Conseco generates earnings primarily by operating life insurance companies and providing services to affiliates and nonaffiliates for fees. In the past, Conseco was also active in acquiring and restructuring life insurance companies in partnership with other investors.
The Company's life insurance operations are conducted through four activities: (i) senior market operations, consisting of the activities of BLH; (ii) annuity operations, consisting of the activities of the Company's annuity companies (Great American Reserve and Beneficial Standard); (iii) other life insurance operations, consisting of the activities of the Company's other wholly owned subsidiaries (National Fidelity, Bankers National and Lincoln American), which have profitable blocks of business but do not currently market their products to new customers; and (iv) Partnership II operations, consisting of the activities of AGP.
Earnings in this segment increase when Conseco adds new clients (either affiliated or unaffiliated) and when Conseco increases the fee-producing activities conducted for clients.
Since commencing operations in 1982, Conseco has acquired 12 life insurance companies and related businesses. Conseco acquired the first seven as wholly owned subsidiaries and the last five through its acquisition partnership. Recent acquisition activity is described in notes 1 and 2 to the consolidated financial statements. All acquisitions have been accounted for as purchases. Therefore, activities of the acquired companies have been included in Conseco's results of operations beginning with the date of purchase.
The following table shows the sources of Conseco's fully diluted earnings per share for the last three years:
The following table analyzes changes in Conseco's fully diluted earnings per share:
Additional Discussion of Consolidated Statement of Operations for the Three Years Ended December 31, 1995:
The following tables and narratives summarize amounts reported in the consolidated statement of operations. Many of the changes from period to period resulted from: (i) the acquisition of AGP on September 29, 1994; and (ii) changes in Conseco's ownership in BLH, WNC and CCP.
Insurance policy income is comprised primarily of individual health premiums, which increased as a result of increases in Medicare supplement and long-term care premiums, partially offset by the decrease in major medical products that was anticipated due to prior steps taken to improve the profitability of this product.
Invested assets grew as a result of: (i) recurring operations; (ii) the recapture in 1994 and 1993 of reinsurance treaties with related assets totaling $371 million and $182 million, respectively; and (iii) capital transactions in connection with BLH's IPO, as discussed in the notes to the consolidated financial statements.
Net trading income and losses often fluctuate from year to year, based on market conditions for trading activities.
Net realized gains and losses often fluctuate from year to year. BLH sold approximately $1.0 billion of fixed maturity securities in 1995, $1.2 billion in 1994 and $2.2 billion in 1993. Net realized gains in 1995 were net of a $2.2 million writedown of certain exchange-rate linked securities as a result of currency fluctuations and a $5.0 million writedown of two corporate securities as a result of changes in conditions which caused BLH to conclude that a decline in their fair values was other than temporary.
Insurance policy income related to other individual health lines has declined over the last three years. BLH has taken steps to increase the profitability of these products; premiums have decreased as a result. Profitability of this line continues to be favorably impacted by such actions, as reflected in the improved ratio of policy benefits to insurance policy income.
Interest expense on annuities and financial products increased over the last three years as a result of the increase in annuity reserves due to: (i) the reinsurance recapture transactions described above; and (ii) increased new sales. At December 31, 1995, 1994 and 1993, the weighted average crediting rate for the Company's annuity liabilities, excluding interest bonuses guaranteed for the first year of the annuity contract, was 5.4 percent, 5.4 percent and 5.7 percent, respectively.
Amortization related to operations was primarily affected by: (i) the increase in the amount of business in force on which acquisition costs are capitalized and amortized in subsequent periods; and (ii) the increase in goodwill related to Conseco's purchases of additional shares of BLH's common stock on September 30, 1994 and in 1995.
Cost of policies purchased represents the portion of Conseco's cost to acquire BLH that is attributable to the right to receive cash flows from insurance contracts in force at the acquisition dates. Some costs incurred subsequent to the purchases on policies issued prior to such dates, which otherwise would have been deferred had it not been for the purchases (because they vary with and are primarily related to the production of the acquired interests in policies), are expensed. Such costs are primarily comprised of certain commissions paid in excess of ultimate commissions which have been expensed as operating expense. However, such amounts were considered in determining the cost of policies purchased and its amortization.
Amortization related to realized gains (losses) fluctuated in the last three years as a result of the changes in realized gains and losses discussed above.
Extraordinary charge related to BLH's prepayment of debt. The 1995 charge was primarily the result of BLH's retirement of its senior term loan using the proceeds from a $110.0 million credit facility. Conseco's share of this charge was $1.4 million. In 1993 BLH retired all of its junior notes, prepaid a portion of its senior term loan and repurchased $20 million of its Series B Senior Subordinated Notes, resulting in an extraordinary charge of $7.9 million. Conseco's share of this charge was $3.1 million.
General. The annuity operations include earnings from the former CCP subsidiaries, Beneficial Standard and Great American Reserve. As described in the notes to the consolidated financial statements, the CCP subsidiaries became wholly owned subsidiaries of Conseco upon the CCP Merger in August 1995. Conseco's consolidated statement of operations reflects these operations on the equity method in 1994 and 1993 based on Conseco's 42 percent and 37 percent average ownership of CCP during those years. Conseco's consolidated statement of operations reflects these operations on a consolidated basis in 1995, based on Conseco's 49 percent average ownership for the first eight months and 100 percent ownership for the last four months of the year. The minority interest adjustment removes from Conseco's net income the portion applicable to other owners during the 1995 period prior to the CCP Merger.
Net investment income increased 6.9 percent in 1995 and decreased 11 percent in 1994. Average invested assets (amortized cost basis) increased 3.5 percent in 1995 to $4.8 billion and increased 1.0 percent in 1994 to $4.7 billion. For 1995 compared to 1994, the percentage increase in net investment income was greater than the percentage increase in average invested assets because: (i) the yield earned on average invested assets increased to 8.2 percent in 1995 from 7.9 percent in 1994; (ii) net investment income generated on dollar-roll transactions increased to $11.7 million in 1995 from $6.7 million in 1994; and (iii) net investment income on separate account assets increased to $19.2 million in 1995 from $2.3 million in 1994. Net investment income from separate account assets for all periods is offset by a corresponding change to interest expense on annuities and financial products. For 1994 compared to 1993, the percentage increase in net investment income was less than the percentage increase in average invested assets because: (i) the yield earned on average invested assets decreased to 7.9 percent in 1994 from 8.9 percent in 1993; and (ii) net investment income from separate account assets decreased to $2.3 million from $11.8 million in 1993.
Interest expense on notes payable increased in 1995 as a result of a higher average notes payable balance which were subject to higher interest rates in 1995. The decrease in 1994 resulted from lower interest rates on a lower average notes payable balance. The average principal balance of notes payable during 1995, 1994 and 1993 was $178 million, $143 million and $210 million, respectively.
Amortization related to net realized gains (losses) fluctuated in the last three years as a result of the fluctuations in realized gains and losses discussed above.
Other operating costs and expenses decreased in 1995 as a result of restructurings made under the Company's expense reduction program.
Insurance policy income related primarily to premiums from products with mortality and morbidity features. Recent declines have resulted from decreased emphasis on generating new premiums from such products.
Net realized gains and losses often fluctuate from year to year. The other life insurance subsidiaries sold fixed maturity securities of $.2 billion in 1995, $.2 billion in 1994 and $.6 billion in 1993. The effect of these sales on the amortization of cost of policies purchased and cost of policies produced is discussed above under BLH. Net realized gains (losses) increased (decreased) amortization of the cost of policies purchased and the cost of polices produced by $1.0 million in 1995, $(2.1) million in 1994 and $11.5 million in 1993.
