Headquarters. Our headquarters is located on a Company-owned 168-acre corporate campus in Carmel, Indiana, immediately north of Indianapolis. The ten buildings on the campus contain approximately 854,500 square feet of space and house Conseco's executive offices and certain administrative operations of its subsidiaries. Management believes that Conseco's offices are adequate for its current needs. Some of our properties are or soon may be available for sale or lease.
Insurance operations. Our professional independent producer distribution channel operations are administered from our Carmel, Indiana headquarters. Our career agent operations are primarily administered from a single facility of 300,000 square feet in downtown Chicago, Illinois, leased under an agreement whereby 107,000 square feet is leased until 2018; 70,000 square feet is leased until 2008; and the remaining 123,000 square feet is leased through November 2003. We also lease approximately 130,000 square feet of warehouse space in a second Chicago facility; this lease has a remaining life of approximately 11 months. Conseco owns an office building (currently listed for sale) in Rockford, Illinois (total of 44,400 square feet), which served as an administrative center for portions of our insurance operations. Conseco owns an office building in Philadelphia, Pennsylvania (127,000 square feet), which serves as the administrative center for our direct response life insurance operations; approximately 60 percent of this space is occupied by the Company, with the remainder leased to tenants. Conseco also leases 215 sales offices in various states totaling approximately 507,000 square feet; these leases are short-term in length, with remaining lease terms ranging from six months to five years.
In this section, we review the consolidated financial condition of Conseco at December 31, 2002 and 2001, the consolidated results of operations for the three years ended December 31, 2002, and, where appropriate, factors that may affect future financial performance. Please read this discussion in conjunction with the accompanying consolidated financial statements, notes and selected consolidated financial data.
All statements, trend analyses and other information contained in this report and elsewhere (such as in filings by Conseco with the Securities and Exchange Commission, press releases, presentations by Conseco or its management or oral statements) relative to markets for Conseco's products and trends in Conseco's operations or financial results, as well as other statements including words such as "anticipate," "believe," "plan," "estimate," "expect," "project," "intend," "may," "will," "would," "contemplate," "possible," "attempts," "seeks," "should," "could," "goal," "target," "on track," "comfortable with," "optimistic" and other similar expressions, constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are subject to known and unknown risks, uncertainties and other factors which may cause actual results, performance or achievements to be materially different from the future results, performance or achievements expressed or implied by the forward-looking statements. Assumptions and other important factors that could cause our actual results to differ materially from those anticipated in our forward-looking statements include, among other things: (i) the ability of Conseco to develop, prosecute, confirm and consummate one or more plans of reorganization with respect to the Chapter 11 petitions under the Bankruptcy Code filed by Conseco and some of its subsidiaries, including CFC and CIHC, Incorporated (the "Chapter 11 petitions"); (ii) the potential adverse impact of the Chapter 11 petitions on Conseco's operations, management and employees; (iii) the outcome and timing of Conseco's efforts to restructure and/or sell assets of Conseco Finance; (iv) general economic conditions and other factors, including prevailing interest rate levels, stock and credit market performance and health care inflation, which may affect (among other things) Conseco's ability to sell its products, its ability to make loans and access capital resources and the costs associated therewith, the market value of Conseco's investments, the lapse rate and profitability of policies, and the level of defaults and prepayments of loans made by Conseco; (v) Conseco's ability to achieve anticipated synergies and levels of operational efficiencies, including from our process excellence initiatives, and to achieve the goals of recent restructuring initiatives undertaken at Conseco Insurance Group; (vi) customer response to new products, distribution channels, marketing initiatives and the Chapter 11 petitions; (vii) mortality, morbidity, usage of health care services and other factors which may affect the profitability of Conseco's insurance products; (viii) performance of our investments; (ix) changes in the Federal income tax laws and regulations which may affect the relative tax advantages of some of Conseco's products; (x) increasing competition in the sale of insurance and annuities and in the finance business; (xi) regulatory changes or actions, including those relating to regulation of the financial affairs of our insurance companies, regulation of the sale, underwriting and pricing of products, and health care regulation affecting health insurance products; (xii) actions by rating agencies and the effects of past or future actions by these agencies on Conseco's business, including the impact of recent rating downgrades; (xiii) the ultimate outcome of lawsuits filed against Conseco; (xiv) the risk factors or uncertainties listed from time to time in Conseco's filings with the SEC and with the U.S. Bankruptcy Court in connection with the Chapter 11 petitions; (xv) our ability to continue as a going concern; and (xvi) our ability to obtain Bankruptcy Court approval with respect to motions in the Chapter 11 proceedings from time to time. Other factors and assumptions not identified above are also relevant to the forward-looking statements, and if they prove incorrect, could also cause actual results to differ materially from those projected.
These and other factors, including the terms of the Plan, will affect the value of our various prepetition liabilities, Trust Preferred Securities and preferred and common stock.
Our Plan would result in holders of CNC's common stock and preferred stock (other than Series F Preferred Stock) receiving no value and the holders of CNC's Trust Preferred Securities and Series F Preferred Stock receiving little value on account of the cancellation of their interests. In addition, holders of unsecured claims against the Debtors would, in most cases, receive less than full recovery for the cancellation of their interests.
As a result of these developments, on August 9, 2002, we announced that we would seek to fundamentally restructure the Company's capital, and announced that we had retained legal and financial advisors to assist us in these efforts. We ultimately decided to seek judicial reorganization under Chapter 11 of the Bankruptcy Code.
As a result of the formalization of the plan to sell the finance business and the filing of petitions under the Bankruptcy Code by the Finance Company Debtors, the finance business is being accounted for as a discontinued operation. Information regarding the planned sale of the finance business appears in Item 1. "Discontinued Finance Business - Planned Sale of CFC".
The consolidated financial statements included in Item 8. "Financial Statements and Supplementary Data" have been prepared on a going concern basis which assumes continuity of operations and realization of assets and satisfaction of liabilities in the ordinary course of business. Our Plan will materially change amounts reported in the financial statements, which do not give effect to all adjustments of the carrying value of assets and liabilities that are necessary as a consequence of reorganization.
The ability of Conseco to continue as a going concern is predicated upon many issues, including various bankruptcy considerations and risks related to our business and financial condition. See "Cautionary Statement Regarding Forward-Looking Information" above.
At December 31, 2002, the carrying value of our investment portfolio was $21.8 billion. The accounting risks associated with these assets relate to the recognition of income, our determination of other-than-temporary impairments and our estimation of fair values.
When we sell a security (other than trading securities or venture capital investments), we report the difference between the sale proceeds and the amortized cost (determined based on specific identification) as a realized investment gain or loss.
We regularly evaluate all of our investments for possible impairment based on current economic conditions, credit loss experience and other investee-specific developments. If there is a decline in a security's net realizable value that is other than temporary, the decline is recognized as a realized loss and the cost basis of the security is reduced to its estimated fair value. For 2002, the Company recorded $556.8 million of writedowns of fixed maturities, equity securities, and other invested assets as a result of conditions that caused us to conclude a decline in the fair value of the investments was other than temporary. The facts and circumstances resulting in the other-than-temporary losses are described in the note to our accompanying financial statements entitled "Investments".
If a decline in value is determined to be other than temporary and the cost basis of the security is written down to fair value, we review the circumstances which caused us to believe that the decline was other than temporary with respect to other investments in our portfolio. If such circumstances exist with respect to other investments, those investments are also written down to fair value. Future events may occur, or additional or updated information may become available, which may necessitate future realized losses of securities in our portfolio. Significant losses in the carrying value of our investments could have a material adverse effect on our earnings in future periods.
During 2002, we sold $19.5 billion of fixed maturity investments which resulted in net realized investment losses (before income taxes) of $40.2 million. Securities sold at a loss are sold for a number of reasons including: (i) changes in the investment environment; (ii) expectation that the market value could deteriorate further; (iii) desire to reduce our exposure to an issuer or an industry; (iv) changes in credit quality; and (v) our analysis indicating there is a high probability that the security is other-than-temporarily impaired.
Each year, we evaluate the recoverability of the unamortized balance of the cost of policies purchased and the cost of policies produced. We consider estimated future gross profits or future premiums, expected mortality or morbidity, interest earned and credited rates, persistency and expenses in determining whether the balance is recoverable. If we determine a portion of the unamortized balance is not recoverable, it is charged to amortization expense.
A valuation allowance of $1,719.6 million (of which $925.7 million relates to discontinued operations) has been provided for the entire net deferred income tax asset balance at December 31, 2002, as we believe the realization of such asset in future periods is uncertain. We reached this conclusion after considering the availability of taxable income in prior carryback years, tax planning strategies, and the likelihood of future taxable income exclusive of reversing temporary differences and carryforwards. This conclusion was greatly influenced by recent unfavorable developments affecting the Company such as rating downgrades that decrease the Company's likelihood to generate adequate future taxable income to realize the tax benefits.
The Company established valuation contingencies related to certain tax uncertainties of the insurance companies we acquired on the date of their acquisition. We have determined that $146.2 million of such valuation contingencies are no longer necessary because the tax uncertainties no longer exist. Pursuant to Financial Accounting Standards Board Statement No. 109, "Accounting for Income Taxes", the benefit for the reduction of such valuation contingencies is first applied to reduce the related goodwill balances related to the acquisition. Accordingly, we reduced such valuation contingencies (increasing deferred taxes) and goodwill balances by $146.2 million during 2002.
The Company is currently in bankruptcy and expects to restructure and emerge from bankruptcy. As a result of the restructuring that is expected to occur upon the anticipated emergence from bankruptcy, the aggregate outstanding indebtedness will be substantially reduced. The cancellation of the indebtedness is expected to result in the realization of COD Income. The COD Income will not be recognized as taxable income because the Company is under the jurisdiction of a court in a Title 11 bankruptcy proceeding. Instead, as a consequence of such exclusion from taxable income, the Company must reduce its tax attributes by the amount of COD Income, which it excluded from taxable income. Tax attributes are reduced in the following order: (i) NOLs; (ii) tax credits and capital loss carryforwards; and (iii) tax basis in assets. Although it is expected that a reduction of tax attributes will be required, because the determination of the COD Income is dependent upon the fair market value of the various debt and capital instruments at the Effective Date, the exact amount of the reduction cannot be predicted.
The restructuring will be accomplished by the formation of New Conseco, which will issue new debt, preferred stock and common stock, in exchange for substantially all of the assets of the Company. The Company intends to accomplish this transaction as a G Reorganization. Assuming that the restructuring constitutes a G Reorganization, the Company will recognize no gain or loss with respect to such transactions to effect the G Reorganization, the Company's taxable year will close on the Effective Date and New Conseco will begin a new taxable year on the day after the Effective Date, and all of the Company's tax attributes existing on the Effective Date, including NOLs and other loss and credit carryovers will be transferred to New Conseco as of the close of the Effective Date.
policyholder redemptions and lapses to increase. In some cases, we have experienced defections among our sales force of agents and/or have increased commissions in order to retain them.
The Finance Company Debtors anticipate that they will be able to close the sale of CFC assets to CFN and GE. There are many factors outside of the Finance Company Debtors control, however, including the ability of CFN and/or GE to finance the purchase and the ability of the Finance Company Debtors to obtain necessary governmental consents to the sale or transfer of certain of their assets. Moreover, it is possible that the Finance Company Debtors may not be able to meet various closing conditions, and that either CFN or GE would elect to cancel their respective sale agreements as a result of these failures. If these sales transactions are not completed, it is possible that the Finance Company Debtors would have to liquidate their assets under Chapter 7 of the Bankruptcy Code.
We will have significant indebtedness even if the Plan is consummated. Furthermore, our historical capital requirements have been significant and our future capital requirements could vary significantly and may be affected by general economic conditions, industry trends, performance, and many other factors that are not within our control. Recently, we have had difficulty financing our operations due, in part, to our significant losses and leveraged condition, and we cannot assure you that we will be able to obtain financing in the future. Even if the Plan is approved and consummated, we cannot assure you that we will not experience losses. Our profitability and ability to generate cash flow will likely depend upon our ability to successfully implement our business strategy and meet or exceed the results forecasted in the projections. However, we cannot assure you that we will be able to accomplish these results.
Our Plan contemplates that we will enter into a senior secured credit facility (the "New Credit Facility") with our lenders in connection with our reorganization. We have agreed to a number of covenants and other provisions that restrict our ability to engage in various financing transactions and pursue certain operating activities without the prior consent of the lenders under the New Credit Facility. We have also agreed to meet or maintain various financial ratios and minimum financial strength ratings for our insurance subsidiaries. For instance, if we experience a ratings downgrade following confirmation of the Plan, if we fail to achieve an "A-" rating by a specified date following confirmation of the Plan or if we experience a ratings downgrade after achieving an "A-" rating, we will suffer an event of default under the New Credit Facility. Our ability to meet these financial and ratings covenants may be affected by events beyond our control. Although we expect to be in compliance with these requirements as of the date the Company emerges from bankruptcy, these requirements represent significant restrictions on the manner in which we may operate our business. If we default under any of these requirements, the lenders could declare all outstanding borrowings, accrued interest and fees to be due and payable. If that were to occur, we cannot assure you that we would have sufficient liquidity to repay or refinance this indebtedness or any of our other debts.
The Obligations of CNC and CIHC are Structurally Subordinated to the Obligations of CNC's and CIHC's Subsidiaries.
If an insurance company subsidiary were to be liquidated, that liquidation would be conducted under the insurance law of its state of domicile by such state's insurance regulator as the receiver with respect to such insurer's property and business. In the event of a default on our debt or our insolvency, liquidation or other reorganization, our creditors and stockholders will not have the right to proceed against the assets of our insurance subsidiaries or to cause their liquidation under federal and state bankruptcy laws.
Our Insurance Business Performance May Decline if Our Premium Rates Are Not Adequate.
We calculate and maintain reserves for the estimated future payment of claims to our policyholders based on assumptions made by our actuaries. For our health insurance business, we establish an active life reserve plus a liability for due and unpaid claims, claims in the course of settlement, and incurred but not reported claims, as well as a reserve for the present value of amounts not yet due on claims. Many factors can affect these reserves and liabilities, such as economic and social conditions, inflation, hospital and pharmaceutical costs, changes in doctrines of legal liability, and extra-contractual damage awards. Therefore, the reserves and liabilities we establish are necessarily based on extensive estimates, assumptions and prior years' statistics. Establishing reserves is an uncertain process, and it is possible that actual claims will materially exceed our reserves and have a material adverse effect on our results of operations and financial condition. Our financial performance depends significantly upon the extent to which our actual claims experience is consistent with the assumptions we used in setting our reserves and pricing our policies. If our assumptions with respect to future claims are incorrect, and our reserves are insufficient to cover our actual losses and expenses, we would be required to increase our liabilities resulting in an adverse effect to our financial results and financial position.
The solvency or guaranty laws of most states in which an insurance company does business may require that company to pay assessments (up to certain prescribed limits) to fund policyholder losses or liabilities of insurance companies that become insolvent. Recent insolvencies of insurance companies increase the possibility that these assessments may be required. These assessments may be deferred or forgiven under most guaranty laws if they would threaten an insurer's financial strength and, in certain instances, may be offset against future premium taxes. We cannot estimate the likelihood and amount of future assessments. Any future assessments may have a material adverse effect on our financial results and financial position.
We are Subject to Further Risk of Loss Notwithstanding Our Reinsurance Arrangements.
We transfer exposure to certain risks to others through reinsurance arrangements. Under these arrangements, other insurers assume a portion of our losses and expenses associated with reported and unreported claims in exchange for a portion of policy premiums. The availability, amount and cost of reinsurance depend on general market conditions and may vary significantly. Furthermore, we face credit risk with respect to reinsurance. When we obtain reinsurance, we are still liable for those transferred risks if the reinsurer cannot meet its obligations. Therefore, the inability of our reinsurers to meet their financial obligations could materially affect our operations and financial condition.
Our insurance business is subject to extensive regulation and supervision in the jurisdictions in which we operate, which is primarily for the benefit and protection of our customers, and not for the benefit of our investors or creditors. Our insurance subsidiaries are subject to state insurance laws that establish supervisory agencies with broad administrative powers relative to granting and revoking licenses to transact business, regulating sales and other practices, licensing agents, approving policy forms, setting reserve and solvency requirements, determining the form and content of required statutory financial statements, limiting dividends and prescribing the type and amount of investments.
We have been operating under heightened scrutiny from state insurance regulators. As described in Item 1. "Competition", our insurance subsidiaries domiciled in Texas, Bankers National Life Insurance Company and Conseco Life Insurance Company of Texas (on behalf of itself and its subsidiaries), entered into consent orders with the Commissioner of Insurance for the State of Texas on October 30, 2002.
Insurance companies historically have been subject to substantial litigation resulting from claims disputes and other matters. In addition to the traditional policy claims associated with their businesses, insurance companies are increasingly facing policyholder suits, class actions and disputes with reinsurers. The class actions and policyholder suits are often in connection with insurance sales practices, policy and claims administration practices and other market conduct issues. State insurance departments are increasingly focusing on sales practices and product issues in their market conduct examinations. Negotiated settlements of class action and other lawsuits have had a material adverse effect on the business, financial condition and results of operations of insurance companies. As a result of these trends, we are in the ordinary course of our business a plaintiff or defendant in actions arising out of our insurance business and investment operations, including class actions and reinsurance disputes, and, from time to time, are also involved in various governmental and administrative proceedings. Such litigation and proceedings may harm our financial strength and reduce our profitability. We cannot assure you that such litigation will not adversely affect our future business, financial condition or results of operations.
As described in Item 3. "Legal Proceedings", entities controlled by Donald J. Trump currently dispute CNC's subsidiary's ability to acquire the GM Building and later to monetize that asset. This dispute could delay our subsidiary's ability to sell the GM Building and distribute the profits of that sale. Our Plan presumes that our interest in the GM Building will be monetized in the first quarter of 2004, although timing of actual resolution of the dispute with Trump and sale of the building is not certain. The mortgages on the GM Building, which total $700 million, are due on August 1, 2003.
