Management's discussion and analysis reviews the consolidated financial condition of Conseco at December 31, 1996 and 1995, the consolidated results of operations for the three years ended December 31, 1996, and, where appropriate, factors that may affect future financial performance. This discussion should be read in conjunction with the accompanying consolidated financial statements, notes thereto and selected financial data.
Total revenues include net investment gains (losses) of $30.4 million in 1996, $188.9 million in 1995 and ($30.5) million in 1994. Excluding net investment gains (losses), total revenues were $3.0 billion in 1996, up 11 percent from $2.7 billion in 1995. Total revenues in 1996 include: (i) LPG revenues after July 1, 1996, the effective date of the LPG Merger; and (ii) restructuring income of $30.4 million, primarily arising from the sale of Conseco's investment in Noble Broadcast Group, Inc. Total revenues excluding net investment gains (losses) were up 42 percent in 1995, from $1.9 billion in 1994. Total revenues in 1995 include: (i) a full year of revenues from ALH, which was acquired on September 29, 1994; (ii) a full year of the revenues of CCP's subsidiaries, which Conseco began to consolidate effective January 1, 1995; and (iii) restructuring income of $15.2 million. Total revenues in 1994 include restructuring income of $80.8 million and equity in earnings of WNC and CCP of $64.9 million.
The following tables and narratives summarize the Company's results of operations by business segment.
(b) Excludes variable annuity products where the credited amount is based on investment income from segregated investments.
Variable annuity collected premiums increased 42 percent to $81.5 million, in 1996. Variable annuities offer contract holders a rate of return based upon the specific investment portfolios into which premiums may be directed. The popularity of such annuities has increased recently as a result of the desire of investors to invest in common stocks. In addition, in 1996 Conseco began to offer more investment options for variable annuity deposits and expanded its marketing efforts, which resulted in increased collected premiums. Profits on variable annuities are derived from the fees charged to contract holders, rather than from the investment spread.
Individual accident and health premiums decreased 15 percent in 1996 and increased 6.8 percent in 1995. Such fluctuations reflect rate increases, policy lapses and the effect of the various acquisition transactions that occurred in 1996, 1995 and 1994. Such premiums collected in 1996 include $9.8 million collected by LPG after the LPG Merger. Such premiums collected in 1995 include $31.5 million collected by CCP after its consolidation and $3.6 million collected by ALH.
At December 31, 1996, fixed maturity investments included $5.5 billion of mortgage-backed securities (32 percent of the fixed maturity security portfolio). The yield characteristics of mortgage-backed securities differ from those of traditional fixed-income securities. Interest and principal payments occur more frequently, often monthly. Mortgage-backed securities are subject to risks associated with variable prepayments. Prepayment rates are influenced by a number of factors that cannot be predicted with certainty, including the relative sensitivity of the underlying mortgages backing the assets to changes in interest rates; a variety of economic, geographic and other factors; and the repayment priority of the securities in the overall securitization structures.
(e) Represents the ratio of debt and the Company-obligated mandatorily redeemable preferred securities of subsidiary trusts to the sum of shareholders' equity, notes payable, minority interest and the Company-obligated mandatorily redeemable preferred securities of subsidiary trusts.
The parent company is a legal entity, separate and distinct from its subsidiaries, and has no business operations. The parent company needs cash for: (i) principal and interest on debt; (ii) dividends on preferred and common stock; (iii) distributions on the Company-obligated mandatorily redeemable preferred stock of subsidiary trusts; (iv) holding company administrative expenses; (v) income taxes; and (vi) investments in subsidiaries. The primary sources of cash to meet these obligations include statutorily permitted payments from Conseco's life insurance subsidiaries including: (i) dividend payments; (ii) tax sharing payments; and (iii) fees for services provided. The parent company may also obtain cash by: (i) issuing debt or equity securities; (ii) borrowing additional amounts under its revolving credit agreement, as described in note 8 to the consolidated financial statements; or (iii) selling all or a portion of its subsidiaries. These sources have historically provided adequate cash flow to fund: (i) the needs of the parent company's normal operations; (ii) internal expansion, acquisitions and investment opportunities; and (iii) the retirement of debt and equity. In 1996, Conseco also issued new shares of its common stock for all or a portion of the cost to acquire LPG, ATC, THI and BLH.