Amortization related to operations decreased in 1995 and 1994 as a result of the previously discussed reinsurance recapture and recent decline in premiums.
Other operating costs and expenses did not change materially over the last three years.
Net investment income increased 21 percent in 1995 and 13 percent in the 1994 periods. Average invested assets (amortized cost basis) increased 7 percent to $4.7 billion in 1995 compared to $4.4 billion in the 1994 periods. The percentage increase in net investment income was greater than the percentage increase in average invested assets because the yield earned on average invested assets increased to 8.8 percent in 1995 from 7.9 percent in 1994. The increase in yield primarily resulted from the application of purchase accounting on the Acquisition date, as discussed above. Average invested assets (amortized cost basis) increased 19 percent, to $4.4 billion in 1994 from $3.7 billion in 1993. The percentage increase in net investment income was less than the percentage increase in average invested assets because the yield earned on average invested assets decreased to 7.9 percent in the 1994 periods from 8.3 percent in 1993. The decrease in yield resulted from the cash flows received during 1994 and 1993 being invested in lower yielding securities due to the general decline in interest rates during 1993, partially offset by the increase in yields during the fourth quarter of 1994 because of the application of purchase accounting. Redemption of fixed maturity investments prior to their regularly scheduled maturity dates resulted in additional investment income of approximately $5.9 million in 1993 and insignificant income in both 1995 and 1994.
Net realized gains (losses) and net trading income (losses) often fluctuate from period to period. AGP sold approximately $2.8 billion of investments (principally fixed maturities) in 1995, $1.1 billion in the 1994 periods and $2.2 billion in 1993. Such sales resulted in net realized gains of $154.9 million and trading income of $1.5 million in 1995, net realized gains of $6.2 million in the 1994 periods and net realized gains of $19.5 million in 1993. Net realized gains from sales of investments in the 1994 periods were offset by a loss on certain interest rate swap contracts that no longer effectively hedged interest rate risks in the second quarter of 1994 and were therefore recorded at fair value, resulting in a net realized loss of $21.3 million. Substantially all of AGP's interest rate swap contracts were terminated after the Acquisition with no additional loss. In addition, during 1995 and the 1994 periods, AGP recorded realized losses on the writedown of investments totaling $7.1 million and $1.2 million, respectively, as a result of changes in conditions which caused AGP to conclude that a decline in fair value of the investments was other than temporary. In 1993, AGP's net realized gains were net of a $.6 million increase to its mortgage loan valuation reserve. Net realized gains increased the amortization of the cost of policies purchased and the cost of policies produced by $83.4 million in 1995, $2.8 million in the 1994 periods and $9.8 million in 1993.
The effect of net realized gains (losses) on the amortization of cost of policies purchased and the cost of policies produced is discussed above under BLH.
Interest expense on notes payable increased in 1995 and the 1994 periods as a result of the full year effect in 1995 of interest on debt incurred in 1994 to finance the Acquisition, partially offset by reductions in interest expense resulting from: (i) the conversion and retirement of $9.2 million principal amount of the Convertible Debentures during 1995 and $44.8 million in the 1994 periods; and (ii) the repayment of subsidiary bank debt that had been outstanding prior to the Acquisition.
Interest expense on investment borrowings increased to $7.7 million in 1995 from $2.8 million in the 1994 periods as a result of increased investment borrowing activity and higher interest rates paid on such borrowings during 1995. There was no investment borrowing activity in 1993.
Amortization related to operations increased 11 percent in 1995 over the 1994 periods and 22 percent in the 1994 periods compared to 1993. Such increase reflects a larger asset balance subject to amortization as a result of the Acquisition and the increase in in-force business.
Extraordinary charge incurred in 1995 related to debt issuance costs that were written off when the former senior loan was paid off with the proceeds of new bank financing, resulting in a net extraordinary charge of $4.0 million. Conseco's share of this charge was $.7 million.
Acquisition and merger expenses incurred by AGP include, among other items, compensation expense recognized upon the cash redemption of certain unexercised stock options and stock appreciation rights upon consummation of the Acquisition.
Prior to the completion of its IPO, WNC was a wholly owned subsidiary of Conseco. Conseco sold 60 percent of WNC in the IPO. Conseco sold its remaining 40 percent equity interest in WNC on December 23, 1994. Amounts included in Conseco's accounts for the year ended December 31, 1994, therefore include: (i) all of WNC's earnings from January 1 through February 15, 1994, the date the IPO was completed; and (ii) 40 percent of WNC's earnings from February 15 through December 23, 1994.
Net investment income fluctuates based on the amount of average invested assets held by this segment during the periods presented. Additionally in 1995, investment income was received on certain fixed maturity investments on which no investment income was accrued in prior periods because they were in default.
Interest expense on notes payable increased to $50.1 million in 1995 from $27.8 million in 1994 as a result of: (i) increases in borrowings under bank credit facilities primarily used to finance the CCP Merger and the purchase of additional shares of BLH; and (ii) interest expense on the $200 million 10.5 percent senior notes issued by CCP for periods after August 31, 1995, the CCP Merger date (such senior notes became direct obligations of Conseco at the CCP Merger date). These increases were partially offset by the repayment of: (i) a $200 million note in February 1994; and (ii) notes payable with book values totaling $19.2 million in March 1994. The Company prepaid the aforementioned notes in 1994 with the proceeds from the sale of shares of WNC. The prepayment resulted in an extraordinary charge in the first quarter of 1994 of $1.9 million (net of a $1.0 million tax benefit). The decrease in the account in 1994 from 1993 was primarily the result of the aforementioned repayments in 1994.
Other operating costs and expenses fluctuated over the last three years principally as the result of compensation expense based on the Company's earnings.
Total premium collections by the companies in which Conseco has ownership interests were as follows:
Premiums collected by senior market operations in 1995 were $1,513.8 million, of which $272.8 million were recorded as deposits to policy liability accounts. This compares with $1,534.5 million collected and $316.3 million recorded as deposits in 1994; and $1,464.7 million collected and $263.7 million recorded as deposits in 1993.
Medicare supplement policies accounted for approximately 39 percent of BLH's total collected premiums over the last three years. The rate of growth in premiums from Medicare supplement policies decreased in 1995, due to the competitive environment, changes in the commission structure to improve the profitability of this product, and an increased focus on sales of other products. The number of new Medicare supplement policies sold in 1995 decreased 30 percent to 62,800 from 1994, following a 3 percent decrease in 1994 from 1993. Annualized new business premiums from such new sales totaled $56.3 million in 1995 compared with $76.3 million in 1994 and $80.5 million in 1993.
Long-term care premiums accounted for 10 percent, 8.6 percent and 7.8 percent of total collected premiums in 1995, 1994 and 1993, respectively. The continued growth in this product line reflects new product introductions, the competitiveness of BLH's existing products, the success of agent cross-selling activities, increased consumer awareness and demand and improved persistency on a larger base of renewal premiums. Annualized new business premiums were $40.9 million, $27.9 million and $21.6 million in 1995, 1994 and 1993, respectively.
Annuity premiums collected decreased by 10 percent in 1995 following a 22 percent increase in 1994. The decrease in 1995 reflects increased competition from alternative investment products.
Collected premiums for other individual health products decreased by 20 percent in 1995 following an 18 percent decrease in 1994. This decrease, which was anticipated, follows steps taken previously to improve the profitability of the comprehensive major medical product included in this category.
