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" section of this Item 7 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 the ultimate outcome of lawsuits filed against us and other legal and regulatory proceedings to which we are subject; and
o customer response to new products, distribution channels and marketing initiatives;
o general economic conditions and other factors, including prevailing interest rate levels, stock and credit market performance and health care inflation, which may affect (among other things) our ability to sell products and access capital on acceptable terms, the market value of our investments, and the lapse rate and profitability of policies;
o Bankers Life, which consists of the businesses of Bankers Life and Casualty and Colonial Penn. Bankers Life and Casualty markets and distributes Medicare supplement insurance, life insurance, long-term care insurance and annuities to the senior market through approximately 4,600 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 Other Business in Run-off, which includes blocks of business that we no longer market or underwrite and are managed separately from our other businesses. This segment consists of long-term care insurance sold through independent agents and major medical insurance.
$1.63 per diluted share. Results for 2004 included net after-tax gains of $17.7 million from net realized investment gains.
Despite low ratings and our decisions to discontinue or curtail sales in certain products in order to conserve capital coming out of bankruptcy, collected premiums in our core products have been relatively stable in the post bankruptcy period.
Estimated fair values for our investments are determined based on estimates from nationally recognized pricing services, broker-dealer market makers and internally developed methods. Our internally developed methods require us to make judgments about the security's credit quality, liquidity and market spread.
During 2004, we sold over $6.2 billion of our fixed maturity investments which resulted in net realized investment gains of $56.6 million. Our fixed maturity investments are generally purchased in the context of a long-term strategy to fund insurance liabilities, so we do not typically generate gains and losses by selling such securities. 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 meet our long-term asset-liability objectives, we may sell certain securities. Of those fixed maturity investments sold in 2004, $2.6 billion resulted in gross realized investment losses (before income taxes) of $46.2 million. Securities sold at a loss are sold 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; and (vi) our analysis indicating there is a high probability that the security is other-than-temporarily impaired.
We seek to balance the duration of our invested assets with the estimated duration of benefit payments arising from contract liabilities. Our efforts to match these durations may cause us to sell investments before their maturity date and could result in the realization of net realized investment gains (losses). When the estimated durations of assets and liabilities are similar, exposure to interest rate risk is minimized because a change in the value of assets should be largely offset by a change in the value of liabilities. A mismatch of the durations of invested assets and insurance liabilities could have a significant impact on our results of operations and financial position. See "-- Quantitative and Qualitative Disclosures About Market Risks" for additional discussion of the duration of our invested assets and insurance liabilities.
The cost assigned to the right to receive future cash flows from contracts existing at August 31, 2003 is referred to as
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. As of December 31, 2004, we no longer believe that a full valuation allowance is necessary. However, as further discussed in the note to the consolidated financial statements entitled "Income Taxes", we believe that it is still necessary to have a valuation allowance on a portion of our deferred tax asset. This determination was made by evaluating each component of the deferred tax asset and the effect of limitations or issues that made it more likely than not that our deferred tax asset would be fully recognized in the future based on objective evidence.
At the fresh-start date, we were required to estimate our tax basis in CFC in order to determine the tax loss carryforward related to the worthlessness of CFC. The determination of this amount and how the loss is recognized was subject to varied interpretations of various tax laws and regulations. During the third quarter of 2004, the Company and the IRS entered into a closing agreement which determined that the tax loss recognized on the worthlessness of CFC was $6.7 billion, instead of our original estimate of $5.4 billion. This determination resulted in $500.1 million of additional deferred tax assets being recognized. We also recognized a $500.1 million valuation allowance, as we had deemed it more likely than not that the deferred tax assets would not be realized. As this increase relates to the period prior to our emergence from bankruptcy, any additional reductions of the deferred income tax valuation allowance will be accounted for as additions to paid-in capital pursuant to SOP 90-7.
The closing agreement with the IRS also determined that the loss recognized on the worthlessness of CFC is an ordinary loss for tax purposes and not a capital loss.
The Code limits the extent to which losses realized by a non-life entity (or entities) may offset income from a life insurance company (or companies) to the lesser of: (i) 35 percent of the income of the life insurance company; or (ii) 35 percent of the total loss of the non-life entities. There is no limitation with respect to the ability to utilize net operating losses generated by a life insurance company. Subsequent to our emergence from bankruptcy, we reorganized certain of our subsidiaries to improve their capital position. As a result of the reorganization, the loss related to CFC was realized by a life insurance company. Accordingly, we believe the loss should be treated as a life insurance loss and would not be subject to the limitations described above. However, if the IRS were to disagree with our conclusion and such determination ultimately prevailed, the loss related to CFC would be subject to the limitation described in the first sentence of this paragraph. The IRS has informed the Company that it will address this matter during its examination of our tax returns for calendar years 2002-2003.
During 2004, the reduction in our deferred income tax valuation allowance was accounted for pursuant to SOP 90-7, as follows: (i) first, to eliminate goodwill; (ii) second, to eliminate other intangible assets; and (iii) last, as an addition to paid-in capital. The reduction of any remaining portion of our deferred income tax valuation allowance will be accounted for as an addition to paid-in capital pursuant to SOP 90-7. Changes in our valuation allowance are summarized as follows (dollars in millions):
At December 31, 2004, the total balance of our liabilities for insurance and asset accumulation products was $25.1 billion. These liabilities are often 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.
awards. Therefore, the reserves and liabilities we establish 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.
In accordance with Statement of Financial Accounting Standards No. 60, "Accounting and Reporting by Insurance Enterprises" and Statement of Financial Accounting Standards No. 97, "Accounting and Reporting by Insurance Enterprises for certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments" ("SFAS 97"), the Predecessor used the original actuarial assumptions determined when traditional long-duration and limited payment insurance contracts were issued in determining liability calculations through the fresh start date, provided the resulting liabilities were adequate to provide for future benefits and expenses under the related contracts. This accounting principle is referred to as the "lock in" principle and is only applicable to traditional insurance and limited pay products. The use of assumptions that are locked in at the time of issue means that absent loss recognition, the same assumptions are used in accounting for a particular block of business unless the block is subject to purchase or fresh start accounting.
Due to the current interest rate environment and the requirement to mark the value of the investment portfolio to 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 is the result of changes in future expected investment earnings.
The insurance liability for asset accumulation products (such as deferred annuities and universal life products) is generally equal to current policyholder account balances. These balances generally do not change as a result of the adoption of fresh start accounting. The fresh-start adjustment to insurance liabilities for interest-sensitive products primarily results from: (i) the adoption of SOP 03-01 as of the Effective Date; and (ii) certain Predecessor insurance liabilities that were different from the present value of estimated future benefits as of August 31, 2003.
We are involved on an ongoing basis in 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 lawsuits 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.
Conseco and its businesses are subject to a number of risks including general business and financial risk factors. Any or all of such factors, which are set forth below, could have a material adverse effect on the business, financial condition or results of operations of Conseco. In addition, please refer to the "Cautionary Statement Regarding Forward-Looking Statements" above.
Certain purported class action lawsuits could harm our financial strength and reduce our profitability.
Our subsidiary, Conseco Life Insurance Company, has been named as a defendant in multiple recently filed purported class actions and individual cases alleging, among other things, breach of contract regarding a change made in the way monthly deductions are calculated for insurance coverage. Conseco Life Insurance Company is also a defendant in a purported nationwide class action lawsuit which seeks unspecified damages in Florida federal court for alleged fraudulent sales practices. Our former subsidiary, Manhattan National Life Insurance Company, is a defendant in a purported nationwide class action lawsuit which seeks unspecified damages in New Mexico state court for alleged fraud by non-disclosure of additional charges to policyholders who desired to pay premiums on other than an annual basis. Four of our subsidiaries have also been named in purported nationwide class action lawsuits which seek unspecified damages in Colorado state court for alleged claims similar to those aforementioned in the New Mexico suit. The ultimate outcome of these lawsuits cannot be predicted with certainty, and although we do not presently believe that any of these lawsuits, individually, are material, they could, in the aggregate, have a material adverse effect on our financial condition and it is possible that an adverse determination in pending litigation could, from time to time, have a material adverse effect on our consolidated results of operations or cash flows in particular quarterly or annual periods. Because our insurance subsidiaries were not part of our bankruptcy proceedings, those proceedings did not result in the discharge of any claims, including claims asserted in litigation, against our insurance subsidiaries.
The announcement of our intention to seek a restructuring of our capital in August 2002 and our subsequent filing of bankruptcy petitions in December 2002 caused significant disruptions in our operations. We believe that adverse publicity in national and local media concerning our distressed financial condition and our disputes with former members of management caused sales of our insurance products to decline and policyholder lapses and redemptions to increase. For example, our total premium collections decreased by 7.2 percent to $3,881.4 million and 8.4 percent to $4,180.9 million for the years ended December 31, 2004 and 2003, respectively, compared to the prior year. In addition, withdrawals from annuities and other investment-type products exceeded deposits by $147.4 million and $615.4 million during the years ended December 31, 2004 and 2003, respectively.
2003. The number of career agents selling products through the Bankers Life segment remained at approximately 4,600 throughout 2004. We implemented sales incentive programs for our agents to retain them during the period when the Company experienced much negative publicity, lower ratings and increased activity from competitor agents. The total cost for the agent incentive programs during 2003 and 2002 was $17 million.
A failure to improve the financial strength ratings of our insurance subsidiaries could cause us to experience decreased sales, increased agent attrition and increased policyholder lapses and redemptions.
We set the premium rates on our health insurance policies based on facts and circumstances known at the time we issue the policies and on assumptions about numerous variables, including the actuarial probability of a policyholder incurring a claim, the probable size of the claim, maintenance costs to administer the policies and the interest rate earned on our investment of premiums. In setting premium rates, we consider historical claims information, industry statistics, the rates of our competitors and other factors, but we cannot predict with certainty the future actual claims on our products. If our actual claims experience proves to be less favorable than we assumed and we are unable to raise our premium rates, our financial results may be adversely affected.
Most of our supplemental health policies allow us to increase premium rates when warranted by our actual claims experience. These rate increases must be approved by the applicable state insurance departments, and we are required to submit actuarial claims data to support the need for such rate increases. The re-rate application and approval process on supplemental health products is a normal recurring part of our business operations and reasonable rate increases are typically approved by the state departments as long as they are supported by actual claims experience and are not unusually large in either dollar amount or percentage increase. For policy types on which rate increases are a normal recurring event, our estimates of insurance liabilities assume we will be able to raise rates if the blocks warrant such increases in the future.
The loss ratio for our long-term care products, included in the other business in run-off segment, has increased in recent periods and was 103 percent during the year ended December 31, 2004. We will have to raise rates or take other actions with respect to some of these policies or our financial results will be adversely affected. During 2004, 2003 and 2002, we received approvals for rate increases totaling $48 million, $37 million and $44 million, respectively, relating to this long-term care business, which had approximately $380 million of collected premiums in 2004.
On home health care policies issued in some areas of Florida and other states, payments made for the benefit of policyholders have exceeded premiums received by a significant margin. Substantially all of these policies were issued through independent agents by certain of our subsidiaries prior to their acquisitions by Conseco in 1996 and 1997. On April 20, 2004, the Florida Office of Insurance Regulation issued an order to our subsidiary, Conseco Senior, which affects approximately 11,000 home health care policies issued in Florida by Conseco Senior and its predecessor companies. Pursuant to the order, Conseco Senior must offer the following three alternatives to holders of these policies:
In setting premium rates, we consider historical claims information and other factors, but we cannot predict future claims with certainty. This is particularly applicable to our long-term care insurance products, for which we have relatively limited historical claims experience. Long-term care products tend to have fewer claims than other health products such as Medicare supplement, but when claims are incurred, they tend to be much higher in dollar amount. Also, long-term care products have a much longer tail, meaning that claims are incurred much later in the life of the policy than most other supplemental health products. As a result of these traits, longer historical experience is necessary to appropriately price products.
Our Bankers Life segment has offered long-term care insurance since 1985. Bankers Life's claims experience on its long-term care blocks has generally been lower than its pricing expectations. However, the lapses on these policies have been lower than our pricing expectations and this is expected to result in higher loss ratios in the future.
Many factors can affect these reserves and liabilities, such as economic and social conditions, inflation, hospital and pharmaceutical costs, regulatory actions, changes in doctrines of legal liability and extra-contractual damage awards. Therefore, the reserves and liabilities we establish are necessarily based on estimates, assumptions and prior years' statistics. 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. We have incurred significant losses beyond our estimates as a result of actual claim costs and persistency of our long-term care business included in the other business in run-off segment. For example, we increased claim reserves by $130 million during 2002 and $85 million during the eight months ended August 31, 2003, as a result of adverse developments and changes in our estimates of ultimate claims for these products. Our financial performance depends significantly upon the extent to which our actual claims experience is consistent with the assumptions we used in setting our reserves. If our assumptions with respect to future claims are incorrect, and our reserves prove to be insufficient to cover our actual losses and expenses, we would be required to increase our liabilities, and our financial results could be adversely affected.
Conseco, Inc. and CDOC, Inc., our wholly owned subsidiary and a guarantor under the Credit Facility, are holding
companies with no business operations of their own. As a result, they depend on their operating subsidiaries for cash to make principal and interest payments on debt, and to pay administrative expenses and income taxes. The cash they receive from insurance subsidiaries consists of dividends and distributions, principal and interest payments on surplus debentures, fees for services, tax-sharing payments, and from our non-insurance subsidiaries, loans and advances. A deterioration in the financial condition, earnings or cash flow of the significant subsidiaries of Conseco or CDOC for any reason could limit their ability to pay cash dividends or other disbursements to Conseco and CDOC. In addition, we may need to contribute additional capital to improve the risk based capital ratios of certain insurance subsidiaries and this could affect the ability of our top tier insurance subsidiary to pay dividends. Accordingly, this would limit the ability of Conseco and CDOC to meet debt service requirements and satisfy other financial obligations.
