The Company's principal operations are located on a 170-acre corporate campus in Carmel, Indiana, immediately north of Indianapolis. These facilities contain approximately 525,000 square feet of space in eight buildings which contain Conseco's executive offices and certain administrative operations of its subsidiaries. These facilities include sufficient capacity for future growth.
Conseco's supplemental health products are primarily administered from a single facility of 300,000 square feet in downtown Chicago leased under agreement with a remaining life of 11 years. Conseco also leases approximately 130,000 square feet of warehouse space in a second Chicago facility with a remaining life of six years. Conseco leases 210 sales offices totaling approximately 363,000 square feet. All of the sales office leases are short-term in length, with remaining lease terms ranging from one to five years.
Conseco's 1995 operating earnings were $131.3 million, or $1.26 per fully diluted share, down 13 percent and up 2 percent, respectively, from 1994. Operating earnings decreased primarily because capital was used to repurchase shares of common stock during 1994 and 1995 (Conseco repurchased 21.6 million of its shares at a cost of $267 million from March 31, 1994 to February 1, 1995). This decrease was partially offset by increased earnings from the CCP Merger and the increased ownership of BLH as a result of purchases of BLH common stock during 1995. Operating earnings per fully diluted share increased despite the decline in operating earnings because of the smaller number of weighted average common shares outstanding in 1995.
Results of Operations by Segment for the Three Years ended December 31, 1996:
SPDA collected premiums decreased 25 percent to $755.4 million, in 1996. The demand for SPDA products offered by all insurance companies decreased during 1996, when relatively low interest rates made other investment products more attractive. The Company introduced an equity-linked SPDA in June 1996 to appeal to consumers' desire for alternative investment products with returns linked to equities. The accumulation value of these annuities is credited with interest at an annual minimum guaranteed rate of 3 percent, but the annuities provide for higher returns based on a percentage of the change in the S&P 500 Index during each year of their term. The Company purchases S&P 500 Index Options, the values of which change as the benefits accrue to these annuities as a result of the equity-linked return feature. Total collected premiums for this product were $87.1 million in 1996.
FPDA collected premiums increased 31 percent to $594.3 million, in 1996. FPDA premiums collected by LPG after the LPG Merger accounted for $30.4 million of such premiums collected during 1996. FPDAs are similar to SPDAs in many respects, except FPDAs allow more than one premium payment.
Insurance policy income includes: (i) premiums received on annuity policies that incorporate significant mortality features; (ii) cost of insurance and expenses charged to annuity policies; and (iii) surrender charges earned on annuity policy withdrawals. In accordance with GAAP, premiums on annuity contracts without mortality features are not reported as revenues, but rather are reported as deposits to insurance liabilities. Insurance policy income increased in 1996 primarily because of increased surrender charges (changes in premiums and other policy charges were not significant). Surrender charges were $41.2 million in 1996 and $28.6 million in 1995. Annuity policy withdrawals were $1.7 billion in 1996, compared with $1.5 billion in 1995. The increase in policy withdrawals and surrender charges generally corresponds to the aging and the growth of the Company's annuity business in force. In addition, policyholders are using the systematic withdrawal features available in several of the Company's annuity policies, and more policyholders are surrendering in order to invest in alternative investments. Total withdrawals and surrenders were 16 percent of insurance liabilities related to surrenderable policies in 1996 and 1995.
Insurance policy income increased in 1995 over 1994, primarily as a result of the acquisition transactions described above under "General."
Net investment income on separate account assets is offset by a corresponding charge to interest credited on variable annuity products. Such income fluctuates in relationship to total separate account assets and the return earned on such assets.
Interest expense on all annuity products, except variable annuities increased 3.6 percent in 1996, primarily due to a larger block of annuity business inforce in 1996, partially offset by a reduction in crediting rates. The weighted average crediting rates for these annuity liabilities were 5.0 percent in 1996 and 5.3 percent in 1995. The increase in interest expense on annuities in 1995 was primarily the result of the acquisition transactions described above under "General."
Interest expense on variable annuity products is equal to the net investment income on separate account assets.
Other operating costs and expenses increased 18 percent in 1996 and 317 percent in 1995. Such increases correspond to the increases in the total business inforce primarily related to acquisition transactions described above under "General."
Selling securities at a gain and reinvesting the proceeds at lower yields may, absent other management action, tend to decrease future investment yields. The Company believes, however, that the following factors mitigate the adverse effect of such decreases on net income: (i) the Company recognized additional amortization of cost of policies purchased and cost of policies produced in order to reflect reduced future yields (thereby reducing such amortization in future periods); (ii) the Company can reduce interest rates credited to some products, thereby diminishing the effect of the yield decrease on the investment spread; and (iii) the investment portfolio grows as a result of reinvesting the realized gains. As a result of the sales of fixed maturity investments, the amortization of the cost of policies produced and the cost of policies purchased increased $30.9 million in 1996, increased $114.8 million in 1995 and decreased $3.0 million in 1994.
General: This segment includes Medicare supplement and long-term care insurance products, primarily sold to senior citizens. Through December 31, 1996, the supplemental health operations consist solely of Bankers Life's Medicare supplement and long-term care products, distributed through a career agency force. Beginning in 1997, this segment will include the specified disease products of THI and CAF and the long-term care products of ATC; these products are distributed through professional independent producers. After the completion of the PFS Merger, the segment will also include various supplemental health products of PFS, which are also distributed through professional independent producers. The profitability of this segment largely depends on the overall level of sales, persistency of inforce business, claim experience and expense control.
Premiums collected on long-term care policies increased 22 percent in 1996, to $194.2 million, and 20 percent in 1995, to $158.8 million. Annualized new business premiums in 1996, 1995 and 1994 were $44.8 million, $40.9 million and $27.9 million, respectively. The continued growth in this product line reflects new product introductions, the competitiveness of the Company's products, the success of agent cross-selling activities, increased consumer awareness and demand, and improved persistency on a larger base of renewal premiums.
Net investment income did not change materially in 1996 and increased 14 percent in 1995. Such investment income fluctuates when changes occur in: (i) the amount of average invested assets supporting insurance liabilities; and (ii) the yield earned on invested assets. During 1996, the segment's average invested assets increased approximately 5.0 percent, to $880 million, and the net yield on invested assets decreased by .4 percentage points, to 7.6 percent. During 1995, the segment's average invested assets increased approximately 4.0 percent, to $840 million, and the net yield on invested assets increased by .7 percentage points, to 8.0 percent. Invested assets grew as a result of the growth in insurance liabilities related to Medicare supplement and long-term care business.
Insurance policy benefits and change in future policy benefits increased in 1996 as a result of the larger amount of business in force on which benefits are incurred, net of the lower incidence of claims. This account increased in 1995 as a result of the larger amount of business in force and a higher incidence of Medicare supplement claims. In 1996, the ratio of policy benefits to insurance policy income for the Medicare supplement policies fell by 3.5 percentage points, to 68.2 percent, reflecting the premium rate increases implemented in 1995 and 1996. In 1995, the ratio of policy benefits to insurance policy income for Medicare supplement policies increased by 5.4 percentage points to 71.7 percent, reflecting a higher incidence of claims incurred during that year.
Interest expense on investment borrowings was affected by changes in investment borrowing activities during the last three years and the higher interest rates paid on such borrowings during 1996 and 1995.
Premiums collected by this segment in 1996 were $453.7 million, up 64 percent over 1995. Premiums collected in 1995 were $276.2 million, up 51 percent over 1994. Such increases reflect the acquisition transactions described above under "General."
