Our Bankers Life segment is primarily administered from two facilities in downtown Chicago, Illinois. Bankers Life
has approximately 114,000 square feet leased under an agreement which expires in 2018 and approximately 222,000 square feet which expires in 2013. We own an office building in Philadelphia, Pennsylvania (127,000 square feet), which serves as the administrative center for the direct marketing operation of our Bankers Life segment. We occupy approximately 60 percent of this space, with the remainder leased to tenants. We also lease 210 sales offices in various states totaling approximately 595,000 square feet. These leases are short-term in length, with remaining lease terms expiring between 2006 and 2011.
Our statements, trend analyses and other information contained in this report and elsewhere (such as in filings by Conseco with the Securities and Exchange Commission, press releases, presentations by Conseco or its management or oral statements) relative to markets for Conseco's products and trends in Conseco's operations or financial results, as well as other statements, 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 provides 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:
o our ability to achieve an upgrade of the financial strength ratings of our insurance company subsidiaries and the impact of prior rating downgrades on our business;
o mortality, morbidity, usage of health care services, persistency and other factors which may affect the profitability of our insurance products;
o the adverse impact of our Predecessor's bankruptcy proceedings on our business operations, and relationships with our customers, employees, regulators, distributors and agents;
o the risk factors or uncertainties listed from time to time in our filings with the Securities and Exchange Commission;
o Conseco Insurance Group, which markets and distributes specified disease insurance, Medicare supplement insurance, and certain life and annuity products to the senior and middle-income markets through over 500 IMOs that represent over 6,000 producing independent agents. This segment markets its products under the "Conseco" brand.
We also have a corporate segment, which consists of holding company activities and certain noninsurance company businesses that are not related to our operating segments.
In accordance with SOP 90-7, we restated all of our assets and liabilities to their current estimated value, reestablished shareholders' equity at the reorganization value determined in connection with our Plan and recorded the portion of the reorganization value which could not be attributed to specific tangible or identified intangible assets as goodwill. As a result, our financial statements for periods following August 31, 2003, are not comparable with those prepared before that date.
o Further reducing operating expenses and improving the efficiency of our operations across all business functions.
We defer any fees received or costs incurred when we originate investments. We amortize fees, costs, discounts and premiums as yield adjustments over the contractual lives of the investments. We consider anticipated prepayments on structured securities when we estimate yields on such securities. When actual prepayments differ from our estimates, the adjustment to yield is recognized as investment income (loss).
We regularly evaluate all of our investments for possible impairment based on current economic conditions, credit loss experience and other investee-specific developments. If there is a decline in a security's net realizable value that we deem to be other than temporary, the decline is recognized as a realized loss and the cost basis of the security is reduced to its estimated fair value. During the year ended December 31, 2005, we recorded $14.7 million of such writedowns of investments.
Our assessment of whether unrealized losses are "other than temporary" requires consideration of the following factors: (i) the extent to which market value is less than the cost basis; (ii) the length of time that the market 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; (iv) the near-term prospects for improvement in the issuer and/or its industry; (v) our view of 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) our ability and intent to hold the investment for a period of time sufficient to allow for any
During 2005, we sold $7.5 billion of fixed maturity investments which resulted in net realized investment gains of $4.2 million. Our fixed maturity investments are generally purchased in the context of a long-term strategy to fund insurance liabilities, so we do not generally seek to purchase and sell such securities to generate gains. In certain circumstances, when securities are selling at prices which exceed our view of their current fair value, and it is possible to reinvest the proceeds to better meet our long-term asset-liability objectives, we may sell certain securities. Of those fixed maturity investments sold in 2005, $3.7 billion resulted in gross investment losses (before income taxes) of $82.3 million. We sell securities at a loss for a number of reasons including, but not limited to: (i) changes in the investment environment; (ii) expectation that the market value could deteriorate further; (iii) desire to reduce our exposure to an issuer or an industry; (iv) changes in credit quality; (v) identification of a superior investment alternative; or (vi) changes in expected liability cash flows.
The value assigned to the right to receive future cash flows from policies existing at September 10, 2003 (the effective date of the reorganization of our Predecessor) is referred to as the value of policies inforce at the Effective Date. 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 for the impact of unrealized gains (losses) in the same manner as the cost of policies produced described below. We expect to amortize approximately 12 percent of the December 31, 2005 balance of value of policies inforce in 2006, 11 percent in 2007, 10 percent in 2008, 8 percent in 2009 and 8 percent in 2010.
business in the period after September 10, 2003. We amortize these costs (using the interest rate credited to the underlying policy for universal life or investment-type products and the projected investment earnings rate for other products): (i) in relation to the estimated gross profits for universal life and investment-type products; or (ii) in relation to future anticipated premium revenue for other products.
At December 31, 2005, the combined balance of the value of policies inforce and cost of policies produced was $3.2 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 the value of policies inforce and the cost of policies produced. We consider estimated future gross profits or future premiums, expected mortality or morbidity, interest earned and credited rates, persistency and expenses in determining whether the balance is recoverable. If we determine a portion of the unamortized balance is not recoverable, it is charged to amortization expense.
Our income tax expense includes deferred income taxes arising from temporary differences between the financial reporting and tax bases of assets and liabilities, capital loss carryforwards and NOLs. We evaluate the realizability of our deferred income tax assets and assess the need for a valuation allowance on an ongoing basis. In evaluating our deferred income tax assets, we consider whether it is more likely than not that the deferred income tax assets will be realized. The ultimate realization of our deferred income tax assets depends upon generating sufficient future taxable income during the periods in which our temporary differences become deductible and before our capital loss carryforwards and NOLs expire. In addition, the use of the Company's NOLs is dependent, in part, on whether: (i) the IRS affirms the tentative settlement agreement related to the allocation of the tax loss on our predecessor's investment in CFC (the "CFC loss"); and (ii) the IRS does not take an adverse position in the future regarding the tax position we plan to take in our tax returns with respect to the allocation of cancellation of indebtedness income. These matters are described below.
Based on our current assessment, we believe that it would be appropriate to reduce the valuation allowance by an additional $275 million if the tentative settlement is ultimately approved. However, the actual reduction would be based on the facts and circumstances existing on such date, if the tentative settlement were approved.
At December 31, 2005, the total balance of our liabilities for insurance products was $25.4 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.
We calculate and maintain reserves for the future payment of claims to our policyholders based on actuarial assumptions. For all our insurance products, we establish an active life reserve, a liability for due and unpaid claims, claims in the course of settlement and incurred but not reported claims. In addition, for our supplemental health insurance business, we establish a reserve for the present value of amounts not yet due on claims. Many factors can affect these reserves and liabilities, such as economic and social conditions, inflation, hospital and pharmaceutical costs, changes in doctrines of legal liability and extra-contractual damage awards. Therefore, our reserves and liabilities are necessarily based on extensive estimates, assumptions and historical experience. Establishing reserves is an uncertain process, and it is possible that actual claims will materially exceed our reserves and have a material adverse effect on our results of operations and financial condition. Our financial results depend significantly upon the extent to which our actual claims experience is consistent with the assumptions we used in determining our reserves and pricing our products. If our assumptions with respect to future claims are incorrect, and our reserves are insufficient to cover our actual losses and expenses, we would be required to increase our liabilities, which would negatively affect our operating results.
Liabilities for insurance products are calculated using management's best judgments, based on our past experience and
standard actuarial tables, of mortality, morbidity, lapse rates, investment experience and expense levels.
The liabilities established for our equity-indexed annuity products (including the value of options attributable to policyholders for the estimated life of the annuity contract and accounted for as embedded derivatives) are established pursuant to different accounting rules than other interest-sensitive products. At the Effective Date, the present value of estimated future benefits for our equity-indexed products exceeded the value of the Predecessor's liabilities by $.2 billion, resulting in a fresh-start adjustment.
We are involved on an ongoing basis in arbitrations and lawsuits, including purported class actions, relating to our operations, including with respect to sales practices, and we and current and former officers and directors are defendants in a pending class action lawsuit asserting claims under the securities laws. The ultimate outcome of these legal matters cannot be predicted with certainty. We recognize an estimated loss from these loss contingencies when we believe it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated. However, it is difficult to measure the actual loss that might be incurred related to litigation. The ultimate outcome of these lawsuits could have a significant impact on our results of operations and financial position.
have taken to collect the D&O loans. At December 31, 2005, we have estimated that approximately $34.4 million of the D&O balance (which is included in other assets) is collectible (net of the cost of collection). An allowance has been established to reduce the recorded balance of the D&O loans to this balance.
Pursuant to the settlement that was reached with the Official Committee of the Trust Originated Preferred Securities ("TOPrS") Holders and the Official Committee of Unsecured Creditors in the Plan, the former holders of TOPrS (issued by Old Conseco's subsidiary trusts and eliminated in our reorganization) who did not opt out of the bankruptcy settlement, will be entitled to receive 45 percent of any proceeds from the collection of certain D&O loans in an aggregate amount not to exceed $30 million. We have established a liability of $17.5 million (which is included in other liabilities), representing our estimate of the amount which will be paid to the former holders of TOPrS pursuant to the settlement.
Due to the application of fresh start accounting, the reported historical financial statements of our Predecessor for periods prior to August 31, 2003 generally are not comparable to our financial statements for periods after that date. Therefore, our results of operations have not been combined with those of our Predecessor. Please read this discussion in conjunction with the consolidated financial statements and notes included in this Form 10-K.
General: Conseco is the top tier holding company for a group of insurance companies operating throughout the United States that develop, market and administer supplemental health insurance, annuity, individual life insurance and other insurance products. We distribute these products through our Bankers Life segment, which utilizes a career agency force and direct response marketing, and through our Conseco Insurance Group segment, which utilizes professional independent producers. Our Other Business in Run-off segment consists of: (i) long-term care products sold in prior years through independent agents; (ii) small group and individual major medical business which we stopped renewing in 2001; and (iii) other group major medical business which we no longer market. Most of the long-term care business in run-off relates to business written by certain subsidiaries prior to their acquisitions by Conseco in 1996 and 1997.
Average liabilities for insurance products, net of reinsurance ceded, were $8.9 billion in 2005; $8.0 billion in 2004; $7.4 billion in the four months ended December 31, 2003; and $6.3 billion in the eight months ended August 31, 2003. The increase in such liabilities since August 31, 2003, was primarily due to increases in annuity reserves resulting from new sales of these products in recent periods. The increase in such liabilities for the four months ended December 31, 2003, was primarily due to the adoption of fresh start accounting and its effects on the reserves for our health insurance.
