were partially offset by the corresponding charge (credit) to amounts added to policyholder account balances for equity-indexed products based on S&P 500 Index. 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 S&P 500 Index to which the returns on such products are linked.
Change in value of embedded derivatives related to modified coinsurance agreements is described in the note to our consolidated financial statements entitled "Summary of Significant Accounting Policies - Accounting for Derivatives." We have transferred the specific block of investments related to these agreements to our trading securities account, which we carry at estimated fair value with changes in such value recognized as trading account income. The change in the value of the embedded derivatives has largely been offset by the change in value of the trading securities.
months ended August 31, 2003, as a result of a change in estimate of future losses on certain policies, as discussed below. Loss ratios are calculated by dividing the related insurance product's insurance policy benefits by insurance policy income.
The loss ratio on Conseco Insurance Group's Medicare supplement products in 2004 was impacted by rate increases. Such rate increases were implemented earlier in 2004 than in prior years, resulting in a lower loss ratio in 2004. In addition, the higher rates increased policyholders' lapses. The release of the policy benefit reserve related to the lapsed business also contributed to the lower loss ratio in 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), after three years, of not less than 65 percent on these products. The loss ratio in 2002 reflected favorable reserve developments in this line of business and was not consistent with our current and past experience.
The loss ratios on Conseco Insurance Group's other products are subject to fluctuations due to the smaller size of these blocks of business. The loss ratio on this business during 2004 reflected improved experience, but given the variability of this ratio in the past, we expect continued fluctuations in the future.
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. During the remainder of 2004, our life mortality experience generally returned to levels comparable to previous periods. While we have no reason to believe the first quarter 2004 experience is indicative of a trend, our earnings are affected when we experience fluctuations in death claims.
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 Statement of Financial Accounting Standards No. 97, "Accounting and Reporting by Insurance Enterprises of Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments." The changes in estimate 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 $260.9 million in 2004; $94.9 million in the four months ended December 31, 2003; $218.4 million in the eight months
Amounts added to equity-indexed products based on S&P 500 Index correspond to the related investment income accounts described above.
Amortization related to operations includes amortization of insurance acquisition costs. We are required to amortize the value of policies inforce in relation to estimated gross profits for universal life-type and investment-type products. We are also required to regularly evaluate the expected gross profits which are used as a basis for determining amortization and adjust the total amortization recorded to date through the statement of operations, if actual experience or other evidence suggests that earlier estimates should be revised. Accordingly, the amount of insurance acquisition costs on our universal life-type and investment-type products that we amortize is dependent on the profits realized during the period and our expectations of future profits. For other products, we amortize insurance acquisition costs in relationship to actual and expected premium revenue, and amortization is only adjusted when our expectations regarding premium revenue change (or if we determine the insurance acquisition cost balance is not recoverable from future profits). As described below, changes in our assumptions used to estimate future profits or premiums have resulted in changes in the amount of amortization we recognized during 2004, 2003 and 2002.
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." Policyholder redemptions of annuity and, to a lesser extent, life products increased following the downgrade of our A.M. Best financial strength rating to "B (Fair)" in August of 2002. When redemptions exceed our previous assumptions, we are required to accelerate the amortization of insurance acquisition costs to write off the balance associated with the redeemed policies. Amortization of insurance acquisition costs increased in 2002 as a result of such acceleration associated with policy redemptions and for changes in future lapse assumptions of the policies inforce. In 2002, we changed the lapse assumptions used to determine the amortization of insurance acquisition costs related to certain universal life products and our annuities to reflect then current estimates of future lapses. For certain universal life products, we changed the ultimate lapse assumption from: (i) a range of 6 percent to 7 percent to; (ii) a tiered assumption based on the level of funding of the policy with a range of 2 percent to 10 percent. We recorded additional amortization related to higher redemptions and changes to our lapse assumptions of $203.2 million in 2002.
Interest expense on investment borrowings fluctuated along with Conseco Insurance Group's investment borrowing activities and the interest rates thereon. Average investment borrowings were $333.2 million during 2004; $304.2 million during the four months ended December 31, 2003; $403.4 million during the eight months ended August 31, 2003; and $639.1 million during 2002. The weighted average interest rates on such borrowings were 1.5 percent during 2004; 1.6 percent during the four months ended December 31, 2003; 1.7 percent during the eight months ended August 31, 2003; and 1.6 percent during 2002.
2004 reflected a $7.9 million reduction related to an actuarial gain from changes made to a post-retirement health plan of an insurance subsidiary and an $11.3 million reduction related to expense recoveries associated with the Predecessor's bankruptcy. In addition, expenses decreased in 2004 due to lower: (i) compensation costs; and (ii) marketing and agency related expenses. The increase in these expenses in the 2003 periods was primarily related to increased policy acquisition costs which were non-deferrable.
Total premium collections in this segment were $395.9 million in 2004; $173.9 million in the four months ended December 31, 2003; $424.4 million in the eight months ended August 31, 2003; and $844.0 million in 2002. We have ceased marketing the long-term care business included in this segment. Accordingly, collected premiums will decrease over time. Changes in long-term care premium collections are the result of policy lapses, partially offset by premium rate increases. We have ceased marketing and have not renewed our major medical business, which has resulted in the significant reduction in major medical collected premiums. See "Premium and Asset Accumulation Product Collections" for further analysis.
Average liabilities for other business in run-off, net of reinsurance ceded were $3.4 billion in 2004; $3.4 billion in the four months ended December 31, 2003; $2.1 billion in the eight months ended August 31, 2003; and $2.0 billion in 2002. The increase in 2003 reflected the adoption of fresh start accounting as further discussed under "Critical Accounting Policies -- Liabilities for Insurance Products."
Net investment income on general account invested assets was $167.5 million in 2004; $55.3 million in the four months ended December 31, 2003; $101.5 million in the eight months ended August 31, 2003; and $155.8 million in 2002. The average balance of general account invested assets was $3.0 billion in 2004; $2.8 billion in the four months ended December 31, 2003; $2.5 billion in the eight months ended August 31, 2003; and $2.4 billion in 2002. The yield on these assets was 5.6 percent in 2004; 5.8 percent in the four months ended December 31, 2003; 6.1 percent in the eight months ended August 31, 2003; and 6.6 percent in 2002. The decrease in yield in 2004 reflected the lower interest rate environment prevailing in 2004. The proceeds from investment maturities and prepayments were reinvested at lower prevailing interest rates, reducing the overall portfolio yield. The decrease in yield 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.
Insurance policy benefits fluctuated primarily as a result of the factors summarized below related to loss ratios in the blocks of long-term care business included in this segment. Loss ratios are calculated by dividing the product's insurance policy benefits by insurance policy income.
o receipt of a paid up policy, allowing the holder to file future claims up to 100 percent of the amount of premiums paid since the inception of the policy.
We expect to complete the process of notifying our home health care policyholders of these choices in 2005. We should know which option each policyholder selects by September 30, 2005.
On July 1, 2004, the Florida Office of Insurance Regulation issued a similar order impacting approximately 4,500 home health care policies which are obligations of Washington National. 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 loss ratios on this business in periods after August 31, 2003 are generally not comparable to prior periods due to the adoption of fresh start accounting which increased the reserves on this block of business. We believe our actions to seek rate increases and to improve our claims adjudication processes are resulting in improved loss ratios on this business. In addition, our 2004 loss ratio reflected $13.2 million of favorable developments from insurance liabilities established in prior periods for our discontinued major medical business.
During 2002 and 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 a consulting actuarial 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.
As a result of the studies completed in 2003 and 2002, we modified our claim continuance tables. Our prior estimates for long-term care reserves were based on claim continuance tables using experience for the period from January 1, 1990 through September 30, 1999. These tables were used to estimate, the length of time an insured will receive covered long-term care for an incurred event. To improve our estimates, we completed studies which indicated that the average length of time an insured will receive covered care had increased in recent periods. In addition, we had experienced significant fluctuations in claim inventories for these products. Accordingly, our actuaries and a consulting actuarial firm concluded that estimates of future claim payments should reflect the longer covered care time being experienced.
Amortization related to operations includes amortization of insurance acquisition costs. The decrease in amortization expense in 2004 and for the four months ended December 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.
Interest expense on investment borrowings fluctuated with our investment borrowing activities which are not significant in this segment.
Other operating costs and expenses were $93.5 million in 2004; $36.2 million in the four months ended December 31, 2003; $75.2 million in the eight months ended August 31, 2003; and $185.1 million in 2002. The decreases in expenses were due primarily to expense reductions in the major medical operations.