Insurance policy income includes: (i) premiums received on traditional life products; (ii) the mortality charges and administrative fees earned on universal life insurance; and (iii) surrender charges on terminated universal life insurance policies. In accordance with GAAP, premiums on universal life products are accounted for as deposits to insurance liabilities. Revenues are earned over time in the form of investment income on policyholder account balances, surrender charges and mortality and other charges deducted from the policyholders' account balances. Insurance policy income included: (i) premiums received on traditional life products of $174.1 million in 1996 and $175.3 million in 1995; (ii) mortality charges and administrative fees of $211.2 million in 1996 and $73.8 million in 1995; and (iii) surrender charges of $8.3 million in 1996 and $5.0 million in 1995.
Net investment income increased 58 percent in 1996 and 97 percent in 1995. Such investment income fluctuates with changes in: (i) the amount of average invested assets supporting insurance liabilities; and (ii) the yield earned on invested assets. During 1996, the segment's average invested assets increased 66 percent, to $3,540 million, and the net yield on invested assets decreased by .5 percentage points, to 7.9 percent. During 1995, the segment's average invested assets increased 85 percent, to $2,130 million, and the net yield on invested assets increased by .5 percentage points, to 8.4 percent. Invested assets primarily grew as a result of the growth in insurance liabilities from the acquisition transactions described above under "General."
Interest expense on financial products increased 88 percent in 1996 and 235 percent in 1995. Such expense fluctuates with changes in: (i) the amount of insurance liabilities for universal life products; and (ii) the interest rate credited to such products. During 1996, such average liabilities increased 98 percent, to $1,960 million and the rate credited decreased .2 percentage points to 5.0 percent. During 1995, such average liabilities increased 230 percent, to $990 million and the rate credited increased .2 percentage points to 5.2 percent. Universal life product liabilities increased primarily as a result of the acquisition transactions described above under "General."
Amortization related to operations increased 44 percent in 1996 and 65 percent in 1995. Such increases reflect a larger balance subject to amortization as a result of the acquisition transactions described above under "General."
(a) Revenues exclude net investment losses; benefits and expenses exclude amortization related to net investment losses.
General: The other segment includes miscellaneous individual and group health insurance premiums related to products that are not currently being emphasized by Conseco, although the inforce business continues to be profitable. The profitability of this business largely depends on the overall persistency of the business inforce, claim experience and expense control.
The segment also includes the fee revenue generated by Conseco's non-life subsidiaries, including the investment advisory fees earned by CCM and commissions earned for insurance product marketing and distribution. Such amounts exclude the fees for services provided to Conseco's consolidated subsidiaries. The profitability of the fee-based business depends on the total fees generated and expense control.
Premiums collected by this segment in 1996 were $389.2 million, down 6.2 percent from 1995. Premiums collected in 1995 were $414.9 million, up 3.6 percent from 1994. Premiums collected in 1995 included $35.1 million of premiums collected by subsidiaries acquired in 1995 and in the fourth quarter of 1994. Over the last three years, a number of steps were taken to improve the profitability of the other health business, including product, price, underwriting and agent compensation revisions. These steps have had the effect of reducing premiums collected.
Amortization related to operations increased 15 percent in 1996 and 22 percent in 1995. The amount was primarily affected by: (i) Conseco's purchases of additional shares of BLH common stock in 1995 and 1996; and (ii) the consolidation of the CCP subsidiaries effective January 1, 1995, as a result of the CCP Merger.
Restructuring income includes the gains Conseco has realized upon the sale of: (i) portions of acquired companies; and (ii) certain venture capital investments. Such income was $30.4 million in 1996, $15.2 million in 1995 and $45.0 million in 1994. The 1996 income primarily arose from the sale of Conseco's investment in Noble Broadcast Group, Inc. The 1995 income primarily arose from the sale of Conseco's investment in Eagle Credit (a finance subsidiary of Harley-Davidson). The 1994 income arose from the sale of Conseco's ownership of WNC, net of expenses incurred in conjunction with a terminated merger.
In accordance with GAAP, insurance policy income shown in Conseco's consolidated statement of operations consists of premiums received 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 rather are reported as deposits to insurance liabilities. Revenues for these products are recognized over time in the form of investment income and surrender or other charges.
Fluctuations in premiums collected are discussed above under "Results of Operations by Segment for the Three Years Ended December 31, 1996." Conseco's recent acquisitions will have a significant effect on future premiums collected. See "Outlook" below for a discussion of recent acquisitions.
Conseco's insurance subsidiaries are regulated by insurance statutes and regulations as to the type of investments that they are permitted to make and the amount of funds that may be used for any one type of investment. In light of these statutes and regulations and the Company's business and investment strategy, Conseco generally seeks to invest in United States government and government agency securities and corporate securities rated investment grade by established nationally recognized rating organizations or, if not rated, in securities of comparable investment quality.
The following table summarizes investment yields earned over the past three years, including ALH and LPG from their acquisition dates, and CCP upon its consolidation (effective January 1, 1995).
At December 31, 1996, the Company's fixed maturity portfolio had net unrealized gains of $103.8 million (equal to approximately .6 percent of the portfolio's carrying value), consisting of $261.7 million of unrealized gains and $157.9 million of unrealized losses. Estimated fair values for fixed maturity investments were determined based on: (i) estimates from nationally recognized pricing services (85 percent of the portfolio); (ii) broker-dealer market makers (13 percent of the portfolio); and (iii) internally developed methods (2 percent of the portfolio).
At December 31, 1996, approximately 4.5 percent of Conseco's invested assets and 5.1 percent of fixed maturity investments were rated below investment grade by nationally recognized statistical rating organizations (or, if not rated by such firms, with ratings below Class 2 assigned by the NAIC). Conseco plans to maintain approximately the present level of below investment grade fixed maturities. These securities generally have greater risks than other corporate debt investments, including risk of loss upon default by the borrower, and are often unsecured and subordinated to other creditors. Below investment grade issuers usually have high levels of indebtedness and are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than are investment grade issuers. The Company is aware of these risks and monitors its below investment grade securities closely. At December 31, 1996, the Company's below investment grade fixed maturity investments had an amortized cost of $871.6 million and an estimated fair value of $879.1 million.
All mortgage-backed securities are subject to risks associated with variable prepayments. As a result, these securities may have a different actual maturity than planned at the time of purchase. When securities having a cost greater than par are backed by mortgages that prepay faster than expected, Conseco records a charge to investment income. When securities having a cost less than par prepay faster than expected, Conseco records investment income.
The amortized cost and estimated fair value of mortgage-backed securities including CMOs at December 31, 1996, summarized by type of security were as follows:
Planned amortization classes and accretion directed bonds are some of the most stable and liquid instruments in the mortgage-backed securities market. Planned amortization class bonds adhere to a fixed schedule of principal payments as long as the underlying mortgage collateral experiences prepayments within a certain range. Changes in prepayment rates are first absorbed by support classes. This insulates the planned amortization classes from the consequences of both faster prepayments (average life shortening) and slower prepayments (average life extension).
Support classes absorb the prepayment risk from which planned amortization and targeted amortization classes are protected. As such, they are usually extremely sensitive to prepayments. Most of the Company's support classes are higher average life instruments that generally will not lengthen if interest rates rise further and will have a tendency to shorten if interest rates decline. However, since these bonds have costs below their par values, higher prepayments will have the effect of increasing yields.