Net investment income on general account invested assets (which excludes income on policyholder and reinsurer accounts) was $488.8 million in 2005; $422.6 million in 2004; $128.9 million in the four months ended December 31, 2003; and $253.4 million in the eight months ended August 31, 2003. The average balance of general account invested assets was $8.6 billion in 2005; $7.7 billion in 2004; $7.0 billion in the four months ended December 31, 2003; and $6.6 billion in the eight months ended August 31, 2003. The average yield on these assets was 5.7 percent in 2005; 5.5 percent in 2004; 5.5 percent in the four months ended December 31, 2003; and 5.7 percent in the eight months ended August 31, 2003. The
increase in general account invested assets is primarily due to sales of our annuity products in recent periods. This segment's investment income included income related to prepayments of securities (including prepayment penalties on mortgages, call premiums on fixed maturities and acceleration of discount amortization, net of premium amortization) of $3.0 million in 2005 and $4.7 million in 2004. The yields in 2004 and for the four months ended December 31, 2003, reflected the adoption of fresh start accounting which reset the yields to market rates at August 31, 2003.
Change in value of embedded derivatives related to modified coinsurance agreements is described in the note to our consolidated financial statements entitled "Summary of Significant Accounting Policies - Accounting for Derivatives." We have transferred the specific block of investments related to these agreements to our trading account, which we carry at estimated fair value with changes in such value recognized as trading account income. We expect the change in the value of the embedded derivatives to be largely offset by the change in value of the trading securities.
Insurance policy benefits fluctuated as a result of 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.
The net cash flows from our long-term care products generally cause an accumulation of amounts in the early years of a policy (accounted for as reserve increases) which will be paid out as benefits in later policy years (accounted for as reserve decreases). Accordingly, as the policies age, the benefit ratio typically increases, but the increase in reserve is partially offset by investment income earned on the accumulated assets. The benefit ratio on this business increased in 2005, consistent with the aging of this block. In addition, the older policies have not lapsed at the rate we assumed in our pricing. In the first quarter of 2005, we began introducing several new long-term care products to replace our previous products which had lower pricing assumptions. To date, these new products have been approved by the regulatory authorities in 46 states. During 2005, we made certain adjustments to the assumptions we use to calculate insurance liabilities for future long-term care benefits, resulting in a net reduction to insurance liabilities of $6.4 million. The primary change related to policies that provide for increased benefits to reflect inflation. Our previous assumptions had reflected the increased projected benefit costs for the inflation benefit in insurance liabilities at the time of billing immediately prior to the policy anniversary date which was earlier than the actual terms of the policy. Our new method calculates the increased projected benefit costs on the policy anniversary date which is in accordance with the actual terms of the policy. The interest-adjusted benefit ratio for long-term care products is calculated by dividing the insurance product's insurance policy benefits less interest income on the accumulated assets backing the insurance liabilities by insurance policy income. The decrease in the interest-adjusted benefit ratio for the four months ended December 31, 2003, was primarily due to the adoption of fresh start accounting which increased the assets backing such insurance liabilities.
The benefit ratios on our 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 $165.4 million in 2005; $149.5 million in 2004; $50.6 million in the four months ended December 31, 2003; and $89.5 million in the eight months ended August 31, 2003. The increases were primarily due to increases in annuity reserves (resulting from higher sales of these products) partially offset by lower average crediting rates. The weighted average crediting rates for these products were 3.7 percent in 2005; 3.9 percent in 2004; 4.4 percent for the four months ended December 31, 2003; and 4.2 percent for the eight months ended August 31, 2003.
Amortization related to operations includes amortization of the value of policies inforce at the Effective Date and the cost of policies produced (collectively referred to as "amortization of insurance acquisition costs"). Insurance acquisition costs are 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 these costs is not recoverable from future profits. Such amounts were generally consistent with the related premium revenue and gross profits for such periods and the assumptions we made when we established the value of policies inforce as of the Effective Date. In addition, during 2005, we recognized additional amortization expense of $4.4 million to reflect revisions to our calculations related to prior period amounts. The assumptions we use to estimate our future gross profits and premiums involve significant judgment. A revision to our current assumptions could result in increases or decreases to amortization expense in future periods. Bankers Life's amortization expense in the first eight months of 2003 was not comparable to subsequent periods due to the application of fresh start accounting effective August 31, 2003.
Interest expense on investment borrowings fluctuated with our investment borrowing activities and the interest rates thereon.
Net realized investment gains (losses) fluctuated each period. During 2005, net realized investment gains (losses) in this segment included $.9 million of net losses from the sales of investments (primarily fixed maturities), and $2.7 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary. During 2004, net realized investment gains in this segment included $21.5 million of net gains from the sales of investments (primarily fixed maturities), net of $4.1 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary. During the four months ended December 31, 2003, net realized investment gains in this segment included $8.6 million of net gains from the sales of investments (primarily fixed maturities), net of $5.2 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary. During the first eight months of 2003, net investment gains included $20.5 million of net gains from the sales of investments (primarily fixed maturities), net of $15.0 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary.
Net investment income related to equity-indexed 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 equity-indexed products. Our equity-indexed products are designed so that the investment income spread earned on the related insurance liabilities is more than adequate to cover the cost of the options and other costs related to these policies. Option costs that are attributable to benefits provided were $34.2 million in 2005; $37.7 million in 2004; $16.2 million in the four months ended December 31, 2003; and $45.8 million in the eight months ended August 31, 2003. These costs are reflected in net investment income. Net investment income (loss) related to equity-indexed products before these costs were $22.2 million in 2005; $48.8 million in 2004; $51.8 million in the four months ended December 31, 2003; and $71.1 million in the eight months ended August 31, 2003. Such amounts also include income on trading securities which are designed to act as hedges for embedded derivatives related to equity-indexed products. Such trading account income (loss) was $(4.3) million in 2005; $6.4 million in 2004; and $4.4 million in the four months ended December 31, 2003. Such amounts were partially offset by the corresponding charge (credit) to amounts added to policyholder account balances for equity-indexed products. Such income and related charges fluctuate based on the value of options embedded in the segment's equity-indexed annuity policyholder account balances subject to this benefit and to the performance of the indices to which the returns on such products are linked.
Fee revenue and other income in the eight months ended August 31, 2003 included $15.6 million of income earned by a subsidiary that earned fees for marketing insurance products of other companies. This subsidiary was sold in September 2003, resulting in decreased fee revenue in subsequent periods.
diagnosis of, or treatment for, a covered type of cancer. Approximately 78 percent of our specified disease 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 (accounted for as reserve increases) which 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 the change in reserve will be partially offset by investment income earned on the accumulated assets. In addition, the benefit ratio for 2005 reflects unfavorable claim experience. The benefit ratio in this block of business is affected by the number of policies which lapse in a period. When policies lapse before reaching the specified age when the return of premium is payable, the reserve established for such benefit through the lapse date is released, resulting in lower insurance policy benefits for the period. In the third quarter of 2004, we changed the criteria pursuant to which we consider a specified disease policy to be lapsed. Although our specified disease policies generally may be lapsed for non-payment of premiums after being delinquent for 90 days, policyholders are permitted to reinstate their coverage by paying past due premiums prior to our final lapse notice. In addition, timing differences and delays in billing, receipt and processing of premiums can affect whether a policy has, in fact, lapsed. We revised our previous methodology of determining which policies have lapsed to consider the fact that many policyholders whose payments are delinquent past their grace periods may, in fact, reinstate their coverage through payment of past due premiums. These changes resulted in an increase to reserves of approximately $6 million in 2004. The effect of variances in lapse rates from our expectations were partially offset by reduced amortization of insurance acquisition costs of $2.2 million in 2004. We had favorable claims experience in the four months ended December 31, 2003. We experienced higher than expected incurred claims on certain cancer insurance policies during the first eight months of 2003.
Amounts added to equity-indexed products fluctuated with the corresponding related investment income accounts described above.
Net realized investment gains (losses) fluctuate each period. During 2005, net realized investment gains included $6.0 million of net gains from the sales of investments (primarily fixed maturities), net of $4.4 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary. During 2004, net realized investment gains in this segment included $32.1 million of net gains from the sales of investments (primarily fixed maturities), net of $10.6 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary. During the four months ended December 31, 2003, net realized investment gains in this segment included $13.4 million of net gains from the sales of investments (primarily fixed maturities), net of $3.9 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary. During the first eight months of 2003, net realized investment losses included $16.8 million of net gains from the sales of investments (primarily fixed maturities), net of $33.9 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary.
Net investment income on general account invested assets was $177.6 million in 2005; $167.5 million in 2004; $55.3 million in the four months ended December 31, 2003; and $101.5 million in the eight months ended August 31, 2003. The average balance of general account invested assets was $3.0 billion in 2005; $3.0 billion in 2004; $2.8 billion in the four months ended December 31, 2003; and $2.5 billion in the eight months ended August 31, 2003. The average yield on these assets was 6.0 percent in 2005; 5.6 percent in 2004; 5.8 percent in the four months ended December 31, 2003; and 6.1 percent in the eight months ended August 31, 2003. The increase in yield in 2005 was primarily due to: (i) lengthening the duration of this portfolio to better match the duration of the related insurance liabilities; and (ii) income of $2.3 million related to prepayments of securities (including prepayment penalties on mortgages, call premiums on fixed maturities and acceleration of discount amortization, net of premium amortization). The decrease in yield in 2004 as compared to the 2003 periods reflected the lower interest rate environment prevailing in 2004. The proceeds from investment maturities and prepayments were reinvested at lower prevailing interest rates in 2004, reducing the overall portfolio yield. The decrease in yield for the four months ended December 31, 2003 reflected the adoption of fresh start accounting which effectively reset the yields to market rates at August 31, 2003.
Insurance policy benefits fluctuated primarily as a result of the factors summarized below related to benefit ratios in the blocks of long-term care business included in this segment. Benefit ratios are calculated by dividing the product's insurance policy benefits by insurance policy income.
During the fourth quarter of 2005, we utilized a new seriatim-based valuation system to determine reserves for the long-term care block of business in run-off. We had previously used a model based valuation system since the fresh-start date. Such conversion to the seriatim-based valuation system resulted in decreases to our insurance liabilities of approximately $38 million in the fourth quarter of 2005. In addition, we completed a new claims cost study and developed new continuance tables based on our recent experience which were used to estimate claim reserves resulting in an increase to insurance liabilities of $40 million in the fourth quarter of 2005.
Other operating costs and expenses were $86.1 million in 2005; $93.5 million in 2004; $36.2 million in the four months ended December 31, 2003; and $75.2 million in the eight months ended August 31, 2003. Other operating costs and expenses, excluding commission expenses, for this segment were $46.3 million in 2005; $50.3 million in 2004; $22.1 million in the four months ended December 31, 2003; and $41.3 million in the eight months ended August 31, 2003. The decrease
reflects our initiatives to reduce operating expenses and improve the efficiency of our operations.