We must attract and retain sales representatives to sell our insurance and annuity products. Strong competition exists among
We sell deferred annuities and some forms of life insurance products which are attractive to purchasers, in part, because policyholders generally are not subject to United States federal income tax on increases in policy values until some form of distribution is made. Recently, Congress enacted legislation to lower marginal tax rates, reduce the federal estate tax gradually over a ten-year period, with total elimination of the federal estate tax in 2010 and increase contributions which may be made to individual retirement accounts and 401(k) accounts. While these tax law changes will sunset at the beginning of 2011 absent future congressional action, they could in the interim diminish the appeal of our annuity and life insurance products. Additionally, Congress has considered, from time to time, other possible changes to the U.S. tax laws, including elimination of the tax deferral on the accretion of value within certain annuities and life insurance products. There can be no assurance that further tax legislation will not be enacted which would contain provisions with possible adverse effects on our annuity and life insurance products.
The Impact of Recent Terrorist Attacks and the War in Iraq May Adversely Affect the Insurance Industry and Financial Markets.
RESULTS OF OPERATIONS FOR THE THREE YEARS ENDED DECEMBER 31, 2002:
We evaluate performance and determine future earnings goals based on operating earnings which we define as income before: (i) net investment gains (losses)(less that portion of amortization of cost of policies purchased and cost of policies produced and income taxes relating to such gains (losses)); (ii) the venture capital income (loss) related to our investment in AT&T Wireless Services, Inc. ("AWE"); (iii) the gain on the sale of our interest in a riverboat; (iv) special items not related to the continuing operations of our businesses (including changes in the deferred income tax valuation allowance, goodwill impairments, special charges and the provision for losses related to loan guarantees); (v) the net income (loss) related to the major medical business in run-off; and (vi) discontinued operations and the effect of accounting changes and extraordinary gain (loss) on extinguishment of debt. The criteria used by management to identify the items excluded from operating earnings include whether the item: (i) relates to other than the continuing operations of our businesses; (ii) is infrequent; (iii) is material to net income (loss); (iv) results from restructuring activities; (v) results from a change in the regulatory environment; and/or (vi) relates to the sale of an investment or the change in estimated market value of our venture capital investments. The non-operating items which may occur will vary from period to period and since these items are determined based on management's discretion, inconsistencies in the application of the criteria may exist. Operating earnings are determined by adjusting GAAP net income for the above mentioned items. While these items may be significant components in understanding and assessing our consolidated financial performance, we believe that the presentation of operating earnings enhances the understanding of our results of operations by highlighting net income attributable to the normal, recurring operations of the business and by excluding events that materially distort trends in net income. However, operating earnings are not a substitute for net income (loss) determined in accordance with GAAP.
General: As more fully described in "Liquidity for insurance and fee-based operations," within "Management's Discussion and Analysis of Financial Condition and Results of Operations", our insurance subsidiaries financial strength ratings were downgraded by A.M. Best on August 14, 2002 to "B (fair)" and the ratings remain "under review with developing implications". The downgrade has caused sales of our insurance products to fall and policyholder redemptions and lapses to increase. This has had a material adverse impact on our financial results. Conseco's insurance subsidiaries develop, market and administer annuity, supplemental health, individual life insurance and other insurance products. We distribute these products through a career agency force, professional independent producers and direct response marketing. This segment excludes our discontinued operations and the major medical business in run-off.
Collections on insurance products from continuing operations in 2002 were $4.5 billion, down 6.5 percent from 2001. Such collections in 2001 were $4.8 billion, down 2.4 percent from 2000. Sales of our insurance products were adversely affected by the declines in our financial strength ratings during 2002, 2001 and 2000. See "Premium and Asset Accumulation Product Collections" for further analysis.
Net investment income on general account invested assets (which excludes income on separate account assets related to variable annuities; and the income (loss), cost and change in the fair value of S&P 500 Call Options related to equity-indexed products) decreased by 9.9 percent, to $1,516.7 million, in 2002, and by 4.5 percent, to $1,683.6 million, in 2001. The average balance of general account invested assets decreased by 2.9 percent in 2002 to $23.3 billion and increased by .7 percent in 2001 to $24.0 billion. The yield on these assets was 6.5 percent in 2002, 7.0 percent in 2001 and 7.4 percent in 2000. The decrease in yield reflects general decreases in market interest rates between periods. Net investment income and the average balance of general account invested assets both reflect the transfer of a portion of our investment portfolio to reinsurers pursuant to recent reinsurance transactions. See the note to our consolidated financial statements entitled "Summary of Significant Accounting Policies" for additional discussion of reinsurance transactions.
Net investment income related to equity-indexed products based on the change in value of the S&P 500 Call Options represents the change in the estimated fair value of our S&P 500 Call Options which are purchased in an effort to cover certain benefits accruing to the policyholders of our equity-indexed products. Our equity-indexed products are designed so that the investment income spread earned on the related insurance liabilities should be more than adequate to cover the cost of the S&P 500 Call Options and other costs related to these policies. Option costs that are attributable to benefits provided were $97.5 million, $119.0 million and $123.9 million in 2002, 2001 and 2000, respectively. These costs are reflected in the change in market value of the S&P 500 Call Options included in the investment income amounts. Net investment income (loss) related to equity-indexed products before this expense was $(3.0) million, $4.8 million and $12.9 million in 2002, 2001 and 2000, respectively. Such amounts were partially offset by the corresponding charge (credit) to amounts added to policyholder account balances for equity-indexed products of $(.3) million, $.8 million and $11.4 million in 2002, 2001 and 2000, respectively. Such income and related charge fluctuated based on the value of options embedded in the Company's equity-indexed annuity policyholder account balances subject to this benefit and to the performance of the S&P 500 Index to which the returns on such products are linked.
Net investment income (loss) from separate account assets is offset by a corresponding charge (credit) to amounts added to policyholder account balances for separate account liabilities. Such income (loss) and related charge (credit) fluctuated in relationship to total separate account assets and the return earned on such assets.
During 2002, the Company conducted an extensive examination of the assumptions used to estimate its claim reserves for long-
term care products sold through its independent agent distribution channel. The examination was prompted by the continuing claim reserve deficiencies that we experienced in recent periods based on the assumptions and estimates made by our actuaries. The Company engaged an independent actuarial firm to assist in the examination.
The Company's prior estimates for long-term care reserves were based on claim continuance tables using experience for the period from January 1, 1990 through September 30, 1999. These tables are used to estimate the length of time an insured will receive covered long-term care for an incurred event. In 2002, we completed studies which indicated that the average length of time an insured will receive covered care has increased in recent periods. In addition, the Company has experienced significant fluctuations in claim inventories for these products. Accordingly, our actuaries and the independent actuarial firm concluded that estimates of future claim payments for incurred claims using the more recent data reflecting the longer covered care time periods were more appropriate than estimates based on prior data. The changes in estimation in calculating the reserves resulted in an increase to insurance policy benefits of $130.0 million in 2002. Excluding this adjustment related to the change in estimate, insurance policy benefits on long-term care policies would have been $880.2 million, the loss ratio for the year ended December 31, 2002 would have been 97.85 percent, and the interest-adjusted loss ratio for the year ended December 31, 2002 would have been 75.84 percent.
We experienced higher than expected claims on our specified disease business in 2002. As a result, our loss ratio increased. Notwithstanding the increased loss ratio, this block of business is performing within our expectations. Our general expectation is for the loss ratio for specified disease products to be approximately 68 percent. The 2001 loss ratio for specified disease products was within our expectations. The higher loss ratio in 2000 reflects changes in estimates of period end claim liabilities. Our estimate of 1999 claim liabilities proved to be inadequate to cover pre-2000 claims.
The loss ratios on our other products will fluctuate due to the smaller size of these blocks of business. The loss ratios on this business have generally been within our expectations.
When we sell securities at a gain (loss) and reinvest the proceeds at a different yield, we increase (reduce) the amortization of cost of policies purchased and cost of policies produced in order to reflect the change in future yields. Sales of fixed maturity investments resulted in a reduction in the amortization of the cost of policies purchased and the cost of policies produced of $21.5 million in 2002, $37.3 million in 2001 and $49.4 million in 2000.
Special charges in 2002 include: (i) losses of $35.0 million on reinsurance and asset sale transactions entered into as part of our cash raising initiatives; and (ii) other items totaling $9.3 million primarily related to severance benefits and costs incurred with the transfer of certain customer service and backroom operations to our India subsidiary. Special charges in 2001 were $21.5 million. Such charges primarily relate to severance benefits and costs incurred in conjunction with the transfer of certain customer service and backroom operations to our former India subsidiary. These charges are described in greater detail in the note to our consolidated financial statements entitled "Special Charges."
Interest expense on corporate debt, net of investment income on cash and cash equivalents has decreased as a result of the repayment of debt and lower interest rates. The average debt outstanding was $4.1 billion, $4.5 billion and $5.2 billion in 2002, 2001 and 2000, respectively. The average interest rate on such debt was 8.0 percent, 8.2 percent and 8.4 percent in 2002, 2001 and 2000, respectively.
Investment income includes the income from our investment in a riverboat casino (prior to its sale in the first quarter of 2001) and miscellaneous other income.
Provision for losses and expense related to stock purchase plan represents the non-cash provision we established in connection with our guarantees of bank loans to approximately 155 current and former directors, officers and key employees and our related loans for interest. The funds from the bank loans were used by the participants to purchase approximately 18.0 million shares of Conseco common stock. In 2002, 2001 and 2000, we established provisions of $240.0 million, $169.6 million and $231.5 million, respectively, in connection with these guarantees and loans. We determine the reserve based upon the value of the collateral held by the banks (primarily the purchased common stock). At December 31, 2002, the reserve for losses on the loan guarantees totaled $660.0 million. The outstanding principal balance on the bank loans was $481.3 million. In addition, Conseco has provided loans to participants for interest on the bank loans totaling $179.2 million. During 2002, Conseco purchased $55.5 million of loans from the banks utilizing cash held in a segregated cash account as collateral for our guarantee of the bank loans (including accrued interest, the balance on these loans was $56.7 million at December 31, 2002). The guarantees of the bank loans are discussed in greater detail in the note to our consolidated financial statements entitled "Other Disclosures."
Reorganization items are professional fees associated with CNC's bankruptcy proceedings which are expensed as incurred in accordance with Statement of Position 90-7 "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7").
Agents, insurance brokers and marketing companies who market our products and prospective purchasers of our products use the ratings of our insurance subsidiaries as an important factor in determining which insurer's products to market or purchase. Ratings have the most impact on our annuity and interest-sensitive life insurance products. During 2000, rating agencies lowered their financial strength ratings of our insurance companies, and many were placed on review as the agencies analyzed the impact of the events which occurred during 2000. Such rating actions adversely affected the marketing and persistency of our insurance products and other asset accumulation products. On November 7, 2000, A.M. Best upgraded the financial strength ratings of our principal insurance subsidiaries to A- (Excellent) from B++ (Very Good). On October 3, 2001, A.M. Best placed the Company's principal insurance subsidiaries "under review with negative implications" following our announcement regarding charges to be taken in the third quarter of 2001. In July 2002, A.M. Best downgraded the financial strength ratings of our primary insurance subsidiaries to "B++ (Very Good)" and placed the ratings "under review with negative implications." On August 14, 2002, A.M. Best further lowered the financial strength ratings of our primary insurance subsidiaries from "B++ (very good)" to "B (fair)." A.M. Best ratings for the industry currently range from "A++ (Superior)" to "F (In Liquidation)" and some companies are not rated. An "A++" ranking indicates superior overall performance and a strong ability to meet obligations to policyholders over a long period of time. The "B" rating is assigned to companies which have, on balance, fair balance sheet strength, operating performance and business profile, when compared to the standards established by A.M. Best, and have an ability in A.M. Best's opinion to meet their current obligations to policyholders, but their financial strength is vulnerable to adverse changes in underwriting and economic conditions. The rating reflects A.M. Best's view of the uncertainty surrounding our restructuring initiatives and the potential adverse financial impact on the subsidiaries if negotiations are protracted and execution of the restructuring plan is delayed. S&P has given our insurance subsidiaries a financial strength rating of "B+". Rating categories from "BB" to "CCC" are classified as "vulnerable," and pluses and minuses show the relative standing within a category. In S&P's view, an insurer rated "B" has the capacity to meet its financial commitments but adverse business conditions could lead to insufficient ability to meet financial commitments.
These ratings downgrades caused sales of our insurance products to decline and policyholder redemptions and lapses to increase. In some cases, the downgrades also caused defections among our independent agent sales force and increases in the commissions we had to pay to retain them. These events have had a material adverse effect on our financial results. Further downgrades by A.M. Best or S&P would likely have further material and adverse effects on our financial results and liquidity.
We introduced our first equity-indexed annuity product in 1996. The accumulation value of these annuities is credited with interest at an annual guaranteed minimum rate of 3 percent (or, including the effect of applicable sales loads, a 1.7 percent compound average interest rate over the term of the contracts). These annuities provide for potentially higher returns based on a percentage of the change in the S&P 500 Index during each year of their term. We purchase S&P 500 Call Options in an effort to hedge increases to policyholder benefits resulting from increases in the S&P 500 Index. Total collected premiums for this product decreased by 42 percent, to $220.1 million, in 2002 and decreased by 41 percent, to $380.9 million, in 2001. The decrease can be attributed to: (i) the general stock market performance which has made other investment products more attractive; and (ii) the effect of the A.M. Best ratings downgrade to "B (fair)".
Premiums collected on long-term care policies increased by 3.3 percent, to $917.4 million, in 2002 and by 6.3 percent, to $888.3 million, in 2001. Such sales have been affected by increased premium rates and new sales. We have determined that we will cease selling new long-term care policies through professional independent producers in the second quarter of 2003.
Premiums collected on specified disease products did not fluctuate significantly in 2002, 2001 and 2000.
Life products are sold through career agents, professional independent producers and direct response distribution channels. Life premiums collected in 2002 were $637.0 million, down 24 percent from 2001. Life premiums collected in 2001 were $839.6 million, down 6.8 percent from 2000. Such decreases are primarily a result of the reinsurance agreements we entered into during 2002. In addition, the A.M. Best ratings downgrade to "B (fair)" has negatively affected our sales of life products. We are currently considering the discontinuation of selling many of our life products through the professional independent producer channel. We expect our review to result in eliminating the sale of many life products.
Group major medical premiums decreased by 15 percent, to $315.6 million, in 2002 and by 26 percent, to $370.9 million, in 2001. We no longer actively market these products.
Variable annuities offer contract holders the ability to direct premiums into specific investment portfolios; rates of return are based on the performance of the portfolio. Profits on variable annuities are earned from the fees charged to contract holders. Variable annuity collected premiums decreased by 36 percent, to $248.6 million in 2002, and by 53 percent, to $386.1 million in 2001. The decreases can be attributed to: (i) the general stock market performance, which has made other investment products more attractive; (ii) our announcement that we planned to sell this business; and (iii) the A.M. Best ratings downgrade to "B (fair)". We sold our variable annuity business in the fourth quarter of 2002.
Life product premiums from discontinued operations represent the life business of CVIC, which was sold in the fourth quarter of 2002.
Our investment strategy is to: (i) maintain a predominately investment-grade fixed income portfolio; (ii) provide adequate liquidity to meet our cash obligations to policyholders and others; and (iii) maximize current investment income and total investment return through active investment management. Consistent with this strategy, investments in fixed maturity securities, mortgage loans and policy loans made up 98 percent of our $21.8 billion investment portfolio at December 31, 2002. The remainder of the invested assets were equity securities, venture capital investments and other invested assets.
The following table summarizes investment yields earned over the past three years on the general account invested assets of our insurance subsidiaries (excluding the investment income from our major medical business in run-off). General account investments exclude our venture capital investment in AWE, separate account assets, the value of S&P 500 call options and the investments held by CFC.
At December 31, 2002, our fixed maturity portfolio had $926.6 million of unrealized gains and $499.0 million of unrealized losses, for a net unrealized gain of $427.6 million. Estimated fair values for fixed maturity investments were determined based on estimates from: (i) nationally recognized pricing services (85 percent of the portfolio); (ii) broker-dealer market makers (8 percent of the portfolio); and (iii) internally developed methods (7 percent of the portfolio).
At December 31, 2002, approximately 5.8 percent of our invested assets (6.5 percent of fixed maturity investments) were fixed maturities rated below-investment grade by nationally recognized statistical rating organizations (or, if not rated by such firms, with ratings below Class 2 assigned by the NAIC). We 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, 2002, our below-investment-grade fixed maturity investments had an amortized cost of $1,435.1 million and an estimated fair value of $1,261.2 million.
We continually evaluate the creditworthiness of each issuer whose securities we hold. We pay special attention to those securities whose market values have declined materially for reasons other than changes in interest rates or other general market conditions. We evaluate the realizable value of the investment, the specific condition of the issuer and the issuer's ability to comply with the material terms of the security. Information reviewed may include the recent operational results and financial position of the issuer, information about its industry, information about the variety of factors affecting the issuer's performance and other information. Conseco employs a staff of experienced securities analysts in a variety of specialty areas who compile and review such data. If evidence does not exist to support a realizable value equal to or greater than the carrying value of the investment, and such decline in market value is determined to be other than temporary, we reduce the carrying amount to its fair value, which becomes the new cost basis. We report the amount of the reduction as a realized loss. We recognize any recovery of such reductions in the cost basis of an investment only upon the sale, repayment or other disposition of the investment. In 2002, we recorded writedowns of fixed maturity investments, equity securities and other invested assets totaling $556.8 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.
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 $60.4 million, $17.6 million and $15.3 million for the years ended December 31, 2002, 2001 and 2000, respectively.
The following table sets forth the par value, amortized cost and estimated fair value of mortgage-backed securities, summarized by interest rates on the underlying collateral at December 31, 2002:
- -------------------- (a) Includes below-investment grade mortgage-backed securities with an amortized cost and estimated fair value of $6.9 million and $2.1 million, respectively.
During 2002, we sold $19.5 billion of investments (primarily fixed maturities), resulting in $40.2 million of net investment losses (before related amortization and taxes). Securities sold at a loss are sold for a number of reasons including: (i) changes in the investment environment; (ii) expectation that the market value could deteriorate; (iii) desire to reduce our exposure to an issuer or an industry; (iv) changes in credit quality; and (v) our analysis indicating there is a high probability that the security is permanently impaired and subject to further declines in value. As discussed in the notes to our consolidated financial statements, the realization of gains and losses affects the timing of the amortization of the cost of policies produced and the cost of policies purchased related to universal life and investment products.
