Since commencing operations in 1982, CNC pursued a strategy of growth through acquisitions. Primarily as a result of these acquisitions and the funding requirements necessary to operate and expand the acquired businesses, CNC amassed outstanding indebtedness of approximately $6.0 billion as of June 30, 2002. In 2001 and early 2002, we undertook a series of steps designed to reduce and extend the maturities of our parent company debt. Notwithstanding these efforts, the Company's financial position continued to deteriorate, principally due to our leveraged condition, losses experienced by our finance business and losses in the value of our investment portfolio.
Under Chapter 11 we are operating as a debtor-in-possession. As of the Petition Date, actions to collect prepetition indebtedness of the Debtors as well as other pending litigation involving the Debtors, are stayed and other contractual obligations generally may not be enforced against the Debtors. Information regarding the Chapter 11 Cases appears in Item 1. "Proceedings Under Chapter 11 of the Bankruptcy Code" of this Form 10-K.
Our income tax expense includes deferred income taxes arising from temporary differences between the financial reporting and tax bases of assets and liabilities, capital loss carryforwards and operating loss carryforwards. The net deferred tax assets totalled $1,719.6 million at December 31, 2002 (including $925.7 million of deferred tax assets related to CFC which is classified as a discontinued operation). In assessing the realization of our deferred income tax assets, we consider whether it is more likely than not that the deferred income tax assets will be realized. The ultimate realization of our deferred income tax assets depends upon generating future taxable income during the periods in which our temporary differences become deductible and before our NOLs expire. We evaluate the recoverability of our deferred income tax assets by assessing the need for a valuation allowance on a quarterly basis.
Any NOLs and other loss and credit carryovers transferred to New Conseco will be limited under the Code to a maximum amount in any one year. This amount is equal to the product of the fair market value of the loss corporation's outstanding stock immediately before the ownership change and the long term tax-exempt rate (which is published monthly by the Treasury Department and most recently was approximately 4.61 percent) in effect for the month in which the ownership change occurs. This amount will not be known until the Effective Date.
CNC and CIHC are Holding Companies and Depend on their Subsidiaries for Cash.
The ability of our insurance subsidiaries to pay dividends is subject to state insurance department regulations. These regulations generally permit dividends to be paid from earned surplus of the insurance company for any 12-month period in amounts equal to the greater of (or in a few states, the lesser of): (i) net gain from operations or net income for the prior year; or (ii) 10 percent of capital and surplus as of the end of the preceding year. Any dividends in excess of these levels require the approval of the director or commissioner of the applicable state insurance department. As described in Item 1. "Government Regulation", Bankers National Life Insurance Company and Conseco Life Insurance Company of Texas (on behalf of itself and its subsidiaries), entered into consent orders with the Commissioner of Insurance for the State of Texas on October 30, 2002. These consent orders, among other things, limit the ability of our insurance subsidiaries to pay dividends. In addition, actions that we may need to take to improve the ACLRBC ratios of our insurance subsidiaries could affect the ability of our insurance subsidiaries to pay dividends.
We set the premium rates on our health insurance policies based on facts and circumstances known at the time we issue the policies and on assumptions about numerous variables, including the actuarial probability of a policyholder incurring a claim, the severity of the claim, and the interest rate earned on our investment of premiums. In setting premium rates, we consider historical claims information, industry statistics, the rates of our competitors and other factors. If our actual claims experience proves to be less favorable than we assumed and we are unable to raise our premium rates, our financial results may be adversely affected. Our estimates of insurance liabilities assume we will be able to raise rates if future experience results in blocks of our health insurance business becoming unprofitable. We generally cannot raise our health insurance premiums in any state unless we first obtain the approval of the insurance regulator in that state. We review the adequacy of our premium rates regularly and file rate increases on our products when we believe existing premium rates are too low. It is possible that we will not be able to obtain approval for premium rate increases from currently pending requests or requests filed in the future. If we are unable to raise our premium rates because we fail to obtain approval for a rate increase in one or more states, our net income may decrease. If we are successful in obtaining regulatory approval to raise premium rates due to unfavorable actual claims experience, the increased premium rates may reduce the volume of our new sales and cause existing policyholders to allow their policies to lapse. This could result in anti-selection if healthier policyholders allow their policies to lapse. This would reduce our premium income in future periods. Increased lapse rates also could require us to expense all or a portion of the deferred policy costs relating to lapsed policies in the period in which those policies lapse, adversely affecting our financial results in that period.
We May Not Achieve the Goals of Certain Initiatives We Have Undertaken With Respect to the Restructuring of Our Principal Insurance Business.
Terrorist attacks in New York City and Washington, D.C. on September 11, 2001 adversely affected commerce throughout the United States and resulted in significant disruption to the insurance industry and significant declines and volatility in financial markets. The continued threat of terrorism within the United States and abroad, and the military action and heightened security measures in response to that threat, including the possibility of extended hostilities in Iraq, may cause additional disruptions to the insurance industry, reduced economic activity and continued volatility in markets throughout the world, which may adversely impact our financial results.
Insurance policy income is comprised of: (i) premiums earned on policies which provide mortality or morbidity coverage; and (ii) fees and other charges made against other policies. See "Premium and Asset Accumulation Product Collections" for further analysis.
Interest expense on investment borrowings decreased in 2002 while our investment borrowing activities increased. Average investment borrowings were $1,155.8 million during 2002, compared to $927.0 million during 2001 and $238.1 million during 2000. The weighted average interest rate on such borrowings were 1.3 percent, 3.3 percent and 6.6 percent during 2002, 2001 and 2000, respectively.
Net investment gains (losses), including related costs and amortization fluctuate from period to period. During 2002, 2001 and 2000, we recognized net investment losses of $597.0 million, $379.4 million and $346.5 million, respectively. The net investment losses during 2002 included: (i) $556.8 million to write down certain securities to fair value due to an other-than-temporary decline in value (including issuers who have faced significant problems: K-Mart Corp., Amerco, Inc., Global Crossing, MCI Communications, Mississippi Chemical, United Airlines and Worldcom, Inc.); and (ii) $40.2 million of net losses from the sales of investments (primarily fixed maturities) which generated proceeds of $19.5 billion. The net investment losses during 2001 included: (i) $141.9 million to recognize the impact of higher default rate assumptions on certain structured investments; (ii) $62.4 million to recognize losses on investments held in our private equity portfolio; (iii) $150.5 million to write down certain securities to fair value due to an other-than-temporary decline in value or the Company's plan to sell the securities in connection with investment restructuring activities (including issuers who have faced significant problems: Sunbeam Corp., Enron Corp., Crown Cork & Seal Company Inc., Global Crossing Ltd. and K-Mart Corp.); and (iv) $24.6 million of losses from the sales of investments (primarily fixed maturities) which generated proceeds of $24.2 billion. During 2000, we recorded $180.6 million of writedowns; $106.7 million of losses from the sales of investments; and a $59.2 million loss related to the termination of certain swap agreements.
Annuities include equity-indexed annuities and other fixed annuities sold through both career agents and professional independent producers. Pursuant to our initiatives to increase capital and focus on the sale of products that result in less strain on our statutory capital and surplus, we are taking actions to de-emphasize the sales of annuity products through professional independent producers.
Mutual fund sales decreased 56 percent, to $207.9 million in 2002, and by 41 percent, to $468.7 million, in 2001. Mutual fund sales have been adversely affected by the recent performance of the stock market and our decreased marketing efforts.
Commercial mortgage-backed securities ("CMBS") are bonds secured by commercial real estate mortgages. Commercial real estate encompasses income producing properties that are managed for economic profit. Property types include multi-family dwellings including apartments, retail centers, hotels, restaurants, hospitals, nursing homes, warehouses, and office buildings. The CMBS market currently offers high yields, strong credits, and call protection compared to similar-rated corporate bonds. Most CMBS have call protection features where borrowers are locked out from prepaying their mortgages for a stated period of time. If the borrower does prepay any or all of the loan, they will be required to pay prepayment penalties.
Total capital shown below excludes the debt of the discontinued finance segment used to fund finance receivables in both periods. Total capital, before the fair value adjustment recorded in accumulated other comprehensive loss, decreased $7.8 billion, or 70 percent, to $3.3 billion. The decrease is primarily due to the net loss realized in 2002, including the cumulative effect of an accounting change to recognize an impairment of our goodwill asset.
Shareholders' equity (deficit), excluding accumulated other comprehensive loss, decreased by $7.8 billion in 2002, to $(2.6) billion. The significant component of the decrease was our net loss of $7.8 billion. The accumulated other comprehensive income (loss) increased by $1.0 billion, principally related to the increase in the unrealized gains of our insurance companies' investment portfolio.
We seek to invest our available funds in a manner that will fund future obligations to policyholders, subject to appropriate risk considerations. We seek to meet this objective through investments that: (i) have similar characteristics to the liabilities they support; (ii) are diversified among industries, issuers and geographic locations; and (iii) make up a predominantly investment-grade fixed maturity securities portfolio. Many of our products incorporate surrender charges, market interest rate adjustments or other features to encourage persistency.
On October 22, 2002, Conseco announced that its board of directors approved a plan to seek new investors or acquirers for CFC's businesses and that it had engaged the investment banking firms of Lazard Freres & Co., LLC and Credit Suisse First Boston to pursue various alternatives, including securing new investors and/or selling CFC's three primary lines of business: (i) manufactured
as expense based on CFC's current assessments of such factors. For loans previously recorded as sales, the anticipated discounted credit losses over the expected life of the loans were reflected through a reduction in the gain-on-sale revenue recorded at the time of securitization or through impairment charges when assessments of estimated losses have changed.
Finance interest expense decreased by 8.5 percent, to $1,130.0 million, in 2002 and increased by 7.1 percent, to $1,234.4 million, in 2001. Such decrease was primarily the result of: (i) lower average borrowing rates; and (ii) decreased borrowings to fund the decreased finance receivables. CFC's average borrowing rate was 6.1 percent, 7.0 percent and 7.7 percent during 2002, 2001 and 2000, respectively. The decrease in average borrowing rates in 2002 as compared to 2001 is primarily due to the decrease in the general interest rate environment between periods and the repurchase and retirement of some of CFC's public debt.
Impairment charges represent reductions in the value of CFC's retained interests in securitization trusts (including interest-only securities and servicing rights) recognized as a loss. CFC carries interest-only securities at estimated fair value and servicing rights at the lower of cost or fair value. Fair value is determined by discounting the projected cash flows over the expected life of the receivables sold using current prepayment, default, loss, interest rate and servicing cost assumptions. CFC considers any potential payments related to the guarantees of certain lower-rated securities issued by the securitization trusts in the projected cash flows used to determine the value of its retained interests. When declines in value considered to be other than temporary occur, CFC reduces the amortized cost to estimated fair value and recognizes a loss. The assumptions used to determine new values are based on the internal evaluations of CFC's management. Under current accounting rules (pursuant to Emerging Issues Task Force Issue No. 99-20, "Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets" ("EITF 99-20")) which were adopted on July 1, 2000, declines in the value of CFC's retained interests are recognized 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. The assumptions used to determine new values for CFC's retained interests are based on internal evaluations. Although CFC believes its methodology is reasonable, many of the assumptions and expectations underlying CFC's determination may prove inaccurate, in which case there may be an adverse effect on CFC's financial results.
As a result of the requirements of EITF 99-20 and the assumption changes described above, CFC recognized an impairment charge of $1,077.2 million in 2002 for the retained interests. CFC also recognized a $336.5 million increase in the valuation allowance related to its servicing rights as a result of the changes in assumptions in 2002. The valuation allowance related to the servicing rights increased as a result of changes to the expected future cost of servicing the finance receivables. The levels of delinquent and defaulting loans have caused servicing costs to increase. In addition, future servicing costs are expected to increase as the portfolio ages. Such assumptions reflect the subordination of the servicing fees to other cash flows in certain securitization transactions. In addition, CFC recognized impairment charges of: (i) $29.3 million to establish a valuation allowance for advances CFC was required to make to the securitization trusts which are estimated to be uncollectible; and (ii) $6.9 million to establish a liability of guarantee payments due to certain holders of lower-rated securities issued by the securitization trusts which CFC was unable to pay.
On December 17, 2002 (the "Petition Date"), CNC, CIHC, CTIHC, Inc. and Partners Health Group, Inc. (collectively, the "Debtors") filed voluntary petitions for reorganization under Chapter 11 of Title 11 of the United States Bankruptcy Code (the "Bankruptcy Code") in the United States Bankruptcy Court (the "Bankruptcy Court") for the Northern District of Illinois. The following discussion provides general background information regarding the Debtors' Chapter 11 cases, but is not intended to be a comprehensive summary. The Debtors are currently operating their business as debtors-in-possession pursuant to the Bankruptcy Code. As debtors-in-possession, the Debtors are authorized to continue to operate as ongoing businesses, but may not engage in transactions outside the ordinary course of business without approval of the Bankruptcy Court, after notice and an opportunity for a hearing. The Company's insurance subsidiaries are separate legal entities and are not included in the petitions filed by the Debtors. On March 18, 2003, the Bankruptcy Court approved the Debtor's Second Amended Joint Plan of Reorganization (the "Plan"), and the Second Amended Disclosure Statement (the "Disclosure Statement").
Overall, CFC is seeking to maximize the value obtainable from all restructuring transactions it contemplates as part of its Chapter 11 filing. However, there can be no assurance that any such transaction will be completed. Moreover, if such a transaction is completed, no proceeds resulting therefrom will be available to satisfy any creditors, other than creditors, of CFC or parties with a security interest in CFC's assets.
When we replace an existing insurance contract with another insurance contract with substantially different terms, all unamortized cost of policies produced related to the replaced contract is immediately written off. When we replace an existing insurance contract with another insurance contract with substantially similar terms, we continue to defer the cost of policies produced associated with the replaced contract. Such costs related to the replaced contracts which continue to be deferred were $7.6 million, $10.0 million and $5.6 million in 2002, 2001 and 2000, respectively.
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 contractholders. 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.
Condensed Consolidating Statement of Cash Flows for the year ended December 31, 2002 (Dollars in millions)
In October 2001, we also entered into new interest rate swap agreements to replace the terminated agreements which convert the fixed rate on our 10.75% senior notes to a variable rate based on LIBOR plus 5.7525 percent. At December 31, 2001, "notes payable-direct corporate obligations" was decreased by $13.5 million to reflect the estimated fair value of such interest rate swap agreements. Such interest rate swap agreements were terminated in April 2002 generating cash proceeds of $3.5 million. Such amount represented $11.9 million of cash due to the Company pursuant to the terms of the swaps, net of $8.4 million which represented the fair value of the interest rate swaps on the date of termination. The $8.4 million will be amortized as additional interest expense over the remaining life of our senior notes.
At December 31, 2002, our corporate securities (including below-investment grade) were concentrated in the following industries:
The following summarizes the investments sold at a loss during 2002 which had been continuously in an unrealized loss position exceeding 20 percent of the amortized cost basis prior to the sale for the period indicated:
During 2002, we recorded writedowns totaling $10.8 million on a fixed maturity investment in an Australian nickel mining company. The construction costs of the processing plant at this start-up nickel project were higher than anticipated and the plant's ultimate production capacity did not meet projected levels. Initially, the project's equity sponsors supported this project through additional equity and cash infusions. However, during the first six months of 2002, the equity sponsors notified bond investors that they were no longer willing to support the project without a restructuring of the issuer's debt. As a result, we believe the decline in market value of this security is other than temporary.
Our investment strategy is to maximize investment income and total investment return through active investment management. Accordingly, we may sell securities at a gain or a loss to enhance the total return of the portfolio as market opportunities change. While we have both the ability and intent to hold securities with unrealized losses until they mature or recover in value, we may sell securities at a loss in the future because of actual or expected changes in our view of the particular investment, its industry, its type or the general investment environment.
The income tax expense (benefit) recorded in 2002 has been allocated entirely to continuing operations before the following items: minority interest, discontinued operations, extraordinary gain, cumulative effect of accounting change and other comprehensive income. This accounting treatment is required because the calculation of income tax expense is the same, both "with and without" the items other than continuing operations discussed above.
In addition, the Company and its subsidiaries are involved on an ongoing basis in other lawsuits and arbitrations (including purported class actions) related to their operations. These actions include one action brought by the Texas Attorney General regarding long-term care policies, two purported nationwide class actions involving claims related to "vanishing premiums," and two purported nationwide class actions involving claims related to "modal premiums" (the alleged imposition and collection of insurance premium surcharges in excess of stated annual premiums. The ultimate outcome of all of these other legal matters pending against the Company or its subsidiaries cannot be predicted, and, although such lawsuits are not expected individually to have a material adverse effect on the Company, such lawsuits could have, in the aggregate, a material adverse effect on the Company's consolidated financial condition, cash flows or results of operations.
The balance sheet at December 31, 2002, includes: (i) accruals of $11.5 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, 2002; and (ii) receivables of $7.5 million that we estimate will be recovered through a reduction in future premium taxes as a result of such assessments. At December 31, 2001, such guaranty fund assessment related accruals were $18.7
In accordance with the terms of the Company's former Chief Executive Officer's employment agreement, Bankers Life & Casualty Company, a wholly-owned subsidiary of the Company, is the guarantor of the former executive's nonqualified supplemental retirement benefit. The liability for such benefit at December 31, 2002 was $14.8 million and is included in the caption "Other liabilities" in the liability section of the consolidated balance sheet.
In April 2000, the Company and the holder of the Redeemable Hybrid Income Overnight Shares ("RHINOS") issued in 1999 agreed to the repurchase by the Company of the RHINOS at their $250 million par value. The Company recognized an extraordinary loss of $3.3 million (net of income taxes of $1.8 million) in the second quarter of 2000 related to the redemption.
The following table summarizes the special charges incurred by the Company during 2002, which are further described in the paragraphs which follow (dollars in millions):
The following table summarizes the special charges incurred by the Company during 2001, which are further described in the paragraphs which follow (dollars in millions):
Litigation expenses primarily include the cost and proposed settlement related to our securities litigation class action lawsuit. Such lawsuit is further discussed in the note to the consolidated financial statements entitled "Other Disclosures".
During 2000, we incurred $9.9 million of non-deferrable advisory and professional fees primarily related to the restructuring of our bank credit facilities.
During the third quarter of 2000, we sold asset-based loans with a carrying value of $63.9 million in whole loan sale transactions. We recognized a loss of $15.2 million on these sales.
The following summarizes selected statement of operations information of CFC for the years ended December 31, 2002, 2001 and 2000:
The following table summarizes quantitative information about delinquencies, net credit losses, and components of managed finance receivables:
At December 31, 2002, actively managed fixed maturities at fair value included $277.8 million of subordinated debt and accrued interest in the GM Building partnership. Other invested assets included our $15 million equity investment at December 31, 2002. The investments in subordinated debt and equity represent our maximum exposure to investment loss as a result of our involvement in the partnership. As more fully described in the note to the consolidated financial statements entitled "Other Disclosures", the other investor in the partnership has filed a lawsuit against Conseco.