Interest expense on corporate debt in 2005 was impacted by the issuance of the Debentures and our Amended Credit Facility which are further discussed in the note to the consolidated financial statements entitled "Notes Payable - Direct Corporate Obligations". Interest expense on corporate debt in 2004 included interest expense on an $800.0 million secured credit agreement (the "Credit Facility") and a $1.3 billion credit agreement (the "Previous Credit Facility"), including a credit agreement charge of $3.8 million. Interest expense in the four months ended December 31, 2003 included interest expense on the Previous Credit Facility. Interest expense in the eight months ended August 31, 2003, reflected interest on notes payable of our Predecessor. The average interest rate on our debt was 5.9 percent in 2005, 6.8 percent in 2004 and 7.8 percent in the four months ended December 31, 2003.
provided loans to participants for interest on such bank loans totaling $179.2 million.
Venture capital income (loss) related to our investment in AWE, a company in the wireless communication business. Our investment in AWE was carried at estimated fair value, with changes in fair value recognized as investment income (loss). We sold all of our holdings in AWE during the fourth quarter of 2003.
Net operating results of variable interest entity represents the Company's investment in a variable interest entity ("VIE"). The VIE is consolidated in accordance with Financial Accounting Standards Board Interpretation No. 46 "Consolidation of Variable Interest Entities", revised December 2003 ("FIN 46R"). Although we do not control this entity, we consolidate it because we are the primary beneficiary. This entity was established to issue securities and use the proceeds to invest in loans and other permitted assets. Such consolidation requirements did not have a material impact on our financial condition or results of operations.
We measure compensation expense for our stock option plans using the intrinsic value method pursuant to Accounting Principles Board Opinion No. 25 "Accounting for Stock Issued to Employees." Under this method, compensation expense is only recorded in our consolidated statement of operations when the quoted market price at the grant date exceeds the amount an employee must pay to acquire the stock. Effective January 1, 2006, we will be required to implement Statement of Financial Accounting Standards No. 123R, "Shareholder Based Payments", pursuant to which stock option awards will be required to be measured at fair value with the related compensation expense recognized in the consolidated statement of operations over the related service period. We will implement this requirement using the modified prospective method, pursuant to which we will begin recognizing compensation expense for all awards granted on or after January 1, 2006. In addition, we will be required to recognize compensation expense over the remaining requisite service period for the portion of outstanding awards that are not vested as of January 1, 2006 and were not previously expensed on a pro forma basis in the disclosure provided in the notes to our consolidated financial statements. We expect that our 2006 operating expenses (before the effect of income taxes) will increase by approximately $6 million as a result of implementing this new standard.
We set premium rates on our health insurance policies based on facts and circumstances known at the time we issue the policies using assumptions about numerous variables, including the actuarial probability of a policyholder incurring a claim, the probable size of the claim, and the interest rate earned on our investment of premiums. We also consider historical claims information, industry statistics, the rates of our competitors and other factors. If our actual claims experience is less favorable than we anticipated and we are unable to raise our premium rates, our financial results may be adversely affected. We generally cannot raise our health insurance premiums in any state until we obtain the approval of the state insurance regulator. We review the adequacy of our premium rates regularly and file rate increases on our products when we believe such rates are too low. It is possible that we will not be able to obtain approval for all requested premium rate increases. If such requests are denied in one or more states, our net income may decrease. If such requests are approved, increased premium rates may reduce the volume of our new sales and may cause existing policyholders to lapse their policies. If the healthier policyholders allow their policies to lapse, this would reduce our premium income and profitability in the future.
Annuities in this segment include equity-indexed and other fixed annuities sold to the senior market through our career agents. Annuity collections totaled $951.1 million in 2005; $950.5 million in 2004; $253.8 million in the four months ended December 31, 2003; and $698.4 million in the eight months ended August 31, 2003. The sales of these products in 2005 and 2004 have generally benefited from the low rates credited on competing products in the marketplace. However, the increase in short-term interest rates during 2005 resulted in lower first-year fixed annuity sales as certain other competing products, such as certificates of deposits, have become attractive. Our equity-indexed products were favorably impacted in 2005 due in part to general stock market conditions which made these products relatively attractive and the introduction of a new equity-indexed product.
Premiums collected on Bankers Life's long-term care policies totaled $564.2 million in 2005; $536.3 million in 2004; $177.9 million in the four months ended December 31, 2003; and $331.5 million in the eight months ended August 31, 2003. The increase in premium collections of our long-term care products was primarily due to persistency of our existing business and new sales in recent periods.
Other health products include various products which we no longer actively market. Premiums collected totaled $12.1 million in 2005; $12.2 million in 2004; $4.4 million in the four months ended December 31, 2003; and $9.0 million in the eight months ended August 31, 2003.
The accumulation value of equity-indexed annuities is credited with interest at an annual guaranteed minimum rate of 3 percent (or, including the effect of applicable sales loads, a 1.7 percent compound average interest rate over the term of the contracts). These annuities provide for potentially higher returns based on a percentage of the change in one of several equity market indices during each year of their term. We purchase options in an effort to hedge increases to policyholder benefits resulting from increases in the indices. Total collected premiums for this product were $104.4 million in 2005; $44.3 million in 2004; $9.4 million in the four months ended December 31, 2003; and $44.9 million
Other fixed rate annuity products include SPDAs, FPDAs and SPIAs, which are credited with a declared rate. SPDA and FPDA policies typically have an interest rate that is guaranteed for the first policy year, after which we have the discretionary ability to change the crediting rate to any rate not below a guaranteed minimum rate. The interest rate credited on SPIAs is based on market conditions existing when a policy is issued and remains unchanged over the life of the SPIA. Annuity premiums on these products were $57.3 million in 2005; $19.4 million in 2004; $8.7 million in the four months ended December 31, 2003; and $29.1 million in the eight months ended August 31, 2003. Collected premiums for this product increased in 2005 due to increased sales efforts as well as attractive crediting rates on certain products. The decrease in 2004 was a result of our emphasis on the sales of other products that are less ratings sensitive.
Premiums collected on specified disease products totaled $359.5 million in 2005; $361.7 million in 2004; $118.7 million in the four months ended December 31, 2003; and $236.4 million in the eight months ended August 31, 2003. Collected premiums have been comparable from period to period.
Premiums collected from other health products totaled $13.2 million in 2005; $16.2 million in 2004; $19.1 million in the four months ended December 31, 2003; and $38.5 million in the eight months ended August 31, 2003. Premiums have decreased from period to period as we no longer actively market many of these products.
Life products in the Conseco Insurance Group segment are sold through professional independent producers. Life premiums collected totaled $335.0 million in 2005; $372.3 million in 2004; $131.5 million in the four months ended December 31, 2003; and $280.7 million in the eight months ended August 31, 2003. Our A.M. Best rating has negatively affected our sales of life products.
Major medical premium collections continue to decrease as we manage the run-off of this block of business.
The following table sets forth fixed maturity investments at December 31, 2005, classified by rating categories. The category assigned is the highest rating by a nationally recognized statistical rating organization or, as to $295.3 million fair value of fixed maturities not rated by such firms, the rating assigned by the NAIC. For purposes of the table, NAIC Class 1 is included in the "A" rating; Class 2, "BBB-"; Class 3, "BB-"; and Classes 4-6, "B+ and below" (dollars in millions):
The following table summarizes investment yields earned over the past three years on the general account invested assets of our insurance subsidiaries. General account investments exclude our venture capital investment in AWE and the value of options (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, 2005 and 2004, the average yield, computed on the cost basis of our actively managed fixed maturity portfolio, was 5.6 percent and 5.6 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 equity-indexed products) was 4.6 percent and 4.7 percent, respectively.
Our actively managed fixed maturity portfolio at December 31, 2005, included primarily debt securities of the United States government, public utilities and other corporations, and structured securities. Structured securities included mortgage-backed securities, collateralized mortgage obligations ("CMOs"), asset-backed securities and commercial mortgage-backed securities.
At December 31, 2005, our fixed maturity portfolio had $351.9 million of unrealized gains and $237.9 million of unrealized losses, for a net unrealized gain of $114.0 million. Estimated fair values of fixed maturity investments were determined based on estimates from: (i) nationally recognized pricing services (93 percent of the portfolio); (ii) broker-dealer market makers (6 percent of the portfolio); and (iii) internally developed methods (1 percent of the portfolio).
At December 31, 2005, approximately 4.0 percent of our invested assets (4.4 percent of fixed maturity investments) were fixed maturities rated below-investment grade by nationally recognized statistical rating organizations (or, if not rated by such firms, with ratings below Class 2 assigned by the NAIC). We currently plan to maintain our present level of investments in below-investment-grade fixed maturities, although this plan could change if market conditions change. Below-investment grade securities have different characteristics than investment grade corporate debt securities. The risk 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 generally unsecured and often subordinated to other creditors of the issuer. Also, issuers of below-investment grade securities usually have higher levels of debt and may be more sensitive to adverse economic conditions, such as recession or increasing interest rates, than investment grade issuers. 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, 2005, our below-investment-grade fixed maturity investments had an amortized cost of $986.9 million and an estimated fair value of $994.4 million.
When a security defaults, our policy is to discontinue the accrual of interest and eliminate all previous interest accruals, if we determine that such amounts will not be ultimately realized in full. Investment income forgone due to defaulted securities was $.8 million and $3.5 million for the years ended December 31, 2005 and 2004, respectively; $5.3 million in the four months ended December 31, 2003; and $12.1 million in the eight months ended August 31, 2003.
At December 31, 2005, fixed maturity investments included $6.2 billion of structured securities (or 28 percent of all fixed maturity securities). Structured securities include mortgage-backed securities, collateralized mortgage obligations and commercial mortgage-backed securities. CMOs are backed by pools of mortgages that are segregated into sections or "tranches" that provide for reprioritizing of principal retirement. Pass-through securities receive principal and interest payments through their regular pro rata share of the payments on the underlying mortgages backing the securities. The yield characteristics of structured securities differ in some respects from those of traditional fixed-income securities. For example, interest and principal payments on mortgage-backed securities occur more frequently, often monthly. In addition, mortgage-backed securities are subject to a higher degree of risk associated with variable prepayments of principal. For example, prepayment rates are influenced by a number of factors that cannot be predicted with certainty, including: the relative sensitivity of the underlying mortgages backing the assets to changes in interest rates; a variety of economic, geographic and other factors; and various security-specific structural considerations (for example, the repayment priority of a given security in a securitization structure).
In general, the rate of prepayments on the underlying mortgage loans and on structured securities backed by these loans increases when prevailing interest rates decline significantly in absolute terms and also relative to the interest rates on the underlying loans. The yields on mortgage-backed securities purchased at a discount to par will increase when the underlying mortgages prepay faster than expected. The yields on mortgage-backed securities purchased at a premium will decrease when the underlying mortgages prepay faster than expected. When interest rates decline, the proceeds from the prepayment of mortgage-backed securities may be reinvested at lower rates than we were earning on the prepaid securities. When interest rates increase, prepayments on mortgage-backed securities decrease as fewer underlying mortgages are refinanced. When this occurs, the average maturity and duration of the mortgage-backed securities increase, which decreases the yield on mortgage-backed securities purchased at a discount, because the discount is realized as income at a slower rate, and increases the yield on those purchased at a premium, because of a decrease in the annual amortization of the premium.
