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<SEC-DOCUMENT>0001224608-06-000006.txt : 20060315
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<ACCEPTANCE-DATETIME>20060315163604
ACCESSION NUMBER: 0001224608-06-000006
CONFORMED SUBMISSION TYPE: 10-K
PUBLIC DOCUMENT COUNT: 9
CONFORMED PERIOD OF REPORT: 20051231
FILED AS OF DATE: 20060315
DATE AS OF CHANGE: 20060315
FILER:
COMPANY DATA:
COMPANY CONFORMED NAME: CONSECO INC
CENTRAL INDEX KEY: 0001224608
STANDARD INDUSTRIAL CLASSIFICATION: ACCIDENT & HEALTH INSURANCE [6321]
IRS NUMBER: 753108137
STATE OF INCORPORATION: DE
FISCAL YEAR END: 1231
FILING VALUES:
FORM TYPE: 10-K
SEC ACT: 1934 Act
SEC FILE NUMBER: 001-31792
FILM NUMBER: 06688685
BUSINESS ADDRESS:
STREET 1: 11825 N PENNSYLVANIA ST
CITY: CARMEL
STATE: IN
ZIP: 46032
BUSINESS PHONE: 3178176100
MAIL ADDRESS:
STREET 1: 11825 NORTH PENNSYLVANIA STREET
CITY: CARMEL
STATE: IN
ZIP: 46032
</SEC-HEADER>
<DOCUMENT>
<TYPE>10-K
<SEQUENCE>1
<FILENAME>form10-k.txt
<DESCRIPTION>FORM 10-K
<TEXT>
================================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K
[X] Annual report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the fiscal year ended December 31, 2005 or
[ ] Transition report pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934 [No Fee Required]
For the transition period from to
------ ------
Commission file number: 001-31792
Conseco, Inc.
Delaware No. 75-3108137
- ------------------------ -------------------------------
State of Incorporation IRS Employer Identification No.
11825 N. Pennsylvania Street
Carmel, Indiana 46032 (317) 817-6100
- -------------------------------------- --------------
Address of principal executive offices Telephone
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
-------------------
Common Stock, par value $0.01 per share
Series A Warrants
Class B Mandatorily Convertible Preferred Stock, par value $0.01 per share
Securities registered pursuant to Section 12(g) of the Act: None
Indicate by check mark if the registrant is a well-known seasoned issuer,
as defined in Rule 405 of the Securities Act. Yes [X] No [ ]
Indicate by check mark if the registrant is not required to file reports
pursuant to Section 13 or 15(d) of the Act. Yes [ ] No [X]
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days: Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
Indicate by check mark whether the Registrant is a large accelerated filer,
an accelerated filer or a non-accelerated filer (see definitions in Rule 12b-2
of the Exchange Act). Large accelerated filer [X] Accelerated filer [ ]
Non-accelerated filer [ ]
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12b-2 of the Exchange Act): Yes [ ] No [X]
At June 30, 2005, the last business day of the Registrant's most recently
completed second fiscal quarter, the aggregate market value of the Registrant's
common equity held by nonaffiliates was approximately $3,291,922,000.
Indicate by check mark whether the Registrant has filed all documents and
reports required to be filed by Section 12, 13 or 15(d) of the Securities
Exchange Act of 1934 subsequent to the distribution of securities under a plan
confirmed by a court. Yes [X] No [ ]
Shares of common stock outstanding as of February 27, 2006: 151,520,608
DOCUMENTS INCORPORATED BY REFERENCE: Portions of the Registrant's
definitive proxy statement for the 2006 annual meeting of shareholders are
incorporated by reference into Part III of this report.
================================================================================
<PAGE>
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
PART I
<S> <C> <C>
Item 1. Business of Conseco......................................................... 3
Item 1A. Risk Factors................................................................ 20
Item 1B. Unresolved Staff Comments................................................... 30
Item 2. Properties.................................................................. 30
Item 3. Legal Proceedings........................................................... 31
Item 4. Submission of Matters to a Vote of Security Holders......................... 32
Executive Officers of the Registrant........................................ 32
Part II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters
and Issuer Purchases of Equity Securities................................... 33
Item 6. Selected Consolidated Financial Data........................................ 34
Item 7. Management's Discussion and Analysis of Consolidated
Financial Condition and Results of Operations............................... 35
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.................. 79
Item 8. Consolidated Financial Statements and Supplementary Data.................... 80
Item 9. Changes in and Disagreements with Accountants and
Financial Disclosure........................................................ 152
Item 9A. Controls and Procedures..................................................... 152
Item 9B. Other Information........................................................... 153
Part III
Part IV
Item 15. Exhibits and Financial Statement Schedules.................................. 153
</TABLE>
2
<PAGE>
PART I
ITEM 1. BUSINESS OF CONSECO.
Conseco, Inc., a Delaware corporation ("CNO"), is the holding company for a
group of insurance companies operating throughout the United States that
develop, market and administer supplemental health insurance, annuity,
individual life insurance and other insurance products. CNO became the successor
to Conseco, Inc., an Indiana corporation ("Old Conseco" or our "Predecessor"),
in connection with our bankruptcy reorganization. The terms "Conseco," the
"Company," "we," "us," and "our" as used in this report refer to CNO and its
subsidiaries and, unless the context requires otherwise, Old Conseco and its
subsidiaries.
We focus on serving the senior and middle-income markets, which we believe
are attractive, high growth markets. We sell our products through three
distribution channels: career agents, professional independent producers (some
of whom sell one or more of our product lines exclusively) and direct marketing.
As of December 31, 2005, we had shareholders' equity of $4.5 billion and assets
of $31.6 billion. For the year ended December 31, 2005, we had revenues of $4.3
billion and net income of $324.9 million.
We conduct our business operations through two operating segments, which
are defined on the basis of product distribution, and a third segment comprised
of businesses in run-off as follows:
o Bankers Life, which consists of the businesses of Bankers Life and
Casualty Company ("Bankers Life and Casualty") and Colonial Penn Life
Insurance Company ("Colonial Penn"). Bankers Life and Casualty markets
and distributes Medicare supplement insurance, life insurance, long-term
care insurance and certain annuity products to the senior market through
approximately 4,800 exclusive career agents and sales managers. Colonial
Penn markets graded benefit and simplified issue life insurance directly
to consumers through television advertising, direct mail, the internet
and telemarketing. Both Bankers Life and Casualty and Colonial Penn
market their products under their own brand names.
o Conseco Insurance Group, which markets and distributes specified disease
insurance, Medicare supplement insurance, and certain life and annuity
products to the senior and middle-income markets through over 500
independent marketing organizations ("IMOs") that represent over 6,000
producing independent agents. This segment markets its products under
the "Conseco" brand.
o Other Business in Run-off, which includes blocks of business that we no
longer market or underwrite and are managed separately from our other
businesses. This segment consists of long-term care insurance sold in
prior years through independent agents and major medical insurance.
We also have a corporate segment, which consists of holding company
activities and certain noninsurance company businesses that are not related to
our operating segments. See the note to the consolidated financial statement
entitled "Business Segments".
OUR EMERGENCE FROM BANKRUPTCY
On December 17, 2002, Old Conseco and certain of its non-insurance company
subsidiaries filed voluntary petitions for relief under Chapter 11 of Title 11
of the United States Bankruptcy Code in the United States Bankruptcy Court for
the Northern District of Illinois, Eastern Division (the "Bankruptcy Court"). We
emerged from bankruptcy protection under the Sixth Amended Joint Plan of
Reorganization (the "Plan"), which was confirmed pursuant to an order of the
Bankruptcy Court on September 9, 2003, and became effective on September 10,
2003 (the "Effective Date"). Upon the confirmation of the Plan, we implemented
fresh start accounting in accordance with Statement of Position 90-7 "Financial
Reporting by Entities in Reorganization under the Bankruptcy Code" ("SOP 90-7").
References to "Predecessor" refer to Old Conseco prior to August 31, 2003.
References to "Successor" refer to the Company on and after August 31, 2003,
after the effects of fresh start reporting. Our accounting and actuarial systems
and procedures are designed to produce financial information as of the end of a
month. Accordingly, for accounting convenience purposes, we applied the effects
of fresh start accounting on August 31, 2003. The activity of the Company for
the period from September 1, 2003 through September 10, 2003 was therefore
included in the Successor's statement of operations and excluded from the
Predecessor's statement of operations.
3
<PAGE>
OUR STRATEGIC DIRECTION AND 2006 PRIORITIES
It is our vision to be a premier provider of insurance products to
America's middle-income families and seniors. Our insurance companies help
protect them from financial adversity: Medicare supplement, long-term care,
cancer, heart/stroke and accident policies protect people against unplanned
expenses; annuities and life products help people plan for their financial
future. We believe our products meet the needs of our target markets.
We believe our middle market target is underserved by a majority of financial
service providers. Strong trends are impacting middle market consumers:
o Increased life expectancy.
o Aging U.S. population.
o Discontinuance or reduction in benefits of pension plans.
o Rising healthcare costs.
o Projected gap between the annual cost of Social Security and the
program's tax revenue under current law.
We believe our multiple distribution channels provide excellent access for the
consumer:
o Consumers may access our products with an agent.
- Through our career agents in the Bankers Life segment.
- Through independent agents in the Conseco Insurance Group segment.
o Without an agent.
- Through Colonial Penn.
o At work.
- Through our Performance Management Associates subsidiary.
- Through independent agents in the Conseco Insurance Group segment.
We continue to make significant progress on the key initiatives that we outlined
a year ago:
o Increasing emphasis on sales and revenue growth.
- First-year collected premiums in 2005 increased by 10 percent over
2004, to $1,378.9 million. At Bankers Life, our career and direct
distribution channels, first-year collected premiums rose 3.9
percent to $1,182.4 million in 2005. At Conseco Insurance Group,
our independent channel, first-year collected premiums rose by 75
percent to $196.5 million in 2005.
o Further reducing operating expenses and improving the efficiency of our
operations across all business functions by consolidating and
streamlining our back office and technology systems to reduce
complexity, lower cost and improve customer and agent services.
- In 2005, Conseco was successful in exceeding its expense savings
targets. By improving claim processes, reducing redundancies and
implementing more efficient back office systems and processes, we
were able to reduce net operating expenses (excluding commissions)
by $43 million in 2005, compared to our expense reduction goal of
$30 million for the year.
4
<PAGE>
o Continuing to build best practices in governance and compliance.
- We continue to work to improve our compliance and governance
practices with the ultimate goal of applying best practices across
our organization.
OTHER INFORMATION
As part of our Chapter 11 reorganization, we sold substantially all of the
assets of our Predecessor's finance business and exited this line of business.
Our finance business was conducted through our Predecessor's indirect
wholly-owned subsidiary, Conseco Finance Corp. ("CFC"). We accounted for our
finance business as a discontinued operation in 2002 once we formalized our
plans to sell it. On April 1, 2003, CFC and 22 of its direct and indirect
subsidiaries, which collectively comprised substantially all of our finance
business, filed liquidating plans of reorganization with the Bankruptcy Court in
order to facilitate the sale of this business. The sale of the finance business
was completed in the second quarter of 2003. We did not receive any proceeds
from this sale for our interest in CFC, nor did any creditors of our
Predecessor. As of March 31, 2003, we ceased to include the assets and
liabilities of CFC on our Predecessor's consolidated balance sheet.
CNO is the successor to Old Conseco. We emerged from bankruptcy on the
Effective Date. Old Conseco was organized in 1979 as an Indiana corporation and
commenced operations in 1982. Our executive offices are located at 11825 N.
Pennsylvania Street, Carmel, Indiana 46032, and our telephone number is (317)
817-6100. Our annual reports on Form 10-K, quarterly reports on Form 10-Q,
current reports on Form 8-K and amendments to those reports filed or furnished
pursuant to Section 13(a) or 15(d) of the Securities Exchange Act are available
free of charge on our website at www.conseco.com as soon as reasonably
practicable after they are electronically filed with, or furnished to, the
Securities and Exchange Commission (the "SEC"). These filings are also available
on the SEC's website at www.sec.gov. In addition, the public may read and copy
any document we file at the SEC's Public Reference Room located at 100 F Street,
NE, Room 1580, Washington, D.C. 20549. The public may obtain information on the
operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.
We have adopted a Code of Business Conduct and Ethics that applies to all
officers, directors and employees regarding their obligations in the conduct of
the Company's affairs. A copy of the Code of Business Conduct and Ethics is
available free of charge on our website at www.conseco.com.
In September 2005, we filed with the New York Stock Exchange ("NYSE") the
Annual CEO Certification regarding the Company's compliance with the NYSE's
Corporate Governance listing standards as required by Section 303A.12(a) of the
New York Stock Exchange Listed Company Manual. In addition, we have filed as
exhibits to this 2005 Form 10-K the applicable certifications of the Company's
Chief Executive Officer and Chief Financial Officer required under Section 302
of the Sarbanes-Oxley Act of 2002 regarding the Company's public disclosures.
Data in Item 1 are provided as of or for the year ended December 31, 2005,
(as the context implies), unless otherwise indicated.
MARKETING AND DISTRIBUTION
Insurance
Our insurance subsidiaries develop, market and administer supplemental
health insurance, annuity, individual life insurance and other insurance
products. We sell these products through three primary distribution channels:
career agents, professional independent producers (many of whom sell one or more
of our product lines exclusively) and direct marketing. We had premium
collections of $3.9 billion in 2005, $3.9 billion in 2004, $1.3 billion in the
four months ended December 31, 2003 and $2.9 billion in the eight months ended
August 31, 2003.
Our insurance subsidiaries collectively hold licenses to market our
insurance products in all fifty states, the District of Columbia, and certain
protectorates of the United States. Sales to residents of the following states
accounted for at least 5 percent of our 2005 collected premiums: Florida (8.8
percent), California (7.3 percent), Texas (6.3 percent) and Pennsylvania (5.1
percent).
We believe that most purchases of life insurance, accident and health
insurance and annuity products occur only after individuals are contacted and
solicited by an insurance agent. Accordingly, the success of our distribution
system is largely
5
<PAGE>
dependent on our ability to attract and retain experienced and highly motivated
agents. A description of our primary distribution channels is as follows:
Career Agents. This agency force of approximately 4,800 agents and sales
managers working from 162 branch offices, establishes one-on-one contact with
potential policyholders and promotes strong personal relationships with existing
policyholders. The career agents sell primarily Medicare supplement and
long-term care insurance policies, life insurance and annuities. In 2005, this
distribution channel accounted for $2,304.9 million, or 59 percent, of our total
collected premiums. These agents sell only Bankers Life and Casualty policies
and typically visit the prospective policyholder's home to conduct personalized
"kitchen-table" sales presentations. After the sale of an insurance policy, the
agent serves as a contact person for policyholder questions, claims assistance
and additional insurance needs.
Professional Independent Producers. Professional independent producers are
a diverse network of independent agents, insurance brokers and marketing
organizations. The general agency and insurance brokerage distribution system is
comprised of independent licensed agents doing business in all fifty states, the
District of Columbia, and certain protectorates of the United States. In 2005,
this distribution channel in our Conseco Insurance Group segment collected
$924.9 million, or 24 percent, of our total premiums, and in our Other Business
in Run-off segment collected $351.9 million, or 9.0 percent, of Conseco's total
collected premiums.
Marketing organizations typically recruit agents for the Conseco Insurance
Group segment by advertising our products and commission structure through
direct mail advertising or through seminars for agents and brokers. These
organizations bear most of the costs incurred in marketing our products. We
compensate the marketing organizations by paying them a percentage of the
commissions earned on new sales generated by agents recruited by such
organizations. Certain of these marketing organizations are specialty
organizations that have a marketing expertise or a distribution system related
to a particular product or market, such as educators. During 1999 and 2000, the
Conseco Insurance Group segment purchased four organizations that specialize in
marketing and distributing supplemental health products. One of these
organizations (which specialized in the sale of long-term care insurance through
independent agents) was sold in September 2003. In 2005, the remaining three
organizations accounted for $233.3 million, or 5.9 percent, of our total
collected premiums.
Direct Marketing. This distribution channel is engaged primarily in the
sale of graded benefit life insurance policies. In 2005, this channel accounted
for $110.9 million, or 2.8 percent, of our total collected premiums.
Products
The premium collection tables presented on pages 7, 8, 10 and 12 combine
the 2003 premium collections of the Predecessor (for the eight months ended
August 31, 2003) with the premium collections of the Successor (for the four
months ended December 31, 2003). This combining facilitates comparison of
premium collections which were not affected by fresh start accounting. Please
refer to "Item 7 - Management's Discussion and Analysis of Consolidated
Financial Condition and Results of Operations - Premium Collections" for a
summary of 2003 premium collections by the Predecessor and Successor.
6
<PAGE>
The following table summarizes premium collections by major category and
segment for the years ended December 31, 2005, 2004 and 2003 (dollars in
millions):
Total premium collections
<TABLE>
<CAPTION>
Years ended
December 31,
--------------------------------
2005 2004 2003
---- ---- ----
<S> <C> <C> <C>
Supplemental health:
Bankers Life............................................................ $1,227.5 $1,188.5 $1,167.5
Conseco Insurance Group................................................. 661.5 729.6 797.3
Other Business in Run-off............................................... 351.9 395.9 598.3
-------- -------- --------
Total supplemental health........................................... 2,240.9 2,314.0 2,563.1
-------- -------- --------
Annuities:
Bankers Life........................................................... 951.1 950.5 952.2
Conseco Insurance Group................................................. 161.7 63.7 92.1
-------- -------- --------
Total annuities..................................................... 1,112.8 1,014.2 1,044.3
-------- -------- --------
Life:
Bankers Life............................................................ 237.2 180.9 161.3
Conseco Insurance Group................................................. 335.0 372.3 412.2
-------- -------- --------
Total life........................................................... 572.2 553.2 573.5
-------- -------- --------
Total premium collections ................................................ $3,925.9 $3,881.4 $4,180.9
======== ======== ========
</TABLE>
7
<PAGE>
Our insurance companies collected premiums from the following products:
Supplemental Health
Supplemental Health Premium Collections (dollars in millions)
<TABLE>
<CAPTION>
Years ended
December 31,
-------------------------------
2005 2004 2003
---- ---- ----
<S> <C> <C> <C>
Medicare supplement:
Bankers Life................................................................. $ 651.2 $ 640.0 $ 644.7
Conseco Insurance Group...................................................... 288.8 351.7 384.6
-------- -------- --------
Total..................................................................... 940.0 991.7 1,029.3
-------- -------- --------
Long-term care:
Bankers Life ................................................................ 564.2 536.3 509.4
Conseco Insurance Group(a) .................................................. N/A N/A N/A
Other Business in Run-off ................................................... 349.1 380.1 402.6
-------- -------- --------
Total..................................................................... 913.3 916.4 912.0
-------- -------- --------
Specified disease products included in
Conseco Insurance Group..................................................... 359.5 361.7 355.1
-------- -------- --------
Major medical business included in Other Business in
Run-off...................................................................... 2.8 15.8 195.7
-------- -------- --------
Other:
Bankers Life ................................................................ 12.1 12.2 13.4
Conseco Insurance Group...................................................... 13.2 16.2 57.6
-------- -------- --------
Total..................................................................... 25.3 28.4 71.0
-------- -------- --------
Total supplemental health premium collections.................................... $2,240.9 $2,314.0 $2,563.1
======== ======== ========
<FN>
- ----------
(a) We have ceased writing long-term care through Conseco Insurance Group
and all major medical insurance. Accordingly, we classify the associated
collected premiums in "Other Business in Run-off."
</FN>
</TABLE>
The following describes our major supplemental health products:
Medicare Supplement. Medicare supplement collected premiums were $940.0
million during 2005 or 24 percent of our total collected premiums. Medicare is a
federal health insurance program for disabled persons and senior citizens (age
65 and older). Part A of the program provides protection against the costs of
hospitalization and related hospital and skilled nursing home care, subject to
an initial deductible, related coinsurance amounts and specified maximum benefit
levels. The deductible and coinsurance amounts are subject to change each year
by the federal government. Part B of Medicare covers doctor's bills and a number
of other medical costs not covered by Part A, subject to deductible and
coinsurance amounts for "approved" charges.
Medicare supplement policies provide coverage for many of the medical
expenses which the Medicare program does not cover, such as deductibles,
coinsurance costs (in which the insured and Medicare share the costs of medical
expenses) and specified losses which exceed the federal program's maximum
benefits. Our Medicare supplement plans automatically adjust coverage to reflect
changes in Medicare benefits. In marketing these products, we currently
concentrate on individuals who have recently become eligible for Medicare by
reaching the age of 65. We offer higher commissions in the early years to agents
for sales to these policyholders and competitive premium pricing for our
policyholders. Approximately 38 percent of new sales of Medicare supplement
policies in 2005 were to individuals who had recently reached the age of 65.
8
<PAGE>
The Medicare Modernization Act provided for the introduction of a
prescription drug benefit (Part D). In order to offer this product to our
current and potential future policyholders without investment in management and
infrastructure, we entered into a national distribution agreement with Coventry
Health Care ("Coventry") to use our career and independent agents to distribute
Coventry's prescription drug plan, Advantra Rx. We will receive a fee based on
the number of plans sold through our distribution channels. In addition, Conseco
has a quota-share reinsurance agreement with Coventry for Conseco enrollees that
provides Conseco in 2006 with 50 percent of net premiums and related profits
subject to a risk corridor. To date, our career and independent channels have
enrolled over 130,000 members, approximately 60 percent of which are current
policyholders. As the Part D program is effective January 1, 2006, Conseco did
not record reinsurance premiums or claims expenses in its 2005 financial results
related to the Part D program. We expect to earn minimal profits on these
arrangements in 2006. However, as a company which serves the senior market, we
concluded it was important to assist our policyholders through the purchase
decisions surrounding this new product.
Both Bankers Life and Conseco Insurance Group sell Medicare supplement
insurance.
Long-Term Care. Long-term care collected premiums were $913.3 million
during 2005, or 23 percent of our total collected premiums. Long-term care
products provide coverage, within prescribed limits, for nursing homes, home
healthcare, or a combination of both. We sell the long-term care plans primarily
to retirees and, to a lesser degree, to older self-employed individuals and
others in middle-income levels.
Current nursing home care policies cover incurred and daily fixed-dollar
benefits with an elimination period (which, similar to a deductible, requires
the insured to pay for a certain number of days of nursing home care before the
insurance coverage begins), subject to a maximum benefit. Home healthcare
policies cover the usual and customary charges after a deductible or elimination
period and are subject to a daily or weekly maximum dollar amount, and an
overall benefit maximum. We monitor the loss experience on our long-term care
products and, when necessary, apply for rate increases in the jurisdictions in
which we sell such products. Regulatory approval is required to increase our
premiums on these products.
The long-term care insurance blocks of business sold through the
professional independent producer distribution channel were largely underwritten
by certain of our subsidiaries prior to their acquisitions by Conseco in 1996
and 1997. The performance of these blocks of business did not meet the
expectations we had when the blocks were acquired. As a result, we ceased
selling new long-term care policies through this distribution channel.
We continue to sell long-term care insurance through the career agent
distribution channel. The long-term care business sold through Bankers Life's
career agents is underwritten using stricter underwriting and pricing standards
than our acquired blocks of long-term care business included in the Other
Business in Run-off segment.
Specified Disease Products. Specified disease collected premiums were
$359.5 million during 2005, or 9 percent of our total collected premiums. These
policies generally provide fixed or limited benefits. Cancer insurance and
heart/stroke products are guaranteed renewable individual accident and health
insurance policies. Payments under cancer insurance policies are generally made
directly to, or at the direction of, the policyholder following diagnosis of, or
treatment for, a covered type of cancer. Heart/stroke policies provide for
payments directly to the policyholder for treatment of a covered heart disease,
heart attack or stroke. Accident products combine insurance for accidental death
with limited benefit disability income insurance. The benefits provided under
the specified disease policies do not necessarily reflect the actual cost
incurred by the insured as a result of the illness, or accident, and benefits
are not reduced by any other medical insurance payments made to or on behalf of
the insured.
Approximately 78 percent of the total number of our specified disease
policies inforce were sold with return of premium or cash value riders. The
return of premium rider generally provides that, after a policy has been in
force for a specified number of years or upon the policyholder reaching a
specified age, we will pay to the policyholder, or in some cases, a beneficiary
under the policy, the aggregate amount of all premiums paid under the policy,
without interest, less the aggregate amount of all claims incurred under the
policy. The cash value rider is similar to the return of premium rider, but also
provides for payment of a graded portion of the return of premium benefit if the
policy terminates before the return of premium benefit is earned.
Major Medical. Our major medical business is included in our Other Business
in Run-off segment. Sales of our major medical health insurance products were
targeted to self-employed individuals, small business owners, large employers
and early retirees. Various deductible and coinsurance options were available,
and most policies require certain utilization review procedures. The
profitability of this business depended largely on the overall persistency of
the business inforce, claim experience and expense management. During 2001, we
decided to discontinue a large block of major medical business by not renewing
these policies because this business was not profitable. The remaining major
medical block, except for certain business that is guaranteed renewable, was
discontinued by not renewing the policies in 2002. During 2005, we collected
major medical premiums of $2.8 million.
9
<PAGE>
Other Supplemental Health Products. Other supplemental health product
collected premiums were $25.3 million during 2005, or 1 percent of our total
collected premiums. These products include various other products such as
disability income insurance. We no longer actively market these products.
Annuities
Annuity premium collections (dollars in millions)
<TABLE>
<CAPTION>
Years ended
December 31,
--------------------------------
2005 2004 2003
---- ---- ----
<S> <C> <C> <C>
Equity-indexed annuity:
Bankers Life ............................................................ $ 130.3 $ 47.5 $ 15.1
Conseco Insurance Group.................................................. 104.4 44.3 54.3
-------- -------- --------
Total equity-indexed annuity premium collections ..................... 234.7 91.8 69.4
-------- -------- --------
Other fixed annuity:
Bankers Life ............................................................ 820.8 903.0 937.1
Conseco Insurance Group.................................................. 57.3 19.4 37.8
-------- -------- --------
Total fixed annuity premium collections .............................. 878.1 922.4 974.9
-------- -------- --------
Total annuity premium collections........................................... $1,112.8 $1,014.2 $1,044.3
======== ======== ========
</TABLE>
During 2005, we collected annuity premiums of $1,112.8 million or 28
percent of our total premiums collected. Annuity products include equity-indexed
annuity, traditional fixed rate annuity and market value-adjusted annuity
products sold through both Bankers Life and Conseco Insurance Group. Annuities
offer a tax-deferred means of accumulating savings for retirement needs, and
provide a tax-efficient source of income in the payout period. Our major source
of income from annuities is the spread between the investment income earned on
the underlying general account assets and the interest credited to
contractholders' accounts.
Sales of many of our annuity products have been affected by the financial
strength ratings assigned to our insurance subsidiaries by independent rating
agencies. Many of our professional independent agents discontinued marketing our
annuity products after A.M. Best Company ("A.M. Best") lowered the financial
strength ratings assigned to our insurance subsidiaries in 2002. In addition,
the annuity business we were selling through this distribution channel required
more statutory capital and surplus than our other insurance products.
Accordingly, we took actions in our Conseco Insurance Group segment in 2003 and
2004 to reduce our marketing of these products and focus instead on selling
products that are less ratings sensitive and capital intensive. In 2005, annuity
sales in our Conseco Insurance Group segment increased due to increased sales
efforts, expanded product offerings and attractive crediting rates on certain
products. In 2006, we expect to increase our annuity sales efforts in this
segment. Career agents selling annuity products in the Bankers Life segment are
less sensitive in the near-term to A.M. Best ratings, since these agents only
sell our products. However, the increase in short-term interest rates during
2005 resulted in lower fixed annuity sales, since certain other competing
products such as certificates of deposits have become more attractive.
Sales of our equity-indexed products in both segments were favorably
impacted in 2005 due in part to general stock market conditions which made these
products relatively attractive. In addition, we introduced several new products.
The following describes the major annuity products:
Equity-Indexed Annuities. These products accounted for $234.7 million, or 6
percent, of our total premium collections during 2005. The account value (or
"accumulation value") of these annuities is credited with interest at an annual
minimum guaranteed average rate over the term of the contract 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), but the annuities have
potentially higher returns based on a percentage (the "participation rate") of
the change in a particular index during each year of their term. We have the
discretionary ability to annually change the participation rate, which ranged
from 50 percent to 100 percent in 2005, and we may include a first-year "bonus"
participation rate, similar to the bonus interest described below for
traditional fixed rate annuity products, which generally ranges from 30 percent
to 40 percent. The minimum guaranteed values are equal to:
10
<PAGE>
o 90 percent of premiums collected for annuities for which premiums are
received in a single payment (single-premium deferred annuities, or
"SPDAs"), or either: (i) 75 percent of first year and 87.5 percent of
renewal premiums collected; or (ii) 87.5 percent of all premium
collections for annuities which allow for more than one payment
(flexible premium deferred annuities, or "FPDAs"); plus
o interest credited on such percentage of the premiums collected at an
annual rate ranging from 1.5 percent to 3 percent.
These annuities provide for penalty-free withdrawals of up to 10 percent of
either premiums or account value in each year after the first year of the
annuity's term. Other withdrawals from SPDA products are generally subject to a
surrender charge of 9 percent over the eight year contract term, at the end of
which, the contract must be renewed or withdrawn. Other withdrawals from FPDA
products are subject to a surrender charge of 11 percent to 22 percent in the
first year, declining to zero over an 8 to 15 year period, depending on issue
age. We buy one-year call options on the applicable indices (primarily the
Standard & Poor's 500 Index) in an effort to offset or "hedge" potential
increases to policyholder benefits resulting from increases in the indices to
which the product's return is linked.
Fixed Rate Annuities. These products include fixed rate SPDAs, FPDAs and
single-premium immediate annuities ("SPIAs"). These products accounted for
$878.1 million, or 22 percent, of our total premium collections during 2005. Our
fixed rate SPDAs and FPDAs typically have an interest rate (the "crediting
rate") that is guaranteed by the Company for the first policy year, after which
we have the discretionary ability to change the crediting rate to any rate not
below a guaranteed minimum rate. The guaranteed rates on annuities written
recently range from 2.5 percent to 3.0 percent, and the rates, on all policies
inforce range from 2.0 percent to 6.0 percent. The initial crediting rate is
largely a function of:
o the interest rate we can earn on invested assets acquired with the new
annuity fund deposits;
o the costs related to marketing and maintaining the annuity products; and
o the rates offered on similar products by our competitors.
For subsequent adjustments to crediting rates, we take into account current and
prospective yields on investments, annuity surrender assumptions, competitive
industry pricing and the crediting rate history for particular groups of annuity
policies with similar characteristics.
In 2005, substantially all of our new annuity sales were "bonus" products.
The initial crediting rate on these products specifies a bonus crediting rate
generally ranging from 1.0 percent to 3.0 percent of the annuity deposit for the
first policy year only. After the first year, the bonus interest portion of the
initial crediting rate is automatically discontinued, and the renewal crediting
rate is established. As of December 31, 2005, the average crediting rate,
excluding bonuses, on our outstanding traditional annuities was 3.7 percent.
The policyholder is typically permitted to withdraw all or part of the
premiums paid plus the accumulated interest credited to his or her accumulation
value, subject to a surrender charge for withdrawals in excess of specified
limits. Most of our traditional annuities allow for penalty-free withdrawals of
up to 10 percent of the accumulation value each year, subject to limitations.
Withdrawals in excess of the penalty-free amounts are assessed a surrender
charge during a penalty period which generally ranges from five to 12 years
after the date a policy is issued. The initial surrender charge generally ranges
from 6 percent to 12 percent of the accumulation value and generally decreases
by approximately 1 to 2 percentage points per year during the penalty period.
Surrender charges are set at levels intended to protect us from loss on early
terminations and to reduce the likelihood that policyholders will terminate
their policies during periods of increasing interest rates. This practice is
intended to lengthen the duration of policy liabilities and to enable us to
maintain profitability on such policies.
SPIAs accounted for $35.8 million, or .9 percent, of our total premiums
collected in 2005. SPIAs are designed to provide a series of periodic payments
for a fixed period of time or for life, according to the policyholder's choice
at the time of issuance. Once the payments begin, the amount, frequency and
length of time over which they are payable are fixed. SPIAs often are purchased
by persons at or near retirement age who desire a steady stream of payments over
a future period of years. The single premium is often the payout from a
terminated annuity contract. The implicit interest rate on SPIAs is based on
market conditions when the policy is issued. The implicit interest rate on our
outstanding SPIAs averaged 7.0 percent at December 31, 2005.
11
<PAGE>
Life Insurance
Life insurance premium collections (dollars in millions)
<TABLE>
<CAPTION>
Years ended
December 31,
------------------------------
2005 2004 2003
---- ---- ----
<S> <C> <C> <C>
Interest-sensitive life products:
Bankers Life............................................................... $ 33.8 $ 35.0 $ 34.2
Conseco Insurance Group.................................................... 204.2 225.6 266.5
------ ------ ------
Total interest-sensitive life premium collections....................... 238.0 260.6 300.7
------ ------ ------
Traditional life:
Bankers Life............................................................... 203.4 145.9 127.1
Conseco Insurance Group.................................................... 130.8 146.7 145.7
------ ------ ------
Total traditional life premium collections.............................. 334.2 292.6 272.8
------ ------ ------
Total life insurance premium collections...................................... $572.2 $553.2 $573.5
====== ====== ======
</TABLE>
Life products include traditional, interest-sensitive and other life
9insurance products. These products are currently sold through both Bankers Life
and Conseco Insurance Group. During 2005, we collected life insurance premiums
of $572.2 million, or 15 percent, of our total collected premiums. In April
2003, we took actions to de-emphasize new sales of several of our life insurance
products through Conseco Insurance Group's professional independent producers.
Sales of life products are affected by the financial strength ratings assigned
to our insurance subsidiaries by independent rating agencies. See "Competition"
below.
Interest-Sensitive Life Products. These products include universal life
and other interest-sensitive life products that provide whole life insurance
w9ith adjustable rates of return related to current interest rates. They
accounted for $238.0 million, or 6 percent of our total collected premiums in
2005. These products are marketed by professional independent producers and, to
a lesser extent, career agents (including those specializing in worksite sales).
The principal differences between universal life products and other
interest-sensitive life products are policy provisions affecting the amount and
timing of premium payments. Universal life policyholders may vary the frequency
and size of their premium payments, and policy benefits may also fluctuate
according to such payments. Premium payments under other interest-sensitive
policies may not be varied by the policyholders.
Traditional Life. These products accounted for $334.2 million, or 9
percent, of our total collected premiums in 2005. Traditional life policies,
in9cluding whole life, graded benefit life and term life products, are marketed
through professional independent producers, career agents and direct response
marketing. Under whole life policies, the policyholder generally pays a level
premium over an agreed period or the policyholder's lifetime. The annual premium
in a whole life policy is generally higher than the premium for comparable term
insurance coverage in the early years of the policy's life, but is generally
lower than the premium for comparable term insurance coverage in the later years
of the policy's life. These policies, which we continue to market on a limited
basis, combine insurance protection with a savings component that gradually
increases in amount over the life of the policy. The policyholder may borrow
against the savings component generally at a rate of interest lower than that
available from other lending sources. The policyholder may also choose to
surrender the policy and receive the accumulated cash value rather than
continuing the insurance protection. Term life products offer pure insurance
protection for life with a guaranteed level premium for a specified period of
time -- typically 10, 15, 20 or 30 years. In some instances, these products
offer an option to return the premium at the end of the guaranteed period. We
ceased most term life product sales through the professional independent
producer distribution channel during the second quarter of 2003, but plan to
reenter the market in 2006.
Traditional life products also include graded benefit life insurance
products. Graded benefit life products accounted for $81.2 million, or 2.1
per9cent, of our total collected premiums in 2005. Graded benefit life insurance
products are offered on an individual basis primarily to persons age 50 to 80,
principally in face amounts of $350 to $25,000, without medical examination or
evidence of insurability. Premiums are paid as frequently as monthly. Benefits
paid are less than the face amount of the policy during the first two years,
except in cases of accidental death. Our Bankers Life segment markets graded
benefit life policies under the Colonial Penn brand name using direct response
marketing techniques. New policyholder leads are generated primarily from
television, print advertisements and direct response mailings.
12
<PAGE>
Traditional life products also include single premium whole life insurance.
This product requires one initial lump sum payment in return for providing life
insurance protection for the insured's entire lifetime. Single premium whole
life products accounted for $32.2 million, or .8 percent of our total collected
premiums in 2005.
ACQUISITIONS
From 1982 to 1998, Old Conseco acquired 19 insurance and related businesses
and Green Tree Financial Corporation (renamed Conseco Finance Corp.) These
acquisitions were primarily responsible for Old Conseco's historical growth.
INVESTMENTS
40|86 Advisors, Inc. ("40|86 Advisors"), a registered investment adviser
and wholly-owned subsidiary of Conseco, Inc., manages the investment portfolios
of our insurance subsidiaries. 40|86 Advisors had approximately $27.0 billion of
assets (at fair value) under management at December 31, 2005, of which $24.9
billion were assets of our subsidiaries and $2.1 billion were assets managed for
third parties. Our general account investment strategies are to: (i) maintain a
largely investment-grade, diversified fixed-income portfolio; (ii) maximize the
spread between the investment income we earn and the yields we pay on investment
products within acceptable levels of risk; (iii) provide adequate liquidity;
(iv) construct our investment portfolio considering expected liability
durations, cash flows and other requirements; and (v) maximize total return
through active investment management. During 2005 and 2004, we recognized net
realized investment gains (losses) of $(2.9) million and $40.6 million,
respectively. In the four months ended December 31, 2003, we recognized net
realized investment gains of $11.8 million and in the eight months ended August
31, 2003, we recognized net realized investment losses of $5.4 million.
Investment activities are an integral part of our business because
investment income is a significant component of our revenues. The profitability
of many of our insurance products is significantly affected by spreads between
interest yields on investments and rates credited on insurance liabilities.
Although substantially all credited rates on SPDAs and FPDAs may be changed
annually (subject to minimum guaranteed rates), changes in crediting rates may
not be sufficient to maintain targeted investment spreads in all economic and
market environments. In addition, competition, minimum guaranteed rates and
other factors, including the impact 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. As of December 31, 2005,
the average yield, computed on the cost basis of our actively managed fixed
maturity portfolio, was 5.6 percent, and the average interest rate credited or
accruing to our total insurance liabilities was 4.6 percent.
We manage the equity-based risk component of our equity-indexed annuity
products by:
o purchasing equity-based call options in an effort to hedge such risk;
and
o adjusting the participation rate to reflect the change in the cost of
such options (such cost varies based on market conditions).
Accordingly, we are able to focus on managing the interest rate spread component
of these products.
We seek to balance the interest rate risk inherent in our invested assets
with the interest rate characteristics of our insurance liabilities. We attempt
to minimize this exposure by managing the durations and cash flows of our fixed
maturity investments and insurance liabilities. For example, duration measures
the expected change in the fair value of assets and liabilities for a given
change in interest rates. If interest rates increase by 1 percent, the fair
value of a fixed maturity security with a duration of 5 years is typically
expected to decrease in value by approximately 5 percent. When the estimated
durations of assets and liabilities are similar, exposure to interest rate risk
is minimized because a change in the value of assets should be largely offset by
a change in the value of liabilities.
We calculate asset and liability durations using our estimates of future
asset and liability cash flows. These cash flows are discounted using
appropriate interest rates based on the current yield curve and investment type.
Duration is determined by calculating the present value of the cash flows using
different interest rates, and estimating the change in value. At December 31,
2005, the duration of our fixed maturity investments (as modified to reflect
prepayments and potential calls) was approximately 6.6 years and the duration of
our insurance liabilities was approximately 7.3 years. The difference between
these durations indicates that our investment portfolio had a shorter duration
and, consequently, was less sensitive to interest rate fluctuations than that of
our liabilities at that date. We generally seek to minimize the gap between
asset and liability durations.
13
<PAGE>
For information regarding the composition and diversification of the
investment portfolio of our subsidiaries, see "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Investments."
COMPETITION
The markets in which we operate are highly competitive. Our current ratings
and our Predecessor's bankruptcy proceedings have had a material adverse impact
on our ability to compete in these markets. Compared to Conseco, many companies
in the financial services industry are larger, have greater capital,
technological and marketing resources, have better access to capital and other
sources of liquidity at a lower cost, broader and more diversified product lines
and have larger staffs. An expanding number of banks, securities brokerage firms
and other financial intermediaries also market insurance products or offer
competing products, such as mutual fund products, traditional bank investments
and other investment and retirement funding alternatives. We also compete with
many of these companies and others in providing services for fees. In most
areas, competition is based on a number of factors, including pricing, service
provided to distributors and policyholders and ratings. Conseco's subsidiaries
must also compete to attract and retain the allegiance of agents, insurance
brokers and marketing companies.
