The Company believes that these facilities are adequate for its current operating needs.
The following table presents certain consolidated financial data for the periods indicated and should be read in conjunction with the consolidated financial statements and notes thereto and Management's Discussion and Analysis of Financial Condition and Results of Operations appearing elsewhere in this Form 10-K. The Acquisition was accounted for as a purchase business combination pursuant to which the reported values of the Company's assets and liabilities were adjusted to their estimated fair values on the Acquisition date, September 29, 1994. The Company's income statement data for the year ended December 31, 1995, and the three months ended December 31, 1994, and the balance sheet data as of December 31, 1995 and 1994, represent results since the date of the Acquisition. Because of the purchase accounting adjustments and the indebtedness incurred in connection with the Acquisition, the financial data for periods following the Acquisition may not be comparable to the financial data for periods prior to the Acquisition. All share and per share information has been adjusted for the August 8, 1995 one-for-two stock split.
Operating data for periods subsequent to the Acquisition reflect the effect of purchase accounting adjustments to record the Company's assets and liabilities at their estimated fair value as of the Acquisition date and, accordingly, financial data of the Company for periods prior to the Acquisition may not be comparable with current financial data. Significant purchase accounting adjustments recorded at the Acquisition date include: (i) a reduction of $454.2 million in the amortized cost basis of fixed maturity investments; (ii) the establishment of a $454.3 million asset for the cost of policies purchased and the elimination of the $346.6 million asset for the cost of policies produced existing at the Acquisition date; (iii) the establishment of a $360.2 million goodwill asset to reflect the excess of the total purchase cost over the fair value of the net assets acquired; and (iv) the establishment of a deferred income tax asset of $129.3 million to reflect the income tax effects of all purchase accounting adjustments. These adjustments impact the comparability of operating data principally by causing net yields on invested assets, and thereby net investment income, to increase and by replacing amortization expense for the cost of policies produced with amortization expense for the cost of policies purchased and goodwill which have different amortization assumptions and bases than the amortization of the cost of policies produced prior to the Acquisition. Comparability is further impacted by the Acquisition due to the additional interest expense resulting from the Acquisition indebtedness and by the incurrence of the Acquisition transaction expenses.
Operating data for 1994 are presented in two periods: the three months ended December 31, 1994, and the nine months ended September 30, 1994 (the period preceding the Acquisition). As explained above, the purchase accounting adjustments resulting from the Acquisition materially affect the comparability of operating data for the periods before and after the Acquisition.
Net realized gains (losses) and net trading income (losses) often fluctuate from period to period. The Company sold approximately $2.8 billion of investments (principally fixed maturities) in 1995 compared to $1.1 billion in the 1994 periods which sales resulted in net realized gains of $154.9 million and trading income of $1.5 million in 1995 compared to net realized gains of $6.9 million and trading losses of $.8 million in the 1994 periods. Net realized gains from sales of investments in the 1994 periods were offset by a loss on certain interest rate swap contracts that no longer effectively hedged interest rate risks in the second quarter of 1994 and were therefore recorded at fair value, resulting in a net realized loss of $21.3 million. Substantially all of the Company's interest rate swap contracts were terminated subsequent to the Acquisition with no additional loss. In addition, during 1995 and the 1994 periods, the Company recorded realized losses on the writedown of investments totalling $7.1 million and $1.2 million, respectively, as a result of changes in conditions which caused the Company to conclude that a decline in fair value of the investments was other than temporary.
Interest expense on annuities and financial products increased 18 percent to $258.8 million in 1995 from $220.1 million in the 1994 periods primarily due to: (i) a larger block of annuity business in force in 1995; and (ii) the expensing of the first year interest rate bonuses of approximately $5.9 million in 1995 on policies issued prior to the Acquisition date as a result of the application of purchase accounting on the Acquisition date. Prior to the Acquisition date, such first year interest rate bonuses (related to policies issued prior to the Acquisition date) were capitalized as a cost of policies produced. At December 31, 1995 and 1994, the weighted average crediting rate for the Company's annuity liabilities excluding interest bonuses guaranteed for the first year of the annuity contract was 5.3 percent.
Amortization related to operations decreased 9 percent to $33.2 million in 1995 from $36.4 million in the 1994 periods. Amortization related to operations during the first nine months of 1994 is comprised solely of amortization of cost of policies produced. Amortization related to operations during 1995 and the last three months of 1994 is comprised of amortization of: (i) the cost of policies purchased for business in force at the Acquisition date; and (ii) the cost of policies produced for business written subsequent to the Acquisition date.
Cost of policies produced represents the cost of producing new business (primarily commissions, bonus interest and certain costs of policy issuance and underwriting) which varies with and is primarily related to the production of new business. Costs deferred may represent amounts paid in the period the new business is written (such as underwriting costs and first year commissions) or in periods after the business is written (such as commissions paid in subsequent years in excess of ultimate commissions paid and bonus interest credited through the first policy anniversary date).
Income tax expense increased to $49.9 million in 1995 from $11.8 million in the 1994 periods. This increase is primarily due to the increase in pretax income to $133.8 million in 1995 from $31.1 million in the 1994 periods. The effective tax rate for 1995 of 37 percent exceeded the statutory corporate federal income tax rate (35 percent) because goodwill amortization is not deductible for federal income tax purposes. The effective tax rate for the 1994 periods of 38 percent exceeded the statutory corporate federal income tax rate because goodwill amortization and certain acquisition and merger expenses are not deductible for federal income tax purposes.
