Headquarters. Our headquarters is located on a 180-acre corporate campus in Carmel, Indiana, immediately north of Indianapolis. The 12 buildings on the campus (all but one of which are owned) contain approximately 956,000 square feet of space and house Conseco's executive offices and certain administrative operations of its subsidiaries. The campus has ample room for additional buildings to support future growth.
Insurance operations. Our career agent operations are primarily administered from a single facility of 300,000 square feet in downtown Chicago, Illinois, leased under an agreement having a remaining life of eight years. We also lease approximately 130,000 square feet of warehouse space in a second Chicago facility; this lease has a remaining life of three years. Conseco owns an office building in Kokomo, Indiana (100,000 square
- ------------------------- (a) Comparison of selected supplemental consolidated financial data in the table above is significantly affected by the following business combinations accounted for as purchases: Washington National Corporation (effective December 1, 1997); Colonial Penn Life Insurance Company and Providential Life Insurance Company (September 30, 1997); Pioneer Financial Services, Inc. (April 1, 1997); Capitol
American Financial Corporation (January 1, 1997); Transport Holdings Inc. (December 31, 1996); American Travellers Corporation (December 31, 1996); FINOVA Acquisition I, Inc. (December 1, 1996); and Life Partners Group, Inc. (July 1, 1996). All financial data have been restated to give retroactive effect to the merger with Conseco Finance accounted for as a pooling of interests.
(c) Net income of $595.0 million for the year ended December 31, 1999, or $1.79 per diluted share, included an impairment charge of $349.2 million (net of taxes), or $1.05 per share, to write down the carrying value of Conseco Finance's interest-only securities and servicing rights. Net income of $467.1 million for the year ended December 31, 1998, or $1.40 per diluted share, included merger-related and impairment charges totaling $503.8 million (net of income taxes), or $1.52 per share. Such amounts were comprised of (i) $148.0 million of merger-related costs; (ii) $549.4 million to write down the carrying value of Conseco Finance's interest-only securities and servicing rights; and (iii) income taxes of $193.6 million.
(e) Amounts under this heading are included to assist the reader in analyzing the Company's financial position and results of operations. Such amounts are not intended to, and do not, represent insurance policy income, net income, shareholders' equity or book value per share prepared in accordance with generally accepted accounting principles ("GAAP").
Net income of $595.0 million in 1999, or $1.79 per diluted share, included: (i) the impairment charge (net of taxes) of $349.2 million, or $1.05 per share, to reduce the value of interest-only securities and servicing rights; and (ii) net investment losses (net of related costs, amortization and taxes) of $111.9 million, or 34 cents per share.
General: Conseco's life insurance subsidiaries develop, market and administer annuity, supplemental health, individual life insurance, individual and group major medical and other insurance products. We distribute these products through a career agency force, professional independent producers and direct response marketing. The segment's 1998 results were affected by several recent acquisitions, including: Pioneer Financial Services, Inc. (acquired April 1, 1997); Colonial Penn Life Insurance Company and Providential Life Insurance Company (September 30, 1997); and Washington National Corporation (December 1, 1997). This segment also includes our venture capital investment activities.
Average insurance liabilities for insurance and asset accumulation products, net of reinsurance receivables, were $26.6 billion in 1999, up 4.2 percent over 1998, and $25.5 billion in 1998, up 17 percent over 1997.
Net investment income on general account invested assets (which excludes income on separate account assets related to variable annuities; the income, cost and change in the fair value of S&P 500 Call Options related to equity-indexed products; and the income related to venture capital investments) increased by 2.1 percent, to $2,012.6 million, in 1999, and by 14 percent, to $1,972.1 million, in 1998. The average balance of general account invested assets increased by 2.2 percent in 1999 to $26.2 billion and by 17 percent in 1998 to $25.7 billion. The increase in invested assets in 1998 was primarily due to the recent acquisitions. The yield on these assets was 7.7 percent in both 1999 and 1998 and 7.9 percent in 1997. The 1998 decrease reflects general decreases in investment interest rates during the period.
Venture capital investment income includes the income earned on the investments made by our venture capital subsidiary. This income will fluctuate from period-to-period based on changes in estimated market values of our venture capital investments. When these investments are publicly traded, fair value is generally based upon market prices. When liquidity is limited because of thinly traded securities, limited partnership structures, large block holdings, restricted shares or other special circumstances, we adjust quoted market prices to determine an estimate of the attainable fair values. During 1999, we invested $53.2 million in a company in the wireless communication business. The market values of many companies in this sector increased significantly in 1999. In the fourth quarter of 1999, our investee sold shares of common stock to the public in an initial public offering. As a result, an ascertainable market value was established for our investment, which we adjusted to recognize liquidity restrictions. In 1999, we recognized venture capital income of $354.8 million related to this investment.
The loss ratios for long-term care products increased in 1999, reflecting unfavorable claims experience, partially offset by the effects of the asset accumulation phase of these products. The net cash flows from our
The 1999 loss ratio for specified-disease products was within our expectations. The 1998 ratio benefited from favorable claim developments which were not expected to continue.
The 1999 loss ratio for major medical policies reflects unfavorable claims experience. During the fourth quarter of 1999, reported claims increased. We believe other companies in these lines experienced similar unfavorable trends. The 1998 loss ratio for major medical products reflects premium rate increases and favorable claim developments. We have been focusing on the individual major medical product lines for the past year while decreasing our group blocks of business. Since individual products have better profitability than group products, this mix change should support our efforts to improve profitability. In addition, we are also raising rates on certain products and exiting certain product lines and states.
The loss ratios on our other products will fluctuate more than other lines due to the smaller size of these blocks of business. Such ratios have generally been within our expectations.
Amortization related to operations includes amortization of: (i) the cost of policies produced; (ii) the cost of policies purchased; and (iii) goodwill. We are required to amortize the cost of policies purchased and produced in relationship to the profits earned on universal life, annuity and investment products. The venture capital income recognized in 1999 resulted from investments backing these products. Accordingly, additional amortization expense was recognized because of the income recognized. Balances subject to amortization increased as a result of recent acquisitions and new policies sold.
Interest expense on investment borrowings decreased along with our investment borrowing activities. Average investment borrowings were $1,081.1 million during 1999, compared to $1,092.4 million during 1998. The weighted average interest rate on such borrowings was 5.4 percent and 6.0 percent during 1999 and 1998, respectively.
Other operating costs and expenses increased in 1999 primarily as a result of our increased business and marketing initiatives. Such expenses increased in 1998 primarily because of recent acquisitions.
On September 8, 1999, we announced that we would no longer structure our securitizations in a manner that results in recording a sale of the loans. Instead, new securitization transactions after that date are being structured to include provisions that entitle the Company to repurchase assets transferred to the special purpose entity when the aggregate unpaid principal balance reaches a specified level. Until these assets are repurchased, however, the assets are the property of the special purpose entity and are not available to satisfy the claims of creditors of the Company. Pursuant to Financial Accounting Standards Board Statement No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities", such securitization transactions are accounted for as secured borrowings whereby the loans and securitization debt remain on the balance sheet, rather than as sales.