In the individual health insurance business, companies compete primarily on
the bases of marketing, service and price. Pursuant to federal regulations, the
Medicare supplement products offered by all companies have standardized policy
features. This increases the comparability of such policies and intensifies
competition based on other factors. See "Insurance Underwriting" and
"Governmental Regulation." In addition to competing with the products of other
insurance companies, commercial banks, thrifts, mutual funds and broker dealers,
our insurance products compete with health maintenance organizations, preferred
provider organizations and other health care-related institutions which provide
medical benefits based on contractual agreements.
An important competitive factor for life insurance companies is the ratings
they receive from nationally recognized rating organizations. Agents, insurance
brokers and marketing companies who market our products and prospective
purchasers of our products use the ratings of our insurance subsidiaries as one
factor in determining which insurer's products to market or purchase. Ratings
have the most impact on our annuity, interest-sensitive life insurance and
long-term care products. Insurance financial strength ratings are opinions
regarding an insurance company's financial capacity to meet the obligations of
its insurance policies in accordance with their terms. They are not directed
toward the protection of investors, and such ratings are not recommendations to
buy, sell or hold securities.
Our insurance companies' financial strength ratings were downgraded by all
of the major rating agencies beginning in July 2002 in connection with the
financial distress that ultimately led to our Predecessor's bankruptcy. These
lowered ratings caused sales of our insurance products to decline, policyholder
redemptions and lapses to increase and increased agent attrition during 2003 and
2004, which in turn negatively affected our financial results.
On August 3, 2005, A.M. Best revised its outlook on our primary insurance
subsidiaries to positive from stable, except Conseco Senior Health Insurance
Company ("Conseco Senior") (the issuer of most of our long-term care business in
our Other Business in Run-off segment), for which the outlook remains stable. On
June 25, 2004, A.M. Best upgraded the financial strength ratings of our primary
insurance subsidiaries from "B (Fair)" to "B++ (Very Good)", except Conseco
Senior, whose "B (Fair)" rating was affirmed by A.M. Best. According to A.M.
Best, these rating actions reflected the substantial recapitalization of our
balance sheet, improved absolute and risk-adjusted capital on a statutory basis
and improving operating fundamentals. The "B++" rating is assigned to companies
that have a good ability, in A.M. Best's opinion, to meet their ongoing
obligations to policyholders. The "B" rating is assigned to companies which have
a fair ability, in A.M. Best's opinion, to meet their current obligations to
policyholders, but are financially vulnerable to adverse changes in underwriting
and economic conditions. A.M. Best ratings for the industry currently range from
"A++ (Superior)" to "F (In Liquidation)" and some companies are not rated. An
"A++" rating indicates a superior ability to meet ongoing obligations to
policyholders. The "B++" rating and the "B" rating from A.M. Best are the fifth
and seventh highest, respectively, of sixteen possible ratings.
On August 2, 2005, Standard & Poor's Corporation ("S&P") revised its
outlook on our primary insurance subsidiaries to positive from stable, except
Conseco Senior, for which the outlook remains stable. On May 27, 2004, S&P
upgraded the financial strength ratings of our primary insurance companies from
"BB-" to "BB+", except Conseco Senior, which was assigned a "CCC" rating. S&P
financial strength ratings range from "AAA" to "R" and some companies are not
rated. Rating categories from "BB" to "CCC" are classified as "vulnerable", and
pluses and minuses show the relative standing within a category. In S&P's view,
an insurer rated "BB" has marginal financial security characteristics and
although positive attributes exist, adverse business conditions could lead to an
insufficient ability to meet financial commitments. In S&P's view, an insurer
rated "CCC" has very weak financial security characteristics and is dependent on
favorable business conditions to meet financial commitments. The "BB+" rating
and the "CCC" rating from S&P are the eleventh and
14
<PAGE>
eighteenth highest of twenty-one possible ratings.
On March 8, 2006, Moody's Investor Services, Inc. ("Moody's") upgraded the
financial strength rating of our primary insurance companies from "Ba1" to
"Baa3" except Conseco Senior, which was affirmed at "Caa1". In addition, all of
Moody's ratings on our insurance subsidiaries now have a positive outlook. On
July 29, 2005, the ratings for our primary insurance subsidiaries were placed on
review for upgrade by Moody's, except Conseco Senior, for which the rating was
affirmed with a developing outlook. On May 27, 2004, Moody's upgraded the
financial strength rating of our primary insurance companies from "Ba3" to "Ba2"
except Conseco Senior, which was assigned a "Caa1" rating. On August 9, 2004,
Moody's again upgraded the financial strength rating of our primary insurance
companies from "Ba2" to "Ba1" and reaffirmed the "Caa1" rating of Conseco
Senior. Moody's financial strength ratings range from "Aaa" to "C". Rating
categories from "Aaa" to "Baa" are classified as "Secure" by Moody's and rating
categories from "Ba" to "C" are classified as "vulnerable" and these ratings may
be supplemented with numbers "1", "2", or "3" to show relative standing within a
category. In Moody's view, an insurer rated "Baa3" offers adequate financial
security, however, certain protective elements may be lacking or may be
characteristically unreliable over any great length of time. In Moody's view, an
insurer rated "Caa" offers very poor financial security and may default on its
policyholder obligations or there may be elements of danger with respect to
punctual payment of policyholder obligations and claims. The "Baa3" rating and
"Caa1" rating from Moody's are the tenth and seventeenth highest, respectively,
of twenty-one possible ratings. A positive outlook by Moody's is an opinion
regarding the likely direction of a rating over the medium term.
A.M. Best, S&P and Moody's review our ratings from time to time. We cannot
provide any assurance that the ratings of our insurance subsidiaries will remain
at their current levels or predict the impact of any future rating changes on
our business.
INSURANCE UNDERWRITING
Under regulations promulgated by the National Association of Insurance
Commissioners ("NAIC") (an association of state regulators and their staffs) and
adopted as a result of the Omnibus Budget Reconciliation Act of 1990, we are
prohibited from underwriting our Medicare supplement policies for certain
first-time purchasers. If a person applies for insurance within six months after
becoming eligible by reason of age, or disability in certain limited
circumstances, the application may not be rejected due to medical conditions.
Some states prohibit underwriting of all Medicare supplement policies. For other
prospective Medicare supplement policyholders, such as senior citizens who are
transferring to our products, the underwriting procedures are relatively
limited, except for policies providing prescription drug coverage.
Before issuing long-term care products, we generally apply detailed
underwriting procedures to assess and quantify the insurance risks. We require
medical examinations of applicants (including blood and urine tests, where
permitted) for certain health insurance products and for life insurance products
which exceed prescribed policy amounts. These requirements vary according to the
applicant's age and may vary by type of policy or product. We also rely on
medical records and the potential policyholder's written application. In recent
years, there have been significant regulatory changes with respect to
underwriting certain types of health insurance. An increasing number of states
prohibit underwriting and/or charging higher premiums for substandard risks. We
monitor changes in state regulation that affect our products, and consider these
regulatory developments in determining the products we market and where we
market them.
Our specified disease policies are individually underwritten using a
simplified issue application. Based on an applicant's responses on the
application, the underwriter either: (i) approves the policy as applied for;
(ii) approves the policy with reduced benefits; or (iii) rejects the
application.
Most of our life insurance policies are underwritten individually, although
standardized underwriting procedures have been adopted for certain low
face-amount life insurance coverages. After initial processing, insurance
underwriters obtain the information needed to make an underwriting decision
(such as medical examinations, doctors' statements and special medical tests).
After collecting and reviewing the information, the underwriter either: (i)
approves the policy as applied for; (ii) approves the policy with an extra
premium charge because of unfavorable factors; or (iii) rejects the application.
We underwrite group insurance policies based on the characteristics of the
group and its past claim experience. Graded benefit life insurance policies are
issued without medical examination or evidence of insurability. There is minimal
underwriting on annuities.
LIABILITIES FOR INSURANCE PRODUCTS
At December 31, 2005, the total balance of our liabilities for insurance
products was $25.4 billion. These liabilities are generally payable over an
extended period of time. The profitability of our insurance products depends on
pricing and other factors. Differences between our expectations when we sold
these products and our actual experience could result in future losses.
We calculate and maintain reserves for the estimated future payment of
claims to our policyholders based on actuarial
15
<PAGE>
assumptions. For all of our insurance products, we establish an active life
reserve, a liability for due and unpaid claims, claims in the course of
settlement and incurred but not reported claims. In addition, for our
supplemental health insurance business, we establish a reserve for the present
value of amounts not yet due on incurred claims. Many factors can affect these
reserves and liabilities, such as economic and social conditions, inflation,
hospital and pharmaceutical costs, changes in doctrines of legal liability and
extra-contractual damage awards. Therefore, our reserves and liabilities are
necessarily based on extensive estimates, assumptions and historical experience.
Establishing reserves is an uncertain process, and it is possible that actual
claims will materially exceed our reserves and have a material adverse effect on
our results of operations and financial condition. Our financial results depend
significantly upon the extent to which our actual claims experience is
consistent with the assumptions we used in determining our reserves and pricing
our products. If our assumptions with respect to future claims are incorrect,
and our reserves are insufficient to cover our actual losses and expenses, we
would be required to increase our liabilities, which would negatively affect our
operating results.
Liabilities for insurance products are calculated using management's best
judgments, based on our past experience and standard actuarial tables, of
mortality, morbidity, lapse rates, investment experience and expense levels.
REINSURANCE
Consistent with the general practice of the life insurance industry, our
subsidiaries enter into both facultative and treaty agreements of indemnity
reinsurance with other insurance companies in order to reinsure portions of the
coverage provided by our insurance products. Indemnity reinsurance agreements
are intended to limit a life insurer's maximum loss on a large or unusually
hazardous risk or to diversify its risk. Indemnity reinsurance does not
discharge the original insurer's primary liability to the insured. Our reinsured
business is ceded to numerous reinsurers. Based on our periodic review of their
financial statements, insurance industry reports and reports filed with state
insurance departments, we believe the assuming companies are able to honor all
contractual commitments.
As of December 31, 2005, the policy risk retention limit of our insurance
subsidiaries was generally $.8 million or less. Reinsurance ceded by Conseco
represented 25 percent of gross combined life insurance inforce and reinsurance
assumed represented 1.5 percent of net combined life insurance inforce. Our
principal reinsurers at December 31, 2005 were as follows (dollars in millions):
<TABLE>
<CAPTION>
Ceded life A.M. Best
Name of Reinsurer insurance inforce rating
- ----------------- ----------------- ----------------
<S> <C> <C>
Swiss Re Life and Health America Inc.................................... $ 4,381.5 A+
Security Life of Denver Insurance Company............................... 4,029.1 A+
Reassure America Life Insurance Company................................. 2,839.7 A+
RGA Reinsurance Company................................................. 1,079.0 A+
Munich American Reassurance Company..................................... 1,021.3 A+
Lincoln National Life Insurance Company................................. 860.1 A+
Revios Reinsurance U.S. Inc............................................. 719.0 A-
Hannover Life Reassurance Company....................................... 540.4 A
All others.............................................................. 2,519.2 (a)
---------
$17,989.3
=========
<FN>
- ---------------------
(a) No other single reinsurer assumed greater than 3 percent of the total ceded
business inforce.
</FN>
</TABLE>
EMPLOYEES
At December 31, 2005, we had approximately 4,000 full time employees,
including 1,700 employees supporting our Bankers Life segment and 2,300
employees supporting our Conseco Insurance Group segment, Other Business in
Run-off segment and corporate segment. None of our employees are covered by a
collective bargaining agreement. We believe that we have good relations with our
employees.
GOVERNMENTAL REGULATION
Our insurance businesses are subject to extensive regulation and
supervision by the insurance regulatory agencies of the jurisdictions in which
they operate. This regulation and supervision is primarily for the benefit and
protection of customers, and not for the benefit of investors or creditors.
State laws generally establish supervisory agencies that have broad regulatory
authority, including the power to:
16
<PAGE>
o grant and revoke business licenses;
o regulate and supervise trade practices and market conduct;
o establish guaranty associations;
o license agents;
o approve policy forms;
o approve premium rates for some lines of business;
o establish reserve requirements;
o prescribe the form and content of required financial statements and
reports;
o determine the reasonableness and adequacy of statutory capital and
surplus;
o perform financial, market conduct and other examinations;
o define acceptable accounting principles;
o regulate the types and amounts of permitted investments; and
In addition, the NAIC issues model laws and regulations, many of which have
been adopted by state insurance regulators, relating to:
o reserve requirements;
o Risk-based capital standards ("RBC");
o codification of insurance accounting principles;
o investment restrictions;
o restrictions on an insurance company's ability to pay dividends; and
o product illustrations.
In addition to the regulations described above, most states have also
enacted laws or regulations regarding the activities of insurance holding
company systems, including acquisitions, the terms of surplus debentures, the
terms of transactions between insurance companies and their affiliates and other
related matters. Various notice and reporting requirements generally apply to
transactions between insurance companies and their affiliates within an
insurance holding company system, depending on the size and nature of the
transactions. These requirements may include prior regulatory approval or prior
notice for certain material transactions. Currently, the Company and its
insurance subsidiaries are registered as a holding company system pursuant to
such laws and regulations in the domiciliary states of the insurance
subsidiaries. In addition, the Company's insurance subsidiaries routinely report
to other jurisdictions.
Insurance regulators may prohibit the payment of dividends or other
payments by our insurance subsidiaries to parent companies if they determine
that such payment could be adverse to our policyholders or contract holders.
Otherwise, the ability of our insurance subsidiaries to pay dividends is subject
to state insurance department regulations. The ability of our insurance
subsidiaries to pay dividends is subject to state insurance department
regulations and is based on the financial statements of our insurance
subsidiaries prepared in accordance with statutory accounting practices
prescribed or permitted by regulatory authorities, which differ from generally
accepted accounting principles ("GAAP"). These regulations generally permit
dividends to be paid from statutory 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:
o statutory net gain from operations or statutory net income for the prior
year; or
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o 10 percent of statutory capital and surplus at 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.
In accordance with an order from the Florida Office of Insurance
Regulation, Conseco Senior may not distribute funds to any affiliate or
shareholder unless such distributions have been approved by the Florida Office
of Insurance Regulation. In addition, the risk-based capital and other capital
requirements described below can also limit, in certain circumstances, the
ability of our insurance subsidiaries to pay dividends.
Most states have also enacted legislation or adopted administrative
regulations that affect the acquisition (or sale) of control of insurance
companies. The nature and extent of such legislation and regulations vary from
state to state. Generally, these regulations require an acquirer of control to
file detailed information and the plan of acquisition, and to obtain
administrative approval prior to the acquisition of control. "Control" is
generally defined as the direct or indirect power to direct or cause the
direction of the management and policies of a person and is rebuttably presumed
to exist if a person or group of affiliated persons directly or indirectly owns
or controls 10 percent or more of the voting securities of another person.
Using statutory statements filed with state regulators annually, the NAIC
calculates certain financial ratios to assist state regulators in monitoring the
financial condition of insurance companies. A "usual range" of results for each
ratio is used as a benchmark. In the past, variances in certain ratios of our
insurance subsidiaries have resulted in inquiries from insurance departments, to
which we have responded. These inquiries have not led to any restrictions
affecting our operations.
The NAIC's RBC requirements provide a tool for insurance regulators to
determine the levels of statutory capital and surplus an insurer must maintain
in relation to its insurance and investment risks and the need for possible
regulatory attention. The RBC requirements provide four levels of regulatory
attention, varying with the ratio of the insurance company's total adjusted
capital (defined as the total of its statutory capital and surplus, asset
valuation reserve ("AVR") and certain other adjustments) to its RBC (as measured
on December 31 of each year), as follows:
o if a company's total adjusted capital is less than 100 percent but
greater than or equal to 75 percent of its RBC (the "Company Action
Level"), the company must submit a comprehensive plan to the regulatory
authority proposing corrective actions aimed at improving its capital
position;
o if a company's total adjusted capital is less than 75 percent but
greater than or equal to 50 percent of its RBC (the "Regulatory Action
Level"), the regulatory authority will perform a special examination of
the company and issue an order specifying the corrective actions that
must be taken;
o if a company's total adjusted capital is less than 50 percent but
greater than or equal to 35 percent of its RBC (the "Authorized Control
Level"), the regulatory authority may take any action it deems
necessary, including placing the company under regulatory control; and
o if a company's total adjusted capital is less than 35 percent of its RBC
(the "Mandatory Control Level"), the regulatory authority must place the
company under its control.
In addition, the RBC requirements provide for a trend test if a company's
total adjusted capital is between 100 percent and 125 percent of its RBC at the
end of the year. The trend test calculates the greater of the decrease in the
margin of total adjusted capital over RBC:
o between the current year and the prior year; and
o for the average of the last 3 years.
It assumes that such decrease could occur again in the coming year. Any company
whose trended total adjusted capital is less than 95 percent of its RBC would
trigger a requirement to submit a comprehensive plan as described above for the
Company Action Level. In order to avoid triggering the trend test with respect
to Conseco Senior, we made a capital contribution of $24.9 million during 2005
to Conseco Senior.
In addition to the RBC requirements, certain states have established
minimum capital requirements for insurance
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companies licensed to do business in their state. These additional requirements
generally have not had a significant impact on the Company's insurance
subsidiaries, but the capital requirements in Florida have caused Conseco Health
Insurance Company to maintain a higher level of capital and surplus than it
would otherwise maintain and have thus limited its ability to pay dividends.
Refer to the note entitled "Statutory Information" in our notes to consolidated
financial statements for more information on our RBC ratios.
In addition, we may need to contribute additional capital to strengthen the
surplus of certain insurance subsidiaries and this could affect the ability of
our top tier insurance subsidiary to pay dividends. The ability of our insurance
subsidiaries to pay dividends is also impacted by various criteria established
by rating agencies for higher ratings. During 2005, we made capital
contributions of $160.5 million to one of our insurance subsidiaries (Bankers
Life & Casualty Company) in an effort to meet such criteria.
The NAIC has adopted model long-term care policy language providing
nonforfeiture benefits and has proposed a rate stabilization standard for
long-term care policies. Various bills are introduced from time to time in the
U.S. Congress which propose the implementation of certain minimum consumer
protection standards in all long-term care policies, including guaranteed
renewability, protection against inflation and limitations on waiting periods
for pre-existing conditions. Federal legislation permits premiums paid for
qualified long-term care insurance to be tax-deductible medical expenses and for
benefits received on such policies to be excluded from taxable income.
Our insurance subsidiaries are required, under guaranty fund laws of most
states, to pay assessments up to prescribed limits to fund policyholder losses
or liabilities of insolvent insurance companies. Assessments can be partially
recovered through a reduction in future premium taxes in some states.
Most states mandate minimum benefit standards and benefit ratios for
accident and health insurance policies. We are generally required to maintain,
with respect to our individual long-term care policies, minimum anticipated
benefit ratios over the entire period of coverage of not less than 60 percent.
With respect to our Medicare supplement policies, we are generally required to
attain and maintain an actual benefit ratio, after three years, of not less than
65 percent. We provide to the insurance departments of all states in which we
conduct business annual calculations that demonstrate compliance with required
minimum benefit ratios for both long-term care and Medicare supplement
insurance. These calculations are prepared utilizing statutory lapse and
interest rate assumptions. In the event that we fail to maintain minimum
mandated benefit ratios, our insurance subsidiaries could be required to provide
retrospective refunds and/or prospective rate reductions. We believe that our
insurance subsidiaries currently comply with all applicable mandated minimum
benefit ratios.
The federal government does not directly regulate the insurance business.
However, federal legislation and administrative policies in several areas,
including pension regulation, age and sex discrimination, financial services
regulation, securities regulation, privacy laws and federal taxation, do affect
the insurance business. Legislation has been introduced from time to time in
Congress that could result in the federal government assuming some direct role
in the regulation of insurance.
Numerous proposals to reform the current health care system (including
Medicare) have been introduced in Congress and in various state legislatures.
Proposals have included, among other things, modifications to the existing
employer-based insurance system, a quasi-regulated system of "managed
competition" among health plans, and a single-payer, public program. Changes in
health care policy could significantly affect our business. For example, Federal
comprehensive major medical or long-term care programs, if proposed and
implemented, could partially or fully replace some of Conseco's current
products. Recent federal and state legislation and legislative proposals
relating to healthcare reform contain features that could severely limit or
eliminate our ability to vary our pricing terms or apply medical underwriting
standards, which could have the effect of increasing our benefit ratios and
adversely affecting our financial results. Also, Medicare reform and legislation
concerning prescription drugs could affect our ability to price or sell our
products.
The United States Department of Health and Human Services has issued
regulations under the Health Insurance Portability and Accountability Act
("HIPAA") relating to standardized electronic transaction formats, code sets and
the privacy of member health information. These regulations, and any
corresponding state legislation, affect our administration of health insurance.
A number of states have passed or are considering legislation that limits
the differentials in rates that insurers could charge for health care coverages
between new business and renewal business for similar demographic groups. State
legislation has also been adopted or is being considered that would make health
insurance available to all small groups by requiring coverage of all employees
and their dependents, by limiting the applicability of pre-existing conditions
exclusions, by requiring insurers to offer a basic plan exempt from certain
benefits as well as a standard plan, or by establishing a
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mechanism to spread the risk of high risk employees to all small group insurers.
Congress and various state legislators have from time to time proposed changes
to the health care system that could affect the relationship between health
insurers and their customers, including external review. We cannot predict with
certainty the effect of any legislative proposals on our insurance businesses
and operation.
The asset management activities of 40|86 Advisors are subject to various
federal and state securities laws and regulations. The SEC and certain state
securities commissions are the principal regulators of our asset management
operations. In addition, Conseco has two subsidiaries that are registered as
broker/dealers. The broker/dealers are regulated by the National Association of
Securities Dealers and by state securities commissioners.
FEDERAL INCOME TAXATION
Our annuity and life insurance products generally provide policyholders
with an income tax advantage, as compared to other savings investments such as
certificates of deposit and bonds, because taxes on the increase in value of the
products are deferred until received by policyholders. With other savings
investments, the increase in value is generally taxed as earned. Annuity
benefits and life insurance benefits, which accrue prior to the death of the
policyholder, are generally not taxable until paid. Life insurance death
benefits are generally exempt from income tax. Also, benefits received on
immediate annuities (other than structured settlements) are recognized as
taxable income ratably, as opposed to the methods used for some other
investments which tend to accelerate taxable income into earlier years. The tax
advantage for annuities and life insurance is provided in the Internal Revenue
Code (the "Code"), and is generally followed in all states and other United
States taxing jurisdictions.
In recent years, Congress enacted legislation to lower marginal tax rates,
reduce the federal estate tax gradually over a ten-year period, with total
elimination of the federal estate tax in 2010, and increase contributions that
may be made to individual retirement accounts and 401(k) accounts. While these
tax law changes will sunset at the beginning of 2011 absent future congressional
action, they could in the interim diminish the appeal of our annuity and life
insurance products. Additionally, Congress has considered, from time to time,
other possible changes to the U.S. tax laws, including elimination of the tax
deferral on the accretion of value of certain annuities and life insurance
products. It is possible that further tax legislation will be enacted which
would contain provisions with possible adverse effects on our annuity and life
insurance products.
Our insurance company subsidiaries are taxed under the life insurance
company provisions of the Code. Provisions in the Code require a portion of the
expenses incurred in selling insurance products to be deducted over a period of
years, as opposed to immediate deduction in the year incurred. This provision
increases the tax for statutory accounting purposes, which reduces statutory
earnings and surplus and, accordingly, decreases the amount of cash dividends
that may be paid by the life insurance subsidiaries.
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 net operating loss carryforwards
("NOLs"). In evaluating 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. In addition, the use
of our NOLs is dependent, in part, on whether the Internal Revenue Service
("IRS") ultimately agrees with the tax position we plan to take in our current
and future tax returns. Accordingly, with respect to our deferred tax assets, we
assess the need for a valuation allowance on an ongoing basis.
Based upon information existing at the time of our emergence from
bankruptcy, we established a valuation allowance equal to our entire balance of
net deferred income tax assets because, at that time, the realization of such
deferred tax assets in future periods was uncertain. As of December 31, 2005 and
2004, we determined that a full valuation allowance was no longer necessary.
However, as further discussed in the note to the consolidated financial
statements entitled "Income Taxes", we continue to believe that it is necessary
to have a valuation allowance on a portion of our deferred tax asset. This
determination was made by evaluating each component of the deferred tax assets
and assessing the effects of limitations or issues on the value of such
component to be fully recognized in the future.
ITEM 1A. RISK FACTORS.
Conseco and its businesses are subject to a number of risks including
general business and financial risk factors. Any or all of such factors could
have a material adverse effect on the business, financial condition or results
of operations of Conseco. In addition, please refer to the "Cautionary Statement
Regarding Forward-Looking Statements" included in "Item 7 - Management's
Discussion and Analysis of Consolidated Financial Condition and Results of
Operations".
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Certain purported class action lawsuits could harm our financial strength
and reduce our profitability.
We are involved in a substantial amount of litigation, including class
action lawsuits. Plaintiffs in class action lawsuits against us may seek very
large or indeterminate amounts, including treble damages. In the event of an
unfavorable outcome in one or more of these matters, the ultimate liability may
be in excess of liabilities we have established and could have a material
adverse effect on our business, financial condition, results of operations and
cash flows.
The Company and certain subsidiaries, including principally Conseco Life
Insurance Company, have been named as defendants in multiple purported class
actions and individual cases alleging, among other things, breach of contract,
violation of California Business and Professions Code Section 17200, fraud and
misrepresentation regarding a change made in 2003 and 2004 in the way cost of
insurance charges and related monthly deductions were calculated for
approximately 86,500 life insurance policies. In April 2005, a nationwide class
was certified with respect to the breach of contract claim and, in California, a
statewide class was certified for injunctive and restitutionary relief pursuant
to California Business and Professions Code Section 17200 and breach of the duty
of good faith and fair dealing. These claims allege that the change to the
calculation of cost of insurance charges allowed us to add $360 million to our
balance sheet. They seek, among other things, an injunction that would require
the reinstatement of the prior method for calculating monthly cost of insurance
charges, and a refund of any additional charges that resulted from the change.
In addition, a few state insurance departments are reviewing the change to the
calculation of monthly deductions.
For a description of other current legal proceedings, see note 9 of the
consolidated financial statements.
The ultimate outcome of these lawsuits cannot be predicted with certainty.
In addition, we and our subsidiaries may become subject to similar litigation in
other jurisdictions. Because our insurance subsidiaries were not part of the
bankruptcy proceedings of our predecessor company and some of its non-insurance
subsidiaries, those proceedings did not discharge any claims asserted in
litigation against our insurance subsidiaries.
The 2002 bankruptcy of our predecessor company and some of its subsidiaries
disrupted our operations and damaged the "Conseco" brand. As a result, we
may experience lower sales, increased agent attrition and policyholder
lapses and redemptions, than we experienced prior to our bankruptcy.
The filing of bankruptcy petitions by our predecessor company and some of
its non-insurance subsidiaries in December 2002 caused significant disruptions
to our predecessor's operations. We believe that adverse publicity in national
and local media outlets concerning our predecessor's bankruptcy and its disputes
with former members of management caused sales of our insurance products to
decline and policyholder lapses and redemptions to increase. For example,
withdrawals from annuities and other investment-type products exceeded deposits
by $77.2 million, $147.4 million and $615.4 million during the years ended
December 31, 2005, 2004 and 2003, respectively. Supplemental health premiums
collected by our Conseco Insurance Group segment decreased to $661.5 million in
2005 compared to $729.6 million in 2004.
We also experienced increased agent attrition, which, in some cases, led us
to increase agents' commissions or sales incentives in order to retain agents.
For example, the number of producing agents and sales managers selling products
through the Conseco Insurance Group segment decreased by approximately 34
percent to 6,000 at December 31, 2005, compared to December 31, 2003. The number
of career agents selling products through the Bankers Life segment remained at
approximately 4,600 throughout 2004 and increased to 4,800 in 2005.
While we cannot precisely quantify the damage to the Conseco brand caused
by the negative publicity of our predecessor's distressed financial condition,
we believe these events contributed significantly to the trends indicated above.
Our successful emergence from bankruptcy in 2003 and capital restructuring in
2004 and 2005 have begun to reverse some of these trends; however, we do not
expect our sales to return to pre-bankruptcy levels in the near-term.
A failure to improve the financial strength ratings of our insurance
subsidiaries could cause us to experience decreased sales, increased agent
attrition and increased policyholder lapses and redemptions.
An important competitive factor for our insurance subsidiaries is the
ratings they receive from nationally recognized rating organizations. Agents,
insurance brokers and marketing companies who market our products, and
prospective policyholders view ratings as an important factor in evaluating an
insurer's products. This is especially true for annuity, interest-sensitive life
insurance and long-term care products. Our insurance companies' financial
strength ratings were downgraded by all of the major rating agencies beginning
in July 2002 in connection with the financial distress that ultimately led to
our predecessor company's bankruptcy. This ratings decline caused decreased
sales of our insurance products, increased policyholder redemptions and lapses
and increased agent attrition, which, in turn, negatively impacted
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our financial results. The financial strength ratings of our primary insurance
subsidiaries (other than Conseco Senior) were upgraded in: (i) March 2006 by
Moody's; (ii) the second quarter of 2004 by A.M. Best, S&P and Moody's; and
(iii) again in the third quarter of 2004 by Moody's. The current financial
strength ratings of our primary insurance subsidiaries (other than Conseco
Senior) from A.M. Best, S&P and Moody's are "B++ (Very Good)," "BB+" and "Baa3,"
respectively. The ratings of Conseco Senior from A.M. Best, S&P and Moody's are
"B (Fair)," "CCC" and "Caa1," respectively. The "B++" rating and the "B" rating
from A.M. Best are the fifth and seventh highest, respectively, of sixteen
possible ratings. The "BB+" rating and the "CCC" rating from S&P are the
eleventh and eighteenth highest, respectively, of twenty-one possible ratings.
The "Baa3" rating and the "Caa1" rating from Moody's are the tenth and
seventeenth highest of twenty-one possible ratings. While our subsidiaries have
recently been assigned positive ratings outlooks by these agencies, most of our
competitors have higher financial strength ratings and, to be competitive, we
believe it is critical to achieve improved ratings.
If we fail to achieve and maintain an "A" category rating from A.M. Best,
we may experience declining sales of our insurance products, defections of our
independent and career sales force, and increased policies being redeemed or
allowed to lapse. These events would adversely affect our financial results,
which could then lead to ratings downgrades.
Our results of operations may be negatively impacted if we are unable to
achieve the goals of our initiatives to restructure our principal insurance
businesses or if our planned conversions result in valuation differences.
Our Conseco Insurance Group segment has experienced decreases in premium
revenues and new annualized premiums in recent years as well as expense levels
that exceed product pricing expense assumptions. We have implemented several
initiatives to improve operating results, including: (i) focusing sales efforts
on higher margin products; (ii) reducing operating expenses by eliminating or
reducing marketing costs of certain products; (iii) streamlining administrative
procedures and reducing personnel; and (iv) increasing retention rates on our
more profitable blocks of inforce business. Our efforts to stabilize the
profitability of the long-term care block of business in run-off sold through
independent agents include premium rate increases, improved claim adjudication
procedures and other actions. Many of our initiatives address issues resulting
from the substantial number of acquisitions of our predecessor. Between 1982 and
1997, our predecessor completed 19 transactions involving the acquisitions of 44
separate insurance companies. Our efforts involve improvements to our policy
administration procedures and significant systems conversions, such as the
elimination of duplicate processing systems for similar business. These
initiatives may result in unforeseen expenses, complications or delays, and may
be inadequate to address all issues. In addition, changes to our claim
adjudication procedures have resulted in increased complaints from our
policyholders and, in some cases, have resulted in inquiries from state
regulators. Some of these initiatives have only recently begun to be executed,
and may not ultimately be successfully completed. While our future operating
performance depends greatly on the success of these efforts, even if we
successfully implement these measures, they alone may not sufficiently improve
our results of operations.
Conversions to new systems can result in valuation differences between the
prior system and the new system. We have recognized such differences in the
past. During the fourth quarter of 2005, our conversion to a seriatim-based
valuation system to determine reserves for the long-term care block of business
in run-off resulted in decreases to insurance liabilities of approximately $38
million. Our planned conversions could result in such valuation adjustments, and
there can be no assurance that these adjustments will not have a material
adverse effect on future earnings.
The results of operations of our insurance business will decline if our
premium rates are not adequate or if we are unable to obtain regulatory
approval to increase rates.
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 probable size of the claim, maintenance costs to
administer the policies 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, but we
cannot predict with certainty the future actual claims on our products. 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.
We review the adequacy of our premium rates regularly and file proposed
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 from future requests. If we are
unable to raise our premium rates because we fail to obtain approval in one or
more states, our net income may decrease. Moreover, in some instances, our
ability to exit unprofitable lines of business is limited by the guaranteed
renewal feature of the policy. Due to this feature, we cannot exit such business
without regulatory approval, and accordingly, we may be required to continue to
service those products at a
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loss for an extended period of time. Most of our long-term care business is
guaranteed renewable, and, if necessary rate increases were not approved, we
would be required to recognize a loss and establish a premium deficiency
reserve. During 2005, the financial statements of our subsidiary, Washington
National Insurance Company, prepared in accordance with statutory accounting
practices prescribed or permitted by regulatory authorities reflected the
establishment of a premium deficiency reserve of approximately $40 million
related to a block of long-term care policies. Due to increases to insurance
liabilities at the fresh-start date described in note 7 to the consolidated
financial statements, we were not required to recognize a similar premium
deficiency reserve in our consolidated financial statements prepared in
accordance with GAAP.
If, however, we are successful in obtaining regulatory approval to raise
premium rates, 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 a significantly higher ratio of claim costs to premiums if
healthier policyholders who get coverage elsewhere allow their policies to
lapse, while policies of less healthy policyholders continue inforce. This would
reduce our premium income and profitability in future periods.
Most of our supplemental health policies allow us to increase premium rates
when warranted by our actual claims experience. These rate increases must be
approved by the applicable state insurance departments, and we are required to
submit actuarial claims data to support the need for such rate increases. The
re-rate application and approval process on supplemental health products is a
normal recurring part of our business operations and reasonable rate increases
are typically approved by the state departments as long as they are supported by
actual claims experience and are not unusually large in either dollar amount or
percentage increase. For policy types on which rate increases are a normal
recurring event, our estimates of insurance liabilities assume we will be able
to raise rates if the blocks warrant such increases in the future.
The benefit ratio for our long-term care products included in the Other
Business in Run-off segment has increased in recent periods and was 100 percent
during 2005. We will have to raise rates or take other actions with respect to
some of these policies or our financial results will be adversely affected.
During 2005, 2004 and 2003, we received approvals (excluding rate increases
permitted in accordance with the Florida orders described in the following
paragraph) for rate increases totaling $6 million, $48 million and $37 million,
respectively, relating to this long-term care business, which had approximately
$350 million of collected premiums in 2005.
On home health care policies issued in some areas of Florida and other
states, payments made for the benefit of policyholders have exceeded premiums
received by a significant margin. Substantially all of these policies were
issued through independent agents by certain of our subsidiaries prior to their
acquisitions by us in 1996 and 1997. On April 20, 2004, the Florida Office of
Insurance Regulation issued an order to our subsidiary, Conseco Senior, which
affects approximately 12,600 home health care policies issued in Florida by
Conseco Senior and its predecessor companies. On July 1, 2004, the Florida
Office of Insurance Regulation issued a similar order impacting approximately
4,800 home health care policies issued in Florida by one of our other insurance
subsidiaries, Washington National Insurance Company and its predecessor
companies ("Washington National"). Pursuant to the orders, Conseco Senior and
Washington National were required to offer the following three alternatives to
holders of these policies:
o retention of their current policy with a rate increase of 50 percent
in the first year and actuarially justified increases in subsequent
years;
o receipt of a replacement policy with reduced benefits and a rate
increase in the first year of 25 percent and no more than 15 percent
in subsequent years; and
o receipt of a paid up policy, allowing the holder to file future claims
up to 100 percent of the amount of premiums paid since the inception
of the policy.
We began to implement premium adjustments with respect to policyholder elections
in the fourth quarter of 2005.
The orders also require Conseco Senior and Washington National to pursue a
similar course of action with respect to approximately 24,000 home health care
policies issued in other states, subject to consideration and approval by other
state insurance departments. If we are unsuccessful in obtaining rate increases
or other forms of relief in other states, or if the policy changes approved by
the Florida Office of Insurance Regulation prove inadequate, our future results
of operations could be adversely affected.
We are also seeking rate increases on approximately 65 percent of the total
long-term care inforce block in the Bankers Life segment. As a result of higher
persistency in this block and lower interest rates than assumed in the original
pricing, the current premium rates are too low. This process is proceeding
according to plan and, to date, we have already received approval for
approximately 70 percent of the total dollar amount of our requested increases.
However, it is possible that we will not be able to obtain approval for premium
rate increases from currently pending requests or future requests. If we are
unable to obtain these rate increases, the profitability of these policies and
the performance of this block of business could be adversely affected. In
addition, such rate increases may reduce the volume of our new sales and cause
existing policyholders to allow their policies to lapse, resulting in reduced
profitability.
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The limited historical claims experience on our long-term care products
could negatively impact our operations if our estimates prove wrong and we
have not adequately set premium rates.
In setting premium rates, we consider historical claims information and
other factors, but we cannot predict future claims with certainty. This is
particularly applicable to our long-term care insurance products, for which we
have relatively limited historical claims experience. Long-term care products
tend to have fewer claims than other health products such as Medicare
supplement, but when claims are incurred, they tend to be much higher in dollar
amount. Also, long-term care products have a much longer tail, meaning that
claims are incurred much later in the life of the policy than most other
supplemental health products. As a result of these traits, it is difficult to
appropriately price this product.
Our Bankers Life segment has offered long-term care insurance since 1985.
Bankers Life's claims experience on its long-term care blocks has generally been
lower than its pricing expectations. However, the lapses on these policies have
been lower than our pricing expectations and this may result in higher benefit
ratios in the future.
The long-term care insurance businesses included in the Other Business in
Run-off segment were acquired through acquisitions completed in 1996 and 1997.
The majority of such business was written between 1990 and 1997. The experience
on these acquired blocks has generally been worse than the acquired companies'
original pricing expectations. We have received necessary regulatory approvals
for numerous premium rate increases in recent years pertaining to these blocks.
Even with these rate increases, these blocks experienced benefit ratios of 100
percent in 2005, 103 percent in 2004, 103 percent in the four months ended
December 31, 2003 and 170 percent in the eight months ended August 31, 2003. If
future claims experience proves to be worse than anticipated as our long-term
care blocks continue to age, our financial results could be adversely affected.
In addition, such rate increases may cause existing policyholders to allow their
policies to lapse, resulting in reduced profitability.
Our reserves for future insurance policy benefits and claims may prove to
be inadequate, requiring us to increase liabilities and resulting in
reduced net income and shareholders' equity.
We calculate and maintain reserves for the estimated future payment of
claims to our policyholders primarily based on assumptions made by our
actuaries. For our life insurance business, our limit of risk retention for each
policy is generally $.8 million or less because amounts above $.8 million are
ceded to reinsurers. For our health insurance business, we establish an active
life reserve, a liability for due and unpaid claims, claims in the course of
settlement, and incurred but not reported claims, and a reserve for the present
value of amounts on incurred claims not yet due. We establish reserves based on
assumptions and estimates of factors either established at the fresh-start date
for business inforce then or considered when we set premium rates for business
written after that date.
Many factors can affect these reserves and liabilities, such as economic
and social conditions, inflation, hospital and pharmaceutical costs, regulatory
actions, changes in doctrines of legal liability and extra-contractual damage
awards. Therefore, the reserves and liabilities we establish are necessarily
based on estimates, assumptions and prior years' statistics. It is possible that
actual claims will materially exceed our reserves and have a material adverse
effect on our results of operations and financial condition. We have incurred
significant losses beyond our estimates as a result of actual claim costs and
persistency of our long-term care business included in the Other Business in
Run-off segment. For example, we increased claim reserves by $85 million during
the eight months ended August 31, 2003, as a result of adverse developments and
changes in our estimates of ultimate claims for these products. We completed a
new claims cost study and developed new continuance tables based on our recent
experience which were used to estimate claim reserves at December 31, 2005,
resulting in an increase to insurance liabilities of $40 million in the fourth
quarter of 2005. Our financial performance depends significantly upon the extent
to which our actual claims experience and future expenses are consistent with
the assumptions we used in setting our reserves. If our assumptions with respect
to future claims are incorrect, and our reserves prove to be insufficient to
cover our actual losses and expenses, we would be required to increase our
liabilities, and our financial results could be adversely affected.
