The comparison of 1993, 1992 and 1991 balances in the consolidated financial statements is largely affected by the transactions described in Note 1 "Significant Accounting Policies - Basis of Presentation" and Note 2 "Acquisitions" to the consolidated financial statements.
- The acquisition and restructuring of life insurance companies, currently conducted through CCP II.
Growth in this activity results from: (i) the acquisition of new companies; (ii) changes in Conseco's ownership interest in the companies; and (iii) changes in the profitability of such companies related to premiums received, investment results, product profitability, expense levels and other factors.
Growth in this activity results from new clients (both affiliated and others) and from increases in the fee-producing activities conducted for such clients.
Future acquisitions will be accomplished through CCP II, in which a subsidiary of Conseco is the sole managing general partner. CCP II was formed in early 1994 with commitments from 36 partners for $624 million of capital for the purpose of completing acquisitions of insurance companies, building value within such acquired companies and realizing such increased value for the investing partners. Commitments to the new partnership include $100 million from Conseco, $25 million from Bankers, $25 million from CCP, $50 million from Western and $36 million from executive officers and directors of Conseco and its affiliates.
Additional Discussion of Consolidated Statement of Operations for the Three Years Ended December 31, 1993:
General. Conseco's 1992 earnings reflected a 44 percent ownership interest in BLH from November 1, 1992, the date Bankers was acquired by the Partnership. In March 1993, BLH completed an IPO of its common stock, thus reducing Conseco's ownership to 31 percent. On September 30, 1993, Conseco acquired 13.3 million additional common shares of BLH, increasing its ownership interest to 56 percent. While all activities of Bankers are included in Conseco's financial statements on a consolidated basis for all periods after November 1, 1992, the minority interest adjustment removes from Conseco's net income the portion applicable to other owners so that net income reflects only Conseco's applicable ownership interest (i.e., 44 percent during 1992 and the first quarter of 1993, 31 percent during the second and third quarters of 1993 and 56 percent during the fourth quarter of 1993). To enhance comparability, the amounts for the ten months ended October 31, 1992, (which was prior to the Partnership's acquisition of Bankers) are separately presented.
Net trading income. Net trading income (after applicable expenses, minority interest and taxes) increased $6.2 million in 1993 compared to total 1992. Bankers' trading activities commenced in November 1992, after its acquisition by the Partnership.
Extraordinary charge. In 1993 Bankers retired all of its junior notes, prepaid a portion of its senior term loan and repurchased $20 million of its Series B Senior Subordinated Notes, resulting in a net extraordinary charge of $7.9 million, of which Conseco's share was $3.1 million.
Insurance policy income. Insurance policy income related primarily to premiums from products with mortality and morbidity features. Declines from 1992 to 1993 have resulted from decreased emphasis on generating new premiums from such products.
Net investment income. Net investment income has increased over the last three years because of the overall growth of invested assets resulting from operations and the reinsurance recaptures described above, partially offset by lower yields on the investment portfolio. In addition, during 1993, 1992 and 1991, fixed maturity investments were redeemed prior to their scheduled maturity dates, resulting in additional investment income of approximately $18.0 million, $12.8 million and $3.5 million, respectively.
Insurance policy benefits. Total insurance policy benefits (including change in future policy benefits), which relate solely to policies with mortality and morbidity features, fluctuated very little over the last three years, due to decreased emphasis on generating new premiums from such products.
Other operating costs and expenses. The decreases in other operating costs and expenses in 1993 from 1992 and in 1992 from 1991 were primarily due to reduced guaranty fund assessments. The decrease in 1993 also reflected decreased commissions on renewal premiums.
Prior to July 1, 1992, Conseco exercised unilateral control over CCP; therefore, the accounts of CCP were included in the consolidated financial statements of Conseco. After CCP's IPO, Conseco no longer had unilateral control over CCP and included CCP's results in its financial statements on the equity, rather than the consolidation, method. The financial information below summarizes the amounts included in Conseco's consolidated financial statements and the total accounts of CCP for the three-year period.
Conseco's direct ownership in BLH and its indirect ownership through CCP represent a controlling interest. Accordingly, Conseco's investment in BLH is accounted for using the consolidation method. Conseco's ownership interest in Bankers through CCP is included in the "Bankers" segment. Conseco's ownership interest in the gain recognized by CCP in conjunction with the IPO is included in the "Acquisitions and Restructuring" segment.
Net investment income. Net investment income decreased from 1992 to 1993 because of the recapture of reinsurance by Western from Conseco's other wholly owned life insurance subsidiaries on March 31, 1993, which resulted in a decrease of $1.3 billion in insurance liabilities and invested assets. Net investment income increased from 1991 to 1992 as a result of the overall growth of invested assets resulting from operations. In addition, during 1993, 1992 and 1991 fixed maturity investments were redeemed prior to their scheduled maturity dates, resulting in additional investment income of approximately $3.7 million, $7.5 million and $.4 million, respectively.
Amortization related to operations. Amortization related to operations decreased in 1993 from 1992 as a result of the recapture of reinsurance, which was previously discussed.
Conseco's fee revenues include: (i) fees for investment management and mortgage origination and servicing; (ii) commissions earned for insurance and investment product marketing and distribution; and (iii) administrative fees for policy administration, data processing, product marketing and executive management services. To the extent these services are provided to entities that are included in the financial statements on a consolidated basis, the intercompany fees are eliminated in consolidation.