Other operating costs and expenses include general corporate expenses, net of amounts charged to subsidiaries for services provided by the corporate operations. 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". In addition, general corporate expenses in 2004 included other severance expense of $8.3 million related to the restructuring of our businesses. 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. This amount also includes expenses in 2002 related to our subsidiary in India, which was sold in the fourth quarter of 2002.
Reorganization items in the eight months ended August 31, 2003 included: (i) $3,151.4 million related to the gain on the discharge of prepetition liabilities; (ii) $(950.0) million related to fresh start adjustments; and (iii) $(70.9) million related to professional fees associated with our bankruptcy proceedings which are expensed as incurred in accordance with SOP 90-7. In 2002, we incurred reorganization items of $14.4 million related to professional fees associated with our bankruptcy proceedings.
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 and interest-sensitive life insurance 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 (other than Conseco Senior) were upgraded by A.M. Best, S&P and Moody's. In the third quarter of 2004, Moody's again upgraded the ratings of our primary insurance subsidiaries (other than Conseco Senior). The current financial strength ratings of our primary insurance subsidiaries (other than Conseco Senior) from A.M. Best, S&P and Moody's are "B++ (Very Good)", "BB+" and "Ba1", 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." Many of our competitors have higher financial strength ratings and we believe it is critical for us to continue to improve our ratings to be competitive. Our lowered ratings were one of the primary reasons our insurance product sales declined and policyholder redemptions and lapses increased during 2002 and 2003. We also experienced increased agent attrition, which, in some cases, led us to increase agent's commissions or sales incentives in order to retain them.
We set premium rates on our health insurance policies based on facts and circumstances known at the time we issue the policies and on assumptions about numerous variables, including the actuarial probability of a policyholder incurring a claim, the probable size of the claim, and the interest rate earned on our investment of premiums. In setting premium rates, we consider historical claims information, industry statistics, the rates of our competitors and other factors. If our actual claims experience is less favorable than we assumed and we are unable to raise our premium rates, our financial results may be adversely affected. Our estimates of insurance liabilities assume we will be able to raise rates if future experience results in blocks of our health insurance business becoming unprofitable. We generally cannot raise our health insurance premiums in any state until we obtain the approval of the insurance regulator in that state. We review the adequacy of our premium rates regularly and file rate increases on our products when we believe such rates are too low. It is possible that we will not be able to obtain approval for premium rate increases from currently pending requests or requests filed in the future. If such requests are denied in one or more states, our net income may decrease. If such requests are approved, increased premium rates may reduce the volume of our new sales and may cause existing policyholders to allow their policies to lapse. If the healthier policyholders allow their policies to lapse, this would reduce our premium income and profitability in future periods. Increased lapse rates also could require us to expense all or a portion of the insurance acquisition costs relating to such lapsed policies, adversely affecting our financial results in that period.
Supplemental health products in the Bankers Life segment include Medicare supplement, long-term care and other insurance products distributed through our career agency force. Our profits on supplemental health policies depend on the overall level of sales, the length of time the business remains inforce, investment yields, claims experience and expense management.
Collected premiums on Medicare supplement policies in the Bankers Life segment totaled $640.0 million in 2004; $225.6 million in the four months ended December 31, 2003; $419.1 million in the eight months ended August 31, 2003; and $663.9 million in 2002. Collected premiums in 2003 declined from 2002 as a result of a decrease in new sales. New sales in 2004 were favorably impacted by improved group policy sales.
Life products in the Bankers Life 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 $180.9 million in 2004; $58.6 million in the four months ended December 31, 2003; $102.7 million in the eight months ended August 31, 2003; and $139.0 million in 2002. Collected premiums have been impacted by increases in new sales.
effort to hedge increases to policyholder benefits resulting from increases in the S&P 500 Index. Total collected premiums for this product were $44.3 million in 2004; $9.4 million in the four months ended December 31, 2003; $44.9 million in the eight months ended August 31, 2003; and $189.7 million in 2002. The decreases are attributed to: (i) the general stock market performance in recent years which has made other investment products more attractive to certain customers; and (ii) the effect of the A.M. Best ratings downgrade in 2002.
Other health products include disability income, dental and various other health insurance products, many of which we no longer actively market. Premiums collected totaled $16.2 million in 2004; $19.1 million in the four months ended December 31, 2003; $38.5 million in the eight months ended August 31, 2003; and $91.8 million in 2002.
Life products in the Conseco Insurance Group segment are sold through professional independent producers. Life premiums collected totaled $372.3 million in 2004; $131.5 million in the four months ended December 31, 2003; $280.7 million in the eight months ended August 31, 2003; and $498.0 million in 2002. Our A.M. Best rating has negatively affected our sales of life products. We stopped actively marketing many of our life insurance products through the professional independent producer channel in the second quarter of 2003.
Long-term care premiums collected in this segment totaled $380.1 million in 2004; $134.6 million in the four months ended December 31, 2003; $268.0 million in the eight months ended August 31, 2003; and $434.5 million in 2002. Most of the long-term care premiums in this segment relate to business written by certain subsidiaries prior to their acquisitions by Conseco in 1996 and 1997. We ceased selling new long-term care policies through professional independent producers in the second quarter of 2003. We expect this segment's long-term care premiums to reflect additional policy lapses in the future, partially offset by premium rate increases. See "Results of Operations - Other Business in Run-Off" for additional discussion related to orders issued by the Florida Office of Insurance Regulation regarding certain blocks of our long-term care business.
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) maximize current investment income and total investment return through active investment management. Consistent with this strategy, investments in fixed maturity
The following table summarizes the composition of our investment portfolio as of December 31, 2004 (dollars in millions):
The following table summarizes the carrying values of our fixed maturity securities by industry category as of December 31, 2004 (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 one percent of our total fixed maturity securities portfolio and consist almost entirely of mortgage-backed securities.
The following table summarizes investment yields earned over the past three years on the general account invested assets of our insurance subsidiaries. General account investments exclude our venture capital investment in AWE, the value of S&P 500 Call Options and the investments held by CFC (dollars in millions).
At December 31, 2004, our fixed maturity portfolio had $652.4 million of unrealized gains and $39.2 million of unrealized losses, for a net unrealized gain of $613.2 million. Estimated fair values of fixed maturity investments were determined based on estimates from: (i) nationally recognized pricing services (94 percent of the portfolio); (ii) broker-dealer market makers (5 percent of the portfolio); and (iii) internally developed methods (1 percent of the portfolio).
At December 31, 2004, approximately 3.5 percent of our invested assets (3.9 percent of fixed maturity investments) were fixed maturities rated below-investment grade by nationally recognized statistical rating organizations (or, if not rated by such firms, with ratings below Class 2 assigned by the NAIC). We currently plan to maintain our present level of investments in below-investment-grade fixed maturities, although this plan could change if market conditions change. These securities generally have greater risks than other corporate debt investments, including risk of loss upon default by the borrower, and are often unsecured and subordinated to other creditors. Below-investment-grade issuers usually have higher levels of indebtedness and are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than investment-grade issuers. We are aware of these risks and monitor our below-investment-grade securities closely. At December 31, 2004, our below-investment-grade fixed maturity investments had an amortized cost of $798.3 million and an estimated fair value of $851.8 million.
We continually evaluate the creditworthiness 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 $18.1 million in 2004. 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.
As of December 31, 2004, our fixed maturity investments in substantive default (i.e., in default due to nonpayment of interest or principal) or technical default (i.e., in default, but not as to the payment of interest or principal) had an amortized cost of $4.7 million and a carrying value of $6.8 million. 40|86 Advisors employs a staff of experienced professionals to manage non-performing and impaired investments. There were no other fixed maturity investments about which we had serious doubts as to the ability of the issuer to comply with the material terms of the instrument on a timely basis.
At December 31, 2004, fixed maturity investments included $5.5 billion of structured securities (or 26 percent of all fixed maturity securities). CMOs are backed by pools of mortgages that are segregated into sections or "tranches" that provide for reprioritizing of principal retirement. Pass-through securities receive principal and interest payments through their regular pro rata share of the payments on the underlying mortgages backing the securities. The yield characteristics of structured securities differ in some respects from those of traditional fixed-income securities. For example, interest and principal payments for mortgage-backed securities occur more frequently, often monthly. In addition, mortgage-backed securities are subject to risks associated with variable prepayments. Prepayment rates are influenced by a number of factors that cannot be predicted with certainty, including: the relative sensitivity of the underlying mortgages backing the assets to changes in interest rates; a variety of economic, geographic and other factors; and the repayment priority of the securities in the overall securitization structure.