Our ability to meet our obligations may be constrained by our subsidiaries'
ability to distribute cash to us.
Conseco, Inc. and CDOC, Inc., our wholly owned subsidiary and a guarantor
under our secured credit agreement (the "Amended Credit Facility"), are holding
companies with no business operations of their own. As a result, they depend on
their operating subsidiaries for cash to make principal and interest payments on
debt and to pay fees for services provided pursuant to service agreements and
income taxes. The cash they receive from insurance subsidiaries consists of
dividends and distributions, principal and interest payments on surplus
debentures, fees for services, tax-sharing payments, and from
24
<PAGE>
our non-insurance subsidiaries, loans and advances. A deterioration in the
financial condition, earnings or cash flow of the significant subsidiaries of us
or CDOC for any reason could limit their ability to pay cash dividends or other
disbursements to us and CDOC. In addition, we may need to contribute additional
capital to improve the risk-based capital ratios of certain insurance
subsidiaries and this could affect the ability of our top tier insurance
subsidiary to pay dividends. Accordingly, this would limit the ability of CDOC
and us to meet debt service requirements and satisfy other financial
obligations.
Insurance regulators may prohibit the payment of dividends or other
payments by our insurance subsidiaries to parent companies if they determine
that such payment could be adverse to our policyholders or contract holders.
Otherwise, the ability of our insurance subsidiaries to pay dividends is subject
to state insurance department regulations. Insurance regulations generally
permit dividends to be paid from statutory earned surplus of the insurance
company without regulatory approval for any 12-month period in amounts equal to
the greater of (or in a few states, the lesser of): (i) statutory net gain from
operations or statutory net income for the prior year; or (ii) 10 percent of
statutory 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. All of the dividends we plan to
have our insurance subsidiaries pay in 2006 will require regulatory approval.
In accordance with an order from the Florida Office of Insurance
Regulation, Conseco Senior may not distribute funds to any affiliate or
shareholder unless such distributions have been approved by the Florida Office
of Insurance Regulation. In addition, the risk-based capital and other capital
requirements described below can also limit, in certain circumstances, the
ability of our insurance subsidiaries to pay dividends.
Certain states have established minimum capital requirements for insurance
companies licensed to do business in their state. These additional requirements
generally have not had a significant impact on the Company's insurance
subsidiaries, but the capital requirements in Florida have caused Conseco Health
Insurance Company to maintain a higher level of capital and surplus than it
would otherwise maintain and have thus limited its ability to pay dividends.
In addition, we may need to contribute additional capital to strengthen the
surplus of certain insurance subsidiaries and this could affect the ability of
our top tier insurance subsidiary to pay dividends. The ability of our insurance
subsidiaries to pay dividends is also impacted by various criteria established
by rating agencies for higher ratings. During 2005, we made capital
contributions of $160.5 million to one of our insurance subsidiaries (Bankers
Life & Casualty Company) in an effort to meet such criteria.
The following table sets forth the aggregate amount of dividends and other
distributions that our insurance subsidiaries paid to us in each of the last two
fiscal years (dollars in millions):
<TABLE>
<CAPTION>
Years ended December 31,
------------------------
2005 2004
---- ----
<S> <C> <C>
Dividends................................................................... $ - $ 45.8
Surplus debenture interest, which for 2004 included $148.0 million
related to prior years.................................................... 54.8 192.1
Fees for services provided pursuant to service agreements................... 90.8 91.0
Tax sharing payments (refunds).............................................. 1.1 (32.0)
------ ------
Total paid................................................................ $146.7 $296.9
====== ======
</TABLE>
Our Amended Credit Facility contains various restrictive covenants and
required financial ratios that limit our operating flexibility.
As of December 31, 2005, we had $524.6 million principal amount of debt
outstanding under our Amended Credit Facility. The Amended Credit Facility
imposes a number of covenants and financial ratios as defined in the Amended
Credit Facility that we must meet or maintain, including: (i) a debt to total
capitalization ratio; (ii) an interest coverage ratio; (iii) an aggregate
risk-based capital ratio; and (iv) a combined statutory capital and surplus
level. At December 31, 2005, we were in compliance with all of the Amended
Credit Facility's covenants and financial ratios. Although our forecasts
indicate we will meet and/or maintain all of the Amended Credit Facility's
covenants and financial ratios, our ability to do so may be affected by events
beyond our control.
Our Amended Credit Facility also imposes restrictions that limit our
flexibility to plan for and react to changes in the economy and industry,
thereby increasing our vulnerability to adverse economic and industry
conditions. These restrictions include limitations on our ability to: (i) incur
additional indebtedness; (ii) transfer or sell assets; (iii) enter into mergers
or other business combinations; (iv) pay cash dividends or repurchase stock; and
(v) make investments and capital expenditures.
25
<PAGE>
S&P has assigned a "BB- (Marginal)" rating on our senior secured debt. In
S&P's view, an obligation rated "BB-" is less vulnerable to nonpayment than
other speculative issues, but faces major ongoing uncertainties or exposure to
adverse business, financial or economic conditions which could lead to the
obligor's inadequate capacity to meet its financial commitment on the
obligation. S&P has a total of twenty-two separate categories rating senior
debt, ranging from "AAA (Extremely Strong)" to "D (Payment Default)." A "BB-"
rating is the thirteenth highest rating. In March 2006, Moody's upgraded our
senior secured debt rating to "Ba3" from "B2" with a positive outlook. In
Moody's view, an obligation rated "Ba" is judged to have speculative elements
and its future can not be considered as being well-assured. The protection of
interest and principal payments may be very moderate, and thereby not
well-safeguarded during both good and bad times over the future. Moody's has a
total of twenty-one separate categories in which to rate senior debt, ranging
from "Aaa (Exceptional)" to "C (Lowest Rated)." A "Ba3" rating is the thirteenth
highest rating. If we were to require additional capital, either to refinance
our existing indebtedness or to help fund future growth, our current senior debt
ratings could restrict our access to such capital. A positive outlook by Moody's
is an opinion regarding the likely direction of a rating over the medium term.
Our net income and revenues will suffer if policyholder surrender levels
differ significantly from our assumptions.
Surrenders of our annuities and life insurance products can result in
losses and decreased revenues if surrender levels differ significantly from
assumed levels. At December 31, 2005, approximately 17 percent of our total
insurance liabilities, or approximately $4.3 billion, could be surrendered by
the policyholder without penalty. The surrender charges that are imposed on our
fixed rate annuities typically decline during a penalty period, which ranges
from five to twelve years after the date the policy is issued. Surrenders and
redemptions could require us to dispose of assets earlier than we had planned,
possibly at a loss. Moreover, surrenders and redemptions require faster
amortization of either the acquisition costs or the commissions associated with
the original sale of a product, thus reducing our net income. We believe
policyholders are generally more likely to surrender their policies if they
believe the issuer is having financial difficulties, or if they are able to
reinvest the policy's value at a higher rate of return in an alternative
insurance or investment product.
Federal and state legislation could adversely affect the financial
performance of our insurance operations.
During recent years, the health insurance industry has experienced
substantial changes, including those caused by healthcare legislation. Recent
federal and state legislation and pending legislative proposals concerning
healthcare reform contain features that could severely limit, or eliminate, our
ability to vary pricing terms or apply medical underwriting standards to
individuals, thereby potentially increasing our benefit ratios and adversely
impacting our financial results. In particular, Medicare reform could affect our
ability to price or sell our products or profitably maintain our blocks in
force. For example, the Medicare Advantage program provides incentives for
health plans to offer managed care plans to seniors. The growth of managed care
plans under this program could decrease sales of the traditional Medicare
supplement products we sell.
Proposals currently pending in Congress and some state legislatures may
also affect our financial results. These proposals include the implementation of
minimum consumer protection standards in all long-term care policies, including:
guaranteed premium rates; protection against inflation; limitations on waiting
periods for pre-existing conditions; setting standards for sales practices for
long-term care insurance; and guaranteed consumer access to information about
insurers, including information regarding lapse and replacement rates for
policies and the percentage of claims denied. Enactment of any proposal that
would limit the amount we can charge for our products, such as guaranteed
premium rates, or that would increase the benefits we must pay, such as
limitations on waiting periods, or that would otherwise increase the costs of
our business, could adversely affect our financial results.
Tax law changes could adversely affect our insurance product sales and
profitability.
We sell deferred annuities and some forms of life insurance that are
attractive, in part, because policyholders generally are not subject to United
States Federal income tax on increases in policy values until some form of
distribution is made. Recently, Congress enacted legislation to lower marginal
tax rates, to reduce the federal estate tax gradually over a ten-year period
(with total elimination of the federal estate tax in 2010) and to increase
contributions that may be made to individual retirement accounts and 401(k)
accounts. While these tax law changes will expire at the beginning of 2011
absent future congressional action, they could in the interim diminish the
appeal of our annuity and life insurance products because the benefit of tax
deferral is lessened when tax rates are lower and because fewer people may
purchase these products when they can contribute more to individual retirement
accounts and 401(k) accounts. Additionally, Congress has considered, from time
to time, other possible changes to U.S. tax laws, including elimination of the
tax deferral on the accretion of value
26
<PAGE>
within certain annuities and life insurance products. Such a change would make
these products less attractive to prospective purchasers and therefore would
likely cause our sales of these products to decline.
Our investment portfolio is subject to several risks that may diminish the
value of our invested assets and negatively impact our profitability.
The value of our investment portfolio is subject to numerous factors, which
are difficult to predict, and are often beyond our control. These factors
include, but are not limited to, the following:
o Changes in interest rates can reduce the value of our investments as
further discussed in the risk factor entitled "Changing interest rates
may adversely affect our results of operations".
o The ability of issuers to make timely repayments on actively managed
fixed maturity investments can reduce the value of our investments.
This risk is significantly greater with respect to below-investment
grade securities, which comprised 4.4 percent of our actively managed
fixed maturity investments as of December 31, 2005. Prior to our
emergence from bankruptcy, our predecessor recognized substantial
credit-related investment losses when a number of large, highly
leveraged issuers experienced significant financial difficulties. For
example, we recognized other-than-temporary declines in value on
several of our investments, including K-Mart Corp., Amerco, Inc.,
Global Crossing, MCI Communications, Mississippi Chemical Corporation,
United Airlines and Worldcom, Inc. We have recorded writedowns of
fixed maturity investments, equity securities and other invested
assets as a result of conditions which caused us to conclude a decline
in the fair value of the investment was other than temporary as
follows: $14.7 million in 2005; $18.1 million in 2004; $9.6 million in
the four months ended December 31, 2003; and $51.3 million in the
eight months ended August 31, 2003.
In order to manage our exposure to credit losses, we have taken a number of
specific steps, including:
o reducing the percentage of below-investment grade fixed maturity
investments from 5.9 percent at December 31, 2001, to 4.4 percent at
December 31, 2005;
o implementing conservative portfolio compliance guidelines which
generally limit our exposure to single issuer risks; and
o expanding our portfolio reporting procedures to proactively identify
changes in value related to credit risk in a more timely manner.
Our structured security investments, which comprised 28 percent of our
actively managed fixed maturity investments at December 31, 2005, are subject to
risks relating to variable prepayment and default on the assets underlying such
securities, such as mortgage loans. When structured securities prepay faster
than expected, investment income may be adversely affected due to the
acceleration of the amortization of purchase premiums or the inability to
reinvest at comparable yields in lower interest rate environments.
In the event of substantial product surrenders or policy claims, we may be
required to maintain highly liquid, and therefore lower-yielding, assets, or to
sell assets at a loss, thereby eroding the performance of our portfolio.
Because a substantial portion of our net income is derived from returns on
our investment portfolio, significant losses in the portfolio may have a direct
and materially adverse impact on our results of operations. In addition, losses
on our investment portfolio could reduce the investment returns that we are able
to credit to our customers of certain products, thereby impacting our sales and
eroding our financial performance.
Changing interest rates may adversely affect our results of operations.
Our profitability is directly affected by fluctuating interest rates. While
we monitor the interest rate environment and have previously employed hedging
strategies to mitigate such impact, our financial results could be adversely
affected by changes in interest rates. Our spread-based insurance and annuity
business is subject to several inherent risks arising from movements in interest
rates, especially if we fail to anticipate or respond to such movements. First,
interest rate changes can cause compression of our net spread between interest
earned on investments and interest credited to customer deposits. Our ability to
adjust for such a compression is limited by the guaranteed minimum rates that we
must credit to policyholders on certain products, as well as the terms on most
of our other products that limit reductions in the crediting rates to
pre-
27
<PAGE>
established intervals. As of December 31, 2005, approximately 41 percent of our
insurance liabilities were subject to interest rates that may be reset annually;
46 percent had a fixed explicit interest rate for the duration of the contract;
9 percent had credited rates that approximate the income we earn; and the
remainder had no explicit interest rates. Second, if interest rate changes
produce an unanticipated increase in surrenders of our spread-based products, we
may be forced to sell invested assets at a loss in order to fund such
surrenders. Third, the profits from many non-spread-based insurance products,
such as long-term care policies, can be adversely affected when interest rates
decline because we may be unable to reinvest the cash from premiums received at
the interest rates anticipated when we sold the policies. Finally, changes in
interest rates can have significant effects on the performance of our structured
securities portfolio, including collateralized mortgage obligations, as a result
of changes in the prepayment rate of the loans underlying such securities. We
follow asset/liability strategies that are designed to mitigate the effects of
interest rate changes on our profitability but do not currently employ
derivative instruments for this purpose. We may not be successful in
implementing these strategies and achieving adequate investment spreads.
We use computer models to simulate our cash flows expected from existing
business under various interest rate scenarios. These simulations help us
measure the potential gain or loss in fair value of our interest-sensitive
financial instruments. With such estimates, we seek to manage the relationship
between the duration of our assets and the expected duration of our liabilities.
When the estimated durations of assets and liabilities are similar, exposure to
interest rate risk is minimized because a change in the value of assets should
be largely offset by a change in the value of liabilities. At December 31, 2005,
the duration of our fixed maturity investments (as modified to reflect
prepayments and potential calls) was approximately 6.6 years, and the duration
of our insurance liabilities was approximately 7.3 years. We estimate that our
fixed maturity securities and short-term investments, net of corresponding
changes in insurance acquisition costs, would decline in fair value by
approximately $685 million if interest rates were to increase by 10 percent from
rates as of December 31, 2005. This compares to a decline in fair value of $630
million based on amounts and rates at December 31, 2004. The calculations
involved in our computer simulations incorporate numerous assumptions, require
significant estimates and assume an immediate change in interest rates without
any management reaction to such change. Consequently, potential changes in the
values of our financial instruments indicated by the simulations will likely be
different from the actual changes experienced under given interest rate
scenarios, and the differences may be material. Because we actively manage our
investments and liabilities, our net exposure to interest rates can vary over
time.
Volatility in the securities markets, and other economic factors, may
adversely affect our business, particularly our sales of certain life
insurance products and annuities.
Fluctuations in the securities markets and other economic factors may
adversely affect sales and/or policy surrenders of our annuities and life
insurance policies. For example, volatility in the equity markets may deter
potential purchasers from investing in equity-indexed annuities and may cause
current policyholders to surrender their policies for the cash value or to
reduce their investments. In addition, significant or unusual volatility in the
general level of interest rates could negatively impact sales and/or lapse rates
on certain types of insurance products.
We face risk with respect to our reinsurance agreements.
We transfer exposure to certain risks to others through reinsurance
arrangements. Under these arrangements, other insurers assume a portion of our
losses and expenses associated with reported and unreported claims in exchange
for a portion of policy premiums. The availability, amount and cost of
reinsurance depend on general market conditions and may vary significantly. As
of December 31, 2005, our reinsurance receivables totaled $887.5 million. Our
ceded life insurance inforce totaled $18.0 billion. Our eight largest reinsurers
accounted for 86 percent of our ceded life insurance inforce. We face credit
risk with respect to reinsurance. When we obtain reinsurance, we are still
liable for those transferred risks if the reinsurer cannot meet its obligations.
Therefore, the inability of our reinsurers to meet their financial obligations
may require us to increase liabilities, thereby reducing our net income and
shareholders' equity.
Our business is subject to extensive regulation, which limits our operating
flexibility and could result in our insurance subsidiaries being placed
under regulatory control or otherwise negatively impact our financial
results.
Our insurance business is subject to extensive regulation and supervision
in the jurisdictions in which we operate. Our insurance subsidiaries are subject
to state insurance laws that establish supervisory agencies. Such agencies have
broad administrative powers including: granting and revoking licenses to
transact business; regulating sales and other practices; approving premium rate
increases; licensing agents; approving policy forms; setting reserve and
solvency requirements; determining the form and content of required statutory
financial statements; limiting dividends; and prescribing the type and amount of
investments insurers can make. The regulations issued by state insurance
agencies can be complex and subject to differing interpretations. If a state
insurance regulatory agency determines that one of our insurance company
subsidiaries is not in compliance with applicable regulations, the subsidiary is
subject to various potential administrative remedies
28
<PAGE>
including, without limitation, monetary penalties, restrictions on the
subsidiary's ability to do business in that state and a return of a portion of
policyholder premiums. In addition, regulatory action or investigations could
cause us to suffer significant reputational harm, which could have an adverse
effect on our business, financial condition and results of operations.
During its bankruptcy period and throughout most of 2003, our predecessor
operated under heightened scrutiny from state insurance regulators and under
certain consent orders, thereby restricting the ability of its insurance
subsidiaries to pay dividends or other amounts to any non-insurance company
parent without prior approval. Our emergence from bankruptcy in 2003 and the
completion of our capital restructuring in 2004 and 2005 reduced the level of
scrutiny from our state insurance regulators; however, we cannot be assured that
regulators will not seek to assert greater supervision and control over our
insurance subsidiaries' businesses and financial affairs in the future. If our
financial condition were to deteriorate, we may be required to enter into
similar orders in the future.
Our insurance subsidiaries are also subject to risk-based capital
requirements. These requirements were designed to evaluate the adequacy of
statutory capital and surplus in relation to investment and insurance risks
associated with asset quality, mortality and morbidity, asset and liability
matching and other business factors. The requirements are used by states as an
early warning tool to discover potential weakly-capitalized companies for the
purpose of initiating regulatory action. Generally, if an insurer's risk-based
capital falls below specified levels, the insurer would be subject to different
degrees of regulatory action depending upon the magnitude of the deficiency. The
2005 statutory annual statements filed with the state insurance regulators of
each of our insurance subsidiaries reflected total adjusted capital in excess of
the levels subjecting the subsidiaries to any regulatory action. However, the
risk-based capital ratio of Conseco Senior, which has experienced losses on its
long-term care business in our Other Business in Run-off segment, was near the
level at which it would have been required to submit a comprehensive plan to
insurance regulators proposing corrective actions aimed at improving its capital
position. We contributed $24.9 million to the capital and surplus of Conseco
Senior in 2005.
Our insurance subsidiaries may be required to pay assessments to fund
policyholder losses or liabilities and this may negatively impact our
financial results.
The solvency or guaranty laws of most states in which an insurance company
does business may require that company to pay assessments up to certain
prescribed limits to fund policyholder losses or liabilities of other insurance
companies that become insolvent. Insolvencies of insurance companies increase
the possibility that these assessments may be required. These assessments may be
deferred or forgiven under most guaranty laws if they would threaten an
insurer's financial strength and, in certain instances, may be offset against
future premium taxes. We cannot estimate the likelihood and amount of future
assessments. Although past assessments have not been material, if there were a
number of large insolvencies, future assessments could be material and could
have a material adverse effect on our operating results and financial position.
Litigation and regulatory investigations are inherent in our business and
may harm our financial strength and reduce our profitability.
Insurance companies historically have been subject to substantial
litigation resulting from claims, disputes and other matters. In addition to the
traditional policy claims associated with their businesses, insurance companies
typically face policyholder suits and class action suits. We also face
significant risks related to regulatory investigations and actions. The
litigation and regulatory investigations we are, have been, or may become
subject to include matters related to sales or underwriting practices, payment
of contingent or other sales commissions, claim payments and procedures, product
design, product disclosure, administration, additional premium charges for
premiums paid on a periodic basis, denial or delay of benefits, charging
excessive or impermissible fees on products and recommending unsuitable products
to customers. Our pending legal and regulatory actions include matters that are
specific to us, as well as matters faced by other insurance companies. State
insurance departments focus on sales practices and product issues in their
market conduct examinations. Negotiated settlements of class action and other
lawsuits have had a material adverse effect on the business, financial condition
and results of operations of insurance companies. We are, in the ordinary course
of our business, a plaintiff or defendant in actions arising out of our
insurance business, including class actions and reinsurance disputes, and, from
time to time, we are also involved in various governmental and administrative
proceedings and investigations and inquiries such as information requests,
subpoenas and books and record examinations, from state, federal and other
authorities. The ultimate outcome of these lawsuits and investigations, however,
cannot be predicted with certainty. In the event of an unfavorable outcome in
one or more of these matters, the ultimate liability may be in excess of
liabilities we have established and could have a material adverse effect on our
business, financial condition, results of operations or cash flows. We could
also suffer significant reputational harm as a result of such litigation,
regulatory action or investigation which could have a material adverse effect on
our business, financial condition, results of operations or cash flows. Because
our insurance subsidiaries were not part of the bankruptcy proceedings of our
predecessor company and some of its non-insurance subsidiaries, those
29
<PAGE>
proceedings did not result in the discharge of any claims, including claims
asserted in litigation, against our insurance subsidiaries.
Competition from companies that have greater market share, higher ratings
and greater financial resources may impair our ability to retain existing
customers and sales representatives, attract new customers and sales
representatives and maintain or improve our financial results.
The supplemental health insurance, annuity and individual life insurance
markets are highly competitive. Competitors include other life and accident and
health insurers, commercial banks, thrifts, mutual funds and broker-dealers.
Our principal competitors vary by product line. Our main competitors for
agent sold long-term care insurance products include Genworth Financial, John
Hancock Financial Services and MetLife. Our main competitors for agent sold
Medicare supplement insurance products include United HealthCare, Blue Cross and
Blue Shield Plans, Mutual of Omaha and United American.
In some of our product lines, such as life insurance and fixed annuities,
we have a relatively small market share. Even in some of the lines in which we
are one of the top five writers, our market share is relatively small. For
example, while our Bankers Life segment ranked fourth in annualized premiums of
individual long-term care insurance in 2005 with a market share of approximately
9 percent, the top three writers of individual long-term care insurance had
annualized premiums with a combined market share of approximately 54 percent
during the period. In addition, while our Bankers Life segment was ranked second
in annualized premiums of individual Medicare supplement insurance in 2005 with
a market share of approximately 26 percent, the top writer of individual
Medicare supplement insurance had annualized premiums with a market share of
approximately 38 percent during the period.
Virtually all of our major competitors have higher financial strength
ratings than we do. Many of our competitors are larger companies that have
greater capital, technological and marketing resources and have access to
capital at a lower cost. Recent industry consolidation, including business
combinations among insurance and other financial services companies, has
resulted in larger competitors with even greater financial resources.
Furthermore, changes in federal law have narrowed the historical separation
between banks and insurance companies, enabling traditional banking institutions
to enter the insurance and annuity markets and further increase competition.
This increased competition may harm our ability to maintain or improve our
profitability.
In addition, because the actual cost of products is unknown when they are
sold, we are subject to competitors who may sell a product at a price that does
not cover its actual cost. Accordingly, if we do not also lower our prices for
similar products, we may lose market share to these competitors. If we lower our
prices to maintain market share, our profitability will decline.
We must attract and retain sales representatives to sell our insurance and
annuity products. Strong competition exists among insurance and financial
services companies for sales representatives. We compete for sales
representatives primarily on the basis of our financial position, financial
strength ratings, support services, compensation and product features. Our
competitiveness for such agents also depends upon the relationships we develop
with these agents. If we are unable to attract and retain sufficient numbers of
sales representatives to sell our products, our ability to compete and our
revenues and profitability would suffer.
ITEM 1B. UNRESOLVED STAFF COMMENTS.
None.
ITEM 2. PROPERTIES.
Our headquarters and the administrative operations of our Conseco Insurance
Group segment are located on a Company-owned 142-acre corporate campus in
Carmel, Indiana, immediately north of Indianapolis. The ten buildings on the
campus contain approximately 854,500 square feet of space and house Conseco's
executive offices and certain administrative operations of its subsidiaries. In
May 2005, we entered into a listing agreement for the sale/lease of 105,535
square feet of unused office space. In July 2005, we entered into a listing
agreement for either the sale of 121,762 square feet or the lease of 115,988
square feet of unused office space, and we also entered into a listing agreement
for the sale of approximately 36 acres of undeveloped land. Management believes
that our remaining office space is adequate for our needs.
Our Bankers Life segment is primarily administered from two facilities in
downtown Chicago, Illinois. Bankers Life
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<PAGE>
has approximately 114,000 square feet leased under an agreement which expires in
2018 and approximately 222,000 square feet which expires in 2013. We own an
office building in Philadelphia, Pennsylvania (127,000 square feet), which
serves as the administrative center for the direct marketing operation of our
Bankers Life segment. We occupy approximately 60 percent of this space, with the
remainder leased to tenants. We also lease 210 sales offices in various states
totaling approximately 595,000 square feet. These leases are short-term in
length, with remaining lease terms expiring between 2006 and 2011.
ITEM 3. LEGAL PROCEEDINGS.
Information required for Item 3 is incorporated by reference to the
discussion under the heading "Legal Proceedings" in note 9 "Commitments and
Contingencies" to our consolidated financial statements included in Item 8 of
this Form 10-K.
31
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ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
Executive Officers of the Registrant
<TABLE>
<CAPTION>
Officer Positions with Conseco, Principal
Name and Age (a) Since Occupation and Business Experience (b)
---------------- ----- --------------------------------------
<S> <C> <C>
Eugene M. Bullis, 60.......................... 2000 Since November 2002, executive vice president and chief financial
officer. From 2000 until 2002, Mr. Bullis served as chief financial
officer of Managed Ops.Com, Inc. From 1999 until 2000 he was
executive vice president and chief financial officer of Manufacturers
Services, Ltd. and from 1998 to 1999 he served as senior vice
president and chief financial officer of Physicians Quality Care.
James E. Hohmann, 50.......................... 2004 Since December 2004, executive vice president and chief administrative
officer. Prior to joining Conseco, Mr. Hohmann served as President
and CEO of XL Life and Annuity from 2001 until December 2004. From
1998 until 2001, he served as president, financial institutions for
Zurich Kemper Life Insurance Company and before that he was the
managing partner of the Tillinghast Life Insurance Practice in Chicago
for Towers Perrin.
Eric R. Johnson, 45........................... 1997 Since September 2003, president and chief executive officer of 40|86
Advisors, Inc. (formerly Conseco Capital Management, Inc.), Conseco's
wholly-owned registered investment advisor. Mr. Johnson has held
various positions since joining Conseco Capital Management, Inc. in
1997.
William S. Kirsch, 49......................... 2004 Since August 2004, president and chief executive officer and director.
From September 2003 until August 2004, he served as our executive vice
president, general counsel and secretary. Mr. Kirsch was with
Kirkland & Ellis LLP from 1981 to 2004.
John R. Kline, 48............................. 1990 Since July 2002, senior vice president and chief accounting officer.
Mr. Kline has served in various accounting and finance capacities
with Conseco since 1990.
</TABLE>
Messrs. Bullis and Kline served as officers of our Predecessor company,
which filed a bankruptcy petition on December 17, 2002. Mr. Bullis also served
as a director and/or officer of several subsidiaries of our Predecessor that
also filed bankruptcy petitions on December 17, 2002.
- -----------
(a)The executive officers serve as such at the discretion of the Board of
Directors and are elected annually.
(b)Business experience is given for at least the last five years.
32
<PAGE>
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS
AND ISSUER PURCHASES OF EQUITY SECURITIES.
MARKET INFORMATION
The following table sets forth the ranges of high and low sales prices per
share for our common stock on the New York Stock Exchange for the quarterly
periods beginning January 1, 2004. There have been no dividends paid or declared
on our common stock during this period.
<TABLE>
<CAPTION>
Period Market price
- ------ ------------------
High Low
---- ---
<S> <C> <C>
2004:
First Quarter........................................... $23.89 $20.90
Second Quarter.......................................... 24.00 17.10
Third Quarter........................................... 20.06 15.43
Fourth Quarter.......................................... 20.15 16.17
2005:
First Quarter........................................... $20.47 $18.80
Second Quarter.......................................... 22.10 19.15
Third Quarter........................................... 22.75 20.23
Fourth Quarter.......................................... 23.59 19.77
</TABLE>
As of February 24, 2006, there were approximately 74,200 holders of the
outstanding shares of common stock, including individual participants in
securities position listings.
DIVIDENDS
The Company does not anticipate declaring or paying cash dividends on its
common stock in the foreseeable future, and is currently limited in doing so
pursuant to our credit agreement. Please refer to "Management's Discussion and
Analysis of Financial Condition and Results of Operations - Liquidity of the
Holding Companies" for a further discussion of these restrictions.
EQUITY COMPENSATION PLAN INFORMATION
The following table summarizes information, as of December 31, 2005,
relating to our common stock that may be issued under the Conseco, Inc. 2003
Amended and Restated Long-Term Incentive Plan.
<TABLE>
<CAPTION>
Number of securities
remaining available for
Number of securities Weighted-average future issuance under
to be issued upon exercise exercise price of equity compensation
of outstanding options, outstanding options, plans (excluding securities
warrants or rights warrants or rights reflected in first column)
------------------ ------------------ --------------------------
<S> <C> <C> <C>
Equity compensation plans
approved by security holders...... 3,536,075 $19.89 4,246,802
Equity compensation plans not
approved by security holders...... - - -
--------- ------ ---------
Total................................. 3,536,075 $19.89 4,246,802
========= ====== =========
</TABLE>
33
<PAGE>
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA.
<TABLE>
<CAPTION>
Successor Predecessor
------------------------------------- ------------------------------
Years
ended Four months Eight months Years ended
December 31, ended ended December 31,
---------------- December 31, August 31, ---------------
2005 2004 2003 2003 2002 2001
---- ---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C> <C>
(Amounts in millions, except per share data)
STATEMENT OF OPERATIONS DATA(a)
Insurance policy income.......................... $2,930.1 $2,949.3 $1,005.8 $2,204.3 $3,602.3 $3,992.7
Net investment income............................ 1,374.6 1,318.6 474.6 969.0 1,334.3 1,550.0
Net realized investment gains (losses) .......... (2.9) 40.6 11.8 (5.4) (556.3) (340.0)
Total revenues................................... 4,326.5 4,330.0 1,505.5 3,203.4 4,450.4 5,492.0
Interest expense (contractual interest:
$268.5 for the eight months ended August 31,
2003; and $345.3 for 2002)..................... 58.3 79.5 36.8 202.5 341.9 400.0
Total benefits and expenses...................... 3,823.1 3,875.9 1,356.0 1,031.2 6,082.6 5,735.4
Income (loss) before income taxes, minority
interest, discontinued operations and
cumulative effect of accounting change......... 503.4 454.1 149.5 2,172.2 (1,632.2) (243.4)
Cumulative effect of accounting change, net
of income tax.................................. - - - - (2,949.2) -
Net income (loss)................................ 324.9 294.8 96.3 2,201.7 (7,835.7) (405.9)
Preferred stock dividends ....................... 38.0 65.5 27.8 - 2.1 12.8
Net income (loss) applicable to common stock..... 286.9 229.3 68.5 2,201.7 (7,837.8) (418.7)
PER SHARE DATA
Net income, basic................................ $ 1.90 $ 1.73 $ .68
Net income, diluted.............................. 1.76 1.63 .67
Book value per common share outstanding.......... $25.42 $21.41 $19.28
Weighted average shares outstanding for
basic earnings................................. 151.2 132.3 100.1
Weighted average shares outstanding for
diluted earnings............................... 185.0 155.9 143.5
Shares outstanding at period-end................. 151.5 151.1 100.1
BALANCE SHEET DATA - AT PERIOD END(a)
Total investments................................ $25,041.2 $24,306.3 $22,796.7 $22,018.3 $21,783.7 $25,067.1
Goodwill ....................................... - - 952.2 99.4 100.0 3,695.4
Total assets..................................... 31,557.3 30,764.6 29,973.5 28,318.1 46,509.0 61,432.2
Corporate notes payable and commercial paper..... 851.5 768.0 1,300.0 - - 4,085.0
Liabilities subject to compromise................ - - - 6,951.4 4,873.3 -
Total liabilities................................ 27,037.5 26,862.4 27,155.9 30,519.5 46,637.9 54,764.7
Company-obligated mandatorily redeemable
preferred securities of subsidiary trusts... - - - - 1,921.5 1,914.5
Shareholders' equity (deficit)................... 4,519.8 3,902.2 2,817.6 (2,201.4) (2,050.4) 4,753.0
STATUTORY DATA(b) - AT PERIOD END
Statutory capital and surplus.................... $1,603.8 $1,510.0 $1,514.1 $ 1,064.4 $ 1,649.8
Asset valuation reserve ("AVR").................. 142.7 117.0 40.9 11.6 105.1
Total statutory capital and surplus and AVR...... 1,746.5 1,627.0 1,555.0 1,076.0 1,754.9
<FN>
- -------------
(a) Our financial condition and results of operations have been significantly
affected during the periods presented by the discontinued finance
operations. As part of the Chapter 11 reorganization of our Predecessor
company and some of its non-insurance subsidiaries, we sold the assets of
our finance business and exited this line of business. We accounted for our
finance business as a discontinued operation in 2002 once we formalized our
plans to sell it. The sale of the finance business was completed in the
second quarter of 2003. We did not receive any proceeds from this sale, nor
did any creditors of our Predecessor. As of March 31, 2003, we ceased to
include the assets and liabilities of the finance business in our
Predecessor's consolidated balance sheet.
(b) We have derived the statutory data from statements filed by our insurance
subsidiaries with regulatory authorities which are prepared in accordance
with statutory accounting principles, which vary in certain respects from
GAAP.
</FN>
</TABLE>
34
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.
In this section, we review the consolidated financial condition of Conseco
at December 31, 2005, and the consolidated results of operations for: (i) the
years ended December 31, 2005 and 2004; (ii) the four months ended December 31,
2003; and (iii) the eight months ended August 31, 2003 and, where appropriate,
factors that may affect future financial performance. Please read this
discussion in conjunction with the consolidated financial statements and notes
included in this Form 10-K.
CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS
Our 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, contain
forward-looking statements within the meaning of the federal securities laws and
the Private Securities Litigation Reform Act of 1995. Forward-looking statements
typically are identified by the use of terms such as "anticipate," "believe,"
"plan," "estimate," "expect," "project," "intend," "may," "will," "would,"
"contemplate," "possible," "attempt," "seek," "should," "could," "goal,"
"target," "on track," "comfortable with," "optimistic" and similar words,
although some forward-looking statements are expressed differently. You should
consider statements that contain these words carefully because they describe our
expectations, plans, strategies and goals and our beliefs concerning future
business conditions, our results of operations, financial position, and our
business outlook or they state other "forward-looking" information based on
currently available information. The "Risk Factors" in Item 1A provides examples
of risks, uncertainties and events that could cause our actual results to differ
materially from the expectations expressed in our forward-looking statements.
Assumptions and other important factors that could cause our actual results to
differ materially from those anticipated in our forward-looking statements
include, among other things:
o our ability to achieve an upgrade of the financial strength ratings of
our insurance company subsidiaries and the impact of prior rating
downgrades on our business;
o the ultimate outcome of lawsuits filed against us and other legal and
regulatory proceedings to which we are subject;
o our ability to obtain adequate and timely rate increases on our
supplemental health products including our long-term care business;
o mortality, morbidity, usage of health care services, persistency and
other factors which may affect the profitability of our insurance
products;
o our ability to achieve anticipated expense reductions and levels of
operational efficiencies;
o the adverse impact of our Predecessor's bankruptcy proceedings on our
business operations, and relationships with our customers, employees,
regulators, distributors and agents;
o performance of our investments;
o our ability to continue to recruit and retain productive agents and
distribution partners and customer response to new products,
distribution channels and marketing initiatives;
o the risk factors or uncertainties listed from time to time in our
filings with the Securities and Exchange Commission;
o 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) our ability to
sell products and access capital on acceptable terms, the returns on
and the market value of our investments, and the lapse rate and
profitability of policies;
o changes in the Federal income tax laws and regulations which may
affect or eliminate the relative tax advantages of some of our
products; and
o regulatory changes or actions, including those relating to regulation
of the financial affairs of our insurance companies, such as the
payment of dividends to us, regulation of financial services affecting
(among other things)
35
<PAGE>
bank sales and underwriting of insurance products, regulation of the
sale, underwriting and pricing of products, and health care regulation
affecting health insurance products.
Other factors and assumptions not identified above are also relevant to the
forward-looking statements, and if they prove incorrect, could also cause actual
results to differ materially from those projected.
All written or oral forward-looking statements attributable to us are
expressly qualified in their entirety by the foregoing cautionary statement. Our
forward-looking statements speak only as of the date made. We assume no
obligation to update or to publicly announce the results of any revisions to any
of the forward-looking statements to reflect actual results, future events or
developments, changes in assumptions or changes in other factors affecting the
forward-looking statements.
OVERVIEW
We are a holding company for a group of insurance companies operating
throughout the United States that develop, market and administer supplemental
health insurance, annuity, individual life insurance and other insurance
products. We focus on serving the senior and middle-income markets, which we
believe are attractive, high growth markets. We sell our products through three
distribution channels: career agents, professional independent producers (some
of whom sell one or more of our product lines exclusively) and direct marketing.
We conduct our business operations through two operating segments, which
are defined on the basis of product distribution, and a third segment comprised
of business in run-off. Prior to September 30, 2003, we conducted our insurance
operations through one segment. In the fourth quarter of 2003, we implemented
changes contemplated in our restructuring plan to conduct our business through
the following segments:
o Bankers Life, which consists of the businesses of Bankers Life and
Casualty and Colonial Penn. Bankers Life and Casualty markets and
distributes Medicare supplement insurance, life insurance, long-term
care insurance and certain annuity products to the senior market
through approximately 4,800 exclusive career agents and sales
managers. Colonial Penn markets graded benefit and simplified issue
life insurance directly to consumers through television advertising,
direct mail, the internet and telemarketing. Both Bankers Life and
Casualty and Colonial Penn market their products under their own brand
names.
o Conseco Insurance Group, which markets and distributes specified
disease insurance, Medicare supplement insurance, and certain life and
annuity products to the senior and middle-income markets through over
500 IMOs that represent over 6,000 producing independent agents. This
segment markets its products under the "Conseco" brand.
o Other Business in Run-off, which includes blocks of business that we
no longer market or underwrite and are managed separately from our
other businesses. This segment consists of long-term care insurance
sold in prior years through independent agents and major medical
insurance.
We also have a corporate segment, which consists of holding company
activities and certain noninsurance company businesses that are not related to
our operating segments.
We emerged from bankruptcy protection under our Plan, which was confirmed
pursuant to an order of the Bankruptcy Court on September 9, 2003, and became
effective on September 10, 2003. Upon the confirmation of the Plan, we
implemented fresh start accounting in accordance with SOP 90-7. Our accounting
and actuarial systems and procedures are designed to produce financial
information as of the end of a month. Accordingly, for accounting convenience
purposes, we applied the effects of fresh start accounting on August 31, 2003.
The activity of the Company for the period September 1, 2003 through September
10, 2003 is therefore included in the Successor's statement of operations and
excluded from the Predecessor's statement of operations. We believe the net
income impact of the use of the convenience date is immaterial.
In accordance with SOP 90-7, we restated all of our assets and liabilities
to their current estimated value, reestablished shareholders' equity at the
reorganization value determined in connection with our Plan and recorded the
portion of the reorganization value which could not be attributed to specific
tangible or identified intangible assets as goodwill. As a result, our financial
statements for periods following August 31, 2003, are not comparable with those
prepared before that date.
For the year ended December 31, 2005, net income after dividends on our
preferred stock totaled $286.9 million, or $1.76 per diluted share.