Any dividends in excess of these levels, as well as principal and interest payments on surplus debentures, require the approval of the director or commissioner of the applicable state insurance department. Prior to their release on November 19, 2003, we were subject to consent orders with the Commissioner of Insurance for the State of Texas that, among other things, limited the ability of our insurance subsidiaries to pay any dividends to any non-insurance company parent without prior approval. The following table sets forth the aggregate amount of dividends and other distributions that our insurance subsidiaries paid to us in each of the last two fiscal years (dollars in millions):
Our Credit Facility also imposes restrictions that limit our flexibility to plan for and react to changes in the economy and industry, thereby increasing our vulnerability to adverse economic and industry conditions. These restrictions include limitations on our ability to: (i) incur additional indebtedness; (ii) transfer or sell assets; (iii) enter into mergers or other business combinations; (iv) pay cash dividends or repurchase stock; and (v) make investments and capital expenditures.
S&P and Moody's have assigned ratings on our senior secured debt of "BB- (Marginal)" and "B2 (Poor)", respectively. In S&P's view, an obligation rated "BB-" is less vulnerable to nonpayment than other speculative issues, but the obligor currently has the capacity to meet its obligation. S&P has a total of twenty-two separate categories rating senior debt, ranging from "AAA (Extremely Strong)" to "D (Payment Default)". A "BB-" rating is the thirteenth highest rating. In Moody's view, an obligation rated "B" generally lacks characteristics of a desirable investment, and any assurance of interest or principal payments or of maintenance of other terms of the contract over any long period of time may be small. Moody's
has a total of twenty-one separate categories in which to rate senior debt, ranging from "Aaa (Exceptional)" to "C (Lowest Rated)". A "B2" rating is the fifteenth highest rating. If we were to require additional capital, either to refinance our existing indebtedness or to help fund future growth, our current senior debt ratings could restrict our access to such capital.
Our net income and revenues will suffer if policyholder surrender levels differ significantly from our assumptions.
During recent years, the health insurance industry has experienced substantial changes, including those caused by healthcare legislation. Recent federal and state legislation and pending legislative proposals concerning healthcare reform contain features that could severely limit, or eliminate, our ability to vary pricing terms or apply medical underwriting standards to individuals, thereby potentially increasing our loss ratios and adversely impacting our financial results. In particular, Medicare reform could affect our ability to price or sell our products or profitably maintain our blocks in force. For example, the Medical Advantage program provides incentives for health plans to offer managed care plans to seniors. The growth of managed care plans under this program could decrease sales of the traditional Medicare supplement products we sell.
o reducing the percentage of below-investment grade fixed maturity investments from 5.9 percent at December 31, 2001, to 3.9 percent at December 31, 2004;
Our structured security investments, which comprised 26 percent of our actively managed fixed maturity investments at December 31, 2004, are subject to risks relating to variable prepayment and default on the assets underlying such securities, such as mortgage loans. To the extent that structured security investments prepay faster than the expected rate of repayment, refinancing or default on the underlying assets, such investments, which have a cost basis in excess of par, may be redeemed at par, thus resulting in a loss.
Our need for liquidity to fund substantial product surrenders or policy claims may require that we maintain highly liquid, and therefore lower-yielding, assets, or that we sell assets at a loss, thereby further eroding the performance of our portfolio.
We have sustained substantial investment losses in the past and may again in the future. Because a substantial portion of our net income is derived from returns on our investment portfolio, significant losses in the portfolio may have a direct and materially adverse impact on our results of operations. In addition, losses on our investment portfolio could reduce the investment returns that we are able to credit to our customers of certain products, thereby impacting our sales and further eroding our financial performance.
Volatility in the securities markets, and other economic factors, may adversely affect our business, particularly our sales of certain life insurance products and annuities.
We transfer exposure to certain risks to others through reinsurance arrangements. Under these arrangements, other insurers assume a portion of our losses and expenses associated with reported and unreported claims in exchange for a portion of policy premiums. The availability, amount and cost of reinsurance depend on general market conditions and may vary significantly. As of December 31, 2004, our reinsurance receivables totaled $975.7 million. Our ceded life insurance in force totaled $20.1 billion. Our seven largest reinsurers accounted for 82 percent of our ceded life insurance in force. We face credit risk with respect to reinsurance. When we obtain reinsurance, we are still liable for those transferred risks if the reinsurer cannot meet its obligations. Therefore, the inability of our reinsurers to meet their financial obligations may require us to increase liabilities, thereby reducing our net income and shareholders' equity.
Our insurance business is subject to extensive regulation and supervision in the jurisdictions in which we operate. Our insurance subsidiaries are subject to state insurance laws that establish supervisory agencies. Such agencies have broad administrative powers including: granting and revoking licenses to transact business; regulating sales and other practices; approving premium rate increases; licensing agents; approving policy forms; setting reserve and solvency requirements; determining the form and content of required statutory financial statements; limiting dividends; and prescribing the type and
During our bankruptcy period and throughout most of 2003, we operated under heightened scrutiny from state insurance regulators and under certain consent orders, thereby restricting the ability of our insurance subsidiaries to pay any dividends or other amounts to any non-insurance company parent without prior approval. The successful completions of the bankruptcy in 2003 and capital restructuring in 2004 reduced the level of scrutiny from our state insurance regulators; however, we cannot be assured that regulators will not seek to assert greater supervision and control over our insurance subsidiaries' businesses and financial affairs in the future. If our financial condition were to deteriorate, we may be required to enter into similar orders in the future.
The solvency or guaranty laws of most states in which an insurance company does business may require that company to pay assessments up to certain prescribed limits to fund policyholder losses or liabilities of other insurance companies that become insolvent. Insolvencies of insurance companies increase the possibility that these assessments may be required. These assessments may be deferred or forgiven under most guaranty laws if they would threaten an insurer's financial strength and, in certain instances, may be offset against future premium taxes. We cannot estimate the likelihood and amount of future assessments. Although past assessments have not been material, if there were a number of large insolvencies, future assessments could be material and could have a material adverse effect on our operating results and financial position.
Competition from companies that have greater market share, higher ratings and greater financial resources may impair our ability to retain existing customers and sales representatives, attract new customers and sales representatives and maintain or improve our financial results.
After our emergence from bankruptcy, we began to 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. Prior to its disposition effective March 31, 2003, we also had a finance segment. The following tables and narratives summarize the operating results of our segments as we currently manage them (dollars in millions):
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 written in prior years through independent agents; (ii) small group and individual major medical business which we began to nonrenew in 2001; and (iii) other group major medical business which we no longer actively 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.
Total premium collections were $2,319.9 million in 2004; $720.3 million in the four months ended December 31, 2003; $1,560.7 million in the eight months ended August 31, 2003; and $2,039.3 million in 2002. Bankers Life's annuity premium collections in 2003 were positively impacted by sales inducements provided to such purchasers and sales incentives provided to our career agents. These programs ended at various times during the second quarter of 2003. Sales of annuity products in 2004 were favorably impacted by attractive minimum guaranteed crediting rates. See "Premium and Asset Accumulation Product Collections" for further analysis of Bankers Life's premium collections.
Average liabilities for insurance and asset accumulation products, net of reinsurance ceded, were $8.0 billion in 2004; $7.4 billion in the four months ended December 31, 2003; $6.3 billion in the eight months ended August 31, 2003; and $5.5 billion in 2002. The increase in such liabilities through August 31, 2003, was primarily due to annuity reserve increases. As discussed above under "Total premium collections", annuity premium collections in our Bankers Life segment were positively impacted during 2003 by sales inducements and incentives. 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 $422.6 million in 2004; $128.9 million in the four months ended December 31, 2003; $253.4 million in the eight months ended August 31, 2003; and $382.2 million in 2002. The average balance of general account invested assets was $7.7 billion in 2004; $7.0 billion in the four months ended December 31, 2003; $6.6 billion in the eight months ended August 31, 2003; and $6.1 billion in 2002. The yield on these assets was 5.5 percent in 2004; 5.5 percent in the four months ended December 31, 2003; 5.7 percent in the eight months ended August 31, 2003; and 6.3 percent in 2002. The decreases in 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. In addition, this segment's net investment income in 2004 included $4.7 million of income related to prepayments of securities (including prepayment penalties on mortgages, call premiums on fixed maturities and accelerated amortization of discount, net of premium) and income from non-traditional investments (including securities that were previously in default). The decrease in yield in the eight months ended August 31, 2003, reflected the lower interest rate environment prevailing during the period and the resulting lower rates earned on invested assets.
Trading account income related to policyholder and reinsurer accounts represents the income on trading security accounts established on August 31, 2003, which are designed to act as a hedge for embedded derivatives related to certain modified coinsurance agreements. The income on our trading account securities is designed to be substantially offset by the change in value of embedded derivatives related to modified coinsurance agreements described below.
Change in value of embedded derivatives related to modified coinsurance agreements is described in the note to our consolidated financial statements for the period ended December 31, 2004, entitled "Summary of Significant Accounting Policies - Accounting for Derivatives." We have transferred the specific block of investments related to these agreements to our trading securities 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 largely to be offset by the change in value of the trading securities.
Net realized investment gains (losses) fluctuated each period. 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 fixed maturity investments, equity securities and other invested assets 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 fixed maturity investments, equity securities and other invested assets resulting from declines in fair values that we concluded were other than temporary. During the first eight months of 2003, net investment gains of $5.5 million included $20.5 million of net gains from the sales of investments (primarily fixed maturities), net of $15.0 million of writedowns of fixed maturity investments, equity securities and other invested assets resulting from declines in fair values that we concluded were other than temporary. During 2002, this segment recognized net realized investment losses of $128.7 million, which included $138.5 million of writedowns to certain securities to fair value due to other-than-temporary declines in value (including issuers who have faced significant problems: K-Mart Corp., Amerco, Inc., Global Crossing, MCI Communications, Mississippi Chemical, United Airlines and Worldcom, Inc.) and $9.8 million of net gains from the sales of investments (primarily fixed maturities).
Insurance policy benefits fluctuated as a result of the factors summarized below for loss ratios. Loss ratios are calculated by dividing the related insurance product's insurance policy benefits by insurance policy income.
The loss ratio on Bankers Life's Medicare supplement business increased in 2004. Our loss experience in the four months ended December 31, 2003 was favorably impacted by positive developments of $5.8 million from insurance liabilities established in prior periods. In 2004, we recognized $1.5 million of positive developments from reserves
Amortization related to net realized investment gains (losses) represents the increases or decreases in amortization which result from realized investment gains or losses. When we sell securities at a gain (loss) and reinvest the proceeds at a different yield, we increase (reduce) the amortization of insurance acquisition costs in order to reflect the change in future expected yields. Sales of fixed maturity investments resulted in an increase (decrease) in the amortization of insurance acquisition costs of $4.7 million in 2004; nil in the four months ended December 31, 2003; $.5 million in the eight months ended August 31, 2003; and $(3.2) million in 2002.
Interest expense on investment borrowings fluctuates with our investment borrowing activities and the interest rates thereon. Average investment borrowings in our Bankers Life segment were $180.1 million during 2004; $173.6 million during the four months ended December 31, 2003; $263.7 million during the eight months ended August 31, 2003; and $452.2 million during 2002. The weighted average interest rates on such borrowings were 1.5 percent during 2004; 1.4 percent during the four months ended December 31, 2003; 1.9 percent during the eight months ended August 31, 2003; and 1.0 percent during 2002.
Special charges in 2002 included: (i) a loss of $39.0 million on a reinsurance transaction entered into as part of our cash raising initiatives; and (ii) other items totaling $6.0 million primarily related to severance benefits and costs incurred
with the transfer of certain customer service and backroom operations to our former India subsidiary.
Collections on insurance products were $1,165.6 million in 2004; $421.6 million in the four months ended December 31, 2003; $880.0 million in the eight months ended August 31, 2003; and $1,680.2 million in 2002. Premium collections by the independent agents in this segment were negatively impacted by the A.M. Best financial strength rating downgrade to "B (Fair)"in August 2002 and our decision to de-emphasize the sale of certain products. During 2005, we expect to increase our annuity sales efforts and to continue to emphasize the sale of specified disease and Medicare supplement insurance products. See "Premium and Asset Accumulation Product Collections" for further analysis.
Net investment income on general account invested assets (which excludes income on policyholder and reinsurer accounts) was $702.3 million in 2004; $242.2 million in the four months ended December 31, 2003; $557.3 million in the
Fee revenue and other income in the eight months ended August 31, 2003 and 2002 included $15.6 million and $23.7 million, respectively, of income earned by a subsidiary that earned fees for marketing insurance products of other companies. This subsidiary (which specialized in the sale of long-term care insurance through independent agents) was sold in September 2003, resulting in decreased fee revenue in subsequent periods.