Our venture capital investment in AWE was made by our subsidiary which engages in venture capital investment activity. AWE is a company in the wireless communication business. In 2002, Conseco sold 10.3 million shares of AWE generating net proceeds of $75.7 million. Our investment in AWE is carried at estimated fair value, with changes in fair value recognized as investment income (loss). At December 31, 2002, our holdings of AWE common stock included 4.1 million shares valued at $25.0 million. The market values of AWE and many other companies in AWE's business sector have declined significantly in recent periods. We recognized venture capital investment losses of $99.3 million, $42.9 million and $199.5 million in 2002, 2001 and 2000, respectively, related to this investment.
At December 31, 2002, we held mortgage loan investments with a carrying value of $1,308.3 million (or 6.0 percent of total invested assets) and a fair value of $1,335.7 million. Mortgage loans were substantially comprised of commercial loans. Noncurrent mortgage loans were insignificant at December 31, 2002. Realized losses on mortgage loans were not significant in any of the past three years. At December 31, 2002, we had a mortgage loan loss reserve of $3.5 million. Approximately 9 percent, 8 percent, 7 percent, 6 percent, 6 percent and 6 percent of the mortgage loan balance were on properties located in New York, Massachusetts, Florida, California, Ohio and Pennsylvania, respectively. No other state accounted for more than 5 percent of the mortgage loan balance.
At December 31, 2002, we held no trading securities; they were historically included in other invested assets. Trading securities were investments we intended to sell in the near term. We carried trading securities at estimated fair value; changes in fair value were reflected in the statement of operations.
As part of our investment strategy, we enter into reverse repurchase agreements and dollar-roll transactions to increase our return on investments and improve our liquidity. Reverse repurchase agreements involve a sale of securities and an agreement to repurchase the same securities at a later date at an agreed-upon price. Dollar rolls are similar to reverse repurchase agreements except that the repurchase involves securities that are only substantially the same as the securities sold. We enhance our investment yield by investing the proceeds from the sales in short-term securities pending the contractual repurchase of the securities at discounted prices in the forward market. We are able to engage in such transactions due to the market demand for mortgage-backed securities to form CMOs. At December 31, 2002, we had investment borrowings of $669.7 million. Such investment borrowings averaged $1,155.8 million during 2002 and were collateralized by investment securities with fair values approximately equal to the loan value. The weighted average interest rate on such borrowings was 1.3 percent in 2002. The primary risk associated with short-term collateralized borrowings is that the counterparty might be unable to perform under the terms of the contract. Our exposure is limited to the excess of the net replacement cost of the securities over the value of the short-term investments (which was not material at December 31, 2002). We believe that the counterparties to our reverse repurchase and dollar-roll agreements are financially responsible and that counterparty risk is minimal.
Changes in our consolidated balance sheet between December 31, 2002 and December 31, 2001, reflect: (i) the accounting for our finance operations as a discontinued operation (as described in the note to our consolidated financial statement entitled "Discontinued Finance Business - Planned Sale of CFC"; (ii) the preparation of such statement in accordance with SOP 90-7, including the segregation of all prepetition liabilities into an account entitled "liabilities subject to compromise" at the estimated amount of allowable claims; (iii) our net loss for 2002, including the effect of establishing a valuation allowance for deferred tax assets; (iv) the cumulative effect of an accounting change recognizing an impairment of our goodwill asset; (v) changes in the fair value of actively managed fixed maturity securities and interest-only securities; and (vi) various financing and reinsurance transactions including the sale of CVIC (as described in the notes to our consolidated financial statements).
Corporate notes payable decreased during 2002 primarily due to: (i) open market repurchases of our 8.5% notes due 2002; partially offset by (ii) the increase in unamortized fair market value of terminated interest rate swap agreements (see the note to our consolidated financial statements entitled "Summary of Significant Accounting Policies"). Pursuant to SOP 90-7, all corporate notes payable have been classified as "liabilities subject to compromise".
Pursuant to SFAS 142, the goodwill impairment test has two steps. For Conseco, the first step consisted of comparing the estimated fair value of each of the business units comprising our insurance segment to the unit's book value. Since all of our goodwill relates to the insurance segment (which is also a reportable segment), the goodwill impairment test is not relevant to the finance business. If the estimated fair value exceeds the book value, the test is complete and goodwill is not impaired. If the fair value is less than the book value, the second step of the impairment test must be performed, which compares the implied fair value of the applicable business unit's goodwill with the book value of that goodwill to measure the amount of goodwill impairment, if any.
impairment charge is reflected in the cumulative effect of an accounting change in the accompanying consolidated statement for the year ended December 31, 2002. Subsequent impairment tests will be performed on an annual basis, or more frequently if circumstances indicate a possible impairment. Subsequent impairment charges are classified as an operating expense. As described below the Company performed additional impairment tests in 2002, as a result of circumstances which indicated a possible impairment.
In connection with our negotiations with debt holders, we retained an outside actuarial consulting firm to assist in valuing our insurance subsidiaries. That valuation work and our internal evaluations were used in performing the additional impairment tests that resulted in an impairment charge to goodwill of $500.0 million. The charge is reflected in the line item entitled "Goodwill impairment" in our consolidated statement of operations for the year ended December 31, 2002. The most significant changes made to the January 1, 2002 valuation that resulted in additional impairment charge were: (i) reduced estimates of projected future sales of insurance products; (ii) increased estimates of future policyholder redemptions and lapses; and (iii) a higher discount rate to reflect the current rates used by the market to value life insurance companies. Management believes that the assumptions and estimates used are reasonable given all available facts and circumstances. However, if projected cash flows are not realized in the future, we may be required to recognize additional impairments.
The ratings downgrades have caused sales of our insurance products to decline and policyholder redemptions and lapses to increase. In some cases, the downgrades have also caused defections among our independent agent sales force and increases in the commissions we must pay. These events have had a material adverse effect on our financial results. Further downgrades by A.M. Best or S&P could have further material and adverse effects on our financial results and liquidity.
The liquidity and capital resources of the Debtors are significantly affected by the Chapter 11 Cases. Our bankruptcy proceedings have resulted in various restrictions on our activities, limitations on financing and a need to obtain Bankruptcy Court approval for various matters. As a result of our bankruptcy filing, the Debtors are not permitted to make any payments on its prepetition liabilities. At December 31, 2002, the Debtors held cash of $41.9 million. In addition, the non-life insurance companies held cash of approximately $60 million.
Under the priority schedule established by the Bankruptcy Code, certain postpetition and prepetition liabilities need to be satisfied before unsecured creditors and holders of CNC's common and preferred stock and Trust Preferred Securities are entitled to receive any distribution. The Plan (as summarized in the Disclosure Statement) sets forth the Debtors' proposed treatment of claims and equity interests. No assurance can be given as to what values, if any, will be ascribed in the bankruptcy proceedings to each of these constituencies. Our Plan would result in holders of CNC's common stock and preferred stock (other than Series F Preferred Stock) receiving no value and the holders of CNC's Trust Preferred Securities and Series F Preferred Stock receiving little value on account of the cancellation of their interests. In addition, holders of unsecured claims against the Debtors would, in most cases, receive less than full recovery for the cancellation of their interests.
CNC and CIHC are holding companies with no business operations of their own; they depend on their operating subsidiaries for cash to make principal and interest payments on debt, and to pay administrative expenses and income taxes. The cash CNC and CIHC receive from insurance subsidiaries consists of fees for services, tax sharing payments, dividends and distributions, and from our non-insurance subsidiaries, loans and advances. A further deterioration in the financial condition, earnings or cash flow of the material subsidiaries of CNC or CIHC for any reason could further limit such subsidiaries' ability to pay cash dividends or other disbursements to CNC and/or CIHC, which, in turn, would limit CNC's and/or CIHC's ability to meet debt service requirements and satisfy other financial obligations.
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 or net income for the prior year; or (ii) 10 percent of capital and surplus as of the end of the preceding year. Any dividends in excess of these levels require the approval of the director or commissioner of the applicable state insurance department. As described in Item 1. "Government Regulation", Bankers National Life Insurance Company and Conseco Life Insurance Company of Texas (on behalf of itself and its subsidiaries), entered into consent orders with the Commissioner of Insurance for the State of Texas on October 30, 2002. These consent orders, among other things, limit the ability of our insurance subsidiaries to pay dividends.
amounts required for us to meet our financial and operating obligations will be available from our subsidiaries and from funds currently held by CNC and CIHC, our results for future periods are subject to numerous uncertainties. We may encounter liquidity problems, which could affect our ability to meet our obligations while attempting to meet competitive pressures or adverse economic conditions.
We will have significant indebtedness even if the Plan is consummated. Further, our historical capital requirements have been significant and our future capital requirements could vary significantly and may be affected by general economic conditions, industry trends, performance, and many other factors that are not within our control. Recently, we have had difficulty financing our operations due, in part, to our significant losses and leveraged condition, and we cannot assure you that we will be able to obtain financing in the future. Even if the Plan is approved and consummated, we cannot assure you that we will not continue to experience losses in the future. Our profitability and ability to generate cash flow will likely depend upon our ability to successfully implement our business strategy. However, we cannot assure you that we will be able to accomplish these results.
Inflation does not have a significant effect on our balance sheet; we have minimal investments in property, equipment or inventories. To the extent that interest rates may change to reflect inflation or inflation expectations, such change would effect our balance sheet and operations. Lower interest rates will typically result in increased value of our fixed maturities investments. Lower rates may also make it more difficult to issue new fixed rate annuities. Rising interest rates will typically result in decreased value of our fixed maturities investments.
result of changes in the prepayment rate of the loans underlying such securities. We follow asset/liability strategies that are designed to mitigate the effect of interest rate changes on our profitability. However, there can be no assurance that management will be successful in implementing such strategies and achieving adequate investment spreads.
We use computer models to simulate the cash flows expected from our existing insurance business under various interest rate scenarios. These simulations help us to measure the potential gain or loss in fair value of our interest rate-sensitive financial instruments. With such estimates, we seek to closely match the duration of our assets to the duration of our liabilities. When the estimated durations of assets and liabilities are similar, exposure to interest rate risk is minimized because a change in the value of assets should be largely offset by a change in the value of liabilities. At December 31, 2002, the adjusted modified duration of our fixed maturity securities and short-term investments was approximately 6.6 years and the duration of our insurance liabilities was approximately 6.0 years. We estimate that our fixed maturity securities and short-term investments (net of corresponding changes in the value of cost of policies purchased, cost of policies produced and insurance liabilities) would decline in fair value by approximately $595 million if interest rates were to increase by 10 percent from their December 31, 2002 levels. This compares to a decline in fair value of $555 million based on amounts and rates at December 31, 2001. The calculations involved in our computer simulations incorporate numerous assumptions, require significant estimates and assume an immediate change in interest rates without any management of the investment portfolio in reaction to such change. Consequently, potential changes in value of our financial instruments indicated by the simulations will likely be different from the actual changes experienced under given interest rate scenarios, and the differences may be material. Because we actively manage our investments and liabilities, our net exposure to interest rates can vary over time.
General: CFC has historically provided financing for manufactured housing, home equity, home improvements, consumer products and equipment, and consumer and commercial revolving credit. As a result of the formalization of the plan to sell the
After September 8, 1999, CFC no longer structured securitizations in a manner that resulted in recording a sale of the loans. Instead, new securitization transactions were structured to include provisions that entitle CFC to repurchase assets transferred to the special purpose entity when the aggregate unpaid principal balance reaches a specified level. Until these assets are repurchased, however, the assets are the property of the special purpose entity and are not available to satisfy the claims of creditors of CFC. In addition, CFC's securitization transactions were structured so that CFC, as servicer for the loans, is able to exercise significant discretion in making decisions about the serviced portfolio. Pursuant to Financial Accounting Standards Board Statement No. 140, "Accounting for the Transfer and Servicing of Financial Assets and Extinguishments of Liabilities" ("SFAS 140"), such discretion requires the securitization transactions to be accounted for as secured borrowings whereby the loans and securitization debt remain on the balance sheet, rather than as sales.
The change to the structure of CFC's securitizations has no effect on the total profit CFC recognizes over the life of each new loan, but it changes the timing of profit recognition. Under the portfolio method (the accounting method required for CFC securitizations which are structured as secured borrowings), CFC recognizes: (i) earnings over the life of new loans as interest revenues are generated; (ii) interest expense on the securities which are sold to investors in the loan securitization trusts; and (iii) provisions for losses. As a result, CFC's reported earnings from new loans securitized in transactions accounted for under the portfolio method are lower in the period in which the loans are securitized (compared to CFC's historical method) and higher in later periods, as interest spread is earned on the loans.
CNC's leveraged condition and liquidity difficulties severely impacted the operations of CFC, principally by eliminating CFC's access to the securitization markets. The securitization markets have been CFC's main source of funding. The loss of access to the securitization markets has severely affected CFC's ability to originate, purchase and sell loans. In addition, CFC has historically relied on these markets to finance the sale of repossessed manufactured housing units which have historically lowered the loss on defaulted loans. CFC's inability to access this market for repossessed manufactured housing units has forced CFC to utilize the wholesale channel to dispose of its repossessed units, resulting in higher losses on these portfolios. Increased losses have resulted in significant reductions in cash flow from servicing and residual income, as well as CFC being obligated to incur increasing amounts of guarantee liabilities on certain securitizations. Additionally, market valuations of CFC's securitization trusts have decreased due to uncertainty regarding CFC's liquidity position and its ability to continue to provide servicing for the securitized portfolios, thereby, reducing the value of CFC's retained interest pledged as collateral on its residual facility.
housing; (ii) mortgage services; and (iii) consumer finance. On December 19, 2002, CFC announced that it had signed a purchase agreement for the sale of substantially all of its assets to CFN. The Bankruptcy Court approved bidding and sales procedures pursuant to which the assets of CFC were sold in a public auction supervised by the Trustee appointed by the Bankruptcy Court, on March 4 and 5 of 2003. On March 14, 2003, the Bankruptcy Court approved the sale of substantially all of the CFC assets to CFN and GE. These sales transactions are expected to close in the second quarter of 2003.
Prior to Conseco's October 22, 2002 announcement, CFC was undertaking efforts to restructure its manufactured housing business. Originations had been significantly curtailed and CFC began analyzing potential approaches to reducing the negative cash flow that currently results from the servicing of this portfolio and the payment of guarantees on the B-2 securities issued in connection with securitizations of manufactured housing receivables. As a result of CFC's decreased liquidity position and inability to sell manufactured housing loans in the wholesale market at reasonable prices, CFC announced it would suspend originating manufactured housing loans November 25, 2002. As part of the Chapter 11 bankruptcy filing, CFC has requested a change in the servicing fee structure for the servicing of manufactured housing portfolios. The contractual servicing rate was 50 bps per annum on receivable balances. On December 18, 2002 the Bankruptcy Court approved an interim order to increase the servicing rate for the manufactured housing portfolios to the lesser of 125 bps per annum based on the balance of the receivables or the costs incurred to service the manufactured portfolio as defined in the motion. During the first quarter of 2003, CFC reached an agreement with bondholders to amend the servicing agreement for the manufactured housing portfolios, which was approved by the Bankruptcy Court on March 14, 2003. The amendment provides for an increase in the servicing fee to 125 bps per annum for one year following closing of the sale of the assets to CFN Investment Holdings, LLC and to 115 bps per annum for subsequent periods based on average unpaid principal balance of finance receivables, excluding those in repossession status.
Loan originations in 2002 were $7.3 billion, down 35 percent from 2001. Loan originations in 2001 were $11.3 billion, down 33 percent from 2000. Given CFC's limited liquidity and inability to access the securitization market, CFC is no longer originating certain types of loans. CFC is limiting future originations primarily to loans that can be sold at a profit in whole-loan sale transactions. CFC discontinued originating manufactured housing loans in November 2002. These decisions and continued constraints on liquidity have resulted in origination volume which is significantly lower than in prior periods.
Sales of finance receivables in 2002 and 2001 include the sale of $2.1 billion and $.8 billion, respectively, of finance receivables, on which CFC recognized a loss of $17.1 million and a gain of $26.9 million, respectively. These sales are further explained below under "Gain on sale of finance receivables". CFC also sold $.5 billion and $.8 billion of certain other finance receivables in 2002 and 2001, respectively, as part of CFC's cash raising arrangements.
Provision for losses related to finance operations increased by 77 percent, to $950.0 million, in 2002 and by 56 percent, to $537.7 million, in 2001. These amounts relate to CFC's on-balance sheet finance receivables. CFC's credit losses as a percentage of related loan balances for the on-balance sheet portfolio have been increasing over the last several quarters (2.26 percent, 2.36 percent, 2.53 percent, 2.61 percent, 2.76 percent and 3.74 percent for the quarters ended September 30, 2001, December 31, 2001, March 31, 2002, June 30, 2002, September 30, 2002 and December 31, 2002, respectively). The increases to the provision and CFC's credit losses are due to many factors including: (i) CFC's inability to finance the sale of repossessed assets, resulting in CFC's use of wholesale markets to sell such assets through which recovery rates are significantly lower; (ii) the natural increase in delinquencies in some of CFC's products as they age into periods in which CFC has historically experienced higher delinquencies; (iii) the increase in retail credit receivables which typically experience higher credit losses; (iv) economic factors which have resulted in an increase in defaults; and (v) a decrease in the manufactured housing recovery rates when repossessed properties are sold given current industry levels of repossessed assets. At December 31, 2002 and 2001, the 60-days-and-over delinquencies as a percentage of on-balance sheet finance receivables were 3.21 percent and 2.19 percent, respectively. Under the portfolio method, CFC estimates an allowance for credit losses based upon its assessment of current and historical loss experience, loan portfolio trends, the value of collateral, prevailing economic and business conditions, and other relevant factors. Increases in CFC's allowance for credit losses are recognized
Delinquencies on loans held in CFC's loan portfolio and CFC's ability to recover collateral and mitigate loan losses are adversely impacted by a variety of factors, many of which are outside of CFC's control. When loans are delinquent and CFC forecloses on the loan, its ability to sell collateral to recover or mitigate its losses is subject to the market value of such collateral. In manufactured housing, these values are affected by the available inventory of manufactured homes on the market, a factor over which CFC has no control. It is also dependent upon demand for new homes, which is tied to economic factors in the general economy. In addition, repossessed collateral is generally in poor condition, which reduces its value.
