Our headquarters and the administrative operations of our Washington National and Other CNO Business segments and certain administrative operations of our subsidiaries are located on a Company-owned corporate campus in Carmel, Indiana, immediately north ofIndianapolis. We currently occupy four buildings on the campus with approximately 422,000 square feet of space.
As a result of the Transfer, as further discussed in the note to the consolidated financial statements entitled “Transfer of Senior Health Insurance Company of Pennsylvania to an Independent Trust”, a substantial portion of our long-term care business is presented as discontinued operations in periods prior to 2009.
Our statements, trend analyses and other information contained in this report and elsewhere (such as in filings by CNO with the SEC, press releases, presentations by CNO or its management or oral statements) relative to markets for CNO’s products and trends in CNO’s operations or financial results, as well as other statements, contain forward-looking statements within the meaning of the federal securities laws and the Private Securities Litigation Reform Act of 1995. Forward-looking statements typically are identified by the use of terms such as “anticipate,” “believe,” “plan,” “estimate,” “expect,” “project,” “intend,” “may,” “will,” “would,” “contemplate,” “possible,” “attempt,” “seek,” “should,” “could,” “goal,” “target,” “on track,” “comfortable with,” “optimistic” and similar words, although some forward-looking statements are expressed differently. You should consider statements that contain these words carefully because they describe our expectations, plans, strategies and goals and our beliefs concerning future business conditions, our results of operations, financial position, and our business outlook or they state other “forward-looking” information based on currently available information. The “Risk Factors” in Item 1A provide examples of risks, uncertainties and events that could cause our actual results to differ materially from the expectations expressed in our 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:
We are a holding company for a group of insurance companies operating throughout the United States that develop, market and administer health insurance, annuity, individual life insurance and other insurance products. We focus on serving the senior and middle-income markets, which we believe are attractive, underserved, high growth markets. We sell our products through three distribution channels: career agents, independent producers (some of whom sell one or more of our product lines exclusively) and direct marketing.
Beginning July 1, 2010, management has changed the manner in which it disaggregates the Company’s operations for making operating decisions and assessing performance. As a result, the Company manages its business through the following operating segments: Bankers Life, Washington National and Colonial Penn, which are defined on the basis of product distribution; Other CNO Business, comprised primarily of products we no longer sell actively; and corporate operations, comprised of holding company activities and certain noninsurance company businesses. The Company’s segments are described below:
Bankers Life, which markets and distributes Medicare supplement insurance, interest-sensitive life insurance, traditional life insurance, fixed annuities and long-term care insurance products to the middle-income senior market through a dedicated field force of career agents and sales managers supported by a network of community-based branch offices. The Bankers Life segment includes primarily the business of Bankers Life. Bankers Life also markets and distributes Medicare Advantage plans primarily through a distribution arrangement with Humana and Medicare Part D prescription drug plans through a distribution and reinsurance arrangement with Coventry.
Other CNO Business, which consists of blocks of interest-sensitive life insurance, traditional life insurance, annuities, long-term care insurance and other supplemental health products. These blocks of business are not being actively marketed and were primarily issued or acquired by Conseco Life and Washington National.
The following summarizes our earnings for the three years ending December 31, 2010 (dollars in millions, except per share data):
At December 31, 2010, the carrying value of our investment portfolio was $23.8 billion.
We regularly evaluate our investments for possible impairment. Our assessment of whether unrealized losses are “other than temporary” requires significant judgment. Factors considered include: (i) the extent to which fair value is less than the cost basis; (ii) the length of time that the fair value has been less than cost; (iii) whether the unrealized loss is event driven, credit-driven or a result of changes in market interest rates or risk premium; (iv) the near-term prospects for specific events, developments or circumstances likely to affect the value of the investment; (v) the investment’s rating and whether the investment is investment-grade and/or has been downgraded since its purchase; (vi) whether the issuer is current on all payments in accordance with the contractual terms of the investment and is expected to meet all of its obligations under the terms of the investment; (vii) whether we intend to sell the investment or it is more likely than not that circumstances will require us to sell the investment before recovery occurs; (viii) the underlying current and prospective asset and enterprise values of the issuer and the extent to which the recoverability of the carrying value of our investment may be affected by changes in such values; (ix) projections of, and unfavorable changes in, cash flows on structured securities including mortgage-backed and asset-backed securities; and (x) other objective and subjective factors.
We estimate the amount of the credit loss component of a fixed maturity security impairment as the difference between amortized cost and the present value of the expected cash flows of the security. The present value is determined using the best estimate of future cash flows discounted at the effective interest rate implicit to the security at the date of purchase or the current yield to accrete an asset-backed or floating rate security. The methodology and assumptions for establishing the best estimate of future cash flows vary depending on the type of security.
securities; certain government or agency securities; certain mortgage and asset-backed securities; and non-exchange-traded derivatives such as call options to hedge liabilities related to our fixed index annuity products.
In conjunction with the implementation of fresh start accounting, we eliminated the historical balances of our Predecessor’s deferred acquisition costs and the present value of future profits and replaced them with the present value of future profits as calculated on the Effective Date.
The value assigned to the right to receive future cash flows from contracts existing at the Effective Date is referred to as the present value of future profits. We also defer renewal commissions paid in excess of ultimate commission levels related to the existing policies in this account. The balance of this account is amortized, evaluated for recovery, and adjusted
The deferred acquisition costs are those costs that vary with, and are primarily related to, producing new insurance business in the period after September 10, 2003. For universal life or investment products, we amortize these costs using the interest rate credited to the underlying policy in relation to the estimated gross profits. For other products, we amortize these costs using the projected investment earnings rate in relation to future anticipated premium revenue. The present value of future profits and the deferred acquisition costs are collectively referred to as “insurance acquisition costs.”
Insurance acquisition costs are amortized to expense over the lives of the underlying policies in relation to future anticipated premiums or gross profits. The insurance acquisition costs for policies other than universal life and investment-type products are amortized with interest (using the projected investment earnings rate) over the estimated premium-paying period of the policies, in a manner which recognizes amortization expense in proportion to each year’s premium income. The insurance acquisition costs for universal life and investment-type products are amortized with interest (using the interest rate credited to the underlying policy) in proportion to estimated gross profits. The interest, mortality, morbidity and persistency assumptions used to amortize insurance acquisition costs are consistent with those assumptions used to estimate liabilities for insurance products. For universal life and investment-type products, these assumptions are reviewed on a regular basis. When actual profits or our current best estimates of future profits are different from previous estimates, we adjust cumulative amortization of insurance acquisition costs to maintain amortization expense as a constant percentage of gross profits over the entire life of the policies.
The blocks of universal life and interest-sensitive products in the Other CNO Business segment have not performed in accordance with prior estimates of future gross profits, resulting in adjustments to amortization expense over the last 3 years. For a description of these adjustments, see “Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations - Results of Operations - Other CNO Business - Amortization Related to Operations”.
When we realize a gain or loss on investments backing our universal life or investment-type products, we adjust the amortization of insurance acquisition costs to reflect the change in estimated gross profits from the products due to the gain or loss realized and the effect on future investment yields. We increased (decreased) amortization expense for such changes by $11.5 million, $(4.0) million and $(21.5) million during the years ended December 31, 2010, 2009 and 2008, respectively. We also adjust insurance acquisition costs for the change in amortization that would have been recorded if fixed maturity securities, available for sale, had been sold at their stated aggregate fair value and the proceeds reinvested at current yields. We include the impact of this adjustment in accumulated other comprehensive income (loss) within shareholders’ equity. We limit the total adjustment related to unrealized losses to the total of the costs capitalized plus interest (or the total value of policies inforce recognized at the Effective Date plus interest with respect to the present value of future profits) related to insurance policies issued in a particular year (or policies inforce at the Effective Date with respect to the present value of future profits). The investment environment during the fourth quarter of 2008 resulted in significant net unrealized losses in our fixed maturity investment portfolio. The total adjustment to accumulated other comprehensive income related to the change in deferred acquisition costs for the negative amortization that would have been recorded if fixed maturity securities, available for sale, had been sold at their stated aggregate fair value would have resulted in the balance of deferred acquisition costs exceeding the total of costs capitalized plus interest for annuity blocks of business issued in certain years. Accordingly, the adjustment made to deferred acquisition costs produced and accumulated other comprehensive income was reduced by $206 million. The total pre-tax impact of such adjustments on accumulated other comprehensive income (loss) was a decrease of $93.8 million at December 31, 2010.
At December 31, 2010, the balance of insurance acquisition costs was $2.8 billion. The recoverability of this amount is dependent on the future profitability of the related business. Each year, we evaluate the recoverability of the unamortized balance of insurance acquisition costs. These evaluations are performed to determine whether estimates of the present value of future cash flows, in combination with the related liability for insurance products, will support the unamortized balance. These future cash flows are based on our best estimate of future premium income, less benefits and expenses. The present value of these cash flows, plus the related balance of liabilities for insurance products, is then compared with the unamortized balance of insurance acquisition costs. In the event of a deficiency, such amount would be charged to amortization expense. The determination of future cash flows involves significant judgment. Revisions to the assumptions which determine such cash flows could have a significant adverse effect on our results of operations and financial position.
The table presented below summarizes our estimates of cumulative adjustments to insurance acquisition costs resulting from hypothetical revisions to certain assumptions. Although such hypothetical revisions are not currently required or anticipated, we believe they could occur based on past variances in experience and our expectations of the ranges of future experience that could reasonably occur. We have assumed that revisions to assumptions resulting in the adjustments
We have excluded the effect of reasonably likely changes in mortality, lapse, surrender and expense assumptions for policies other than universal life and investment-type products. Our estimates indicate such changes would not result in any portion of the $2.2 billion balance of unamortized insurance acquisition costs related to these policies being unrecoverable.
The Medicare Prescription Drug, Improvement and Modernization Act of 2003 provided for the introduction of a PDP product. In order to offer this product to our current and potential future policyholders without investing in management and infrastructure, we entered into a national distribution agreement with Coventry to use our career and independent agents to distribute Coventry’s prescription drug plan, Advantra Rx. We receive a fee based on the premiums collected on plans sold through our distribution channels. In addition, CNO has a quota-share reinsurance agreement with Coventry for CNO enrollees that provides CNO with 50 percent of net premiums and related policy benefits subject to a risk corridor. The Part D program was effective January 1, 2006.
CNO expanded its strategic alliance with Coventry by entering into a national distribution agreement under which our career agents began distributing Coventry’s PFFS plan, beginning January 1, 2007. Under the agreement, we received a fee based on the number of PFFS plans sold through our distribution channels. In addition, CNO had a quota-share reinsurance agreement with Coventry for CNO enrollees that provided CNO with a specified percentage of the net premiums and related profits. Coventry decided to cease selling PFFS plans effective January 1, 2010. In July 2009, we announced a strategic alliance under which we would offer Humana’s Medicare Advantage plans to our policyholders and consumers through our career agency force and will receive marketing fees based on sales. Effective January 1, 2010, we no longer assume the underwriting risk related to PFFS business.
During 2007 and 2008, CNO entered into three quota-share reinsurance agreements with Coventry related to the PFFS business written by Coventry under certain group policies. CNO received a specified percentage of the net premiums and related profits associated with this business as long as the ceded revenue margin was less than or equal to five percent. CNO received a specified percentage of the net premiums and related profits on the ceded margin in excess of five percent. In order to reduce the required statutory capital associated with the assumption of this business, CNO terminated two group policy quota-share agreements as of December 31, 2008 and terminated the last agreement on June 30, 2009. The following summarizes the premiums assumed, related expenses and pre-tax income of this business (dollars in millions):
Recovery of our deferred tax assets is dependent on achieving the projections of future taxable income embedded in our analysis and failure to do so would result in an increase in the valuation allowance in a future period. Any future increase in the valuation allowance may result in additional income tax expense and reduce shareholders’ equity, and such an increase could have a significant impact upon our earnings in the future. In addition, the use of the Company’s NOLs is dependent, in part, on whether the IRS does not take an adverse position in the future regarding the tax position we have taken in our tax returns with respect to the allocation of a portion of the cancellation of indebtedness income resulting from the bankruptcy of our Predecessor and the classification of the loss we recognized as a result of the transfer of Senior Health to an Independent Trust (as further described below).
At December 31, 2010, the total balance of our liabilities for insurance products was $24.5 billion. These liabilities are generally payable over an extended period of time and the profitability of the related products is dependent on the pricing of the products and other factors. Differences between our expectations when we sold these products and our actual experience could result in future losses.
Non-forfeiture benefits offered in conjunction with a rate increase - In some cases, non-forfeiture benefits are offered to policyholders who wish to lapse their policies at the time of a significant rate increase. In these cases, exercise of this option is treated as an extinguishment of the original contract and issuance of a new contract. The balance of our reserves and deferred insurance acquisition costs are released, and a reserve for the new contract is established.
We manage our business through the following operating segments: Bankers Life, Colonial Penn and Washington National, which are defined on the basis of product distribution; Other CNO Business, comprised primarily of products we no longer sell actively; and corporate operations, comprised of holding company activities and certain noninsurance company businesses.
Total premium collections were $2,575.2 million in 2010, down 14 percent from 2009, and $3,000.9 million in 2009, down 9.6 percent from 2008. Premium collections include $1.1 million, $369.0 million and $542.4 million in 2010, 2009, and 2008, respectively, of premiums collected pursuant to the PFFS quota-share agreements with Coventry which were terminated or expired prior to 2010 and are described above under “Accounting for marketing and reinsurance agreements with Coventry”. See “Premium Collections” for further analysis of Bankers Life’s premium collections.
