The Company's principal operations are located on a 150-acre corporate campus in Carmel, Indiana, immediately north of Indianapolis. These facilities contain approximately 416,000 square feet of space in seven buildings which contain Conseco's executive offices and certain administrative operations of its subsidiaries. These facilities include sufficient capacity for future growth.
Statesman owns the building housing its principal operations in Des Moines, Iowa, consisting of approximately 107,000 square feet of space. The land underlying the building is subject to a long-term lease expiring in 2016, at which time title to the building will pass to the lessor. Statesman owns another building housing its operations in Birmingham, Alabama consisting of 44,000 square feet.
This discussion should be read in conjunction with the accompanying consolidated financial statements, notes thereto and financial statistics. Changes in 1994, 1993 and 1992 balances in the consolidated financial statements are caused primarily by the transactions described in note 1 "Significant Accounting Policies - Basis of Presentation" and note 2 "Acquisitions/Dispositions" to the consolidated financial statements.
- Acquiring and restructuring life insurance companies in partnership with other investors (currently through Partnership II).
Of the first seven companies acquired as wholly owned subsidiaries by Conseco, four were subsequently sold (including WNC through an IPO in February 1994 and the subsequent sale of Conseco's remaining interest in WNC in December 1994, as described in note 2 to the consolidated financial statements) and three remain as wholly owned subsidiaries. The first three companies acquired by Partnership I (two of which were merged at the end of 1994) are now wholly owned subsidiaries of CCP in which Conseco currently holds a 49 percent interest. The fourth and final acquisition of Partnership I became a wholly owned subsidiary of BLH, in which Conseco currently holds a 60 percent interest. In addition, Conseco currently holds a 25 percent interest in the acquisition made by Partnership II.
Additional Discussion of Consolidated Statement of Operations for the Three Years Ended December 31, 1994:
The following tables and narratives summarize amounts reported in the consolidated statement of operations. Many of the changes from period to period resulted from: (i) acquisitions of new affiliates; (ii) restructurings that changed Conseco's percentage ownership in the affiliates; and (iii) changes in control of the affiliates (which affected whether the affiliate was included in Conseco's statement of operations under the consolidation or the equity method of accounting).
Insurance policy benefits (including change in future policy benefits) increased primarily due to a larger volume of business in force in 1994 and an increase in death benefits paid. .
WNC's operating earnings during the above periods were affected by the growth in invested assets from annuity sales, interest income, and the recapture on March 31, 1994, of a $1.3 billion block of business previously reinsured with subsidiaries of Conseco, offset in part by fluctuations in prepayment income included in net investment income and interest expense on notes payable. WNC's net investment income included prepayment income of $3.1 million in 1994, $18.0 million in 1993 and $12.8 million in 1992. WNC's net income was affected by these factors, and also changes in realized gains (losses) and trading income.
Conseco's equity in the earnings of CCP was affected by these factors, and also by changes in Conseco's ownership interest in CCP resulting from CCP's IPO and other transactions described in note 2 to the consolidated financial statements. In addition, Conseco's equity in the earnings of CCP included an extraordinary charge of $2.1 million in 1994 and $3.9 million in 1992 related to CCP's prepayment of debt. At December 31, 1994, Conseco owned 45 percent of the common stock of CCP. Such shares owned by Conseco had a net carrying value of $195.4 million, a fair value of approximately $235.4 million, and a total cost to Conseco of $102.8 million.
CCP participated in Partnership I's investment in BLH. In conjunction with BLH's IPO, CCP's investment in Partnership I was exchanged for approximately 2.8 percent of the common stock of BLH. CCP had recognized equity in earnings of BLH of $1.2 million in 1993 (through the date of the IPO) and $.7 million in 1992. CCP recognized a gain on the sale of stock by BLH of $10.5 million at the time of the IPO. Since the IPO, CCP carries its investment in BLH at fair value, with any unrealized gain or loss, net of income tax, included directly in shareholders' equity.
Conseco's direct ownership in BLH, together with its indirect ownership through CCP, represents a controlling interest in BLH. Accordingly, Conseco accounts for its investment in BLH using the consolidation method. Conseco's ownership interest in BLH through CCP is included in the BLH segment. Conseco's ownership interest in the gain recognized by CCP in conjunction with the BLH IPO is included in Conseco's Restructuring Activities segment.
Net investment income declined over the last three years because of the recapture of reinsurance by WNC from Conseco's other wholly owned life insurance subsidiaries on March 31, 1993, which resulted in a decrease of $1.3 billion in insurance liabilities and invested assets. In addition, the redemption of fixed maturity investments prior to their scheduled maturity date resulted in additional investment income of approximately $.1 million in 1994, $3.7 million in 1993 and $7.5 million in 1992.
Net trading income and losses often fluctuate from year to year based on market conditions for trading activities.
Net realized gains and losses often fluctuate from year to year. The wholly owned subsidiaries sold fixed maturity investments of $.2 billion in 1994, $.6 billion in 1993 and $.9 billion in 1992. The effect of these sales on the amortization of cost of policies purchased and cost of policies produced is discussed above under BLH. Net realized gains (losses) increased (decreased) amortization of the cost of policies purchased and the cost of polices produced by $(2.1) million in 1994, $11.5 million in 1993 and $15.1 million in 1992.
In March 1993, Conseco acquired Bankmark, an insurance marketing company which helps financial institutions provide insurance and investment products to their customers. Through Bankmark, financial institutions can offer products from several insurance companies, including Conseco affiliated and nonaffiliated companies. After its acquisition by Conseco, Bankmark began a formal program to actively expand its business by developing relationships with a few large money-center banks. As a result of the costs incurred in conjunction with Bankmark's expansion, Bankmark incurred a net loss of $.8 million in 1994 and $3.7 million in 1993.
Fee growth during the last three years came from new clients (both affiliated and others) and from increasing Bankmark's fee-producing activities. Bankmark's commission revenues totaled $16.5 million in 1994, compared with $7.4 million in 1993.