Extraordinary charge incurred in 1995 relates to debt issuance costs that were written off when the former senior term loan was paid off with the proceeds of new bank financing.
Insurance policy income increased 8 percent to $53.8 million during the 1994 periods from $50.0 million in 1993, primarily because increased annuity policy withdrawals during 1994 resulted in higher surrender charges. Surrender charges assessed against annuity withdrawals for the 1994 periods were $10.2 million compared to $6.2 million for 1993 while annuity policy withdrawals were $532.8 million and $277.9 million for the same periods, respectively. Surrender charges as a percentage of annuity policy withdrawals declined in the 1994 periods as a result of increased withdrawals of a certain policy form whose surrender charge expired in 1994 upon such policies reaching their sixth anniversary. In addition, the Company experienced increases in withdrawals during the 1994 periods due to: (i) the increased size of the Company's annuity portfolio; and (ii) the increases in interest rates during 1994, which caused some policyholders to surrender policies and incur a surrender charge to invest funds in higher yielding alternative investments.
Net investment income increased 12 percent to $343.6 million in the 1994 periods from $304.8 million in 1993 on a 19 percent increase in average invested assets (amortized cost basis) to $4.4 billion in the 1994 periods compared to $3.7 billion in 1993. The percentage increase in net investment income was less than the percentage increase in average invested assets because the yield earned on average invested assets decreased to 7.88 percent in the 1994 periods from 8.27 percent in 1993. The decrease in yield resulted from the cash flows received during 1994 and 1993 being invested in lower yielding securities due to the general decline in interest rates during 1993, partially offset by the increase in yields during the fourth quarter of 1994 because of the application of purchase accounting. Redemption of fixed maturity investments prior to their regularly scheduled maturity dates resulted in additional investment income of approximately $.5 million in the 1994 periods compared to $5.9 million in 1993.
Net realized gains (losses) and net trading income (losses) often fluctuate from period to period. The Company sold approximately $1.1 billion and $2.2 billion of investments (principally fixed maturities) in the 1994 periods and 1993, respectively, which sales resulted in net realized gains of $6.9 million and trading losses of $.8 million, in the 1994 periods compared to net realized gains of $19.5 million in 1993. Net realized gains from sales of investments in the 1994 periods were offset by a loss on certain interest rate swap contracts that no longer effectively hedged the interest rate exposure and were therefore recorded at fair value resulting in a net realized loss of $21.3 million in the second quarter of 1994. Substantially all of the Company's interest rate swap contracts were terminated subsequent to the Acquisition at no additional loss. Net realized losses in 1994 also included a $1.2 million write-down of an equity security as a result of changes in conditions which caused the Company to conclude that a decline in the fair value of such security was other than temporary. Net realized gains in 1993 were net of a $.6 million increase to the mortgage loan valuation reserve.
Interest expense on annuities and financial products increased 12 percent to $220.1 million in the 1994 periods from $195.9 million in 1993 primarily due to a larger block of annuity business in force in 1994, higher crediting rates and with respect to the fourth quarter of 1994, the expensing of first year interest rate bonuses on policies issued prior to the Acquisition date on which interest had previously been capitalized as a cost of policies produced. The weighted average crediting rate for the Company's annuity liabilities excluding interest bonuses guaranteed for the first year of the annuity contract was 5.3 percent at December 31, 1994 and 1993.
Amortization of goodwill of $2.2 million for the three months ended December 31, 1994 reflects amortization of the goodwill recorded at the Acquisition date. Goodwill amortization prior to the Acquisition was insignificant.
Income tax expense decreased 47 percent to $11.8 million during the 1994 periods from $22.4 million during 1993 primarily as a result of the decrease in pretax income. The effective tax rate for 1994 of 38 percent exceeded the statutory corporate federal income tax rate (35 percent) because goodwill amortization and certain acquisition and merger expenses are not deductible for federal income tax purposes. The effective tax rate for 1993 of 33 percent was less than the statutory corporate federal income tax rate primarily because of a reduction in the valuation allowance for net operating loss carryforwards.
Dividends on preferred stock increased 88 percent to $3.0 million in 1994 from $1.6 million in 1993 primarily due to the dividend on the 1994 Series Preferred Stock issued in connection with the Acquisition. This increase was partially offset by the elimination of the dividends on the other issues of preferred stock retired at the Acquisition date.
The Company's insurance subsidiaries are regulated by insurance statutes and regulations as to the type of investments that they are permitted to make and the amount of funds that may be used for any one type of investment. In light of these statutes and regulations and the Company's business and investment strategy, the Company generally seeks to invest in United States government and government agency securities and corporate securities rated investment grade by established nationally recognized rating organizations or, if not rated, in securities of comparable investment quality.