Net investment income related to fixed index products represents the change in the estimated fair value of options which are purchased in an effort to hedge certain potential benefits accruing to the policyholders of our fixed index products. Our fixed index products are designed so that the investment income spread earned on the related insurance liabilities is expected to be more than adequate to cover the cost of the options and other costs related to these policies. Net investment income (loss) related to fixed index products was $21.1 million, $38.5 million and $(67.0) million in 2010, 2009 and 2008, respectively. Net investment income related to fixed index products also includes income (loss) on trading securities which are held to act as hedges for embedded derivates related to fixed index products. Such trading account income (loss) was $11.5 million, $(14.0) million and $17.6 million in 2010, 2009 and 2008, respectively. Such amounts are generally offset by the corresponding charge (credit) to amounts added to policyholder account balances for fixed index products based on the change in value of the indices. Such income and related charges fluctuate based on the value of options embedded in the segment’s fixed index annuity policyholder account balances subject to this benefit and to the performance of the index to which the returns on such products are linked.
The Medicare supplement business consists of both individual and group policies. Government regulations generally require us to attain and maintain a ratio of total benefits incurred to total premiums earned (excluding changes in policy benefit reserves), after three years from the original issuance of the policy and over the lifetime of the policy, of not less than 65 percent on individual products and not less than 75 percent on group products, as determined in accordance with statutory accounting principles. Since the insurance product liabilities we establish for Medicare supplement business are subject to significant estimates, the ultimate claim liability we incur for a particular period is likely to be different than our initial estimate. Our insurance policy benefits reflected reserve redundancies from prior years of $8.1 million, $7.7 million and $.5 million in 2010, 2009 and 2008, respectively. Excluding the effects of prior year claim reserve redundancies, our benefit ratios would have been 72.1 percent, 71.9 percent and 70.8 percent in 2010, 2009 and 2008, respectively. The increase in the benefit ratios reflects unfavorable claim experience.
The insurance policy benefits on our PDP and PFFS business result from our quota-share reinsurance agreements with Coventry. Coventry decided to cease selling PFFS plans effective January 1, 2010. Effective January 1, 2010, the Company no longer assumes the underwriting risk related to PFFS business. In the third quarter of 2009, Bankers Life began offering Humana’s Medicare Advantage plans to its policyholders and consumers nationwide through its career agency force and receives marketing fees based on sales. Insurance margins (insurance policy income less insurance policy benefits) on the PDP business were $15.2 million, $12.0 million and $4.8 million in 2010, 2009 and 2008, respectively. Insurance margins on the PFFS business were $17.4 million, $47.5 million and $19.6 million in 2010, 2009 and 2008, respectively. The increase in margin in 2009 is primarily due to increases in our share of risk adjustment premium payments made by the Centers for Medicare and Medicaid Services. Both 2010 and 2009 reflect favorable reserve developments. During 2008, we recognized a $3 million increase in insurance policy benefits due to changes in our estimates of prior period claim costs on the PFFS business we assumed from Coventry.
Over the past several years, we have implemented rate increases in the long-term care block in the Bankers Life segment. In the fourth quarter of 2009, additional filings were initiated in states that had not granted approval of the full amount of the previous rate increase requests. Approximately $13 million of additional rate increases have been approved as of December 31, 2010. All expected approvals for these filings have been received. In October 2010, we commenced additional rate increase filings on certain long-term care blocks. We expect to implement rate increases of approximately $35 million after approval from all states. Approximately $5.5 million of approvals had been received as of December 31, 2010.
Amortization related to operations includes amortization of deferred acquisition costs and the present value of future profits (collectively referred to as “amortization of insurance acquisition costs”). Insurance acquisition costs are generally amortized either: (i) in relation to the estimated gross profits for universal life and investment-type products; or (ii) in relation to actual and expected premium revenue for other products. In addition, for universal life and investment-type products, we are required to adjust the total amortization recorded to date through the statement of operations if actual experience or other evidence suggests that earlier estimates of future gross profits should be revised. Accordingly, amortization for universal life and investment-type products is dependent on the profits realized during the period and on our expectation of future profits. For other products, we amortize insurance acquisition costs in relation to actual and expected premium revenue, and amortization is only adjusted if expected premium revenue changes or if we determine the balance of
Amortization related to net realized investment losses is the increase or decrease in the amortization of insurance acquisition costs which results from realized investment gains or losses. When we sell securities which back our universal life and investment-type products at a gain (loss) and reinvest the proceeds at a different yield, we increase (reduce) the amortization of insurance acquisition costs in order to reflect the change in estimated gross profits due to the gains (losses) realized and the resulting effect on estimated future yields. Sales of fixed maturity investments resulted in an increase (decrease) in the amortization of insurance acquisition costs of $10.2 million, $.2 million and $(15.8) million in 2010, 2009 and 2008, respectively.
These non-GAAP financial measures of “interest-adjusted benefit ratios” differ from “benefit ratios” due to the deduction of interest income on the accumulated assets backing the insurance liabilities from the product’s insurance policy benefits used to determine the ratio. Interest income is an important factor in measuring the performance of health products that are expected to be inforce for a longer duration of time, are not subject to unilateral changes in provisions (such as non-cancelable or guaranteed renewable contracts) and require the performance of various functions and services (including insurance protection) for an extended period of time. The net cash flows from supplemental health products generally cause an accumulation of amounts in the early years of a policy (accounted for as reserve increases) that will be paid out as benefits in later policy years (accounted for as reserve decreases). Accordingly, as the policies age, the benefit ratio will typically increase, but the increase in benefits will be partially offset by interest income earned on the accumulated assets. The interest-adjusted benefit ratio reflects the effects of the interest income offset. Since interest income is an important factor in measuring the performance of these products, management believes a benefit ratio that includes the effect of interest income is useful in analyzing product performance. We utilize the interest-adjusted benefit ratio in measuring segment performance because we believe that this performance measure is a better indicator of the ongoing businesses and trends in the business. However, the “interest-adjusted benefit ratio” does not replace the “benefit ratio” as a measure of current period benefits to current period insurance policy income. Accordingly, management reviews both “benefit ratios” and “interest-adjusted benefit ratios” when analyzing the financial results attributable to these products. The investment income earned on the accumulated assets backing the supplemental health reserves was $125.1 million, $127.7 million and $125.2 million in 2010, 2009 and 2008, respectively.
Total premium collections were $581.1 million in 2010, down 2.6 percent from 2009, and $596.4 million in 2009, down 3.9 percent from 2008. See “Premium Collections” for further analysis of fluctuations in premiums collected by product.
Insurance policy income is comprised of premiums earned on traditional insurance policies which provide mortality or morbidity coverage and fees and other charges assessed on other policies. The decrease in insurance policy income is primarily due to lower premiums from our life insurance block reflecting the impact of the completion of the coinsurance transaction with Wilton Re in 2009. See “Premium Collections” for further analysis.
Insurance policy benefits were affected by: (i) lower benefits from our life insurance block including the impact of the completion of the coinsurance transaction with Wilton Re in 2009; and (ii) the factors summarized below for benefit ratios. Benefit ratios are calculated by dividing the related insurance product’s insurance policy benefits by insurance policy income.
Washington National’s supplemental health products (including specified disease, accident and hospital indemnity products) generally provide fixed or limited benefits. For example, payments under cancer insurance policies are generally made directly to, or at the direction of, the policyholder following diagnosis of, or treatment for, a covered type of cancer. Approximately three-fourths of our supplemental health policies inforce (based on policy count) are sold with return of premium or cash value riders. The return of premium rider generally provides that after a policy has been inforce for a specified number of years or upon the policyholder reaching a specified age, we will pay to the policyholder, or a beneficiary under the policy, the aggregate amount of all premiums paid under the policy, without interest, less the aggregate amount of all claims incurred under the policy. The cash value rider is similar to the return of premium rider, but also provides for payment of a graded portion of the return of premium benefit if the policy terminates before the return of premium benefit is earned. Accordingly, the net cash flows from these products generally result in the accumulation of amounts in the early years of a policy (reflected in our earnings as reserve increases) which will be paid out as benefits in later policy years (reflected in our earnings as reserve decreases which offset the recording of benefit payments). As the policies age, the benefit ratio will typically increase, but the increase in benefits will be partially offset by investment income earned on the accumulated assets. The benefit ratio will fluctuate depending on the claim experience during the year. Insurance margins (insurance policy income less insurance policy benefits) on these products were $78.6 million, $78.2 million and $85.0 million in 2010, 2009 and 2008, respectively. The increase in the margin in 2008 includes a $12 million correction to insurance policy benefits resulting from our material control weakness remediation procedures.
Other operating costs and expenses were $155.4 million, $156.5 million and $166.9 million in 2010, 2009 and 2008, respectively. Other operating costs and expenses include commission expense of $64.8 million, $63.6 million and $67.5 million in 2010, 2009 and 2008, respectively.
Net realized investment gains (losses) fluctuate each period. During 2010, net realized investment losses in this segment included $23.5 million of net gains from the sales of investments (primarily fixed maturities) and $30.9 million of writedowns of investments for other than temporary declines in fair value recognized through net income ($31.1 million, prior to the $.2 million of impairment losses recognized through accumulated other comprehensive income (loss)). During
2009, net realized investment losses in this segment included $25.7 million of net gains from the sales of investments (primarily fixed maturities) and $28.3 million of writedowns of investments for other than temporary declines in fair value recognized through net income ($64.4 million, prior to the $36.1 million of impairment losses recognized through accumulated other comprehensive income (loss)). During 2008, net realized investment losses included $3.9 million of net gains from the sales of investments (primarily fixed maturities) and $20.1 million of writedowns of investments resulting from declines in fair value that we concluded were other than temporary.
Total premium collections decreased .4 percent, to $194.1 million, in 2010 and increased 6.4 percent, to $194.8 million, in 2009. See “Premium Collections” for further analysis of Colonial Penn’s premium collections.
Insurance policy income is comprised of premiums earned on policies which provide mortality or morbidity coverage and fees and other charges assessed on other policies. In 2009, insurance policy income includes the recognition of a $3.4
Net investment income on general account invested assets (which excludes income on policyholder and reinsurer accounts) did not fluctuate significantly during the three years ended December 31, 2010. The average balance of general account invested assets was $662.8 million in 2010, $659.9 million in 2009 and $676.0 million in 2008. The average yield on these assets was 5.93 percent in 2010, 5.86 percent in 2009 and 5.94 percent in 2008.
Trading account income related to reinsurer accounts represented the income on trading securities, which were designed to act as hedges for embedded derivatives related to a modified coinsurance agreement. The income on our trading account securities was designed to be substantially offset by the change in value of embedded derivatives related to a modified coinsurance agreement. As a result of the recapture of the modified coinsurance agreement in the fourth quarter of 2007, such trading account securities were sold in the first quarter of 2008.
These non-GAAP financial measures of “interest-adjusted benefit ratios” differ from “benefit ratios” due to the deduction of interest income on the accumulated assets backing the insurance liabilities from the product’s insurance policy benefits used to determine the ratio. Interest income is an important factor in measuring the performance of health products that are expected to be inforce for a longer duration of time, are not subject to unilateral changes in provisions (such as non-cancelable or guaranteed renewable contracts) and require the performance of various functions and services (including insurance protection) for an extended period of time. The net cash flows from long-term care products generally cause an accumulation of amounts in the early years of a policy (accounted for as reserve increases) that will be paid out as benefits in later policy years (accounted for as reserve decreases). Accordingly, as the policies age, the benefit ratio will typically increase, but the increase in benefits will be partially offset by interest income earned on the accumulated assets. The interest-adjusted benefit ratio reflects the effects of the interest income offset. Since interest income is an important factor in measuring the performance of these products, management believes a benefit ratio that includes the effect of interest income is useful in analyzing product performance. We utilize the interest-adjusted benefit ratio in measuring segment performance because we believe that this performance measure is a better indicator of the ongoing businesses and trends in the business. However, the “interest-adjusted benefit ratio” does not replace the “benefit ratio” as a measure of current period benefits to current period insurance policy income. Accordingly, management reviews both “benefit ratios” and “interest-adjusted benefit ratios” when analyzing the financial results attributable to these products. The investment income earned on the accumulated assets backing the long-term care reserves was $26.0 million, $25.2 million and $26.3 million in 2010, 2009 and 2008, respectively.
Insurance policy income is comprised of policyholder charges on our interest-sensitive products and premiums earned on traditional insurance policies which provide mortality or morbidity coverage. The decrease in insurance policy income is
Net investment income on general account invested assets (which excludes income on policyholder and reinsurer accounts) decreased 1.4 percent, to $352.1 million, in 2010 and 9.3 percent, to $357.1 million, in 2009. The average balance of general account invested assets was $6.0 billion in 2010, $6.3 billion in 2009 and $6.7 billion in 2008. The average yield on these assets was 5.84 percent in 2010, 5.71 percent in 2009 and 5.87 percent in 2008. The increase in yield in 2010 primarily resulted from shifts among asset classes to increase income, and from bond prepayment income. Prepayment income was $5.1 million and $(.9) million in 2010 and 2009, respectively. The reduction in average yield in 2009 reflects lower new money rates due to tighter credit spreads for many investments. The reduction in average invested assets was primarily due to the coinsurance transaction with Wilton Re completed in 2009.
Net investment income related to fixed index products represents the change in the estimated fair value of options which are purchased in an effort to hedge certain potential benefits accruing to the policyholders of our fixed index products. Our fixed index products are designed so that the investment income spread earned on the related insurance liabilities is expected to be more than adequate to cover the cost of the options and other costs related to these policies. Net investment income (loss) related to fixed index products were $7.1 million, $12.2 million and $(37.3) million in 2010, 2009 and 2008, respectively. Net investment income related to fixed index products also includes income (loss) on trading securities which are held to act as hedges for embedded derivatives related to fixed index products. Such trading account income (loss) was $2.7 million, $(5.2) million and $8.9 million in 2010, 2009 and 2008, respectively. Such amounts were mostly offset by the corresponding charge (credit) to amounts added to policyholder account balances for fixed index products. Such income and related charges fluctuate based on the value of options embedded in the segment’s fixed index annuity policyholder account balances subject to this benefit and to the performance of the indices to which the returns on such products are linked.
