-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, F+mGlckOW3om8PIyc/pQo0A4FicRdsihff3Wfr+njxldGG0TdDPIOr1tqdJtIhLL Yi0bp1sGAo3qQ7w/GDOZnw== 0001224608-04-000040.txt : 20041109 0001224608-04-000040.hdr.sgml : 20041109 20041109152949 ACCESSION NUMBER: 0001224608-04-000040 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 20040930 FILED AS OF DATE: 20041109 DATE AS OF CHANGE: 20041109 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-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-31792 FILM NUMBER: 041129339 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 10-Q 1 conseco10q.txt FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 Form 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the period ended September 30, 2004 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to ------ ------ Commission File Number 001-31792 Conseco, Inc. Delaware 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 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 whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act): Yes [X] No [ ] 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 November 1, 2004: 151,126,610 PART I - FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS. CONSECO, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (Dollars in millions) ASSETS
Successor --------------------------------- September 30, December 31, 2004 2003 ---- ---- (unaudited) Investments: Actively managed fixed maturities at fair value (amortized cost: September 30, 2004 - $20,745.9; December 31, 2003 - $19,470.7)....................... $21,306.3 $19,840.1 Equity securities at fair value (cost: September 30, 2004 - $62.5; December 31, 2003 - $71.8)........................................................... 67.6 74.5 Mortgage loans......................................................................... 1,089.4 1,139.5 Policy loans........................................................................... 465.9 503.4 Trading securities..................................................................... 908.9 915.1 Other invested assets ................................................................. 133.2 324.1 --------- --------- Total investments.................................................................. 23,971.3 22,796.7 Cash and cash equivalents: Unrestricted........................................................................... 1,078.0 1,228.7 Restricted............................................................................. 18.9 31.9 Accrued investment income................................................................. 318.1 315.5 Value of policies in force at the Effective Date.......................................... 2,706.9 2,949.5 Cost of policies produced................................................................. 327.7 101.8 Reinsurance receivables................................................................... 967.6 983.9 Income tax assets......................................................................... 12.2 24.6 Goodwill.................................................................................. 785.3 952.2 Other intangible assets................................................................... 149.4 155.2 Assets held in separate accounts.......................................................... 31.9 37.7 Other assets.............................................................................. 558.9 395.8 --------- --------- Total assets....................................................................... $30,926.2 $29,973.5 ========= =========
(continued on next page) The accompanying notes are an integral part of the consolidated financial statements. 2 CONSECO, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET, continued (Dollars in millions) LIABILITIES AND SHAREHOLDERS' EQUITY
Successor -------------------------------- September 30, December 31, 2004 2003 ---- ---- (unaudited) Liabilities: Liabilities for insurance and asset accumulation products: Interest-sensitive products............................................................ $12,432.5 $12,480.4 Traditional products................................................................... 11,589.5 11,485.2 Claims payable and other policyholder funds............................................ 922.3 892.3 Liabilities related to separate accounts............................................... 31.9 37.7 Other liabilities........................................................................ 847.8 573.0 Investment borrowings.................................................................... 584.8 387.3 Notes payable - direct corporate obligations............................................. 788.6 1,300.0 --------- --------- Total liabilities.................................................................. 27,197.4 27,155.9 --------- --------- Commitments and Contingencies Shareholders' equity: Preferred stock.......................................................................... 667.8 887.5 Common stock ($0.01 par value, 8,000,000,000 shares authorized, shares issued and outstanding: September 30, 2004 - 151,123,275; December 31, 2003 - 100,115,772)........................................................................... 1.5 1.0 Additional paid-in-capital............................................................... 2,535.8 1,641.9 Accumulated other comprehensive income................................................... 302.8 218.7 Retained earnings........................................................................ 220.9 68.5 --------- --------- Total shareholders' equity......................................................... 3,728.8 2,817.6 --------- --------- Total liabilities and shareholders' equity......................................... $30,926.2 $29,973.5 ========= =========
The accompanying notes are an integral part of the consolidated financial statements. 3 CONSECO, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS (Dollars in millions, except per share data) (unaudited)
Successor Predecessor --------------------------------- -------------- Three months One month Two months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Revenues: Insurance policy income.............................................. $ 737.8 $256.2 $ 516.8 Net investment income: General account invested assets.................................... 329.7 106.0 232.5 Policyholder and reinsurer accounts................................ (9.8) (2.1) 11.7 Venture capital income (loss) related to investment in AT&T Wireless Services, Inc...................................... - (2.7) 2.0 Net realized investment gains (losses)............................. 6.0 6.7 (35.9) Fee revenue and other income......................................... 5.2 2.2 9.0 -------- ------ --------- Total revenues................................................... 1,068.9 366.3 736.1 -------- ------ --------- Benefits and expenses: Insurance policy benefits............................................ 688.4 243.3 390.9 Provision for losses................................................. - - 24.5 Interest expense (contractual interest of $73.7 for the two months ended August 31, 2003)...................................... 12.9 7.0 55.4 Amortization......................................................... 91.9 26.9 61.3 Other operating costs and expenses................................... 170.8 51.3 108.0 Reorganization items................................................. - - (2,163.0) -------- ------- --------- Total benefits and expenses...................................... 964.0 328.5 (1,522.9) -------- ------ --------- Income before income taxes....................................... 104.9 37.8 2,259.0 Income tax expense on period income..................................... 37.6 13.6 17.7 -------- ------ --------- Net income....................................................... 67.3 24.2 2,241.3 Preferred stock dividends............................................... 9.4 5.3 - -------- ------ --------- Net income applicable to common stock............................ $ 57.9 $ 18.9 $ 2,241.3 ======== ====== =========
(continued) The accompanying notes are an integral part of the consolidated financial statements. 4 CONSECO, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS, continued (Dollars in millions, except per share data) (unaudited)
Successor --------------------------------- Three months One month ended ended September 30, September 30, 2004 2003 ---- ---- Earnings per common share: Basic: Weighted average shares outstanding........................ 150,885,000 100,098,000 =========== =========== Net income................................................. $.38 $.19 ==== ==== Diluted: Weighted average shares outstanding........................ 189,195,000 144,671,000 =========== =========== Net income................................................. $.36 $.17 ==== ====
(continued) The accompanying notes are an integral part of the consolidated financial statements. 5 CONSECO, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS, continued (Dollars in millions, except per share data) (unaudited)
Successor Predecessor -------------------------------- ------------ Nine months One month Eight months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Revenues: Insurance policy income............................................. $2,223.2 $256.2 $ 2,204.3 Net investment income: General account invested assets................................... 960.1 106.0 928.4 Policyholder and reinsurer accounts............................... (8.9) (2.1) 30.1 Venture capital income (loss) related to investment in AT&T Wireless Services, Inc..................................... - (2.7) 10.5 Net realized investment gains (losses)............................ 27.5 6.7 (5.4) Fee revenue and other income........................................ 17.1 2.2 35.5 -------- ------ --------- Total revenues.................................................. 3,219.0 366.3 3,203.4 -------- ------ --------- Benefits and expenses: Insurance policy benefits........................................... 2,074.6 243.3 2,136.4 Provision for losses................................................ - - 55.6 Interest expense (contractual interest of $268.5 for the eight months ended August 31, 2003)............................................ 65.1 7.0 202.5 Amortization........................................................ 272.4 26.9 343.7 Gain on extinguishment of debt...................................... (2.8) - - Other operating costs and expenses.................................. 485.6 51.3 423.5 Reorganization items................................................ - - (2,130.5) -------- ------ --------- Total benefits and expenses..................................... 2,894.9 328.5 1,031.2 -------- ------ --------- Income before income taxes and discontinued operations.......... 324.1 37.8 2,172.2 Income tax expense (benefit) on period income.......................... 115.7 13.6 (13.5) -------- ------ --------- Income before discontinued operations........................... 208.4 24.2 2,185.7 Discontinued operations, net of income taxes........................... - - 16.0 -------- ------ --------- Net income...................................................... 208.4 24.2 2,201.7 Preferred stock dividends.............................................. 56.0 5.3 - -------- ------ --------- Net income applicable to common stock........................... $ 152.4 $ 18.9 $ 2,201.7 ======== ====== =========
(continued) The accompanying notes are an integral part of the consolidated financial statements. 6 CONSECO, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF OPERATIONS, continued (Dollars in millions, except per share data) (unaudited)
Successor --------------------------------- Nine months One month ended ended September 30, September 30, 2004 2003 ---- ---- Earnings per common share: Basic: Weighted average shares outstanding........................ 126,016,000 100,098,000 =========== =========== Net income................................................. $1.21 $.19 ===== ==== Diluted: Weighted average shares outstanding........................ 145,592,000 144,671,000 =========== =========== Net income................................................. $1.15 $.17 ===== ====
The accompanying notes are an integral part of the consolidated financial statements. 7 CONSECO, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (DEFICIT) (Dollars in millions) (unaudited)
Common stock Accumulated other Retained Preferred and additional comprehensive earnings Total stock paid-in capital income (loss) (deficit) ----- ----- --------------- ------------- ------- Successor balance, January 1, 2004................... $ 2,817.6 $ 887.5 $ 1,642.9 $ 218.7 $ 68.5 Comprehensive income, net of tax: Net income...................................... 208.4 - - - 208.4 Change in unrealized appreciation of investments (net of applicable income tax expense of $46.1)............................. 84.1 - - 84.1 - --------- Total comprehensive income.................. 292.5 Issuance of shares for stock options and for employee benefit plans.................... 12.2 - 12.2 - - 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 - - Payment-in-kind dividends on convertible exchangeable preferred stock.................. 41.4 41.4 - - - Dividends on preferred stock.................... (56.0) - - - (56.0) --------- ------- --------- ------- --------- Successor balance, September 30, 2004................ $ 3,728.8 $ 667.8 $ 2,537.3 $ 302.8 $ 220.9 ========= ======= ========= ======= ========= Predecessor balance, January 1, 2003................. $(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...................................... 24.2 - - - 24.2 Change in unrealized appreciation of investments (net of applicable income tax expense of $154.4)............................ 273.2 - - 273.2 - --------- Total comprehensive income.................. 297.4 Payment-in-kind dividends on convertible exchangeable preferred stock.................. 5.3 5.3 - - - Dividends on preferred stock.................... (5.3) - - - (5.3) --------- ------- --------- ------- --------- Successor balance, September 30, 2003................ $ 2,797.4 $ 865.0 $ 1,640.3 $ 273.2 $ 18.9 ========= ======= ========= ======= =========
The accompanying notes are an integral part of the consolidated financial statements. 8 CONSECO, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (Dollars in millions) (unaudited)
Successor Predecessor ---------------------------------- -------------- Nine months One month Eight months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Cash flows from operating activities: Insurance policy income............................................ $ 1,931.7 $ 223.7 $ 1,876.2 Net investment income.............................................. 1,082.6 103.6 928.6 Fee revenue and other income....................................... 17.1 2.2 35.5 Insurance policy benefits.......................................... (1,523.4) (178.1) (1,461.2) Interest expense................................................... (60.4) - - Policy acquisition costs........................................... (267.1) (25.6) (287.5) Reorganization items............................................... - - (26.5) Other operating costs.............................................. (418.8) (73.6) (362.0) Taxes.............................................................. 11.7 .3 44.2 ---------- --------- --------- Net cash provided by operating activities........................ 773.4 52.5 747.3 ---------- --------- --------- Cash flows from investing activities: Sales of investments............................................... 9,947.7 2,121.9 5,378.9 Maturities and redemptions of investments.......................... 1,450.0 288.7 1,854.7 Purchases of investments........................................... (12,396.4) (1,225.6) (7,385.9) Consolidation of partnership which held General Motors building.... - 28.4 - Change in restricted cash.......................................... 13.0 (17.0) 26.2 Other.............................................................. (35.5) 4.3 (19.6) ---------- --------- --------- Net cash provided (used) by investing activities ................ (1,021.2) 1,200.7 (145.7) ---------- --------- --------- Cash flows from financing activities: Issuance of notes payable, net..................................... 790.2 - - Issuance of preferred stock, net................................... 667.8 - - Issuance of common stock, net...................................... 882.3 - - Payments on notes payable.......................................... (1,302.0) - - Redemption of preferred stock...................................... (928.9) - - Amounts received for deposit products.............................. 1,203.3 121.8 1,272.7 Withdrawals from deposit products.................................. (1,399.7) (133.1) (1,784.2) Investment borrowings.............................................. 197.5 (700.0) (145.3) Dividends paid on preferred stock.................................. (9.8) - - Other.............................................................. (3.6) - - ---------- --------- --------- Net cash provided (used) by financing activities............... 97.1 (711.3) (656.8) ---------- --------- --------- Net increase (decrease) in cash and cash equivalents........... (150.7) 541.9 (55.2) Cash and cash equivalents, beginning of period........................ 1,228.7 1,162.4 1,217.6 ---------- --------- --------- Cash and cash equivalents, end of period.............................. $ 1,078.0 $ 1,704.3 $ 1,162.4 ========== ========= =========
The accompanying notes are an integral part of the consolidated financial statements. 9 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- The following notes should be read together with the notes to the consolidated financial statements included in the 2003 Form 10-K of Conseco, Inc. 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"), 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. OUR RECENT EMERGENCE FROM BANKRUPTCY We emerged from bankruptcy protection under the Sixth Amended Joint Plan of Reorganization (the "Plan"), which was confirmed pursuant to an order of the United States Bankruptcy Court for the Northern District of Illinois, Eastern Division (the "Bankruptcy Court") on September 9, 2003 (the "Confirmation Date"), 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 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 giving effect to the implementation 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. BASIS OF PRESENTATION Upon our emergence from bankruptcy, we implemented fresh start reporting 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 the Plan, and record any portion of the reorganization value which cannot be attributed to specific tangible or identified intangible assets as goodwill. As a result, the Company's financial statements for periods following August 31, 2003, will not be comparable with those of Old Conseco prepared before that date. Pursuant to SOP 90-7, professional fees associated with the Chapter 11 cases are expensed as incurred and reported as reorganization items. Interest expense is reported only to the extent that it was paid during the Chapter 11 cases. The Company recognized expenses associated with the Chapter 11 cases for fees payable to professionals to assist with the Chapter 11 cases totaling $70.9 million in the eight months ended August 31, 2003. Our unaudited consolidated financial statements reflect normal recurring adjustments that are necessary to present fairly our financial position and results of operations on a basis consistent with that of our prior audited consolidated financial statements. As permitted by rules and regulations of the Securities and Exchange Commission applicable to quarterly reports on Form 10-Q, we have condensed or omitted certain information and disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles ("GAAP"). We have also reclassified certain amounts from the prior periods to conform to the 2004 presentation. These reclassifications have no effect on net income or shareholders' equity. Results for interim periods are not necessarily indicative of the results that may be expected for a full year. The balance sheet at December 31, 2003, presented herein, has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by accounting principles generally accepted in the United States for complete financial statements. When we prepare financial statements in conformity with GAAP, we are required to make estimates and assumptions that significantly affect various reported amounts of 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 in calculating values for the cost of policies produced, the cost of policies purchased, 10 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- the value of policies in force at the Effective Date, certain investments, assets and liabilities related to income taxes, goodwill, liabilities for insurance and asset accumulation products, liabilities related to litigation, guaranty fund assessment accruals and amounts recoverable from loans to certain former directors and employees. If our future experience differs from these estimates and assumptions, our financial statements would be materially affected. Our consolidated financial statements exclude the results of material transactions between us and our consolidated affiliates, or among our consolidated affiliates. FRESH START REPORTING Upon the confirmation of the Plan on September 9, 2003, we implemented fresh start reporting in accordance with SOP 90-7. However, in light of the proximity of this date to the August month end, for accounting convenience purposes, we have reported the effects of fresh start accounting as if they occurred on 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. Under fresh start reporting, a new reporting entity is 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 any portion of the reorganization value which could not be attributed to 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. 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 consist of the following (dollars in millions):
Two months Eight months ended ended August 31, 2003 August 31, 2003 --------------- --------------- Gain on discharge of prepetition liabilities......... $ 3,151.4 $ 3,151.4 Fresh start adjustments.............................. (950.0) (950.0) Professional fees.................................... (38.4) (70.9) --------- --------- Total reorganization items....................... $ 2,163.0 $ 2,130.5 ========= =========
GOODWILL Upon our emergence from bankruptcy, 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 the $1,141.6 million of the reorganization value which could not be attributed to specific tangible or identified intangible assets as goodwill. Under current accounting rules (which became effective January 1, 2002) goodwill is not amortized but is subject to an annual impairment test (or more frequent under certain circumstances). We obtained an independent appraisal of our business in connection with the preparation of the Plan and our implementation of fresh start accounting. 11 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- Although the goodwill balance will not be subject to amortization, it will be reduced by future use of the Company's net deferred income tax assets (including the tax operating loss carryforwards) existing at August 31, 2003 (such balance was reduced by $166.9 million and $189.4 million in the nine months ended September 30, 2004 and the four months ended December 31, 2003, respectively). A valuation allowance has been provided for the remaining balance of such net deferred income tax assets due to the uncertainties regarding their realization. See the note entitled "Income Taxes" for further discussion. Changes in the carrying amount of goodwill are as follows (dollars in millions):
Successor ----------- Nine months ended September 30, 2004 ---- Goodwill balance, beginning of period.................................. $ 952.2 Recognition of tax valuation reserve established at the Effective Date.................................................... (166.9) ------- Goodwill balance, end of period........................................ $ 785.3 =======
ACCOUNTING FOR INVESTMENTS We classify our fixed maturity securities into 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); and (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. At August 31, 2003, we established trading security accounts which are designed to act as a hedge for embedded derivatives related to: (i) our equity-indexed annuity products; and (ii) certain modified coinsurance agreements. See the note entitled "Accounting for Derivatives" for further discussion regarding the embedded derivatives and the trading accounts. In addition, the trading account includes the investments backing the market strategies of our multibucket annuity products. The change in market value of these securities is substantially offset by the change in insurance policy benefits for these products. All of our trading securities totaled $908.9 million at September 30, 2004. The change in the market value of these securities is recognized currently in investment income (classified as income from policyholder and reinsurer accounts). 12 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- Accumulated other comprehensive income is primarily comprised of unrealized appreciation on actively managed fixed maturity investments. These amounts, included in shareholders' equity as of September 30, 2004, and December 31, 2003, were as follows (dollars in millions):
Successor ------------------------------ September 30, December 31, 2004 2003 ---- ---- Net unrealized appreciation on investments............................................ $ 568.1 $ 375.2 Adjustments to value of policies inforce at the Effective Date........................ (89.0) (33.5) Adjustment to cost of policies produced............................................... (7.2) - Deferred income tax liability......................................................... (169.1) (123.0) ------- ------- Accumulated other comprehensive income........................................... $ 302.8 $ 218.7 ======= =======
VENTURE CAPITAL INVESTMENT IN AT&T WIRELESS SERVICES, INC. Prior to its sale in December 2003, our 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). We recognized venture capital investment income (losses) of $(2.7) million in the one month ended September 30, 2003; $2.0 million in the two months ended August 31, 2003; and $10.5 million in the eight months ended August 31, 2003, related to this investment. AMORTIZATION OF THE VALUE OF POLICIES INFORCE AT THE EFFECTIVE DATE 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 as of the Effective Date. The cost assigned to the right to receive future cash flows from contracts existing at August 31, 2003 is referred to as the value of policies inforce as of the Effective Date. We also defer renewal commissions paid in excess of ultimate commission levels related to the existing policies in this account. 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-type and investment-type products; or (ii) in relation to future anticipated premium revenue for other products. Our future estimated gross profits used to determine the value of policies inforce at the Effective Date and the amortization of these costs, reflect assumptions that current expense levels that exceed product pricing, will decline over time. If we are unable to achieve such cost savings, the profitability of the policies inforce at the Effective Date will be adversely affected. 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 of the event 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 (loss) within shareholders' equity. The Company expects to amortize approximately 10 percent of the December 31, 2003 balance of the value of policies inforce at the Effective Date in 2004, 10 percent in 2005, 9 percent in 2006, 8 percent in 2007 and 8 percent in 2008. In accordance with Statement of Financial Accounting Standards No. 97 "Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts and Realized Gains and Losses from the Sale of Investments" ("SFAS 97"), we are required to amortize the value of policies inforce in relation to estimated gross profits for universal life-type products and investment-type products. SFAS 97 also requires that estimates of expected gross profits used as a basis for amortization be evaluated regularly, and that the total amortization recorded to date be adjusted by a charge or credit to the statement of operations, if actual experience or other evidence suggests that earlier estimates should be revised. 13 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- During the second quarter of 2004, we evaluated certain amortization assumptions used to estimate gross profits for universal life-type 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 retroactive reduction to the amortization of the value of policies inforce at the Effective Date of $7.7 million in the second quarter of 2004. EARNINGS PER SHARE A reconciliation of net income and shares used to calculate basic and diluted earnings per share is as follows:
Successor ---------------------------------------------------- Three months Nine months One month ended ended ended September 30, September 30, September 30, 2004 2004 2003 ---- ---- ---- (Dollars in millions and shares in thousands) Net income................................................. $67.3 $208.4 $24.2 Preferred stock dividends.................................. (9.4) (56.0) (5.3) ----- ------ ------ Net income applicable to common stock for basic earnings per share.......................... 57.9 152.4 18.9 Effect of dilutive securities: Preferred stock dividends............................... 9.4 14.7 5.3 ----- ------ ----- Net income applicable to common stock for diluted earnings per share.................................... $67.3 $167.1 $24.2 ===== ====== ===== Shares: Weighted average shares outstanding for basic earnings per share.......................... 150,885 126,016 100,098 Effect of dilutive securities on weighted average shares: Class B mandatorily convertible preferred stock....... 37,809 19,054 - Class A convertible exchangeable preferred stock...... - - 44,566 Stock options and employee benefit plans.............. 501 522 7 ------- ------- ------- Weighted average shares outstanding for diluted earnings per share.................................... 189,195 145,592 144,671 ======= ======= =======
For the nine months ended September 30, 2004, equivalent common shares of 26.5 million related to the assumed conversion of Class A convertible exchangeable preferred stock were not included in the computation of diluted earnings per share because doing so would have been antidilutive. Basic earnings per common share is computed by dividing income applicable to common stock by the weighted average number of common shares outstanding for the period. Restricted shares are not included in basic earnings per share until vested. Diluted earnings per share reflects the potential dilution that could occur if outstanding stock options were exercised and restricted stock was vested. The dilution from stock options and restricted shares are calculated using the treasury stock method. Under this method we assume the proceeds from the exercise of the options (or the unrecognized 14 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- compensation expense with respect to restricted stock) will be used to purchase shares of our common stock at the average market price during the period, reducing the dilutive effect of the exercise of the options (or the vesting of the restricted stock). ACCOUNTING FOR STOCK OPTIONS In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148, "Accounting for Stock-Based Compensation - Transition and Disclosure", an Amendment of FASB Statement No. 123 ("SFAS 148"), which provides three alternative methods of transition to the fair value method of accounting for stock options. SFAS 148 also amends the disclosure requirements of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation" ("SFAS 123"). We apply Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" and related interpretations in accounting for our stock option plans. Had compensation cost been determined based on the fair value at the grant dates for awards granted after January 1, 1995, consistent with the method of SFAS 123, the Company's pro forma net income (loss) and pro forma earnings per share would have been as follows (dollars in millions, except per share amounts):
Successor Predecessor ---------------------------------- ------------ Three months One month Two months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Net income, as reported ............................................. $67.3 $24.2 $2,241.3 Less stock-based employee compensation ..expense determined under the fair value based method for all awards, net of income taxes............................. (2.1) - 2.0 ----- ----- -------- Pro forma net income................................................. $65.2 $24.2 $2,243.3 ===== ===== ======== Earnings per share: Basic, as reported.............................................. $ .38 $ .19 Basic, pro forma................................................ .37 .19 Diluted, as reported............................................ $ .36 $ .17 Diluted, pro forma.............................................. .34 .17
15 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements -------------------
Successor Predecessor --------------------------------- ------------ Nine months One month Eight months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Net income, as reported ............................................. $208.4 $24.2 $2,201.7 Less stock-based employee compensation ..expense determined under the fair value based method for all awards, net of income taxes............................. (3.2) - (7.2) ------ ----- -------- Pro forma net income................................................. $205.2 $24.2 $2,194.5 ====== ===== ======== Earnings per share: Basic, as reported.............................................. $ 1.21 $.19 Basic, pro forma................................................ 1.18 .19 Diluted, as reported............................................ $ 1.15 $.17 Diluted, pro forma.............................................. 1.13 .17
All outstanding stock options of the Predecessor were cancelled pursuant to the Plan. Pro forma compensation expense in the two and eight months ended August 31, 2003, has been reduced by $5.0 million due to the reversal of expense for options that were not vested upon cancellation of the outstanding stock options of the Predecessor. BUSINESS SEGMENTS After our emergence from bankruptcy, we began to manage our business operations through two primary operating segments, based on method of product distribution, and a third segment comprised of business in run-off. We refer to these segments as: (i) Bankers Life; (ii) Conseco Insurance Group; and (iii) Other Business in Run-Off. We also have a corporate segment, which consists of holding company activities and certain noninsurance company businesses that are not related to our other operating segments. Prior period segment data has been reclassified to conform to the current period presentation. 16 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- Operating information regarding our segments was as follows (dollars in millions):
Successor Predecessor --------------------------------- ------------- Three months One month Two months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Revenues: Bankers Life: Insurance policy income: Annuities.............................................. $ 13.4 $ 5.0 $ 9.2 Supplemental health.................................... 295.1 95.5 191.2 Life................................................... 42.7 10.2 24.6 Other.................................................. 4.1 1.0 2.0 Net investment income (a)................................... 105.1 31.0 68.6 Fee revenue and other income (a)............................ .1 .4 .2 Net realized investment gains (a)........................... 2.5 2.8 1.7 --------- ------ ------ Total Bankers Life segment revenues................ 463.0 145.9 297.5 --------- ------ ------ Conseco Insurance Group: Insurance policy income: Annuities.............................................. 6.1 2.3 6.8 Supplemental health.................................... 178.7 62.4 123.2 Life................................................... 96.0 33.4 70.2 Other.................................................. 3.4 4.8 6.5 Net investment income (a)................................... 172.1 59.3 145.7 Fee revenue and other income (a)............................ 1.0 - 4.9 Net realized investment gains (losses) (a).................. 2.5 3.7 (36.9) --------- ------ ------ Total Conseco Insurance Group segment revenues............................... 459.8 165.9 320.4 --------- ------ ------ Other Business in Run-Off: Insurance policy income - supplemental health............... 98.3 41.6 83.1 Net investment income (a)................................... 41.8 13.5 26.7 Fee revenue and other income (a)............................ .1 .3 .1 Net realized investment gains (a)........................... 1.0 .6 .9 --------- ------ ------ Total Other Business in Run-Off segment revenues............................... 141.2 56.0 110.8 --------- ------ ------ Corporate: Net investment income (a)................................... .9 .1 3.2 Venture capital income (loss) related to investment in AWE................................................... - (2.7) 2.0 Fee and other income (a).................................... 4.0 1.5 3.8 Net realized investment gains (losses) (a).................. - (.4) (1.6) --------- ------ ------ Total corporate segment revenues................... 4.9 (1.5) 7.4 --------- ------ ------ Total revenues..................................... 1,068.9 366.3 736.1 --------- ------ ------
(continued on next page) 17 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- (continued from previous page)
Successor Predecessor ------------------------------------ -------------- Three months One month Two months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Expenses: Bankers Life: Insurance policy benefits...................................... $318.1 $ 94.5 $ 205.3 Amortization................................................... 48.8 15.5 29.1 Interest expense on investment borrowings...................... .6 .2 .6 Other operating costs and expenses............................. 41.3 10.8 19.5 ------ ------ --------- Total Bankers Life segment expenses....................... 408.8 121.0 254.5 ------ ------ --------- Conseco Insurance Group: Insurance policy benefits...................................... 274.0 105.8 4.5 Amortization................................................... 39.0 9.9 24.1 Interest expense on investment borrowings...................... 1.3 .4 1.3 Other operating costs and expenses............................. 77.5 29.0 59.7 ------ ------ --------- Total Conseco Insurance Group segment expenses................................................ 391.8 145.1 89.6 ------ ------ --------- Other Business in Run-Off: Insurance policy benefits...................................... 96.3 43.0 181.1 Amortization................................................... 4.1 1.5 8.1 Interest expense on investment borrowings...................... - - - Other operating costs and expenses............................. 23.3 8.1 21.1 ------ ------ --------- Total Other Business in Run-Off segment expenses............................................... 123.7 52.6 210.3 ------ ------ --------- Corporate: Interest expense on corporate debt............................. 11.0 6.4 53.5 Provision for losses and interest expense related to stock purchase plan...................................... - - 24.5 Gain on extinguishment of debt................................. - - - Other operating costs and expenses............................. 28.7 3.4 7.7 Reorganization items........................................... - - (2,163.0) ------ ------ --------- Total corporate segment expenses.......................... 39.7 9.8 (2,077.3) ------ ------ --------- Total expenses............................................ 964.0 328.5 (1,522.9) ------ ------ --------- Income (loss) before income taxes and discontinued operations: Bankers Life................................................... 54.2 24.9 43.0 Conseco Insurance Group........................................ 68.0 20.8 230.8 Other Business in Run-Off...................................... 17.5 3.4 (99.5) Corporate operations........................................... (34.8) (11.3) 2,084.7 ------ ------ --------- Income before income taxes and discontinued operations................................. $104.9 $ 37.8 $ 2,259.0 ====== ====== ========= - ------------------- (a) It is not practicable to provide additional components of revenue by product or services.