Subordinated CMO classes have both prepayment and credit risk. The subordinated classes are used to enhance the credit quality of the senior securities and as such, rating agencies require that this support not deteriorate due to the prepayment of the subordinated securities. The credit risk of subordinated classes is derived from the negative leverage of owning a small percentage of the underlying mortgage loan collateral while bearing a majority of the risk of loss due to homeowner defaults.
If the Company determines that it will dispose of an investment held in the actively managed fixed maturity category, Conseco will either sell the security or transfer it to the trading account at its fair value and recognize the gain or loss immediately. There were no such transfers in 1996. During 1996, the Company sold actively managed fixed maturity securities with an $8.2 billion book value, resulting in $126.8 million of net investment gains and $52.5 million of net 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. The realization of gains and losses affects the timing of the amortization of the cost of policies produced and the cost of policies purchased, as explained in note 11 to the consolidated financial statements.
Credit-tenant loans are loans on commercial properties where the lease of the principal tenant is assigned to the lender. The principal tenant, or any guarantor of such tenant's obligations, must have a credit rating at the time of origination of the loan of at least BBB- or its equivalent. The underwriting guidelines consider such factors as: (i) the lease term of the property; (ii) the mortgagee's management ability, including business experience, property management capabilities and financial soundness; and (iii) such economic, demographic or other factors that may affect the income generated by the property or its value. The underwriting guidelines also generally require a loan-to-value ratio of 75 percent or less. Credit-tenant loans are carried at amortized cost and totaled $447.1 million at December 31, 1996, or 2.3 percent of total invested assets. The total estimated fair value of credit-tenant loans was $446.3 million at December 31, 1996.
assets included in the CMO portfolios. If prepayments vary from projections on the mortgage loan assets included in such CMO portfolios, the total cash flows to the Company from such junior and residual interests could change from projected cash flows, resulting in a gain or loss.
Short-term investments totaled $281.6 million, or 1.4 percent of invested assets at December 31, 1996, and consisted primarily of commercial paper and repurchase agreements relating to government securities.
The total capital of Conseco at December 31, 1996 and 1995, was as follows:
Company-obligated mandatorily redeemable preferred securities of subsidiary trusts totaling $600.0 million were issued during 1996. In accordance with GAAP, such securities are not considered shareholders' equity of Conseco, but are classified as minority interest.
Minority interest, excluding the Company-obligated mandatorily redeemable preferred securities, at December 31, 1996, included: (i) $97.0 million of redeemable preferred stock of a subsidiary of ALH; and (ii) $.7 million interest in the common stock of a subsidiary of ALH. At December 31, 1995, minority interest also included the interests of the non-Conseco shareholders in ALH and BLH. Conseco acquired such ownership interests from the minority interest in the ALH Stock Purchase and the BLH Merger.
Book value per common share outstanding increased to $16.86 at December 31, 1996, from $10.22 at December 31, 1995. Such increase was primarily attributable to the value of shares issued for: (i) Conseco's recent acquisitions; and (ii) the conversion of preferred stock. Excluding unrealized appreciation of fixed maturity securities in accordance with SFAS 115, book value per common share outstanding was $16.62 at December 31, 1996, compared to $8.83 at December 31, 1995.
Total assets increased by $8.3 billion in 1996, to $25.6 billion, principally due to the assets acquired in the LPG Merger, the ATC Merger, and the THI Merger.
(a) These ratios are included to assist the reader in analyzing the impact of interest on annuities and financial products (which is not generally required to be paid in cash in the period it is recognized). Such ratios are not intended to, and do not represent the following ratios prepared in accordance with GAAP: the ratio of earnings to fixed charges; the ratio of earnings to fixed charges and preferred dividends; the ratio of earnings to fixed charges, preferred dividends and distributions on Company-obligated mandatorily redeemable preferred securities of subsidiary trusts; or the ratio of adjusted statutory earnings to cash interest.
(d) Excludes the effect of reporting fixed maturities at fair value which the Company began to do in 1992 as described in note 1 to the consolidated financial statements.
Conseco's insurance operating companies generally receive adequate cash flow from premium collections and investment income to meet their obligations. Life insurance and annuity liabilities are generally long term in nature. Policyholders may, however, withdraw funds or surrender their policies, subject to surrender and withdrawal penalty provisions. The Company seeks to balance the duration of its invested assets with the estimated duration of benefit payments arising from contract liabilities.
Of the Company's total insurance liabilities at December 31, 1996, approximately 20 percent could be surrendered by the policyholder without a penalty. Approximately 65 percent could be surrendered by the policyholder subject to penalty or the release of an insurance liability in excess of surrender benefits paid. Payment characteristics of the insurance liabilities at December 31, 1996, were as follows (dollars in millions):
Of the above insurance liabilities under contracts containing fixed payment dates, approximately 55 percent related to payments that will be made for the lifetime of the contract holder. Conseco considers expected mortality in determining the amount of this liability. The remaining insurance liabilities having fixed payment dates are payable regardless of the contract holder's survival.
The following summarizes insurance liabilities for investment contracts by credited rate (excluding interest rate bonuses for the first policy year only) at December 31, 1996 (dollars in millions):
At December 31, 1996, the parent company and its non-life subsidiaries had short-term investments of $115.1 million, of which $12.6 million was expended in January 1997 for accrued interest and dividends. The parent company and its non-life subsidiaries had additional investments in fixed maturities, equity securities and other invested assets of $65.3 million at December 31, 1996, which, if needed, could be liquidated or contributed to the insurance subsidiaries.
Insurance departments in the states where the Company's life insurance subsidiaries are domiciled or do business require insurance companies to make annual and quarterly filings. Portions of surplus, called the IMR and the asset valuation reserve ("AVR"), are required to be appropriated and reported as liabilities. The IMR captures all investment gains and losses resulting from changes in interest rates and provides for such amounts to be amortized into statutory net income on a basis reflecting the remaining lives of the assets sold. The AVR captures investment gains and losses related to changes in creditworthiness; it is also adjusted each year based on a formula related to the quality and loss experience of the Company's investment portfolio. These reserves affect the ability of the Company's insurance subsidiaries to reflect investment gains and losses in statutory earnings and surplus.
Conseco's debt agreements require the Company to maintain minimum working capital and RBC and limit the Company's ability to incur additional indebtedness. They also restrict the amount of retained earnings that are available for dividends and require Conseco to maintain certain minimum ratings at its insurance subsidiaries.
Medical cost inflation has had a significant impact on the Company's supplemental health operations. In recent years, these costs have increased more rapidly than the Consumer Price Index. Medical costs will likely continue to rise. The impact on Conseco's operations depends upon its ability to increase its premium rates. Such increases are subject to approval by state insurance departments. Before Medicare supplement plans were standardized, approximately two-thirds of the states permitted rate plans with automatic escalation clauses. This permitted Conseco, in periods following initial approval, to adjust premium rates for changes in Medicare deductibles and increases in medical cost inflation without refiling with the regulators. Currently, all rate changes for standardized plans must be individually approved by each state. Conseco prices its new standardized supplement plans to reflect the impact of these filings and the lengthening of the period required to implement rate increases.
Conseco believes that the consolidation of the U.S. life insurance industry will continue, and Conseco intends to participate in this process. Conseco believes that, under appropriate circumstances, it is more advantageous to acquire companies with large books of in-force life and health insurance and annuities and strong distribution channels, than to produce new business or develop or enlarge distribution channels. Conseco believes that the purchased blocks of business and the acquired distribution channels make more predictable profit analysis possible.