36
<PAGE>
Despite low ratings and our decisions to discontinue or curtail sales in
certain products in order to conserve capital coming out of bankruptcy,
collected premiums in our core products have been relatively stable in the post
bankruptcy period.
We continue to focus on the factors that we believe are most important to
achieving improved financial strength ratings for our insurance subsidiaries.
Our major goals for 2006 are to continue to strengthen our balance sheet and
improve our execution on the basics of our business by:
o Increasing emphasis on sales and revenue growth.
o Further reducing operating expenses and improving the efficiency of
our operations across all business functions.
o Consolidating and streamlining our back-office systems to reduce
complexity, lower our costs and improve customer service.
o Continuing to build best practices in governance and compliance.
CRITICAL ACCOUNTING POLICIES
The preparation of financial statements in accordance with GAAP requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Management has made estimates in the past
that we believed to be appropriate but were subsequently revised to reflect
actual experience. If our future experience differs materially from these
estimates and assumptions, our results of operations and financial condition
could be affected.
We base our estimates on historical experience and other assumptions that
we believe are reasonable under the circumstances. We continually evaluate the
information used to make these estimates as our business and the economic
environment change. The use of estimates is pervasive throughout our financial
statements. The accounting policies and estimates we consider most critical are
summarized below. Additional information on our accounting policies is included
in the note to our consolidated financial statements entitled "Summary of
Significant Accounting Policies".
Investments
At December 31, 2005, the carrying value of our investment portfolio was
$25.0 billion. The accounting risks associated with investments relate to the
recognition of income, our determination of other-than-temporary impairments and
our estimation of fair values.
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
structured securities when we estimate yields on such securities. When actual
prepayments differ from our estimates, the adjustment to yield is recognized as
investment income (loss).
We regularly evaluate all of our investments for possible impairment based
on current economic conditions, credit loss experience and other
investee-specific developments. If there is a decline in a security's net
realizable value that we deem to be other than temporary, the decline is
recognized as a realized loss and the cost basis of the security is reduced to
its estimated fair value. During the year ended December 31, 2005, we recorded
$14.7 million of such writedowns of investments.
Our evaluation of investments for impairment requires significant
judgments, including: (i) the identification of potentially impaired securities;
(ii) the determination of their estimated fair value; and (iii) the assessment
of whether any decline in estimated fair value is other than temporary. If new
information becomes available or the financial condition of the investee
changes, our judgments may change resulting in the recognition of a realized
investment loss at that time.
Our assessment of whether unrealized losses are "other than temporary"
requires consideration of the following factors: (i) the extent to which market
value is less than the cost basis; (ii) the length of time that the market value
has been less than cost; (iii) whether the unrealized loss is event driven,
credit-driven or a result of changes in market interest rates; (iv) the
near-term prospects for improvement in the issuer and/or its industry; (v) our
view of the investment's rating and whether the investment is investment-grade
and/or has been downgraded since its purchase; (vi) whether the issuer is
current on all payments in accordance with the contractual terms of the
investment and is expected to meet all of its obligations under the terms of the
investment; (vii) our ability and intent to hold the investment for a period of
time sufficient to allow for any
37
<PAGE>
anticipated recovery; and (viii) the underlying current and prospective asset
and enterprise values of the issuer and the extent to which our investment may
be affected by changes in such values. At December 31, 2005, our net accumulated
other comprehensive income included gross unrealized losses on investments of
$238.2 million, which we consider to be temporary declines in estimated fair
value.
When the cost basis of a security is written down to fair value due to an
other than temporary decline, we review the circumstances of that particular
investment in relation to other investments in our portfolio. If such
circumstances exist with respect to other investments, those investments are
also written down to fair value. Future events may occur, or additional or
updated information may become available, which may necessitate future realized
losses of securities in our portfolio. Significant realized losses on our
investments could have a material adverse effect on our earnings in future
periods.
Estimated fair values for our investments are determined by using
nationally recognized pricing services, broker-dealer market makers and
internally developed methods. Our internally developed methods require us to
make judgments about the security's credit quality, liquidity and market spread.
Below-investment grade securities have different characteristics than
investment grade corporate debt securities. Risk of default by the borrower is
significantly greater for below-investment grade securities and in many cases,
severity of loss is relatively greater as such securities are generally
unsecured and often subordinated to other creditors of the issuer. Also, issuers
of below-investment grade securities usually have higher levels of debt and may
be more sensitive to adverse economic conditions, such as recession or
increasing interest rates, than are investment grade issuers. The Company
attempts to reduce the overall risk related to its investment in
below-investment grade securities, as in all investments, through careful credit
analysis, strict investment policy guidelines, and diversification by issuer
and/or guarantor and by industry.
During 2005, we sold $7.5 billion of fixed maturity investments which
resulted in net realized investment gains of $4.2 million. Our fixed maturity
investments are generally purchased in the context of a long-term strategy to
fund insurance liabilities, so we do not generally seek to purchase and sell
such securities to generate gains. In certain circumstances, when securities are
selling at prices which exceed our view of their current fair value, and it is
possible to reinvest the proceeds to better meet our long-term asset-liability
objectives, we may sell certain securities. Of those fixed maturity investments
sold in 2005, $3.7 billion resulted in gross investment losses (before income
taxes) of $82.3 million. We sell securities at a loss for a number of reasons
including, but not limited to: (i) changes in the investment environment; (ii)
expectation that the market value could deteriorate further; (iii) desire to
reduce our exposure to an issuer or an industry; (iv) changes in credit quality;
(v) identification of a superior investment alternative; or (vi) changes in
expected liability cash flows.
We generally seek to balance the duration and cash flows of our invested
assets with the estimated duration and cash flows of benefit payments arising
from contract liabilities. These efforts may cause us to sell investments before
their maturity date and could result in the realization of net realized
investment gains (losses). When the estimated durations of assets and
liabilities are similar, exposure to interest rate risk is minimized because a
change in the value of assets should be largely offset by a change in the value
of liabilities. In certain circumstances, a mismatch of the durations or related
cash flows of invested assets and insurance liabilities could have a significant
impact on our results of operations and financial position. See "-- Quantitative
and Qualitative Disclosures About Market Risks" for additional discussion of the
duration of our invested assets and insurance liabilities.
For more information on our investment portfolio and our critical
accounting policies related to investments, see the note to our consolidated
financial statements entitled "Investments".
Value of Policies Inforce at the Effective Date and Cost of Policies
Produced
In conjunction with the implementation of fresh start accounting, we
eliminated the historical balances of Old Conseco's cost of policies purchased
and cost of policies produced as of the Effective Date and replaced them with
the value of policies inforce at the Effective Date.
The value assigned to the right to receive future cash flows from policies
existing at September 10, 2003 (the effective date of the reorganization of our
Predecessor) is referred to as the value of policies inforce at the Effective
Date. We also defer renewal commissions paid in excess of ultimate commission
levels related to the existing policies in this account. The balance of this
account is amortized, evaluated for recovery, and adjusted for the impact of
unrealized gains (losses) in the same manner as the cost of policies produced
described below. We expect to amortize approximately 12 percent of the December
31, 2005 balance of value of policies inforce in 2006, 11 percent in 2007, 10
percent in 2008, 8 percent in 2009 and 8 percent in 2010.
The cost of policies produced are those costs that vary with, and are
primarily related to, producing new insurance
38
<PAGE>
business in the period after September 10, 2003. We amortize these costs (using
the interest rate credited to the underlying policy for universal life or
investment-type products and the projected investment earnings rate for other
products): (i) in relation to the estimated gross profits for universal life and
investment-type products; or (ii) in relation to future anticipated premium
revenue for other products.
When we realize a gain or loss on investments backing our universal life or
investment-type products, we adjust the amortization to reflect the change in
estimated gross profits from the products due to the gain or loss realized and
the effect on future investment yields. We also adjust the value of policies
inforce at the Effective Date for the change in amortization that would have
been recorded if actively managed fixed maturity securities had been sold at
their stated aggregate fair value and the proceeds reinvested at current yields.
We include the impact of this adjustment in accumulated other comprehensive
income within shareholders' equity.
At December 31, 2005, the combined balance of the value of policies inforce
and cost of policies produced was $3.2 billion. The recoverability of this
amount is dependent on the future profitability of the related business. Each
year, we evaluate the recoverability of the unamortized balance of the value of
policies inforce and the cost of policies produced. We consider estimated future
gross profits or future premiums, expected mortality or morbidity, interest
earned and credited rates, persistency and expenses in determining whether the
balance is recoverable. If we determine a portion of the unamortized balance is
not recoverable, it is charged to amortization expense.
The assumptions we use to amortize and evaluate the recoverability of the
value of policies inforce and the cost of policies produced both involve
significant judgment. A revision to these assumptions could have a significant
adverse effect on our results of operations and financial position.
Income Taxes
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 NOLs. We evaluate the
realizability of our deferred income tax assets and assess the need for a
valuation allowance on an ongoing basis. In evaluating 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 sufficient future taxable income during the
periods in which our temporary differences become deductible and before our
capital loss carryforwards and NOLs expire. In addition, the use of the
Company's NOLs is dependent, in part, on whether: (i) the IRS affirms the
tentative settlement agreement related to the allocation of the tax loss on our
predecessor's investment in CFC (the "CFC loss"); and (ii) the IRS does not take
an adverse position in the future regarding the tax position we plan to take in
our tax returns with respect to the allocation of cancellation of indebtedness
income. These matters are described below.
Based upon information existing at the time of our emergence from
bankruptcy, we established a valuation allowance against our entire balance of
net deferred income tax assets as we believed that the realization of such net
deferred income tax assets in future periods was uncertain. During 2004 and
2005, we concluded that it was no longer necessary to hold certain portions of
the previously established valuation allowance. Accordingly, we reduced our
valuation allowance by $947.0 million in 2004 and $585.8 million in 2005.
However, we are required to continue to hold a valuation allowance of $1,043.8
million because we have determined that it is more likely than not that a
portion of our deferred tax assets will not be realized. This determination was
made by evaluating each component of the deferred tax asset and assessing the
effects of limitations or interpretations on the value of such component to be
fully recognized in the future.
The Code limits the extent to which losses realized by a non-life entity
(or entities) may offset income from a life insurance company (or companies) to
the lesser of: (i) 35 percent of the income of the life insurance company; or
(ii) 35 percent of the total loss of the non-life entities (including NOLs of
the non-life entities). There is no limitation on the ability to utilize NOLs
generated by a life insurance company.
In addition, the timing and manner in which the Company will be able to
utilize some of its NOLs is limited by Section 382 of the Code. Section 382
imposes limitations on a corporation's ability to use its NOLs when the company
undergoes an ownership change. Because the Company underwent an ownership change
pursuant to its reorganization, this limitation applies to the Company. Any
losses that are subject to the Section 382 limitation will only be utilized by
the Company up to approximately $140 million per year with any unused amounts
carried forward to the following year.
39
<PAGE>
The reduction in our deferred income tax valuation allowance is accounted
for pursuant to SOP 90-7, as follows: (i) first, to eliminate goodwill; (ii)
second, to eliminate other intangible assets; and (iii) last, as an addition to
paid-in capital. Since all goodwill and applicable intangible assets were
eliminated in 2004, the reduction of any remaining portion of our deferred
income tax valuation allowance will be accounted for as an addition to paid-in
capital pursuant to SOP 90-7. Changes in our valuation allowance are summarized
as follows (dollars in millions):
<TABLE>
<S> <C>
Balance at December 31, 2003............................................. $2,362.1
Realization of deferred income taxes recognized
in 2004 (a)......................................................... (168.6)
Release of tax valuation reserve related to unrealized
gains during 2004 (a)............................................... (65.4)
Recovery of amounts related to our bankruptcy and
state taxes (a)..................................................... (4.1)
Increase in deferred tax assets related to the worthlessness
of CFC.............................................................. 500.1
Release of valuation allowance (a)..................................... (947.0)
Deferred tax assets not realizable..................................... (47.5)
--------
Balance at December 31, 2004............................................. 1,629.6
Release of valuation allowance (b)..................................... (585.8)
--------
Balance at December 31, 2005............................................. $1,043.8
========
<FN>
- --------------
(a) There is a corresponding increase (decrease) for these items in the
following accounts: (i) goodwill - ($952.2) million; (ii) other intangible
assets - $(171.1) million; and (iii) additional paid-in capital - $61.8
million.
(b) There is a corresponding increase to additional paid-in capital.
</FN>
</TABLE>
As of December 31, 2005, we had $4.6 billion of NOLs and $1.1 billion of
capital loss carryforwards, which expire as follows (dollars in millions):
<TABLE>
<CAPTION>
Net operating
loss carryforwards(a) Total loss carryforwards
--------------------- Capital loss Total loss ---------------------------------------
Year of expiration Life Non-life carryforwards carryforwards Subject to ss.382 Not subject to ss.382
- ------------------ ---- -------- ------------- ------------- ----------------- ---------------------
<S> <C> <C> <C> <C> <C> <C>
2006....... $ .1 $ .1 $ 5.5 $ 5.7 $ 5.7 $ -
2007....... 5.7 - 459.7 465.4 465.4 -
2008....... - .1 583.7 583.8 583.8 -
2009....... - 10.5 86.2 96.7 10.5 86.2
2010....... - 2.6 - 2.6 2.6 -
2011....... - .4 - .4 .4 -
2012....... - 15.1 - 15.1 15.1 -
2016....... 49.3 - - 49.3 49.3 -
2017....... 33.2 - - 33.2 33.2 -
2018....... 2,170.6 (a) 12.0 - 2,182.6 56.1 2,126.5
2019....... - .7 - .7 .7 -
2020....... 63.5 - - 63.5 - 63.5
2022....... - - - - - -
2023....... - 2,125.9 (a) - 2,125.9 76.2 2,049.7
2024....... - 1.3 - 1.3 - 1.3
2025....... - 106.9 - 106.9 - 106.9
-------- -------- -------- -------- -------- --------
Total...... $2,322.4 $2,275.6 $1,135.1 $5,733.1 $1,299.0 $4,434.1
======== ======== ======== ======== ======== ========
<FN>
- -------------
(a) The allocation of the NOLs summarized above assumes: (i) the IRS
affirms the tentative settlement agreement related to the allocation
of the CFC loss; and (ii) the IRS does not take an adverse position in
the future regarding the tax position we plan to take in our tax
returns with respect to the allocation of cancellation of indebtedness
income. These matters are described below. If the IRS does not approve
the tentative settlement agreement, a question would exist as to
whether $2.1 billion of NOLs expiring in 2018 relate to the life
companies (as presented
</FN>
</TABLE>
40
<PAGE>
above) or to the non-life companies. If the IRS approves the tentative
settlement agreement but disagrees with the tax position we plan to
take with respect to the allocation of cancellation of indebtedness
income, and their position prevails, $631 million of the NOLs expiring
in 2018 would be characterized as non-life NOLs.
The following paragraphs describe some of the open matters related to the
classification of our NOLs.
Conseco and its affiliates are currently under examination by the IRS for
the tax year ending December 31, 2003. During the 2003 audit, the IRS questioned
the Company's tax position on the CFC loss, and requested Technical Advice from
the National Office of the IRS. The Technical Advise Memorandum ("TAM") issued
by the National Office confirmed the Company's position that the CFC loss would
be treated as a post-emergence loss and therefore would not be subject to the
Section 382 limitation. However, the TAM was adverse to the Company's position
that the CFC loss was incurred by a life insurance company. The Company then
requested, pursuant to its appeal rights, that the issue be resolved through the
IRS's Fast-Track resolution process, and a settlement was reached. The
settlement was incorporated as an adjustment in the audit. The tentative
settlement characterized $2.1 billion of the CFC loss as life insurance company
losses and the remaining amount as non-life losses prior to application of the
cancellation of indebtedness attribute reductions described below. Due to the
carryback of capital losses during the audit period resulting in a refund in
excess of $2 million, the audit is not final until the Joint Committee on
Taxation (the "Joint Committee"), which is a committee composed of 10 members
(five of whom are members of the Committee on Finance of the United States
Senate and five of whom are members of the Committee on Ways and Means of the
United States House of Representatives), has approved it. Generally, the IRS
must audit and the Joint Committee must approve any tax years in which there is
a refund in excess of $2 million, as required by Internal Revenue Code Section
6405. The IRS has proposed to the Joint Committee, in a special report as
mandated by IRC ss.6405(b), that the audited tax years for 2002-2003 be accepted
as adjusted. This special report was sent to the Joint Committee in February of
2006. If the Joint Committee does not approve the audit, the Committee will
explain its objections to the IRS and the IRS must then address those objections
in the audit and resubmit the audit for approval. Review by the Joint Committee
can take as long as nine months to complete.
Based on our current assessment, we believe that it would be appropriate to
reduce the valuation allowance by an additional $275 million if the tentative
settlement is ultimately approved. However, the actual reduction would be based
on the facts and circumstances existing on such date, if the tentative
settlement were approved.
The Code provides that any income realized as a result of the cancellation
of indebtedness in bankruptcy (cancellation of debt income or "CODI") must
reduce NOLs. We realized an estimated $2.5 billion of CODI when we emerged from
bankruptcy. Pursuant to the Company's interpretation of the tax law, the CODI
reductions were all used to reduce non-life NOLs. However, if the IRS were to
disagree with our interpretation and ultimately prevail, we believe $631 million
of NOLs classified as life company NOLs would be re-characterized as non-life
NOLs and subject to the 35% limitation discussed above. Such a
re-characterization would also extend the year of expiration as life company
NOLs expire after 15 years whereas non-life NOLs expire after 20 years. The
Company does not expect the IRS to consider this issue for a number of years.
Liabilities for Insurance Products
At December 31, 2005, the total balance of our liabilities for insurance
products was $25.4 billion. These liabilities are generally payable over an
extended period of time and the profitability of the related products is
dependent on the pricing of the products and other factors. Differences between
our expectations when we sold these products and our actual experience could
result in future losses.
We calculate and maintain reserves for the future payment of claims to our
policyholders based on actuarial assumptions. For all our insurance products, we
establish an active life reserve, a liability for due and unpaid claims, claims
in the course of settlement and incurred but not reported claims. In addition,
for our supplemental health insurance business, we establish a reserve for the
present value of amounts not yet due on claims. Many factors can affect these
reserves and liabilities, such as economic and social conditions, inflation,
hospital and pharmaceutical costs, changes in doctrines of legal liability and
extra-contractual damage awards. Therefore, our reserves and liabilities are
necessarily based on extensive estimates, assumptions and historical experience.
Establishing reserves is an uncertain process, and it is possible that actual
claims will materially exceed our reserves and have a material adverse effect on
our results of operations and financial condition. Our financial results depend
significantly upon the extent to which our actual claims experience is
consistent with the assumptions we used in determining our reserves and pricing
our products. If our assumptions with respect to future claims are incorrect,
and our reserves are insufficient to cover our actual losses and expenses, we
would be required to increase our liabilities, which would negatively affect our
operating results.
Liabilities for insurance products are calculated using management's best
judgments, based on our past experience and
41
<PAGE>
standard actuarial tables, of mortality, morbidity, lapse rates, investment
experience and expense levels.
In accordance with SOP 90-7, the Successor established insurance
liabilities and an asset for the value of policies inforce at the Effective Date
using current assumptions. The adjustments to the Predecessor's liabilities for
insurance products as of August 31, 2003 are summarized below (dollars in
millions):
<TABLE>
<CAPTION>
Predecessor Fresh start Successor
balance sheet adjustments balance sheet
------------- ----------- -------------
<S> <C> <C> <C>
Liabilities for insurance products:
Traditional and limited payment products:
Traditional life insurance products............................... $ 1,885.3 $ 320.3 $ 2,205.6
Limited pay annuities............................................. 880.0 140.0 1,020.0
Individual accident and health ................................... 5,245.8 1,887.9 7,133.7
Group life and health............................................. 692.0 136.7 828.7
Unearned premiums................................................. 3.3 - 3.3
--------- -------- ---------
Total liabilities for traditional and limited payment products. 8,706.4 2,484.9 11,191.3
--------- -------- ---------
Interest-sensitive products:
Investment contracts ............................................. 8,489.8 132.9 8,622.7
Universal life products .......................................... 3,994.6 (15.4) 3,979.2
--------- -------- ---------
Total liabilities for interest-sensitive products.............. 12,484.4 117.5 12,601.9
--------- -------- ---------
Other liabilities for insurance products:
Separate accounts and investment trusts .......................... 87.7 - 87.7
Claims payable and other policyholder funds ...................... 897.1 (10.3) 886.8
--------- -------- ---------
Total other liabilities for insurance
products................................................... 984.8 (10.3) 974.5
--------- -------- ---------
Total liabilities for insurance products................................. $22,175.6 $2,592.1 $24,767.7
========= ======== =========
</TABLE>
The following provides explanations for the fresh-start adjustment to
insurance liabilities related to our insurance inforce at the Effective Date.
Traditional insurance and limited pay products
In accordance with Statement of Financial Accounting Standards No. 60,
"Accounting and Reporting by Insurance Enterprises" and Statement of Financial
Accounting Standards No. 97, "Accounting and Reporting by Insurance Enterprises
for certain Long-Duration Contracts and for Realized Gains and Losses from the
Sale of Investments" ("SFAS 97"), the Predecessor used the original actuarial
assumptions determined when traditional long-duration and limited payment
insurance contracts were issued in determining liability calculations through
the fresh start date, provided the resulting liabilities were adequate to
provide for future benefits and expenses under the related contracts. This
accounting principle is referred to as the "lock in" principle and is only
applicable to traditional insurance and limited pay products. The use of
assumptions that are locked in at the time of issue means that absent loss
recognition, the same assumptions are used in accounting for a particular block
of business unless the block is subject to purchase or fresh start accounting.
At the Effective Date, the Successor established insurance liabilities at
the present value of future benefits and expenses less future premiums
associated with the policies, by using current best-estimate assumptions with
provisions for adverse deviation. Such assumptions included estimates as to
investment yields, mortality, morbidity, withdrawals, lapses and maintenance
expenses. The current best-estimate assumptions for these blocks of business
differed from the original actuarial assumptions determined when the business
was acquired or issued as further described in the following paragraphs.
Due to the current interest rate environment and the requirement to mark
the value of the investment portfolio to market, we changed our assumptions
related to future investment earnings. The weighted average expected yield on
our investment portfolio decreased to approximately 5.6 percent at the Effective
Date from 6.7 percent at December 31, 2002. Approximately $.9 billion of the
fresh-start increase to insurance liabilities was the result of changes in
future expected investment earnings.
42
<PAGE>
The performance of our long-term care business (especially the acquired
block originally sold through independent agents) has generally been unfavorable
relative to the Predecessor's assumptions established when these blocks of
business were acquired. For example, variances in actual morbidity, lapses and
expenses have been unfavorable compared to original estimates. Approximately
$1.4 billion of the increase to insurance liabilities was the result of changes
in non-interest assumptions for our long-term care policies. Our assumption
changes for the long-term care business included: (i) changes in morbidity
assumptions from estimates made when the business was acquired to recent Company
experience; (ii) changes in mortality assumptions related to certain blocks of
this business from the 1958 and 1980 Commissioners Standard Ordinary Mortality
table to the 1983 Group Annuity Mortality table; and (iii) changes in ultimate
lapse ratios from a range of approximately 3 percent to 5.5 percent prior to the
adoption of fresh start accounting to a range of 2 percent to 3.5 percent.
Interest-sensitive products subject to requirements of SFAS 97
The insurance liability for asset accumulation products (such as deferred
annuities and universal life products) is generally equal to current
policyholder account balances. These balances generally do not change as a
result of the adoption of fresh start accounting. The fresh-start adjustment to
insurance liabilities for interest-sensitive products primarily resulted from:
(i) the adoption of SOP 03-01 as of the Effective Date; and (ii) certain
Predecessor insurance liabilities that were different from the present value of
estimated future benefits as of August 31, 2003.
The adoption of SOP 03-01 as of the Effective Date required a change in
methodology regarding persistency bonuses provided to policyholders who continue
to keep their policies inforce for a stated period of time. The Predecessor
recognized the cost of this benefit over the period prior to the time the
benefit would be credited in proportion to estimated gross profits and assumed a
certain number of policies would terminate before the benefit was credited.
Under SOP 03-01, the cost for such benefits is recognized ratably over the
period prior to the time the benefit is credited without assuming policy
terminations. Insurance liabilities increased by approximately $.1 billion as a
result of the adoption of SOP 03-01.
In addition, the insurance liabilities for certain Predecessor insurance
liabilities were different than the present value of estimated future benefits
as of the Effective Date.
The Predecessor had previously established an insurance liability related
to certain business, to recognize the future loss expected to be recognized for
the former practice of reducing the cost of insurance charges to amounts below
the level permitted under the provisions of the policy. The Predecessor
amortized this liability into income in proportion to estimated gross profits on
the business, consistent with SFAS 97 requirements for unearned revenues. The
Predecessor had previously decided to discontinue the practice of providing this
nonguaranteed benefit. Accordingly, the remaining insurance liability
established for this benefit was no longer required at August 31, 2003,
resulting in a $.1 billion reduction to reserves in conjunction with our
adoption of fresh-start accounting.
The liabilities established for our equity-indexed annuity products
(including the value of options attributable to policyholders for the estimated
life of the annuity contract and accounted for as embedded derivatives) are
established pursuant to different accounting rules than other interest-sensitive
products. At the Effective Date, the present value of estimated future benefits
for our equity-indexed products exceeded the value of the Predecessor's
liabilities by $.2 billion, resulting in a fresh-start adjustment.
Liabilities for Loss Contingencies Related to Lawsuits and Our Guarantees
of Bank Loans and Related Interest Loans
We are involved on an ongoing basis in arbitrations and lawsuits, including
purported class actions, relating to our operations, including with respect to
sales practices, and we and current and former officers and directors are
defendants in a pending class action lawsuit asserting claims under the
securities laws. The ultimate outcome of these legal matters cannot be predicted
with certainty. We recognize an estimated loss from these loss contingencies
when we believe it is probable that a loss has been incurred and the amount of
the loss can be reasonably estimated. However, it is difficult to measure the
actual loss that might be incurred related to litigation. The ultimate outcome
of these lawsuits could have a significant impact on our results of operations
and financial position.
In conjunction with the Plan, $481.3 million principal amount of bank loans
made to certain former directors and employees to enable them to purchase common
stock of Old Conseco were transferred to the Company. These loans had been
guaranteed by Old Conseco. We received all rights to collect the balances due
pursuant to the original terms of these loans. In addition, we hold loans to
participants for interest on the loans which exceed $230 million. The former
bank loans and the interest loans are collectively referred to as the "D&O
loans." We regularly evaluate the collectibility of these loans in light of the
collateral we hold, the credit worthiness of the participants and the current
status of various legal actions we
43
<PAGE>
have taken to collect the D&O loans. At December 31, 2005, we have estimated
that approximately $34.4 million of the D&O balance (which is included in other
assets) is collectible (net of the cost of collection). An allowance has been
established to reduce the recorded balance of the D&O loans to this balance.
Pursuant to the settlement that was reached with the Official Committee of
the Trust Originated Preferred Securities ("TOPrS") Holders and the Official
Committee of Unsecured Creditors in the Plan, the former holders of TOPrS
(issued by Old Conseco's subsidiary trusts and eliminated in our reorganization)
who did not opt out of the bankruptcy settlement, will be entitled to receive 45
percent of any proceeds from the collection of certain D&O loans in an aggregate
amount not to exceed $30 million. We have established a liability of $17.5
million (which is included in other liabilities), representing our estimate of
the amount which will be paid to the former holders of TOPrS pursuant to the
settlement.
44
<PAGE>
RESULTS OF OPERATIONS:
We manage our business through the following: two primary operating
segments, Bankers Life and Conseco Insurance Group, which are defined on the
basis of product distribution; a third segment comprised of other business in
run-off; and corporate operations, which consists of holding company activities
and certain noninsurance businesses.
Due to the application of fresh start accounting, the reported historical
financial statements of our Predecessor for periods prior to August 31, 2003
generally are not comparable to our financial statements for periods after that
date. Therefore, our results of operations have not been combined with those of
our Predecessor. Please read this discussion in conjunction with the
consolidated financial statements and notes included in this Form 10-K.
The following tables and narratives summarize the operating results of our
segments (dollars in millions):
<TABLE>
<CAPTION>
Successor Predecessor
----------------------------------- ------------
Years
ended Four months Eight months
December 31, ended ended
---------------- December 31, August 31,
2005 2004 2003 2003
---- ---- ---- ----
<S> <C> <C> <C> <C>
Income (loss) before net realized investment gains
(losses), net of related amortization, income taxes
and discontinued operations (a non-GAAP measure)(a):
Bankers Life .......................................... $254.4 $ 228.9 $ 82.1 $ 154.6
Conseco Insurance Group................................ 256.7 257.7 85.9 316.1
Other Business in Run-off.............................. 77.2 65.8 13.5 (177.6)
Corporate operations................................... (84.8) (125.5) (42.7) 1,884.1
------ ------- ------ --------
503.5 426.9 138.8 2,177.2
------ ------- ------ --------
Net realized investment gains (losses), net of related
amortization:
Bankers Life .......................................... (2.6) 12.7 3.4 5.0
Conseco Insurance Group................................ 3.4 12.8 8.4 (16.2)
Other Business in Run-off.............................. .5 4.5 (.7) 6.3
Corporate operations................................... (1.4) (2.8) (.4) (.1)
------ ------- ------ --------
(.1) 27.2 10.7 (5.0)
----- ------- ------ --------
Income (loss) before income taxes:
Bankers Life .......................................... 251.8 241.6 85.5 159.6
Conseco Insurance Group................................ 260.1 270.5 94.3 299.9
Other Business in Run-off.............................. 77.7 70.3 12.8 (171.3)
Corporate operations................................... (86.2) (128.3) (43.1) 1,884.0
------ ------- ------ --------
Income before income taxes and discontinued
operations.......................................... $503.4 $ 454.1 $149.5 $2,172.2
====== ======= ====== ========
<FN>
- ------------
(a) We believe that an analysis of income (loss) before net realized investment
gains (losses), net of related amortization, and income taxes (a non-GAAP
measure) is important to evaluate the financial performance of our
business, and is a measure commonly used in the life insurance industry.
Management uses this measure to evaluate performance because realized gains
or losses can be affected by events that are unrelated to a company's
underlying fundamentals. However, the non-GAAP measure does not replace the
corresponding GAAP measure. The table above reconciles the non-GAAP measure
to the corresponding GAAP measure.
</FN>
</TABLE>
General: Conseco is the top tier holding company for a group of insurance
companies operating throughout the United States that develop, market and
administer supplemental health insurance, annuity, individual life insurance and
other insurance products. We distribute these products through our Bankers Life
segment, which utilizes a career agency force and direct response marketing, and
through our Conseco Insurance Group segment, which utilizes professional
independent producers. Our Other Business in Run-off segment consists of: (i)
long-term care products sold in prior years through independent agents; (ii)
small group and individual major medical business which we stopped renewing in
2001; and (iii) other group major medical business which we no longer market.
Most of the long-term care business in run-off relates to business written by
certain subsidiaries prior to their acquisitions by Conseco in 1996 and 1997.
45
<PAGE>
<TABLE>
<CAPTION>
Bankers Life (dollars in millions)
Successor Predecessor
--------------------------------------- ------------
Years
ended Four months Eight months
December 31, ended ended
-------------------- December 31, August 31,
2005 2004 2003 2003
---- ---- ---- ----
<S> <C> <C> <C> <C>
Premium collections:
Annuities............................................. $ 951.1 $ 950.5 $ 253.8 $ 698.4
Supplemental health................................... 1,227.5 1,188.5 407.9 759.6
Life.................................................. 237.2 180.9 58.6 102.7
-------- -------- -------- --------
Total collections................................... $2,415.8 $2,319.9 $ 720.3 $1,560.7
======== ======== ======== ========
Average liabilities for insurance products:
Annuities:
Mortality based................................... $ 357.5 $ 356.5 $ 331.8 $ 286.5
Equity-indexed.................................... 324.9 276.5 262.9 264.8
Deposit based..................................... 4,091.8 3,506.7 3,150.1 2,847.7
Health................................................ 3,061.2 2,803.1 2,620.8 1,916.3
Life:
Interest sensitive................................ 353.8 335.4 333.0 324.4
Non-interest sensitive............................ 752.2 749.3 747.3 652.4
-------- -------- -------- --------
Total average liabilities for insurance
products, net of reinsurance ceded............ $8,941.4 $8,027.5 $7,445.9 $6,292.1
======== ======== ======== ========
Revenues:
Insurance policy income............................... $1,507.0 $1,405.1 $ 456.8 $ 892.7
Net investment income:
General account invested assets..................... 488.8 422.6 128.9 253.4
Equity-indexed products based on the change
in value of options............................... (2.6) 2.6 6.6 4.8
Trading account income related to policyholder
and reinsurer accounts............................ (6.1) 3.7 5.2 -
Change in value of embedded derivatives related
to modified coinsurance agreements................ 6.1 (3.7) (5.2) -
Fee revenue and other income.......................... 1.8 1.9 .5 .9
-------- -------- -------- --------
Total revenues.................................... 1,995.0 1,832.2 592.8 1,151.8
-------- -------- -------- --------
Expenses:
Insurance policy benefits............................. 1,216.8 1,099.9 336.4 692.4
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life
products other than those listed below............ 165.4 149.5 50.6 89.5
Equity-indexed products based on change in
value of indices.................................. 1.7 8.6 8.8 13.2
Amortization related to operations.................... 199.8 182.6 62.3 113.4
Interest expense on investment borrowings............. 1.7 2.6 .8 3.4
Other operating costs and expenses.................... 155.2 160.1 51.8 85.3
-------- -------- -------- --------
Total expenses.................................... 1,740.6 1,603.3 510.7 997.2
-------- -------- -------- --------
Income before net realized investment gains (losses),
net of related amortization, income taxes and
discontinued operations............................... 254.4 228.9 82.1 154.6
-------- -------- -------- --------
Net realized investment gains (losses).............. (3.6) 17.4 3.4 5.5
Amortization related to net realized investment
gains (losses).................................... 1.0 (4.7) - (.5)
-------- -------- -------- --------
Net realized investment gains (losses),
net of related amortization................... (2.6) 12.7 3.4 5.0
-------- -------- -------- --------
Income before income taxes and discontinued operations..... $ 251.8 $ 241.6 $ 85.5 $ 159.6
======== ======== ======== ========
</TABLE>
(continued)
46
<PAGE>
(continued from previous page)
<TABLE>
<CAPTION>
Successor Predecessor
--------------------------------------- ------------
Years
ended Four months Eight months
December 31, ended ended
-------------------- December 31, August 31,
2005 2004 2003 2003
---- ---- ---- ----
<S> <C> <C> <C> <C>
Health benefit ratios:
All health lines:
Insurance policy benefits........................ $1,001.7 $929.2 $283.7 $578.5
Benefit ratio (a)................................ 81.5% 78.0% 73.1% 75.3%
Medicare supplement:
Insurance policy benefits........................ $468.2 $443.3 $133.3 $283.3
Benefit ratio (a)................................ 71.6% 68.9% 62.8% 66.4%
Long-term care:
Insurance policy benefits........................ $526.2 $477.5 $148.0 $287.2
Benefit ratio (a)................................ 93.6% 89.3% 86.1% 86.1%
Interest-adjusted benefit ratio (b).............. 65.1% 62.3% 60.0% 69.3%
Other:
Insurance policy benefits........................ $7.3 $8.4 $2.4 $8.0
Benefit ratio (a)................................ 59.8% 63.4% 63.8% 101.1%
<FN>
- ----------------
(a) We calculate benefit ratios by dividing the related product's insurance
policy benefits by insurance policy income.
(b) We calculate the interest-adjusted benefit ratio (a non-GAAP measure) for
Bankers Life's long-term care products by dividing such product's insurance
policy benefits less interest income on the accumulated assets backing the
insurance liabilities by insurance policy income. Interest income is an
important factor in measuring the performance of this product. The net cash
flows from long-term care products generally cause an accumulation of
amounts in the early years of a policy (accounted for as reserve increases)
which will be paid out as benefits in later policy years (accounted for as
reserve decreases). Accordingly, as the policies age, the benefit ratio
will typically increase, but the increase in the change in reserve will be
partially offset by interest income earned on the accumulated assets. The
interest-adjusted benefit ratio reflects the effects of the interest income
offset. Since interest income is an important factor in measuring the
performance of this product, management believes a benefit ratio which
includes the effect of interest income is useful in analyzing product
performance. The investment income earned on the accumulated assets backing
Bankers Life's long-term care reserves was $160.3 million in 2005; $144.2
million in 2004; $44.7 million in the four months ended December 31, 2003;
and $56.1 million in the eight months ended August 31, 2003.
</FN>
</TABLE>
Total premium collections were $2,415.8 million in 2005; $2,319.9 million
in 2004; $720.3 million in the four months ended December 31, 2003; and $1,560.7
million in the eight months ended August 31, 2003. See "Premium Collections" for
further analysis of Bankers Life's premium collections.
Average liabilities for insurance products, net of reinsurance ceded, were
$8.9 billion in 2005; $8.0 billion in 2004; $7.4 billion in the four months
ended December 31, 2003; and $6.3 billion in the eight months ended August 31,
2003. The increase in such liabilities since August 31, 2003, was primarily due
to increases in annuity reserves resulting from new sales of these products in
recent periods. The increase in such liabilities for the four months ended
December 31, 2003, was primarily due to the adoption of fresh start accounting
and its effects on the reserves for our health insurance.
Insurance policy income is comprised of premiums earned on policies which
provide mortality or morbidity coverage and fees and other charges assessed on
other policies. See "Premium Collections" for further analysis.
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) was $488.8 million in 2005;
$422.6 million in 2004; $128.9 million in the four months ended December 31,
2003; and $253.4 million in the eight months ended August 31, 2003. The average
balance of general account invested assets was $8.6 billion in 2005; $7.7
billion in 2004; $7.0 billion in the four months ended December 31, 2003; and
$6.6 billion in the eight months ended August 31, 2003. The average yield on
these assets was 5.7 percent in 2005; 5.5 percent in 2004; 5.5 percent in the
four months ended December 31, 2003; and 5.7 percent in the eight months ended
August 31, 2003. The
47
<PAGE>
increase in general account invested assets is primarily due to sales of our
annuity products in recent periods. This segment's investment income included
income related to prepayments of securities (including prepayment penalties on
mortgages, call premiums on fixed maturities and acceleration of discount
amortization, net of premium amortization) of $3.0 million in 2005 and $4.7
million in 2004. The yields in 2004 and for the four months ended December 31,
2003, reflected the adoption of fresh start accounting which reset the yields to
market rates at August 31, 2003.
Net investment income related to equity-indexed products based on the
change in value of options represents the change in the estimated fair value of
options which are purchased in an effort to hedge certain potential benefits
accruing to the policyholders of our equity-indexed products. Our equity-indexed
products are designed so that the investment income spread earned on the related
insurance liabilities is more than adequate to cover the cost of the options and
other costs related to these policies. Option costs attributable to benefits
provided were $7.8 million in 2005; $7.1 million in 2004; $2.9 million in the
four months ended December 31, 2003; and $7.7 million in the eight months ended
August 31, 2003. These costs are reflected in net investment income. Investment
income related to equity-indexed products before these costs was $5.2 million in
2005; $9.7 million in 2004; $9.5 million in the four months ended December 31,
2003; and $12.5 million in the eight months ended August 31, 2003. Such amounts
are generally offset by the corresponding charge (credit) to amounts added to
policyholder account balances for equity-indexed products based on the change in
value of the indices. Such income and related charges fluctuate based on the
value of options embedded in the segment's equity-indexed annuity policyholder
account balances subject to this benefit and to the performance of the index to
which the returns on such products are linked.
Trading account income related to policyholder and reinsurer accounts
represents the income on trading securities, which are designed to act as hedges
for embedded derivatives related to certain modified coinsurance agreements. The
income on our trading account securities is designed to be substantially offset
by the change in value of embedded derivatives related to modified coinsurance
agreements described below.
Change in value of embedded derivatives related to modified coinsurance
agreements is described in the note to our consolidated financial statements
entitled "Summary of Significant Accounting Policies - Accounting for
Derivatives." We have transferred the specific block of investments related to
these agreements to our trading account, which we carry at estimated fair value
with changes in such value recognized as trading account income. We expect the
change in the value of the embedded derivatives to be largely offset by the
change in value of the trading securities.
Insurance policy benefits fluctuated as a result of the factors summarized
below for benefit ratios. Benefit ratios are calculated by dividing the related
insurance product's insurance policy benefits by insurance policy income.