Premiums collected by other life insurance operations were $80.0 million, $83.0 million and $142.2 million in 1995, 1994 and 1993, respectively. These subsidiaries are no longer writing new business, except that during 1995, 1994 and 1993, they collected $6.6 million, $5.6 million and $61.8 million, respectively, of premiums from guaranteed investment contracts and deposit funds for qualified retirement plans maintained by the Company.
Premiums collected by Partnership II operations were $825.6 million in 1995 and $284.4 million for the three months ended December 31, 1994. AGP's products include single premium deferred annuities, flexible premium deferred annuities, interest sensitive life insurance products (including universal life insurance), traditional life insurance products and accident and health insurance products. Of the $825.6 million in premiums collected in 1995, 91 percent was from sales of annuities (primarily SPDAs and FPDAs), 6 percent was from life insurance products, 3 percent from single premium immediate annuities and less than 1 percent from accident and health insurance products.
For the full year 1994 and 1993, premiums collected were $1,129.1 million and $1,064.9 million, respectively. Sales of annuities declined in 1995 as the result of several factors. The demand for annuity products offered by all insurance companies decreased during 1995. Such decrease is believed to be attributable to increased competition from products such as mutual funds, traditional bank investments and other investment and retirement funding alternatives. In addition, AGP has generally maintained a less competitive crediting rate position on new business since the Acquisition in order to manage its asset growth relative to its capital position.
Although investment income is a significant component of total revenues, the profitability of Conseco's annuity business is determined primarily by spreads between interest rates earned and rates credited on annuity contracts. At December 31, 1995, the average yield, computed on the cost basis of the Company's investment portfolio, was 8.0 percent and the average interest rate credited on the Company's total liability portfolio was 5.3 percent, excluding interest bonuses guaranteed for the first year of the contract.
At December 31, 1995, the Company's fixed maturity portfolio had net unrealized gains of $608.2 million (equal to approximately 4.7 percent of the portfolio's carrying value), consisting of $663.3 million of unrealized gains and $55.1 million of unrealized losses. Estimated fair values for fixed maturity investments were determined based on estimates from nationally recognized pricing services (88 percent of the portfolio), broker-dealer market makers (11 percent of the portfolio) and internally developed methods.
Conseco periodically evaluates the creditworthiness of each issuer whose securities are held in the portfolio. Special attention is paid to those securities whose market values have declined materially for reasons other than changes in interest rates or other general market conditions. The Company considers available information to evaluate the realizable value of the investment, the specific condition of the issuer, and the issuer's ability to comply with the material terms of the security. Information reviewed may include the recent operational results and financial position of the issuer, information about its industry, recent press releases and other information. Conseco employs a staff of experienced securities analysts in a variety of specialty areas. Among other responsibilities, this staff compiles and reviews such evidence. If evidence does not exist to support a realizable value equal to or greater than the carrying value of the investment and such decline in market value is determined to be other than temporary, Conseco reduces the
As of December 31, 1995, the amortized cost and estimated fair value of fixed maturity investments in substantive default (i.e., in default due to nonpayment of interest or principal) were $3.3 million and $3.2 million, respectively. The Company had no fixed maturity investment in technical (but not substantive) default (i.e., in default, but not as to the payment of interest or principal). There were no other fixed maturity investments about which management had serious doubts as to the ability of the issuer to comply on a timely basis with the material terms of the instruments.
Support classes absorb the prepayment risk from which planned amortization and targeted amortization classes are protected. As such, they are usually extremely sensitive to prepayments. Most of the Company's support classes are higher average life instruments that generally will not lengthen if interest rates rise further and will have a tendency to shorten if interest rates decline. However, since these bonds have costs below par values, higher prepayments will have the effect of increasing yields.
The degree to which a mortgage-backed security is susceptible to income fluctuations is influenced by: (i) the difference between its cost and par; (ii) the relative sensitivity of the underlying mortgages backing the security to prepayment in a changing interest rate environment; and (iii) the repayment priority of the security in the overall securitization structure. The Company limits the extent of these risks by : (i) purchasing securities which are backed by collateral with lower prepayment sensitivity (such as mortgages priced at a discount to par value and mortgages that are extremely seasoned); (ii) avoiding securities whose values are heavily influenced by changes in prepayments (such as interest-only and principal-only securities); and (iii) investing in securities structured to reduce prepayment risk (such as planned amortization class ("PAC") and targeted amortization class ("TAC") collateralized mortgage obligations). PAC and TAC instruments represented approximately 30 percent of the Company's mortgage-backed securities at December 31, 1995. The call-adjusted modified duration of the Company's mortgage-backed securities at December 31, 1995, was 6.0 years.
If the Company determines that it will dispose of an investment held in the actively managed fixed maturity category, Conseco will either sell the security or transfer it to the trading account at its fair value; the gain or loss is recognized immediately. There were no such transfers in 1995. During 1995, the Company sold actively managed fixed maturity securities with a $5.5 billion book value, resulting in $236.7 million of investment gains (before related expenses, amortization and taxes). Such securities were sold in response to changes in the investment environment which created opportunities to enhance the total return of the investment portfolio without adversely affecting the quality of the portfolio or the matching of expected maturities of assets and liabilities. The realization of gains and losses affects the timing of the amortization of the cost of policies produced and the cost of policies purchased, as explained in note 11 to the consolidated financial statements.
At December 31, 1995, the Company held mortgage loan investments with a carrying value of $339.9 million (or 2.4 percent of total invested assets) and a fair value of $363.3 million. Substantially all of the mortgage loan investments were commercial loans. Approximately 2 percent of the Company's mortgage loan balance consisted of investments in junior and residual interests of CMOs. Investments in junior and residual interests of CMOs are instruments that entitle the Company to the excess cash flows arising from the difference between: (i) the cash flows required to make principal and interest payments on the related senior interests in the CMOs; and (ii) the actual cash flows received on the mortgage loan assets included in the CMO portfolios. If prepayments vary from projections on the mortgage loan assets included in such CMO portfolios, the total cash flows to the Company from such junior and residual interests could change from projected cash flows, resulting in a gain or loss.
As a result of the CCP Merger, the accounts of the subsidiaries of CCP are consolidated with Conseco's, effective January 1, 1995. The effect of the consolidation on the accounts of Conseco is summarized in note 1 to the consolidated financial statements.
Of the above insurance liabilities under contracts containing fixed payment dates, approximately 36 percent related to payments that will be made for the lifetime of the contract holder. Expected mortality is considered in determining the amount of this liability. The remaining insurance liabilities with fixed payment dates are payable regardless of the contract holder's survival.
Approximately 13 percent of insurance liabilities were subject to an average interest rate of approximately 7 percent, fixed for the life of the contract. The remaining liabilities generally were subject to interest rates that could be reset at least annually.
The Company believes that it has adequate short-term investments and readily marketable investment grade securities to cover the payments under contracts containing fixed payment dates plus any likely cash needs for all other contracts. The Company's investment portfolio at December 31, 1995, included $.2 billion of short-term investments, $4.3 billion of U.S. Government/agency and mortgage-backed securities and $11.5 billion of publicly traded investment grade bonds. The Company believes that such investments could be readily sold at or near carrying value or used to facilitate borrowings under reverse repurchase agreements. At December 31, 1995, the Company's portfolio of bonds, notes and redeemable preferred stocks had an aggregate unrealized gain of $608.2 million.
BLI's ability to service its obligation under the surplus debenture depends upon its ability to receive dividend and tax sharing due from Bankers Life. Bankers Life may pay dividends up to $86.0 million without regulatory approval during 1996. Under an intercompany tax sharing agreement, Bankers Life remits tax payments to BLI based upon its tax liabilities calculated on a separate company basis.
