Finance operations. Certain corporate servicing operations are housed in Saint Paul, Minnesota, in 110,000 square feet of a building owned by the Company. The finance segment operates 51 manufactured housing regional service centers and three commercial finance business centers. Such offices are leased, typically for a term of three to five years, and range in size from 1,700 to 22,000 square feet. We also operate a central servicing center in Rapid City, South Dakota. The lease on this facility is for a term of five years, with an option to purchase, and consists of 137,000 square feet. The home improvement and consumer product divisions lease their main office in Saint Paul, Minnesota. The lease is for a term of five years and consists of 125,000 square feet. The home equity business has operations in six regional locations and 114 regional satellite offices, plus a service center in Tempe, Arizona, which opened in February 1997. The equipment and leasing business is housed in leased facilities in Bloomington, Minnesota (22,000 square feet) and Paramus, New Jersey (44,000 square feet). The finance division's insurance business and certain corporate functions are housed in a leased facility in Eagan, Minnesota. This facility provides 83,000 square feet with a lease commitment of two years.
(b) Net income of $467.1 million for the year ended December 31, 1998, or $1.40 per diluted share, included nonrecurring and impairment charges totaling $503.8 million (net of taxes), or $1.52 per share. Such amounts were comprised of (i) $148.0 million of merger-related costs; (ii) $549.4 million to write down the carrying value of Green Tree's interest-only securities and servicing rights; and (iii) income taxes of $193.6 million.
(e) Includes premiums received from universal life products and products without mortality or morbidity risk. Such premiums are not reported as revenues under GAAP and were $2,585.7 million in 1998; $2,099.4 million in 1997; $1,881.3 million in 1996; $1,757.5 million in 1995; and $634.6 million in 1994. Also includes deposits in mutual funds and certificates of deposits totaling $117.1 million in 1998 and $19.9 million in 1997.
(f) Represents income before extraordinary charge, net investment gains (losses) of our life insurance and corporate segments (less that portion of amortization of cost of policies purchased and cost of policies produced and income taxes relating to such gains (losses)), and nonrecurring and impairment charges (net of income taxes).
(h) Excludes the effects of reporting fixed maturities at fair value and recording the unrealized gain or loss on such securities as a component of shareholders' equity, net of tax and other adjustments.
In this section, we review the consolidated financial condition of Conseco at December 31, 1998 and 1997, the consolidated results of operations for the three years ended December 31, 1998, and where appropriate, factors that may affect future financial performance. We have prepared all financial information to give retroactive effect to the merger with Green Tree (the "Green Tree Merger") accounted for as a pooling of interests. Please read this discussion in conjunction with the accompanying consolidated financial statements, notes and selected consolidated financial data.
Net income of $467.1 million in 1998, or $1.40 per diluted share, included (i) net investment losses (net of related costs, amortization and taxes) of $32.8 million, or 10 cents per share; (ii) an extraordinary charge (net of taxes) of $42.6 million, or 13 cents per share, related to early retirement of debt; (iii) the impairment loss (net of taxes) of $355.8 million, or $1.08 per share, to reduce the value of interest-only securities and servicing rights; and (iv) a nonrecurring charge (net of taxes) of $148.0 million, or $.44 per share, related primarily to merger costs incurred in conjunction with the Green Tree Merger.
Net income of $866.4 million in 1997, or $2.52 per diluted share, included: (i) net investment gains (net of related costs, amortization and taxes) of $44.1 million, or 13 cents per diluted share; (ii) an extraordinary charge of $6.9 million, or 2 cents per share, related to early retirement of debt; (iii) a charge of 4 cents per share related to the induced conversion of preferred stock (treated as a preferred stock dividend); (iv) an impairment loss totaling $117.8 million or 35 cents per share and (v) nonrecurring charges totaling $44.8 million, or 13 cents per share. Nonrecurring charges included: (i) $40.5 million related to premium deficiencies on our Medicare supplement business in the state of Massachusetts; and (ii) $4.3 million related to the death of an executive officer. The impairment loss represents a charge to reduce the value of interest-only securities and servicing rights generally due to adverse prepayments.
Net income of $452.2 million in 1996, or $1.69 per diluted share, included: (i) net investment gains (net of related costs, amortization and taxes) of $11.2 million, or 4 cents per diluted share; and (ii) an extraordinary charge of $26.5 million, or 10 cents per share, related to early retirement of debt.
RESULTS OF OPERATIONS BY SEGMENT FOR THE THREE YEARS ENDED DECEMBER 31, 1998:
The following tables and narratives summarize our operating results by business segment.
- ------------------------- (a) Revenues exclude net investment gains (losses); benefits and expenses exclude amortization related to realized gains.
General: Conseco's life insurance subsidiaries develop, market and administer annuity, supplemental health, individual life insurance, individual and group major medical and other insurance products. We distribute these products through a career agency force, professional independent producers and direct response marketing. The segment's 1998 results were affected by several recent acquisitions, including: Pioneer Financial Services, Inc. (acquired April 1, 1997); Colonial Penn Life Insurance Company and Providential Life Insurance Company (September 30, 1997); and Washington National Corporation (December 1, 1997).