At December 31, 2002, CFC had a total of 20,918 unsold manufactured housing properties (11,939 of which relate to off-balance sheet securitizations) in repossession, compared to 15,057 properties (10,814 of which relate to off-balance sheet securitizations) at December 31, 2001. CFC reduces the value of repossessed property to its estimate of net realizable value upon repossession. CFC liquidated 25,017 managed manufactured housing units at an average loss severity rate (the ratio of the loss realized to the principal balance of the foreclosed loan) of 65 percent in 2002 compared to 25,750 units at an average loss severity rate of 57 percent in 2001. The loss severity rate related to the on-balance sheet manufactured housing portfolio was 59 percent in 2002, compared to 49 percent in 2001. The higher industry levels of repossessed manufactured homes which existed in the marketplace in 2002, have adversely affected recovery rates, specifically wholesale severity, as other lenders (including lenders who have exited the manufactured home lending business) have acted to more quickly dispose of repossessed manufactured housing inventory. Additionally, the higher level of repossessed inventory that currently exists in the marketplace has made it more difficult for CFC to liquidate its inventory at rates it has recovered in the past. CFC also believes the higher average severity rate in 2002 related to the on-balance sheet manufactured housing portfolio is partially due to the increased age of such portfolio.
During the quarter ended September 30, 2002, CFC's ability to access the securitization markets was eliminated. The securitization markets had been CFC's main source of funding for loans made to purchasers of repossessed manufactured homes. CFC believes that its severity rates have been historically positively impacted when it used retail channels to dispose of repossessed inventory (where the repossessed units are sold through company-owned sales lots or its dealer network). Since CFC is no longer able to fund the loans made on repossessed homes sold through these channels, sales through these channels have decreased and CFC must rely on the wholesale channel to dispose of repossessed manufactured housing units, through which recovery rates are significantly lower.
Other operating costs and expenses include the costs associated with servicing CFC's managed receivables, non-deferrable costs related to originating new loans and other operating costs. Such expense decreased by 4.1 percent, to $616.0 million, in 2002 and by 15 percent, to $642.4 million, in 2001. In 2002, CFC accrued $26.8 million pursuant to judgments issued in two arbitration proceedings. Such litigation is described in greater detail in the note to Conseco's consolidated financial statements entitled "Other Disclosures". Excluding the litigation accrual, such costs have decreased due to the realization of the benefits from cost saving initiatives and a decrease in origination volumes. In 2001, CFC began to realize some of the cost savings from its restructuring.
Special charges in the finance segment for 2002 include: (i) the loss of $96.0 million related to the sales of certain finance receivables of $463 million and $1.6 million of additional loss related to receivables required to be repurchased from the purchaser of the vendor services receivables pursuant to the repurchase clauses in the agreements; (ii) a $39.4 million charge for costs associated with various modifications to financing arrangements and recognition of deferred expenses for terminated warehouse facilities; (iii) a $16.3 million charge for the abandonment of computer processing systems; (iv) a $38.1 million benefit due to the reduction in the value of the warrant held by Lehman to purchase five percent of CFC, which is currently expected to have no value due to CFC's bankruptcy proceedings; and (v) restructuring and other charges of $6.7 million. Special charges recorded in 2001 include: (i) the loss related to the sale of certain finance receivables of $11.2 million; (ii) severance benefits, litigation reserves and other restructuring charges of $12.8 million; (iii) a $7.5 million charge related to the decision to discontinue the sale of certain types of life insurance in conjunction with lending transactions; and (iv) a $10.0 million benefit due to the reduction in the value of the warrant held by Lehman to purchase five percent of CFC which was caused by a decrease in the value of CFC. Special charges recorded in 2000 include: (i) the $103.3 million reduction in the value of finance receivables identified for sale; (ii) the $53.0 million loss on the sale of asset-based loans; (iii) $29.5 million of costs related to closing offices and streamlining businesses; (iv) $35.8 million related to the abandonment of computer processing systems; (v) $30.3 million of fees paid to Lehman including a $25.0 million fee paid in conjunction with the sale of $1.3 billion of finance receivables to Lehman; (vi) the issuance of a warrant valued at $48.1 million related to the modification of the Lehman master repurchase financing facilities; (vii) the $51.0 million loss on sale of transportation loans and vendor services financing business; (viii) a $48.0 million increase in the allowance for loan losses at our bank subsidiary; and (ix) $4.7 million of net gains related to the sale of certain lines of business, net of other items. These charges are described in greater detail in the note to Conseco's consolidated financial statements entitled "Financial Information Regarding CFC."
During 2002, CFC's ability to access the securitization markets was eliminated. The securitization markets had been CFC's main source of funding for loans made to purchasers of repossessed manufactured homes. CFC believes that its loss severity rates historically have been positively impacted when it used retail channels to dispose of repossessed inventory (where the repossessed units are sold through company-owned sales lots or CFC's dealer network). Since CFC is no longer able to fund the loans made on repossessed homes, sales through these channels have ceased and CFC must rely on the wholesale channel to dispose of repossessed
manufactured housing units, through which recovery rates are significantly lower. Accordingly, CFC changed the loss severity assumptions used to value its retained interests to reflect the higher loss severity CFC expects to experience in the future. In addition, CFC's previous assumptions reflected its belief that the adverse manufactured housing default experience in recent periods would continue through the first half of 2002 and then improve over time. Default experience did not improve as expected. Accordingly, CFC increased the default assumptions used to value its retained interests to reflect CFC's future expectations based on current default rates. CFC's home equity/home improvement assumptions have also been adjusted to reflect recent default experience as well as CFC's future expectations.
CFC's access to liquidity was further limited during the fourth quarter of 2002. CFC was unable to access alternative funding sources to replace the financing it previously obtained through the securitization markets. Further, CFC continued to experience high levels of delinquencies and foreclosures. As a result of the inability to obtain financing, CFC was required to suspend all originations of manufactured housing loans, including the financing of repossessed manufactured housing units, in the fourth quarter of 2002. In addition, CFC discontinued the use of some of its loss mitigation strategies including its inventory loan assumption program. Prices of used manufactured housing units in the wholesale channels are at historical lows due to the high levels of repossessed manufactured housing inventories available in the market. Accordingly, CFC increased the loss severity and default assumptions used to value its retained interests to reflect CFC's future expectations based on current experience. During 2002, CFC increased the assumption for the expected rates of loss severity (the expected weighted average ratio of losses realized to the principal balance of the foreclosed loans) from 65.4 percent to 89.5 percent. CFC increased the assumption for the expected rates of default (the expected weighted average constant ratio of defaulting loans to the balance of all loans sold) from 2.34 percent to 2.97 percent.
CFC recognized an impairment charge of $386.9 million in 2001 which included an impairment charge of $264.8 million related to its interest-only securities. During 2001, CFC's interest-only securities did not perform as well as anticipated. In addition, CFC's expectations regarding future economic conditions changed. Accordingly, CFC increased its loss severity assumptions related to the performance of the underlying loans to be consistent with its expectations. CFC increased the assumption for the expected rates of loss severity (the expected weighted average ratio of losses realized to the principal balance of the foreclosed loans) from 59.8 percent to 65.4 percent. The impairment charge also included a $122.1 million increase in the valuation allowance related to CFC's servicing rights as a result of the changes in assumptions. CFC carries its servicing rights at the lower of carrying value or estimated fair value. Refer to "Finance Receivables and Retained Interests in Securitization Trusts - Retained Interests in Securitization Trusts" for additional discussion of the impairment charge and interest-only securities.
During 2000, actual default and loss trends were worse than CFC's previous estimates. In light of these trends, CFC's management analyzed the assumptions used to determine the estimated fair value of the interest-only securities and made changes to the credit loss assumptions and the discount rate used to determine the value of its securities. These changes also reflected other economic factors and further methodology enhancements made by CFC. During 2000, CFC increased the assumption for the expected rates of default (the expected weighted average constant ratio of defaulting loans to the balance of all loans sold) from 2.25 percent to 2.45 percent. CFC also increased the assumption for the expected rates of loss severity (the expected weighted average ratio of losses realized to the principal balance of the foreclosed loans) from 55.3 percent to 59.8 percent. As a result, the expected future cash flows from interest-only securities changed adversely from previous estimates. Pursuant to the requirements of EITF 99-20, the effect of these changes was reflected immediately in earnings as an impairment charge. The effect of the impairment charge and adjustments to the value of CFC's interest-only securities and servicing rights totaled $515.7 million ($324.9 million after the income tax benefit) for 2000 (in addition to the cumulative effect of adopting EITF 99-20 of $70.2 million, or $45.5 million after the income tax benefit).
Finance Receivables and Retained Interests in Securitization Trusts Held by CFC
During the last several years, CFC has completed several actions in an attempt to raise cash and improve its financial position and results of operations. These actions have caused significant fluctuations in account balances. See the section above entitled "Operating Results of the Discontinued Finance Operations" for a description of such actions. Finance receivables, including receivables which serve as collateral for the notes issued to investors in securitization trusts of $12,460.0 million and $14,198.5 million at December 31, 2002 and 2001, respectively, summarized by business line and categorized as either a part of CFC's primary lines or a part of other lines (discontinued in previous periods), were as follows:
As stated above in the section entitled "Operating Results of the Discontinued Finance Operations", CFC changed the manner in which it structured securitization of loans on September 8, 1999. The securitizations structured prior to the September 8, 1999, announcement met the applicable criteria to be accounted for as sales. At the time the loans were securitized and sold, CFC recognized a gain and recorded its retained interest represented by the interest-only security. The interest-only security represents the right to receive, over the life of the pool of receivables: (i) the excess of the principal and interest received on the receivables transferred to the special purpose entity over the principal and interest paid to the holders of other interests in the securitization; and (ii) contractual servicing fees. CFC considers any potential payments related to the guarantees of certain lower-rated securities issued by the securitization trusts in the projected cash flows used to determine the value of its interest-only securities. In some of those securitizations, CFC also retained certain lower-rated securities that are senior in payment priority to the interest-only securities. Such retained securities had a par value, fair market value and amortized cost of $718.7 million, $611.5 million and $548.0 million, respectively, at December 31, 2002.
In conjunction with the sale of certain finance receivables, CFC provided guarantees related to the principal and interest payments of certain lower-rated securities issued to third parties by the securitization trusts. Such securities had a total principal balance outstanding of $1.4 billion at December 31, 2002. CFC considers any potential payments related to these guarantees in the projected net cash flows used to determine the value of its retained interests. At December 31, 2002, the net deficit value of CFC's retained interests of $(74.1) million, reflected estimated guarantee payments related to bonds held by others of $326.7 million.
CFC carries its servicing rights at the lower of carrying value or estimated fair value stratified by product type and year of securitization. To the extent the recorded amount exceeds the fair value for a given strata, CFC establishes a valuation allowance through a charge to earnings. Such valuation allowance increased by $336.5 million and $122.1 million in 2002 and 2001, respectively. The fees CFC receives for servicing the securitized portfolio are often subordinate to the interests of other security holders in the trusts.
No assurances can be given that CFC's current valuation of retained interests will prove accurate in future periods. In addition, CFC has retained certain contingent risks in the form of guarantees of certain lower-rated securities issued by the securitization trusts. If CFC has to make more payments on these guarantees than anticipated, CFC may be required to recognize additional impairment charges or to make payments on the guarantees, which, in turn, could have a material adverse effect on its financial condition or results of operations.
The most significant source of liquidity for CFC has historically been its ability to finance the receivables it originates in the secondary markets through loan securitizations. Under certain securitization structures, CFC has provided a variety of credit enhancements, which have taken the form of corporate guarantees with respect to certain securitizations (although such guarantees were not provided during 2001 and 2002), and have also included bank letters of credit, surety bonds, cash deposits and over-collateralization or other equivalent collateral. The nominal value of these guarantees is approximately $1.4 billion. CFC suspended guarantee payments in the fourth quarter of 2002 and without additional liquidity in the near future, CFC will be unable to make these guarantee payments when such payments are required to be made. See the section above entitled "Retained Interests in Securitization Trusts" for additional information on the guarantee payments.
The ratings downgrades that followed announcements regarding CNC's defaulted debt and restructuring discussions with debt holders (see the section entitled "Liquidity of Conseco (parent company)" in this "Management's Discussion and Analysis of Financial Condition and Results of Operations") have eliminated CFC's access to the securitization markets. The securitization markets have been CFC's main source of funding. The loss of access to the securitization markets has severely affected CFC's ability to originate, purchase and sell loans. It has also affected the value of the retained interests CFC holds in securitization trusts, since CFC relied on these markets to finance the sale of repossessed manufactured housing units which often helped to minimize the loss on defaulted loans (compared to selling directly to the manufactured housing wholesale channel).
CFC's remaining liquidity sources (excluding its bank subsidiaries) are a warehouse and a residual facility with Lehman and a postpetition financing facility. CFC's inability to access the securitization markets and the constrained liquidity under its other funding sources have had a material adverse effect on its business and results of operations, resulting in CFC's petition for relief under the Bankruptcy Code. As part of the Chapter 11 bankruptcy filing, CFC requested and received an interim order from the Bankruptcy Court to increase the servicing fees it is paid by the securitization trusts for manufactured housing loans (see the section above entitled "Operating Results of the Discontinued Finance Operations").
In April 2002, CFC completed a tender offer pursuant to which it purchased $158.5 million par value of its medium term notes due September 2002 and $3.7 million par value of its medium term notes due April 2003. The purchase price was equal to 100 percent of the principal amount of the notes plus accrued interest. In June 2002, CFC commenced a tender offer for the remaining $8.2 million par value of its medium term notes due September 2002. Pursuant to the tender offer $5.5 million par value of the notes was tendered in July. The purchase price was equal to 101 percent of the principal amount of the notes plus accrued interest. The remaining principal amount outstanding of the medium term notes after giving effect to both tender offers and other debt repurchases completed prior to the tender offers of $2.7 million was retired at maturity on September 26, 2002. Since that date, CFC has had no outstanding public debt.
CFC has historically pursued alternative and supplementary methods to finance its lending operations. In late 1998, CFC began issuing certificates of deposit through its bank subsidiaries. At December 31, 2002, $2.3 billion of such deposits were outstanding. The average annual rate paid on these deposits was 3.9 percent during 2002. Proceeds from the issuance of the certificates of deposit are used to fund the origination of certain consumer/credit card finance receivables. To the extent that CFC is unable to issue certificates of deposit, loan origination activities would be adversely affected, which would have additional material adverse effects on its operations, financial results and cash position. The sale of Mill Creek Bank, CFC's subsidiary which issues the certificates of deposit, to GE was approved by the Bankruptcy Court on March 14, 2003.
Profitability may be directly affected by the level of and fluctuations in interest rates which affect CFC's ability to earn a spread between interest received on loans and the costs of liabilities. While CFC monitors the interest rate environment, its financial results could be adversely affected by changes in interest rates. During periods of increasing interest rates, CFC has historically experienced market pressure to reduce servicing spreads in its financing operations. In addition, increases in interest rates have historically decreased the demand for consumer credit. If CFC was able to resume originating loans and finance them through securitization transactions, a substantial and sustained increase in interest rates could, among other things: (i) adversely affect CFC's ability to purchase or originate loans or other assets; (ii) reduce the average size of loans underwritten; and (iii) increase securitization funding costs. A significant decline in interest rates could decrease the size of CFC's loan servicing portfolio by increasing the level of loan prepayments, thereby shortening the life and impairing the value of CFC's interest-only securities. Fluctuating interest rates also may affect CFC's net interest income earned resulting from the difference between the yield to CFC on loans held pending securitization and the cost of funds obtained by CFC to finance such loans.
levels. This compares to a decline in fair value of $362.3 million based on amounts and rates at December 31, 2001. The increase in the estimated decline corresponds with the increase to its finance receivable balances.
CFC's finance receivables were primarily funded with the fixed rate asset-backed securities purchased by investors in securitization transactions and floating-rate debt. Such borrowings included bank credit facilities, master repurchase agreements and the notes payable related to securitized finance receivables structured as collateralized borrowings ($10.9 billion of which was at fixed rates and $3.0 billion of which was at floating rates). Based on the interest rate exposure and prevalent rates at December 31, 2002, a relative 10 percent decrease in interest rates would increase the fair value of the finance segment's fixed-rate borrowed capital by approximately $65 million. The interest expense on this segment's floating-rate debt will fluctuate as prevailing interest rates change. CFC is exposed to market risk from the time a loan is originated to the time the loan is financed as interest rates may fluctuate during such period of time.
In our opinion, the accompanying consolidated balance sheet and the related consolidated statements of operations, shareholders' equity (deficit) and cash flows present fairly, in all material respects, the financial position of Conseco, Inc. and subsidiaries at December 31, 2002 and 2001, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States of America, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
As discussed in note 4 to the consolidated financial statements, the Company adopted Emerging Issues Task Force Issue No. 99-20, "Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets" in 2000 and Statement of Financial Accounting Standards No. 142, "Goodwill and Other Intangible Assets" in 2002.
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002) CONSOLIDATED BALANCE SHEET December 31, 2002 and 2001 (Dollars in millions)
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002) CONSOLIDATED BALANCE SHEET (Continued) December 31, 2002 and 2001 (Dollars in millions)
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002) CONSOLIDATED STATEMENT OF OPERATIONS for the years ended December 31, 2002, 2001 and 2000 (Dollars in millions, except per share data)
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002) CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (DEFICIT) for the years ended December 31, 2002, 2001 and 2000 (Dollars in millions)
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002) CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (DEFICIT) (Continued) for the years ended December 31, 2002, 2001 and 2000 (Dollars in millions)
(DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002) CONSOLIDATED STATEMENT OF CASH FLOWS for the years ended December 31, 2002, 2001 and 2000 (Dollars in millions)
Our insurance subsidiaries develop, market and administer supplemental health insurance, annuity, individual life insurance and other insurance products. Our finance business has historically provided a variety of finance products including manufactured housing and floor plan loans, home equity mortgages, home improvement and consumer product loans and private label credit cards.
Under the priority schedule established by the Bankruptcy Code, certain postpetition and prepetition liabilities need to be satisfied before unsecured creditors and holders of CNC's common and preferred stock and Trust Preferred Securities are entitled to receive any distribution. The Plan (as summarized in the Disclosure Statement) sets forth the Debtors' proposed treatment of claims and equity interests. No assurance can be given as to what values, if any, will be ascribed in the bankruptcy proceedings to each of these constituencies. Our Plan would result in holders of CNC's common stock and preferred stock (other than Series F Common-Linked Convertible Preferred Stock ("Series F Preferred Stock")) receiving no value and the holders of CNC's Trust Preferred Securities and Series F Preferred Stock receiving little value on account of the cancellation of their interests. In addition, holders of unsecured claims against the Debtors would, in most cases, receive less than full recovery for the cancellation of their interests.