Growth in total fees during the last three years was the result of new clients (both affiliated and others) and from growth in fee-producing activities provided to such clients. Commission revenues of Bankmark, subsequent to its acquisition in March 1993, totaled $7.4 million.
These operations include financing costs for debt on which Conseco is directly liable and the costs associated with the holding company operations.
The 32 percent decline in interest expense on long term debt from 1991 to 1992 was attributable to declines in long-term debt through scheduled and unscheduled principal payments. Interest expense for 1993 reflected: (i) the decline in long-term debt through scheduled and unscheduled principal payments; (ii) the refinancing of 12.75 percent senior subordinated notes through the issuance of 8.125 percent senior notes; and (iii) the $200 million senior secured loan used to acquire additional shares of Bankers in September 1993 (such debt was repaid in February 1994 with a portion of the proceeds from the IPO of WNC).
Other operating costs and expenses increased over the last three years principally as the result of compensation expense based on the Company's increased earnings.
Insurance policy income shown in the Company's consolidated statement of operations in accordance with generally accepted accounting principles consists of premiums received for policies which 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 products recognized as deposits to insurance liabilities are recognized over time in the form of investment income and surrender or other charges.
The Company's investment strategy is to maintain a predominately investment-grade fixed-income portfolio, provide adequate liquidity for expected liability durations and other requirements and maximize total return through active investment management. At December 31, 1993, the Company had invested assets of approximately $11.7 billion. These assets were primarily actively managed fixed maturities, credit-tenant loans, policy loans, trading account securities, investment in CCP and short-term investments.
A general decline in interest rates has reduced investment yields over the past three years. Investment income is a significant component of the Company's total revenues, but profitability is determined by spreads between interest rates earned and rates credited on annuity contracts. At December 31, 1993, the average yield on the Company's investment portfolio was 8.2 percent and the average interest rate credited on the Company's total liability portfolio was 6.5 percent.
As discussed in the notes to the consolidated financial statements, when the carrying values of actively managed fixed maturity investments are adjusted for changes in fair value, cost of polices purchased, cost of policies produced and insurance liabilities are also adjusted to reflect the change in amortization that would be needed had those fixed maturity investments actually been sold at their fair values and the proceeds reinvested at current interest rates.
The creditworthiness of each issuer whose securities are held in the portfolio is evaluated periodically, with special attention to those securities whose market values have declined materially for reasons other than changes in interest rates or other general market conditions. Available evidence is considered to evaluate the realizable value of the investment, including specific conditions of the issuer and its ability to comply with the material terms of the security. Evidence reviewed may include the recent operational results and financial position of the issuer, information about its industry, recent press releases and other information. A staff of experienced securities analysts is employed in a variety of specialty areas. Among other responsibilities, this staff compiles and reviews such evidence. If evidence does not exist to support a realizable value equal to or greater than the carrying value of the investment and such decline in market value is determined to be other than temporary, the carrying amount is reduced to its net realizable value, which becomes the new cost basis. The amount of the reduction is reported as a realized loss. Any recovery of such reductions in the cost basis of an investment will be recognized as a realized gain only upon the sale, repayment or other disposition of the investment. The Company recorded writedowns of investments of $7.9 million as a result of conditions which arose in 1993 which caused the Company to conclude the issuer may be unable to comply with the material terms of the security.
All mortgage-backed securities are subject to risks associated with variable prepayments. This may result in these securities having a different actual maturity than planned at the time of purchase. Securities that have a carrying value greater than par which are backed by mortgages that prepay faster than expected will result in an adjustment charged to investment income. Those securities that have a carrying value less than par that prepay faster than expected will result in an adjustment credited to investment income. The degree to which a security is susceptible to either gains or losses is influenced by the difference between its carrying value and par, the relative sensitivity of the underlying mortgages backing the assets to prepayment in a changing interest environment and the repayment priority of the securities in the overall securitization structure.
If the Company determines that actively managed fixed maturity investments will be disposed of, the security will be either (i) sold and the gain or loss recognized or (ii) transferred to the trading account at its fair value. There
During 1993, fixed maturity investments with par values totaling $1.2 billion were redeemed prior to the scheduled maturity date. Such redemptions resulted in the recognition of additional investment income of approximately $22.5 million.
Credit-tenant loans are commercial loans which require the principal tenant, or any guarantor of such tenant's obligations, to 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 the lease term of the property; the mortgagee's management ability, including business experience, property management capabilities and financial soundness; and such economic, demographic or other factors that may affect the income generated by the property or its value. The underwriting guidelines also require a loan to value ratio of 75 percent or less. Credit-tenant loans are carried at amortized cost and were $326.9 million at December 31, 1993, or 2.8 percent of total invested assets. The total estimated fair value of credit-tenant loans was $325 million at December 31, 1993.
Approximately 22 percent of the Company's mortgage loan balance consisted of investments in junior and residual interests of CMOs. Investments in junior and residual interests of CMOs are instruments that entitle the Company to the projected excess cash flows arising from the difference between (i) the cash flows required to make principal and interest payments on the related CMOs and (ii) the actual cash flows received on the mortgage loan assets included in the CMO portfolios. If prepayments vary from projections on the mortgage loan assets included in such CMO portfolios, the total cash flows to the Company from such residual interests could change from projected cash flows, resulting in a gain or loss.