Conseco earned incentive earnings allocations from Partnership I when the total returns realized by the other partners exceeded prescribed targets. Such amounts were recorded: (i) in 1992, based on the returns resulting from the value of the CCP shares distributed to the partners; and (ii) in 1993, based on the value of BLH shares so distributed. Income from the sale of stock in 1992 resulted from Conseco's sale of its ownership in Life Re and from Conseco's share of the gain realized from the public sale of shares by CCP. The 1993 gain related to the public sale of shares by BLH. Expenses incurred in conjunction with the terminated acquisition are described in note 9 to the consolidated financial statements.
Corporate and other includes financing costs for debt on which Conseco is directly liable and the costs associated with the holding company operations.
Interest expense on long-term debt has declined over the last three years because of: (i) the decrease in long-term debt through scheduled and unscheduled principal payments; and (ii) the refinancing of 12.75 percent senior subordinated notes, partially offset by the $200 million senior secured loan used to acquire additional shares of BLH in September 1993 (such debt was repaid in February 1994) and amounts drawn on Conseco's revolving line of credit during 1994 (such amounts were repaid in December 1994).
In accordance with generally accepted accounting principles, insurance policy income shown in Conseco's consolidated statement of operations consists of premiums received for policies which have life contingencies or morbidity features. For annuity and universal life contracts without such features, premiums collected are not reported as revenues, but rather are reported as deposits to insurance liabilities. Revenues for these products are recognized over time in the form of investment income and surrender or other charges.
Premiums collected by BLH in 1994 were $1,534.5 million, of which $316.3 million were recorded as deposits to policy liability accounts. This compares with $1,464.7 million collected ($263.7 million recorded as deposits) in 1993 and $1,368.9 million collected ($233.3 million recorded as deposits) in 1992. BLH's amounts in 1992, which are used as a basis of comparison in this discussion include periods prior to Partnership I's acquisition of BLH in November 1992. Collected premiums by type are provided in the following table:
Collected premiums for other individual health products decreased by 18 percent in 1994 following an 11 percent decrease in 1993. This decrease, which was anticipated, follows steps taken previously to improve the profitability of the comprehensive major medical product included in this category.
Premiums collected in 1993 and 1992 include $563.0 million and $840.7 million, respectively, of premiums collected by WNC. As previously discussed, Conseco's equity interest in WNC was sold in 1994.
Premiums collected by Statesman since Partnership II's acquisition on September 29, 1994, were $284.4 million (compared to $234.9 million collected by Statesman in the fourth quarter of 1993). Statesman's products include single premium deferred annuities, flexible premium deferred annuities, interest sensitive life insurance products (including universal life insurance), traditional life insurance products and accident and health insurance products. Of the $284.4 million in premiums collected since Partnership II's acquisition, 65 percent was from single premium deferred annuities, 30 percent was from flexible premium deferred annuities, 4 percent was from life insurance products and less than 1 percent was from accident and health insurance.
Although investment income is a significant component of the Company's total revenues, Conseco's profitability is determined by spreads between interest rates earned and rates credited on annuity contracts. At December 31, 1994, the average yield, computed on the cost basis of the Company's investment portfolio, was 8.5 percent and the average interest rate credited on the Company's total liability portfolio was 5.9 percent.
At December 31, 1994, the Company's fixed maturity portfolio had net unrealized losses of $373.4 million (equal to approximately 5.3 percent of the portfolio's carrying value), consisting of $25.1 million of unrealized gains and $398.5 million of unrealized losses. Estimated fair values for fixed maturity investments were determined based on estimates from nationally recognized pricing services, broker-dealer market makers and internally developed methods.
At December 31, 1994, approximately 3.4 percent of Conseco's invested assets and 4.0 percent of fixed maturity investments were rated below investment grade by nationally recognized statistical rating organizations (or, if not rated by such firms, with ratings below Class 2 assigned by the National Association of Insurance Commissioners). Conseco plans to maintain approximately the present level of below investment grade fixed maturities. These securities generally have greater risks than other corporate debt investments, including risk of loss upon default by the borrower. These securities generally are unsecured and often are subordinated to other creditors. Issuers usually have high levels of indebtedness and are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than are investment grade issuers. The Company is aware of these risks and monitors its below investment grade securities closely.
The degree to which a mortgage-backed security is susceptible to income fluctuations is influenced by: (i) the difference between its carrying value and par; (ii) the relative sensitivity of the underlying mortgages backing the security to prepayment in a changing interest rate environment; and (iii) the repayment priority of the security in the overall securitization structure. The Company limits the extent of these risks by : (i) purchasing securities which are backed by collateral with lower prepayment sensitivity (such as mortgages priced at a discount to par value and mortgages that are extremely seasoned); (ii) avoiding securities whose values are heavily influenced by changes in prepayments (such as interest-only and principal-only securities); and (iii) investing in securities structured to reduce prepayment risk (such as planned amortization class ("PAC") and targeted amortization class ("TAC") collateralized mortgage obligations). PAC and TAC instruments represented approximately 43 percent of the Company's mortgage-backed securities at December 31, 1994. The call-adjusted modified duration of the Company's mortgage-backed securities at December 31, 1994, was 7.3 years.
During 1994, fixed maturity investments with par values totaling $66.9 million were redeemed prior to the scheduled maturity date. As a result of such redemptions, Conseco recognized losses of approximately $.1 million which were charged to investment income.
At December 31, 1994, the Company held mortgage loan investments with a carrying value of $142.6 million (or 1.7 percent of total invested assets) and a fair value of $146.7 million. Approximately 91 percent of the mortgage loan investments were commercial loans. Approximately 7 percent of the Company's mortgage loan balance consisted of investments in junior and residual interests of CMOs. Investments in junior and residual interests of CMOs are instruments that entitle the Company to the excess cash flows arising from the difference between: (i) the cash flows required to make principal and interest payments on the related senior interests in the CMOs; and (ii) the actual cash flows received on the mortgage loan assets included in the CMO portfolios. If prepayments vary from projections on the mortgage loan assets included in such CMO portfolios, the total cash flows to the Company from such junior and residual interests could change from projected cash flows, resulting in a gain or loss.