Premiums and deposits collected in 1998 were $6.1 billion, up 20 percent over 1997. Premiums and deposits collected in 1997 were $5.1 billion, up 55 percent over 1996. These increases were primarily due to recent acquisitions and premium rate increases. On a pro forma basis, including in all periods premiums and deposits collected by companies owned at year end 1998 (excluding discontinued health products) collected premiums and deposits increased by 8.4 percent in 1998 and 2.6 percent in 1997.
Average insurance liabilities, net of reinsurance receivables, were $24.6 billion in 1998, up 15 percent over 1997, and $21.4 billion in 1997, up 37 percent over 1996.
Insurance policy income is comprised of: (i) premiums earned on policies which provide mortality or morbidity coverage; and (ii) fees and other charges made against other policies. See "Sales by Insurance Subsidiaries" for further analysis.
Net investment income from separate account assets is offset by a corresponding charge to amounts added to policyholder account balances for variable annuity products. Such income and related charge fluctuated in relationship to total separate account assets and the return earned on such assets.
The 1998 and 1997 loss ratios for major medical products reflect recent premium rate increases and claim management activities. The 1998 loss ratio also benefited from favorable claim developments.
The loss ratios on our other products have fluctuated over the last three years primarily because of the different characteristics of policies included in this category sold by recently acquired companies.
Contract originations in 1998 were $21.4 billion, up 37 percent over 1997. Contract originations in 1997 were $15.6 billion, up 48 percent over 1996.
Net investment income on finance receivables and other consists of: (i) interest earned on unsold finance receivables; and (ii) interest income on short-term and other investments. Such income increased by 29 percent, to $251.3 million, in 1998 and by 55 percent, to $194.6 million, in 1997, consistent with the increases in average finance receivables. The weighted average yield earned on finance receivables was 9.4 percent, 11.3 percent and 13.4 percent during 1998, 1997 and 1996, respectively.
Our gain on sale of finance receivables decreased by 4.4 percent, to $745.0 million, in 1998 and increased by 94 percent, to $779.0 million, in 1997. Our gain recognized at the time of the sale fluctuates when changes occur in: (i) the amount of loans sold; (ii) market conditions (such as the market interest rates available on securities sold in our securitizations); (iii) the amount and type of interest in the receivables sold that we retain; and (iv) assumptions used to calculate the gain. The account also reflects a charge of $200 million in 1996 as a result of adjustments necessary to fully consider the effects of partial prepayments on projected future interest collections and the impact of changes in projected future interest due to investors. Such adjustments were calculated using the cash out method to measure the period of time for which projected cash flows related to securitizations should be discounted.
Finance interest expense increased by 33 percent, to $213.7 million, in 1998 and by 130 percent, to $160.9 million, in 1997. We increased borrowings to fund the increase in our average inventory of finance receivables from increases in our loan originations, commercial revolving credit and lease portfolio financings and securities held from our securitizations. These increases were offset somewhat by a decrease in our average borrowing rate, which was 7.2 percent, 8.1 percent and 8.7 percent during 1998, 1997 and 1996, respectively, and a reduction in borrowings attributable to the proceeds of the $1.1 billion capital contribution from Conseco in 1998.
Other operating costs and expenses include the costs associated with servicing our managed receivables, and non-deferrable costs related to originating new loans. Such expense increased by 33 percent, to $591.9 million, in 1998 and by 35 percent, to $444.5 million, in 1997, reflecting: (i) the growth in our servicing portfolio; and (ii) the increased volume of contracts originated.
a portion of the impairment charge would be recognized in earlier periods. After analysis and discussion with the relevant auditors, we concluded that all of this charge should be recognized in 1998. The 1997 charge was generally due to adverse prepayment experience.
Our recent acquisitions have a significant effect on premiums collected. Total premiums and deposits collected for all currently consolidated companies for 1998, 1997 and 1996 (including periods prior to their acquisition by Conseco) are provided below:
Life products are sold through career agents, professional independent producers and direct response distribution channels. Life premiums collected in 1998 were $928.8 million, up 31 percent over 1997. Life premiums collected in 1997 were $709.2 million, up 76 percent over 1996. Such increases relate primarily to premiums collected by recently acquired companies in periods after their acquisition.
Traditional fixed-rate annuity products include single-premium deferred annuities ("SPDAs"), flexible-premium deferred annuities ("FPDAs") and single-premium immediate annuities ("SPIAs"), which are credited with a guaranteed rate. The demand for traditional fixed-rate annuity contracts has decreased in recent years, as relatively low interest rates have made other investment products more attractive. SPDA and FPDA policies typically have an interest rate that is guaranteed for the first policy year, after which we have the discretionary ability to change the crediting rate to any rate not below a guaranteed rate. The interest rate credited on a SPIA is based on the market conditions existing when the policy is issued and remains unchanged over the life of the SPIA. Annuity premiums on these products decreased by 17 percent, to $773.6 million, in 1998 and by 24 percent, to $937.3 million, in 1997.
Supplemental health products include Medicare supplement, long-term care and specified disease insurance products distributed through a career agency force and professional independent producers. Our profits on supplemental health policies depend on the overall level of sales, the persistency of the in-force business, claim experience and expense management.