Loan originations in 1999 were $25.1 billion, up 17 percent over 1998. Loan originations in 1998 were $21.4 billion, up 37 percent over 1997.
Manufactured housing loan originations increased by $529.8 million, or 9 percent, during 1999 and by $598.2 million, or 11 percent, during 1998. The increase in 1999 is primarily due to an increase in the number
of contracts written. The increase in 1998 is primarily due to an increase in the average size of the contracts written.
Mortgage services loan originations increased by $1.5 billion, or 29 percent, during 1999 and by $1.7 billion, or 50 percent, during 1998. The increase reflects growth in both home equity and home improvement business. We have continued to expand these origination networks.
Consumer/credit card loan originations increased by $513.4 million, or 19 percent, during 1999 and by $1.2 billion, or 81 percent, during 1998. The increase is primarily the result of our successful marketing efforts, including a number of new private label credit card relationships with large retailers.
Net investment income on interest-only securities is the accretion recognized on the interest-only securities we retain after we sell finance receivables. Such income increased by 39 percent, to $185.1 million, in 1999 and by 5.6 percent, to $132.9 million, in 1998. The increase is consistent with the change in the average balance of interest-only securities and the June 30, 1998, increase in the discount rate assumption we use to value our interest-only securities. The weighted average yields earned on interest-only securities were 13.5 percent, 13.2 percent and 11.2 percent during 1999, 1998 and 1997, respectively. As a result of the change in the structure of our securitizations, we will account for future transactions as secured borrowings and we will not recognize gain-on-sale revenue or additions to interest-only securities. Accordingly, future investment income accreted on the interest-only security will decrease, as cash remittances from the prior gain-on-sale securitizations reduce the interest-only security balances. The balance of the interest-only securities was reduced further in 1999 by the portion of the impairment charge related to the interest-only security ($546.8 million) which will cause a reduction in interest income accreted to this security in future years. We regularly analyze future expected cash flows from this security to determine the appropriate interest accretion rate. If we determine that this rate should be lower, investment income accreted on the interest-only security will decrease in future periods.
regional economic conditions and changes in interest rates. In addition, actual losses incurred as a result of loan defaults may vary from projected performance.
In recent periods, the Company has emphasized the inclusion of points and origination fees in finance receivables originated. Points and origination fees collected upon the securitization of finance receivables increased to $390.0 million (or 71 percent of the gain on sale recognized) in 1999 compared to $298.3 million (or 40 percent of the gain on sale recognized) in 1998; and $179.8 million (or 23 percent of the gain on sale recognized) in 1997.
In recent periods, conditions in the credit markets have resulted in less-attractive pricing of certain lower-rated securities in our securitization structure. As a result, we have chosen to hold rather than sell some of the securities in the securitization trusts, particularly securities having corporate guarantee provisions. Prior to our September 8, 1999, announcement, the securities that we hold were treated as retained interests in the securitization trusts. We recognized no gain on the portion of the assets related to such securities, but we expect to recognize greater interest income, net of related interest expense, over the term we hold them. At December 31, 1999 and 1998, we held $694.3 million and $340.8 million, respectively, of such securities which are classified as actively managed fixed maturities.
Provision for losses related to finance operations increased by 191 percent, to $128.7 million, in 1999 and by 71 percent, to $44.2 million, in 1998. The increase is principally due to the increase of loans held on our balance sheet. Under the portfolio method (which is used for securitizations structured as secured borrowings), we recognize the credit losses on the loans on our balance sheet as the losses are incurred. For loans previously recorded as sales, the anticipated discounted credit losses are reflected through a reduction in the gain-on-sale revenue recorded at the time of securitization.
Finance interest expense increased by 60 percent, to $341.3 million, in 1999 and by 33 percent, to $213.7 million, in 1998. Our borrowings grew in order to fund the increase in finance receivables. These increases were offset somewhat by a decrease in our average borrowing rate, which was 6.4 percent, 7.2 percent and 8.1 percent during 1999, 1998 and 1997, respectively, and a reduction in borrowings attributable to the proceeds of the $1.1 billion capital contribution from Conseco in 1998.
Other operating costs and expenses include the costs associated with servicing our managed receivables, and non-deferrable costs related to originating new loans. Such expense increased by 18 percent, to $697.2 million, in 1999 and by 33 percent, to $591.9 million, in 1998, reflecting: (i) the growth in our servicing portfolio; and (ii) the growth of our loan origination offices and infrastructure.
Impairment charges represent reductions in the value of interest-only securities and servicing rights recognized as a loss in the statement of operations. We carry interest-only securities at estimated fair value, which is determined by discounting the projected cash flows over the expected life of the receivables sold using current prepayment, default, loss and interest rate assumptions. Estimates for prepayments, defaults and losses for manufactured housing loans are determined based on a macroeconomic model developed by the Company with the assistance of outside experts. We record any unrealized gain or loss determined to be temporary, net of tax, as a component of shareholders' equity. Declines in value are considered to be other than temporary when the present value of estimated future cash flows discounted at a risk free rate using current assumptions is less than the book value of the interest-only securities. When declines in value considered to be other than temporary occur, we reduce the amortized cost to estimated fair value and recognize a loss in the statement of operations. The assumptions used to determine new values are based on our internal evaluations and consultation with external advisors having significant experience in valuing these securities.
During the second quarter of 1998, prepayments on securitized loan contracts continued to exceed our expectations and we concluded that such prepayments were likely to continue to be higher than expected in future periods as well. As a result of these developments, we concluded that the value of the interest-only securities and servicing rights had been impaired and we determined a new value using current assumptions. In addition, during the second quarter of 1998, the market yields of publicly traded securities similar to our interest-only securities increased. The new assumptions reflect the following changes from the assumptions previously used: (i) an increase in prepayment rates; (ii) an increase in the discount rate used to determine the present value of future cash flows to 15 percent from 11.5 percent; and (iii) an increase in anticipated default rates. We recognized a $549.4 million ($355.8 million after tax) impairment charge in 1998 to reduce the carrying value of the interest-only securities and servicing rights.
In 1997, we conducted a review of the systems, financial modeling and assumptions used in the valuation of our interest-only securities. The review was part of our ongoing process to ascertain the appropriateness of assumptions, systems and methods of modeling to determine the valuation of our interest-only securities. The nature and extent of the review procedures were influenced by our experiencing higher manufactured housing loan prepayments in 1997. We recognized a $190.0 million ($117.8 million after tax) impairment charge in 1997 to take into account the adverse prepayment experience in 1997 and our expectations of future prepayments, the effect upon the interest-only securities of partial prepayments (principal curtailments), and the impact that higher prepayments have on the weighted average rate of projected future interest due to investors.