The Company, in conjunction with CCM, periodically evaluates the creditworthiness of each issuer whose securities are held in the portfolio. Special attention is paid to those securities whose market values have declined materially for reasons other than changes in interest rates or other general market conditions. The Company considers available information to evaluate the realizable value of the investment, the specific condition of the issuer, and the issuer's ability to comply with the material terms of the security. Information reviewed may include the recent operational results and financial position of the issuer, information about its industry, recent press releases and other 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, the Company reduces the carrying amount to its net realizable value, which becomes the new cost basis, and the amount of the reduction is reported as a realized loss. The Company recognizes any recovery of such reductions in the cost basis of an investment as a realized gain only upon the sale, repayment or other disposition of the investment. During 1995 and 1994, the Company recorded realized losses for investment writedowns of $7.1 million and $1.2 million, respectively, as a result of changes in the financial condition of an issuer and changes in the value of the underlying collateral, which caused the Company to conclude that the decline in fair value of such investments was
Proceeds from sales of fixed maturity investments during 1993 were $2.2 billion and resulted in net realized gains of $23.0 million. These securities were principally sold to create taxable capital gains to offset capital losses prior to the expiration of the capital loss carryforward period.
At December 31, 1995, fixed maturity investments included $1.5 billion (30 percent of the fixed maturity investment portfolio) of mortgage-backed securities of which $941.9 million were CMOs and $574.7 million were pass-through securities. CMOs are securities backed by pools of pass-through securities and/or mortgages that are segregated into sections or "tranches" which provide for sequential retirement of principal rather than the pro rata share of principal return which occurs through regular monthly principal payments on pass-through securities.
The amortized cost and estimated fair value of mortgage-backed securities including CMOs at December 31, 1995, summarized by type of security, were as follows:
Support classes absorb the prepayment risk from which planned amortization and targeted amortization classes are protected. As such, they are usually extremely sensitive to prepayments. Most of the Company's support classes are higher average life instruments that generally will not lengthen if interest rates rise from year end levels and will have a tendency to shorten if interest rates decline. However, since these bonds have costs below par values, higher prepayments will have the effect of increasing yields.
The increases in policy withdrawals and surrender payments generally correspond to the aging and growth of the Company's annuity business in force, and to a certain extent, during 1995 and the second half of 1994, the reductions in the Company's ratings described in the previous paragraph. In addition, the Company has experienced increases in policyholder utilization of the systematic withdrawal features in several of its annuity policies and a moderate increase in surrenders and withdrawals as a result of interest rates increasing during 1994 and the first quarter of 1995 which has increased the yields on alternative investments.
next 12 months since sales of this product peaked in the second quarter of 1989 and were effectively discontinued after June 30, 1990. At December 31, 1995, the aggregate account balances still in force for this product were $651.5 million, of which $152.9 million still carried a surrender charge of at least 4 percent. With respect to such product, the Company's recent experience indicates that approximately 50 percent of the account balances that still have a surrender charge in place at December 31, 1995, will surrender within one year after the affected policies reach their sixth anniversary. There can be no assurance that surrenders of such account balances will not exceed 50 percent in the future.
Most of the Company's assets are invested in bonds and other securities, substantially all of which are readily marketable. Although there is no present need or intent to dispose of such investments, the Company could liquidate portions of its investments or use them to facilitate borrowings under reverse repurchase agreements if such a need arose. At December 31, 1995, the Company's portfolio of bonds, notes and redeemable preferred stocks had an aggregate net unrealized gain of $415.8 million.
The Acquisition of the Company by Partnership II and related transactions were funded with $45.9 million in cash contributions made to Partnership II by its partners, which was effectively contributed to the Company as part of the Acquisition, $57 million in cash from the issuance in a private placement of the 1994 Series Preferred Stock and $320 million in cash from the issuance of long-term debt by American Life Holding.
The cash consideration to acquire the Company included $69.0 million for the conversion of the Convertible Debentures. As of December 31, 1995, $54.0 million principal amount of the Convertible Debentures had been converted and $15.0 million principal amount remained outstanding. In addition, the Company is obligated to pay the holders of the Contingent Payment Rights or the holder of the 1988 Series Preferred Stock (depending on the outcome of the Savings Bank Litigation) upon conversion of the 1988 Series Preferred Stock, an amount of not less than approximately $30 million. Funds to make these payments are available under the Company's Senior Credit Facility as discussed hereafter.
AGP and American Life Holding need liquidity primarily to service their debt, pay dividends on their capital stock and pay operating expenses. The primary sources of funds for these payments are dividends on capital stock from subsidiaries and interest payments on surplus notes and net tax sharing payments received from American Life and Casualty.
AGP has no direct ownership interest in the insurance subsidiaries and must rely on dividends from American Life Holding and payments under the tax sharing agreement with its subsidiaries to fund its operating expenses and any dividends or interest expense it may seek or be obligated to pay. Since the Acquisition, AGP's direct obligations for dividends on preferred stock and interest on indebtedness have been substantially reduced as a result of the retirement of certain preferred stock as part of the Acquisition and the conversion of $54.0 million principal amount of the Convertible Debentures. AGP remains obligated to pay interest on the remaining $15.0 million principal balance of the Convertible Debentures as long as such amounts remain outstanding.
American Life Holding has two series of redeemable preferred stock outstanding. Principal and interest payments on American Life Holding's indebtedness have priority over dividend payments on these issues of preferred stock, however the rights of the holders of such preferred stock with respect to the securities segregated in escrow accounts for the future redemption of that stock are unaffected by the incurrence of the new indebtedness.