The ability of Conseco's insurance subsidiaries to pay dividends is subject to state insurance department regulations. These regulations generally permit dividends to be paid for any twelve-month period in amounts equal to the greater of (or in a few states, the lesser of): (i) net gain from operations; or (ii) 10 percent of 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. The amount of dividends that the Company's insurance subsidiaries could pay in 1997 without prior approval is approximately $151.0 million.
If renewal premiums collected, investment spread, investment gains or losses, mortality and morbidity costs or other factors differ from our expectations, we adjust our amortization of the cost of policies purchased. For example, the sale of a fixed maturity investment may result in a gain (or loss). If the sale proceeds are reinvested at a lower (or higher) earnings rate, there may also be a reduction (or increase) in our future investment spread. We must then increase (or decrease) amortization to reflect the change in the incidence of expected cash flows. We adjust amortization consistent with the methods used with the cost of policies produced (described below).
The cost of policies purchased related to acquisitions completed prior to November 19, 1992 (representing 12 percent of the balance of cost of policies purchased at December 31, 1996) is amortized under a slightly different method than that described above. However, the effect of the different method on 1996 net income was insignificant.
On September 29, 1994, Partnership II completed the acquisition of ALH. ALH's former stockholders received $15.25 in cash per common equivalent share. They also received a contingent payment right to receive up to another $2.00 in cash per common equivalent share (the "Contingent Consideration"), based on the outcome of ALH's pending litigation against the U.S. Government concerning ALH's former savings bank subsidiary (the "ALH Litigation").
The Acquisition and related transactions were funded with: (i) $45.9 million of cash contributions from Partnership II (including $7.4 million provided by Conseco, $1.8 million by BLH, and $1.8 million by CCP); (ii) $57.0 million in cash from the sale in a private placement of payment-in-kind preferred stock (the "1994 Series PIK Preferred Stock") (including $25.9 million purchased by BLH and $24.0 million purchased by CCP, $3.0 million of which was sold by CCP in December 1994); (iii) $150.0 million in cash from the sale in a public offering of 11-1/4% Senior Subordinated Notes due 2004 (the "Senior Subordinated Notes"); and (iv) $200.0 million in cash from a senior secured loan (the "Senior Term Loan"). The sources and uses of this financing are summarized below (dollars in millions):
Investments in mortgage-backed securities at December 31, 1996, included collateralized mortgage obligations ("CMOs") of $2,766.6 million and mortgage-backed pass-through securities of $2,748.6 million. CMOs are securities backed by pools of pass-through securities and/or mortgages that are segregated into sections or "tranches." These securities provide for sequential retirement of principal, rather than the pro rata share of principal return that occurs through regular monthly principal payments on pass-through securities.
As part of its investment strategy, the Company enters into reverse repurchase agreements and dollar-roll transactions to increase its return on investments and improve its 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. These transactions are accounted for as short-term collateralized borrowings. Such borrowings averaged approximately $424.7 million during 1996 (compared to an average of $393.7 million during 1995) and were collateralized by investment securities with fair values approximately equal to the loan value. The weighted average interest rate on short-term collateralized borrowings was 5.2 percent in 1996 and 5.6 percent in 1995. The primary risk associated with short-term collateralized borrowings is that the counterparty will be unable to perform under the terms of the contract. The Company's exposure is limited to the excess of the net replacement cost of the securities over the value of the short-term invesments (which was not material at December 31, 1996). The Company believes that the counterparties to its reverse repurchase and dollar roll agreements are financially responsible and that the counterparty risk is minimal.