Collected premiums on Medicare supplement policies increased by 15 percent, to $916.7 million, in 1998 and by 29 percent, to $796.2 million, in 1997, primarily reflecting our recent acquisitions, a reinsurance assumption agreement and rate increases. Sales of Medicare supplement policies have been affected by: (i) steps taken to improve profitability by increasing premium rates and changing our commission structure and underwriting criteria; (ii) increased competition from alternative providers, including HMOs; and (iii) reduced production in Massachusetts due to our decision to cease writing new business in that state (as announced in the third quarter of 1997).
Premiums collected on specified disease products were $392.3 million and $383.6 million in 1998 and 1997, respectively. Substantially all of the premiums collected in both periods are from recently acquired companies.
Individual and group major medical products include individual and group major medical health insurance products. Group premiums increased by 5.3 percent, to $554.4 million, in 1998 and by 81 percent, to $526.3 million, in 1997. Individual health premiums increased by 49 percent, to $323.8 million, in 1998 and by 328 percent, to $217.7 million in 1997. The increases principally reflect recent acquisitions.
Other health products include: (i) various other health insurance products that are not currently being actively marketed; and (ii) in 1998, the specialty health insurance products of a recently acquired company marketed to educators. Premiums collected in 1998 were $120.7 million, up 74 percent over 1997. Premiums collected in 1997 were $69.3 million, up 27 percent over 1996. We have discontinued the sale of our other health products; collected premiums will decrease in future periods. The in-force business continues to be profitable.
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 income and total investment return through active investment management. Consistent with this strategy, investments in fixed maturity securities, mortgage loans, policy loans, separate accounts and short-term investments made up 90 percent of our $29.2 billion investment portfolio at December 31, 1998. The remainder of the invested assets were equity securities and other invested assets.
Although investment income is a significant component of total revenues, the profitability of certain of our insurance products is determined primarily by the spreads between the interest rates we earn and the rates we credit or accrue to our insurance liabilities. At December 31, 1998, the average yield, computed on the cost basis of our investment portfolio, was 7.3 percent, and the average interest rate credited or accruing to our total insurance liabilities was 5.1 percent, excluding interest bonuses guaranteed only for the first year of the contract.
Our actively managed fixed maturity portfolio at December 31, 1998, included primarily debt securities of the United States government, public utilities and other corporations, and mortgage-backed securities. Mortgage-backed securities included collateralized mortgage obligations ("CMOs") and mortgage-backed pass-through securities.
At December 31, 1998, approximately 6.9 percent of our invested assets (9.2 percent of fixed maturity investments) were rated below-investment grade by nationally recognized statistical rating organizations (or, if not rated by such firms, with ratings below Class 2 assigned by the NAIC). We plan to maintain approximately the present level of below-investment-grade fixed maturities. These securities generally have greater risks than other corporate debt investments, including risk of loss upon default by the borrower, and are
often unsecured and subordinated to other creditors. Below-investment-grade issuers usually have higher levels of indebtedness and are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than are investment-grade issuers. We are aware of these risks and monitor our below-investment-grade securities closely. At December 31, 1998, our below-investment-grade fixed maturity investments had an amortized cost of $2,237.1 million and an estimated fair value of $1,999.6 million.
We periodically 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. Information reviewed may include the recent operational results and financial position of the issuer, information about its industry, recent press releases and other information. Conseco employs a staff of experienced securities analysts in a variety of specialty areas. Among its other responsibilities, this staff is charged with compiling and reviewing such information. 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 net realizable 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 in the cost basis of an investment only upon the sale, repayment or other disposition of the investment. In 1998, we recorded writedowns of fixed maturity investments, equity securities and other invested assets totaling $32.4 million. 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, 1998, our fixed maturity investments in substantive default (i.e., in default due to nonpayment of interest or principal) had an amortized cost and carrying value of $56.5 million and $48.7 million, respectively. The Company had no fixed maturity investments in technical (but not substantive) default (i.e., in default, but not as to the payment of interest or principal). There were no other fixed maturity investments about which we had serious doubts as to the ability of the issuer to comply on a timely basis with the material terms of the instrument.
When a security defaults, our policy is to discontinue the accrual of interest and eliminate all previous interest accruals, if we determine that such amounts will not be ultimately realized in full. Investment income forgone due to defaulted securities was not significant in any of the three years ended December 31, 1998.
Mortgage-backed securities held in our fixed maturity portfolio at December 31, 1998, summarized by interest rates on the underlying collateral were as follows:
Mortgage-backed securities held in our fixed maturity portfolio at December 31, 1998, summarized by security type, were as follows:
Planned amortization classes and accretion-directed bonds are some of the most stable and liquid instruments in the mortgage-backed securities market. Planned amortization class bonds adhere to a fixed
schedule of principal payments as long as the underlying mortgage collateral experiences prepayments within a certain range. Changes in prepayment rates are first absorbed by support classes. This insulates the planned amortization classes from the consequences of both faster prepayments (average life shortening) and slower prepayments (average life extension).
At December 31, 1998, we held $349.0 million of trading securities; they are included in other invested assets. Trading securities are investments we intend to sell in the near term. We carry trading securities at estimated fair value; changes in fair value are reflected in the statement of operations.