At December 31, 1995, BLH's debt service obligations included a $110.0 million principal amount revolving credit facility due in 1996 and $180 million principal amount of senior subordinated notes due in 2002. Future annual debt service requirements are discussed in note 8 to the consolidated financial statements. Significant changes occurring after January 1, 1996, in these debt instruments are discussed in note 16 to the consolidated financial statements.
In addition, depending on the outcome of the AGP Litigation as described in note 2 to the consolidated financial statements, dividends may be payable on the 1988 Series Preferred Stock. The 1988 Series Preferred Stock provides for cumulative annual dividends of approximately $1.1 million. Cumulative dividends in arrears on the 1988 Series Preferred Stock through December 31, 1995, were $7.0 million, of which $5.5 million have been accrued.
At December 31, 1995, the parent company and its non-life subsidiaries had short-term investments of $24.2 million, of which $5.8 million was expended in January 1996 for accrued interest and dividends. The life subsidiaries are permitted to distribute $97.9 million to the parent company in 1996. The parent company and its non-life subsidiaries had additional investments in nonaffiliates of $11.2 million at December 31, 1995, which, if needed, could be liquidated or contributed to the insurance subsidiaries. Conseco believes that it could generate additional liquidity, if needed in the future, through equity offerings, debt issuance, borrowing additional amounts under its Credit Agreement with a group of banks as discussed in note 8 to the consolidated financial statements, or the conversion of existing assets to cash, including the sale of a partial or entire interest in its affiliates.
As described in the preceding section, Conseco receives funds from its wholly owned insurance subsidiaries from dividends and fees for shared expenses, tax sharing payments, and principal and interest on surplus debentures. Annual dividends in excess of maximum amounts prescribed by state statutes (so-called "extraordinary dividends") may not be paid without the approval of the insurance commissioner of each state of domicile.
Statutory operating results and statutory surplus are determined according to statutes adopted by each state in which the subsidiaries do business. Statutory surplus bears no direct relationship to equity as determined under generally accepted accounting principles ("GAAP"). With respect to new business, statutory accounting practices require that: (i) acquisition costs and (ii) reserves for future guaranteed principal payments and interest in excess of statutory rates, be expensed in the year the new business is written. These items cause a statutory loss ("surplus strain") on many insurance products in the year they are issued. The Company designs its products to minimize such first-year losses, but certain products continue to cause a statutory loss in the year written. For each product, the Company controls the amount of new premiums written in order to manage the effect of such statutory surplus strain.
Note 13 to the consolidated financial statements shows the difference between pretax income reported using statutory accounting practices (before deduction of expenses paid to affiliates and transfers to and from amortization of IMR) and GAAP.
Medical cost inflation has had a significant impact on BLH's operations. In recent years, these costs have increased more than increases in the Consumer Price Index. Medical costs will likely continue to rise. The impact on BLH's operations depends upon its ability to increase its premium rates. Such increases are subject to approval by the insurance departments of each state in which BLH sells its products. Prior to the standardization of Medicare supplement plans, approximately two-thirds of the states permitted rate plans with automatic escalation clauses. This permitted BLH, in periods following initial approval, to adjust premium rates for changes in Medicare deductibles and increases in medical cost inflation without refiling with the regulators. Currently, all rate changes for standardized plans must be individually approved by each state. BLH's pricing of its new standardized supplement plans reflects the impact of these filings and the lengthening of the period required to implement rate increases.
LPG is a recognized leader in the sale of universal life insurance and has recently increased its annuity sales results. Upon completion of the LPG merger, Conseco intends to concentrate on programs to increase the effectiveness of LPG's marketing programs and to seek ways to cross-sell LPG products in Conseco's other marketing programs and provide other Conseco products to LPG's marketing force.
Conseco believes that the statutory surplus of its insurance subsidiaries and investees is adequate. Conseco believes that statutory earnings in 1996 will exceed amounts needed by the holding companies for debt service and other requirements. Such excesses would increase statutory capital of the life insurance subsidiaries and investees so that their internal growth can continue.
Conseco's ability to complete acquisitions that achieve those objectives depends on a number of external factors, including: (i) the attitudes of rating agencies toward Conseco's strategic plan and capital structure; (ii) the availability and cost of both debt and equity capital; (iii) pressures that motivate companies to seek to be acquired at a reasonable cost; and (iv) competition from other acquirers, which affects the cost of acquisitions.
As part of its program of exploring opportunities to improve its capital structure, Conseco continually reviews its corporate structure and the need and desirability of restructuring the existing debt and equity of the Company and its affiliates.
Management of Conseco, Inc. is responsible for the reliability of the financial information in this annual report. The financial statements are prepared in accordance with generally accepted accounting principles, and the other financial information in this annual report is consistent with that of the financial statements (except for such information described as being in accordance with regulatory or statutory accounting requirements).
The Audit Committee of the Board of Directors, composed solely of nonmanagement directors, meets periodically with management, internal auditors and the independent accountants to review internal accounting control, audit activities and financial reporting matters. The internal auditors and the independent accountants have full and free access to the Audit Committee.
Stephen C. Hilbert Rollin M. Dick Chairman of the Board, Executive Vice President and President and Chief Financial Officer Chief Executive Officer
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Conseco, Inc. and Subsidiaries as of December 31, 1995 and 1994, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1995, in conformity with generally accepted accounting principles.
CONSOLIDATED BALANCE SHEET December 31, 1995 and 1994 (Dollars in millions)
CONSOLIDATED BALANCE SHEET (Continued) December 31, 1995 and 1994 (Dollars in millions)
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY for the years ended December 31, 1995, 1994 and 1993 (Dollars in millions)
CONSOLIDATED STATEMENT OF CASH FLOWS for the years ended December 31, 1995, 1994 and 1993 (Dollars in millions)
Conseco, Inc. ("We," "Conseco" or "the Company") is a financial services holding company engaged primarily in the development, marketing and administration of annuity, supplemental health and individual life products. Conseco's earnings result primarily from: (i) operating life insurance companies; and (ii) providing investment management, administrative and other fee-based services to affiliated businesses as well as non-affiliates. Conseco's operating strategy is to grow the insurance business within its subsidiaries by focusing its resources on the development and expansion of profitable products and strong distribution channels. Conseco has supplemented such growth by acquisitions of companies that have profitable niche products, strong distribution systems and progressive management teams who can work with Conseco to implement Conseco's operating and growth strategies. Once a company has been acquired, Conseco's operating strategy has been to consolidate and streamline management and administrative functions, to realize superior investment returns through active asset management, to eliminate unprofitable products and distribution channels, and to expand the profitable distribution channels and products. Our principal wholly owned life insurance subsidiaries are Great American Reserve Insurance Company ("Great American Reserve"), Beneficial Standard Life Insurance Company ("Beneficial Standard"), Bankers National Life Insurance Company ('Bankers National"), National Fidelity Life Insurance Company ("National Fidelity") and Lincoln American Life Insurance Company ("Lincoln American"). We also own 88 percent (90.5 percent as of March 5, 1996) of the common stock of Bankers Life Holding Corporation ("BLH"), which is the holding company for Bankers Life and Casualty Company ("Bankers Life"); and through our interests in Conseco Capital Partners II, L.P. ("Partnership II") and our direct investments, we have a 36 percent ownership interest in American Life Group, Inc. ("AGP") (formerly known as The Statesman Group, Inc. prior to its name change in August 1995).