The payment of dividends and other distributions, including surplus note payments, by American Life and Casualty are subject to regulation by the Iowa Insurance Division. Currently, American Life and Casualty may pay dividends or make other distributions without the prior approval of the Iowa Insurance Division, unless such payments, together with all other such payments within the preceding 12 months, exceed the greater of (1) American Life and Casualty's net gain from operations (excluding net realized capital gains or losses) for the preceding calendar year or (2) 10 percent of its statutory surplus at the preceding December 31. For 1996, up to $31.0 million can be distributed as dividends or surplus note payments without prior approval of the Iowa Insurance Division. In addition, dividends and surplus note payments may be made only out of earned surplus, and all surplus note payments are subject to prior approval by regulatory authorities. Vulcan Life, which is subject to similar regulatory limitations on its ability to pay dividends, has not paid a dividend during the entire period of time it has been a subsidiary of the Company and no future dividend payments by Vulcan Life are currently contemplated.
The maximum distributions permitted by law is not necessarily indicative of an insurer's actual ability to pay such distributions, which may be constrained by business and regulatory considerations, such as the impact of such distributions on surplus, which could affect an insurer's ratings or competitive position, the amount of premiums that can be written and the ability to pay future dividends or make other distributions. Further, the Iowa insurance laws and regulations require that the statutory surplus of American Life and Casualty following any dividend or distribution be reasonable in relation to its outstanding liabilities and adequate for its financial needs. The Iowa Insurance Division may bring an action to enjoin or rescind the payment of a dividend or distribution by American Life and Casualty that would, in its judgment, cause American Life and Casualty's statutory surplus to be unreasonable or inadequate under this standard.
The transfer of funds by the Company's insurance subsidiaries is also restricted by certain covenants in the Company's loan agreements which, among other things, require American Life and Casualty to maintain statutory capital and surplus (including the asset valuation and interest maintenance reserves) of $250 million. Under the most restrictive of these limitations, $24.2 million of earned surplus at December 31, 1995 would be available for distribution by American Life and Casualty to American Life Holding in the form of dividends or other distributions.
American Life Holding's cash flow also includes dividends and tax sharing payments derived from American Life and Casualty Marketing Division Co.'s ("AMCO") income, if any. AMCO functions as a general agent for American Life and Casualty, and its primary purpose is to pay commissions to American Life and Casualty's agents on annuity and life insurance policies issued by American Life and Casualty pursuant to a general agency commission and servicing agreement between AMCO and American Life and Casualty. This agreement initially benefits the statutory surplus of American Life and Casualty by extending the payment of first year commissions by American Life and Casualty to AMCO on certain deferred annuity policies over a longer period of time. In subsequent periods, American Life and Casualty's statutory surplus is reduced through the payment of renewal commissions to AMCO equal to a specified percentage of the accumulated policyholder account values of certain deferred annuity policies in force issued by American Life and Casualty since July 1990 remaining in force. These renewal commissions and capital contributions and/or advances from American Life Holding are the sources of funds for AMCO's payment of the first year commissions to agents on the deferred annuity policies issued by American Life and Casualty.
Jon P. Newsome Rollin M. Dick President and Chief Executive Officer Executive Vice President and Chief Financial Officer
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of American Life Group, Inc. and subsidiaries as of December 31, 1995 and 1994, and the consolidated results of their operations and their cash flows for the year ended December 31, 1995, and the three months ended December 31, 1994 and the consolidated results of operations and cash flows for the nine months ended September 30, 1994 of American Life Group, Inc. in conformity with generally accepted accounting principles.
We have audited the accompanying consolidated statements of operations, shareholders' equity, and cash flows of American Life Group, Inc. (formerly known as The Statesman Group, Inc.) and subsidiaries for the year ended December 31, 1993. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit.
Des Moines, Iowa January 27, 1994, except for the August 8, 1995 one-for-two stock split as to which the date is August 9, 1995
The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles ("GAAP"), which, as to the subsidiary insurance companies, differ in some respects from statutory accounting practices followed in the preparation of financial statements submitted to state insurance departments. All share and per share amounts have been restated to reflect the August 8, 1995 one-for-two stock split, unless otherwise noted. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the preparation period. Actual results could differ from those estimates. Significant estimates and assumptions are utilized in the calculation of cost of policies produced, cost of policies purchased, goodwill, insurance liabilities, liabilities related to litigation, guaranty fund assessment accruals and deferred income taxes. It is reasonably possible that actual experience could differ from the estimates and assumptions utilized which could have a material impact on the financial statements.
On September 29, 1994, Conseco Capital Partners II, L.P. ("Partnership II"), a Delaware limited partnership, completed the acquisition (the "Acquisition") of the Company. Under an Agreement and Plan of Merger dated May 1, 1994, the Company merged with a subsidiary of Partnership II. The Company's former shareholders received $15.25 (not adjusted for the August 8, 1995 one-for- two stock split) in cash per common equivalent share plus a contingent payment right (the "Contingent Payment Right") to receive up to another $2.00 (not adjusted for the August 8, 1995 one-for-two stock split) in cash per common equivalent share (the "Contingent Consideration"), based on the outcome of the Company's pending litigation against the U.S. Government concerning its former savings bank subsidiary (the "Savings Bank Litigation") (see note 9).
Partnership II was formed by Conseco, Inc. ("Conseco") to invest in privately negotiated acquisitions of specialized annuity, life and accident and health insurance companies and related businesses. The sole general partner of Partnership II is a wholly owned subsidiary of Conseco. Conseco is a publicly-held specialized financial services holding company which manages several wholly or partially owned life insurance companies and provides services to its managed companies and other businesses for fees. After the Acquisition and related financing transactions, Partnership II owns 80 percent of the Company's outstanding common stock. Conseco, through its direct investment and interests in certain of its subsidiaries and affiliates, has a 36 percent ownership interest in the Company.