Non-current mortgage loans were not significant at December 31, 1993. The Company realized losses of approximately $6.1 million on mortgage loans for the year ended December 31, 1993, including $5.8 million from permanent write-downs of residual interests in collateralized mortgage obligation investments. At December 31, 1993, the Company had a loan loss reserve of $3.9 million. Approximately 22 percent, 15 percent, 10 percent and 8 percent of the mortgage loans were on properties located in Texas, New York, Virginia and Missouri, respectively. No other state comprised greater than 7 percent of the mortgage loan balance.
Changes in the Consolidated Balance Sheet of 1993 Compared to 1992
Insurance liabilities increased primarily as a result of additional annuity deposits and interest credited on annuity deposits, net of withdrawals.
As described in Note 1 to the consolidated financial statements, Bankers competed an IPO in March 1993. The net proceeds from the offering of $405.3 million were used, in part, to redeem all of the $52.2 million par value Bankers' preferred stock held by minority interests. The change in minority interest during 1993 was attributable to the minority interests' share of: (i) the net increase in Bankers' shareholders' equity attributable to the IPO and related transactions; and (ii) the results of Bankers' operations for the year, offset by Conseco's purchase of additional common stock of Bankers in September 1993 and the redemption of Bankers' preferred stock.
The following table sets forth selected debt ratios for each of the five years ended December 31, 1993.
Conseco's insurance operating companies generally provide adequate cash flow from premium collections and investment income to meet their obligations. The liabilities related to insurance policies are primarily long term and generally are paid from future cash flows. Most of the assets, other than policy loans and the investment in CCP, are invested in bonds and other securities, substantially all of which are readily marketable. Although there is no present need or intent to dispose of such investments, the life companies could liquidate portions of the investments if such a need arose. To increase their return on investments and improve liquidity, the life companies from time to time will lend United States Treasury securities in reverse repurchase agreements. The life companies may also lend mortgage-backed securities to increase yield and income through the better financing rate typically found in such dollar roll transactions, which are specialized forms of collateralized lending involving mortgage-backed securities.
Of the above insurance liabilities under contracts containing fixed payment dates, approximately 35 percent related to payments that will be made on such date only if the contract holder is living. Expected mortality is considered in determining the amount of this liability. The remainder of the insurance liabilities with fixed payment dates were payable regardless of the contract holder's survival.
Approximately 29 percent of the insurance liabilities were subject to interest rates, ranging from 3 percent to 12 percent, fixed for the life of the contract. The remaining liabilities generally were subject to interest rates that may be reset at least annually.
The Company believes that it has adequate short-term investments and readily marketable investment grade securities to cover the payments under contracts containing fixed payment dates plus any likely cash needs for all other contracts. The Company's investment portfolio at December 31, 1993, included $.2 billion of short-term investments (net of investment borrowings), $.1 billion of trading account securities, $3.2 billion of U.S. government/agency and mortgage-backed securities and $5.8 billion of publicly-traded investment grade bonds. The Company believes that such investments could be readily sold at or near carrying value or used to facilitate borrowings under reverse repurchase agreements. At December 31, 1993, the Company's portfolio of bonds, notes and redeemable preferred stocks had an aggregate unrealized gain of $295.7 million.
As a holding company whose principal assets are the securities of its insurance subsidiaries, BLH's ability to meet debt service obligations and pay operating expenses and dividends is dependent primarily on the receipt of sufficient funds from its subsidiaries. Bankers Life Insurance Company of Illinois ("BLI", the parent of Bankers Life) provides liquidity to BLH by paying principal and interest on a surplus debenture and by paying dividends.
A summary of maturity dates and amounts (dollars in millions) of the surplus debenture is shown below. Interest is payable quarterly generally at prime plus two percent (8.0 percent at December 31, 1993).
BLI's ability to service its obligation under the surplus debenture is dependent upon its ability to receive dividends and tax sharing payments from Bankers Life. Bankers Life may pay dividends up to $82.5 million without regulatory approval during 1994.
Under an inter-company tax sharing agreement, Bankers Life remits tax payments to BLI based upon its tax liabilities calculated on a separate company basis.
At December 31, 1993, BLH's debt service obligations included a $110 million principal amount senior term loan payable in annual installments and $180 million principal amount of senior subordinated notes due in 2002. Future annual debt service requirements are discussed in Note 8 to the consolidated financial statements.
At December 31, 1993, BLH had short-term investments of $21.4 million. Conseco believes that BLH could generate additional liquidity, if needed in the future, through equity offerings, debt issuance or by the conversion of existing assets to cash, including the sale or transfer of existing blocks of insurance through reinsurance arrangements.
BLH contributed $114 million of the proceeds from its IPO to the capital of its subsidiaries. BLH believes its life subsidiaries are adequately capitalized and will not require additional investment to maintain their current operations.
BLH makes cash distributions for fees for administrative services provided by Conseco's wholly owned subsidiaries and for dividend payments on common stock to all its shareholders.
- In January 1993, the Company completed a public offering of 5.75 million shares of Series D Cumulative Convertible Preferred Stock at $50 per share. Proceeds from the offering of approximately $278.5 million (after underwriting and associated costs) were added to the Company's general funds.
- In July 1993, the Company redeemed its $50.0 million stated value Series B Preferred Stock.
