Life insurance operation earnings increase when Conseco: (i) improves the profitability of owned companies by increasing their sales, investment income or product profitability, or by reducing their expenses; (ii) increases its ownership interest in the partially owned companies; or (iii) acquires an interest in additional companies.
In addition to its life insurance acquisitions, two wholly owned subsidiaries (Conseco Private Capital Group and Conseco Global Investments) make direct strategic investments in growing companies, providing these firms with the capital or financing they need to continue their growth, make acquisitions or realize the potential of their businesses. When these investments are sold, Conseco reports the gains in this segment.
Interest expense on notes payable decreased over the last three years. Debt was reduced through scheduled and unscheduled principal payments totaling $16.0 million, $11.0 million and $130.0 million in 1995, 1994 and 1993, respectively.
Interest expense on annuities and financial products increased 18 percent in 1995 over the 1994 periods primarily due to: (i) a larger block of annuity business in force in 1995; and (ii) the expensing of the first year interest rate bonuses of approximately $5.9 million in 1995 on policies issued prior to the Acquisition date as a result of the application of purchase accounting on the Acquisition date. Prior to the Acquisition date, such first year interest rate bonuses (related to policies issued prior to the Acquisition date) were capitalized as a cost of policies produced. Interest expense on annuities and financial products increased 12 percent, to $220.1 million in the 1994 periods from $195.9 million in 1993, primarily due to a larger block of annuity business in force in 1994, higher crediting rates, and in the fourth quarter of 1994, the expensing of first year interest rate bonuses on policies issued prior to the Acquisition date on which interest had previously been capitalized as a cost of policies produced. At December 31, 1995, 1994 and 1993, the weighted average crediting rate for the Company's annuity liabilities, excluding interest bonuses guaranteed for the first year of the annuity contract, was 5.3 percent.
Minority interest for periods prior to September 30, 1994, represents dividends on preferred stock of a subsidiary of AGP. After that date, minority interest includes such dividends and the portion of earnings applicable to other owners of AGP.
The following table summarizes investment yields earned over the past three years, including AGP from the Acquisition date, WNC until the date of its deconsolidation (effective January 1, 1994), and CCP upon its consolidation (effective January 1, 1995).
Conseco's actively managed fixed maturity portfolio at December 31, 1995, was comprised primarily of 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.
In the fourth quarter of 1995, AGP: (i) sold 2,142,857 shares of its common stock for $30.0 million in a private placement transaction; (ii) made a $30.0 million unscheduled principal payment on the then outstanding senior term loan; (iii) executed a new credit facility to provide for aggregate borrowings of up to $225.0 million (the "Senior Credit Facility"); and (iv) borrowed $125 million under the Senior Credit Facility and repaid in full the remaining principal balance under the then outstanding senior term loan. Eighty percent of the common shares sold were purchased by Partnership II and the remaining shares were purchased by other holders of AGP's common stock. The proceeds from the issuance of the shares were used to make a $30.0 million capital contribution to ALHC to enable ALHC to prepay its prior senior term loan. The general terms and conditions of the Senior Credit Facility are discussed in note 8 of the accompanying consolidated financial statements. AGP believes the Senior Credit Facility provides greater flexibility to ALHC than the prior senior term loan because the Senior Credit Facility: (i) makes available additional working capital by increasing the aggregate maximum borrowings to $225.0 million; (ii) provides for a revolving credit facility; (iii) has more favorable interest rates; (iv) has less restrictive covenants; and (v) has a more favorable repayment schedule.
ALHC needs liquidity primarily to service its debt, pay dividends on two series of preferred stock described below, pay dividends to AGP on common stock and pay operating expenses. The primary sources of funds for these payments are: (i) dividends on the capital stock of American Life and Casualty; (ii) interest payments on surplus notes from American Life and Casualty; and (iii) payments from American Life and Casualty and Vulcan Life under a tax sharing agreement.
Dividends on ALHC's common stock are limited by: (i) the rights of holders of its preferred stock to receive cumulative dividends in full before any dividends may be paid on common stock; and (ii) the covenants of the Senior Credit Facility. Under the most restrictive covenants of the Senior Credit Facility, ALHC is limited to paying dividends of $3.0 million per year to AGP. In the event that AGP is required to pay unpaid dividends on the 1988 Series Preferred Stock, limitations in the Senior Credit Facility would require AGP (absent a waiver from the lenders) to seek sources of funds other than dividends from ALHC or borrowing. AGP believes it will have sufficient resources to pay such preferred stock dividends. ALHC currently has redeemable preferred stock outstanding, on which aggregate dividends of $8.7 million are payable annually. The two series of redeemable preferred stock outstanding must be redeemed in 2007 and 2008 at their respective par values of $69.0 million and $30.0 million. ALHC holds zero coupon U.S. Treasury securities in escrow which will provide adequate funds for the redemption of the preferred shares on their respective mandatory redemption dates.