Insurance policy benefits were affected by a number of items as summarized below for benefit ratios. Benefit ratios are calculated by dividing the related insurance product’s insurance policy benefits by insurance policy income.
In each quarterly period, we calculate our best estimate of claim reserves based on all of the information available to us at that time, which necessarily takes into account new experience emerging during the period. Our actuaries estimate these claim reserves using various generally recognized actuarial methodologies which are based on informed estimates and judgments that are believed to be appropriate. As additional experience emerges and other data become available, these estimates and judgments are reviewed and may be revised. Significant assumptions made in estimating claim reserves for
The benefit ratios on Other CNO Business’ other products are subject to fluctuations due to the smaller size of these blocks of business.
Amounts added to policyholder account balances for annuity products and interest-sensitive life products were $127.6 million, $138.8 million and $152.1 million in 2010, 2009 and 2008, respectively. The decrease was primarily due to a smaller block of annuity and interest-sensitive life business inforce due to: (i) lapses exceeding new sales in recent periods; and (ii) the completion of the coinsurance transaction with Wilton Re in 2009. The weighted average crediting rates for these products were 4.0 percent, 4.1 percent and 4.2 percent in 2010, 2009 and 2008, respectively.
During 2010, we were required to recognize $13 million of additional amortization expense resulting from decreased projected future investment yields related to interest-sensitive insurance products. Also in 2010, amortization increased by $6 million representing the write-off of the balance of the present value of future profits related to this segment’s long-term care insurance block. Such write-off was based on actuarial studies indicating such balance was no longer expected to be recoverable from future profits. Amortization on our annuity block of business decreased $15 million in 2010, primarily due to better persistency.
We were also required to accelerate the amortization of insurance acquisition costs due to changes in our assumptions related to future profits on our universal life products in this segment during 2008. During 2008, an analysis was performed on a universal life block of business that led to changes in our assumptions of future mortality, surrenders, premium persistency, expenses and investment income. We recognized additional amortization expense of approximately $8 million to reflect these changes. The additional amortization expense in 2008 was net of planned increases to associated policyholder charges.
we have increased our expected surrender assumptions in future periods. These annuities also have a MVA feature, which effectively reduced (or in some cases, eliminated) the charges paid upon the surrender of these policies in the recent periods as the 10-year treasury rate dropped. The impact of both the historical experience and the projected increased surrender activity and higher MVA benefits has reduced our expectations on the profitability of this block to approximately break-even. We recognized additional amortization of approximately $6.8 million, $8.5 million and $5 million in 2010, 2009 and 2008, respectively, related to the actual and expected future changes in the experience of this block. We continue to hold insurance acquisition costs of approximately $52 million related to these products. Results for this block are expected to exhibit increased volatility in the future, because the difference between our assumptions and actual experience will be reflected in earnings in the period such differences occur.
Net operating results of variable interest entities represent the operating results of variable interest entities (“VIEs”). The VIEs are consolidated in accordance with GAAP. These entities were established to issue securities and use the proceeds to invest in loans and other permitted assets. Refer to the note to the consolidated financial statements entitled “Investments in Variable Interest Entities” for more information on the VIEs.
Other operating costs and expenses include general corporate expenses, net of amounts charged to subsidiaries for services provided by the corporate operations. These amounts fluctuate as a result of expenses such as consulting, legal and severance costs which often vary from period to period.
Collected premiums on Medicare supplement policies in the Bankers Life segment increased 6.7 percent, to $697.8 million, in 2010 and 2.7 percent, to $653.7 million, in 2009.
Premiums collected on Bankers Life’s long-term care policies decreased 2.8 percent, to $584.6 million, in 2010 and 3.9 percent, to $601.6 million, in 2009. The decrease in 2010 was primarily attributable to higher lapses following premium rate increases in recent periods. The decrease in 2009 was primarily attributable to a long-term care reinsurance agreement pursuant to which we reinsured 70 percent of Bankers Life’s new 2009 long-term care business. The amount reinsured decreased to 50 percent for the first quarter of 2010 and to 25 percent thereafter.
Premiums collected on PDP and PFFS business relate to various quota-share reinsurance agreements with Coventry. In order to reduce the required statutory capital associated with the assumption of group PFFS business, we terminated two group policy quota-share agreements as of December 31, 2008 and terminated the last agreement on June 30, 2009. Coventry decided to cease selling PFFS plans effective January 1, 2010. Effective January 1, 2010, the Company no longer assumes the underwriting risk related to PFFS business. In the third quarter of 2009, Bankers Life began offering Humana’s Medicare Advantage plans to its policyholders and consumers nationwide through its career agency force and receives marketing fees based on sales. Premiums collected on the PFFS business were $1.1 million, $369.0 million and $542.4 million in 2010, 2009 and 2008, respectively. The PFFS premiums recognized in 2010 related to adjustments to prior year contracts. These agreements are described in “Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations - Critical Accounting Policies”.
Life products in this segment are sold primarily to the senior market. Life premiums collected in this segment increased .2 percent, to $187.7 million, in 2010 and 7.6 percent, to $187.3 million, in 2009. Graded benefit life products sold through our direct response marketing channel accountedfor $184.1 million, $180.5 million and $168.5 million of collected premiums in 2010, 2009 and 2008, respectively. In 2009, renewal premiums for our life insurance products include the receipt of a $3.4 million final distribution and commutation payment following the termination of a group insurance pool that Colonial Penn previously participated in.
Annuities in this segment include fixed index and other fixed annuities. We are no longer actively pursuing sales of annuity products in this segment. Total annuity collected premiums in this segment decreased 79 percent, to $16.4 million, in 2010 and 40 percent, to $78.4 million, in 2009.
Our investment strategy is to: (i) maintain a predominately investment-grade fixed income portfolio; (ii) provide liquidity to meet our cash obligations to policyholders and others; and (iii) generate stable and predictable investment income through active investment management. Consistent with this strategy, investments in fixed maturity securities, mortgage loans and policy loans made up 95 percent of our $23.8 billion investment portfolio at December 31, 2010. The remainder of the invested assets was trading securities, investments held by variable interest entities, equity securities and other invested assets.
At each reporting date, we classify assets and liabilities into the three input levels based on the lowest level of input that is significant to the measurement of fair value for each asset and liability reported at fair value. This classification is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established, the characteristics specific to the transaction and overall market conditions. Our assessment of the significance of a particular input to the fair value measurement and the ultimate classification of each asset and liability requires judgment.
which are determined based on comparison to securities with similar ratings, maturities and industries that are rated by independent third party rating agencies. Our process also considers the ratings assigned by the NAIC to the Level 3 securities on an annual basis. Each quarter, a review is performed to determine the reasonableness of the initial valuations from the model. If an initial valuation appears unreasonable based on our knowledge of a security and current market conditions, we make appropriate adjustments to our valuation inputs. The remaining securities classified as Level 3 are primarily valued based on non-binding broker quotes or internally developed models using estimated future cash flows. We recognized other-than-temporary impairments on securities classified as Level 3 investments of $75.9 million during 2010 ($72.0 million, prior to the $(3.9) million of impairment losses recognized through accumulated other comprehensive income (loss)).
As the Company is responsible for the determination of fair value, we perform monthly quantitative and qualitative analysis on the prices received from third parties to determine whether the prices are reasonable estimates of fair value. The Company’s analysis includes: (i) a review of the methodology used by third party pricing services; (ii) a comparison of pricing services’ valuation to other pricing services’ valuations for the same security; (iii) a review of month to month price fluctuations; (iv) a review to ensure valuations are not unreasonably stale; and (v) back testing to compare actual purchase and sale transactions with valuations received from third parties. As a result of such procedures, the Company may conclude the prices received from third parties are not reflective of current market conditions. In those instances, we may request additional pricing quotes or apply internally developed valuations. However, the number of instances is insignificant and the aggregate change in value of such investments is not materially different from the original prices received.
The categorization of fair value measurements, by input level, for our fixed maturity securities, equity securities, trading securities, certain other invested assets and assets held in separate accounts at December 31, 2010 is as follows (dollars in millions):
The following table presents additional information about assets measured at fair value on a recurring basis and for which we have utilized significant unobservable (Level 3) inputs to determine fair value for the year ended December 31, 2010 (dollars in millions):
We review the fair value hierarchy classifications each reporting period. Transfers in and/or (out) of Level 3 in 2010 were primarily due to changes in the observability of the valuation attributes resulting in a reclassification of certain financial assets or liabilities. Such reclassifications are reported as transfers in and out of Level 3 at the beginning fair value for the reporting period in which the changes occur.
Investment ratings are assigned the second lowest rating by a nationally recognized statistical rating organization (primarily Moody’s, S&P or Fitch Ratings (“Fitch”)), or if not rated by such firms, the rating assigned by the NAIC. NAIC designations of “1” or “2” include fixed maturities generally rated investment grade (rated “Baa3” or higher by Moody’s or rated “BBB-” or higher by S&P and Fitch. NAIC designations of “3” through “6” are referred to as below investment grade (which generally are rated “Ba1” or lower by Moody’s or rated “BB+” or lower by S&P and Fitch). References to investment grade or below investment grade throughout our consolidated financial statements are based on such nationally recognized statistical ratings. The following table sets forth fixed maturity investments at December 31, 2010, classified by ratings (dollars in millions):
Although investment income is a significant component of total revenues, the profitability of certain of our insurance products is determined primarily by the spreads between the interest rates we earn and the rates we credit or accrue to our insurance liabilities. At December 31, 2010 and 2009, the average yield, computed on the cost basis of our fixed maturity portfolio, was 5.9 percent and 5.7 percent, respectively, and the average interest rate credited or accruing to our total insurance liabilities (excluding interest rate bonuses for the first policy year only and excluding the effect of credited rates attributable to variable or fixed index products) was 4.5 percent and 4.5 percent, respectively.
At December 31, 2010, our fixed maturity portfolio had $815.0 million of unrealized gains and $336.9 million of unrealized losses, for a net unrealized gain of $478.1 million. Estimated fair values of fixed maturity investments were determined based on estimates from: (i) nationally recognized pricing services (85 percent of the portfolio); (ii) broker-dealer market makers (3 percent of the portfolio); and (iii) internally developed methods (12 percent of the portfolio).
At December 31, 2010, approximately 7.5 percent of our invested assets (8.7 percent of fixed maturity investments) were fixed maturities rated below-investment grade. Our level of investments in below-investment-grade fixed maturities could change based on market conditions or changes in our management policies. Below-investment grade corporate debt securities have different characteristics than investment grade corporate debt securities. Based on historical performance, probability of default by the borrower is significantly greater for below-investment grade securities and in many cases severity of loss is relatively greater as such securities are often subordinated to other indebtedness of the issuer. Also, issuers of below-investment grade securities frequently have higher levels of debt relative to investment-grade issuers, hence, all other things being equal, are more sensitive to adverse economic conditions, such as recession or increasing interest rates. The Company attempts to reduce the overall risk related to its investment in below-investment grade securities, as in all investments, through careful credit analysis, strict investment policy guidelines, and diversification by issuer and/or guarantor and by industry. At December 31, 2010, our below-investment-grade fixed maturity investments had an amortized cost of $1,805.2 million and an estimated fair value of $1,791.5 million.
We continually evaluate the creditworthiness of each issuer whose securities we hold. We pay special attention to large investments and to those securities whose fair values have declined materially for reasons other than changes in interest rates or other general market conditions. We evaluate the realizable value of the investment, the specific condition of the issuer and the issuer’s ability to comply with the material terms of the security. We review the recent operational results and financial position of the issuer, information about its industry, information about factors affecting the issuer’s performance and other information. 40|86 Advisors employs 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 amortized cost of the investment, and such decline in fair value is determined to be other than temporary, we reduce the amortized cost to its fair value, which becomes the new cost basis. We report the amount of the reduction as a realized loss. We recognize any
As of December 31, 2010, we had investments in substantive default (i.e., in default due to nonpayment of interest or principal) that had an estimated fair value of $0.6 million. 40|86 Advisors employs professionals with experience in managing non-performing and impaired investments. There were no other fixed maturity investments about which we had serious doubts as to the recoverability of the carrying value of the investment.
When a security defaults or securities (other than structured securities) are other-than-temporarily impaired, 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 on nonperforming investments was $2.7 million, $6.7 and $.9 for the years ended December 31, 2010, 2009 and 2008, respectively.
The following table sets forth the par value, amortized cost and estimated fair value of structured securities, summarized by interest rates on the underlying collateral at December 31, 2010 (dollars in millions):
At December 31, 2010, we held commercial mortgage loan investments with a carrying value of $1,761.2 million (or 7 percent of total invested assets) and a fair value of $1,762.6 million. None of the commercial mortgage loan balance was noncurrent at December 31, 2010. During 2010, we recognized $40.8 million of writedowns of commercial mortgage loans resulting from declines in fair value that we concluded were other than temporary. During 2009, we recognized $40.9 million of writedowns of commercial mortgage loans resulting from declines in fair value that we concluded were other than temporary. During 2008, we recognized $5.8 million of writedowns of commercial mortgage loans for other-than-temporary declines in fair value and recognized losses of $22.1 million from the liquidation of several delinquent commercial mortgage loans. We had no allowance for loss on mortgage loans at both December 31, 2010 and 2009. Approximately 7 percent, 7 percent, 6 percent, 6 percent, 5 percent and 5 percent of the mortgage loan balance were on properties located in Minnesota, California, Arizona, Florida, North Carolina and Indiana, respectively. No other state comprised greater than five percent of the mortgage loan balance.
The following table shows the distribution of our commercial mortgage loan portfolio by property type as of December 31, 2010 (dollars in millions):
The following table provides the weighted average loan-to-value ratio for our outstanding mortgage loans as of December 31, 2010 (dollars in millions):
Loan-to-value ratios are calculated as the ratio of: (i) the carrying value of the commercial mortgage loans; to (ii) the estimated fair value of the underlying commercial property.