Short-term investments totaled $1,704.7 million, or 5.8 percent of invested assets at December 31, 1998, and consisted primarily of commercial paper and repurchase agreements relating to government securities.
equal to the loan value. The weighted average interest rate on short-term collateralized borrowings was 5.4 percent in 1998. The primary risk associated with short-term collateralized borrowings is that the counterparty will be unable to perform under the terms of the contract. Our exposure is limited to the excess of the net replacement cost of the securities over the value of the short-term investments (which was not material at December 31, 1998). We believe that the counterparties to our reverse repurchase and dollar-roll agreements are financially responsible and that counterparty risk is minimal.
In some securitizations, we also retain certain lower-rated securities which are senior in payment priority to the interest-only securities. These securities had a fair market value of $340.8 million at December 31, 1998, and are classified as actively managed fixed maturity securities. We intend to hold these securities for investment purposes, but may sell them in the future. In addition, our life insurance subsidiaries, from time-to-time prior to our merger with Green Tree, have purchased interests in the securities of the special purpose entities. These securities are also classified as fixed maturity investments.
(c) Includes receivables in the process of foreclosure and repossessed collateral in process of liquidation as a percentage of managed finance receivables at period end.
On a quarterly basis, we estimate the fair value of our interest-only securities by discounting the projected future cash flows using current assumptions. If we determine that the differences between the estimated fair value and the carrying value of these securities is a temporary difference, we adjust shareholders' equity. At December 31, 1998, this adjustment, which was considered to be a temporary decline, decreased the carrying value of the interest-only securities by $8.2 million. Declines in value are considered to be other than temporary when the present value of the estimated future cash flows discounted at a risk free rate using current assumptions is less than the carrying value of the interest-only securities. When this occurs, we reduce the amortized cost to the estimated fair value and recognize a loss in the statement of operations.
During the second quarter of 1998, prepayments on loan contracts continued to exceed expectations and management concluded that such prepayments were likely to continue to be higher than expected in future periods as well. We recognized a $549.4 million impairment charge to reduce the carrying value of interest-only securities and servicing rights, in the second quarter of 1998 as described above under "Finance Operations."
Total capital (excluding the notes payable of the finance segment used to fund finance receivables) at December 31, 1998 and 1997, was as follows:
Shareholders' equity increased by $59.7 million in 1998, to $5.3 billion. Significant components of the increase included: (i) net income of $467.1 million; (ii) the conversion of convertible debentures into common stock having a value of $67.4 million; and (iii) the issuance of common stock related to stock options and employee benefit plans of $221.2 million (including the tax benefit thereon). These increases were partially offset by: (i) repurchases of common stock for $308.4 million; (ii) common and preferred stock dividends totaling $166.3 million; and (iii) the decrease in net unrealized appreciation of $229.1 million.
- ------------------------- (a) Excludes the effect of reporting fixed maturities at fair value.
(e) These ratios are calculated in a manner discussed with rating agencies.
(g) Total capital includes amounts for the purchase of common shares pursuant to stock purchase contracts related to FELINE PRIDES (as described in the notes to the consolidated financial statements) as if such shares had been purchased.
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 surrender and withdrawal penalty provisions. We seek to balance the duration of our invested assets with the estimated duration of benefit payments arising from our contract liabilities.
Insurance liabilities for interest-sensitive products by credited rate (excluding interest rate bonuses for the first policy year only) at December 31, 1998 were as follows (dollars in millions):
The most important liquidity source for our finance operations has been our ability to sell finance receivables in the secondary markets through loan securitizations. Under certain securitized sales structures, we have provided a variety of credit enhancements, which generally take the form of corporate guarantees, but have also included bank letters of credit, surety bonds, cash deposits and over-collateralization or other equivalent collateral. When choosing the appropriate structure for a securitized loan sale, we analyze the cash flows unique to each transaction, as well as the marketability and projected economic value of such transactions. The structure of each securitized sale depends, to a great extent, on conditions in the fixed-income markets at the time of sale as well as on cost considerations and the availability and effectiveness of the various enhancement methods.
In some recent securitizations, we elected to hold certain lower-rated securities rather than sell them at market prices prevalent in recent months. We may also choose to retain additional securities from future securitizations. We believe there are adequate sources of liquidity to continue to hold a reasonable quantity of such securities while still maintaining current levels of loan originations. Holding these securities results in reduced gains from the sale of finance receivables and comparable increases in the interest income spread we earn while the securities are held. In addition, volatility in the asset-backed securities markets may cause a reduction in the profits we realize on the finance receivables we sell. Several competing lenders have announced in recent months that they are no longer lending in product lines that provide the majority of our new loans. Brokers who previously expected to sell completed loans to such lenders have solicited bids from us and others to purchase these loans. Moreover, we and other lenders have increased the interest rates charged on new loans in recent months. We are unable to estimate the amount of increased business, if any, or the level of profitability thereon that might result from these events.