At December 31, 1993, the parent company and its non-life subsidiaries had short-term investments of $42.3 million, of which $8.7 million was expended in January 1994 for accrued interest and dividends. In addition, the life subsidiaries are permitted to distribute $18.7 million to the parent company in 1994. The parent company and its non-life subsidiaries had additional investments in nonaffiliates of $52.2 million at December 31, 1993, which, if needed, could be liquidated or contributed to the insurance subsidiaries. Conseco believes that it could generate additional liquidity, if needed in the future, through equity offerings, debt issuance or by the conversion of existing assets to cash, including the sale of a partial interest in its minority owned affiliates. As described in the notes to the consolidated financial statements, on February 15, 1994, Conseco sold a 60 percent interest in WNC. Net pretax proceeds from the sale and related transactions totaling $537.9 million were used to repay a $200 million senior unsecured loan and for other general corporate purposes.
Statutory operating results and statutory surplus are governed by statutes adopted by each state in which the subsidiaries do business; therefore, statutory surplus bears no direct relationship to equity as determined under generally accepted accounting principles ("GAAP"). With respect to new business, statutory accounting practices require that (i) acquisition costs and (ii) reserves for future guaranteed principal payments and interest in excess of statutory rates be expensed in the year the new business is written. These items cause a statutory loss ("surplus strain") on many insurance products in the year they are issued. The Company designs its products to minimize such first-year losses but certain products continue to cause a statutory loss in the year written. The Company controls the amount of new premiums written in order to manage the effect of such statutory surplus strain.
Statement of Financial Accounting Standards No. 115, "Accounting for Certain Investments in Debt and Equity Securities" ("SFAS 115"), requires the Company to carry certain investments at current estimated fair value when there is not a positive intent to hold such investments to maturity. The Company's former policy was similar to that mandated by SFAS 115, with the most significant exception being that unrealized gains and losses on trading account securities, which had been included as an adjustment to shareholders' equity, are recognized in income under the provisions of SFAS 115. The early adoption of SFAS 115 as of December 31, 1993, resulted in an immaterial increase in income from the unrealized gain on trading account securities.
Conseco's life insurance operations include: (i) Bankers, in which Conseco has a 56 percent ownership interest; (ii) Western, in which Conseco has a 40 percent interest (wholly owned by Conseco until Western's IPO was completed on February 15, 1994); (iii) CCP, in which Conseco has a 40 percent ownership interest; and (iv) the wholly owned life insurance subsidiaries (excluding Western), principally Bankers National and National Fidelity.
Conseco owns 30.4 million common shares of Bankers, or 56 percent of Bankers' outstanding common shares. At December 31, 1993, the Bankers shares owned by Conseco had a net carrying value of approximately $518.8 million, a fair value of approximately $652.8 million (based on the closing price of $21.50 per share) and a cost of $313.1 million. On March 8, 1994, Bankers announced an increase in its quarterly cash dividend to 15 cents per share from 2 cents. During 1993, Bankers implemented several measures to enhance efficiency and reduce operating costs, including the relocation of its office space, which was previously scattered in 27 separate buildings. Also during 1993, Bankers' agent force grew 7 percent and Bankers sold 3 percent more Medicare supplement policies than the prior year. The increased sales of Medicare supplement policies provide Bankers with opportunities for cross-selling in its niche market, senior citizens. As a result of cross-selling, 1993 annualized new business premiums increased 19 percent for long-term products and 27 percent for annuities. It is too early to analyze what changes, if any, will occur in the business activity of Bankers as a result of the current legislative debate on health care.
Premiums on SPDAs collected by Western decreased $262.8 million in 1993, or 39 percent. The decline in premiums collected reflected primarily: (i) increased competition from other carriers (including those with higher ratings); (ii) increased competition from other investments and retirement funding alternatives, such as variable annuities and mutual funds, during these periods of low interest rates; and (iii) Western's focus on maintaining profitability levels on SPDAs. Management believes that with the recent marketing initiatives intended to address the decrease in SPDA premiums collected, the trend of decreasing premiums will be reversed in 1994. In late 1993, Western entered into a significant sales agreement with Oregon-based U.S. Bancorp to market Western's products through the bank's 400 branches in Northern California and the Pacific Northwest.
Conseco continues to provide various combinations of services to Bankers, Western, CCP and the wholly owned subsidiaries (excluding Western) including investment management, mortgage origination and servicing, policy administration, data processing, product marketing and executive management services. Additionally, Conseco provides such services to unaffiliated insurance companies. It is the Company's intent to provide investment management services to all companies acquired by CCP II, and to provide administrative, data processing and other services to such companies when appropriate. It is also the Company's intent to expand its service fee revenue by seeking similar arrangements with other unaffiliated insurers in order to profit from the Company's ability to administer products and investments without the need to provide additional capital needed to support those products. In March 1993, Conseco acquired Bankmark, an insurance marketing company which develops relationships with financial institutions to provide insurance and investment products to their customers. After its acquisition by Conseco, Bankmark began a formal program to actively expand its business by developing relationships with a few large money-center banks.
The Company believes there will be a period in the future when it will be more difficult to obtain financing for acquisitions because of conditions in the capital markets, causing a greater dependence on equity capital financing, such as that obtained through CCP II. Conseco will actively seek alternative capital sources, if needed, to finance acquisitions. Continuation of those conditions in the capital markets may also affect the availability of appropriate acquisition targets if sellers of insurance companies decide to wait for more favorable conditions. In addition, Conseco's increased size and evolving strategies will eliminate a number of potential acquisition candidates who are either too small or inappropriate strategic targets. However, Conseco believes it has the resources and capabilities to continue its strategy of acquiring and restructuring 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.