Insurance policy benefits fluctuated as a result of the factors summarized below for loss ratios and, in the eight
Conseco Insurance Group's specified disease products generally provide fixed or limited benefits. For example, payments under cancer insurance policies are generally made directly to, or at the direction of, the policyholder following diagnosis of, or treatment for, a covered type of cancer. Approximately 77 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 loss ratio will typically increase, but the increase in the change in reserve will be partially offset by investment income earned on the accumulated assets. The interest-adjusted loss ratio for specified disease 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 loss ratio in this block of business is affected by the number of policies which surrender in a period. When policies surrender before reaching the specified age when the return of premium is payable, the reserve established for such benefit through the surrender 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 lapsed policies to consider these circumstances. These changes resulted in an increase to reserves of approximately $6 million. The effect of variances in lapse rates from our expectations were partially offset by reduced amortization of insurance acquisition costs of $2.2 million. 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.
During 2004, we evaluated certain amortization assumptions used to estimate gross profits for universal life and investment-type products by comparing them to our actual experience. We revised previous assumptions related to investment income to match the actual experience and our estimates of 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 insurance acquisition costs of $7.7 million. The rate increases implemented in early 2004 on our Medicare supplement products resulted in higher lapses than we anticipated. We recognized additional amortization expense of approximately $4.4 million as a result of the unexpected lapses (and the resulting impact on our estimates of future expected premium income). 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.
Amortization related to net realized investment gains (losses) represents the increases or decreases in amortization which result from realized investment gains or losses. When we sell securities at a gain (loss) and reinvest the proceeds at a different yield, we increase (reduce) the amortization of insurance acquisition costs in order to reflect the change in future expected yields. Sales of fixed maturity investments resulted in an increase (decrease) in the amortization of insurance acquisition costs of $8.7 million in 2004; $1.1 million in the four months ended December 31, 2003; $(.9) million in the eight months ended August 31, 2003; and $(24.6) million in 2002.
Other operating costs and expenses were $306.3 million in 2004; $115.6 million in the four months ended December 31, 2003; $222.6 million in the eight months ended August 31, 2003; and $292.1 million in 2002. Operating expenses in
Net realized investment gains (losses) fluctuated each period. During 2004, net realized investment gains in this segment included $5.1 million of net gains from the sales of investments (primarily fixed maturities), net of $.6 million of writedowns of fixed maturity investments, equity securities and other invested assets resulting from declines in fair values that we concluded were other than temporary. During the four months ended December 31, 2003, net realized investment losses in this segment included $.2 million of net losses from the sales of investments and $.5 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 gains of $6.3 million included $8.7 million of net gains from the sales of investments (primarily fixed maturities), net of $2.4 million of writedowns of fixed maturity investments, equity securities and other invested assets resulting from declines in fair values that we concluded were other than temporary. During 2002, we recognized net realized investment losses in this segment of $58.2 million which included $51.8 million to writedown certain securities to fair value due to an other-than-temporary decline in value (including issuers who have faced significant problems: K-Mart Corp., Amerco, Inc., Global Crossing, MCI Communications, Mississippi Chemical, United Airlines and Worldcom, Inc.) and $6.4 million of net losses from the sales of investments (primarily fixed maturities).
This segment includes long-term care insurance inforce, substantially all of which was issued through independent agents by certain subsidiaries prior to their acquisitions by Conseco in 1996 and 1997. The loss experience on these products has been worse than we originally expected. Although we anticipated a higher level of benefits to be paid out on these products as the policies age, the paid claims have exceeded our expectations. We have experienced adverse developments on home health care policies issued in certain areas of Florida and other states. This adverse experience is reflected in the higher loss ratios. We have been aggressively seeking rate increases and pursuing other actions on such long-term care policies. In addition, during 2004, we have been actively managing our long-term care cases and claim adjudication processes. On April 20, 2004, the Florida Office of Insurance Regulation issued an order to our subsidiary, Conseco Senior, that affected approximately 11,000 home health care policies issued in Florida by Conseco Senior and its predecessor companies. The order provides for Conseco Senior to offer the following three alternatives to holders of these policies:
The losses we have experienced since August 31, 2003 have generally been consistent with the revised assumptions resulting from the actuarial studies completed in 2003. However, as described below, estimating losses on long-term care products involves significant judgment and our prior estimates have not always been accurate.
The change in estimates resulting from the actuarial studies increased our claim reserves and loss ratios in the eight months ended August 31, 2003 and the year ended December 31, 2002. The changes in 2003 resulted in an increase to claim reserves of $130 million and an increase to the loss ratio of 15 percent. The changes in 2002 resulted in an increase to claim reserves of $85 million and an increase to the loss ratio of 20 percent.
The net cash flows from long-term care products generally cause an accumulation of amounts in the early years of a policy (accounted for as reserve increases) which will be paid out as benefits in later policy years (accounted for as reserve
decreases). Accordingly, as the policies age, the loss ratio will typically increase, but the increase in the change in reserve will be partially offset by investment income earned on the assets which have accumulated. The interest-adjusted loss 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.
Interest expense on corporate debt in 2004 included interest expense on the Credit Facility and 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 decreased in the eight months ended August 31, 2003, primarily as a result of our ceasing to accrue interest on notes payable (excluding certain indebtedness of our Predecessor). Interest expense in 2002 reflected interest on notes payable of the Predecessor. The average interest rate on our debt was 6.8 percent in 2004 and 7.8 percent in the four months ended December 31, 2003.
Provision for losses and expense related to stock purchase plan represents the non-cash provision for our Predecessor's guarantees of the bank loans of approximately 155 current and former directors, officers and key employees and the related loans for interest. The funds from the bank loans were used by the participants to purchase approximately 18.0 million shares of our Predecessor's common stock. In the first eight months of 2003 and in 2002, our Predecessor established provisions of $55.6 million and $240.0 million, respectively, in connection with these guarantees and loans. Our Predecessor determined the reserve based upon the value of the collateral held by the banks. The outstanding principal balance on the bank loans was $481.3 million. In addition, our Predecessor provided loans to participants for interest on such bank loans totaling $179.2 million. During 2002, our Predecessor purchased $55.5 million of loans from the banks utilizing cash held in a segregated cash account as collateral for our guarantee of the bank loans. Including accrued interest, the balance on these
In conjunction with the Plan, the principal amount of the bank loans of $481.3 million was transferred to the Company. We received all rights to collect the balances due pursuant to the original terms of these loans. In addition, we hold loans to participants for interest on the bank loans which exceeded $265 million at December 31, 2004. The former bank loans and the interest loans are collectively referred to as the "D&O loans." We regularly evaluate the collectibility of these loans in light of the collateral we hold and the creditworthiness of the participants. At December 31, 2004, we estimated that approximately $46 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.
Fee revenue and other income includes: (i) revenues we receive for managing investments for other companies; and (ii) fees received for marketing insurance products of other companies. In 2002, this amount included $16.7 million of affiliated fee revenue earned by our subsidiary in India. Such revenue is eliminated in consolidation. Excluding such affiliated income, fee revenue and other income decreased primarily as a result of a decrease in the market value of investments managed for others, upon which these fees are based. We sold our India subsidiary in the fourth quarter of 2002 and have substantially eliminated the customer service and other operations conducted there. Fee revenue and other income in the four months ended December 31, 2003, included $5.6 million of interest received on a Federal income tax refund.
Net realized investment losses often fluctuate each period. In 2004 and 2002, we recognized writedowns of $2.9 million and $1.3 million, respectively, due to other-than-temporary declines in value on certain securities.
Special charges in the Corporate segment in 2002 included: (i) a loss of $20.0 million from the sale of our India subsidiary; (ii) $17.7 million related to debt modification and refinancing transactions; (iii) other items totaling $22.0 million; partially offset by (iv) net gains of $7.5 million related to the sale of certain non-core assets.
Gain on extinguishment of debt of $2.8 million in 2004 resulted from the repayment of our Previous Credit Facility as further described in the notes to the consolidated financial statements entitled "Note Payable - Direct Corporate Obligations". The gain resulted from the release of a $6.3 million accrual for a fee that would have been required to be paid under the Previous Credit Facility, partially offset by the write-off of unamortized amendment fees.
During 2002, we recognized a gain on the extinguishment of debt of $1.8 million when we repurchased $77.4 million par value of our Predecessor's notes payable.
Our insurance segments sell products through three primary distribution channels -- career agents and direct marketing (our Bankers Life segment) and independent producers (our Conseco Insurance Group segment). Our career agency force in the Bankers Life segment sells primarily Medicare supplement and long-term care insurance policies, senior life insurance and annuities. These agents visit the customer's home, which permits one-on-one contact with potential policyholders and promotes strong personal relationships with existing policyholders. Bankers Life's direct marketing distribution channel is engaged primarily in the sale of "graded benefit life" insurance policies which are sold directly to the policyholder. Our independent producer distribution channel in the Conseco Insurance Group segment consists of a general agency and insurance brokerage distribution system comprised of independent licensed agents doing business in all fifty states, the District of Columbia, and certain protectorates of the United States. Independent producers are a diverse network of independent agents, insurance brokers and marketing organizations.
Annuities in this segment include equity-indexed and other fixed annuities sold to the senior market through our career agents. In order to retain our career agents and managers during the parent company's Chapter 11 reorganization process, we provided certain sales inducements to purchasers of annuities and sales incentives to our career agents and managers. These programs ended at various times during the second quarter of 2003. Annuity collections from career agents totaled $950.5 million in 2004; $253.8 million in the four months ended December 31, 2003; $698.4 million in the eight months ended August 31, 2003; and $740.9 million in 2002. Annuity premium collections in 2003 were favorably impacted by our sales inducements and incentives. In addition, during 2003 and 2004, the minimum guaranteed crediting rates on certain of our annuity products were very attractive. Such rates ranged from 3.25 percent to 4.0 percent for annuities sold in 2003 and was 3.25 percent during most of 2004. These rates were higher than the minimum guaranteed crediting rates of most of our competitors during 2003 and 2004. In 2005, we plan to increase our sales efforts of annuities through our career agents.
Other health products include various products which we no longer actively market. Premiums collected totaled $12.2 million in 2004; $4.4 million in the four months ended December 31, 2003; $9.0 million in the eight months ended August 31, 2003; and $12.6 million in 2002.
Annuities in this segment include equity-indexed and other fixed annuities sold through professional independent producers, many of whom discontinued marketing our products after A.M. Best lowered our financial strength ratings. Accordingly, we took actions to reduce our marketing expenses related to these products and began to focus instead on selling products that were less ratings sensitive (such as specified disease and Medicare supplement products). During 2005, we expect to increase our annuity sales efforts in this segment. Total annuity collected premiums in this segment were $63.7 million in 2004; $18.1 million in the four months ended December 31, 2003; $74.0 million in the eight months ended August 31, 2003; and $351.9 million in 2002.
We introduced our first equity-indexed annuity product in 1996. The accumulation value of these annuities is credited interest at an annual guaranteed minimum rate of 3 percent (or, including the effect of applicable sales loads, a 1.7 percent compound average interest rate over the term of the contracts). These annuities provide for potentially higher returns based on a percentage of the change in the S&P 500 Index during each year of their term. We purchase S&P 500 Call Options in an
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 $19.4 million in 2004; $8.7 million in the four months ended December 31, 2003; $29.1 million in the eight months ended August 31, 2003; and $162.2 million in 2002. The decreases are attributed to our emphasis on the sales of other products that are less ratings sensitive and the effect of the A.M. Best ratings downgrade in 2002.
Collected premiums on Medicare supplement policies in the Conseco Insurance Group segment were $351.7 million in 2004; $134.2 million in the four months ended December 31, 2003; $250.4 million in the eight months ended August 31, 2003; and $369.9 million in 2002. New Medicare supplement sales have been affected by increases in premium rates and our A. M. Best ratings downgrade in 2002.
Group major medical premiums totaled $12.6 million in 2004; $36.7 million in the four months ended December 31, 2003; $152.4 million in the eight months ended August 31, 2003; and $315.6 million in 2002. In early 2002, we decided to stop renewing all inforce small group business and we discontinued new sales.
Individual major medical premiums collected were $3.2 million in 2004; $2.6 million in the four months ended December 31, 2003; $4.0 million in the eight months ended August 31, 2003; and $93.9 million in 2002. In early 2002, we decided to stop renewing all inforce individual major medical business and we discontinued new sales.
securities, mortgage loans and policy loans made up 95 percent of our $24.3 billion investment portfolio at December 31, 2004. The remainder of the invested assets were trading securities, equity securities and other invested assets.
The following table sets forth fixed maturity investments at December 31, 2004, classified by rating categories. The category assigned is the highest rating by a nationally recognized statistical rating organization or, as to $459.8 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).
Our actively managed fixed maturity portfolio at December 31, 2004, 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-
Our investment strategy is to maximize, over a sustained period and within acceptable parameters of risk, investment income and total investment return through active investment management. Accordingly, we may sell securities at a gain or a loss to enhance the total return of the portfolio as market opportunities change or to better match certain characteristics of our investment portfolio with the corresponding characteristics of our insurance liabilities. While we have both the ability and intent to hold securities with unrealized losses until they mature or recover in value, we may sell securities at a loss in the future because of actual or expected changes in our view of the particular investment, its industry, its type or the general investment environment. As described in the note to our consolidated financial statements entitled "Recently Issued Accounting Standards", certain guidance related to determining when an impairment of an investment is other than temporary is being considered by the Financial Accounting Standards Board ("FASB"). Depending on the ultimate guidance issued, including guidance regarding management's assertion about intent and ability to hold actively managed fixed maturities for a period of time sufficient to allow for any anticipated recovery, the Company's practice of selling securities at a loss could result in a requirement to report unrealized losses in a different manner, including reflecting unrealized losses in the income statement as other-than-temporary impairments.
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 $3.5 million for the year ended December 31, 2004; $5.3 million in the four months ended December 31, 2003; $12.1 million in the eight months ended August 31, 2003; and $60.4 million for the year ended December 31, 2002.