The parent company is a legal entity, separate and distinct from its subsidiaries, and has no business operations. The parent company needs cash for: (i) principal and interest payments on debt; (ii) dividends on preferred and common stock; (iii) payments to subsidiary trusts to be used for distributions on the Company-obligated mandatorily redeemable preferred securities of subsidiary trusts; (iv) holding company administrative expenses; (v) income taxes; and (vi) investments in subsidiaries. The primary sources of cash to meet these obligations are payments from our operating subsidiaries. The statutorily permitted payments from our life insurance subsidiaries include: (i) fees for services provided; (ii) tax sharing payments; (iii) dividend payments; and (iv) surplus debenture interest and principal payments. We also receive dividend and tax-sharing payments from our non-insurance subsidiaries. The parent company may also obtain cash by: (i) issuing debt or equity securities; (ii) borrowing additional amounts under its revolving credit agreement, as described in the notes to the consolidated financial statements; or (iii) selling all or a portion of its subsidiaries. These sources have historically provided adequate cash flow to fund: (i) the needs of the parent company's normal operations; (ii) internal expansion, acquisitions and investment opportunities; and (iii) the retirement of debt and equity.
The ability of our insurance subsidiaries to pay dividends is subject to state insurance department regulations. These regulations generally permit dividends to be paid from 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) net gain from operations for the prior year; or (ii) 10 percent of 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. After deduction of $205.1 million of fees and interest paid to Conseco in 1998, the remaining statutory earnings of our insurance subsidiaries permit distributions to Conseco in 1999 of approximately $202 million without the permission of regulatory authorities. In addition, our finance subsidiary had operating cash flows of approximately $350.0 million and our subsidiaries other than insurance and finance had operating cash flows of approximately $95.0 million.
Medical cost inflation has had a significant impact on our supplemental health operations. Generally, these costs have increased more rapidly than the Consumer Price Index. Medical costs will likely continue to rise. The impact of medical cost inflation on our operations depends on our ability to increase premium rates. Such increases are subject to approval by state insurance departments. We seek to price our new standardized supplement plans to reflect the impact of these filings and the lengthening of the period required to implement rate increases.
For some of our year-2000 issues, we are working to complete the previously planned conversions of older systems to the more modern, year-2000-ready systems already used in other areas of the Company. In other cases, we are purchasing new, more modern systems; these costs are being capitalized as assets and amortized over their expected useful lives. In the remaining cases, we are modifying existing systems; these costs are being charged to operating expense.
We currently estimate that the total expense of our year-2000 projects will be approximately $70 million. This expense is not material to Conseco's financial position and we are funding it through operating cash flows. Approximately 75 percent of this expense was incurred in 1996, 1997 and 1998. This expense related primarily to modifying existing software systems.
The impact of year-2000 issues will depend not only on the corrective actions we take, but also on the way in which year-2000 issues are addressed by governmental agencies, businesses and other third parties: (i) that provide services, utilities or data to the Company; (ii) that receive services or data from the Company; or (iii) whose financial condition or operating capability is important to the Company. We are in the process of identifying risks and updating assessments of potential year-2000 risks associated with our external business relationships, such as third-party administrators, utilities and financial institutions. These procedures are necessarily limited to matters over which we are able to reasonably exercise control. We have been informed by our key financial institutions and utilities that they will be year-2000 ready at year-end 1999.
The failure to correct a material year-2000 problem could result in an interruption in, or failure of, a number of normal business activities or operations. Such failures could materially and adversely affect the Company's results of operations, liquidity and financial condition. Due to the general uncertainty inherent in the year-2000 problem, including the uncertainty of the preparedness of our external business relationships, we are not able to currently determine whether the consequences of year-2000 failures will have a material impact on the Company's results of operations, liquidity and financial condition. However, we believe our year-2000 readiness efforts will minimize the likelihood of a material adverse impact.
Our finance receivables are funded primarily with floating-rate debt. We substantially reduce interest rate risk by selling such receivables through securitizations. The finance receivables sold and the asset-backed securities purchased by investors generally both have fixed rates. Principal payments on the assets are passed through to investors in the securities as received, thereby reducing interest rate exposure in these transactions that might otherwise arise from maturity mismatches between debt instruments and assets.
We use computer models to simulate the cash flows expected from our interest-only securities under various interest rate scenarios. These simulations enable us to measure the potential gain or loss in fair value of these financial instruments, including the effects of changes in interest rates on prepayments. We estimate that our interest-only securities would decline in fair value by approximately $79 million if interest rates were to decrease by 10 percent from their December 31, 1998 levels. 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 interest-only securities in reaction to such change. Consequently, potential changes in value of our interest-only securities indicated by the simulations will likely
be different from the actual changes experienced under given interest rate scenarios, and the differences may be material.
For investment purposes, we periodically enter into interest rate swap agreements which effectively exchange a fixed rate of interest on a notional amount ($1.7 billion at December 31, 1998) for a floating rate. At December 31, 1998, such interest rate swap agreements were scheduled to mature in various years through 2008 and had an average remaining life of five years (the average call date is 2.7 years). If the counterparties of these interest rate swaps do not meet their obligations, Conseco could have a loss. Conseco limits its exposure to such a loss by diversifying among several counterparties believed to be financially sound and creditworthy. At December 31, 1998, all of the counterparties were rated "A" or higher by Standard & Poor's Corporation. Based on the interest rate exposure and prevalent rates at December 31, 1998, a relative 10 percent increase in interest rates would cause the value of our interest rate swaps to decrease by $4.1 million.