The accompanying consolidated financial statements have been prepared on a going concern basis, which assumes continuity of operations and realization of assets and liabilities in the ordinary course of business, and in accordance with Statement of Position 90-7 "Financial Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7"). Accordingly, all prepetition liabilities subject to compromise have been segregated in the consolidated balance sheet and classified as "liabilities subject to compromise" at the estimated amount of allowable claims.
The Company is currently operating under the jurisdiction of Chapter 11 of the Bankruptcy Code and the Bankruptcy Court, and continuation of Conseco as a going concern is contingent upon our ability to obtain confirmation of the Plan, our ability to return to profitability, generate sufficient cash flows from operations, obtain financing sources to meet our future obligations and many other
issues, ongoing other bankruptcy considerations and risks related to our business and financial condition. These matters raise substantial doubt about Conseco's ability to continue as a going concern. The accompanying consolidated financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might result from the outcome of these uncertainties. Additionally, our Plan will materially change amounts reported in the consolidated financial statements, which do not give effect to all adjustments of the carrying value of assets and liabilities that are necessary as a consequence of a reorganization under Chapter 11 of the Bankruptcy Code.
During the third quarter of 2002, Conseco entered into an agreement to sell Conseco Variable Insurance Company ("CVIC"), its wholly owned subsidiary and the primary writer of its variable annuity products. The sale was completed in October 2002. The operating results of CVIC have been reported as discontinued operations in all periods presented in the accompanying consolidated statement of operations. See the note to the consolidated financial statements entitled "Financial Information Regarding CVIC."
On July 31, 2001, we completed the acquisition of ExlService.com, Inc. ("Ex1"), a firm that specializes in customer service and backroom outsourcing with operations in India. We issued 3.4 million shares of our common stock in exchange for Ex1's common stock. The total value of the transaction was $52.1 million. The Conseco Board of Directors (without Gary C. Wendt, the Company's former Chief Executive Officer, voting) approved the transaction, after receiving the recommendation of a special committee of outside directors. Mr. Wendt was one of the founders of Exl. Mr. Wendt and his wife owned 20.3 percent of Exl and his other relatives owned an additional 9.4 percent. Mr. Wendt and his wife received 692,567 shares of Conseco common stock in the transaction (worth approximately $9.7 million at the time the agreement was negotiated). However, these shares were restricted until Conseco recovered its $52.1 million acquisition price through cost savings achieved by transferring work to Exl and/or pre-tax profits from services provided to third parties by Exl. The shares also become unrestricted upon a change of control of 51 percent of the outstanding shares of Conseco common stock. In November 2002, the Company completed the sale of Exl and recognized a loss of $20.0 million on the transaction. The Company had previously written off a significant portion of the value of this investment in conjunction with the impairment charge related to goodwill pursuant to the Company's adoption of SFAS 142 (as defined in the following paragraph). Since Conseco did not recover the acquisition price prior to its sale of Exl, the shares held by Mr. Wendt and his wife remain restricted.
The following summary explains the significant accounting policies we use to prepare 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 ("FASB"), the American Institute of Certified Public Accountants ("AICPA") and the Securities and Exchange Commission (the "SEC").
Retained interests in securitization trusts represent the right to receive certain future cash flows from securitization transactions structured prior to our September 8, 1999 announcement (see "Revenue Recognition for Sales of Finance Receivables and Amortization of Servicing Rights" below). 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 retained interests 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. We determine the appropriate discount rate to value these securities based on our estimates of current market rates of interest for securities with similar yield, credit quality and maturity characteristics. The discount rate was 16 percent at December 31, 2002 and December 31, 2001. 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: (i) the fair value of the security is less than its carrying value; and (ii) the timing and/or amount of cash expected to be received from the security has changed adversely from the previous valuation which determined the carrying value of the security. When declines in value considered to be other than temporary occur, we reduce the amortized cost to estimated fair value and recognize a loss in the statement of operations. The assumptions used to determine new values are based on our internal evaluations. See the note to the consolidated financial statements entitled "Financial Information Regarding CFC" for additional discussion of gain on sale of receivables and interest-only securities.
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. When declines in value considered to be other than temporary occur, we reduce the amortized cost to estimated fair value and recognize a loss in the statement of operations.
Venture capital investment in AT&T Wireless Services, Inc. ("AWE") is carried at fair value, with changes in such value recognized as venture capital investment income (loss). In 2002, we sold 10.3 million shares of AWE common stock which generated proceeds of $75.7 million. At December 31, 2002, we held 4.1 million shares of AWE common stock with a value of $25 million. The market values of AWE common stock and other companies in AWE's business sector have declined significantly in recent periods. We recognized venture capital investment losses of $99.3 million, $42.9 million and $199.5 million in 2002, 2001 and 2000, respectively, related to this investment.
Other invested assets include: (i) trading securities; (ii) Standard & Poor's 500 Index Call Options ("S&P 500 Call Options"); and (iii) certain non-traditional investments. Trading securities are carried at market value with the change in value recognized as a charge to net income (loss). These securities are expected to be sold in the near term or relate to our multibucket annuity products as described under "Multibucket Annuity Product" below. We carry the S&P 500 Call Options at estimated fair value as further described below under "Accounting for Derivatives". Non-traditional investments include investments in certain limited partnerships and promissory notes; we account for them using either the cost method, or for investments in partnerships, the equity method.
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 fair value that is other than temporary, we treat it as a realized loss and reduce the cost basis of the security to its estimated fair value.
These liabilities relate to the certificates of deposits issued by the bank subsidiaries of CFC. The liability and interest expense account are also increased for the interest which accrues on the deposits. At December 31, 2002 and 2001, the weighted average interest crediting rate on these deposits was 3.5 percent and 4.7 percent, respectively.
In the first quarter of 2002, we completed a reinsurance agreement pursuant to which we ceded 80 percent of the inforce traditional life business of our subsidiary, Bankers Life & Casualty Company, to Reassure America Life Insurance Company (rated A++ by A.M. Best). The total insurance liabilities ceded pursuant to the contract were approximately $400 million. The reinsurance agreement and the related dividends of $110.5 million were approved by the appropriate state insurance departments and the dividends were paid to CNC. The ceding commission approximated the amount of the cost of policies purchased and cost of policies produced related to the ceded business.
On June 28, 2002, we completed a reinsurance transaction pursuant to which we ceded 100 percent of the traditional life and interest-sensitive life insurance business of our subsidiary, Conseco Variable Insurance Company, to Protective Life Insurance Company (rated A+ by A.M. Best). The total insurance liabilities ceded pursuant to the contract were approximately $470 million. Our insurance subsidiary received a ceding commission of $49.5 million.
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 a result of the failure of one of our reinsurers is considered remote. The cost of reinsurance is recognized over the life of the reinsured policies using assumptions consistent with those used to account for the underlying policy. The cost of reinsurance ceded totaled $327.8 million,
$249.4 million and $237.2 million in 2002, 2001 and 2000, respectively. A receivable is recorded for the reinsured portion of insurance policy benefits paid and liabilities for insurance products. Reinsurance recoveries netted against insurance policy benefits totaled $323.6 million, $201.3 million and $273.2 million in 2002, 2001 and 2000, 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 substantially the same as the securities sold (rather than being the same security). Such borrowings averaged $1,155.8 million during 2002 and $927.0 million during 2001. These borrowings 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 1.3 percent and 3.3 percent in 2002 and 2001, respectively. 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, 2002). We believe the counterparties to our reverse repurchase and dollar-roll agreements are financially responsible and that the counterparty risk is minimal.
The following table summarizes the components of the liabilities included in the line "liabilities subject to compromise" in our consolidated balance sheet as of December 31, 2002 (dollars in millions):
Condensed Consolidating Statement of Operations for the year ended December 31, 2002 (Dollars in millions)
Condensed Consolidating Statement of Operations for the year ended December 31, 2002 (Continued) (Dollars in millions)
Approximately 9,000 proofs of claim have been filed in connection with the February 21, 2003, bar date, and the Debtors have begun reconciling claims that differ from their records. Any remaining differences that cannot be resolved by negotiated agreement between the Debtors and the claimants will be resolved by the Bankruptcy Court.
Certain creditors have filed claims substantially in excess of amounts reflected in the Debtors' records. Consequently, the amount included in the consolidated balance sheet at December 31, 2002, as liabilities subject to compromise may be adjusted.
In early October 2001, we terminated these interest rate swap agreements for cash proceeds of $19.0 million (the value of the terminated swap agreements). No gain was recognized upon the termination of the interest rate swap agreements. Instead, the change in the fair value of the senior notes recorded while the interest rate swaps were outstanding will be amortized as a reduction to interest expense over the remaining life of our senior notes.
The Company's multibucket annuity is a fixed annuity product that credits interest based on the experience of a particular market strategy. Policyholders allocate their annuity premium payments to several different market strategies based on different asset classes within the Company's investment portfolio. Interest is credited to this product based on the market return of the given strategy, less management fees, and funds may be moved between different strategies. The Company guarantees a minimum return of premium plus approximately 3 percent per annum over the life of the contract. The investments backing the market strategies of these products are designated by the Company as trading securities. The change in the fair value of these securities is included in investment income which is substantially offset by the change in insurance policy benefits for these products.
For securitizations structured prior to September 8, 1999, CFC accounted for the transfer of finance receivables as sales. In accordance with GAAP, CFC recognized 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. CFC determined such carrying value by allocating the carrying value of the finance receivables between the portion sold and the interests retained (generally interest-only securities, servicing rights and, in some instances, other subordinated securities), based on each portion's relative fair values on the date of the sale.
CFC amortizes the servicing rights it retains after the sale of finance receivables in proportion to, and over the estimated period of, net servicing income.
CFC evaluates servicing rights for impairment on an ongoing basis, stratified by product type and securitization period. To the extent that the recorded amount exceeds the fair value for any strata, CFC establishes a valuation allowance through a charge to
Cash and cash equivalents. The carrying amount for these instruments approximates their estimated fair value.
Pursuant to SFAS 142, the goodwill impairment test has two steps. For Conseco, the first step consisted of comparing the estimated fair value of each of the business units comprising our insurance segment to the unit's book value. Since all of our goodwill relates to the insurance segment (which is also a reportable segment), the goodwill impairment test is not relevant to the finance
business. If the estimated fair value exceeds the book value, the test is complete and goodwill is not impaired. If the fair value is less than the book value, the second step of the impairment test must be performed, which compares the implied fair value of the applicable business unit's goodwill with the book value of that goodwill to measure the amount of goodwill impairment, if any.
Pursuant to the transitional rules of SFAS 142, we completed the two-step impairment test during 2002 and, as a result of that test, we recorded the cumulative effect of the accounting change for the goodwill impairment charge of $2,949.2 million. The impairment charge is reflected in the cumulative effect of an accounting change in the accompanying consolidated statement of operations for the year ended December 31, 2002. Subsequent impairment tests will be performed on an annual basis, or more frequently if circumstances indicate a possible impairment. Subsequent impairment charges are classified as an operating expense. As described below, the Company performed additional impairment tests in 2002, as a result of circumstances which indicated a possible impairment.
In connection with our negotiations with debt holders, we retained an outside actuarial consulting firm to assist in valuing our insurance subsidiaries. That valuation work and our internal evaluation were used in performing the additional impairment tests that resulted in an impairment charge to goodwill of $500.0 million. The charge is reflected in the line item entitled "Goodwill impairment" in our consolidated statement of operations for the year ended December 31, 2002. The most significant changes made to the January 1, 2002 valuation that resulted in the additional impairment charge were: (i) reduced estimates of projected future sales of insurance products; (ii) increased estimates of future policyholder redemptions and lapses; and (iii) a higher discount rate to reflect the current rates used by the market to value life insurance companies. Management believes that the assumptions and estimates used are reasonable given all available facts and circumstances. However, if projected cash flows are not realized in the future, we may be required to recognize additional impairments.
In accordance with SFAS 142, we discontinued the amortization of goodwill expense effective January 1, 2002. The following information summarizes the impact of goodwill amortization on income before discontinued operations, extraordinary gain (loss) and cumulative effect of accounting change; net income; and the respective earnings per share amounts for the periods presented in our consolidated statement of operations for periods prior to January 1, 2002:
Pursuant to the transitional rules of SFAS 142, the cumulative effect of the accounting change for goodwill impairment is reflected in the consolidated financial statements for the quarter ended March 31, 2002. Accordingly, the consolidated statement of operations for the three months ended March 31, 2002, has been restated to reflect the change as summarized below (dollars in millions, except per share data):
Under the new accounting rule, declines in value are recognized when: (i) the fair value of the retained beneficial interests are less than their carrying value; and (ii) the timing and/or amount of cash expected to be received from the retained beneficial interests have changed adversely from the previous valuation which determined the carrying value of the retained beneficial interests. When both occur, the retained beneficial interests are written down to fair value.
During 2002, 2001 and 2000, the retained interests held by CFC did not perform as well as anticipated. In addition, CFC's expectations regarding future economic conditions changed. Accordingly, CFC changed various underlying assumptions (including default, severity, credit loss, discount rate and servicing cost assumptions) related to the future performance of the underlying loans to be consistent with management's expectations. As a result, the expected future cash flows (including any potential payments related to the guarantees of certain lower-rated securities issued by the securitization trusts) from interest-only securities changed adversely from previous estimates. Pursuant to the requirements of EITF 99-20, the effect of these changes was reflected immediately in earnings as an impairment charge. In 2002, CFC recognized an impairment charge of $1,077.2 million related to its retained interests. CFC also recognized a $336.5 million increase in the valuation allowance related to its servicing rights as a result of the changes in assumptions in 2002. The valuation allowance related to the servicing rights increased as a result of changes to the expected future cost of servicing the finance receivables. The levels of delinquent and defaulting loans have caused servicing costs to increase. In addition, future servicing costs are expected to increase as the portfolio ages. In addition, CFC recognized impairment charges of: (i) $29.3 million to establish a valuation allowance for advances CFC was required to make to the securitization trusts which are potentially uncollectible; and (ii) $6.9 million to establish a liability of guarantee payments due to certain holders of lower-rated securities issued by the securitization trusts which CFC was unable to pay. In 2001, CFC recognized an impairment charge of $264.8 million ($171.3 million after the income tax benefit) related to its retained interests. CFC also recognized a $122.1 million ($79.1 million after the income tax benefit) increase in the valuation allowance related to its servicing rights as a result of the changes in assumptions in 2001. In 2000, the effect of the impairment charge and adjustments to the value of its retained interests totaled $515.7 million ($324.9 million after the income tax benefit) in addition to the cumulative effect of adopting EITF 99-20 of $70.2 million ($45.5 million after the income tax benefit).
The FASB issued FASB Interpretation No. 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" ("FIN 45") in November 2002. FIN 45 requires certain guarantees to be recognized as liabilities at fair value. In addition, it requires a guarantor to make new disclosures regarding its obligations. We implemented the new disclosure requirements as of December 31, 2002; see the note to the consolidated financial statements entitled "Other Disclosures." FIN 45's liability recognition requirement is effective on a prospective basis for guarantees issued or modified after December 31, 2002.
We do not expect that FIN 45 will materially impact the Company's results of operations or financial condition.
The FASB issued Statement of Financial Accounting Standards No. 146, "Accounting for Exit or Disposal Activities" ("SFAS 146") in June 2002. SFAS 146 addresses financial accounting and reporting for costs that are associated with exit and disposal activities and supersedes Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)" ("EITF 94-3"). SFAS 146 is required to be used to account for exit or disposal activities that are initiated after December 31, 2002. The provisions of EITF 94-3 shall continue to apply for an exit activity initiated prior to the adoption of SFAS 146. SFAS 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of commitment to an exit or disposal plan. The Company plans to adopt the provisions of SFAS 146 on January 1, 2003. We do not expect the initial adoption of SFAS 146 to have a material impact on the Company's consolidated financial statements.
The FASB issued Statement of Financial Accounting Standards No. 145, "Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections" ("SFAS 145") in April 2002. Under previous guidance all gains and losses resulting from the extinguishment of debt were required to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. SFAS 145 rescinds that guidance and requires that gains and losses from extinguishments of debt be classified as extraordinary items only if they are both unusual and infrequent in occurrence. SFAS 145 also amends previous guidance to require certain lease modifications that have economic effects similar to sale-leaseback transactions be accounted for in the same manner as sale-leaseback transactions. This new guidance is effective for fiscal years beginning after May 15, 2002. We do not expect SFAS 145 to materially impact the Company's results of operations and financial position.
The FASB issued Statement of Financial Accounting Standards No. 144, "Accounting for the Impairment of Long-Lived Assets" ("SFAS 144") in August 2001. This standard addresses the measurement and reporting for impairment of all long-lived assets. It also broadens the definition of what may be presented as a discontinued operation in the consolidated statement of operations to include components of a company's business segments. SFAS 144 requires that long-lived assets currently in use be written down to fair value when considered impaired. Long-lived assets to be disposed of are written down to the lower of cost or fair value less the estimated cost to sell. The Company adopted this standard on January 1, 2002. We have followed this standard in determining when it is appropriate to recognize impairments on assets we have decided to sell as part of our efforts to raise cash. We have also followed this standard in determining that our variable annuity business line and CFC should be presented as discontinued operations in our consolidated financial statements (see the notes to the consolidated financial statements entitled "Financial Information Regarding CFC" and "Financial Information Regarding CVIC").
The FASB issued SFAS 141 and SFAS 142 in June 2001. Under the new rules, intangible assets with an indefinite life are no longer amortized in periods subsequent to December 31, 2001, but are subject to annual impairment tests (or more frequently under certain circumstances), effective January 1, 2002. The Company adopted SFAS 141 and SFAS 142 effective January 1, 2002 (see the note to the consolidated financial statements entitled "Summary of Significant Accounting Policies" for additional discussion).