In general, prepayments on the underlying mortgage loans and the securities backed by these loans increase when prevailing interest rates decline significantly in absolute terms and also relative to the interest rates on such loans. The yields on mortgage-backed securities purchased at a discount to par will increase when the underlying mortgages prepay faster than expected. The yields on mortgage-backed securities purchased at a premium will decrease when the underlying mortgages prepay faster than expected. When interest rates decline, the proceeds from the prepayment of mortgage-backed securities may be reinvested at lower rates than we were earning on the prepaid securities. When interest rates increase, prepayments on mortgage-backed securities decrease, as fewer underlying mortgages are refinanced. When this occurs, the average maturity and duration of the mortgage-backed securities increase, which decreases the yield on mortgage-backed securities purchased at a discount, because the discount is realized as income at a slower rate, and increases the yield on those purchased at a premium as a result of a decrease in the annual amortization of the premium.
The 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, 2004 (dollars in millions):
Pass-throughs and sequential and targeted amortization classes have similar prepayment variability. Pass-through securities are used frequently in the dollar roll market and can be used as the collateral for collateralized mortgage obligations. Sequential classes are a series of tranches that return principal to the various tranche holders sequentially. Targeted amortization classes offer slightly better structure in return of principal than sequentials when prepayment speeds are close to the speed anticipated when created.
Commercial mortgage-backed securities ("CMBS") are bonds secured by commercial real estate mortgages. Commercial real estate encompasses income producing properties that are managed for profit. Property types include multi-family dwellings including apartments, retail centers, hotels, restaurants, hospitals, nursing homes, warehouses, and office buildings. The CMBS market generally offers higher yields than similar-rated corporate bonds. Most CMBS have call protection features whereby underlying borrowers may not prepay their mortgages for stated periods of time or have prepayment penalties.
At December 31, 2004, we held mortgage loan investments with a carrying value of $1,123.8 million (or 5.2 percent of total invested assets) and a fair value of $1,167.2 million. Mortgage loans were substantially comprised of commercial loans. Noncurrent mortgage loans were insignificant at December 31, 2004. Realized losses on mortgage loans were not significant in any of the past three years. Our allowance for loss on mortgage loans was $2.4 million at December 31, 2004. At December 31, 2003, we had no allowance for losses on mortgage loans (mortgage loans were recorded at market values at August 31, 2003, in conjunction with our adoption of fresh start accounting). Approximately 9 percent, 7 percent, 6 percent, 6 percent and 6 percent of the mortgage loan balance were on properties located in Ohio, Massachusetts, New York, Pennsylvania and Florida, respectively. No other state accounted for more than 5 percent of the mortgage loan balance.
The following table shows the distribution of our mortgage loan portfolio by property type as of December 31, 2004 (dollars in millions):
As part of our investment strategy, we enter into reverse repurchase agreements and dollar-roll transactions to increase our return on investments and improve our liquidity. Reverse repurchase agreements involve a sale of securities and an agreement to repurchase the same securities at a later date at an agreed-upon price. Dollar rolls are similar to reverse repurchase agreements except that the repurchase involves securities that are only substantially the same as the securities sold. We enhance our investment yield by investing the proceeds from the sales in short-term securities pending the contractual repurchase of the securities at discounted prices in the forward market. In many cases, such transactions arise from the market demand for mortgage-backed securities to form CMOs. At December 31, 2004, we had investment borrowings of $433.9 million. Such investment borrowings averaged approximately $522.6 million during 2004 and were collateralized by investment securities with fair values approximately equal to the loan values. The weighted average interest rate on such borrowings was 1.5 percent during 2004. The primary risk associated with short-term collateralized borrowings is that the counterparty might be unable to perform under the terms of the contract. Our exposure is limited to the excess of the net replacement cost of the securities over the value of the short-term investments (which was not material at December 31, 2004). We believe that the counterparties to our reverse repurchase and dollar-roll agreements are financially responsible and that counterparty risk is minimal.
The Company's significant contractual obligations as of December 31, 2004, were as follows (dollars in millions):
While we seek to balance the duration of our invested assets with the estimated duration of benefit payments arising from contract liabilities, there could be significant variations in the timing of such cash flows. The claim experience on our long-term care business in the Other Business in Run-off segment has been worse than our original pricing expectations. Although we believe our current estimates properly project future claim experience, if these estimates prove to be wrong, and our experience would further worsen (as it did in some prior periods) our future liquidity could be adversely affected.
Our insurance operating companies generally receive adequate cash flow from premium collections and investment income to meet their obligations. Life insurance and annuity liabilities are generally long-term in nature. Policyholders may, however, withdraw funds or surrender their policies, subject to any applicable penalty provisions. We seek to balance the duration of our invested assets with the estimated duration of benefit payments arising from contract liabilities.
On May 27, 2004, S&P upgraded the financial strength ratings of our primary insurance companies from "BB-" to "BB+", other than 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. A "BB+" rating from S&P is the eleventh highest of twenty-one possible ratings, and a "CCC" rating from S&P is the eighteenth highest of twenty-one possible ratings.
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. The lowered ratings assigned to our insurance subsidiaries were one of the primary factors causing sales of our insurance products to decline and policyholder redemptions and lapses to increase beginning in 2002. We also experienced increased agent attrition, which in some cases led us to increase commissions or sales incentives in an effort to retain them. These events have had a negative effect on our ability to market our products and attract and retain agents, which in turn negatively affected our financial results.
As more fully described in the note to our consolidated financial statements entitled "Statutory Information", our two insurance subsidiaries domiciled in Texas entered into consent orders with the Texas Department of Insurance, which were formally released on November 19, 2003. The consent orders applied to all of our insurance subsidiaries and, among other things, restricted the ability of our insurance subsidiaries to pay any dividends or other amounts to any non-insurance company parent without prior approval. State laws generally give state insurance regulatory agencies broad authority to protect policyholders in their jurisdictions. Accordingly, we cannot be assured that the regulators will not seek to assert
At December 31, 2004, Conseco Inc. and CDOC held unrestricted cash of $28.3 million. In addition, our other non-life insurance companies held unrestricted cash of approximately $37.3 million which could be upstreamed to the parent companies if needed.
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, fees for services and tax-sharing payments, as well as cash from non-insurance subsidiaries consisting of loans and advances. A further 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 improve the RBC ratios of certain insurance subsidiaries 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 based on the financial statements of our insurance subsidiaries prepared in accordance with statutory accounting practices prescribed or permitted by regulatory authorities, which differ from GAAP. These regulations generally permit dividends to be paid from statutory earned surplus of the insurance company for any 12-month period in amounts equal to the greater of (or in a few states, the lesser of): (i) statutory net gain from operations or 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.
Under our Credit Facility, we have agreed to a number of covenants and other provisions that restrict our ability to engage in various financing transactions and pursue certain operating activities without the prior consent of the lenders. We have also agreed to meet or maintain various financial ratios. These requirements represent significant restrictions on the manner in which we may operate our business and our ability to meet these financial covenants may be affected by events beyond our control. If we default under any of these requirements (subject to certain remedies), the lenders could declare all outstanding borrowings, accrued interest and fees to be immediately due and payable. If that were to occur, we cannot provide assurance that we would have sufficient liquidity to repay or refinance this indebtedness.
Our spread-based insurance business is subject to several inherent risks arising from movements in interest rates, especially if we fail to anticipate or respond to such movements. First, interest rate changes can cause compression of our net
spread between interest earned on investments and interest credited on customer deposits, thereby adversely affecting our results. Second, if interest rate changes produce an unanticipated increase in surrenders of our spread-based products, we may be forced to sell investment assets at a loss in order to fund such surrenders. At December 31, 2004, approximately 18 percent of our total insurance liabilities (or approximately $4.4 billion) could be surrendered by the policyholder without penalty. Finally, changes in interest rates can have significant effects on the performance of our structured securities portfolio, including collateralized mortgage obligations, as a result of changes in the prepayment rate of the loans underlying such securities. We follow asset/liability strategies that are designed to mitigate the effect of interest rate changes on our profitability. However, there can be no assurance that management will be successful in implementing such strategies and achieving adequate investment spreads.
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, 2004, the adjusted modified duration of our fixed maturity securities and short-term investments was approximately 6.4 years and the duration of our insurance liabilities was approximately 7.0 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 $630 million if interest rates were to increase by 10 percent from their levels at December 31, 2004. This compares to a decline in fair value of $625 million based on amounts and rates at December 31, 2003. The calculations involved in our computer simulations incorporate 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.