OTHER COMPONENTS OF INCOME BEFORE INCOME TAXES, MINORITY INTEREST AND EXTRAORDINARY CHARGE:
In accordance with GAAP, insurance policy income as shown in our consolidated statement of operations consists of premiums earned for policies that have life contingencies or morbidity features. For annuity and universal life contracts without such features, premiums collected are not reported as revenues, but as deposits to insurance liabilities. We recognize revenues for these products over time in the form of investment income and surrender or other charges.
We introduced our first equity-indexed annuity product in 1996. The accumulation value of these annuities is credited with interest at an annual guaranteed minimum rate of 3 percent (or, including the effect of applicable sales loads, a 1.7 percent compound average interest rate over the term of the contracts). These annuities provide for potentially higher returns based on a percentage of the change in the S&P500 Index during each year of their term. We purchase S&P500 Call Options in an effort to hedge increases to policyholder benefits resulting from increases in the S&P 500 Index. Total collected premiums for this product increased by 14 percent, to $911.8 million, in 1999 and by 106 percent, to $798.2 million, in 1998.
On September 8, 1999, we announced that we would no longer structure the securitization of loans we originate in a manner that results in gain-on-sale revenues. Our new securitizations are being structured as secured borrowings and are accounted for using the portfolio method.
Our investment strategy is to: (i) maintain a predominately investment-grade fixed income portfolio; (ii) provide adequate liquidity to meet our cash obligations to policyholders and others; and (iii) maximize current income and total investment return through active investment management. Consistent with this strategy, investments in fixed maturity securities, mortgage loans and policy loans made up 91 percent of our $26.4 billion investment portfolio at December 31, 1999. The remainder of the invested assets were interest-only securities, equity securities, venture capital investments and other invested assets.
The following table summarizes investment yields earned over the past three years on the general account invested assets of our insurance subsidiaries. General account investments exclude venture capital investments, separate account assets, the value of S&P 500 call options and the investments held by our finance segment.
Although investment income is a significant component of total revenues, the profitability of certain of our insurance products is determined primarily by the spreads between the interest rates we earn and the rates we credit or accrue to our insurance liabilities. At December 31, 1999, the average yield, computed on the cost basis of our actively managed fixed maturity portfolio, was 7.2 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 5.0 percent.
At December 31, 1999, our fixed maturity portfolio had $77.0 million of unrealized gains and $1,563.6 million of unrealized losses, for a net unrealized loss of $1,486.6 million. Estimated fair values for fixed maturity investments were determined based on: (i) estimates from nationally recognized pricing services (82 percent of the portfolio); (ii) broker-dealer market makers (2 percent of the portfolio); and (iii) internally developed methods (16 percent of the portfolio).
At December 31, 1999, approximately 6.6 percent of our invested assets (7.9 percent of fixed maturity investments) were fixed maturities rated below-investment grade by nationally recognized statistical rating organizations (or, if not rated by such firms, with ratings below Class 2 assigned by the NAIC). We plan to maintain approximately the present level of below-investment-grade fixed maturities. These securities generally have greater risks than other corporate debt investments, including risk of loss upon default by the borrower, and are often unsecured and subordinated to other creditors. Below-investment-grade issuers usually have higher levels of indebtedness and are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than are investment-grade issuers. We are aware of these risks and monitor our below-investment-grade securities closely. At December 31, 1999, our below-investment-grade fixed maturity investments had an amortized cost of $1,939.7 million and an estimated fair value of $1,763.8 million.
experienced securities analysts in a variety of specialty areas. Among its other responsibilities, this staff is charged with compiling and reviewing such information. If evidence does not exist to support a realizable value equal to or greater than the carrying value of the investment, and such decline in market value is determined to be other than temporary, we reduce the carrying amount to its net realizable value, which becomes the new cost basis; we report the amount of the reduction as a realized loss. We recognize any recovery of such reductions in the cost basis of an investment only upon the sale, repayment or other disposition of the investment. In 1999, we recorded writedowns of fixed maturity investments, equity securities and other invested assets totaling $27.8 million. Our investment portfolio is subject to the risks of further declines in realizable value. However, we attempt to mitigate this risk through the diversification and active management of our portfolio.
As of December 31, 1999, our fixed maturity investments in substantive default (i.e., in default due to nonpayment of interest or principal) had an amortized cost and carrying value of $52.2 million and $42.8 million, respectively. The Company had no fixed maturity investments in technical (but not substantive) default (i.e., in default, but not as to the payment of interest or principal). There were no other fixed maturity investments about which we had serious doubts as to the ability of the issuer to comply on a timely basis with the material terms of the instrument.
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 not significant in any of the three years ended December 31, 1999.
At December 31, 1999, fixed maturity investments included $7.3 billion of mortgage-backed securities (or 33 percent of all fixed maturity securities). CMOs are backed by pools of mortgages that are segregated into sections or "tranches" that provide for reprioritizing of retirement of principal. Pass-through securities receive principal and interest payments through their regular pro rata share of the payments on the underlying mortgages backing the securities. The yield characteristics of mortgage-backed securities differ from those of traditional fixed-income securities. Interest and principal payments occur more frequently, often monthly. Mortgage-backed securities are subject to risks associated with variable prepayments. Prepayment rates are influenced by a number of factors that cannot be predicted with certainty, including: the relative sensitivity of the underlying mortgages backing the assets to changes in interest rates; a variety of economic, geographic and other factors; and the repayment priority of the securities in the overall securitization structures.
The following table sets forth the par value, amortized cost and estimated fair value of mortgage-backed securities, summarized by interest rates on the underlying collateral at December 31, 1999:
During 1999, we sold $15.8 billion of investments (primarily fixed maturities), resulting in $131.3 million of investment gains and $189.9 million of investment losses (both before related expenses, amortization and taxes). Such securities were sold in response to changes in the investment environment, which created opportunities to enhance the total return of the investment portfolio without adversely affecting the quality of the portfolio or the matching of expected maturities of assets and liabilities. As discussed in the notes to the 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.
involve a sale of securities and an agreement to repurchase the same securities at a later date at an agreed-upon price. Dollar rolls are similar to reverse repurchase agreements except that the repurchase involves securities that are only substantially the same as the securities sold. We enhance our investment yield by investing the proceeds from the sales in short-term securities pending the contractual repurchase of the securities at discounted prices in the forward market. We are able to engage in such transactions due to the market demand for mortgage-backed securities to form CMOs. Such investment borrowings averaged $1,081.1 million during 1999 and were collateralized by investment securities with fair values approximately equal to the loan value. The weighted average interest rate on short-term collateralized borrowings was 5.4 percent in 1999. The primary risk associated with short-term collateralized borrowings is that the counterparty might be unable to perform under the terms of the contract. Our exposure is limited to the excess of the net replacement cost of the securities over the value of the short-term investments (which was not material at December 31, 1999). We believe that the counterparties to our reverse repurchase and dollar-roll agreements are financially responsible and that counterparty risk is minimal.