Non-current mortgage loans were not significant at December 31, 1994. The Company had no realized losses on mortgage loans for the year ended December 31, 1994. At December 31, 1994, the Company had a loan loss reserve of $1.9 million. Approximately 11 percent, 10 percent and 10 percent of the mortgage loans were on properties located in Texas, New York and Florida, respectively. No other state comprised greater than 8 percent of the mortgage loan balance.
At December 31, 1994, the Company held trading account securities with a carrying value of $21.6 million. Trading account securities are investments that are purchased with the intent to be traded prior to their maturity, or are believed likely to be disposed of in the foreseeable future as a result of market or issuer developments. Effective December 31, 1993, with the Company's adoption of Statement of Financial Accounting Standards No. 115 ("SFAS 115"), trading account securities are carried at estimated fair value, with the changes in fair value reflected in the statement of operations. Prior to the adoption of SFAS 115, unrealized gains or losses on trading account securities were reflected as a component of shareholders' equity and not in the statement of operations. The net unrealized gain (loss) on trading account securities at December 31, 1994 and 1993, recorded in trading income as a result of adopting SFAS 115, was immaterial.
Short-term investments totaled $295.4 million, or 3.6 percent of invested assets at December 31, 1994, and consisted primarily of commercial paper and repurchase agreements relating to government securities.
Changes in the consolidated balance sheet of 1994 compared to 1993 reflected the operations of the Company and the capital and financing transactions discussed below.
Total investments decreased principally because of: (i) the unrealized loss adjustment to fixed maturity investments recognized as an adjustment to shareholders' equity in accordance with SFAS 115; (ii) the sale of WNC (iii) the decrease in investment borrowings described in the following paragraph; and (iv) Conseco's repurchase of shares of its common stock. These decreases were partially offset by: (i) the acquisition of Statesman by Partnership II; and (ii) investments received by BLH related to the recapture of annuity business ceded in prior years.
Minority interest increased by $97.9 million during 1994 (further described in note 9 to the consolidated financial statements). This was attributable to: (i) the minority interests' equity in Statesman and its subsidiaries; and (ii) the minority interest's equity in the net income of the Company's subsidiaries. These changes were partially offset by: (i) the repurchase by BLH of common shares held by the minority interest; (ii) the minority interest's share of the unrealized depreciation of securities; and (iii) dividends attributable to the minority interest.
Conseco's insurance operating companies generally receive adequate cash flow from premium collections and investment income to meet their obligations. Insurance policy liabilities are primarily long-term and generally are paid from future cash flows. Most of Conseco's assets, other than policy loans and its investment in CCP, are invested in bonds and other securities, substantially all of which are readily marketable. Although there is no present need or intent to dispose of such investments, the life companies could liquidate portions of their investments if such a need arose. To increase their return on investments and improve liquidity, the life companies from time to time will lend U.S. Treasury securities in reverse repurchase agreements or lend mortgage-backed securities in dollar-roll transactions.
Of the above insurance liabilities under contracts containing fixed payment dates, approximately 60 percent related to payments that will be made on such date only if the contract holder is living. Expected mortality is considered in determining the amount of this liability. The remaining insurance liabilities with fixed payment dates are payable regardless of the contract holder's survival.
As a holding company whose principal assets are the securities of its insurance subsidiaries, BLH's ability to meet debt service obligations and pay operating expenses and dividends depends primarily on the receipt of sufficient funds from its subsidiaries. Bankers Life Insurance Company of Illinois ("BLI", the parent of Bankers Life) provides liquidity to BLH by paying principal and interest on a surplus debenture and by paying dividends.
BLI's ability to service its obligation under the surplus debenture depends upon its ability to receive dividends and tax sharing payments from Bankers Life. Bankers Life may pay dividends up to $93.4 million without regulatory approval during 1995. Under an intercompany tax sharing agreement, Bankers Life remits tax payments to BLI based upon its tax liabilities calculated on a separate company basis.
In addition to its debt service obligations, BLH uses cash to pay for administrative services provided by Conseco's wholly owned subsidiaries and to pay dividends on its common stock.
Statesman has $57.0 million par value 1994 Series Preferred Stock outstanding. Dividends on such preferred stock accrue annually at 13 percent in additional shares through September 2006.
ALHC needs liquidity primarily to service its debt, pay dividends on its capital stock and pay operating expenses. The primary sources of funds for these payments are: (i) dividends on the capital stock of American Life; (ii) interest payments on surplus notes from American Life; and (iii) payments from American Life and Vulcan Life under a tax sharing agreement.
ALHC has $150.0 million principal indebtedness outstanding under its senior subordinated notes and $170.0 million principal indebtedness under its senior term loan (see note 6 to the consolidated financial statements). ALHC's annual interest payments for 1995 will be: (i) approximately $16.9 million with respect to the senior notes; and (ii) approximately $13.4 million with respect to the senior term loan, (based on rates in effect at December 31, 1994). ALHC currently plans to borrow an additional $30.0 million under the senior term loan to fund the Contingent Payment Rights as described in note 2 to the consolidated financial statements or a payment to the holder of the Government Preferred Stock. The outstanding principal balance under the senior term loan must be repaid in installments beginning in 1995 through 2002 and bears interest at a variable rate.
The parent company (Conseco, Inc.) uses cash primarily to service its debt, pay dividends on preferred and common stock and meet administrative expenses. The wholly owned subsidiaries, BLH and CCP provide liquidity to Conseco by paying dividends and fees for services provided. The parent Company may also issue debt or equity securities or sell all or a portion of its investments in subsidiaries or affiliates. These sources have historically provided adequate cash flow to fund (i) the needs of the parent company's normal operations; (ii) internal expansion, acquisitions and investment opportunities; (iii) the retirement of debt and equity.