The Medicare supplement business consists of both individual and group
policies. Government regulations generally require us to attain and maintain a
ratio of total benefits incurred to total premiums earned (as calculated based
on amounts reported for statutory accounting purposes, which differ from the
amounts reported for GAAP purposes), after three years, of not less than 65
percent on individual products and not less than 75 percent on group products.
The benefit ratio experienced in 2005 reflected a $2.0 million claim reserve
deficiency resulting from the ultimate development of reserves at December 31,
2004, as well as a higher level of paid claims compared to 2004. In 2004, we
recognized $1.5 million of positive developments from reserves established in
prior periods. Our loss experience in the four months ended December 31, 2003
was favorably impacted by positive developments of $5.8 million from insurance
liabilities established in prior periods.
The net cash flows from our long-term care products generally cause an
accumulation of amounts in the early years of a policy (accounted for as reserve
increases) which will be paid out as benefits in later policy years (accounted
for as reserve decreases). Accordingly, as the policies age, the benefit ratio
typically increases, but the increase in reserve is partially offset by
investment income earned on the accumulated assets. The benefit ratio on this
business increased in 2005, consistent with the aging of this block. In
addition, the older policies have not lapsed at the rate we assumed in our
pricing. In the first quarter of 2005, we began introducing several new
long-term care products to replace our previous products which had lower pricing
assumptions. To date, these new products have been approved by the regulatory
authorities in 46 states. During 2005, we made certain adjustments to the
assumptions we use to calculate insurance liabilities for future long-term care
benefits, resulting in a net reduction to insurance liabilities of $6.4 million.
The primary change related to policies that provide for increased benefits to
reflect inflation. Our previous assumptions had reflected the increased
projected benefit costs for the inflation benefit in insurance liabilities at
the time of billing immediately prior to the policy anniversary date which was
earlier than the actual terms of the policy. Our new method calculates the
increased projected benefit costs on the policy anniversary date which is in
accordance with the actual terms of the policy. The interest-adjusted benefit
ratio for long-term care products is calculated by dividing the insurance
product's insurance policy benefits less interest income on the accumulated
assets backing the insurance liabilities by insurance policy income. The
decrease in the interest-adjusted benefit ratio for the four months ended
December 31, 2003, was primarily due to the adoption of fresh start accounting
which increased the assets backing such insurance liabilities.
48
<PAGE>
We are seeking rate increases on approximately 65 percent of the total
long-term care inforce block in the Bankers Life segment. As a result of higher
persistency in this block and lower interest rates than assumed in the original
pricing, the current premium rates are too low. This process is proceeding
according to plan and, to date, we have already received approval for
approximately 70 percent of the total dollar amount of our requested rate
increases.
The benefit ratios on our other products are subject to fluctuations due to
the smaller size of these blocks of business.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $165.4 million in 2005; $149.5 million in
2004; $50.6 million in the four months ended December 31, 2003; and $89.5
million in the eight months ended August 31, 2003. The increases were primarily
due to increases in annuity reserves (resulting from higher sales of these
products) partially offset by lower average crediting rates. The weighted
average crediting rates for these products were 3.7 percent in 2005; 3.9 percent
in 2004; 4.4 percent for the four months ended December 31, 2003; and 4.2
percent for the eight months ended August 31, 2003.
Amounts added to equity-indexed products based on change in value of the
indices fluctuated with the corresponding related investment income accounts
described above.
Amortization related to operations includes amortization of the value of
policies inforce at the Effective Date and the cost of policies produced
(collectively referred to as "amortization of insurance acquisition costs").
Insurance acquisition costs are amortized either: (i) in relation to the
estimated gross profits for universal life and investment-type products; or (ii)
in relation to actual and expected premium revenue for other products. In
addition, for universal life and investment-type products, we are required to
adjust the total amortization recorded to date through the statement of
operations if actual experience or other evidence suggests that earlier
estimates of future gross profits should be revised. Accordingly, amortization
for universal life and investment-type products is dependent on the profits
realized during the period and on our expectation of future profits. For other
products, we amortize insurance acquisition costs in relation to actual and
expected premium revenue, and amortization is only adjusted if expected premium
revenue changes or if we determine the balance of these costs is not recoverable
from future profits. Such amounts were generally consistent with the related
premium revenue and gross profits for such periods and the assumptions we made
when we established the value of policies inforce as of the Effective Date. In
addition, during 2005, we recognized additional amortization expense of $4.4
million to reflect revisions to our calculations related to prior period
amounts. The assumptions we use to estimate our future gross profits and
premiums involve significant judgment. A revision to our current assumptions
could result in increases or decreases to amortization expense in future
periods. Bankers Life's amortization expense in the first eight months of 2003
was not comparable to subsequent periods due to the application of fresh start
accounting effective August 31, 2003.
Interest expense on investment borrowings fluctuated with our investment
borrowing activities and the interest rates thereon.
Other operating costs and expenses in our Bankers Life segment were $155.2
million in 2005; $160.1 million in 2004; $51.8 million in the four months ended
December 31, 2003; and $85.3 million in the eight months ended August 31, 2003.
The decrease in 2005, as compared to 2004, was due primarily to: (i) lower
policy maintenance expenses reflecting our cost reduction initiatives, partially
offset by; (ii) higher advertising expenses in our direct response marketing
channel and higher commission expense. These expenses were higher in 2004
compared to the 2003 periods due primarily to higher sales and career agency
infrastructure costs and lower reinsurance expense allowances. Other operating
costs and expenses, excluding commission expenses, for this segment were $135.4
million in 2005; $144.4 million in 2004; $45.4 million in the four months ended
December 31, 2003; and $75.9 million in the eight months ended August 31, 2003.
Net realized investment gains (losses) fluctuated each period. During 2005,
net realized investment gains (losses) in this segment included $.9 million of
net losses from the sales of investments (primarily fixed maturities), and $2.7
million of writedowns of investments resulting from declines in fair values that
we concluded were other than temporary. During 2004, net realized investment
gains in this segment included $21.5 million of net gains from the sales of
investments (primarily fixed maturities), net of $4.1 million of writedowns of
investments resulting from declines in fair values that we concluded were other
than temporary. During the four months ended December 31, 2003, net realized
investment gains in this segment included $8.6 million of net gains from the
sales of investments (primarily fixed maturities), net of $5.2 million of
writedowns of investments resulting from declines in fair values that we
concluded were other than temporary. During the first eight months of 2003, net
investment gains included $20.5 million of net gains from the sales of
investments (primarily fixed maturities), net of $15.0 million of writedowns of
investments resulting from declines in fair values that we concluded were other
than temporary.
49
<PAGE>
Amortization related to net realized investment gains (losses) is the
increase or decrease in the amortization of insurance acquisition costs which
results from realized investment gains or losses. When we sell securities at a
gain (loss) and reinvest the proceeds at a different yield, we increase (reduce)
the amortization of insurance acquisition costs in order to reflect the change
in future expected yields. Sales of fixed maturity investments resulted in an
increase (decrease) in the amortization of insurance acquisition costs of $(1.0)
million in 2005; $4.7 million in 2004; nil in the four months ended December 31,
2003; and $.5 million in the eight months ended August 31, 2003.
50
<PAGE>
Conseco Insurance Group (dollars in millions)
<TABLE>
<CAPTION>
Successor Predecessor
--------------------------------------- ------------
Years
ended Four months Eight months
December 31, ended ended
-------------------- December 31, August 31,
2005 2004 2003 2003
---- ---- ---- ----
<S> <C> <C> <C> <C>
Premium collections:
Annuities............................................ $ 161.7 $ 63.7 $ 18.1 $ 74.0
Supplemental health.................................. 661.5 729.6 272.0 525.3
Life................................................. 335.0 372.3 131.5 280.7
--------- --------- --------- ---------
Total collections.................................. $ 1,158.2 $ 1,165.6 $ 421.6 $ 880.0
========= ========= ========= =========
Average liabilities for insurance products:
Annuities:
Mortality based...................................... $ 269.8 $ 245.2 $ 243.5 $ 171.0
Equity-linked...................................... 1,349.0 1,485.5 1,561.4 1,514.7
Deposit based...................................... 3,470.2 3,790.4 4,027.8 4,245.4
Separate accounts and investment trust liabilities. 30.6 33.9 50.1 401.3
Health............................................... 2,375.1 2,331.6 2,286.3 2,045.4
Life:
Interest sensitive................................. 3,121.0 3,249.1 3,349.8 3,407.8
Non-interest sensitive............................. 1,431.0 1,446.2 1,485.3 1,495.3
--------- --------- --------- ---------
Total average liabilities for insurance products,
net of reinsurance ceded....................... $12,046.7 $12,581.9 $13,004.2 $13,280.9
========= ========= ========= =========
Revenues:
Insurance policy income.............................. $ 1,064.0 $ 1,148.4 $ 398.5 $ 892.8
Net investment income:
General account invested assets.................... 718.6 702.3 242.2 557.3
Equity-indexed products............................ (16.3) 17.5 40.0 25.3
Trading account income related to policyholder and
reinsurer accounts............................... (3.3) 5.2 7.5 -
Change in value of embedded derivatives related to
modified coinsurance agreements.................. 3.0 (1.2) (1.0) -
Fee revenue and other income......................... 1.9 4.8 .5 17.0
--------- --------- --------- ---------
Total revenues..................................... 1,767.9 1,877.0 687.7 1,492.4
--------- --------- --------- ---------
Expenses:
Insurance policy benefits............................ 798.5 844.5 279.7 454.5
Amounts added to policyholder account balances:
Annuity products and interest-sensitive life
products other than those listed below........... 254.5 260.9 94.9 218.4
Equity-indexed products............................ 12.6 45.7 46.8 73.4
Amortization related to operations................... 168.6 156.7 63.2 202.7
Interest expense on investment borrowings............ 4.9 5.2 1.6 4.7
Other operating costs and expenses................... 272.1 306.3 115.6 222.6
--------- --------- --------- ---------
Total expenses..................................... 1,511.2 1,619.3 601.8 1,176.3
--------- --------- --------- ---------
Income before net realized investment gains (losses),
net of related amortization, income taxes and
discontinued operations.............................. 256.7 257.7 85.9 316.1
--------- --------- --------- ---------
Net realized investment gains (losses)............... 1.6 21.5 9.5 (17.1)
Amortization related to net realized investment
(gains) losses..................................... 1.8 (8.7) (1.1) .9
--------- --------- --------- ---------
Net realized investment gains (losses),
net of related amortization...................... 3.4 12.8 8.4 (16.2)
--------- --------- --------- ---------
Income before income taxes and
discontinued operations.............................. $ 260.1 $ 270.5 $ 94.3 $ 299.9
========= ========= ========= =========
</TABLE>
(continued)
51
<PAGE>
(continued from previous page)
<TABLE>
<CAPTION>
Successor Predecessor
--------------------------------------- ------------
Years
ended Four months Eight months
December 31, ended ended
-------------------- December 31, August 31,
2005 2004 2003 2003
---- ---- ---- ----
<S> <C> <C> <C> <C>
Health benefit ratios:
All health lines:
Insurance policy benefits...................... $462.0 $492.9 $171.4 $381.3
Benefit ratio (a).............................. 68.7% 67.0% 64.9% 71.0%
Medicare supplement:
Insurance policy benefits...................... $178.5 $225.5 $86.5 $167.2
Benefit ratio (a).............................. 59.4% 63.2% 66.6% 65.5%
Specified disease:
Insurance policy benefits...................... $273.6 $256.9 $74.5 $184.7
Benefit ratio (a).............................. 76.2% 71.0% 61.6% 75.8%
Interest-adjusted benefit ratio (b)............ 45.1% 40.9% 30.6% 46.3%
Other:
Insurance policy benefits...................... $9.9 $10.5 $10.4 $29.4
Benefit ratio (a).............................. 75.9% 64.6% 79.1% 76.7%
<FN>
- -------------
(a) We calculate benefit ratios by dividing the related product's insurance
policy benefits by insurance policy income.
(b) We calculate the interest-adjusted benefit ratio (a non-GAAP measure) for
Conseco Insurance Group's specified disease products by dividing such
product's insurance policy benefits less interest income on the accumulated
assets backing the insurance liabilities by policy income. Interest income
is an important factor in measuring the performance of this product. The
net cash flows from specified disease products generally cause an
accumulation of amounts in the early years of a policy (accounted for as
reserve increases) which will be paid out as benefits in later policy years
(accounted for as reserve decreases). Accordingly, as the policies age, the
benefit ratio will typically increase, but the increase in the change in
reserve will be partially offset by interest income earned on the
accumulated assets. The interest-adjusted benefit ratio reflects the
effects of the interest income offset. Since interest income is an
important factor in measuring the performance of this product, management
believes a benefit ratio which includes the effect of interest income is
useful in analyzing product performance. The investment income earned on
the accumulated assets backing the specified disease reserves was $111.7
million in 2005; $108.8 million in 2004; $37.4 million in the four months
ended December 31, 2003; and $71.8 million in the eight months ended August
31, 2003.
</FN>
</TABLE>
Collections on insurance products were $1,158.2 million in 2005; $1,165.6
million in 2004; $421.6 million in the four months ended December 31, 2003; and
$880.0 million in the eight months ended August 31, 2003. Decreases in premium
collections have been significantly impacted by decreases in collected premiums
on Medicare supplement policies in this segment, which were $288.8 million in
2005; $351.7 million in 2004; $134.2 million in the four months ended December
31, 2003; and $250.4 million in the eight months ended August 31, 2003. We
implemented increases in premium rates in both 2005 and 2004. These rate
increases resulted in higher than expected lapses which reduced premiums
collected for this segment. In addition, we believe premium collections in this
segment have been impacted by our A.M. Best financial strength rating. See
"Premium Collections" for further analysis of fluctuations in premiums collected
by product. The premiums collected by this segment have decreased in each of the
last two years. We expect further decreases in 2006.
Average liabilities for insurance products, net of reinsurance ceded were
$12.0 billion in 2005; $12.6 billion in 2004; $13.0 billion in the four months
ended December 31, 2003; and $13.3 billion in the eight months ended August 31,
2003. The decrease in such liabilities was due primarily to policyholder
redemptions and lapses exceeding new sales due in part to our A.M. Best
financial strength rating. The liabilities for insurance products in this
segment were not significantly affected by the adoption of fresh start
accounting.
Insurance policy income is comprised of premiums earned on policies which
provide mortality or morbidity coverage and fees and other charges assessed on
other policies. See "Premium Collections" for further analysis.
52
<PAGE>
Net investment income on general account invested assets (which excludes
income on policyholder and reinsurer accounts) was $718.6 million in 2005;
$702.3 million in 2004; $242.2 million in the four months ended December 31,
2003; and $557.3 million in the eight months ended August 31, 2003. The average
balance of general account invested assets was $12.1 billion in 2005; $12.5
billion in 2004; $12.7 billion in the four months ended December 31, 2003; and
$13.7 billion in the eight months ended August 31, 2003. The average yield on
these assets was 5.9 percent in 2005; 5.6 percent in 2004; 5.7 percent in the
four months ended December 31, 2003; and 6.1 percent in the eight months ended
August 31, 2003. This segment's investment income included income related to
prepayments of securities (including prepayment penalties on mortgages, call
premiums on fixed maturities and acceleration of discount amortization, net of
premium amortization) of $22.8 million and $5.0 million in 2005 and 2004,
respectively. This additional investment income in 2005 resulted in additional
amortization expense of $9.4 million to reflect the higher gross profits for
universal life and investment-type products. The decreases in yields in 2004 and
for the four months ended December 31, 2003, reflected the adoption of fresh
start accounting which effectively reset the yields to market rates at August
31, 2003.
Net investment income related to equity-indexed products represents the
change in the estimated fair value of options which are purchased in an effort
to hedge certain potential benefits accruing to the policyholders of our
equity-indexed products. Our equity-indexed products are designed so that the
investment income spread earned on the related insurance liabilities is more
than adequate to cover the cost of the options and other costs related to these
policies. Option costs that are attributable to benefits provided were $34.2
million in 2005; $37.7 million in 2004; $16.2 million in the four months ended
December 31, 2003; and $45.8 million in the eight months ended August 31, 2003.
These costs are reflected in net investment income. Net investment income (loss)
related to equity-indexed products before these costs were $22.2 million in
2005; $48.8 million in 2004; $51.8 million in the four months ended December 31,
2003; and $71.1 million in the eight months ended August 31, 2003. Such amounts
also include income on trading securities which are designed to act as hedges
for embedded derivatives related to equity-indexed products. Such trading
account income (loss) was $(4.3) million in 2005; $6.4 million in 2004; and $4.4
million in the four months ended December 31, 2003. Such amounts were partially
offset by the corresponding charge (credit) to amounts added to policyholder
account balances for equity-indexed products. Such income and related charges
fluctuate based on the value of options embedded in the segment's equity-indexed
annuity policyholder account balances subject to this benefit and to the
performance of the indices to which the returns on such products are linked.
Trading account income related to policyholder and reinsurer accounts
represents the income on trading securities which are designed to act as hedges
for embedded derivatives related to certain modified coinsurance agreements. In
addition, such income includes the income on investments backing the market
strategies of certain annuity products which provide for different rates of cash
value growth based on the experience of a particular market strategy. The income
on our trading account securities is designed to substantially offset: (i) the
change in value of embedded derivatives related to modified coinsurance
agreements described below; and (ii) certain amounts included in insurance
policy benefits.
Change in value of embedded derivatives related to modified coinsurance
agreements is described in the note to our consolidated financial statements
entitled "Summary of Significant Accounting Policies - Accounting for
Derivatives." We have transferred the specific block of investments related to
these agreements to our trading securities account, which we carry at estimated
fair value with changes in such value recognized as trading account income. The
change in the value of the embedded derivatives has largely been offset by the
change in value of the trading securities.
Fee revenue and other income in the eight months ended August 31, 2003
included $15.6 million of income earned by a subsidiary that earned fees for
marketing insurance products of other companies. This subsidiary was sold in
September 2003, resulting in decreased fee revenue in subsequent periods.
Insurance policy benefits fluctuated as a result of the factors summarized
below for benefit ratios and, in the eight months ended August 31, 2003, as a
result of a change in estimate of future losses on certain policies, as
discussed below. Benefit ratios are calculated by dividing the related insurance
product's insurance policy benefits by insurance policy income.
The benefit ratios on Conseco Insurance Group's Medicare supplement
products in 2005 and 2004 were impacted by rate increases. The higher rates
caused an increase in policyholder lapses. The release of the policy benefit
reserve related to the lapsed business contributed to the lower benefit ratios
in 2005 and 2004. Government regulations generally require us to attain and
maintain a ratio of total benefits incurred to total premiums earned (as
calculated based on amounts reported for statutory accounting purposes, which
differ from the amounts reported for GAAP purposes), after three years, of not
less than 65 percent on these products. On a statutory accounting basis, such
benefit ratios exceeded the minimum requirement in 2005 and 2004.
Conseco Insurance Group's specified disease products generally provide
fixed or limited benefits. For example, payments under cancer insurance policies
are generally made directly to, or at the direction of, the policyholder
following
53
<PAGE>
diagnosis of, or treatment for, a covered type of cancer. Approximately 78
percent of our specified disease policies inforce (based on policy count) are
sold with return of premium or cash value riders. The return of premium rider
generally provides that after a policy has been inforce for a specified number
of years or upon the policyholder reaching a specified age, we will pay to the
policyholder, or a beneficiary under the policy, the aggregate amount of all
premiums paid under the policy, without interest, less the aggregate amount of
all claims incurred under the policy. The cash value rider is similar to the
return of premium rider, but also provides for payment of a graded portion of
the return of premium benefit if the policy terminates before the return of
premium benefit is earned. Accordingly, the net cash flows from these products
generally result in the accumulation of amounts in the early years of a policy
(accounted for as reserve increases) which will be paid out as benefits in later
policy years (accounted for as reserve decreases). Accordingly, as the policies
age, the benefit ratio will typically increase, but the increase in the change
in reserve will be partially offset by investment income earned on the
accumulated assets. In addition, the benefit ratio for 2005 reflects unfavorable
claim experience. The benefit ratio in this block of business is affected by the
number of policies which lapse in a period. When policies lapse before reaching
the specified age when the return of premium is payable, the reserve established
for such benefit through the lapse date is released, resulting in lower
insurance policy benefits for the period. In the third quarter of 2004, we
changed the criteria pursuant to which we consider a specified disease policy to
be lapsed. Although our specified disease policies generally may be lapsed for
non-payment of premiums after being delinquent for 90 days, policyholders are
permitted to reinstate their coverage by paying past due premiums prior to our
final lapse notice. In addition, timing differences and delays in billing,
receipt and processing of premiums can affect whether a policy has, in fact,
lapsed. We revised our previous methodology of determining which policies have
lapsed to consider the fact that many policyholders whose payments are
delinquent past their grace periods may, in fact, reinstate their coverage
through payment of past due premiums. These changes resulted in an increase to
reserves of approximately $6 million in 2004. The effect of variances in lapse
rates from our expectations were partially offset by reduced amortization of
insurance acquisition costs of $2.2 million in 2004. We had favorable claims
experience in the four months ended December 31, 2003. We experienced higher
than expected incurred claims on certain cancer insurance policies during the
first eight months of 2003.
The benefit ratios on Conseco Insurance Group's other products are subject
to fluctuations due to the smaller size of these blocks of business. Although
the benefit ratio on this business reflected improved experience in 2004, we
expect continued fluctuations in the future.
From time-to-time, we experience higher (or lower) than expected death
claims in the life business of the Conseco Insurance Group segment. For example,
during the first quarter of 2004, we experienced adverse life mortality of
approximately $4.4 million. Since the first quarter of 2004, our life mortality
experience generally returned to levels comparable to previous periods.
In August 2003, we decided to change a non-guaranteed element of certain
Conseco Insurance Group policies that was not required by the policy. This
change eliminated the former practice of reducing the cost of insurance charges
below the levels permitted under the policies. As a result, our estimates of
future expected gross profits on these products, which is used as a basis for
amortizing insurance acquisition costs, and our estimate of insurance
liabilities changed. We adjusted the total amortization and reserve charges
which we had recorded since the acquisition of these policies as a result of
these changes in earlier estimates in accordance with SFAS 97. The changes in
these estimates resulted in a $220.2 million reduction to insurance policy
benefits and a $39.8 million reduction to amortization recorded in the eight
months ended August 31, 2003.
Amounts added to policyholder account balances for annuity products and
interest-sensitive life products were $254.5 million in 2005; $260.9 million in
2004; $94.9 million in the four months ended December 31, 2003; and $218.4
million in the eight months ended August 31, 2003. The fluctuations are
primarily due to a smaller block of annuity business inforce. The weighted
average crediting rates for these products were 4.0 percent in 2005; 3.8 percent
in 2004; 4.0 percent for the four months ended December 31, 2003; and 4.4
percent for the eight months ended August 31, 2003.
Amounts added to equity-indexed products fluctuated with the corresponding
related investment income accounts described above.
Amortization related to operations includes amortization of insurance
acquisition costs. Insurance acquisition costs are amortized either: (i) in
relation to the estimated gross profits for universal life and investment-type
products; or (ii) in relation to actual and expected premium revenue for other
products. In addition, for universal life and investment-type products, we are
required to adjust the total amortization recorded to date through the statement
of operations if actual experience or other evidence suggests that earlier
estimates of future gross profits should be revised. Accordingly, amortization
for universal life and investment-type products is dependent on the profits
realized during the period and on our expectation of future profits. For other
products, we amortize insurance acquisition costs in relation to actual and
expected premium revenue, and amortization is only adjusted if expected premium
revenue changes or if we determine the balance of
54
<PAGE>
these costs is not recoverable from future profits. The rate increases
implemented in early 2005 and in 2004 on our Medicare supplement products
resulted in higher lapses than we anticipated. These lapses reduced our
estimates of future expected premium income and, accordingly, we recognized
additional amortization expense in 2005 and 2004. The assumptions we use to
estimate our future gross profits and premiums involve significant judgment. A
revision to our current assumptions could result in increases or decreases to
amortization expense in future periods.
During 2004, we evaluated certain amortization assumptions used to estimate
gross profits for universal life products and investment-type products by
comparing them to our actual experience. We made refinements to the previous
assumptions related to investment income to match the actual experience and our
estimates for future assumptions. The changes we made did not affect our
expectations for the total estimated profits to be earned on this business, but
did affect how we expect the profits to emerge over time. These new assumptions
resulted in a reduction to the amortization of insurance acquisition costs of
$7.7 million in the second quarter of 2004.
Conseco Insurance Group's amortization recorded in the eight months ended
August 31, 2003, was affected by the change in estimates of future losses on
certain policies described above under "insurance policy benefits."
Interest expense on investment borrowings fluctuated with Conseco Insurance
Group's investment borrowing activities and the interest rates thereon.
Other operating costs and expenses were $272.1 million in 2005; $306.3
million in 2004; $115.6 million in the four months ended December 31, 2003; and
$222.6 million in the eight months ended August 31, 2003. The decrease in 2005
operating expense is primarily due to reduced commission expenses resulting from
lower premium collections and reduced compensation costs resulting from our cost
reduction initiatives. Other operating costs and expenses, excluding commission
expenses, for this segment were $177.9 million in 2005; $194.4 million in 2004;
$70.3 million in the four months ended December 31, 2003; and $149.5 million in
the eight months ended August 31, 2003. Operating expenses in 2005 and 2004
reflected expense recoveries associated with the Predecessor's bankruptcy of
$7.6 million and $11.3 million, respectively. Operating expenses in 2005 and
2004 also reflected reductions of amounts related to a postretirement health
plan of an insurance subsidiary. A reduction of $8.8 million in 2005 related to
the termination of the postretirement plan and a $7.9 million reduction in 2004
related to an actuarial gain resulting either from actual experience being
different than expected or changes in actuarial assumptions. In addition,
expenses decreased in 2004 as compared to 2003 due to lower: (i) compensation
costs; and (ii) marketing and agency related expenses.
Net realized investment gains (losses) fluctuate each period. During 2005,
net realized investment gains included $6.0 million of net gains from the sales
of investments (primarily fixed maturities), net of $4.4 million of writedowns
of investments resulting from declines in fair values that we concluded were
other than temporary. During 2004, net realized investment gains in this segment
included $32.1 million of net gains from the sales of investments (primarily
fixed maturities), net of $10.6 million of writedowns of investments resulting
from declines in fair values that we concluded were other than temporary. During
the four months ended December 31, 2003, net realized investment gains in this
segment included $13.4 million of net gains from the sales of investments
(primarily fixed maturities), net of $3.9 million of writedowns of investments
resulting from declines in fair values that we concluded were other than
temporary. During the first eight months of 2003, net realized investment losses
included $16.8 million of net gains from the sales of investments (primarily
fixed maturities), net of $33.9 million of writedowns of investments resulting
from declines in fair values that we concluded were other than temporary.
Amortization related to net realized investment gains (losses) is the
increase or decrease in the amortization of insurance acquisition costs which
results from realized investment gains or losses. When we sell securities at a
gain (loss) and reinvest the proceeds at a different yield, we increase (reduce)
the amortization of insurance acquisition costs in order to reflect the change
in future expected yields. Sales of fixed maturity investments resulted in an
increase (decrease) in the amortization of insurance acquisition costs of $(1.8)
million in 2005; $8.7 million in 2004; $1.1 million in the four months ended
December 31, 2003; and $(.9) million in the eight months ended August 31, 2003.
55
<PAGE>
Other Business in Run-Off (dollars in millions)
<TABLE>
<CAPTION>
Successor Predecessor
--------------------------------------- ------------
Years
ended Four months Eight months
December 31, ended ended
-------------------- December 31, August 31,
2005 2004 2003 2003
---- ---- ---- ----
<S> <C> <C> <C> <C>
Premium product collections:
Long-term care........................................ $ 349.1 $ 380.1 $ 134.6 $ 268.0
Major medical........................................ 2.8 15.8 39.3 156.4
-------- -------- -------- --------
Total collections................................ $ 351.9 $ 395.9 $ 173.9 $ 424.4
======== ======== ======== ========
Average liabilities for insurance products:
Long-term care........................................ $3,288.4 $3,281.8 $3,296.2 $1,977.9
Major medical......................................... 41.5 73.4 103.8 120.0
-------- -------- -------- --------
Total average liabilities for insurance products,
net of reinsurance ceded....................... $3,329.9 $3,355.2 $3,400.0 $2,097.9
======== ======== ======== ========
Revenues:
Insurance policy income............................... $ 359.1 $ 395.8 $ 150.5 $ 418.8
Net investment income on general account
invested assets..................................... 177.6 167.5 55.3 101.5
Fee revenue and other income.......................... .5 .8 .9 .5
-------- -------- -------- --------
Total revenues.................................... 537.2 564.1 206.7 520.8
-------- -------- -------- --------
Expenses:
Insurance policy benefits............................. 351.1 386.1 150.7 595.0
Amortization related to operations.................... 22.8 18.5 6.3 28.0
Interest expense on investment borrowings............. - .2 - .2
Other operating costs and expenses.................... 86.1 93.5 36.2 75.2
-------- -------- -------- --------
Total expenses.................................... 460.0 498.3 193.2 698.4
-------- -------- -------- --------
Income (loss) before net realized investment
gains (losses), income taxes and discontinued
operations.............................................. 77.2 65.8 13.5 (177.6)
Net realized investment gains (losses)................ .5 4.5 (.7) 6.3
-------- -------- -------- --------
Income (loss) before income taxes and
discontinued operations................................. $ 77.7 $ 70.3 $ 12.8 $ (171.3)
======== ======== ======== ========
Health benefit ratios:
Insurance policy benefits........................... $351.1 $386.1 $150.7 $595.0
Benefit ratio (a)................................... 97.8% 97.5% 100.2% 142.1%
Interest-adjusted benefit ratio (b)................. 49.2% 56.2% 67.2% 119.4%
<FN>
- -----------
(a) We calculate benefit ratios by dividing the related product's insurance
policy benefits by insurance policy income.
(b) We calculate the interest-adjusted benefit ratio (a non-GAAP measure) for
long-term care products by dividing such product's insurance policy
benefits less interest income on the accumulated assets backing the
insurance liabilities by insurance policy income. Interest income is an
important factor in measuring the performance of this product. The net cash
flows from long-term care products generally cause an accumulation of
amounts in the early years of a policy (accounted for as reserve increases)
which will be paid out as benefits in later policy years (accounted for as
reserve decreases). Accordingly, as the policies age, the benefit ratio
will typically increase, but the increase in the change in reserve will be
partially offset by interest income earned on the accumulated assets. The
interest-adjusted benefit ratio reflects the effects of the interest income
offset. Since interest income is an important factor in measuring the
56
<PAGE>
performance of this product, management believes a benefit ratio which
includes the effect of interest income is useful in analyzing product
performance. The investment income earned on the accumulated assets backing
long-term care reserves in our Other Business in Run-off segment was $174.5
million in 2005; $163.5 million in 2004; $49.7 million in the four months
ended December 31, 2003; and $94.9 million in the eight months ended August
31, 2003.
</FN>
</TABLE>
Total premium collections were $351.9 million in 2005; $395.9 million in
2004; $173.9 million in the four months ended December 31, 2003; and $424.4
million in the eight months ended August 31, 2003. We have ceased marketing the
long-term care business and major medical business of this segment. Accordingly,
collected premiums will decrease over time as policies lapse, partially offset
by premium rate increases. See "Premium Collections" for further analysis.
Average liabilities for insurance products, net of reinsurance ceded were
$3.3 billion in 2005; $3.4 billion in 2004; $3.4 billion in the four months
ended December 31, 2003; and $2.1 billion in the eight months ended August 31,
2003. The increase in 2003 reflected the adoption of fresh start accounting as
further discussed under "Critical Accounting Policies -- Liabilities for
Insurance Products."
Insurance policy income is comprised of premiums earned on the segment's
long-term care and major medical policies. See "Premium Collections" for further
analysis.
Net investment income on general account invested assets was $177.6 million
in 2005; $167.5 million in 2004; $55.3 million in the four months ended December
31, 2003; and $101.5 million in the eight months ended August 31, 2003. The
average balance of general account invested assets was $3.0 billion in 2005;
$3.0 billion in 2004; $2.8 billion in the four months ended December 31, 2003;
and $2.5 billion in the eight months ended August 31, 2003. The average yield on
these assets was 6.0 percent in 2005; 5.6 percent in 2004; 5.8 percent in the
four months ended December 31, 2003; and 6.1 percent in the eight months ended
August 31, 2003. The increase in yield in 2005 was primarily due to: (i)
lengthening the duration of this portfolio to better match the duration of the
related insurance liabilities; and (ii) income of $2.3 million related to
prepayments of securities (including prepayment penalties on mortgages, call
premiums on fixed maturities and acceleration of discount amortization, net of
premium amortization). The decrease in yield in 2004 as compared to the 2003
periods reflected the lower interest rate environment prevailing in 2004. The
proceeds from investment maturities and prepayments were reinvested at lower
prevailing interest rates in 2004, reducing the overall portfolio yield. The
decrease in yield for the four months ended December 31, 2003 reflected the
adoption of fresh start accounting which effectively reset the yields to market
rates at August 31, 2003.
Insurance policy benefits fluctuated primarily as a result of the factors
summarized below related to benefit ratios in the blocks of long-term care
business included in this segment. Benefit ratios are calculated by dividing the
product's insurance policy benefits by insurance policy income.
This segment includes long-term care insurance inforce, which was primarily
issued through independent agents by certain subsidiaries prior to their
acquisitions by Conseco in 1996 and 1997. The loss experience on these products
has been worse than we originally expected. Although we anticipated a higher
level of benefits to be paid on these products as the policies aged, the paid
claims have exceeded our expectations. In particular, we have experienced
adverse developments on home health care policies issued in certain areas of
Florida and other states. This adverse experience is reflected in our high
benefit ratios. We have been aggressively seeking rate increases and pursuing
other actions on such long-term care policies. Since mid-2004, we have been
actively managing our long-term care cases under improved claim adjudication
processes. On April 20, 2004, the Florida Office of Insurance Regulation issued
an Order to our subsidiary, Conseco Senior, that affected approximately 12,600
home health care policies issued in Florida by Conseco Senior and its
predecessor companies. On July 1, 2004, the Florida Office of Insurance
Regulation issued a similar Order impacting approximately 4,800 home health care
policies issued in Florida by our subsidiary, Washington National and its
predecessor companies. Pursuant to the Orders, Conseco Senior and Washington
National offered the following three alternatives to holders of these policies:
o retention of their current policy with a rate increase of 50 percent in
the first year and actuarially justified increases in subsequent years
(which is also the default election for policyholders who fail to make
an election by the deadline) ("option one");
o receipt of a replacement policy with reduced benefits and a rate
increase in the first year of 25 percent and no more than 15 percent in
subsequent years ("option two"); or
o receipt of a paid-up policy, allowing the holder to file future claims
up to 100 percent of the amount of premiums paid since the inception of
the policy ("option three").
As of December 31, 2005, we have received election notice responses (or
policyholders have defaulted to option one due to failure to elect an option)
from approximately 15,100 policyholders, 53 percent of whom elected (or
defaulted) to option one, 4 percent selected option two and 43 percent selected
option three. Policyholders selecting option one or option two are entitled to
receive a contingent non-forfeiture benefit if their policy subsequently lapses.
In addition, policyholders may change their initial election any time up to 30
days prior to the anniversary date of their policies. We began to implement
premium adjustments with respect to policyholder elections in the fourth quarter
of 2005. In 2005, we did not make any adjustments to the insurance liabilities
when these elections were made, although the future profitability of this block
is expected to improve. The changes in reserves due to the structural changes
arising from such elections are being recognized prospectively over the expected
remaining life of the policies pursuant to the lock-in concept of Statement of
Financial Accounting Standards No. 60, "Accounting and Reporting by Insurance
Enterprises" and related interpretive accounting and actuarial guidance.
57
<PAGE>
The orders also require Conseco Senior and Washington National to pursue a
similar course of action with respect to approximately 24,000 home health care
policies in other states, subject to consideration and approval by the other
state insurance departments. If we are unsuccessful in obtaining rate increases
or other forms of relief in those states, or if the policy changes approved by
the Florida Office of Insurance Regulation prove inadequate, our future results
of operations could be adversely affected.
During the fourth quarter of 2005, we utilized a new seriatim-based
valuation system to determine reserves for the long-term care block of business
in run-off. We had previously used a model based valuation system since the
fresh-start date. Such conversion to the seriatim-based valuation system
resulted in decreases to our insurance liabilities of approximately $38 million
in the fourth quarter of 2005. In addition, we completed a new claims cost study
and developed new continuance tables based on our recent experience which were
used to estimate claim reserves resulting in an increase to insurance
liabilities of $40 million in the fourth quarter of 2005.
The benefit ratios on this business in periods after August 31, 2003 are
generally not comparable to prior periods due to the adoption of fresh start
accounting which increased the reserves on this block of business. We believe
our actions to seek rate increases and to improve our claims adjudication
processes are resulting in improved benefit ratios on this business. In
addition, our 2004 benefit ratio reflected the elimination of reserve
redundancies of $13.2 million related to our discontinued major medical
business.
The benefits we have experienced since August 31, 2003 have generally been
consistent with the revised assumptions resulting from the actuarial studies
completed in 2003. However, as described below, estimating benefits on long-term
care products involves significant judgment and our prior estimates have not
always been accurate.
During the first eight months of 2003, we conducted various actuarial
studies to evaluate this segment's long-term care reserves given our recent
adverse experience and claim reserve deficiencies. We engaged an actuarial
consulting firm to assist us with the examination. The performance of this
business had been generally unfavorable relative to the assumptions established
when these blocks of business were acquired. Although we considered historical
claim experience and recent trends in establishing our reserves, we had
relatively limited historical claim experience. In addition, these products tend
to have fewer claims than other products such as Medicare supplement, but when
claims are incurred, they tend to be much higher in dollar amount. Also,
long-term care product claims are incurred much later in the life of the policy
than most other supplemental health products. These factors make it more
difficult to estimate claim reserves for this product. The change in estimates
resulting from the actuarial studies increased our claim reserves by $85 million
and our benefit ratio by 20 percent in the eight months ended August 31, 2003.
The net cash flows from long-term care products generally cause an
accumulation of amounts in the early years of a policy (accounted for as reserve
increases) which will be paid out as benefits in later policy years (accounted
for as reserve decreases). Accordingly, as the policies age, the benefit ratio
will typically increase, but the increase in the change in reserve will be
partially offset by investment income earned on the assets which have
accumulated. The interest-adjusted benefit ratio for long-term care products is
calculated by dividing the insurance product's insurance policy benefits less
interest income on the accumulated assets backing the insurance liabilities by
insurance policy income.
Amortization related to operations includes amortization of insurance
acquisition costs. The decrease in amortization expense subsequent to August 31,
2003, reflected the adoption of fresh start accounting, and also reflected the
relatively small amount of value of policies inforce associated with the
business comprising this segment.
Interest expense on investment borrowings fluctuated with our investment
borrowing activities which are not significant in this segment.
Other operating costs and expenses were $86.1 million in 2005; $93.5
million in 2004; $36.2 million in the four months ended December 31, 2003; and
$75.2 million in the eight months ended August 31, 2003. Other operating costs
and expenses, excluding commission expenses, for this segment were $46.3 million
in 2005; $50.3 million in 2004; $22.1 million in the four months ended December
31, 2003; and $41.3 million in the eight months ended August 31, 2003. The
decrease
58
<PAGE>
reflects our initiatives to reduce operating expenses and improve the efficiency
of our operations.
Net realized investment gains (losses) fluctuated each period. During 2005,
net realized investment gains included $6.8 million of net gains from the sales
of investments (primarily fixed maturities), net of $6.3 million of writedowns
of investments resulting from declines in fair values that we concluded were
other than temporary. During 2004, net realized investment gains in this segment
included $5.1 million of net gains from the sales of investments (primarily
fixed maturities), net of $.6 million of writedowns of investments resulting
from declines in fair values that we concluded were other than temporary. During
the four months ended December 31, 2003, net realized investment losses in this
segment included $.2 million of net losses from the sales of investments and $.5
million of writedowns of investments resulting from declines in fair values that
we concluded were other than temporary. During the first eight months of 2003,
net realized investment gains included $8.7 million of net gains from the sales
of investments (primarily fixed maturities), net of $2.4 million of writedowns
of investments resulting from declines in fair values that we concluded were
other than temporary.