The integrity of the financial information relies in large part on maintaining a system of internal control that is established by management to provide reasonable assurance that assets are safeguarded and transactions are properly authorized, recorded and reported. Reasonable assurance is based upon the premise that the cost of controls should not exceed the benefits derived from them. The Company's internal auditors continually evaluate the adequacy and effectiveness of this system of internal control and actions are taken to correct deficiencies as they are identified.
The Audit Committee of the Board of Directors, composed solely of independent directors, meets periodically with management, internal auditors and the independent accountants to review internal accounting control, audit activities and financial reporting matters. The internal auditors, independent accountants and Audit Committee have full and free access to each other.
We have audited the accompanying consolidated balance sheet of Conseco, Inc. and Subsidiaries as of December 31, 1998 and 1997, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1998. The consolidated financial statements give retroactive effect to the merger of Conseco, Inc. and Green Tree Financial Corporation on June 30, 1998, which has been accounted for as a pooling of interests as described in note 1 to the consolidated financial statements. 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 did not audit the consolidated financial statements of Green Tree Financial Corporation and subsidiaries as of and for the years ended December 31, 1997 and 1996 which statements reflect total assets of 11 percent as of December 31, 1997 and total revenues of 16 percent and 19 percent for the years ended December 31, 1997 and 1996, respectively, of the related consolidated financial statement totals. Those statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to data included for Green Tree Financial Corporation, is based solely on the report of the other auditors.
In our opinion, based on our audits and the report of other auditors, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Conseco, Inc. and Subsidiaries as of December 31, 1998 and 1997, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1998, after giving retroactive effect to the merger of Conseco, Inc. and Green Tree Financial Corporation described in note 1 to the financial statements, all in conformity with generally accepted accounting principles.
CONSOLIDATED BALANCE SHEET (CONTINUED) DECEMBER 31, 1998 AND 1997 (DOLLARS IN MILLIONS)
CONSOLIDATED STATEMENT OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY, CONTINUED FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996 (DOLLARS IN MILLIONS)
The following summary explains the accounting policies we use to arrive at the more significant numbers in our financial statements. We prepare our financial statements in accordance with generally accepted accounting principles ("GAAP"). We follow the accounting standards established by the Financial Accounting Standards Board, the American Institute of Certified Public Accountants and the Securities and Exchange Commission. We have restated all share and per-share amounts for the two-for-one stock splits distributed February 11, 1997 and April 1, 1996.
Fixed maturities are securities that mature more than one year after issuance and include bonds, notes receivable and redeemable preferred stock. Fixed maturities that we may sell prior to maturity are classified as actively managed and are carried at estimated fair value, with any unrealized gain or loss, net of tax and related adjustments, recorded as a component of shareholders' equity. Fixed maturity securities that we intend to sell in the near term are classified as trading and included in other invested assets. We include any unrealized gain or loss on trading securities in net investment gains.
Interest-only securities represent the right to receive certain future cash flows from our securitized receivable sales. Such cash flows generally are equal to the value of the principal and interest to be collected on the underlying financial contracts of each securitization in excess of the sum of the principal and interest to be paid on the securities sold and contractual servicing fees. We carry interest-only securities at estimated fair value. We determine fair value by discounting the projected cash flows over the expected life of the receivables sold using current prepayment, default, loss and interest rate assumptions. In 1997, we adopted the cash out method to measure the period of time for which projected cash flows related to securitizations should be discounted and used that method to measure the adjustment recorded as a restatement of the carrying value of the interest-only securities as of December 31, 1996 and the valuation of the interest-only securities as of December 31, 1997. We record any unrealized gain or loss determined to be temporary, net of tax, as a component of shareholders' equity. Declines in value are considered to be other than temporary when the CONSECO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
Equity securities include investments in common stocks and non-redeemable preferred stock. We carry these investments at estimated fair value. We record any unrealized gain or loss, net of tax and related adjustments, as a component of shareholders' equity.
Other invested assets include: (i) trading securities; (ii) Standard & Poor's 500 Call Options ("S&P 500 Call Options"); and (iii) certain non-traditional investments. We carry the S&P 500 Call Options at estimated fair value as further described below under "Standard & Poor's 500 Index Call Options and Interest Rate Swap Agreements". Non-traditional investments include investments in venture capital funds, limited partnerships, mineral rights and promissory notes; we account for them using either the cost method, or for investments in partnerships over whose operations the Company exercises significant influence, the equity method. Non-traditional investments at December 31, 1998, also included $511.7 million of investments held in trust for the benefit of the purchasers of certain products of our asset management subsidiary; this amount is offset by the liabilities account, "liabilities related to deposit products", the value of which fluctuates in relation to changes in the values of these investments. Because we hold the residual interests in the cash flows from the trust and actively manage its investments, we are required to include the accounts of the trust in our consolidated financial statements.
When we sell a security (other than a trading security), we report the difference between our sale proceeds and its amortized cost (determined based on specific identification) as an investment gain or loss.