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, 2005 (dollars in millions):
(a) Includes below-investment grade structured securities with both an amortized cost and estimated fair value of $.4 million.
During 2005, we sold $3.7 billion of fixed maturity investments which resulted in gross investment losses (before income taxes) of $82.3 million. We sell securities at a loss for a number of reasons including but not limited to: (i) changes in the investment environment; (ii) expectation that the market value could deteriorate further; (iii) desire to reduce our exposure to an issuer or an industry; (iv) changes in credit quality; (v) identification of a superior investment alternative; or (vi) our analysis indicates there is a high probability that the security is other-than-temporarily impaired. As discussed in the notes to our consolidated financial statements, the realization of gains and losses affects the timing of the amortization of insurance acquisition costs related to universal life and investment products.
At December 31, 2005, we held mortgage loan investments with a carrying value of $1,264.2 million (or 5.0 percent of total invested assets) and a fair value of $1,297.6 million. The mortgage loan balance was primarily comprised of commercial loans. Noncurrent mortgage loans were insignificant at December 31, 2005. Realized losses on mortgage loans were not significant in any of the past three years. Our allowance for loss on mortgage loans was $2.4 million at both December 31, 2005 and 2004. Approximately 9 percent, 7 percent, 6 percent, 5 percent and 5 percent of the mortgage loan balance were on properties located in Ohio, Kentucky, New York, Massachusetts and Florida, respectively. No other state comprised greater than 5 percent of the mortgage loan balance.
The following table shows the distribution of our mortgage loan portfolio by property type as of December 31, 2005 (dollars in millions):
At December 31, 2005, we held $716.3 million of trading securities. We carry trading securities at estimated fair value; changes in fair value are reflected in the statement of operations. Our trading securities are designed to act as hedges for embedded derivatives related to our equity-indexed annuity products and certain modified coinsurance agreements. See the note to the consolidated financial statements entitled "Summary of Significant Accounting Policies - Accounting for Derivatives" for further discussion regarding the embedded derivatives and the trading accounts. In addition, the trading account includes investments backing the market strategies of our multibucket annuity products.
Changes in our consolidated balance sheet between December 31, 2005 and December 31, 2004, primarily reflect: (i) our net income for 2005; (ii) a reduction to our deferred income tax valuation allowance; (iii) the consolidation of a variable interest entity; and (iv) changes in the fair value of actively managed fixed maturity securities.
In accordance with GAAP, we record our actively managed fixed maturity investments, equity securities and certain other invested assets at estimated fair value with any unrealized gain or loss (excluding impairment losses, which are recognized through earnings), net of tax and related adjustments, recorded as a component of shareholders' equity. At December 31, 2005, we increased the carrying value of such investments by $120.9 million as a result of this fair value adjustment.
The following table summarizes certain financial ratios as of and for the years ended December 31, 2005 and 2004:
The Company's significant contractual obligations as of December 31, 2005, were as follows (dollars in millions):
o For products such as immediate annuities and structured settlement annuities without life contingencies, the payment obligation is fixed and determinable based on the terms of the policy.
(b) Includes projected interest payments based on market rates, as applicable, as of December 31, 2005. Refer to the notes to the consolidated financial statements entitled "Notes Payable - Direct Corporate Obligations" for additional information on notes payable.
(c) These borrowings primarily represent the securities issued by a variable interest entity and include projected interest payments based on market rates, as applicable, as of December 31, 2005.
(d) Includes benefits expected to be paid pursuant to our deferred compensation plan and postretirement plans based on numerous actuarial assumptions and interest credited at 5.5 percent.
(e) Refer to the notes to the consolidated financial statements entitled "Commitments and Contingencies" for additional information on operating leases and certain other contractual commitments.
On March 8, 2006, Moody's upgraded the financial strength rating of our primary insurance companies from "Ba1" to "Baa3" except Conseco Senior, which was affirmed at "Caa1". In addition, all of Moody's ratings on our insurance subsidiaries now have a positive outlook. On July 29, 2005, the ratings for our primary insurance subsidiaries were placed on review for upgrade by Moody's, except Conseco Senior, for which the rating was affirmed with a developing outlook. On May 27, 2004, Moody's upgraded the financial strength ratings of our primary insurance companies from "Ba3" to "Ba2", except Conseco Senior, which was assigned a "Caa1" rating. On August 9, 2004, Moody's again upgraded the financial strength ratings of our primary insurance companies from "Ba2" to "Ba1" and reaffirmed the "Caa1" rating of Conseco Senior. Moody's financial strength ratings range from "Aaa" to "C". Rating categories from "Aaa" to "Baa" are classified as "Secure" by Moody's and rating categories from "Ba" to "C" are considered "vulnerable" and these ratings may be supplemented with numbers "1", "2", or "3" to show relative standing within a category. In Moody's view, an insurer rated "Baa3" offers adequate financial security, however, certain protective elements may be lacking or may be characteristically unreliable over any great length of time. In Moody's view, an insurer rated "Caa" offers very poor financial security and may default on its policyholder obligations or there may be elements of danger with respect to punctual payment of policyholder obligations and claims. The "Baa3" rating and the "Caa1" rating from Moody's are the tenth and seventeenth highest, respectively, of twenty-one possible ratings. A positive outlook by Moody's is an opinion regarding the likely direction of a rating over the medium term.
Our insurance companies' financial strength ratings were downgraded by all of the major rating agencies beginning in July 2002 in connection with the financial distress that ultimately led to our Predecessor's bankruptcy. These lowered ratings caused sales of our insurance products to decline, policyholder redemptions and lapses to increase and increased agent attrition in 2003 and 2004, which in turn has negatively affected our financial results.
We have adopted several initiatives designed to reduce the expense levels that exceed product pricing in our Conseco Insurance Group segment. These initiatives include system conversions which will eliminate duplicate processing systems. We expect to spend over $23 million on capital expenditures in 2006 (including amounts related to these initiatives). We believe we have adequate cash flows from operations to fund these initiatives.
The Amended Credit Facility includes an $80.0 million revolving credit facility that can be used for general corporate purposes and that would mature on June 22, 2009. There were no amounts outstanding under the revolving credit facility at December 31, 2005. The Company pays a commitment fee equal to .50 percent of the unused portion of the revolving credit facility on an annualized basis.
based on the financial statements of our insurance subsidiaries prepared in accordance with statutory accounting practices prescribed or permitted by regulatory authorities, which differ from GAAP. These regulations generally permit dividends to be paid from statutory earned surplus of the insurance company for any 12-month period in amounts equal to the greater of (or in a few states, the lesser of): (i) statutory net gain from operations or net income for the prior year; or (ii) 10 percent of statutory capital and surplus as of the end of the preceding year. Any dividends in excess of these levels require the approval of the director or commissioner of the applicable state insurance department.
Under our Amended Credit Facility, we have agreed to a number of covenants and other provisions that restrict our ability to engage in various financing transactions and pursue certain operating activities without the prior consent of the lenders. We have also agreed to meet or maintain various financial ratios. These requirements represent significant restrictions on the manner in which we may operate our business and our ability to meet these financial covenants may be affected by events beyond our control. If we default under any of these requirements (subject to certain remedies), the lenders could declare all outstanding borrowings, accrued interest and fees to be immediately due and payable. If that were to occur, we cannot provide assurance that we would have sufficient liquidity to repay or refinance this indebtedness.
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, 2005, approximately 17 percent of our total insurance liabilities, or approximately $4.3 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, 2005, approximately 41 percent of our insurance liabilities had interest rates that may be reset annually; 46 percent had a fixed explicit interest rate for the duration of the contract; 9 percent had credited rates which approximate the income earned by the Company; and the remainder had no explicit interest rates. At December 31, 2005, the average yield, computed on the cost basis of our actively managed fixed maturity portfolio, was 5.6 percent, and the average interest rate credited or accruing to our total insurance liabilities
We are subject to the risk that our investments will decline in value. This has occurred in the past and may occur again. During 2005, we recognized net realized investment losses of $2.9 million, which were comprised of $11.8 million of net gains from the sales of investments (primarily fixed maturities) with proceeds of $11.5 billion, net of $14.7 million of writedowns of investments resulting from a decline in the fair value of an investment that we concluded was other than temporary. During 2004, we recognized net realized investment gains of $40.6 million, which were comprised of $58.7 million of net gains from the sales of investments (primarily fixed maturities) with proceeds of $12.7 billion, net of $18.1 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary. During the four months ended December 31, 2003, we recognized net realized investment gains of $11.8 million, which were comprised of $21.4 million of net gains from the sales of investments (primarily fixed maturities) with proceeds of $4.7 billion, net of $9.6 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary. During the first eight months of 2003, we recognized net realized investment losses of $5.4 million, which were comprised of $45.9 million of net gains from the sales of investments (primarily fixed maturities) with proceeds of $5.4 billion, net of $51.3 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary.
The operations of the Company are subject to risk resulting from fluctuations in market prices of our equity securities. In general, these investments have more year-to-year price variability than our fixed maturity investments. However, returns over longer time frames have been consistently higher. We manage this risk by limiting our equity securities to a relatively small portion of our total investments.
We have completed integrated audits of Conseco, Inc.'s (Successor Company) 2005 and 2004 consolidated financial statements and of its internal control over financial reporting as of December 31, 2005 and an audit of its consolidated financial statements for the period from September 1, 2003 through December 31, 2003 in accordance with the standards of the Public Company Accounting Oversight Board (United States). Our opinions, based on our audits, are presented below.