Report of Management. . . . . . . . . . . . . . . . . . . . . . . . 46
Report of Independent Accountants . . . . . . . . . . . . . . . . . 47
Consolidated Statement of Cash Flows for the years ended December 31, 1993, 1992 and 1991. . . . . . . . . . . . . . . . . 53
Notes to Consolidated Financial Statements. . . . . . . . . . . . . 55
We have audited the accompanying consolidated balance sheet of Conseco, Inc. and Subsidiaries as of December 31, 1993 and 1992, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1993. 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.
As a result of the public offering in March 1993 by Bankers Life Holding Corporation ("BLH"), a company formed by the Partnership to acquire Bankers Life (collectively referred to herein as "Bankers"), Conseco no longer had unilateral control of Bankers. However, after the acquisition by Conseco of additional shares of BLH in September 1993, Conseco's ownership position in Bankers increased to 56 percent. Accordingly, the accounts of Bankers have been consolidated with Conseco's accounts in the accompanying consolidated financial statements throughout 1993.
- For transfers to the trading category, the unrealized gain or loss is recognized in earnings;
- For transfers to held to maturity from actively managed, the unrealized gain or loss at the date of transfer continues to be reported in shareholders' equity, but is amortized over the remaining life of the security as an adjustment of yield.
Prior to adopting SFAS 115, the above investments were transferred to the new category at the lower of cost or fair value at the date of transfer. Unrealized losses were recognized upon such transfers; and unrealized gains were deferred until the final disposition of the securities. Transfers between categories in 1993 and 1992 and the resulting gains were immaterial.
Other invested assets (principally investments in unconsolidated limited partnerships) are generally accounted for using the equity method.
The Company regularly evaluates mortgage loans, credit-tenant loans and other securities based on current economic conditions, past credit loss experience and other circumstances of the investee. Impaired loans are revalued at the present value of expected cash flows discounted at the loan's effective interest rate when it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the agreement. A decline in a security's net realizable value that is other than temporary is treated as a realized loss and the cost basis of the security is reduced to its estimated fair value.
The method used by the Company to value the cost of policies purchased is consistent with the valuation methods used most commonly to value blocks of insurance business, which is also consistent with the basic methodology generally used to value assets. The method used by the Company is summarized as follows:
The discount rate used to determine the value of the cost of policies purchased is the rate of return required in order for the Company to invest in the business being acquired. In determining the rate of return to be used by the Company, the following factors are considered:
Costs of producing new business (primarily commissions and certain costs of policy issuance and underwriting, net of fees charged to the policy in excess of ultimate fees charged), which vary with and are primarily related to the production of new business, are deferred to the extent recoverable from future profits. Such costs are amortized with interest as follows:
- For traditional life and accident and health products, in relation to future anticipated premium revenue using the same assumptions that are used in calculating the insurance liabilities.
The excess of the cost to acquire purchased companies over the net assets acquired is recorded as goodwill and is amortized on the straight-line basis over a 40-year period.
Reserves for universal life-type and investment-type contracts are based on the contract account balance, if future benefit payments in excess of the account balance are not guaranteed, or on the present value of future benefit payments when such payments are guaranteed. Additions to insurance liabilities are made if future cash flows including investment income are insufficient to cover future benefits and expenses.
Reserves for traditional and limited-payment contracts are generally calculated using the net level premium method and assumptions as to investment yields, mortality, withdrawals and dividends. The assumptions are based on projections of past experience and include provisions for possible unfavorable deviation. These assumptions are made at the time the contract is issued or, in the case of contracts acquired by purchase, at the purchase date.
For contracts with mortality risk, but with premiums paid for only a limited period (such as single-premium immediate annuities with benefits paid for the life of the annuitant), the accounting treatment is similar to traditional contracts. However, the excess of the gross premium over the net premium is deferred and recognized in relation to the present value of expected future benefit payments (when accounting for annuity contracts) or in relation to insurance in force (when accounting for life insurance contracts).
In the normal course of business, the Company seeks to limit its exposure to loss on any single insured and to recover a portion of the benefits paid by ceding reinsurance to other insurance enterprises or reinsurers under excess coverage and coinsurance contracts. The Company has set its retention limit for acceptance of risk on life insurance policies at various levels up to $.8 million.
Income tax expense includes deferred taxes arising from temporary differences between the tax and financial reporting basis of assets and liabilities. Additionally, this liability method of accounting for income taxes requires the effect of a tax rate change on accumulated deferred income taxes to be reflected in income in the period in which the change is enacted.
Market development and start-up costs are expensed as incurred. After its acquisition by Conseco in March 1993, Marketing Distribution Systems Consulting Group, Inc. and Subsidiaries ("Bankmark") began a program to expand its business. Start-up costs of approximately $2.4 million were expensed in 1993 related to such program.
All applicable share and per share data have been adjusted for the two-for-one stock splits distributed on July 1, 1991 and April 1, 1992. Primary net income per share is computed by dividing earnings, less preferred dividend requirements and an adjustment for the dilutive securities of affiliates and of subsidiaries of the Partnership, by the weighted average number of common and common equivalent shares outstanding for the year. Fully diluted net income per share is computed on that same basis, except (i) the number of common equivalent shares related to stock options is based on the year-end market value of the shares if that is more dilutive than the average market value and (ii) the conversion of the convertible preferred stock into common shares is assumed.
The following methods and assumptions are used by the Company in determining estimated fair values of financial instruments:
Other invested assets: The estimated fair values of other invested assets are determined using quoted market prices for similar instruments.