The FASB issued SFAS 140 (which is a replacement for Statement of Financial Accounting Standards No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities") and a related implementation guide in September 2000. SFAS 140 and the implementation guide have changed the criteria that must be met for securitization transactions to be recorded under the portfolio method. We did not need to make any significant changes to our securitization structures to meet the new criteria which are effective for securitization transactions completed after March 31, 2001. We first adopted the SFAS 140 requirement for additional disclosures on securitization in our December 31, 2000, consolidated financial statements.
Statement of Position No. 98-7, "Accounting for Insurance and Reinsurance Contracts That Do Not Transfer Insurance Risk" ("SOP 98-7") provides guidance on the method of accounting for insurance and reinsurance contracts that do not transfer risk. We adopted SOP 98-7 on January 1, 2000. The adoption did not have a material impact on the Company's consolidated financial condition or results of operations.
At December 31, 2002, the amortized cost and estimated fair value of actively managed fixed maturities and equity securities were as follows:
With respect to our corporate securities, no other industry accounted for more than 5.0 percent of amortized cost or estimated fair value.
The carrying value of fixed maturity investments and mortgage loans not accruing investment income totaled $169.6 million, $140.2 million and $98.0 million at December 31, 2002, 2001 and 2000, respectively.
Investment losses, net of related investment expenses, were included in revenue as follows:
Net realized investment losses during 2002 included: (i) $556.8 million of writedowns of fixed maturity investments, equity securities and other invested assets as a result of conditions which caused us to conclude a decline in fair value of the investment was other than temporary; and (ii) $40.2 million of net losses from the sales of investments (primarily fixed maturities) which generated proceeds of $19.5 billion. At December 31, 2002, fixed maturity securities in default as to the payment of principal or interest had an aggregate amortized cost of $203.9 million and a carrying value of $174.8 million. Net realized investment losses during 2001 included: (i) $361.7 million of writedowns of fixed maturity investments, equity securities and other invested assets as a result of conditions which caused us to conclude a decline in fair value of the investment was other than temporary; and (ii) $17.7 million of net losses from the sales of investments (primarily fixed maturities).
During 2002, we recorded writedowns of fixed maturity investments, equity securities and other invested assets totaling $556.8 million. The following is a brief description of the facts and circumstances that resulted in the other-than-temporary losses.
During 2002, we recorded writedowns totaling $130.1 million on securitized investments backed by various debt securities and/or commercial loans (referred to herein as "collateralized debt obligations" or "CDOs"). Principal and interest payments on CDOs are made from cash flows from underlying loans held by the trusts. The current value of these investments are influenced by a number of factors, such as the performance of the underlying loans, the current and future expected economic environment, and the payment priority of our investment in the securitization structure. In recent periods, general rates of defaults on commercial loans have increased. In addition, the ratings of several CDOs which we hold have been downgraded by nationally recognized statistical rating organizations. Accordingly, we reviewed our CDO portfolio for potential other-than-temporary impairments in accordance with EITF 99-20.
During 2002, we recorded writedowns totaling $29.9 million related to investments in a large capitalization stock fund, a balanced fund, and a diversified science and technology fund. The events of September 11, 2001 caused a decline in the value of most equity securities, including net assets in these funds. Based on the belief that the economy was improving at year-end 2001, combined with the general equity market improvement in late 2001, we concluded that the unrealized loss at December 31, 2001 was temporary. However, the equity markets in the first half of 2002 suffered additional significant losses due to a combination of corporate restatements, fears over a double-dip recession and decreased corporate capital spending. We changed our intent to hold these funds once we concluded that the loss was other than temporary. All of our holdings in such funds were sold by August 5, 2002.
During 2002, we recorded writedowns totaling $30.2 million related to an investment in a telecommunications company that was rated investment grade at the time of purchase and was subsequently downgraded to below-investment grade. The issuer faced significant financial difficulties and accounting irregularities that resulted in sequential and material restatements of its financial statements. The issuer defaulted and filed for Chapter 11 Bankruptcy protection in July 2002.
During 2002, we recorded writedowns totaling $24.5 million related to holdings of fixed maturity investments in a retail chain that defaulted in early 2002. A writedown was taken as of December 31, 2001 based upon the estimated fair value of the investment at that time. Given the subsequent decrease in the estimated fair value of our investment, subsequent writedowns were taken in 2002.
During 2002, we recorded writedowns totaling $26.5 million based upon our analysis of the value of the underlying collateral of various investments in the airline sector. Many major airlines are facing significant liquidity issues and we believe the current market value of the collateral backing these loans is less than the book value of our investment. We believe that the decline in fair value of these investments is other than temporary.
During 2002, we recorded writedowns totaling $8.5 million related to investments issued by a moving and storage company. The issuer failed to make a scheduled principal payment on a public debt security. The issuer recently cancelled a proposed offering of long-term notes. While the issuer has publicly expressed its intention and belief that a successful refinancing can be completed, we believe that the decline in market value of this security is other than temporary.
During 2002, we recorded writedowns of $8.1 million of fixed maturity investments issued by a copper producer. The financial condition of this issuer is significantly affected by the price of copper, which has dropped from as high as $0.80 per pound earlier this year to a low of $0.68 near the end of the second quarter. In addition, the issuer was downgraded by a national rating agency during the first six months of 2002. Despite the fact that the issuer was still making the coupon payments on this issue, we believed that the decline in market value of this security was other than temporary. All of our holdings in this issuer were sold by August 8, 2002.
Our evaluation of investments for impairment requires significant judgments to be made including: (i) the identification of potentially impaired securities; (ii) the determination of their estimated fair value; and (iii) assessment of whether any decline in estimated fair value is other than temporary. If new information becomes available or the financial condition of the investee changes, our judgments may change resulting in the recognition of an investment loss at that time.
The following table sets forth the amortized cost and estimated fair value of those actively managed fixed maturities with unrealized losses at December 31, 2002, 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.
The following summarizes the investments in our portfolio rated below-investment grade or classified as equity-type securities which have been continuously in an unrealized loss position exceeding 20 percent of the cost basis for the period indicated as of December 31, 2002:
Based on management's current assessment of these securities and other investments with unrealized losses at December 31, 2002, the Company believes the issuers of the securities will continue to meet their obligations (or with respect to equity-type securities, the investment value will recover to its cost basis). The Company has no current plans to sell these securities and has the ability to hold them to maturity. The recognition of an other-than-temporary impairment through a charge to earnings may be recognized in future periods if management later concludes that the decline in market value below the cost basis is other than temporary.
The following is a brief description of our assessment of the potential other-than-temporary losses related to investments in our below-investment grade portfolio (or equity-type securities) with significant unrealized losses at December 31, 2002 (unrealized losses which exceed $7.0 million and 20 percent of the cost basis of the securities by the same issuer):
At December 31, 2002, we held fixed maturity investments in an oil-related production facility rated Ba1 with an amortized cost basis of $53.9 million and an estimated fair value of $35.5 million. Proceeds from the sale of the oil produced are used to service the debt. This joint venture includes purchase guarantees from investment grade companies that will provide sufficient liquidity to service the debt. Therefore, we concluded that the unrealized loss at December 31, 2002 is temporary.
At December 31, 2002, we held secured fixed maturity investments issued by a commercial airline rated Ba2/BB+ with an amortized cost of $17.2 million and an estimated fair value of $10.5 million. The issuer is facing financial challenges that affect the entire industry, but is implementing a plan to increase liquidity, reduce debt and reduce costs. Given that the issuer has demonstrated that it has sufficient cash flows and liquidity to meet its obligations, we concluded that the unrealized loss at December 31, 2002 is temporary.
At December 31, 2002, we held fixed maturity investments issued by a commercial airline rated Ba3/B+ and Caa1/CCC+ with an amortized cost of $29.8 million and an estimated fair value of $14.4 million. We previously recorded writedowns related to these securities. We believe the collateral supporting these investments is sufficient and, therefore, concluded that the unrealized loss at December 31, 2002 is temporary.
The other investor in the building has filed a lawsuit against Conseco which is described in the note to the consolidated financial statements entitled "Other Disclosures". See the caption "Investment in General Motors Building" in the note to the consolidated financial statements entitled "Investments in Variable Interest Entities" for further information on this investment.
Commercial mortgage-backed securities ("CMBS") are bonds secured by commercial real estate mortgages. Commercial real estate encompasses income producing properties that are managed for economic profit. Property types include multi-family dwellings including apartments, retail centers, hotels, restaurants, hospitals, nursing homes, warehouses, and office buildings. The CMBS market currently offers high yields, strong credits, and call protection compared to similar-rated corporate bonds. Most CMBS have strong call protection features where borrowers are locked out from prepaying their mortgages for a stated period of time. If the
borrower does prepay any or all of the loan, he or she will be required to pay prepayment penalties.
Subordinated and mezzanine tranches are classes that provide credit enhancement to the senior tranches. The rating agencies require that this credit enhancement not deteriorate due to prepayments for a period of time, usually five years of complete lockout, followed by another period of time where prepayments are shared pro rata with senior tranches. The credit risk of subordinated and mezzanine tranches is derived from owning a small percentage of the mortgage collateral, while bearing a majority of the risk of loss due to property owner defaults. Subordinated bonds can be rated "AA" or lower; we typically do not buy anything rated lower than "BB".
Our investment borrowings averaged approximately $1,155.8 million during 2002, compared with approximately $927.0 million during 2001 and were collateralized by investment securities with fair values approximately equal to the loan value. The weighted average interest rates on such borrowings were 1.3 percent and 3.3 percent during 2002 and 2001, respectively.
Life insurance companies are required to maintain certain investments on deposit with state regulatory authorities. Such assets had an aggregate carrying value of $144.5 million at December 31, 2002.
Changes in the unpaid claims reserve and liabilities related to accident and health insurance were as follows:
Our income tax expense includes deferred income taxes arising from temporary differences between the financial reporting and tax bases of assets and liabilities, capital loss carryforwards and net operating loss carryforwards. The net deferred tax assets totaled $1,719.6 million at December 31, 2002 (including $925.7 million of deferred tax assets related to CFC which are classified as discontinued operations). In assessing the realization of our deferred income tax assets, we consider whether it is more likely than not that the deferred income tax assets will be realized. The ultimate realization of our deferred income tax assets depends upon generating future taxable income during the periods in which our temporary differences become deductible and before our net operating loss carryforwards expire. We evaluate the realizability of our deferred income tax assets by assessing the need for a valuation allowance on a quarterly basis. A valuation allowance of $1,719.6 million (of which $925.7 million relates to discontinued operations) has been provided for the entire balance of net deferred income tax assets at December 31, 2002, as we believe the realization of such assets in future periods is uncertain. We reached this conclusion after considering the availability of taxable income in prior carryback years, tax planning strategies, and the likelihood of future taxable income exclusive of reversing temporary differences and carryforwards. This conclusion was greatly influenced by recent unfavorable developments affecting the Company such as rating downgrades that decrease the Company's likelihood to generate adequate future taxable income to realize the tax benefits.
The Company established valuation contingencies related to certain tax uncertainties of the insurance companies we acquired on the date of their acquisition. We have determined that $146.2 million of such valuation contingencies are no longer necessary because the tax uncertainties no longer exist. Pursuant to Statement of Financial Accounting Standards Statement No. 109, "Accounting for Income Taxes", the benefit for the reduction of such valuation contingencies shall be first applied to reduce the goodwill balance related to the acquisition. Accordingly, in the second quarter of 2002, we reduced such valuation contingencies (increasing deferred tax asset) and reduced goodwill by $146.2 million. The components of the Company's income tax assets and liabilities were as follows:
Included in the components of the consolidated net deferred tax asset are $925.7 million of net deferred tax assets related to CFC (see the note entitled "Financial Information Regarding CFC" for further detail). These assets are offset by a $925.7 million valuation reserve. The CFC deferred taxes are presented assuming a continuation of its business. The actual realization of CFC's deferred items may be materially different as the result of the conclusion of bankruptcy proceedings and the disposition of certain businesses.
At December 31, 2002, Conseco had $322.4 million of capital loss carryforwards. These carryforwards will expire as follows: $23.2 million in 2006; and $299.2 million in 2007.
Conseco and its affiliates are currently under examination by the Internal Revenue Service for tax years ending June 30, 1998 through December 31, 1999. The outcome of the examination is not expected to result in material adverse deficiencies, but may result in utilization or adjustment to the income tax loss carryforwards reported above.
We sometimes refer to the 93 Notes and the 94 Notes collectively as the "93/94 Notes." The 93/94 Notes are secured by the stock of CIHC, Conseco Capital Management, Inc. (a registered investment advisor and wholly-owned subsidiary of CNC), CFC and certain of its subsidiaries and certain intercompany notes. It is anticipated that substantially all of CFC's assets will be sold in connection with the Company's reorganization. If certain of these assets have been pledged to the holders of the 93/94 Notes, and if proceeds of these pledged assets are used to pay the 93/94 Notes, then CFC may assert, by subrogation, the rights of such holders against the Debtors.
The collateral that secures the 93/94 Notes was pledged pursuant to an "equal and ratable" clause in the indentures governing the 93/94 Notes. The indentures of the 93/94 Notes provide that if another creditor obtains a security interest in certain property of CNC or any of its significant subsidiaries, then the 93/94 Notes will automatically obtain an "equal and ratable" security interest in such property. Certain parties have alleged that the legal mechanism by which the 93/94 Notes obtained a security interest somehow impairs that security interest. Such parties allege that because the holders of the 93/94 Notes did not provide consideration for the security interest that they received simply because another party received that security interest, the 93/94 Notes' security interest may be voided under a theory of unjust enrichment, fraudulent conveyance or lack of consideration. Wilmington Trust Company, the indenture trustee under the 93/94 Notes, maintains that any and all claims with respect to the avoidability of the 93/94 Notes are frivolous and wholly without merit.
Our Senior Credit Facility requires the Company to maintain various financial ratios and balances, as defined in the agreement. At December 31, 2002, we were not in compliance with these covenants in our Senior Credit Facility. We were in violation of the following financial covenants we agreed to maintain at December 31, 2002: (i) a debt to capitalization ratio of less than ..375:1.0 at December 31, 2002 and decreasing over time, as defined in the agreement, to 0.300:1.0 at March 31, 2004 and thereafter (such ratio was ..567:1.0 at December 31, 2002); (ii) an interest coverage ratio greater than 1.10:1.0 for the four quarters ending December 31, 2002 and changing over time, as defined in the agreement, to 2.50:1.0 for the four quarters ending June 30, 2004 and thereafter (such ratio was .11:1.0 for the four quarters ended December 31, 2002); (iii) adjusted earnings, as defined in the agreement, of at least $1,300.0 million for the four quarters ending December 31, 2002 and increasing over time, as defined in the agreement, to $1,700.0 million for the four quarters ending September 30, 2004 (the adjusted earnings for the four quarters ended December 31, 2002 were $926.7 million); and (iv) CFC tangible net worth, as defined in the agreement, of at least $1.2 billion at December 31, 2002; and $1.6 billion at March 31, 2005 (such tangible net worth was less than zero at December 31, 2002). We also agreed to maintain the ratio of aggregate total adjusted capital to aggregate authorized control level risk-based capital (as defined by the National Association of Insurance Commissioners) with respect to our insurance subsidiaries of at least 250 percent (such ratio was greater than 250 percent at December 31, 2002). Our amended credit facility provides that any charges taken to write off goodwill to the extent required by SFAS 142 will be excluded from the various financial ratios and covenants that we are required to meet or maintain.
The Senior Credit Facility reduces the 90-day moving average cash balance we must maintain at the parent company from $100 million to $50 million. The Company is required to have at least $50 million of cash on hand immediately after making a trust preferred dividend payment in addition to the 90-day moving average requirement. The parent company had less than $50 million in cash at December 31, 2002. The Senior Credit Facility also states that in the event one of Conseco's significant insurance subsidiaries is rated "B" or below by A.M. Best, the Company must take certain actions to generate liquidity and accelerate the repayment of the amended credit facility. All of our significant insurance subsidiaries are rated "B" by A.M. Best.
The Senior Credit Facility prohibits the payment of cash dividends on our common stock until the Company has received investment grade ratings on its outstanding public debt. Such agreement also prohibits the repurchase of our common stock. The Senior Credit Facility limits the issuance of additional debt, contingent obligations, liens, asset dispositions, other restrictive agreements, affiliate transactions, change in business and modification of terms of debt or preferred stock, all as defined in the agreements. The obligations under our credit facility are also guaranteed by CIHC.
Effective September 9, 2002, we were subject to the default interest rate on the Senior Credit Facility. Such rate is based on the prime rate plus a margin of 3.75 percent. Prior to September 9, 2002, the interest rate on the amended credit facility was based on an IBOR rate plus a margin of 3.25 percent. Borrowings under our Senior Credit Facility averaged $1,499.2 million during 2002, at a weighted average interest rate of 6.0 percent. The interest rate on the Senior Credit Facility was 8.0 percent at December 31, 2002.
On June 29, 2001, the Company completed the public offering of $400.0 million of senior notes with a stated rate of 10.75 percent (the "10.75% Original Notes") due June 15, 2008. We entered into interest rate swap agreements to convert the fixed rate on these notes to a weighted average variable rate based on LIBOR plus approximately 5.75 percent. Such interest rate swap agreements were terminated in 2002. See the note to the consolidated financial statements entitled "Summary of Significant Accounting Policies" for additional information on these interest rate swap agreements. The indenture for the 10.75% Original Notes limits our ability to, among other things (all as described in the indenture): (i) incur additional debt and issue preferred stock; (ii) make loans and investments; (iii) pay dividends; (iv) create additional loans on our assets; (v) engage in transactions with our affiliates; (vi) consolidate, merge or transfer all or substantially all our assets; or (vii) change lines of business. Most of the foregoing restrictions will expire if the 10.75% Original Notes have been rated as investment grade securities by either S & P or Moody's. The 10.75% Original Notes are unsecured and rank equally with all other unsecured senior indebtedness of CNC. Proceeds from the offering of approximately $385.9 million (after underwriting discounts and estimated offering expenses) were used to reduce amounts outstanding under our credit facilities. As a result, we recognized an extraordinary charge of $.4 million (net of an income tax benefit of $.2 million) in 2001.