In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Conseco, Inc. and subsidiaries (Successor Company) at December 31, 2005 and 2004, and the results of their operations and their cash flows for each of the two years in the period ended December 31, 2005 and for the period from September 1, 2003 through December 31, 2003 in conformity with accounting principles generally accepted in the United States of America. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit of financial statements includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
CONSOLIDATED BALANCE SHEET December 31, 2005 and 2004 (Dollars in millions)
CONSOLIDATED BALANCE SHEET (Continued) December 31, 2005 and 2004 (Dollars in millions)
CONSOLIDATED STATEMENT OF OPERATIONS (Dollars in millions, except per share data)
1. DESCRIPTION OF BUSINESS AND OUR EMERGENCE FROM BANKRUPTCY IN 2003
Conseco, Inc., a Delaware corporation ("CNO"), is a holding company for a group of insurance companies operating throughout the United States that develop, market and administer supplemental health insurance, annuity, individual life insurance and other insurance products. CNO became the successor to Conseco, Inc., an Indiana corporation ("Old Conseco" or our "Predecessor"), in connection with our bankruptcy reorganization. The terms "Conseco", the "Company", "we", "us", and "our" as used in this report refer to CNO and its subsidiaries or, when the context requires otherwise, Old Conseco and its subsidiaries. We focus on serving the senior and middle-income markets, which we believe are attractive, high growth markets. We sell our products through three distribution channels: career agents, professional independent producers (some of whom sell one or more of our product lines exclusively) and direct marketing.
o Bankers Life, which consists of the businesses of Bankers Life and Casualty Company ("Bankers Life and Casualty") and Colonial Penn Life Insurance Company ("Colonial Penn"). Bankers Life and Casualty markets and distributes Medicare supplement insurance, life insurance, long-term care insurance and certain annuity products to the senior market through approximately 4,800 exclusive career agents and sales managers. Colonial Penn markets graded benefit and simplified issue life insurance directly to consumers through television advertising, direct mail, the internet and telemarketing. Both Bankers Life and Casualty and Colonial Penn market their products under their own brand names.
o approximately 34.4 million shares of Class A Preferred Stock with an initial aggregate liquidation preference of approximately $859.7 million (which has been subsequently redeemed as further discussed in the note to the consolidated financial statements entitled "Shareholders' Equity");
o 100.0 million shares of common stock, excluding shares issued to our chairman upon his appointment and shares issued or to be issued to directors, officers or employees under an equity incentive plan; and
As part of our Chapter 11 reorganization, we sold substantially all of the assets of our Predecessor's finance business and exited this line of business. Our finance business was conducted through our Predecessor's indirect wholly-owned subsidiary, Conseco Finance Corp. ("CFC"). We accounted for our finance business as a discontinued operation in 2002 once we formalized our plans to sell it. On April 1, 2003, CFC and 22 of its direct and indirect subsidiaries, which collectively comprised substantially all of our finance business, filed liquidating plans of reorganization with the Bankruptcy Court in order to facilitate the sale of this business. The sale of the finance business was completed in the second quarter of 2003. We did not receive any proceeds from this sale for our interest in CFC, nor did any creditors of our Predecessor. As of March 31, 2003, we ceased to include the assets and liabilities of CFC on our Predecessor's consolidated balance sheet.
We prepare our financial statements in accordance with accounting principles generally accepted in the United States of America ("GAAP"). We follow the accounting standards established by the Financial Accounting Standards Board ("FASB"), the American Institute of Certified Public Accountants and the Securities and Exchange Commission (the "SEC").
Upon our emergence from bankruptcy, we implemented fresh start reporting in accordance with SOP 90-7 as further described in the note entitled "Fresh Start Reporting". As a result, the Company's financial statements for periods following August 31, 2003, are not comparable with those of Old Conseco prepared before that date.
Upon the confirmation of the Plan on September 9, 2003, we implemented fresh start reporting in accordance with SOP 90-7. For accounting convenience purposes, we have reported the effects of fresh start accounting as if they occurred on August 31, 2003. Under fresh start reporting, a new reporting entity was considered to be created and the Company was required to revalue its assets and liabilities to current estimated fair value, re-establish shareholders' equity at the reorganization value determined in connection with the Plan, and record the excess of the reorganization value over specific tangible or identified intangible assets as goodwill. In addition, all accounting standards that were required to be adopted in the financial statements within twelve months following the adoption of fresh start accounting were adopted as of August 31, 2003.
Pursuant to SOP 90-7, professional fees associated with Chapter 11 cases are expensed as incurred and reported as reorganization items. Interest expense was reported only to the extent that it was paid during the Chapter 11 cases. The Company recognized expenses of $70.9 million in the eight months ended August 31, 2003 for fees payable to professionals who assisted with the Chapter 11 cases.
Adjustments to the Predecessor's consolidated balance sheet as of August 31, 2003, to reflect the discharge of debt, change in capital structure and the fair value of our assets and liabilities are presented in the following table (dollars in millions):
- ----------------- (a) Predecessor balance sheet as of August 31, 2003, prior to the discharge of prepetition liabilities and the effects of the fresh start adjustments.
(e) The Company's historical cost of policies purchased and cost of policies produced balances were eliminated and replaced with the value of policies in force at the Effective Date. The value of policies in force reflected the estimated fair value of the Company's business in force and represents the value of the right to receive future cash flows from the policies in force on the Effective Date.
Venture capital investment in AT&T Wireless Services, Inc. ("AWE") was carried at fair value, with changes in such value recognized as investment income (loss). In December 2003, we sold our remaining 4.1 million shares of AWE common stock. We recognized venture capital investment income (losses) of $(5.5) million in the four months ended December 31, 2003; and $10.5 million in the eight months ended August 31, 2003, related to this investment.
We regularly evaluate all of our investments based on current economic conditions, credit loss experience and other investee-specific developments. When we conclude there is a decline in a security's fair value that is other than temporary, we treat it as a realized investment loss and reduce the cost basis of the security to its estimated fair value.
During the first eight months of 2003, we established an additional provision for losses related to our guarantees of the bank loans and related interest loans to approximately 155 current and former directors, officers and key employees for the purchase of the common stock of Old Conseco (see the note to the consolidated financial statements entitled "Commitments and Contingencies" for additional information).
The costs that vary with, and are primarily related to, producing new insurance business subsequent to September 10, 2003 are referred to as cost of policies produced. For universal life or investment products, we amortize these costs using the interest rate credited to the underlying policies 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.
When we replace an existing insurance contract with another insurance contract with substantially different terms, all unamortized cost of policies produced for such replaced contract is immediately expensed. When we replace an existing insurance contract with another insurance contract with substantially similar terms, we continue to defer the cost of policies produced associated with the replaced contract. Such costs which continue to be deferred related to replaced contracts were nil in both 2005 and 2004 and the four months ended December 31, 2003; and $2.9 million in the eight months ended August 31, 2003.
The value assigned to the right to receive future cash flows from contracts existing at September 10, 2003 is referred to as the value of policies inforce at the Effective Date. 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 for the impact of unrealized gains (losses) in the same manner as described above for the cost of policies produced.
Pursuant to SOP 90-7, any reduction of the deferred income tax valuation allowance established at the emergence date is accounted for as a reduction of goodwill until goodwill is eliminated. As further described in the note entitled "Income Taxes", the reduction of our deferred income tax valuation allowance resulted in the elimination of our goodwill in 2004.
Reorganization items represent amounts the Predecessor incurred as a result of its Chapter 11 reorganization, and are presented separately in the consolidated statement of operations. These items consisted of the following (dollars in millions):
The following summarizes other identifiable intangible assets as of December 31, 2004 (dollars in millions):
Separate accounts are funds on which investment income and gains or losses accrue directly to certain policyholders. The assets of these accounts are legally segregated. They are not subject to the claims that may arise out of any other business of Conseco. We report separate account assets at market value; the underlying investment risks are assumed by the contractholders. We record the related liabilities at amounts equal to the separate account assets. We record the fees earned for administrative and contractholder services performed for the separate accounts in insurance policy income.
In addition, prior to its liquidation in the third quarter of 2003, we held investments in a trust for the benefit of the
purchasers of certain products of our asset management subsidiary. Because we held the residual interests in the cash flows from the trust and actively managed its investments, we were required to include the accounts of the trust in our consolidated financial statements. We recorded the fees earned for investment management and other services provided to the trust as fee revenue. See the caption "Brickyard Loan Trust" in the note to the consolidated financial statements entitled "Investments in Variable Interest Entities" for further information on these investments.
From time-to-time, we assume insurance from other companies. Any costs associated with the assumption of insurance are amortized consistent with the method used to amortize the cost of policies produced described above. Reinsurance
premiums assumed totaled $60.1 million in 2005; $70.2 million in 2004; $31.9 million in the four months ended December 31, 2003; and $57.3 million in the eight months ended August 31, 2003.
At December 31, 2005, investment borrowings also include the securities issued to other entities by a variable interest entity which is consolidated in our financial statements. Refer to the note entitled "Investments in Variable Interest Entities" for further discussion.
Our equity-indexed annuity products provide a guaranteed base rate of return and a higher potential return that is based on a percentage (the "participation rate") of a particular index, such as the Standard & Poor's 500 Index over an annual period. At the beginning of each policy year, a new index period begins. We are able to change the participation rate at the beginning of each index period, subject to contractual minimums. We buy one-year call options on the applicable indices in an effort to hedge potential increases to policyholder benefits resulting from increases in the particular index to which the product's return is linked. We include the cost of the options in the pricing of these products. Policyholder account balances for these annuities fluctuate in relation to changes in the values of these options. We reflect changes in the estimated market
The Company accounts for the options attributed to the policyholder for the estimated life of the annuity contract as embedded derivatives as defined by Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities", as amended by Statement of Financial Accounting Standards No. 137, "Deferral of the Effective Date of FASB Statement No. 133" and Statement of Financial Accounting Standards No. 138, "Accounting for Certain Derivative Instruments and Certain Hedging Activities" (collectively referred to as "SFAS 138"). We record the changes in the fair values of the embedded derivatives in current earnings as a component of policyholder benefits. The fair value of these derivatives, which are classified as "liabilities for interest-sensitive products", was $210.7 million and $236.7 million at December 31, 2005 and 2004, respectively. We maintain a specific block of investments which are equal to the balance of these liabilities 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). The change in value of these trading securities should largely offset the portion of the change in the value of the embedded derivative that is caused by interest rate fluctuations.
We measure compensation cost for our stock option plans using the intrinsic value method pursuant to Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations ("APB 25").
Under this method, compensation cost is recorded when the quoted market price at the grant date exceeds the amount an employee must pay to acquire the stock. When the Company issues employee stock options with the exercise price equal to or greater than the market price of our stock on the grant date, no compensation cost is recorded. Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123") and Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation - - Transition and Disclosure" require disclosures of the pro forma effects of using the fair value method of accounting for stock options.
The exercise price was equal to the market price of our stock for all options granted in 2005. The weighted average fair value of options granted in 2004 whose exercise price is equal to the market price of our stock on the grant date was $6.67 per share. The weighted average fair value of options granted in 2004 whose exercise price exceeds the market price of our stock on the grant date was $6.29 per share.
The estimated fair values of our financial instruments at December 31, 2005 and 2004, were as follows (dollars in millions):
During the third quarter of 2002, Old Conseco entered into an agreement to sell Conseco Variable Insurance Company ("CVIC"), its wholly owned subsidiary and the primary writer of its variable annuity products. The sale was completed in October 2002 and was accounted for as a discontinued operation.
During 2002, we recognized estimated losses related to the ultimate sale and disposition of the aforementioned discontinued businesses, including estimated costs to sell and costs related to the resolution of contingencies. During the eight months ended August 31, 2003, we reduced the accrual for such estimated costs by $16.0 million (after income taxes of $.7 million). We recorded the reduction of such accrual as income from discontinued operations.