18 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements -------------------
Successor Predecessor --------------------------------- ------------ Nine months One month Eight months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Revenues: Bankers Life: Insurance policy income: Annuities.............................................. $ 39.2 $ 5.0 $ 32.9 Supplemental health.................................... 881.4 95.5 760.4 Life................................................... 116.7 10.2 91.5 Other.................................................. 9.7 1.0 7.9 Net investment income (a)................................... 307.7 31.0 258.2 Fee revenue and other income (a)............................ .6 .4 .9 Net realized investment gains (a)........................... 13.9 2.8 5.5 -------- ------ -------- Total Bankers Life segment revenues................ 1,369.2 145.9 1,157.3 -------- ------ -------- Conseco Insurance Group: Insurance policy income: Annuities.............................................. 17.1 2.3 51.6 Supplemental health.................................... 550.4 62.4 499.0 Life................................................... 294.3 33.4 303.9 Other.................................................. 12.1 4.8 38.3 Net investment income (a)................................... 519.1 59.3 582.6 Fee revenue and other income (a)............................ 4.3 - 17.0 Net realized investment gains (losses) (a).................. 13.6 3.7 (17.1) -------- ------ -------- Total Conseco Insurance Group segment revenues............................... 1,410.9 165.9 1,475.3 -------- ------ -------- Other Business in Run-Off: Insurance policy income - supplemental health............... 302.3 41.6 418.8 Net investment income (a)................................... 123.0 13.5 101.5 Fee revenue and other income (a)............................ .6 .3 .5 Net realized investment gains (a)........................... 2.8 .6 6.3 -------- ------ -------- Total Other Business in Run-Off segment revenues............................... 428.7 56.0 527.1 -------- ------ -------- Corporate: Net investment income (a)................................... 1.4 .1 16.2 Venture capital income (loss) related to investment in AWE................................................... - (2.7) 10.5 Fee and other income (a).................................... 11.6 1.5 17.1 Net realized investment losses (a).......................... (2.8) (.4) (.1) -------- ------ -------- Total corporate segment revenues................... 10.2 (1.5) 43.7 -------- ------ -------- Total revenues..................................... 3,219.0 366.3 3,203.4 -------- ------ --------
(continued on next page) 19 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- (continued from previous page)
Successor Predecessor ---------------------------------- -------------- Nine months One month Eight months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Expenses: Bankers Life: Insurance policy benefits..................................... $ 932.8 $ 94.5 $ 795.1 Amortization.................................................. 138.1 15.5 113.9 Interest expense on investment borrowings..................... 1.7 .2 3.4 Other operating costs and expenses............................ 120.9 10.8 85.3 -------- ------ --------- Total Bankers Life segment expenses...................... 1,193.5 121.0 997.7 -------- ------ --------- Conseco Insurance Group: Insurance policy benefits..................................... 848.3 105.8 746.3 Amortization.................................................. 120.7 9.9 201.8 Interest expense on investment borrowings..................... 3.4 .4 4.7 Other operating costs and expenses............................ 235.7 29.0 222.6 -------- ------ --------- Total Conseco Insurance Group segment expenses............................................... 1,208.1 145.1 1,175.4 -------- ------ --------- Other Business in Run-Off: Insurance policy benefits..................................... 293.5 43.0 595.0 Amortization.................................................. 13.6 1.5 28.0 Interest expense on investment borrowings..................... .1 - .2 Other operating costs and expenses............................ 71.7 8.1 75.2 -------- ------ --------- Total Other Business in Run-Off segment expenses.............................................. 378.9 52.6 698.4 -------- ------ --------- Corporate: Interest expense on corporate debt............................ 59.9 6.4 194.2 Provision for losses and interest expense related to stock purchase plan..................................... - - 55.6 Gain on extinguishment of debt................................ (2.8) - - Other operating costs and expenses............................ 57.3 3.4 40.4 Reorganization items.......................................... - - (2,130.5) -------- ------ --------- Total corporate segment expenses......................... 114.4 9.8 (1,840.3) -------- ------ --------- Total expenses........................................... 2,894.9 328.5 1,031.2 -------- ------ --------- Income (loss) before income taxes and discontinued operations: Bankers Life.................................................. 175.7 24.9 159.6 Conseco Insurance Group....................................... 202.8 20.8 299.9 Other Business in Run-Off..................................... 49.8 3.4 (171.3) Corporate operations.......................................... (104.2) (11.3) 1,884.0 -------- ------ --------- Income before income taxes and discontinued operations................................ $ 324.1 $ 37.8 $ 2,172.2 ======== ====== ========= - ------------------- (a) It is not practicable to provide additional components of revenue by product or services.
20 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- ACCOUNTING FOR DERIVATIVES Our equity-indexed annuity products provide a guaranteed base rate of return and a higher potential return linked to the performance of the Standard & Poor's 500 Index ("S&P 500 Index") based on a percentage (the "participation rate") 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 S&P 500 Call Options in an effort to hedge potential increases to policyholder benefits resulting from increases in the S&P 500 Index to which the product's return is linked. We include the cost of the S&P 500 Call Options in the pricing of these products. Policyholder account balances for these annuities fluctuate in relation to changes in the values of these options. We reflect changes in the estimated market value of these options in net investment income (classified as investment income from policyholder accounts). Option costs that are attributable to benefits provided were $33.8 million in the first nine months of 2004; $5.2 million in the one month ended September 30, 2003; and $53.5 million in the eight months ended August 31, 2003. These costs are reflected in the change in market value of the S&P 500 Call Options included in investment income. Net investment income (loss) related to equity-indexed products before this expense was $20.3 million in the first nine months of 2004; $(3.1) million in the one month ended September 30, 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 the S&P 500 Call Options was $28.4 million and $119.6 million at September 30, 2004 and December 31, 2003, 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 $204.7 million and $214.7 million at September 30, 2004 and December 31, 2003, respectively. We have transferred a specified block of investments which are equal to the balance of these liabilities to 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 accounts). The change in value of these trading securities should largely offset the portion of the change in the value of the embedded derivative which 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 September 30, 2004, all of the 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 $31.4 million and $27.2 million at September 30, 2004 and December 31, 2003, respectively. We record the change in the fair value of these derivatives as a component of investment income (classified as investment income from reinsurer accounts). 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 investment income (also classified as investment income from reinsurer accounts). The change in value of these trading securities should largely offset the change in value of the embedded derivatives. GUARANTEES 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 $250 million. The former bank loans and the 21 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- 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 have taken to collect the D&O loans. At September 30, 2004, we have estimated that approximately $50.0 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 $23.0 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. In accordance with the terms of two of the Company's former Chief Executive Officer's employment agreements, certain wholly-owned subsidiaries of the Company are the guarantors of the former executives' nonqualified supplemental retirement benefits. The liability for such benefits at September 30, 2004 and December 31, 2003 was $21.8 million and $18.1 million, respectively, and is included in the caption "Other liabilities" in the liability section of the consolidated balance sheet. REINSURANCE The cost of reinsurance ceded totaled $197.3 million in the first nine months of 2004; $25.0 million in the one month ended September 30, 2003; and $196.4 million in the eight months ended August 31, 2003. We deducted this cost from insurance policy income. In each case, the ceding Conseco subsidiary is contingently liable for claims reinsured if the assuming company is unable to pay. Reinsurance recoveries netted against insurance policy benefits totaled $225.8 million in the first nine months of 2004; $24.9 million in the one month ended September 30, 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. Reinsurance premiums assumed totaled $53.1 million in the first nine months of 2004; $10.6 million in the one month ended September 30, 2003; and $57.3 million in the eight months ended August 31, 2003. See the note entitled "Accounting for Derivatives" for a discussion of the derivative embedded in the payable related to certain modified coinsurance agreements. INCOME TAXES The components of income tax expense (benefit) are as follows (dollars in millions):
Successor Predecessor --------------------------------- ----------- Three months One month Two months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Current tax provision (benefit).................................. $(2.2) $ .6 $17.7 Deferred tax provision........................................... 39.8 13.0 - ----- ----- ----- Income tax expense on period income........................... $37.6 $13.6 $17.7 ===== ===== =====
22 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements -------------------
Successor Predecessor --------------------------------- ------------ Nine months One month Eight months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Current tax provision (benefit).................................. $ .8 $ .6 $(13.5) Deferred tax provision........................................... 114.9 13.0 - ------ ----- ------ Income tax expense (benefit) on period income................. $115.7 $13.6 $(13.5) ====== ===== ======
A reconciliation of the U.S. statutory corporate tax rate to the effective rate reflected in the consolidated statement of operations is as follows:
Successor Predecessor --------------------------------- ------------ Nine months One month Eight months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- U.S. statutory corporate rate......................................... 35.0% 35.0% 35.0% Valuation allowance................................................... - - 25.8 Gain on debt restructuring............................................ - - (39.7) Subsidiary stock basis adjustment..................................... - - (21.8) Other nondeductible expenses.......................................... .6 .1 (.1) State taxes........................................................... .1 .9 .2 ---- ---- ----- Effective tax rate........................................... 35.7% 36.0% (.6)% ==== ==== =====
23 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- The components of the Company's income tax assets and liabilities were as follows (dollars in millions):
Successor -------------------------------- September 30, December 31, 2004 2003 ---- ---- Deferred tax assets: Net operating loss carryforwards: Portion attributable to worthless investment in Conseco Finance Corp........... $ 1,545.6 $ 1,183.0 Other.......................................................................... 177.0 84.2 Capital loss carryforwards........................................................ 396.8 411.2 Deductible temporary differences: Insurance liabilities.......................................................... 1,677.0 1,688.0 Reserve for loss on loan guarantees............................................ 207.3 217.2 --------- --------- Gross deferred tax assets.................................................... 4,003.7 3,583.6 --------- --------- Deferred tax liabilities: Actively managed fixed maturities.............................................. (79.6) (80.9) Cost of policies purchased and cost of policies produced....................... (738.8) (716.3) Unrealized appreciation of investments......................................... (169.1) (123.0) Other.......................................................................... (328.3) (301.3) --------- --------- Gross deferred tax liabilities............................................... (1,315.8) (1,221.5) --------- --------- Valuation allowance............................................................ (2,687.9) (2,362.1) --------- --------- Net deferred tax assets...................................................... - - Current income taxes prepaid.......................................................... 12.2 24.6 --------- --------- Net income tax assets................................................................. $ 12.2 $ 24.6 ========= =========
Conseco and its affiliates are currently under examination by the Internal Revenue Service (the "IRS") for tax years ending December 31, 1999 through December 31, 2001. At the request of the Company, the IRS has commenced its examination of the Company for years ending December 31, 2002 through 2003. The outcome of these examinations is not expected to result in material adverse deficiencies, but may result in utilization or adjustment to the income tax loss carryforwards reported below, and is expected to resolve the Section 382 limitation and the life insurance limitation issues more fully discussed later. 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. The net deferred tax assets totaled $2.7 billion at September 30, 2004. In assessing the realization of 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 capital loss carryforwards and net operating loss carryforwards expire. In addition, the use of the Company's net ordinary loss carryforwards is dependent, in part, on whether the IRS ultimately agrees with the tax position we plan to take in our current and future tax returns. We evaluate the realizability of our deferred income tax assets by assessing 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 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. As of September 30, 2004, we continue to believe that the realization of our net deferred income tax asset is uncertain and that a valuation allowance is required for our entire balance of net deferred income tax assets. We reached this conclusion after considering the losses realized by the Company in recent years, the uncertainties related to the tax treatment for the 24 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- worthlessness of our investment in Conseco Finance Corp. ("CFC"), (which is more fully discussed below), and the likelihood of future taxable income and capital gains exclusive of reversing temporary differences and carryforwards. The reduction of any portion of our deferred income tax valuation allowance (including the capital loss carryforwards and net operating loss carryforwards) existing as of August 31, 2003, will be accounted for as a reduction of goodwill when utilized pursuant to SOP 90-7. If goodwill is eliminated, any additional reduction of the valuation allowance existing at August 31, 2003 will be accounted for as a reduction of other intangible assets until exhausted and thereafter as an addition to paid-in-capital. Changes in our valuation allowance are summarized as follows (dollars in millions): Balance at December 31, 2003............................................. $2,362.1 Realization of deferred income taxes recognized in the current period(a)............................................ (114.9) Release of tax valuation reserve related to unrealized gains during the period(a).......................................... (46.1) Recovery of amounts related to our bankruptcy and state taxes(a)...................................................... (5.9) Increase in deferred tax assets related to the worthlessness of CFC as further discussed below................................... 500.1 Other.................................................................. (7.4) -------- Balance at September 30, 2004............................................ $2,687.9 ======== - -------------- (a) Goodwill has a corresponding reduction for these items.
As of September 30, 2004, we had $4.9 billion of net operating loss carryforwards and $1.1 billion of capital loss carryforwards (after taking into account the reduction in tax attributes described in the paragraph which follows and the loss resulting from the worthlessness of CFC discussed below), which expire as follows (dollars in millions):
Operating loss carryforwards Capital loss carryforwards ------------------------------------------- ----------------------------------------- Year of expiration Subject to ss.382 Not subject to ss.382 Subject to ss.382 Not subject to ss.382 ------------------ ----------------- --------------------- ----------------- --------------------- 2005........................... $ .2 $ - $ 2.7 $ - 2006........................... .1 - 5.5 - 2007........................... 5.8 - 484.4 - 2008 .......................... 1.5 - 583.7 - 2009........................... 10.5 - - 57.4 2010........................... 3.6 - - - 2011........................... .5 - - - 2016........................... 20.9 - - - 2017........................... 51.3 - - - 2018........................... 57.8 4,452.4 - - 2019........................... .7 - - - 2020........................... .7 - - - 2023........................... 292.4 - - - 2024........................... - 23.1 - - ------ -------- -------- ----- Total.......................... $446.0 $4,475.5 $1,076.3 $57.4 ====== ======== ======== =====
The timing and manner in which we will utilize the net operating loss carryforwards and capital loss carryforwards in any year or in total may be limited by various provisions of the Internal Revenue Code (the "Code") (and interpretation thereof) and our ability to generate sufficient future taxable income in the relevant carryforward period. 25 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- The Code provides that any income realized as a result of the cancellation of indebtedness (cancellation of debt income or "CODI") in bankruptcy, will reduce certain tax attributes including net operating loss carryforwards. We realized an estimated $2.5 billion of CODI when we emerged from bankruptcy. Accordingly, our net operating loss carryforwards were reduced by $2.5 billion as of December 31, 2003. At the fresh-start date, we were required to estimate our tax basis in CFC in order to determine the tax loss carryforward related to the worthlessness of CFC. The determination of this amount and how the loss is recognized was subject to varied interpretations of various tax laws and regulations. During the third quarter of 2004, the Company and the IRS entered into a closing agreement which determined that the tax loss recognized on the worthlessness of CFC was $6.7 billion, instead of our original estimate of $5.4 billion. This determination resulted in $500.1 million of additional deferred tax assets being recognized. We also recognized a $500.1 million valuation allowance, as we have deemed it more likely than not that the deferred tax assets will not be realized. As this increase relates to the period prior to our emergence from bankruptcy, a reduction of any portion of the deferred income tax valuation allowance will be accounted for as a reduction of goodwill pursuant to SOP 90-7. The closing agreement with the IRS also determined that the loss recognized on the worthlessness of CFC is an ordinary loss for tax purposes and not a capital loss. The following paragraphs summarize some of the unresolved limitations and contingencies which exist with respect to the future utilization of the net operating loss carryforwards. 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. There is no limitation with respect to the ability to utilize net operating losses generated by a life insurance company. Subsequent to our emergence from bankruptcy, we reorganized certain of our subsidiaries to improve their capital position. As a result of the reorganization, the loss related to CFC was realized by a life insurance company. Accordingly, we believe the loss should be treated as a life insurance loss and would not be subject to the limitations described above. However, if the IRS were to disagree with our conclusion and such determination ultimately prevailed, the loss related to CFC would be subject to the limitation described in the first sentence of this paragraph. The IRS has informed the Company that it will address this matter during its examination of our tax returns for calendar years 2002-2003. The timing and manner in which the Company will be able to utilize some or all of its net operating loss carryforward may be limited by Section 382 of the Code. Section 382 imposes limitations on a corporation's ability to use its net operating losses if the company undergoes an ownership change. Because the Company underwent an ownership change pursuant to its reorganization, we have determined that this limitation applies to the Company. In order to determine the amount of this limitation we must determine how much of our net operating loss carryforward relates to the period prior to our emergence from bankruptcy (such amount will be subject to the 382 limitation) and how much relates to the period after emergence (such amount will not be subject to the 382 limitation). When the Company filed its 2003 federal income tax return, it elected to specifically identify transactions in each period and record it in the period it actually occurred. We believe this election will result in the loss related to CFC being treated as post emergence and therefore not subject to the Section 382 limitation. 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. The IRS has informed the Company that it will address this matter during its examination of our tax returns for calendar years 2002-2003. 26 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- CHANGES IN DIRECT CORPORATE OBLIGATIONS Notes payable representing direct corporate obligations of the Company at September 30, 2004 and December 31, 2003, were as follows (dollars in millions):
Successor ------------------------------- September 30, December 31, 2004 2003 ---- ---- $800.0 million secured credit agreement ("Credit Facility")............................. $798.0 $ - $1.3 billion credit agreement ("Previous Credit Facility").............................. - 1,300.0 Unamortized issuance costs.............................................................. (9.4) - ------ -------- Direct corporate obligations....................................................... $788.6 $1,300.0 ====== ========
In the second quarter of 2004, our Previous Credit Facility was repaid as follows: (i) $620.0 million from the proceeds from our issuance of common and preferred stock as further discussed in the note entitled "Changes in Common Stock and Preferred Stock"; (ii) $674.3 million from amounts borrowed under our Credit Facility; as further described below; and (iii) a $5.7 million required prepayment pursuant to a provision in the Previous Credit Facility. The repayment of the Previous Credit Facility resulted in a gain from the extinguishment of debt totaling $2.8 million. 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. In January 2004, our Previous Credit Facility was amended to remove requirements that our insurance subsidiaries maintain minimum A.M. Best Company ("A.M. Best") financial strength ratings. In March 2004, the Previous Credit Facility was further amended to change the definition of a financial ratio we were required to maintain. The change was made to clarify how the ratio was calculated. The definition in the amended facility was consistent with calculations used to determine the original covenant levels. The fees incurred to obtain these amendments totaled $3.6 million which was amortized as interest expense until the Previous Credit Facility was repaid in full. On June 22, 2004, we entered into the Credit Facility with a principal balance of $800.0 million. The Credit Facility is a six-year term loan, the proceeds of which were used: (i) to refinance in full all indebtedness, including accrued interest, under the Previous Credit Facility; (ii) to repurchase $106.6 million of certain affiliated preferred stock; and (iii) for other general corporate purposes. We are required to make quarterly principal payments of $2.0 million commencing on September 30, 2004, and continuing until March 31, 2010. The remaining balance of $754.0 million is due on June 22, 2010. The borrowings bear interest, payable at least quarterly, based on either a eurodollar rate or a base rate. The eurodollar rate is equal to LIBOR plus 4 percent. The base rate is equal to: (i) the greater of: (a) the Federal funds rate plus .50 percent; or (b) Bank of America's prime rate; plus (ii) 3 percent. The margins on the eurodollar rate and the base rate were each reduced by .5 percent during the third quarter of 2004 as the Company's senior secured long-term debt was rated at least B2 by Moody's Investors Service, Inc. ("Moody's") and BB- by S&P, in each case with a stable outlook. On September 30, 2004, the interest rate on our Credit Facility was 5.33 percent. Pursuant to the Credit Facility, as long as the interest coverage ratio (as defined in the Credit Facility) is less than 4.0:1.0, the Company is required to make mandatory prepayments with all or a portion of the proceeds from the following transactions or events including: (i) the issuance of certain indebtedness; (ii) equity issuances; (iii) certain asset sales or casualty events; and (iv) excess cash flow as defined in the Credit Facility. The Company may make optional prepayments at any time in minimum amounts of $3.0 million. In the event that the Company refinances or otherwise repays in full the outstanding principal balance of the Credit Facility prior to June 22, 2005, we are subject to a one percent prepayment fee on the then outstanding principal amount of the Credit Facility. The Credit Facility requires the Company to maintain various financial ratios and balances, as defined in the agreement including: (i) a debt to total capitalization ratio of not more than 25 percent at all times (such ratio was 19 percent at September 30, 2004); (ii) an interest coverage ratio greater than or equal to 1.85:1.0 for the quarter ending September 30, 27 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- 2004, 2.00:1.0 for each rolling four quarters ending (or, if less, the number of full quarters commencing after June 22, 2004) during the period October 1, 2004 through June 30, 2007, and 2.50:1.0 for the four quarters ending September 30, 2007 and for each rolling four quarters thereafter (such ratio exceeded 2.85:1.0 for the quarter ending September 30, 2004); (iii) EBITDA, as defined in the Credit Facility, greater than or equal to $725.0 million for each rolling four quarters ending during the period July 1, 2004 through December 31, 2005, $775.0 million for each rolling four quarters ending during the period January 1, 2006 through December 31, 2006, and $825.0 million for each rolling four quarters thereafter (such amount was greater than $1.0 billion for the four quarters ended September 30, 2004); (iv) an aggregate risk-based capital ratio, as defined in the Credit Facility, greater than or equal to 240 percent for each quarter ending during the period from September 30, 2004 through March 31, 2005, 245 percent for each quarter ending during the period June 30, 2005 through March 31, 2006, and 250 percent for each quarter ending thereafter (such ratio exceeded the minimum risk-based capital requirement at September 30, 2004); (v) a combined statutory capital and surplus level, as defined in the Credit Facility of greater than $1,270.0 million (combined statutory capital and surplus at September 30, 2004 exceeded such requirement); and (vi) specified investment portfolio requirements (such investment portfolio requirements were met at September 30, 2004). The Credit Facility prohibits or restricts, among other things: (i) the payment of cash dividends on the Company's common stock; (ii) the repurchase of our common stock; (iii) the issuance of additional debt or capital stock; (iv) liens; (v) asset dispositions; (vi) affiliate transactions; (vii) certain investment activities; (viii) change in business; and (ix) prepayment of indebtedness (other than the Credit Facility). The obligations under our Credit Facility are guaranteed by Conseco's current and future domestic subsidiaries, other than: (i) its insurance companies; (ii) subsidiaries of the insurance companies; or (iii) certain immaterial subsidiaries as defined in the Credit Facility. This guarantee was secured by granting liens on substantially all the assets of the guarantors including the capital stock of our top tier insurance company, Conseco Life Insurance Company of Texas. 28 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- CHANGES IN COMMON STOCK AND PREFERRED STOCK In the second quarter of 2004, we completed the public offerings, including underwriter over-allotments, of 50.6 million shares of our common stock at an offering price of $18.25 per share and 27.6 million shares of our 5.5 percent Class B mandatorily convertible preferred stock (the "Preferred Stock") at an offering price of $25 per share. Proceeds from the offerings, net of issuance costs of $63.4 million, totaled $1,550.1 million. Such proceeds were used as follows: o $928.9 million to redeem all outstanding shares of our class A preferred stock. o $620.7 million to repay indebtedness under our Previous Credit Facility, including accrued interest of $.7 million. o $.5 million for general corporate purposes. The Preferred Stock has a par value of $.01 per share and a liquidation preference of $25 per share. Dividends are payable in cash at a rate of 5.5 percent of the liquidation preference per share, payable quarterly on February 15, May 15, August 15 and November 15. The Preferred Stock is mandatorily convertible into common stock of Conseco on May 15, 2007. The conversion rate for each share of Preferred Stock will range from 1.1228 and 1.3699 shares of Conseco common stock depending on the applicable market value of our common stock, as defined in the certificate of designations, on the mandatory conversion date. At any time prior to May 15, 2007, the holders of the Preferred Stock may convert such shares at the minimum conversion rate of 1.1228 shares of our common stock for each share of Preferred Stock. If at any time prior to May 15, 2007, the closing price of our common stock exceeds 150 percent of the threshold appreciation price of $22.27, subject to adjustment under certain circumstances, for a certain period of time, the Company, at its option, may elect to convert all outstanding Preferred Stock at the minimum conversion rate of 1.1228 shares of our common stock for each share of Preferred Stock. In addition, if the Company elects such conversion, it must pay the holders of the Preferred Stock, in cash, an amount equal to the present value of all remaining unpaid dividend payments on the Preferred Stock through and including May 15, 2007. If the Company is involved in a merger prior to May 15, 2007, in which at least 30 percent of the consideration for our common stock consists of cash or cash equivalents, then the holders of the Preferred Stock have the right to convert their shares into shares of our common stock at the conversion rate in effect immediately prior to such merger. Holders of the Preferred Stock are only entitled to voting rights in limited circumstances as further described in the certificate of designations. EXECUTIVE TERMINATION In the third quarter of 2004, the Company terminated the employment of William J. Shea, the Company's former Chief Executive Officer. Pursuant to Mr. Shea's employment agreement dated May 27, 2003 and other compensation arrangements, Mr. Shea received or is entitled to the following amounts or benefits: (i) A $6.25 million cash severance payment. (ii) Mr. Shea became immediately vested in 240,753 shares of restricted stock and 240,753 stock options with an exercise price of $16.40 per share. The stock options may be exercised at any time through November 11, 2004. All remaining stock options or restricted stock granted to Mr. Shea did not vest and were cancelled. We recognized compensation expense of $2.0 million during the third quarter of 2004 related to the vesting of the aforementioned restricted shares and stock options. (iii) A pro rata portion of his 2004 bonus which is estimated to be $.6 million. (iv) Certain supplemental retirement, insurance and other benefits for which we recognized expenses of $2.4 million during the third quarter of 2004. 