In March 1996, Conseco announced it is terminating Partnership II because changes in the regulatory and rating agency environment have made it impractical to structure leveraged acquisitions of life insurance companies in a manner that produces the expected returns to the limited partners (see note 16).
The Acquisition and related transactions were funded with: (i) $45.9 million of cash contributions from Partnership II (including $14.7 million provided by Conseco and its affiliates); (ii) $57.0 million in cash from the sale in a private placement of the Company's 1994 Series Preferred Stock $1 Par (the "1994 Series Preferred Stock" - see note 8)(including $49.9 million provided by Conseco and its affiliates, of which $3.0 million was sold in December 1994 to an unaffiliated company); and (iii) $320.0 million in cash from the issuance of notes payable by American Life Holding (see note 6). As partial consideration for the purchase of the 1994 Series Preferred Stock, the purchasers received 20 percent of the outstanding common stock of the Company.
o Actively managed fixed maturity securities that may be sold prior to maturity due to changes that might occur in market interest rate risks, changes in the security's prepayment risk, the management of income tax position, general liquidity needs, an increase in loan demand, the need to increase regulatory capital, changes in foreign currency risk or similar factors. Actively managed fixed maturity securities and equity securities are carried at fair value and the unrealized gain or loss is recorded as a component of shareholders' equity, net of tax and the related adjustments described in the second following paragraph.
There was no effect on net income as a result of adopting SFAS 115.
Anticipated returns, including realized gains and losses, from the investment of policyholder balances are considered in determining the amortization of the cost of policies purchased and the cost of policies produced. When actively managed fixed maturity securities are stated at fair value, an adjustment to the cost of policies purchased and the cost of policies produced may be necessary if a change in amortization would have been recorded if such securities had been sold at their fair value and the proceeds reinvested at current yields. Furthermore, if future yields expected to be earned on such securities decline, it may be necessary to increase certain insurance liabilities. Adjustments to such liabilities are required when their balances, in addition to future net cash flows including investment income, are insufficient to cover future benefits and expenses.
o For transfers to actively managed from held to maturity, the unrealized gain or loss is recognized in shareholders' equity; and
o For transfers to held to maturity from actively managed, the unrealized gain or loss at the date of transfer continues to be reported in shareholders' equity, but is amortized over the remaining life of the security as an adjustment of yield.
As part of its investment strategy, the Company enters into reverse repurchase agreements and dollar roll transactions to increase its return on investments and improve liquidity. These transactions are accounted for as collateral borrowings, where the amount borrowed is equal to the sales price of the underlying securities.
Credit-tenant loans are loans for commercial properties. When these loans are made: (i) the lease of the principal tenant is assigned to the Company; (ii) the lease must produce adequate cash flow to fund substantially all the requirements of the loan; and (iii) the principal tenant or the guarantor of such tenant's obligations must have an investment-grade credit rating when the loan is made. These loans also must be secured by the value of the related property. Underwriting guidelines take into account such factors as: (i) the lease term of the property; (ii) the borrower's management ability, including business experience, property management capabilities and financial soundness; and (iii) such economic, demographic or other factors that may affect the income generated by the property, or its value. The underwriting guidelines generally require a loan-to-value ratio of 75 percent or less. Credit-tenant loans and traditional mortgage loans are carried at amortized cost.
Policy loans are stated at their current unpaid principal balance. Short-term investments include commercial paper, invested cash and other investments purchased with maturities less than three months and are carried at amortized cost, which approximates estimated fair value. The Company considers all short-term investments to be cash equivalents.
o Identify the rate of return that the Company believes it must earn in order to accept the risks inherent in realizing the cash flows, based on consideration of the factors summarized below.
o The magnitude of the risks associated with each of the actuarial assumptions used in determining expected future cash flows as described in the preceding paragraphs.
o The perceived likelihood of changes in projected future cash flows that might occur if there are changes in insurance regulations and tax laws.
After the cost of purchased policies is determined using the methods described above, the amount is amortized based on the incidence of the expected cash flows and the interest rate credited to the underlying products.
For investment contracts with mortality risk, but with premiums paid for only a limited period (such as single-premium immediate annuities with benefits paid for the life of the annuitant), the accounting treatment is similar to traditional contracts. However, the excess of the gross premium over the net premium is deferred and recognized in relation to the present value of expected future benefit payments (when accounting for annuity contracts) or in relation to insurance in force (when accounting for life insurance contracts).
A charge is made against consolidated income representing: (i) the share of earnings of Vulcan Life attributable to its minority interest; and (ii) dividends on the redeemable preferred stock of American Life Holding. Shareholders' equity attributable to the minority interests is shown separately on the consolidated balance sheet.
Securities Segregated for the Future Redemption of Redeemable Preferred Stock of a Subsidiary
Securities segregated for the future redemption of redeemable preferred stock of American Life Holding are reported at amortized cost. The Company has the positive intent and ability to hold these securities until maturity. See note 7 for a description of these securities and the redeemable preferred stock.