Finance receivables (at December 31, 1999, include $4,730.7 million which serve as collateral for the notes issued to investors in securitization trusts) summarized by type, were as follows:
We service for a fee all of the finance receivables we previously sold in securitization transactions accounted for as sales. We collect, in the special purpose securitization entity, loan payments, and where applicable, other payments from borrowers and remit principal and interest payments to holders of the securities backed by the finance receivables we have sold. The cash applicable to the servicing fee and residual interest is remitted from the special purpose entity to the Company, after payment of all required principal and interest.
The securitizations structured after our September 8, 1999, announcement are accounted for under the portfolio method. At December 31, 1999, finance receivables of $4,730.5 million are held on our balance sheet as collateral for the notes of $4,641.8 million issued to investors in the securitization trusts.
(a) As a percentage of managed finance receivables at period end, excluding receivables already in repossession or foreclosure.
These ratios increased during 1999 primarily as a result of: (i) the expected increases in delinquencies and credit losses as the portfolios age; (ii) changes in the mix of managed receivables; and (iii) underlying loss experience.
CHANGES IN THE CONSOLIDATED BALANCE SHEET OF 1999 COMPARED WITH 1998
In accordance with GAAP, we record our actively managed fixed maturity investments, interest-only securities, equity securities and certain other invested assets at estimated fair value with any unrealized gain or loss, net of tax and related adjustments, recorded as a component of shareholders' equity. At December 31, 1999, primarily because of the recent increases in interest rates and related decrease in values of interest-bearing securities, we decreased the carrying value of such investments by $1,504.3 million as a result of this fair value adjustment. The fair value adjustment resulted in a $40.4 million decrease in carrying value at year-end 1998.
Corporate notes payable and commercial paper decreased during 1999 primarily due to the repayment of debt using the proceeds from the issuance of $300.0 million of 9.44% Trust Originated Preferred Securities ("9.44% TOPrS") and $250.0 million of Redeemable Hybrid Income Overnight Shares ("RHINOS").
Company-obligated mandatorily redeemable preferred securities of subsidiary trusts increased during 1999 due to the aforementioned issuances of 9.44% TOPrS and RHINOS.
(b) We include these ratios to assist you in analyzing the impact of interest expense on debt related to finance receivables and other investments (which is generally offset by interest earned on finance receivables and other investments financed by such debt). Such ratios are not intended to, and do not, represent the following ratios prepared in accordance with GAAP: the ratio of earnings and operating earnings to fixed charges; and the ratio of earnings and operating earnings to fixed charges, preferred dividends and distributions on Company-obligated mandatorily redeemable preferred securities of subsidiary trusts.
Approximately 64 percent of insurance liabilities were subject to interest rates (or participation rates for equity-indexed annuities) that may be reset annually; 3 percent have a fixed explicit interest rate for the duration of the contract; and the remainder have no explicit interest rate.
Insurance liabilities for interest-sensitive products by credited rate (excluding interest rate bonuses for the first policy year only) at December 31, 1999 were as follows (dollars in millions):
We believe that the diversity of our investment portfolio and the concentration of investments in high-quality, liquid securities provide sufficient liquidity to meet foreseeable cash requirements. At December 31, 1999, we held $1.7 billion of cash and cash equivalents and $17.5 billion of publicly traded investment grade bonds. Although there is no present need or intent to dispose of such investments, our life insurance subsidiaries could readily liquidate portions of their investments, if such a need arose. In addition, investments could be used to facilitate borrowings under reverse-repurchase agreements or dollar-roll transactions. Such borrowings have been used by the life companies from time to time to increase their return on investments and to improve liquidity.
On March 31, 2000, we announced that we plan to explore the sale of Conseco Finance. During the time prior to completion of the sale, should it occur, we intend to continue our prior financing practices, as described in the following paragraphs, to provide the cash needed to originate finance receivables. Should there be any disruption in the availability of cash from these sources, we would seek to take other actions, including selling our loans through the resale markets or negotiating forward funding agreements. The use of prior financing practices or new actions during this period is likely to increase the cost of funds.
Our finance operations require cash to originate finance receivables. Our primary sources of cash are the collection of receivable balances; proceeds from the issuance of debt, certificate of deposits and securitization of loans; cash provided by operations; and cash provided by the parent company from its credit sources.
Several competing lenders have announced in recent periods that they are no longer lending in product lines in which we compete. We and other lenders have increased the interest rates charged on new loans in recent periods. We are unable to estimate the effect, if any, of these events on the amount of new loans we originate, or the level of profitability of that business. We are also unable to estimate the period of time that these conditions will persist.
Independent rating agencies, financial institutions, analysts and other interested parties monitor the leverage ratio of our finance segment. Such ratio (calculated, as discussed with independent rating agencies, as the ratio of debt to equity of our finance subsidiary calculated on a pro forma basis as if we had accounted for the securitizations of our finance receivables as financing transactions throughout the Company's history) was 22-to-1 at both December 31, 1999 and 1998.
The Company and its subsidiaries generated consolidated cash flows from operating activities of $1,788.6 million, $979.6 million and $609.5 million, during the years ended December 31, 1999, 1998 and 1997, respectively. Excess operating cash flows, together with cash flows from financing activities, were primarily used to increase investment portfolios, originate finance receivables and fund policyholder account withdrawals.
The ability of our insurance subsidiaries to pay dividends is subject to state insurance department regulations. These regulations generally permit dividends to be paid from earned surplus of the insurance
We completed several transactions during 1999 to improve our capital structure. We contributed capital of $481.3 million to our life insurance subsidiaries to provide additional capital to fund current and projected growth. In the fourth quarter of 1999, we issued Series F Common-Linked Convertible Preferred Stock with net proceeds of $478.2 million and $1.0 billion of term debt. Such amounts were used to repay other debt and support our future growth in the financing segment. Subsequent to these actions, Moody's upgraded: (i) its ratings of Conseco's debt and preferred stock (for example, the rating on our senior debt was upgraded to "Baa3" from "Ba1"); and (ii) the financial strength ratings of Conseco's principal insurance companies (upgraded to "Baa1" from "Baa2"). Moody's also retained its positive ratings outlook on Conseco. Duff & Phelps reaffirmed all existing ratings of Conseco and its subsidiaries and moved its outlook for all Conseco-related fixed income ratings from stable to positive.
Our debt agreements require us to maintain minimum working capital and risk-based capital ratios, and limit our ability to incur additional indebtedness. They also restrict the amount of retained earnings that is available for dividends and require Conseco to maintain certain minimum ratings at its insurance subsidiaries.