Changes in our consolidated balance sheet between December 31, 2010 and December 31, 2009, primarily reflect: (i) our net income for 2010; (ii) changes in the fair value of our fixed maturity securities, available for sale; and (iii) the changes to corporate notes payable in 2010 as further described in the note to the consolidated financial statements entitled “Notes Payable - Direct Corporate Obligations”.
Our capital structure as of December 31, 2010 and 2009 was as follows (dollars in millions):
Such ratio excludes accumulated other comprehensive income (loss) from total capital. In addition, debt is defined as par value plus accrued interest and certain other items. Management believes this non-GAAP measure is useful as the level of such ratio impacts certain provisions in our senior secured credit facility.
The Company’s significant contractual obligations as of December 31, 2010, were as follows (dollars in millions):
Includes projected interest payments based on market rates, as applicable, as of December 31, 2010. Refer to the note to the consolidated financial statements entitled “Notes Payable - Direct Corporate Obligations” for additional information on notes payable.
These borrowings represent the securities issued by VIEs and include projected interest payments based on market rates, as applicable, as of December 31, 2010.
During 2010, the financial statements of one of our subsidiaries prepared in accordance with statutory accounting practices prescribed or permitted by regulatory authorities reflected asset adequacy or premium deficiency reserves. Total asset adequacy and premium deficiency reserves for Washington National were $75.3 million at December 31, 2010. Due to differences between statutory and GAAP insurance liabilities, we were not required to recognize a similar premium deficiency reserve in our consolidated financial statements prepared in accordance with GAAP. The determination of the need for and amount of asset adequacy reserves is subject to numerous actuarial assumptions, including the Company’s ability to change nonguaranteed elements related to certain products consistent with contract provisions.
Financial strength ratings provided by A.M. Best, S&P and Moody’s are the rating agency’s opinions of the ability of our insurance subsidiaries to repay policyholder claims and obligations when due.
On December 22, 2010, A.M. Best upgraded the financial strength ratings of our primary insurance subsidiaries, except Conseco Life, to “B+” from “B”. A.M. Best also affirmed the financial strength rating of “B-“ of Conseco Life and revised the outlook for the rating of Conseco Life to stable from negative. On March 23, 2010, A.M. Best affirmed the financial strength rating of “B” of our primary insurance subsidiaries, except Conseco Life, whose “B” rating was downgraded to “B-”. A.M. Best also revised the outlook for the ratings of our primary insurance subsidiaries to stable from negative, except for Conseco Life, whose outlook of negative was affirmed. A “stable” designation means that there is a low likelihood of a rating change due to stable financial market trends. The “B+” rating is assigned to companies that have a good ability, in A.M. Best’s opinion, to meet their ongoing obligations to policyholders. A “B-” rating is assigned to companies that have a fair ability, in A.M. Best’s opinion, to meet their current obligations to policyholders, but are financially vulnerable to adverse changes in underwriting and economic conditions. A.M. Best ratings for the industry currently range from “A++ (Superior)” to “F (In Liquidation)” and some companies are not rated. An “A++” rating indicates a superior ability to meet ongoing obligations to policyholders. A.M. Best has sixteen possible ratings. There are five ratings above the “B+” rating of our primary insurance subsidiaries, other than Conseco Life, and ten ratings that are below that rating. There are seven ratings above the “B-” rating of Conseco Life and eight ratings that are below that rating.
vulnerability within the range; a “CC” rating indicates the highest degree of vulnerability. Pluses and minuses show the relative standing within a category. In S&P’s view, an insurer rated “BB” has marginal financial security characteristics and although positive attributes exist, adverse business conditions could lead to an insufficient ability to meet financial commitments. S&P has twenty-one possible ratings. There are eleven ratings above our “BB” rating and nine ratings that are below our rating.
Availability and Sources and Uses of Holding Company Liquidity; Limitations on Ability of Insurance Subsidiaries to Make Dividend and Surplus Debenture Interest Payments to the Holding Companies
Bankers Life paid ordinary dividends of $86.0 million to Conseco Life of Texas in 2010.
A significant deterioration in the financial condition, earnings or cash flow of the material subsidiaries of CNO or CDOC for any reason could hinder such subsidiaries’ ability to pay cash dividends or other disbursements to CNO and/or CDOC, which, in turn, could limit CNO’s ability to meet debt service requirements and satisfy other financial obligations. In addition, we may choose to retain capital in our insurance subsidiaries or to contribute additional capital to our insurance subsidiaries to strengthen their surplus, and these decisions could limit the amount available at our top tier insurance subsidiaries to pay dividends to the holding companies. In the past, we have made capital contributions to our insurance subsidiaries to meet debt covenants and minimum capital levels required by certain regulators and it is possible we will be required to do so in the future. In 2010, the cash dividends we received from our insurance subsidiaries exceeded capital contributions to such subsidiaries by $51.6 million.
The scheduled principal and interest payments on our direct corporate obligations (including payments required under the New Senior Credit Agreement, the Senior Health Note, the 9.0% Senior Secured Notes and the 7.0% Debentures) are as follows (dollars in millions):
In connection with the Transfer further discussed in the note to the consolidated financial statements entitled “Transfer of Senior Health Insurance Company of Pennsylvania to an Independent Trust”, the Company issued the Senior Health Note. The Senior Health Note has a 6 percent interest rate and requires annual principal payments of $25.0 million. Such amounts are expected to be funded by the Company’s operating activities. CNO agreed that it would not pay cash dividends on its common stock while any portion of the Senior Health Note remained outstanding. At December 31, 2010, the outstanding balance under the Senior Health Note was $75.0 million.
On December 21, 2010, the Company entered the New Senior Secured Credit Agreement. The net proceeds of $363.6 million were used to repay a portion of the amount outstanding under the Previous Senior Credit Agreement.
The New Senior Credit Agreement contains covenants that limit the Company’s ability to take certain actions and perform certain activities, including (each subject to exceptions as set forth in the New Senior Credit Agreement):
Mandatory prepayments of the New Senior Secured Credit Agreement will be required in an amount equal to: (i) 100 percent of the net cash proceeds from certain asset sales or casualty events; (ii) 100 percent of the net cash proceeds received by the Company or any of its subsidiaries from certain debt issuances; (iii) 50 percent of the net cash proceeds received from certain equity issuances; and (iv) 100 percent of the amount of certain restricted payments made (including any common stock dividends and share repurchases) as defined in the New Senior Secured Credit Agreement.
Notwithstanding the foregoing, no mandatory prepayments pursuant to items (i) or (iii) in the preceding paragraph shall be required if: (x) the debt to total capitalization ratio is equal or less than 20 percent; and (y) either (A) the financial strength rating of certain insurance subsidiaries is equal or better than A- (stable) from A.M. Best or (B) the New Senior Secured Credit Agreement is rated equal or better than BBB- (stable) from S&P and Baa3 (stable) by Moody’s.
The Indenture provides for customary events of default (subject in certain cases to customary grace and cure periods), which include nonpayment, breach of covenants in the Indenture, failure to pay at maturity or acceleration of other indebtedness, a failure to pay certain judgments and certain events of bankruptcy and insolvency. Generally, if an event of default occurs, the Trustee or holders of at least 25% in principal amount of the then outstanding 9.0% Senior Secured Notes may declare the principal of and accrued but unpaid interest, including any additional interest, on all of the 9.0% Senior Secured Notes to be due and payable.
In connection with the issuance of the 9.0% Senior Secured Notes and entry into the New Senior Secured Credit Agreement, the Agent and Wilmington Trust FSB, as collateral agent and authorized representative with respect to the 9.0% Senior Secured Notes, entered into an Intercreditor Agreement, dated as of December 21, 2010 (the “Intercreditor Agreement”), which sets forth agreements with respect to the first-priority liens granted by the Company and the Subsidiary Guarantors pursuant to the Indenture and the New Senior Secured Credit Agreement.
Our spread-based insurance business is subject to several inherent risks arising from movements in interest rates, especially if we fail to anticipate or respond to such movements. First, interest rate changes can cause compression of our net spread between interest earned on investments and interest credited on customer deposits, thereby adversely affecting our results. Second, if interest rate changes produce an unanticipated increase in surrenders of our spread-based products, we may be forced to sell investment assets at a loss in order to fund such surrenders. Many of our products include surrender charges, market interest rate adjustments or other features to encourage persistency; however at December 31, 2010, approximately 23 percent of our total insurance liabilities, or approximately $5.6 billion, could be surrendered by the policyholder without penalty. Finally, changes in interest rates can have significant effects on the performance of our structured securities portfolio as a result of changes in the prepayment rate of the loans underlying such securities. We follow asset/liability strategies that are designed to mitigate the effect of interest rate changes on our profitability. However, there can be no assurance that management will be successful in implementing such strategies and achieving adequate investment spreads.
The profitability of many of our products depends on the spread between the interest earned on investments and the rates credited on our insurance liabilities. In addition, changes in competition and other factors, including the level of surrenders and withdrawals, may limit our ability to adjust or to maintain crediting rates at levels necessary to avoid narrowing of spreads under certain market conditions. As of December 31, 2010, approximately 40 percent of our insurance liabilities had interest rates that may be reset annually; 41 percent had a fixed explicit interest rate for the duration of the contract; 14 percent had credited rates which approximate the income earned by the Company; and the remainder had no explicit interest rates. At December 31, 2010, the average yield, computed on the cost basis of our fixed maturity portfolio, was 5.9 percent, and the average interest rate credited or accruing to our total insurance liabilities (excluding interest rate bonuses for the first policy year only and excluding the effect of credited rates attributable to variable or fixed index products) was 4.5 percent.
As further discussed in the note to the consolidated financial statements entitled “Transfer of Senior Health Insurance Company of Pennsylvania to an Independent Trust”, the long-term care business of Senior Health is reflected as a discontinued operation in all periods presented. As a result, the comparison of the 2008 operating results to prior periods is impacted by the Transfer. The following summarizes the operating results of our discontinued operations (dollars in millions):
These non-GAAP financial measures of “interest-adjusted benefit ratios” differ from “benefit ratios” due to the deduction of interest income on the accumulated assets backing the insurance liabilities from the product’s insurance policy benefits used to determine the ratio. Interest income is an important factor in measuring the performance of health products that are expected to be inforce for a longer duration of time, are not subject to unilateral changes in provisions (such as non-cancelable or guaranteed renewable contracts) and require the performance of various functions and services (including insurance protection) for an extended period of time. The net cash flows from long-term care products generally cause an accumulation of amounts in the early years of a policy (accounted for as reserve increases) that will be paid out as benefits in later policy years (accounted for as reserve decreases). Accordingly, as the policies age, the benefit ratio will typically increase, but the increase in benefits will be partially offset by interest income earned on the accumulated assets. The interest-adjusted benefit ratio reflects the effects of the interest income offset. Since interest income is an important factor in measuring the performance of this product, management believes a benefit ratio that includes the effect of interest income is useful in analyzing product performance. We utilize the interest-adjusted benefit ratio in measuring segment performance because we believe that this performance measure is a better indicator of the ongoing businesses and trends in the business. However, the “interest-adjusted benefit ratio” does not replace the “benefit ratio” as a measure of current period benefits to current period insurance policy income. Accordingly, management reviews both “benefit ratios” and “interest-adjusted benefit ratios” when analyzing the financial results attributable to these products. The investment income earned on the accumulated assets backing long-term care reserves in our discontinued operations was $156.9 million in 2008.
Total premium collections were $225.9 million in 2008. We ceased marketing this long-term care business in 2003. Accordingly, collected premiums have decreased over time as policies lapsed, partially offset by premium rate increases.
This long-term care business was primarily issued by Senior Health prior to its acquisition by our Predecessor in 1996. The loss experience on these products has been worse than we originally expected. Although we anticipated a higher level of benefits to be paid on these products as the policies aged, the paid claims have exceeded our expectations. In addition, there has been an increase in the incidence and duration of claims in recent periods. This adverse experience is reflected in the higher insurance policy benefits experienced in 2008.
receipt of a paid-up policy, allowing the holder to file future claims up to 100 percent of the amount of premiums paid since the inception of the policy (“option three”).
Loss on Transfer and transaction expenses relates to the loss on the transfer of Senior Health to an independent trust as further discussed in the note to the consolidated financial statements entitled “Transfer of Senior Health Insurance Company of Pennsylvania to an Independent Trust”.
Other operating costs and expenses were $54.0 million in 2008. Other operating costs and expenses, excluding commission expenses, for this segment were $29.7 million in 2008.
Net realized investment gains (losses) fluctuated each period. During 2008, net realized investment losses included $.4 million of net gains from the sales of investments (primarily fixed maturities) and $380.5 million of writedowns of investments (which were transferred to the Independent Trust) as a result of our intent not to hold such investments for a period of time sufficient to allow for a full recovery in value.
To the Shareholders and Board of Directors CNO Financial Group, Inc.:
Beginning July 1, 2010, management changed the manner in which it disaggregates the Company’s operations for making operating decisions and assessing performance. As a result, the Company manages its business through the following operating segments: Bankers Life, Colonial Penn and Washington National, which are defined on the basis of product distribution; Other CNO Business, comprised primarily of products we no longer sell actively; and corporate operations, comprised of holding company activities and certain noninsurance company businesses. Our segments are described below.
Colonial Penn, which markets primarily graded benefit and simplified issue life insurance directly to customers through television advertising, direct mail, the internet and telemarketing. The Colonial Penn segment includes primarily the business of Colonial Penn Life Insurance Company (“Colonial Penn”).
We classify our fixed maturity securities into one of three categories: (i) “available for sale” (which we carry at estimated fair value with any unrealized gain or loss, net of tax and related adjustments, recorded as a component of shareholders’ equity); (ii) “trading” (which we carry at estimated fair value with changes in such value recognized as trading income); or (iii) “held to maturity” (which we carry at amortized cost). We had no fixed maturity securities classified as held to maturity during the periods presented in these financial statements.