Conseco believes it has the resources and capabilities to continue being a successful acquirer of life insurance companies. It also believes that its past record of successfully acquiring, financing and operating life insurance companies will be an advantage compared to others who may attempt to acquire available candidates. The pro forma capital structure of Conseco (giving effect to the CAF Merger, completed in March 1997; and the PFS Merger, expected to be completed in the second quarter of 1997) includes only 30 percent debt.
As part of its program of exploring opportunities to improve its capital structure, Conseco continually reviews its corporate structure and the need and desirability of restructuring the existing debt and equity of the Company.
As a result of its recent acquisitions and the planned PFS Merger, Conseco will have significant in-force business and marketing activity in multiple segments of the life insurance industry, including universal life, ordinary life, term life, single- and flexible-premium deferred and immediate annuities (including both variable and fixed), Medicare supplement, long-term care, specified disease, and individual and group health insurance.
The following pro forma consolidated financial information as of and for the year ended December 31, 1996, is provided for informational purposes only and may not be indicative of the results of operations or financial condition that would have been achieved had the transactions set forth below actually occurred as of the dates indicated or of future results of operations or financial condition of Conseco. Conseco anticipates cost savings and additional benefits as a result of completing the transactions set forth below. Such benefits and any other changes that might have resulted from management of the combined companies have not been included as adjustments to the pro forma consolidated financial information.
The pro forma consolidated balance sheet information at December 31, 1996, in the column headed "Pro forma for completed transactions" reflects the application of certain pro forma adjustments for the CAF Merger, which was completed March 4, 1997. The pro forma consolidated balance sheet data at December 31, 1996, in the column headed "Pro forma for completed transactions and the PFS Merger" reflect further adjustments to the financial position of Conseco as if the PFS Merger had occurred on December 31, 1996.
(c) Includes premiums received from annuities and universal life policies. Such premiums are not reported as revenues under GAAP.
(e) Excludes the effects of reporting fixed maturities at fair value and recording the unrealized gain or loss on such securities as a component of shareholders' equity, net of tax and other adjustments. Such adjustments, which the Company began to do in 1992, are in accordance with SFAS 115, as described in note 1 to the consolidated financial statements.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Conseco, Inc. and Subsidiaries as of December 31, 1996 and 1995, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles.
The following summary explains the accounting policies we use to arrive at some of the more significant numbers in our financial statements. We have restated all share and per-share amounts for the two-for-one stock splits distributed April 1, 1996, and February 11, 1997. We prepare our financial statements in accordance with generally accepted accounting principles ("GAAP"). We follow the accounting standards established by the Financial Accounting Standards Board, the American Institute of Certified Public Accountants and the Securities and Exchange Commission.
We own the following life insurance companies: Bankers Life and Casualty Company ("Bankers Life"), Bankers Life Insurance Company of Illinois, Certified Life Insurance Company, Great American Reserve Insurance Company ("Great American Reserve"), Beneficial Standard Life Insurance Company ("Beneficial Standard"), Jefferson National Life Insurance Company of Texas, Bankers National Life Insurance Company, National Fidelity Life Insurance Company, Lincoln American Life Insurance Company, American Life and Casualty Insurance Company ("ALC"), Vulcan Life Insurance Company, Philadelphia Life Insurance Company, Massachusetts General Life Insurance Company, Lamar Life Insurance Company, Wabash Life Insurance Company, American Travellers Life Insurance Company, United General Life Insurance Company, American Travellers Insurance Company of New York, TLIC Life Insurance Company, Transport Life Insurance Company ("TLIC") and Continental Life Insurance Company.
CCP Insurance, Inc. ("CCP"), a newly organized holding company for Partnership I's first three acquisitions, completed an initial public offering ("IPO") in July 1992. As a result of the IPO, we no longer had unilateral control over those entities and stopped including their accounts in our consolidated financial statements. We carried our investment in CCP and its subsidiaries in our financial statements on the equity basis in 1994 and 1993. In August 1995, we completed the purchase of all the shares of CCP common stock we did not previously own in a transaction pursuant to which CCP was merged with Conseco, with Conseco being the surviving corporation (the merger and related transactions are referred to herein as the "CCP Merger"). As a result, CCP's subsidiaries (Great American Reserve and Beneficial Standard) became wholly owned subsidiaries of the Company. The Company's consolidated statements reflect the operations of CCP on a consolidated basis effective January 1, 1995.
Bankers Life Holding Corporation ("BLH"), a company formed by Partnership I to acquire Bankers Life, completed an IPO in March 1993. As a result of the IPO, Conseco owned 31 percent of BLH and no longer had unilateral control of BLH. However, after we acquired additional common shares of BLH in September 1993, our ownership position in BLH increased to 56 percent. In June 1995, we purchased additional common shares of BLH, increasing the Company's ownership of BLH to 85 percent. Conseco's ownership of BLH increased to 88 percent at December 31, 1995, and 90.5 percent at March 5, 1996, as a result of share repurchases by BLH. On December 31, 1996, we completed the purchase of BLH common shares we did not already own in a transaction pursuant to which BLH merged with a wholly owned subsidiary of Conseco (the "BLH Merger"). The accounts of BLH are consolidated with Conseco's accounts for all periods in the accompanying consolidated financial statements.
Western National Corporation ("WNC"), the holding company for Western National Life Insurance Company ("Western National"), completed an IPO in February 1994. Prior to the IPO, WNC was a wholly owned subsidiary of Conseco. We sold 60 percent of our equity interest in the IPO and our remaining 40 percent interest in WNC on December 23, 1994. Our equity in earnings of WNC in 1994 therefore reflected: (i) all of WNC's earnings for the period through February 15, 1994; and (ii) 40 percent of WNC's earnings for the period from February 15, 1994, through December 23, 1994.
Conseco Capital Partners II, L.P. ("Partnership II"), Conseco's second investment partnership, acquired American Life Holdings, Inc. ("ALH" and the parent of ALC) on September 29, 1994. Because Conseco was the sole general partner of Partnership II, Conseco controlled Partnership II and ALH even though our ownership interest was less than 50 percent. Because of this control, Conseco's consolidated financial statements were required to include the accounts of ALH. Immediately after the acquisition of ALH, Conseco, through its direct investment and through its equity interests in the investments made by BLH, CCP and WNC, had approximately a 27 percent ownership interest in ALH.
On November 30, 1995, ALH issued 2,142,857 shares of its common stock for $30.0 million (including $13.2 million paid by Conseco and its subsidiaries) in a private placement transaction. Conseco's ownership interest in ALH increased to 36 percent at December 31, 1995, as a result of this transaction and changes in our ownership of affiliated companies with ownership interests in ALH.
On August 2, 1996, we completed the acquisition (the "LPG Merger") of Life Partners Group, Inc. ("LPG") and LPG became a wholly owned subsidiary of Conseco. On December 17, 1996, we completed the acquisition (the "ATC Merger") of American Travellers Corporation ("ATC") and ATC was merged with and into Conseco, with Conseco being the surviving corporation. On December 23, 1996, we completed the acquisition (the "THI Merger") of Transport Holdings Inc. ("THI") and THI was merged with and into Conseco with Conseco being the surviving corporation. Accordingly, the accounts of LPG are consolidated with Conseco effective July 1, 1996 and the accounts of ATC and THI are consolidated effective December 31, 1996.
Actively managed - fixed maturity securities that we may sell prior to maturity in response to changes in interest rates, issuer credit quality or our liquidity requirements. We carry actively managed securities at estimated fair value. We record any unrealized gain or loss, net of tax and the related adjustments described below, as a component of shareholders' equity.