Many computer programs were originally designed to identify each year using two digits. If not corrected, these computer programs could cause system failures or miscalculations in the year 2000, with possible adverse effects on our operations. In 1996, we initiated a comprehensive corporate-wide program designed to ensure that our computer programs function properly in the year 2000. Our year-2000 projects were completed on schedule and our year-end processing proceeded smoothly. There were no significant problems experienced. The total expense incurred on our year-2000 projects during the last four years was approximately $75 million, of which $23 million was incurred during 1999. This expense is not material to Conseco's financial position and it was funded through operating cash flows. The expense related primarily to modifying existing software systems. During the last three years, our year-2000 projects were the highest priority for our information technology and many other employees. Other projects continued while our year-2000 projects were being completed and, in many cases, we accelerated system upgrades when the new systems addressed year-2000 issues.
We use computer models to simulate the cash flows expected from our existing insurance business under various interest rate scenarios. These simulations help us to measure the potential gain or loss in fair value of our interest rate-sensitive financial instruments. With such estimates, we seek to closely match the duration of our assets to the duration of our liabilities. 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. At December 31, 1999, the adjusted modified duration of our fixed maturity securities and short-term investments was approximately 6.6 years and the duration of our insurance liabilities was approximately 6.6 years. We estimate that our fixed maturity securities and short-term investments (net of corresponding changes in the value of cost of policies purchased, cost of policies produced and insurance liabilities) would decline in fair value by approximately $605 million if interest rates were to increase by 10 percent from their December 31, 1999 levels. This compares to a decline in fair value of $490 million based on amounts and rates at December 31, 1998. The calculations involved in our computer simulations
On September 8, 1999, we announced that we would no longer structure the securitizations of the loans we originate in a manner that results in gain-on-sale revenues. Our new securitizations are being structured as secured borrowings. Prior to September 8, 1999, we retained interests in the finance receivables sold through investments in interest-only securities that are subordinated to the rights of other investors. Interest-only securities do not have a stated maturity or amortization period. The expected amount of the cash flow as well as the timing depends on the performance of the underlying collateral supporting each securitization. The actual cash flow of these instruments could vary substantially if performance is different from our assumptions. We develop assumptions to value these investments by analyzing past portfolio performance, current loan characteristics, current and expected market conditions and the expected effect of our actions to mitigate adverse performance. Assumptions used as of December 31, 1999, are summarized in the notes to the consolidated financial statements.
We use computer models to simulate the cash flows expected from our interest-only securities under various interest rate scenarios. These simulations help us to measure the potential gain or loss in fair value of these financial instruments, including the effects of changes in interest rates on prepayments. We estimate that our interest-only securities would decline in fair value by approximately $72.4 million if interest rates were to decrease by 10 percent from their December 31, 1999 levels. This compares to a decline in fair value of $79 million based on amounts and rates at December 31, 1998. The calculations involved in our computer simulations incorporate numerous assumptions, require significant estimates and assume an immediate change in interest rates without any management of the interest-only securities in reaction to such change. Consequently, potential changes in value of our interest-only securities indicated by the simulations will likely be different from the actual changes experienced under given interest rate scenarios, and the differences may be material.
We estimate that our finance receivables (including both "finance receivables" and "finance receivables-securitized") would decline in fair value by approximately $128.8 million if interest rates were to increase by 10 percent from their December 31, 1999 levels. This compares to a decline in fair value of $43.6 million based on amounts and rates at December 31, 1998.
Our finance receivables are primarily funded with the fixed rate asset-backed securities purchased by investors in our securitizations and floating-rate debt. Such borrowings included bank credit facilities, master repurchase agreements, intercompany loans and the notes payable related to securitized finance receivables
The fair value of our borrowed capital also varies with credit ratings and other conditions in the capital markets. Following our announcement of March 31, 2000, concerning our plan to explore the sale of Conseco Finance, the capital markets reacted by lowering the value of our publicly traded securities.
In our opinion, based on our audits and the report of other auditors, the accompanying consolidated balance sheet and the related consolidated statements of operations, shareholders' equity and cash flows present fairly, in all material respects, the financial position of Conseco, Inc. and subsidiaries at December 31, 1999 and 1998, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. The consolidated financial statements give retroactive effect to the merger of Conseco Finance Corp. (formerly Green Tree Financial Corporation) on June 30, 1998 in a transaction accounted for as a pooling of interests, as described in Note 1 to the consolidated financial statements. We did not audit the financial statements of Conseco Finance Corp., which statements reflect total revenues of $1,307.3 million for the year ended December 31, 1997. Those statements were audited by other auditors whose report thereon has been furnished to us, and our opinion expressed herein, insofar as it relates to the amounts included in 1997 for Conseco Finance Corp., is based solely on the report of the other auditors. We conducted our audits of these statements in accordance with auditing standards generally accepted in the United States, which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for the opinion expressed above.
CONSOLIDATED BALANCE SHEET DECEMBER 31, 1999 AND 1998 (DOLLARS IN MILLIONS)
CONSOLIDATED BALANCE SHEET (CONTINUED) DECEMBER 31, 1999 AND 1998 (DOLLARS IN MILLIONS)
CONSOLIDATED STATEMENT OF OPERATIONS FOR THE YEARS ENDED DECEMBER 31, 1999, 1998, AND 1997 (DOLLARS IN MILLIONS, EXCEPT PER SHARE DATA)
Consolidation issues. The consolidated financial statements give retroactive effect to the merger (the "Merger") with Conseco Finance Corp. ("Conseco Finance", formerly Green Tree Financial Corporation prior to its name change in November 1999) in a transaction accounted for as a pooling of interests (see note 2, "Acquisitions"). The pooling of interests method of accounting requires the restatement of all periods presented as if Conseco and Conseco Finance had always been combined. The consolidated statement of shareholders' equity therefore reflects the accounts of the Company as if additional shares of Conseco common stock issued in the Merger had been outstanding during all periods presented. We have eliminated intercompany transactions prior to the Merger and we have made certain reclassifications to Conseco Finance's financial statements to conform to Conseco's presentations. See note 2 for additional discussion of the Merger.
On March 31, 2000, we announced that we plan to explore the sale of Conseco Finance. If the planned sale is completed, the Company will no longer have finance operations.
Interest-only securities represent the right to receive certain future cash flows from securitization transactions structured prior to our September 8, 1999 announcement (see "Revenue Recognition for Sales of Finance Receivables and Amortization of Servicing Rights" below). Such cash flows generally are equal to the value of the principal and interest to be collected on the underlying financial contracts of each
Venture capital investments include equity and equity-type investments made by our subsidiary which engages in venture capital investment activity. At the time we enter into these investments, we believe they have high growth or appreciation potential. These investments are carried at estimated fair value, with changes in fair value recognized as investment income. When these venture capital investments are publicly traded, fair value is generally based upon market prices. When liquidity is limited because of thinly traded securities, limited partnership structures, large-block holdings, restricted shares or other special situations, we adjust quoted market prices to produce an estimate of the attainable fair values. We estimate the fair values of securities that are not publicly traded based upon transactions which directly affect the value of such securities and consideration of the investee's financial results, conditions and prospects.