CCP Insurance, Inc. ("CCP"), a newly organized holding company for Partnership I's first three acquisitions, completed an initial public offering (IPO) in July 1992. As a result of the IPO, we no longer had unilateral control over those entities and stopped including their accounts in our consolidated financial statements. We carried our investment in CCP and its subsidiaries in our financial statements on the equity basis in 1994 and 1993. As described in note 2, in August 1995, Conseco completed the purchase of all the shares of common stock of CCP we did not previously own in a transaction pursuant to which CCP was merged with Conseco, with Conseco being the surviving corporation (the merger and related transactions are referred to herein as the "CCP Merger"). As a result, CCP's subsidiaries (Great American Reserve and Beneficial Standard) became wholly owned subsidiaries of the Company. The Company's consolidated statements reflect the operations of CCP on a consolidated basis effective January 1, 1995.
BLH's former owner continued to own 40 percent of BLH following Partnership I's acquisition of BLH in 1992. Partnership I and Conseco were therefore required to account for that acquisition as a "step acquisition transaction" in accordance with the guidance provided in Issue Number 88-16 of the Emerging Issues Task Force of the Financial Accounting Standards Board entitled "Basis in Leveraged Buyout Transactions." We also used step acquisition accounting when we bought more BLH stock in September 1993 and during 1995. As a result, the assets and liabilities of BLH included in Conseco's 1995 consolidated balance sheet represent the following combination of values: (i) the portion of BLH's net assets acquired by Conseco in the November 1992 acquisition made by Partnership I is valued as of that acquisition date; (ii) the portion of BLH's net assets acquired in September 1993 is valued as of that date; (iii) the portion of BLH's net assets acquired during 1995 is valued as of the date of their purchase (for accounting convenience June 30, 1995, has been used); and (iv) the portion of BLH's net assets owned by minority interests is valued based on a combination of the former owner's historical bases of net assets acquired in the initial acquisition in 1992 and the values defined in clause (i).
Western National Corporation ("WNC"), a company formed in October 1993 to be the holding company for Western National Life Insurance Company ("Western National"), completed an IPO in February 1994. Prior to the IPO, WNC was a wholly owned subsidiary of Conseco. We sold 60 percent of our equity interest in the IPO. As a result of the IPO, we no longer had unilateral control of WNC and we ceased including the accounts of WNC in our consolidated financial statements as of January 1, 1994. We sold our remaining 40 percent interest in WNC on December 23, 1994 (refer to note 2 for further discussion of the transactions involving WNC). Our equity in earnings of WNC in 1994 therefore reflected: (i) all of WNC's earnings for the period through February 15, 1994; and (ii) 40 percent of WNC's earnings for the period from February 15, 1994, through December 23, 1994.
On November 30, 1995, AGP issued 2,142,857 shares of its common stock for $30.0 million (including $13.2 million paid by Conseco and its subsidiaries) in a private placement transaction. Eighty percent of the shares were purchased by Partnership II and the remainder were purchased by the other holders of AGP's common stock. Conseco's ownership interest in AGP increased to 36 percent at December 31, 1995, as the result of this transaction and changes in our ownership of BLH and CCP (which have ownership interests in Partnership II and its subsidiaries), partially offset by the following transactions which occurred in December 1994: (i) the sale of Conseco's remaining equity interest in WNC; and (ii) the sale of a portion of its investment in AGP to an unaffiliated company.
Held to maturity - (all other fixed maturities) securities which we have the ability and positive intent to hold to maturity. When we own such securities, we carry them at amortized cost. We may dispose of these securities if the credit quality of the issuer deteriorates, if regulatory requirements change or under other unforeseen circumstances. We have not held any held to maturity securities since implementing SFAS 115.
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 which 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 contract holders. We record the related liabilities at amounts equal to the underlying assets; the fair value of these liabilities is equal to their carrying amount.
discounted present value of such expected future profits equals the unamortized asset balance (this rate may not exceed the rate initially used and may not be lower than the rate earned on invested assets). For acquisitions made after November 19, 1992, we adjust amortization consistent with the methods used with the cost of policies produced (described below).
Goodwill is the excess of the amount we paid to acquire a company over the fair value of its net assets. We amortize goodwill on the straight-line basis over a 40-year period. We continually monitor the value of our goodwill based on our estimates of future earnings. We determine whether goodwill is fully recoverable from projected undiscounted net cash flows from earnings of the subsidiaries over the remaining amortization period. If we were to determine that a material change has occurred in the factors supporting recoverability of goodwill over the remaining amortization period, we would reduce its carrying value with a corresponding charge to expense or shorten the amortization period (no such changes have occurred.).
We carry property and equipment at depreciated cost. We depreciate property and equipment on a straight-line basis over the estimated useful lives of the assets, which average approximately 13 years. Our depreciation expense was $9.3 million in 1995, $8.3 million in 1994 and $6.0 million in 1993.
Our reserves for traditional and limited-payment life contracts are generally calculated using the net level premium method, based on assumptions as to investment yields, mortality, withdrawals and dividends. We make these assumptions at the time the contract is issued or, in the case of contracts acquired by purchase, at the purchase date. We base these assumptions on projections from past experience, modified as necessary to reflect anticipated trends and making allowance for possible unfavorable deviation.
Our income tax expense includes deferred income taxes arising from temporary differences between the tax and financial reporting basis of assets and liabilities. This liability method of accounting for income taxes also requires us to reflect the effect of a tax rate change on accumulated deferred income taxes in income in the period in which the change is enacted.
Our consolidated financial statements include all of the assets, liabilities, revenues and expenses of BLH, AGP (since its acquisition by Partnership II on September 29, 1994), and CCP (since January 1, 1995, as a result of the CCP Merger). We make a charge against consolidated income for the share of earnings allocable to the minority interests. We show the shareholders' equity of such entities allocable to the minority interests separately on our consolidated balance sheet.
We compute primary net income per share by dividing earnings less preferred dividend requirements by the weighted average number of common and common equivalent shares outstanding for the period. We compute fully diluted net income per share on the same basis, except that, if more dilutive: (i) the number of common equivalent shares related to stock options is based on the period- end market value of the shares, instead of the average market value; and (ii) convertible preferred stock is assumed to be converted into common shares. We have restated all share and per share amounts for the April 1, 1996 two-for-one stock split.
During the preparation of financial statements in conformity with GAAP we are required to make estimates and assumptions that affect the reported assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the preparation period. Actual results could differ from those estimates. We utilize significant estimates and assumptions in the calculation of cost of policies produced, cost of policies purchased, goodwill, insurance liabilities, guaranty fund assessment accruals and deferred income taxes. It is reasonably possible that actual experience could differ from the estimates and assumptions utilized which could have a material impact on the financial statements.
Securities segregated for the future redemption of redeemable preferred stock of a subsidiary. Estimated fair values of the U.S. Treasury securities held in escrow for the future redemption of redeemable preferred stock of a subsidiary of AGP are based on quoted market prices.
In August 1995, we completed the purchase of all of the shares of common stock of CCP we did not previously own. A total of 11.8 million shares were purchased for $281.8 million (including transaction costs and the cost to settle outstanding stock options of CCP) in a transaction pursuant to which CCP was merged with Conseco, with Conseco being the surviving corporation. Income tax expense was reduced by $8.4 million in the third quarter of 1995 as a result of the release of deferred income taxes previously accrued on income related to CCP. Such deferred tax is no longer required because the CCP Merger was completed without incurring additional tax.