Trading account - fixed maturity securities that we buy principally for the purpose of selling in the near term. We carry trading account securities at estimated fair value. We include any unrealized gain or loss in net investment gains (losses). We did not hold any trading account securities at December 31, 1996 or 1995.
When there are changes in conditions that cause us to transfer a fixed maturity investment to a different category (i.e., actively managed, trading or held to maturity), we transfer it at its fair value on that date. We account for the security's unrealized gain or loss (such amounts were immaterial in 1996) as follows:
For a transfer to the trading category - we recognize the unrealized gain or loss immediately in earnings.
Other invested assets include certain non-traditional investments, including investments in venture capital funds, limited partnerships, mineral rights and promissory notes. Such investments are accounted for 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 our CTLs, mortgage loans and other 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 we reduce our cost basis of the security to its estimated fair value. If a loan becomes impaired (i.e., it becomes probable that we will be unable to collect all amounts due according to the contractual terms of the agreement), we revalue the loan at the present value of expected cash flows, discounted at the loan's effective interest rate. We accrue interest thereafter on its net carrying amount.
Separate accounts are funds on which investment income and gains or losses accrue directly to certain policyholders. The assets of these accounts are legally segregated. They are not subject to the claims which may arise out of any other business of Conseco. We report separate account assets at market value; the underlying investment risks are assumed by the contract holders. We record the related liabilities at amounts equal to the underlying assets; the fair value of these liabilities equals their carrying amount.
When we acquire an insurance company, we assign a portion of its cost to the right to receive future cash flows from insurance contracts existing at the date of the acquisition. This cost of policies purchased represents the actuarially determined present value of the projected future cash flows from the acquired policies. To determine this value, we use a method that is consistent with methods commonly used to value blocks of insurance business and with the basic methodology generally used to value assets. It can be summarized as follows:
- Identify the risks to realizing those cash flows (i.e., assess the probability that the cash flows will be realized).
The expected future cash flows we use in determining such value are based on actuarially determined projections of future premium collections, mortality, surrenders, operating expenses, changes in insurance liabilities, investment yields on the assets held to back the policy liabilities and other factors. These projections take into account all factors known or expected at the valuation date, based on the collective judgment of Conseco's management. Our actual experience on purchased business may vary from projections due to differences in renewal premiums collected, investment spread, investment gains or losses, mortality and morbidity costs and other factors.
After we determine the cost of policies purchased, we amortize that amount based on the incidence of the expected cash flows. We amortize this asset using the interest rate credited to the underlying policies.
The costs that vary with and are primarily related to producing new business are referred to as cost of policies produced. They consist primarily of commissions, first-year bonus interest and certain costs of policy issuance and underwriting, net of fees charged to the policy in excess of ultimate fees charged. To the extent that they are recoverable from future profits, we defer these costs and amortize them with interest as follows:
- For universal life-type contracts and investment-type contracts, in relation to the present value of expected gross profits from the contracts, discounted using the interest rate credited to the policy.
For investment contracts without mortality risk (such as deferred annuities and immediate annuities with benefits paid for a period certain) and for contracts that permit either Conseco or the insured to make changes in the contract terms (such as single- premium whole life and universal life), we are required to record premium deposits and benefit payments as increases or decreases in a liability account, rather than as revenue and expense. We record as revenue any amounts charged against the liability account for the cost of insurance, policy administration and surrender penalties. We record as expense any interest credited to the liability account and any benefit payments that exceed the contract liability account balance.
For traditional life insurance contracts, we recognize premiums as income when due or, for short-duration contracts, over the period to which the premiums relate. We recognize benefits and expenses as a level percentage of earned premiums. We accomplish this by providing for future policy benefits and by amortizing deferred policy acquisition costs.
We report assets and liabilities related to insurance contracts before the effects of reinsurance. We report reinsurance receivables and prepaid reinsurance premiums (including amounts related to insurance liabilities) as assets. We recognize estimated reinsurance receivables in a manner consistent with the liabilities related to the underlying reinsured contracts.
Our income tax expense includes deferred income taxes arising from temporary differences between the tax and financial reporting basis of assets and liabilities. This liability method of accounting for income taxes also requires us to reflect in income the effect of a tax-rate change on accumulated deferred income taxes in the period in which the change is enacted.
In assessing the realization of 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 deferred income tax assets depends upon generating future taxable income during the periods in which temporary differences become deductible. If future income is not generated as expected, deferred income tax assets may need to be written off.
We compute primary net income per share by dividing earnings less preferred dividend requirements by the weighted average number of common and common equivalent shares outstanding for the period. We compute fully diluted net income per share on the same basis, except that, if more dilutive: (i) the number of common equivalent shares related to stock options is based on the period- end market value of the shares, instead of the average market value; and (ii) convertible preferred stock is assumed to be converted into common shares. We have restated all share and per-share amounts for the two-for-one stock splits distributed April 1, 1996 and February 11, 1997.
Our financial statements have been prepared in accordance with GAAP. As such, they include amounts based on our informed estimates and judgment, with consideration given to materiality. We use many estimates and assumptions calculating cost of policies produced, cost of policies purchased, goodwill, insurance liabilities, guaranty fund assessment accruals and deferred income taxes. Actual experience may differ from those estimates.
The Company's use of derivative financial instruments is primarily limited to S&P 500 Index Options. We buy these options in order to offset changes in policyholder liabilities resulting from certain policy benefits tied to the S&P 500 Index. We buy these options at the time we issue the related annuity contracts, with similar maturity dates and benefit features that fluctuate as the value of the options change. Accordingly, changes in the value of the options are offset by changes to policyholder liabilities; such changes are reflected in the consolidated statement of operations. The credit risk associated with these options is considered low because such options are purchased from strong creditworthy parties. Both the carrying value and fair value of these contracts were $7.2 million at December 31, 1996. Such instruments are classified as other invested assets.
Investment securities. For fixed maturity securities (including redeemable preferred stocks) and for equity and trading account 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.
Insurance liabilities for investment contracts. We use discounted cash flow calculations based on interest rates currently being offered for similar contracts having maturities consistent with the contracts being valued.
Redeemable preferred stock of a subsidiary of ALH (a component of minority interest). The estimated fair value of redeemable preferred stock which is publicly-traded is based on quoted market prices. The estimated fair value of the privately placed redeemable preferred stock is determined by discounting expected future cash flows using assumed incremental dividend rates for similar duration securities.
In February 1997, the Financial Accounting Standards Board released Statement of Financial Accounting Standards No. 128, "Earnings Per Share" ("SFAS 128"). SFAS 128 changes the computational guidelines for earnings per share information. We will adopt the provisions of SFAS 128 in our December 31, 1997, consolidated financial statements. SFAS 128 will eliminate the presentation of primary earnings per share and replace it with basic earnings per share. Basic earnings per share differs from primary earnings per share because common stock equivalents are not considered in computing basic earnings per share. Fully diluted earnings per share will be replaced with diluted earnings per share. Diluted earnings per share is similar to fully diluted earnings per share, except in determining the number of dilutive shares outstanding for options and warrants, the proceeds that would be received upon the conversion of all dilutive options and warrants are assumed to be used to repurchase the Company's common shares at the average market price of such stock during the period. For fully diluted earnings per share, the higher of the average market price or ending market price is used. If SFAS 128 had been in effect, Conseco would have reported basic earnings per share of $2.32 and diluted earnings per share of $1.82 for the year ended December 31, 1996.