Other invested assets include: (i) trading securities; (ii) Standard & Poor's 500 Call Options ("S&P 500 Call Options"); and (iii) certain non-traditional investments. We carry the S&P 500 Call Options at estimated fair value as further described below under "Standard & Poor's 500 Index Call Options and Interest Rate Swap Agreements". Non-traditional investments include investments in certain limited partnerships, mineral rights and promissory notes; we account for them using either the cost method, or for investments in partnerships over whose operations the Company exercises significant influence, the equity method.
We regularly evaluate all of our investments based on current economic conditions, credit loss experience and other investee-specific developments. If there is a decline in a security's net realizable value that is other
than temporary, we treat it as a realized loss and reduce our cost basis of the security to its estimated fair value.
Cash and cash equivalents include commercial paper, invested cash and other investments purchased with maturities of less than three months. We carry them at amortized cost, which approximates their estimated fair value.
Finance receivables transferred to securitization trusts in transactions structured as securitized borrowings are classified as finance receivables -- securitized. These receivables are held as collateral for the notes issued to investors in the securitization trusts. Finance receivables held by us without such collateral restrictions are classified as finance receivables.
When we replace an existing insurance contract with another insurance contract with substantially different terms, all unamortized cost of policies produced related to the replaced contract is immediately written off. 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 related to the replaced contracts which continue to be deferred were $8.6 million, $9.1 million and $9.1 million in 1999, 1998 and 1997, respectively.
Each year, we evaluate the recoverability of the unamortized balance of the cost of policies produced. We consider estimated future gross profits or future premiums, expected mortality or morbidity, interest earned and credited rates, persistency and expenses in determining whether the balance is recoverable.
The discount rate used to determine the cost of policies purchased for each of our 1997 acquisitions was 18 percent.
RECOGNITION OF INSURANCE POLICY INCOME AND RELATED BENEFITS AND EXPENSES ON INSURANCE CONTRACTS
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 $547.8 million, $316.0 million and $290.3 million in 1999, 1998 and 1997, respectively.
As part of our investment strategy, we may enter into reverse repurchase agreements and dollar-roll transactions to increase our investment return or to improve our liquidity. We account for these transactions as collateral borrowings, where the amount borrowed is equal to the sales price of the underlying securities. Reverse repurchase agreements involve a sale of securities and an agreement to repurchase the same securities at a later date at an agreed-upon price. Dollar rolls are similar to reverse repurchase agreements except that, with dollar rolls, the repurchase involves securities that are only substantially the same as the securities sold. Such borrowings averaged $1,081.1 million during 1999 and $1,092.4 million during 1998. These borrowings were collateralized by investment securities with fair values approximately equal to the loan value. The weighted average interest rate on short-term collateralized borrowings was 5.4 percent and 6.0 percent in 1999 and 1998, respectively. The primary risk associated with short-term collateralized borrowings is that a counterparty will be unable to perform under the terms of the contract. Our exposure is limited to the excess of the net replacement cost of the securities over the value of the short-term investments (such excess was not material at December 31, 1999). We believe the counterparties to our reverse repurchase and dollar-roll agreements are financially responsible and that the counterparty risk is minimal.
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 cost of policies purchased, interest-only securities, venture capital investments, servicing rights, goodwill, liabilities for insurance and asset accumulation products, liabilities related to litigation, guaranty fund assessment accruals, gain on sale of finance receivables, allowance for credit losses on finance receivables and deferred income taxes. If our future experience differs materially from these estimates and assumptions, our financial statements could be affected.
For securitizations structured prior to September 8, 1999, we accounted for the sale of finance receivables in accordance with SFAS 125. In applying SFAS 125 to our securitized sales, we recognized a gain, representing the difference between the proceeds from the sale (net of related sale costs) and the carrying value of the component of the finance receivable sold. We determined such carrying amount by allocating the carrying value of the finance receivables between the portion we sell and the interests we retain (generally interest-only securities, servicing rights and, in some instances, other securities), based on each portion's relative fair values on the date of the sale.
We evaluate servicing rights for impairment on an ongoing basis, stratified by product type and origination period. To the extent that the recorded amount exceeds the fair value, we establish a valuation allowance through a charge to earnings. If we determine, upon subsequent measurement of the fair value of these servicing rights, that the fair value equals or exceeds the amortized cost, any previously recorded valuation allowance would be deemed unnecessary and restored to earnings.
Other invested assets. We use quoted market prices, where available. When quotes are not available, we estimate the fair value based on: (i) discounted future expected cash flows; or (ii) independent transactions which establish a value for our investment. When we are unable to estimate a fair value, we assume a market value equal to carrying value.
Company-obligated mandatorily redeemable preferred securities of subsidiary trusts. We use quoted market prices.
During 1999 and early 2000 the Company reevaluated its interest-only securities and servicing rights, including the underlying assumptions, in light of loss experience exceeding previous expectations. The principal change in the revised assumptions resulting from this process was an increase in expected future credit losses, relating primarily to reduced assumptions as to future housing price inflation, recent loss experience and refinements to the methodology of the model. The effect of this change was offset somewhat by a revision to the estimation methodology to incorporate the value associated with the cleanup call rights held by the Company in securitizations. We recognized a $554.3 million impairment charge ($349.2 million after tax) in 1999 to reduce the book value of the interest-only securities and servicing rights.
expected in future periods as well. As a result of these developments, we concluded that the value of the interest-only securities and servicing rights had been impaired, and we determined a new value using current assumptions. In addition, the market yields of publicly traded securities similar to our interest-only securities also increased during the second quarter. The assumptions used to determine the new value at that time were based on our internal evaluations and consultation with external investment managers having significant experience in valuing these securities. The new assumptions reflect the following changes from the assumptions previously used: (i) an increase in prepayment rates; (ii) an increase (to 15 percent from 11.5 percent) in the discount rate used to determine the present value of future cash flows; and (iii) an increase in anticipated default rates. We recognized a $549.4 million impairment charge in 1998 to reduce the carrying value of the interest-only securities and servicing rights.
In 1997, we conducted a review of the systems, financial modeling and assumptions used in the valuation of our interest-only securities. The review was part of our ongoing process to ascertain the appropriateness of assumptions, systems and methods of modeling to determine the valuation of our interest-only securities. The nature and extent of the review procedures were influenced by our experiencing higher manufactured housing loan prepayments in 1997. We recognized a $190.0 million impairment charge in 1997 to take into account the adverse prepayment experience in 1997 and our expectations of future prepayments, the effect upon the interest-only securities of partial prepayments (principal curtailments), and the impact that higher prepayments have on the weighted average rate of projected future interest due to investors.
Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), as amended by Statement of Financial Accounting Standards No. 137, "Deferral of the Effective Date of FASB Statement No. 133" requires all derivative instruments to be recorded on the balance sheet at estimated fair value. Changes in the fair value of derivative instruments are to be recorded each period either in current earnings or other comprehensive income, depending on whether a derivative is designated as part of a hedge transaction and, if it is, on the type of hedge transaction. SFAS 133 is required to be implemented in year 2001. We are currently evaluating the impact of SFAS 133; at present, we do not believe it will have a material effect on our consolidated financial position or results of operations. Because of ongoing changes to implementation guidance, we do not plan on adopting the new standard until the first quarter of 2001.
The following acquisitions were accounted for under the purchase method of accounting. Under this method, we allocated the cost to acquire the company to the assets and liabilities acquired based on fair values as of the acquisition date and we recorded goodwill equal to the excess of the total purchase cost over the fair value of the assets acquired less the fair value of the liabilities assumed.
Accumulated other comprehensive loss is primarily comprised of unrealized losses on actively managed fixed maturity investments. Such amounts, included in shareholders' equity as of December 31, 1999 and 1998, were as follows:
(a) Includes below-investment grade mortgage-backed securities with an amortized cost and estimated fair value of $27.4 million and $26.6 million, respectively.
The carrying value of fixed maturity investments and mortgage loans not accruing investment income totaled $48.3 million, $50.1 million and $3.1 million at December 31, 1999, 1998 and 1997, respectively.
The interest-only securities on our balance sheet represent an allocated portion of the cost basis of the finance receivables in the securitization transactions accounted for as sales related to transactions structured prior to September 8, 1999. We used the following assumptions to adjust the amortized cost to estimated fair value at December 31, 1999. The difference between estimated fair value and the amortized cost of the interest-only securities is included in accumulated other comprehensive loss, net of taxes.
We used the assumptions in the table below to determine the initial value of the interest-only securities related to securitizations accounted for as sales in 1999.
(a) The stated interest rate reflects reductions in rates due to collection of points. Including such points, the effective yield on manufactured housing finance receivables was approximately 10.8 percent in 1999.
At December 31, 1999, Conseco had federal income tax loss carryforwards of $771.1 million available (subject to various statutory restrictions) for use on future tax returns. Portions of these carryforwards begin expiring in 2003. The following restrictions exist with respect to the utilization of portions of the loss carryforwards: (i) $44.7 million may be used only to offset income from our non-life insurance companies; (ii) $107.0 million (attributable to acquired companies) may be used only to offset the income from those companies; and (iii) $619.4 million is available to offset income from certain life insurance subsidiaries, our finance subsidiaries and all other non-life insurance subsidiaries. None of the carryforwards are available to reduce the future tax provision for financial reporting purposes.
NOTES PAYABLE AND COMMERCIAL PAPER (EXCLUDING NOTES PAYABLE RELATED TO SECURITIZED FINANCE RECEIVABLES STRUCTURED AS COLLATERALIZED BORROWINGS)
The maturities of notes payable and commercial paper (excluding notes payable related to securitized finance receivables structured as collateralized borrowings) at December 31, 1999, were as follows (dollars in millions):
NOTES PAYABLE RELATED TO SECURITIZED FINANCE RECEIVABLES STRUCTURED AS COLLATERALIZED BORROWINGS
Notes payable related to securitized finance receivables structured as collateralized borrowings were $4,641.8 million at December 31, 1999. The principal and interest on these notes are paid using the cash flows from the underlying finance receivables which serve as collateral for the notes. Accordingly, the timing of the principal payments on these notes is dependent on the payments received on the underlying finance receivables which back the notes. The average interest rate on these notes at December 31, 1999 was 7.6 percent.
We used the following weighted average assumptions to calculate benefit obligations for our 1999 and 1998 valuations: discount rate of approximately 6.9 percent and 6.5 percent, respectively; an expected return on plan assets of approximately 8.2 percent and 7.9 percent, respectively; and an assumed rate of
Components of the cost we recognized related to pension and postretirement plans were as follows:
Conseco Finance was served with various related lawsuits filed in the United States District Court for the District of Minnesota. These lawsuits were generally filed as purported class actions on behalf of persons or entities who purchased common stock or options of Conseco Finance during alleged class periods that generally run from February 1995 to January 1998. One action (Florida State Board of Admin. v. Green Tree Financial Corp., Case No. 98-1162) did not include class action claims. In addition to Conseco Finance, certain current and former officers and directors of Conseco Finance are named as defendants in one or more of the lawsuits. Conseco Finance and other defendants obtained an order consolidating the lawsuits seeking class action status into two actions, one of which pertains to a purported class of common stockholders (In re Green Tree Financial Corp. Stock Litig., Case No. 97-2666) and the other which pertains to a purported class action of stock option traders (In re Green Tree Financial Corp. Options Litig., Case No. 97-2679). Plaintiffs in the lawsuits assert claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. In each case, plaintiffs allege that Conseco Finance and the other defendants violated federal securities laws by, among other things, making false and misleading statements about the current state and future prospects of Conseco Finance (particularly with respect to prepayment assumptions and performance of certain loan portfolios of Conseco Finance) which allegedly rendered Conseco Finance's financial statements false and misleading. On August 24, 1999, the United States District Court for the District of Minnesota issued an order to dismiss with prejudice all claims alleged in the lawsuits. The plaintiffs subsequently appealed the decision to the U.S. Court of Appeals for the 8th Circuit, and the appeal is currently pending. The Company believes that the lawsuits are without merit and intends to continue to defend them vigorously. The ultimate outcome of these lawsuits cannot be predicted with certainty.
Four lawsuits have been filed against Conseco in the United States District Court for the Southern District of Indiana. The cases, captioned Luisi v. Conseco, Inc., et al., Case No. IP00-C-0593 B/S, Sechrist v.
Conseco, Inc., et at., Case No. IP00-C-0585-M/S, Klein v. Conseco, Inc., et al., Case No. IP00-0602 C-M/S, and Brody v. Conseco, Inc., et at., Case No. IP00-0609 C-M/S, were filed as purported class actions on behalf of persons or entities that purchased Conseco common stock during the alleged class periods that generally run from April of 1999 through April of 2000. Two officers/directors of Conseco are named as defendants in the lawsuits. In each case, the plaintiffs assert claims under Section 10(b) and 20(a) of the Securities Exchange Act of 1934. In each case, plaintiffs allege that Conseco and the individual defendants violated federal securities laws by, among other things, making false and misleading statements about the current state and future prospects of Conseco Finance (particularly with respect to performance of certain loan portfolios of Conseco Finance) which allegedly rendered Conseco's financial statements false and misleading. The Company believes that the lawsuits are without merit and intends to defend them vigorously. The ultimate outcome of these lawsuits cannot be predicted with certainty.
In addition, the Company and its subsidiaries are involved on an ongoing basis in lawsuits related to their operations. Although the ultimate outcome of certain of such matters cannot be predicted, such lawsuits currently pending against the Company or its subsidiaries are not expected, individually or in the aggregate, to have a material adverse effect on the Company's consolidated financial condition, cash flows or results of operations.