Corporate Operations (dollars in millions)
<TABLE>
<CAPTION>
Successor Predecessor
--------------------------------------- ------------
Years
ended Four months Eight months
December 31, ended ended
-------------------- December 31, August 31,
2005 2004 2003 2003
---- ---- ---- ----
<S> <C> <C> <C> <C>
Corporate operations:
Interest expense on corporate debt.................. $(48.1) $ (71.5) $(34.4) $ (194.2)
Investment income .................................. 5.4 2.1 .6 16.2
Provision for losses related to stock purchase plan. - - - (55.6)
Venture capital income (loss) related to investment
in AT&T Wireless Service, Inc. ("AWE"), net
of related expenses............................... - - (5.5) 10.5
Fee revenue and other income........................ 20.2 14.0 11.4 17.1
Net operating results of variable interest entity... .1 - - -
Other operating costs and expenses.................. (58.7) (72.9) (14.8) (40.4)
Gain (loss) on extinguishment of debt............... (3.7) 2.8 - -
Reorganization items................................ - - - 2,130.5
------ ------- ------ --------
Income (loss) before net realized investment losses,
income taxes and discontinued operations....... (84.8) (125.5) (42.7) 1,884.1
Net realized investment losses...................... (1.4) (2.8) (.4) (.1)
------ ------- ------ --------
Income (loss) before income taxes and
discontinued operations........................ $(86.2) $(128.3) $(43.1) $1,884.0
====== ======= ====== ========
</TABLE>
Interest expense on corporate debt in 2005 was impacted by the issuance of
the Debentures and our Amended Credit Facility which are further discussed in
the note to the consolidated financial statements entitled "Notes Payable -
Direct Corporate Obligations". Interest expense on corporate debt in 2004
included interest expense on an $800.0 million secured credit agreement (the
"Credit Facility") and a $1.3 billion credit agreement (the "Previous Credit
Facility"), including a credit agreement charge of $3.8 million. Interest
expense in the four months ended December 31, 2003 included interest expense on
the Previous Credit Facility. Interest expense in the eight months ended August
31, 2003, reflected interest on notes payable of our Predecessor. The average
interest rate on our debt was 5.9 percent in 2005, 6.8 percent in 2004 and 7.8
percent in the four months ended December 31, 2003.
Investment income primarily included income earned on short-term
investments held by the Corporate segment and miscellaneous other income and
fluctuated along with the change in the amount of invested assets in this
segment.
Provision for losses and expense related to stock purchase plan represents
the non-cash provision for our Predecessor's guarantees of the bank loans of
approximately 155 former directors and employees and the related loans for
interest. The funds from the bank loans were used by the participants to
purchase approximately 18.0 million shares of our Predecessor's common stock. In
the first eight months of 2003, our Predecessor established a provision of $55.6
million in connection with these guarantees and loans. Our Predecessor
determined the reserve based upon the value of the collateral held by the banks.
The outstanding principal balance on the bank loans was $481.3 million. In
addition, our Predecessor
59
<PAGE>
provided loans to participants for interest on such bank loans totaling $179.2
million.
In conjunction with the Plan, the principal amount of the bank loans of
$481.3 million was transferred to the Company. We received all rights to collect
the balances due pursuant to the original terms of these loans. In addition, we
hold loans to participants for interest on the bank loans which exceeded $230
million at December 31, 2005. We regularly evaluate the collectibility of these
loans in light of the collateral we hold, the credit worthiness of the
participants and the current status of various legal actions we have taken to
collect the D&O loans. At December 31, 2005, we have established a liability of
$17.5 million (which is included in other liabilities), representing our
estimate of the amount which will be paid to the former holders of TOPrS
pursuant to the settlement.
Venture capital income (loss) related to our investment in AWE, a company
in the wireless communication business. Our investment in AWE was carried at
estimated fair value, with changes in fair value recognized as investment income
(loss). We sold all of our holdings in AWE during the fourth quarter of 2003.
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. In 2005, our wholly owned investment management
subsidiary recognized a performance-based fee of $8.1 million earned in
conjunction with its management of a $510 million portfolio of loans for an
issuer of structured securities. This portfolio was liquidated and the related
securities were redeemed on September 1, 2005, resulting in the receipt of this
fee which was largely based on the market value of the managed loan portfolio at
the redemption date. Excluding such performance-based fee, fee revenue and other
income decreased primarily as a result of a decrease in the market value of
investments managed for others, upon which these fees are based. Fee revenue and
other income in the four months ended December 31, 2003, included $5.6 million
of interest received on a Federal income tax refund.
Net operating results of variable interest entity represents the Company's
investment in a variable interest entity ("VIE"). The VIE is consolidated in
accordance with Financial Accounting Standards Board Interpretation No. 46
"Consolidation of Variable Interest Entities", revised December 2003 ("FIN
46R"). Although we do not control this entity, we consolidate it because we are
the primary beneficiary. This entity was established to issue securities and use
the proceeds to invest in loans and other permitted assets. Such consolidation
requirements did not have a material impact on our financial condition or
results of operations.
Other operating costs and expenses include general corporate expenses, net
of amounts charged to subsidiaries for services provided by the corporate
operations. These amounts fluctuate as a result of expenses such as consulting,
legal and severance costs which often vary from period to period. In 2005, other
operating costs and expenses are net of a $3.2 million recovery related to our
evaluation of the collectibility of the D&O loans. In 2004, we incurred expenses
of $13.2 million related to our executive transition as further discussed in the
notes to consolidated financial statements entitled "Other Disclosures" under
the captions "Executive Termination" and "Executive Hiring". General corporate
expenses included other severance expense of $2.4 million and $8.3 million in
2005 and 2004, respectively. During the first eight months of 2003, disputes
with our insurance carriers were resolved and a liability of $40 million
previously established in 2002 was released. This was substantially offset by
increases to various litigation reserves of $30 million.
We measure compensation expense for our stock option plans using the
intrinsic value method pursuant to Accounting Principles Board Opinion No. 25
"Accounting for Stock Issued to Employees." Under this method, compensation
expense is only recorded in our consolidated statement of operations when the
quoted market price at the grant date exceeds the amount an employee must pay to
acquire the stock. Effective January 1, 2006, we will be required to implement
Statement of Financial Accounting Standards No. 123R, "Shareholder Based
Payments", pursuant to which stock option awards will be required to be measured
at fair value with the related compensation expense recognized in the
consolidated statement of operations over the related service period. We will
implement this requirement using the modified prospective method, pursuant to
which we will begin recognizing compensation expense for all awards granted on
or after January 1, 2006. In addition, we will be required to recognize
compensation expense over the remaining requisite service period for the portion
of outstanding awards that are not vested as of January 1, 2006 and were not
previously expensed on a pro forma basis in the disclosure provided in the notes
to our consolidated financial statements. We expect that our 2006 operating
expenses (before the effect of income taxes) will increase by approximately $6
million as a result of implementing this new standard.
Gain (loss) on extinguishment of debt of ($3.7) million in 2005, resulted
from the write-off of certain debt issuance costs related to the reduction of
the principal amount borrowed under the Amended Credit Facility. The gain on
extinguishment of debt of $2.8 million in 2004 resulted from the repayment of
our Previous Credit Facility as further described in the notes to the
consolidated financial statements entitled "Note Payable - Direct Corporate
Obligations". The gain resulted from the release of a $6.3 million accrual for a
fee that would have been required to be paid under the Previous Credit Facility,
partially offset by the write-off of unamortized amendment fees.
60
<PAGE>
Reorganization items in the eight months ended August 31, 2003 included:
(i) $3,151.4 million related to the gain on the discharge of prepetition
liabilities; (ii) $(950.0) million related to fresh start adjustments; and (iii)
$(70.9) million related to professional fees associated with our predecessor's
bankruptcy proceedings which were expensed as incurred in accordance with SOP
90-7.
Net realized investment losses often fluctuate each period. During 2005,
net realized investment losses in this segment included $.1 million of net
losses from the sale of investments (primarily fixed maturities), and $1.3
million of writedowns due to other-than-temporary declines in value on certain
securities. During 2004, we recognized writedowns of $2.9 million due to
other-than-temporary declines in value on certain securities.
PREMIUM COLLECTIONS
In accordance with GAAP, insurance policy income in our consolidated
statement of operations consists of premiums earned for policies that have life
contingencies or morbidity features. For annuity and universal life contracts
without such features, premiums collected are not reported as revenues, but as
deposits to insurance liabilities. We recognize revenues for these products over
time in the form of investment income and surrender or other charges.
Our insurance segments sell products through three primary distribution
channels -- career agents and direct marketing (our Bankers Life segment) and
independent producers (our Conseco Insurance Group segment). Our career agency
force in the Bankers Life segment sells primarily Medicare supplement and
long-term care insurance policies, life insurance and annuities. These agents
visit the customer's home, which permits one-on-one contact with potential
policyholders and promotes strong personal relationships with existing
policyholders. Bankers Life's direct marketing distribution channel is engaged
primarily in the sale of "graded benefit life" and simplified issue life
insurance policies which are sold directly to the policyholder. Our independent
producer distribution channel in the Conseco Insurance Group segment consists of
a general agency and insurance brokerage distribution system comprised of
independent licensed agents doing business in all fifty states, the District of
Columbia, and certain protectorates of the United States. Independent producers
are a diverse network of independent agents, insurance brokers and marketing
organizations. Our independent producer distribution channel sells primarily
specified disease and Medicare supplement insurance policies, universal life
insurance and annuities.
Agents, insurance brokers and marketing companies who market our products
and prospective purchasers of our products use the financial strength ratings of
our insurance subsidiaries as an important factor in determining whether to
market or purchase. Ratings have the most impact on our annuity,
interest-sensitive life insurance and long-term care products. Our insurance
companies' financial strength ratings were downgraded by all of the major rating
agencies beginning in July 2002, in connection with the financial distress that
ultimately led to our Predecessor's bankruptcy. In the second quarter of 2004,
such ratings of our primary insurance subsidiaries (except Conseco Senior) were
upgraded by A.M. Best, S&P and Moody's. Moody's again upgraded the ratings of
our primary insurance subsidiaries (except Conseco Senior) in the third quarter
of 2004 and the first quarter of 2006. The current financial strength ratings of
our primary insurance subsidiaries (except Conseco Senior) from A.M. Best, S&P
and Moody's are "B++ (Very Good)", "BB+" and "Baa3", respectively. The current
financial strength ratings of Conseco Senior from A.M. Best, S&P and Moody's are
"B (Fair)", "CCC" and "Caa1", respectively. For a description of these ratings
and additional information on our ratings, see "Management's Discussion and
Analysis of Financial Condition and Results of Operations -- Liquidity for
Insurance Operations."
We set premium rates on our health insurance policies based on facts and
circumstances known at the time we issue the policies using assumptions about
numerous variables, including the actuarial probability of a policyholder
incurring a claim, the probable size of the claim, and the interest rate earned
on our investment of premiums. We also consider historical claims information,
industry statistics, the rates of our competitors and other factors. If our
actual claims experience is less favorable than we anticipated and we are unable
to raise our premium rates, our financial results may be adversely affected. We
generally cannot raise our health insurance premiums in any state until we
obtain the approval of the state insurance regulator. We review the adequacy of
our premium rates regularly and file rate increases on our products when we
believe such rates are too low. It is possible that we will not be able to
obtain approval for all requested premium rate increases. If such requests are
denied in one or more states, our net income may decrease. If such requests are
approved, increased premium rates may reduce the volume of our new sales and may
cause existing policyholders to lapse their policies. If the healthier
policyholders allow their policies to lapse, this would reduce our premium
income and profitability in the future.
61
<PAGE>
Total premiums and accumulation product collections were as follows:
Bankers Life (dollars in millions)
<TABLE>
<CAPTION>
Successor Predecessor
--------------------------------------- ------------
Years
ended Four months Eight months
December 31, ended ended
-------------------- December 31, August 31,
2005 2004 2003 2003
---- ---- ---- ----
<S> <C> <C> <C> <C>
Premiums collected by product:
Annuities:
Equity-indexed (first-year).......................... $ 130.3 $ 47.5 $ 5.1 $ 10.0
-------- -------- ------ --------
Other fixed (first-year)............................. 818.0 901.2 247.7 685.4
Other fixed (renewal)................................ 2.8 1.8 1.0 3.0
-------- -------- ------ --------
Subtotal - other fixed annuities................... 820.8 903.0 248.7 688.4
-------- -------- ------ --------
Total annuities.................................... 951.1 950.5 253.8 698.4
-------- -------- ------ --------
Supplemental health:
Medicare supplement (first-year)..................... 74.1 69.7 20.5 37.6
Medicare supplement (renewal)........................ 577.1 570.3 205.1 381.5
-------- -------- ------ --------
Subtotal - Medicare supplement..................... 651.2 640.0 225.6 419.1
-------- -------- ------ --------
Long-term care (first-year).......................... 65.4 69.1 24.6 48.7
Long-term care (renewal)............................. 498.8 467.2 153.3 282.8
-------- -------- ------ --------
Subtotal - long-term care.......................... 564.2 536.3 177.9 331.5
-------- -------- ------ --------
Other health (first-year)............................ 1.1 .9 .3 .8
Other health (renewal)............................... 11.0 11.3 4.1 8.2
-------- -------- ------ --------
Subtotal - other health............................ 12.1 12.2 4.4 9.0
-------- -------- ------ --------
Total supplemental health.......................... 1,227.5 1,188.5 407.9 759.6
-------- -------- ------ --------
Life insurance:
First-year........................................... 93.5 50.1 15.3 25.1
Renewal.............................................. 143.7 130.8 43.3 77.6
-------- -------- ------ --------
Total life insurance............................... 237.2 180.9 58.6 102.7
-------- -------- ------ --------
Collections on insurance products:
Total first-year premium collections on insurance
products........................................... 1,182.4 1,138.5 313.5 807.6
Total renewal premium collections on insurance
products........................................... 1,233.4 1,181.4 406.8 753.1
-------- -------- ------ --------
Total collections on insurance products............ $2,415.8 $2,319.9 $720.3 $1,560.7
======== ======== ====== ========
</TABLE>
Annuities in this segment include equity-indexed and other fixed annuities
sold to the senior market through our career agents. Annuity collections totaled
$951.1 million in 2005; $950.5 million in 2004; $253.8 million in the four
months ended December 31, 2003; and $698.4 million in the eight months ended
August 31, 2003. The sales of these products in 2005 and 2004 have generally
benefited from the low rates credited on competing products in the marketplace.
However, the increase in short-term interest rates during 2005 resulted in lower
first-year fixed annuity sales as certain other competing products, such as
certificates of deposits, have become attractive. Our equity-indexed products
were favorably impacted in 2005 due in part to general stock market conditions
which made these products relatively attractive and the introduction of a new
equity-indexed product.
Supplemental health products include Medicare supplement, long-term care
and other insurance products distributed through our career agents. Our profits
on supplemental health policies depend on the overall level of sales, the length
of time
62
<PAGE>
the business remains inforce, investment yields, claims experience and expense
management.
Collected premiums on Medicare supplement policies in the Bankers Life
segment totaled $651.2 million in 2005; $640.0 million in 2004; $225.6 million
in the four months ended December 31, 2003; and $419.1 million in the eight
months ended August 31, 2003.
Premiums collected on Bankers Life's long-term care policies totaled $564.2
million in 2005; $536.3 million in 2004; $177.9 million in the four months ended
December 31, 2003; and $331.5 million in the eight months ended August 31, 2003.
The increase in premium collections of our long-term care products was primarily
due to persistency of our existing business and new sales in recent periods.
Other health products include various products which we no longer actively
market. Premiums collected totaled $12.1 million in 2005; $12.2 million in 2004;
$4.4 million in the four months ended December 31, 2003; and $9.0 million in the
eight months ended August 31, 2003.
Life products in this segment are sold primarily to the senior market
through our career agents and our direct response distribution channel. Life
premiums collected in this segment totaled $237.2 million in 2005; $180.9
million in 2004; $58.6 million in the four months ended December 31, 2003; and
$102.7 million in the eight months ended August 31, 2003. Collected premiums
have been impacted by an increased focus on life products, including the
introduction in the first quarter of 2005 of a new single premium whole life
product and increased advertising in our direct response marketing channel.
During 2005, the new single premium whole life products accounted for $32.2
million of our collected premiums. Graded benefit life products sold through our
direct response marketing channel accounted for $81.2 million of our total
collected premiums in 2005, compared to $72.3 million in 2004.
63
<PAGE>
Conseco Insurance Group (dollars in millions)
<TABLE>
<CAPTION>
Successor Predecessor
--------------------------------------- ------------
Years
ended Four months Eight months
December 31, ended ended
-------------------- December 31, August 31,
2005 2004 2003 2003
---- ---- ---- ----
<S> <C> <C> <C> <C>
Premiums collected by product:
Annuities:
Equity-indexed (first-year)...................... $ 94.4 $ 31.8 $ 5.2 $ 32.8
Equity-indexed (renewal)......................... 10.0 12.5 4.2 12.1
-------- -------- ------ ------
Subtotal - equity-indexed annuities............ 104.4 44.3 9.4 44.9
-------- -------- ------ ------
Other fixed (first-year)......................... 47.5 7.2 1.6 14.3
Other fixed (renewal)............................ 9.8 12.2 7.1 14.8
-------- --------- ------ ------
Subtotal - other fixed annuities............... 57.3 19.4 8.7 29.1
-------- -------- ------ ------
Total annuities................................ 161.7 63.7 18.1 74.0
-------- -------- ------ ------
Supplemental health:
Medicare supplement (first-year)................. 15.8 21.9 16.0 36.5
Medicare supplement (renewal).................... 273.0 329.8 118.2 213.9
-------- -------- ------ ------
Subtotal - Medicare supplement................. 288.8 351.7 134.2 250.4
-------- -------- ------ ------
Specified disease (first-year)................... 30.6 32.9 10.0 19.7
Specified disease (renewal)...................... 328.9 328.8 108.7 216.7
-------- -------- ------ ------
Subtotal - specified disease................... 359.5 361.7 118.7 236.4
-------- -------- ------ ------
Other health (first-year)........................ - .1 4.3 9.7
Other health (renewal)........................... 13.2 16.1 14.8 28.8
-------- -------- ------ ------
Subtotal - other health........................ 13.2 16.2 19.1 38.5
-------- -------- ------ ------
Total supplemental health...................... 661.5 729.6 272.0 525.3
-------- -------- ------ ------
Life insurance:
First-year....................................... 8.2 18.4 9.0 20.6
Renewal.......................................... 326.8 353.9 122.5 260.1
-------- -------- ------ ------
Total life insurance........................... 335.0 372.3 131.5 280.7
-------- -------- ------ ------
Collections on insurance products:
Total first-year premium collections on
insurance products............................ 196.5 112.3 46.1 133.6
Total renewal premium collections on
insurance products............................. 961.7 1,053.3 375.5 746.4
-------- -------- ------ ------
Total collections on insurance products........ $1,158.2 $1,165.6 $421.6 $880.0
======== ======== ====== ======
</TABLE>
Annuities in this segment include equity-indexed and other fixed annuities
sold through professional independent producers. Total annuity collected
premiums in this segment were $161.7 million in 2005; $63.7 million in 2004;
$18.1 million in the four months ended December 31, 2003; and $74.0 million in
the eight months ended August 31, 2003. Total annuity premiums collected in 2005
increased due to sales efforts in this segment, expanded product offerings and
attractive crediting rates on certain products. In 2004 and 2003, we took
actions to reduce our marketing of these products and focus instead on selling
products that were less ratings sensitive (such as specified disease and
Medicare supplement products).
The accumulation value of equity-indexed 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 one of several equity market
indices during each year of their term. We purchase options in an effort to
hedge increases to policyholder benefits resulting from increases in the
indices. Total collected premiums for this product were $104.4 million in 2005;
$44.3 million in 2004; $9.4 million in the four months ended December 31, 2003;
and $44.9 million
64
<PAGE>
in the eight months ended August 31, 2003. Collected premiums for this product
increased in 2005 due to the introduction of four new products. In addition,
these products have become relatively attractive due to general stock market
conditions in recent periods.
Other fixed rate annuity products include SPDAs, FPDAs and SPIAs, which are
credited with a declared rate. SPDA and FPDA policies typically have an interest
rate that is guaranteed for the first policy year, after which we have the
discretionary ability to change the crediting rate to any rate not below a
guaranteed minimum rate. The interest rate credited on SPIAs is based on market
conditions existing when a policy is issued and remains unchanged over the life
of the SPIA. Annuity premiums on these products were $57.3 million in 2005;
$19.4 million in 2004; $8.7 million in the four months ended December 31, 2003;
and $29.1 million in the eight months ended August 31, 2003. Collected premiums
for this product increased in 2005 due to increased sales efforts as well as
attractive crediting rates on certain products. The decrease in 2004 was a
result of our emphasis on the sales of other products that are less ratings
sensitive.
Supplemental health products in the Conseco Insurance Group segment include
Medicare supplement, specified disease and other insurance products distributed
through professional independent producers. Our profits on supplemental health
policies depend on the overall level of sales, the length of time the business
remains inforce, investment yields, claim experience and expense management.
Collected premiums on Medicare supplement policies in the Conseco Insurance
Group segment were $288.8 million in 2005; $351.7 million in 2004; $134.2
million in the four months ended December 31, 2003; and $250.4 million in the
eight months ended August 31, 2003. We implemented increases in premium rates in
both 2005 and 2004. These rate increases resulted in higher than expected lapses
which reduced the premiums collected for these products in this segment. In
2005, we began selling Medicare supplement policies which are more competitively
priced in another subsidiary.
Premiums collected on specified disease products totaled $359.5 million in
2005; $361.7 million in 2004; $118.7 million in the four months ended December
31, 2003; and $236.4 million in the eight months ended August 31, 2003.
Collected premiums have been comparable from period to period.
Premiums collected from other health products totaled $13.2 million in
2005; $16.2 million in 2004; $19.1 million in the four months ended December 31,
2003; and $38.5 million in the eight months ended August 31, 2003. Premiums have
decreased from period to period as we no longer actively market many of these
products.
Life products in the Conseco Insurance Group segment are sold through
professional independent producers. Life premiums collected totaled $335.0
million in 2005; $372.3 million in 2004; $131.5 million in the four months ended
December 31, 2003; and $280.7 million in the eight months ended August 31, 2003.
Our A.M. Best rating has negatively affected our sales of life products.
65
<PAGE>
Other Business in Run-Off (dollars in millions)
<TABLE>
<CAPTION>
Successor Predecessor
--------------------------------------- ------------
Years
ended Four months Eight months
December 31, ended ended
-------------------- December 31, August 31,
2005 2004 2003 2003
---- ---- ---- ----
<S> <C> <C> <C> <C>
Premiums collected by product:
Long-term care:
First-year......................................... $ - $ .3 $ .6 $ 3.2
Renewal............................................ 349.1 379.8 134.0 264.8
------ ------ ------ ------
Total long-term care............................. 349.1 380.1 134.6 268.0
------ ------ ------ ------
Major medical:
Group (renewal).................................... .2 12.6 36.7 152.4
Individual (renewal)............................... 2.6 3.2 2.6 4.0
------ ------ ------ ------
Total major medical.............................. 2.8 15.8 39.3 156.4
------ ------ ------ ------
Collections on insurance products:
Total first-year premium collections on
insurance products............................... - .3 .6 3.2
Total renewal premium collections on
insurance products............................... 351.9 395.6 173.3 421.2
------ ------ ------ ------
Total collections on insurance products.......... $351.9 $395.9 $173.9 $424.4
====== ====== ====== ======
</TABLE>
As described elsewhere, the Other Business in Run-off segment includes: (i)
long-term care products written in prior years through independent agents; and
(ii) group and individual major medical business in run-off.
Long-term care premiums collected in this segment totaled $349.1 million in
2005; $380.1 million in 2004; $134.6 million in the four months ended December
31, 2003; and $268.0 million in the eight months ended August 31, 2003. Most of
the long-term care premiums in this segment relate to business written by
certain subsidiaries prior to their acquisitions by Conseco in 1996 and 1997. We
ceased selling new long-term care policies through professional independent
producers in the second quarter of 2003. We expect this segment's long-term care
premiums to reflect additional policy lapses in the future, partially offset by
premium rate increases. See "Results of Operations - Other Business in Run-off"
for additional discussion related to orders issued by the Florida Office of
Insurance Regulation regarding certain blocks of our long-term care business.
Major medical premium collections continue to decrease as we manage the
run-off of this block of business.
INVESTMENTS
Our investment strategy is to: (i) maintain a predominately
investment-grade fixed income portfolio; (ii) provide adequate liquidity to meet
our cash obligations to policyholders and others; and (iii) generate stable and
predictable investment income and total investment return through active
investment management. Consistent with this strategy, investments in fixed
maturity securities, mortgage loans and policy loans made up 97 percent of our
$25.0 billion investment portfolio at December 31, 2005. The remainder of the
invested assets were trading securities, equity securities and other invested
assets.
66
<PAGE>
The following table summarizes the composition of our investment portfolio
as of December 31, 2005 (dollars in millions):
<TABLE>
<CAPTION>
Carrying Percent of
value total investments
----- -----------------
<S> <C> <C>
Actively managed fixed maturities............................................... $22,494.2 90%
Equity securities............................................................... 27.1 -
Mortgage loans.................................................................. 1,264.2 5
Policy loans.................................................................... 429.8 2
Trading securities.............................................................. 716.3 3
Partnership investments......................................................... 38.2 -
Other invested assets........................................................... 71.4 -
--------- ---
Total investments............................................................ $25,041.2 100%
========= ===
</TABLE>
Insurance statutes regulate the types 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.
The following table summarizes the carrying values of our fixed maturity
securities by category as of December 31, 2005 (dollars in millions):
<TABLE>
<CAPTION>
Percent of
Carrying value fixed maturities
-------------- ----------------
<S> <C> <C>
Structured securities................................................................ $ 6,227.8 27.7%
Manufacturing........................................................................ 2,411.5 10.7
Bank and finance..................................................................... 2,338.4 10.4
Services............................................................................. 1,585.3 7.1
U.S. Government...................................................................... 1,556.4 6.9
Utilities............................................................................ 1,426.4 6.3
Communications....................................................................... 1,162.4 5.2
States and political subdivisions.................................................... 901.3 4.0
Agriculture, forestry and mining..................................................... 828.4 3.7
Asset-backed securities.............................................................. 720.3 3.2
Transportation....................................................................... 603.1 2.7
Retail and wholesale................................................................. 591.1 2.6
Other................................................................................ 2,141.8 9.5
--------- -----
Total fixed maturity securities................................................... $22,494.2 100.0%
========= =====
</TABLE>
Our fixed maturity securities consist predominantly of publicly traded
securities. We classify securities issued in the Rule 144A market as publicly
traded. Our privately traded securities comprise less than four percent of our
total fixed maturity securities portfolio.
The following table sets forth fixed maturity investments at December 31,
2005, classified by rating categories. The category assigned is the highest
rating by a nationally recognized statistical rating organization or, as to
$295.3 million fair value of fixed maturities not rated by such firms, the
rating assigned by the NAIC. For purposes of the table, NAIC Class 1 is included
in the "A" rating; Class 2, "BBB-"; Class 3, "BB-"; and Classes 4-6, "B+ and
below" (dollars in millions):
67
<PAGE>
<TABLE>
<CAPTION>
Estimated fair value
-------------------------
Percent of
Amortized fixed
Investment rating cost Amount maturities
- ----------------- ---- ------ ----------
<S> <C> <C> <C>
AAA...................................................................... $ 8,518.8 $ 8,466.2 38%
AA....................................................................... 1,672.1 1,676.6 7
A........................................................................ 5,542.9 5,635.6 25
BBB+..................................................................... 2,423.1 2,459.4 11
BBB...................................................................... 2,415.4 2,436.9 11
BBB-..................................................................... 821.0 825.1 4
--------- --------- ---
Investment grade..................................................... 21,393.3 21,499.8 96
--------- --------- ---
BB+ ..................................................................... 275.5 273.5 1
BB ..................................................................... 252.6 255.3 1
BB- ..................................................................... 182.8 187.3 1
B+ and below............................................................. 276.0 278.3 1
--------- --------- ---
Below-investment grade............................................... 986.9 (a) 994.4 (a) 4
--------- --------- ---
Total fixed maturity securities................................... $22,380.2 $22,494.2 100%
========= ========= ===
<FN>
- ---------
(a) Below-investment grade fixed maturity securities with an amortized cost
of $289.1 million and an estimated fair value of $287.7 million are
securities held by a variable interest entity that we are required to
consolidate. These fixed maturity securities are legally isolated and
are not available to the Company. The liabilities of such variable
interest entity will be satisfied from the cash flows generated by
these securities. At December 31, 2005, our total investment in the
variable interest entity was $32.8 million, and such investment was
rated BBB.
</FN>
</TABLE>
The following table summarizes investment yields earned over the past three
years on the general account invested assets of our insurance subsidiaries.
General account investments exclude our venture capital investment in AWE and
the value of options (dollars in millions).
<TABLE>
<CAPTION>
Successor Predecessor
--------------------------------------- ------------
Years
ended Four months Eight months
December 31, ended ended
-------------------- December 31, August 31,
2005 2004 2003 2003
---- ---- ---- ----
<S> <C> <C> <C> <C>
Weighted average general account invested assets
as defined:
As reported ................................... $24,219.7 $23,586.4 $23,045.4 $23,311.5
Excluding unrealized appreciation
(depreciation) (a)........................... 23,710.9 23,136.6 22,501.0 22,777.3
Net investment income on general account
invested assets.................................... 1,385.0 1,292.4 426.4 912.2
Yields earned:
As reported.................................... 5.7% 5.5% 5.6% 5.9%
Excluding unrealized appreciation
(depreciation) (a) .......................... 5.8% 5.6% 5.7% 6.0%
<FN>
- ----------------------
(a) Excludes the effect of reporting fixed maturities at fair value as
described in the note to our consolidated financial statements entitled
"Investments".
</FN>
</TABLE>
Although investment income is a significant component of total revenues,
the profitability of certain of our insurance products is determined primarily
by the spreads between the interest rates we earn and the rates we credit or
accrue to our insurance liabilities. At December 31, 2005 and 2004, the average
yield, computed on the cost basis of our actively managed fixed maturity
portfolio, was 5.6 percent and 5.6 percent, respectively, 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 4.6
percent and 4.7 percent, respectively.
68
<PAGE>
Actively Managed Fixed Maturities
Our actively managed fixed maturity portfolio at December 31, 2005,
included primarily debt securities of the United States government, public
utilities and other corporations, and structured securities. Structured
securities included mortgage-backed securities, collateralized mortgage
obligations ("CMOs"), asset-backed securities and commercial mortgage-backed
securities.
At December 31, 2005, our fixed maturity portfolio had $351.9 million of
unrealized gains and $237.9 million of unrealized losses, for a net unrealized
gain of $114.0 million. Estimated fair values of fixed maturity investments were
determined based on estimates from: (i) nationally recognized pricing services
(93 percent of the portfolio); (ii) broker-dealer market makers (6 percent of
the portfolio); and (iii) internally developed methods (1 percent of the
portfolio).
At December 31, 2005, approximately 4.0 percent of our invested assets (4.4
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 currently plan to maintain our present level of investments in
below-investment-grade fixed maturities, although this plan could change if
market conditions change. Below-investment grade securities have different
characteristics than investment grade corporate debt securities. The risk of
default by the borrower is significantly greater for below-investment grade
securities and in many cases, severity of loss is relatively greater as such
securities are generally unsecured and often subordinated to other creditors of
the issuer. Also, issuers of below-investment grade securities usually have
higher levels of debt and may be more sensitive to adverse economic conditions,
such as recession or increasing interest rates, than investment grade issuers.
The Company attempts to reduce the overall risk related to its investment in
below-investment grade securities, as in all investments, through careful credit
analysis, strict investment policy guidelines, and diversification by issuer
and/or guarantor and by industry. At December 31, 2005, our
below-investment-grade fixed maturity investments had an amortized cost of
$986.9 million and an estimated fair value of $994.4 million.
We continually evaluate the credit worthiness 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. We review the recent operational
results and financial position of the issuer, information about its industry,
information about factors affecting the issuer's performance and other
information. 40|86 Advisors employs a staff of experienced securities analysts
in a variety of specialty areas who compile and review such data. 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 fair 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 as investment income
over the remaining life of the investment (but only to the extent our current
valuations indicate such amounts will ultimately be collected), or upon the
sale, repayment or other disposition of the investment. We recorded writedowns
of fixed maturity investments, equity securities and other invested assets
totaling $14.7 million in 2005. 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.
Our investment strategy is to maximize, over a sustained period and within
acceptable parameters of risk, 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 or to better match certain characteristics of our
investment portfolio with the corresponding characteristics of our insurance
liabilities. 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.
As of December 31, 2005, our investments in substantive default (i.e., in
default due to nonpayment of interest or principal) or technical default (i.e.,
in default, but not as to the payment of interest or principal) had an amortized
cost of $26.6 million and a carrying value of $27.7 million. 40|86 Advisors
employs a staff of experienced professionals to manage non-performing and
impaired investments. There were no other fixed maturity investments about which
we had serious doubts as to the ability of the issuer to comply with the
material terms of the instrument on a timely basis.
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 $.8 million and $3.5 million for the years ended
December 31, 2005 and 2004, respectively; $5.3 million in the four months ended
December 31, 2003; and $12.1 million in the eight months ended August 31, 2003.
69
<PAGE>
At December 31, 2005, fixed maturity investments included $6.2 billion of
structured securities (or 28 percent of all fixed maturity securities).
Structured securities include mortgage-backed securities, collateralized
mortgage obligations and commercial mortgage-backed securities. CMOs are backed
by pools of mortgages that are segregated into sections or "tranches" that
provide for reprioritizing of principal retirement. Pass-through securities
receive principal and interest payments through their regular pro rata share of
the payments on the underlying mortgages backing the securities. The yield
characteristics of structured securities differ in some respects from those of
traditional fixed-income securities. For example, interest and principal
payments on mortgage-backed securities occur more frequently, often monthly. In
addition, mortgage-backed securities are subject to a higher degree of risk
associated with variable prepayments of principal. For example, 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 various security-specific structural considerations (for example,
the repayment priority of a given security in a securitization structure).
In general, the rate of prepayments on the underlying mortgage loans and on
structured securities backed by these loans increases when prevailing interest
rates decline significantly in absolute terms and also relative to the interest
rates on the underlying 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 the underlying mortgages prepay faster than
expected. When interest rates decline, the proceeds from the prepayment of
mortgage-backed securities may 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, because the discount is
realized as income at a slower rate, and increases the yield on those purchased
at a premium, because of a decrease in the annual amortization of the premium.
The following table sets forth the par value, amortized cost and estimated
fair value of structured securities, summarized by interest rates on the
underlying collateral at December 31, 2005 (dollars in millions):
<TABLE>
<CAPTION>
Par Amortized Estimated
value cost fair value
----- ---- ----------
<S> <C> <C> <C>
Below 4 percent............................................................ $ 213.3 $ 213.2 $ 209.7
4 percent - 5 percent...................................................... 1,457.5 1,406.3 1,393.9
5 percent - 6 percent...................................................... 3,934.7 3,886.4 3,843.3
6 percent - 7 percent...................................................... 568.1 584.4 586.7
7 percent - 8 percent...................................................... 169.1 174.6 174.8
8 percent and above........................................................ 17.7 18.6 19.4
-------- -------- --------
Total structured securities (a)..................................... $6,360.4 $6,283.5 $6,227.8
======== ======== ========
<FN>
- --------------------
(a) Includes below-investment grade structured securities with both an
amortized cost and estimated fair value of $.4 million.
</FN>
</TABLE>
The amortized cost and estimated fair value of structured securities at
December 31, 2005, summarized by type of security, were as follows (dollars in
millions):
<TABLE>
<CAPTION>
Estimated fair value
-------------------------
Percent of
Amortized fixed
Type cost Amount maturities
- ---- ---- ------ ----------
<S> <C> <C> <C>
Pass-throughs and sequential and targeted amortization classes.......... $3,993.9 $3,956.9 18%
Planned amortization classes and accretion-directed bonds............... 875.0 866.2 4
Commercial mortgage-backed securities................................... 1,409.7 1,399.8 6
Other................................................................... 4.9 4.9 -
-------- -------- --
Total structured securities (a).................................. $6,283.5 $6,227.8 28%
======== ======== ==
</TABLE>
70
<PAGE>
- ------------
(a) Includes below-investment grade structured securities with both an
amortized cost and estimated fair value of $.4 million.
Pass-through securities and sequential and targeted amortization class
securities have different prepayment variability characteristics. Pass-through
securities typically return principal to the holders based on cash payments from
the underlying mortgage obligations. Sequential classes return principal to
tranche holders in a detailed hierarchy. Targeted amortization classes, planned
amortization classes and accretion-directed bonds adhere to fixed schedules of
principal payments as long as the underlying mortgage loans experience
prepayments within certain estimated ranges. Changes in prepayment rates are
first absorbed by support or companion classes. This insulates the timing of
receipt of cash flows from the consequences of both faster prepayments (average
life shortening) and slower prepayments (average life extension).
Commercial mortgage-backed securities ("CMBS") are secured by commercial
real estate mortgages, generally income producing properties that are managed
for profit. Property types include multi-family dwellings including apartments,
retail centers, hotels, restaurants, hospitals, nursing homes, warehouses, and
office buildings. CMBS generally offer higher yields than corporate bonds with
similar credit ratings. Most CMBS have call protection features whereby
underlying borrowers may not prepay their mortgages for stated periods of time
without incurring prepayment penalties.
During 2005, we sold $3.7 billion of fixed maturity investments which
resulted in gross investment losses (before income taxes) of $82.3 million. We
sell securities at a loss for a number of reasons including but not limited to:
(i) changes in the investment environment; (ii) expectation that the market
value could deteriorate further; (iii) desire to reduce our exposure to an
issuer or an industry; (iv) changes in credit quality; (v) identification of a
superior investment alternative; or (vi) our analysis indicates there is a high
probability that the security is other-than-temporarily impaired. As discussed
in the notes to our consolidated financial statements, the realization of gains
and losses affects the timing of the amortization of insurance acquisition costs
related to universal life and investment products.
Venture Capital Investment in AT&T Wireless Services, Inc.
Our venture capital investment in AWE was made by our subsidiary which
engaged in venture capital investment activity. AWE is a company in the wireless
communication business. In December 2003, we sold our remaining 4.1 million
shares of AWE common stock. We recognized venture capital investment income
(losses) related to this investment of $(5.5) million in the four months ended
December 31, 2003; and $10.5 million in the eight months ended August 31, 2003.
Other Investments
At December 31, 2005, we held mortgage loan investments with a carrying
value of $1,264.2 million (or 5.0 percent of total invested assets) and a fair
value of $1,297.6 million. The mortgage loan balance was primarily comprised of
commercial loans. Noncurrent mortgage loans were insignificant at December 31,
2005. Realized losses on mortgage loans were not significant in any of the past
three years. Our allowance for loss on mortgage loans was $2.4 million at both
December 31, 2005 and 2004. Approximately 9 percent, 7 percent, 6 percent, 5
percent and 5 percent of the mortgage loan balance were on properties located in
Ohio, Kentucky, New York, Massachusetts and Florida, respectively. No other
state comprised greater than 5 percent of the mortgage loan balance.
The following table shows the distribution of our mortgage loan portfolio
by property type as of December 31, 2005 (dollars in millions):
<TABLE>
<CAPTION>
Number of Carrying
loans value
----- -----
<S> <C> <C>
Retail.......................................................................... 330 $ 912.6
Office building................................................................. 67 174.5
Industrial...................................................................... 38 68.0
Multi-family.................................................................... 10 16.7
Other........................................................................... 45 92.4
--- --------
Total mortgage loans......................................................... 490 $1,264.2
=== ========
</TABLE>
71
<PAGE>
The following table shows our mortgage loan portfolio by loan size (dollars
in millions):
<TABLE>
<CAPTION>
Number Principal
of loans balance
-------- -------
<S> <C> <C>
Under $5 million................................................................ 427 $ 711.5
$5 million but less than $10 million............................................ 48 332.1
$10 million but less than $20 million........................................... 15 224.7
--- --------
Total mortgage loans......................................................... 490 $1,268.3
=== ========
</TABLE>
The following table summarizes the distribution of maturities of our
mortgage loans (dollars in millions):
<TABLE>
<CAPTION>
Number Principal
of loans balance
-------- -------
<S> <C> <C>
2006............................................................................ 8 $ 1.6
2007............................................................................ 16 2.2
2008............................................................................ 14 29.8
2009............................................................................ 30 97.7
2010............................................................................ 8 8.2
after 2010...................................................................... 414 1,128.8
--- --------
Total mortgage loans......................................................... 490 $1,268.3
=== ========
</TABLE>
At December 31, 2005, we held $716.3 million of trading securities. We
carry trading securities at estimated fair value; changes in fair value are
reflected in the statement of operations. Our trading securities are designed to
act as hedges for embedded derivatives related to our equity-indexed annuity
products and certain modified coinsurance agreements. See the note to the
consolidated financial statements entitled "Summary of Significant Accounting
Policies - Accounting for Derivatives" for further discussion regarding the
embedded derivatives and the trading accounts. In addition, the trading account
includes investments backing the market strategies of our multibucket annuity
products.
Other invested assets also include options backing our equity-linked
products and certain nontraditional investments, including investments in
limited partnerships, promissory notes and real estate investments held for
sale.
From time-to-time, 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. In many cases, such transactions arise from the market demand for
mortgage-backed securities to form CMOs. During the third quarter of 2005, the
market spread on these transactions declined to a level at which our continued
participation in these transactions was not profitable. As a result, these
transactions were terminated. Investment borrowings related to repurchase and
dollar-roll transactions averaged approximately $234.2 million and $522.6
million during the years ended December 31, 2005 and 2004, respectively, and
were collateralized by investment securities with fair values approximately
equal to the loan values. The weighted average interest rates on such borrowings
were 2.9 percent and 1.5 percent during the years ended December 31, 2005 and
2004, respectively. 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.
72
<PAGE>
Investment borrowings consisted of the following (dollars in millions):
<TABLE>
<CAPTION>
December 31, December 31,
2005 2004
------------ ------------
<S> <C> <C>
Borrowings related to repurchase
and dollar-roll transactions........... $ - $419.6
Securities issued by variable
interest entity........................ 302.2 -
Other..................................... 12.9 14.3
------ ------
Total.................................. $315.1 $433.9
====== ======
</TABLE>
Securities issued by the variable interest entity are the liabilities of a
collateralized loan trust which is consolidated with the Company. Repayment of
the securities is primarily dependent on cash flows generated by the invested
assets of the trust.
CONSOLIDATED FINANCIAL CONDITION
Changes in the Consolidated Balance Sheet
Changes in our consolidated balance sheet between December 31, 2005 and
December 31, 2004, primarily reflect: (i) our net income for 2005; (ii) a
reduction to our deferred income tax valuation allowance; (iii) the
consolidation of a variable interest entity; and (iv) changes in the fair value
of actively managed fixed maturity securities.
In accordance with GAAP, we record our actively managed fixed maturity
investments, equity securities and certain other invested assets at estimated
fair value with any unrealized gain or loss (excluding impairment losses, which
are recognized through earnings), net of tax and related adjustments, recorded
as a component of shareholders' equity. At December 31, 2005, we increased the
carrying value of such investments by $120.9 million as a result of this fair
value adjustment.
Our capital structure as of December 31, 2005 and 2004, was as follows
(dollars in millions):
<TABLE>
<CAPTION>
Successor
------------------
2005 2004
---- ----
<S> <C> <C>
Total capital:
Corporate notes payable ...................................... $ 851.5 $ 768.0
Shareholders' equity:
Preferred stock ........................................... 667.8 667.8
Common stock............................................... 1.5 1.5
Additional paid-in capital................................. 3,194.1 2,597.8
Accumulated other comprehensive income..................... 71.7 337.3
Retained earnings.......................................... 584.7 297.8
-------- --------
Total shareholders' equity............................. 4,519.8 3,902.2
-------- --------
Total capital.......................................... $5,371.3 $4,670.2
======== ========
</TABLE>
73
<PAGE>
The following table summarizes certain financial ratios as of and for the
years ended December 31, 2005 and 2004:
<TABLE>
<CAPTION>
Successor
---------------------------
December 31, December 31,
2005 2004
---- ----
<S> <C> <C>
Book value per common share................................................................... $25.42 $21.41
Book value per common share, excluding accumulated other comprehensive income (a)............. 24.95 19.18
Ratio of earnings to fixed charges............................................................ 2.03x 1.90x
Ratio of earnings to fixed charges and preferred dividends.................................... 1.81x 1.58x
Debt to total capital ratios:
Corporate debt to total capital.......................................................... 16% 16%
Corporate debt to total capital, excluding accumulated other comprehensive income (a).... 16% 18%
Corporate debt and preferred stock to total capital...................................... 28% 31%
Corporate debt and preferred stock to total capital, excluding accumulated other
comprehensive income (a)............................................................... 29% 33%
<FN>
- --------------------
(a) This non-GAAP measure differs from the corresponding GAAP measure presented
immediately above, because accumulated other comprehensive income has been
excluded from the value of capital used to determine this measure.
Management believes this non-GAAP measure is useful because it removes the
volatility that arises from changes in accumulated other comprehensive
income. Such volatility is often caused by changes in the estimated fair
value of our investment portfolio resulting from changes in general market
interest rates rather than the business decisions made by management.
However, this measure does not replace the corresponding GAAP measure.
</FN>
</TABLE>
Contractual Obligations
The Company's significant contractual obligations as of December 31, 2005,
were as follows (dollars in millions):
<TABLE>
<CAPTION>
Payment due in
-------------------------------------------------------
Total 2006 2007-2008 2009-2010 Thereafter
----- ---- --------- --------- ----------
<S> <C> <C> <C> <C>
Insurance liabilities (a)............ $57,259.7 $3,932.9 $7,592.6 $6,720.3 $39,013.9
Notes payable (b).................... 1,059.7 50.9 100.8 908.0 -
Investment borrowings (c)............ 491.8 17.1 37.4 32.4 404.9
Postretirement plans (d)............. 146.4 3.4 6.7 7.6 128.7
Operating leases and certain other
contractual commitments (e)...... 231.5 35.4 53.5 43.3 99.3
--------- -------- -------- -------- ---------
Total............................ $59,189.1 $4,039.7 $7,791.0 $7,711.6 $39,646.8
========= ======== ======== ======== =========
<FN>
- -------------
(a) These cash flows represent our estimates of the payments we expect to make
to our policyholders, without consideration of future premiums or
reinsurance recoveries. These estimates are based on numerous assumptions
(depending on the product type) related to mortality, morbidity, lapses,
withdrawals, future premiums, future deposits, interest rates on
investments, credited rates, expenses and other factors which affect our
future payments. The cash flows presented are undiscounted for interest. As
a result, total outflows for all years exceed the corresponding liabilities
of $25.4 billion included in our consolidated balance sheet as of December
31, 2005. As such payments are based on numerous assumptions, the actual
payments may vary significantly from the amounts shown.
</FN>
</TABLE>
In estimating the payments we expect to make to our policyholders, we
considered the following:
o For products such as immediate annuities and structured settlement
annuities without life contingencies, the payment obligation is fixed
and determinable based on the terms of the policy.
74
<PAGE>
o For products such as universal life, ordinary life, long-term care,
specified disease and fixed rate annuities, the future payments are
not due until the occurrence of an insurable event (such as death or
disability) or a triggering event (such as a surrender or partial
withdrawal). We estimated these payments using actuarial models based
on historical experience and our expectation of the future payment
patterns.
o For short-term insurance products such as Medicare supplement
insurance, the future payments relate only to amounts necessary to
settle all outstanding claims, including those that have been incurred
but not reported as of the balance sheet date. We estimated these
payments based on our historical experience and our expectation of
future payment patterns.
o The average interest rate we assumed would be credited 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) over the term of
the contracts was 4.6 percent.
(b) Includes projected interest payments based on market rates, as applicable,
as of December 31, 2005. Refer to the notes to the consolidated financial
statements entitled "Notes Payable - Direct Corporate Obligations" for
additional information on notes payable.
(c) These borrowings primarily represent the securities issued by a variable
interest entity and include projected interest payments based on market
rates, as applicable, as of December 31, 2005.
(d) Includes benefits expected to be paid pursuant to our deferred compensation
plan and postretirement plans based on numerous actuarial assumptions and
interest credited at 5.5 percent.
(e) Refer to the notes to the consolidated financial statements entitled
"Commitments and Contingencies" for additional information on operating
leases and certain other contractual commitments.
It is possible that the ultimate outcomes of various uncertainties could
affect our liquidity in future periods. For example, the following events could
have a material adverse effect on our cash flows:
o An adverse decision in pending or future litigation.
o An inability to obtain rate increases on certain of our insurance
products.
o Worse than anticipated claims experience.
o Lower than expected dividends and/or surplus debenture interest
payments from our insurance subsidiaries (resulting from inadequate
earnings or capital or regulatory requirements).
o An inability to meet and/or maintain the covenants in our Amended
Credit Facility.
o A significant increase in policy surrender levels.
o A significant increase in investment defaults.
o An inability of our reinsurers to meet their financial obligations.
While we seek to balance the duration and cash flows of our invested assets
with the estimated duration and cash flows of benefit payments arising from
contract liabilities, there could be significant variations in the timing of
such cash flows. The claim experience on our long-term care business in the
Other Business in Run-off segment has been worse than our original pricing
expectations. Although we believe our current estimates properly project future
claim experience, if these estimates prove to be wrong, and our experience
worsens (as it did in some prior periods), our future liquidity could be
adversely affected.
Liquidity for Insurance Operations
Our insurance operating companies generally receive adequate cash flows
from premium collections and investment income to meet their obligations. Life
insurance and annuity liabilities are generally long-term in nature.
Policyholders may,
75
<PAGE>
however, withdraw funds or surrender their policies, subject to any applicable
penalty provisions. We seek to balance the duration of our invested assets with
the estimated duration of benefit payments arising from contract liabilities.
On August 3, 2005, A.M. Best revised its outlook on our primary insurance
subsidiaries to positive from stable, except Conseco Senior (the issuer of most
of our long-term care business in our Other Business in Run-off segment), for
which the outlook remains stable. On June 25, 2004, A.M. Best upgraded the
financial strength ratings of our primary insurance subsidiaries from "B (Fair)"
to "B++ (Very Good)", except Conseco Senior, whose "B (Fair)" rating was
affirmed by A.M. Best. According to A.M. Best, these rating actions reflected
the substantial recapitalization of our balance sheet, improved absolute and
risk-adjusted capital on a statutory basis and improving operating fundamentals.
The "B++" rating is assigned to companies that have a good ability, in A.M.
Best's opinion, to meet their ongoing obligations to policyholders. The "B"
rating is assigned to companies which have a fair ability in A.M. Best's opinion
to meet their current obligations to policyholders, but are financially
vulnerable to adverse changes in underwriting and economic conditions. A.M. Best
ratings for the industry currently range from "A++ (Superior)" to "F (In
Liquidation)" and some companies are not rated. An "A++" rating indicates a
superior ability to meet ongoing obligations to policyholders. The "B++" rating
and the "B" rating from A.M. Best are the fifth and seventh highest,
respectively, of sixteen possible ratings.
On August 2, 2005, S&P revised its outlook on our primary insurance
subsidiaries to positive from stable, except Conseco Senior, for which the
outlook remains stable. On May 27, 2004, S&P upgraded the financial strength
ratings of our primary insurance companies from "BB-" to "BB+", except Conseco
Senior, which was assigned a "CCC" rating. S&P financial strength ratings range
from "AAA" to "R" and some companies are not rated. Rating categories from "BB"
to "CCC" are classified as "vulnerable", and pluses and minuses show the
relative standing within a category. In S&P's view, an insurer rated "BB" has
marginal financial security characteristics and although positive attributes
exist, adverse business conditions could lead to an insufficient ability to meet
financial commitments. In S&P's view, an insurer rated "CCC" has very weak
financial security characteristics and is dependent on favorable business
conditions to meet financial commitments. The "BB+" rating and the "CCC" rating
from S&P are the eleventh and eighteenth highest, respectively, of twenty-one
possible ratings.
On March 8, 2006, Moody's upgraded the financial strength rating of our
primary insurance companies from "Ba1" to "Baa3" except Conseco Senior, which
was affirmed at "Caa1". In addition, all of Moody's ratings on our insurance
subsidiaries now have a positive outlook. On July 29, 2005, the ratings for our
primary insurance subsidiaries were placed on review for upgrade by Moody's,
except Conseco Senior, for which the rating was affirmed with a developing
outlook. On May 27, 2004, Moody's upgraded the financial strength ratings of our
primary insurance companies from "Ba3" to "Ba2", except Conseco Senior, which
was assigned a "Caa1" rating. On August 9, 2004, Moody's again upgraded the
financial strength ratings of our primary insurance companies from "Ba2" to
"Ba1" and reaffirmed the "Caa1" rating of Conseco Senior. Moody's financial
strength ratings range from "Aaa" to "C". Rating categories from "Aaa" to "Baa"
are classified as "Secure" by Moody's and rating categories from "Ba" to "C" are
considered "vulnerable" and these ratings may be supplemented with numbers "1",
"2", or "3" to show relative standing within a category. In Moody's view, an
insurer rated "Baa3" offers adequate financial security, however, certain
protective elements may be lacking or may be characteristically unreliable over
any great length of time. In Moody's view, an insurer rated "Caa" offers very
poor financial security and may default on its policyholder obligations or there
may be elements of danger with respect to punctual payment of policyholder
obligations and claims. The "Baa3" rating and the "Caa1" rating from Moody's are
the tenth and seventeenth highest, respectively, of twenty-one possible ratings.
A positive outlook by Moody's is an opinion regarding the likely direction of a
rating over the medium term.
Our insurance companies' financial strength ratings were downgraded by all
of the major rating agencies beginning in July 2002 in connection with the
financial distress that ultimately led to our Predecessor's bankruptcy. These
lowered ratings caused sales of our insurance products to decline, policyholder
redemptions and lapses to increase and increased agent attrition in 2003 and
2004, which in turn has negatively affected our financial results.
We have adopted several initiatives designed to reduce the expense levels
that exceed product pricing in our Conseco Insurance Group segment. These
initiatives include system conversions which will eliminate duplicate processing
systems. We expect to spend over $23 million on capital expenditures in 2006
(including amounts related to these initiatives). We believe we have adequate
cash flows from operations to fund these initiatives.
State laws generally give state insurance regulatory agencies broad
authority to protect policyholders in their jurisdictions. Regulators have used
this authority in the past to restrict the ability of our insurance subsidiaries
to pay any dividends or other amounts to any non-insurance company parent
without prior approval. We cannot be assured that the regulators will not seek
to assert greater supervision and control over our insurance subsidiaries'
businesses and financial affairs.
76
<PAGE>
Liquidity of the Holding Companies
In August 2005, we completed the private offering of $330.0 million of
Debentures. The net proceeds from the offering of approximately $320 million
were used to repay amounts outstanding under the Company's Credit Facility.
The Debentures are senior, unsecured obligations and bear interest at a
rate of 3.50 percent per year, payable semi-annually, beginning on March 31,
2006 and ending on September 30, 2010. Thereafter, the principal balance of the
Debentures will accrete at a rate that provides holders with an aggregate yield
to maturity of 3.50 percent, computed on a semi-annual, bond-equivalent basis.
Beginning with the six-month interest period commencing September 30, 2010, the
Company will pay contingent interest on the Debentures if the average trading
price per Debenture for the five trading day period immediately preceding the
six-month interest period equals or exceeds a certain level, as described in the
Indenture.
Upon the occurrence of certain specified events, the Debentures will be
convertible, at the option of the holders, into cash or, under certain
circumstances, cash and shares of the Company's common stock at an initial
conversion price of approximately $26.66 per share. The number of shares to be
received by a converting holder is subject to adjustment for certain dilutive
events. The amount of cash to be received upon conversion is equal to the lesser
of: (i) the accreted principal amount of the converting Debenture; or (ii) the
conversion value of such Debentures (as calculated in accordance with the
Indenture).
On or after October 5, 2010, the Company may redeem for cash all or a
portion of the Debentures at any time at a redemption price equal to 100 percent
of the accreted principal amount of the Debentures plus accrued and unpaid
interest, including additional interest and contingent interest, if any, to the
redemption date. Holders may require the Company to repurchase in cash all or
any portion of the Debentures on September 30, 2010, 2015, 2020, 2025 and 2030
at a repurchase price equal to 100 percent of the accreted principal amount of
the Debentures to be repurchased, plus accrued and unpaid interest, including
additional interest and contingent interest, if any, to the applicable
repurchase date.
In August 2005, we entered into the Amended Credit Facility with a balance
of $447.0 million. The proceeds of the Amended Credit Facility were used to
repay the remaining principal amount of the Credit Facility. The Amended Credit
Facility provided for a one-time increase in the facility or the addition of a
new facility of up to $325.0 million. In December 2005, we borrowed an
additional $80.0 million pursuant to this provision. The proceeds from the
additional borrowing were used to increase the capital and surplus of our
insurance subsidiaries. During 2005, we made principal payments totaling $2.4
million on our Amended Credit Facility. Under the terms of the Amended Credit
Facility, we are required to make quarterly principal payments of .25 percent
(approximately $1.3 million) of the initial principal amount through March 31,
2010. The remaining principal balance is due on June 22, 2010. At December 31,
2005, the interest rate on our Amended Credit Facility was 6.4 percent.
The Amended Credit Facility includes an $80.0 million revolving credit
facility that can be used for general corporate purposes and that would mature
on June 22, 2009. There were no amounts outstanding under the revolving credit
facility at December 31, 2005. The Company pays a commitment fee equal to .50
percent of the unused portion of the revolving credit facility on an annualized
basis.
The Debentures and Amended Credit Facility are discussed in further detail
in the note to the consolidated financial statements entitled "Notes Payable -
Direct Corporate Obligations".
At December 31, 2005, Conseco Inc. and CDOC held unrestricted cash of $89.5
million. Conseco Inc. and CDOC are holding companies with no business operations
of their own; they depend on their operating subsidiaries for cash to make
principal and interest payments on debt, and to pay administrative expenses and
income taxes. Conseco and CDOC receive cash from insurance subsidiaries,
consisting of dividends and distributions, principal and interest payments on
surplus debentures and tax-sharing payments, as well as cash from non-insurance
subsidiaries consisting of dividends, distributions, loans and advances. The
principal non-insurance subsidiaries that provide cash to Conseco and CDOC are
40|86 Advisors, which receives fees from the insurance subsidiaries for
investment services, and Conseco Services, LLC which receives fees from the
insurance subsidiaries for providing administrative services. A deterioration in
the financial condition, earnings or cash flow of the material subsidiaries of
Conseco or CDOC for any reason could hinder such subsidiaries' ability to pay
cash dividends or other disbursements to Conseco and/or CDOC, which, in turn,
would limit Conseco's and/or CDOC's ability to meet debt service requirements
and satisfy other financial obligations. In addition, we may need to contribute
additional capital to certain insurance subsidiaries to strengthen their surplus
and this could affect the ability of our top tier insurance subsidiary to pay
dividends.
The ability of our insurance subsidiaries to pay dividends is subject to
state insurance department regulations and is
77
<PAGE>
based on the financial statements of our insurance subsidiaries prepared in
accordance with statutory accounting practices prescribed or permitted by
regulatory authorities, which differ from GAAP. These regulations generally
permit dividends to be paid from statutory 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) statutory net gain from operations or net income for
the prior year; or (ii) 10 percent of statutory 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.
Our cash flow may be affected by a variety of factors, many of which are
outside of our control, including insurance and banking regulatory issues,
competition, financial markets and other general business conditions. We cannot
provide assurance that we will possess sufficient income and liquidity to meet
all of our liquidity requirements and other obligations.
If an insurance company subsidiary were to be liquidated, that liquidation
would be conducted following the insurance law of its state of domicile with
such state's insurance regulator as the receiver for such insurer's property and
business. In the event of a default on our debt or our insolvency, liquidation
or other reorganization, our creditors and stockholders would have no right to
proceed against the assets of our insurance subsidiaries or to cause their
liquidation under federal and state bankruptcy laws.
Under our Amended Credit Facility, we have agreed to a number of covenants
and other provisions that restrict our ability to engage in various financing
transactions and pursue certain operating activities without the prior consent
of the lenders. We have also agreed to meet or maintain various financial
ratios. These requirements represent significant restrictions on the manner in
which we may operate our business and our ability to meet these financial
covenants may be affected by events beyond our control. If we default under any
of these requirements (subject to certain remedies), the lenders could declare
all outstanding borrowings, accrued interest and fees to be immediately due and
payable. If that were to occur, we cannot provide assurance that we would have
sufficient liquidity to repay or refinance this indebtedness.
MARKET-SENSITIVE INSTRUMENTS AND RISK MANAGEMENT
Our spread-based insurance business is subject to several inherent risks
arising from movements in interest rates, especially if we fail to anticipate or
respond to such movements. First, interest rate changes can cause compression of
our net spread between interest earned on investments and interest credited on
customer deposits, thereby adversely affecting our results. Second, if interest
rate changes produce an unanticipated increase in surrenders of our spread-based
products, we may be forced to sell investment assets at a loss in order to fund
such surrenders. Many of our products include surrender charges, market interest
rate adjustments or other features to encourage persistency; however at December
31, 2005, approximately 17 percent of our total insurance liabilities, or
approximately $4.3 billion, could be surrendered by the policyholder without
penalty. Finally, changes in interest rates can have significant effects on the
performance of our structured securities portfolio as a result of changes in the
prepayment rate of the loans underlying such securities. We follow
asset/liability strategies that are designed to mitigate the effect of interest
rate changes on our profitability. However, there can be no assurance that
management will be successful in implementing such strategies and achieving
adequate investment spreads.
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 cash flow
characteristics with the liabilities they support; (ii) are diversified among
industries, issuers and geographic locations; and (iii) are predominantly
investment-grade fixed maturity securities.
Our investment strategy is to maximize, over a sustained period and within
acceptable parameters of risk, investment income and total investment return
through active investment management. Accordingly, 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 are a relatively small portion of our total portfolio.
The profitability of many of our products depends on the spread between the
interest earned on investments and the rates credited on our insurance
liabilities. In addition, changes in competition and other factors, including
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. As of December 31, 2005, approximately 41 percent of
our insurance liabilities had interest rates that may be reset annually; 46
percent had a fixed explicit interest rate for the duration of the contract; 9
percent had credited rates which approximate the income earned by the Company;
and the remainder had no explicit interest rates. At December 31, 2005, the
average yield, computed on the cost basis of our actively managed fixed maturity
portfolio, was 5.6 percent, and the average interest rate credited or accruing
to our total insurance liabilities
78
<PAGE>
(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 4.6 percent.
We use computer models to simulate the cash flows expected from our
existing insurance business under various interest rate scenarios. These
simulations help us to measure the potential gain or loss in fair value of our
interest rate-sensitive financial instruments and to manage the relationship
between the duration of our assets and the expected duration of our liabilities.
When the estimated durations of assets and liabilities are similar, exposure to
interest rate risk is minimized because a change in the value of assets should
be largely offset by a change in the value of liabilities. At December 31, 2005,
the adjusted modified duration of our fixed maturity investments (as modified to
reflect payments and potential calls) was approximately 6.6 years and the
duration of our insurance liabilities was approximately 7.3 years. We estimate
that our fixed maturity securities and short-term investments (net of
corresponding changes in insurance acquisition costs) would decline in fair
value by approximately $685 million if interest rates were to increase by 10
percent from their levels at December 31, 2005. This compares to a decline in
fair value of $630 million based on amounts and rates at December 31, 2004. Our
computer simulated calculations include numerous assumptions, require
significant estimates and assume an immediate change in interest rates without
any management of the investment portfolio in reaction to such change.
Consequently, potential changes in value of our financial instruments indicated
by the simulations will likely be different from the actual changes experienced
under given interest rate scenarios, and the differences may be material.
Because we actively manage our investments and liabilities, our net exposure to
interest rates can vary over time.
We are subject to the risk that our investments will decline in value. This
has occurred in the past and may occur again. During 2005, we recognized net
realized investment losses of $2.9 million, which were comprised of $11.8
million of net gains from the sales of investments (primarily fixed maturities)
with proceeds of $11.5 billion, net of $14.7 million of writedowns of
investments resulting from a decline in the fair value of an investment that we
concluded was other than temporary. During 2004, we recognized net realized
investment gains of $40.6 million, which were comprised of $58.7 million of net
gains from the sales of investments (primarily fixed maturities) with proceeds
of $12.7 billion, net of $18.1 million of writedowns of investments resulting
from declines in fair values that we concluded were other than temporary. During
the four months ended December 31, 2003, we recognized net realized investment
gains of $11.8 million, which were comprised of $21.4 million of net gains from
the sales of investments (primarily fixed maturities) with proceeds of $4.7
billion, net of $9.6 million of writedowns of investments resulting from
declines in fair values that we concluded were other than temporary. During the
first eight months of 2003, we recognized net realized investment losses of $5.4
million, which were comprised of $45.9 million of net gains from the sales of
investments (primarily fixed maturities) with proceeds of $5.4 billion, net of
$51.3 million of writedowns of investments resulting from declines in fair
values that we concluded were other than temporary.
The operations of the Company are subject to risk resulting from
fluctuations in market prices of our equity securities. In general, these
investments have more year-to-year price variability than our fixed maturity
investments. However, returns over longer time frames have been consistently
higher. We manage this risk by limiting our equity securities to a relatively
small portion of our total investments.
Our investment in options backing our equity-linked products is closely
matched with our obligation to equity-indexed annuity holders. Market value
changes associated with that investment are substantially offset by an increase
or decrease in the amounts added to policyholder account balances for
equity-indexed products.
Inflation
Inflation rates may impact the financial statements and operating results
in several areas. Inflation influences interest rates, which in turn impact the
market value of the investment portfolio and yields on new investments.
Inflation also impacts a portion of our insurance policy benefits affected by
increased medical coverage costs. Operating expenses, including payrolls, are
impacted to a certain degree by the inflation rate.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
The information included under the caption "Market-Sensitive Instruments
and Risk Management" in Item 7. "Management's Discussion and Analysis of
Consolidated Financial Condition and Results of Operations" is incorporated
herein by reference.
79
<PAGE>
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
Index to Consolidated Financial Statements
<TABLE>
<CAPTION>
Page
----
<S> <C>
Report of Independent Registered Public Accounting Firm - Successor periods........................................... 81
Report of Independent Registered Public Accounting Firm - Predecessor period.......................................... 82
Consolidated Balance Sheet at December 31, 2005
and December 31, 2004 (Successor)................................................................................. 83
Consolidated Statement of Operations for the years ended December 31, 2005 and 2004, the four months
ended December 31, 2003 (Successor), and the eight months ended August 31, 2003 (Predecessor)..................... 85
Consolidated Statement of Shareholders' Equity for the years ended December 31, 2005 and 2004, the
four months ended December 31, 2003 (Successor), and the eight months ended August 31, 2003 (Predecessor)......... 87
Consolidated Statement of Cash Flows for the years ended December 31, 2005 and 2004, the four months
ended December 31, 2003 (Successor), and the eight months ended August 31, 2003 (Predecessor)..................... 89
Notes to Consolidated Financial Statements............................................................................ 90
</TABLE>
80
<PAGE>
Report of Independent Registered Public Accounting Firm
-------------------------------------------------------
To the Shareholders and Board of Directors
Conseco, Inc.:
We have completed integrated audits of Conseco, Inc.'s (Successor Company) 2005
and 2004 consolidated financial statements and of its internal control over
financial reporting as of December 31, 2005 and an audit of its consolidated
financial statements for the period from September 1, 2003 through December 31,
2003 in accordance with the standards of the Public Company Accounting Oversight
Board (United States). Our opinions, based on our audits, are presented below.
Consolidated financial statements
- ---------------------------------
In our opinion, the consolidated financial statements listed in the accompanying
index present fairly, in all material respects, the financial position of
Conseco, Inc. and subsidiaries (Successor Company) at December 31, 2005 and
2004, and the results of their operations and their cash flows for each of the
two years in the period ended December 31, 2005 and for the period from
September 1, 2003 through December 31, 2003 in conformity with accounting
principles generally accepted in the United States of America. 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. We conducted our audits of these statements in accordance with the
standards of the Public Company Accounting Oversight Board (United States).
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit of financial statements includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
As discussed in Note 1 to the consolidated financial statements, the United
States Bankruptcy Court for the Northern District of Illinois, Eastern Division
confirmed the Company's Sixth Amended Joint Plan of Reorganization (the "Plan")
on September 9, 2003. The provisions of the Plan are described in detail in Note
1. The Plan was substantially consummated on September 10, 2003 and the Company
emerged from bankruptcy. In connection with its emergence from bankruptcy, the
Company adopted fresh start accounting as of August 31, 2003.
Internal control over financial reporting
- -----------------------------------------
Also, in our opinion, management's assessment, included in Management's Report
on Internal Control Over Financial Reporting appearing under Item 9A, that the
Company maintained effective internal control over financial reporting as of
December 31, 2005 based on criteria established in Internal Control - Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission (COSO), is fairly stated, in all material respects, based on those
criteria. Furthermore, in our opinion, the Company maintained, in all material
respects, effective internal control over financial reporting as of December 31,
2005, based on criteria established in Internal Control - Integrated Framework
issued by the COSO. The Company's management is responsible for maintaining
effective internal control over financial reporting and for its assessment of
the effectiveness of internal control over financial reporting. Our
responsibility is to express opinions on management's assessment and on the
effectiveness of the Company's internal control over financial reporting based
on our audit. We conducted our audit of internal control over financial
reporting in accordance with the standards of the Public Company Accounting
Oversight Board (United States). Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether effective
internal control over financial reporting was maintained in all material
respects. An audit of internal control over financial reporting includes
obtaining an understanding of internal control over financial reporting,
evaluating management's assessment, testing and evaluating the design and
operating effectiveness of internal control, and performing such other
procedures as we consider necessary in the circumstances. We believe that our
audit provides a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (i) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (ii)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (iii) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or disposition of the
company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies or procedures may deteriorate.
/s/PricewaterhouseCoopers LLP
- -----------------------------
Indianapolis, Indiana
March 14, 2006
81
<PAGE>
Report of Independent Registered Public Accounting Firm
-------------------------------------------------------
To the Shareholders and Board of Directors
Conseco, Inc.
In our opinion, the accompanying consolidated statements of operations,
shareholders' equity (deficit) and cash flows present fairly, in all material
respects, the results of their operations and their cash flows of Conseco, Inc.
and subsidiaries (Predecessor Company) for the period from January 1, 2003
through August 31, 2003 in conformity with accounting principles generally
accepted in the United States of America. 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 audit. We conducted our audit
of these statements in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements, assessing the accounting principles used and significant estimates
made by management, and evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
As discussed in Note 1 to the consolidated financial statements, the Company
filed a petition on December 17, 2002 with the United States Bankruptcy Court
for the Northern District of Illinois, Eastern Division for reorganization under
the provisions of Chapter 11 of the Bankruptcy Code. The Company's Sixth Amended
Joint Plan of Reorganization (the "Plan") was substantially consummated on
September 10, 2003 and the Company emerged from bankruptcy. In connection with
its emergence from bankruptcy, the Company adopted fresh start accounting.
/s/PricewaterhouseCoopers LLP
- -----------------------------
Indianapolis, Indiana
March 10, 2004
82
<PAGE>
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
December 31, 2005 and 2004
(Dollars in millions)
ASSETS
<TABLE>
<CAPTION>
Successor
-----------------------
2005 2004
---- ----
<S> <C> <C>
Investments:
Actively managed fixed maturities at fair value (amortized cost:
2005 - $22,380.2; 2004 - $21,015.4)............................................... $22,494.2 $21,633.4
Equity securities at fair value (cost: 2005 - $25.6; 2004 - $32.7).................. 27.1 33.9
Mortgage loans...................................................................... 1,264.2 1,123.8
Policy loans........................................................................ 429.8 448.5
Trading securities.................................................................. 716.3 902.3
Other invested assets .............................................................. 109.6 164.4
--------- ---------
Total investments................................................................. 25,041.2 24,306.3
Cash and cash equivalents:
Unrestricted........................................................................ 237.8 776.6
Restricted.......................................................................... 35.2 18.9
Accrued investment income................................................................ 315.4 308.4
Value of policies inforce at the Effective Date.......................................... 2,414.0 2,629.6
Cost of policies produced................................................................ 758.8 409.1
Reinsurance receivables.................................................................. 887.5 975.7
Income tax assets, net................................................................... 1,496.6 967.2
Assets held in separate accounts......................................................... 29.8 32.9
Other assets............................................................................. 341.0 339.9
--------- ---------
Total assets...................................................................... $31,557.3 $30,764.6
========= =========
</TABLE>
(continued on next page)
The accompanying notes are an integral part
of the consolidated financial statements.
83
<PAGE>
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET (Continued)
December 31, 2005 and 2004
(Dollars in millions)
LIABILITIES AND SHAREHOLDERS' EQUITY
<TABLE>
<CAPTION>
Successor
----------------------
2005 2004
---- ----
<S> <C> <C>
Liabilities:
Liabilities for insurance products:
Interest-sensitive products........................................................ $12,686.8 $12,508.2
Traditional products............................................................... 11,872.2 11,741.3
Claims payable and other policyholder funds........................................ 842.1 879.8
Liabilities related to separate accounts........................................... 29.8 32.9
Other liabilities.................................................................... 440.0 498.3
Investment borrowings................................................................ 315.1 433.9
Notes payable - direct corporate obligations......................................... 851.5 768.0
--------- ---------
Total liabilities................................................................ 27,037.5 26,862.4
--------- ---------
Commitments and Contingencies (Note 9)
Shareholders' equity:
Preferred stock...................................................................... 667.8 667.8
Common stock ($0.01 par value, 8,000,000,000 shares authorized,
shares issued and outstanding: 2005 - 151,513,434; 2004 - 151,057,863)............ 1.5 1.5
Additional paid-in capital........................................................... 3,194.1 2,597.8
Accumulated other comprehensive income............................................... 71.7 337.3
Retained earnings.................................................................... 584.7 297.8
--------- ---------
Total shareholders' equity....................................................... 4,519.8 3,902.2
--------- ---------
Total liabilities and shareholders' equity....................................... $31,557.3 $30,764.6
========= =========
</TABLE>
The accompanying notes are an integral part
of the consolidated financial statements.
84
<PAGE>
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(Dollars in millions, except per share data)
<TABLE>
<CAPTION>
Successor Predecessor
--------------------------------------- ------------
Years
ended Four months Eight months
December 31, ended ended
-------------------- December 31, August 31,
2005 2004 2003 2003
---- ---- ---- ----
<S> <C> <C> <C> <C>
Revenues:
Insurance policy income............................... $2,930.1 $2,949.3 $1,005.8 $ 2,204.3
Net investment income (loss):
General account assets............................. 1,390.4 1,294.5 427.0 928.4
Policyholder and reinsurer accounts................ (15.8) 24.1 53.1 30.1
Venture capital income (loss) related to investment
in AT&T Wireless Services, Inc................... - - (5.5) 10.5
Net realized investment gains (losses) ............... (2.9) 40.6 11.8 (5.4)
Fee revenue and other income.......................... 24.7 21.5 13.3 35.5
-------- -------- -------- ---------
Total revenues..................................... 4,326.5 4,330.0 1,505.5 3,203.4
-------- -------- -------- ---------
Benefits and expenses:
Insurance policy benefits............................. 2,800.6 2,795.2 967.9 2,136.4
Provision for losses.................................. - - - 55.6
Interest expense (contractual interest: $268.5 for the
eight months ended August 31, 2003)................ 58.3 79.5 36.8 202.5
Amortization.......................................... 388.4 371.2 132.9 343.7
Other operating costs and expenses.................... 572.1 632.8 218.4 423.5
(Gain) loss on extinguishment of debt................. 3.7 (2.8) - -
Reorganization items.................................. - - - (2,130.5)
-------- -------- -------- ---------
Total benefits and expenses........................ 3,823.1 3,875.9 1,356.0 1,031.2
-------- -------- -------- ---------
Income before income taxes and
discontinued operations.......................... 503.4 454.1 149.5 2,172.2
Income tax expense (benefit) on period income............. 178.5 159.3 53.2 (13.5)
-------- -------- -------- ---------
Income before discontinued operations.............. 324.9 294.8 96.3 2,185.7
Discontinued operations, net of income taxes.............. - - - 16.0
-------- -------- -------- ---------
Net income......................................... 324.9 294.8 96.3 2,201.7
Preferred stock dividends................................. 38.0 65.5 27.8 -
-------- ---------- -------- ---------
Net income applicable to common stock.............. $ 286.9 $ 229.3 $ 68.5 $ 2,201.7
======== ========= ======== =========
</TABLE>
(continued)
The accompanying notes are an integral part
of the consolidated financial statements.
85
<PAGE>
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS (Continued)
(Dollars in millions, except per share data)
<TABLE>
<CAPTION>
Successor
------------------------------------------
Years
ended Four months
December 31, ended
------------------- December 31,
2005 2004 2003
---- ---- ----
<S> <C> <C> <C>
Earnings per common share:
Basic:
Weighted average shares outstanding............................. 151,160,000 132,280,000 100,110,000
=========== =========== ===========
Net income...................................................... $1.90 $1.73 $.68
===== ===== ====
Diluted:
Weighted average shares outstanding............................. 185,040,000 155,930,000 143,486,000
=========== =========== ===========
Net income...................................................... $1.76 $1.63 $.67
===== ===== ====
</TABLE>
The accompanying notes are an integral part
of the consolidated financial statements.
86
<PAGE>
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (DEFICIT) (Continued)
(Dollars in millions)
<TABLE>
<CAPTION>
Common stock Accumulated other
Preferred and additional comprehensive Retained
Total stock paid-in capital income (loss) earnings (deficit)
----- ----- --------------- ------------ ------------------
<S> <C> <C> <C> <C> <C>
Predecessor balance, December 31, 2002............ $(2,050.4) $ 501.7 $ 3,497.0 $ 580.6 $(6,629.7)
Comprehensive income, net of tax:
Net income................................... 2,201.7 - - - 2,201.7
Change in unrealized appreciation
of investments (net of applicable
income tax benefit of nil)................. (151.6) - - (151.6) -
---------
Total comprehensive income............... 2,050.1
Change in shares for employee benefit plans.... .3 - .3 - -
--------- ------- --------- ------- ---------
Predecessor balance, August 31, 2003.............. - 501.7 3,497.3 429.0 (4,428.0)
Elimination of Predecessor's
equity securities.............................. (3,999.0) (501.7) (3,497.3) - -
Issuance of Successor's
equity securities.............................. 2,500.0 859.7 1,640.3 - -
Fresh start adjustments........................... 3,999.0 - - (429.0) 4,428.0
--------- ------- --------- -------- ---------
Successor balance, August 31, 2003................ 2,500.0 859.7 1,640.3 - -
Comprehensive income, net of tax:
Net income................................... 96.3 - - - 96.3
Change in unrealized appreciation
of investments (net of applicable
income tax expense of $123.0).............. 218.7 - - 218.7 -
---------
Total comprehensive income............... 315.0
Issuance of shares for stock options and for
employee benefit plans....................... 2.6 - 2.6 - -
Payment-in-kind dividends on convertible
exchangeable preferred stock................. 27.8 27.8 - - -
Dividends on preferred stock................... (27.8) - - - (27.8)
--------- ------- --------- ------- ---------
Successor balance, December 31, 2003.............. $ 2,817.6 $ 887.5 $ 1,642.9 $ 218.7 $ 68.5
</TABLE>
(continued on following page)
The accompanying notes are an integral part
of the consolidated financial statements.
87
<PAGE>
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (Continued)
(Dollars in millions)
<TABLE>
<CAPTION>
Common stock Accumulated other
Preferred and additional comprehensive Retained
Total stock paid-in capital income earnings
----- ----- --------------- ------ --------
<S> <C> <C> <C> <C> <C>
Successor balance, December 31, 2003
(carried forward from prior page)................. $2,817.6 $887.5 $1,642.9 $ 218.7 $ 68.5
Comprehensive income, net of tax:
Net income...................................... 294.8 - - - 294.8
Change in unrealized appreciation of
investments (net of applicable income tax
expense of $65.4)............................. 118.6 - - 118.6 -
--------
Total comprehensive income.................. 413.4
Issuance of shares for stock options and
for employee benefit plans, net................. 12.4 - 12.4 - -
Issuance of mandatorily convertible
preferred stock, net............................ 667.8 667.8 - - -
Redemption of cumulative convertible
exchangeable preferred stock.................... (928.9) (928.9) - - -
Issuance of common stock, net..................... 882.2 - 882.2 - -
Reduction of deferred income tax valuation
allowance....................................... 61.8 - 61.8 - -
Payment-in-kind dividends on convertible
exchangeable preferred stock.................... 41.4 41.4 - - -
Dividends on preferred stock...................... (65.5) - - - (65.5)
-------- ------ -------- ------- ------
Successor balance, December 31, 2004................. 3,902.2 667.8 2,599.3 337.3 297.8
Comprehensive income, net of tax:
Net income...................................... 324.9 - - - 324.9
Change in unrealized appreciation of
investments (net of applicable income tax
benefit of $148.7)............................ (265.6) - - (265.6) -
--------
Total comprehensive income.................. 59.3
Reduction of deferred income tax valuation
allowance....................................... 585.8 - 585.8 - -
Stock option and restricted stock plans........... 9.1 - 9.1 - -
Reduction of tax liabilities related to various
contingencies recognized at the fresh-start
date............................................ 1.4 - 1.4 - -
Dividends on preferred stock...................... (38.0) - - - (38.0)
-------- ------ -------- ------- ------
Successor balance, December 31, 2005................. $4,519.8 $667.8 $3,195.6 $ 71.7 $584.7
======== ====== ======== ====== ======
</TABLE>
The accompanying notes are an integral part
of the consolidated financial statements.