Effective January 1, 1993, the Company adopted Statement of Financial Accounting Standards No. 106, "Employers' Accounting for Postretirement Benefits Other Than Pensions," and Statement of Financial Accounting Standards No. 112, "Employers' Accounting for Postemployment Benefits." These statements require companies to recognize expense related to anticipated postretirement and postemployment benefits (other than pensions) over the period the employee provides services. Adoption of these statements did not have a material impact on results of operations for the year ended December 31, 1993, and the cumulative effect of these changes in accounting principle was not material.
Investment securities: The estimated fair values for fixed maturity securities (including redeemable preferred stocks) and equity securities are based on quotes from independent pricing services, where available. For investment securities for which such quotes are not available, the estimated fair values are determined using values obtained from broker-dealer market makers or by discounting expected future cash flows using current market interest rates applicable to the yield, credit quality and, for fixed maturity securities, the maturity of the investments.
Short-term investments: The estimated fair values for short-term investments are based on quoted market prices. The carrying amount reported in the consolidated balance sheet for these instruments approximates their estimated fair value.
Other invested assets: The estimated fair value of these assets, which are not material, have been assumed to be equal to carrying value.
Insurance liabilities for investment contracts: The estimated fair values of the Company's liabilities under investment-type insurance contracts are determined using discounted cash flow calculations using interest rates currently being offered for similar contracts with maturities consistent with those remaining for the contracts being valued.
Notes payable: The estimated fair value of the Company's convertible subordinated debentures is based on the outstanding principal amount, which is approximately equal to the cash held in an escrow account for their conversion. The estimated fair value of variable rate notes payable approximates their par value. The estimated fair value of fixed rate notes payable (other than the convertible subordinated debentures) is based on quoted market prices.
The following table sets forth the amortized cost and estimated fair value of fixed maturities at December 31, 1995, based upon the pricing source used to determine the estimated fair value:
At December 31, 1995, approximately 85 percent of the estimated fair value of the Company's mortgage-backed securities was determined by nationally recognized pricing services and 15 percent was determined by broker-dealer market makers.
As part of its investment strategy, the Company enters into reverse repurchase agreements and dollar roll transactions to increase its return on investments and improve its liquidity. These transactions are accounted for as short-term collateralized borrowings. Such borrowings averaged approximately $132.8 million and $105.0 million during the year ended December 31, 1995, and the nine months ended September 30, 1994, respectively, and were collateralized by mortgage-backed securities with fair values approximately equal to the loan value. The weighted average interest rate on short-term collateralized borrowings was 5.8 percent in 1995 and 3.5 percent in the first nine months of 1994. Investment borrowings were not significant in the fourth quarter of 1994.
Life insurance companies are required to maintain certain amounts of assets on deposit with state regulatory authorities. Such assets had an aggregate carrying value of $22.7 million at December 31, 1995.
Investments, all of which are fixed maturities, in any single entity in excess of ten percent of shareholders' equity at December 31, 1995, other than mortgage-backed securities and investments issued or guaranteed by the United States Government or a United States Government agency, were as follows:
Reinsurance contracts do not relieve the Company from its obligations to its policyholders. The Company remains contingently liable to its policyholders for the portion reinsured to the extent that the reinsuring companies do not meet their obligations assumed under the reinsurance agreements. The aggregate receivable from reinsurers at December 31, 1995 and 1994, was $8.7 million and $5.2 million, respectively, all of which was deemed collectible. At December 31, 1995, the reinsurance receivable balance from the Company's largest reinsurer was $4.0 million and no other balance from a single reinsurer exceeded $1.5 million. Ceded reinsurance premiums deducted from premiums and policy fund charges were $6.0 million, $1.2 million, $3.9 million and $4.4 million for the year ended December 31, 1995, the three months ended December 31, 1994, the nine months ended September 30, 1994, and the year ended December 31, 1993, respectively.
The $38.0 million deferred income tax liability at December 31, 1995 includes $105.0 million which is attributed to the effect of the fair value adjustment to actively managed fixed maturities pursuant to SFAS 115.
The Omnibus Reconciliation Act of 1993 changed the Company's prevailing federal income tax rate from 34 percent to 35 percent effective January 1, 1993. The Company recognized additional federal income tax expense of $.8 million in 1993 due to the increase in the tax rate.
In connection with the financing of the Acquisition, American Life Holding executed a $200 million senior term loan with a group of banks. In 1995, American Life Holding made a $15.0 million scheduled payment and a $30.0 million unscheduled payment on the senior term loan. As discussed in note 10, the $30.0 million unscheduled principal payment was made using the proceeds from the issuance of common stock. In addition, American Life Holding executed a $225 million credit facility (the "Senior Credit Facility") and simultaneously borrowed $125.0 million under the Senior Credit Facility. Such proceeds were used for the repayment in full of the remaining principal balance under the existing senior term loan, resulting in an extraordinary charge of $4.0 million (net of a $2.2 million income tax benefit).
In April 1993, the Company issued $69.0 million face amount of Convertible Debentures in a public offering. As of December 31, 1995, $54.0 million principal amount of the Convertible Debentures have been converted. In connection with the Acquisition, the Convertible Debentures became convertible into $15.25 in cash plus a Contingent Payment Right for each common equivalent share into which such debenture was convertible immediately prior to the Acquisition. The requirement to hold funds in escrow for the conversion of the outstanding Convertible Debentures was eliminated upon execution of the Senior Credit Facility and repayment of the senior term loan. The Convertible Debentures continue to receive interest semi-annually at a rate of 6.25 percent until maturity or redemption. The debentures are redeemable, in whole or in part, at the option of the Company, at any time on or after May 1, 1996, initially at 106 percent of the principal amount and declining to 100 percent of the principal amount on or after May 1, 1999.