Pursuant to fresh start reporting, we were required to mark all of our investments to market value. The current interest rate environment is much lower than when most of our investments were purchased. Accordingly, the fresh start values of our investments generally exceed the par values and the actual costs of such investments. The amount of value exceeding par is referred to as a "purchase premium", which is amortized against future income. If prepayments in any period are higher than expected, purchase premium amortization is increased. In periods of unexpectedly high prepayment activity, the increased amortization will reduce net investment income.
Subordinated and mezzanine tranches are classes that provide credit enhancement to senior tranches. The rating agencies require that this credit enhancement not deteriorate due to prepayments for a period of time, usually five years of complete lockout, followed by another period of time where prepayments are shared pro rata with senior tranches. Subordinated and mezzanine tranches bear a majority of the risk of loss due to property owner defaults. Subordinated bonds are generally rated "AA" or lower; we typically do not hold structured securities rated lower than "BB".
During 2004, we sold $2.6 billion of fixed maturity investments which resulted in gross investment losses (before income taxes) of $46.2 million. Securities sold at a loss are sold 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; and (vi) our analysis indicating 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 the cost of policies produced and the cost of policies purchased related to universal life and investment products.
Our venture capital investment in AWE was made by our subsidiary which engaged in venture capital investment activity. AWE is a company in the wireless communication business. In December 2003, we sold our remaining 4.1 million shares of AWE common stock. In 2002, we sold 10.3 million shares of AWE common stock which generated proceeds of $75.7 million. At December 31, 2002, we held 4.1 million shares of AWE common stock with a value of $25.0 million. We recognized venture capital investment income (losses) related to this investment of $(5.5) million in the four months ended December 31, 2003; $10.5 million in the eight months ended August 31, 2003; and $(99.3) million in 2002.
At December 31, 2004, we held $902.3 million of trading securities. We carry trading securities at estimated fair value; changes in fair value are reflected in the statement of operations. At August 31, 2003, we established trading security accounts which 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.
Other invested assets also include S&P 500 Call Options and certain nontraditional investments, including investments in limited partnerships and promissory notes.
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, 2004, we increased the carrying value of such investments by $621.6 million as a result of this fair value adjustment.
Our capital structure as of December 31, 2004 and 2003, is as follows (dollars in millions):
The following table summarizes certain financial ratios as of and for the year ended December 31, 2004 and as of and for the four months ended December 31, 2003:
It is possible that the ultimate outcome of various uncertainties could affect our liquidity in future periods. For example, the following events could have a material adverse effect on our cash flows:
o An inability to meet and/or maintain the covenants in our Credit Facility.
On June 25, 2004, A.M. Best upgraded the financial strength ratings of our primary insurance subsidiaries from "B (Fair)" to "B++ (Very Good)", other than Conseco Senior (the issuer of most of our long-term care business in our Other Business in Run-off segment), whose "B (Fair)" rating was affirmed by A.M. Best. According to A.M. Best, these rating actions reflected the substantial recapitalization of our balance sheet, improved absolute and risk-adjusted capital on a statutory basis and improving operating fundamentals. The "B++" rating is assigned to companies that have a good ability, in A.M. Best's opinion, to meet their ongoing obligations to policyholders. The "B" rating is assigned to companies which have a fair ability in A.M. Best's opinion to meet their current obligations to policyholders, but are financially vulnerable to adverse changes in underwriting and economic conditions. A.M. Best ratings for the industry currently range from "A++ (Superior)" to "F (In Liquidation)" and some companies are not rated. An "A++" rating indicates a superior ability to meet ongoing obligations to policyholders. A "B++" rating from A.M. Best is the fifth highest of sixteen possible ratings, and a "B" rating from A.M. Best is the seventh highest of sixteen possible ratings.
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 $15 million on capital expenditures in 2005 (including amounts related to these initiatives). We believe we have adequate cash flows from operations to fund these initiatives.
greater supervision and control over our insurance subsidiaries' businesses and financial affairs.
We seek to invest our available funds in a manner that will fund future obligations to policyholders, subject to appropriate risk considerations. We seek to meet this objective through investments that: (i) have similar cash flow characteristics with the liabilities they support; (ii) are diversified among industries, issuers and geographic locations; and (iii) are predominantly investment-grade fixed maturity securities. Many of our products include surrender charges, market interest rate adjustments or other features to encourage persistency.
The profitability of many of our products depends on the spreads 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, 2004, approximately 41 percent of our insurance liabilities were subject to interest rates that may be reset annually; 46 percent have a fixed explicit interest rate for the duration of the contract; 9 percent have credited rates which approximate the income earned by the Company; and the remainder have no explicit interest rates. At December 31, 2004, 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 (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 4.7 percent.
As part of our Chapter 11 reorganization, we sold substantially all of the assets of our Predecessor's finance business and exited from this line of business. Our finance business was conducted through our Predecessor's indirect wholly-owned subsidiary, CFC. We accounted for our finance business as a discontinued operation in 2002 after 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 the 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, nor did any creditors of our Predecessor. The consolidated statement of operations reflects the operations of the discontinued finance business in the caption "Discontinued operations" for all periods. The following tables and narratives discuss CFC's results of operations during the periods presented in our consolidated financial statements.
Net investment income on finance receivables and other consisted of: (i) interest earned on finance receivables; and (ii) interest income on short-term and other investments. Such income decreased by 4.4 percent, to $2,074.2 million, in 2002 consistent with the changes in average on-balance sheet finance receivables. The weighted average yield earned on finance receivables and other investments was 11.5 percent during 2002. The average yields decreased due to the declining interest rate environment, change in product mix of the portfolio and rising delinquencies primarily in CFC's manufactured housing business.
Net investment income on retained interests was the income recognized on the retained interests in securitizations CFC retained after it sold finance receivables. Such income decreased by 40 percent, to $75.0 million, in 2002. The decrease was consistent with the change in the average balance of retained interests. The weighted average yield earned on retained interests was 12.3 percent during 2002. As a result of the change in the structure of CFC's securitizations, securitization transactions were accounted for as secured borrowings and CFC did not recognize gain-on-sale revenue or additions to retained interests from such transactions. In addition, the balance of the retained interests was reduced by $1,077.2 million in 2002 due to impairment charges. Impairment charges are further explained below. The weighted average yield was also adversely affected by the decline in guarantee payments received on certain lower-rated securities in the fourth quarter of 2002.
Provision for losses related to finance operations increased by 77 percent, to $950.0 million, in 2002. These amounts related to CFC's on-balance sheet finance receivables. CFC's credit losses as a percentage of related loan balances for the on-balance sheet portfolio consistently increased during 2002 to 3.74 percent at December 31, 2002. The increases to the provision and CFC's credit losses were due to many factors including: (i) CFC's inability to finance the sale of repossessed assets, resulting in CFC's use of wholesale markets through which recovery rates were significantly lower; (ii) the natural increase in delinquencies in some of CFC's products as they aged into periods in which CFC had historically experienced higher delinquencies; (iii) the increase in retail credit receivables which typically experienced higher credit losses; (iv) economic factors which had increased defaults; and (v) a decrease in the manufactured housing recovery rates when repossessed properties were sold. At December 31, 2002, the 60-days-and-over delinquencies as a percentage of on-balance sheet finance receivables were 3.21 percent. Under the portfolio method, CFC estimated an allowance for credit losses based upon its assessment of current and historical loss experience, loan portfolio trends, the value of collateral, prevailing economic and business conditions, and other relevant factors. Increases in CFC's allowance for credit losses were expensed based on CFC's assessments of such factors. For loans previously recorded as sales, the anticipated discounted credit losses over the expected life of the loans were reflected through a reduction in the gain-on-sale revenue recorded at the time of securitization or through impairment charges when assessments of estimated losses had changed.
At December 31, 2002, CFC had a total of 20,918 unsold manufactured housing properties (11,939 of which related to off-balance sheet securitizations) in repossession, compared to 15,057 properties (10,814 of which related to off-balance sheet securitizations) at December 31, 2001. CFC reduced the value of repossessed property to its estimate of net realizable value upon repossession. CFC liquidated 25,017 managed manufactured housing units at an average loss severity rate (the ratio of the loss realized to the principal balance of the foreclosed loan) of 65 percent in 2002. The loss severity rate related to the on-balance sheet manufactured housing portfolio was 59 percent in 2002. The higher industry levels of repossessed manufactured homes which existed in the marketplace in 2002, adversely affected recovery rates, specifically wholesale severity. Additionally, such higher levels of repossessed inventory made it more difficult for CFC to liquidate its inventory at rates it had recovered in the past. CFC also believed the higher average severity rate in 2002 for the on-balance sheet
CFC believed that its historical loss experience had been favorably affected by various loss mitigation policies. Under one such policy, CFC worked with the defaulting obligor and its dealer network to find a new buyer who met CFC's underwriting standards and was willing to assume the defaulting obligor's loan. Under other loss mitigation policies, CFC permitted qualifying obligors to defer scheduled payments or CFC reduced the interest rate on the loan, in an effort to avoid loan defaults.
Due to the prevailing economic conditions in 2002, CFC increased the use of the aforementioned mitigation policies. Based on past experience, CFC believed these policies would reduce ultimate losses. If CFC applied loss mitigation policies, CFC generally reflected the customer's delinquency status as not being past due. Accordingly, the loss mitigation policies favorably impacted CFC's delinquency ratios. CFC attempted to appropriately reserve for the effects of these loss mitigation policies when establishing loan loss reserves. These policies were also considered when CFC determined the value of its retained interests in securitization trusts. Loss mitigation policies were applied to 10.7 percent of average managed accounts in 2002. Due to CFC's liquidity limitations, many loss mitigation policies were curtailed in the fourth quarter of 2002.
Finance interest expense decreased by 8.5 percent, to $1,130.0 million, in 2002. Such decrease was primarily the result of lower average borrowing rates and reduced borrowings to fund the decreased finance receivables. CFC's average borrowing rate was 6.1 percent during 2002. The decrease in the average borrowing rate in 2002 was primarily due to the decrease in the general interest rate environment and the repurchase and retirement of some of CFC's public debt.
Other operating costs and expenses included the costs associated with servicing CFC's managed receivables, non-deferrable costs related to originating new loans and other operating costs. Such expense decreased by 4.1 percent, to $616.0 million, in 2002. In 2002, CFC accrued $26.8 million pursuant to judgments issued in two arbitration proceedings. Excluding the litigation accrual, such costs had decreased due to the realization of the benefits from cost saving initiatives and a decrease in origination volume.
Impairment charges represented losses related to reductions in the value of CFC's retained interests in securitization trusts (including interest-only securities and servicing rights). CFC carried interest-only securities at estimated fair value and servicing rights at the lower of cost or fair value. Fair value was determined by discounting the projected cash flows over the expected life of the receivables sold using current prepayment, default, loss, interest rate and servicing cost assumptions. CFC included any potential payments related to the guarantees of certain lower-rated securities issued by the securitization trusts in such projected cash flows. When other-than-temporary declines in value occurred, CFC reduced the amortized cost to estimated fair value and recognized a loss. The assumptions used to determine new values were based on the internal evaluations of CFC's management. Under accounting rules (pursuant to Emerging Issues Task Force Issue No. 99-20, "Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets" ("EITF 99-20")) which were adopted on July 1, 2000, declines in the value of CFC's retained interests were recognized when: (i) the fair value of the security was less than its carrying value; and (ii) the timing and/or amount of cash expected to be received from the security had changed adversely from the previous valuation which determined the carrying value of the security. When both occurred, the security was written down to fair value. The assumptions used to determine new values for CFC's retained interests were based on internal evaluations.
The determination of the value of CFC's retained interests in securitization trusts required significant judgment. CFC recognized significant charges when the retained interests did not perform as well as anticipated. In securitizations to which these retained interests related, CFC had retained certain contingent risks in the form of guarantees of certain lower-rated securities issued by the securitization trusts. As of December 31, 2002, the total amount of these guarantees was approximately $1.4 billion. CFC considered any potential payments related to these guarantees in the projected cash flows used to determine the value of its retained interests.
During 2002, CFC's ability to access the securitization markets was eliminated. The securitization markets had been CFC's main source of funding for loans made to purchasers of repossessed manufactured homes. CFC believed that its loss severity rates historically had been positively impacted when it used retail channels to dispose of repossessed inventory (where the repossessed units were sold through company-owned sales lots or CFC's dealer network). Since CFC was no longer able to fund the loans made on repossessed homes, sales through these channels ceased and CFC relied on the wholesale channel to dispose of repossessed manufactured housing units, through which recovery rates were significantly lower. Accordingly, CFC changed the loss severity assumptions used to value its retained interests to reflect the higher loss severity CFC expected to experience in the future. In addition, CFC increased the default assumptions used to value its retained interests to reflect CFC's future expectations based on then current default rates.
CFC's access to liquidity was further limited during the fourth quarter of 2002. CFC was unable to access alternative funding sources to replace the financing it previously obtained through the securitization markets. Further, CFC continued to experience high levels of delinquencies and foreclosures. As a result of the inability to obtain financing, CFC was required to suspend all originations of manufactured housing loans, including the financing of repossessed manufactured housing units, in the fourth quarter of 2002. In addition, CFC discontinued the use of some of its loss mitigation strategies including its inventory loan assumption program. Prices of used manufactured housing units in the wholesale channels were at historical lows due to the high levels of repossessed manufactured housing inventories available in the market. Accordingly, CFC increased the loss severity and default assumptions used to value its retained interests to reflect CFC's future expectations based on current experience. During 2002, CFC increased the assumption for the expected rates of loss severity (the expected weighted average ratio of losses realized to the principal balance of the foreclosed loans) from 65.4 percent to 89.5 percent. CFC increased the assumption for the expected rates of default (the expected weighted average constant ratio of defaulting loans to the balance of all loans sold) from 2.34 percent to 2.97 percent.