In connection with the organization of WNC and the transfer of the stock of Western National to WNC by Conseco, WNC issued 60 million shares of its common stock and a $150.0 million, 6.75 percent senior note due March 31, 1996 (the "Conseco Note") to Conseco. On February 15, 1994, WNC completed the IPO of 37.2 million shares of its common stock. Of these shares, 2.3 million were new shares sold by WNC and 34.9 million were sold by Conseco. In addition, Conseco sold .2 million WNC shares to the president of WNC at the IPO price, less underwriting discounts and commissions. On February 22, 1994, WNC completed a public offering of $150.0 million aggregate principal amount of 7.125 percent senior notes due February 15, 2004. The net proceeds from the offering of $147.5 million (after original issue discount, underwriting discount and offering expenses) together with some of the proceeds from WNC's IPO of common stock, were used to repay the Conseco Note.
The shares sold by Conseco represented a 60 percent interest in WNC. Net pre-tax proceeds to Conseco from the repayment of the Conseco Note and the sale of WNC shares totaled $537.3 million. These proceeds were used to repay a $200 million senior unsecured loan and for other general corporate purposes. In the first quarter of 1994, Conseco reported restructuring income of approximately $42.4 million (net of taxes of $22.9 million) as a result of these transactions.
The LPG Merger was accounted for under the purchase method of accounting. Under this method, we allocated the cost to acquire LPG to the assets and liabilities acquired based on their fair values as of July 1, 1996, and recorded the excess of the total purchase cost over the fair value of the liabilities we assumed as goodwill. The LPG Merger did not qualify to be accounted for under the pooling of interest method in accordance with Accounting Principles Board Opinion No. 16, Business Combinations ("APB No. 16"), because of Conseco's significant common stock repurchases within the last two years.
The ATC Merger was accounted for under the purchase method of accounting effective December 31, 1996. Under this method, we allocated the cost to acquire ATC to the assets and liabilities acquired based on fair values as of the date of the ATC Merger, and reported the excess of the total purchase cost over the fair value of the assets acquired less the fair values of the liabilities assumed as goodwill. The ATC Merger did not qualify to be accounted for under the pooling of interests method in accordance with APB No. 16 because an affiliate of ATC sold a portion of the Conseco common stock received in the ATC Merger shortly after the consummation of the ATC Merger.
(1) We have excluded $80.8 million from pro forma total revenues, $46.5 million from income before extraordinary charge and $.46 from income before extraordinary charge per fully diluted common share. These amounts related to the initial public offering of WNC and the sale of the Company's remaining equity interest in WNC.
At December 31, 1996, the amortized cost and estimated fair value of actively managed fixed maturities were as follows:
At December 31, 1995, the amortized cost and estimated fair value of actively managed fixed maturities were as follows:
At December 31, 1996, the amortized cost and estimated fair value of actively managed fixed maturities based upon the pricing source used to determine estimated fair value were as follows:
The proceeds from sales of fixed maturity investments were $8.2 billion in 1996, $7.9 billion in 1995 and $2.8 billion in 1994.
Investment gains (losses), net of investment gain expenses, were included in revenue as follows:
At December 31, 1996, net appreciation of equity securities (before income tax) was $2.1 million, consisting of $3.6 million of appreciation and $1.5 million of depreciation.
The following table sets forth the par value, amortized cost and estimated fair value of investments in mortgage-backed securities including CMOs at December 31, 1996, summarized by interest rates on the underlying collateral:
The amortized cost and estimated fair value of mortgage-backed securities including CMOs at December 31, 1996, summarized by type of security were as follows (dollars in millions):
At December 31, 1996, approximately 84 percent of the estimated fair value of Conseco's mortgage-backed securities was determined by nationally recognized pricing services, 13 percent was determined by broker-dealer market makers, and 3 percent was determined by internally developed methods.
At December 31, 1996, the mortgage loan balance was primarily comprised of commercial loans, including multifamily residential loans. Approximately 30 percent, 12 percent and 6 percent of the mortgage loan balance were on properties located in California, Texas and Mississippi, respectively. No other state comprised greater than 5 percent of the mortgage loan balance. Less than 1 percent of the mortgage loan balance was noncurrent at December 31, 1996. At December 31, 1996, the Company had an allowance for loss on mortgage loans of $2.4 million.
At December 31, 1996, we held $447.1 million of CTLs. CTLs are mortgage loans for commercial properties that we make based on the underwriting guidelines described in note 1. We classify CTLs as a separate class of securities because they are principally underwritten based on the creditworthiness of the tenant rather than the value of the underlying property. As with commercial mortgages, CTLs are additionally collateralized by liens on the underlying property.
Other invested assets include certain non-traditional investments, including investments in venture capital funds, limited partnerships, mineral rights and promissory notes. During 1996, Conseco sold its investment in Noble Broadcast Group, Inc.: restructuring income of $30.0 million was recognized. During 1995, Conseco sold its investment in Eagle Credit (a finance subsidiary of Harley-Davidson): restructuring income of $20.6 million was recognized.
Income tax expense differed from that computed at the applicable federal statutory rate (35 percent) for the following reasons:
reduce the tax provision for financial reporting purposes. With respect to determining that the Company's net operating loss carryforwards will be fully utilized, the Company is relying upon its past history of earnings.
The IRS has completed its examination of Conseco's consolidated tax returns for years through 1992 and is currently conducting an examination for years 1993 through 1994. Certain companies acquired in the LPG Merger have been audited by the IRS for years 1990 and 1991 and are appealing the proposed adjustments to the IRS's Appeals Division. Certain companies acquired in the LPG Merger are currently being audited by the IRS for years 1992 through 1994. We believe adjustments, if any, related to these audits will not be significant.
Notes payable of the Company at December 31, 1996 and 1995, were as follows:
Maturities of notes payable at December 31, 1996, were as follows (dollars in millions):
Borrowings under revolving credit agreements. The Company's current revolving credit agreement (the "Credit Facility"), executed in November 1996, permits borrowings up to $1.4 billion. Borrowings bear interest at the bank's base rate, a Eurodollar rate or a rate determined based on a solicitation of bids from lenders. Eurodollar rates are equal to the reserve-adjusted LIBOR rate plus a margin of .225 percent to .75 percent, based on the credit rating of Conseco's senior notes. The current margin of .375 percent will increase by .125 percent after December 31, 1997, if Conseco's debt to total capitalization ratio exceeds 35 percent. Borrowings
at December 31, 1996, bore interest at a weighted average rate of 5.90 percent. The Credit Facility also permits revolving Swingline loans up to $50.0 million. Such loans are due within 7 days and bear interest at the bank's base rate or a reserve adjusted three-month CD rate plus the Eurodollar rate margin and an assessment rate. Maximum permitted borrowings under the Credit Facility are reduced by any aggregate outstanding commercial paper of Conseco.
Borrowings are due in November 2001. Mandatory prepayments, which reduce the maximum permitted borrowings, are required under the Credit Facility upon the sale or disposition of any significant assets other than in the ordinary course of business. The Credit Facility contains various restrictive covenants that primarily pertain to levels of indebtedness, limitations on payment of dividends, limitations on the quality and types of investments, and capital expenditures. Additionally, the Company must comply with several financial covenant restrictions, including maintaining: (i) shareholders' equity in excess of $1.75 billion at December 31, 1996, $2.4 billion in 1997 and 1998 and $3.5 billion thereafter; (ii) the interest coverage ratio in excess of 2.0:1 through March 1997 (escalating to 3.0:1 after 1997); and (iii) the debt to total capital ratio less than .45:1. As of December 31, 1996, the Company was in compliance with all covenants under its debt agreements.