Aggregate maturities of notes payable during each of the five years subsequent to 1995 are as follows: 1996 - none; 1997 - $.3 million; 1998 - $15.3 million; and 1999 and 2000 - $20.3 million; thereafter $233.8 million.
American Life Holding's redeemable preferred stock is entitled to annual cumulative cash dividends of $2.16 per share on the 2.8 million shares and $2.32 per share on the 1.2 million shares, each payable quarterly. The 2.8 million and 1.2 million redeemable preferred shares are mandatorily redeemable in September 2007 and February 2008, respectively, at a redemption price of $25 per share, plus cumulative unpaid dividends. In liquidation, holders of the redeemable preferred stock are entitled to $25 per share (aggregate $99.0 million) plus cumulative unpaid dividends.
In connection with the Acquisition, American Life Holding's redeemable preferred stock was recorded at its estimated fair value at September 29, 1994 of $99.0 million.
In connection with the Acquisition, the Company issued 57,000 shares ($57.0 million) of 1994 Series Preferred Stock in a private placement transaction. Dividends are cumulative and accrue annually at 13 percent in additional shares of 1994 Series Preferred Stock through September 2005. Thereafter, dividends are payable quarterly at 15 percent per annum in cash. At December 31, 1995, the $66.6 million reported value of the 1994 Series Preferred Stock includes $2.2 million of paid-in-kind dividends accrued but undistributed through December 31, 1995. The 1994 Series Preferred Stock ranks senior to the Company's common stock with respect to dividends, and upon liquidation will have a liquidation preference equal to $1,000 per share, plus accrued unpaid dividends. The shares are redeemable at the option of the Company, in whole or from time to time in part, at a redemption price of $1,000 per share, plus accrued and unpaid dividends, and generally have no voting rights.
The Company issued 200,000 shares of its 1976 Series Preferred Stock $1 Par to its employee stock ownership plan (the "ESOP") of which 5,000 shares were converted into 7,641 shares of common stock during 1993. The remaining 195,000 shares outstanding at December 31, 1993 were converted into the merger consideration on September 29, 1994 as a result of the Acquisition. Prior to their conversion, the 1976 Series Preferred Stock received annual cumulative cash dividends of $.425 per share.
The Company issued 100,000 shares of 1987 Series II Preferred Stock $1 Par of which 18,099 had been exchanged for common stock prior to 1993. During 1994 and 1993 the Company exchanged 453 shares and 35,255 shares, respectively, of its common stock with the ESOP for 66 shares and 4,771 shares, respectively, of its 1987 Series II shares for the purpose of making distributions to terminated ESOP plan participants. The remaining 77,064 1987 Series II shares outstanding at September 29, 1994, were converted into the merger consideration and retired as a result of the Acquisition.
Cash dividends paid on the 1987 Series II shares were $.4 million and $.6 million for the nine months ended September 30, 1994, and the year ended December 31, 1993, respectively. Such dividends were used by the ESOP to fund the interest expense on the ESOP's note obligation.
See note 9 for a discussion regarding the 1988 Series I and II Preferred Stock (the "1988 Series Preferred Stock").
The Company has filed suit in the United States Court of Federal Claims (the "Court of Federal Claims") against the United States of America for breach of certain contractual agreements which were made by certain former government regulatory agencies to induce the Company to capitalize its former savings bank subsidiary (the "Savings Bank") in connection with the acquisition of four failed thrift institutions in March 1988 and the subsequent seizure of the Savings Bank by the Office of Thrift Supervision in July 1990 (the "Savings Bank Litigation"). In the Savings Bank Litigation, the Company claims that the defendant breached its contractual agreements with respect to regulatory capital and contends that this breach, which resulted in the disallowance of $21 million of capital which the defendant promised would be perpetual for regulatory accounting purposes, and such subsequent seizure, constitutes a taking of the Company's property without just compensation and due process of law, in violation of the Fifth Amendment of the United States Constitution.
If the Savings Bank Litigation results in the return of the 1988 Series Preferred Stock to the Company, the $30.1 million amount referred to above will be payable to the holders of the Contingent Payment Rights, together with any money damages recovered by the Company, subject to certain adjustments and limitations. If, however, the Company is unsuccessful in the Savings Bank Litigation, the $30.1 million amount will instead become payable to the holder of the 1988 Series Preferred Stock upon the conversion thereof or as otherwise directed by the court. Since the timing of a final determination of the Savings Bank Litigation is uncertain, the Company is unable to predict when such $30.1 million amount will become payable.
The terms of the 143,640 shares of the 1988 Series Preferred Stock provide for: (i) cash dividends of $8 per share, payable quarterly; (ii) redemption, at the Company's option, any time after 1999 at a price of $100 per share plus cumulative dividends; and (iii) no voting rights (except if the Company fails to pay dividends for six consecutive quarters, in which case the holder is entitled to one vote per share on each matter submitted to a vote at any meeting of the Company's shareholders). The Company has accrued all cumulative dividends on the 1988 Series Preferred Stock through the Acquisition date. Cumulative dividends in arrears on the 1988 Series Preferred Stock through December 31, 1995, were $7.0 million, of which $5.5 million have been accrued.