29 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- EXECUTIVE HIRING In the third quarter of 2004, the Company hired William S. Kirsch as its President and Chief Executive Officer. Pursuant to the terms of his employment agreement, Mr. Kirsch received a payment of $1.7 million and was granted options to purchase an aggregate of 400,000 shares of Conseco common stock at a price of $16.20 per share (the closing price on the New York Stock Exchange on the date of the grant). The options vest over four years with one-fourth vesting on each anniversary of the grant date. The options expire on August 17, 2014. The Company also issued 400,000 shares of restricted stock to Mr. Kirsch with one-half vesting on the second anniversary of the grant date and an additional one-fourth vesting on the third and fourth anniversary of the grant date, respectively. The value of the restricted shares ($6.5 million) will be recognized as an expense to the Company over the four year vesting period. The Company also incurred $.6 million of professional fees and other expenses related to the executive transition. RECENTLY ISSUED ACCOUNTING STANDARDS In March 2004, the Emerging Issues Task Force issued Emerging Issues Task Force Topic No. 03-01, "The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments" ("EITF 03-01"). EITF 03-01 provides additional guidance on determining whether an impairment of an investment is other-than-temporary. EITF 03-01 also includes guidance on accounting for an investment subsequent to an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in EITF 03-01 is effective for the quarter ended September 30, 2004. However, certain guidance related to determining when an impairment of an investment is other than temporary has been delayed pending the issuance of additional guidance. The guidance effective for the quarter ended September 30, 2004 did not significantly change our procedures for evaluating impairments, although additional disclosures have been added to the notes to the consolidated financial statements. We will evaluate the impact of the additional guidance when it is finalized. Pursuant to SOP 90-7, we have implemented the provisions of accounting principles required to be adopted within twelve months of the adoption of fresh start accounting. The following summarizes the new accounting pronouncements we have recently adopted: The FASB's Derivative Implementation Group issued 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. See the note entitled "Accounting for Derivatives" for a discussion of the impact of implementing this guidance. The FASB issued Financial Accounting Standards No. 149 "Amendment of SFAS No. 133 on Derivative Instruments and Hedging Activities" ("SFAS 149") in April 2003. SFAS 149 amends and clarifies accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities." Except for certain implementation guidance included in SFAS 149 which is already effective, the new guidance is effective for: (i) contracts entered into or modified after June 30, 2003; and (ii) hedging relationships designated after June 30, 2003. The adoption of SFAS 149 did not have a material impact on the Company's consolidated financial statements. The FASB issued Financial Accounting Standards No. 150, "Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity" ("SFAS 150") in May 2003. SFAS 150 establishes standards for classifying and measuring certain financial instruments that embody obligations of the issuer and have characteristics of both liabilities and equity. For example, mandatorily redeemable preferred stock is required to be classified as a liability pursuant to SFAS 150. SFAS 150 is effective immediately for financial instruments entered into or modified after May 31, 2003, and for all other financial instruments beginning with the third quarter of 2003. Effective July 1, 2003, Old Conseco's Company-obligated mandatorily redeemable preferred securities of subsidiary trusts, or TOPrS, with an aggregate carrying value of $1,921.5 million, were reclassified to liabilities pursuant to the provisions of SFAS 150. The Company-obligated mandatorily redeemable preferred securities of subsidiary trusts were not outstanding after the Effective Date. We reviewed the guidance 30 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- of SFAS 150 in determining that the Class B mandatorily convertible preferred stock issued in the second quarter of 2004 is properly classified as a component of shareholders' equity. The Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position 03-01 "Accounting and Reporting by Insurance Enterprises for Certain Nontraditional Long-Duration Contracts and for Separate Accounts" ("SOP 03-01") in July 2003. SOP 03-01 provides guidance on several insurance company disclosure and accounting matters including the appropriate accounting for: (i) separate accounts; (ii) additional interest (for example, persistency bonus) accruing to the investment contract holder; (iii) the liability for contracts where the amounts assessed against the contract holder each period are assessed in a manner that is expected to result in profits in earlier years and losses in subsequent years; (iv) potential benefits to annuity holders in addition to their account balance; (v) sales inducements to contract holders; and (vi) other provisions. The Company sold most of its separate account business in 2002. Accordingly, the new guidance related to separate accounts will have no impact on the Company's consolidated financial position, results of operations or cash flows. As a result of our adoption of fresh start accounting, we were required to revalue our insurance product liabilities and record them at their estimated fair market value. In calculating the value of the liabilities for insurance and asset accumulation products, we followed the guidance of SOP 03-01. We have changed the way we classify the costs related to sales inducements in accordance with the new guidance. However, such change was not material. Our reserve for persistency bonus benefits was $317.2 million at September 30, 2004. In January 2003, the FASB issued Interpretation No. 46 "Consolidation of Variable Interest Entities" ("FIN 46"), which requires expanded disclosures for and, in some cases, consolidation of significant investments in variable interest entities ("VIE"). A VIE is an entity in which the equity investors do not have the characteristics of a controlling financial interest, or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. Under FIN 46, a company is required to consolidate a VIE if it is the primary beneficiary of the VIE. FIN 46 defines primary beneficiary as the party which will absorb a majority of the VIE's expected losses or receive a majority of the VIE's expected residual returns, or both. The Company has investments in various types of VIEs, some of which require additional disclosure under FIN 46, and several of which require consolidation under FIN 46. As further discussed in the note to the consolidated financial statements entitled "Investments in Variable Interest Entities", we have consolidated all of our investments in VIEs. The adoption of the consolidation requirements of FIN 46 did not have a material impact on our financial condition or results of operations. The note entitled "Investments in Variable Interest Entities" includes the expanded disclosures required by FIN 46. The FASB issued Statement of Financial Accounting Standards No. 146, "Accounting for Exit or Disposal Activities" ("SFAS 146") in June 2002. SFAS 146 addresses financial accounting and reporting for costs that are associated with exit and disposal activities and supersedes Emerging Issues Task Force Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)" ("EITF 94-3"). SFAS 146 is required to be used to account for exit or disposal activities that are initiated after December 31, 2002. The provisions of EITF 94-3 shall continue to apply for an exit activity initiated prior to the adoption of SFAS 146. SFAS 146 requires companies to recognize costs associated with exit or disposal activities when they are incurred rather than at the date of commitment to an exit or disposal plan. The Company adopted the provisions of SFAS 146 on January 1, 2003. The initial adoption of SFAS 146 did not have an impact on the Company's consolidated financial statements. The FASB issued Statement of Financial Accounting Standards No. 145, "Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections" ("SFAS 145") in April 2002. Under previous guidance all gains and losses resulting from the extinguishment of debt were required to be aggregated and, if material, classified as an extraordinary item, net of related income tax effect. SFAS 145 rescinds that guidance and requires that gains and losses from extinguishments of debt be classified as extraordinary items only if they are both unusual and infrequent in occurrence. SFAS 145 also amends previous guidance to require certain lease modifications that have economic effects similar to sale-leaseback transactions to be accounted for in the same manner as sale-leaseback transactions. The Company adopted SFAS 145 on January 1, 2003. DISCONTINUED OPERATIONS 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 31 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- subsidiary, 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 the 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 in respect of 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. During the third quarter of 2002, Old Conseco entered into an agreement to sell Conseco Variable Insurance Company ("CVIC"), its wholly owned subsidiary and the primary writer of its variable annuity products. The sale was completed in October 2002 and was accounted for as a discontinued operation. During 2002, we recognized estimated losses related to the ultimate sale and disposition of the aforementioned discontinued businesses, including estimated costs to sell and costs related to the resolution of contingencies. During the eight months ended August 31, 2003, we reduced the accrual for such estimated costs by $16.0 million (after income taxes of $.7 million). We recorded the reduction of such accrual as income from discontinued operations. LITIGATION AND OTHER LEGAL PROCEEDINGS We are involved on an ongoing basis in lawsuits, including purported class actions, relating to our operations, including with respect to sales practices, and we and current and former officers and former directors are defendants in pending class action lawsuits asserting claims under the securities laws. The ultimate outcome of these lawsuits cannot be predicted with certainty and we have estimated the potential exposure for each of the matters and have recorded a liability if a loss is deemed probable. Securities Litigation Since we announced our intention to restructure our capital on August 9, 2002, a total of eight purported securities fraud class action lawsuits have been filed in the United States District Court for the Southern District of Indiana. The complaints name us as a defendant, along with certain of our current and former officers. These lawsuits were filed on behalf of persons or entities who purchased our Predecessor's common stock on various dates between October 24, 2001 and August 9, 2002. In each case the plaintiffs allege claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended (the "Exchange Act") and allege material omissions and dissemination of materially misleading statements regarding, among other things, the liquidity of Conseco and alleged problems in CFC's manufactured housing division, allegedly resulting in the artificial inflation of our Predecessor's stock price. On March 13, 2003, all of these cases were consolidated into one case in the United States District Court for the Southern District of Indiana, captioned Franz Schleicher, et al. v. Conseco, Inc., Gary Wendt, William Shea, Charles Chokel and James Adams, et al., Case No. 02-CV-1332 DFH-TAB. The lawsuit was stayed as to all defendants by order of the United States Bankruptcy Court for the Northern District of Illinois. The stay was lifted on October 15, 2003. The plaintiffs have filed a consolidated class action complaint with respect to the individual defendants. Our liability with respect to this lawsuit was discharged in the Plan and our obligation to indemnify individual defendants who were not serving as one of our officers or directors on the Effective Date of the Plan is limited to $3 million in the aggregate under the Plan. Our liability to indemnify individual defendants who were serving as an officer or director on the Effective Date, of which there is one such defendant, is not limited by the Plan. A motion to dismiss was filed on behalf of defendants Shea, Wendt and Chokel and has been set for hearing on November 19, 2004. We believe this lawsuit is without merit and intend to defend it vigorously. The ultimate outcome of this lawsuit cannot be predicted with certainty. Other Litigation Collection efforts by the Company and its wholly owned subsidiary, Conseco Services, LLC ("Conseco Services"), related to the 1996-1999 director and officer loan programs have been commenced against various past board members and executives with outstanding loan balances. In addition, certain former officers and directors have sued the companies for declaratory relief concerning their liability for the loans. Currently, we are involved in litigation with Stephen C. Hilbert, James D. Massey, Dennis E. Murray, Sr., Rollin M. Dick, James S. Adams, Maxwell E. Bublitz, Ngaire E. Cuneo, David R. Decatur, Donald F. Gongaware and Bruce A. Crittenden. The specific lawsuits include: Hilbert v. Conseco, Case No. 03A 04283 (Bankr. Northern District, Illinois); Conseco Services v. Hilbert, Case No. 29C01-0310-MF-1296 (Circuit Court, 32 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- Hamilton County, Indiana); Murray and Massey v. Conseco, Case No. 1:03-CV-1701-LJM-VSS (Southern District, Indiana); Conseco v. Adams, et al., Case No. 03A 04545 9 (Bankr. Northern District, Illinois); Conseco Services v. Dick, et al., Case No. 06C01-0311-CC-536 (Circuit Court, Boone County, Indiana); Stephen C. Hilbert v. Conseco, Inc. and Kroll Inc., Case No. 29D02-0312-PL-1026 (Superior Court, Hamilton County, Indiana); Crittenden v. Conseco, Case No. IP02-1823-C B/S (Southern District, Indiana); Conseco v. Dick, Case No. 04L 002811 (Circuit Court, Cook County, Illinois) Conseco Services v. Adams, Case No. 29D02-0404-CC-000376 (Superior Court, Hamilton County, Indiana); Conseco Services v. Bublitz, Case No. 29D02-0404-CC-377 (Superior Court, Hamilton County, Indiana); Conseco Services v. Cuneo, et al., Case No. 1:04-CV-0929-DFH-WTL (Southern District, Indiana); Conseco Services v. Murray., Case No. 29D02-0404-CC-381 (Superior Court, Hamilton County, Indiana); Conseco Services v. Massey, Case No. 29D01-0406-CC-477 (Superior Court, Hamilton County, Indiana); Conseco Services v. Gongaware, Case No. 29D02-0404-CC-380 (Superior Court, Hamilton County, Indiana). David Decatur filed for bankruptcy on May 12, 2004. The Company and Conseco Services believe that all amounts due under the director and officer loan programs, including all applicable interest, are valid obligations owed to the companies. As part of the Plan, we have agreed to pay 45 percent of any net proceeds recovered in connection with these lawsuits, in an aggregate amount not to exceed $30 million, to former holders of our Predecessor's trust preferred securities that did not opt out of a settlement reached with the committee representing holders of these securities. We intend to prosecute these claims to obtain the maximum recovery possible. Further, with regard to the various claims brought against the Company and Conseco Services by certain former directors and officers, we believe that these claims are without merit and intend to defend them vigorously. The ultimate outcome of the lawsuits cannot be predicted with certainty. We have reached a settlement agreement with Thomas J. Kilian. On October 20, 2004, the judge in the Conseco Services v. Hilbert case granted partial final summary judgment in favor of Conseco Services in the amount of $62.7 million plus interest. Mr. Hilbert has filed a notice of appeal. In October 2002, Roderick Russell, on behalf of himself and a class of persons similarly situated, and on behalf of the ConsecoSave Plan, filed an action in the United States District Court for the Southern District of Indiana against our Predecessor, Conseco Services and certain of our current and former officers (Roderick Russell, et al. v. Conseco, Inc., et al., Case No. 1:02-CV-1639 LJM). The purported class action consists of all individuals whose 401(k) accounts held common stock of our Predecessor at any time since April 28, 1999. The complaint alleges, among other things, breaches of fiduciary duties under ERISA by continuing to permit employees to invest in our Predecessor's common stock without full disclosure of the Company's true financial condition. This lawsuit was stayed as to all defendants by order of the Bankruptcy Court. The stay was lifted on October 15, 2003. On March 22, 2004, plaintiffs filed an amended complaint and added additional former officers as named defendants and dismissed Conseco, Inc. as a party. We filed a motion to dismiss the amended complaint on June 1, 2004. On July 30, 2004, the Russell matter was dismissed. On August 25, 2004, the plaintiffs filed a notice of appeal in the 7th Circuit Court of Appeals. On February 13, 2004, the Company's fiduciary insurance carrier, RLI Insurance Company, filed a declaratory judgment action asking the court to find no liability under its policy for the claims made in the Russell matter (RLI Insurance Company v. Conseco, Inc., Stephen Hilbert, et al., Case No. 1:04-CV-0310DFH-TAB (Southern District, Indiana)). On March 15, 2004, RLI filed an amended complaint adding Conseco Services as an additional defendant. On July 28, 2004, we filed a motion to stay the RLI matter until Russell is resolved. On September 2, 2004, RLI filed a motion for judgment on all counterclaims. On October 5, 2004, our motion to stay this matter was granted. We believe the lawsuits are without merit and intend to defend them vigorously. The ultimate outcome of the lawsuits cannot be predicted with certainty. On June 24, 2002, the heirs of a former officer, Lawrence Inlow, commenced an action against our Predecessor, Conseco Services and two former officers in the Circuit Court of Boone County, Indiana (Inlow et al. v. Conseco, Inc., et al., Cause No. 06C01-0206-CT-244). The heirs asserted that unvested options to purchase 756,248 shares of our Predecessor's common stock should have been vested at Mr. Inlow's death. The heirs further claimed that if such options had been vested, they would have been exercised, and that the resulting shares of common stock would have been sold for a gain of approximately $30 million based upon a stock price of $58.125 per share, the highest stock price during the alleged exercise period of the options. The maximum exposure to the Company for this lawsuit was estimated to be $33 million. The heirs did not file a proof of claim with the Bankruptcy Court. A settlement agreement has been reached by all of the parties. On June 27, 2001, two suits against the Company's subsidiary, Philadelphia Life Insurance Company (now known as Conseco Life Insurance Company), both purported nationwide class actions seeking unspecified damages, were consolidated in the U.S. District Court, Middle District of Florida (In Re PLI Sales Litigation, Cause No. 01-MDL-1404), alleging among other things, fraudulent sales and a "vanishing premium" scheme. Philadelphia Life filed a motion for summary judgment 33 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- against both named plaintiffs, which motion was granted in June 2002. Plaintiffs appealed to the 11th Circuit Court of Appeals. The 11th Circuit, in July 2003, affirmed in part and reversed in part, allowing two fraud counts with respect to one plaintiff to survive. The plaintiffs' request for a rehearing with respect to this decision has been denied. Philadelphia Life filed a summary judgment motion with respect to the remaining claims. This summary judgment was denied in February 2004. In March 2004, the remaining plaintiff filed a motion to substitute plaintiff, to which Philadelphia Life has objected. We expect the court to set a trial date during the June 2005 trial term. On September 27, 2004, Philadelphia Life was named in a purported nationwide class action filed by the same plaintiff's attorney seeking unspecified damages in the District Court of Clark County, Nevada (Emma Gilbertson individually and on behalf of others similarly situated v. Conseco Life Insurance Company f/k/a Philadelphia Life Insurance Company, Cause No. A492738), alleging breach of contract pertaining to notice of premium increases. Philadelphia Life believes both lawsuits are without merit and intends to defend them vigorously. The ultimate outcome of the lawsuits cannot be predicted with certainty. On December 1, 2000, the Company's former subsidiary, Manhattan National Life Insurance Company, was named in a purported nationwide class action seeking unspecified damages in the First Judicial District Court of Santa Fe, New Mexico (Robert Atencio and Theresa Atencio, for themselves and all other similarly situated v. Manhattan National Life Insurance Company, an Ohio corporation, Cause No. D-0101-CV-2000-2817), alleging among other things fraud by non-disclosure of additional charges for those policyholders paying via premium modes other than annual. We retained liability for this litigation in connection with the sale of Manhattan National Life in June 2002. We believe this lawsuit is without merit and intend to defend it vigorously. The ultimate outcome of the lawsuit cannot be predicted with certainty. On December 19, 2001, four of the Company's subsidiaries were named in a purported nationwide class action seeking unspecified damages in the District Court of Adams County, Colorado (Jose Medina and others similarly situated v. Conseco Annuity Assurance Company, Conseco Life Insurance Company, Bankers National Life Insurance Company and Bankers Life and Casualty Company, Cause No. 01-CV-2465), alleging among other things breach of contract regarding alleged non-disclosure of additional charges for those policy holders paying via premium modes other than annual. On July 14 and 15, 2003 the plaintiff's motion for class certification was heard and the court took the matter under advisement. On November 10, 2003, the court denied the motion for class certification. On January 26, 2004, the plaintiff appealed the trial court's ruling denying class certification. All further proceedings have been stayed pending the outcome of the appeal. The defendants believe this lawsuit is without merit and intend to defend it vigorously. The ultimate outcome of the lawsuit cannot be predicted with certainty. The Company and its subsidiaries, Conseco Life Insurance Company and Bankers Life and Casualty Company, have been named in purported class actions and an individual lawsuit alleging, among other things, breach of contract with regard to a change made in the way monthly deductions are calculated for insurance coverage. Many of these nationwide purported class action lawsuits were filed in Federal courts across the United States. The Judicial Panel on Multidistrict Litigation consolidated these lawsuits into the case now referred to as In Re Conseco Life Insurance Co. Cost of Insurance Litigation, Cause No. MDL 1610 (Central District, California). Other nationwide purported class actions and an individual lawsuit are filed in Illinois, Indiana and California state courts. The case filed in Illinois state court is Barry A. Feinberg, Trustee of the Linda Leventhal Irrevocable Trust, individually and on behalf of all other persons and entities similarly situated v. Conseco Life Insurance Company, f/k/a Massachusetts General Life Insurance Company, Case No. 04CH17937 (Circuit Court, Cook County, Illinois). Those cases filed in Indiana state courts have been consolidated into the case now referred to as Alene P. Mangelson, et al. v. Conseco Life Insurance Company, Cause No. 29D01-0403-PL-211 (Superior Court, Hamilton County, Indiana). Those cases filed in California state courts are as follows: Stephen Hook, an individual, on behalf of himself and all others similarly situated v. Conseco Life Insurance Company and Bankers Life and Casualty Company and Does 1 through 10, Case No. CGC-04-428872 (Superior Court, San Francisco County, California); Michael S. Kuhn, on behalf of himself and all others similarly situated v. Conseco Life Insurance Company and Does 1 through 100, Case No. 03-416786 (Superior Court, San Francisco County, California); Sidney H. Levine and Judith A. Levine v. Conseco Life Insurance Company, Mark Peters Insurance Services, Inc., Hon. John Garamendi (in his capacity as Insurance Commissioner for the State of California) and Does 1 through 10, Case 04 CV 125 LAB (BLM) (Superior Court, San Diego County, California); Steven Rose, on Behalf of Himself and All Others Similarly Situated, and on Behalf of the General Public for the State of California v. Conseco Life Insurance Company, Case No. GIC 827178 (Superior Court, San Diego County, California); Alfonso Tamayo, individually and on behalf of all others similarly situated and on behalf of the General Public v. Conseco Life Insurance Co., Inc., an Indiana Corp., successor to Philadelphia Life Insurance Co. and formerly doing business as Massachusetts General Life Insurance Company, Case No 04-431660 (Superior Court, San Francisco County, California). We have filed a motion with the Judicial Council of California requesting consolidation of all the California state court cases. 34 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- We believe these lawsuits are without merit and intend to defend them vigorously. The ultimate outcome of the lawsuits cannot be predicted with certainty. On February 7, 2003, the Company's subsidiary, Conseco Life Insurance Company, was named in a purported Texas statewide class action seeking unspecified damages in the County Court of Cameron County, Texas (Lawrence Onderdonk and Yolanda Carrizales v. Conseco Life Insurance Company, and Pete Ramirez, III Cause No. 2003-CCL-102-C). On February 12, 2004, the complaint was amended to allege a purported nationwide class and to name Conseco Services as an additional defendant. On March 5, 2004, the complaint was amended a second time naming additional plaintiffs. The purported class consists of all former Massachusetts General Flexible Premium Adjustable Life Insurance Policy policyholders who were converted to Conseco Life Flexible Premium Adjustable Life Insurance Policies and whose accumulated values in the Massachusetts General policies were applied to first year premiums on the Conseco Life policies. The complaint alleged, among other things, civil conspiracy to convert the accumulated cash values of the plaintiffs and the class, and the violation of insurance laws nationwide. The parties have reached a settlement agreement on a class wide basis. On October 14, 2004, the judge signed an order preliminarily approving the settlement. The hearing for final approval is set for January 31, 2005. On December 30, 2002 and December 31, 2002, four suits were filed in various Mississippi counties against Conseco Life Insurance Company (Kathie Allen, et al. v. Conseco Life Insurance Company, et al., Circuit Court of Jones County, Mississippi, Cause No. 2002-448-CV12; Anthony Cascio, et al. v. Conseco Life Insurance Company, et al, Circuit Court of LeFlore County, Mississippi, Cause No. CV-2002-0242-CICI; William Garrard, et al. v. Conseco Life Insurance Company, et al., Circuit Court of Sunflower County, Mississippi, Cause No. CV-2002-0753-CRL; and William Weaver, et al. v. Conseco Life Insurance Company, et al., Circuit Court of LeFlore County, Mississippi, Cause No. CV-2002-0238-CICI) alleging, among other things, a "vanishing premium" scheme. In August 2004, the parties agreed to a settlement of these four suits. On September 21, 1999, Conseco Health Insurance Company ("Conseco Health"), Conseco Services, Performance Matters Associates (one of our subsidiaries), and a subsidiary officer were named in an action seeking damages in the United States District Court for the Northern District of Alabama (Danny McFarlin; Tennessee Capitol Associates, Inc.; Neal Nielsen; Group Marketing Services, Inc.; Eleanor D. Newman; Dick Manley; Commonwealth General Group, Inc.; Robert E. Taylor; Benefits of America Limited, Inc.; and Daniel Smith v. Conseco, Inc.; Conseco Services, LLC.; Conseco Health Insurance f/k/a Capitol American Life Insurance Company; Consolidated Marketing Group; Suncoast Fringe Benefits, Inc.; Performance Matters Associates, Inc.; Christopher L. Weaver; Jim Hobbs, Mike Foster and David King; Cause No: 99-CV-2282-S) alleging among other things fraud, tortious interference with business and contractual relations, conspiracy, breach of contract, unjust enrichment, extortion and interstate travel in aid of extortion under the Racketeer Influenced and Corrupt Organization Act ("RICO") and mail/wire fraud under RICO. The case concerns the consolidation of plaintiffs' independent marketing organizations under a wholly owned subsidiary of Conseco. In May 2003, the Court dismissed the tortious interference claim as to Conseco Health, the breach of contract claims as to all defendants other than Conseco Health, and the extortion-related RICO claims as to all defendants on summary judgment. The case was on appeal to the 11th Circuit Court of Appeals but was recently remanded to the district court and is currently set for trial in March 2005. Conseco believes the lawsuit is without merit and intends to defend it vigorously. The ultimate outcome of the lawsuit cannot be predicted with certainty. In addition, the Company and its subsidiaries are involved on an ongoing basis in other arbitrations and lawsuits, including purported class actions, related to their operations. The ultimate outcome of all of these other legal matters pending against the Company or its subsidiaries cannot be predicted, and, although such lawsuits are not expected individually to have a material adverse effect on the Company, such lawsuits could have, in the aggregate, a material adverse effect on the Company's consolidated financial condition, cash flows or results of operations. 35 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- Other Proceedings On September 18, 2003, the Company received a grand jury subpoena from the U.S. District Court for the Southern District of Indiana in connection with a Department of Justice investigation requiring production of documents relating to the valuation of interest-only securities held by CFC, our Predecessor's former finance subsidiary, contemporaneous earnings estimates for the Predecessor, certain personnel records and other accounting and financial disclosure records for the period June 1, 1998 to June 30, 2000. The Company has subsequently received follow-up grand jury document subpoenas concerning other matters. All of these follow-up requests have been limited to the time period prior to the December 17, 2002 bankruptcy filing. The Company has been advised by the Department of Justice that neither it nor any of its current directors or employees are subjects or targets of this investigation. The Company is cooperating fully with the Department of Justice investigation. CONSOLIDATED STATEMENT OF CASH FLOWS The following disclosures supplement our consolidated statement of cash flows (dollars in millions):
Successor Predecessor --------------------------------- -------------- Nine months One month Eight months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Cash flows from operating activities: Net income...................................................... $ 208.4 $ 24.2 $ 2,201.7 Adjustments to reconcile net income to net cash provided by operating activities: Provision for losses........................................ - - 55.6 Amortization and depreciation............................... 294.8 30.3 372.1 Income taxes................................................ 127.4 13.9 31.4 Insurance liabilities....................................... 239.4 35.8 263.5 Accrual and amortization of investment income............... 151.7 (.7) 43.2 Deferral of policy acquisition costs........................ (267.1) (25.6) (287.5) Reorganization items........................................ - - (2,157.0) Net realized investment (gains) losses...................... (27.5) (6.7) 5.4 Discontinued operations..................................... - - (16.7) Gain on extinguishment of debt.............................. (2.8) - - Other....................................................... 49.1 (18.7) 235.6 ------- ------ --------- Net cash provided by operating activities................. $ 773.4 $ 52.5 $ 747.3 ======= ====== ========= Non-cash items not reflected in the investing and financing activities sections of the consolidated statement of cash flows: Issuance of common stock under stock option and employee benefit plans............................................... $12.2 $ - $.3 Issuance of convertible exchangeable preferred shares......... 41.4 5.3 -