The Company provides certain health care and life insurance benefits for certain eligible retired employees under partially funded and unfunded plans in existence at the date on which certain subsidiaries were acquired. Certain postretirement benefit plans are contributory, with participants' contributions adjusted annually. Amounts related to the postretirement benefit plans were as follows:
Components of the cost we recognized related to postretirement plans were as follows:
The Company has qualified defined contribution plans for which substantially all employees are eligible. Company contributions, which match certain voluntary employee contributions to the plan, totaled $6.6 million in 2002, $4.7 million in 2001, and $9.1 million in 2000. Prior to 2002, employer matching contributions were made in CNC common stock. For the first nine months of 2002, employer matching
As described in the note to the consolidated financial statements entitled "Proceedings under Chapter 11 of the Bankruptcy Code", CNC and several of its subsidiaries filed voluntary petitions for reorganization under Chapter 11 of the Bankruptcy Code in the Bankruptcy Court. The Company's insurance subsidiaries and other subsidiaries who did not file petitions are separate legal entities and are not included in the petitions filed by the parent. The Debtors retain control of the insurance subsidiaries and related subsidiaries and are authorized to operate these businesses as debtors-in-possession while being subject to the jurisdiction of the Bankruptcy Court. The Finance Company Debtors filed a separate plan in connection with their Chapter 11 Cases on April 2, 2003. As of the Petition Date, pending litigation against the Debtors or the Finance Company Debtors is stayed, and absent further order of the Bankruptcy Court, substantially all prepetition liabilities of the Debtors and the Finance Company Debtors are subject to settlement under a plan of reorganization. Based on the Plan of the Debtors, liabilities subject to compromise exceed the fair value of the Debtors' assets, and unsecured claims will be satisfied at less than 100 percent of their fair value.
A total of forty-five suits were filed in 2000 against CNC in the United States District Court for the Southern District of Indiana. Nineteen of these cases were putative class actions on behalf of persons or entities that purchased CNC's common stock during alleged class periods that generally run from April 1999 through April 2000. Two cases were putative class actions on behalf of persons or entities that purchased CNC's bonds during the same alleged class periods. Three cases were putative class actions on behalf of persons or entities that purchased or sold option contracts, not issued by CNC, on CNC's common stock during the same alleged class periods. One case was a putative class action on behalf of persons or entities that purchased CNC's "FELINE PRIDES" convertible preferred stock instruments during the same alleged class periods. With four exceptions, in each of these twenty-five cases two former officers/directors of CNC were named as defendants. In each case, the plaintiffs asserted claims under Sections 10(b) (and Rule 10b-5 promulgated thereunder) and 20(a) of the Securities Exchange Act of 1934. In each case, plaintiffs alleged that CNC and the individual defendants violated the federal securities laws by, among other things, making false and misleading statements about the current state and future prospects of CFC (particularly with respect to performance of certain loan portfolios of CFC) which allegedly rendered CNC's financial statements false and misleading.
All of the CNC securities cases were consolidated into one case in the United States District Court for the Southern District of Indiana, captioned: "In Re Conseco, Inc. Securities Litigation", Case number IP00-C585-Y/S (the "securities litigation"). An amended complaint was filed on January 12, 2001, which asserted claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, and Sections 11, 12(a)(2), and 15 of the Securities Act of 1933, with respect to common stock and various other securities issued by CNC and Conseco Financing Trust VII. The Company filed a motion to dismiss the amended complaint on April 27, 2001. On January 10, 2002, CNC entered into a Memorandum of Understanding (the "MOU") to settle the litigation for $120 million subject to court approval. Under the MOU, as amended on February 12, 2002, $106 million was required to be placed in escrow by March 8, 2002; the remaining $14 million was to be paid in two installments: $6 million by April 1, 2002, and $8 million by October 1, 2002 (all payments with interest from January 25, 2002). The $106 million due on March 8, 2002, was not paid, for reasons set forth in the following paragraph, and the MOU was terminated by the plaintiffs. On April 15, 2002, a new MOU was executed (the "April 15 MOU"). Pursuant to the April 15 MOU, $95 million was funded on April 25, 2002, with the remaining $25 million to await the outcome of the coverage litigation between CNC and certain of its directors' and officers' liability insurance carriers as described in the next paragraph. Court approval of the settlement was received on August 7, 2002.
We maintained certain directors' and officers' liability insurance that was in force at the time the Indiana securities and derivative litigation (the derivative litigation is described below) was commenced and which, in our view, applies to the claims asserted in that litigation. The insurers denied coverage for those claims, so we commenced a lawsuit against them on June 13, 2001, in Marion County Circuit Court in Indianapolis, Indiana (Conseco, Inc., et al. v. National Union Fire Insurance Company of Pittsburgh, PA, Royal & SunAlliance, Westchester Fire Insurance Company, RLI Insurance Company, Greenwich Insurance Company and Certain Underwriters at Lloyd's of London, Case No. 49C010106CP001467) (the "coverage litigation") seeking, among other things, a judicial declaration that coverage for those claims exists. The primary insurance carrier, National Union Fire Insurance Co. of Pittsburgh, PA, has paid its full $10 million in policy proceeds toward the settlement of the securities litigation; in return, National Union has been released from the coverage litigation. The first excess insurance carrier, Royal & SunAlliance ("Royal"), has paid its full $15 million in policy proceeds toward the settlement, but reserved rights to continue to litigate coverage. Royal subsequently asserted counterclaims seeking repayment of the $15 million it previously provided to CNC as part of the
settlement. The second excess insurance carrier, Westchester Fire Insurance Company, has paid its full $15 million in policy proceeds toward the settlement without a reservation of rights and has been released from the coverage litigation. The third excess insurance carrier, RLI Insurance Company ("RLI"), has paid its full $10 million in policy proceeds toward the settlement, but initially reserved rights to continue to litigate coverage. RLI has subsequently settled (for $50,000 paid by certain of the individual insureds as partial payment of RLI's attorneys' fees incurred in the coverage litigation), and RLI is no longer continuing to dispute coverage. The fourth excess insurance carrier, Greenwich Insurance Company ("Greenwich"), has paid its full $25 million in policy proceeds toward the settlement without a reservation of rights and has been released from the coverage litigation. The final excess carrier, Certain Underwriters at Lloyd's of London ("Lloyd's"), refused to pay or to escrow its $25 million in policy proceeds toward the settlement and is continuing to litigate coverage. Under the April 15 MOU, the settlement of the securities litigation will proceed notwithstanding the continuing coverage litigation between CNC, Royal and Lloyd's. Since the United States District Court for the Southern District of Indiana has approved the settlement of the securities litigation prior to resolution of the coverage litigation, $90 million plus accrued interest is available for distribution to the putative class. The remaining funds, with interest, will be distributed at the conclusion of the coverage litigation (or, in the case of the $25 million at issue in the litigation with Lloyd's, on December 31, 2005, if the litigation with Lloyd's has not been resolved by that date), with such funds coming either from Lloyd's (if CNC prevails in the coverage litigation) or from CNC (if CNC does not prevail). We intend to pursue our coverage rights vigorously. Because the directors' and officers' liability insurance that was in force at the time the litigation commenced provides for coverage of $100 million, CNC believes its exposure in the litigation should be $20 million (i.e., the excess of the $100 million in coverage). CNC believes that the insurance applies to the claims in the securities litigation and that the two insurers who are continuing to litigate the coverage issue were obligated to pay their policy limits to fund the settlement, as the other four carriers have done. We recorded $20 million as our best estimate of a probable loss in 2001. Such amount has been placed in escrow. We also previously established the estimated remaining liability of $40 million and a claim receivable of $40 million. Such amount includes: (i) $15 million related to Royal who paid its portion of the settlement into a fund but reserved its rights to continue to litigate coverage (which litigation is proceeding); and (ii) $25 million related to Lloyd's who has refused to pay. Following the filing of our Chapter 11 Case, the trial court granted Lloyd's motion to dismiss our lawsuit resulting in our decision to establish an allowance for the entire $40 million claim receivable CNC believes is due from Royal and Lloyd's. We intend to appeal the decision to dismiss in part because we believe the decision violates the stay in the Chapter 11 Case. CNC believes that the coverage litigation should result in a determination that the insurer that paid under a reservation of rights has no right to recoup the payment that it made, and that the insurer that refused to pay is obligated to do so under its policy. We believe the latter insurer should pay its portion of the coverage once such determination is made. The ultimate outcome cannot be predicted with certainty. CNC is also pursuing settlement discussions with Royal and Lloyd's. In the event that CNC does not reach settlement and does not prevail in the coverage litigation, it will seek to subordinate the securities plaintiffs' claims under section 510 of the Bankruptcy Code, or disallow such claims under sections 502(d) and 547 of the Bankruptcy Code, in which case CNC may not be required to pay the portion of the settlement not covered by its directors' and officers' liability insurance. CNC has asked the Bankruptcy Court to stay the Indiana state court action, and the Bankruptcy Court is scheduled to hear that motion on May 19, 2003.
Nine shareholder derivative suits were filed in 2000 in the United States District Court for the Southern District of Indiana. The complaints named as defendants the current directors, certain former directors, certain non-director officers of CNC (in one case), and, alleging aiding and abetting liability, certain banks that allegedly made loans in relation to CNC's "Stock Purchase Plan" (in three cases). CNC is also named as a nominal defendant in each complaint. Plaintiffs allege that the defendants breached their fiduciary duties by, among other things, intentionally disseminating false and misleading statements concerning the acquisition, performance and proposed sale of CFC, and engaged in corporate waste by causing CNC to guarantee loans that certain officers, directors and key employees of CNC used to purchase stock under the Stock Purchase Plan. These cases have now been consolidated into one case in the United States District Court for the Southern District of Indiana, captioned: "In Re Conseco, Inc. Derivative Litigation", Case Number IP00655-C-Y/S. An amended complaint was filed on April 12, 2001, making generally the same allegations and allegations of violation of the Federal Reserve Board's margin rules. Three similar cases have been filed in the Hamilton County Superior Court in Indiana. Schweitzer v. Hilbert, et al., Case No. 29D01-0004CP251; Evans v. Hilbert, et al., Case No. 29D01-0005CP308 (both Schweitzer and Evans name as defendants certain non-director officers); Gintel v. Hilbert, et al., Case No. 29003-0006CP393 (naming as defendants, and alleging aiding and abetting liability as to, banks that allegedly made loans in relation to the Stock Purchase Plan). CNC believes that these lawsuits are without merit and intends to defend them vigorously. The cases filed in Hamilton County have been stayed pending resolution of the derivative suits filed in the United States District Court. CNC asserts that these lawsuits are assets of the estate pursuant to section 541(a) of the Bankruptcy Code and does not currently intend to pursue them postpetition because they are meritless. The ultimate outcome of these lawsuits cannot be predicted with certainty.
On January 15, 2002, Carmel Fifth, LLC ("Carmel"), an indirect, wholly-owned subsidiary of CNC, exercised its rights to require 767 Manager, LLC ("Manager"), an affiliate of Donald J. Trump, to elect within 60 days, either to acquire Carmel's interests in 767 LLC for $499.4 million, or to sell its interests in 767 LLC to Carmel for $15.6 million (the "Buy/Sell Right"). Such rights were exercised pursuant to the Limited Liability Company Agreement of 767 LLC. 767 LLC is a Delaware limited liability company that indirectly owns the General Motors Building, a 50-story office building in New York, New York (the "GM Building"). 767 LLC is owned by Carmel and Manager. On February 6, 2002, Mr. Trump commenced a civil action against CNC, Carmel and 767 LLC in New York State Supreme Court, entitled Donald J. Trump v. Conseco, Inc., et al. (the "State Court Action"). Plaintiff claims that CNC and Carmel breached an agreement, dated July 3, 2001, to sell Carmel's interests to plaintiff for $295 million on or before September 15, 2001 (the "July 3rd Agreement"). Specifically, plaintiff claims that CNC and Carmel improperly refused to accept a reasonable guaranty of plaintiff's payment obligations, refused to complete the sale of Carmel's interest before the September 15, 2001 deadline, repudiated an oral promise to extend the September 15 deadline indefinitely and repudiated the July 3rd Agreement by exercising Carmel's Buy/Sell Right. Plaintiff asserts claims for breach of contract, breach of the implied covenant of good faith and fair dealing, promissory estoppel, unjust enrichment and breach of fiduciary duty. Plaintiff is seeking compensatory and punitive damages of approximately $1 billion and declaratory and injunctive relief blocking Carmel's Buy/Sell Right. On March 25, 2002, Carmel filed a Demand for Arbitration and Petition and Statement of Claim with the American Arbitration Association ("AAA") to have the issues relating to the Buy/Sell Right resolved by arbitration (the "Arbitration"). Manager and Mr. Trump requested the New York State Supreme Court to stay that arbitration, but the Court denied Manager's and Trump's request on May 2, 2002, allowing the arbitration to proceed. In addition, CNC and Carmel filed a Motion to Dismiss Mr. Trump's lawsuit on March 25, 2002. By Stipulation and Order, dated June 14, 2002, the State Court Action was stayed, pending resolution of the Arbitration. CNC plans to vigorously pursue its options to compel prompt resolution of this dispute. CNC believes that Mr. Trump's lawsuit is without merit and intends to vigorously pursue its own rights to acquire the GM Building. The ultimate outcome cannot be predicted with certainty. On February 21, 2003, the Trump entities filed a proof of claim asserting a general unsecured claim of $1 billion against CNC. On March 3, 2003, CNC and Carmel Fifth initiated an adversary proceeding against the Trump entities. CNC and Carmel Fifth's adversary complaint seeks declaratory and injunctive relief against the Trump entities. CNC and Carmel Fifth's adversary action requests that the court find (1) that the July 3rd Agreement terminated due to Trump's failure to comply with the terms of that agreement, and (2) that the Trump entities are required to convey their interest in 767 LLC to Carmel Fifth pursuant to Carmel Fifth's rights under the LLC Agreement. On March 5, 2003, CNC and Carmel Fifth, in the adversary proceeding, filed an emergency motion for preliminary injunction and an emergency motion for expedited hearing. Through those motions, CNC and Carmel Fifth sought: an accelerated schedule for resolution of their claims against the Trump entities, removal of Mr. Trump from management of the GM Building, and
CNC is also a party to litigation related to the death of Lawrence Inlow with the manufacturer of a corporate helicopter and other parties. This litigation was consolidated in the United States District Court for the Southern District of Indiana (In re: Inlow Accident Litigation, Cause No. IP99-0830-C-H/G) and is currently on appeal to the Seventh Circuit Court of Appeals. The maximum exposure for this litigation is estimated to be $25 million, although CNC believes that the claims against it are without merit. The ultimate outcome cannot be predicted with certainty. CNC is also party to litigation with Associated Aviation Underwriters, Inc. in Hamilton County Superior Court (Associated Aviation Underwriters, Inc. v. Conseco Inc., et al, Cause No. 29C01-9909-CP588) relating to Associated Aviation Underwriters' obligation to defend and/or indemnify CNC in the aforementioned litigation. If CNC prevails in this lawsuit, Associated Underwriters may be obligated to indemnify CNC for all or part of its liability in the aforementioned litigation. This litigation has been stayed until final judgments are rendered in the former litigation.
The Company has been notified that the staff of the SEC has obtained a formal order of investigation in connection with an inquiry that relates to events in and before the spring of 2000, including CFC's accounting for its interest-only securities and servicing rights. These issues were among those addressed in the Company's write-down and restatement in the spring of 2000, and were the subject of shareholder class action litigation, which has recently been settled as described above. The Company is cooperating with the SEC staff in this matter.
The Company has been notified that the Alabama Securities Commission is examining the Company's 1998 Directors/Officers & Key Employees Stock Purchase Program and the 2000 Employee Stock Purchase Program Work-Down Plan. The Company is cooperating with the Commission's staff in this matter.
We have guaranteed D&O loans totaling $481.3 million. As previously described, Conseco has defaulted on certain notes, which has resulted in the immediate maturity of the D&O loans through cross-acceleration and cross-default provisions contained in the governing instruments. The proceeds of the bank loans were used by the participants to purchase approximately 18.0 million shares of Conseco common stock in open market or negotiated transactions with independent parties. Such shares have been held by the D&O lenders as collateral for the loans. In addition, Conseco has provided loans to participants for interest on the D&O loans totaling $179.2 million.
The Company is exploring a number of alternatives to reduce the balance of certain participants' D&O loans. The plan currently being considered would reduce the D&O loan balance of certain participants who collectively owe less than 10 percent of the entire amount due under the stock purchase program. Conseco also granted a security interest in most of its assets in conjunction with the guarantee of a portion of the bank loans. In 2002, 2001, and 2000, we established a noncash provision in connection with these guarantees and loans of $240.0 million, $169.6 million and $231.5 million, respectively. Such provision is included as a component of the provision for losses. At December 31, 2002, the reserve for losses on the loan guarantees and on the loans held by Conseco totaled $660.0 million. During 2002, Conseco purchased $55.5 million of loans from the banks utilizing cash held in a segregated cash account as collateral for our guarantee of the bank loans (including accrued interest, the balance on these loans was $56.7 million at December 31, 2002). At December 31, 2002, the guaranteed bank loans and interest loans exceeded the value of the collateral held and the reserve for losses by approximately $50 million. All participants have agreed to indemnify Conseco for any loss incurred on their loans. We regularly evaluate these guarantees and loans in light of the collateral and the creditworthiness of the participants.
Certain wholly-owned subsidiary trusts have issued preferred securities in public offerings. The trusts used the proceeds from these offerings to purchase subordinated debentures from Conseco. The terms of the preferred securities parallel the terms of the debentures, which account for substantially all trust assets. The preferred securities are to be redeemed on a pro rata basis, to the same extent as the debentures are repaid. Under certain circumstances involving a change in law or legal interpretation, the debentures may be distributed to the holders of the preferred securities. Our obligations under the debentures and related agreements, taken together, provide a full and unconditional guarantee of payments due on the preferred securities. The debentures issued to the subsidiary trusts
Loss related to reinsurance transactions and businesses sold to raise cash
We completed various asset sales and reinsurance transactions to raise cash which resulted in net losses of $47.5 million in 2002. Such amounts included: (i) a loss of $39.0 million related to the reinsurance of a portion of our life insurance business; (ii) a loss of $20.0 million associated with the sale of Exl; partially offset by (iii) asset sales resulting in a net gain of $11.5 million.