Changes in the number of shares of common stock outstanding are as follows:
As a result of the Acquisition, all common stock outstanding prior to the Acquisition was exchanged or converted for the merger consideration of $15.25 (not adjusted for the August 8, 1995 one-for-two stock split) in cash per common share plus the Contingent Consideration.
Under the terms of two stock option plans adopted by the Company's stockholders, options to purchase up to 623,146 shares of the Company's common stock were available for grant prior to 1994 to certain officers and key employees of the Company and its subsidiaries. Because the exercise price of all stock options awarded under these plans could be no less than the fair market value of a share of optioned stock at the date of grant, no compensation expense was recorded for these awards at the date of grant or at any time subsequent thereto prior to September 29, 1994. On September 29, 1994, options to purchase 94,125 shares of the Company's common stock were redeemed for cash pursuant to the terms of the merger agreement between the Company and Partnership II and accordingly, compensation expense of $1.6 million equal to the difference between the merger consideration of $15.25 (not adjusted for the August 8, 1995 one-for-two stock split) per share and the option price, was recorded at that time and included in the consolidated statement of operations for the nine months ended September 30, 1994.
In addition, one of the stock option plans provided for the granting of stock appreciation rights ("SARs") on a maximum of 232,517 shares of the Company's common stock. SARs entitle the holder to receive, upon exercise, a cash payment equal to the excess of the fair market value of a share of common stock on the date of exercise over the option price. Compensation expense of $.5 million and $.1 million attributable to the exercise or redemption of the SARs is included in the consolidated statement of operations for the nine months ended September 30, 1994, and the year ended December 31, 1993, respectively.
Changes in the number of stock options and SARs outstanding for the nine months ended September 30, 1994, and the year ended December 31, 1993, were as follows. All shares and option prices have been adjusted to give retroactive effect to stock dividends declared and the August 8, 1995 one-for-two stock split subsequent to the date of grant.
See note 9 for a description of the Savings Bank Litigation.
Since the Acquisition, the Company and certain of its subsidiaries have received services from or shared expenses with subsidiaries of Conseco under written agreements or based on cost allocation principles in accordance with GAAP, including investment advisory agreements which provide investment management and related accounting and reporting services. The fee for such investment related services is .0625 percent of the value of managed investable assets at the beginning of each quarter. Fees charged under all such arrangements totaled $14.2 million and $2.6 million for the year ended December 31, 1995, and the three months ended December 31, 1994, respectively.
The seven states with the largest shares of the subsidiaries' premiums collected in 1995 were Florida (11.9 percent), California (8.1 percent), Pennsylvania (6.5 percent), Michigan (6.4 percent), Texas (6.2 percent), Illinois (6.0 percent), and New Jersey (5.6 percent). No other state accounted for more than 4 percent of total collected premiums.
Based on current conditions and assumptions as to future events on all policies in force, the Company expects to amortize approximately 10 percent of the cost of policies purchased balance in each of the next 5 years. The discount rate used to determine the amortization of the cost of policies purchased was approximately 5 percent.
The net assets of the insurance subsidiaries available for transfer to stockholders are limited to the amounts by which the insurance subsidiaries' net assets, as determined in accordance with statutory accounting practices prescribed or permitted by state regulatory authorities, exceed minimum regulatory statutory capital and surplus requirements; however, payment of dividends or other distributions to stockholders may also be subject to prior approval by regulatory authorities. The Iowa laws require that the statutory surplus of American Life and Casualty following any dividend or distribution be reasonable in relation to its outstanding liabilities and adequate for its financial needs (as determined under standards contained therein). The Iowa Insurance Commissioner may bring an action to enjoin or rescind the payment of a dividend or distribution by an insurer domiciled in its state that would cause such insurer's statutory surplus to be unreasonable or inadequate under this standard.
In addition, the ability of the insurance subsidiaries to transfer funds to stockholders is limited by certain provisions in the Company's loan agreements relating to the maintenance of specified minimum levels of statutory capital and surplus (see note 6) and minimum levels of statutory risk-based capital. At December 31, 1995, $24.2 million was available to be transferred from American Life and Casualty (based on amounts reported in accordance with statutory accounting practices) to American Life Holding in the form of dividends, surplus note payments, loans or advances.
Most states have adopted risk-based capital ("RBC") rules, to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks. The RBC formula is designed as an early warning tool to help state regulators identify possible weakly capitalized companies for the purpose of initiating regulatory action. At December 31, 1995, the ratios of total adjusted capital to RBC, as defined by the rules, for the Company's insurance subsidiaries were approximately twice the level at which regulatory attention is triggered.
The results of operations for 1995 and the fourth quarter of 1994 represent results since the date of the Acquisition and are reported based on the purchase method of accounting. The results of operations for the first three quarters of 1994 are reported based on historical accounting. Net income, as previously reported for the quarterly period ended June 30, 1994, has been adjusted for the $13.8 million net realized loss (net of income taxes of $7.5 million) incurred on interest rate swap contracts as discussed in note 11 to the consolidated financial statements.
In March 1996, Conseco announced that Partnership II would be dissolved. Accordingly, the partners have no further commitment to make additional contributions of capital to Partnership II or the Company. In accordance with the partnership agreement, all of Partnership II's assets (primarily its investment in AGP) will be distributed to its partners subject to the conditions contained in the partnership agreement. In any event, Partnership II's assets must be distributed within two years of the effective date of dissolution.