Prior to January 1, 1995, Conseco's investment in CCP was accounted for under the equity method because Conseco did not control CCP's operations. Conseco's investment in WNC was accounted for under the equity method during 1994, prior to the sale of our remaining interest in WNC in December 1994.
(2) At December 31, 1995, notes payable with a carrying value of $584.7 million (consisting of borrowings under revolving credit agreements of $235.0 million; subordinated notes due 2004 of $150.0 million; other debt of $195.0 million; and unamortized discount and issuance costs of $4.7 million) were notes payable of affiliates, which were not direct obligations of Conseco. As a result of the ALH Stock Purchase and the BLH Merger, such notes payable became direct obligations of Conseco.
Zero coupon U.S. Government bonds have been placed in an escrow account to be used for the future redemption of the $2.16 Preferred Shares and the $2.32 Preferred Shares on or before their mandatory redemption dates. The aggregate redemption values and the maturity dates of such bonds correspond to the redemption values (excluding cumulative unpaid dividends) and the mandatory redemption dates of the $2.16 Preferred Shares and the $2.32 Preferred Shares. At December 31, 1996, the bonds had an amortized cost of $45.6 million and an estimated fair value of $49.1 million.
During 1996, the Company repurchased preferred stock of ALH with a value of $12.6 million and acquired 260,000 shares of the $2.32 Preferred Stock in the LPG Merger.
Based on current conditions and assumptions as to future events on all policies in force, the Company expects to amortize approximately 11 percent of the December 31, 1996, balance of cost of policies purchased in 1997, 11 percent in 1998, 10 percent in 1999, 8 percent in 2000, and 8 percent in 2001. The discount rates used to determine the amortization of the cost of policies purchased prior to November 19, 1992, ranged from 15 percent to 20 percent during the three-year period ended December 31, 1996. The discount rates used to determine the amortization of the cost of policies purchased ranged from 4 percent to 8 percent and averaged 5.5 percent.
On December 15, 1996, Conseco and Pioneer Financial Services, Inc. ("PFS") entered into an Agreement and Plan of Merger (the "PFS Merger Agreement") pursuant to which PFS will become a wholly owned subsidiary of Conseco (the "PFS Merger"). Under the PFS Merger Agreement, each of the approximately 16.9 million shares of PFS common stock and common stock equivalents would be converted into the right to receive a fraction of a share of Conseco common stock having a value between $25.00 and $28.00, calculated as follows: (i) if the Conseco/PFS Share Price (as defined below) is greater than or equal to $28.00 per share and less than or equal to $31.36 per share, .89280 of a share of Conseco common stock; (ii) if the Conseco/PFS Share Price is less than $28.00 per share, the fraction (rounded to the nearest ten-thousandth) of a share of Conseco common stock determined by dividing $25.00 by the Conseco/PFS Share Price; or (iii) if the Conseco/PFS Share Price is greater than $31.36 per share, the fraction (rounded to the nearest ten-thousandth) of a share of Conseco common stock determined by dividing $28.00 by the Conseco/PFS Share Price. The "Conseco/PFS Share Price" shall be equal to the average of the closing prices of the Conseco common stock on the NYSE Composite Transactions Reporting System for the ten trading days immediately preceding the second trading day prior to the date of the PFS Merger. Assuming each PFS common and common equivalent share is exchanged for the right to receive a fraction of a share of Conseco common stock determined based on a Conseco/PFS Share Price that exceeds $28.00 per share (such price being exceeded on March 14, 1997), Conseco will issue 8.7 million shares of Conseco common stock with a value of approximately $352.4 million to acquire the PFS common stock. In addition, Conseco will assume notes payable of PFS of $27.8 million and the 6 1/2% Convertible Subordinated Notes due 2003 of PFS, which will be convertible into an assumed 3.0 million shares of Conseco common stock with a value of approximately $120.7 million.