We are subject to the risk that our investments will decline in value. This has occurred in the past and may occur again. 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 fixed maturity investments, equity securities and other invested assets resulting from declines in fair values that we concluded were other than temporary. 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 fixed maturity investments, equity securities and other invested assets resulting from declines in fair values that we concluded were other than temporary. 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 fixed maturity investments, equity securities and other invested assets resulting from declines in fair values that we concluded were other than temporary. During 2002, we recognized net realized investment losses of $556.3 million, which were comprised of $556.8 million of writedowns of fixed maturity investments, equity securities and other invested assets resulting from declines in fair values that we concluded were other than temporary net of $.5 million of net gains from the sales of investments (primarily fixed maturities) with proceeds of $19.5 billion. During 2002, we recognized other-than-temporary declines in value of several investments including K-Mart Corp., Amerco, Inc., Global Crossing, MCI Communications, Mississippi Chemical, United Airlines and Worldcom, Inc.
Loan originations in 2002 were $7.3 billion. Given CFC's limited liquidity and inability to access the securitization market, CFC discontinued originating certain types of loans. CFC also limited future originations primarily to loans that could be sold at a profit in whole-loan sale transactions. CFC discontinued originating manufactured housing loans in November 2002. These decisions and continued constraints on liquidity resulted in origination volume which was significantly lower than in prior periods.
Sales of finance receivables in 2002 included the sale of $2.1 billion of finance receivables, on which CFC recognized a loss of $17.1 million. These sales are further explained below under "Gain on sale of finance receivables". CFC also sold $.5 billion of certain other finance receivables in 2002, as part of CFC's cash raising arrangements.
Gain (loss) on sales of finance receivables resulted from various loan sale transactions in 2002. During 2002, CFC sold $2.1 billion of finance receivables which generated net losses of $17.1 million. In 2002, CFC also recognized a $32.4 million loss to reduce the value of unsecuritized finance receivables, which were being held for eventual sale and had market values below their cost basis.
manufactured housing portfolio was partially due to the increased age of such portfolio.
Special charges in 2002 included: (i) the loss of $96.0 million related to the sales of certain finance receivables totaling $463 million and an additional $1.6 million loss related to receivables required to be repurchased from the purchaser of the vendor services receivables; (ii) a $39.4 million charge for costs associated with various modifications to financing arrangements and recognition of deferred expenses for terminated warehouse facilities; (iii) a $16.3 million charge for the abandonment of computer processing systems; (iv) a $38.1 million benefit due to the reduction in the value of the warrant held by Lehman to purchase five percent of CFC, which was expected to have no value due to CFC's bankruptcy proceedings; and (v) restructuring and other charges of $6.7 million. These charges are described in greater detail in the note to Conseco's consolidated financial statements entitled "Financial Information Regarding CFC."
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Conseco, Inc. and subsidiaries (Successor Company) at December 31, 2004 and 2003, and the results of their operations and their cash flows for the period ended December 31, 2004 and for the period from September 1, 2003 through December 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 audits. We conducted our audits 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 of financial statements 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 audits provide a reasonable basis for our opinion.
As discussed in Note 1 to the consolidated financial statements, the United States Bankruptcy Court for the Northern District of Illinois, Eastern Division confirmed the Company's Sixth Amended Joint Plan of Reorganization (the "Plan") on September 9, 2003. The provisions of the Plan are described in detail in Note 1. The Plan was substantially consummated on September 10, 2003 and the Company emerged from bankruptcy. In connection with its emergence from bankruptcy, the Company adopted fresh start accounting as of August 31, 2003.
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, and for the year ended December 31, 2002 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 audits. We conducted our audits 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 audits provide a reasonable basis for our opinion.
CONSOLIDATED BALANCE SHEET December 31, 2004 and 2003 (Dollars in millions)
CONSOLIDATED BALANCE SHEET (Continued) December 31, 2004 and 2003 (Dollars in millions)
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 two operating segments, which are defined on the basis of product distribution, and a third segment comprised of business in run-off, as follows:
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 450 independent marketing organizations ("IMOs") that represent over 6,200 producing independent agents. This segment markets its products under the "Conseco" brand.
We also have a corporate segment, which consists of holding company activities and certain noninsurance businesses that are unrelated to our operating segments.
On December 17, 2002 (the "Petition Date"), 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 (the "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 the 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.
Under the terms of the Plan, we distributed the equity securities to the creditors of our Predecessor as outlined below:
o holders of our Predecessor's senior notes received approximately 32.3 million shares of our common stock;
In November 2002, Old Conseco completed the sale of ExlServices.com, Inc. ("Exl"), a firm that specialized in customer service and backroom outsourcing with operations in India. Old Conseco recognized a loss of $20.0 million on the transaction. Old Conseco had previously written off a significant portion of the value of this investment in conjunction with the impairment charge related to goodwill pursuant to the Company's adoption of Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" ("SFAS 142") described below under "Recently Issued Accounting Standards".
The accompanying financial statements include the accounts of the Company and all of its wholly owned insurance subsidiaries. Our consolidated financial statements exclude the results of material transactions between us and our consolidated affiliates, or among our consolidated affiliates. We reclassified certain amounts in our 2003 and 2002 consolidated financial statements and notes to conform with the 2004 presentation. These reclassifications have no effect on net income (loss) or shareholders' equity.
Upon the confirmation of the Plan on September 9, 2003, we implemented fresh start reporting in accordance with SOP 90-7. However, for accounting convenience purposes, we have reported the effects of fresh start accounting as if they occurred on August 31, 2003. We engaged an independent financial advisor to assist in the determination of our reorganization value as defined in SOP 90-7. We determined a reorganization value, together with our financial advisor, using various valuation methods, including: (i) selected comparable companies analysis; and (ii) actuarial valuation analysis. These analyses are necessarily based on a variety of estimates and assumptions which, though considered reasonable by management, may not be realized, and are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are beyond our control. Changes in these estimates and assumptions may have had a significant effect on the determination of our reorganization value. The estimated reorganization value of the Company was calculated to be approximately $3.7 billion to $3.9 billion. We selected the midpoint of the range, $3.8 billion, as the reorganization value. Such value was confirmed by the Bankruptcy Court on the Confirmation Date.
Under fresh start reporting, a new reporting entity was considered to be created and the Company was required to revalue its assets and liabilities to current estimated fair value, re-establish shareholders' equity at the reorganization value determined in connection with the Plan, and record the excess of the reorganization value over specific tangible or identified intangible assets as goodwill. In addition, all accounting standards that were required to be adopted in the financial statements within twelve months following the adoption of fresh start accounting were adopted as of August 31, 2003. Adjustments to the Predecessor's consolidated balance sheet as of August 31, 2003, to reflect the discharge of debt, change in capital structure and the fair value of our assets and liabilities are presented in the following table (dollars in millions):
At August 31, 2003, we established trading security accounts which 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 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 is substantially offset by the change in insurance policy benefits for these products. Our trading securities totaled $902.3 million and $915.1 million at December 31, 2004 and 2003, respectively. The change in the market value of these securities is recognized currently in investment income (classified as income from policyholder and reinsurer accounts).
Venture capital investment in AT&T Wireless Services, Inc. ("AWE") was carried at fair value, with changes in such value recognized as investment income (loss). In December 2003, we sold our remaining 4.1 million shares of AWE common stock. In 2002, we sold 10.3 million shares of AWE common stock for proceeds of $75.7 million. We recognized venture capital investment income (losses) of $(5.5) million in the four months ended December 31, 2003; $10.5 million in the eight months ended August 31, 2003; and $(99.3) million in 2002, related to this investment.
During 2003 and 2002, we established additional provisions for losses related to our guarantees of the bank loans and related interest loans to approximately 155 current and former directors, officers and key employees for the purchase of the common stock of Old Conseco (see the note to the consolidated financial statements entitled "Commitments and Contingencies" for additional information).
Upon the implementation of fresh start accounting, we eliminated the historical balance of Old Conseco's cost of policies produced as of August 31, 2003, and replaced it with the value of policies inforce as of the Effective Date.
The costs that vary with, and are primarily related to, producing new insurance business subsequent to August 31, 2003 are referred to as cost of policies produced. For universal life or investment products, we amortize these costs using the interest rate credited to the underlying policies in relation to the established gross profits. For other products, we amortize these costs using the projected investment earnings rate in relation to future anticipated premium revenue.
The value assigned to the right to receive future cash flows from contracts existing at August 31, 2003 is referred to as the value of policies inforce as of the Effective Date. We also defer renewal commissions paid in excess of ultimate commission levels related to the existing policies in this account. The balance of this account is amortized, evaluated for recovery, and adjusted for the impact of unrealized gains (losses) in the same manner as described above for the cost of policies produced.