On March 25, 1993, BLH completed an IPO of 19.6 million shares of its common stock at $22 per share. Proceeds from the offering of $405.3 million (after underwriting and issuance costs) were used by BLH to redeem all outstanding preferred stock, to retire all junior subordinated debt, to prepay a portion of the senior debt and for other corporate purposes. After the offering, Conseco owned 31 percent of the common shares of BLH. As a result of the offering, Conseco recorded a one-time gain of $58.8 million (net of tax of $40.4 million) in the first quarter of 1993, representing Conseco's direct percentage share of the increase in BLH's shareholders' equity account attributable to the proceeds from the offering. In addition, Conseco recorded a gain of $2.2 million (net of tax of $.1 million) in the first quarter of 1993, representing Conseco's indirect percentage share (through the Company's ownership of CCP) of CCP's percentage share of the increase in BLH's shareholders' equity account attributable to the proceeds from the offering. The Partnership I agreement provided for incentive compensation to Conseco as the general partner in the event that returns to the limited partners were in excess of prescribed targeted returns. The distribution of BLH shares to the limited partners caused such targets to be exceeded, resulting in incentive compensation to Conseco of $22.3 million, net of tax of $14.3 million.
The acquisition of additional shares of BLH common stock by Conseco and share repurchases by BLH in 1995 had the following effects on Conseco's consolidated balance sheet accounts as of the acquisition dates (dollars in millions):
Conseco acquired all the outstanding common stock of Bankmark in 1993 and 1995 for $6.6 million. Bankmark is a marketing company which develops marketing relationships with financial institutions to provide insurance and investment products to their customers.
On November 30, 1995, AGP issued 2,142,857 shares of its common stock for $30.0 million (including $13.2 million paid by Conseco and its subsidiaries) in a private placement transaction. Eighty percent of the shares were purchased by Partnership II and the remainder were purchased by the other holders of AGP's common stock. The proceeds from the sale were used to reduce the amount of AGP's outstanding debt (see note 8). In accordance with the Partnership II agreement, Conseco earned fees of $.2 million (net of taxes of $.1 million) for services in connection with such transaction.
The following unaudited pro forma results of operations of the Company are presented as if the following had occurred as of January 1, 1994: (i) the CCP Merger; (ii) the acquisition of additional shares of BLH common stock in 1995; (iii) the acquisition of AGP by Partnership II; (iv) the IPO of WNC; and (v) the sale by Conseco of its remaining 40 percent equity interest in WNC.
The following unaudited pro forma results of operations of the Company are presented as if the following had occurred as of January 1, 1993: (i) Partnership II's acquisition of AGP; (ii) the IPO of WNC; (iii) the sale by Conseco of its remaining 40 percent equity interest in WNC; (iv) the IPO of BLH; and (v) Conseco's purchases in 1993 of additional shares of BLH and CCP. Prior operations of Bankmark are not included in the following table; the effect is not material.
The amortized cost and estimated fair value of actively managed fixed maturities were as follows at December 31, 1994:
The following table sets forth below investment grade fixed maturity investments as of December 31, 1995, summarized by the amount their amortized cost exceeds fair value:
The following table sets forth the amortized cost and estimated fair value of actively managed fixed maturities at December 31, 1995, by contractual maturity. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties and because most mortgage-backed securities provide for periodic payments throughout their lives.
At December 31, 1995, the amortized cost and fair value of fixed maturity investments in default as to the payment of principal or interest totaled $3.3 million and $3.2 million, respectively. Conseco recorded writedowns of fixed maturity investments of $21.9 million in 1995, $1.0 million in 1994 and $7.9 million in 1993. These writedowns were the result of changes in conditions which caused the Company to conclude that it would not collect all amounts due according to the terms of the securities.
Investments in mortgage-backed securities at December 31, 1995, included collateralized mortgage obligations ("CMOs") of $2,055.9 million and mortgage-backed pass-through securities of $1,963.2 million. CMOs are securities backed by pools of pass-through securities and/or mortgages that are segregated into sections or "tranches." These securities provide for sequential retirement of principal, rather than the pro rata share of principal return which occurs through regular monthly principal payments on pass-through securities.
At December 31, 1995, the mortgage loan balance was primarily comprised of commercial loans, including multifamily residential loans. Approximately 40 percent, 9 percent and 7 percent of the mortgage loan balance were on properties located in California, Texas and Indiana, respectively. No other state comprised greater than 6 percent of the mortgage loan balance. Less than 1 percent of the mortgage loan balance was noncurrent at December 31, 1995. At December 31, 1995, the Company had an allowance for loss on mortgage loans of $5.2 million.
As part of its investment strategy, the Company enters into reverse repurchase agreements and dollar-roll transactions to increase its return on investments and improve its liquidity. These transactions are accounted for as short-term collateralized borrowings. Such borrowings averaged approximately $393.7 million during 1995 (compared to an average of $208.0 million during 1994) and were collateralized by investment securities with fair values approximately equal to the loan value. The weighted average interest rate on short-term collateralized borrowings was 5.6 percent in 1995 and 3.7 percent in 1994.
Asset-backed securities issued by a single entity in excess of ten percent of shareholders' equity at December 31, 1995, other than mortgage-backed securities issued or guaranteed by the United States Government or a United States Government agency, were as follows. Asset-backed securities issued by non-government entities are aggregated by the issuing entity with the number of individual securities (if greater than one) identified parenthetically following the issuer's name. The creditworthiness of such asset- backed securities is based solely on the underlying segregated pools of asset loan collateral and related credit enhancements rather than the general creditworthiness of the issuing entity.
See note 2 for a description of transactions affecting Conseco's ownership of CCP. As a result of the CCP Merger, CCP was merged with Conseco and CCP's subsidiaries and are now wholly-owned subsidiaries of Conseco. Effective January 1, 1995, the accounts of CCP are consolidated with those of Conseco. Conseco's investment in CCP for 1994 and 1993 was carried on the equity basis. During 1994 and 1993, Conseco amortized the difference of $22.8 million between the carrying value of its investment in CCP and the amount of its underlying equity in net assets on the straight-line basis over a 40-year period.
In 1994, CCP repaid its senior loan using a portion of the proceeds of a public offering of $200 million 10.5 percent senior notes due 2004. This repayment resulted in an extraordinary charge of $2.1 million to Conseco in 1994.
Participating policies represented approximately 12 percent, 8 percent and 11 percent of total life insurance in force at December 31, 1995, 1994 and 1993, respectively. Participating policies represented approximately 1 percent, 2 percent and 3 percent of premium income for 1995, 1994 and 1993, respectively. Dividends on participating policies amounted to $12.3 million, $12.0 million and $16.0 million in 1995, 1994 and 1993, respectively.
Cost of reinsurance ceded where the reinsured policy contains mortality risks totaled $72.6 million, $33.4 million and $35.8 million in 1995, 1994 and 1993, respectively. This cost was deducted from insurance premium revenue. Conseco is contingently liable for claims reinsured if the assuming company is unable to pay. Reinsurance recoveries netted against insurance policy benefits totaled $59.8 million, $23.7 million and $31.0 million in 1995, 1994 and 1993, respectively.
Effective October 1, 1995, WNC recaptured certain annuity business ceded to Great American Reserve through a reinsurance agreement. Reserves related to these policies totaled $72.8 million. Recapture fees of $.7 million were recognized as income during the fourth quarter of 1995.
Notes payable that are direct obligations of the Company at December 31, 1995 and 1994, were as follows:
Tranche A and Tranche B borrowings bear interest based on either an offshore rate or a base rate. Offshore rates are equal to the reserve adjusted Interbank Offered Rate plus an applicable margin based on: (i) our aggregate outstanding bank debt; and (ii) the rating of our senior notes by Moody's and Standard & Poor's. Such margin varies from .75 percent to 1.75 percent. Base rates are equal to the bank's reference rate plus the offshore rate margin less 1.25 percent (provided such margin is not less than zero). At December 31, 1995, borrowings under Tranche A and Tranche B bear interest at a weighted average interest rate of 7.47 percent and 7.32 percent, respectively.