We regularly evaluate all of our investments 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, we treat it as a realized loss and reduce our cost basis of the security to its estimated fair value.
When we sell investments backing our universal life or investment-type product business at a gain or loss, we adjust the amortization to reflect the change in future investment yields resulting from the sale (thereby changing the future amortization to offset the change in yield). We also adjust the cost of policies produced for the change in amortization that would have been recorded if actively managed fixed maturity securities had been sold at their stated aggregate fair value and the proceeds reinvested at current yields. We include the impact of this adjustment in net unrealized appreciation (depreciation) within shareholders' equity.
In the normal course of business, we seek to limit our exposure to loss 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. If any reinsurer could not meet its obligations, the Company would assume the liability. The likelihood of a material loss being incurred as the result of the failure of one of our reinsurers is considered remote. The cost of reinsurance ceded totaled $541.3 million, $499.0 million and $313.8 million in 1998, 1997 and 1996, respectively. Reinsurance recoveries netted against insurance policy benefits totaled $484.3 million, $587.5 million and $281.4 million in 1998, 1997 and 1996, respectively.
As part of our investment strategy, we may enter into reverse repurchase agreements and dollar-roll transactions to increase our investment return or to improve our liquidity. We account for these transactions as collateral borrowings, where the amount borrowed is equal to the sales price of the underlying securities. 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, with dollar rolls, the repurchase involves securities that are only substantially the same as the securities sold. We account for these transactions as short-term collateralized borrowings. Such borrowings averaged approximately $1,092.4 million during 1998 (compared with an average of $719.3 million during 1997) and were collateralized by investment securities with fair values approximately equal to the loan value. The weighted average interest rate on short-term collateralized borrowings was 5.4 percent in 1998 and 5.8 percent in 1997. The primary risk associated with short-term collateralized borrowings is that a counterparty will be unable to perform under the terms of the contract. Our exposure is limited to the excess of the net replacement cost of the securities over the value of the short-term investments (such excess was not material at December 31, 1998). We believe the counterparties to our reverse repurchase and dollar-roll agreements are financially responsible and that the counterparty risk is minimal.
When we prepare financial statements in conformity with GAAP, we are required to make estimates and assumptions that significantly affect various reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting periods. For example, we use significant estimates and assumptions in calculating values for the cost of policies produced, the cost of policies purchased, interest-only securities, servicing rights, goodwill, liabilities for insurance and deposit products, liabilities related to litigation, guaranty fund assessment accruals, gain on sale of finance receivables and deferred income taxes. If our future experience differs from these estimates and assumptions, our financial statements could be materially affected.
If the counterparties of the aforementioned financial instruments fail to meet their obligations, Conseco may have to recognize a loss. Conseco limits its exposure to such a loss by diversifying among several counterparties believed to be strong and creditworthy. At December 31, 1998, all of the counterparties were rated "A" or higher by Standard & Poor's Corporation.
REVENUE RECOGNITION FOR SALES OF FINANCE RECEIVABLES AND AMORTIZATION OF SERVICING RIGHTS
Effective January 1, 1997, we account for the sale of finance receivables in accordance with Statement of Financial Accounting Standards No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities "("SFAS 125"). In applying SFAS 125 to our securitized sales, we are required to recognize a gain, representing the difference between the proceeds from the sale (net of related sale costs) and the carrying value of the component of the finance receivable sold. We determine such carrying amount by allocating the carrying value of the finance receivables between the portion we sell and the interests we retain (generally interest-only securities, other securities classified as fixed maturity securities, and servicing rights), based on each portion's relative fair values on the date of the sale.
Investment securities. For fixed maturity securities (including redeemable preferred stocks) and for equity and trading securities, we use quotes from independent pricing services, where available. For investment securities for which such quotes are not available, we use values obtained from broker-dealer market makers or by discounting expected future cash flows using a current market rate appropriate for the yield, credit quality, and (for fixed maturity securities) the maturity of the investment being priced.
Short-term investments. We use quoted market prices. The carrying amount for these instruments approximates their estimated fair value.
Insurance liabilities for investment contracts. We discount future expected cash flows based on interest rates currently being offered for similar contracts with similar maturities.
- ------------------------- (1) The estimated fair value of the liabilities for investment contracts was approximately equal to its carrying value at December 31, 1998 and 1997. This was because interest rates credited on the vast majority of account balances approximate current rates paid on similar investments and because these rates are not generally guaranteed beyond one year. We are not required to disclose fair values for insurance liabilities, other than those for investment contracts. However, we take into consideration the estimated fair values of all insurance liabilities in our overall management of interest rate risk. We attempt to minimize exposure to changing interest rates by matching investment maturities with amounts due under insurance contracts.
We recognized a $190.0 million impairment charge in 1997 generally due to adverse prepayment experience.
The following table sets forth the amortized cost and estimated fair value of actively managed fixed maturities at December 31, 1998, 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 mortgage-backed securities shown below provide for periodic payments throughout their lives.
Conseco had no investments in any single entity in excess of 10 percent of shareholders' equity at December 31, 1998, other than investments issued or guaranteed by the United States government or a United States government agency.