On the last day of each quarter, we pay a commitment fee that ranges from .08 percent to .25 percent per annum (depending on the credit rating of Conseco's senior debt) on the average daily unused commitments during the quarter. This fee was .125 percent per annum during the fourth quarter of 1996.
8.125% senior notes due 2003 were issued to the public in 1993, are unsecured and rank pari passu with all other unsecured and unsubordinated indebtedness of the Company. The notes are not redeemable prior to maturity.
10.5% senior notes due 2004 were issued to the public by CCP in 1994, are unsecured and rank pari passu with all other unsecured and unsubordinated indebtedness of Conseco. The notes are not redeemable prior to maturity.
Other debt. In March 1996, BLH completed a tender offer in which it repurchased $148.3 million principal balance of its senior subordinated notes. In addition, Conseco repurchased $28.5 million of such notes during 1996. Conseco recognized an extraordinary charge of $9.0 million (net of a $4.9 million tax benefit) related to such repurchases.
Conseco recognized extraordinary charges of $2.1 million (net of a $1.5 million tax benefit) in 1995 and $4.0 million (net of a $2.2 million tax benefit) in 1994, related to the repayment of notes payable.
The Company has qualified defined contribution plans in which substantially all employees are eligible to participate. Company contributions, which match certain voluntary employee contributions to the plan, totaled $2.0 million in 1996, $2.2 million in 1995 and $1.7 million in 1994. These contributions may be made either in cash or in Conseco common stock.
BLH has a noncontributory, unfunded deferred compensation plan for qualifying members of its career agency force. Benefits are based on years of service and career earnings. The liability recognized in the consolidated balance sheet for the agents' deferred compensation plan was $34.5 million and $32.2 million at December 31, 1996 and 1995, respectively. Substantially all of this liability represents vested benefits. Costs incurred on this plan, primarily representing interest on unfunded benefit costs, were $3.2 million, $2.8 million and $2.7 million during 1996, 1995 and 1994, respectively.
BLH also provides certain health care and life insurance benefits for eligible retired employees. Benefits are provided under a contributory unfunded plan which includes cost-sharing features determined at the discretion of management. During 1994, several modifications were made to postretirement benefit plans that: (i) established cost-sharing for certain future retirees; (ii) established maximum annual costs and benefits; and (iii) revised certain other benefits. Such changes made in 1994 resulted in a $9.2 million amendment gain and a $5.2 million curtailment gain. The amendment gain is amortized over the remaining service period of active plan participants. The curtailment gain is included in other income. Amounts related to the postretirement benefit plan consisted of the following:
The discount rates used in determining the accumulated postretirement benefit obligation was 7 percent at December 31, 1996 and 1995. Future increases in salaries and the assumed health care cost trend rates produce no change in the accumulated postretirement benefit obligation at December 31, 1996 and 1995, because of the employer's maximum cost sharing provisions discussed above. The net periodic cost of providing these benefits is not significant.
From time to time, mandatory assessments are levied on the Company's insurance subsidiaries by life and health guaranty associations of most states in which these subsidiaries are licensed. These assessments are to cover losses to policyholders of insolvent or rehabilitated insurance companies. The associations levy assessments (up to prescribed limits) on all insurers in a particular state in order to pay claims on the basis of the proportionate share of premiums written by insurers in the lines of business in which the insolvent or rehabilitated insurer is engaged. These assessments may be deferred or forgiven in certain states if they would threaten an insurer's financial strength and, in some states, these assessments can be partially recovered through a reduction in future premium taxes. The balance sheet at December 31, 1996, includes accruals of $17.2 million, which approximate the Company's estimate of: (i) all known assessments that will be levied against the Company's insurance subsidiaries by various state guaranty associations based on premiums that have been written through December 31, 1996; less (ii) amounts that would be recoverable through a reduction in future premium taxes as a result of such assessments. Such estimate is subject to change as the associations determine more precisely the losses that have occurred and how such losses will be allocated to insurance companies. The Company's cost for such assessments incurred by its insurance company subsidiaries and equity investees was $4.0 million in 1996, $3.2 million in 1995 and $8.0 million in 1994.
In November 1994, Conseco and another company agreed to terminate a merger agreement. Conseco incurred pre-tax expenses totaling approximately $35.8 million including: (i) $15.1 million of fees to banks for financing commitments; (ii) $9.8 million loss on the decline in fair value of common stock acquired by Conseco in connection with the proposed merger; and (iii) $10.9 million of legal, accounting and actuarial fees and other expenses.
At December 31, 1996, the preferred stock consists of 2,760,000 shares of $2.16 Redeemable Cumulative Preferred Stock (the "$2.16 Preferred Shares") and 940,000 shares of $2.32 Redeemable Cumulative Preferred Stock (the "$2.32 Preferred Shares") of a subsidiary of ALH.
The $2.32 Preferred Shares are entitled to cash dividends of $2.32 per share per annum payable quarterly and may be redeemed, in whole or in part, at any time after February 2, 1998, at $26.25 per share declining to $25.00 per share on or after February 1, 2001, plus unpaid cumulative dividends. The $2.32 Preferred Shares are mandatorily redeemable on February 15, 2008.
Authorized preferred stock is 20,000,000 shares. On January 23, 1996, Conseco completed the offering of 4.37 million shares of PRIDES. Proceeds from the offering of $257.7 million (after underwriting and other associated costs) were used to repay notes payable of Conseco. Each share of PRIDES pays quarterly dividends at the annual rate of 7 percent of the $61.125 liquidation preference per share (equivalent to an annual amount of $4.279 per share). On February 1, 2000, unless either previously redeemed by Conseco or converted at the option of the holder, each share of PRIDES will mandatorily convert into four shares of Conseco common stock, subject to adjustment in certain events. Shares of PRIDES are not redeemable prior to February 1, 1999. From February 1, 1999 through February 1, 2000, the Company may redeem any or all of the outstanding shares of PRIDES. Upon such redemption, each holder will receive, in exchange for each share of PRIDES, the number of shares of Conseco common stock equal to (i) the sum of (a) $62.195, declining after February 1, 1999 to $61.125, and (b) accrued and unpaid dividends divided by (ii) the market price of Conseco common stock at such date. In no event will a holder receive less than 3.42 shares of Conseco common stock. During 1996, 400 shares of PRIDES were converted by holders of such shares into 1,368 shares of Conseco common stock.
Conseco issued 5,750,000 shares of Series D Cumulative Convertible Preferred Stock ("Series D preferred stock") with annual dividends of $3.25 per share and with a total stated value of $287.5 million ($50 per share) in January 1993 in a public offering. During 1993, 274 Series D preferred shares were converted to 860 common shares. In December 1994, the Company repurchased 80,000 Series D preferred shares in open market transactions in connection with its stock repurchase program at a total cost of $3.3 million. Such preferred shares would have been convertible into 250,980 shares of common stock. In 1996, the Company exercised its right to redeem all outstanding Series D preferred stock. A total of 6,358 Series D shares were redeemed at $52.916 per share including $.641 per share of accrued and unpaid dividends. Holders of the remaining 5,381,437 Series D shares elected to convert their shares into 16,882,390 shares of Conseco common stock.
Dividends declared on common stock for 1996, 1995 and 1994, were $.083, $.046 and $.125 per common share, respectively. A liability was accrued for dividends declared but unpaid at December 31, 1996, totaling $4.8 million. Such dividends were paid in January 1997.