Securities lending collateral primarily consisted of fixed maturities, equity securities and cash and cash equivalents. We carried these investments at estimated fair value. We recorded any unrealized gain or loss, net of tax, as a component of shareholders’ equity. In the third quarter of 2010, the Company discontinued its securities lending program.
The costs that vary with, and are primarily related to, producing new insurance business subsequent to September 10, 2003 are referred to as deferred acquisition costs. For universal life or investment products, we amortize these costs in relation to the estimated gross profits using the interest rate credited to the underlying policies. For other products, we amortize these costs in relation to future anticipated premium revenue using the projected investment earnings rate.
The value assigned to the right to receive future cash flows from contracts existing at September 10, 2003 is referred to as the present value of future profits. We also defer renewal commissions paid in excess of ultimate commission levels related to the existing policies in this account. The balance of this account is amortized and evaluated for recovery in the same manner as described above for deferred acquisition costs. We also adjust the present value of future profits for the change in amortization that would have been recorded if the fixed maturity securities, available for sale, had been sold at their stated aggregate fair value and the proceeds reinvested at current yields, similar to the manner described above for deferred acquisition costs. We limit the total adjustment related to the impact of unrealized losses to the total present value of future profits plus interest.
We also have a small block of short duration accident and health products. Premiums on these products are recognized as revenue over the premium coverage period.
We establish liabilities for traditional life, accident and health insurance, and life contingent payment annuity products
Many of our long-term care policies were subject to premium rate increases in the three years ending December 31, 2010. In some cases, these premium rate increases were materially consistent with the assumptions we used to value the particular block of business at the fresh-start date. With respect to the 2006 premium rate increases, some of our policyholders were provided an option to cease paying their premiums and receive a non-forfeiture option in the form of a paid-up policy with limited benefits. In addition, our policyholders could choose to reduce their coverage amounts and premiums in the same proportion, when permitted by our contracts or as required by regulators. The following describes how we account for these policyholder options:
receipt of a paid-up policy, allowing the holder to file future claims up to 100 percent of the amount of premiums paid since the inception of the policy.
CNO expanded its strategic alliance with Coventry by entering into a national distribution agreement under which our career agents began distributing Coventry’s Private-Fee-For-Service (“PFFS”) plan, beginning January 1, 2007. The Advantra Freedom product is a Medicare Advantage plan designed to provide seniors with more choices and better coverage at lower cost than original Medicare and Medicare Advantage plans offered through HMOs. Under the agreement, we received a fee based on the number of PFFS plans sold through our distribution channels. In addition, CNO had a quota-share reinsurance agreement with Coventry for CNO enrollees that provided CNO with a specified percentage of the net premiums and related profits. Coventry decided to cease selling PFFS plans effective January 1, 2010. In July 2009, we announced a strategic alliance under which we would offer Humana’s Medicare Advantage plans to our policyholders and consumers through our career agency force and will receive marketing fees based on sales. Effective January 1, 2010, we no longer assumed the underwriting risk related to PFFS business.
During 2007 and 2008, CNO entered into three quota-share reinsurance agreements with Coventry related to the PFFS business written by Coventry under two large group policies. CNO received a specified percentage of the net premiums and related profits associated with this business as long as the ceded revenue margin (as defined in the quota-share reinsurance agreements) was less than or equal to five percent. CNO also received a specified percentage of the net premiums and related profits on the ceded margin in excess of five percent. In order to reduce the required statutory capital associated with the assumption of this business, CNO terminated two group policy quota-share agreements as of December 31, 2008 and terminated the last agreement on June 30, 2009. Premiums assumed through these reinsurance agreements totaled $47.5 million in 2009. The income before income taxes related to the assumed business was $14.0 million during the year ended December 31, 2009.
See the section of this note entitled “Accounting for Derivatives” for a discussion of the derivative embedded in the payable related to certain modified coinsurance agreements.
In September 2009, we completed a transaction under which Washington National and Conseco Insurance Company coinsured, with an effective date of January 1, 2009, about 104,000 non-core life insurance policies in the Other CNO Business segment with Wilton Reassurance Company (“Wilton Re”). In the transaction, Wilton Re paid a ceding commission of $55.8 million and coinsures and administers 100 percent of these policies. The CNO insurance companies transferred to Wilton Re $401.6 million in cash and policy loans and $457.4 million of policy and other reserves. Most of the policies involved in the transaction were issued by companies prior to their acquisition by CNO. We recorded a deferred gain of approximately $26 million in 2009 which is being recognized over the remaining life of the block of insurance policies coinsured with Wilton Re. We also increased our deferred tax valuation allowance by $20 million in 2009 as a result of reassessing the recovery of our deferred tax assets upon completion of the transaction.
In November 2009, we entered into a transaction under which Bankers Life coinsured, with an effective date of October 1, 2009, about 234,000 life insurance policies with Wilton Re. In the transaction, Wilton Re paid a ceding commission of $44 million and is 50% coinsuring these policies, which continue to be administered by Bankers Life. In the transaction, Bankers Life transferred to Wilton Re $73 million in investment securities and policy loans and $117 million of policy and other reserves. As a result of the transaction, we recorded an increase to our deferred tax valuation allowance of $18 million in 2009, as a result of reassessing the recovery of our deferred tax assets upon completion of the transaction. We also recorded a pre-tax deferred cost of reinsurance of $32 million in 2009, which, in accordance with GAAP, is being amortized over the life of the block.
common stock as a requirement of membership in the FHLB, and additional amounts based on the amount of the borrowings. At December 31, 2010, the carrying value of the FHLB common stock was $60.0 million. As of December 31, 2010, collateralized borrowings from the FHLB totaled $1.2 billion (of which, $750.0 million was borrowed in 2010) and the proceeds were used to purchase fixed maturity securities. The borrowings are classified as investment borrowings in the accompanying consolidated balance sheet. The borrowings are collateralized by investments with an estimated fair value of $1.5 billion at December 31, 2010, which are maintained in a custodial account for the benefit of the FHLB. Such investments are classified as fixed maturities, available for sale, in our consolidated balance sheet. Interest expense of $20.8 million, $20.3 million and $21.9 million in 2010, 2009 and 2008, respectively, was recognized related to the borrowings.
The Company accounts for the options attributed to the policyholder for the estimated life of the annuity contract as embedded derivatives. The expected future cost of options on fixed index annuity products is used to determine the value of embedded derivatives. The Company purchases options to hedge liabilities for the next policy year on each policy anniversary date and must estimate the fair value of the forward embedded options related to the policies. These accounting requirements often create volatility in the earnings from these products. We record the changes in the fair values of the embedded derivatives in current earnings as a component of policyholder benefits. Effective January 1, 2008, we adopted authoritative guidance related to fair value measurements which required us to value the embedded derivatives reflecting a hypothetical market perspective for fair value measurement. We recorded a charge of $1.8 million to net income (after the effects of the amortization of the present value of future profits and deferred acquisition costs (collectively referred to as “amortization of insurance acquisition costs”) and income taxes), attributable to changes in the fair value of the embedded derivatives as a result of adopting such guidance. The fair value of these derivatives, which are classified as “liabilities for interest-sensitive products”, was $553.6 million and $494.4 million at December 31, 2010 and 2009, respectively. We maintain a specific block of investments in our trading securities account, which we carry at estimated fair value with changes in such value recognized as investment income (classified as investment income from policyholder and reinsurer accounts and other special-purpose portfolios). The change in value of these trading securities attributable to interest fluctuations is intended to offset a portion of the change in the value of the embedded derivative.
Certain of our reinsurance payable balances contain embedded derivatives. Such derivatives had an estimated fair value of $(.4) million and $1.6 million at December 31, 2010 and 2009, respectively. We record the change in the fair value of these derivatives as a component of investment income (classified as investment income from policyholder and reinsurer accounts and other special-purpose portfolios). We maintain a specific block of investments related to these agreements in our trading securities account, which we carry at estimated fair value with changes in such value recognized as investment income (also classified as investment income from policyholder and reinsurer accounts and other special-purpose portfolios). The change in value of these trading securities attributable to interest fluctuations is intended to offset the change in value of the embedded derivatives. However, differences will occur as corporate spreads change.
Level 1 - includes assets and liabilities valued using inputs that are quoted prices in active markets for identical assets or liabilities. Our Level 1 assets include exchange traded securities.
Level 2 - includes assets and liabilities valued using inputs that are quoted prices for similar assets in an active market, quoted prices for identical or similar assets in a market that is not active, observable inputs, or observable inputs that can be corroborated by market data. Level 2 assets and liabilities include those financial instruments that are valued by independent pricing services using models or other valuation methodologies. These models are primarily industry-standard models that consider various inputs such as interest rate, credit spread, reported trades, broker/dealer quotes, issuer spreads and other inputs that are observable or derived from observable information in the marketplace or are supported by observable levels at which transactions are executed in the marketplace. Financial instruments in this category primarily include: certain public and private corporate fixed maturity securities; certain government or agency securities; certain mortgage and asset-backed securities; and non-exchange-traded derivatives such as call options to hedge liabilities related to our fixed index annuity products.
At each reporting date, we classify assets and liabilities into the three input levels based on the lowest level of input that is significant to the measurement of fair value for each asset and liability reported at fair value. This classification is impacted
Includes $553.6 million of embedded derivatives associated with our fixed index annuity products and $(.4) million of embedded derivatives associated with a modified coinsurance agreement.
The estimated fair values of our financial instruments at December 31, 2010 and 2009, were as follows (dollars in millions):
The estimated fair value of insurance liabilities for interest-sensitive products was approximately equal to its carrying value at December 31, 2010 and 2009. This was because interest rates credited on the vast majority of account balances approximate current rates paid on similar products and because these rates are not generally guaranteed beyond one year.
In October 2010, the FASB issued authoritative guidance that modifies the definition of the types of costs incurred by insurance entities that can be capitalized in the acquisition of new and renewal contracts. The guidance specifies that an insurance entity shall only capitalize incremental direct costs related to the successful acquisition of new or renewal insurance contracts. The guidance also states that advertising costs should be included in deferred acquisition costs only if the capitalization criteria in the direct-response advertising guidance are met. The guidance is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011. The guidance should be applied prospectively upon adoption. Retrospective application to all prior periods presented upon the date of adoption also is permitted, but not required. We are in the process of evaluating the impact the guidance will have on our consolidated financial statements and we believe that the guidance will reduce the amount of costs that we can capitalize.
In January 2010, the FASB issued authoritative guidance which requires new disclosures and clarifies existing disclosure requirements related to fair value. An entity is also required to disclose significant transfers in and out of Levels 1 and 2 of the fair value hierarchy. In addition, the guidance amends the fair value disclosure requirement for pension and postretirement benefit plan assets to require this disclosure at the investment class level. The guidance is effective for interim and annual reporting periods beginning after December 15, 2009. Such disclosures are included in the note to the consolidated financial statements entitled “Fair Value Measurements”. The adoption of this guidance did not have a material impact on our consolidated financial statements.
In June 2009, the FASB issued authoritative guidance that requires an entity to perform a qualitative analysis to determine whether a primary beneficiary interest is held in a VIE. Under the new qualitative model, the primary beneficiary must have both the power to direct the activities of the VIE and the obligation to absorb either losses or gains that could be significant to the VIE. The guidance also requires ongoing reassessments to determine whether a primary beneficiary interest is held and additional disclosures, including the financial statement effects of the entity’s involvement with VIEs. The guidance is effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter. The impact of adoption of this guidance is as follows (dollars in millions):
2009, and this guidance did not have a material effect on our consolidated financial statements.
On April 9, 2009, the FASB issued authoritative guidance which requires that the fair value of financial instruments be disclosed in an entity’s financial statements in both interim and annual periods. The guidance also requires disclosure of methods and assumptions used to estimate fair values. The guidance is effective for interim reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009. We adopted the guidance for the quarter ended June 30, 2009, which did not have a material effect on our consolidated balance sheet or statement of operations.
Amounts related to the 3.5% Debentures are reflected in our consolidated balance sheet at December 31, 2009, as follows (dollars in millions):
In March 2008, the FASB issued authoritative guidance regarding whether unvested share based payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are to be treated as participating securities prior to vesting and, therefore, must be included in the earnings allocation in calculating earnings per share under the two-class method. The guidance is effective for financial statements issued for fiscal years beginning after December 15,
In December 2007, the FASB issued authoritative guidance which establishes new standards governing the accounting for and reporting of noncontrolling interests (previously referred to as minority interests). The guidance establishes reporting requirements which include, among other things, that noncontrolling interests be reflected as a separate component of equity, not as a liability. It also requires that the interests of the parent and the noncontrolling interest be clearly identifiable. Additionally, increases and decreases in a parent’s ownership interest that leave control intact shall be reflected as equity transactions, rather than step acquisitions or dilution gains or losses. The guidance is effective for fiscal years beginning on or after December 15, 2008. The initial adoption of this guidance had no effect on our consolidated financial statements.
In February 2007, the FASB issued authoritative guidance which allows entities to choose to measure many financial instruments and certain other items, including insurance contracts, at fair value (on an instrument-by-instrument basis) that are not currently required to be measured at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. We adopted the guidance on January 1, 2008. We did not elect the fair value option for any of our financial assets or liabilities.
At December 31, 2010, the amortized cost, gross unrealized gains and losses, other-than-temporary impairments in accumulated other comprehensive income (loss) and estimated fair value of fixed maturities, available for sale, were as follows (dollars in millions):
At December 31, 2009, the amortized cost, gross unrealized gains and losses, other-than-temporary impairments in other comprehensive loss and estimated fair value of fixed maturities, available for sale, were as follows (dollars in millions):
The present value of future profits is the value assigned to the right to receive future cash flows from contracts existing at September 10, 2003 (the date our Predecessor emerged from bankruptcy).