Maximum borrowings under Tranche A are reduced (requiring principal payments if current borrowings exceed maximum borrowings) as follows: 1997 - $30.0 million; 1998 - $50.0 million; 1999 - $65.0 million; 2000 - $65.0 million; and 2001 - $140.0 million. Tranche B borrowings are due in 1999; such date may be extended to 2001 subject to defined conditions.
In February 1993, the Company completed a public offering of $200 million of 8.125% senior notes due in 2003. The notes are unsecured and rank pari passu with all other unsecured and unsubordinated indebtedness of the Company. The notes are not redeemable prior to maturity. Proceeds from the offering of approximately $195.6 million (after original issue discount and other associated costs) were used to repurchase in open market transactions or redeem the remaining outstanding 12.75 percent senior subordinated notes issued in July 1987, and for general corporate purposes. The repurchase and redemption of the senior subordinated notes resulted in an extraordinary charge of $8.4 million, net of a $4.3 million tax benefit, in 1993.
On February 15, 1994, the Company repaid a $200 million senior unsecured loan, resulting in an extraordinary charge of $1.2 million (net of a $.6 million tax benefit). In 1994 and 1993, the Company repaid the remaining principal balances outstanding on the promissory notes executed as part of the acquisition of National Fidelity resulting in an extraordinary charge of $.8 million (net of a $.4 million tax benefit) in 1994 and $.4 million (net of a $.3 million tax benefit) in 1993.
At December 31, 1995, notes payable of Partnership II entities, which are not direct obligations of Conseco, were as follows:
Unless otherwise extended, the revolving credit agreement will mature, and all principal and interest thereon will become due and payable in October 1998. The revolving credit agreement may be extended in one year increments through October 2001, subject to defined conditions.
Principal amounts by maturity dates of the various notes, including the effects of the transactions which occurred after December 31, 1995, as described in note 16, were as follows:
The Company has qualified defined contribution plans in which substantially all employees of the Company's wholly owned subsidiaries, BLH and AGP are eligible to participate. Company contributions, which match certain voluntary employee contributions to the plan, totaled $2.2 million, $1.7 million and $1.4 million in the years ended December 31, 1995, 1994 and 1993, respectively, and may be made in cash or the Company's common stock.
The Company also has a stock bonus and deferred compensation program for certain officers and directors of Conseco and its wholly owned subsidiaries whereby the participants may voluntarily defer a portion of their compensation. Company contributions vary based on the profitability of the Company and the amount of compensation voluntarily deferred by each participant. Each year's contribution, which is fully funded in the form of Conseco's common stock, vests five years later or upon certain other events. The cost of the program is charged to expense over the vesting period and amounted to $3.7 million, $1.4 million and $2.3 million in 1995, 1994 and 1993, respectively. The market value of Conseco's common stock held under the program (included in other assets and other liabilities) was $46.0 million and $29.9 million at December 31, 1995, and 1994, respectively.
BLH 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 liability recognized in the consolidated balance sheet for the agents' deferred compensation plan was $32.2 million and $29.5 million at December 31, 1995 and 1994, respectively, substantially all of which represents vested benefits. Costs incurred on this plan, primarily representing interest on unfunded benefit costs, were $2.8 million, $2.7 million and $2.8 million during 1995, 1994 and 1993, respectively.
The discount rates used in determining the accumulated postretirement benefit obligation were 7 percent and 8 percent at December 31, 1995 and 1994, respectively. Future increases in salaries and the assumed health care cost trend rates produce no change in the accumulated postretirement benefit obligation at December 31, 1995 and 1994, because of the employer's maximum cost sharing provisions discussed above.
BLH has a stock option plan which authorizes the grant to employees or directors of options to purchase shares of common stock. A maximum of 3.5 million shares of common stock may be issued under options and related rights granted under the plan. The exercise price may not be less than the fair market value of the underlying shares on the date of the grant. Options may become exercisable immediately or over a period of time and remain exercisable for up to 10 years after grant. At December 31, 1995, options for a total of 1,157,800 shares at prices between $20.00 and $23.63 were outstanding of which 163,660 options were exercisable and approximately 2.3 million shares were available for future grant. The plan also authorizes the issuance of stock appreciation rights or limited rights (rights exercisable only in the event of a tender offer for or acquisition of 25 percent or more of BLH's outstanding common stock), but none have been granted.
Changes in minority interest during 1995 and 1994 are summarized below:
Changes in the number of shares of common stock outstanding for the years 1995, 1994 and 1993 were as follows:
In addition to 16,942,832 shares of common stock reserved for issuance under the 1983 and 1994 stock option plans, 1,238,833 shares of common stock are reserved for issuance under stock bonus and deferred compensation plans. The common stock and additional paid-in capital account was reduced by $6.1 million at December 31, 1995, for the unearned portion of the incentive deferred compensation program.
In February 1994, Conseco implemented an option exercise program under which its chief executive officer and four of its executive vice presidents exercised outstanding options to purchase approximately 7.2 million shares of the Company's common stock. The options would otherwise have remained exercisable until the years 1999 and 2000. As a result of the exercise, the Company realized a tax deduction equal to the aggregate tax gain recognized by the executives. The tax benefit of $67.8 million (net of payroll taxes incurred of $2.9 million) and the proceeds from the exercise of these options of $15.4 million were reflected as increases to common stock and paid-in capital. The Company withheld sufficient shares to cover federal and state taxes owed by the executives as a result of the exercise transactions. Net of withheld shares, the Company issued approximately 3.6 million common shares to the executives. The Company also granted to the executive officers new options to purchase a total of 6,032,000 shares of the Company's common stock at $29.625 per share (the market price at the date of such grant) under the 1994 Stock and Incentive Plan to replace the shares surrendered for taxes and the exercise price on these and other recent option exercises and as the 1994 incentive grant to the executives.
The five states with the largest shares of premiums collected in 1995 were Illinois (11 percent), Florida (10 percent), Michigan (7.5 percent), California (6.7 percent) and Texas (6.6 percent). No other state accounted for more than 5 percent of total collected premiums.
Conseco considers anticipated returns from the investment of policyholder balances in determining the amortization of the cost of policies purchased and cost of policies produced. Sales of fixed maturity investments change the incidence of profits on such policies because gains (losses) are recognized currently and, if the sale proceeds are reinvested at the current market yields, the expected future yields on the investment of policyholder balances are reduced (increased). Accordingly, amortization of the cost of policies purchased was increased (decreased) by $106.4 million, $(3.9) million and $46.0 million in the years ended December 31, 1995, 1994 and 1993, respectively, and amortization of the cost of policies produced was increased (decreased) by $20.2 million, $(1.4) million and $43.2 million in the years ended December 31, 1995, 1994 and 1993, respectively.
Based on current conditions and assumptions as to future events on all policies in force, the Company expects to amortize approximately 14 percent of the December 31, 1995, balance of cost of policies purchased in 1996, 13 percent in 1997, 12 percent in 1998, 11 percent in 1999, and 10 percent in 2000. The discount rates used to determine the amortization of the cost of policies purchased prior to November 19, 1992, ranged from 15 percent to 20 percent during the three-year period ended December 31, 1995. The discount rates used to determine the amortization of the cost of policies purchased after November 19, 1992, ranged from 4 percent to 8 percent.