The following table shows the cash flow activity of the parent company and its non-life subsidiaries:
Note 13 to the consolidated financial statements shows the difference between pretax income reported using statutory accounting practices (before deduction of expenses paid to affiliates and transfers to and from IMR and the amortization of IMR) and GAAP as follows:
Medical cost inflation has had a significant impact on BLH's operations. These costs have continued to increase in recent years in excess of the Consumer Price Index. Medical costs will likely continue to rise, although recently the rate of increase has slowed. The impact on BLH's operations depends upon its ability to increase its premium rates. Such increases are subject to approval by the insurance departments of each state in which BLH sells its products. Prior to the standardization of Medicare supplement plans, approximately two-thirds of the states permitted rate plans with automatic escalation clauses. This permitted BLH, in periods following initial approval, to adjust premium rates for changes in Medicare deductibles and increases in medical cost inflation without refiling with the regulators. Currently, all rate changes for standardized plans must be individually approved by each state. BLH's pricing of its new standardized supplement plans reflects the impact of these filings and the lengthening of time required to implement rate increases.
As indicated throughout this report, Conseco intends to continue its strategy of growth through its three principal sources of earnings: operating life insurance companies, providing services for fees to the affiliated companies and others, and acquiring and restructuring life insurance companies.
Conseco's life insurance operations include: (i) BLH, in which Conseco had a 58 percent ownership interest at December 31, 1994, and a 60.3 percent ownership interest at February 28, 1995; (ii) Statesman, in which Conseco has a 25 percent ownership interest; (iii) CCP, in which Conseco had a 45 percent ownership interest at December 31, 1994, and a 49.5 percent ownership interest at February 28, 1995, and (iv) the wholly owned life insurance subsidiaries, principally Bankers National and National Fidelity.
Conseco continues to provide various services to BLH, Statesman, CCP and the wholly owned subsidiaries including investment management, mortgage origination and servicing, policy and claims administration, data processing, product marketing and executive management services. Additionally, Conseco provides such services to other unaffiliated clients, principally insurance companies. Conseco intends to provide investment management services to all companies acquired by Partnership II, and to provide administrative, data processing and other services to such companies when appropriate. Conseco also intends to expand its service fee revenue by seeking similar arrangements with other unaffiliated clients. Such arrangements would take advantage of Conseco's ability to administer products and investments without requiring Conseco to provide additional capital needed to support those products. In March 1993, Conseco acquired Bankmark, an insurance marketing company which develops relationships with financial institutions to provide insurance and investment products to their customers. After its acquisition by Conseco, Bankmark began a formal program to actively expand its business by developing relationships with a few large money-center banks.
For a transfer to actively managed from held to maturity - we recognize the unrealized gain or loss immediately in shareholders' equity.
For a transfer to held to maturity from actively managed - we continue to report the unrealized gain or loss at the date of transfer in shareholders' equity, but we amortize the gain or loss over the remaining life of the security as an adjustment of yield.
Before we adopted SFAS 115, we transferred the above investments to the new category at the lower of cost or fair value at the date of transfer. We recognized any unrealized losses immediately upon such transfers; we deferred any unrealized gains until the final disposition of the securities. Transfers between categories in 1993 and 1992 (and any resulting gains or losses) were immaterial.
As part of our investment strategy, we may enter into reverse repurchase agreements and dollar-roll transactions to increase our investment return or improve our liquidity. We account for these transactions as collateral borrowings, where the amount borrowed is equal to the sales price of the underlying securities.
Other invested assets consist principally of investments in unconsolidated limited partnerships. We generally account for them using the equity method.
When we acquire an insurance company, we assign a portion of its cost to the right to receive future cash flows from insurance contracts existing at the date of the acquisition. This cost of policies purchased represents the actuarially determined present value of the projected future cash flows from the acquired policies. To determine this value, we use a method which is consistent with methods commonly used to value blocks of insurance business and with the basic methodology generally used to value assets. It can be summarized as follows:
- Identify the expected future cash flows from the blocks of business.
- Identify the risks to realizing those cash flows (i.e., assess the probability that the cash flows will be realized). - Identify the rate of return that we must earn in order to accept these risks, based on consideration of the factors summarized below.
- Determine the value of the policies purchased by discounting the expected future cash flows by the discount rate we need to earn.
- Our cost of the capital required to fund the acquisition.
- Recent prices (i.e., discount rates used in determining valuations) paid by others to acquire similar blocks of business.
If renewal premiums collected, investment spread, investment gains or losses, mortality and morbidity costs or other factors differ from our expectations, we adjust our amortization of the cost of policies purchased. For example, the sale of a fixed maturity investment may result in a gain (or loss). If the sale proceeds are reinvested at a lower (or higher) earnings rate, there may also be a reduction (or increase) in our future investment spread. We must then increase (or decrease) amortization to reflect the change in the incidence of expected cash flows. For acquisitions made on or before November 19, 1992, we adjust amortization in the current and future years to reflect: (i) our revised estimate of future cash flows; and (ii) the revised interest rate at which the discounted present value of such expected future profits equals the unamortized asset balance (this rate may not exceed the rate initially used and may not be lower than the rate earned on invested assets). For acquisitions made after November 19, 1992, we adjust amortization consistent with the methods used with the cost of policies produced (described below).
The costs directly related to producing new business are referred to as cost of policies produced. They consist primarily of commissions and certain costs of policy issuance and underwriting, net of fees charged to the policy in excess of ultimate fees charged. To the extent that they are recoverable from future profits, we defer these costs and amortize them with interest as follows:
For investment contracts without mortality risk (such as deferred annuities and immediate annuities with benefits paid for a period certain) and for contracts that permit either Conseco or the insured to make changes in the contract terms (such as single-premium whole life and universal life), we record premium deposits and benefit payments as increases or decreases in a liability account, rather than as revenue and expense. We record as revenue any amounts charged against the liability account for the cost of insurance, policy administration and surrender penalties. We record as expense any interest credited to the liability account and any benefit payments which exceed of the contract liability account balance.
We report assets and liabilities related to insurance contracts before the effects of reinsurance. We report reinsurance receivables and prepaid reinsurance premiums (including amounts related to insurance liabilities) as assets. We recognize estimated reinsurance receivables in a manner consistent with the liabilities related to the underlying reinsured contracts, in accordance with Statement of Financial Accounting Standards No. 113, "Accounting and Reporting for Reinsurance of Short-Duration and Long-Duration Contracts."