At September 30, 2004, restricted cash consisted of: (i) $15.0 million held in an escrow account pursuant to a settlement with the Securities and Exchange Commission and the New York Attorney General concerning their joint investigation into market timing in variable annuities issued by a former subsidiary of Old Conseco; (ii) $3.8 million held in trust for the payment of bankruptcy-related professional fees; and (iii) $.1 million of segregated cash held for the benefit of the former holders of TOPrS. 36 CONSECO, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements ------------------- INVESTMENTS IN VARIABLE INTEREST ENTITIES The Company has investments in various types of special purpose entities and other entities, some of which are VIEs under FIN 46 as described in the note entitled "Recently Issued Accounting Standards". In December 1998, Old Conseco formed three investment trusts which invested in various fixed maturity, limited partnership and other types of investments. The initial capital structure of each of the trusts consisted of: (i) principal-protected senior notes; (ii) subordinated junior notes; and (iii) equity. The senior principal-protected notes were collateralized by zero coupon treasury notes with par values and maturities matching the par values and maturities of the principal-protected senior notes. Conseco's life insurance subsidiaries owned 100 percent of the senior principal-protected notes. Certain of Conseco's non-life insurance subsidiaries owned all of the subordinated junior notes, which had a preferred return equal to the total return on the trusts' assets in excess of principal and interest on the senior notes. The equity of the trusts was owned by unrelated third parties. The three investment trusts were VIEs under FIN 46 because the trusts' equity represented significantly less than 10 percent of total capital and the subordinated junior notes were intended to absorb expected losses and receive virtually all expected residual returns. Based on our 100 percent ownership of the subordinated junior notes, we were the primary beneficiary of the investment trusts. All three trusts were consolidated in our financial statements at December 31, 2003. The carrying value of the total invested assets in the three trusts was approximately $228 million at December 31, 2003, which also represented Conseco's maximum exposure to loss as a result of our ownership interests in the trusts. The trusts had no obligations or debt to outside parties. During the fourth quarter of 2003, the trusts began liquidating their portfolios, a process that was completed in the first quarter of 2004. The investments held by the trusts were reflected in our investments in the consolidated balance sheet at December 31, 2003. 37 CONSECO, INC. AND SUBSIDIARIES ------------------- ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. In this section, we review the consolidated financial condition of Conseco at September 30, 2004, and the consolidated results of operations for: (i) the three and nine months ended September 30, 2004; (ii) the one month ended September 30, 2003; (iii) the two months ended August 31, 2003; and (iv) 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 accompanying consolidated financial statements and notes. 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" section of this Item 2 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 the potential adverse impact of our Predecessor's Chapter 11 petition on our business operations, and relationships with our customers, employees, regulators, distributors and agents; o our ability to operate our business under the restrictions imposed by our Credit Facility or future credit facilities; o our ability to improve the financial strength ratings of our insurance company subsidiaries and the impact of prior rating downgrades on our business; o our ability to obtain adequate and timely rate increases on our supplemental health products including our long-term care business; 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 market value of our investments, and the lapse rate and profitability of policies; o our ability to achieve anticipated expense reductions and levels of operational efficiencies; o customer response to new products, distribution channels and marketing initiatives; o mortality, morbidity, usage of health care services, persistency and other factors which may affect the profitability of our insurance products; o performance of our investments; o changes in the Federal income tax laws and regulations which may affect or eliminate the relative tax advantages of some of our products; o our ability to satisfy the requirements of Section 404 of the Sarbanes Oxley Act in a timely manner; 38 CONSECO, INC. AND SUBSIDIARIES ------------------- o regulatory changes or actions, including those relating to regulation of the financial affairs of our insurance companies, including the payment of dividends to us, regulation of financial services affecting (among other things) bank sales and underwriting of insurance products, regulation of the sale, underwriting and pricing of products, and health care regulation affecting health insurance products; o the ultimate outcome of lawsuits filed against us and other legal and regulatory proceedings to which we are subject; and o the risk factors or uncertainties listed from time to time in our filings with the Securities and Exchange Commission. 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 primary operating segments, based primarily on method of product distribution, and a third segment comprised of businesses 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 Life Insurance Company ("Colonial Penn"). Bankers Life and Casualty markets and distributes Medicare supplement insurance, life insurance, long-term care insurance and fixed annuities to the senior market through 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 professional independent producers. 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 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 have restated all historical periods presented in "Management's Discussion and Analysis of Financial Condition and Results of Operations" to reflect our new segments. 39 CONSECO, INC. AND SUBSIDIARIES ------------------- CRITICAL ACCOUNTING POLICIES Refer to "Critical Accounting Policies" in Conseco's 2003 Annual Report on Form 10-K for information on accounting policies that we consider critical in preparing our consolidated financial statements. Under fresh start reporting 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 any portion of the reorganization value which can not be attributed to specific tangible or identified intangible assets as goodwill. As a result, the Company's financial statements for periods following August 31, 2003, will not be comparable with those of Old Conseco prepared before that date. Consistent with SOP 90-7 we implemented accounting standards that were required to be adopted in our consolidated financial statements within twelve months of our Effective Date. RISK FACTORS We are subject to a number of risks. These risks could have a material adverse effect on our business, financial condition or results of operations. While we believe that we currently have adequate internal control procedures in place, we are subject to uncertainties related to recent legislation requiring companies to evaluate internal controls for financial reporting under Section 404 of the Sarbanes Oxley Act of 2002. We are continuing to take action to comply with the requirements of Section 404 of the Sarbanes Oxley Act of 2002 ("Section 404"), which will require us to include a report in our Form 10-K for the year ending December 31, 2004 containing an assessment of the effectiveness of our internal control structure and procedures for financial reporting as of December 31, 2004. Our external auditors are required to attest to, and report on, the assessment made by management. We have substantially completed procedures to document our internal controls and have implemented various enhancements which are designed to improve our internal controls. We are currently testing our internal controls to confirm that such controls are designed properly and operating effectively. When our testing identifies potential weaknesses, we are taking necessary remediation actions. After our tests are completed, our external auditors perform additional procedures and tests of our internal controls. Our efforts to comply with Section 404 are complicated by the substantial number of acquisitions undertaken by our Predecessor and the resulting number of policy administration systems we use to process our business. We have several initiatives underway to eliminate duplicate processing systems by converting similar business accounted for on multiple systems to a fewer number of systems. However, many of these initiatives have only recently been adopted, and will not be implemented prior to the required attestation as of December 31, 2004. The new regulations have resulted in increased expenses and the commitment of significant managerial resources. We have retained a large international accounting firm and a number of consultants to assist us in completing the required procedures. While we anticipate being able to fully satisfy the requirements of Section 404 in a timely manner, we cannot be certain as to the timing of completion of our evaluation, testing and remediation actions or the impact of these actions on our operations. In addition, since the new rules are subject to varying interpretations, there is uncertainty regarding how compliance will be measured. If we are unable to timely assess the effectiveness of our internal controls under Section 404, or if we or our external auditors discover any material weaknesses related to our internal controls which would preclude us from determining that our internal controls are effective, investor confidence could be adversely affected and cause our stock price to decline. Our recent bankruptcy may continue to disrupt our operations and hamper our efforts to restore confidence in the "Conseco" brand, which may contribute to lower sales, increased agent attrition and policyholder lapses and redemptions. The announcement of our intention to seek a restructuring of our capital in August 2002 and our subsequent filing of bankruptcy petitions in December 2002 caused significant disruptions in our operations. We believe that adverse publicity in 40 CONSECO, INC. AND SUBSIDIARIES ------------------- national and local media concerning our distressed financial condition and disputes with former members of our management caused sales of our insurance products to decline and policyholder lapses and redemptions to increase. For example, our total premium collections decreased by 8.4 percent to $4,180.9 million for the year ended December 31, 2003, compared to 2002. In addition, withdrawals from annuities and other investment-type products exceeded deposits received by $615.4 million during the year ended December 31, 2003. 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 selling products through the Conseco Insurance Group segment decreased by approximately 45 percent to 9,100 at December 31, 2003 compared to a year earlier. The number of career agents selling products through the Bankers Life segment remained at approximately 4,000 throughout 2003. We implemented agent sales incentive programs to retain the career agency force during periods of negative media coverage, decreased ratings and increased competitive activity from agents selling competitors' products. The total cost for the agent incentive programs during 2003 and 2002 was $17 million. While we cannot quantify with specificity the portion of these adverse changes that were caused by our distressed financial condition and the associated negative publicity, we believe that these events contributed significantly to these trends. Although we believe that the successful completion of the bankruptcy and our continuing restructuring efforts will reverse these trends and will enable us to restore confidence in the "Conseco" brand among customers, agents, regulators and our other constituencies, we only recently emerged from bankruptcy and although the level of surrenders of our in force insurance have decreased in recent periods, the level of our sales have not improved. Legal proceedings that arose in the context of our bankruptcy and current regulatory investigations may continue to disrupt our operations, subject us to material liability and hamper our efforts to restore confidence in the "Conseco" brand, which may negatively impact our financial results and liquidity. We continue to be involved in various legal proceedings that arose in the context of our restructuring. For example, since our August 2002 announcement that we would seek to restructure our capital, we and/or our Predecessor and several of our former, and in some instances current, officers and directors have been named as defendants in lawsuits, including class action lawsuits, alleging, among other things, securities fraud and breaches of fiduciary duty under ERISA. While we were discharged from pre-petition obligations of our Predecessor in connection with the bankruptcy, we still owe indemnity obligations to some of our current and former officers and directors for expenses and losses they may incur in connection with these lawsuits. Our ultimate financial exposure with respect to this indemnity may be limited by the availability of insurance, but not all of the cases relating to periods prior to our bankruptcy are so limited and we cannot predict with certainty what our ultimate liability in these cases may be. We have commenced litigation against certain of our former officers and directors in connection with our efforts to collect amounts outstanding under our Predecessor's director and officer loan programs. We believe that adverse publicity in national and local media concerning the above proceedings may hamper our efforts to restore confidence in the "Conseco" brand, and impose impediments to our customers' willingness to continue to buy our products and our ability to attract new customers. Similarly, the adverse publicity concerning these proceedings may make it more difficult for us to attract and retain agents and independent marketing organizations to market our products. While we believe that these events have affected, and may continue to affect, our customers' and agents' willingness to do business with us, we cannot quantify the extent of these effects with specificity. A failure to improve and maintain the financial strength ratings of our insurance subsidiaries could cause us to experience lower 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 purchasers of our products view ratings as an important factor in determining which insurer's products to market or purchase. 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's bankruptcy. The lowered ratings assigned to our insurance subsidiaries were one of the primary factors causing sales of our insurance products to decline and policyholder redemptions and lapses to increase during 2002 and 2003 and the first half of 2004. We also experienced increased agent attrition, which 41 CONSECO, INC. AND SUBSIDIARIES ------------------- in some cases led us to increase commissions or sales incentives in an effort to retain them. These events have had a negative effect on our ability to market our products and attract and retain agents, which in turn negatively affected our financial results. Such financial strength ratings were upgraded in the second quarter of 2004, and again in the third quarter of 2004 by Moody's, for our primary insurance subsidiaries, other than Conseco Senior Health Insurance Company ("Conseco Senior"). The current financial strength ratings of our primary insurance subsidiaries from A.M. Best, S&P and Moody's are "B++ (Very Good)," "BB+" and "Ba1," respectively, except that the current financial strength ratings of Conseco Senior from A.M. Best, S&P and Moody's are "B (Fair)," "CCC" and "Caa1," respectively. A "B++" rating from A.M. Best is the fifth highest of sixteen possible ratings, and a "B" rating from A.M. Best is the seventh highest of sixteen possible ratings. A "BB+" rating from S&P is the eleventh highest of twenty-one possible ratings, and a "CCC" rating from S&P is the eighteenth highest of twenty-one possible ratings. A "Ba1" rating from Moody's is the eleventh highest of twenty-one possible ratings, and a "Caa1" rating from Moody's is the seventeenth highest of twenty-one possible ratings. Most of our competitors have higher financial strength ratings and we believe it is critical for us to continue to improve our ratings to be competitive. Our Plan contemplated that our insurance subsidiaries would achieve an "A" category rating from A.M. Best approximately by the end of 2004. Based on recent discussions with A.M. Best, they will not review our insurance subsidiaries for a possible upgrade until at least June 2005. We believe the following past and expected future accomplishments will warrant an upgrade to an "A" category rating from A.M. Best: (i) the improved capital position of our insurance subsidiaries; (ii) our lower debt to capital ratio following the completion of the offerings referred to in the notes to our consolidated financial statements included in this Form 10-Q entitled "Changes in Common Stock and Preferred Stock"; (iii) our current expectation of future financial results; and (iv) the results of various other initiatives. However, the decision to upgrade is a subjective one that will be made if and when A.M. Best believes it is warranted. If we fail to achieve and maintain an "A" category rating from A.M. Best, sales of our insurance products could fall further, we may face further defections among our independent and career sales force, and existing policyholders may redeem or allow their policies to lapse, adversely affecting our financial results, which in turn could lead to further downgrades. If our financial performance or business prospects deteriorate, and we experience a downgrade in our current ratings, our product sales would likely decline significantly, we would likely experience substantial defections among our independent and career sales force, and our existing policyholders would likely redeem or allow their policies to lapse at higher rates. In addition, events that may cause the ratings agencies to downgrade our financial strength ratings may also cause us to be in breach of covenants under our Credit Facility, which would entitle our lenders to accelerate these borrowings. We presently do not have sufficient liquidity to repay these borrowings if they were to be accelerated, and we may not have such liquidity in the future or we may not be able to borrow money from other lenders to enable us to refinance these loans. If we are unable to repay or refinance these loans, we may be forced to seek bankruptcy protection again. 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 the 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 administrative expenses 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 our non-insurance subsidiaries, loans and advances. A deterioration in the financial condition, earnings or cash flow of the significant subsidiaries of Conseco or CDOC for any reason could limit their ability to pay cash dividends or other disbursements to Conseco and CDOC, which, in turn, would limit the ability of Conseco and CDOC to meet debt service requirements and satisfy other financial obligations. 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 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 o 10 percent of statutory capital and surplus as of the end of the preceding year. 42 CONSECO, INC. AND SUBSIDIARIES ------------------- Any dividends in excess of these levels require the approval of the director or commissioner of the applicable state insurance department. Also, we have agreed with the Texas Department of Insurance to provide up to 30 days prior notice of the payment of dividends by an insurance subsidiary to any non-insurance company parent. Prior to their release on November 19, 2003, we were subject to consent orders with the Commissioner of Insurance for the State of Texas that, among other things, limited the ability of our insurance subsidiaries to pay dividends to any non-insurance company parent without prior approval. The following table sets forth the aggregate amount of dividends and other distributions that our insurance subsidiaries would have been able to pay to us in each of the last two fiscal years without obtaining specific approval from state insurance regulators, assuming that the Texas consent orders released in November 2003 had not been in effect (dollars in millions):
2003 2002 ---- ---- Dividends............................................................. $340.6 $230.8 Surplus debenture interest............................................ 52.1 56.0 ------ ------ Total that was available to be paid .............................. $392.7 $286.8 ====== ======
Our business may be adversely impacted as a result of our substantial indebtedness, which requires the use of a substantial portion of our excess cash flow and may limit our access to additional capital. We continue to have significant indebtedness after our emergence from bankruptcy. As of September 30, 2004, we had $798.0 million of indebtedness under our Credit Facility. The following table sets forth the aggregate amount of our debt payment obligations, including estimated interest, for the periods indicated (dollars in millions):
Three months ended December 31, 2004 2005 2006 2007 2008 Total ---- ---- ---- ---- ---- ----- Scheduled principal payments.......................... $ 2.0 $ 8.0 $ 8.0 $ 8.0 $ 8.0 $ 34.0 Projected interest payments .......................... 10.9 42.9 42.4 42.0 41.6 179.8 ----- ----- ----- ----- ----- ------ Total debt service................................ $12.9 $50.9 $50.4 $50.0 $49.6 $213.8 ===== ===== ===== ===== ===== ======
As of September 30, 2004, our debt to total capital ratio was 17 percent. This ratio is higher than the ratio of some of our competitors. Consequences resulting from our substantial indebtedness could include: o increasing our vulnerability to adverse economic and industry conditions by limiting our flexibility in planning for and reacting to changes in our business and industry; o requiring us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, therefore diverting funds from other beneficial uses; o limiting our ability to make strategic acquisitions or take other significant corporate actions; o placing us at a competitive disadvantage compared to our competitors that have proportionately less debt; and o limiting our ability to borrow funds and increase the cost of funds that we can borrow. Moreover, if we are unable to meet our repayment obligations, our lenders are entitled to accelerate their loans, and we may be forced to seek bankruptcy protection again. 43 CONSECO, INC. AND SUBSIDIARIES ------------------- S&P and Moody's have assigned ratings on our senior secured debt of "BB- (Marginal)" and "B2 (Poor)", respectively. In S&P's view, an obligation rated "BB-" is less vulnerable to 0nonpayment than other speculative issues, but the obligor currently has the capacity to meet its commitment on the obligation. S&P has a total of twenty-two separate categories in which to rate senior debt, ranging from "AAA (Extremely Strong)" to "D (Payment Default)". A "BB-" rating is the thirteenth highest rating. In Moody's view, an obligation rated "B" generally lacks characteristics of a desirable investment, and any assurance of interest or principal payments or of maintenance of other terms of the contract over any long period of time may be small. 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 "B2" rating is the fifteenth highest rating. Our current senior debt ratings may restrict our access to capital. If we fail to meet or maintain various covenants and financial ratios under our Credit Facility, our lenders are entitled to accelerate the repayment of these loans; if the loans are accelerated and we do not have sufficient liquidity to repay them, we may be forced to seek bankruptcy protection again. Our Credit Facility imposes a number of covenants and financial ratios that we must meet or maintain. For example, we must: o have earnings before interest, taxes, depreciation and amortization, as defined in the Credit Facility, of greater than or equal to $725.0 million for each rolling four quarters ending during the period July 1, 2004 through December 31, 2005, $775.0 million for each rolling four quarters ending during the period January 1, 2006 through December 31, 2006, and $825.0 million for each rolling four quarters thereafter. This amount was greater than $1.0 billion for the four quarters ended September 30, 2004; o have a debt to total capitalization ratio, as defined in the Credit Facility, of not more than 25 percent at all times. At September 30, 2004, our debt to total capitalization ratio was 19 percent; o have an interest coverage ratio of greater than or equal to 1.85:1.0 for the quarter ending September 30, 2004, 2.00:1.0 for each rolling four quarters ending (or, if less, the number of full quarters commencing after June 22, 2004) during the period October 1, 2004 through June 30, 2007, and 2.50:1.0 for the four quarters ending September 30, 2007 and for each rolling four quarters thereafter. Such ratio exceeded 2.85:1.0 for the quarter ending September 30, 2004. Although we believe we are on track to meet and/or maintain these covenants and financial ratios, our ability to do so may be affected by events outside of our control. If we default under these requirements, the lenders could declare all outstanding borrowings immediately due and payable, the aggregate amount of which was $798.0 million as of September 30, 2004. We presently do not have sufficient liquidity to repay these borrowings if they were to be accelerated, and we may not have sufficient liquidity in the future and may not be able to borrow money from other lenders to enable us to refinance these loans. Accordingly, if we default under these requirements and the loans are accelerated, we may be forced to seek bankruptcy protection again. Our operating flexibility is limited in significant respects by the restrictive covenants in our Credit Facility. Our Credit Facility imposes restrictions on us that could increase our vulnerability to adverse economic and industry conditions by limiting our flexibility in planning for and reacting to changes in our business and industry. Specifically, these restrictions limit our ability to: o incur additional indebtedness; o issue stock of subsidiaries; o create liens; o transfer or sell assets; o enter into transactions with affiliates; 44 CONSECO, INC. AND SUBSIDIARIES ------------------- o fundamentally change the type of business in which we engage; o enter into mergers or other types of business combination transactions; o pay cash dividends and make cash distributions on certain classes of equity securities; o repurchase stock; o make investments; and o make capital expenditures. Our ability to engage in these types of transactions is generally limited by the terms of our Credit Facility, even if we believe that a specific transaction would contribute to our future growth, operating results or profitability. If we are able to enter into these types of transactions under the terms of our Credit Facility, or if we obtain a waiver from our lenders with respect to any specific transaction, that transaction may cause our indebtedness to increase, may not result in the benefits we anticipate or may cause us to incur greater costs or suffer greater disruptions in our business than we anticipate, and could therefore negatively impact our business and operating results. 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 what the actual claims on our products will be. 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. 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 the 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 loss ratio for our long-term care products included in the other business in run-off segment has increased in recent periods and was 103 percent during the nine months ended September 30, 2004. 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 2002 and 2003, we filed for and received approval on rate increases totaling $44 million and $37 million, respectively, relating to this long-term care business that had approximately $400 million of collected premiums. 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 requests filed in the future. If we are unable to raise our premium rates because we fail to obtain approval for a rate increase in one or more states, our net income may decrease. Moreover, in some instances our ability to exit unprofitable lines of business is limited by the guaranteed renewal feature of the policy. In that situation we cannot exit the business without regulatory approval, which may require that we continue to service products at a loss for an extended period of time. For example, most of our long-term care business is guaranteed renewable, meaning we cannot terminate these policies without regulatory approval. Therefore, without approval of necessary rate increases, we may have no other option but to operate this business at a loss for an extended period of time. 45 CONSECO, INC. AND SUBSIDIARIES ------------------- If 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 significantly higher claim costs as a percentage of premiums if healthier policyholders who can get coverage elsewhere allow their policies to lapse, while policies related to less healthy policyholders continue in force. This would reduce our premium income and profitability in future periods. On home health care policies issued in some areas of Florida and other states, payments for the benefit of policyholders have exceeded the premiums we receive by a significant amount. On April 20, 2004, the Florida Office of Insurance Regulation issued an order to our subsidiary, Conseco Senior, that affects approximately 11,000 home health care policies issued in Florida by Conseco Senior and its predecessor companies. The order provides for Conseco Senior to offer the following three alternatives to holders of these policies: o retention of their current policy with a maximum 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 maximum rate increase in the first year of 25 percent and no more than 15 percent in subsequent years; 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. On July 1, 2004, the Florida Office of Insurance Regulation issued a similar order impacting approximately 4,500 home health care policies which are obligations of one of our other insurance subsidiaries, Washington National Insurance Company ("Washington National"). 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 aggressively seeking rate increases on other long-term care policies in our other business in run-off segment. 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 with certainty what the actual claims on our products will be. This is particularly true in the context of setting premium rates on our long-term care insurance products, for which we have relatively limited historical claims experience. Long-term care products tend to have lower frequency of claims than other health products such as Medicare supplement or specified disease, but when claims are incurred on long-term care policies 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 other supplemental health products. As a result of these product traits, longer historical experience is necessary in order to price products appropriately. Our Bankers Life segment has offered long-term care insurance since 1985. Bankers Life's claim 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 which is expected to result in higher loss ratios in the future. Our acquired blocks of long-term care insurance included in the other business in run-off segment were acquired through acquisitions completed in 1996 and 1997. The majority of the 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 requested and received approval for numerous premium rate increases in recent years on these blocks. Even with the various rate increases, these blocks experienced loss ratios of 103 percent in the nine months ended September 30, 2004, 103 percent in the four months ended December 31, 2003, 170 percent in the eight months ended August 31, 2003, 139 percent in 2002 and 96 percent in 2001. 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. 46 CONSECO, INC. AND SUBSIDIARIES ------------------- 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 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 plus a liability for due and unpaid claims, claims in the course of settlement, and incurred but not reported claims, as well as a reserve for the present value of amounts on claims not yet due. For our long-term care insurance business, we establish reserves based on the assumptions and estimates of factors: (i) established at the fresh-start date for business inforce at that time; or (ii) that we consider 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. 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. We have incurred significant losses which have exceeded our expectations 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 $130 million during 2002 and $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. Our financial performance depends significantly upon the extent to which our actual claims experience is consistent with the assumptions we used in setting our reserves. 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, and it could result in a default under our Credit Facility. 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, 2003, approximately 18 percent of our total insurance liabilities, or approximately $4.5 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 the acquisition costs or 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. For example, policyholder redemptions of annuity and, to a lesser extent, life products increased following the downgrade of our A.M. Best financial strength rating to "B (Fair)" in August of 2002. When redemptions are greater than our previous assumptions, we are required to accelerate the amortization of insurance intangibles to write off the balance associated with the redeemed policies. We recorded additional amortization related to higher redemptions and changes to our lapse assumptions of $203.2 million in 2002. Such additional amortization was not significant in 2003 and the first nine months of 2004. Recently enacted and pending or future 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 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 with respect to individuals, which could have the effect of increasing our loss ratios and have an adverse effect on 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, recent reforms provide some additional incentives under the Medical Advantage program for health plans to offer managed care plans to seniors. Any resulting growth of managed care plans over time 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 for inclusion in all long-term care policies, 47 CONSECO, INC. AND SUBSIDIARIES ------------------- 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 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 increase in benefits we must pay, such as limitations on waiting periods, or otherwise increase the costs associated with 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 products which we believe are attractive to purchasers, 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, reduce the federal estate tax gradually over a ten-year period, with total elimination of the federal estate tax in 2010, and increase contributions which 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 since the benefit of tax deferral is not as great if tax rates are lower and because fewer people may purchase these products if they are able to contribute more money to individual retirement accounts and 401(k) accounts. 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 within certain annuities and life insurance products, which would make these products less attractive to prospective purchasers and therefore would be likely to reduce our sales of these products. Our results of operations may be negatively impacted if we are unable to achieve the goals of the initiatives we have undertaken with respect to the restructuring of our principal insurance businesses. Our Conseco Insurance Group segment has experienced declining sales and expense levels that exceed product pricing. We have adopted several initiatives designed to improve these operations, including focusing sales efforts on higher margin products, such as our specified disease products; reducing operating expenses by eliminating or reducing the costs of marketing some of our products; personnel reductions and streamlined administrative procedures; increasing retention rates on our more profitable blocks of inforce business; stabilizing the profitability of the long-term care block of business in run-off sold through independent agents through premium rate increases, improved claim adjudication procedures and other actions as necessary; and combining legal insurance entities to improve the efficient use of capital and eliminate the costs of separate financial reporting requirements. Conseco Insurance Group has 29 separate policy administration systems for its three main lines of business: life, health and annuities. Many of our initiatives are intended to address issues resulting from the substantial number of acquisitions undertaken by our Predecessor. Between 1982 and 1997, our Predecessor completed 19 transactions involving the acquisition of 44 separate insurance companies. Our future performance depends, in part, on our ability to successfully integrate these prior acquisitions. This process of integration may involve unforeseen expenses, complications and delays, including, among other things, further difficulties in integrating the systems and operations of the acquired companies, and our current initiatives may be inadequate to address such issues. In addition, some of our initiatives have only recently been adopted, and may not be successfully implemented. Our initiatives include the elimination of duplicate processing systems by converting similar business currently accounted for on multiple systems to a much smaller number of systems. We expect to spend over $35 million on capital expenditures in 2004 (including amounts related to these initiatives). Even if we are able to successfully implement these measures, these measures alone may not be sufficient to improve our results of operations. Our investment portfolio is subject to several risks which may diminish the value of our invested assets and negatively impact our profitability. The values of the assets in our investment portfolio are subject to numerous factors, which are difficult to predict, and are in many instances 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. Actively managed fixed maturity investments comprised 87 percent of our total investments as of December 31, 2003. The value of these investments can be affected by changing levels of market interest rates. For example, an increase in interest rates of 10 percent could reduce the value of our actively managed fixed maturity investments and short-term investments, net of corresponding changes in the value of insurance intangibles, by approximately $625 million, in the absence of other factors. 48 CONSECO, INC. AND SUBSIDIARIES ------------------- o Our actively managed fixed maturity investments are subject to a deterioration in the ability of the issuer to make timely repayment of the securities. This risk is significantly greater with respect to below-investment grade securities, which comprised 3.7 percent of our actively managed fixed maturity investments as of September 30, 2004. We have sustained substantial credit-related investment losses in recent periods when a number of large, highly leveraged issuers experienced significant financial difficulties resulting in our recognition of other-than-temporary impairments. For example, we have recognized other-than-temporary declines in value of several of our investments, including K-Mart Corp., Amerco, Inc., Global Crossing, MCI Communications, Mississippi Chemical, 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: $17.8 million in the nine months ended September 30, 2004; $9.6 million in the four months ended December 31, 2003; $51.3 million in the eight months ended August 31, 2003; $556.8 million in 2002; and $361.7 million in 2001. In order to reduce our exposure to similar 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 3.7 percent at September 30, 2004; 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 25 percent of our actively managed fixed maturity investments at September 30, 2004, are subject to risks relating to variable prepayment and default on the assets underlying such securities, such as mortgage loans. To the extent that structured security investments prepay faster than the expected rate of repayment, refinancing or default on the assets underlying the securities, such investments, which have a cost basis in excess of par, may be redeemed at par, thus resulting in a loss. Our need for liquidity to fund substantial product surrenders or policy claims may require that we maintain highly liquid, and therefore lower-yielding, assets, or that we sell assets at a loss, thereby further eroding the performance of our portfolio. We have sustained substantial investment losses in the past and may again in the future. 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 which we are able to credit to our customers on certain of our products, thereby impacting our sales and further eroding our financial performance. Changing interest rates may adversely affect our results of operations. Our profitability may be directly affected by the level of and fluctuations in interest rates. While we monitor the interest rate environment and have previously employed hedging strategies designed to mitigate the impact of changes in interest rates, 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 on customer deposits, thereby adversely affecting our results. Our ability to adjust for such a compression is limited by virtue of the guaranteed minimum rates that we must credit to policyholders on certain of our products, as well as by the fact that we are able to reduce the crediting rates on most of our products only at limited, pre-established intervals. As of December 31, 2003, approximately 40 percent of our insurance liabilities were subject to interest rates that may be reset annually; 45 percent have a fixed explicit interest rate for the duration of the contract; 10 percent have credited rates which approximate the income we earn; and the remainder have 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. The profits from many non-spread-based insurance products, such as long- 49 CONSECO, INC. AND SUBSIDIARIES ------------------- term care policies, are adversely affected when interest rates decline because we may be unable to reinvest the cash flows generated from premiums received and our investment portfolio 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 effect 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 the cash flows expected from our existing insurance 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, 2003, the duration of our fixed maturity securities and short-term investments was approximately 6.7 years, and the duration of our insurance liabilities was approximately 7.2 years. We estimate that our fixed maturity securities and short-term investments, net of corresponding changes in the value of insurance intangibles, would decline in fair value by approximately $625 million if interest rates were to increase by 10 percent from their December 31, 2003 levels. This compares to a decline in fair value of $595 million based on amounts and rates at December 31, 2002. The calculations involved in our computer simulations incorporate 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. A decline or increased volatility in the securities markets, and other economic factors, may adversely affect our business, particularly our sales of certain of our 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 cause potential new purchasers of equity-indexed annuities to refrain from purchasing these products and may cause current policyholders to surrender their policies for the cash value or reduce their investments. For example, our sales of these products decreased significantly in 2001 and 2002 during periods of significant declines in the equity markets. Sales of equity-indexed annuities totaled $220.1 million in 2002 and $380.9 million in 2001, as compared to $643.5 million in 2000. 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 are subject to further risk of loss notwithstanding 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, 2003, our reinsurance receivables totaled $930.5 million. Our ceded life insurance in force totaled $23.4 billion. Our seven largest reinsurers accounted for 80 percent of our ceded life insurance in force. 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 goodwill and other intangible assets are subject to impairment tests, which may require us to reduce shareholders' equity. Upon our emergence from bankruptcy, we revalued our assets and liabilities to estimated fair value as of August 31, 2003 and established our capital accounts at the reorganization value determined in conjunction with our Plan. We recorded the $1,141.6 million of reorganization value which could not be attributed to specific tangible or identified intangible assets as goodwill. Under GAAP, we are required to evaluate our goodwill and other intangible assets for impairment on an annual basis, 50 CONSECO, INC. AND SUBSIDIARIES ------------------- or more frequently if there is an indication that an impairment may exist. If certain criteria are met, we are required to record an impairment charge. We obtained independent appraisals to determine the value of the Company in conjunction with the preparation of our Plan which indicated no impairments of our goodwill or other intangible assets existed. However, we cannot assure you that we will not have to recognize an impairment charge in future periods. The appraisals prepared to determine the value of our subsidiaries are based on numerous 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. These estimates and assumptions had a significant effect on the determination of our reorganization value and the amount of goodwill we recognized. Accordingly, if our actual experience differs from our estimates and assumptions, it is possible we will have to recognize an impairment charge in future periods. 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 with broad administrative powers relative to 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 we can make. We have been operating under heightened scrutiny from state insurance regulators. For example, our insurance subsidiaries domiciled in Texas, Bankers National Life Insurance Company and Conseco Life Insurance Company of Texas, on behalf of itself and its subsidiaries, entered into consent orders with the Commissioner of Insurance for the State of Texas on October 30, 2002, which were formally released on November 19, 2003. These consent orders applied to all of our insurance subsidiaries and, among other requirements, restricted the ability of our insurance subsidiaries to pay any dividends or other amounts to any non-insurance company parent without prior approval. Notwithstanding the release of these consent orders, we agreed with the Texas Department of Insurance to provide prior notice of certain transactions, including up to 30 days prior notice for the payment of dividends by an insurance subsidiary to any non-insurance company parent, and to provide information periodically concerning our financial performance and condition. As noted above, state laws generally provide state insurance regulatory agencies with broad authority to protect policyholders in their jurisdictions. Accordingly, we cannot assure you that regulators will not seek to assert greater supervision and control over our insurance subsidiaries' businesses and financial affairs. If our financial condition were to deteriorate, we may be required to enter into similar orders in the future. 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. 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 potentially 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 2003 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, as a result of losses on the long-term care business within our other business in run-off segment, the risk-based capital ratio of Conseco Senior, which issued most of the long-term care business in our other business in run-off segment, is near the level which would require it to submit a comprehensive plan aimed at improving its capital position. 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, 51 CONSECO, INC. AND SUBSIDIARIES ------------------- 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 financial 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. The class action and policyholder suits are often in connection with insurance sales practices, policy and claims administration practices and other market conduct issues. 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, are also involved in various governmental and administrative proceedings and investigations. Our subsidiary, Philadelphia Life Insurance Company, which is now known as Conseco Life Insurance Company, is a defendant in a purported nationwide class action lawsuits alleging fraudulent sales practices and seeking unspecified damages in Florida federal court. Our former subsidiary, Manhattan National Life Insurance Company, is a defendant in a purported nationwide class action lawsuit alleging fraud by non-disclosure of additional charges for policyholders wishing to pay premiums on other than an annual basis and seeking unspecified damages in New Mexico state court. Four of our subsidiaries have also been named in purported nationwide class action lawsuits seeking unspecified damages in Colorado state court alleging claims similar to those alleged in the New Mexico suit naming Manhattan National Life Insurance Company. Conseco Life Insurance Company has been named as a defendant in multiple recently filed purported class actions and individual cases alleging, among other things, breach of contract with regard to a change made in the way monthly deductions are calculated for insurance coverage. The ultimate outcome of these lawsuits, however, cannot be predicted with certainty, and although we do not presently believe that any of these lawsuits, individually, are material, they could, in the aggregate, have a material adverse effect on our financial condition. Because our insurance subsidiaries were not part of our bankruptcy proceedings, the bankruptcy 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, Lincoln Benefit Life, MetLife and Unum Provident. Our main competitors for agent sold Medicare supplement insurance products include Mutual of Omaha, Blue Cross and Blue Shield of Florida, Physicians Mutual and Standard Life and Accident. 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 third in agent sold long-term care insurance products in 2003 with a market share of approximately seven percent, the top two writers of agent sold long-term care insurance products had a combined market share of approximately 45 percent during the period. In addition, while our Bankers Life segment was ranked third and our Conseco Insurance Group segment was ranked fourth in agent sold Medicare supplement insurance products in 2003 with a combined market share of approximately 17 percent, the top two writers of agent sold Medicare supplement insurance products had a combined market share of approximately 63 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 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, recent changes in federal law have narrowed 52 CONSECO, INC. AND SUBSIDIARIES ------------------- the historical separation between banks and insurance companies, enabling traditional banking institutions to enter the insurance and annuity markets and further increase competition. This increasing competition may harm our ability to maintain or increase 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 with other insurance and financial services companies for sales representatives primarily on the basis of our financial position, financial strength ratings, support services and 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 would suffer. If we are unable to attract and retain independent agents for the distribution of products sold through the Conseco Insurance Group segment, sales of our products will decline. Our Conseco Insurance Group segment markets and distributes its products, including specified disease insurance, Medicare supplement insurance, equity-indexed life insurance and equity-indexed annuities, exclusively through independent agents. Premiums collected by our Conseco Insurance Group segment through independent distributors totaled: $1,301.6 million, or 31 percent, of our collected premiums in 2003; $1,680.2 million, or 37 percent, of collected premiums in 2002; and $2,048.0 million, or 40 percent, of collected premiums in 2001. Given the significance of this distribution channel to our business, our ability to maintain our relationships with these independent agents is critical to our financial performance. This ability is dependent upon, among other things, the compensation we offer independent distributors and the overall attractiveness of our products to their customers. In addition, the distribution of our life insurance and annuity products through this channel is particularly sensitive to the financial strength ratings of our insurance subsidiaries. The downgrades of our ratings in 2002, as well as our bankruptcy, caused significant defections among our independent agents and increased our costs of retaining them, which had a material adverse effect on our results of operations. Following the downgrade of our A.M. Best rating to "B" in August 2002, the premiums we collected from business distributed by independent agents decreased to $762.6 million in the last six months of 2002 and $668.7 million in the first six months of 2003, compared to $917.6 million in the first six months of 2002, the period immediately preceding the downgrade. In the event that we are unable to attract and retain qualified independent distributors of our products, our operations and financial results may be materially adversely affected. We may require additional capital in the future, which may not be available or may only be available on unfavorable terms. Our future capital requirements depend on many factors, including our ability to write new business successfully and to establish premium rates and reserves at levels sufficient to cover policyholder benefits. While we currently expect to fund our capital needs for the next several years from our operations, if those prove to be insufficient we may need to raise additional funds through future financings and, if we are unable to raise additional funds, we may need to curtail our growth and reduce our assets. Any equity or debt financing, if available at all, may be on terms that are not favorable to us. In the case of equity financings, dilution to our shareholders could result, and in any case such securities may have rights, preferences and privileges that are senior to the shares currently outstanding. If we cannot obtain adequate capital on favorable terms or at all, our business, operating results and financial condition could be adversely affected. Our financial results would be negatively impacted if we are required to indemnify the purchasers of businesses that we have recently sold. We are subject to retained liabilities and indemnification obligations related to businesses we have sold. For example, we retained liabilities for certain purported class action litigation in connection with our sale of Manhattan National Life Insurance Company in June 2002. In addition, the agreement entered into in connection with our sale of CVIC imposes continuing indemnification obligations with respect to liabilities relating to our period of ownership of CVIC, and the agreement entered into in connection with our sale of CFC imposes continuing tax sharing obligations with respect to tax 53 CONSECO, INC. AND SUBSIDIARIES ------------------- liabilities relating to our period of ownership of CFC. We cannot assure you that we will not be subject to claims with respect to these continuing or residual obligations, or that any such claims would not be material. RESULTS OF OPERATIONS 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. Please read this discussion in conjunction with the consolidated financial statements and notes included in this Form 10-Q. After our emergence from bankruptcy, we began to manage our business operations through two primary operating segments, based on method of product distribution, and a third segment comprised of business in run-off. We refer to these segments as: (i) Bankers Life; (ii) Conseco Insurance Group; and (iii) Other Business in Run-Off. Prior to its disposition effective March 31, 2003, we also had a finance segment. We also have a corporate segment, which consists of holding company activities and certain noninsurance company businesses that are not related to our other operating segments. The following tables and narratives summarize the operating results of our segments for the periods presented as we currently manage them (dollars in millions):
Successor Predecessor -------------------------------- ----------- Three months One month Two months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Earnings (losses) before taxes: Bankers Life (a)................................................. $ 54.2 $ 24.9 $ 43.0 Conseco Insurance Group (b)...................................... 68.0 20.8 230.8 Other Business in Run-off (c).................................... 17.5 3.4 (99.5) Corporate operations (d)......................................... (34.8) (11.3) 2,084.7 ------ ------ -------- Income before income taxes and discontinued operations....................................... $104.9 $ 37.8 $2,259.0 ====== ====== ========
Successor Predecessor --------------------------------- ------------ Nine months One month Eight months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Earnings (losses) before taxes: Bankers Life (a)................................................. $ 175.7 $ 24.9 $ 159.6 Conseco Insurance Group (b)...................................... 202.8 20.8 299.9 Other Business in Run-off (c).................................... 49.8 3.4 (171.3) Corporate operations (d)......................................... (104.2) (11.3) 1,884.0 ------- ------ -------- Income before income taxes and discontinued operations....................................... $ 324.1 $ 37.8 $2,172.2 ======= ====== ======== - ---------------- (a) The earnings before taxes of the Bankers Life segment included realized gains (losses), net of related amortization, of $(1.6) million and $9.8 million for the three and nine months ended September 30, 2004, respectively; $2.8 million in the one month ended September 30, 2003; $1.4 million in the two months ended August 31, 2003; and $5.0 million in the eight months ended August 31, 2003. (b) The earnings before taxes of the Conseco Insurance Group segment included realized gains (losses), net of related amortization, of $.4 million and $6.1 million for the three and nine months ended September 30, 2004, respectively; $3.7 million in the one month ended September 30, 2003; $(36.1) million in the two months ended August 31, 2003; and $(16.2) million in the eight months ended August 31, 2003.
54 CONSECO, INC. AND SUBSIDIARIES ------------------- (c) The earnings (losses) before taxes of the Other Business in Run-off segment included realized gains (losses), net of related amortization, of $1.0 million and $2.8 million for the three and nine months ended September 30, 2004, respectively; $.6 million in the one month ended September 30, 2003; $.9 million in the two months ended August 31, 2003; and $6.3 million in the eight months ended August 31, 2003. (d) The losses before taxes in our Corporate operations segment included: (i) realized gains (losses) of nil and $(2.8) million for the three and nine months ended September 30, 2004, respectively; $(.4) million in the one month ended September 30, 2003; $(1.6) million in the two months ended August 31, 2003; and $(.1) million in the eight months ended August 31, 2003; and (ii) venture capital income (loss) of $(2.7) million in the one month ended September 30, 2003; $2.0 million in the two months ended August 31, 2003; and $10.5 million in the eight months ended August 31, 2003. There was no venture capital income (loss) in the 2004 periods. 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 a career agency force and direct response marketing (which, together, represent our Bankers Life segment) and through professional independent producers (which represent our Conseco Insurance Group segment). Our Other Business in Run-off segment consists of: (i) long-term care products written in prior years through independent agents; (ii) small group and individual major medical business which we began to nonrenew in 2001; and (iii) other group major medical business which we no longer actively market. Most of the long-term care business in run-off relates to business written by certain of our subsidiaries prior to their acquisitions by Conseco in 1996 and 1997. 55 CONSECO, INC. AND SUBSIDIARIES ------------------- Bankers Life (dollars in millions)
Successor Predecessor --------------------------------- ----------- Three months One month Two months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Premiums and asset accumulation product collections: Annuities..................................................... $ 254.2 $ 63.5 $ 149.4 Supplemental health........................................... 294.3 96.6 191.6 Life.......................................................... 46.4 12.0 30.3 -------- -------- -------- Total premium collections................................... $ 594.9 $ 172.1 $ 371.3 ======== ======== ======== Average liabilities for insurance products: Annuities: Mortality based........................................... $ 357.7 $ 324.6 $ 290.6 Equity-linked............................................. 278.4 262.3 264.0 Deposit based............................................. 3,569.4 3,112.9 3,035.3 Health...................................................... 2,832.6 2,597.0 1,965.7 Life: Interest sensitive........................................ 336.4 333.3 328.1 Non-interest sensitive.................................... 748.1 743.9 653.7 -------- -------- -------- Total average liabilities for insurance products, net of reinsurance ceded...................... $8,122.6 $7,374.0 $6,537.4 ======== ======== ======== Revenues: Insurance policy income....................................... $ 355.3 $ 111.7 $ 227.0 Net investment income: General account invested assets............................. 108.0 32.4 66.9 Equity-indexed products based on the change in value of the S&P 500 Call Options...................... (2.9) (1.4) 1.7 Trading account income related to policyholder and reinsurer accounts.................................... 9.7 6.4 - Change in value of embedded derivatives related to modified coinsurance agreements................ (9.7) (6.4) - Net realized investment gains................................. 2.5 2.8 1.7 Fee revenue and other income.................................. .1 .4 .2 -------- -------- -------- Total revenues............................................ 463.0 145.9 297.5 -------- -------- -------- Expenses: Insurance policy benefits..................................... 281.6 83.1 177.8 Amounts added to policyholder account balances: Annuity products and interest-sensitive life products other than those listed below.................... 37.8 12.6 24.2 Equity-indexed products based on S&P 500 Index............................................. (1.3) (1.2) 3.3 Amortization expense.......................................... 48.8 15.5 29.1 Interest expense on investment borrowings..................... .6 .2 .6 Other operating costs and expenses............................ 41.3 10.8 19.5 -------- -------- -------- Total benefits and expenses............................... 408.8 121.0 254.5 -------- -------- -------- Income before income taxes and discontinued operations......................................... $ 54.2 $ 24.9 $ 43.0 ======== ======== ========
(continued) 56 CONSECO, INC. AND SUBSIDIARIES ------------------- (continued from previous page)
Successor Predecessor --------------------------------- ------------ Three months One month Two months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Health loss ratios: All health lines: Insurance policy benefits................................... $235.5 $73.0 $147.5 Loss ratio (a).............................................. 78.70% 75.73% 76.36% Medicare Supplement: Insurance policy benefits................................... $112.3 $35.3 $63.5 Loss ratio (a).............................................. 70.19% 66.50% 59.83% Long-Term Care: Insurance policy benefits................................... $120.3 $37.2 $82.1 Loss ratio (a).............................................. 89.10% 87.81% 96.60% Interest-adjusted loss ratio (b)............................ 62.01% 62.37% 79.27% Other: Insurance policy benefits................................... $2.9 $.5 $1.9 Loss ratio (a).............................................. 68.58% 52.48% 92.61% - ---------------- (a) We calculate loss ratios by taking the related product's: (i) insurance policy benefits; divided by (ii) insurance policy income. (b) We calculate the interest-adjusted loss ratio for Bankers Life's long-term care products by taking the product's: (i) insurance policy benefits less interest income on the accumulated assets which back the insurance liabilities; divided by (ii) insurance policy income. Interest income is an important factor in measuring losses on this product. The net cash flows from long-term care 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 loss 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 loss ratio reflects the effects of the investment income offset.