The following table summarizes the carrying values and gross unrealized losses of our fixed maturity securities, available for sale, by category as of December 31, 2010 (dollars in millions):
The following table sets forth the amortized cost and estimated fair value of fixed maturities, available for sale, at December 31, 2010, by contractual maturity. Actual maturities will differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties. In addition, structured securities (such as asset-backed securities, collateralized debt obligations, commercial mortgage-backed securities, mortgage pass-through securities and collateralized mortgage obligations, collectively referred to as “structured securities”) frequently permit periodic unscheduled payments throughout their lives (dollars in millions):
The following table sets forth the net realized investment gains (losses) for the periods indicated (dollars in millions):
During 2008, we recognized net realized investment losses of $262.4 million, which were comprised of: (i) $100.1 million of net losses from the sales of investments (primarily fixed maturities); and (ii) $162.3 million of writedowns of investments for other than temporary declines in fair value (no single investment accounted for more than $10 million of such writedowns).
At December 31, 2010, fixed maturity securities in default or considered nonperforming had both an aggregate amortized cost and carrying value of $.6 million.
During 2010, we recorded an impairment charge of $70.6 million on an investment made by our Predecessor in a guaranteed investment contract issued by a Bermuda insurance company. We recently decided to pursue the early commutation of this investment in exchange for interests in certain underlying invested assets held by the insurance company. Current information related to these underlying invested assets obtained in late December 2010 and early 2011 resulted in the recognition of the impairment charge. The guaranteed investment contract matures in December 2029 and had a projected future yield of 1.33% (the guaranteed minimum rate) immediately prior to the impairment charge. The estimated fair value of our investment in the guaranteed investment contract was $213 million at December 31, 2010. Also during 2010, other-than-temporary impairments recorded in earnings included: (i) $23.6 million of losses related to mortgage-backed and asset-backed securities, primarily reflecting changes related to the estimated future cash flows of the underlying assets and, for certain securities, changes in our intent to hold the securities; (ii) $40.8 million of losses related to commercial mortgage loans reflecting our concerns regarding the issuers’ ability to continue to make contractual payments related to these loans and our estimate of the value of the underlying properties; (iii) $1.6 million related to a home office building which is available for sale; and (iv) $13.2 million of additional losses primarily related to various corporate securities and other invested assets following unforeseen issue-specific events or conditions.
We regularly evaluate our investments for possible impairment. Our assessment of whether unrealized losses are “other than temporary” requires significant judgment. Factors considered include: (i) the extent to which fair value is less than the cost basis; (ii) the length of time that the fair value has been less than cost; (iii) whether the unrealized loss is event driven, credit-driven or a result of changes in market interest rates or risk premium; (iv) the near-term prospects for specific events, developments or circumstances likely to affect the value of the investment; (v) the investment’s rating and whether the investment is investment-grade and/or has been downgraded since its purchase; (vi) whether the issuer is current on all payments in accordance with the contractual terms of the investment and is expected to meet all of its obligations under the terms of the investment; (vii) whether we intend to sell the investment or it is more likely than not that circumstances will
The following table summarizes the amount of credit losses recognized in earnings on fixed maturity securities, available for sale, held at the beginning of the period, for which a portion of the other-than-temporary impairment was also recognized in accumulated other comprehensive income (loss) for the years ended December 31, 2010 and 2009 (dollars in millions):
Represents securities for which the amount previously recognized in accumulated other comprehensive income (loss) was recognized in earnings because we intend to sell the security or we more likely than not will be required to sell the security before recovery of its amortized cost basis.
The following summarizes the investments in our portfolio rated below-investment grade which have been continuously in an unrealized loss position exceeding 20 percent of the cost basis for the period indicated as of December 31, 2010 (dollars in millions):
Our investment strategy is to maximize, over a sustained period and within acceptable parameters of quality and risk, investment income and total investment return through active investment management. Accordingly, we may sell securities at a gain or a loss to enhance the projected total return of the portfolio as market opportunities change, to reflect changing perceptions of risk, or to better match certain characteristics of our investment portfolio with the corresponding characteristics of our insurance liabilities. While we do not have the intent to sell securities with unrealized losses and it is not more likely than not that we will be required to sell securities with unrealized losses prior to their anticipated recovery, we may sell securities at a loss in the future because of actual or expected changes in our view of the particular investment, its industry, its type or the general investment environment. If a loss is recognized from a sale subsequent to a balance sheet date due to these unexpected developments, the loss is recognized in the period in which we had the intent to sell the securities before their anticipated recovery.
In general, the rate of prepayments on structured securities increases when prevailing interest rates decline significantly in absolute terms and also relative to the interest rates on the underlying assets. The yields recognized on structured securities purchased at a discount to par will increase (relative to the stated rate) when the underlying assets prepay faster than expected. The yields recognized on structured securities purchased at a premium will decrease (relative to the stated rate) when the underlying assets prepay faster than expected. When interest rates decline, the proceeds from prepayments may be reinvested at lower rates than we were earning on the prepaid securities. When interest rates increase, prepayments may decrease. When this occurs, the average maturity and duration of the structured securities increase, which decreases the yield on structured securities purchased at a discount because the discount is realized as income at a slower rate,
For structured securities included in fixed maturities, available for sale, that were purchased at a discount or premium, we recognize investment income using an effective yield based on anticipated future prepayments and the estimated final maturity of the securities. Actual prepayment experience is periodically reviewed and effective yields are recalculated when differences arise between the prepayments originally anticipated and the actual prepayments received and currently anticipated. For credit sensitive mortgage-backed and asset-backed securities, and for securities that can be prepaid or settled in a way that we would not recover substantially all of our investment, the effective yield is recalculated on a prospective basis. Under this method, the amortized cost basis in the security is not immediately adjusted and a new yield is applied prospectively. For all other structured and asset-backed securities, the effective yield is recalculated when changes in assumptions are made, and reflected in our income on a retrospective basis. Under this method, the amortized cost basis of the investment in the securities is adjusted to the amount that would have existed had the new effective yield been applied since the acquisition of the securities. Such adjustments were not significant in 2010.
The Company participated in a securities lending program whereby certain fixed maturity securities from our investment portfolio were loaned to third parties via a lending agent for a short period of time. We maintain ownership of the loaned securities. We required collateral equal to 102 percent of the fair value of the loaned securities. The collateral was invested by the lending agent in accordance with our guidelines. The fair value of the loaned securities was monitored on a daily basis with additional collateral obtained as necessary. In the third quarter of 2010, the Company discontinued its securities lending program. As of December 31, 2009, the fair value of the loaned securities was $178.5 million. As of December 31, 2009, the Company had received collateral of $185.7 million. Income generated from the program, net of expenses is recorded as net investment income and totaled $.2 million, $1.2 million and $2.4 million in 2010, 2009 and 2008, respectively.
Life insurance companies are required to maintain certain investments on deposit with state regulatory authorities. Such assets had aggregate carrying values of $77.7 million and $83.3 million at December 31, 2010 and 2009, respectively.
In 2010 and 2009, all of this liability represented account balances where future benefits are not guaranteed.
The Company establishes reserves for insurance policy benefits based on assumptions as to investment yields, mortality, morbidity, withdrawals, lapses and maintenance expenses. These reserves include amounts for estimated future payment of claims based on actuarial assumptions. The balance is based on the Company’s best estimate of the future policyholder benefits to be incurred on this business, given recent and expected future changes in experience.
A reduction of the net carrying amount of deferred tax assets by establishing a valuation allowance is required if, based on the available evidence, it is more likely than not that such assets will not be realized. We evaluate the need to
Concluding that a valuation allowance is not required is difficult when there has been significant negative evidence, such as cumulative losses in recent years. We utilize a three year rolling calculation of actual income before income taxes as our primary measure of cumulative losses in recent years. Our analysis of whether there needs to be any changes to the deferred tax valuation allowance recognizes that as of December 31, 2010, we have incurred a cumulative loss over the evaluation period, resulting from the substantial loss during 2008 primarily related to the Transfer of Senior Health to an independent trust as described in the note to these consolidated financial statements entitled “Transfer of Senior Health Insurance Company of Pennsylvania to an Independent Trust”. As a result of the cumulative losses recognized in recent years, our evaluation of the need to increase the valuation allowance for deferred tax assets was primarily based on our historical taxable earnings. However, because a substantial portion of the cumulative losses for the three-year period ended December 31, 2010, relates to transactions to dispose of blocks of businesses, we have adjusted the three-year cumulative results for the income and losses from the blocks of business disposed of in the past and the business transferred as further described in the note to these financial statements entitled “Transfer of Senior Health Insurance Company of Pennsylvania to an Independent Trust”. We consider this to be non-recurring and have reflected our best estimates of when temporary differences will reverse over the carryforward periods.
The $856.2 million increase to our valuation allowance during 2008 included increases of: (i) $452 million of deferred tax assets related to Senior Health, which was transferred to an independent trust during 2008; (ii) $298 million related to our reassessment of the recovery of our deferred tax assets in accordance with GAAP, following the additional losses incurred as a result of the transaction to transfer Senior Health to an independent trust; (iii) $60 million related to the recognition of additional realized investment losses for which we are unlikely to receive any tax benefit; and (iv) $45 million related to the estimated additional future expense following the modifications to our Senior Credit Agreement as described in the note to these consolidated financial statements entitled “Notes Payable - Direct Corporate Obligations.”
Section 382 imposes limitations on a corporation’s ability to use its NOLs when the company undergoes an ownership change. Future transactions and the timing of such transactions could cause an ownership change for Section 382 income tax purposes. Such transactions may include, but are not limited to, additional repurchases or issuances of common stock
(including upon conversion of our outstanding 7.0% Convertible Senior Debentures due 2016 (the “7.0% Debentures”), or acquisitions or sales of shares of CNO stock by certain holders of our shares, including persons who have held, currently hold or may accumulate in the future five percent or more of our outstanding common stock for their own account. Many of these transactions are beyond our control. If an additional ownership change were to occur for purposes of Section 382, we would be required to calculate an annual restriction on the use of our NOLs to offset future taxable income. The annual restriction would be calculated based upon the value of CNO’s equity at the time of such ownership change, multiplied by a federal long-term tax exempt rate (3.67 percent at December 31, 2010), and the annual restriction could effectively eliminate our ability to use a substantial portion of our NOLs to offset future taxable income. We regularly monitor ownership change (as calculated for purposes of Section 382) and, as of December 31, 2010, we were below the 50 percent ownership change level that would trigger further impairment of our ability to utilize our NOLs.
Under the Section 382 Rights Agreement, one right was distributed for each share of our common stock outstanding as of the close of business on January 30, 2009. Effective January 20, 2009, if any person or group (subject to certain exemptions) becomes a “5 percent shareholder” of CNO without the approval of the Board of Directors, there would be a triggering event causing significant dilution in the voting power and economic ownership of that person or group. Existing shareholders who currently are “5 percent shareholders” will trigger a dilutive event only if they acquire additional shares exceeding one percent of our outstanding shares without prior approval from the Board of Directors.
On May 11, 2010, our shareholders approved an amendment to CNO’s certificate of incorporation designed to prevent certain transfers of common stock which could otherwise adversely affect our ability to use our NOLs (the “Section 382 Charter Amendment”). Subject to the provisions set forth in the Section 382 Charter Amendment, transfers of our common stock would be void and of no effect if the effect of the purported transfer would be to: (i) increase the direct or indirect ownership of our common stock by any person or public group (as such term is defined in the regulations under Section 382) from less than 5% to 5% or more of our common stock; (ii) increase the percentage of our common stock owned directly or indirectly by a person or public group owning or deemed to own 5% or more of our common stock; or (iii) create a new public group. The Section 382 Charter Amendment will continue in effect until December 31, 2013.
Although authoritative guidance allowed a change in accounting, the Company has chosen to continue its past accounting policy of classifying interest and penalties as income tax expense in the consolidated statement of operations. No such amounts were recognized in 2010, 2009 or 2008. The liability for accrued interest and penalties was not significant at December 31, 2010 or December 31, 2009.
We recognized a $742 million loss on our investment in Senior Health which was worthless when it was transferred to an Independent Trust in 2008. We have treated the loss as a capital loss when determining the deferred tax benefit we may receive. We also established a full valuation allowance as we believe we will not generate capital gains to utilize the benefit. However, due to uncertainties in the tax code, we have reflected this loss as an ordinary loss in our tax return, contrary to certain IRS rulings. If classifying this loss as ordinary is ultimately determined to be correct, our valuation allowance would be reduced by approximately $160 million based on income projections used in our valuation allowance at December 31, 2010.
The following notes payable were direct corporate obligations of the Company as of December 31, 2010 and 2009 (dollars in millions):
In February 2010, we completed a second closing of $64 million aggregate principal amount of our 7.0% Debentures and in May 2010, we completed a third closing of $52.5 million aggregate principal amount of our 7.0% Debentures. These issuances were made pursuant to the purchase agreement that we entered into in October 2009 relating to the private offering of up to $293 million of 7.0% Debentures. We received aggregate net proceeds (after taking into account the discounted
The 7.0% Debentures rank equally in right of payment with all of the Company’s unsecured and unsubordinated obligations. The 7.0% Debentures are governed by an Indenture dated as of October 16, 2009 (the “7.0% Indenture”) between the Company and The Bank of New York Mellon Trust Company, N.A., as trustee (“Mellon”). The 7.0% Debentures bear interest at a rate of 7.0% per annum, payable semi-annually on June 30 and December 30 of each year, commencing on the interest payment date immediately succeeding the issuance date of such series. The 7.0% Debentures will mature on December 30, 2016, unless earlier converted. The 7.0% Debentures may not be redeemed at the Company’s election prior to the stated maturity date and the holders may not require the Company to repurchase the 7.0% Debentures at any time. The 7.0% Debentures are not convertible prior to June 30, 2013, except under limited circumstances. Commencing on June 30, 2013, the 7.0% Debentures will be convertible into shares of our common stock at the option of the holder at any time, subject to certain exceptions and subject to our right to terminate such conversion rights under certain circumstances relating to the sale price of our common stock. If the holders elect to convert their 7.0% Debentures upon the occurrence of certain changes of control of CNO or certain other events, we will be required, under certain circumstances, to increase the conversion rate for such holders of the 7.0% Debentures who convert in connection with such events. Initially, the 7.0% Debentures will be convertible into 182.1494 shares of our common stock for each $1,000 principal amount of 7.0% Debentures, which is equivalent to an initial conversion price of approximately $5.49 per share. The conversion rate is subject to adjustment following the occurrence of certain events in accordance with the terms of the 7.0% Indenture.