Our consolidated financial statements include all of the assets, liabilities, revenues and expenses of Partnership I (for periods prior to its liquidation on March 31, 1993), Partnership II, and BLH. We make a charge against consolidated income for the share of earnings of these partially owned entities allocable to the minority interests. We show the shareholders' equity of such entities allocable to the minority interests separately on our consolidated balance sheet.
We have adjusted all applicable share and per share data for the two-for-one stock split distributed on April 1, 1992. We compute primary net income per share by dividing earnings (less preferred dividend requirements and an adjustment for the dilutive securities of affiliates and of subsidiaries of Partnership I) by the weighted average number of common and common equivalent shares outstanding for the period. We compute fully diluted net income per share the same basis, except that, if more dilutive: (i) the number of common equivalent shares related to stock options is based on the period-end market value of the shares, instead of the average market value; and (ii) convertible preferred stock is assumed to be converted into common shares.
Investment securities. For fixed maturity securities (including redeemable preferred stocks) and for equity and trading account securities, we use quoted market prices, where available. For fixed maturity securities not actively traded, we use values obtained from independent pricing services or, in the case of private placements, by discounting expected future cash flows using a current market rate appropriate for the yield, credit quality and maturity of the investment being priced.
Other invested assets. We have assumed that these assets, which are not material, have a market value equal to carrying value.
Investment borrowings and notes payable. We use either: (i) discounted cash flow analyses based on our current incremental borrowing rates for similar types of borrowing arrangements; or (ii) current market values for publicly traded debt.
In July 1992, CCP, a newly organized holding company for Partnership I's first three acquisitions, completed an IPO of 8,010,700 shares of common stock. Net proceeds to CCP totaled $111.2 million. The shares issued in the offering represented a 31 percent ownership interest in the common stock outstanding of CCP. The remaining ownership interest in CCP was held by Conseco and others who received common stock of CCP in a liquidating distribution from Partnership I.
In early 1994, CCP announced a program to repurchase up to 2.0 million shares of its common stock in the open market or through negotiated transactions. In October 1994, CCP expanded the repurchase program to 4.0 million shares. During 1994, CCP acquired 3.5 million shares of its common stock under this program at a cost of $71.8 million. CCP's repurchases increased Conseco's ownership interest in CCP to 45 percent.
The Partnership I agreement provided for incentive compensation to the general partner in the event returns to the limited partners were in excess of prescribed targets. The distribution of CCP shares to the limited partners in 1992 caused such targets to be exceeded, resulting in incentive compensation to Conseco of $6.1 million, net of tax of $3.2 million. In addition, Conseco's income in 1992 included $1.9 million, net of tax of $7.3 million, representing Conseco's percentage share in the increase in CCP's shareholders' equity account attributable to the proceeds from CCP's IPO.
Conseco acquired 95 percent of the outstanding common stock of Bankmark in March 1993 for $6.1 million. Bankmark is a marketing company which develops marketing relationships with financial institutions to provide insurance and investment products to their customers.
On September 29, 1994, Partnership II completed the acquisition of Statesman (the "Acquisition"). Under an Agreement and Plan of Merger dated May 1, 1994, Statesman merged with a subsidiary of Partnership II. Statesman's former stockholders received $15.25 in cash per common equivalent share. They also received a contingent payment right to receive up to another $2.00 in cash per common equivalent share (the "Contingent Consideration"), based on the outcome of Statesman's pending litigation against the U.S. Government concerning Statesman's former savings bank subsidiary (the "Statesman Litigation").
The Acquisition and related transactions were funded with: (i) $45.9 million of cash contributions from Partnership II (including $7.4 million provided by Conseco, $1.8 million by BLH, $1.8 million by CCP and $3.7 million by WNC); (ii) $57.0 million in cash from the sale in a private placement of payment-in-kind preferred stock (the "Statesman PIK Preferred Stock") (including $25.9 million purchased by BLH and $24.0 million purchased by CCP, $3.0 million of which was sold by CCP in December 1994); (iii) $150.0 million in cash from the sale in a public offering of 11-1/4% Senior Subordinated Notes due 2004 (the "ALHC Senior Subordinated Notes"); and (iv) $200.0 million in cash from a senior secured loan (the "ALHC Senior Term Loan"). The sources and uses of this financing are summarized below (dollars in millions):
The acquisitions of CCP, BLH, Bankmark and Statesman described above were recorded in the consolidated statement of cash flows as follows:
The following unaudited pro forma results of operations of the Company are presented as if the following had occurred as of January 1, 1993: (i) Partnership II's acquisition of Statesman; (ii) the IPO of WNC; (iii) the sale by Conseco of its remaining 40 percent equity interest in WNC; (iv) the IPO of BLH; and (v) Conseco's subsequent purchases of additional shares of BLH and CCP. Prior operations of Bankmark are not included in the following table; their effect is not material.
The following unaudited pro forma results of operations of the Company are presented as if the following had occurred as of January 1, 1992: (i) Partnership I's acquisition of Bankers; (ii) the IPOs of BLH and CCP; and (iii) Conseco's subsequent purchases of additional shares of BLH and CCP.
At December 31, 1994, the amortized cost and estimated fair value of actively managed fixed maturities were as follows:
The amortized cost and estimated fair value of actively managed fixed maturities were as follows at December 31, 1993:
The following table sets forth below investment grade fixed maturity investments as of December 31, 1994, summarized by the amount their amortized cost exceeds fair value:
The following table sets forth the amortized cost and estimated fair value of actively managed fixed maturities at December 31, 1994, 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 and because most mortgage-backed securities provide for periodic payments throughout their lives.)
Realized gains (losses), net of realized gain expenses, were included in revenue as follows:
At December 31, 1994, the amortized cost and fair value of fixed maturity investments in default as to the payment of principal or interest totaled $9.8 million and $10.1 million, respectively. Conseco recorded writedowns of fixed maturity investments of $1.0 million in 1994 and $7.9 million in 1993. These writedowns were the result of changes in conditions which caused the Company to conclude that it would not collect all amounts due according to the terms of the securities. The Company recorded no such writedowns in 1992.