In 2003, the FASB issued Financial Accounting Standards Board Interpretation No. 46 "Consolidation of Variable Interest Entities", revised December 2003 ("FIN 46R"), which required expanded disclosures for and, in some cases, consolidation of significant investments in variable interest entities ("VIE"). A VIE is an entity in which the equity investors do not have the characteristics of a controlling financial interest, or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. Under FIN 46R, a company is required to consolidate a VIE if it is the primary beneficiary of the VIE. FIN 46R defines primary beneficiary as the party which will absorb a majority of the VIE's expected losses or receive a majority of the VIE's expected residual returns, or both. The Company has investments in various types of VIEs, some of which require additional disclosure under FIN 46R, and some of which require consolidation under FIN 46R. As further discussed in the note to the consolidated financial statements entitled "Investments in Variable Interest Entities", we consolidated all of our investments in VIEs for which we are the primary beneficiary. Such consolidation requirements did not have a material impact on our financial condition or results of operations. The note entitled "Investments in Variable Interest Entities" includes the expanded disclosures required by FIN 46R.
The following table summarizes the carrying values of our actively managed fixed maturity securities by category as of December 31, 2005 (dollars in millions):
Below-investment grade fixed maturity securities with an amortized cost of $289.1 million and an estimated fair value of $287.7 million are securities held by a variable interest entity that we are required to consolidate. These fixed maturity securities are legally isolated and are not available to the Company. The liabilities of such variable interest entity will be satisfied from the cash flows generated by these securities. At December 31, 2005, our total investment in the variable interest entity was $32.8 million, and such investment was rated BBB.
Below-investment grade securities have different characteristics than investment grade corporate debt securities. Risk 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 generally unsecured and often subordinated to other creditors of the issuer. Also, issuers of below-investment grade securities usually have higher levels of debt and may be 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.
We regularly evaluate our investments for possible impairment based on current economic conditions, credit loss experience and other investee-specific developments. When we conclude that a decline in a security's net realizable value is other than temporary, the decline is recognized as a realized loss and the cost basis of the security is reduced to its estimated fair value.
The following table sets forth the amortized cost and estimated fair value of those actively managed fixed maturities with unrealized losses at December 31, 2005, by contractual maturity. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Most of the structured securities shown below provide for periodic payments throughout their lives (dollars in millions).
The following table summarizes the gross unrealized losses and fair values of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that such securities have been in a continuous unrealized loss position, at December 31, 2005 (dollars in millions):
The following table summarizes the gross unrealized losses and fair values of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that such securities have been in a continuous unrealized loss position, at December 31, 2004 (dollars in millions):
Based on management's current assessment of investments with unrealized losses at December 31, 2005, the Company believes the issuers of the securities will continue to meet their obligations (or with respect to equity-type securities, the investment value will recover to its cost basis). The Company has no current plans to sell these securities and has the ability to hold them to maturity. If the Company concludes in future periods that the unrealized loss is other than temporary, a charge to earnings would be recognized.
Prior to the sale, we were the primary beneficiary of a partnership which owned the GM building. Therefore, the partnership was consolidated in our financial statements effective August 31, 2003, in accordance with the requirements of FIN 46R, which was implemented in conjunction with fresh start accounting. Net investment income for the four months ended December 31, 2003, reflected $2.9 million related to this investment (representing our equity interest in the income from the building for the 26 days prior to the sale).
At December 31, 2005, fixed maturity investments included $6.2 billion of structured securities (or 28 percent of all fixed maturity securities). Structured securities include mortgage-backed securities, collateralized mortgage obligations and commercial mortgage-backed securities. The yield characteristics of structured securities differ in some respects from those of traditional fixed-income securities. For example, interest and principal payments on mortgage-backed securities occur more frequently, often monthly. In addition, mortgage-backed securities are subject to a higher degree of risk associated with variable prepayments of principal. For example, prepayment rates are influenced by a number of factors that cannot be
predicted with certainty, including: the relative sensitivity of the underlying mortgages backing the assets to changes in interest rates; a variety of economic, geographic and other factors; and various security-specific structural considerations (for example, the repayment priority of a given security in a securitization structure).
At December 31, 2005, the mortgage loan balance was primarily comprised of commercial loans. Approximately 9 percent, 7 percent, 6 percent, 5 percent and 5 percent of the mortgage loan balance were on properties located in Ohio, Kentucky, New York, Massachusetts and Florida, respectively. No other state comprised greater than 5 percent of the mortgage loan balance. Substantially less than one percent of the mortgage loan balance was noncurrent at December 31, 2005. Our allowance for loss on mortgage loans was $2.4 million at both December 31, 2005 and 2004.
Life insurance companies are required to maintain certain investments on deposit with state regulatory authorities. Such assets had aggregate carrying values of $129.3 million and $142.2 million at December 31, 2005 and 2004, respectively.
In accordance with SOP 90-7, the Successor established insurance liabilities and an asset for the value of policies inforce at the Effective Date using current assumptions. The adjustments to the Predecessor's liabilities for insurance products as of August 31, 2003 are summarized below (dollars in millions):
market, we changed our assumptions related to future investment earnings. The weighted average expected yield on our investment portfolio decreased to approximately 5.6 percent at the Effective Date from 6.7 percent at December 31, 2002. Approximately $.9 billion of the fresh-start increase to insurance liabilities was the result of changes in future expected investment earnings.
In addition, the insurance liabilities for certain Predecessor insurance liabilities were different than the present value of estimated future benefits as of the Effective Date.
The liabilities established for our equity-indexed annuity products (including the value of options attributable to policyholders for the estimated life of the annuity contract and accounted for as embedded derivatives) were established pursuant to different accounting rules than other interest-sensitive products. At the Effective Date, the present value of estimated future benefits for our equity-indexed products exceeded the value of the Predecessor's liabilities by $.2 billion, resulting in a fresh-start adjustment.
In 2005, the IRS completed its examination of the Company for the tax year ending December 31, 2002, and there were no significant adjustments. Conseco and its affiliates are currently under examination by the IRS for the tax year ending December 31, 2003. The outcome of this examination (including any appeals thereof) is not expected to have a material adverse affect on our operating results, but may result in utilization or adjustment of the income tax loss carryforwards reported below.
Our income tax expense includes deferred income taxes arising from temporary differences between the financial reporting and tax bases of assets and liabilities, capital loss carryforwards and NOLs. We evaluate the realizability of our deferred income tax assets and assess the need for a valuation allowance on an ongoing basis. In evaluating our deferred income tax assets, we consider whether it is more likely than not that the deferred income tax assets will be realized. The ultimate realization of our deferred income tax assets depends upon generating sufficient future taxable income during the periods in which our temporary differences become deductible and before our capital loss carryforwards and NOLs expire. In addition, the use of the Company's NOLs is dependent, in part, on whether: (i) the IRS affirms the tentative settlement agreement related to the allocation of the CFC loss; and (ii) the IRS does not take an adverse position in the future regarding the tax position we plan to take in our tax returns with respect to the allocation of cancellation of indebtedness income. These matters are described below.
Based upon information existing at the time of our emergence from bankruptcy, we established a valuation allowance against our entire balance of net deferred income tax assets as we believed that the realization of such net deferred income tax assets in future periods was uncertain. During 2004 and 2005, we concluded that it was no longer necessary to hold certain portions of the previously established valuation allowance. Accordingly, we reduced our valuation allowance by $947.0 million in 2004 and $585.8 million in 2005. However, we are required to continue to hold a valuation allowance of $1,043.8
As of December 31, 2005, we had $4.6 billion of NOLs and $1.1 billion of capital loss carryforwards, which expire as follows (dollars in millions):
The following notes payable were direct corporate obligations of the Company as of December 31, 2005 and 2004 (dollars in millions):
In August 2005, we completed the private offering of $330 million of 3.50% Convertible Debentures due September 30, 2035 (the "Debentures"). The Debentures were offered only to qualified institutional buyers under Rule 144A of the Securities Act of 1933, as amended. Related issuance costs of $7.9 million were recorded as deferred charges and will be amortized as an increase to interest expense through September 30, 2010, which is the earliest date the Debenture holders may require the Company to repurchase them. The net proceeds from the offering of approximately $320 million were used to repay term loans outstanding under the Company's Credit Facility. The terms of the Debentures are governed by an indenture dated as of August 15, 2005 between the Company and The Bank of New York Trust Company, N.A., as trustee (the "Indenture"). At December 31, 2005, unamortized issuance costs (classified as other assets) related to the Debentures were $7.4 million.
The Amended Credit Facility requires the Company to maintain various financial ratios and balances, as defined in the agreement, including: (i) a debt to total capitalization ratio of not more than 25 percent at all times (such ratio was 16 percent at December 31, 2005); (ii) an interest coverage ratio greater than or equal to 2.00 to 1 for each rolling four quarters ending June 30, 2007, and 2.50 to 1 for each rolling four quarters thereafter (such ratio exceeded the minimum requirement for the four quarters ending December 31, 2005); (iii) an aggregate risk-based capital ratio, as defined in the Amended Credit Facility, greater than or equal to 245 percent for each quarter ending during the period from September 30, 2005 through March 31, 2006, and 250 percent for each quarter ending thereafter (such ratio exceeded the minimum risk-based capital requirements at December 31, 2005); (iv) a combined statutory capital and surplus level of greater than $1,270.0 million (combined statutory capital and surplus at December 31, 2005 exceeded such requirement); and (v) specified investment portfolio requirements (such investment portfolio requirements were met at December 31, 2005).
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. 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. 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 the cases described below, we have disclosed any specific dollar amounts sought in the complaints. In our experience, monetary demands in complaints bear little relation to the ultimate loss, if any, to the Company. However, for the reasons stated above, it is not possible to make meaningful estimates of the amount or range of loss that could result from some of these matters at this time. The Company reviews these matters on an ongoing basis and follows the provisions of Statement of Financial Accounting Standards No. 5, "Accounting for Contingencies", when making accrual and disclosure decisions. When assessing reasonably possible and probable outcomes, the Company bases its decisions on its assessment of the ultimate outcome following all appeals.