Investment borrowings and notes payable: The estimated fair values of the Company's investment borrowings and notes payable are determined using discounted cash flow analyses based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. The carrying amount of the Company's investment borrowings approximates its estimated fair value.
The purchase price of $600.0 million was funded with the net proceeds of the following securities issued by BLH: $175.0 million senior loan from a group of lending banks; $200.0 million senior subordinated notes; $45.0 million payment-in-kind junior subordinated notes (including $8.3 million provided by Conseco and $34.7 million provided by ICH); $158.3 million of payment-in-kind preferred stock (of which $108.3 million was provided by Conseco and $50.0 million was provided by ICH); and $66.7 million of common stock of BLH, including $16.7 million directly provided by ICH and $50.0 million provided by the Partnership (including $25.5 million provided by Conseco and $9.6 million provided by ICH). The notes are not direct obligations of Conseco. After this acquisition, Conseco owned approximately 44 percent of the common equity interest in BLH through direct investments and investments in the Partnership. For accounting convenience, the acquisition was reported as of November 1, 1992, and adjustments were made to reflect financing costs for the period between that date and the actual date of acquisition, November 9, 1992.
On March 25, 1993, BLH completed an IPO of 19.6 million shares of its common stock at $22 per share. Proceeds from the offering of $405.3 million (after underwriting and issuance costs) were used by BLH to redeem all outstanding preferred stock, to retire all junior subordinated debt, to prepay a portion of the senior debt and for other corporate purposes. After the offering, Conseco owned 31 percent of the common shares of BLH. As a result of the offering, Conseco recorded a one-time gain of $59.3 million (net of tax of $39.9 million) in the first quarter of 1993, representing Conseco's direct percentage share of the increase in Bankers' shareholders' equity account attributable to the proceeds from the offering. In addition, Conseco recorded a gain of $2.2 million (net of tax of $.1 million) in the first quarter of 1993, representing Conseco's indirect percentage share (through the Company's ownership of CCP) of CCP's percentage share of the increase in Bankers' shareholders' equity account attributable to the proceeds from the offering. The Partnership agreement provided incentive compensation to Conseco as the general partner in the form of transfers from the limited partners of a portion of their returns in excess of prescribed targeted returns. The distribution of BLH shares to the limited partners caused such targets to be exceeded, resulting in incentive compensation to Conseco of $21.9 million, net of tax of $14.7 million.
The closing price of BLH's shares on the New York Stock Exchange on December 31, 1993, was $21.50 per share. This indicated a total fair value of Conseco's investment in BLH of $652.8 million, compared to the cost to Conseco totaling $313.1 million and net equity included in these consolidated financial statements of $518.8 million. Shares held by the Company are not freely tradable, and sale of such shares may require a registration statement with the Securities and Exchange Commission.
At December 31, 1992, the amortized cost and estimated fair value of fixed maturities were as follows:
The following table sets forth the quality of total fixed maturity investments as of December 31, 1993, classified in accordance with the highest rating by a nationally recognized statistical rating organization or, as to $69.1 million fair value of fixed maturities not rated by such firms, based on ratings assigned by the National Association of Insurance Commissioners ("NAIC") as follows: for purposes of the table, NAIC Class 1 is included in the "A" rating; Class 2, "BBB-"; Class 3, "BB-"; and Classes 4-6, "B+ and below."
The carrying value of investments not accruing investment income totaled $19.6 million, $24.8 million and $36.8 million at December 31, 1993, 1992 and 1991, respectively.
Realized gains (losses) from trading account securities, net of investment expenses, were included in revenue as follows:
Realized gains (losses), net of investment expenses, were included in revenue as follows:
At December 31, 1993, the balance of mortgage loans was comprised of 78 percent commercial loans and 22 percent junior and residual interests in collateralized mortgage obligations. The total estimated fair value of mortgage loans was approximately $175 million and $190 million at December 31, 1993 and 1992, respectively. Approximately 22 percent, 15 percent, 10 percent and 8 percent of the mortgage loans were on properties located in Texas, New York, Virginia and Missouri, respectively. No other state comprised greater than 7 percent of the mortgage loan balance. At December 31, 1993, the Company had an allowance for loss on mortgage loans of $3.9 million. During the year ended December 31, 1993, the Company realized losses of $6.1 million on mortgage loans, of which $5.8 million related to other than temporary declines in the value of certain residual interests in collateralized mortgage obligations.
In 1992, the Company entered into an interest rate guarantee contract to convert the characteristics of certain investments to match those of related insurance liabilities. The agreement expires in January 1995 and provides for a constant yield on $100.0 million indexed to current rates on U.S. Treasuries. The estimated fair value of the agreement was approximately $.1 million and $.9 million at December 31, 1993 and 1992, respectively, which was not recognized in the accompanying consolidated balance sheet.
See Note 2 for a description of transactions affecting Conseco's ownership of CCP.
The difference of $22.8 million between the carrying value of Conseco's investment in CCP and the amount of its underlying equity in net assets is amortized on the straight-line basis over a 40-year period. Financial information of CCP at December 31, 1993 and 1992, for the year ended December 31, 1993, and for the six months ended December 31, 1992 (the period CCP and its subsidiaries were included in Conseco's financial statements on the equity basis) were as follows:
At December 31, 1991, the Company owned a 31 percent equity interest (after exercise of warrants held by others) in the common stock and $30.0 million of 12 percent junior preferred stock of Life Re Corporation ("Life Re"), a company engaged in the life reinsurance business. In November 1992, Life Re completed an initial public offering of its common stock and redeemed all of the common and preferred stock held by the Company. As a result, a gain of $15.2 million (net of tax of $21.2 million) was recorded in 1992. The following amounts were recorded in Conseco's financial statements related to the results of operations of Life Re:
The sales of fixed maturity investments during 1993 reduced the expected future yields on the investment of policyholder balances to the extent that projected future cash flows on certain products were insufficient to cover future benefits and expenses. Accordingly, additional estimated insurance liabilities of $37.1 million were established by a charge to expense.