As a result of the requirements of EITF 99-20 and the assumption changes described above, CFC recognized an impairment charge of $1,077.2 million in 2002 for the retained interests. CFC also recognized a $336.5 million increase in the valuation allowance related to its servicing rights as a result of changes in the expected future costs of servicing the finance receivables. Such servicing costs increased due to higher levels of delinquent and defaulting loans. These assumptions reflected the subordination of the servicing fees to other cash flows in certain securitization transactions. In addition, CFC recognized impairment charges of: (i) $29.3 million to establish a valuation allowance for advances CFC was required to make to the securitization trusts which were estimated to be uncollectible; and (ii) $6.9 million to establish a liability of guarantee payments due to certain holders of lower-rated securities issued by the securitization trusts which CFC was unable to pay.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to
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 annuities to the senior market through approximately 4,600 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.
The Plan generally provided for the full payment or reinstatement of allowed administrative claims, priority claims, fully secured claims and certain intercompany claims, and the distribution of new equity securities (including warrants) to partially secured and unsecured creditors of our Predecessor. Holders of claims arising under our Predecessor's $1.5 billion senior bank credit facility also received a pro rata interest in our $1.3 billion credit agreement. Holders of our Predecessor's common stock and preferred stock did not receive any distribution under the Plan, and these securities, together with all other
prepetition securities and the $1.5 billion senior bank credit facility of our Predecessor, were cancelled on the Effective Date.
o warrants to purchase 6.0 million shares of our common stock (the "Series A Warrants").
o lenders under our Predecessor's senior bank credit facility and director and officer loan program received approximately 34.4 million shares of our Class A Preferred Stock, with an initial aggregate liquidation preference of $859.7 million;
o holders of our Predecessor's guaranteed senior notes received approximately 60.6 million shares of our common stock;
o holders of our Predecessor's general unsecured claims received approximately 3.8 million shares of our common stock; and
o holders of trust preferred securities issued by our Predecessor's subsidiary trusts received approximately 1.5 million shares of our common stock and Series A Warrants to purchase 6.0 million shares of our common stock at an exercise price of $27.60 per share.
The distribution of our common stock summarized above represented approximately 98 percent of all of the shares of common stock to be distributed under the Plan. As of December 31, 2003, approximately 1.8 million of our outstanding shares of common stock were reserved for distribution under the Plan for unresolved disputed claims. During 2004, .6 million of these reserved shares were distributed due to the resolution of disputed claims. If reserved shares remain after resolution of pending disputed claims, such shares will be reallocated to other general unsecured creditors of our Predecessor as provided for under the Plan.
Upon our emergence from bankruptcy, we implemented fresh start reporting in accordance with SOP 90-7. These rules required the Company 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. 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.
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, and $14.4 million in 2002 for fees payable to professionals who assisted with the Chapter 11 cases.
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. The operating results of CVIC have been reported as discontinued operations in all periods presented in the accompanying consolidated statement of operations. See the note to the consolidated financial statements entitled "Financial Information Regarding CVIC."
- ----------------- (a) Predecessor balance sheet as of August 31, 2003, prior to the recording of the discharge of prepetition liabilities and the effects of the fresh start adjustments.
(b) These adjustments to the fresh start balance sheet reflected the reorganization value of Conseco of $3,800.0 million. After deducting from Conseco's reorganization value the long-term indebtedness of Conseco at the Effective Date, consisting of $1,300.0 million under the senior secured bank credit facility, the total equity of Conseco was $2,500.0 million. After deducting from Conseco's total equity the value of the new preferred stock of $859.7 million, the value of the new common stock was $1,640.3 million. These adjustments also reflected the gain on the discharge of prepetition liabilities.
(e) The Company's historical cost of policies purchased and cost of policies produced 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.
The value of policies in force was determined using a discount rate of 12 percent, which was the rate of return that our management (with assistance from a consulting actuarial firm) believed would be required by a purchaser of the business, based on conditions existing as of the Effective Date. In determining such rate of return, the following factors, among others, were considered:
o Market rates of interest that would be applicable to an acquisition of the business;
o The perceived likelihood of changes in insurance regulations and tax laws;
(f) Assets and liabilities were adjusted to reflect their estimated fair market value. The portion of the reorganization value that could not be attributed to specific tangible or identified intangible assets was recorded as goodwill.
(g) The Company establishes reserves for insurance policy benefits based on assumptions as to investment yields, mortality, morbidity, withdrawals and lapses. These reserves include amounts for estimated future payment of claims based on actuarial assumptions. Many factors can affect these reserves, such as economic conditions, inflation, hospital and pharmaceutical costs, changes in doctrines of legal liability and extra contractual damage awards. The fresh-start balance was based on the Company's best estimate (with assistance from a consulting actuarial firm) of the future performance of this business, given recent and expected changes in experience. Adjustments to the Predecessor's liabilities for insurance and asset accumulation products are further discussed in the note to the consolidated financial statements entitled "Liabilities for Insurance and Asset Accumulation Products".
We classify our fixed maturity securities into three categories: (i) "actively managed" (which we carry at estimated fair value with any unrealized gain or loss, net of tax and related adjustments, recorded as a component of shareholders' equity); (ii) "trading" (which we carry at estimated fair value with changes in such value recognized as trading income); and (iii) "held to maturity" (which we carry at amortized cost). We had no fixed maturity securities classified as held to maturity during the periods presented in these financial statements.
Other invested assets include: (i) Standard & Poor's 500 Index Call Options ("S&P 500 Call Options"); and (ii) certain non-traditional investments. We carry the S&P 500 Call Options at estimated fair value as further described below under "Accounting for Derivatives". Non-traditional investments include investments in certain limited partnerships, which are accounted for using the equity method, and promissory notes, which are accounted for using the cost method.
When we realize a gain or loss on investments backing our universal life or investment-type products, we adjust the amortization to reflect the change in estimated gross profits from the products due to the gain or loss realized and the effect of the event on future investment yields. We also adjust the cost of policies produced for the change in amortization that would have been recorded if actively managed fixed maturity securities had been sold at their stated aggregate fair value and the proceeds reinvested at current yields. We included the impact of this adjustment in accumulated other comprehensive income (loss) within shareholders' equity.
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 2004 and the four months ended December 31, 2003; $2.9 million in the eight months ended August 31, 2003; and $7.6 million in 2002.
The Company expects to amortize the balance of the value of policies inforce at the Effective Date as of December 31, 2004 as follows: 11 percent in 2005, 10 percent in 2006, 9 percent in 2007, 8 percent in 2008 and 7 percent in 2009.
The goodwill recognized upon our emergence from bankruptcy resulted from the revaluation of our balance sheet accounts. We revalued our assets and liabilities to current estimated fair value and established our capital accounts at the reorganization value determined in connection with the Plan. We recorded goodwill of $1,141.6 million representing the excess of the reorganization value over specific tangible or identified intangible assets. The goodwill balance was not amortized pursuant to current accounting rules (which became effective January 1, 2002).
(a) We implemented fresh start accounting on August 31, 2003 in accordance with SOP 90-7. These rules required the Company to revalue its assets and liabilities to current estimated fair value, re-establish shareholders' equity at the reorganization value determined in connection with our Plan and record the excess of the reorganization value over tangible or identified intangible assets as goodwill. Fresh start adjustments are the adjustments made to the Predecessor's balance sheet to reflect the revaluation. The total fresh start adjustments of $950 million corresponded to the net of the total adjustments to the assets and liabilities on the Predecessor balance sheet as of August 31, 2003, as summarized in the note entitled "Fresh Start Reporting".
The other intangible assets identified at the emergence date were valued with assistance from a consulting valuation firm. In accordance with SFAS 142, other intangible assets with indefinite lives were not amortized and other intangible assets with finite useful lives were amortized over their estimated useful lives. We amortized the value of our career agency force and our independent agency force over their estimated useful lives of 15 years using the straight line method.
The following summarizes other identifiable intangible assets as of December 31, 2004 and 2003 (dollars in millions):
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
For investment and universal life-type contracts that do not involve significant mortality or morbidity risk, the amounts collected from policyholders are considered deposits and are not included in revenue. Revenues for these contracts consist of charges for policy administration, cost of insurance charges and surrender charges assessed against policyholders' account balances. Such revenues are recognized when the service or coverage is provided, or when the policy is surrendered.
Traditional life and the majority of our accident and health products (including long-term care, Medicare supplement and specified disease products) are long duration insurance contracts. Premiums on these products are recognized as revenues when due from the policyholders.
We establish liabilities for traditional life, accident and health insurance, and life contingent payment annuity products using morbidity and mortality tables in general use in the United States, which are modified to reflect the Company's actual experience when appropriate. These reserves are computed at amounts that, with additions from estimated future premiums received and with interest on such reserves at estimated future rates, are expected to be sufficient to meet our obligations under the terms of the policy. Liabilities for future policy benefits are computed on a net-level premium method based upon assumptions as to investment yields, mortality, morbidity, withdrawals, policy dividends and maintenance expenses determined when the policies were issued (or with respect to policies inforce at August 31, 2003, the Company's best estimate of such assumptions on the fresh-start date). Once established, assumptions on these products are generally not changed. We make an additional provision to allow for potential adverse deviation for some of our assumptions.
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 $70.2 million in 2004; $31.9 million in the four months ended December 31, 2003; $57.3 million in the eight months ended August 31, 2003; and $78.7 million in 2002.
Our income tax expense includes deferred income taxes arising from temporary differences between the financial reporting and tax bases of assets and liabilities, capital loss carryforwards and net operating loss carryforwards. The net deferred tax assets totaled $2.6 billion at December 31, 2004. 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 future taxable income during the periods in which our temporary differences become deductible and before our capital loss carryforwards and net operating loss carryforwards expire. In addition, the use of the Company's net ordinary loss carryforwards is dependent, in part, on whether the Internal Revenue Service ("IRS") ultimately agrees with the tax position we have taken and plan to take in our current and future tax returns. We evaluate the realizability of our deferred income tax assets and assess the need for a valuation allowance on an ongoing basis. Based upon information existing at the Effective Date, we established a valuation allowance equal to our entire balance of net deferred income tax assets because, at that time, the realization of such net deferred income tax assets in future periods was uncertain. As of December 31, 2004, we no longer believed that a full valuation allowance was necessary. However, as further discussed in the note entitled "Income Taxes", we believed that it was necessary to have a valuation allowance on a portion of our deferred tax assets. This determination was made by evaluating each component of the deferred tax assets and assessing the effects of limitations or issues on such component's ability to be fully recognized in the future.
When we prepare financial statements in conformity with GAAP, we are required to make estimates and assumptions that significantly affect various reported amounts of assets and liabilities, and the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting periods. For example, we use significant estimates and assumptions in calculating values for the cost of policies produced, the value of policies inforce at the Effective Date, certain investments, assets and liabilities related to income taxes, goodwill, liabilities for insurance and asset accumulation products, liabilities related to litigation, guaranty fund assessment accruals and amounts recoverable from loans to certain former directors and former employees. If our future experience differs from these estimates and assumptions, our financial statements would be materially affected.
Our equity-indexed annuity products provide a guaranteed base rate of return and a higher potential return linked to the performance of the Standard & Poor's 500 Index ("S&P 500 Index") based on a percentage (the "participation rate") 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 S&P 500 Call Options in an effort to hedge potential increases to policyholder benefits resulting from increases in the S&P 500 Index to which the product's return is linked. We include the cost of the S&P 500 Call 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 value of these options in net investment income (classified as investment income from policyholder accounts). Option costs that are attributable to benefits provided were $44.8 million during 2004; $19.1 million during the four months ended December 31, 2003; $53.5 million during the eight months ended August 31, 2003; and $97.5 million during 2002. These costs are reflected in the change in market value of the S&P 500 Call Options included in investment income. Net investment income (loss) related to equity-indexed products before this expense was $58.5 million in 2004; $61.3 million in the four months ended December 31, 2003; $83.6 million in the eight months ended August 31, 2003; and $(3.0) million in 2002. These amounts were substantially offset by the corresponding charge to insurance policy benefits. The estimated fair value of the S&P 500 Call Options was $50.4 million and $119.6 million at December 31, 2004 and 2003, respectively. We classify these instruments as other invested assets.
The Company entered into a forward sale contract related to a portion of its venture capital investment in AWE. Such contract was carried at market value, with the change in value being recognized as venture capital income (loss). The value of the derivative fluctuated in relation to the AWE common stock. In the third quarter of 2002, we agreed with the counterparties to unwind the forward sale contract, which resulted in a small gain.