The discount rate we used to determine the value of the value of policies inforce as of the Effective Date was 12 percent. See note entitled "Fresh Start Reporting", for further explanation of this rate.
We establish liabilities for investment and universal life-type products equal to the accumulated policy account values, which include an accumulation of deposit payments plus credited interest, less withdrawals and the amounts assessed against the policyholder through the end of the period. Sales inducements provided to the policyholders of these products are recognized as liabilities over the period that the contract must remain in force to qualify for the inducement. The options attributed to the policyholder related to our equity-indexed annuity products are accounted for as embedded derivatives as described in the section of this note entitled "Accounting for Derivatives".
In the first quarter of 2002, we completed a reinsurance agreement pursuant to which we ceded 80 percent of the inforce traditional life business of our subsidiary, Bankers Life and Casualty, to Reassure America Life Insurance Company (rated A+ by A.M. Best Company, or "A.M. Best"). The total insurance liabilities ceded pursuant to the contract were approximately $400 million. The reinsurance agreement and the related dividends of $110.5 million were approved by the appropriate state insurance departments and the dividends were paid to Old Conseco. The ceding commission approximated the amount of the cost of policies purchased and cost of policies produced related to the ceded business.
$123.0 million and we recognized a loss of $39.0 million related to the transaction.
In the normal course of business, we seek to limit our loss exposure on any single insured or to certain groups of policies by ceding reinsurance to other insurance enterprises. We currently retain no more than $.8 million of mortality risk on any one policy. We diversify the risk of reinsurance loss by using a number of reinsurers that have strong claims-paying ratings. In each case, the ceding Conseco subsidiary is contingently liable for claims reinsured if the assuming company is unable to pay. The likelihood of a material loss being incurred as a result of the failure of one of our reinsurers is considered remote. The cost of reinsurance is recognized over the life of the reinsured policies using assumptions consistent with those used to account for the underlying policy. The cost of reinsurance ceded totaled $255.2 million in 2004; $92.1 million in the four months ended December 31, 2003; $196.4 million in the eight months ended August 31, 2003; and $327.8 million in 2002. We deduct this cost from insurance policy income. Reinsurance recoveries netted against insurance policy benefits totaled $281.8 million in 2004; $94.3 million in the four months ended December 31, 2003; $199.2 million in the eight months ended August 31, 2003; and $323.6 million in 2002.
In October 2001, we entered into new interest rate swap agreements to replace the terminated agreements and, in doing so, converted the fixed rate on our 10.75% senior notes to a variable rate based on LIBOR plus 5.7525 percent. Such interest rate swap agreements were terminated in April 2002 generating cash proceeds of $3.5 million. Such amount represented $11.9 million of cash due to the Company pursuant to the terms of the swaps, net of $8.4 million which represented the fair value of the interest rate swaps on the date of termination. The $8.4 million was amortized as additional interest expense over the remaining lives of our senior notes until such notes were discharged in accordance with the Plan.
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, 2004, all of our counterparties were rated "A" or higher by Standard & Poor's Corporation ("S&P").
The Company's multibucket annuity is a fixed annuity product that credits interest based on the experience of a particular market strategy. Policyholders allocate their annuity premium payments to several different market strategies based on different asset classes within the Company's investment portfolio. Interest is credited to this product based on the market return of the given strategy, less management fees, and funds may be moved between different strategies. The Company guarantees a minimum return of premium plus approximately 3 percent per annum over the life of the contract. The investments backing the market strategies of these products are designated by the Company as trading securities. The change in the fair value of these securities is recognized currently in investment income (classified as income from policyholder and reinsurer accounts), which is substantially offset by the change in insurance policy benefits for these products.
The estimated fair values of our financial instruments at December 31, 2004 and 2003, were as follows (dollars in millions):
supportable. The assumptions we used to determine the discounted cash flows involve significant judgments regarding the best estimate of future premiums, expected mortality and morbidity, interest earned and credited rates, persistency and expenses. The discount rate used was based on an analysis of the weighted average cost of capital for several insurance companies and considered the specific risk factors related to Conseco. Under SFAS 142, quoted market prices in active markets are the best evidence of fair value and should be used when available.
In connection with the preparation of the Plan, we retained a consulting actuarial firm to assist in valuing our insurance subsidiaries. That valuation work and our internal evaluation were used in performing the additional impairment tests that resulted in an impairment charge to goodwill of $500.0 million. The charge was classified with operating expenses in our consolidated statement of operations for the year ended December 31, 2002. The most significant changes made to the January 1, 2002 valuation were: (i) reduced estimates of projected future sales of insurance products; (ii) increased estimates of future policyholder redemptions and lapses; and (iii) a higher discount rate to reflect the current rates used by the market to value life insurance companies. Management believes that the assumptions and estimates used were reasonable given all available facts and circumstances at that time.
Changes in the carrying amount of Predecessor's goodwill for the eight months ended August 31, 2003, and the year ended December 31, 2002, were as follows (dollars in millions):
The FASB's Derivative Implementation Group issued 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. See the note entitled "Accounting for Derivatives" for a discussion of the impact of implementing this guidance.
The Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position 03-01 "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts" ("SOP 03-01") in July 2003. SOP 03-01 provides guidance on several insurance company disclosure and accounting matters including the appropriate accounting for: (i) separate accounts; (ii) additional interest (for example, persistency bonus) accruing to the investment contract holder; (iii) the liability for contracts where the amounts assessed against the contract holder each period are expected to result in profits in earlier years and losses in subsequent years; (iv) potential benefits to annuity holders in addition to their account balance; (v) sales inducements to contract holders; and (vi) other provisions. The Company sold most of its separate account business in 2002. Accordingly,
the new guidance related to separate accounts had no impact on the Company's consolidated financial position, results of operations or cash flows. As a result of our adoption of fresh start accounting, we were required to revalue our insurance product liabilities and record them at their estimated fair market value. In calculating the value of the liabilities for insurance and asset accumulation products, we followed the guidance of SOP 03-01. We have changed the way we classify the costs related to sales inducements in accordance with the new guidance. However, such change was not material. Our reserve for persistency bonus benefits was $313.2 million and $282.8 million at December 31, 2004 and 2003, respectively. Our annuity products include contracts that offered enhanced crediting rates or bonus payments. These enhanced rates are considered sales inducements under SOP 03-01. Such amounts are deferred and amortized in the same manner as the cost of policies produced. Sales inducements deferred totaled $14.3 million in 2004 and $4.8 million in the four months ended December 31, 2003, and amounts amortized totaled $2.9 million in 2004 and $.4 million in the four months ended December 31, 2003. The unamortized balance of deferred sales inducements at December 31, 2004 and 2003, was $15.8 million and $4.4 million, respectively.
The FASB issued Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment of Long-Lived Assets" ("SFAS 144") in August 2001. This standard addresses the measurement and reporting for impairment of all long-lived assets. It also broadens the definition of what may be presented as a discontinued operation in the consolidated statement of operations to include components of a company's business segments. SFAS 144 requires that long-lived assets currently in use be written down to fair value when considered impaired. Long-lived assets to be disposed of are written down to the lower of cost or fair value less the estimated cost to sell. The Company adopted this standard on January 1, 2002. We followed this standard in determining when to recognize impairments on assets we decided to sell as part of our cash raising efforts. We also followed this standard in presenting our variable annuity business line and CFC as discontinued operations in our consolidated financial statements (see the note to the consolidated financial statements entitled "Discontinued Operations").
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, 2004 and 2003, were as follows (dollars in millions):
The following table sets forth the amortized cost and estimated fair value of actively managed fixed maturities at December 31, 2004, 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 following summarizes the investments sold at a loss during 2004 which had been continuously in an unrealized loss position exceeding 20 percent of the amortized cost basis for the period indicated prior to the sale (dollars in millions):
During 2004, we recorded writedowns of fixed maturity investments, equity securities and other invested assets totaling $18.1 million, which included a loss of $3.4 million related to an issuer in the airline industry rated Caa/CCC-. Although this investment is in a major airline, this company remains highly leveraged and the entire industry is currently facing a difficult operating environment including rising fuel prices. Accordingly, we concluded that the decline in fair value was other than temporary. In addition to the specific investment discussed above, we recorded $14.7 million of writedowns related to various other investments, of which no single issuer exceeded $3.0 million.
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 or updated information may become available, which may necessitate future realized losses of securities in our portfolio. Significant losses in the carrying value of our investments could have a material adverse effect on our earnings in future periods.