After our Predecessor announced its intention to restructure on August 9, 2002, eight purported securities fraud class action lawsuits were filed in the United States District Court for the Southern District of Indiana. The complaints named us as a defendant, along with certain of our former officers. These lawsuits were filed on behalf of persons or entities who purchased our Predecessor's common stock on various dates between October 24, 2001 and August 9, 2002. The plaintiffs allege claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended (the "Exchange Act") and allege material omissions and dissemination of materially misleading statements regarding, among other things, the liquidity of Conseco and alleged problems in CFC's manufactured housing division, allegedly resulting in the artificial inflation of our Predecessor's stock price. On March 13, 2003, all of these cases were consolidated into one case in the United States District Court for the Southern District of Indiana, captioned Franz Schleicher, et al. v. Conseco, Inc., Gary Wendt, William Shea, Charles Chokel and James Adams, et al., Case No. 02-CV-1332 DFH-TAB. The complaint seeks an unspecified amount of damages. The plaintiffs have filed an amended consolidated class action complaint with respect to the individual defendants on December 8, 2003. Our liability with respect to this lawsuit was discharged in our Predecessor's plan of reorganization and our obligation to indemnify individual defendants who were not serving as an officer or director on the Effective Date is limited to $3 million in the aggregate under such plan. This limit was reached in May of 2005. Our liability to indemnify individual defendants who were serving as an officer or director on the Effective Date, of which there is one such defendant, is not limited by such plan. A motion to dismiss was filed on behalf of defendants Shea, Wendt and Chokel and on July 14, 2005, this matter was dismissed. Plaintiffs were given until August 24, 2005 to amend their complaint a second time. Plaintiffs filed a second amended complaint on August 24, 2005. We filed a motion to dismiss the second amended complaint on November 7, 2005. James S. Adams filed for bankruptcy on July 29, 2005, Case No. 1:02-cv-1332-DFH-TAB (Southern District, Indiana). We believe this lawsuit is without merit and intend to defend it vigorously; however, the ultimate outcome cannot be predicted with certainty. Our current estimate of the maximum loss that we could reasonably incur on this case is approximately $1.5 million. We do not believe that the potential loss related to the individual defendant who served as an officer on the Effective Date is material.
The Company and certain subsidiaries, including principally Conseco Life Insurance Company ("Conseco Life"), have been named in numerous purported class action and individual lawsuits alleging, among other things, breach of contract, fraud and misrepresentation with regard to a change made in 2003 and 2004 in the way cost of insurance charges are calculated for life insurance policies sold primarily under the names "Lifestyle" and "Lifetime". Approximately 86,500 of these policies were subject to the change, which resulted in increased monthly charges to the policyholders' accounts. Many of the purported class action lawsuits were filed in Federal courts across the United States. On or about June 23, 2004, the Judicial Panel on Multidistrict Litigation ("JPML") consolidated these lawsuits into the action now referred to as In Re Conseco Life Insurance Co. Cost of Insurance Litigation, Cause No. MDL 1610 (Central District, California). On or about September 23, 2004, plaintiffs in the multi-district action filed an amended consolidated complaint and, at that time, added Conseco, Inc. as a defendant. The amended complaint alleges, among other things, that the change enabled Conseco, Inc. to add $360 million to its balance sheet. The amended complaint seeks unspecified compensatory, punitive and exemplary damages as well as an injunction that would require the Company to reinstate the prior method of calculating cost of insurance charges and refund any increased charges that resulted from the change. On April 26, 2005, the Judge in the multi-district action certified a nationwide class on the claims for breach of contract and injunctive relief. On April 27, 2005, the Judge issued an order certifying a statewide California class for injunctive and restitutionary relief pursuant to California Business and Professions Code Section 17200 and breach of the duty of good faith and fair dealing, but denied certification on the claims for fraud and intentional misrepresentation and fraudulent concealment. Trial is currently set to begin on or about September 5, 2006. On May 24, 2005 a lawsuit was filed in Illinois on behalf of a putative statewide class captioned William J. Harte, individually and on behalf of all others similarly situated v. Conseco Life Insurance Company, Case No. 05CH08925 (Circuit Court of Cook County, Illinois, Chancery Division), which has been removed to the United States District Court for the Northern District of Illinois, transferred to California and consolidated and coordinated with MDL 1610. On September 14, 2005, an individual lawsuit was filed in Hawaii by approximately 800 plaintiffs captioned AE Ventures For Archie Murakami et al. v. Conseco, Inc. and Conseco Life Insurance Company and Doe Defendants 1-100; Case No. CV05-00594SOM (U.S. District Court, District of Hawaii). The AE Ventures action has been transferred to California and consolidated and coordinated with MDL 1610. Other cases now pending include purported nationwide class actions in Indiana and California state courts. Those cases filed in Indiana state courts have been consolidated into the case now referred to as Arlene P. Mangelson, et al. v. Conseco Life Insurance Company, Cause No. 29D01-0403-PL-211 (Superior Court, Hamilton County, Indiana). Four putative nationwide and/or statewide class-action lawsuits filed in California state courts have been consolidated and are being coordinated in the Superior Court of San Francisco County under the new caption Cost of Insurance Cases, Judicial Council Coordination Proceeding No. 4384 (Judicial Council of California). On January 25, 2005 an Amended Complaint making similar allegations was filed in the case captioned William Schwartz v. Jeffrey Landerman, Diann P. Urbanek, Metro Insurance, Inc., Samuels Jacky Insurance Agency, Conseco Life Insurance Company, Successor to Philadelphia Life Insurance Company, Case No. GD 00-011432 (Court of Common Pleas, Allegheny County, Pennsylvania). Additionally, Mr. Schwartz filed a purported nationwide class action captioned William Schwartz and Rebecca R. Frankel, Trustee of the Robert M. Frankel Irrevocable Insurance Trust v. Conseco Life Ins. Co. et al., Case No. GD 05-3742 (Court of Common Pleas, Allegheny County, Pennsylvania). On December 22, 2005 a lawsuit was filed in Pennsylvania captioned Lisa M. Jordan v. Allen R. Shank and Conseco Life Insurance Company, Case No. 05-10204 (Court of Common Pleas, Chester County, Pennsylvania). We believe these lawsuits are without merit and intend to defend them vigorously. However, the ultimate outcome of the lawsuits cannot be predicted with certainty and an adverse decision could have a material impact on the Company's consolidated financial condition, cash flows or results of operations.
In October 1997, an action was filed against CVIC, a former subsidiary of the Company, and general agent Glenn H. Guffey by nine South Carolina agents, who alleged that they had suffered losses as a result of defendants' breach of contract, fraud and misleading conduct relating to the sale of Flex II annuities. In the action, Thomas Allen et al v. Great American Reserve Insurance Company, Glenn H. Guffey and American Home Assurance Company, Case Number 29C01-9709-CP751 in the Circuit Court of Hamilton County, Indiana, plaintiffs claim that Mr. Guffey told them that the annuities would have no initial administrative fees charged to the owner of the annuity (when in fact they did) and that as a result, they had been selling the annuities on that basis. Plaintiffs demanded unspecified compensatory and punitive damages, and allege that they have lost commissions and renewals and that their business reputations have been damaged as a result of Mr. Guffey's misrepresentations. They further contend that CVIC should be held liable as it negligently supervised Mr. Guffey and knew about his fraudulent conduct. Defendants were granted a Summary Judgment on February 9, 2000, but plaintiffs appealed the judgment, and the Indiana Supreme Court overturned it on April 2, 2002. Mr. Guffey has settled with plaintiffs, and the case against CVIC is now set for a jury trial commencing March 27, 2006. We retained liability for CVIC's involvement in this litigation in connection with the sale of CVIC. We believe this action is without merit, and intend to defend it vigorously. The ultimate outcome of the action cannot be predicted with certainty.
On February 13, 2004, a declaratory judgment action, RLI Insurance Company v. Conseco, Inc., et al 1:04-cv-00310-LJM-WTL, was filed in the United States District Court for the Southern District of Indiana by RLI Insurance Company ("RLI"), Conseco's fiduciary insurance carrier. RLI is asking the court to find that is has no liability under its policy for the claims made against Conseco in Roderick Russell, et al. v. Conseco, Inc., et al., Case No. 1:02-CV-1639 LJM. In this 2004 Declaratory Judgment action, RLI claims that releases provided to them pursuant to RLI's agreement to settle a prior case involving the Predecessor, RLI Insurance Company v. Conseco, Inc., Stephen Hilbert, et al., Case No. 1:04-CV-0310DFH-TAB (Southern District, Indiana), absolved it of any further liability for claims by Conseco. The Company is pursuing recovery from RLI of the $10 million paid to settle the Russell matter, and has filed counterclaims for declaratory judgment and breach of contract. The court stayed this case until the Russell matter was resolved; however, the stay was lifted as of November 15, 2005. We believe that RLI's position is without merit because the previous release is not applicable to the Russell matter. We plan to vigorously pursue all claims against RLI, but the ultimate outcome of the lawsuit cannot be predicted with certainty. We expect to ultimately recover from RLI a substantial portion of the amount we paid in settlement of the Russell matter.
On July 9, 1999, a complaint was filed in the Supreme Court of the State of New York, County of New York, PRG Planning & Development, LLC v. LateNite Magic, Inc., Daurio & Russo & Sons Construction Co., Inc., Specialized Audio Visual, Inc., Farmore Realty, Inc. f/k/a Sweetheart Theatres, Inc., The City of New York and the State of New York Cause No: 114077/99. The complaint seeks damages in the amount of $3.9 million with interest thereon from January 20, 1998. This is a lien foreclosure suit that is the result of an April 1996 lease agreement entered into by LateNite Magic and Farmore Realty, Inc. to develop a theme restaurant based on the magic of David Copperfield. CVIC and our subsidiary Conseco Annuity Assurance Company (now known as Conseco Insurance Company) purchased preferred stock of LateNite and acquired the right to an assignment of the April 1996 lease. An amended complaint was filed on December 2, 1999 naming CVIC and Conseco Annuity Assurance Company as co-defendants. The trial in this case commenced on March 10, 2005 and concluded on May 20, 2005. The post trial briefs have been submitted and a decision could come at any time. We retained liability for CVIC's involvement in this litigation in connection with the sale of CVIC. We believe that we have established adequate reserves in the event we are found liable under this lawsuit. The ultimate outcome of the lawsuit cannot be predicted with certainty.