The FASB's Derivative Implementation Group issued SFAS No. 133 Implementation Issue No. B36, "Embedded Derivatives: Modified Coinsurance Arrangements and Debt Instruments that Incorporate Credit Risk Exposures that are Unrelated or Only Partially Related to the Creditworthiness of the Obligor of Those Instruments" ("DIG B36") in April 2003. DIG B36 addresses specific circumstances under which bifurcation of an instrument into a host contract and an embedded derivative is required. DIG B36 requires the bifurcation of a derivative from the receivable or payable related to a modified coinsurance agreement, where the yield on the receivable and payable is based on a return of a specified block of assets rather than the creditworthiness of the ceding company. We implemented this guidance on August 31, 2003, in conjunction with our adoption of fresh start accounting. We have determined that certain of our reinsurance payable balances contain embedded derivatives. Such derivatives had an estimated fair value of $32.1 million and $27.2 million at December 31, 2004 and 2003, respectively. We record the change in the fair value of these derivatives as a component of investment income (classified as investment income from policyholder and reinsurer accounts). We have transferred the specific block of investments related to these agreements to our trading securities account, which we carry at estimated fair value with changes in such value recognized as investment income (also classified as investment income from reinsurer accounts). The change in value of these trading securities should largely offset the change in value of the embedded derivatives.
In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure", an Amendment of FASB Statement No. 123 ("SFAS 148"), which provides three alternative methods for transition to the fair value method of accounting for stock options. SFAS 148 also amends the disclosure requirements of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123").
We apply Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations ("APB 25") in accounting for our stock option plans. If compensation cost had been determined based on the fair value at the grant dates for awards granted after January 1, 1995, consistent with the method of SFAS 123, the Company's pro forma net income (loss) and pro forma earnings per share would have been as follows (dollars in millions, except per share amounts):
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.
Investment securities. For fixed maturity securities (including redeemable preferred stocks) and for equity and trading securities, we use quotes from independent pricing services, where available. For investment securities for which such quotes are not available, we use values obtained from broker-dealer market makers or by discounting expected future cash flows using a current market rate appropriate for the yield, credit quality, and, for fixed maturity securities, the maturity of the investment being priced.
The FASB issued SFAS 142 in June 2001. Under the new rule, intangible assets with an indefinite life are no longer amortized in periods subsequent to December 31, 2001, but are subject to annual impairment tests (or more frequent under certain circumstances), effective January 1, 2002. The Company determined that all of its goodwill had an indefinite life and was therefore subject to the new rules. The Company adopted SFAS 142 on January 1, 2002.
On August 14, 2002, our insurance subsidiaries' financial strength ratings were downgraded by A.M. Best to "B (fair)" and on September 8, 2002, the Company defaulted on its public debt. These developments caused sales of our insurance products to fall and policyholder redemptions and lapses to increase. This adverse impact on our insurance subsidiaries required that an additional impairment test be performed as of September 30, 2002, in accordance with SFAS 142.
The FASB issued Statement of Financial Accounting Standards No. 123 (revised 2004) "Share-Based Payment" ("SFAS 123R") in December 2004. SFAS 123R revises SFAS 123 and supersedes APB 25. SFAS 123R provides additional guidance on accounting for share-based payments and will require all such awards to be measured at fair value with the related compensation cost recognized in the statement of operations over the related service period. SFAS 123R is effective for all awards granted, modified, repurchased or cancelled in the interim period beginning after June 15, 2005 and requires the recognition of compensation cost over the remaining vesting period for the portion of outstanding awards that are not vested as of the effective date. SFAS 123R also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow rather than as an operating cash flow, as currently required. The Company's net income would have been reduced by $4.1 million in 2004 if we had recognized stock-based employee compensation as determined under the fair value method, net of income taxes.
The FASB issued Statement of Financial Accounting Standards No. 153, "Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29" ("SFAS 153") in December 2004. SFAS 153 amends prior guidance to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. A nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. The provisions of SFAS 153 are effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005 and shall be applied prospectively. SFAS 153 is not expected to have a material impact on the Company's consolidated financial statements at the
In March 2004, the Emerging Issues Task Force issued Emerging Issues Task Force Topic No. 03-01, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" ("EITF 03-01"). EITF 03-01 provides additional guidance for determining whether an impairment of an investment is other than temporary. EITF 03-01 also includes guidance for accounting for an investment subsequent to an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. Certain guidance in EITF 03-01 was effective for the quarter ended September 30, 2004. The guidance effective for the quarter ended September 30, 2004 did not significantly change our procedures for evaluating impairments, although additional disclosures have been added to the notes to the consolidated financial statements. The FASB is currently considering additional guidance, which we will evaluate when finalized.
The Company has investments in various types of VIEs, some of which required additional disclosure under FIN 46, and several of which required consolidation under FIN 46. 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 46.
The FASB issued Statement of Financial Accounting Standards No. 146, "Accounting for Exit or Disposal Activities" ("SFAS 146") in June 2002. SFAS 146 addressed financial accounting and reporting for costs that are associated with exit and disposal activities and supersedes Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)" ("EITF 94-3"). SFAS 146 is required to be used to account for exit or disposal activities that are initiated after December 31, 2002. SFAS 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of commitment to an exit or disposal plan. The Company adopted the provisions of SFAS 146 on January 1, 2003, and such adoption did not have an impact on the Company's consolidated financial statements.
The FASB issued Statement of Financial Accounting Standards No. 145, "Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections" ("SFAS 145") in April 2002. Under previous guidance all gains and losses resulting from the extinguishment of debt were required to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. SFAS 145 rescinds that guidance and requires that gains and losses from extinguishments of debt be classified as extraordinary items only if they are both unusual and infrequent in occurrence. SFAS 145 also amends previous guidance to require certain lease modifications that have economic effects similar to sale-leaseback transactions to be accounted for in the same manner as sale-leaseback transactions. The Company adopted SFAS 145 on January 1, 2003, and prior period amounts related to extraordinary gains on the extinguishment of debt have been reclassified accordingly.
Below-investment grade securities have different characteristics than investment grade corporate debt securities. Risk of loss upon default by the borrower is significantly greater for below-investment grade securities. Below-investment grade securities are generally unsecured and are often subordinated to other creditors of the issuer. Also, issuers of below-investment grade securities usually have higher levels of debt and are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than are 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.
The carrying value of fixed maturity investments and mortgage loans not accruing investment income totaled $7.2 million, $50.7 million and $169.6 million at December 31, 2004, 2003 and 2002, respectively.
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 fixed maturity investments, equity securities and other invested assets 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 fixed maturity investments, equity securities and other invested assets 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 fixed maturity investments, equity securities and other invested assets resulting from declines in fair values that we concluded were other than temporary. Net realized investment losses during 2002 included $556.8 million of writedowns of fixed maturity investments, equity securities and other invested assets resulting from declines in fair values that we concluded were other than temporary net of $.5 million of net gains from the sales of investments (primarily fixed maturities) with proceeds of $19.5 billion. At December 31, 2004, fixed maturity securities in default as to the payment of principal or interest had an aggregate amortized cost of $4.7 million and a carrying value of $6.8 million.
During 2004, we sold $2.6 billion of fixed maturity investments which resulted in gross investment losses (before income taxes) of $46.2 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.
We implemented fresh start reporting on August 31, 2003, in accordance with SOP 90-7, which required us to revalue our actively managed fixed maturities to current estimated fair value. Accordingly, as of December 31, 2003, none of the actively managed fixed maturities, with gross unrealized losses of $34.4 million, had been in a continuous unrealized loss position for 12 months or greater.
Based on management's current assessment of investments with unrealized losses at December 31, 2004, 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.
Our investment in the GM building was made through a partnership which acquired the building in 1998 for $878 million. The initial capital structure of the partnership consisted of: (i) a $700 million senior mortgage; (ii) $200 million of subordinated debt with a stated fixed return of 12.7 percent payable-in-kind, and the opportunity to earn an additional residual return; and (iii) $30 million of partnership equity, owned 50 percent by Conseco and 50 percent by an affiliate of Donald Trump. A Trump affiliate also served as general manager of the acquired building. We owned 100 percent of the subordinated debt.
expected residual returns. Based on our 100 percent ownership of the subordinated debt, we were the primary beneficiary of the GM building. The partnership was consolidated in our financial statements effective August 31, 2003, in accordance with the requirements of FIN 46, which was implemented in conjunction with fresh start accounting. The August 31, 2003 fresh start balance sheet reflected the following balances of the partnership: the GM building at $1,336.3 million; cash of $28.4 million; and a non-recourse loan of $700 million. 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).
In general, prepayments on the underlying mortgage loans and the securities backed by these loans increase when prevailing interest rates decline significantly in absolute terms and also relative to the interest rates on such 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 as a result 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, 2004 (dollars in millions):
The amortized cost and estimated fair value of structured securities at December 31, 2004, summarized by type of security, were as follows (dollars in millions):
Planned amortization classes and accretion-directed bonds adhere to fixed schedules of principal payments as long as the underlying mortgages experience prepayments within a certain range. Changes in prepayment rates are first absorbed by support or companion classes. This insulates planned amortization classes from the consequences of both faster prepayments (average life shortening) and slower prepayments (average life extension).
Subordinated and mezzanine tranches are classes that provide credit enhancement to senior tranches. The rating agencies require that this credit enhancement not deteriorate due to prepayments for a period of time, usually five years of complete lockout, followed by another period of time where prepayments are shared pro rata with senior tranches. Subordinated and mezzanine tranches bear a majority of the risk of loss due to property owner defaults. Subordinated bonds are generally rated "AA" or lower; we typically do not hold such securities rated lower than "BB".
At December 31, 2004, the mortgage loan balance was primarily comprised of commercial loans. Approximately 9 percent, 7 percent, 6 percent, 6 percent and 6 percent of the mortgage loan balance were on properties located in Ohio, Massachusetts, New York, Pennsylvania and Florida, respectively. No other state comprised greater than 5 percent of the mortgage loan balance. Less than one percent of the mortgage loan balance was noncurrent at December 31, 2004. Our allowance for loss on mortgage loans was $2.4 million at December 31, 2004. At December 31, 2003, we had no allowance for losses on mortgage loans (mortgage loans were recorded at market values at August 31, 2003, in conjunction with our adoption of fresh start accounting).
Our investment borrowings averaged approximately $522.6 million during the year ended December 31, 2004; $488.9 million during the four months ended December 31, 2003; and $689.1 million during the eight months ended August 31, 2003 and were collateralized by investment securities with fair values approximately equal to the loan value. The weighted average interest rates on such borrowings were 1.5 percent during the year ended December 31, 2004; 1.5 percent during the four months ended December 31, 2003; and 1.8 percent during the eight months ended August 31, 2003.
Life insurance companies are required to maintain certain investments on deposit with state regulatory authorities. Such assets had aggregate carrying values of $142.2 million and $127.3 million at December 31, 2004 and 2003, respectively.
At the Effective Date, the Successor established insurance liabilities at the present value of future benefits and expenses less future premiums associated with the policies, by using current best-estimate assumptions with provisions for adverse deviation. Such assumptions included estimates as to investment yields, mortality, morbidity, withdrawals, lapses and maintenance expenses. The current best-estimate assumptions for these blocks of business differed from the original actuarial assumptions determined when the business was acquired or issued as further described in the following paragraphs.
Due to the current interest rate environment and the requirement to mark the value of the investment portfolio to
In 2004, the IRS completed its examination of the Company for tax years ending December 31, 1999 through December 31, 2001, and there were no significant adjustments. Conseco and its affiliates are currently under examination by the IRS for tax years ending December 31, 2002 through December 31, 2003. The outcome of this examination is not expected to result in material adverse deficiencies, but may result in utilization or adjustment of the income tax loss carryforwards reported below, and is expected to resolve the Section 382 limitation and the life insurance limitation issues more fully discussed below.
the Internal Revenue Code (the "Code") applies to limit the net operating losses related to Conseco Finance, and whether such net operating losses are eligible to offset life insurance income without limitation. We intend to maintain a sufficient valuation allowance against our deferred tax assets until objective evidence exists to further reduce or eliminate it.
We also evaluated the likelihood that we would have sufficient taxable income to offset the available deferred tax assets. This assessment required significant judgment. Over the past three years, the Company sustained a cumulative total net loss primarily due to the losses incurred by the Company's Predecessor in 2002. Based upon our estimates of future income (based on projections completed in early 2005), we believe that we will more likely than not recover $947.0 million of our deferred tax assets through reductions of our tax liabilities in future periods. However, recovery is dependent on achieving our projections of future taxable income, and failure to do so would result in an increase in the valuation allowance in a future period. Any future increase in the valuation allowance would result in additional income tax expense and reduce shareholders' equity, and such an increase could have a significant impact upon our earnings in the future.
As of December 31, 2004, we had $4.4 billion of net operating loss carryforwards and $1.1 billion of capital loss carryforwards (after taking into account the reduction in tax attributes described in the paragraph which follows and the loss resulting from the worthlessness of CFC discussed below), which expire as follows (dollars in millions):
The timing and manner in which we will utilize the net operating loss carryforwards and capital loss carryforwards in any year or in total may be limited by various provisions of the Code (and interpretation thereof) and our ability to generate sufficient future taxable income in the relevant carryforward period.
The closing agreement with the IRS also determined that the loss recognized on the worthlessness of CFC was an ordinary loss for tax purposes and not a capital loss.
The timing and manner in which the Company will be able to utilize some or all of its net operating loss carryforwards may be limited by Section 382 of the Code. Section 382 imposes limitations on a corporation's ability to use its net operating loss carryforwards when the company undergoes an ownership change. Because the Company underwent an ownership change pursuant to its reorganization, this limitation applies to the Company. In order to determine the amount of this limitation, we must determine the amount of our net operating loss carryforwards related to the period prior to our emergence from bankruptcy (such amount will be subject to the 382 limitation) and the amount related to the period after emergence (such amount will not be subject to the 382 limitation). When the Company filed its 2003 federal income tax return, it elected to specifically identify transactions in each period and record them in the period they actually occurred. As a result, we believe the loss related to CFC will be treated as post emergence and therefore not subject to the Section 382 limitation. Any losses that are subject to the Section 382 limitation will only be utilized by the Company up to approximately $140 million per year with any unused amounts carried forward to the following year. The IRS has informed the Company that it will address this matter during its examination of our tax returns for calendar years 2002-2003.