The following table sets forth the amortized cost and estimated fair value of those actively managed fixed maturities with unrealized losses at December 31, 2004, 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).
At December 31, 2004, we had no investments in fixed maturities rated below-investment grade or classified as equity-type securities in an unrealized loss position exceeding 20 percent of the cost basis.
The $30 million of partnership equity represented less than 10 percent of the total capital of the partnership. In addition, the subordinated debt was intended to absorb virtually all expected losses and receive a significant portion of
At December 31, 2004, fixed maturity investments included $5.5 billion of structured securities (or 26 percent of all fixed maturity securities). Structured securities include mortgage-backed securities, collateralized mortgage obligations, asset-backed securities and commercial mortgage-backed securities. The yield characteristics of structured securities differ in some respects from those of traditional fixed-income securities. For example, interest and principal payments on mortgage-backed securities occur more frequently, often monthly. In addition, mortgage-backed securities are subject to risks associated with variable prepayments. Prepayment rates are influenced by a number of factors that cannot be predicted with certainty, including: the relative sensitivity of the underlying mortgages backing the assets to changes in interest rates; a variety of economic, geographic and other factors; and the repayment priority of the securities in the overall securitization structures.
Pass-throughs and sequential and targeted amortization classes have similar prepayment variability. Pass-through securities are used frequently in the dollar roll market and can be used as collateral for collateralized mortgage obligations. Sequential classes are a series of tranches that return principal to the tranche holders sequentially. Targeted amortization classes offer slightly better structure in return of principal than sequentials when prepayment speeds are close to the speed anticipated when created.
Commercial mortgage-backed securities ("CMBS") are bonds secured by commercial real estate mortgages. Commercial real estate encompasses income producing properties that are managed for profit. Property types include multi-family dwellings including apartments, retail centers, hotels, restaurants, hospitals, nursing homes, warehouses, and office buildings. The CMBS market generally offers higher yields, than similar-rated corporate bonds. Most CMBS have call protection features whereby underlying borrowers may not prepay their mortgages for stated periods of time or have prepayment penalties.
Conseco had one investment in excess of 10 percent of shareholders' equity at December 31, 2004 and three investments in excess of 10 percent of shareholders' equity at December 31, 2003 (other than investments issued or guaranteed by the United States government or a United States government agency), which are summarized below (dollars in millions):
In accordance with Statement of Financial Accounting Standards No. 60, "Accounting and Reporting by Insurance Enterprises" and Statement of Financial Accounting Standards No. 97, "Accounting and Reporting by Insurance Enterprises for certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments" ("SFAS 97"), the Predecessor used the original actuarial assumptions determined when the traditional long-duration and limited payment insurance contracts were issued in determining liability calculations as of the fresh start date, provided the resulting liabilities were adequate to provide for future benefits and expenses under the related contracts. This accounting principle is referred to as the "lock in" principle and is only applicable to traditional insurance and limited pay products. The use of assumptions that are locked in at the time of issue means that, absent loss recognition, the same assumptions are used in accounting for a particular block of business unless the block is subject to purchase or fresh start accounting.
The adoption of SOP 03-01 as of the Effective Date required a change in methodology regarding persistency bonuses provided to policyholders who continue to keep their policies inforce for a stated period of time. The Predecessor recognized the cost of this benefit over the period prior to the time the benefit would be credited in proportion to estimated gross profits and assumed a certain number of policies would terminate before the benefit was credited. Under SOP 03-01, the cost for such benefits is recognized ratably over the period prior to the time the benefit is credited without assuming policy terminations. Insurance liabilities increased by approximately $.1 billion as a result of the adoption of SOP 03-01.
Changes in the unpaid claims reserve (included in claims payable) and disabled life reserves related to accident and health insurance (included in individual and group accident and health liabilities) were as follows (dollars in millions):
The income tax expense recorded in 2002 was allocated entirely to continuing operations before the following items: minority interest, discontinued operations, cumulative effect of accounting change and other comprehensive income. This accounting treatment was required because the calculation of income tax expense was the same, both "with and without" the items other than continuing operations discussed above.
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. The net deferred tax assets before valuation allowance totaled $2.6 billion at December 31, 2004. 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 future taxable income during the periods in which our temporary differences become deductible and before our capital loss carryforwards and net operating loss carryforwards expire. In addition, the use of the Company's net ordinary loss carryforwards is dependent, in part, on whether the IRS ultimately agrees with the tax position we have taken and plan to take in our current and future tax returns. We evaluate the realizability of our deferred income tax assets and assess the need for a valuation allowance on an ongoing basis. Based upon information existing at the Effective Date, we established a valuation allowance equal to our entire balance of net deferred income tax assets because, at that time, the realization of such net deferred income tax assets in future periods was uncertain. As of December 31, 2004, we no longer believed that a full valuation allowance was necessary. However, as further discussed below, we believed that it was necessary to have a valuation allowance on a portion of our deferred tax assets. This determination was made by evaluating each component of the deferred tax assets and assessing the effects of limitations or issues on such component's ability to be fully recognized in the future. Two significant issues include whether section 382 of
The Code provides that any income realized as a result of the cancellation of indebtedness (cancellation of debt income or "CODI") in bankruptcy, will reduce certain tax attributes including net operating loss carryforwards. We realized an estimated $2.5 billion of CODI when we emerged from bankruptcy. Accordingly, our net operating loss carryforwards were reduced by $2.5 billion as of December 31, 2003.
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 following paragraphs summarize some of the unresolved limitations and contingencies which exist with respect to the future utilization of our net operating loss carryforwards which will cause a reassessment of the need for a major portion of the valuation allowance when resolved.
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. There is no limitation on the ability to utilize net operating losses generated by a life insurance company. Subsequent to our emergence from bankruptcy, we reorganized certain of our subsidiaries to improve their capital position. As a result of the reorganization, the loss related to CFC was realized by a life insurance company. Accordingly, we believe the loss should be treated as a life insurance loss and would not be subject to the Code limitations described above. However, if the IRS were to disagree with our conclusion and such determination ultimately prevailed, the loss related to CFC would be subject to such limitation. The IRS has informed the Company that it will address this matter during its examination of our tax returns for calendar years 2002-2003.
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 2005 and 2006 without incurring any tax liability. The aggregate balance in this account at December 31, 2004 was $258.3 million, which prior to the 2004 Act would have resulted in federal income taxes payable of $90.4 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.
The following notes payable were direct corporate obligations of the Company as of December 31, 2004 and 2003 (dollars in millions):
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
On June 22, 2004, we entered into the Credit Facility with a principal balance of $800.0 million. The Credit Facility is 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.
Pursuant to the Credit Facility, as long as the interest coverage ratio (as defined in the Credit Facility) is less than 4.0:1.0, 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 Credit Facility. The Company may make optional prepayments at any time in minimum amounts of $3.0 million. In the event that the Company refinances or otherwise repays in full the Credit Facility prior to June 22, 2005, we will incur a one percent prepayment fee on the remaining principal balance of the Credit Facility.
In October 2002, Roderick Russell, on behalf of himself and purportedly on behalf of a class of persons similarly situated, and on behalf of the ConsecoSave Plan, filed an action in the United States District Court for the Southern District of Indiana against our Predecessor, Conseco Services and certain of our current and former officers, Roderick Russell, et al. v. Conseco, Inc., et al., Case No. 1:02-CV-1639 LJM. The complaint seeks an unspecified amount of damages. The purported class action consists of all individuals whose 401(k) accounts held common stock of our Predecessor at any time since April 28, 1999. The complaint alleges, among other things, breaches of fiduciary duties under ERISA by continuing to permit employees to invest in our Predecessor's common stock without full disclosure of the Company's true financial condition. We reached a tentative settlement with the Russell plaintiffs for $10 million in February 2005, subject to the negotiation of a final settlement agreement. The proposed class action settlement must also be approved by the district court after a fairness hearing is conducted. We have established a liability of $10 million for the cost of the tentative settlement.
Visual, Inc., Farmore Realty, Inc. f/k/a Sweetheart Theatres, Inc., The City of New York and the State of New York Cause No: 114077/99. The complaint seeks damages in the amount of $3.9 million with interest thereon from January 20, 1998. This is a lien foreclosure suit that is the result of an April 1996 lease agreement entered into by LateNite Magic and Farmore Realty, Inc. to develop a theme restaurant based on the magic of David Copperfield. CVIC and Conseco Annuity Assurance Company (now known as Conseco Insurance Company) purchased preferred stock of LateNite and acquired the right to an assignment of the April 1996 lease. An amended complaint was filed on December 2, 1999 naming CVIC and Conseco Annuity Assurance Company as co-defendants. The trial in this case commenced on March 10, 2005. We retained liability for CVIC's involvement in this litigation in connection with the sale of CVIC. Conseco believes the lawsuit is without merit and intends to defend it vigorously. The ultimate outcome of the lawsuit cannot be predicted with certainty.