During 2001, Conseco undertook several restructuring actions in an effort to improve the Company's operations and profitability. The planned changes included moving a significant number of jobs to India. Pursuant to GAAP, the Company is required to recognize the costs associated with most restructuring activities as the costs are incurred. However, costs associated with severance benefits are required to be recognized when the costs are: (i) attributable to employees' services that have already been rendered; (ii) relate to obligations that accumulate; and (iii) are probable and can be reasonably estimated. Since the severance costs associated with our planned activities met these requirements, we recognized a charge of $12.4 million in 2001.
The Company incurred significant special charges during 2000, primarily related to the restructuring of our debt, asset sales to raise cash and payments made pursuant to employment contracts. The following table summarizes the special charges, which are further described in the paragraphs which follow (dollars in millions):
During the second quarter of 2000, we sold all of the finance receivables of our subprime automobile financing and servicing companies and terminated their operations. We recognized a net loss on these sales of $71.6 million.
We paid Lehman $20.0 million in fees for its efforts to form an investor group to purchase Conseco Finance. In addition, the Company paid other investment banks and financial institutions $24.0 million in advisory fees related to the potential sale of Conseco Finance and consultation regarding various other transactions.
On April 28, 2000, Conseco and Stephen C. Hilbert, the Company's former Chairman and Chief Executive Officer, entered into an agreement pursuant to which Mr. Hilbert's employment was terminated. As contemplated by the terms of his employment agreement, Mr. Hilbert received: (i) $72.5 million (prior to required withholdings for taxes), an amount equal to five times his salary and the non-discretionary bonus amount (as defined in his employment agreement) for 2000; less (ii) the amount due under a secured loan of $23 million, plus accrued interest, made to Mr. Hilbert on April 6, 2000. Mr. Hilbert also received the bonus of $3,375,000 payable under his employment agreement for the first quarter of 2000. Conseco agreed to continue to treat Mr. Hilbert as though he were an employee/participant for purposes of the guaranteed bank loans and the loans for interest on such loans pursuant to the stock purchase program. Conseco also entered into a consulting agreement with Mr. Hilbert pursuant to which Mr. Hilbert agreed to provide consulting services up to an average of 25 hours per month for a period of three years. Mr. Hilbert also agreed not to compete with Conseco during the term of the consulting agreement. On April 27, 2000, Mr. Hilbert was granted options to purchase an aggregate of 2,000,000 shares of Conseco common stock at a price of $5.75 per share (the average of the high and low sales prices on the New York Stock Exchange on such date). The options expire on April 26, 2003.
We are authorized to issue up to 20 million shares of preferred stock. On December 15, 1999, we issued $500.0 million (2.6 million shares) of Series F Preferred Stock to Thomas H. Lee Company and affiliated investors. The Series F Preferred Stock is convertible into Conseco common stock at a common equivalent rate of $19.25 per share. The Series F Preferred Stock pays a 4 percent dividend, of which an amount at least equal to the common dividend will be payable in cash, and the remainder may be paid in additional Series F shares valued at a common equivalent rate of $19.25 per share. In September 2000, we suspended the payment of common stock dividends and, as a result, all dividend payments since that date have been paid in additional Series F shares (the carrying value of such additional shares is determined based on the fair value of the equivalent number of Conseco common shares that such shares are convertible into as of the date the dividend is paid). The Series F Preferred Stock ranks senior to the common stock outstanding and has a liquidation preference of $192.50 per share plus all declared and unpaid dividends.
Changes in the number of shares of common stock outstanding during the years ended December 31, 2002, 2001 and 2000 were as follows:
Dividends declared on common stock for 2000, were $.10 per common share. No dividends were declared in 2002 or 2001.
The following table summarizes information about stock options outstanding at December 31, 2002 (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. Since the amount an employee must pay to acquire the stock is equal to the market price of the stock on the grant date, no compensation cost has been recognized for our stock option 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", the Company's pro forma net income (loss) and pro forma earnings (loss) per share for the years ended December 31, 2002, 2001 and 2000 would have been as follows:
We estimated the fair value of each option grant used to determine the pro forma amounts summarized above using the Black-Scholes option valuation model with the following weighted average assumptions for 2002, 2001 and 2000:
The five states with the largest shares of 2002 collected premiums were Florida (8.5 percent), California (7.5 percent), Illinois (7.3 percent), Texas (7.1 percent), and Michigan (5.3 percent). No other state accounted for more than 5 percent of total collected premiums.
Based on current conditions and assumptions as to future events on all policies inforce, the Company expects to amortize approximately 12 percent of the December 31, 2002 balance of cost of policies purchased in 2003, 11 percent in 2004, 9 percent in 2005, 8 percent in 2006 and 7 percent in 2007. The discount rates used to determine the amortization of the cost of policies purchased averaged 7 percent in 2002, 6 percent in 2001 and 7 percent in 2000.
Policyholder redemptions of annuity and, to a lesser extent, life products have increased in recent periods. We have experienced additional redemptions following the downgrade of our A.M. Best financial strength rating to "B (fair)". When redemptions are greater than our previous assumptions, we are required to accelerate the amortization of our cost of policies produced and cost of policies purchased to write off the balance associated with the redeemed policies. Accordingly, amortization expense has increased. We have changed the lapse assumptions used to determine the amortization of the cost of policies produced and the cost of policies purchased related to certain universal life products and our annuities to reflect our current estimates of future lapses. For certain universal life products, we changed the ultimate lapse assumption from: (i) a range of 6 percent to 7 percent; to (ii) a tiered assumption based on the level of funding of the policy of a range of 2 percent to 10 percent. Policyholder withdrawals in recent periods have exceeded our estimates. Such withdrawals were $3,708.3 million in 2002 and $2,528.3 million in 2001. Accordingly, we increased the expected future lapse rates on these products to reflect our current belief that lapses on these policies will continue to be higher than previously expected for the next several quarters. These changes resulted in additional amortization of the cost of policies produced and the cost of policies purchased of $203.2 million in 2002.
over the life of our annuity products. As a result of economic developments, actual experience of our products and changes in our expectations, we changed our investment yield assumptions used in calculating the estimated gross profits to be earned on our annuity products. Such changes resulted in additional amortization of the cost of policies produced and the cost of policies purchased of $35.0 million (of which $7.2 million related to discontinued operations) and $25.6 million in 2001 and 2000, respectively.
The following reconciles net loss to net cash provided by operating activities:
On October 30, 2002, Bankers National Life Insurance Company and Conseco Life Insurance Company of Texas (on behalf of itself and its insurance subsidiaries), our insurance subsidiaries domiciled in Texas, each entered into consent orders with the Commissioner of Insurance for the State of Texas whereby they agreed: (i) not to request any dividends or other distributions before January 1, 2003 and, thereafter, not to pay any dividends or other distributions to parent companies outside of the insurance system without the prior approval of the Texas Insurance Commissioner; (ii) to continue to maintain sufficient capitalization and reserves as required by the Texas Insurance Code; (iii) to request approval from the Texas Insurance Commissioner before making any disbursements not in the ordinary course of business; (iv) to complete any pending transactions previously reported to the proper insurance regulatory officials prior to and during Conseco's restructuring, unless not approved by the Texas Insurance Commissioner; (v) to obtain a commitment from Conseco and CIHC to maintain their infrastructure, employees, systems and physical facilities prior
The National Association of Insurance Commissioners ("NAIC") adopted codified statutory accounting principles in a process referred to as codification. Such principles are summarized in the Accounting Practices and Procedures Manual. The revised manual was effective January 1, 2001. The domiciliary states of our insurance subsidiaries have adopted the provisions of the revised manual or, with respect to some states, adopted the manual with certain modifications. The revised manual has changed, to some extent, prescribed statutory accounting practices and resulted in changes to the accounting practices that our insurance subsidiaries use to prepare their statutory-basis financial statements. The impact of these changes increased our insurance subsidiaries' statutory-based capital and surplus as of January 1, 2001, by approximately $198 million.
The NAIC's Risk-Based Capital for Life and/or Health Insurers Model Act (the "Model Act") provides a tool for insurance regulators to determine the levels of statutory capital and surplus an insurer must maintain in relation to its insurance and investment risks and whether there is a need for possible regulatory attention. The Model Act provides four levels of regulatory attention, varying with the ratio of the insurance company's total adjusted capital (defined as the total of its statutory capital and surplus, asset valuation reserve and certain other adjustments) to its authorized control level risk based capital ("ACLRBC"): (i) if a company's total adjusted capital is less than or equal to 200 percent but greater than 150 percent of its ACLRBC (the "Company Action Level"), the company must submit a comprehensive plan to the regulatory authority proposing corrective actions aimed at improving its capital position; (ii) if a company's total adjusted capital is less than or equal to 150 percent but greater than 100 percent of its ACLRBC (the "Regulatory Action Level"), the regulatory authority will perform a special examination of the company and issue an order specifying the corrective actions that must be followed; (iii) if a company's total adjusted capital is less than or equal to 100 percent but greater than 70 percent of its ACLRBC (the "Authorized Control Level"), the regulatory authority may take any action it deems necessary, including placing the company under regulatory control; and (iv) if a company's total adjusted capital is less than or equal to 70 percent of its ACLRBC (the "Mandatory Control Level"), the regulatory authority must place the company under its control. In addition the Model Law provides for an annual trend test if a company's total adjusted capital is between 200 percent and 250 percent of its ACLRBC at the end of the year. The trend test calculates the greater of the decrease in the margin of total adjusted capital over ACLRBC: (i) between the current year and the prior year; and (ii) for the average of the last 3 years. It assumes that such decrease could occur again in the coming year. Any company whose trended total adjusted capital is less than 190 percent of its ACLRBC would trigger a requirement to submit a comprehensive plan as described above for the Company Action Level.
The aggregate ACLRBC ratio for our insurance subsidiaries was 332 percent at December 31, 2002, compared to 480 percent at December 31, 2001. The ratios for our insurance subsidiaries that are subject to the four levels of regulatory attention described above ranged from 250 percent (just above the trend test level) to 563 percent. We are taking actions intended to improve the ACLRBC ratios of our insurance subsidiaries. Such actions include: (i) discontinuing or reducing sales of products that create initial reductions in statutory surplus because of the costs of selling the products; (ii) reducing operating expenses; (iii) merging some of our insurance subsidiaries with other insurance subsidiaries; and (iv) restructuring our investment portfolio to better match the risk profile of the portfolio with the insurance subsidiary's earnings and capital requirements. We have discussed these actions with insurance regulators in each of the states in which our insurance subsidiaries are domiciled. The audited financial statements of our insurance subsidiaries generally are not completed until around June 1 of each year (the date such audited financial statements are generally required to be filed with state insurance departments). Any significant audit adjustments to the financial statements of our insurance subsidiaries resulting in a reduction in capital could cause the ACLRBC ratio of one or more of our insurance subsidiaries to fall below the trend test level requiring the trended total adjusted capital to be calculated. In addition, the Company has been and will be discussing the appropriate statutory accounting treatment for certain investments with the state insurance regulators. If the ultimate outcome of these discussions resulted in adjustments to the December 31, 2002 statutory financial statements of our insurance subsidiaries, some of our subsidiaries could be required to complete the trend test. If a trend test were required for any of our subsidiaries, such a test would likely result in trended total adjusted capital which is less than 190 percent of ACLRBC.
We have historically managed our business operations through two segments, based on the products offered, in addition to the corporate segment.
Finance segment. CFC has historically provided a variety of finance products including: (i) loans for the purchase of manufactured housing, home improvements and various consumer products; (ii) home equity loans; and (iii) private label credit card programs. As a result of the formalization of the plan to sell the finance business and the filing of petitions under the Bankruptcy Code by the Finance Company Debtors, the finance business is being accounted for as a discontinued business in Conseco's consolidated financial statements. See the note to our consolidated financial statements entitled "Discontinued Finance Business - Planned Sale of CFC" for additional information on this segment.
CONSECO, INC. AND SUBSIDIARIES (DEBTOR-IN-POSSESSION AS OF DECEMBER 17, 2002) Notes to Consolidated Financial Statements --------------------------
Operating information regarding the insurance and corporate segments was as follows:
CFC CONSOLIDATED BALANCE SHEET INFORMATION December 31, 2002 and 2001 (Dollars in millions)
(a) CFC's statement of operations information has been presented as a discontinued operation in Conseco's consolidated financial statements for the periods summarized. (b) Intercompany accounts were eliminated when consolidated with Conseco and its other wholly-owned subsidiaries.
The following table reconciles CFC's loss before extraordinary gain (loss) and cumulative effect of accounting change as presented on the previous page to the amount included in discontinued operations in the accompanying consolidated statement of operations:
During 2002, CFC completed six securitization transactions, securitizing $2.7 billion of finance receivables. These securitizations were structured in a manner that requires them to be accounted for as secured borrowings, whereby the loans and securitization debt remain on our balance sheet, rather than as sales, pursuant to SFAS 140. Such accounting method is referred to as the "portfolio method".
During 2002 and 2001, CFC completed various loan sale transactions. During 2002, CFC sold $2.1 billion of finance receivables which generated net losses of $49.5 million. CFC also recognized a loss of $96.0 million related to the sale of $.5 billion of certain finance receivables sold as part of its cash raising initiatives in order to meet its debt obligations. See "Special Charges" elsewhere in the notes to the consolidated financial statements. In 2001, CFC sold $1.6 billion of receivables including: (i) $802.3 million vendor services loan portfolio (which was marked-to-market in the fourth quarter of 2000 and no additional gain or loss was recognized in 2001); (ii) $568.4 million of high-loan-to-value mortgage loans; and (iii) $269.0 million of other loans. These sales resulted in net gains of $26.9 million in 2001.
The following table summarizes CFC's finance receivables - securitized by business line and categorized as either part of CFC's primary lines or part of other lines (discontinued in previous periods):
The changes in CFC's allowance for credit losses included in finance receivables (both securitized and other portfolios) were as follows:
During 2002 and 2001, CFC recognized no gain on sale related to securitized transactions.
The determination of the value of CFC's retained interests in securitization trusts requires significant judgment. CFC has recognized significant charges when the interest-only securities did not perform as well as anticipated based on its assumptions and expectations. CFC's current valuation of retained interests may prove inaccurate in future periods. In securitizations to which these retained interests relate, CFC has retained certain contingent risks in the form of guarantees of certain lower-rated securities issued by the securitization trusts. As of December 31, 2002, the total nominal amount of these guarantees was approximately $1.4 billion. CFC considers any potential payments related to these guarantees in the projected cash flows used to determine the value of its retained interests. The discounted present value of the expected future payments related to the guarantees are classified as the "Guarantee liability related to interests in securitization trusts held by others" in CFC's balance sheet. If CFC would have to make more payments on these guarantees than anticipated, or if CFC experienced higher than anticipated rates of repayment, including due to foreclosure or charge-offs, or any adverse changes in its assumptions used for valuation, CFC would be required to recognize additional impairment charges. The $1.4 billion nominal amount of these guarantees represents the par value of the guaranteed lower-rated securities. The maximum potential amount of undiscounted future payments which CFC could be required to make on these guarantees would include both the par value and interest. Because the guaranteed securities do not have fixed maturity dates, such maximum potential amount is not possible to calculate. During 2002, 2001 and 2000, interest and principal payments related to such guarantees totaled $45.5 million, $32.7 million and $22.3 million, respectively. CFC suspended guarantee payments in the fourth quarter of 2002 and without additional liquidity in the near future, CFC will be unable to make these guarantee payments when such payments are required to be made.
Together, the interest-only securities and the B-2 securities, represent CFC's retained interests in these securitization trusts.
positively impacted when it used retail channels to dispose of repossessed inventory (where the repossessed units are sold through company-owned sales lots or its dealer network). Since CFC is no longer able to fund the loans made on repossessed homes sold through these channels, sales through these channels have decreased and CFC must use the wholesale channel to dispose of repossessed manufactured housing units, through which recovery rates are significantly lower. Accordingly, CFC changed the loss severity assumptions used to value its retained interests to reflect the higher loss severity expected to be experienced in the future. In addition, CFC's previous assumptions reflected its belief that the adverse manufactured housing default experience in recent periods would continue through the first half of 2002 and then improve over time. Given recent circumstances, default experience is not expected to improve as previously expected. Accordingly, CFC increased the default assumptions it used to value its retained interests to reflect its future expectations. CFC's home equity/home improvement assumptions have also been adjusted to reflect recent default experience as well as CFC's future expectations.
As a result of the requirements of EITF 99-20 and the assumption changes described above, CFC recognized an impairment charge of $1,077.2 million in 2002 for the retained beneficial interests. CFC also recognized a $336.5 million increase in the valuation allowance as a result of changes to the expected future cost of servicing the finance receivables. The levels of delinquent and defaulting loans have caused servicing costs to increase. In addition, future servicing costs are expected to increase as the portfolio ages.
The following table summarizes certain cash flows received from and paid to the securitization trusts during 2002 and 2001 (dollars in millions):
These sensitivities are hypothetical and should be used with caution. As the figures indicate, changes in fair value based on a 10 percent variation in assumptions generally cannot be extrapolated because the relationship of the change in assumption to the change in fair value may not be linear. Also, in this table, the effect of a variation in a particular assumption on the fair value of the retained interest is calculated without changing any other assumption; in reality, changes in one factor may result in changes in another (for example, increases in market interest rates may result in lower prepayments and increased credit losses), which might magnify or counteract the sensitivities.
The following schedule reconciles CFC's retained interests, net of guarantee liabilities, from the beginning to the end of the years presented:
CFC's income tax expense includes deferred income taxes arising from temporary differences between the financial reporting and tax bases of assets and liabilities. These amounts are reflected in the balance of deferred income tax assets which totaled $925.7 million at December 31, 2002. In assessing the realization of deferred income tax assets, CFC considers whether it is more likely than not that the deferred income tax assets will be realized. The ultimate realization of deferred income tax assets depends upon generating future taxable income during the periods in which temporary differences become deductible. CFC evaluates the realizability of its deferred income tax assets by assessing the need for a valuation allowance on a quarterly basis. A valuation allowance of $925.7 million has been provided for the entire net deferred tax asset balance as of December 31, 2002, as CFC believes that the realization of such assets in future periods is uncertain. The components of CFC's income tax assets and liabilities were as follows:
At December 31, 2002, CFC had $552.4 million of net operating loss carryforwards. The carryforwards will expire as follows: $54.7 in 2018; $273.6 in 2020; and $224.1 in 2022.
CFC provided certain pension benefits for certain eligible retired employees under a partially funded plan. Amounts related to the pension plan were as follows: