In this section, we review the consolidated financial condition of Conseco at December 31, 2000 and 1999, the consolidated results of operations for the three years ended December 31, 2000, and where appropriate, factors that may affect future financial performance. Please read this discussion in conjunction with the accompanying consolidated financial statements, notes and selected consolidated financial data.
All statements, trend analyses and other information contained in this report and elsewhere (such as in filings by Conseco with the Securities and Exchange Commission, press releases, presentations by Conseco or its management or oral statements) relative to markets for Conseco's products and trends in Conseco's operations or financial results, as well as other statements including words such as "anticipate," "believe," "plan," "estimate," "expect," "intend," "should," "could," "goal," "target," "on track," "comfortable with," "optimistic" and other similar expressions, constitute forward-looking statements under the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to known and unknown risks, uncertainties and other factors which may cause actual results to be materially different from those contemplated by the forward-looking statements. Such factors include, among other things: (i) general economic conditions and other factors, including prevailing interest rate levels, stock and credit market performance and health care inflation, which may affect (among other things) Conseco's ability to sell its products, its ability to make loans and access capital resources and the costs associated therewith, the market value of Conseco's investments, the lapse rate and profitability of policies, and the level of defaults and prepayments of loans made by Conseco; (ii) Conseco's ability to achieve anticipated synergies and levels of operational efficiencies; (iii) customer response to new products, distribution channels and marketing initiatives; (iv) mortality, morbidity, usage of health care services and other factors which may affect the profitability of Conseco's insurance products; (v) performance of our investments; (vi) changes in the Federal income tax laws and regulations which may affect the relative tax advantages of some of Conseco's products; (vii) increasing competition in the sale of insurance and annuities and in the finance business; (viii) regulatory changes or actions, including those relating to regulation of financial services affecting (among other things) bank sales and underwriting of insurance products, regulation of the sale, underwriting and pricing of products, and health care regulation affecting health insurance products; (ix) the outcome of Conseco's efforts to sell assets and reduce, refinance or modify indebtedness and the availability and cost of capital in connection with this process; (x) actions by rating agencies and the effects of past or future actions by these agencies on Conseco's business; and (xi) the risk factors or uncertainties listed from time to time in Conseco's filings with the Securities and Exchange Commission.
The net loss applicable to common stock of $1,202.2 million in 2000, or $3.69 per diluted share, included: (i) net investment losses (net of related costs, amortization and taxes) of $198.1 million, or 61 cents per share; (ii) an impairment charge of $324.9 million (net of an income tax benefit of $190.8 million), or $1.00 per share, related to the Company's interest-only securities and servicing rights; (iii) special charges of $518.3 million (net of an income tax benefit of $181.0 million), or $1.59 per share, as summarized in note 9 to the consolidated financial statements entitled "Special Charges"; (iv) the provision for loss of $150.0 million (net of an income tax benefit of $80.5 million), or 46 cents per share, related to the Company's guarantee of bank loans made to directors, officers and key employees to purchase shares of Conseco common stock; (v) a loss of $99.4 million, or 31 cents per share, related to our venture capital investment in TeleCorp; (vi) net income of $13.6 million, or 4 cents per share, related to the major medical lines of business which we intend to sell and other non- recurring items; (vii) the cumulative effect of an accounting change of $55.3 million (net of an income tax benefit of $29.8 million), or 17 cents per share, related to new requirements for the valuation of interest-only securities; and (viii) an extraordinary charge of $5.0 million (net of an income tax benefit of $2.7 million), or 1 cent per share, related to the early retirement of debt.
Collections on insurance products from continuing operations in 2000 were $5.5 billion, down 3.5 percent from 1999. Rating actions during a portion of 2000 adversely affected the marketing of our insurance products. On November 7, 2000, A.M. Best upgraded the financial strength ratings of our principal life insurance subsidiaries to A- (Excellent) from B++ (Very Good). Such collections in 1999 were $5.7 billion, up 11 percent over 1998. These increases were primarily due to increased production and premium rate increases in 1999.
Net investment income related to equity-indexed products based on the S&P 500 Index is substantially offset by a corresponding charge to amounts added to policyholder account balances for equity-indexed products. Such income and related charge fluctuated based on the policyholder account balances subject to this provision and the performance of the S&P 500 Index to which the returns on such products are linked. During 2000, we recorded income from the S&P 500 Options of $12.9 million and added amounts to policyholders' account balances of the equity-indexed products of $11.4 million.
Fee revenue and other income includes: (i) revenues we receive for managing investments for other companies; and (ii) fees received for marketing insurance products of other companies. This amount increased in 2000 primarily due to the revenues of an insurance marketing company purchased in 2000. This amount increased in 1999 as a result of growth in both of the aforementioned businesses.
The loss ratio for Medicare supplement products increased in 2000, for the following reasons: (i) our year end reserves developed adversely; (ii) the mix of our Medicare supplement business in 2000 includes a higher percent of less profitable standard Medicare supplement policies than the prior year (and a lower percent of more profitable nonstandard policies that we are no longer able to offer to new policyholders); and (iii) Medicare supplement business has recently experienced higher persistency among older blocks of business. While the Company benefits from the additional profits earned on the larger blocks of business, the loss ratio will generally increase since the older policies have higher claim costs. Governmental regulations generally require us to attain and maintain a loss ratio, after three years, of not less than 65 percent.
The loss ratios on our other products will fluctuate more than other lines due to the smaller size of these blocks of business. While the increase in 2000 reflects worse than expected experience, the loss ratios on this business have generally been within our expectations.
Amortization related to operations includes amortization of: (i) the cost of policies produced; and (ii) the cost of policies purchased. Amortization has increased in relationship to the total account balances subject to amortization. In addition, amortization increased in 2000 as a result of adjustments to the surrender and lapse assumptions to reflect our current estimate of future experience related to certain blocks of business.
Net investment gains (losses), including related costs and amortization fluctuate from period to period. We recorded writedowns of fixed maturity securities and other invested assets of $189.3 million, $27.8 million and $32.4 million during 2000, 1999 and 1998, respectively, as a result of conditions which caused us to conclude a decline in fair value of the investment was other than temporary. In addition, we realized a $59.2 million loss related to the termination of certain swap agreements during 2000.
When we sell securities at a gain (loss) and reinvest the proceeds at a different yield, we increase (reduce) the amortization of cost of policies purchased and cost of policies produced in order to reflect the change in future yields. Sales of fixed maturity investments resulted in a reduction in the amortization of the cost of policies purchased and the cost of policies produced of $53.4 million in 2000 and an increase in such amortization in 1999 of $15.9 million and in 1998 of $236.5 million.
During 2000, we announced several courses of action with respect to Conseco Finance, including: (i) the sale, closing or runoff of five units (i.e., asset-based lending, vendor finance, bankcards, transportation and park construction); (ii) efforts to better utilize existing assets so as to increase cash; and (iii) cost savings and restructuring of ongoing businesses such as streamlining of the field force in the manufactured housing and home equity divisions.
Sales of finance receivables decreased as a result of the change in the structure of our securitizations. We no longer structure our securitizations in a manner that results in recording a sale of the loans. Sales of finance receivables in 2000 represent the sale of whole loans (with no interest retained by the Company).
Net investment income on finance receivables and other consists of: (i) interest earned on finance receivables; and (ii) interest income on short-term and other investments. Such income increased by 199 percent, to $1,933.8 million, in 2000 and by 119 percent, to $647.1 million, in 1999, consistent with the increases in average on-balance sheet finance receivables. The weighted average yields earned on finance receivables and other investments were 13.0 percent, 11.1 percent and 10.8 percent during 2000, 1999 and 1998, respectively. As a result of the change in the structure of our securitizations, future interest earned on finance receivables should increase as our average on-balance sheet finance receivables increase.
Conditions in the credit markets during the past several years have resulted in less-attractive pricing of certain lower- rated securities in our securitization structures. As a result, we have chosen to hold rather than sell some of the securities in the securitization trusts, particularly securities having corporate guarantee provisions. Prior to our September 8, 1999, announcement, the securities that we held were treated as retained interests in the securitization trusts. We recognized no gain on the portion of the assets related to such securities, but we expect to recognize greater interest income, net of related interest expense, over the term we hold them. At December 31, 2000 and 1999 we held $494.6 million and $694.3 million, respectively, of such securities which are classified as actively managed fixed maturities.
Finance interest expense increased by 238 percent, to $1,152.4 million, in 2000 and by 60 percent, to $341.3 million, in 1999. Our borrowings grew in order to fund the increase in finance receivables. Our average borrowing rate was 7.7 percent, 5.8 percent and 7.2 percent during 2000, 1999 and 1998, respectively.
Other operating costs and expenses include the costs associated with servicing our managed receivables, and non- deferrable costs related to originating new loans. Such expense increased by 8.1 percent, to $753.5 million, in 2000 and by 18 percent, to $697.2 million, in 1999. Such costs increased consistent with the prior business plans for the segment, partially offset in 2000 by cost savings from the restructuring of Conseco Finance. Other operating costs and expenses decreased $62.5 million to $345.5 million in the second half of 2000, as compared to the first half of 2000.
During the second quarter of 1998, prepayments on securitized loan contracts exceeded our expectations and management concluded that such prepayments were likely to continue to be higher than expected in future periods as well. As a result of these developments, we concluded that the value of the interest-only securities and servicing rights had been impaired, and we determined a new value using then current assumptions. In addition, the market yields of publicly traded securities similar to our interest-only securities also increased during the second quarter of 1998. The assumptions used to determine the new value at that time were based on our internal evaluations and consultation with external investment managers having significant experience in valuing these securities. Such assumptions reflected the following changes from the assumptions previously used: (i) an increase in prepayment rates; (ii) an increase in the discount rate used to determine the present value of future cash flows; and (iii) an increase in anticipated default rates. We recognized a $549.4 million ($355.8 million after tax) impairment charge in 1998 to reduce the carrying value of the interest-only securities and servicing rights.
Investment income includes the income from our investment in a riverboat casino and miscellaneous other income.
We introduced our first equity-indexed annuity product in 1996. The accumulation value of these annuities is credited with interest at an annual guaranteed minimum rate of 3 percent (or, including the effect of applicable sales loads, a 1.7 percent compound average interest rate over the term of the contracts). These annuities provide for potentially higher returns based on a percentage of the change in the S&P 500 Index during each year of their term. We purchase S&P 500 Call Options in an effort to hedge increases to policyholder benefits resulting from increases in the S&P 500 Index. Total collected premiums for this product decreased by 29 percent, to $643.5 million, in 2000 and increased by 14 percent, to $911.8 million, in 1999.
Premiums collected on long-term care policies increased by 5.4 percent, to $836.0 million, in 2000 and by 8.9 percent, to $793.5 million, in 1999 due to increases in premium rates and increased sales volume.
Individual and group major medical products include major medical health insurance products sold to individuals and groups. We have previously announced our intent to sell these lines of business. In recent periods, we have emphasized the sale of more profitable individual major medical products and are de-emphasizing the sale of group
products. With respect to group major medical products, we are: (i) seeking rate increases; (ii) converting the members of groups to individual policies; or (iii) opting not to renew the group policies. Group premiums decreased by 4.3 percent, to $503.3 million, in 2000 and decreased by 5.1 percent, to $526.0 million, in 1999. Individual health premiums increased by 24 percent, to $407.3 million, in 2000 and increased by 1.8 percent, to $329.7 million, in 1999.
Insurance statutes regulate the type of investments that our insurance subsidiaries are permitted to make and limit the amount of funds that may be used for any one type of investment. In light of these statutes and regulations and our business and investment strategy, we generally seek to invest in United States government and government-agency securities and corporate securities rated investment grade by established nationally recognized rating organizations or in securities of comparable investment quality, if not rated.
Our actively managed fixed maturity portfolio at December 31, 2000, included primarily debt securities of the United States government, public utilities and other corporations, and mortgage-backed securities. Mortgage-backed securities included collateralized mortgage obligations ("CMOs") and mortgage-backed pass-through securities.
At December 31, 2000, approximately 7.6 percent of our invested assets (8.7 percent of fixed maturity investments) were fixed maturities rated below-investment grade by nationally recognized statistical rating organizations (or, if not rated by such firms, with ratings below Class 2 assigned by the NAIC). We plan to maintain approximately the present level of below-investment-grade fixed maturities. These securities generally have greater risks than other corporate debt investments, including risk of loss upon default by the borrower, and are often unsecured and subordinated to other creditors. Below-investment-grade issuers usually have higher levels of indebtedness and are more sensitive to adverse economic conditions, such as recession or increasing interest rates, than are investment-grade issuers. We are aware of these risks and monitor our below-investment-grade securities closely. At December 31, 2000, our below-investment-grade fixed maturity investments had an amortized cost of $2,407.7 million and an estimated fair value of $1,887.9 million.
We periodically evaluate the creditworthiness of each issuer whose securities we hold. We pay special attention to those securities whose market values have declined materially for reasons other than changes in interest rates or other general market conditions. We evaluate the realizable value of the investment, the specific condition of the issuer and the issuer's ability to comply with the material terms of the security. Information reviewed may include the recent operational results and financial position of the issuer, information about its industry, recent press releases and other information. Conseco employs a staff of experienced securities analysts in a variety of specialty areas. Among their responsibilities, this staff is charged with compiling and reviewing such information. If evidence does not exist to support a realizable value equal to or greater than the carrying value of the investment, and such decline in market value is determined to be other than temporary, we reduce the carrying amount to its net realizable value, which becomes the new cost basis; we report the amount of the reduction as a realized loss. We recognize any recovery of such reductions in the cost basis of an investment only upon the sale, repayment or other disposition of the investment. In 2000, we recorded writedowns of fixed maturity investments, equity securities and other invested assets totaling $189.3 million. Our investment portfolio is subject to the risks of further declines in realizable value. However, we attempt to mitigate this risk through the diversification and active management of our portfolio.
When a security defaults, our policy is to discontinue the accrual of interest and eliminate all previous interest accruals, if we determine that such amounts will not be ultimately realized in full. Investment income forgone due to defaulted securities was $15.3 million and $8.7 million for the years ended December 31, 2000 and 1999, respectively.
In general, prepayments on the underlying mortgage loans and the securities backed by these loans increase when prevailing interest rates decline significantly relative to the interest rates on such loans. The yields on mortgage-backed securities purchased at a discount to par will increase when the underlying mortgages prepay faster than expected. The yields on mortgage-backed securities purchased at a premium will decrease when they prepay faster than expected. When interest rates decline, the proceeds from the prepayment of mortgage-backed securities are likely to be reinvested at lower rates than we were earning on the prepaid securities. When interest rates increase, prepayments on mortgage-backed securities decrease, as fewer underlying mortgages are refinanced. When this occurs, the average maturity and duration of the mortgage-backed securities increase, which decreases the yield on mortgage-backed securities purchased at a discount,
The following table sets forth the par value, amortized cost and estimated fair value of mortgage-backed securities, summarized by interest rates on the underlying collateral at December 31, 2000:
The amortized cost and estimated fair value of mortgage-backed securities at December 31, 2000, summarized by type of security, were as follows:
Our venture capital investment in TeleCorp was made by our subsidiary which engages in venture capital investment activity. TeleCorp is a company in the wireless communication business. At the time we purchased this investment, we believed it had high growth or appreciation potential. Our investment in TeleCorp is carried at estimated fair value, with changes in fair value recognized as investment income. Since there are restrictions on our ability to sell this investment , we adjust the quoted market price to produce an estimate of the attainable fair value. At December 31, 2000, we held 17.2 million common shares of TeleCorp. The market values of many companies in TeleCorp's business sector have been subject to market valuation volatility in recent periods. We recognized venture capital investment income (loss) of $(199.5) million in 2000 and $354.8 million in 1999, primarily related to this investment.
At December 31, 2000, we held $15.0 million of trading securities; they are included in other invested assets. Trading securities are investments we intend to sell in the near term. We carry trading securities at estimated fair value; changes in fair value are reflected in the statement of operations.
As part of our investment strategy, we enter into reverse repurchase agreements and dollar-roll transactions to increase our return on investments and improve our liquidity. Reverse repurchase agreements involve a sale of securities and an agreement to repurchase the same securities at a later date at an agreed-upon price. Dollar rolls are similar to reverse repurchase agreements except that the repurchase involves securities that are only substantially the same as the securities sold. We enhance our investment yield by investing the proceeds from the sales in short-term securities pending the contractual repurchase of the securities at discounted prices in the forward market. We are able to engage in such transactions due to the market demand for mortgage-backed securities to form CMOs. Such investment borrowings averaged $324.4 million during 2000 and were collateralized by investment securities with fair values approximately equal to the loan value. The weighted average interest rate on such borrowings was 5.7 percent in 2000. The primary risk associated with short-term collateralized borrowings is that the counterparty might be unable to perform under the terms of the contract. Our exposure is limited to the excess of the net replacement cost of the securities over the value of the short- term investments (which was not material at December 31, 2000). We believe that the counterparties to our reverse repurchase and dollar-roll agreements are financially responsible and that counterparty risk is minimal.
Interest-only securities represent interests we retained in securitization transactions structured prior to September 8, 1999, and are carried at estimated fair value. On a quarterly basis, we estimate the fair value of these securities by discounting the projected future cash flows using current assumptions. If we determine that the differences between the estimated fair value and the book value of these securities is a temporary difference we adjust shareholders' equity. At December 31, 2000, this adjustment increased the carrying value of the interest-only securities by $1.7 million to $432.9 million. Declines in value are considered to be other than temporary when: (i) the fair value of the security is less than its carrying value; and (ii) the timing and/or amount of cash expected to be received from the security has changed adversely from the previous valuation which determined the carrying value of the security. When both occur, the security is written down to fair value.
Changes in the consolidated balance sheet of 2000 compared with 1999
Changes in the consolidated balance sheet at December 31, 2000, compared to 1999, reflect: (i) our operating results; (ii) our origination of finance receivables; (iii) the transfer of finance receivables to securitization trusts and sale of notes to investors in transactions accounted for as secured borrowings; (iv) the sale of finance receivables to Lehman; (v) the sale of assets of our subprime automobile, bankcard and transportation businesses; (vi) changes in the fair value of actively managed fixed maturity securities and interest-only securities; and (vii) various financing and restructuring transactions described in the notes to the consolidated financial statements.
In accordance with GAAP, we record our actively managed fixed maturity investments, interest-only securities, equity securities and certain other invested assets at estimated fair value with any unrealized gain or loss, net of tax and related adjustments, recorded as a component of shareholders' equity. At December 31, 2000, we decreased the carrying
Corporate notes payable and commercial paper increased $430.8 million during 2000. Increases were primarily due to: (i) the settlement of a forward contract described in note 10 to the accompanying consolidated financial statements; (ii) the redemption of $250 million par value of Company-obligated mandatorily redeemable preferred securities of subsidiary trusts; (iii) the acquisition of a long-term care insurance marketing organization for $32.9 million; (iv) cash required for special charges of $216.3 million; and (v) an increase in cash and cash equivalents held at the parent company of approximately $374 million. These increases were reduced by the actions completed during 2000 to generate cash in order to reduce corporate debt. Through December 31, 2000, we have completed transactions which generated cash proceeds in excess of $1.0 billion (see note 1 to the consolidated financial statements).
Goodwill (representing the excess of the amounts we paid to acquire companies over the fair value of net assets acquired in transactions accounted for as purchases) was $3,800.8 million and $3,927.8 million at December 31, 2000 and 1999, respectively. Goodwill as a percentage of shareholders' equity was 87 percent and 71 percent at December 31, 2000 and 1999, respectively. Goodwill as a percentage of total capital, excluding other comprehensive loss, was 30 percent and 29 percent at December 31, 2000 and 1999, respectively. We believe that the life of our goodwill is indeterminable and, therefore, have generally amortized its balance over 40 years as permitted by generally accepted accounting principles. Amortization of goodwill totaled $112.5 million, $110.1 million, and $106.2 million during 2000, 1999 and 1998,
respectively. If we had determined the estimated useful life of our goodwill was less than 40 years, amortization expense would have been higher.
We continually monitor the value of our goodwill based on our best estimates of future earnings considering all available evidence. We determine whether goodwill is fully recoverable from projected undiscounted net cash flows from earnings of the business acquired over the remaining amortization period. At December 31, 2000, goodwill is also recoverable from projected net cash flows from estimated earnings (including earnings on projected amounts of new business consistent with the Company's business plan), discounted at rates we believe are appropriate for the business. If we were to determine that changes in undiscounted projected cash flows no longer support the recoverability of goodwill over the remaining amortization period, we would reduce its carrying value with a corresponding charge to expense or shorten the amortization period. Cash flows considered in such an analysis are those of the business acquired, if separately identifiable, or the product line of the business acquired, if such earnings are not separately identifiable. During 2000, we recognized a special charge and reduced goodwill by $20.3 million, representing the difference between: (i) the carrying value of the net assets of the vendor services financing business; and (ii) the anticipated proceeds from the sale of such business, which was completed in the first quarter of 2001.
Our 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 any applicable surrender and withdrawal penalty provisions. We seek to balance the duration of our invested assets with the estimated duration of benefit payments arising from contract liabilities.
Approximately 45 percent of insurance liabilities were subject to interest rates that may be reset annually; 30 percent have a fixed explicit interest rate for the duration of the contract; 20 percent have credited rates which approximate the income earned by the Company; and the remainder have no explicit interest rate.
We believe that the diversity of our investment portfolio and the concentration of investments in high-quality, liquid securities provide sufficient liquidity to meet foreseeable cash requirements. At December 31, 2000, we held $.6 billion of cash and cash equivalents and $16.8 billion of publicly traded investment grade bonds. Although there is no present need or intent to dispose of such investments, our life insurance subsidiaries could readily liquidate portions of their investments, if such a need arose. In addition, investments could be used to facilitate borrowings under reverse-repurchase agreements or dollar-roll transactions. Such borrowings have been used by the life companies from time to time to increase their return on investments and to improve liquidity.
The market for securities backed by receivables is a cost-effective source of funds. Conditions in the credit markets during the last several years resulted in less-attractive pricing of certain lower rated securities typically included in loan securitization transactions. As a result, we chose to hold rather than sell some of the securities in the securitization trusts, particularly securities having corporate guarantee provisions.
Market conditions in the credit markets for loan securitizations and loan sales change from time to time. For example, during certain periods of 1999, the general levels of interest rates had increased on securities issued in securitizations, causing us to incur higher interest costs on securitizations completed during those periods. Changes in market conditions could affect the interest rate spreads we earn on the loans we originate and the cash provided by our finance operations. We adjust interest rates on our lending products to strive to maintain our targeted spread in the current interest rate environment.
At December 31, 2000, we had $3.5 billion in master repurchase agreements, commercial paper conduit facilities and other facilities with various banking and investment banking firms for the purpose of financing our consumer and commercial finance loan production. These facilities typically provide financing of a certain percentage of the underlying collateral and are subject to the availability of eligible collateral and, in many cases, the willingness of the banking firms to continue to provide financing. Some of these agreements provide for annual terms which are extended either quarterly or semi-annually by mutual agreement of the parties for an additional annual term based upon receipt of updated quarterly financial information. At December 31, 2000, we had borrowed $1.8 billion of the $3.5 billion available under such agreements. The average interest rate incurred under such agreements during 2000 was 7.4 percent.
Although we plan to continue to finance the receivables we originate through loan securitizations subsequent to September 8, 1999, we will no longer structure future securitizations in a manner that results in gain-on-sale revenues. This change has not had any material effect on the amount or timing of cash flows we receive, but the change required us to classify certain activities differently on our cash flow statement (e.g., certain cash flows recorded as "operating cash flows" under the gain-on-sale method must be recorded as "investing activities" under the portfolio method and vice versa).
During 2000, the Company restructured its bank credit facilities. The amended facilities include: (i) a $1.5 billion five year facility (the "$1.5 billion facility"); and (ii) other bank credit facilities due December 31, 2001 (the "near-term facilities"). The $1.5 billion facility is due December 31, 2003; however, subject to the absence of any default, the Company may further extend its maturity to March 31, 2005, provided that: (i) Conseco pays an extension fee of 3.5 percent of the amount extended; and (ii) cumulative principal payments of at least $150 million have been paid by September 30, 2002 and at least $300 million by September 30, 2003.
Inflation does not have a significant effect on our balance sheet; we have minimal investments in property, equipment or inventories. To the extent that interest rates may change to reflect inflation or inflation expectations, there would be an effect on our balance sheet and operations. Lower interest rates experienced in periods prior to 1999 have increased the value of our investment in fixed maturities and may have increased the amount of new finance receivables originated. These lower rates may also have made it more difficult to issue new fixed rate annuities and may have accelerated prepayments of finance receivables. Rising interest rates experienced in 2000 decreased the value of our investments in fixed maturities and may have slowed the issuance of new finance receivables and the prepayment of existing finance receivables. Changes in interest rates can also affect the value of the finance receivables we hold.
medical cost inflation on our operations depends on our ability to increase premium rates. Such increases are subject to approval by state insurance departments. We seek to price our new standardized supplement plans to reflect the impact of these filings and the lengthening of the period required to implement rate increases.
We seek to maximize the total return on our investments through active investment management. Accordingly, we have determined that our entire portfolio of fixed maturity securities is available to be sold in response to: (i) changes in market interest rates; (ii) changes in relative values of individual securities and asset sectors; (iii) changes in prepayment risks; (iv) changes in credit quality outlook for certain securities; (v) liquidity needs; and (vi) other factors. From time to time, we invest in securities for trading purposes, although such investments account for a relatively small portion of our total portfolio.
The profitability of many of our products depends on the spreads between the interest yield we earn on investments and the rates we credit on our insurance liabilities. In addition, changes in competition and other factors, including the impact of the level of surrenders and withdrawals, may limit our ability to adjust or to maintain crediting rates at levels necessary to avoid narrowing of spreads under certain market conditions. Approximately 45 percent of our insurance liabilities were subject to interest rates that may be reset annually; 30 percent have a fixed explicit interest rate for the duration of the contract; 20 percent have credited rates which approximate the income earned by the Company; and the remainder have no explicit interest rates. As of December 31, 2000, the average yield, computed on the cost basis of our investment portfolio, was 7.2 percent, and the average interest rate credited or accruing to our total insurance liabilities (excluding interest rate bonuses for the first policy year only and excluding the effect of credited rates attributable to variable or equity-indexed products) was 4.9 percent.
We manage the ratio of borrowed capital to total capital and the portion of our outstanding capital subject to fixed and variable rates, taking into consideration the current interest rate environment and other market conditions. Our borrowed capital at December 31, 2000, included notes payable and Company-obligated mandatorily redeemable preferred securities of subsidiary trusts totaling $7.5 billion ($5.5 billion of which is at fixed rates and $2.0 billion of which is at floating rates). Based on the interest rate exposure and prevalent rates at December 31, 2000, a relative 10 percent decrease in interest rates would increase the fair value of our fixed-rate borrowed capital by approximately $38 million. This compares to a $47 million increase based on our borrowed capital and prevalent rates at December 31, 1999. Our interest expense on floating-rate debt will fluctuate as prevailing interest rates change.
Conseco, Inc. ("we", "Conseco" or the "Company") is a financial services holding company with subsidiaries operating throughout the United States. Our insurance subsidiaries develop, market and administer supplemental health insurance, annuity, individual life insurance and other insurance products. Our finance subsidiaries originate, securitize and service manufactured housing, home equity, retail credit and floorplan loans. Conseco's operating strategy is to grow its business by focusing its resources on the development and expansion of profitable products and strong distribution channels, to seek to achieve superior investment returns through active asset management and to control expenses.
During 2000, we announced several courses of action with respect to Conseco Finance Corp. ("Conseco Finance", formerly Green Tree Financial Corporation prior to its name change in November 1999), a wholly owned subsidiary of Conseco, as well as our intent to sell our individual and group major medical insurance lines and certain non-strategic assets held at the parent company level. These actions are designed to reduce parent company debt over time and are an integral part of the restructuring of the bank debt which occurred during the third quarter of 2000. The actions with respect to Conseco Finance include: (i) the sale, closing or runoff of five units (i.e., asset-based lending, vendor leasing, bankcards, transportation and park construction); (ii) efforts to better utilize existing assets so as to increase cash; and (iii) cost savings and restructuring of ongoing businesses such as the streamlining of loan origination operations in the manufactured housing and home equity lending divisions. The actions with respect to the sale of certain non-strategic assets include the sales of our investment in the wireless communication company, TeleCorp PCS Inc. ("TeleCorp"), our interest in the riverboat casino in Lawrenceberg, Indiana, and our subprime auto loan portfolio. These actions had a significant effect on the Company's operating results during 2000.
(iii) We have made significant progress in achieving our asset liquidation and monetization transaction goals. Through December 31, 2000, we have completed transactions which generated cash proceeds in excess of $1.0 billion including the sale of our subprime auto, asset-based, bankcard and transportation lending businesses;
(v) On January 31, 2001, we completed the sale of the vendor leasing business of Conseco Finance, generating cash proceeds of approximately $180 million; and
Fixed maturities are securities that mature more than one year after issuance and include bonds, certain notes receivable and redeemable preferred stock. Fixed maturities that we may sell prior to maturity are classified as actively managed and are carried at estimated fair value, with any unrealized gain or loss, net of tax and related adjustments, recorded as a component of shareholders' equity. Fixed maturity securities that we intend to sell in the near term are classified as trading and included in other invested assets. We include any unrealized gain or loss on trading securities in net investment gains.
Other invested assets include: (i) trading securities; (ii) Standard & Poor's 500 Call Options ("S&P 500 Call Options"); and (iii) certain non-traditional investments. We carry the S&P 500 Call Options at estimated fair value as further described below under "Standard & Poor's 500 Index Call Options and Interest Rate Swap Agreements". Non- traditional investments include investments in certain limited partnerships, mineral rights and promissory notes; we account for them using either the cost method, or for investments in partnerships over whose operations the Company exercises significant influence, the equity method.
We defer any fees received or costs incurred when we originate investments. We amortize fees, costs, discounts and premiums as yield adjustments over the contractual lives of the investments. We consider anticipated prepayments on mortgage-backed securities in determining estimated future yields on such securities.
In addition, during 1999 and 2000, we established a provision for losses related to our guarantees of bank loans and the related interest loans to approximately 160 current and former directors, officers and key employees for the purchase of
Goodwill is the excess of the amount we paid to acquire a company over the fair value of its net assets. Our analysis of acquired businesses indicates that the anticipated ongoing cash flows from the earnings of the purchased businesses extend beyond the maximum 40-year period allowed for goodwill amortization. Accordingly, we amortize goodwill on the straight-line basis generally over a 40-year period. The total accumulated amortization of goodwill was $503.7 million and $391.2 million at December 31, 2000 and 1999, respectively. We continually monitor the value of our goodwill based on our estimates of future earnings. We determine whether goodwill is fully recoverable from projected undiscounted net cash flows from earnings of the subsidiaries over the remaining amortization period. At December 31, 2000, goodwill is also recoverable from projected net cash flows from estimated earnings (including earnings on projected amounts of new
business consistent with the Company's business plan), discounted at rates we believe are appropriate for the business. If we were to determine that changes in undiscounted projected cash flows no longer support the recoverability of goodwill over the remaining amortization period, we would reduce its carrying value with a corresponding charge to expense or shorten the amortization period. Cash flows considered in such an analysis are those of the business acquired, if separately identifiable, or the product line that acquired the business, if such earnings are not separately identifiable. See note 9 regarding the reduction in goodwill related to the sale of the vendor services financing business.
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 that 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 market value of the underlying assets. We record the fees earned for administrative and contractholder services performed for the separate accounts in insurance policy income.
In the normal course of business, we seek to limit our exposure to loss on any single insured or to certain groups of policies by ceding reinsurance to other insurance enterprises. We currently retain no more than $.8 million of mortality risk on any one policy. We diversify the risk of reinsurance loss by using a number of reinsurers that have strong claims-paying ratings. If any reinsurer could not meet its obligations, the Company would assume the liability. The likelihood of a material loss being incurred as a result of the failure of one of our reinsurers is considered remote. The cost of reinsurance is recognized over the life of the reinsured policies using assumptions consistent with those used to account for the underlying policy. The cost of reinsurance ceded totaled $248.3 million, $418.6 million and $541.3 million in 2000, 1999 and 1998, respectively. A receivable is recorded for the reinsured portion of insurance policy benefits paid and liabilities for insurance products. Reinsurance recoveries netted against insurance policy benefits totaled $283.2 million, $392.0 million and $484.3 million in 2000, 1999 and 1998, respectively.
From time-to-time, we assume insurance from other companies. Any costs associated with the assumption of insurance are amortized consistent with the method used to amortize the cost of policies produced described above. Reinsurance premiums assumed totaled $305.4 million, $547.8 million and $316.0 million in 2000, 1999 and 1998 respectively.
As part of our investment strategy, we may enter into reverse repurchase agreements and dollar-roll transactions to increase our investment return or to improve our liquidity. We account for these transactions as collateral borrowings, where the amount borrowed is equal to the sales price of the underlying securities. Reverse repurchase agreements involve a sale of securities and an agreement to repurchase the same securities at a later date at an agreed-upon price. Dollar rolls are similar to reverse repurchase agreements except that, with dollar rolls, the repurchase involves securities that are only substantially the same as the securities sold. Such borrowings averaged $324.4 million during 2000 and $1,081.1 million during 1999. These borrowings were collateralized by investment securities with fair values approximately equal to the loan value. The weighted average interest rate on short-term collateralized borrowings was 5.7 percent and 5.4 percent in 2000 and 1999, respectively. The primary risk associated with short-term collateralized borrowings is that a counterparty will be unable to perform under the terms of the contract. Our exposure is limited to the excess of the net replacement cost of the securities over the value of the short-term investments (such excess was not material at December 31, 2000). We believe the counterparties to our reverse repurchase and dollar-roll agreements are financially responsible and that the counterparty risk is minimal.
Standard & Poor's 500 Index Call Options and Interest Rate Swap Agreements
Our equity-indexed annuity products provide a guaranteed base rate of return and a higher potential return linked to the performance of the Standard & Poor's 500 Index ("S&P 500 Index"). We buy S&P 500 Call Options in an effort to hedge potential increases to policyholder benefits resulting from increases in the S&P 500 Index to which the product's return is linked. We include the cost of the S&P 500 Call Options in the pricing of these products. Policyholder account balances for these annuities fluctuate in relation to changes in the values of these options. We reflect changes in the value of these options in net investment income. During 2000, 1999 and 1998, net investment income included $12.9 million, $142.3 million and $103.9 million, respectively, related to these changes. Such investment income was substantially offset by increases to policyholder account balances. The value of the S&P 500 Call Options was $30.4 million and $129.2 million at December 31, 2000 and 1999, respectively. We classify such instruments as other invested assets. We defer the premiums paid to purchase the S&P 500 Call Options and amortize them to investment income over their terms. Such amortization was $123.9 million, $96.3 million and $52.0 million during 2000, 1999 and 1998, respectively. The unamortized premium of the S&P 500 Call Options was $63.0 million and $59.5 million at December 31, 2000 and 1999, respectively.
Subsequent to September 8, 1999, we are using the portfolio method (the accounting method required for securitizations which are now structured as secured borrowings) to account for securitization transactions. Our securitizations are now structured in a manner that requires them to be accounted for under the portfolio method, whereby the loans and securitization debt remain on our balance sheet, pursuant to Financial Accounting Standards Board Statement No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities" ("SFAS 125").
During 1999 and 1998, the Company sold $9.7 billion and $13.4 billion, respectively, of finance receivables in securitizations structured as sales and recognized gains of $550.6 million and $745.0 million, respectively. The gains recognized were dependent in part on the previous carrying amount of the finance receivables included in the securitization transactions, allocated between the assets sold and our retained interests based on their relative fair value at the date of transfer. To obtain fair values, quoted market prices were used if available. However, quotes were generally not available for retained interests, so we estimated the fair values based on the present value of future expected cash flows using our best estimates of the key assumptions - credit losses, prepayment speeds, forward yield curves, and discount rates commensurate with the risks involved.
We use the following methods and assumptions to determine the estimated fair values of financial instruments:
Venture capital investment in TeleCorp. We carry this investment at estimated fair value based on quoted market prices adjusted to produce an estimate of attainable fair value due to the restrictions on our ability to sell this investment.
Liabilities related to certificates of deposit. We estimate the fair value of these liabilities using discounted cash flow analyses based on current crediting rates. Since crediting rates are generally not guaranteed beyond one year, market value approximates carrying value.
During the third quarter of 2000, the Emerging Issues Task Force of the Financial Accounting Standards Board issued EITF 99-20, a new accounting requirement for the recognition of impairment on interest-only securities and other retained beneficial interests in securitized finance assets.
We adopted the new accounting rule on July 1, 2000. The cumulative effect of the accounting change for periods prior to July 1, 2000 was a decrease to net income of $55.3 million (net of an income tax benefit of $29.9 million), or $.17 per diluted share. The cumulative effect of the accounting change includes: (i) $45.5 million (net of an income tax benefit of $24.7 million) related to interest-only securities; and (ii) $9.8 million (net of an income tax benefit of $5.2 million) related to other retained beneficial interests in securitized financial assets held by our insurance segment.
The Financial Accounting Standards Board recently issued Statement of Financial Accounting Standards No. 140, "Accounting for the Transfer and Servicing of Financial Assets and Extinguishments of Liabilities" ("SFAS 140") which is a replacement for SFAS 125; and a related implementation guide. SFAS 140 and the implementation guide have changed the criteria that must be met for securitization transactions to be recorded under the portfolio method. We do not believe we will need to make any significant changes to our securitization structures to meet the new criteria which are effective for securitization transactions completed after March 31, 2001.
The following table sets forth the amortized cost and estimated fair value of actively managed fixed maturities at December 31, 2000, by contractual maturity. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Most of the mortgage-backed securities shown below provide for periodic payments throughout their lives.
Life insurance companies are required to maintain certain investments on deposit with state regulatory authorities. Such assets had an aggregate carrying value of $225.0 million at December 31, 2000.
Conseco had no investments in any single entity in excess of 10 percent of shareholders' equity at December 31, 2000, other than investments issued or guaranteed by the United States government or a United States government agency.
Subsequent to September 8, 1999, we are using the portfolio method to account for new securitization transactions. Our new securitizations are structured in a manner that requires them to be accounted for under the portfolio method, whereby the loans and securitization debt remain on our balance sheet, rather than as sales, pursuant to SFAS 125.
The following table summarizes our finance receivables - securitized by business line and categorized as either: (i) a part of our continuing lines; or (ii) a part of the business units we have decided to sell, close or runoff (the "discontinued lines"):
The interest-only securities on our balance sheet represent an allocated portion of the cost basis of the finance receivables in the securitization transactions accounted for as sales related to transactions structured prior to September 8, 1999. Our interest-only securities and other retained interests in those securitization transactions are subordinate to the interests of other investors. Their values are subject to credit, prepayment, and interest rate risk on the securitized finance receivables. We include the difference between estimated fair value and the amortized cost of the interest-only securities (after adjustments for impairments required to be recognized in earnings) in "accumulated other comprehensive loss, net of taxes".
At December 31, 2000, key economic assumptions used to determine the estimated fair value of our retained interests in securitizations and the sensitivity of the current fair value of residual cash flows to immediate 10 percent and 20 percent
The following table summarizes certain cash flows received from and paid to the securitization trusts during 2000 (dollars in millions):
We have projected lower cash flows from our interest-only securities in 2001, reflecting our assumption that the adverse loss experience in 2000 will continue into 2001 and then improve over time. As a result of these assumptions, we project that payments related to guarantees issued in conjunction with the sales of certain finance receivables will exceed the amounts paid in previous periods. These projected payments are considered in the projected cash flows we use to value our interest-only securities. See note 8 to the consolidated financial statements for additional information about the guarantees.
At December 31, 2000, Conseco had federal income tax loss carryforwards of $1,123.5 million available (subject to various statutory restrictions) for use on future tax returns. Portions of these carryforwards begin expiring in 2002. The following restrictions exist with respect to the utilization of portions of the loss carryforwards: (i) $52.0 million may be used only to offset income from our non-life insurance companies; (ii) $107.0 million (attributable to acquired companies) may be used only to offset the income from those companies; and (iii) $964.5 million is available to offset income from certain life insurance subsidiaries, our finance subsidiaries and other non-life insurance subsidiaries. None of the carryforwards are available to reduce the future tax provision for financial reporting purposes.
Notes payable and commercial paper, representing direct corporate obligations at December 31, 2000 and 1999, were as follows (interest rates as of December 31, 2000):
(b) the remaining 50 percent would be retained by Conseco. No assurance can be provided as to the timing, proceeds, or other terms related to any potential asset sale or financing transaction.
The amended bank credit facilities require the Company to maintain various financial ratios and balances, as defined in the agreement including: (i) a debt-to-total capitalization ratio to be less than .450:1.0 at December 31, 2000 and decreasing over time, as defined in the agreement, to 0.30:1.0 at March 31, 2004 and thereafter (such ratio was .41:1.0 at December 31, 2000); (ii) an interest coverage ratio greater than 1.00:1.0 for the quarter ending December 31, 2000 and increasing over time, as defined in the agreement, to 2.00:1.0 for the four quarters ending December 31, 2003 and thereafter (such ratio was 1.11:1.0 at December 31, 2000); (iii) adjusted earnings, as defined in the agreement, of at least $650 million for the six months ending March 31, 2001 and increasing over time, as defined in the agreement, to $2,175.0 million for the year ending December 31, 2004 (the adjusted earnings for the fourth quarter of 2000 exceed one-half of the requirement for the six months ended March 31, 2001); (iv) Conseco Finance tangible net worth, as defined in the agreement, of at least $950.0 million at December 31, 2000; $1.2 billion at December 31, 2001; $1.4 billion at December 31, 2002; $1.65 billion at December 31, 2003; and $2.0 billion at December 31, 2004 (such tangible net worth was in excess of $1.2 billion at December 31, 2000); and (v) an aggregate risk-based capital ratio with respect to our insurance subsidiaries of at least 200 percent (such ratio was greater than 240 percent at December 31, 2000).
Notes payable, representing direct finance obligations (excluding notes payable related to securitized finance receivables structured as collateralized borrowings) at December 31, 2000 and 1999, were as follows (interest rates as of December 31, 2000):
Amounts borrowed under master repurchase agreements have increased as the balance of finance receivables eligible as collateral for these agreements has increased. At December 31, 2000, we had $3.5 billion in master repurchase agreements, commercial paper conduit facilities and other facilities with various banking and investment banking firms for the purpose of financing our consumer and commercial finance loan production. These facilities typically provide financing of a certain percentage of the underlying collateral and are subject to the availability of eligible collateral and, in some cases, the willingness of the banking firms to continue to provide financing. Some of these agreements provide for annual terms which are extended either quarterly or semi-annually by mutual agreement of the parties for an additional annual term based upon receipt of updated quarterly financial information. At December 31, 2000, we had borrowed $1.8 billion of the $3.5 billion available under such agreements.
Notes payable related to securitized finance receivables structured as collateralized borrowings were $12,100.6 million and $4,641.8 million at December 31, 2000 and 1999, respectively. The principal and interest on these notes are paid using the cash flows from the underlying finance receivables which serve as collateral for the notes. Accordingly, the timing of the principal payments on these notes is dependent on the payments received on the underlying finance receivables which back the notes. The average interest rate on these notes was 7.7 percent and 7.6 percent at December 31, 2000 and 1999, respectively.
The Company rents office space, equipment and computer software under noncancellable operating leases. Rental expense was $70.6 million in 2000, $61.5 million in 1999 and $50.6 million in 1998. Future required minimum rental payments as of December 31, 2000, were as follows (dollars in millions):
The Company provides certain pension, health care and life insurance benefits for certain eligible retired employees under partially funded and unfunded plans in existence at the date on which certain subsidiaries were acquired. Certain postretirement benefit plans are contributory, with participants' contributions adjusted annually. Amounts related to the pension and postretirement benefit plans were as follows:
We used the following weighted average assumptions to calculate benefit obligations for our 2000 and 1999 valuations: discount rate of approximately 7.1 percent and 6.9 percent, respectively; an expected return on plan assets of approximately 8.4 percent and 8.2 percent, respectively; and an assumed rate of compensation increase of 5.5 percent in
The Company has qualified defined contribution plans for which substantially all employees are eligible. Company contributions, which match certain voluntary employee contributions to the plan, totaled $9.1 million in 2000, $10.3 million in 1999, and $6.2 million in 1998. Matching contributions are required to be made either in cash or in Conseco common stock.
Conseco Finance was served with various related lawsuits filed in the United States District Court for the District of Minnesota. These lawsuits were generally filed as purported class actions on behalf of persons or entities who purchased common stock or options to purchase common stock of Conseco Finance during alleged class periods that generally run from February 1995 to January 1998. One action (Florida State Board of Admin. v. Green Tree Financial Corp., Case No. 98-1162) did not include class action claims. In addition to Conseco Finance, certain current and former officers and directors of Conseco Finance are named as defendants in one or more of the lawsuits. Conseco Finance and other defendants obtained an order consolidating the lawsuits seeking class action status into two actions, one of which pertains to a purported class of common stockholders (In re Green Tree Financial Corp. Stock Litig., Case No. 97-2666) and the other which pertains to a purported class action of stock option traders (In re Green Tree Financial Corp. Options Litig., Case No. 97-2679). Plaintiffs in the lawsuits assert claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. In each case, plaintiffs allege that Conseco Finance and the other defendants violated federal securities laws by, among other things, making false and misleading statements about the current state and future prospects of Conseco Finance (particularly with respect to prepayment assumptions and performance of certain loan portfolios of Conseco Finance) which allegedly rendered Conseco Finance's financial statements false and misleading. On August 24, 1999, the United States District Court for the District of Minnesota issued an order to dismiss with prejudice all claims alleged in the lawsuits. The plaintiffs subsequently appealed the decision to the U.S. Court of Appeals for the 8th Circuit, and the appeal is currently pending. The Company believes that the lawsuits are without merit and intends to continue to defend them vigorously. The ultimate outcome of these lawsuits cannot be predicted with certainty.
A total of forty-five suits were filed against the Company in the United States District Court for the Southern District of Indiana. Nineteen of these cases were putative class actions on behalf of persons or entities that purchased the Company's common stock during alleged class periods that generally run from April 1999 through April 2000. Two cases were
Nine shareholder derivative suits were filed in United States District Court. The complaints named as defendants the current directors, certain former directors, certain non-director officers of the Company (in one case), and, alleging aiding and abetting liability, certain banks which allegedly made loans in relation to the Company's "Stock Purchase Plan" (in these cases). The Company is also named as a nominal defendant in each complaint. Plaintiffs allege that the defendants breached their fiduciary duties by, among other things, intentionally disseminating false and misleading statements concerning the acquisition, performance and proposed sale of Conseco Finance, and engaged in corporate waste by causing the Company to guarantee loans that certain officers, directors and key employees of the Company used to purchase stock under the Stock Purchase Plan. These cases have now been consolidated into one case in the United States District Court for the Southern District of Indiana, captioned: "In Re Conseco, Inc. Derivative Litigation", cause number IP00655-C-Y/S. An amended complaint is expected to be filed in April 2001. Three similar cases have been filed in the Hamilton County Superior Court in Indiana. Schweitzer v. Hilbert, et al., Cause No. 29001-0004CP251; Evans v. Hilbert, et al., Cause No. 29001-0005CP308 (both Schweitzer and Evans name as defendants certain non-director officers); Gintel v. Hilbert, et al., Cause No. 29003-0006CP393 (naming as defendants, and alleging aiding and abetting liability as to, banks which allegedly made loans in relation to the Stock Purchase Plan). The Company believes that these lawsuits are without merit and intends to defend them vigorously. The ultimate outcome of these lawsuits cannot be predicted with certainty.
Conseco, Inc. and its subsidiaries, Conseco Services, LLC, Washington National Insurance Company and United Presidential Life Insurance Company are currently named defendants in a lawsuit filed in the Circuit Court of Claiborne County, Mississippi, Cause No. CV-99-0106, and captioned "Carla Beaugez, Lois Dearing, Lee Eaton and all other persons identified in the lawsuit v. Conseco, Inc., Conseco Services, Inc., Washington National Company, United Presidential Life Insurance Company and Larry Ratcliff." The claims of the eighty-seven plaintiffs arise out of allegedly wrongful increases of the cost of insurance and decrease in the credited interest rates on universal life policies issued to the plaintiffs by United
Presidential Life. The plaintiffs asserted claims including negligent and intentional misrepresentation, fraudulent concealment, fraudulent inducement, common law fraud, and deceptive sales practices. The Company believes this lawsuit is without merit and is defending it vigorously. The ultimate outcome of this lawsuit cannot be predicted with certainty.
Conseco Finance is a defendant in two arbitration proceedings in South Carolina (Lackey v. Green Tree Financial Corporation, n/k/a Conseco Finance Corp. and Bazzle v. Green Tree Financial Corporation, n/k/a Conseco Finance Corp.) where the arbitrator, over Conseco Finance's objection, allowed the plaintiffs to pursue purported class action claims in arbitration. The two purported arbitration classes consist of South Carolina residents who obtained real estate secured credit from Conseco Finance's Manufactured Housing Division (Lackey) and Home Improvement Division (Bazzle) in the early and mid 1990s, and did not receive a South Carolina specific disclosure form relating to selection of attorneys in connection with the credit transactions. The arbitrator, in separate awards issued on July 24, 2000, awarded a total of $26.8 million in penalties and attorneys' fees. The awards were confirmed as judgements in both Lackey and Bazzle. These matters are currently on appeal at the South Carolina Supreme Court. Conseco Finance intends to vigorously challenge the awards and believes that the arbitrator erred by, among other things, conducting class action arbitrations without the authority to do so and misapplying South Carolina law when awarding the penalties. The ultimate outcome of these proceedings cannot be predicted with certainty.
In addition, the Company and its subsidiaries are involved on an ongoing basis in other lawsuits related to their operations. Although the ultimate outcome of certain of such matters cannot be predicted, such lawsuits currently pending against the Company or its subsidiaries are not expected, individually or in the aggregate, to have a material adverse effect on the Company's consolidated financial condition, cash flows or results of operations.
The balance sheet at December 31, 2000, includes: (i) accruals of $20.4 million, representing our estimate of all known assessments that will be levied against the Company's insurance subsidiaries by various state guaranty associations based on premiums written through December 31, 2000; and (ii) receivables of $11.9 million that we estimate will be recovered through a reduction in future premium taxes as a result of such assessments. At December 31, 1999, such guaranty fund assessment related accruals were $29.2 million and such receivables were $13.1 million. These estimates are subject to change when the associations determine more precisely the losses that have occurred and how such losses will be allocated among the insurance companies. We recognized expense for such assessments of $8.4 million in 2000, $5.0 million in 1999 and $16.2 million in 1998.
In conjunction with certain sales of finance receivables, we provided guarantees aggregating approximately $1.5 billion at December 31, 2000. We consider any potential payments related to these guarantees in the projected net cash flows used to determine the value of our interest-only securities. During 2000, advances of interest and principal payments related to such guarantees totaled $23.2 million.
We have guaranteed bank loans totaling $552.9 million to approximately 160 current and former directors, officers and key employees. The funds were used by the participants to purchase approximately 18.4 million shares of Conseco common stock in open market or negotiated transactions with independent parties. Such shares are held by the bank as collateral for the loans. In addition, Conseco has provided loans to participants for interest on the bank loans totaling $96.8 million. During the third quarter of 2000, the Company negotiated a new guarantee with the banks which expires on December 31, 2003, and is available to participants who qualify and choose to participate in a new lending program. A key goal of the program is to reduce the balance of each participant's bank and interest loans to $25 per share of stock purchased through the program. Such reductions are to occur through cash payments and pay for performance programs. In order to receive the pay for performance program benefits, participants in the new program are required to put to the Company, 75 percent of the value in excess of $25 per share of the shares purchased through this program, as determined on December 31, 2003. A subsidiary of Conseco has pledged $50 million of cash collateral in conjunction with the guarantee of a portion of the bank loans. Conseco also granted a security interest in most of its assets in conjunction with the guarantee of a portion of the bank loans. At December 31, 2000, the guaranteed bank loans and interest loans exceeded the value of the common stock collateralizing the loans by approximately $450 million. All participants have agreed to
On July 27, 2000, we announced several courses of action to restructure our finance business, including the sale or runoff of the finance receivables of several business lines. The carrying value of the loans held for sale has been reduced to the lower of cost or market, consistent with our accounting policy for such loans. The reduction in value of these loans of $103.3 million (including a $45.9 million increase to the allowance for credit losses) primarily relates to transportation finance receivables (primarily loans for the purchase of trucks and buses). These loans have experienced a significant decrease in value as a result of the adverse economic effect that the recent increases in oil prices and competition have had on borrowers in the transportation business.
Loss on sale of transportation loans and vendor services financing business
Our restructuring activities included the closing of several branch offices and streamlining our businesses. These activities included a reduction in the work force of approximately 1,700 employees. The Company incurred a charge of $8.6 million related to severance costs paid to terminated employees in 2000. The Company also incurred lease termination and direct closing costs of $12.3 million associated with the branch offices closed in conjunction with the restructuring activities. In addition, fixed assets and leasehold improvements of $10.3 million were abandoned when the branch offices were closed.
Lehman has also amended its master repurchase financing facilities with our finance operations to expand the types of assets financed. As partial consideration for the financing transaction, Lehman received a warrant, with a nominal exercise price, for five percent of the common stock of Conseco Finance. The warrant has a five-year term. After three years, the holder of the warrant or Conseco Finance may cause the warrant and any stock issued upon its exercise to be purchased for cash at an appraised value. Since the warrant permits cash settlement at fair value at the option of the holder of the warrant, it has been classified as a liability measured at fair value, with changes in its value reported in earnings.
The warrant would be cancelled in certain circumstances in the event the holder thereof or an affiliate participates in a group that purchases Conseco Finance. The initial $48.1 million estimated value of the warrant was recognized as an expense during the second quarter of 2000. The estimated fair value of the warrant did not change materially during 2000.
We also paid Lehman $20.0 million in fees for its efforts to form an investor group to purchase Conseco Finance. In addition, the Company paid other investment banks and financial institutions $24.0 million in advisory fees related to the potential sale of Conseco Finance and consultation regarding various other transactions.
On April 28, 2000, Conseco and Stephen C. Hilbert, the Company's former Chairman and Chief Executive Officer, entered into an agreement pursuant to which Mr. Hilbert's employment was terminated. As contemplated by the terms of his employment agreement, Mr. Hilbert received: (i) $72.5 million (prior to required withholdings for taxes), an amount equal to five times his salary and the non-discretionary bonus amount (as defined in his employment agreement) for this year; less (ii) the amount due under a secured loan of $23 million, plus accrued interest, made to Mr. Hilbert on April 6, 2000. Mr. Hilbert also received the bonus of $3,375,000 payable under his employment agreement for the first quarter of 2000. Conseco agreed to continue to treat Mr. Hilbert as though he was an employee/participant for purposes of the guaranteed bank loans and the loans for interest on such loans pursuant to the stock purchase program. Conseco also entered into a consulting agreement with Mr. Hilbert pursuant to which Mr. Hilbert has agreed to provide consulting services up to an average of 25 hours per month for a period of three years. Mr. Hilbert also agreed not to compete with Conseco during the term of the consulting agreement. On April 27, 2000, Mr. Hilbert was granted options to purchase an aggregate of 2,000,000 shares of Conseco common stock at a price of $5.75 per share (the average of the high and low sales prices on the New York Stock Exchange on such date). The options expire on April 26, 2003.
On June 28, 2000, the Company hired Gary C. Wendt as its Chief Executive Officer. Pursuant to the terms of his employment agreement, Mr. Wendt received a payment of $45 million (prior to required withholdings for taxes) and was granted options to purchase an aggregate of 10,000,000 shares of Conseco common stock at a price of $5.875 per share (the average of the high and low sales price on the New York Stock Exchange on the date on which the substantial terms of Mr. Wendt's employment were agreed to). The options vest over the next five years and expire on June 28, 2010. The Company also issued 3,200,000 shares of restricted stock to Mr. Wendt. The restrictions on the stock lapse if Mr. Wendt remains employed by Conseco through June 30, 2002, or upon a "change in control" of the Company. The value of the restricted shares ($18.8 million) will be recognized as an expense to the Company over the two year period ending June 30, 2002. Mr. Wendt is also being provided certain supplemental retirement, insurance and other benefits under the terms of his employment agreement.
In conjunction with Mr. Wendt's hiring and his release from noncompete provisions of a prior agreement, the Company issued a warrant to a subsidiary of General Electric Company to purchase 10,500,000 shares of Conseco common
stock at a purchase price of $5.75 per share. The estimated value of the warrant at the date of issuance ($21.0 million) was recognized as a special charge.
We are authorized to issue up to 20 million shares of preferred stock. On December 15, 1999, we issued $500.0 million (2.6 million shares) of Series F Common-Linked Convertible Preferred Stock (the "Series F Preferred Stock") to Thomas H. Lee Company and affiliated investors. The Series F Preferred Stock is convertible into Conseco common stock at a common equivalent rate of $19.25 per share. The Series F Preferred Stock pays a 4 percent dividend, of which an amount at least equal to the common dividend will be payable in cash, and the remainder may be paid in additional Series F shares valued at $19.25 per share. In September 2000, we suspended the payment of common stock dividends, so the entire third and fourth quarter dividends on the Series F shares were paid in additional Series F shares. The Series F Preferred Stock ranks senior to the common stock outstanding and has a liquidation preference of $192.50 per share plus all declared and unpaid dividends.
Conseco's 1994 Stock and Incentive Plan authorizes the granting of options to employees and directors of the Company to purchase up to 24 million shares of Conseco common stock at a price not less than its market value on the date the option is granted. In 1997, the Company adopted the 1997 Non-qualified Stock Option Plan, which authorizes the granting of non-qualified options to employees of the Company to purchase shares of Conseco common stock. The aggregate number of shares of common stock for which options may be granted under the 1997 plan, when added to all outstanding, unexpired options under the Company's employee benefit plans, shall not exceed 20 percent of the total of shares of common stock outstanding plus the number of shares issuable upon conversion of any outstanding convertible security on the date of grant (calculated in the manner set forth in the 1997 plan). The options may become exercisable immediately or over a period of time. The plans also permit granting of stock appreciation rights and certain other awards.
The following table summarizes information about stock options outstanding at December 31, 2000 (shares in thousands):
We apply Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations in accounting for our stock option plans. Since the amount an employee must pay to acquire the stock is equal to the market price of the stock on the grant date, no compensation cost has been recognized for our stock option plans. Had compensation cost been determined based on the fair value at the grant dates for awards granted after January 1, 1995, consistent with the method of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation", the Company's pro forma net income and pro forma earnings per share for the years ended December 31, 2000, 1999 and 1998 would have been as follows:
At December 31, 2000, a total of 125 million shares of common stock were reserved for issuance under stock options, stock bonus and deferred compensation plans, Series F Preferred Stock, warrants to buy 700,000 shares of Conseco common stock for $19.71 per share at anytime through September 29, 2006 and warrants to buy 10,500,000 shares of Conseco common stock for $5.75 at any time through June 2005.
The four states with the largest shares of 2000 collected premiums were California (9.6 percent), Illinois (8.0 percent), Florida (8.0 percent) and Texas (6.8 percent). No other state accounted for more than 6 percent of total collected premiums.
Based on current conditions and assumptions as to future events on all policies in force, the Company expects to amortize approximately 13 percent of the December 31, 2000, balance of cost of policies purchased in 2001, 11 percent in 2002, 9 percent in 2003, 8 percent in 2004 and 7 percent in 2005. The discount rates used to determine the amortization of the cost of policies purchased averaged 7 percent in each of the three years ended December 31, 2000.
The statutory net income (loss) of our life insurance subsidiaries was $(70.8) million, $181.1 million and $276.0 million in 2000, 1999 and 1998, respectively. Included in such net income (loss) are net realized capital gains (losses), net of income taxes, of $(200.8) million, $1.2 million and $(6.5) million in 2000, 1999 and 1998, respectively. In addition, the insurance subsidiaries pay fees and interest to Conseco or its non-life subsidiaries; such amounts totaled $264.4 million, $274.3 million and $205.1 million in 2000, 1999 and 1998, respectively.
Insurance and fee-based segment. Our insurance and fee-based segment provides supplemental health, annuity and life insurance products to a broad spectrum of customers through multiple distribution channels, each focused on a specific market segment. These products are primarily marketed through career agents, professional independent producers and direct