In 1994, the Company received fees totaling $16.3 million for services it provided by Conseco to WNC. Conseco also received dividends on WNC common stock totaling $3.0 million in 1994.
Participating policies represented approximately 8 percent, 11 percent and 12 percent of total life insurance in force at December 31, 1994, 1993 and 1992, respectively. Participating policies represented approximately 2 percent, 3 percent and 8 percent of premium income for 1994, 1993 and 1992, respectively. Dividends on participating policies amounted to $12.0 million, $16.0 million and $11.1 million in 1994, 1993 and 1992, respectively.
Cost of reinsurance ceded where the reinsured policy contains mortality risks totaled $33.4 million, $35.8 million and $41.9 million in 1994, 1993 and 1992, respectively. This cost was deducted from insurance premium revenue. Conseco is contingently liable for claims reinsured if the assuming company is unable to pay. Reinsurance recoveries netted against insurance policy benefits totaled $23.7 million, $31.0 million and $45.4 million in 1994, 1993 and 1992, respectively.
At December 31, 1992, insurance liabilities of approximately $182.0 million were reinsured by BLH with a subsidiary of Southwestern Life. During the first quarter of 1993, BLH recaptured the reinsured business with assets approximately equal to the insurance liabilities. Recapture fees of $15.5 million were capitalized as a component of cost of policies purchased.
At December 31, 1994, Conseco's largest reinsurer accounted for less than .08 percent of total insurance liabilities and less than 16 percent of total reinsurance receivables.
The income tax asset at December 31, 1995 includes $6.3 million which will be recovered upon the filing of the Company's tax returns. The remaining $188.9 million is a deferred asset, of which $108.1 million is attributed to the effect of the fair value adjustment to actively managed fixed maturities pursuant to SFAS 115 and the remaining amount is predominantly due to the Company's Net Operating loss ("NOL") carryforward. The Company has determined that all of the benefits of this tax asset will be eventually recovered although there are uncertainties surrounding the realization of this asset. In making this determination as related to the SFAS 115 adjustment, the Company has concluded that it has the ability to hold these assets (primarily market depreciated bonds) until such time as the Company can utilize the benefits or the bond market returns to its normal interest rate levels, and the Company has adopted a tax-planning strategy of not selling significant amounts of depreciated bonds unless the losses incurred will result in a tax benefit. With respect to determining that the Company's NOL will be fully utilized, the Company is relying upon its past history of earnings.
Income tax expense differed from that computed at the applicable federal statutory rate (35 percent during 1994 and 1993 and 34 percent during 1992) for the following reasons:
The Omnibus Budget Reconciliation Act of 1993 (the "Act") was enacted on August 10, 1993. The most significant provision of the Act affecting the Company was the increase in the corporate income tax rate to 35 percent from 34 percent, effective for taxable income reported for the year 1993. As a result of the increase in the tax rate in 1993, the Company recognized additional tax expense of $8.9 million, consisting of: (i) $5.6 million related to 1993 income; (ii) $1.9 million related to a one-time adjustment of accumulated deferred taxes relating to prior years' income; and (iii) $1.4 million related to unrealized appreciation of securities at the date the new law was enacted. In addition, Conseco's equity in earnings of CCP was reduced by $1.6 million as a result of the Company's share of the additional tax expense recorded by CCP because of the increase in the tax rate. The impact of other provisions of the Act was not material to the Company.
The IRS has completed its examination of the Company for years through 1990 and is currently conducting an examination for years 1991 through 1992. All amounts due determined by completed examinations have been either paid or accrued.
On September 30, 1993, the Company executed a $200 million senior unsecured loan due to a group of banks as financing for Conseco's purchase of common shares of BLH (described in note 2). As discussed in note 1, on February 15, 1994, the loan was repaid in full, resulting in an extraordinary charge of $1.2 million (net of a $.6 million tax benefit) in the first quarter of 1994.
In June 1990, the Company, as partial acquisition financing for Great American Reserve, executed a subordinated promissory note in the amount of $6.0 million. This note was repaid in full in March 1994.
In 1994, the Company entered into revolving credit agreements which provide a $140.0 million facility through May 1, 1997, and a $60.0 million facility through December 7, 1995. The credit agreements are with the same financial institution and have similar terms. No amounts were drawn on either facility at December 31, 1994. The agreements permit borrowings based on defined rates plus an applicable margin, based on the rating of the Company's unsecured 8.125 percent senior notes. The Company pays a commitment fee equal to .25 percent per annum on the average daily unused commitments. The Company must prepay the borrowings under the loan if certain ratios are not maintained. The largest balance outstanding under the agreements during 1994 was $150 million and the average balance was $31.8 million.
The following notes payable, which are not direct obligations of Conseco, were issued by BLH to finance its acquisition by Partnership I:
The $175.0 million senior term loan from a group of banks has principal due in varying amounts through 1999. The interest rate is based on either LIBOR plus an applicable margin or prime rate plus an applicable margin for periods of one, two, three or six months as selected by BLH from time to time (such rate was 7.75 percent at December 31, 1994). The applicable margin over prime rate will vary from .75 percent to 1.5 percent, depending on: (i) the principal amount of the senior term loan outstanding; and (ii) a defined cash coverage ratio, based generally on cash flows relative to certain fixed charges. The applicable margin over the LIBOR rate will vary from 2.0 percent to 2.75 percent, depending on such principal amount and ratio. Under the provisions of the note agreement, the subsidiaries of BLH are limited in the amount of dividends they may pay on common stock, and BLH must comply with other covenants, including the maintenance of specific financial ratios. The senior term loan is collateralized by the majority of the common stock of BLH and the common stock and surplus debentures issued by its life insurance subsidiary to BLH.