In January 2004, our Previous Credit Facility was amended to remove the requirement that our insurance subsidiaries maintain minimum A.M. Best financial strength ratings. In March 2004, the Previous Credit Facility was further amended to change the definition of a financial ratio we were required to maintain and clarify how the ratio was calculated. The fees incurred to obtain these amendments totaled $3.6 million, which were amortized as interest expense until the Previous Credit Facility was repaid in full.
We are required to make quarterly principal payments of $2.0 million commencing September 30, 2004, and continuing until March 31, 2010. The remaining principal balance is due on June 22, 2010. The Company made an optional prepayment of $28.0 million in December 2004. The Company is required to make an additional mandatory prepayment of $1.2 million (after consideration of the $28.0 million prepayment) by March 31, 2005, based on the Company's excess cash flows at December 31, 2004, as defined in the Credit Facility. The borrowing bears interest, payable at least quarterly, based on either a eurodollar rate or a base rate. The eurodollar rate is equal to LIBOR plus 4 percent. The base rate is equal to 3 percent plus the greater of: (i) the Federal funds rate plus .50 percent; or (ii) Bank of America's prime rate. The margins on the eurodollar rate and the base rate were each reduced by .5 percent during the third quarter of 2004 because the Company's senior secured long-term debt was rated at least B2 by Moody's Investors Service, Inc. ("Moody's") and BB- by S&P, in each case with a stable outlook. On December 31, 2004, the interest rate on our Credit Facility was 5.9 percent.
The 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 18 percent at December 31, 2004); (ii) an interest coverage ratio greater than or equal to 2.0:1.0 for each rolling four quarters ending (or, if less, the number of full quarters commencing after June 22, 2004) during the period October 1, 2004 through June 30, 2007, and 2.5:1.0 for the four quarters ending September 30, 2007 and for each rolling four quarters thereafter (such ratio exceeded 2.5:1.0 for the two quarters ending December 31, 2004); (iii) EBITDA, as defined in the Credit Facility, greater than or equal to $725.0 million for each rolling four quarters ending during the period July 1, 2004 through December 31, 2005, $775.0 million for each rolling four quarters ending during the period January 1, 2006 through December 31, 2006, and $825.0 million for each rolling four quarters thereafter (such amount was greater than $990 million for the four quarters ended December 31, 2004); (iv) an aggregate risk-based capital ratio, as defined in the Credit Facility, greater than or equal to 240 percent for each quarter ending during the period from December 31, 2004 through March 31, 2005, 245 percent for each quarter ending during the period June 30, 2005 through March 31, 2006, and 250 percent for each quarter ending thereafter (such ratio was 318 percent at December 31, 2004); (v) a combined statutory capital and surplus level, as defined in the Credit Facility of greater than $1,270.0 million (combined statutory capital and surplus at December 31, 2004 exceeded such requirement); and (vi) specified investment portfolio requirements (such investment portfolio requirements were met at December 31, 2004).
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 arising from either pending or threatened legal actions, after consideration of provisions made for losses, will have a material adverse effect on the financial condition, operating results or cash flows of the Company. Nonetheless, given the large or indeterminate amounts sought in certain of these actions, and the inherent unpredictability of litigation, it is possible that an adverse outcome in certain matters could, from time to time, have a material adverse effect on the Company's consolidated results of operations or cash flows in particular quarterly or annual periods.
In the cases described below we have set out 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 the 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.
Since we announced our intention to restructure our capital on August 9, 2002, a total of eight purported securities fraud class action lawsuits have been filed in the United States District Court for the Southern District of Indiana. The complaints name us as a defendant, along with certain of our current and 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. In each case 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, Case No. 02-CV-1332 DFH-TAB. The complaint seeks an unspecified amount of damages. The stay was lifted on October 15, 2003. The plaintiffs have filed a consolidated class action complaint with respect to the individual defendants. Our liability with respect to this lawsuit was discharged in the Plan and our obligation to indemnify individual defendants who were not serving as one of our officers or directors on the Effective Date of the Plan is limited to $3 million in the aggregate under the Plan. 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 the Plan. A motion to dismiss was filed on behalf of defendants Shea, Wendt and Chokel. The motion was heard on November 19, 2004 and we await a ruling on same. We believe this lawsuit is without merit and intend to defend it vigorously. Our current estimate of the maximum loss that we could reasonably incur on this case is approximately $3.0 million (based on our obligation to indemnify individual defendants under the Plan). We do not believe that the potential loss related to the individual defendant who served as an officer on the Effective Date is material. However, the ultimate outcome of this lawsuit cannot be predicted with certainty.
The Company and certain subsidiaries including principally Conseco Life Insurance Company, have been named in numerous purported class actions and individual lawsuits alleging, among other things, breach of contract, fraud and misrepresentation with regard to a change made in the way monthly deductions are calculated for insurance coverage. These cases relate to life insurance policies sold primarily under the names "Lifestyle" and "Lifetime". Approximately 86,500 policies were subject to the change. Many of these nationwide purported class action lawsuits were filed in Federal courts across the United States. The Judicial Panel on Multidistrict Litigation consolidated these lawsuits into the case now referred to as In Re Conseco Life Insurance Co. Cost of Insurance Litigation, Cause No. MDL 1610 (Central District, California). The complaint seeks unspecified compensatory, punitive and exemplary damages and specifically alleges, among other things, that the change made in the way monthly deductions are calculated for insurance coverage enabled Conseco, Inc. to add $360 million to its balance sheet. A class certification hearing was held on March 7, 2005 and the Judge has not yet issued a ruling. 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 Alene P. Mangelson, et al. v. Conseco Life Insurance Company, Cause No. 29D01-0403-PL-211 (Superior Court, Hamilton County, Indiana). Those cases filed in California state courts have been consolidated and are being coordinated under the new caption Cost of Insurance Cases, Judicial Council Coordination Proceeding No. 4384 (Judicial Council of California). On January 13, 2005, a multi-plaintiff federal action was filed in Hawaii. Clifford Arakaki et al. v. Conseco Life Insurance Company and Does 1-100, Case No.CV05-00026SPKLEK (District of Hawaii) seeks a minimum of $5 million. This case has been conditionally transferred to In Re Conseco Life Insurance Co. Cost of Insurance Litigation. 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, 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). We believe these lawsuits are without merit and intend to defend them vigorously. The ultimate outcome of the lawsuits cannot be predicted with certainty.
The Company will pursue recovery of any settlement in the Russell matter, from its fiduciary insurance carrier, RLI Insurance Company ("RLI"). However, on February 13, 2004, RLI filed a declaratory judgment action asking the court to find no liability under its policy for the claims made in the Russell matter due to certain releases provided to them pursuant to RLI's agreement to settle a case involving the Predecessor related to a different policy coverage, RLI Insurance Company v. Conseco, Inc., Stephen Hilbert, et al., Case No. 1:04-CV-0310DFH-TAB (Southern District, Indiana). On March 15, 2004, RLI filed an amended complaint adding Conseco Services as an additional defendant. On March 30, 2004, RLI filed a second amended complaint adding certain individual plan fiduciaries as defendants. On May 24, 2004, we filed our answer to the second amended complaint and counterclaims for declaratory judgment and breach of contract. On September 2, 2004, RLI filed a motion for judgment on all counterclaims. The court has stayed this matter until the Russell matter is resolved. We believe RLI's position is without merit because the previous release is not applicable to the Russell matter. We plan to vigorously defend all claims against the Company and to vigorously pursue all claims against RLI, but the ultimate outcome of the lawsuit cannot be predicted with certainty. We expect to ultimately recover a substantial portion of the $10 million we expect to pay in settlement of the Russell matter from RLI.
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
On December 10, 2004, an arbitration award was issued by the American Arbitration Association finding for American Worldwide Insurance, Inc. ("AWI") and Todd Green ("Green"), individually, and against Conseco Life Insurance Company ("Conseco Life"). The arbitrated dispute arises from a marketing agreement initially entered into in 1994. AWI and Green alleged breach of contract and bad faith and sought $4.3 million actual damages and unspecified punitive damages. The award resulted in total actual damages of $2.1 million, as well as future payments of $.9 million due on September 9, 2005, $.8 million due on September 9, 2006, and $.6 million due on September 9, 2007. The panel also found that AWI and Green failed to prove that either Conseco Life or Conseco Marketing, LLC acted in bad faith and refused an award of punitive damages. We have filed an application in Federal court in the case captioned, Conseco Life Insurance Company and Conseco Marketing, LLC v. American Worldwide Insurance, Inc. and Todd Green, Cause No. 1:04-CV-2035-DFH-TAB (Southern District, Indiana) requesting, among other things, to vacate the arbitration award because it is contrary to applicable law and order a new arbitration proceeding. AWI and Green have filed a motion in opposition and a motion to confirm the arbitration award. The issues are to be fully briefed by April 4, 2005. Our estimate of the ultimate loss we may incur in this matter is between $1 million and $4.3 million.
named plaintiffs, which motion was granted in June 2002. Plaintiffs appealed to the 11th Circuit Court of Appeals. The 11th Circuit, in July 2003, affirmed in part and reversed in part, allowing two fraud counts with respect to one plaintiff to survive. The plaintiffs' request for a rehearing with respect to this decision has been denied. Conseco Life filed a summary judgment motion with respect to the remaining claims. This summary judgment was denied in February 2004. In March 2004, the remaining plaintiff filed a motion to substitute plaintiff, to which Conseco Life has objected. The motion to substitute plaintiff has been denied. On April 23, 2004, a similar case was filed. Harold R. Arthur, individually and as Trustee of the Harold A. Arthur Revocable Living Trust, on behalf of himself and all others similarly situated v. Conseco Life Insurance Company, Case no. 6:04-CV-587-ORL-31KRS (U.S. District Court, Middle District of Florida). The case was consolidated with the PLI Sales Practices Litigation in May 2004. Conseco Life filed a motion for summary judgment on all of Plaintiff Arthur's claims and the court took that motion under advisement on February 10, 2005. Briefing continues on class certification. If no class is certified and if Plaintiff Arthur's claims are not summarily adjudicated, trial on the individual claims of both plaintiffs will be set during the June 2005 trial term. Given the uncertainties regarding the outcome of these proceedings, we are unable to estimate the possible range of loss that may result from this pending litigation.
On September 27, 2004, Conseco Life was named in a purported nationwide class action seeking unspecified compensatory damages in the District Court of Clark County, Nevada, Emma Gilbertson individually and on behalf of others similarly situated v. Conseco Life Insurance Company f/k/a Philadelphia Life Insurance Company, Cause No. A492738, alleging breach of contract pertaining to notice of premium increases. Conseco Life believes these lawsuits are without merit and intends to defend them vigorously. Given the uncertainties regarding the outcome of these proceedings, we are unable to estimate the possible range of loss that may result from this pending litigation.
Collection efforts by the Company and its wholly owned subsidiary, Conseco Services, LLC ("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. Cuneo, et al., Case No. 04 CV 09113 (Southern District, New York); Conseco Inc. v. Adams, et al. Case No. 603870/04 (New York Supreme Court); Conseco Inc. v. Adams, et al., Case No. 04 L 012974 (Circuit Court, Cook County,
The balance sheet at December 31, 2004, included: (i) accruals of $10.3 million, representing our estimate of all known assessments that will be levied against the Company's insurance subsidiaries by various state guaranty associations based on premiums written through December 31, 2004; and (ii) receivables of $7.8 million that we estimate will be recovered through a reduction in future premium taxes as a result of such assessments. At December 31, 2003, such guaranty fund assessment accruals were $11.5 million and such receivables were $5.8 million. These estimates are subject to change when the associations determine more precisely the losses that have occurred and how such losses will be allocated among the insurance companies. We recognized expense (benefit) for such assessments of $(.6) million in 2004; $1.2 million in the four months ended December 31, 2003; $4.1 million in the eight months ended August 31, 2003; and $(1.7) million in 2002.
In conjunction with the Plan, bank loans made to certain former directors and employees to enable them to purchase common stock of Old Conseco, were transferred to the Company. These loans with a principal amount of $481.3 million had been guaranteed by Old Conseco. We received all rights to collect the balances due pursuant to the original terms of these loans. In addition, we hold loans to participants for interest on the bank loans which exceed $265 million. The former bank loans and the interest loans are collectively referred to as the "D&O loans." We regularly evaluate the collectibility of these loans in light of the collateral we hold, the credit worthiness of the participants and the current status of various legal actions we have taken to collect the D&O loans. At December 31, 2004, we have estimated that approximately $46 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.
For our deferred compensation plan and postretirement plans, in periods subsequent to the Effective Date, it is our policy to immediately recognize changes in the actuarial benefit obligation resulting from either actual experience being different than expected or changes in actuarial assumptions (which differs from the method used by our Predecessor, whereby, such gains (losses) were recognized over the expected service lives of the participants).
A one percentage point change in the assumed health care cost trend rate would have the following effects (dollars in millions):
The Company does not expect to make any contributions to our postretirement benefit plans in 2005. The benefits expected to be paid pursuant to our deferred compensation plan and postretirement benefit plans as of December 31, 2004 were as follows (dollars in millions):
The changes in unrealized appreciation (depreciation) included in comprehensive income are net of reclassification adjustments for after-tax net gains (losses) from the sale of investments included in net income (loss) of approximately $75 million and $545 million for the years ended December 31, 2004 and 2002, respectively. Such changes for the 2003 periods were not significant.