57 CONSECO, INC. AND SUBSIDIARIES -------------------
Successor Predecessor --------------------------------- ------------ Nine months One month Eight months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Premiums and asset accumulation product collections: Annuities..................................................... $ 661.9 $ 63.5 $ 698.4 Supplemental health........................................... 890.6 96.6 759.6 Life.......................................................... 130.5 12.0 102.7 -------- -------- -------- Total premium collections................................... $1,683.0 $ 172.1 $1,560.7 ======== ======== ======== Average liabilities for insurance products: Annuities: Mortality based........................................... $ 357.1 $ 324.6 $ 286.5 Equity-linked............................................. 272.2 262.3 264.8 Deposit based............................................. 3,421.2 3,112.9 2,847.7 Health...................................................... 2,772.7 2,597.0 1,916.3 Life: Interest sensitive........................................ 333.1 333.3 324.4 Non-interest sensitive.................................... 751.9 743.9 652.4 -------- -------- -------- Total average liabilities for insurance products, net of reinsurance ceded...................... $7,908.2 $7,374.0 $6,292.1 ======== ======== ======== Revenues: Insurance policy income....................................... $1,047.0 $ 111.7 $ 892.7 Net investment income: General account invested assets............................. 309.7 32.4 253.4 Equity-indexed products based on the change in value of the S&P 500 Call Options...................... (2.0) (1.4) 4.8 Trading account income related to policyholder and reinsurer accounts.................................... 2.8 6.4 - Change in value of embedded derivatives related to modified coinsurance agreements................ (2.8) (6.4) - Net realized investment gains................................. 13.9 2.8 5.5 Fee revenue and other income.................................. .6 .4 .9 -------- -------- -------- Total revenues............................................ 1,369.2 145.9 1,157.3 -------- -------- -------- Expenses: Insurance policy benefits..................................... 820.9 83.1 692.4 Amounts added to policyholder account balances: Annuity products and interest-sensitive life products other than those listed below.................... 109.7 12.6 89.5 Equity-indexed products based on S&P 500 Index............................................. 2.2 (1.2) 13.2 Amortization expense.......................................... 138.1 15.5 113.9 Interest expense on investment borrowings..................... 1.7 .2 3.4 Other operating costs and expenses............................ 120.9 10.8 85.3 -------- -------- -------- Total benefits and expenses............................... 1,193.5 121.0 997.7 -------- -------- -------- Income before income taxes and discontinued operations......................................... $ 175.7 $ 24.9 $ 159.6 ======== ======== ========
(continued) 58 CONSECO, INC. AND SUBSIDIARIES ------------------- (continued from previous page)
Successor Predecessor --------------------------------- ------------ Nine months One month Eight months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Health loss ratios: All health lines: Insurance policy benefits................................... $691.6 $73.0 $578.5 Loss ratio (a).............................................. 77.61% 75.73% 75.30% Medicare Supplement: Insurance policy benefits................................... $329.6 $35.3 $283.3 Loss ratio (a).............................................. 68.26% 66.50% 66.39% Long-Term Care: Insurance policy benefits................................... $355.3 $37.2 $287.2 Loss ratio (a).............................................. 89.16% 87.81% 86.08% Interest-adjusted loss ratio (b)............................ 62.41% 62.37% 69.26% Other: Insurance policy benefits................................... $6.7 $.5 $8.0 Loss ratio (a).............................................. 68.36% 52.48% 101.05% - ---------------- (a) We calculate loss ratios by taking the related product's: (i) insurance policy benefits; divided by (ii) insurance policy income. (b) We calculate the interest-adjusted loss ratio for Bankers Life's long-term care products by taking the product's: (i) insurance policy benefits less interest income on the accumulated assets which back the insurance liabilities; divided by (ii) insurance policy income. Interest income is an important factor in measuring losses on this product. The net cash flows from long-term care 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 loss 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 loss ratio reflects the effects of the investment income offset.
Total premium collections were $594.9 million and $1,683.0 million in the three and nine months ended September 30, 2004, respectively; $172.1 million in the one month ended September 30, 2003; $371.3 million in the two months ended August 31, 2003; and $1,560.7 million in the eight months ended August 31, 2003. Bankers Life's annuity premium collections in 2003 were positively impacted by sales inducements provided to purchasers of our annuities and sales incentives to our career agents. These programs ended at various times during the second quarter of 2003. Sales of annuity products in the third quarter of 2004 were favorably impacted by attractive minimum guarantee crediting rates. See "-- Premium and Asset Accumulation Product Collections" for further analysis of Bankers Life's premium collections. Average liabilities for insurance and asset accumulation products, net of reinsurance ceded were $8.1 billion and $7.9 billion in the three and nine months ended September 30, 2004, respectively; $7.4 billion in the one month ended September 30, 2003; $6.5 billion in the two months ended August 31, 2003; and $6.3 billion in the eight months ended August 31, 2003. The increase in such liabilities is primarily due to: (i) the adoption of fresh start accounting and its effects on the reserves for our health insurance; and (ii) increases in annuity reserves resulting from increased sales of these products in the Bankers Life segment. As discussed above under "-- Total premium collections", annuity premium collections in our Bankers Life segment were positively impacted during the first half of 2003 by sales inducements and incentives. Insurance policy income is comprised of: (i) premiums earned on policies which provide mortality or morbidity coverage; and (ii) fees and other charges made against other policies. See "-- Premium and Asset Accumulation Product Collections" for further analysis. 59 CONSECO, INC. AND SUBSIDIARIES ------------------- Net investment income on general account invested assets (which excludes income on policyholder and reinsurer accounts) was $108.0 million and $309.7 million in the three and nine months ended September 30, 2004, respectively; $32.4 million in the one month ended September 30, 2003; $66.9 million in the two months ended August 31, 2003; and $253.4 million in the eight months ended August 31, 2003. The average balance of general account invested assets was $7.8 billion and $7.5 billion in the three and nine months ended September 30, 2004, respectively; $6.9 billion in the one month ended September 30, 2003; $6.8 billion in the two months ended August 31, 2003; and $6.6 billion in the eight months ended August 31, 2003. The yield on these assets was 5.5 percent in both the three and nine months ended September 30, 2004; 5.6 percent in the one month ended September 30, 2003; 5.9 percent in the two months ended August 31, 2003; and 5.7 percent in the eight months ended August 31, 2003. Net investment income on general account invested assets in the 2004 period is not comparable to the 2003 period due to the application of fresh start accounting which reset the cost basis and yield of our investments to market as of August 31, 2003. In the third quarter of 2004, net investment income was favorably impacted by: (i) prepayments on mortgage loans which had a cost basis below the principal amount of the loan (due to the application of fresh start accounting); and (ii) income from nontraditional investments. Net investment income related to equity-indexed products based on the change in value of the S&P 500 Call Options represents the change in the estimated fair value of Bankers Life's S&P 500 Index Call Options which are purchased in an effort to cover certain 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 should be more than adequate to cover the cost of the S&P 500 Call Options and other costs related to these policies. Option costs that are attributable to benefits provided were $1.3 million and $4.9 million in the three and nine months ended September 30, 2004, respectively; $.8 million in the one month ended September 30, 2003; $1.5 million in the two months ended August 31, 2003; and $7.7 million in the eight months ended August 31, 2003. These costs are reflected in the change in market value of the S&P 500 Call Options included in the investment income amounts. Net investment income (loss) related to equity-indexed products before this expense was $(1.6) million and $2.9 million in the three and nine months ended September 30, 2004, respectively; $(.6) million in the one month ended September 30, 2003; $3.2 million in the two months ended August 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 S&P 500 Index. Such income and related charge 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 S&P 500 Index to which the returns on such products are linked. Change in value of embedded derivatives related to modified coinsurance agreements are described in the note to our consolidated financial statements entitled "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. We expect the change in the value of the embedded derivatives largely to be offset by the change in value of the trading securities. Net realized investment gains (losses) fluctuate from period to period. During the nine months ended September 30, 2004, net realized investment gains in our Bankers Life segment included: (i) $17.9 million of net gains from the sales of investments (primarily fixed maturities); net of (ii) $4.0 million of writedowns of fixed maturity investments, equity securities and other invested assets as a result of conditions which caused us to conclude a decline in fair value of the investment was other than temporary. During the one month ended September 30, 2003, we recognized net realized investment gains in our Bankers Life segment of $2.8 million related to the net gains from the sales of investments (primarily fixed maturities). There were no writedowns of fixed maturity investments in the one month period. During the first eight months of 2003, we recognized net investment gains of $5.5 million. During the first eight months of 2003, the net realized investment gains included: (i) $20.5 million of net gains from the sales of investments (primarily fixed maturities); net of (ii) $15.0 million of writedowns of fixed maturity investments, equity securities and other invested assets as a result of conditions which caused us to conclude a decline in fair value of the investment was other than temporary. Insurance policy benefits fluctuated as a result of the factors summarized in the explanations for loss ratios related to specific products which follow. Loss ratios are calculated by taking the related insurance product's: (i) insurance policy benefits; divided by (ii) insurance policy income. The loss ratio on Bankers Life's Medicare supplement products for the first nine months of 2004 continues to be within our pricing targets. Losses have increased in the 2004 periods compared to favorable experience in 2003. Governmental 60 CONSECO, INC. AND SUBSIDIARIES ------------------- 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), after three years, of not less than 65 percent on individual products and not less than 75 percent on group products. We experience quarterly fluctuations in this ratio from time to time. The net cash flows from our long-term care 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 loss 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 loss ratio on this business has increased over the last year, consistent with the aging of this block. We have recently been experiencing lower than expected lapses on this business, which has also caused the loss ratio to increase. The interest-adjusted loss ratio for long-term care products is calculated by taking the insurance product's: (i) insurance policy benefits less interest income on the accumulated assets which back the insurance liabilities divided by (ii) policy income. The decrease in the interest-adjusted loss ratio for the 2004 periods, is primarily due to the adoption of fresh start accounting which increased the assets assigned to back the insurance liabilities on this block of business. The loss ratios on our other products fluctuate due to the smaller size of these blocks of business. The loss ratios on this business have generally been in line with our expectations. Amounts added to policyholder account balances for annuity products and interest-sensitive life products were $37.8 million and $109.7 million in the three and nine months ended September 30, 2004, respectively; $12.6 million in the one month ended September 30, 2003; $24.2 million in the two months ended August 31, 2003; and $89.5 million in the eight months ended August 31, 2003. The increases are primarily due to increases in annuity reserves partially offset by the decrease in average crediting rates. The weighted average crediting rates for these products were 3.9 percent in both the three and nine months ended September 30, 2004; 4.4 percent in the one month ended September 30, 2003; and 4.2 percent in the eight months ended August 31, 2003. Amounts added to equity-indexed products based on S&P 500 Index correspond to the related investment income accounts described above. Amortization expense includes amortization of the value of policies inforce at the Effective Date, cost of policies produced and the cost of policies purchased (such amortization is collectively referred to as "amortization of insurance intangibles"). Insurance intangibles are amortized: (i) in relation to the estimated gross profits for universal life-type and investment-type products; or (ii) in relation to future anticipated premium revenue for other products. Bankers Life's amortization expense in the 2004 periods is not comparable to the 2003 periods due to the application of fresh start accounting effective August 31, 2003. Amortization expense was $46.8 million in the fourth quarter of 2003, $45.7 million in the first quarter of 2004, $43.6 million in the second quarter of 2004 and $48.8 million in the third quarter of 2004. Such amounts are in line with our expectations given the related premium revenue and gross profits for the periods. The amount that we amortize is also dependent on investment gains and losses realized. When we sell securities at a gain (loss) and reinvest the proceeds at a different yield, we increase (reduce) the amortization of insurance intangibles 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 intangibles of $4.1 million in both the three and nine months ended September 30, 2004; $.3 million in the two months ended August 31, 2003; and $.5 million in the eight months ended August 31, 2003. There was no such amortization in the one month ended September 30, 2003. Interest expense on investment borrowings fluctuates along with our investment borrowing activities and the interest rates thereon. Average investment borrowings in our Bankers Life segment were $183.7 million during the first nine months of 2004; $208.1 million during the one month ended September 30, 2003; and $263.7 million during the eight months ended August 31, 2003. The weighted average interest rates on such borrowings were 1.3 percent during the first nine months of 2004; 1.1 percent during the one month ended September 30, 2003; and 1.9 percent during the eight months ended August 31, 2003. Other operating costs and expenses in our Bankers Life segment increased in the 2004 periods due to higher sales and agent related costs and a decrease in deferrable acquisition expenses. 61 CONSECO, INC. AND SUBSIDIARIES ------------------- Conseco Insurance Group (dollars in millions)
Successor Predecessor --------------------------------- ------------- Three months One month Two months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Premiums and asset accumulation product collections: Annuities....................................................... $ 16.1 $ 5.2 $ 11.5 Supplemental health............................................. 180.3 65.0 128.3 Life............................................................ 93.7 34.5 73.8 ---------- --------- --------- Collections on insurance products............................. $ 290.1 $ 104.7 $ 213.6 ========== ========= ========= Average liabilities for insurance and asset accumulation: Annuities: Mortality based............................................... $ 238.4 $ 244.0 $ 168.2 Equity-linked................................................. 1,463.1 1,566.6 1,460.6 Deposit based................................................. 3,752.1 4,057.5 4,073.8 Separate accounts and investment trust liabilities............ 32.7 62.6 271.9 Health.......................................................... 2,333.2 2,276.9 2,040.1 Life: Interest sensitive............................................ 3,223.2 3,347.3 3,322.2 Non-interest sensitive........................................ 1,443.5 1,501.7 1,493.1 --------- --------- --------- Total average liabilities for insurance and asset accumulation products, net of reinsurance ceded......................................... $12,486.2 $13,056.6 $12,829.9 ========= ========= ========= Revenues: Insurance policy income........................................... $ 284.2 $ 102.9 $ 206.7 Net investment income: General account invested assets................................. 179.0 60.0 135.7 Equity-indexed products based on the change in value of the S&P 500 Call Options............................. (15.4) (6.9) 10.0 Trading account income related to policyholder and reinsurer accounts........................................ 11.2 8.4 - Change in value of embedded derivatives related to modified coinsurance agreements............................ (2.7) (2.2) - Net realized investment gains (losses)............................ 2.5 3.7 (36.9) Fee revenue and other income...................................... 1.0 - 4.9 --------- --------- --------- Total revenues................................................ 459.8 165.9 320.4 --------- --------- --------- Expenses: Insurance policy benefits......................................... 213.7 83.8 (67.6) Amounts added to policyholder account balances: Annuity products and interest-sensitive life products other than those listed below........................ 64.6 25.0 52.8 Equity-indexed products based on S&P 500 Index.................. (4.3) (3.0) 19.3 Amortization expense.............................................. 39.0 9.9 24.1 Interest expense on investment borrowings......................... 1.3 .4 1.3 Other operating costs and expenses................................ 77.5 29.0 59.7 --------- --------- --------- Total benefits and expenses................................... 391.8 145.1 89.6 --------- --------- --------- Income before income taxes and discontinued operations........................................................ $ 68.0 $ 20.8 $ 230.8 ========= ========= =========
(continued) 62 CONSECO, INC. AND SUBSIDIARIES ------------------- (continued from previous page)
Successor Predecessor -------------------------------- ------------- Three months One month Two months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Health loss ratios: All health lines: Insurance policy benefits..................................... $127.3 $44.5 $100.5 Loss ratio (a)................................................ 69.88% 66.17% 77.40% Medicare Supplement: Insurance policy benefits..................................... $55.4 $22.0 $38.8 Loss ratio (a)................................................ 63.41% 68.24% 61.73% Specified Disease: Insurance policy benefits..................................... $70.3 $18.3 $49.7 Loss ratio (a)................................................ 76.98% 60.68% 82.48% Interest-adjusted loss ratio (b).............................. 47.86% 30.90% 52.32% - ------------- (a) We calculate loss ratios by taking the related product's: (i) insurance policy benefits; divided by (ii) insurance policy income. (b) We calculate the interest-adjusted loss ratio for Conseco Insurance Group's specified disease products by taking the product's: (i) insurance policy benefits less interest income on the accumulated assets which back the insurance liabilities; divided by (ii) insurance policy income. Interest income is an important factor in measuring losses on this product. The net cash flows from specified disease 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 loss 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 loss ratio reflects the effects of the investment income offset.
63 CONSECO, INC. AND SUBSIDIARIES -------------------
Successor Predecessor --------------------------------- ------------ Nine months One month Eight months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Premiums and asset accumulation product collections: Annuities....................................................... $ 45.4 $ 5.2 $ 74.0 Supplemental health............................................. 553.0 65.0 525.3 Life............................................................ 285.7 34.5 280.7 --------- --------- ---------- Collections on insurance products............................. $ 884.1 $ 104.7 $ 880.0 ========= ========= ========== Average liabilities for insurance and asset accumulation: Annuities: Mortality based............................................... $ 239.5 $ 244.0 $ 171.0 Equity-linked................................................. 1,502.3 1,566.6 1,514.7 Deposit based................................................. 3,829.2 4,057.5 4,245.4 Separate accounts and investment trust liabilities............ 34.4 62.6 401.3 Health.......................................................... 2,323.2 2,276.9 2,045.4 Life: Interest sensitive............................................ 3,273.4 3,347.3 3,407.8 Non-interest sensitive........................................ 1,448.2 1,501.7 1,495.3 --------- --------- --------- Total average liabilities for insurance and asset accumulation products, net of reinsurance ceded......................................... $12,650.2 $13,056.6 $13,280.9 ========= ========= ========= Revenues: Insurance policy income........................................... $ 873.9 $ 102.9 $ 892.8 Net investment income: General account invested assets................................. 526.0 60.0 557.3 Equity-indexed products based on the change in value of the S&P 500 Call Options............................. (11.5) (6.9) 25.3 Trading account income related to policyholder and reinsurer accounts........................................ 6.0 8.4 - Change in value of embedded derivatives related to modified coinsurance agreements............................ (1.4) (2.2) - Net realized investment gains (losses)............................ 13.6 3.7 (17.1) Fee revenue and other income...................................... 4.3 - 17.0 --------- --------- --------- Total revenues................................................ 1,410.9 165.9 1,475.3 --------- --------- --------- Expenses: Insurance policy benefits......................................... 641.6 83.8 456.4 Amounts added to policyholder account balances: Annuity products and interest-sensitive life products other than those listed below........................ 196.3 25.0 218.4 Equity-indexed products based on S&P 500 Index.................. 10.4 (3.0) 71.5 Amortization expense.............................................. 120.7 9.9 201.8 Interest expense on investment borrowings......................... 3.4 .4 4.7 Other operating costs and expenses................................ 235.7 29.0 222.6 --------- --------- --------- Total benefits and expenses................................... 1,208.1 145.1 1,175.4 --------- --------- --------- Income before income taxes and discontinued operations........................................................ $ 202.8 $ 20.8 $ 299.9 ========= ========= =========
(continued) 64 CONSECO, INC. AND SUBSIDIARIES ------------------- (continued from previous page)
Successor Predecessor --------------------------------- ------------- Nine months One month Eight months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Health loss ratios: All health lines: Insurance policy benefits..................................... $374.0 $44.5 $381.3 Loss ratio (a)................................................ 66.49% 66.17% 70.95% Medicare Supplement: Insurance policy benefits..................................... $173.2 $22.0 $167.2 Loss ratio (a)................................................ 62.43% 68.24% 65.49% Specified Disease: Insurance policy benefits..................................... $192.4 $18.3 $184.6 Loss ratio (a)................................................ 70.49% 60.68% 75.77% Interest-adjusted loss ratio (b).............................. 40.51% 30.90% 46.33% - ------------- (a) We calculate loss ratios by taking the related product's: (i) insurance policy benefits; divided by (ii) insurance policy income. (b) We calculate the interest-adjusted loss ratio for Conseco Insurance Group's specified disease products by taking the product's: (i) insurance policy benefits less interest income on the accumulated assets which back the insurance liabilities; divided by (ii) insurance policy income. Interest income is an important factor in measuring losses on this product. The net cash flows from specified disease 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 loss 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 loss ratio reflects the effects of the investment income offset.
Collections on insurance products were $290.1 million and $884.1 million in the three and nine months ended September 30, 2004, respectively; $104.7 million in the one month ended September 30, 2003; $213.6 million in the two months ended August 31, 2003; and $880.0 million in the eight months ended August 31, 2003. Premium collections through the independent agents in our Conseco Insurance Group segment have been negatively impacted by the A.M. Best ratings downgrade to "B (Fair)"in August 2002 and our decision to de-emphasize the sale of certain products. See "-- Premium and Asset Accumulation Product Collections" for further analysis. Average liabilities for insurance and asset accumulation products, net of reinsurance ceded were $12.5 billion and $12.7 billion in the three and nine months ended September 30, 2004, respectively; $13.1 billion in the one month ended September 30, 2003; $12.8 billion in the two months ended August 31, 2003; and $13.3 billion in the eight months ended August 31, 2003. The decrease in such liabilities is primarily due to the increase in policyholder redemptions and lapses. The liabilities for insurance and asset accumulation products in this segment were not significantly affected by the adoption of fresh start accounting. Insurance policy income is comprised of: (i) premiums earned on policies which provide mortality or morbidity coverage; and (ii) fees and other charges made against other policies. See "-- Premium and Asset Accumulation Product Collections" for further analysis. Net investment income on general account invested assets (which excludes income on policyholder and reinsurer accounts) was $179.0 million and $526.0 million in the three and nine months ended September 30, 2004, respectively; $60.0 million in the one month ended September 30, 2003; $135.7 million in the two months ended August 31, 2003; and $557.3 million in the eight months ended August 31, 2003. The average balance of general account invested assets was $12.5 billion 65 CONSECO, INC. AND SUBSIDIARIES ------------------- in both the three and nine months ended September 30, 2004; $12.7 billion in the one month ended September 30, 2003; $13.2 billion in the two months ended August 31, 2003; and $13.7 billion in the eight months ended August 31, 2003. The yield on these assets was 5.7 percent and 5.6 percent in the three and nine months ended September 30, 2004, respectively; 5.7 percent in the one month ended September 30, 2003; 6.2 percent in the two months ended August 31, 2003; and 6.1 percent in the eight months ended August 31, 2003. Net investment income on general account invested assets in the 2004 periods is not comparable to the 2003 periods due to the application of fresh start accounting which reset the cost basis and yield of our investments to market as of August 31, 2003. In the third quarter of 2004, net investment income was favorably impacted by: (i) prepayments on mortgage loans which had a cost basis below the principal amount of the loan (due to the application of fresh start accounting); and (ii) income from nontraditional investments. Net investment income on general account invested assets in the fourth quarter of 2003 was $180.9 million and the yield on these investments was 5.7 percent. The decrease in income and yield from the fourth quarter of 2003 through the first half of 2004 reflects: (i) the lower interest rate environment prevailing in periods subsequent to August 31, 2003; and (ii) the high level of prepayments experienced on fixed maturity investments (primarily mortgage-backed securities) which have a new cost basis in excess of par value. To the extent investments with a cost basis in excess of par value prepay faster than expected, a reduction in yield will occur due to the acceleration of premium amortization. In addition, the proceeds from investment maturities and prepayments were reinvested at the lower prevailing interest rates, further reducing the overall portfolio yield. Net investment income related to equity-indexed products based on the change in value of the S&P 500 Call Options represents the change in the estimated fair value of Conseco Insurance Group's S&P 500 Index Call Options which are purchased in an effort to cover certain 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 should be more than adequate to cover the cost of the S&P 500 Call Options and other costs related to these policies. Option costs that are attributable to benefits provided were $9.3 million and $28.9 million in the three and nine months ended September 30, 2004, respectively; $4.4 million in the one month ended September 30, 2003; $10.5 million in the two months ended August 31, 2003; and $45.8 million in the eight months ended August 31, 2003. These costs are reflected in the change in market value of the S&P 500 Call Options included in the investment income amounts. Net investment income (loss) related to equity-indexed products before this expense was $(6.1) million and $17.4 million in the three and nine months ended September 30, 2004, respectively; $(2.5) million in the one month ended September 30, 2003; $20.5 million in the two months ended August 31, 2003; and $71.1 million in the eight months ended August 31, 2003. Such amounts were partially offset by the corresponding charge (credit) to amounts added to policyholder account balances for equity-indexed products based on S&P 500 Index. Such income and related charge 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 S&P 500 Index to which the returns on such products are linked. Trading account income related to policyholder and reinsurer accounts represents the income on trading security accounts established on August 31, 2003, which are designed to act as a hedge for embedded derivatives related to: (i) Conseco Insurance Group's equity-indexed products; and (ii) 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 are described in the note to our consolidated financial statements entitled "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. Net realized investment gains (losses) fluctuate from period to period. During the nine months ended September 30, 2004, we recognized net realized investment gains in our Conseco Insurance Group segment which included: (i) $23.9 million of net gains from the sales of investments (primarily fixed maturities); net of (ii) $10.3 million of writedowns of fixed maturity investments, equity securities and other invested assets as a result of conditions which caused us to conclude a decline in fair value of the investment was other than temporary. During the one month ended September 30, 2003, we recognized net realized investment gains in our Conseco Insurance Group segment of $3.7 million related to the net gains from the sales of investments (primarily fixed maturities). There were no writedowns of fixed maturity investments in the one month period. During the first eight months of 2003, the net realized investment losses included: (i) $16.8 million of net 66 CONSECO, INC. AND SUBSIDIARIES ------------------- gains from the sales of investments (primarily fixed maturities); net of (ii) $33.9 million of writedowns of fixed maturity investments, equity securities and other invested assets as a result of conditions which caused us to conclude a decline in fair value of the investment was other than temporary. Fee revenue and other income in the 2003 periods primarily included income earned by a subsidiary (which was sold in September 2003) which earned fees for marketing insurance products of other companies. Insurance policy benefits fluctuated as a result of the factors summarized in the explanations for loss ratios related to specific products which follow. Loss ratios are calculated by taking the related insurance product's: (i) insurance policy benefits; divided by (ii) insurance policy income. The loss ratio on Conseco Insurance Group's Medicare supplement products in the first nine months of 2004 was impacted by rate increases. Such rate increases were implemented earlier in 2004 than in prior years, resulting in a lower loss ratio in the 2004 periods. In addition, the higher rates caused some policyholders to lapse their policies. The release of the policy benefit reserve related to the lapsed business also contributed to the lower loss ratio in the 2004 periods. Governmental 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), after three years, of not less than 65 percent on these products. We experience quarterly fluctuations in this ratio from time to time. Conseco Insurance Group's specified disease products generally provide fixed or limited benefits. 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. Approximately three-fourths 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. 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 loss 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 loss ratio for specified disease products is calculated by taking the insurance product's: (i) insurance policy benefits less interest income on the accumulated assets which back the insurance liabilities; divided by (ii) policy income. The loss ratio in this block of business is affected by the number of policies which surrender in a period. When policies surrender before reaching the specified age when the return of premium is payable, the reserve established for such benefit through the surrender 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 policies which 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. The effect of variances in lapse rates from our expectations are partially offset by reduced amortization of insurance intangibles of $2.2 million. In the first quarter of 2004, the Conseco Insurance Group segment experienced higher than expected death claims. In the second and third quarters of 2004, our death claim experience returned to the level we generally expect. In August 2003, we decided to change a non-guaranteed element of certain Conseco Insurance Group policies. This element was not required by the policy and the change will eliminate the former practice of reducing the cost of insurance charges to amounts below the level permitted under the provisions of the policies. As a result of this decision, our estimates of future expected gross profits on these products used as a basis for amortization of insurance intangibles and the establishment of insurance liabilities has changed. We adjusted the total amortization and reserve charge we had recorded since the acquisition of these policies as a result of the change to our earlier estimates in accordance with Statement of Financial Accounting Standards No. 97, "Accounting and Reporting by Insurance Enterprises of Certain Long-Duration Contracts and for Realized Gains and Losses from the Sale of Investments." The effect of the change in estimate was a $220.2 million reduction to insurance policy benefits and a $39.8 million reduction to amortization recorded in the two and eight months ended August 31, 2003. Amounts added to policyholder account balances for annuity products and interest-sensitive life products were $64.6 million and $196.3 million in the three and nine months ended September 30, 2004, respectively; $25.0 million in the one month ended September 30, 2003; $52.8 million in the two months ended August 31, 2003; and $218.4 million in the eight months ended August 31, 2003. The decrease is primarily due to a smaller block of annuity business inforce and 67 CONSECO, INC. AND SUBSIDIARIES ------------------- changes in the weighted average crediting rates. The weighted average crediting rates for these products were 3.8 percent in both the three and nine months ended September 30, 2004; 4.2 percent in the one month ended September 30, 2003; and 4.4 percent in the eight months ended August 31, 2003. Amounts added to equity-indexed products based on S&P 500 Index correspond to the related investment income accounts described above. Amortization expense includes amortization of insurance intangibles. Conseco Insurance Group's amortization expense in the 2004 period is not comparable to the 2003 period due to the application of fresh start accounting effective August 31, 2003. Amortization expense was $54.5 million in the fourth quarter of 2003, $47.7 million in the first quarter of 2004, $34.0 million in the second quarter of 2004 and $39.0 million in the third quarter of 2004. In accordance with SFAS 97, we are required to amortize the value of policies inforce in relation to estimated gross profits for universal life-type products and investment-type products. SFAS 97 also requires that estimates of expected gross profits used as a basis for amortization be evaluated regularly, and that the total amortization recorded to date be adjusted by a charge or credit to the statement of operations, if actual experience or other evidence suggests that earlier estimates should be revised. Accordingly, the amount of insurance intangibles on our universal life-type and investment-type products that we amortize is dependent on the profits realized during the period and our expectations of future profits. During the second quarter of 2004, we evaluated certain amortization assumptions used to estimate gross profits for universal life-type 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 retroactive reduction to the amortization of insurance intangibles of $7.7 million in the second quarter of 2004. Amortization expense decreased in the first quarter of 2004 as a result of the higher than expected death claims. In addition, amortization expense is affected by the lapse experience on our insurance business. Amortization expense will generally increase when lapses exceed our assumptions and will decrease when lapses are lower than our assumptions. The amount that we amortize is also dependent on investment gains and losses realized. When we sell securities at a gain (loss) and reinvest the proceeds at a different yield, we increase (reduce) the amortization of insurance intangibles 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 intangibles of $2.1 million and $7.5 million in the three and nine months ended September 30, 2004, respectively; $(.8) million in the two months ended August 31, 2003; and $(.9) million in the eight months ended August 31, 2003. There was no such amortization in the one month ended September 30, 2003. Interest expense on investment borrowings fluctuates along with Conseco Insurance Group's investment borrowing activities and the interest rates thereon. Average investment borrowings were $335.3 million during the first nine months of 2004; $308.4 million during the one month ended September 30, 2003; and $403.4 million during the eight months ended August 31, 2003. The weighted average interest rates on such borrowings were 1.3 percent during the first nine months of 2004; 1.5 percent during the one month ended September 30, 2003; and 1.7 percent during the eight months ended August 31, 2003. Other operating costs and expenses in the 2004 periods were lower than the comparable 2003 periods primarily due to lower: (i) compensation costs; and (ii) marketing and agency related expenses. 68 CONSECO, INC. AND SUBSIDIARIES ------------------- Other Business in Run-Off (dollars in millions)
Successor Predecessor --------------------------------- ----------- Three months One month Two months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Premiums and asset accumulation product collections: Long-term care.................................................. $ 92.7 $ 30.1 $ 70.6 Major medical.................................................. 3.6 17.9 31.8 -------- -------- -------- Total premium collections.................................. $ 96.3 $ 48.0 $ 102.4 ======== ======== ======== Average liabilities for other business in run-off: Long-term care.................................................. $3,277.5 $3,294.5 $2,047.5 Major medical................................................... 71.4 108.6 110.5 -------- -------- --------- Total average liabilities for other business in run-off, net of reinsurance ceded...................... $3,348.9 $3,403.1 $2,158.0 ======== ======== ======== Revenues: Insurance policy income......................................... $ 98.3 $ 41.6 $ 83.1 Net investment income on general account invested assets............................................... 41.8 13.5 26.7 Net realized investment gains................................... 1.0 .6 .9 Fee revenue and other income.................................... .1 .3 .1 -------- -------- -------- Total revenues.............................................. 141.2 56.0 110.8 -------- -------- -------- Expenses: Insurance policy benefits....................................... 96.3 43.0 181.1 Amortization expense............................................ 4.1 1.5 8.1 Other operating costs and expenses.............................. 23.3 8.1 21.1 -------- -------- -------- Total benefits and expenses................................. 123.7 52.6 210.3 -------- -------- -------- Income (loss) before income taxes and discontinued operations................................... $ 17.5 $ 3.4 $ (99.5) ======== ======== ======== Health loss ratios: Insurance policy benefits..................................... $ 96.3 $ 43.0 $ 181.1 Loss ratio (a)................................................ 97.93% 103.24% 217.91% Interest-adjusted loss ratio (b).............................. 56.45% 74.39% 188.54% - ----------- (a) We calculate loss ratios by taking the related product's: (i) insurance policy benefits; divided by (ii) insurance policy income. (b) We calculate the interest-adjusted loss ratio for long-term care products included in this segment by taking the product's: (i) insurance policy benefits less interest income on the accumulated assets which back the insurance liabilities; divided by (ii) policy income. Interest income is an important factor in measuring losses on this product. The net cash flows from long-term care 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 loss ratio will typically increase, but the increase in the change
69 CONSECO, INC. AND SUBSIDIARIES ------------------- in reserve will be partially offset by investment income earned on the assets which have accumulated. The interest-adjusted loss ratio reflects the effects of the investment income offset.