The 7.0% Indenture provides that on and after the date of the 7.0% Indenture, the Company may not: (i) consolidate with or merge into any other person or sell, convey, lease or transfer the Company’s consolidated properties and assets substantially as an entirety to any other person in any one transaction or series of related transactions; or (ii) permit any person to consolidate with or merge into the Company, unless certain requirements set forth in the 7.0% Indenture are satisfied.
In accordance with GAAP, we are required to consider on each issuance date whether the 7.0% Debentures issued on such date are issued with a beneficial conversion feature. A beneficial conversion feature will exist if the 7.0% Debentures may be convertible into common stock at an effective conversion price (calculated by dividing the proceeds from the issuance of 7.0% Debentures issued on that date (per $1,000 principal amount of debentures) by the then effective conversion rate) that is lower than the market price of a share of common stock on the date of issuance. When a beneficial conversion feature exists, we are required to separately recognize the beneficial conversion feature at issuance by allocating a portion of the proceeds to the intrinsic value of that feature. The value of the beneficial conversion feature is recorded, net of taxes, as an increase to additional paid-in capital. If a beneficial conversion feature exists on the actual date(s) of issuance, a discount equal to the intrinsic value of the beneficial conversion feature will be recorded against the carrying value of the 7.0% Debentures. Such discount will be amortized from the actual date(s) of issuance to the stated maturity date of the 7.0% Debentures using the effective interest method. Accordingly, the interest expense we recognize related to the 7.0% Debentures will be dependent upon whether a beneficial conversion feature exists on the actual date(s) of issuance and the amount by which the market price(s) of our common stock exceeds the effective conversion price on such actual date(s) of issuance.
On December 21, 2010, the Company entered into a $375 million senior secured term loan facility maturing on September 30, 2016, pursuant to an agreement among the Company, Morgan Stanley Senior Funding, Inc., as administrative agent (the “Agent”), and the lenders from time to time party thereto (the “New Senior Secured Credit Agreement”). The net proceeds of $363.6 million were used to repay a portion of the amount outstanding under our Second Amended and Restated Credit Agreement dated as of October 10, 2006 among CNO, Bank of America, N.A. as agent, J.P. Morgan Chase Bank, N.A., as Syndication Agent and other parties (the “Previous Senior Credit Agreement”).
The interest rate applicable to the New Senior Secured Credit Agreement is, at our option (in most instances), a Eurodollar rate of Libor plus 6.00 percent (subject to a Libor “floor” of 1.5 percent) or a Base Rate plus 5.00 percent (subject to a Base Rate “floor” of 2.5 percent). The pricing terms for the New Senior Secured Credit Agreement included upfront fees of 1.25 percent paid to the lenders. At December 31, 2010, the interest rate on our New Senior Secured Credit Agreement was 7.5 percent. The New Senior Secured Credit Agreement is guaranteed by our primary non-insurance company subsidiaries, as defined in the New Senior Secured Credit Agreement (collectively, the “Subsidiary Guarantors”) and secured by substantially all of our and the Subsidiary Guarantors’ assets.
In addition, the New Senior Secured Credit Agreement requires the Company to maintain: (i) a debt to total capitalization ratio of not more than 30 percent (such ratio was 19.99 percent at December 31, 2010); (ii) an interest coverage ratio of not less than 2.00 to 1.00 for each rolling four quarters (or, if less, the number of full fiscal quarters commencing after the effective date of the New Senior Secured Credit Agreement) (such ratio was not applicable for the period ended December 31, 2010); (iii) an aggregate ratio of total adjusted capital to company action level risk-based capital for the Company’s insurance subsidiaries of not less than 225 percent on or prior to December 31, 2011 and 250 percent thereafter
(such ratio was 332 percent at December 31, 2010); and (iv) a combined statutory capital and surplus for the Company’s insurance subsidiaries of at least $1,200.0 million (combined statutory capital and surplus at December 31, 2010, was $1,596.4 million).
The 9.0% Senior Secured Notes will mature on January 15, 2018. Interest on the 9.0% Senior Secured Notes accrues at a rate of 9.0% per annum and is payable semiannually in arrears on January 15 and July 15 of each year, commencing on July 15, 2011. The 9.0% Senior Secured Notes and the guarantees thereof (the “Guarantee”) are senior secured obligations of the Company and the Subsidiary Guarantors and rank equally in right of payment with all of the Company’s and the Subsidiary Guarantor’s existing and future senior obligations, and senior to all of the Company’s and the Subsidiary Guarantors’ existing and future subordinated indebtedness. The 9.0% Senior Secured Notes are secured by substantially all of the assets of the Company and the Subsidiary Guarantors, subject to certain exceptions. The 9.0% Senior Secured Notes and the Guarantees are pari passu to all of the Company’s and the Subsidiary Guarantors’ existing and future secured indebtedness under the New Senior Secured Credit Agreement.
Upon the occurrence of a change of control (as defined in the Indenture), each holder of the 9.0% Senior Secured Notes may require the Company to repurchase all or a portion of the 9.0% Senior Secured Notes in cash at a price equal to 101% of the aggregate principal amount of the 9.0% Senior Secured Notes to be repurchased, plus accrued and unpaid interest, if any, to the date of repurchase.
The Indenture contains covenants that, among other things, limit (subject to certain exceptions) the Company’s ability and the ability of the Company’s Restricted Subsidiaries (as defined in the Indenture) to:
incur restrictions on the Company’s ability and the ability of the Restricted Subsidiaries to pay dividends or make other payments to the Company;
The Indenture provides for customary events of default (subject in certain cases to customary grace and cure periods), which include nonpayment, breach of covenants in the Indenture, failure to pay at maturity or acceleration of other indebtedness, a failure to pay certain judgments and certain events of bankruptcy and insolvency. Generally, if an event of default occurs, Wilmington or holders of at least 25% in principal amount of the then outstanding 9.0% Senior Secured Notes may declare the principal of and accrued but unpaid interest, including any additional interest, on all of the 9.0% Senior Secured Notes to be due and payable.
In December 2010, we repaid the $652.1 million outstanding principal balance under our Previous Senior Credit Agreement using: (i) the proceeds from the New Senior Secured Credit Agreement and the issuance of the 9.0% Senior Secured Notes; and (ii) available cash.
On March 30, 2009, we completed Amendment No. 2 to our Previous Senior Credit Agreement, which provided for, among other things: (i) additional margins between our then current financial status and certain financial covenant requirements through June 30, 2010; (ii) higher interest rates and the payment of a fee; (iii) new restrictions on the ability of the Company to incur additional indebtedness; and (iv) the ability of the lender to appoint a financial advisor at the Company’s expense.
the debt to total capital ratio requirement was 32.5% though December 31, 2009 and decreased to 30% thereafter (the debt to total capital ratio requirement was previously scheduled to return to 30% after June 30, 2010).
The amendment also provided that the 1% payment in kind, or PIK, interest that had accrued since March 30, 2009 as an addition to the principal balance under the Previous Senior Credit Agreement was replaced with a payment of an equal amount of cash interest. The amount of accrued PIK interest ($6.3 million) was paid in cash when the amendment became effective. The deletion of the 1% PIK interest and the payment of an equal amount of cash interest did not impact reported interest expense.
During 2009 and 2008, we made scheduled principal payments totaling $5.3 million and $8.7 million, respectively, on our Previous Senior Credit Agreement. Also, during 2009, we made a mandatory prepayment of $1.2 million based on the Company’s excess cash flows at December 31, 2008 as defined in the Previous Senior Credit Agreement. There were $5.4 million of unamortized issuance costs (classified as other assets) related to our Previous Senior Credit Agreement at December 31, 2009.
In accordance with Amendment No. 3 to our Previous Senior Credit Agreement, the applicable interest rate on the Previous Senior Credit Agreement, payable at least quarterly, was based on either a Eurodollar rate or a base rate. The Eurodollar rate was equal to LIBOR plus 5 percent with a minimum LIBOR rate of 2.5 percent. The base rate was equal to 4 percent plus the greater of: (i) the Federal funds rate plus .50 percent; or (ii) Bank of America’s prime rate.
In 2009, we recognized an aggregate loss on the extinguishment or modification of debt totaling $22.2 million resulting from expenses incurred and the write-off of unamortized discount or issuance costs related to the following transactions which are described above: (i) the Tender Offer; (ii) repayment of principal amounts on the Previous Senior Credit Agreement from the issuance of common stock; and (iii) modifications to our Previous Senior Credit Agreement in March 2009 and December 2009.
The Company and its subsidiaries are involved in various legal actions in the normal course of business, in which claims for compensatory and punitive damages are asserted, some for substantial amounts. Some of the pending matters have been filed as purported class actions and some actions have been filed in certain jurisdictions that permit punitive damage awards that are disproportionate to the actual damages incurred. The amounts sought in certain of these actions are often large or indeterminate and the ultimate outcome of certain actions is difficult to predict. In the event of an adverse outcome in one or more of these matters, the ultimate liability may be in excess of the liabilities we have established and could have a material adverse effect on our business, financial condition, results of operations and cash flows. In addition, the resolution of pending or future litigation may involve modifications to the terms of outstanding insurance policies or could impact the timing and amount of rate increases, which could adversely affect the future profitability of the related insurance policies. Although there can be no assurances, at the present time the Company does not anticipate that the ultimate liability from either pending or threatened legal actions, after consideration of existing loss provisions, will have a material adverse effect on the financial condition, operating results or cash flows of the Company.
On March 4, 2008, a complaint was filed in the United States District Court for the Central District of California, Celedonia X. Yue, M. D. on behalf of the class of all others similarly situated, and on behalf of the General Public v. Conseco Life Insurance Company, successor to Philadelphia Life Insurance Company and formerly known as Massachusetts General Life Insurance Company, Cause No. CV08-01506 CAS. Plaintiff in this putative class action owns a Valulife universal life policy insuring the life of Ruth S. Yue originally issued by Massachusetts General Life Insurance Company in 1995. Plaintiff is claiming breach of contract on behalf of the proposed national class and seeks injunctive and restitutionary relief pursuant to California Business & Professions Code Section 17200 and declaratory relief. The putative class consists of all owners of Valulife and Valuterm universal life insurance policies issued by either Massachusetts General or Philadelphia Life and that were later acquired and serviced by Conseco Life. Plaintiff alleges that members of the class will be damaged by increases in the cost of insurance (a non-guaranteed element) that are set to take place in the twenty first policy year of Valulife and Valuterm policies. No such increases have yet been applied to the subject policies. During 2010, Conseco Life voluntarily agreed not to implement the cost of insurance rate increase at issue in this litigation and is following a process with respect to any future cost of insurance rate increases as set forth in the regulatory settlement agreement described below. Plaintiff filed a motion for certification of a nationwide class and a California state class. On December 7, 2009, the court granted that motion. On October 8, 2010, the court dismissed the causes of actions alleged in the California state class. On January 19, 2011, the court granted the plaintiff’s motion for summary judgment as to the declaratory relief claim and on February 2, 2011, the court issued an advisory opinion, in the form of a declaratory judgment, as to what, in its view, Conseco Life could consider in implementing future cost of insurance rate increases related to its Valulife and Valuterm block of policies. On February 17, 2011, Conseco Life filed notice that it is appealing the court’s decision. We believe the action is without merit, and intend to defend it vigorously. The ultimate outcome of the action cannot be predicted with certainty.
On December 8, 2008, a purported Florida state class action was filed in the U.S. District Court for the Southern District of Florida, Sydelle Ruderman individually and on behalf of all other similarly situated v. Washington National Insurance Company, Case No. 08-23401-CIV-Cohn/Selzer. In the complaint, plaintiff alleges that the inflation escalation rider on her policy of long-term care insurance operates to increase the policy’s lifetime maximum benefit, and that Washington National breached the contract by stopping her benefits when they reached the lifetime maximum. The Company takes the position that the inflation escalator only affects the per day maximum benefit. Plaintiffs filed their motion for class certification, and the motion has been fully briefed by both sides. The court has not yet ruled on the motion or set it for hearing. Additional parties have asked the court to allow them to intervene in the action, and on January 5, 2010, the court granted the motion to intervene and granted the plaintiff’s motion for class certification. The court certified a (B) (3) Florida state class alleging damages and a (B) (2) Florida state class alleging injunctive relief. The parties have reached a settlement in principle of the (B) (3) class. The plaintiffs filed a motion for summary judgment as to the (B) (2) class which was granted by the court on September 8, 2010. The Company filed a notice of appeal on October 6, 2010. We believe the action is without merit, and intend to defend it vigorously. The ultimate outcome of the action cannot be predicted with certainty.