On February 7, 2003, the Company's subsidiary, Conseco Life Insurance Company, was named in a purported Texas statewide class action seeking unspecified damages in the County Court of Cameron County, Texas, Lawrence Onderdonk and Yolanda Carrizales v. Conseco Life Insurance Company, and Pete Ramirez, III Cause No. 2003-CCL-102-C. On February 12, 2004, the complaint was amended to allege a purported nationwide class and to name Conseco Services as an additional defendant. On March 5, 2004, the complaint was amended a second time naming additional plaintiffs. The purported class consists of all former Massachusetts General Flexible Premium Adjustable Life Insurance Policy policyholders who were converted to Conseco Life Flexible Premium Adjustable Life Insurance Policies and whose accumulated values in the Massachusetts General policies were applied to first year premiums on the Conseco Life policies. The complaint alleged, among other things, civil conspiracy to convert the accumulated cash values of the plaintiffs and the class, and the violation of insurance laws nationwide. The parties have reached a settlement agreement on a class wide basis which requires a payment which had been accrued at December 31, 2004. On October 14, 2004, the judge signed an order preliminarily approving the settlement. The hearing for final approval was held January 31, 2005 and we expect a final order approving class settlement to become effective by March 31, 2005.
On September 21, 1999, Conseco Health Insurance Company ("Conseco Health"), Conseco Services, Performance Matters Associates (one of our subsidiaries), and a subsidiary officer were named in an action seeking unspecified compensatory, punitive, consequential and treble damages in the United States District Court for the Northern District of Alabama, Danny McFarlin; Tennessee Capitol Associates, Inc.; Neal Nielsen; Group Marketing Services, Inc.; Eleanor D. Newman; Dick Manley; Commonwealth General Group, Inc.; Robert E. Taylor; Benefits of America Limited, Inc.; and Daniel Smith v. Conseco, Inc.; Conseco Services, LLC.; Conseco Health Insurance f/k/a Capitol American Life Insurance Company; Consolidated Marketing Group; Suncoast Fringe Benefits, Inc.; Performance Matters Associates, Inc.; Christopher L. Weaver; Jim Hobbs, Mike Foster and David King; Cause No: 99-CV-2282-S, alleging among other things fraud, tortious interference with business and contractual relations, conspiracy, breach of contract, unjust enrichment, extortion and interstate travel in aid of extortion under the Racketeer Influenced and Corrupt Organization Act ("RICO") and mail/wire fraud under RICO. The case concerns the consolidation of plaintiffs' independent marketing organizations under a wholly owned subsidiary of Conseco. This matter was settled in January 2005 for an amount which had been accrued at December 31, 2004.
On June 27, 2001, two suits against the Company's subsidiary, Conseco Life Insurance Company, both purported nationwide class actions seeking unspecified compensatory and punitive damages, were consolidated in the U.S. District Court, Middle District of Florida, In Re PLI Sales Litigation, Cause No. 01-MDL-1404. The complaint alleges, among other things, fraudulent sales and a "vanishing premium" scheme. Conseco Life filed a motion for summary judgment against both
On December 19, 2001, four of the Company's subsidiaries were named in a purported nationwide class action seeking unspecified damages in the District Court of Adams County, Colorado, Jose Medina and others similarly situated v. Conseco Annuity Assurance Company, Conseco Life Insurance Company, Bankers National Life Insurance Company and Bankers Life and Casualty Company, Cause No. 01-CV-2465, alleging among other things breach of contract regarding alleged non-disclosure of additional charges for those policyholders paying via premium modes other than annual. On November 10, 2003, the court denied the plaintiff's motion for class certification. On January 26, 2004, the plaintiff appealed the trial court's ruling denying class certification. All further proceedings have been stayed pending the outcome of the appeal. The defendants 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.
Illinois); Conseco Inc. v. Cuneo, et al., Case No. 04 C 7469 (Northern District, Illinois). David Decatur filed for bankruptcy on May 12, 2004, Case No. 04-08772-JKC-11 (Southern District, Indiana).
On October 20, 2004, the judge in the Conseco Services v. Hilbert case granted partial final summary judgment in favor of Conseco Services in the amount of $62.7 million plus interest. Mr. Hilbert has filed a notice of appeal. We filed an objection to Decatur's bankruptcy on December 9, 2004. The Company and Conseco Services believe that all amounts due under the director and officer loan programs, including all applicable interest, are valid obligations owed to the companies. As part of the Plan, we have agreed to pay 45 percent of any net proceeds recovered in connection with these lawsuits, in an aggregate amount not to exceed $30 million, to former holders of our Predecessor's trust preferred securities that did not opt out of a settlement reached with the committee representing holders of these securities. We intend to prosecute these claims to obtain the maximum recovery possible. Further, with regard to the various claims brought against the Company and Conseco Services by certain former directors and officers, we believe that these claims are without merit and intend to defend them vigorously. The ultimate outcome of the lawsuits cannot be predicted with certainty. At December 31, 2004, we have estimated that approximately $46 million, net of collection costs, of the remaining amounts due under the loan program will be collected and that $19 million will be paid to the former holders of our Predecessor's trust preferred securities.
In August 2004, the Company entered into a settlement with the SEC and the New York Attorney General (the "NYAG") concerning their joint investigation into market timing in variable annuities issued by a former subsidiary of Old Conseco. Without admitting or denying the alleged findings of the investigation, the Company consented to the entry of a cease and desist order requiring its future compliance with securities laws. The settlement called for the payment of $5.0 million and for the SEC and NYAG to file a claim for an additional $10.0 million against the bankruptcy estate of a subsidiary of Old Conseco. Old Conseco sold its variable annuity subsidiary to an unrelated third party before filing for bankruptcy in December 2002, and no Conseco affiliates have issued any new variable annuity policies since the divestiture.
On September 18, 2003, the Company received a grand jury subpoena from the U.S. District Court for the Southern District of Indiana in connection with a Department of Justice investigation requiring production of documents relating to the valuation of interest-only securities held by CFC, our Predecessor's former finance subsidiary, contemporaneous earnings estimates for the Predecessor, certain personnel records and other accounting and financial disclosure records for the period June 1, 1998 to June 30, 2000. The Company has subsequently received follow-up grand jury document subpoenas concerning other matters. All of these follow-up requests have been limited to the time period prior to the December 17, 2002 bankruptcy filing. The Company has been advised by the Department of Justice that neither it nor any of its current directors or employees are subjects or targets of this investigation. The Company was informed by the Department of Justice in December 2004 that the Department has decided not to seek any indictments from the grand jury as a result of the investigation.
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 proceeds from the collection of certain D&O loans in an aggregate amount not to exceed $30 million. We have established a liability of $19 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, 2004 and 2003, was $22.0 million and $18.1 million, respectively, and is included in the caption "Other liabilities" in the liability section of 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 $44.1 million in 2004; $20.3 million in the four months ended December 31, 2003; $29.0 million in the eight months ended August 31, 2003; and $45.0 million in 2002. Future required minimum payments as of December 31, 2004, were as follows (dollars in millions):
One of our insurance subsidiaries has a noncontributory, unfunded deferred compensation plan for qualifying members of its career agency force. Benefits are based on years of service and career earnings. The liability recognized in the consolidated balance sheet for the agents' deferred compensation plan was $70.8 million and $64.7 million at December 31, 2004 and 2003, respectively. Substantially all of this liability represented vested benefits. Costs incurred on this plan were $8.9 million (including the recognition of losses of $2.7 million resulting from actual experience being different than expected or changes in actuarial assumptions) during 2004; $1.5 million in the four months ended December 31, 2003; $4.0 million in the eight months ended August 31, 2003; and $5.1 million during 2002.
contributions, which match certain voluntary employee contributions to the plan, totaled $4.1 million in 2004 and $6.6 million in 2002. No employer contributions were made during the 2003 periods. For the first nine months of 2002, employer matching contributions were made in cash. In September 2002, the plans were amended to make future employer matching contributions discretionary. Effective January 1, 2004, the Company resumed making matching contributions in cash.