Successor Predecessor --------------------------------- ------------ Nine months One month Eight months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Premiums and asset accumulation product collections: Long-term care.................................................. $ 283.4 $ 30.1 $ 268.0 Major medical....................................................... 15.0 17.9 156.4 -------- -------- -------- Total premium collections.................................. $ 298.4 $ 48.0 $ 424.4 ======== ======== ======== Average liabilities for other business in run-off: Long-term care.................................................. $3,284.5 $3,294.5 $1,977.9 Major medical................................................... 77.4 108.6 120.0 -------- -------- -------- Total average liabilities for other business in run-off, net of reinsurance ceded...................... $3,361.9 $3,403.1 $2,097.9 ======== ======== ======== Revenues: Insurance policy income......................................... $ 302.3 $ 41.6 $ 418.8 Net investment income on general account invested assets............................................... 123.0 13.5 101.5 Net realized investment gains................................... 2.8 .6 6.3 Fee revenue and other income.................................... .6 .3 .5 -------- -------- -------- Total revenues.............................................. 428.7 56.0 527.1 -------- -------- -------- Expenses: Insurance policy benefits....................................... 293.5 43.0 595.0 Amortization expense............................................ 13.6 1.5 28.0 Interest expense on investment borrowings....................... .1 - .2 Other operating costs and expenses.............................. 71.7 8.1 75.2 -------- -------- -------- Total benefits and expenses................................. 378.9 52.6 698.4 -------- -------- -------- Income (loss) before income taxes and discontinued operations................................... $ 49.8 $ 3.4 $ (171.3) ======== ======== ======== Health loss ratios: Insurance policy benefits..................................... $ 293.5 $ 43.0 $ 595.0 Loss ratio (a)................................................ 97.06% 103.24% 142.06% Interest-adjusted loss ratio (b).............................. 57.42% 74.39% 119.40% - ----------- (a) We calculate loss ratios by taking the related product's: (i) insurance policy benefits; divided by (ii) insurance policy income. (b) We calculate the interest-adjusted loss ratio for long-term care products included in this segment by taking the product's: (i) insurance policy benefits less interest income on the accumulated assets which back the insurance liabilities; divided by (ii) policy income. Interest income is an important factor in measuring losses on this product. The net cash flows from long-term care 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
70 CONSECO, INC. AND SUBSIDIARIES ------------------- (accounted for as reserve decreases). Accordingly, as the policies age, the loss 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 loss ratio reflects the effects of the investment income offset. Total premium collections in this segment were $96.3 million and $298.4 million in the three and nine months ended September 30, 2004, respectively; $48.0 million in the one month ended September 30, 2003; $102.4 million in the two months ended August 31, 2003; and $424.4 million in the eight months ended August 31, 2003. We have ceased marketing the long-term care business included in this segment. Accordingly, collected premiums will decrease over time. Changes in long-term care premium collections are the result of policy lapses, partially offset by premium rate increases. We have ceased marketing and have not renewed our major medical business, which has resulted in the significant reduction in major medical collected premiums. See "-- Premium and Asset Accumulation Product Collections" for further analysis. Average liabilities for other business in run-off, net of reinsurance ceded were $3.3 billion and $3.4 billion in the three and nine months ended September 30, 2004, respectively; $3.4 billion in the one month ended September 30, 2003; $2.2 billion in the two months ended August 31, 2003; and $2.1 billion in the eight months ended August 31, 2003. Liabilities for this block of long-term care business were significantly affected by the adoption of fresh start accounting. Refer to note 6, "Liabilities for Insurance and Asset Accumulation Products" to our consolidated financial statements included in Form 10-K for the year ended December 31, 2003 for additional information on the effect of fresh start accounting on our insurance liabilities. Insurance policy income is comprised of premiums earned on the segment's long-term care and major medical policies. See "-- Premium and Asset Accumulation Product Collections" for further analysis. Net investment income on general account invested assets was $41.8 million and $123.0 million in the three and nine months ended September 30, 2004, respectively; $13.5 million in the one month ended September 30, 2003; $26.7 million in the two months ended August 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 both the three and nine months ended September 30, 2004; $2.8 billion in the one month ended September 30, 2003; $2.5 billion in the two months ended August 31, 2003; and $2.5 billion in the eight months ended August 31, 2003. The yield on these assets was 5.6 percent and 5.5 percent in the three and nine months ended September 30, 2004, respectively; 5.8 percent in the one month ended September 30, 2003; 6.3 percent in the two months ended August 31, 2003; and 6.1 percent in the eight months ended August 31, 2003. Net investment income on general account invested assets in the 2004 periods is not comparable to the 2003 periods due to the application of fresh start accounting which reset the cost basis and yield of our investments to market as of August 31, 2003. Net investment income on general account invested assets in the fourth quarter of 2003 was $41.8 million and the yield on these investments was 5.8 percent. The decrease in income and yield from the fourth quarter of 2003 through the first half of 2004 reflects: (i) the lower interest rate environment prevailing in periods subsequent to August 31, 2003; and (ii) the high level of prepayments experienced on fixed maturity investments (primarily mortgage-backed securities) which have a new cost basis in excess of par value. To the extent investments with a cost basis in excess of par value prepay faster than expected, a reduction in yield will occur due to the acceleration of premium amortization. In addition, the proceeds from investment maturities and prepayments were reinvested at the lower prevailing interest rates, further reducing the overall portfolio yield. Net realized investment gains fluctuate from period to period. During the nine months ended September 30, 2004, net realized investment gains in our Other Business in Run-off segment included: (i) $3.4 million of net gains from the sales of investments (primarily fixed maturities); net of (ii) $.6 million of write-downs of fixed maturity investments as a result of conditions which caused us to conclude a decline in the fair value of the investment was other than temporary. During the one month ended September 30, 2003, we recognized net realized investment gains of $.6 million in our Other Business in Run-off segment related to the net gains from the sales of investments (primarily fixed maturities). There were no writedowns of fixed maturity investments in the one month period. During the first eight months of 2003, we recognized net realized investment gains of $6.3 million. During the first eight months of 2003, the net realized investment gains included: (i) $8.7 million of net gains from the sales of investments (primarily fixed maturities); net of (ii) $2.4 million of writedowns of fixed maturity investments, equity securities and other invested assets as a result of conditions which caused us to conclude a decline in fair value of the investment was other than temporary. Insurance policy benefits fluctuated primarily as a result of the factors summarized below related to loss ratios in the blocks of long-term care business in this segment. Loss ratios are calculated by taking the product's: (i) insurance policy benefits; divided by (ii) insurance policy income. 71 CONSECO, INC. AND SUBSIDIARIES ------------------- This segment includes long-term care insurance inforce, substantially all of which was issued through independent agents by certain of our 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 out on these products as the policies age, the paid claims have exceeded our expectations. 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 the higher loss ratios. We have been aggressively seeking rate increases and pursuing other actions on certain of these long-term care policies. In addition, during 2004, we have been actively managing our long-term care cases and claim adjudication processes. On April 20, 2004, the Florida Office of Insurance Regulation issued an order to our subsidiary, Conseco Senior, that affects approximately 11,000 home health care policies issued in Florida by Conseco Senior and its predecessor companies. The order provides for Conseco Senior to offer the following three alternatives to holders of these policies: o retention of their current policy with a maximum 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 maximum rate increase in the first year of 25 percent and no more than 15 percent in subsequent years; 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 currently expect to complete the process of notifying our home health care policyholders of these choices in early 2005. We should know which options these policyholders have selected by September 30, 2005. On July 1, 2004, the Florida Office of Insurance Regulation issued a similar order impacting approximately 4,500 home health care policies which are obligations of Washington National. 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 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. The loss ratios for the 2004 periods reflect: (i) unfavorable claims experience on our long-term care products; partially offset by (ii) the elimination of $1.5 million in the third quarter of 2004 ($11.5 million in the first nine months of 2004) of reserve redundancies related to our major medical policies. The decrease in the loss ratios as compared to the 2003 periods also reflects the adoption of fresh start accounting. The net cash flows from long-term care 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 loss 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 loss ratio for long-term care products is calculated by taking the insurance product's: (i) insurance policy benefits less interest income on the accumulated assets which back the insurance liabilities; divided by (ii) policy income. Amortization expense includes amortization of insurance intangibles. The decrease in amortization expense in the 2004 periods reflects the adoption of fresh start accounting, and also reflects the relatively small amount of value of policies inforce associated with the business comprising this segment. Other operating costs and expenses were $23.3 million and $71.7 million in the three and nine months ended September 30, 2004, respectively; $8.1 million in the one month ended September 30, 2003; $21.1 million in the two months ended August 31, 2003; and $75.2 million in the eight months ended August 31, 2003. The decreases in expenses were due primarily to expense reductions in the major medical operations. 72 CONSECO, INC. AND SUBSIDIARIES ------------------- Corporate (dollars in millions)
Successor Predecessor --------------------------------- ----------- Three months One month Two months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Corporate operations: Interest expense on corporate debt............................... $(11.0) $ (6.4) $ (53.5) Net investment income ........................................... .9 .1 3.2 Provision for losses and expense related to stock purchase plan.................................................. - - (24.5) Venture capital income (loss) related to investment in AWE, net of related expenses................................... - (2.7) 2.0 Fee revenue and other income..................................... 4.0 1.5 3.8 Net realized investment losses................................... - (.4) (1.6) Other operating costs and expenses............................... (28.7) (3.4) (7.7) Reorganization items............................................. - - 2,163.0 ------ ------ -------- Income (loss) before income taxes.............................. $(34.8) $(11.3) $2,084.7 ====== ====== ========
Successor Predecessor --------------------------------- ------------ Nine months One month Eight months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Corporate operations: Interest expense on corporate debt............................... $ (59.9) $ (6.4) $ (194.2) Net investment income ........................................... 1.4 .1 16.2 Provision for losses and expense related to stock purchase plan.................................................. - - (55.6) Venture capital income (loss) related to investment in AWE, net of related expenses................................... - (2.7) 10.5 Fee revenue and other income..................................... 11.6 1.5 17.1 Net realized investment losses................................... (2.8) (.4) (.1) Gain on extinguishment of debt................................... 2.8 - - Other operating costs and expenses............................... (57.3) (3.4) (40.4) Reorganization items............................................. - - 2,130.5 ------- ------ -------- Income (loss) before income taxes.............................. $(104.2) $(11.3) $1,884.0 ======= ====== ========
Interest expense on corporate debt in the 2004 periods includes interest expense on the Credit Facility and Previous Credit Facility, including a credit agreement charge of $3.8 million (none of which was recognized in the third quarter of 2004). Interest expense in the one month ended September 30, 2003 reflected interest expense on the Previous Credit Facility. Interest expense in the eight months ended August 31, 2003 reflected interest on notes payable of the Predecessor. Investment income primarily included income earned on short-term investments held by the Corporate segment and miscellaneous other income. The Corporate segment held less invested assets in the 2004 periods, as compared to the same periods in 2003. Provision for losses and expense related to stock purchase plan represents the non-cash provision we established in connection with our guarantees of bank loans to approximately 155 current and former directors, officers and key employees and our 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 eight months ended August 31, 2003, we established a provision of 73 CONSECO, INC. AND SUBSIDIARIES ------------------- $55.6 million in connection with these guarantees and loans. We 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 conjunction with the Plan, the $481.3 million principal amount of bank loans 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 loans which exceed $250 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 and the creditworthiness of the participants. At September 30, 2004, we have estimated that approximately $50.0 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. 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. 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. Net realized investment losses often fluctuate from period to period. In the first nine months of 2004, we recognized a writedown of $2.9 million due to an other-than-temporary decline in value. Gain on extinguishment of debt of $2.8 million resulted from the repayment of our Previous Credit Facility as further described in the note to the consolidated financial statements entitled "Changes in 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. Other operating costs and expenses include general corporate expenses, net of amounts charged to subsidiaries for services provided by the corporate operations. In the third quarter of 2004, we incurred expenses of $13.5 million related to our executive transition as further discussed in the notes to the consolidated financial statements under the captions entitled "Executive Termination" and "Executive Hiring". In addition, general corporate expenses in the three and nine months ended September 30, 2004 included severance expense of $.4 million and $7.2 million, respectively. Reorganization items in the two 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) $(38.4) million related to professional fees associated with our bankruptcy proceedings which are expensed as incurred in accordance with SOP 90-7. The 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. PREMIUM AND ASSET ACCUMULATION PRODUCT COLLECTIONS In accordance with GAAP, insurance policy income as shown 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. Agents, insurance brokers and marketing companies who market our products and prospective purchasers of our products use the ratings of our insurance subsidiaries as an important factor in determining which insurer's products to market or purchase. Ratings have the most impact on our annuity and interest-sensitive life insurance 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, the financial strength ratings of our primary insurance subsidiaries (with the exception of Conseco Senior) were upgraded by A.M. Best, S&P and Moody's. In the third quarter of 2004, Moody's again upgraded the financial strength ratings of our primary insurance subsidiaries (with the exception of Conseco Senior). The current financial strength ratings of our primary insurance subsidiaries (with the exception of Conseco Senior) from A.M. Best, S&P and Moody's are "B++ (Very Good)", 74 CONSECO, INC. AND SUBSIDIARIES ------------------- "BB+" and "Ba1", 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 the ratings issued by these firms and additional information on our ratings, see " -- Liquidity for Insurance Operations." Many of our competitors have higher financial strength ratings and we believe it is critical for us to continue to improve our ratings to be competitive. 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, and the interest rate earned on our investment of premiums. In setting premium rates, we consider historical claims information, industry statistics, the rates of our competitors and other factors. If our actual claims experience proves to be less favorable than we assumed and we are unable to raise our premium rates, our financial results may be adversely affected. Our estimates of insurance liabilities assume we will be able to raise rates if future experience results in blocks of our health insurance business becoming unprofitable. We generally cannot raise our health insurance premiums in any state unless we first obtain the approval of the insurance regulator in that state. We review the adequacy of our premium rates regularly and file rate increases on our products when we believe existing premium rates are too low. It is possible that we will not be able to obtain approval for premium rate increases from currently pending requests or requests filed in the future. If we are unable to raise our premium rates because we fail to obtain approval for a rate increase in one or more states, our net income may decrease. If we are successful in obtaining regulatory approval to raise premium rates due to unfavorable actual claims experience, the increased premium rates may reduce the volume of our new sales and cause existing policyholders to allow their policies to lapse. This could result in anti-selection if healthier policyholders allow their policies to lapse. This would reduce our premium income and profitability in future periods. Increased lapse rates also could require us to expense all or a portion of our insurance intangibles relating to lapsed policies in the period in which those policies lapse, adversely affecting our financial results in that period. Our insurance segments sell insurance 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, senior 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" 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. Total premiums and accumulation product collections were as follows: 75 CONSECO, INC. AND SUBSIDIARIES ------------------- Bankers Life (dollars in millions):
Successor Predecessor --------------------------------- ------------ Three months One month Two months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Premiums collected: Annuities: Equity-indexed (first-year)..................................... $ 13.4 $ .6 $ 2.5 ------ ------ ------ Other fixed (first-year)........................................ 240.5 62.7 146.6 Other fixed (renewal)........................................... .3 .2 .3 ------ ------ ------ Subtotal - other fixed annuities.............................. 240.8 62.9 146.9 ------ ------ ------ Total annuities............................................... 254.2 63.5 149.4 ------ ------ ------ Supplemental health: Medicare supplement (first-year)................................ 17.4 4.7 9.5 Medicare supplement (renewal)................................... 138.6 48.3 94.4 ------ ------ ------ Subtotal - Medicare supplement................................ 156.0 53.0 103.9 ------ ------ ------ Long-term care (first-year)..................................... 17.7 6.0 12.2 Long-term care (renewal)........................................ 117.6 36.6 73.2 ------ ------ ------ Subtotal - long-term care..................................... 135.3 42.6 85.4 ------ ------ ------ Other health (first-year)....................................... .2 - .2 Other health (renewal).......................................... 2.8 1.0 2.1 ------ ------ ------ Subtotal - other health....................................... 3.0 1.0 2.3 ------ ------ ------ Total supplemental health..................................... 294.3 96.6 191.6 ------ ------ ------ Life insurance: First-year...................................................... 12.5 3.9 8.3 Renewal......................................................... 33.9 8.1 22.0 ------ ------ ------ Total life insurance.......................................... 46.4 12.0 30.3 ------ ------ ------ Collections on insurance products: Total first-year premium collections on insurance products...................................................... 301.7 77.9 179.3 Total renewal premium collections on insurance products...................................................... 293.2 94.2 192.0 ------ ------ ------ Total collections on insurance products....................... $594.9 $172.1 $371.3 ====== ====== ======
76 CONSECO, INC. AND SUBSIDIARIES -------------------
Successor Predecessor --------------------------------- ------------- Nine months One month Eight months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Premiums collected: Annuities: Equity-indexed (first-year)................................... $ 27.3 $ .6 $ 10.0 -------- ------ -------- Other fixed (first-year)...................................... 633.3 62.7 685.4 Other fixed (renewal)......................................... 1.3 .2 3.0 -------- ------ -------- Subtotal - other fixed annuities............................ 634.6 62.9 688.4 -------- ------ -------- Total annuities............................................. 661.9 63.5 698.4 -------- ------ -------- Supplemental health: Medicare supplement (first-year).............................. 51.5 4.7 37.6 Medicare supplement (renewal)................................. 427.6 48.3 381.5 -------- ------ -------- Subtotal - Medicare supplement.............................. 479.1 53.0 419.1 -------- ------ -------- Long-term care (first-year)................................... 52.4 6.0 48.7 Long-term care (renewal)...................................... 349.7 36.6 282.8 -------- ------ -------- Subtotal - long-term care................................... 402.1 42.6 331.5 -------- ------ -------- Other health (first-year)..................................... .7 - .8 Other health (renewal)........................................ 8.7 1.0 8.2 -------- ------ -------- Subtotal - other health..................................... 9.4 1.0 9.0 -------- ------ -------- Total supplemental health................................... 890.6 96.6 759.6 -------- ------ -------- Life insurance: First-year.................................................... 36.3 3.9 25.1 Renewal....................................................... 94.2 8.1 77.6 -------- ------ -------- Total life insurance........................................ 130.5 12.0 102.7 -------- ------ -------- Collections on insurance products: Total first-year premium collections on insurance products.................................................... 801.5 77.9 807.6 Total renewal premium collections on insurance products.................................................... 881.5 94.2 753.1 -------- ------ -------- Total collections on insurance products..................... $1,683.0 $172.1 $1,560.7 ======== ====== ========
Annuities in the Bankers Life segment include equity-indexed and other fixed annuities sold to the senior market through our career agents. In order to maintain our career agency distribution force during the parent company's Chapter 11 reorganization process, we provided certain sales inducements to purchasers of annuities and sales incentives to our career agents. These programs ended at various times during the second quarter of 2003. Annuity collections from career agents were $254.2 million and $661.9 million in the three and nine months ended September 30, 2004, respectively; $63.5 million in the one month ended September 30, 2003; $149.4 million in the two months ended August 31, 2003; and $698.4 million in the eight months ended August 31, 2003. Annuity premium collections in 2003 were favorably impacted by the sales inducements and incentives discussed above. In addition, in the first half of 2003 and the first nine months of 2004, the minimum guaranteed crediting rates on certain of our annuity products were very attractive. 77 CONSECO, INC. AND SUBSIDIARIES ------------------- Supplemental health products in the Bankers Life segment include Medicare supplement, long-term care and other insurance products distributed through our career agency force. 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 Bankers Life segment were $156.0 million and $479.1 million in the three and nine months ended September 30, 2004, respectively; $53.0 million in the one month ended September 30, 2003; $103.9 million in the two months ended August 31, 2003; and $419.1 million in the eight months ended August 31, 2003. Premiums collected on Bankers Life's long-term care policies were $135.3 million and $402.1 million in the three and nine months ended September 30, 2004, respectively; $42.6 million in the one month ended September 30, 2003; $85.4 million in the two months ended August 31, 2003; and $331.5 million in the eight months ended August 31, 2003. Sales of first-year long-term care policies through our career agents were comparable to the same period in 2003. Other health products include various other health insurance products which we have not been actively marketing. Premiums collected in the 2004 periods were comparable to the 2003 periods. Life products in our Bankers Life segment are sold primarily to the senior market through our career agents and our direct response distribution channel. Life premiums collected in this were $46.4 million and $130.5 million in the three and nine months ended September 30, 2004, respectively; $12.0 million in the one month ended September 30, 2003; $30.3 million in the two months ended August 31, 2003; and $102.7 million in the eight months ended August 31, 2003. Collected premiums have been impacted by increases in new sales. 78 CONSECO, INC. AND SUBSIDIARIES ------------------- Conseco Insurance Group (dollars in millions)
Successor Predecessor ---------------------------------- ------------ Three months One month Two months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Premiums collected: Annuities: Equity-indexed (first-year)..................................... $ 7.9 $ 1.4 $ 1.3 Equity-indexed (renewal)........................................ 2.6 .9 5.7 ------ ------ ------ Subtotal - equity-indexed annuities........................... 10.5 2.3 7.0 ------ ------ ------ Other fixed (first-year)........................................ 2.7 .6 1.4 Other fixed (renewal)........................................... 2.9 2.3 3.1 ------ ------ ------ Subtotal - other fixed annuities.............................. 5.6 2.9 4.5 ------ ------ ------ Total annuities............................................... 16.1 5.2 11.5 ------ ------ ------ Supplemental health: Medicare supplement (first-year)................................ 4.8 4.0 8.4 Medicare supplement (renewal)................................... 81.2 25.8 57.3 ------ ------ ------ Subtotal - Medicare supplement................................ 86.0 29.8 65.7 ------ ------ ------ Specified disease (first-year).................................. 8.3 2.4 2.6 Specified disease (renewal)..................................... 82.3 27.1 50.9 ------ ------ ------ Subtotal - specified disease.................................. 90.6 29.5 53.5 ------ ------ ------ Other health (first-year)....................................... - 1.9 6.1 Other health (renewal).......................................... 3.7 3.8 3.0 ------ ------ ------ Subtotal - other health....................................... 3.7 5.7 9.1 ------ ------ ------ Total supplemental health..................................... 180.3 65.0 128.3 ------ ------ ------ Life insurance: First-year...................................................... 4.3 1.7 4.0 Renewal......................................................... 89.4 32.8 69.8 ------ ------ ------ Total life insurance.......................................... 93.7 34.5 73.8 ------ ------ ------ Collections on insurance products: Total first-year premium collections on insurance products...................................................... 28.0 12.0 23.8 Total renewal premium collections on insurance products...................................................... 262.1 92.7 189.8 ------ ------ ------ Total collections on insurance products....................... $290.1 $104.7 $213.6 ====== ====== ======
79 CONSECO, INC. AND SUBSIDIARIES -------------------
Successor Predecessor --------------------------------- -------------- Nine months One month Eight months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Premiums collected: Annuities: Equity-indexed (first-year)..................................... $ 20.1 $ 1.4 $ 32.8 Equity-indexed (renewal)........................................ 9.8 .9 12.1 ------ ------ ------ Subtotal - equity-indexed annuities........................... 29.9 2.3 44.9 ------ ------ ------ Other fixed (first-year)........................................ 5.9 .6 14.3 Other fixed (renewal)........................................... 9.6 2.3 14.8 ------ ------ ------ Subtotal - other fixed annuities.............................. 15.5 2.9 29.1 ------ ------ ------ Total annuities............................................... 45.4 5.2 74.0 ------ ------ ------ Supplemental health: Medicare supplement (first-year)................................ 18.3 4.0 36.5 Medicare supplement (renewal)................................... 249.0 25.8 213.9 ------ ------ ------ Subtotal - Medicare supplement................................ 267.3 29.8 250.4 ------ ------ ------ Specified disease (first-year).................................. 25.0 2.4 19.7 Specified disease (renewal)..................................... 248.3 27.1 216.7 ------ ------ ------ Subtotal - specified disease.................................. 273.3 29.5 236.4 ------ ------ ------ Other health (first-year)....................................... .1 1.9 9.7 Other health (renewal).......................................... 12.3 3.8 28.8 ------ ------ ------ Subtotal - other health....................................... 12.4 5.7 38.5 ------ ------ ------ Total supplemental health..................................... 553.0 65.0 525.3 ------ ------ ------ Life insurance: First-year...................................................... 14.9 1.7 20.6 Renewal......................................................... 270.8 32.8 260.1 ------ ------ ------ Total life insurance.......................................... 285.7 34.5 280.7 ------ ------ ------ Collections on insurance products: Total first-year premium collections on insurance products...................................................... 84.3 12.0 133.6 Total renewal premium collections on insurance products...................................................... 799.8 92.7 746.4 ------ ------ ------ Total collections on insurance products....................... $884.1 $104.7 $880.0 ====== ====== ======