Cost of reinsurance ceded where the reinsured policy contains mortality risks totaled $34.9 million, $41.9 million and $63.8 million in 1993, 1992 and 1991, respectively, and was deducted from insurance premium revenue. The Company is contingently liable for claims reinsured if the assuming company is unable to pay. Reinsurance recoveries netted against insurance policy benefits totaled $41.9 million, $45.4 million and $68.1 million in 1993, 1992 and 1991, respectively.
At December 31, 1993 and 1992, reinsurance receivables with carrying values of $398.5 million and $420.0 million, respectively, were associated with annuity business ceded by Bankers to an unaffiliated company and retroceded on substantially identical terms to an ICH affiliate. Bankers provides investment management, administrative, data processing and general management services related to the reinsured business in exchange for annual fees equal to .45 percent of reinsured reserves. Administrative fees earned were $1.8 million and $.3 million for 1993 and the two months ended December 31, 1992, respectively. Experience refunds including administrative fees, earned during 1993 and the two months ended December 31, 1992, were $3.2 million and $.3 million, respectively.
On June 30, 1993, the Company recaptured certain annuity business with insurance liabilities of $156.5 million that had previously been reinsured with an unaffiliated company. Assets with a fair value approximating the insurance liabilities were transferred to the Company.
Income tax expense differed from that computed at the applicable federal statutory rate (35 percent during 1993 and 34 percent during 1992 and 1991) for the following reasons:
In June 1990, the Company, as partial acquisition financing for Great American Reserve, executed a subordinated promissory note in the amount of $6.0 million. In March 1994, this note was repaid in full.
The following notes payable, which are not direct obligations of Conseco, were issued by Bankers to finance its acquisition by the Partnership:
The $200.0 million senior subordinated notes bear interest at 13 percent, payable semi-annually on May 1 and November 1, are due November 1, 2002, and may be redeemed, at the Company's option, on or after November 1, 1997, at a redemption price initially at 106.5 percent and declining thereafter. In December 1993, Bankers repurchased $20.0 million of the notes in open market transactions for $24.0 million, resulting in an extraordinary charge, net of tax, of $3.1 million. Conseco's share of this charge ($1.0 million) was included as an extraordinary charge in the consolidated financial statements.
The PIK subordinated notes were subordinated in right of payment to the prior payment in full of the senior term loan and, in certain circumstances, the senior subordinated notes. In 1993, Bankers retired all of its PIK subordinated notes totaling $38.3 million and prepaid $55.0 million of its senior term loan. The repayment of this debt resulted in an extraordinary charge for Bankers of $4.8 million, net of a $2.5 million tax benefit, in 1993. Conseco's share of this charge ($2.1 million) was included as an extraordinary charge in the consolidated financial statements.
Some officers of the Company are employed pursuant to long-term employment agreements. One of these agreements provides for a base salary plus an annual bonus equal to 3 percent of the Company's consolidated defined pretax profits. This agreement renews annually for a five-year period unless either party notifies the other, in which case the agreement expires five years from the last renewal date. Additionally, a $1.9 million interest-free loan has been granted to the officer with repayment due two years after termination of the officer's employment contract.
The Company has a qualified defined contribution plan in which substantially all employees of the Company's wholly owned subsidiaries are eligible to participate. Company contributions, which match certain voluntary employee contributions to the plan, totaled $.3 million, $.9 million and $.1 million in the years ended December 31, 1993, 1992 and 1991, respectively, and are in the form of Conseco's common stock. In addition, a stock bonus and deferred compensation program was adopted for certain executives and directors whereby the participants may voluntarily defer a portion of their compensation. Company contributions vary based on the amount of the increase in earnings per share of the Company and the amount of compensation of each participant. Each year's contribution, which is in the form of Conseco's common stock, vests five years later or upon certain other events. The cost of the program is charged to expense over the vesting period and amounted to $2.3 million, $1.9 million and $1.8 million in 1993, 1992 and 1991, respectively.
Net pension costs included in other operating expenses consisted of the following:
During 1993, Bankers announced several changes to its postretirement plan that: (i) established a maximum annual cost-sharing amount for Bankers; (ii) eliminated Bankers' cost-sharing for certain future retirees; and (iii) effective July 1, 1993, revised certain assumptions to the plan resulting in a $41.5 million reduction to its accumulated post retirement benefit obligation ("APBO"). Such changes also resulted in a net unrecognized reduction to prior service costs of $7.8 million and a net unrecognized gain of $1.3 million. The APBO and net unrecognized amounts consist of the following:
The discount rate used in determining the accumulated postretirement benefit obligation was 7 percent and 8 percent at December 31, 1993 and 1992, respectively. The assumed annual increase in salary levels used in determining the portion of the postretirement benefit obligation related to life benefits was 5.2 percent and 5.3 percent at December 31, 1993 and 1992, respectively. The average annual assumed rate of increase in the per capita cost of covered benefits is 12 percent for 1994 and is assumed to decrease gradually to 5 percent for 2006 and remain at that level thereafter. Increasing the assumed health care cost trend rates by 1 percentage point in each year would increase the accumulated postretirement benefit obligation by $1.7 million at December 31, 1993, and the postretirement benefit cost by $.3 million for 1993.