88
<PAGE>
CONSECO, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(Dollars in millions)
<TABLE>
<CAPTION>
Successor Predecessor
--------------------------------------- ------------
Years
ended Four months Eight months
December 31, ended ended
-------------------- December 31, August 31,
2005 2004 2003 2003
---- ---- ---- ----
<S> <C> <C> <C> <C>
Cash flows from operating activities:
Insurance policy income................................. $ 2,565.3 $ 2,567.5 $ 876.3 $ 1,876.2
Net investment income................................... 1,461.0 1,494.9 433.4 928.6
Fee revenue and other income............................ 24.7 21.5 14.5 35.5
Net sales of trading securities......................... 165.8 21.1 49.0 -
Insurance policy benefits............................... (2,044.8) (2,058.9) (569.9) (1,461.2)
Interest expense........................................ (40.6) (72.2) (25.5) -
Policy acquisition costs................................ (400.9) (364.4) (111.6) (287.5)
Reorganization items.................................... - - - (26.5)
Other operating costs................................... (596.8) (579.5) (255.9) (362.0)
Taxes................................................... 28.4 17.6 77.8 44.2
---------- ----------- --------- ---------
Net cash provided by operating activities........... 1,162.1 1,047.6 488.1 747.3
---------- ----------- --------- ---------
Cash flows from investing activities:
Sales of investments.................................... 11,479.9 12,707.9 4,662.5 5,378.9
Maturities and redemptions of investments............... 1,455.3 1,882.3 1,003.2 1,854.7
Purchases of investments................................ (14,438.0) (16,000.9) (5,141.1) (7,385.9)
Change in restricted cash............................... (16.3) 13.0 (6.8) 26.2
Other................................................... (31.6) (57.6) 1.4 (19.6)
---------- ----------- --------- ---------
Net cash provided (used) by investing activities ... (1,550.7) (1,455.3) 519.2 (145.7)
---------- ----------- --------- ---------
Cash flows from financing activities:
Issuance of notes payable, net.......................... 853.7 790.2 - -
Issuance of preferred stock, net........................ - 667.8 - -
Issuance of common stock, net........................... .5 882.2 - -
Payments on notes payable............................... (770.4) (1,332.0) - -
Redemption of preferred stock........................... - (928.9) - -
Amounts received for deposit products................... 1,709.8 1,648.3 479.6 1,272.7
Withdrawals from deposit products....................... (1,787.0) (1,795.7) (583.5) (1,784.2)
Investment borrowings................................... (118.8) 46.6 (837.1) (145.3)
Dividends paid on preferred stock....................... (38.0) (19.3) - -
Other................................................... - (3.6) - -
---------- ----------- --------- ---------
Net cash used by financing activities............... (150.2) (44.4) (941.0) (656.8)
---------- ----------- --------- ---------
Net increase (decrease) in cash and cash equivalents (538.8) (452.1) 66.3 (55.2)
Cash and cash equivalents, beginning of the period......... 776.6 1,228.7 1,162.4 1,217.6
---------- ----------- --------- ---------
Cash and cash equivalents, end of the period............... $ 237.8 $ 776.6 $ 1,228.7 $ 1,162.4
========== =========== ========= =========
</TABLE>
The accompanying notes are an integral part
of the consolidated financial statements.
89
<PAGE>
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
1. DESCRIPTION OF BUSINESS AND OUR EMERGENCE FROM BANKRUPTCY IN 2003
Conseco, Inc., a Delaware corporation ("CNO"), is a holding company for a
group of insurance companies operating throughout the United States that
develop, market and administer supplemental health insurance, annuity,
individual life insurance and other insurance products. CNO became the successor
to Conseco, Inc., an Indiana corporation ("Old Conseco" or our "Predecessor"),
in connection with our bankruptcy reorganization. The terms "Conseco", the
"Company", "we", "us", and "our" as used in this report refer to CNO and its
subsidiaries or, when the context requires otherwise, Old Conseco and its
subsidiaries. We focus on serving the senior and middle-income markets, which we
believe are attractive, high growth markets. We sell our products through three
distribution channels: career agents, professional independent producers (some
of whom sell one or more of our product lines exclusively) and direct marketing.
Prior to September 30, 2003, we conducted our insurance operations through
one segment. In the fourth quarter of 2003, we implemented changes contemplated
in our restructuring plan to conduct our business through two operating
segments, which are defined on the basis of product distribution, and a third
segment comprised of business in run-off, as follows:
o Bankers Life, which consists of the businesses of Bankers Life and
Casualty Company ("Bankers Life and Casualty") and Colonial Penn Life
Insurance Company ("Colonial Penn"). Bankers Life and Casualty markets
and distributes Medicare supplement insurance, life insurance,
long-term care insurance and certain annuity products to the senior
market through approximately 4,800 exclusive career agents and sales
managers. Colonial Penn markets graded benefit and simplified issue
life insurance directly to consumers through television advertising,
direct mail, the internet and telemarketing. Both Bankers Life and
Casualty and Colonial Penn market their products under their own brand
names.
o Conseco Insurance Group, which markets and distributes specified
disease insurance, Medicare supplement insurance, and certain life and
annuity products to the senior and middle-income markets through over
500 independent marketing organizations that represent over 6,000
producing independent agents. This segment markets its products under
the "Conseco" brand.
o Other Business in Run-off, which includes blocks of business that we
no longer market or underwrite and are managed separately from our
other businesses. This segment consists of long-term care insurance
sold in prior years through independent agents and major medical
insurance.
We also have a corporate segment, which consists of holding company
activities and certain noninsurance company businesses that are unrelated to our
operating segments.
On December 17, 2002, Old Conseco and certain of its non-insurance company
subsidiaries filed voluntary petitions for relief under Chapter 11 of Title 11
of the United States Bankruptcy Code in the United States Bankruptcy Court for
the Northern District of Illinois, Eastern Division (the "Bankruptcy Court"). We
emerged from bankruptcy protection under the Sixth Amended Joint Plan of
Reorganization (the "Plan"), which was confirmed pursuant to an order of the
Bankruptcy Court on September 9, 2003 (the "Confirmation Date"), and became
effective on September 10, 2003 (the "Effective Date"). Upon confirmation of the
Plan, we implemented fresh start accounting in accordance with Statement of
Position 90-7 "Financial Reporting by Entities in Reorganization under the
Bankruptcy Code" ("SOP 90-7"). References in these consolidated financial
statements to "Predecessor" refer to Old Conseco prior to August 31, 2003.
References to "Successor" refer to the Company on and after August 31, 2003,
after the effects of fresh start reporting. Our accounting and actuarial systems
and procedures are designed to produce financial information as of the end of a
month. Accordingly, for accounting convenience purposes, we applied the effects
of fresh start accounting on August 31, 2003. The activity of the Company for
the period from September 1, 2003 through September 10, 2003 was therefore
included in the Successor's statement of operations and excluded from the
Predecessor's statement of operations. We believe the net income impact of the
use of a convenience date is immaterial.
The Plan generally provided for the full payment or reinstatement of
allowed administrative claims, priority claims, fully secured claims and certain
intercompany claims, and the distribution of new equity securities (including
warrants) to partially secured and unsecured creditors of our Predecessor.
Holders of claims arising under our Predecessor's $1.5 billion senior bank
credit facility also received a pro rata interest in a $1.3 billion credit
agreement. Holders of our Predecessor's common stock and preferred stock did not
receive any distribution under the Plan, and these securities, together with all
other
90
<PAGE>
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
prepetition securities and the $1.5 billion senior bank credit facility of our
Predecessor, were cancelled on the Effective Date.
On the Effective Date, under the terms of the Plan, we emerged from the
bankruptcy proceedings with a capital structure consisting of:
o a $1.3 billion credit agreement, (the "Previous Credit Facility",
which has been subsequently repaid as further discussed in the note to
the consolidated financial statements entitled "Notes Payable - Direct
Corporate Obligations");
o approximately 34.4 million shares of Class A Preferred Stock with an
initial aggregate liquidation preference of approximately $859.7
million (which has been subsequently redeemed as further discussed in
the note to the consolidated financial statements entitled
"Shareholders' Equity");
o 100.0 million shares of common stock, excluding shares issued to our
chairman upon his appointment and shares issued or to be issued to
directors, officers or employees under an equity incentive plan; and
o warrants to purchase 6.0 million shares of our common stock (the
"Series A Warrants").
The distribution of our common stock represented approximately 98 percent
of all of the shares of common stock to be distributed under the Plan. As of
December 31, 2003, approximately 1.8 million of our outstanding shares of common
stock were reserved for distribution under the Plan for unresolved disputed
claims. During 2004 and 2005, a total of .6 million of these reserved shares
were distributed upon the resolution of certain disputed claims. If reserved
shares remain after resolution of pending disputed claims, such shares will be
reallocated to other general unsecured creditors of our Predecessor as provided
for under the Plan.
As part of our Chapter 11 reorganization, we sold substantially all of the
assets of our Predecessor's finance business and exited this line of business.
Our finance business was conducted through our Predecessor's indirect
wholly-owned subsidiary, Conseco Finance Corp. ("CFC"). We accounted for our
finance business as a discontinued operation in 2002 once we formalized our
plans to sell it. On April 1, 2003, CFC and 22 of its direct and indirect
subsidiaries, which collectively comprised substantially all of our finance
business, filed liquidating plans of reorganization with the Bankruptcy Court in
order to facilitate the sale of this business. The sale of the finance business
was completed in the second quarter of 2003. We did not receive any proceeds
from this sale for our interest in CFC, nor did any creditors of our
Predecessor. As of March 31, 2003, we ceased to include the assets and
liabilities of CFC on our Predecessor's consolidated balance sheet.
91
<PAGE>
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
2. BASIS OF PRESENTATION
We prepare our financial statements in accordance with accounting
principles generally accepted in the United States of America ("GAAP"). We
follow the accounting standards established by the Financial Accounting
Standards Board ("FASB"), the American Institute of Certified Public Accountants
and the Securities and Exchange Commission (the "SEC").
The accompanying financial statements include the accounts of the Company
and its subsidiaries. Our consolidated financial statements exclude the results
of material transactions between us and our consolidated affiliates, or among
our consolidated affiliates. We have reclassified certain amounts in our 2004
and 2003 consolidated financial statements and notes to conform with the 2005
presentation. These reclassifications have no effect on net income or
shareholders' equity.
Upon our emergence from bankruptcy, we implemented fresh start reporting in
accordance with SOP 90-7 as further described in the note entitled "Fresh Start
Reporting". As a result, the Company's financial statements for periods
following August 31, 2003, are not comparable with those of Old Conseco prepared
before that date.
When we prepare financial statements in conformity with GAAP, we are
required to make estimates and assumptions that significantly affect reported
amounts of various assets and liabilities and the disclosure of contingent
assets and liabilities at the date of the financial statements and revenues and
expenses during the reporting periods. For example, we use significant estimates
and assumptions to calculate values for the cost of policies produced, the value
of policies inforce at the Effective Date, certain investments, assets and
liabilities related to income taxes, liabilities for insurance products,
liabilities related to litigation, guaranty fund assessment accruals and amounts
recoverable from loans to certain former directors and former employees. If our
future experience differs from these estimates and assumptions, our financial
statements would be materially affected.
3. FRESH START REPORTING
Upon the confirmation of the Plan on September 9, 2003, we implemented
fresh start reporting in accordance with SOP 90-7. For accounting convenience
purposes, we have reported the effects of fresh start accounting as if they
occurred on August 31, 2003. Under fresh start reporting, a new reporting entity
was considered to be created and the Company was required to revalue its assets
and liabilities to current estimated fair value, re-establish shareholders'
equity at the reorganization value determined in connection with the Plan, and
record the excess of the reorganization value over specific tangible or
identified intangible assets as goodwill. In addition, all accounting standards
that were required to be adopted in the financial statements within twelve
months following the adoption of fresh start accounting were adopted as of
August 31, 2003.
We engaged an independent financial advisor to assist in the determination
of our reorganization value as defined in SOP 90-7. We determined a
reorganization value, together with our financial advisor, using various
valuation methods, including: (i) selected comparable companies analysis; and
(ii) actuarial valuation analysis. These analyses are necessarily based on a
variety of estimates and assumptions which, though considered reasonable by
management, may not be realized, and are inherently subject to significant
business, economic and competitive uncertainties and contingencies, many of
which are beyond our control. Changes in these estimates and assumptions may
have had a significant effect on the determination of our reorganization value.
The estimated reorganization value of the Company was calculated to be
approximately $3.7 billion to $3.9 billion. We selected the midpoint of the
range, $3.8 billion, as the reorganization value. Such value was confirmed by
the Bankruptcy Court on the Confirmation Date.
Pursuant to SOP 90-7, professional fees associated with Chapter 11 cases
are expensed as incurred and reported as reorganization items. Interest expense
was reported only to the extent that it was paid during the Chapter 11 cases.
The Company recognized expenses of $70.9 million in the eight months ended
August 31, 2003 for fees payable to professionals who assisted with the Chapter
11 cases.
92
<PAGE>
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Adjustments to the Predecessor's consolidated balance sheet as of August
31, 2003, to reflect the discharge of debt, change in capital structure and the
fair value of our assets and liabilities are presented in the following table
(dollars in millions):
<TABLE>
<CAPTION>
Debt Fresh
Predecessor discharge and start Successor
balance sheet(a) reorganization (b) adjustments balance sheet
---------------- ------------------ ----------- -------------
<S> <C> <C> <C> <C>
Assets:
Investments .............................................. $22,018.3 $ - $ 1,043.5 (c) $23,101.3
39.5 (d)
Cash and cash equivalents................................. 1,187.5 - 28.4 (c) 1,215.9
Accrued investment income................................. 304.6 - - 304.6
Value of policies in force at the Effective Date.......... - - 3,102.6 (e) 3,102.6
Cost of policies purchased................................ 1,099.2 - (1,099.2) (e) -
Cost of policies produced................................. 2,019.5 - (2,019.5) (e) -
Reinsurance receivables................................... 878.3 - 44.3 (f) 922.6
Goodwill.................................................. 99.4 - 1,042.2 (f) 1,141.6
Other intangible assets................................... 22.6 - 164.3 (f) 186.9
Income tax assets......................................... 88.0 - - 88.0
Assets held in separate accounts and investment trust..... 87.7 - - 87.7
Other assets.............................................. 513.0 - 3.6 (f) 516.6
--------- --------- --------- ---------
Total assets......................................... $28,318.1 $ - $ 2,349.7 $30,667.8
========= ========= ========= =========
Liabilities:
Liabilities for insurance products........................ $22,175.6 $ - $ 2,592.1 (g) $24,767.7
Other liabilities......................................... 868.1 - (23.2) (f) 875.7
30.8 (c)
Investment borrowings..................................... 524.4 - 700.0 (c) 1,224.4
Notes payable - direct corporate obligations.............. - 1,300.0 - 1,300.0
--------- --------- --------- ---------
Total liabilities not subject to compromise.......... 23,568.1 1,300.0 3,299.7 28,167.8
Liabilities subject to compromise......................... 6,951.4 (6,951.4) - -
--------- --------- --------- ---------
Total liabilities ................................... 30,519.5 (5,651.4) 3,299.7 28,167.8
--------- --------- --------- ---------
Shareholders' equity (deficit):
Convertible preferred stock............................... 501.7 - (501.7) -
Convertible exchangeable preferred stock.................. - 859.7 - 859.7
Common stock and additional paid-in capital............... 3,497.3 1,640.3 (3,497.3) 1,640.3
Retained earnings (accumulated deficit)................... (6,629.4) 3,151.4 3,478.0 -
Accumulated other comprehensive income.................... 429.0 - (429.0) -
--------- --------- --------- ---------
Total shareholders' equity (deficit)................. (2,201.4) 5,651.4 (950.0) 2,500.0
--------- --------- --------- ---------
Total liabilities and shareholders' equity (deficit). $28,318.1 $ - $ 2,349.7 $30,667.8
========= ========= ========= =========
</TABLE>
93
<PAGE>
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
- -----------------
(a) Predecessor balance sheet as of August 31, 2003, prior to the
discharge of prepetition liabilities and the effects of the fresh
start adjustments.
(b) These adjustments reflected the reorganization value of Conseco of
$3,800.0 million. After deducting from Conseco's reorganization value
the long-term indebtedness of Conseco at the Effective Date,
consisting of $1,300.0 million under the senior secured bank credit
facility, the total equity of Conseco was $2,500.0 million. After
deducting from Conseco's total equity the value of the new preferred
stock of $859.7 million, the value of the new common stock was
$1,640.3 million. These adjustments also reflected the gain on the
discharge of prepetition liabilities.
(c) In accordance with a new accounting pronouncement, the Company was
required to consolidate the assets and liabilities of a partnership
which owned the General Motors building. As a result of the
consolidation and the adoption of fresh start accounting, we increased
our investment in the General Motors building by $1,043.5 million and
recognized the following other assets and liabilities held by the
partnership which owned the General Motors building: (i) cash of $28.4
million; (ii) other liabilities of $30.8 million; and (iii) a note
payable of $700 million. We sold the General Motors building in
September 2003 at a value that was approximately equal to the fresh
start value. The note payable of the partnership was paid in full and
the net proceeds from the sale were distributed to the partners.
(d) The values of our mortgage loans, policy loans and other invested
assets were adjusted to market value at the Effective Date. In
addition, the cost basis of our actively managed fixed maturities was
increased to the market value at the Effective Date.
(e) The Company's historical cost of policies purchased and cost of
policies produced balances were eliminated and replaced with the value
of policies in force at the Effective Date. The value of policies in
force reflected the estimated fair value of the Company's business in
force and represents the value of the right to receive future cash
flows from the policies in force on the Effective Date.
The value of policies in force was determined using a discount rate of
12 percent, which was the rate of return that our management (with
assistance from a consulting actuarial firm) believed would be
required by a purchaser of the business, based on conditions existing
as of the Effective Date. In determining such rate of return, the
following factors, among others, were considered:
o The magnitude of the risks associated with each of the
actuarial assumptions used in determining the expected cash
flows;
o Market rates of interest that would be applicable to an
acquisition of the business;
o The perceived likelihood of changes in insurance regulations
and tax laws;
o The complexity of the business; and
o Prices paid for similar blocks of business.
(f) Assets and liabilities were adjusted to reflect their estimated fair
market value. The portion of the reorganization value that could not
be attributed to specific tangible or identified intangible assets was
recorded as goodwill.
(g) The Company establishes reserves for insurance policy benefits based
on assumptions as to investment yields, mortality, morbidity,
withdrawals and lapses. These reserves include amounts for estimated
future payment of claims based on actuarial assumptions. Many factors
can affect these reserves, such as economic conditions, inflation,
hospital and pharmaceutical costs, changes in doctrines of legal
liability and extra contractual damage awards. The fresh-start balance
was based on the Company's best estimate (with assistance from a
consulting actuarial firm) of the future performance of this business,
given recent and expected changes in experience. Adjustments to the
Predecessor's liabilities for insurance products are further discussed
in the note to the consolidated financial statements entitled
"Liabilities for Insurance Products".
94
<PAGE>
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The following summary explains the significant accounting policies we use
to prepare our financial statements.
Investments
We classify our fixed maturity securities into one of three categories: (i)
"actively managed" (which we carry at estimated fair value with any unrealized
gain or loss, net of tax and related adjustments, recorded as a component of
shareholders' equity); (ii) "trading" (which we carry at estimated fair value
with changes in such value recognized as trading income); or (iii) "held to
maturity" (which we carry at amortized cost). We had no fixed maturity
securities classified as held to maturity during the periods presented in these
financial statements.
Equity securities include investments in common stock and non-redeemable
preferred stock. We carry these investments at estimated fair value. We record
any unrealized gain or loss, net of tax and related adjustments, as a component
of shareholders' equity. When declines in value considered to be other than
temporary occur, we reduce the amortized cost to estimated fair value and
recognize a loss in the statement of operations.
Mortgage loans held in our investment portfolio are carried at amortized
unpaid balances, net of provisions for estimated losses.
Policy loans are stated at current unpaid principal balances.
Our trading securities are designed to act as hedges for embedded
derivatives related to our equity-indexed annuity products and certain modified
coinsurance agreements. See the note entitled "Accounting for Derivatives" for
further discussion regarding embedded derivatives and the trading accounts. In
addition, the trading account includes investments backing the market strategies
of our multibucket annuity products. The change in market value of these
securities, which is recognized currently in income from policyholder and
reinsurer accounts (a component of investment income), is substantially offset
by the change in insurance policy benefits for these products. Our trading
securities totaled $716.3 million and $902.3 million at December 31, 2005 and
2004, respectively.
Other invested assets include: (i) certain call options purchased in an
effort to hedge the effects of certain policyholder benefits; and (ii) certain
non-traditional investments. We carry the call options at estimated fair value
as further described below under "Accounting for Derivatives". Non-traditional
investments include investments in certain limited partnerships, which are
accounted for using the equity method, and promissory notes, which are accounted
for using the cost method.
Venture capital investment in AT&T Wireless Services, Inc. ("AWE") was
carried at fair value, with changes in such value recognized as investment
income (loss). In December 2003, we sold our remaining 4.1 million shares of AWE
common stock. We recognized venture capital investment income (losses) of $(5.5)
million in the four months ended December 31, 2003; and $10.5 million in the
eight months ended August 31, 2003, related to this investment.
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.
When we sell a security (other than trading securities or venture capital
investments), we report the difference between the sale proceeds and amortized
cost (determined based on specific identification) as a realized investment gain
or loss.
We regularly evaluate all of our investments based on current economic
conditions, credit loss experience and other investee-specific developments.
When we conclude there is a decline in a security's fair value that is other
than temporary, we treat it as a realized investment loss and reduce the cost
basis of the security to its estimated fair value.
95
<PAGE>
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
Cash and Cash Equivalents
Cash and cash equivalents include commercial paper, invested cash and other
investments purchased with original maturities of less than three months. We
carry them at amortized cost, which approximates estimated fair value.
Provision for Losses
During the first eight months of 2003, we established an additional
provision for losses related to our guarantees of the bank loans and related
interest loans to approximately 155 current and former directors, officers and
key employees for the purchase of the common stock of Old Conseco (see the note
to the consolidated financial statements entitled "Commitments and
Contingencies" for additional information).
Cost of Policies Produced
Upon the implementation of fresh start accounting, we eliminated the
historical balance of Old Conseco's cost of policies produced as of September
10, 2003 (the effective date of the reorganization of our Predecessor), and
replaced it with the value of policies inforce at the Effective Date.
The costs that vary with, and are primarily related to, producing new
insurance business subsequent to September 10, 2003 are referred to as cost of
policies produced. For universal life or investment products, we amortize these
costs using the interest rate credited to the underlying policies in relation to
the estimated gross profits. For other products, we amortize these costs using
the projected investment earnings rate in relation to future anticipated premium
revenue.
When we realize a gain or loss on investments backing our universal life or
investment-type products, we adjust the amortization to reflect the change in
estimated gross profits from the products due to the gain or loss realized and
the effect on future investment yields. We also adjust the cost of policies
produced for the change in amortization that would have been recorded if
actively managed fixed maturity securities had been sold at their stated
aggregate fair value and the proceeds reinvested at current yields. We include
the impact of this adjustment in accumulated other comprehensive income within
shareholders' equity.
When we replace an existing insurance contract with another insurance
contract with substantially different terms, all unamortized cost of policies
produced for such replaced contract is immediately expensed. 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 which continue to be deferred related to
replaced contracts were nil in both 2005 and 2004 and the four months ended
December 31, 2003; and $2.9 million in the eight months ended August 31, 2003.
We regularly evaluate the recoverability of the unamortized balance of the
cost of policies produced. We consider estimated future gross profits or future
premiums, expected mortality or morbidity, interest earned and credited rates,
persistency and expenses in determining whether the balance is recoverable. If
we determine a portion of the unamortized balance is not recoverable, it is
charged to amortization expense.
Value of Policies Inforce at the Effective Date
Upon the implementation of fresh start accounting, we eliminated the
historical balances of Old Conseco's cost of policies purchased and cost of
policies produced as of August 31, 2003, and replaced them with the value of
policies inforce at the Effective Date.
The value assigned to the right to receive future cash flows from contracts
existing at September 10, 2003 is referred to as the value of policies inforce
at the Effective Date. We also defer renewal commissions paid in excess of
ultimate commission levels related to the existing policies in this account. The
balance of this account is amortized, evaluated for recovery, and adjusted for
the impact of unrealized gains (losses) in the same manner as described above
for the cost of policies produced.
The discount rate we used to determine the value of the value of policies
inforce at the Effective Date was 12 percent.
96
<PAGE>
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
See note entitled "Fresh Start Reporting", for further explanation of this rate.
The Company expects to amortize the balance of the value of policies
inforce at the Effective Date as of December 31, 2005 as follows: 12 percent in
2006, 11 percent in 2007, 10 percent in 2008, 8 percent in 2009 and 8 percent in
2010.
Goodwill
The goodwill recognized upon our emergence from bankruptcy resulted from
the revaluation of our balance sheet accounts. We revalued our assets and
liabilities to current estimated fair value and established our capital accounts
at the reorganization value determined in connection with the Plan. We recorded
goodwill of $1,141.6 million representing the excess of the reorganization value
over specific tangible or identified intangible assets. In accordance with GAAP,
the goodwill balance was not amortized.
Pursuant to SOP 90-7, any reduction of the deferred income tax valuation
allowance established at the emergence date is accounted for as a reduction of
goodwill until goodwill is eliminated. As further described in the note entitled
"Income Taxes", the reduction of our deferred income tax valuation allowance
resulted in the elimination of our goodwill in 2004.
The changes in goodwill were as follows (dollars in millions):
<TABLE>
<CAPTION>
Successor
-------------------------------
Year Four months
ended ended
December 31, December 31,
2004 2003
---- ----
<S> <C> <C>
Goodwill balance, beginning of period................................ $ 952.2 $1,141.6
Reduction of tax valuation allowance established at the
Effective Date.................................................. (952.2) (189.4)
------- --------
Goodwill balance, end of period...................................... $ - $ 952.2
======= ========
</TABLE>
Reorganization Items
Reorganization items represent amounts the Predecessor incurred as a result
of its Chapter 11 reorganization, and are presented separately in the
consolidated statement of operations. These items consisted of the following
(dollars in millions):
<TABLE>
<CAPTION>
Eight months
ended
August 31, 2003
---------------
<S> <C>
Gain on discharge of prepetition liabilities.................. $ 3,151.4
Fresh start adjustments (a)................................... (950.0)
Professional fees............................................. (70.9)
---------
Total reorganization items................................ $ 2,130.5
=========
</TABLE>
97
<PAGE>
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
- -------------
(a) We implemented fresh start accounting on August 31, 2003 in accordance
with SOP 90-7. These rules required the Company to revalue its assets
and liabilities to current estimated fair value, re-establish
shareholders' equity at the reorganization value determined in
connection with our Plan and record the excess of the reorganization
value over tangible or identified intangible assets as goodwill. Fresh
start adjustments are the adjustments made to the Predecessor's
balance sheet to reflect the revaluation. The total fresh start
adjustments of $950 million corresponded to the net of the total
adjustments to the assets and liabilities on the Predecessor balance
sheet as of August 31, 2003, as summarized in the note entitled "Fresh
Start Reporting".
Other Intangible Assets
Pursuant to SOP 90-7, the reduction of the deferred income tax valuation
allowance established at the emergence date is first accounted for as a
reduction of goodwill, and second as a reduction of other intangible assets. As
further described in the note entitled "Income Taxes", the reduction of a
portion of our deferred income tax valuation allowance resulted in the
elimination of our other intangible assets in 2004.
The other intangible assets identified at the emergence date were valued
with assistance from a consulting valuation firm. In accordance with Statement
of Financial Accounting Standards No. 142, "Goodwill and Other Intangible
Assets", other intangible assets with indefinite lives were not amortized and
other intangible assets with finite useful lives were amortized over their
estimated useful lives. We amortized the value of our career agency force and
our independent agency force over their estimated useful lives of 15 years using
the straight line method.
The following summarizes other identifiable intangible assets as of
December 31, 2004 (dollars in millions):
<TABLE>
<CAPTION>
Successor
---------
2004
----
<S> <C>
Indefinite lived other intangible assets:
Trademarks and tradenames.............................................. $ 25.1
State licenses and charters............................................ 17.0
--------
Total indefinite lived other intangible assets..................... 42.1
--------
Finite lived other intangible assets:
Career agency force.................................................... 64.7
Independent agency force............................................... 49.8
Intangible assets associated with insurance agencies................... 29.1
Other.................................................................. 1.2
Less accumulated amortization.......................................... (15.8)
--------
Total finite lived other intangible assets......................... 129.0
Reduction of deferred income tax valuation allowance................... (171.1)
--------
Total other intangible assets...................................... $ -
========
</TABLE>
Assets Held in Separate Accounts and Investment Trust
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 separate account assets. We
record the fees earned for administrative and contractholder services performed
for the separate accounts in insurance policy income.
In addition, prior to its liquidation in the third quarter of 2003, we held
investments in a trust for the benefit of the
98
<PAGE>
CONSECO, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
--------------------------
purchasers of certain products of our asset management subsidiary. Because we
held the residual interests in the cash flows from the trust and actively
managed its investments, we were required to include the accounts of the trust
in our consolidated financial statements. We recorded the fees earned for
investment management and other services provided to the trust as fee revenue.
See the caption "Brickyard Loan Trust" in the note to the consolidated financial
statements entitled "Investments in Variable Interest Entities" for further
information on these investments.
Recognition of Insurance Policy Income and Related Benefits and Expenses on
Insurance Contracts
For universal life and investment contracts that do not involve significant
mortality or morbidity risk, the amounts collected from policyholders are
considered deposits and are not included in revenue. Revenues for these
contracts consist of charges for policy administration, cost of insurance
charges and surrender charges assessed against policyholders' account balances.
Such revenues are recognized when the service or coverage is provided, or when
the policy is surrendered.
We establish liabilities for investment and universal life products equal
to the accumulated policy account values, which include an accumulation of
deposit payments plus credited interest, less withdrawals and the amounts
assessed against the policyholder through the end of the period. Sales
inducements provided to the policyholders of these products are recognized as
liabilities over the period that the contract must remain in force to qualify
for the inducement. The options attributed to the policyholder related to our
equity-indexed annuity products are accounted for as embedded derivatives as
described in the section of this note entitled "Accounting for Derivatives".
Traditional life and the majority of our accident and health products
(including long-term care, Medicare supplement and specified disease products)
are long duration insurance contracts. Premiums on these products are recognized
as revenues when due from the policyholders.
We also have a small block of short duration accident and health products.
Premiums on these products are recognized as revenue over the premium paying
period.
We establish liabilities for traditional life, accident and health
insurance, and life contingent payment annuity products using morbidity and
mortality tables in general use in the United States, which are modified to
reflect the Company's actual experience when appropriate. These reserves are
computed at amounts that, with additions from estimated future premiums received
and with interest on such reserves at estimated future rates, are expected to be
sufficient to meet our obligations under the terms of the policy. Liabilities
for future policy benefits are computed on a net-level premium method based upon
assumptions as to investment yields, mortality, morbidity, withdrawals, policy
dividends and maintenance expenses determined when the policies were issued (or
with respect to policies inforce at August 31, 2003, the Company's best estimate
of such assumptions on the fresh-start date). Once established, assumptions on
these products are generally not changed. We make an additional provision to
allow for potential adverse deviation for some of our assumptions.
We establish claim reserves based on our estimate of the loss to be
incurred on reported claims plus estimates of incurred but unreported claims
based on our past experience.
Reinsurance
In the normal course of business, we seek to limit our loss exposure 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. In each case, the
ceding Conseco subsidiary is contingently liable for claims reinsured if the
assuming company is unable to pay. 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 $232.2 million in 2005;
$255.2 million in 2004; $92.1 million in the four months ended December 31,
2003; and $196.4 million in the eight months ended August 31, 2003. We deduct
this cost from insurance policy income. Reinsurance recoveries netted against
insurance policy benefits totaled $231.6 million in 2005; $281.8 million in
2004; $94.3 million in the four months ended December 31, 2003; and $199.2
million in the eight months ended August 31, 2003.
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
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Notes to Consolidated Financial Statements
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premiums assumed totaled $60.1 million in 2005; $70.2 million in 2004; $31.9
million in the four months ended December 31, 2003; and $57.3 million in the
eight months ended August 31, 2003.
See "Accounting for Derivatives" for a discussion of the derivative
embedded in the payable related to certain modified coinsurance agreements.
Income Taxes
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 net operating loss carryforwards
("NOLs"). The net deferred tax assets before valuation allowance totaled $2.5
billion at December 31, 2005. In evaluating 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 sufficient future taxable income during the periods in
which our temporary differences become deductible and before our capital loss
carryforwards and NOLs expire. In addition, the use of the Company's NOLs is
dependent, in part, on whether: (i) the IRS affirms the tentative settlement
agreement related to the allocation of the tax loss on our predecessor's
investment in CFC (the "CFC loss"); and (ii) the IRS does not take an adverse
position in the future regarding the tax position we plan to take in our tax
returns with respect to the allocation of cancellation of indebtedness income.
These matters are further described in the note entitled "Income Taxes".
Based upon information existing at the time of our emergence from
bankruptcy, we established a valuation allowance against our entire balance of
net deferred income tax assets as we believed that the realization of such net
deferred income tax assets in future periods was uncertain. During 2004 and
2005, we concluded that it was no longer necessary to hold certain portions of
the previously established valuation allowance. Accordingly, we reduced our
valuation allowance by $947.0 million in 2004 and $585.8 million in 2005.
However, we are required to continue to hold a valuation allowance of $1,043.8
million because we have determined that it is more likely than not that a
portion of our deferred tax assets will not be realized. This determination was
made by evaluating each component of the deferred tax asset and assessing the
effects of limitations or interpretations on the value of such component to be
fully recognized in the future.
Investment Borrowings
As part of our investment strategy, we may enter into repurchase agreements
and dollar-roll transactions to increase our investment return or to improve our
liquidity. We account for these transactions as collateralized borrowings, where
the amount borrowed is equal to the sales price of the underlying securities.
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 repurchase agreements except that, with dollar rolls, the
repurchase involves securities that are substantially the same as the securities
sold (rather than being the same security). Such borrowings averaged $234.2
million during 2005 and $522.6 million during 2004. These borrowings were
collateralized by investment securities with fair values approximately equal to
the loan value. The weighted average interest rates on such borrowings were 2.9
percent during 2005 and 1.5 percent during 2004. The primary risk associated
with short-term collateralized borrowings is that a counterparty will be unable
to perform under the terms of the contract. Exposure is limited to the excess of
the net replacement cost of the securities over the value of the short-term
investments. During the third quarter of 2005, the market spread on these
transactions declined to a level at which our continued participation in these
transactions was not profitable. As a result, these transactions were
terminated.
At December 31, 2005, investment borrowings also include the securities
issued to other entities by a variable interest entity which is consolidated in
our financial statements. Refer to the note entitled "Investments in Variable
Interest Entities" for further discussion.
Accounting for Derivatives
Our equity-indexed annuity products provide a guaranteed base rate of
return and a higher potential return that is based on a percentage (the
"participation rate") of a particular index, such as the Standard & Poor's 500
Index over an annual period. At the beginning of each policy year, a new index
period begins. We are able to change the participation rate at the beginning of
each index period, subject to contractual minimums. We buy one-year call options
on the applicable indices in an effort to hedge potential increases to
policyholder benefits resulting from increases in the particular index to which
the product's return is linked. We include the cost of the 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 estimated market
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Notes to Consolidated Financial Statements
--------------------------
value of these options in net investment income (classified as investment income
from policyholder and reinsurer accounts). Option costs that are attributable to
benefits provided were $42.0 million during 2005; $44.8 million during 2004;
$19.1 million during the four months ended December 31, 2003; and $53.5 million
during the eight months ended August 31, 2003, and were included in investment
income. Net investment income (loss) related to equity-indexed products before
these option costs were $27.4 million in 2005; $58.5 million in 2004; $61.3
million in the four months ended December 31, 2003; and $83.6 million in the
eight months ended August 31, 2003. These amounts were substantially offset by
the corresponding charge to insurance policy benefits. The estimated fair value
of these options was $44.5 million and $50.4 million at December 31, 2005 and
2004, respectively. We classify these instruments as other invested assets.
The Company accounts for the options attributed to the policyholder for the
estimated life of the annuity contract as embedded derivatives as defined by
Statement of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities", as amended by Statement of Financial
Accounting Standards No. 137, "Deferral of the Effective Date of FASB Statement
No. 133" and Statement of Financial Accounting Standards No. 138, "Accounting
for Certain Derivative Instruments and Certain Hedging Activities" (collectively
referred to as "SFAS 138"). We record the changes in the fair values of the
embedded derivatives in current earnings as a component of policyholder
benefits. The fair value of these derivatives, which are classified as
"liabilities for interest-sensitive products", was $210.7 million and $236.7
million at December 31, 2005 and 2004, respectively. We maintain a specific
block of investments which are equal to the balance of these liabilities in our
trading securities account, which we carry at estimated fair value with changes
in such value recognized as investment income (classified as investment income
from policyholder and reinsurer accounts). The change in value of these trading
securities should largely offset the portion of the change in the value of the
embedded derivative that is caused by interest rate fluctuations.
If the counterparties for the derivatives we hold fail to meet their
obligations, we may have to recognize a loss. We limit our exposure to such a
loss by diversifying among several counterparties believed to be strong and
creditworthy. At December 31, 2005, all of our counterparties were rated "A" or
higher by Standard & Poor's Corporation ("S&P").
The FASB's Derivative Implementation Group issued SFAS No. 133
Implementation Issue No. B36, "Embedded Derivatives: Modified Coinsurance
Arrangements and Debt Instruments that Incorporate Credit Risk Exposures that
are Unrelated or Only Partially Related to the Creditworthiness of the Obligor
of Those Instruments" ("DIG B36") in April 2003. DIG B36 addresses specific
circumstances under which bifurcation of an instrument into a host contract and
an embedded derivative is required. DIG B36 requires the bifurcation of a
derivative from the receivable or payable related to a modified coinsurance
agreement, where the yield on the receivable and payable is based on a return of
a specified block of assets rather than the creditworthiness of the ceding
company. We implemented this guidance on August 31, 2003, in conjunction with
our adoption of fresh start accounting. We have determined that certain of our
reinsurance payable balances contain embedded derivatives. Such derivatives had
an estimated fair value of $17.4 million and $32.1 million at December 31, 2005
and 2004, respectively. We record the change in the fair value of these
derivatives as a component of investment income (classified as investment income
from policyholder and reinsurer accounts). We maintain a specific block of
investments related to these agreements in our trading securities account, which
we carry at estimated fair value with changes in such value recognized as
investment income (also classified as investment income from policyholder and
reinsurer accounts). The change in value of these trading securities should
largely offset the change in value of the embedded derivatives.
Multibucket Annuity Product
The Company's multibucket annuity is a fixed annuity product that credits
interest based on the experience of a particular market strategy. Policyholders
allocate their annuity premium payments to several different market strategies
based on different asset classes within the Company's investment portfolio.
Interest is credited to this product based on the market return of the given
strategy, less management fees, and funds may be moved between different
strategies. The Company guarantees a minimum return of premium plus
approximately 3 percent per annum over the life of the contract. The investments
backing the market strategies of these products are designated by the Company as
trading securities. The change in the fair value of these securities is
recognized currently in investment income (classified as income from
policyholder and reinsurer accounts), which is substantially offset by the
change in insurance policy benefits for these products.