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
We completed various asset sales and reinsurance transactions in order to raise cash, which resulted in net losses of $47.5 million in 2002. These amounts included: (i) a loss of $39.0 million related to the reinsurance of a portion of our life insurance business; (ii) a loss of $20.0 million associated with the sale of our subsidiary in India; partially offset by (iii) asset sales resulting in a net gain of $11.5 million.
In conjunction with the various modifications to borrowing arrangements (including the debt exchange offer completed in April 2002) entered into in 2002, we incurred costs of $17.7 million which are not permitted to be deferred pursuant to GAAP.
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 on March 1 and September 1 at a rate equal to 10.5 percent of the liquidation preference per share. These dividends were payable in additional shares of class A preferred stock until the later of: (i) September 10, 2005; or (ii) the beginning of the first fiscal quarter after which our primary insurance companies have received a financial strength rating of at least "A-" by A.M. Best. The class A convertible exchangeable preferred stock was convertible, at the option of the holder, into common stock of CNO at any time on or after September 30, 2005. The conversion rate was equal to the total liquidation preference plus cumulative unpaid dividends thereon divided by $20.35, which was the average price of CNO's common stock, as defined, for each of the trading days in the 60 calendar day period immediately preceding January 8, 2004. 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. Restricted share grants are limited to 3.3 million shares. 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 the next three years. During 2004, the Company granted 2.0 million restricted shares of CNO common stock to certain directors, officers and employees of the Company. The fair value of such grants totaled $37.1 million. Such amount is recognized as compensation expense over the vesting period of the restricted stock. The vesting period ranges from immediate vesting to a period of four years. We recognized compensation expense of $13.7 million and $1.8 million in 2004 and the four months ended December 31, 2003, respectively, related to the vesting of restricted stock, net of forfeitures. At December 31, 2004, the unrecognized compensation expense totaled $27.2 million.
The Predecessor's 1994 Stock and Incentive Plan authorized the granting of options to employees and directors of the Company to purchase up to 24 million shares of Old Conseco common stock at a price not less than its market value on the date the option was granted. In 1997, the Company adopted the 1997 Non-qualified Stock Option Plan, which authorized the granting of non-qualified options to employees of the Company to purchase shares of Old Conseco common stock.
A summary of the Company's stock option activity and related information is presented below (shares in thousands):
The four states with the largest shares of 2004 collected premiums were Florida (8.4 percent), California (6.9 percent), Texas (6.5 percent) and Illinois (5.1 percent). No other state accounted for more than 5 percent of total collected premiums.
The discount rates used to determine the amortization of the cost of policies purchased averaged 7 percent in the eight months ended August 31, 2003, and 7 percent in 2002.
In accordance with SFAS 97, we are required to amortize the value of policies inforce in relation to estimated gross profits for universal life-type 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.
At December 31, 2003, restricted cash consisted of: (i) $17.3 million held in trust for the payment of bankruptcy-related professional fees; and (ii) $14.6 million held by three investment trusts (which are further described in the note to the consolidated financial statements entitled "Investments in Variable Interest Entities").
Statutory capital and surplus included investments in upstream affiliates of $52.4 million and $159.0 million at December 31, 2004 and 2003, respectively, all of 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.
The ability of our insurance subsidiaries to pay dividends is subject to state insurance department regulations. In addition, we may need to contribute additional capital to improve the RBC ratios of certain insurance subsidiaries and this could affect the ability of our top tier insurance subsidiary to pay dividends. Insurance 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 statutory 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. 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 2005, our insurance subsidiaries may pay dividends of $150.8 million to its non-insurance company parent without prior regulatory approval.
On October 30, 2002, Bankers National Life Insurance Company and Conseco Life Insurance Company of Texas, our insurance subsidiaries domiciled in Texas, each entered into consent orders with the Commissioner of Insurance for the State of Texas (on behalf of all Conseco insurance subsidiaries), whereby they agreed: (i) not to request to pay any dividends or other distributions before January 1, 2003 and, thereafter, not to pay any dividends or other distributions to non-insurance companies without the prior approval of the Texas Insurance Commissioner; (ii) to continue to maintain sufficient capitalization and reserves as required by the Texas Insurance Code; (iii) to request approval from the Texas Insurance Commissioner before making any disbursements not in the ordinary course of business; (iv) to complete any pending transactions previously reported to the proper insurance regulatory officials prior to and during Conseco's restructuring, unless not approved by the Texas Insurance Commissioner; (v) to obtain a commitment from Conseco to maintain their infrastructure, employees, systems and physical facilities prior to and during Conseco's restructuring; and (vi) to continue to permit the Texas Insurance Commissioner to examine its books, papers, accounts, records and affairs. The consent orders were formally released on November 19, 2003.
The National Association of Insurance Commissioners' Risk-Based Capital ("RBC") for Life and/or Health Insurers Model Act (the "Model Act") provides a tool for insurance regulators to determine the levels of statutory capital and surplus
an insurer must maintain in relation to its insurance and investment risks and the need for possible regulatory attention. The Model Act provides four levels of regulatory attention, varying with the ratio of the insurance company's total adjusted capital (defined as the total of its statutory capital and surplus, AVR and certain other adjustments) to its RBC as follows: (i) if a company's total adjusted capital is less than 100 percent but greater than or equal to 75 percent of its RBC (the "Company Action Level"), the company must submit a comprehensive plan to the regulatory authority proposing corrective actions aimed at improving its capital position; (ii) if a company's total adjusted capital is less than 75 percent but greater than or equal to 50 percent of its RBC (the "Regulatory Action Level"), the regulatory authority will perform a special examination of the company and issue an order specifying the corrective actions that must be taken; (iii) if a company's total adjusted capital is less than 50 percent but greater than or equal to 35 percent of its RBC (the "Authorized Control Level"), the regulatory authority may take any action it deems necessary, including placing the company under regulatory control; and (iv) if a company's total adjusted capital is less than 35 percent of its RBC (the "Mandatory Control Level"), the regulatory authority must place the company under its control. In addition, the Model Act provides for a trend test if a company's total adjusted capital is between 100 percent and 125 percent of its RBC at the end of the year. The trend test calculates the greater of the decrease in the margin of total adjusted capital over RBC: (i) between the current year and the prior year; and (ii) for the average of the last 3 years. It assumes that such decrease could occur again in the coming year. Any company whose trended total adjusted capital is less than 95 percent of its RBC would trigger a requirement to submit a comprehensive plan as described above for the Company Action Level.
The 2004 statutory annual statements filed with the state insurance regulators of each of our insurance subsidiaries reflected total adjusted capital in excess of the levels subjecting the subsidiaries to any regulatory action. However, as a result of losses on the long-term care business within the Other Business in Run-off segment, the RBC ratio of Conseco Senior was near the Company Action Level. See "-- Other Business in Run-off" for additional discussion related to an order issued by the Florida Office of Insurance Regulation regarding certain blocks of Conseco Senior's long-term care business.
- ------------------- (a) It is not practicable to provide additional components of revenue by product or services.
Brickyard Loan Trust ("Brickyard") was a collateralized debt obligation trust which participated in an underlying pool of commercial loans. The trust was formed by the Predecessor and was fully liquidated in the third quarter of 2003. The initial capital structure of Brickyard consisted of $575 million of senior financing provided by unrelated third party investors and $127 million of notes and subordinated certificates owned by the Company and others. As a result of our 85 percent ownership
In the fourth quarter of 2002, the trust began to liquidate its portfolio of commercial loans. The trust planned to use the proceeds to repay the senior debt and distribute residual proceeds to the subordinated certificate holders. As a result of the trust's intent to sell the commercial loans, we determined the decline in value of certain commercial loans was other than temporary. Accordingly, we recognized the decline in value of $45.5 million in 2002 as a realized loss and the cost basis of the commercial loans was reduced to estimated fair value. We included the $410.2 million carrying value of the underlying commercial loans in "assets held in separate accounts and investment trust" at December 31, 2002. Such carrying value approximated the estimated fair value of the trust's assets. The liabilities and minority interest of the trust totaled $392 million at December 31, 2002, and included: (i) $384 million due to the holders of the senior note obligations (including principal amount due plus accrued interest less $92 million held in a cash reserve account for the benefit of the senior note holders); and (ii) $8 million representing the interests of the minority holders of the subordinated certificates. These amounts were included in "liabilities related to separate accounts and investment trust". The senior note obligations of the trust had no recourse to the general credit of the Company.
In December 1998, Old Conseco formed three investment trusts which invested in various fixed maturity, limited partnership and other types of investments. The trusts were formed by our Predecessor and were fully liquidated in early 2004. The initial capital structure of each of the trusts consisted of: (i) principal-protected senior notes; (ii) subordinated junior notes; and (iii) equity. The senior principal-protected notes were collateralized by zero coupon treasury notes with par values and maturities matching the par values and maturities of the principal-protected senior notes. Conseco's life insurance subsidiaries owned 100 percent of the senior principal-protected notes. Certain of Conseco's non-life insurance subsidiaries owned all of the subordinated junior notes, which had a preferred return equal to the total return on the trusts' assets in excess of principal and interest on the senior notes. The equity of the trusts was owned by unrelated third parties.
As part of our Chapter 11 reorganization, we sold substantially all of the assets of our Predecessor's finance business and exited from this line of business. Our finance business was conducted through our Predecessor's indirect wholly-owned subsidiary, CFC. We accounted for our finance business as a discontinued operation in 2002 after 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 the 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, 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. The consolidated statement of operations reflects the operations of the discontinued finance business in the caption "Discontinued operations" for the year ended December 31, 2002.
The following summarizes selected statement of operations information of CFC for the year ended December 31, 2002:
The following accounting policies were relevant to CFC but not to the continuing operations of Conseco. Accordingly, these accounting policies were not described in the note entitled "Summary of Significant Accounting Policies".
collateral for the notes issued to investors as assets and the notes issued to investors in the securitization trusts as liabilities.
During 2002, CFC completed various loan sale transactions. CFC sold $2.1 billion of finance receivables, which generated net losses of $49.5 million. CFC also recognized a loss of $96.0 million related to the sale of $.5 billion of certain finance receivables sold as part of its cash raising initiatives. During 2002, CFC recognized no gain on sale related to securitized transactions.
In securitizations related to certain retained interests, CFC retained certain contingent risks in the form of guarantees of certain lower-rated securities issued by the securitization trusts. During 2002, interest and principal payments related to such guarantees totaled $45.5 million. CFC suspended guarantee payments in the fourth quarter of 2002.
CFC's income tax expense included deferred income taxes arising from temporary differences between the financial reporting and tax bases of assets and liabilities.
In April 2002, CFC completed a tender offer pursuant to which it purchased $158.5 million par value of its medium term notes due September 2002 and $3.7 million par value of its medium term notes due April 2003. The purchase price was equal to 100 percent of the principal amount of the notes plus accrued interest. In June 2002, CFC tendered for the remaining $8.2 million par value of its medium term notes due September 2002. Pursuant to the tender offer, $5.5 million par value of the notes was tendered in July. The purchase price was equal to 101 percent of the principal amount of the notes plus accrued interest. The remaining principal amount outstanding of the medium term notes, after giving effect to both tender offers and other debt repurchases completed prior to the tender offers of $2.7 million, was retired at maturity on September 26, 2002.
CFC completed various asset sales which resulted in net losses of $97.6 million in 2002. Such amounts included the loss of $96.0 million related to the sales of $463 million of certain finance receivables and $1.6 million of additional loss related to receivables required to be repurchased from the purchaser of the vendor services receivables, pursuant to the repurchase clauses in the agreements.
In conjunction with the various modifications to borrowing arrangements and refinancing transactions and the recognition of deferred expenses for terminated financing arrangements, CFC incurred costs of $39.4 million in 2002 which were not permitted to be deferred pursuant to GAAP.
As partial consideration for a financing transaction, CFC issued a warrant to Lehman which permitted the holder to purchase 5 percent of CFC at a nominal price. Lehman and CFC each had the ability to cause the warrant, and any stock issued upon its exercise, to be purchased for cash at an appraised value in May 2003. Since the warrant permitted cash settlement at fair value at the option of the holder of the warrant, it was included in other liabilities and was measured at fair value, with changes in its value reported in earnings. The estimated fair value of the warrant at December 31, 2002 was nil based on current valuations of CFC. Accordingly, CFC recorded a $38.1 million reduction in the value of the warrant during 2002.
In October 2002, Conseco Life Insurance Company of Texas (a wholly-owned subsidiary of the Company) completed the sale of CVIC to Inviva, Inc. ("Inviva"). CVIC marketed tax qualified annuities and certain employee benefit-related insurance products through professional independent agents. Pursuant to SFAS 144, CVIC is accounted for as a discontinued operation in our consolidated statement of operations for all periods. The consideration received from Inviva at closing (subject to adjustment based upon the adjusted statutory balance sheet of CVIC at September 30, 2002) totaled $83.7 million, of which $35.0 million was in the form of Series D Preferred Shares (the "Preferred Shares") issued by Inviva and the remainder was in cash. The purchase price was finalized in July 2003, which reduced the amount of Preferred Shares received by $10.5 million. In addition, Conseco Life Insurance Company of Texas received a dividend of approximately $75 million from CVIC immediately prior to the closing. We recognized a loss on the sale of $93.1 million. There was no income tax benefit recognized on the transaction. As part of the CVIC sale, Conseco agreed that it would not engage in the variable annuity or variable insurance business for a period of three years after the closing.