The following non-cash items were not reflected in the consolidated statement of cash flows in 1995: (i) the redemption of convertible subordinated debentures of a subsidiary with a principal amount of $9.2 million using segregated cash; (ii) the issuance of Conseco's common stock to employee benefit plans of $4.2 million; and (iii) the tax benefit of $.4 million related to the issuance of Conseco's common stock under employee benefit plans. The following non-cash items were not reflected in 1994: (i) recapture of insurance liabilities and invested assets totaling $390.2 million and $371.0 million, respectively, described in note 6; (ii) redemption of convertible subordinated debentures of a subsidiary with a principal amount of $44.8 million using segregated cash; (iii) the issuance of Conseco;'s common stock to employee benefit plans of $2.4 million; and (iv) the tax benefit of $69.2 million related to issuance of Conseco's common stock under employee benefit plans. The following non-cash items were not reflected in 1993: (i) the surrender for redemption of $50.0 million stated value of ICH preferred stock in exchange for common shares of BLH (as described in note 2 to the consolidated financial statements); (ii) recapture of insurance liabilities and invested assets each totaling approximately $338.5 million in connection with the recapture of reinsurance as described in note 6; (iii) the issuance of Conseco's common stock to employee benefit plans of $3.2 million; and (iv) the tax benefit of $15.3 million related to issuance of Conseco's common stock under employee benefit plans.
Cash flows from operations included interest paid on debt of $112.0 million, $54.3 million and $58.8 million in 1995, 1994 and 1993, respectively. Income taxes paid were $90.3 million, $99.8 million and $204.9 million in 1995, 1994 and 1993, respectively.
Statutory accounting practices prescribed or permitted for the Company's insurance subsidiaries by regulatory authorities differ from GAAP. The Company's life insurance subsidiaries reported the following amounts to regulatory agencies, after appropriate eliminations of intercompany accounts among such subsidiaries:
Combined statutory net income of the Company's life insurance subsidiaries was $183.8 million, $112.5 million and $162.3 million in 1995, 1994 and 1993, respectively, after appropriate eliminations of intercompany amounts among such subsidiaries.
In connection with the acquisition of BLH, the capital of one of the life insurance subsidiaries (Bankers Life Insurance Company of Illinois) was increased by providing cash in exchange for a surplus debenture. The remaining balance of the surplus debenture of $430.0 million at December 31, 1995, is considered a part of statutory capital and surplus of the life insurance subsidiary. Payments to BLH of principal and interest on the surplus debenture may be made from available funds only with the approval of the Illinois Department of Insurance when its Director is satisfied that the financial condition of the subsidiary warrants that action. Such approval may not be withheld provided the surplus of the subsidiary exceeds, after such payment, approximately $128 million. Such subsidiary's surplus at December 31, 1995, was $359.1 million.
American Life and Casualty's capital and surplus includes a surplus note with a balance of $50.0 million at December 31, 1995. Each payment of interest or principal on the surplus notes requires the prior approval of the Iowa Insurance Division. The Iowa insurance law also provides that payments of dividends on capital stock and interest and principal on surplus notes may be made only out of an insurer's earned surplus. At December 31, 1995, American Life and Casualty had earned surplus of $109.5 million. American Life and Casualty follows certain permitted accounting practices which are not specifically prescribed in state laws, regulations, general administrative rules and various NAIC publications. Such permitted accounting practices do not affect statutory surplus.
As a result of the acquisitions and subsequent recapitalization transactions of CCP's insurance subsidiaries, a CCP insurance subsidiary issued a surplus debenture to its direct parent company. As required by the state regulatory authorities, the debenture is classified as a part of statutory capital and surplus of the insurance subsidiary to the extent that such capital and surplus equals the level of capital and surplus required by the regulators. The balance of the debenture in excess of such amount is carried as a liability on the statutory balance sheet. This amount, however, would be reclassified to statutory capital and surplus to the extent subsequently needed to meet the level of capital and surplus required by the regulators.
The following table compares the consolidated pretax income determined on a statutory accounting basis with such income reported herein in accordance with GAAP:
State insurance laws generally restrict the ability of insurance companies to pay dividends or make other distributions. Net assets of the Company's wholly owned life insurance subsidiaries, determined in accordance with generally accepted accounting principles, aggregated approximately $1.7 billion at December 31, 1995, of which approximately $97.9 million is available for distribution to Conseco in 1995 without the permission of state regulatory authorities.
Most states have adopted risk-based capital ("RBC") rules to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks. The RBC formula is designed as an early warning tool to help state regulators identify possible weakly capitalized companies for the purpose of initiating regulatory action. At December 31, 1995, the ratios of total adjusted capital to RBC, as defined by the rules, for the primary insurance subsidiaries of Conseco, BLH and AGP were greater than twice the level at which regulatory attention is triggered.
Conseco's earnings result from three different activities: (i) operating life insurance companies; (ii) providing services to affiliates and others for fees; and (iii) acquiring and restructuring investments, including life insurance companies held in partnership with other investors. Conseco's life insurance operations are primarily conducted through the following segments: (i) senior market operations (consisting of the activities of BLH, which distributes Medicare supplement policies and other life and health products to the senior citizens market and others through career agents, most of whom sell only BLH's products); (ii) annuity operations (consisting of the operations of Great American Reserve and Beneficial Standard which were subsidiaries of CCP prior to August 31, 1995, and which distribute tax qualified annuities and certain employee benefit-related products primarily to school teachers and administrators through educator market specialists and annuities and life insurance products through other diversified cost effective distribution channels); (iii) other life insurance operations (consisting of the operations of National Fidelity, Bankers National and Lincoln American which have profitable blocks of business, but do not currently market their products to new customers); (iv) partnership operations (consisting of the activities of AGP which distributes annuities and life insurance products through a general agency and brokerage distribution system and which was acquired through Partnership II in September 1994); and (v) WNC (which distributes single premium deferred annuities through financial institutions and other annuity products through personal producing general agents and which was disposed of in 1994).
On January 23, 1996, Conseco completed the offering of 4.37 million shares of Preferred Redeemable Increased Dividend Equity Securities, 7% Convertible Preferred Stock ("PRIDES"). Proceeds from the offering of approximately $258 million (after underwriting and other associated costs) were used to repay amounts outstanding under the Credit Agreement.
BLH's new revolving credit agreement contains a number of covenants with respect to BLH, including among other things, prohibitions or limitations on indebtedness, liens, mergers, acquisitions, sales of assets outside of the normal course of business and certain transactions with affiliates.
The following table sets forth the capitalization of the Company as of December 31, 1995, and the pro forma capitalization of the Company to give effect the following transactions as further described above) as if each had occurred on December 31, 1995: (i) the issuance of the PRIDES and use of the proceeds therefrom to reduce notes payable; and (ii) the BLH tender offer and related financing.
In March 1996, Conseco implemented an option exercise program under which its chief executive officer and four of its executive vice presidents exercised outstanding options to purchase approximately 1.5 million shares of the Company's common stock. The options would otherwise have remained exercisable until the years 2000 through 2002. As a result of the exercise, the Company will be able to realize a tax deduction of approximately $45.3 million, equal to the aggregate tax gain recognized by executives as a result of the exercise. The Company withheld sufficient shares to cover federal and state taxes owed by the executives as a result of the exercise transaction. Net of withheld shares, the Company issued approximately .8 million shares of common stock to the executives. The Company also granted to the executive officers new options to purchase a total of .7 million shares at $32.44 (the market price of a share on the grant date) to replace the shares surrendered for taxes and the exercise price. The tax benefit related to Conseco's tax deduction, together with the proceeds from the exercise of the options, will be reflected as an increase, and the cost of the shares withheld to cover taxes and exercise price will be reflected as a decrease, to paid-in capital.