4. FINANCE RECEIVABLES, INTEREST-ONLY SECURITIES AND SERVICING RIGHTS OF FINANCE SUBSIDIARIES:
We pool and securitize substantially all of the finance receivables we originate. In a typical securitization, we establish a special purpose entity for the limited purpose of purchasing the finance receivables. This special-purpose entity issues and sells interest-bearing securities that represent interests in the receivables,
In some securitizations, we also retain certain lower-rated securities that are senior in payment priority to the interest-only securities. Such securities had a fair market value of $340.8 million at December 31, 1998, and were classified as actively managed fixed maturity securities.
The account value was adjusted to estimated fair value at December 31, 1997, using the following assumptions:
The following summarizes information with respect to the 60-days-and-over contractual dollar delinquencies, loss experience and repossessed collateral experience of our managed finance receivables:
Activity in the interest-only securities account during 1998 and 1997 is as follows:
The activity in the servicing rights account during 1998 and 1997 is as follows:
(c) In both 1998 and 1997: (i) approximately 95 percent of this liability represented account balances where future benefits are not guaranteed; and (ii) approximately 5 percent represented the present value of guaranteed future benefits determined using an average interest rate of approximately 6 percent.
The maturities of corporate and finance notes payable and commercial paper at December 31, 1998, were as follows:
The Company rents office space, equipment and computer software under noncancellable operating leases. Rental expense was $50.6 million in 1998, $48.2 million in 1997 and $30.0 million in 1996. Future required minimum rental payments as of December 31, 1998, were as follows (dollars in millions):
We used the following weighted average assumptions to calculate benefit obligations for our 1998 and 1997 valuations: discount rate of approximately 6.5 percent; an expected return on plan assets of approximately 7.5 percent; and an assumed rate of compensation increase of 5.5 percent. For measurement CONSECO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
purposes, we assumed a 9.5 percent annual rate of increase in the per capita cost of covered health care benefits for 1999, decreasing gradually to 5.0 percent in 2011 and remaining level thereafter.
In addition, the Company and its subsidiaries are involved on an ongoing basis in lawsuits related to their operations. Although the ultimate outcome of certain of such matters cannot be predicted, none of such lawsuits currently pending against the Company or its subsidiaries is expected, individually or in the aggregate, to have a material adverse effect on the Company's consolidated financial condition, cash flows or results of operations.
Conseco has guaranteed bank loans totaling $428.6 million to approximately 180 directors, officers and key employees. The funds were used by the participants to purchase approximately 12.5 million Conseco shares in open market on negotiated transactions with independent parties. Such shares are held by the bank as collateral for the loans. At December 31, 1998, the guaranteed bank loans exceeded the value of the common stock collateralizing the loans by $74.6 million. All participants have agreed to indemnify Conseco for any loss incurred on their note.
- ------------------------- (a) These securities may be redeemed anytime at: (i) the principal balance; plus (ii) a premium equal to the excess, if any, of the sum of the discounted present value of the remaining scheduled payments of principal and interest using a current market interest rate over the principal amount of securities to be redeemed.
(b) Each FELINE PRIDES includes: (a) a stock purchase contract under which the holder: (i) will purchase a number of shares of Conseco common stock on February 16, 2001 (ranging from .9363 and 1.1268 shares per FELINE PRIDES) under the terms specified in the stock purchase contract; and CONSECO, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
We are authorized to issue up to 20 million shares of preferred stock. At December 31, 1998, $105.5 million of PRIDES were outstanding, all of which were redeemed by the Company in February 1999 in exchange for 5.9 million shares of Conseco common stock.
As a result of the Green Tree Merger, all options previously issued by Green Tree became immediately exercisable on June 30, 1998. The following table summarizes information about stock options outstanding at December 31, 1998 (shares in thousands):
We apply Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations in accounting for our stock option plans. Accordingly, no compensation cost has been recognized for such plans. Had compensation cost been determined based on the fair value at the grant dates for awards granted after January 1, 1995, consistent with the method of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), the Company's pro forma net income and pro forma earnings per share for the years ended December 31, 1998, 1997 and 1996 would have been as follows:
At December 31, 1998, a total of 88.9 million shares of common stock were reserved for issuance under the convertible subordinated debentures, PRIDES, FELINE PRIDES, stock option, stock bonus and deferred compensation plans and for warrants to buy 700,000 shares of Conseco common stock for $13.8 million at anytime through September 29, 2006.
A reconciliation of income and shares used to calculate basic and diluted earnings per share is as follows:
Nonrecurring charges in 1997 included a $41.5 million increase to claim reserves and a $20.9 million write-off of cost of policies produced and cost of policies purchased related to premium deficiencies on our Medicare supplement business in Massachusetts. Regulators in that state have not allowed premium increases for Medicare supplement products needed to avoid losses on the business. We are currently seeking such rate increases. We are no longer writing new Medicare supplement business in Massachusetts. Nonrecurring charges in 1997 also included expenses of $9.3 million (net of proceeds from a life insurance policy) related to the death of an executive officer.
We have restated amounts previously reported for the second quarter of 1998 to reflect a correction to the impairment charge we previously reported. This change increased the previously reported net loss by $19.5 million ($.06 per diluted share).