Prior to 2003, certain wholly-owned subsidiary trusts had issued preferred securities in public offerings. The trusts used the proceeds from these offerings to purchase subordinated debentures from Conseco. The terms of the preferred securities were parallel to the terms of the debentures, which accounted for substantially all trust assets. The preferred securities were to be redeemed on a pro rata basis, to the same extent as the debentures were repaid. Under certain circumstances involving a change in law or legal interpretation, the debentures could be distributed to the holders of the preferred securities. Our obligations under the debentures and related agreements, taken together, provided a full and unconditional guarantee of payments due on the preferred securities. The debentures issued to the subsidiary trusts and the common securities purchased by Conseco from the subsidiary trusts were eliminated in the consolidated financial statements. The Trust Preferred Securities guaranteed by Old Conseco prior to our emergence from bankruptcy were discharged in accordance with the Plan. Such Trust Preferred Securities had a par value of $1,930.0 million and a weighted average distribution rate of 8.9 percent.
recognized as an expense to the Company over the four year vesting period. The Company also incurred $.6 million of professional fees and other expenses related to the executive transition.
Other items included expenses incurred: (i) in conjunction with the transfer of certain customer service and backroom operations to our India subsidiary; (ii) for severance benefits related to the transfer of such operations; and (iii) for other items which are not individually significant. The Company sold its India subsidiary in the fourth quarter of 2002 and has significantly reduced the customer service and backroom operations conducted there.
o $620.7 million to repay indebtedness under our Previous Credit Facility, including accrued interest of $.7 million.
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. 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.
If the Company is involved in a merger prior to May 15, 2007, in which at least 30 percent of the consideration for our common stock consists of cash or cash equivalents, then the holders of the Preferred Stock have the right to convert their shares into shares of our common stock at the conversion rate in effect immediately prior to such merger.
The following table summarizes information about stock options outstanding at December 31, 2004 (shares in thousands):
During 2004, equivalent common shares of 19.9 million related to the assumed conversion of Class A convertible exchangeable preferred stock were not included in the computation of diluted earnings per share because doing so would have been antidilutive.
Basic earnings per common share is computed by dividing 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 are 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 11 percent of the December 31, 2004 balance of the value of policies inforce at the Effective Date in 2005, 10 percent in 2006, 9 percent in 2007, 8 percent in 2008 and 7 percent in 2009. The discount rate used to determine the amortization of the value of policies inforce at the Effective Date averaged 5 percent in both the year ended December 31, 2004, and the four months ended December 31, 2003.
During the second quarter of 2004, we evaluated certain amortization assumptions used to estimate gross profits for universal life-type products and investment-type products by comparing them to our actual experience. We made refinements to the previous assumptions related to investment income to match actual experience and our estimates for future assumptions. The changes we made did not affect our expectations for the total estimated profits to be earned on this business, but did affect how we expect the profits to emerge over time. These new assumptions resulted in a retroactive reduction to the amortization of the value of policies inforce at the Effective Date of $7.7 million in the second quarter of 2004.
Policyholder redemptions of annuity and, to a lesser extent, life products increased in 2002. We experienced additional redemptions following the downgrade of our A.M. Best financial strength rating to "B (fair)" in August of 2002. When redemptions are greater than our previous assumptions, we are required to accelerate the amortization of our cost of policies produced and cost of policies purchased to write off the balance associated with the redeemed policies. Accordingly, amortization expense was increased. In 2002, we changed the lapse assumptions used to determine the amortization of the cost of policies produced and the cost of policies purchased related to certain universal life products and our annuities to reflect our then current estimates of future lapses. For certain universal life products, we changed the ultimate lapse assumption from: (i) a range of 6 percent to 7 percent; to (ii) a tiered assumption based on the level of funding of the policy with a range of 2 percent to 10 percent. We recorded additional amortization of the cost of policies produced and the cost of policies purchased related to higher redemptions and changes to our lapse assumptions of $203.2 million in 2002.
At December 31, 2004, restricted cash 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 adequacy 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 $(3.3) million, $286.1 million and $(465.0) million in 2004, 2003 and 2002, respectively. Included in such net income (loss) were net realized capital gains (losses), net of income taxes, of $(17.7) million, $32.8 million and $(516.1) million in 2004, 2003 and 2002, respectively. In addition, such net income (loss) included amounts for fees and interest to Conseco or its non-life subsidiaries totaling $283.1 million (including $148 million related to prior years), $85.8 million and $112.4 million in 2004, 2003 and 2002, respectively.
interest in the subordinated certificates, we were the primary beneficiary of Brickyard. In accordance with ARB 51 "Consolidated Financial Statements", Brickyard was consolidated in our financial statements because our investment management subsidiary, 40|86 Advisors, Inc., was the investment manager and we owned a significant interest in the subordinated certificates.
The trust sold all of the commercial loans, repaid the senior notes and distributed its remaining assets to the subordinated certificate holders by the third quarter of 2003. We recognized an impairment loss of $11.1 million during the second quarter of 2003 to record an other-than-temporary decline in the value of certain of the trust's commercial loans. No additional gain or loss was recognized upon the ultimate disposition of Brickyard.
The three investment trusts were VIEs under FIN 46 because the trusts' equity represented significantly less than 10 percent of total capital and the subordinated junior notes were intended to absorb expected losses and receive virtually all residual returns. Based on our 100 percent ownership of the subordinated junior notes, we were the primary beneficiary of the investment trusts. All three trusts were consolidated in our financial statements at December 31, 2003. The carrying value of the total invested assets in the three trusts was approximately $228 million at December 31, 2003, which also represented Conseco's maximum exposure to loss as a result of our ownership interests in the trusts. The trusts had no obligations or debt to outside parties.
- ---------------- (a) CFC's statement of operations information has been presented as a discontinued operation in Conseco's consolidated financial statements for the year ended December 31, 2002. (b) Intercompany accounts were eliminated when consolidated with Conseco and its other wholly-owned subsidiaries.
The following table reconciles CFC's net loss as presented on the previous page to the amount of discontinued operations included in the accompanying consolidated statement of operations (dollars in millions):
CFC amortized retained servicing rights in proportion to, and over the estimated period of, net servicing income.
Subsequent to September 8, 1999, CFC structured its securitizations in a manner that required them to be accounted for as financing transactions, whereby the finance receivables and securitization debt remained on CFC's balance sheet.
CFC carried finance receivables at amortized cost, net of an allowance for credit losses. CFC deferred fees received and costs incurred in originating finance receivables, then amortized such deferred fees, costs, discounts and premiums over the estimated lives of the receivables.
During 2002, CFC completed six securitization transactions, securitizing $2.7 billion of finance receivables. These securitizations were structured in a manner that required them to be accounted for as secured borrowings pursuant to Statement of Financial Accounting Standards No. 140, "Accounting for the Transfer and Servicing of Financial Assets and Extinguishment of Liabilities". CFC classified the finance receivables transferred to the securitization trusts and held as
During 2002, CFC's ability to access the securitization markets was eliminated. The securitization markets were CFC's main source of funding for loans made to purchasers of repossessed manufactured homes. Since CFC was no longer able to fund the loans made on repossessed homes through these channels, CFC had to use the wholesale channel to dispose of repossessed manufactured housing units, through which recovery rates were significantly lower. Accordingly, CFC changed its loss severity assumptions used to value its retained interests to reflect the higher loss severity expected in the future. As a result of these assumption changes, CFC recognized an impairment charge of $1,077.2 million in 2002 for the retained beneficial interests. CFC also recognized a $336.5 million increase in the valuation allowance as a result of changes to the expected future cost of servicing the finance receivables. The levels of delinquent and defaulting loans caused servicing costs to increase. CFC increased the default assumptions it used to value its retained interests to reflect its future expectations. CFC's home equity/home improvement assumptions were adjusted to reflect recent default experience as well as CFC's future expectations.
Components of the cost CFC recognized related to its pension plan were as follows (dollars in millions):
Notes Payable, Representing Direct Finance Obligations (Excluding Notes Payable Related to Securitized Finance Receivables Structured as Collateralized Borrowings)
During 2002, CFC repurchased $46.9 million par value of its senior subordinated notes and medium term notes resulting in a gain on the extinguishment of debt of $6.3 million. In March 2002, CFC completed a tender offer pursuant to which it purchased $75.8 million par value of its senior subordinated notes due June 2002. The purchase price was equal to 100 percent of the principal amount of the notes plus accrued interest. The remaining principal amount outstanding of $58.5 million (including $23.7 million held by Conseco) of the senior subordinated notes was retired at maturity on June 3, 2002.
In 2002, CFC incurred a $16.3 million charge for the abandonment of certain computer processing systems. CFC was abandoning such systems as a result of recent changes to its business and its decision to no longer originate certain types of loans.
The following summarizes selected financial information of CVIC (dollars in millions):