BLH's $200.0 million senior subordinated notes bear interest at 13 percent, payable semi-annually on May 1 and November 1. The notes are due November 1, 2002, and may be redeemed, at the Company's option, on or after November 1, 1997, at a redemption price initially at 106.5 percent and declining thereafter. In December 1993, BLH repurchased $20.0 million of the notes in open market transactions for $24.0 million, resulting in an extraordinary charge, net of tax, of $3.1 million. Conseco's share of this charge ($1.0 million) was included as an extraordinary charge in the consolidated financial statements.
As discussed in note 2, BLH issued $36.7 million of paid-in-kind ("PIK") subordinated notes in connection with its acquisition by Partnership I. The PIK subordinated notes were subordinated in right of payment to the prior payment in full of the senior term loan and, in certain circumstances, the senior subordinated notes. In 1993, BLH retired all of its PIK subordinated notes totaling $38.3 million and prepaid $55.0 million of its senior term loan. Repayment of this debt resulted in an extraordinary charge for BLH of $4.8 million, net of a $2.5 million tax benefit, in 1993. Conseco's share of this charge ($2.1 million) was included as an extraordinary charge in the consolidated financial statements.
In September 1994, ALHC completed a public offering of $150 million of its 11-1/4% senior subordinated notes due September 15, 2004, in connection with the acquisition of Statesman by Partnership II. Interest is payable semiannually on March 15 and September 15. The senior subordinated notes are redeemable at the option of ALHC, in whole or in part, at any time on and after September 15, 1999, initially at 105.625 percent of their principal amount, plus accrued interest, declining to 100 percent of their principal amount, plus accrued interest, on and after September 15, 2001.
The Company rents office space, equipment and computer software under noncancellable operating leases. Rental expense during 1994, 1993 and 1992, amounted to $18.8 million, $11.9 million and $6.2 million, respectively. Future required minimum rental payments as of December 31, 1994, were as follows (dollars in millions):
Statesman has entered into employment continuation agreements with certain of its officers and officers of its subsidiaries that provide for payments to these officers of amounts up to four times their annual compensation if the terms of their employment are changed following the change of control that occurred September 29, 1994. The maximum contingent liability under the agreements at December 31, 1994, is $6.7 million.
The Company also has a stock bonus and deferred compensation program for certain officers and directors of Conseco and its wholly owned subsidiaries whereby the participants may voluntarily defer a portion of their compensation. Company contributions vary based on the profitability of the Company and the amount of compensation voluntarily deferred by each participant. Each year's contribution, which is fully funded in the form of Conseco's common stock, vests five years later or upon certain other events. The cost of the program is charged to expense over the vesting period and amounted to $1.4 million, $2.3 million and $1.9 million in 1994, 1993 and 1992, respectively. The market value of Conseco's common stock held under the program (included in other assets and other liabilities) was $29.9 million and $39.4 million at December 31, 1994, and 1993, respectively.
BLH has an incentive stock option plan which is authorized to grant employees or directors options to purchase shares of common stock. A maximum of 3.5 million shares of common stock may be issued under options and related rights granted under the plan. The exercise price may not be less than the fair market value of the underlying shares on the date of the grant. Options may become exercisable immediately or over a period of time and remain exercisable for up to 10 years after grant. At December 31, 1994, options for a total of 1,253,850 shares at prices between $20.00 and $23.63 were outstanding of which 24,750 options were exercisable and approximately 2.3 million shares were available for future grant. The plan also authorized issuance of stock appreciation rights or limited rights (rights exercisable only in the event of a tender offer for or acquisition of 25 percent or more of BLH's outstanding common stock), but none have been granted.
From time to time, mandatory assessments are levied on the Company's insurance subsidiaries by life and health guaranty associations of most states in which these subsidiaries are licensed. These assessments are to cover losses to policyholders of insolvent or rehabilitated insurance companies. The associations levy assessments (up to prescribed limits) on all member insurers in a particular state in order to pay claims on the basis of the proportionate share of premiums written by member insurers in the lines of business in which the insolvent or rehabilitated insurer engaged. These assessments may be deferred or forgiven in certain states if they would threaten an insurer's financial strength and, in some states, these assessments can be partially recovered through a reduction in future premium taxes. The accompanying financial statements include accruals which approximate the Company's estimated potential liability for guaranty assessments. The Company's share of such assessments incurred by its insurance company subsidiaries and equity investees was $8.0 million in 1994, $2.9 million in 1993 and $3.5 million in 1992.
No significant gain or loss was recognized on these contracts during the three months ended December 31, 1994, and they are carried in the balance sheet as a liability at their fair values of $10.6 million at December 31, 1994.
Until these contracts expire in May 1996 or are disposed of, Statesman remains exposed to the risk of interest rate fluctuation. These contracts expose Statesman to additional liability as follows:
- As to $250 million notional amount, at the amount by which LIBOR is less than 6.00 percent, and
- As to $250 million notional amount, at the amount by which LIBOR exceeds 7.35 percent.
A director of the Company is a principal in several entities that received a total of approximately $9.5 million from the Company during the three years ended December 31, 1994, for the sale of land and the construction of facilities, and approximately $1.3 million for management and rental of offices. In 1989, the Company loaned the director $8.0 million on an eight-year note with interest at the prime interest rate plus one percentage point. The note is repayable in annual installments of $1.0 million and had a balance of $2.0 million at December 31, 1994.
Minority interest represents the interest of investors other than Conseco in BLH and Partnership II and its subsidiaries. Minority interest at December 31, 1994, included: (i) $173.0 million interest in the common stock of BLH; (ii) $99.0 million interest in the redeemable preferred stock of a subsidiary of Statesman; (iii) $31.1 million interest in the Statesman PIK Preferred Stock; and (iv) $18.6 million interest in the limited partnership and common stock of Partnership II and its subsidiaries.