The balance sheet at December 31, 1999, includes: (i) accruals of $29.2 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, 1999; and (ii) receivables of $13.1 million that we estimate will be recovered through a reduction in future premium taxes as a result of such assessments. 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 for such assessments of $5.0 million in 1999, $16.2 million in 1998 and $3.7 million in 1997.
We have guaranteed bank loans totaling $575.8 million to approximately 170 directors, officers and key employees. The funds were used by the participants to purchase approximately 19.0 million Conseco shares in open market or negotiated transactions with independent parties. Such shares are held by the bank as CONSECO, INC. AND SUBSIDIARIES
.25 percent of the value of the security; and (b) a beneficial ownership of a 6.75 percent trust originated preferred security. Each holder will receive aggregate cumulative cash distributions at the annual rate of 7 percent of the $50 stated amount per security, payable quarterly. The applicable distribution rate on the trust originated preferred securities that remain outstanding during the period February 16, 2001, through February 16, 2003, will be reset so that the market value of the trust originated preferred securities will be equal to 100.5 percent of the par value. Conseco may limit the market rate reset to be no higher than the rate on the two-year benchmark Treasury plus 200 basis points.
(d) The mandatory redemption dates of these securities may be extended for up to 19 years.
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 of approximately $(25) million, $475 million and $105 million for the years ended December 31, 1999, 1998 and 1997, respectively.
Preferred stock dividends in 1997 include $13.2 million of payments made to induce the conversion of certain preferred stock to common shares.
Changes in the number of shares of common stock outstanding during the years ended December 31, 1999, 1998 and 1997 were as follows:
Such dividends were paid in January 2000. Cash dividends are paid quarterly at an amount determined by our Board of Directors. As part of our plan to strengthen our capital structure, the Board of Directors reduced the cash dividend on our common stock to a quarterly rate of 5 cents per share, beginning with the dividend to be paid in April of 2000.
As a result of the Merger, all options previously issued by Conseco Finance became immediately exercisable on June 30, 1998. The following table summarizes information about stock options outstanding at December 31, 1999 (shares in thousands):
We apply Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees", and related interpretations in accounting for our stock option plans. Since the amount an employee must pay to acquire the stock is equal to the market price of the stock on the grant date, no compensation cost has been recognized for our stock option plans. Had compensation cost been determined based on the fair value at the grant dates for awards granted after January 1, 1995, consistent with the method of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation", the Company's pro forma net income and pro forma earnings per share for the years ended December 31, 1999, 1998 and 1997 would have been as follows:
We estimated the fair value of each option grant used to determine the pro forma amounts summarized above using the Black-Scholes option valuation model with the following weighted average assumptions for 1999, 1998 and 1997:
At December 31, 1999, a total of 131 million shares of common stock were reserved for issuance under the FELINE PRIDES, stock option, stock bonus and deferred compensation plans, forward underwriting agreement (entered into at the time we issued the RHINOS), Series F Common-Linked Preferred Stock and warrants to buy 700,000 shares of Conseco common stock for $13.8 million at anytime through September 29, 2006.
The four states with the largest shares of 1999 collected premiums were California (9.8 percent), Florida (8.6 percent), Illinois (8.2 percent) and Texas (6.9 percent). No other state accounted for more than 5 percent of total collected premiums.
During 1997, we recorded a $41.5 million increase to claim reserves and a $20.9 million write-off of cost of policies produced and cost of policies purchased related to premium deficiencies on our Medicare supplement business in Massachusetts. Regulators in that state have not allowed premium increases for Medicare supplement products needed to avoid losses on the business. We are currently seeking such rate increases. We are no longer writing new Medicare supplement business in Massachusetts. Other operating costs and expenses in 1997 also included expenses of $9.3 million (net of proceeds from a life insurance policy) related to the death of an executive officer.
Based on current conditions and assumptions as to future events on all policies in force, the Company expects to amortize approximately 13 percent of the December 31, 1999, balance of cost of policies purchased in 2000, 11 percent in 2001, 10 percent in 2002, 8 percent in 2003 and 7 percent in 2004. The discount rates used to determine the amortization of the cost of policies purchased averaged 7 percent in each of the three years ended December 31, 1999.
Statutory accounting requires that all commissions be charged to expense when incurred. Because of the significant increase in ordinary and reinsurance premium collections in 1999, the total net commission expense charged against statutory income was $815 million in 1999, an increase of $98.9 million compared to 1998. In addition, the insurance subsidiaries pay fees and interest to Conseco or its non-life subsidiaries; such amounts totaled $274.3 million, $205.1 million and $170.6 million in 1999, 1998 and 1997, respectively. The combined effect of increases in commission expense and fees and interest paid to Conseco decreased the statutory after-tax net income $109.2 million in 1999 compared to 1998. The statutory net income of our life insurance subsidiaries (after the expenses described above) was $181.1 million, $276.0 million and $243.4 million in 1999, 1998 and 1997, respectively.
In 1998, the National Association of Insurance Commissioners adopted codified statutory accounting principles, which are expected to constitute the only source of prescribed statutory accounting practices and are effective in 2001. The changes to statutory accounting practices resulting from the codification are not expected to have a material effect on the statutory capital and surplus or statutory operating earnings data shown above.
Finance segment. Our finance segment provides a variety of finance products including: loans for the purchase of manufactured housing, home improvements and various consumer products; private label credit card programs; and commercial loans such as floorplan and equipment financing. These products are primarily marketed through intermediary channels such as dealers, vendors, contractors and retailers. On March 31, 2000, we announced that we plan to explore the sale of Conseco Finance. If the planned sale is completed, the Company will no longer have finance operations.
(a) It is not practicable to provide additional components of revenue by product or services.
(a) We have restated amounts previously reported for the first, second and third quarters of 1999 to reflect adjustments, principally related to (i) impairment charges relating to interest-only securities and servicing rights; (ii) delaying the recognition of revenue from sales of loans to certain commercial paper conduit trusts until the loans were subsequently placed in their final securitization structures; (iii) the reallocation of gain on sale revenues relating to a securitization closed over two quarters; and CONSECO, INC. AND SUBSIDIARIES
(b) Included in the first, second, third and fourth quarters of 1999 are impairment charges of $12.2 million ($7.7 million after tax), $71.6 million ($45.1 million after tax), $100.1 million ($63.1 million after tax) and $370.4 million ($233.3 million after tax), respectively.
(d) We have restated amounts previously reported for the second quarter of 1998 to reflect a correction to the impairment charge we previously reported. This change increased the previously reported net loss by $19.5 million ($.06 per diluted share).
(e) Includes: (i) an impairment charge of $549.4 million ($355.8 million after tax or $1.15 per diluted share); and (ii) merger-related expenses of $148.0 million ($148.0 million after tax or $.48 per diluted share).