We have audited the accompanying consolidated balance sheet of Conseco, Inc. and Subsidiaries as of December 31, 1995 and 1994, and the related consolidated statements of operations, shareholders' equity, and cash flows for each of the three years in the period ended December 31, 1995. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
Trading account - fixed maturity and equity securities that we buy principally for the purpose of selling in the near term. We carry trading account securities at estimated fair value. We include any unrealized gain or loss in net trading income. We did not hold any trading account securities at December 31, 1995.
Unrealized gains and losses and the related adjustments described above have no effect on our earnings. We record them, net of tax, to shareholders' equity. The following table summarizes the effect of these adjustments on Conseco's actively managed fixed maturities as of December 31, 1995:
- For traditional life and accident and health products, in relation to future anticipated premium revenue, using the same assumptions that are used in calculating the insurance liabilities.
We evaluate annually the recoverability of the unamortized balance of the cost of policies produced. For universal life-type contracts and investment-type contracts, we increase or decrease the accumulated amortization whenever there is a material change in the estimated gross profits expected over the life of a block of business. We do this in order to maintain a constant relationship between the cumulative amortization and the present value (discounted at the rate of interest that accrues to the policies) of expected gross profits. For most other contracts, we reduce the unamortized asset balance (by a charge to income) only when the present value of future cash flows, net of the policy liabilities, is insufficient to recover the asset balance.
Interest rate swaps. Estimated fair values of interest rate swap contracts are based on estimates of fair value from dealers which represent the net value or the cost of terminating the contracts at the balance sheet date.
The following tables summarize financial information of CCP for the periods during which CCP and its subsidiaries were included in Conseco's financial statements on the equity basis:
At December 31, 1995, Conseco had federal income tax loss carryforwards of $408.3 million available (subject to various statutory restrictions) for use on future tax returns. Portions of these carryforwards begin expiring in 1999. Of the loss carryforwards, $41.8 million may be used to offset income only from the non-life insurance companies and $51.0 million may be used to offset income only from AGP's life insurance subsidiaries. None of the carryforwards are available to reduce the tax provision for financial reporting purposes. With respect to determining that the Company's net operating loss carryforward will be fully utilized, the Company is relying upon its past history of earnings.
The Company rents office space, equipment and computer software under noncancellable operating leases. Rental expense during 1995, 1994 and 1993, amounted to $20.8 million, $18.8 million and $11.9 million, respectively. Future required minimum rental payments as of December 31, 1995, were as follows (dollars in millions):
Prior to the Acquisition, AGP entered into several contracts to hedge interest rate risks. At the date of the Acquisition, these contracts had ceased to effectively hedge the risks and were recorded at their fair value pursuant to purchase accounting. All such contracts were terminated in 1994 and 1995, with no significant gain or loss recognized. The contracts were carried in the balance sheet as a liability at their fair value of $10.6 million at December 31, 1994.
Authorized preferred stock is 20,000,000 shares. Conseco issued 100,000 shares of $55 Series B Redeemable Preferred Stock ("Series B preferred stock") with a stated value of $50.0 million ($500 per share) in 1987 and redeemed all of the shares at stated value in 1993. Conseco issued 5,750,000 shares of Series D Cumulative Convertible Preferred Stock ("Series D preferred stock") with a stated value of $287.5 million ($50 per share) in January 1993 in a public offering. Annual dividends of $3.25 on each Series D preferred share are cumulative from the date of original issue and are payable quarterly. The Series D preferred stock is convertible at the holder's option into shares of Conseco's common stock at a conversion price of $31.875 per share, equivalent to a ratio of approximately 1.5686 shares of common stock for each share of preferred stock. Proceeds from the offering of approximately $278.5 million (after underwriting and other associated costs) were used to redeem the Series B preferred stock and were added to the Company's general funds. During 1993, 274 Series D preferred shares were converted to 430 common shares. In 1994 and 1995, no Series D preferred shares were converted to common shares. In December 1994, the Company repurchased 80,000 Series D preferred shares in open market transactions in connection with its stock repurchase program at a total cost of $3.3 million. Such preferred shares would have been convertible into 125,490 shares of common stock.
In March 1996, Conseco and Life Partners Group, Inc. ("LPG") signed a definitive merger agreement, whereby LPG would become a wholly owned subsidiary of Conseco. In the merger, each of the issued and outstanding shares of LPG common stock would be converted into the right to receive a fraction of a share of Conseco common stock determined by dividing $21.00 by the average closing price of Conseco common stock during the 20 trading days ending two days prior to the merger (such fraction to be not more than 0.7000 nor less than 0.5833). The total value of the transaction would be approximately $850 million, including $600 million of common stock to be issued by Conseco and $250 million of existing LPG long-term debt to be assumed by Conseco. Consummation of the merger, which is subject to customary terms and conditions, including approval by the stockholders of both LPG and Conseco and regulatory approvals, is expected before the end of June 1996. A termination fee of $20 million is payable under certain circumstances by either party if its shareholders do not approve the transaction. At September 30, 1995, LPG had total assets of $5.1 billion and total shareholders' equity of $.4 billion.