Changes in minority interest during 1994 and 1993 are summarized below:
Authorized preferred stock is 20,000,000 shares. Conseco issued 100,000 shares of $55 Series B Redeemable Preferred Stock("Series B preferred stock") with a stated value of $50.0 million ($500 per share) in 1987 and redeemed all of the shares at stated value in 1993. Conseco issued 5,750,000 shares of Series D Cumulative Convertible Preferred Stock ("Series D preferred stock") with a stated value of $287.5 million ($50 per share) in January 1993 in a public offering. Annual dividends of $3.25 on each Series D preferred share are cumulative from the date of original issue and are payable quarterly. The Series D preferred stock is convertible at the holder's option into shares of Conseco's common stock at a conversion price of $63.75 per share, equivalent to a ratio of approximately 0.7843 shares of common stock for each share of preferred stock. Proceeds from the offering of approximately $278.5 million (after underwriting and other associated costs) were used to redeem the Series B preferred stock and were added to the Company's general funds. During 1993, 274 Series D preferred shares were converted to 215 common shares. In 1994, no Series D preferred shares were converted to common shares. In December 1994, the Company repurchased 80,000 Series D preferred shares in open market transactions in connection with its stock repurchase program at a total cost of $3.3 million. Such preferred shares would have been convertible into 62,745 shares of common stock.
Changes in the number of shares of common stock outstanding for the years 1994, 1993 and 1992, were as follows:
Dividends declared on common stock for 1994, 1993 and 1992, were $.50, $.30 and $.085 per common share, respectively. A liability was accrued for dividends declared but unpaid at December 31, 1994, totaling $2.8 million. Such dividends were paid in January 1995.
The Company repurchased approximately 7 million shares of its common stock for $360.2 million in 1994 in connection with its stock repurchase program.
The Company's 1983 employee stock option plan was authorized to grant options to purchase up to 12.0 million shares of the Company's common stock at a price not less than its market value on the date the option is granted. The 1983 stock option plan continues to govern options granted thereunder, but expired in all other respects in December 1993. A new plan was adopted in 1994 which authorizes the granting of options to purchase up to 6.0 million shares of the Company's common stock at a price not less than its market value on the date the option is granted. The options are exercisable for up to 10 years from date of grant and may become exercisable immediately or over a period of time. The plan also permits granting of stock appreciation rights.
Cash flows from operations included interest paid on debt of $54.3 million, $58.8 million and $42.7 million in 1994, 1993 and 1992, respectively. Income taxes paid were $99.8 million, $204.9 million and $108.5 million in 1994, 1993 and 1992, respectively.
Combined statutory net income of the Company's life insurance subsidiaries was $112.5 million, $162.3 million and $133.5 million in 1994, 1993 and 1992, respectively, after appropriate eliminations of intercompany accounts among such subsidiaries.
In connection with the acquisition of BLH, the capital of one of the life insurance subsidiaries (Bankers Life Insurance Company of Illinois) was increased by providing cash in exchange for a surplus debenture. The remaining balance of the surplus debenture of $460.0 million at December 31, 1994, is considered a part of statutory capital and surplus of the life insurance subsidiary. Payments to BLH of principal and interest on the surplus debenture may be made from available funds only with the approval of the Illinois Department of Insurance when its Director is satisfied that the financial condition of the subsidiary warrants that action. Such approval may not be withheld provided the surplus of the subsidiary exceeds, after such payment, approximately $128 million. Such subsidiary's surplus at December 31, 1994, was $327.4 million.
American Life's capital and surplus includes surplus notes with a balance of $51.2 million at December 31, 1994. Each payment of interest or principal on the surplus notes requires the prior approval of the Iowa Insurance Division. The Iowa insurance law also provides that payments of dividends on capital stock and interest and principal on surplus notes may only be made out of an insurer's earned surplus. At December 31, 1994, American Life had earned surplus of $131.3 million. American Life follows certain permitted accounting practices which are not specifically prescribed in state laws, regulations, general administrative rules and various NAIC publications. Such permitted accounting practices do not enhance statutory surplus.
Statutory accounting practices require the asset valuation reserve ("AVR") and the interest maintenance reserve ("IMR"), be reported as liabilities. The purpose of these reserves is to stabilize statutory surplus against fluctuations in the market value of investments. The IMR captures all realized investment gains and losses, net of income tax, on debt instruments resulting from changes in interest rates and provides for subsequent amortization of such amounts into statutory net income on a basis reflecting the remaining lives of the assets sold. The AVR captures all realized, net of income tax, and unrealized investment gains and losses related to changes in creditworthiness and is also adjusted each year based on a formula related to the quality and loss experience of the Company's investment portfolio.
State insurance laws generally restrict the ability of insurance companies to pay dividends or make other distributions. Net assets of the Company's wholly owned life insurance subsidiaries,determined in accordance with generally accepted accounting principles, aggregated approximately $1.1 billion at December 31, 1994, of which approximately $48.4 million is available for distribution to Conseco in 1995 without the permission of state regulatory authorities. On March 13, 1995, $40 million of such amount was distributed to Conseco.
Most states have adopted risk-based capital ("RBC") rules to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks. The RBC formula is designed as an early warning tool to help state regulators identify possible weakly capitalized companies for the purpose of initiating regulatory action. At December 31, 1994, the ratios of total adjusted capital to RBC, as defined by the rules, for the primary insurance subsidiaries of BLH, Statesman and CCP were greater than twice the level at which regulatory attention is triggered.
Conseco's earnings result from three different activities: (i) operating life insurance companies; (ii) providing services to affiliates and others for fees; and (iii) acquiring and restructuring life insurance companies. Conseco's life insurance operations through 1994 were primarily conducted through: (i) BLH (which distributes Medicare supplement policies and other life and health products to the senior citizens market through career agents, most of whom sell only BLH's products); (ii) Statesman (which distributes annuities and life insurance products through a general agency and brokerage distribution system and which was acquired through Partnership II in September 1994); (iii) WNC (which distributes single premium deferred annuities through financial institutions and other annuity products through personal producing general agents and which was disposed of in 1994); (iv) CCP (which distributes tax qualified annuities and certain employee benefit-related products primarily to school teachers and administrators through educator market specialists and annuities and life insurance products through other diversified cost effective distribution channels); and (v) Conseco's other wholly owned subsidiaries (which have profitable blocks of in-force life business, although new sales are currently not being emphasized).