On December 24, 2008, a purported class action was filed in the U.S. District Court for the Northern District of California, Cedric Brady, et. al. individually and on behalf of all other similarly situated v. Conseco, Inc. and Conseco Life Insurance Company Case No. 3:08-cv-05746. The plaintiffs allege that Conseco Life and Conseco, Inc. committed breach of contract and insurance bad faith and violated various consumer protection statutes in the administration of various interest sensitive whole life products sold primarily under the name “Lifetrend” by requiring the payment of additional cash amounts to maintain the policies in force and by making changes to certain non-guaranteed elements in their policies. On April 23, 2009, the plaintiffs filed an amended complaint adding the additional counts of breach of fiduciary duty, fraud, negligent misrepresentation, conversion and declaratory relief. On May 29, 2009, Conseco, Inc. and Conseco Life filed a motion to dismiss the amended complaint. On July 29, 2009, the court granted in part and denied in part the motion to dismiss. The court dismissed the allegations that Conseco Life violated various consumer protection statutes, the breach of fiduciary duty count, and dismissed Conseco, Inc. for lack of personal jurisdiction. On October 15, 2009, Conseco Life filed a motion with the Judicial Panel on Multidistrict Litigation (“MDL”), seeking the establishment of an MDL proceeding consolidating this case and the McFarland case described below into a single action. On February 3, 2010, the Judicial Panel on MDL ordered this case be consolidated for pretrial proceedings. On July 7, 2010, plaintiffs filed an amended motion for class certification of a nationwide class and a California state class. The Company filed its motion in opposition on July 21, 2010. On October 6, 2010, the court granted the motion for certification of a nationwide class and denied the motion for certification of a California state class. Trial is set for May 7, 2012. The Company believes the action is without merit and intends to defend it vigorously. The ultimate outcome of the action cannot be predicted with certainty.
On January 26, 2009, a purported class action complaint was filed in the United States District Court for the Northern District of Illinois, Samuel Rowe and Estella Rowe, individually and on behalf of themselves and all others similarly situated v. Bankers Life & Casualty Company and Bankers Life Insurance Company of Illinois, Case No. 09CV491. The plaintiffs are alleging violation of California Business and Professions Code Sections 17200 et seq. and 17500 et seq., breach of common law fiduciary duty, breach of implied covenant of good faith and fair dealing and violation of California Welfare and Institutions Code Section 15600 on behalf of the proposed national class and seek injunctive relief, compensatory damages, punitive damages and attorney fees. The plaintiff alleges that the defendants used an improper and misleading sales and marketing approach to seniors that fails to disclose all facts, misuses consumers’ confidential financial information, uses misleading sales and marketing materials, promotes deferred annuities that are fundamentally inferior and less valuable than readily available alternative investment products and fails to adequately disclose other principal risks including maturity dates, surrender penalties and other restrictions which limit access to annuity proceeds to a date beyond the applicants actuarial life expectancy. Plaintiffs have amended their complaint attempting to convert this from a California only class action to a national class action. In addition, the amended complaint adds causes of action under the Racketeer Influenced and Corrupt Organization Act (“RICO”); aiding and abetting breach of fiduciary duty and for unjust enrichment. On September 13, 2010, the court dismissed the plaintiff’s RICO claims. On October 25, 2010, the plaintiffs filed a second amended complaint re-alleging their RICO claims. A hearing date on the motion for class certification has not been set. We believe the action is without merit, and intend to defend it vigorously. The ultimate outcome of the action cannot be predicted with certainty.
The states of Pennsylvania, Illinois, Texas, Florida and Indiana led a multistate examination of the long-term care claims administration and complaint handling practices of Senior Health and Bankers Life, as well as the sales and marketing practices of Bankers Life. On May 7, 2008, we announced a settlement among the state insurance regulators and Senior Health and Bankers Life. This examination covered the years 2005, 2006 and 2007. More than 40 states are parties to the settlement, which included a Senior Health fine of up to $2.3 million, with up to an additional $10 million payable, on the part of either Senior Health and/or Bankers Life, in the event the process improvements and benchmarks are not met. The
process improvement plan is being monitored by the lead states and pursuant to the settlement agreement, the lead states are conducting a re-examination of Bankers Life to confirm compliance with the process improvements and benchmarks.
In accordance with the terms of the employment agreements of two of the Company’s former chief executive officers, certain wholly-owned subsidiaries of the Company are the guarantors of the former executives’ nonqualified supplemental retirement benefits. The liability for such benefits was $22.6 million and $22.0 million at December 31, 2010 and 2009,
One of our insurance subsidiaries has a noncontributory, unfunded deferred compensation plan for qualifying members of its career agency force. Benefits are based on years of service and career earnings. The actuarial measurement date of this deferred compensation plan is December 31. The liability recognized in the consolidated balance sheet for the agents’ deferred compensation plan was $114.4 million and $106.3 million at December 31, 2010 and 2009, respectively. Costs incurred on this plan were $13.0 million, $11.9 million and $7.7 million during 2010, 2009 and 2008, respectively (including the recognition of gains (losses) of $(3.6) million, $(3.3) million and $.6 million in 2010, 2009 and 2008, respectively, resulting from actual experience being different than expected or from changes in actuarial assumptions). The estimated net loss for the agent deferred compensation plan that will be amortized from accumulated other comprehensive income (loss) into the net periodic benefit cost during 2011 is $.8 million. In 2006, we purchased Company-owned life insurance (“COLI”) as an investment vehicle to fund the agent deferred compensation plan. The COLI assets are not assets of the agent deferred compensation plan, and as a result, are accounted for outside the plan and are recorded in the consolidated balance sheet as other invested assets. The carrying value of the COLI assets was $102.7 million and $78.0 million at December 31, 2010 and 2009, respectively. Changes in the cash surrender value (which approximates net realizable value) of the COLI assets are recorded as net investment income.
The Company has qualified defined contribution plans for which substantially all employees are eligible. Company contributions, which match certain voluntary employee contributions to the plan, totaled $4.1 million, $4.2 million and $4.4 million in 2010, 2009 and 2008, respectively. Employer matching contributions are discretionary.
The changes in unrealized appreciation (depreciation) included in accumulated other comprehensive income (loss) are net of reclassification adjustments for after-tax net gains (losses) from the sale of investments included in net income (loss) of approximately $(175) million, $(593) million and $(19) million for the years ended December 31, 2010, 2009 and 2008, respectively.
In November 2009, concurrently with the completion of the private placement of our common stock and warrants, we entered into an investor rights agreement with Paulson, pursuant to which we granted to Paulson, among other things, certain registration rights with respect to certain securities and certain preemptive rights, and Paulson agreed to, among other things, certain restrictions on transfer of certain securities, certain voting limitations and certain standstill provisions.
Pursuant to the Plan, we issued warrants to purchase 6.0 million shares of our common stock (the “Series A Warrants”) entitling the holders to purchase shares of CNO common stock at a price of $27.60 per share. The Series A Warrants expired on September 10, 2008.
A summary of the Company’s stock option activity and related information for 2009 is presented below (shares in thousands; dollars in millions, except per share amounts):
We recognized compensation expense related to stock options totaling $7.1 million ($4.6 million after income taxes) in 2010, $6.9 million ($4.5 million after income taxes) in 2009 and $6.0 million ($3.9 million after income taxes) in 2008. Compensation expense related to stock options reduced both basic and diluted earnings (loss) per share by 2 cents in 2010, 2009 and 2008. At December 31, 2010, the unrecognized compensation expense for non-vested stock options totaled $9.8 million which is expected to be recognized over a weighted average period of 1.8 years. Cash received from the exercise of stock options was $.1 million, nil and nil during 2010, 2009 and 2008, respectively.
restricted stock awards totaling $2.5 million, $.9 million and $1.4 million in 2010, 2009 and 2008, respectively. The fair value of restricted stock that vested during 2010, 2009 and 2008 was $1.3 million, $.8 million and $1.9 million, respectively.
There were no dilutive common stock equivalents during 2008 because of the net loss recognized by the Company during such period. Therefore, all potentially dilutive shares are excluded in the weighted average shares outstanding for diluted earnings per share.
In 2010, 2009 and 2008, the Company granted performance shares totaling 686,900, 620,225 and 645,100, respectively, pursuant to its long-term incentive plan to certain officers of the Company. The criteria for payment for such awards are based on certain company-wide performance levels that must be achieved within a specified performance time, each as defined in the award. Unless antidilutive, the diluted weighted average shares outstanding would reflect the number of performance shares expected to be issued, using the treasury stock method.
The four states with the largest shares of 2010 collected premiums were Florida (7.8 percent), California (7.2 percent), Texas (6.1 percent) and Pennsylvania (6.1 percent). No other state accounted for more than five percent of total collected premiums.
Our consolidated statement of cash flows for 2008 combines the cash flows from discontinued operations with the cash flows from continuing operations within each major category (operating, investing and financing) of the cash flow statement.
At December 31, 2010, restricted cash and cash equivalents consisted of $26.8 million held by VIEs.
Statutory capital and surplus included investments in upstream affiliates of $52.4 million at both December 31, 2010 and 2009, which was eliminated in the consolidated financial statements prepared in accordance with GAAP.
Statutory earnings build the capital required by ratings agencies and regulators. Statutory earnings, fees and interest paid by the insurance companies to the parent company create the “cash flow capacity” the parent company needs to meet its obligations, including debt service. The consolidated statutory net income (loss) (a non-GAAP measure) of our insurance subsidiaries was $181.9 million, $77.5 million and $(96.9) million in 2010, 2009 and 2008, respectively. Included in such net income (loss) were net realized capital losses, net of income taxes, of $79.6 million, $186.5 million and $217.1 million in 2010, 2009 and 2008, respectively. In addition, such net income (loss) included pre-tax amounts for fees and interest to CNO or its non-life subsidiaries totaling $132.4 million, $137.1 million and $139.6 million in 2010, 2009 and 2008, respectively.
Insurance regulators may prohibit the payment of dividends or other payments by our insurance subsidiaries to parent companies if they determine that such payment could be adverse to our policyholders or contract holders. Otherwise, the ability of our insurance subsidiaries to pay dividends is subject to state insurance department regulations. Insurance regulations generally permit dividends to be paid from statutory earned surplus of the insurance company without regulatory approval for any 12-month period in amounts equal to the greater of (or in a few states, the lesser of): (i) statutory net gain from operations or statutory net income for the prior year; or (ii) 10 percent of statutory capital and surplus as of the end of the preceding year, excluding $76.1 million of additional surplus recognized due to temporary modifications in statutory prescribed practices related to certain deferred tax assets. This type of dividend is referred to as “ordinary dividends”. Any dividends in excess of these levels require the approval of the director or commissioner of the applicable state insurance department. This type of dividend is referred to as “extraordinary dividends”. During 2010, our insurance subsidiaries paid extraordinary dividends of $166.0 million to CDOC (which is the immediate parent of Washington National, Conseco Life and Conseco Life Insurance Company of Texas).
At December 31, 2010, the consolidated RBC ratio of our insurance subsidiaries exceeded the minimum RBC requirement included in our New Senior Secured Credit Agreement. See the note to the consolidated financial statements entitled “Notes Payable - Direct Corporate Obligations” for further discussion of various financial ratios and balances we are required to maintain. We calculate the consolidated RBC ratio by assuming all of the assets, liabilities, capital and surplus and other aspects of the business of our insurance subsidiaries are combined together in one insurance subsidiary, with appropriate intercompany eliminations.
We measure segment performance by excluding realized investment gains (losses) because we believe that this performance measure is a better indicator of the ongoing business and trends in our business. Our primary investment focus is on investment income to support our liabilities for insurance products as opposed to the generation of realized investment gains (losses), and a long-term focus is necessary to maintain profitability over the life of the business. Realized investment gains (losses) depend on market conditions and do not necessarily relate to the underlying business of our segments.
Realized investment gains (losses) may affect future earnings levels since our underlying business is long-term in nature and changes in our investment portfolio may impact our ability to earn the assumed interest rates needed to maintain the profitability of our business.
A reconciliation of segment revenues and expenses to consolidated revenues and expenses is as follows (dollars in millions):
Fall Creek CLO Ltd. (“Fall Creek”) and Eagle Creek CLO Ltd. (“Eagle Creek”) are collateralized loan trusts that were established to issue securities and use the proceeds to principally invest in corporate loans and other permitted investments. The assets held by the trusts are legally isolated and not available to the Company. The liabilities of Fall Creek and Eagle Creek are expected to be satisfied from the cash flows generated by the underlying loans, not from the assets of the Company. Repayment of the remaining principal balance of the borrowings of Fall Creek and Eagle Creek are based on available cash flows from the assets and such borrowings mature in 2017 and 2018, respectively. The Company has no further commitments to Fall Creek or Eagle Creek.
Certain of our subsidiaries are noteholders of the VIEs and, as a result, could absorb part of the losses of the VIEs. Another subsidiary of the Company is the investment manager for both Fall Creek and Eagle Creek. As such, it has the power to direct the most significant activities of the VIEs which materially impacts the economic performance of the VIEs.
The following table provides supplemental information about the assets and liabilities of Fall Creek and Eagle Creek which have been consolidated in accordance with authoritative guidance (dollars in millions):
The following table summarizes the carrying values of the investments held by the VIEs by category as of December 31, 2010 (dollars in millions):
The following table sets forth the amortized cost and estimated fair value of those investments held by the VIEs with unrealized losses at December 31, 2010, 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.
During 2010, we recognized net realized investment losses on the VIE investments of $3.7million, which were comprised of $.4 million of net losses from the sales of fixed maturities, and $3.3 million of writedowns of investments for other than temporary declines in fair value recognized through net income. During 2009, we recognized net realized investment losses on the VIE investments of $14.2 million, which were comprised of $.7 million of net losses from the sales of fixed maturities, and $13.5 million of writedowns of investments for other than temporary declines in fair value recognized through net income.
At December 31, 2010, investments held by the VIEs that were in default had an aggregate amortized cost of $6.8 million and a carrying value of $7.3 million, of which $2.3 million (carrying value) were subsequently sold.
At December 31, 2010, the VIEs held: (i) investments with a fair value of $26.7 million and gross unrealized losses of $.8 million that had been in an unrealized loss position for less than twelve months; and (ii) investments with a fair value of $229.1 million and gross unrealized losses of $10.0 million that had been in an unrealized loss position for greater than twelve months.