A director of the Company is a principal in several entities that received a total of approximately $8.3 million from the Company during the three years ended December 31, 1993, for the sale of land and the construction of facilities and approximately $2.7 million for management and rental of offices. In 1989, the Company loaned the director $8.0 million on an eight-year note with interest at the prime interest rate plus one percentage point. The note is repayable in annual installments of $1.0 million and had a balance of $2.0 million at December 31, 1993.
Minority interest represents the interest of investors other than Conseco in Bankers and included: (i) $295.0 million, which represented such interests in the common equity of Bankers; and (ii) $(71.2), which represented the excess of the value received by BLH for the issuance of common stock over the historical accounting bases of the net assets of Bankers as described in Note 1.
Authorized preferred stock is 20,000,000 shares, of which 100,000 shares of $55 Series B Redeemable Preferred Stock with a stated value of $50.0 million ($500 per share) were issued in 1987, 400,000 shares of Series C Preferred Stock with a stated value of $10.0 million ($25 per share) were issued in 1990 and 5,750,000 shares of Series D Cumulative Preferred Stock with a stated value of $287.5 million ($50 per share) were issued in January 1993 in a public offering. The Series B and Series C preferred stocks were redeemed at their stated values in 1993 and 1991, respectively. The Series D Cumulative Preferred Stock is convertible at the holder's option into shares of common stock at a conversion price of $63.75 per share, equivalent to a ratio of approximately 0.7843 shares of common stock for each share of preferred stock. Proceeds from the offering of approximately $278.5 million (after underwriting and other associated costs) were used to redeem the Series B preferred stock and were added to the Company's general funds. During 1993, 274 Series D preferred shares were converted to 215 common shares.
Changes in the number of shares of common stock outstanding for the years 1993, 1992 and 1991, were as follows:
Dividends declared on common stock for 1993, 1992 and 1991, were $.30, $.085 and $.07 per common share, respectively.
In addition to 12,699,284 shares of common stock reserved for issuance under the 1983 and 1994 employee stock option plans, 711,764 shares of common stock are reserved for issuance under the defined contribution and the stock bonus and deferred compensation plans. The common stock account was reduced by $8.5 million, consisting of the unearned portion of the incentive deferred compensation program.
Anticipated returns from the investment of policyholder balances are considered in determining the amortization of the cost of policies purchased and cost of policies produced. Sales of fixed maturity investments change the incidence of profits on such policies because capital gains (losses) are recognized currently and the expected future yields on the investment of policyholder balances are reduced (increased). Accordingly, amortization of the cost of policies purchased was increased by $46.0 million, $63.3 million and $33.0 million in the years ended December 31, 1993, 1992 and 1991, respectively, and amortization of the cost of policies produced was increased by $43.2 million, $30.1 million and $17.4 million in the years ended December 31, 1993, 1992 and 1991, respectively.
The changes in the cost of policies purchased were as follows:
The changes in the cost of policies produced were as follows:
The following non-cash items were not reflected in the consolidated statement of cash flows: in 1993, the surrender for redemption of $50.0 million stated value of ICH preferred stock in exchange for common shares of Bankers (as described in Note 2 to the consolidated financial statements) and the recapture of insurance liabilities and invested assets each totaling approximately $338.5 million in connection with the recapture of reinsurance as described in Note 6 to the consolidated financial statements.
Cash flows from operations included interest paid on debt of $58.8 million, $42.7 million and $63.9 million in 1993, 1992 and 1991, respectively. Income taxes paid were $204.9 million, $108.5 million and $59.3 million in 1993, 1992 and 1991, respectively.
Statutory accounting practices prescribed or permitted for the Company's insurance subsidiaries by regulatory authorities differ from generally accepted accounting principles. The Company's life insurance subsidiaries reported the following amounts to regulatory agencies, after appropriate eliminations of intercompany accounts among such subsidiaries:
Statutory accounting practices require that portions of surplus, called the asset valuation reserve ("AVR") and the interest maintenance reserve ("IMR"), be appropriated and 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 investment gains and losses 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 life of the assets sold. The AVR captures investment gains and losses related to changes in creditworthiness and 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 generally accepted accounting principles:
Most states have adopted risk-based capital ("RBC") rules, effective December 31, 1993, to evaluate the adequacy of statutory capital and surplus in relation to investment and insurance risks. The RBC formula is designed as an early warning tool to help state regulators identify possible weakly capitalized companies for the purpose of initiating regulatory action. At December 31, 1993, the ratios of total adjusted capital to RBC, as defined by the rules, for all of Conseco's primary subsidiaries and investees were greater than twice the level at which regulatory attention is triggered.
Earnings per common share for each quarter are computed independently of earnings per share for the year. Due to the transactions affecting the weighted average number of shares outstanding in each quarter and due to the uneven distribution of earnings during the year, the sum of the quarterly earnings per share may not equal the earnings per share for the year.
Quarterly results of operations are based on numerous estimates, principally related to policy reserves, the amortization of cost of policies purchased, the amortization of cost of policies produced and income taxes. Such estimates are revised quarterly and are ultimately adjusted to year-end amounts. When such revisions are determined, they are reported as part of operations of the current quarter.