Conseco implemented two option exercise programs under which its chief executive officer and four of its executive vice presidents exercised outstanding options to purchase 3.1 million shares of Conseco common stock under a March 1996 program (the "1996 Program") and 14.4 million shares under a February 1994 program (the "1994 Program"). The options exercised would otherwise have remained exercisable until the years 2000 through 2002 with respect to the 1996 Program and 1999 and 2000 with respect to the 1994 Program. We implemented these programs in order to accelerate: (i) the tax benefits we derived from the exercise of the options; and (ii) the receipt of the exercise price of the options. The programs resulted in the following increases to common stock and additional paid-in capital: (i) a tax benefit of $15.1 million (net of payroll taxes incurred of $.7 million) and exercise proceeds of $5.2 million related to the 1996 Program; and (ii) a tax benefit of $67.8 million (net of payroll taxes incurred of $2.9 million) and exercise proceeds of $15.4 million related to the 1994 Program. The Company withheld shares to cover federal and state taxes owed by the executives as a result of the exercise transactions. Net of shares withheld, the Company issued approximately 1.6 million and 7.2 million shares of common stock to the executives under the 1996 Program and the 1994 Program, respectively. As an inducement to encourage the exercise of options prior to their expiration date, the Company granted to the executive officers new options to purchase a total of 1.6 million shares at $16.22 per share and 8.1 million shares at $14.81 per share (in each case equal to the market price per share on the grant date) to replace the shares surrendered for taxes and the exercise price in connection with the 1996 and 1994 Programs, respectively.
In April 1996, Conseco approved a Director, Executive and Senior Officer Stock Purchase Plan to encourage direct, long-term ownership of Conseco stock by Board members, executive officers and certain senior officers. Under the program, up to 4 million shares of Conseco common stock could be purchased in open market or negotiated transactions with independent parties. Participants could elect to purchase up to 50 percent of their participation in the form of Conseco PRIDES. Purchases were financed by personal loans to the participants from a bank. Such loans were collateralized by the Conseco stock purchased. Conseco guaranteed the loans, but has recourse to the participants if it incurs a loss under the guarantee. In addition, Conseco has agreed to provide loans to the
In December 1996, the Company granted options to selected key managers to purchase 1,100,000 shares at a price of $30.41 per share (the "Key Manager Program"). These options contain lengthy vesting and non-compete requirements designed to encourage continuity of employment with these individuals. The options are fully vested only upon both: (i) eleven years of continuous employment; and (ii) the earlier of: (a) two years after the termination of employment during which time the individual is not in competition with the Company; (b) the grantee reaching age 65; or (c) death or disability of the grantee. In certain cases the options remain exercisable throughout the lifetime of the grantee.
The Company applies Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations in accounting for its stock option plans. Accordingly, no compensation cost has been recognized for such plans. Had compensation cost been determined based on the fair value at the grant dates for awards in 1996 and 1995 under the plan consistent with the method of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"), the Company's pro forma net income and pro forma earnings per share for the years ended December 31, 1996 and 1995, would have been as follows:
In conjunction with the LPG Merger, the ATC Merger, the THI Merger and the BLH Merger, outstanding options to purchase common stock of LPG, ATC, THI or BLH were converted into options that are immediately exercisable for the same consideration payable to exercise such options immediately prior to the respective mergers for the number of shares of Conseco common stock that the holders would have been entitled to receive at the dates of the mergers had the options been fully vested and exercised at that time. The fair value of these options is not included in the pro forma net income summarized above but is included in the cost to acquire the companies (see note 2). A summary of options issued in connection with the mergers and related information is presented below:
A summary of the Company's stock option activity and related information for the years ended December 31, 1996, 1995 and 1994, is presented below:
In addition to 25,680,392 shares of common stock reserved for issuance under the employee stock option plans, 3,039,856 shares are reserved for issuance related to the recent mergers, 3,186,782 shares of common stock are reserved for issuance under stock bonus and deferred compensation plans and 900,000 shares are reserved for the warrants described below. The common stock and additional paid-in capital account was reduced by $9.0 million at December 31, 1996, for the unearned portion of amounts granted under such plans.
The five states with the largest shares of premiums collected in 1996 were Illinois (10 percent), Florida (9.1 percent), California (8.7 percent), Texas (7.6 percent) and Michigan (6.6 percent). No other state accounted for more than 5 percent of total collected premiums.
The following non-cash items were not reflected in the consolidated statement of cash flows in 1996: (i) the effects of the LPG Merger, the ATC Merger, the THI Merger, the ALH Stock Purchase and the BLH Merger and share repurchases summarized in note 2; (ii) the conversion of Series D preferred stock of Conseco with a value of $283.2 million into 16.9 million shares of Conseco common stock; (iii) the issuance of Conseco common stock to employee benefit plans of $12.2 million; and (iv) the tax benefit of $15.9 million related to the issuance of Conseco common stock under employee benefit plans; and (v) the acquisition of $25.0 million par value of Conseco's 8.125% senior notes and $6.5 million par value of preferred stock of ALH that were held by LPG prior to the LPG Merger. The following non-cash items were not reflected in 1995: (i) the redemption of convertible subordinated debentures of a subsidiary with a principal amount of $9.2 million using segregated cash; (ii) the issuance of Conseco common stock to employee benefit plans of $4.2 million; and (iii) the tax benefit of $.4 million related to the issuance of Conseco common stock under employee benefit plans. The following non-cash items were not reflected in 1994: (i) recapture of insurance liabilities and invested assets totaling $390.2 million and $371.0 million, respectively; (ii) redemption of convertible subordinated debentures of a subsidiary with a principal amount of $44.8 million using segregated cash; (iii) the issuance of Conseco common stock to employee benefit plans of $2.4 million; and (iv) the tax benefit of $69.2 million related to issuance of Conseco common stock under employee benefit plans.
Combined statutory net income of the Company's life insurance subsidiaries was $215.0 million, $183.8 million and $112.5 million in 1996, 1995 and 1994, respectively, after appropriate eliminations of intercompany amounts among such subsidiaries.
Statutory accounting practices require the asset valuation reserve ("AVR") and the interest maintenance reserve ("IMR") be reported as liabilities. The purpose of these reserves is to stabilize statutory surplus against fluctuations in the market value of investments. The IMR captures all realized investment gains and losses, net of income tax, on debt instruments resulting from changes in interest rates and provides for subsequent amortization of such amounts into statutory net income on a basis reflecting the remaining lives of the assets sold. The AVR captures all realized, net of income tax, and unrealized investment gains and losses related to equity investments and to changes in creditworthiness of debt instruments. AVR is also adjusted each year based on a formula related to the quality and loss experience of the Company's investment portfolio.
Included in statutory capital and surplus shown above are the following investments in affiliates, all of which are eliminated in the consolidated financial statements prepared in accordance with GAAP:
State insurance laws generally restrict the ability of insurance companies to pay dividends or make other distributions. Net assets of the Company's wholly owned life insurance subsidiaries, determined in accordance with GAAP, aggregated approximately $5.1 billion at December 31, 1996, of which approximately $151.0 million is available for distribution to Conseco in 1997 without the permission of state regulatory authorities.
Our quarterly results of operations are based on numerous estimates, principally related to policy reserves, amortization of cost of policies purchased, amortization of cost of policies produced and income taxes. We revise all such estimates each quarter and we ultimately adjust them to year-end amounts. When we determine revisions are necessary, we report them as part of operations of the current quarter.