Collection efforts by the Company and Conseco Services related to the 1996-1999 director and officer loan programs have been commenced against various past board members and executives with outstanding loan balances. In addition, certain former officers and directors have sued the companies for declaratory relief concerning their liability for the loans. Currently, we are involved in litigation with Stephen C. Hilbert, James D. Massey, Dennis E. Murray, Sr., James S. Adams, Maxwell E. Bublitz, Ngaire E. Cuneo and David R. Decatur. The specific lawsuits now pending include: Hilbert v. Conseco, Case No. 03CH 15330 (Circuit Court, Cook County, Illinois); Conseco Services v. Hilbert, Case No. 29C01-0310-MF-1296 (Circuit Court, Hamilton County, Indiana); Murray and Massey v. Conseco, Case No. 1:03-CV-1701-LJM-VSS (Southern District, Indiana); Stephen C. Hilbert v. Conseco, Inc. and Kroll Inc., Case No. 29D02-0312-PL-1026 (Superior Court, Hamilton County, Indiana); Conseco Services v. Adams, Case No. 29D02-0404-CC-000376 (Superior Court, Hamilton County, Indiana); Conseco Services v. Bublitz, Case No. 29D02-0404-CC-377 (Superior Court, Hamilton County, Indiana); Conseco Services v. Cuneo, et al., Case No. 1:04-CV-0929-DFH-WTL (Southern District, Indiana); Conseco Services v. Murray, Case No. 29D02-0404-CC-381 (Superior Court, Hamilton County, Indiana); Conseco Services v. Massey, Case No. 29D01-0406-CC-477 (Superior Court, Hamilton County, Indiana); Conseco Inc. v. Adams, et al., Case No. 04 L 012974 (Circuit Court, Cook County, Illinois); Conseco Inc. v. Cuneo, et al., Case No. 04 C 7469 (Northern District, Illinois); Conseco Services v. Decatur, Case No. 29D02-0404-CC-000379 (Superior Court, Hamilton County, Indiana); Conseco, Inc. v. Murray, Case No. 1:05-cv-01580-JDT-TAB (Southern District, Indiana); Conseco, Inc. v. Massey, Case No. 2005-L-011316 (Circuit court, Cook County, Illinois). David Decatur filed for bankruptcy on May 12, 2004, Case No. 04-08772-JKC-11 (Southern District, Indiana). Maxwell E. Bublitz filed for bankruptcy on May 2, 2005, Case No. 05-08168-7 (Southern District, Indiana). James S. Adams filed for bankruptcy on July 29, 2005, Case No. 1:02-cv-1332-DFH-TAB (Southern District, Indiana).
The Company and Conseco Services believe that all amounts due under the director and officer loan programs, including all applicable interest, are valid obligations owed to the companies. As part of our Predecessor's plan of
reorganization, we have agreed to pay 45 percent of any net proceeds recovered in connection with these lawsuits, in an aggregate amount not to exceed $30 million, to former holders of our Predecessor's trust preferred securities that did not opt out of a settlement reached with the committee representing holders of these securities. We intend to prosecute these claims to obtain the maximum recovery possible. Further, with regard to the various claims brought against the Company and Conseco Services by certain former directors and officers, we believe that these claims are without merit and intend to defend them vigorously. The ultimate outcome of the lawsuits cannot be predicted with certainty. At December 31, 2005, we estimated that approximately $34.4 million, net of collection costs, of the remaining amounts due under the loan program will be collected and that $17.5 million will be paid to the former holders of our Predecessor's trust preferred securities.
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 our deferred compensation plan is December 31. The liability recognized in the consolidated balance sheet for the agents' deferred compensation plan was $79.0 million and $70.8 million at December 31, 2005 and 2004, respectively. Substantially all of this liability represented vested benefits. Costs incurred on this plan were $11.3 million in 2005; $8.9 million during 2004; $1.5 million in the four months ended December 31, 2003; and $4.0 million in the eight months ended August 31, 2003 (including the recognition of losses of $4.0 million in 2005 and $2.7 million in 2004 resulting from actual experience being different than expected or from changes in actuarial assumptions).
The discount rate is based on the yield of a hypothetical portfolio of high quality debt instruments which could effectively settle plan benefits on a present value basis as of the measurement date. At both December 31, 2005 and 2004, for our deferred compensation plan for qualifying members of our career agency force, we assumed a 5 percent annual increase in compensation until the participant's normal retirement date (age 65 and completion of five years of service).
In the third quarter of 2004, the Company terminated the employment of William J. Shea, the Company's former Chief Executive Officer. Pursuant to Mr. Shea's employment agreement dated May 27, 2003 and other compensation arrangements, Mr. Shea received or is entitled to the following amounts or benefits:
(i) A $6.25 million cash severance payment. (ii) Immediate vesting in 240,753 shares of restricted stock and 240,753 stock options with an exercise price of $16.40 per share. Such options were exercised on November 9, 2004. The Company withheld 309,500 shares to cover the exercise price of the stock options and the federal and state taxes owed by Mr. Shea on the restricted stock and stock options. The shares withheld were then cancelled. The following changes to common stock and additional paid-in capital resulted from the above transactions: (i) an increase of $5.9 million related to the exercise price of the stock options and vesting of the restricted stock; (ii) a decrease of $5.5 million related to shares withheld for the exercise price and for federal and state taxes owed by Mr. Shea; and (iii) a decrease of $.1 million related to the tax liability recognized by the Company on the exercise of non-qualified stock options and vesting of restricted stock. We recognized compensation expense of $2.0 million during the third quarter of 2004 related to the vesting of the aforementioned restricted shares and stock options. Additional stock options or restricted stock granted to Mr. Shea did not vest and were cancelled. (iii) A pro rata portion of his 2004 bonus of $.3 million.
In the third quarter of 2004, the Company hired William S. Kirsch as its President and Chief Executive Officer. Pursuant to the terms of his employment agreement, Mr. Kirsch received a payment of $1.7 million and was granted options to purchase an aggregate of 400,000 shares of Conseco common stock at a price of $16.20 per share (the closing price on the New York Stock Exchange on the date of the grant). The options vest over four years with one-fourth vesting on each anniversary of the grant date. The options expire on August 17, 2014. The Company also issued 400,000 shares of restricted stock to Mr. Kirsch with one-half vesting on the second anniversary of the grant date and an additional one-fourth vesting on the third and fourth anniversaries of the grant date, respectively. The value of the restricted shares ($6.5 million) will be recognized as an expense to the Company over the four year vesting period. The Company also incurred $.6 million of professional fees and other expenses related to the executive transition.
Pursuant to the Plan, CNO issued 34.4 million shares of class A convertible exchangeable preferred stock with an aggregate liquidation preference of approximately $859.7 million. The preferred stock had a par value of $.01 per share and a liquidation preference of $25 per share. Dividends were payable semi-annually in additional shares of class A preferred stock on March 1 and September 1 at a rate equal to 10.5 percent of the liquidation preference per share. The class A preferred stock was redeemed in the second quarter of 2004, as further discussed below.
On the Effective Date, the Successor adopted a new long-term incentive plan, which permits the grant of CNO incentive or non-qualified stock options and restricted stock awards to certain directors, officers and employees of CNO and certain other individuals who perform services for the Company. A maximum of 10 million shares may be issued under the plan. During September 2003, the Company granted options to purchase 500,000 shares of CNO common stock at $16.40 per share and 500,000 restricted shares of CNO common stock to a former Chief Executive Officer in accordance with his employment agreement. The employment of such Chief Executive Officer was terminated in 2004. The amounts and benefits that our former Chief Executive Officer was entitled to receive are discussed in the note to the consolidated financial statements entitled "Other Disclosures" under the caption "Executive Termination". In addition, the Company granted options to purchase 500,000 shares of CNO common stock at $19.61 per share and 500,000 restricted shares of CNO common stock to the Chairman of the Board of Directors in accordance with his agreement. These options and restricted shares vest over a three-year period. During 2005 and 2004, the Company granted .2 million and 2.0 million restricted shares, respectively, of CNO common stock to certain directors, officers and employees of the Company at a weighted average fair value of $21.41 per share and $18.85 per share, respectively. The fair value of such grants totaled $4.7 million and $37.1 million in 2005 and 2004, respectively. Such amounts are recognized as compensation expense over the vesting period of the restricted stock. The vesting periods range from immediate vesting to a period of four years. We recognized compensation expense of $11.4 million, $13.7 million and $1.8 million in 2005, 2004 and the four months ended December 31, 2003, respectively, related to the vesting of restricted stock, net of forfeitures. At December 31, 2005 and 2004, the unrecognized compensation expense totaled $18.3 million and $27.2 million, respectively.
The four states with the largest shares of 2005 collected premiums were Florida (8.8 percent), California (7.3 percent), Texas (6.3 percent) and Pennsylvania (5.1 percent). No other state accounted for more than 5 percent of total collected premiums.
In accordance with SFAS 97, we are required to amortize the value of policies inforce in relation to estimated gross profits for universal life products and investment-type products. SFAS 97 also requires that estimates of expected gross profits used as a basis for amortization be evaluated regularly, and that the total amortization recorded to date be adjusted by a charge or credit to the statement of operations, if actual experience or other evidence suggests that earlier estimates should be revised.
During the second quarter of 2004, we evaluated certain amortization assumptions used to estimate gross profits for universal life products and investment-type products by comparing them to our actual experience. We made refinements to the previous assumptions related to investment income to match actual experience and our estimates for future assumptions. The changes we made did not affect our expectations for the total estimated profits to be earned on this business, but did affect how we expect the profits to emerge over time. These new assumptions resulted in a retroactive reduction to the amortization of the value of policies inforce at the Effective Date of $7.7 million 2004.
Changes in our predecessor's cost of policies purchased for the eight months ended August 31, 2003, were as follows (dollars in millions):
Changes in the cost of policies produced were as follows (dollars in millions):
Statutory capital and surplus included investments in upstream affiliates of $52.4 million at both December 31, 2005 and 2004, which were eliminated in the consolidated financial statements prepared in accordance with GAAP. In the second quarter of 2004, $106.6 million of affiliated preferred stock held by our insurance subsidiaries was redeemed by the parent using the proceeds from the refinancing of our Previous Credit Facility. In 2004, a non-cash dividend of $45.8 million representing affiliated preferred stock was paid to CDOC. In 2003, a non-cash dividend of $4.5 million representing affiliated common stock was paid to CDOC.
In addition, we may need to contribute additional capital to strengthen the surplus of certain insurance subsidiaries and this could affect the ability of our top tier insurance subsidiary to pay dividends. The ability of our insurance subsidiaries to pay dividends is also impacted by various criteria established by rating agencies for higher ratings. During 2005, we made capital contributions of $160.5 million to one of our insurance subsidiaries (Bankers Life & Casualty Company) in an effort to meet such criteria.
At December 31, 2005, the consolidated RBC ratio of our insurance subsidiaries exceeded the minimum risk-based capital requirement included in our Amended Credit Facility. 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 manage our business through the following: two primary operating segments, Bankers Life and Conseco Insurance Group, which are defined on the basis of product distribution; a third segment comprised of other business in run-off; and corporate operations, which consists of holding company activities and certain noninsurance businesses.
Fall Creek CLO Ltd. ("Fall Creek") is a collateralized loan trust that was established to issue securities and use the proceeds to invest in loans and other permitted investments. The assets held by the trust are legally isolated and are not available to the Company. The liabilities of Fall Creek will be satisfied from the cash flows generated by the underlying loans, not from the assets of the Company, which has no legal obligation to satisfy those liabilities. Repayment of the principal balance of the investment borrowings of Fall Creek begin in 2012 based on available cash flows from the assets and such borrowings mature in 2017. At December 31, 2005, our total investment in Fall Creek was $32.8 million. The following tables provide supplemental information about the assets, liabilities, revenues and expenses of Fall Creek which have been consolidated in accordance with FIN 46R, after giving effect to the elimination of our investment in Fall Creek and investment management fees earned by a subsidiary of the Company (dollars in millions):