Annuities in our Conseco Insurance Group segment include equity-indexed annuities and other fixed annuities sold through professional independent producers. Many professional independent producers discontinued marketing our annuity products after A.M. Best lowered our financial strength ratings. Accordingly, we took actions to reduce our expenses related to marketing these products through this distribution channel, and began to focus instead on the sale of products that were less ratings sensitive. Total annuity collected premiums in this segment were $16.1 million and $45.4 million in the three and nine months ended September 30, 2004, respectively; $5.2 million in the one month ended September 30, 2003; $11.5 million in the two months ended August 31, 2003; and $74.0 million in the eight months ended August 31, 2003. We introduced our first equity-indexed annuity product in 1996. The accumulation value of these annuities is credited with interest at an annual guaranteed minimum rate of 3 percent (or, including the effect of applicable sales loads, a 1.7 80 CONSECO, INC. AND SUBSIDIARIES ------------------- percent compound average interest rate over the term of the contracts). These annuities provide for potentially higher returns based on a percentage of the change in the S&P 500 Index during each year of their term. We purchase S&P 500 Call Options in an effort to hedge increases to policyholder benefits resulting from increases in the S&P 500 Index. Total collected premiums for this product were $10.5 million and $29.9 million in the three and nine months ended September 30, 2004, respectively; $2.3 million in the one month ended September 30, 2003; $7.0 million in the two months ended August 31, 2003; and $44.9 million in the eight months ended August 31, 2003. The decrease can be attributed to the general stock market performance in recent periods which has made other investment products more attractive to certain customers. 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 $5.6 million and $15.5 million in the three and nine months ended September 30, 2004, respectively; $2.9 million in the one month ended September 30, 2003; $4.5 million in the two months ended August 31, 2003; and $29.1 million in the eight months ended August 31, 2003. The decrease can be attributed to our emphasis on the sales of other products that are less ratings sensitive. Supplemental health products in our 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 $86.0 million and $267.3 million in the three and nine months ended September 30, 2004, respectively; $29.8 million in the one month ended September 30, 2003; $65.7 million in the two months ended August 31, 2003; and $250.4 million in the eight months ended August 31, 2003. New Medicare supplement sales have been affected by increases in premium rates. Premiums collected on specified disease products were $90.6 million and $273.3 million in the three and nine months ended September 30, 2004, respectively; $29.5 million in the one month ended September 30, 2003; $53.5 million in the two months ended August 31, 2003; and $236.4 million in the eight months ended August 31, 2003. The 2004 periods were favorably impacted by a slight increase in new sales. Other health products include disability income, dental and various other health insurance products. We no longer actively market many of these products. Premiums collected were $3.7 million and $12.4 million in the three and nine months ended September 30, 2004, respectively; $5.7 million in the one month ended September 30, 2003; $9.1 million in the two months ended August 31, 2003; and $38.5 million in the eight months ended August 31, 2003. Life products in the Conseco Insurance Group segment are sold through professional independent producers. Life premiums collected were $93.7 million and $285.7 million in the three and nine months ended September 30, 2004, respectively; $34.5 million in the one month ended September 30, 2003; $73.8 million in the two months ended August 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. We stopped actively marketing certain of our life insurance products sold through the professional independent producer channel in the second quarter of 2003. 81 CONSECO, INC. AND SUBSIDIARIES ------------------- Other Business in Run-Off (dollars in millions)
Successor Predecessor ---------------------------------- ------------- Three months One month Two months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Premiums collected: Long-term care: First-year......................................................... $ - $ .2 $ .5 Renewal............................................................ 92.7 29.9 70.1 ----- ----- ------ Subtotal - long-term care........................................ 92.7 30.1 70.6 ----- ----- ------ Major medical: Group (first-year)................................................. - - - Group (renewal).................................................... 2.7 17.4 28.6 ----- ----- ------ Subtotal - group major medical................................... 2.7 17.4 28.6 ----- ----- ------ Individual (first-year)............................................ - - - Individual (renewal)............................................... .9 .5 3.2 ----- ----- ------ Subtotal - individual major medical.............................. .9 .5 3.2 ----- ----- ------ Total major medical.............................................. 3.6 17.9 31.8 ----- ----- ------ Collections on insurance products: Total first-year premium collections on insurance products......................................................... - .2 .5 Total renewal premium collections on insurance products......................................................... 96.3 47.8 101.9 ----- ----- ------ Total collections on insurance products.......................... $96.3 $48.0 $102.4 ===== ===== ======
82 CONSECO, INC. AND SUBSIDIARIES -------------------
Successor Predecessor --------------------------------- ------------ Nine months One month Eight months ended ended ended September 30, September 30, August 31, 2004 2003 2003 ---- ---- ---- Premiums collected: Long-term care: First-year...................................................... $ .2 $ .2 $ 3.2 Renewal......................................................... 283.2 29.9 264.8 ------ ----- ------ Subtotal - long-term care..................................... 283.4 30.1 268.0 ------ ----- ------ Major medical: Group (first-year).............................................. - - - Group (renewal)................................................. 12.3 17.4 152.4 ------ ----- ------ Subtotal - group major medical................................ 12.3 17.4 152.4 ------ ----- ------ Individual (first-year)......................................... - - - Individual (renewal)............................................ 2.7 .5 4.0 ------ ----- ------ Subtotal - individual major medical........................... 2.7 .5 4.0 ------ ----- ------ Total major medical........................................... 15.0 17.9 156.4 ------ ----- ------ Collections on insurance products: Total first-year premium collections on insurance products..................................................... .2 .2 3.2 Total renewal premium collections on insurance products...................................................... 298.2 47.8 421.2 ------ ----- ------ Total collections on insurance products....................... $298.4 $48.0 $424.4 ====== ===== ======
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 were $92.7 million and $283.4 million in the three and nine months ended September 30, 2004, respectively; $30.1 million in the one month ended September 30, 2003; $70.6 million in the two months ended August 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 of our 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 "-- 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. Group major medical premiums were $2.7 million and $12.3 million in the three and nine months ended September 30, 2004, respectively; $17.4 million in the one month ended September 30, 2003; $28.6 million in the two months ended August 31, 2003; and $152.4 million in the eight months ended August 31, 2003. We no longer actively market new sales of group products. In early 2002, we decided to stop renewing all inforce small group business and discontinued new sales. Individual major medical premiums collected are not significant. In the second half of 2001, we stopped renewing a large portion of our major medical lines of business. In early 2002, we decided to stop renewing all inforce individual major medical business and discontinued new sales. 83 CONSECO, INC. AND SUBSIDIARIES ------------------- LIQUIDITY AND CAPITAL RESOURCES Changes in our consolidated balance sheet between September 30, 2004 and December 31, 2003, primarily reflect: (i) the issuance of common stock and preferred stock and the use of proceeds from such offerings, as further described in the note to the consolidated financial statements entitled "Changes in Common Stock and Preferred Stock"; (ii) the refinancing of our Previous Credit Facility, as further described in the note to the consolidated financial statements entitled "Changes in Direct Corporate Obligations"; (iii) our net income for the nine months ended September 30, 2004; 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 September 30, 2004, and December 31, 2003, we increased the carrying value of such investments by $568.1 million and $375.2 million, respectively, as a result of this fair value adjustment. Our capital structure as of September 30, 2004, and December 31, 2003, was as follows (dollars in millions):
Successor ----------------------------- September 30, December 31, 2004 2003 ---- ---- Total capital: Corporate notes payable................................................ $ 788.6 $1,300.0 Shareholders' equity: Preferred stock..................................................... 667.8 887.5 Common stock........................................................ 1.5 1.0 Additional paid-in-capital.......................................... 2,535.8 1,641.9 Accumulated other comprehensive income.............................. 302.8 218.7 Retained earnings................................................... 220.9 68.5 -------- -------- Total shareholders' equity....................................... 3,728.8 2,817.6 -------- -------- Total capital.................................................... $4,517.4 $4,117.6 ======== ========
The following table summarizes certain financial ratios as of and for the nine months ended September 30, 2004 and as of and for the four months ended December 31, 2003:
Successor --------------------------- September 30, December 31, 2004 2003 ---- ---- Book value per common share.................................................................. $20.25 $19.28 Book value per common share, excluding accumulated other comprehensive income(1)............. 18.25 17.09 Ratio of earnings to fixed charges........................................................... 1.85x 1.79x Ratio of earnings to fixed charges and preferred dividends................................... 1.51x 1.46x Debt to total capital ratios: Corporate debt to total capital........................................................... 17% 32% Corporate debt to total capital, excluding accumulated other comprehensive income(1)...... 19% 33% Corporate debt and preferred stock to total capital....................................... 32% 53% Corporate debt and preferred stock to total capital, excluding accumulated other comprehensive income(1).............................................................. 35% 56% - ----------------------- (1) This non-GAAP measure differs from the corresponding GAAP measure presented immediately above, because accumulated other comprehensive income (loss) 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 from changes in accumulated other comprehensive income (loss) in the value of capital. 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.
84 CONSECO, INC. AND SUBSIDIARIES ------------------- Liquidity for insurance operations Our insurance operating companies generally receive adequate cash flow from premium collections and investment income to meet their obligations. Life insurance and annuity liabilities are generally long-term in nature. Policyholders may, however, withdraw funds or surrender their policies, subject to any applicable surrender and withdrawal penalty provisions. We seek to balance the duration of our invested assets with the estimated duration of benefit payments arising from contract liabilities. In July 2002, A.M. Best downgraded the financial strength ratings of our primary insurance subsidiaries from "A- (Excellent)" to "B++ (Very good)" and placed the ratings "under review with negative implications." On August 14, 2002, A.M. Best again lowered the financial strength ratings of our primary insurance subsidiaries from "B++ (Very Good)" to "B (Fair)". 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 superior overall performance and a superior ability to meet ongoing obligations to policyholders. The "B" rating is assigned to companies which have, on balance, fair balance sheet strength, operating performance and business profile, when compared to the standards established by A.M. Best, and 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. On June 25, 2004, A.M. Best upgraded the financial strength ratings of our primary insurance subsidiaries from "B (Fair)" to "B++ (Very Good)", with the exception of 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. On August 2, 2002, S&P downgraded the financial strength rating of our primary insurance companies from BB+ to B+. On November 19, 2003, S&P assigned a "BB-" counterparty credit and financial strength rating to our primary insurance companies, with the exception of Conseco Senior, which was assigned a "CCC" rating. On May 27, 2004, S&P upgraded the financial strength ratings of our primary insurance companies from "BB-" to "BB+", with the exception of 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. On July 1, 2003, Moody's downgraded the financial strength rating of our primary insurance companies from "Ba3" to "B3". On December 4, 2003, Moody's assigned a "Ba3" rating to our primary insurance companies with the exception of Conseco Senior, which was assigned a "Caa1" rating. On May 27, 2004, Moody's upgraded the financial strength rating of our primary insurance companies from "Ba3" to "Ba2" with the exception of 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 "Ba" to "C" are classified as "vulnerable" by Moody's, and may be supplemented with numbers "1", "2", or "3" to show relative standing within a category. In Moody's view, an insurer rated "Ba" offers questionable financial security and the ability of the insurer to meet policyholder obligations may be very moderate and thereby not well safeguarded in the future. 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 lowered ratings assigned to our insurance subsidiaries caused sales of our insurance products to decline and policyholder redemptions and lapses to increase during 2002, 2003 and the first half of 2004. We also experienced increased agent attrition, which in some cases led us to increase commissions or sales incentives we must pay in order to retain them. These events have had a material adverse effect on our financial results. Our insurance subsidiaries domiciled in Texas, Bankers National Life Insurance Company and Conseco Life Insurance Company of Texas, on behalf of itself and its subsidiaries, entered into consent orders with the Texas Department of Insurance, on October 30, 2002, which were formally released on November 19, 2003. The consent orders applied to all of our insurance subsidiaries and, among other requirements, restricted the ability of our insurance subsidiaries to pay any dividends or other amounts to any non-insurance company parent without prior approval. Notwithstanding the release of the 85 CONSECO, INC. AND SUBSIDIARIES ------------------- consent orders, we agreed with the Texas Department of Insurance to provide prior notice of certain transactions, including up to 30 days prior notice for the payment of dividends by an insurance subsidiary to any non-insurance company parent. State laws generally provide state insurance regulatory agencies with broad authority to protect policyholders in their jurisdictions. Accordingly, we cannot assure you that the regulators will not seek to assert greater supervision and control over our insurance subsidiaries' businesses and financial affairs. Liquidity of the Holding Companies On June 22, 2004, we entered into the Credit Facility with a principal balance of $800.0 million. The Credit Facility is a six-year term loan, the proceeds of which were used: (i) to refinance in full all indebtedness, including accrued interest, under the Previous Credit Facility; (ii) to repurchase $106.6 million of certain affiliated preferred stock; and (iii) for other general corporate purposes. We are required to make quarterly principal payments of $2.0 million commencing on September 30, 2004, and continuing until March 31, 2010. The remaining balance of $754.0 million is due on June 22, 2010. See the note to the consolidated financial statements entitled "Changes in Direct Corporate Obligations" for further discussion related to the Credit Facility. At September 30, 2004, Conseco Inc. and CDOC held unrestricted cash of $74.9 million. In addition, our other non-life insurance companies held unrestricted cash of approximately $59.4 million which could be upstreamed to the parent companies if needed. Conseco 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. The cash which Conseco and CDOC receive from insurance subsidiaries consists of dividends and distributions, principal and interest payments on surplus debentures, fees for services, tax-sharing payments, and from our non-insurance subsidiaries, loans and advances. A further deterioration in the financial condition, earnings or cash flow of the material subsidiaries of Conseco or CDOC for any reason could further limit 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. 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 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; and (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. Also, we have agreed with the Texas Department of Insurance to provide up to 30 days prior notice of the payment of dividends by an insurance subsidiary to any non-insurance company parent. We recently were subject to consent orders with the Commissioner of Insurance for the State of Texas that, among other requirements, restricted the ability of our insurance subsidiaries to pay any dividends to any non-insurance company parent without prior approval. If our financial condition were to deteriorate, we may be required to enter into similar orders in the future. 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. 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 assure you 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 under the insurance law of its state of domicile by such state's insurance regulator as the receiver with respect to 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 will not have the right to proceed against the assets of our insurance subsidiaries or to cause their liquidation under federal and state bankruptcy laws. We have adopted several initiatives designed to reduce the expense levels that exceed product pricing at our Conseco Insurance Group segment. These initiatives include the elimination of duplicate processing systems by converting similar systems to a much smaller number of systems. We expect to spend over $35 million on capital expenditures in 2004 86 CONSECO, INC. AND SUBSIDIARIES ------------------- (including amounts related to the aforementioned initiatives). We believe we have adequate cash flows from operations to fund these initiatives. Under our 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. Our ability to meet these financial covenants may be affected by events beyond our control. These requirements represent significant restrictions on the manner in which we may operate our business. 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 assure you that we would have sufficient liquidity to repay or refinance this indebtedness or any of our other debts. INVESTMENTS At September 30, 2004, the amortized cost and estimated fair value of actively managed fixed maturities and equity securities were as follows (dollars in millions):
Gross Gross Estimated Amortized unrealized unrealized fair cost gains losses value ---- ----- ------ ----- Investment grade: Corporate securities................................................ $12,158.0 $423.3 $21.4 $12,559.9 United States Treasury securities and obligations of United States government corporations and agencies................ 1,635.2 24.9 2.5 1,657.6 States and political subdivisions................................... 747.3 15.8 4.8 758.3 Debt securities issued by foreign governments....................... 115.9 3.7 .1 119.5 Structured securities .............................................. 5,338.9 90.9 5.8 5,424.0 Below-investment grade (primarily corporate securities)................ 750.6 43.3 6.9 787.0 --------- ------ ----- --------- Total actively managed fixed maturities............................. $20,745.9 $601.9 $41.5 $21,306.3 ========= ====== ===== ========= Equity securities...................................................... $62.5 $5.2 $.1 $67.6 ===== ==== === =====
Concentration of Actively Managed Fixed Maturity Securities The following table summarizes the carrying values of our fixed maturity securities by industry category as of September 30, 2004 (dollars in millions):
Percent of Carrying value fixed maturities -------------- ---------------- Structured securities................................................................ $ 5,426.9 25.4% Bank and finance..................................................................... 3,478.2 16.4 Services............................................................................. 2,702.0 12.7 Manufacturing........................................................................ 2,471.3 11.6 Utilities............................................................................ 1,421.8 6.7 Communications....................................................................... 1,059.4 5.0 Government (US)...................................................................... 898.1 4.2 Agriculture, forestry and mining..................................................... 830.0 3.8 Asset-backed securities.............................................................. 724.7 3.4 Retail and wholesale................................................................. 659.7 3.1 Transportation....................................................................... 593.4 2.8 Other................................................................................ 1,040.8 4.9 --------- ----- Total fixed maturity securities................................................... $21,306.3 100.0% ========= =====
87 CONSECO, INC. AND SUBSIDIARIES ------------------- Below-Investment Grade Securities At September 30, 2004, the amortized cost of the Company's fixed maturity securities in below-investment grade securities was $750.6 million, or 3.6 percent of the Company's fixed maturity portfolio. The estimated fair value of the below-investment grade portfolio was $787.0 million, or 105 percent of the amortized cost. The value of these securities varies based on the economic terms of the securities, structural considerations and the creditworthiness of the issuer of the securities. Below-investment grade securities have different characteristics than investment grade corporate debt securities. Risk of loss upon default by the borrower is significantly greater with respect to below-investment grade securities than with other corporate debt securities. Below-investment grade securities are generally unsecured and are often subordinated to other creditors of the issuer. Also, issuers of below-investment grade securities usually have higher levels of debt and are 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 in the below-investment grade portfolio, as in all investments, through careful credit analysis, strict investment policy guidelines, and diversification by issuer and/or guarantor and by industry. Net Realized Investment Gains (Losses) During the first nine months of 2004, we recognized net realized investment gains of $27.5 million. The net realized investment gains during the first nine months of 2004 included: (i) $45.3 million of net gains from the sales of investments (primarily fixed maturities) which generated proceeds of $9.9 billion; net of (ii) $17.8 million of writedowns of fixed maturity investments, equity securities and other invested assets as a result of conditions which caused us to conclude a decline in fair value of the investment was other than temporary. During the one month ended September 30, 2003, we recognized net realized investment gains of $6.7 million resulting from the sales of investments (primarily fixed maturities) which generated proceeds of $2.1 billion. There were no writedowns of fixed maturity investments as a result of conditions which caused us to conclude a decline in fair value of the investment was other than temporary. During the first eight months of 2003, we recognized net realized investment losses of $5.4 million. The net realized investment losses during the first eight months of 2003 included: (i) $45.9 million of net gains from the sales of investments (primarily fixed maturities) which generated proceeds of $5.4 billion; net of (ii) $51.3 million of writedowns of fixed maturity investments, equity securities and other invested assets as a result of conditions which caused us to conclude a decline in fair value of the investment was other than temporary. At September 30, 2004, fixed maturity securities in default as to the payment of principal or interest had an aggregate amortized cost of $5.1 million and a carrying value of $6.9 million. During the nine months ended September 30, 2004, we sold $2.0 billion of fixed maturity investments which resulted in gross investment losses (before income taxes) of $34.5 million. Securities sold at a loss are sold 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; and (v) our analysis indicating there is a high probability that the security is other-than-temporarily impaired. Investments with Other-Than-Temporary Losses During the nine months ended September 30, 2004, we recorded writedowns of fixed maturity investments, equity securities and other invested assets totaling $17.8 million. During the nine months ended September 30, 2004, we recognized a loss of $3.5 million related to an issuer in the airline industry rated Caa/CCC-. Although this investment is in a major airline, this company remains highly leveraged and the entire industry is currently facing a difficult operating environment including rising fuel prices. Accordingly, we concluded that the decline in fair value was other than temporary. In addition to the specific investment discussed above, we recorded $14.3 million of writedowns related to various other investments. No other writedown of a single issuer exceeded $3.0 million. Recognition of Losses 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 is 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. 88 CONSECO, INC. AND SUBSIDIARIES ------------------- Our evaluation of investments for impairment requires significant judgments to be made including: (i) the identification of potentially impaired securities; (ii) the determination of their estimated fair value; and (iii) 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 an investment loss at that time. Our periodic assessment of whether unrealized losses are "other than temporary" requires significant judgment. Factors considered include: (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) whether the investment is investment-grade and our view of the investment's rating and whether the investment 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 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. If a decline in value is determined to be other than temporary and the cost basis of the security is written down to fair value, we review the circumstances which caused us to believe that the decline was other than temporary with respect 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 losses in the carrying value of our investments could have a material adverse effect on our earnings in future periods. The following table sets forth the amortized cost and estimated fair value of those actively managed fixed maturities with unrealized losses at September 30, 2004, by contractual maturity. Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties. Most of the structured securities shown below provide for periodic payments throughout their lives (dollars in millions).
Estimated Amortized fair cost value --------- --------- Due in one year or less................................................................... $ 62.4 $ 62.2 Due after one year through five years..................................................... 345.8 341.9 Due after five years through ten years.................................................... 848.7 836.4 Due after ten years....................................................................... 816.6 797.3 -------- -------- Subtotal............................................................................... 2,073.5 2,037.8 Structured securities..................................................................... 1,001.3 995.5 -------- -------- Total.................................................................................. $3,074.8 $3,033.3 ======== ========
At September 30, 2004, we had no investments in fixed maturities rated below-investment grade or classified as equity-type securities in an unrealized loss position exceeding 20 percent of the cost basis. 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 described in the note to our consolidated financial statements entitled "Recently Issued Accounting Standards", certain guidance related to determining when an impairment of an investment is other than temporary is being considered by the Emerging Issues Task Force. Depending on the ultimate guidance issued, including guidance regarding management's assertion about intent and ability to hold actively managed fixed maturities for a period of time sufficient to allow for any anticipated recovery, the Company's practice of selling securities at a loss could result in a 89 CONSECO, INC. AND SUBSIDIARIES ------------------- requirement to report unrealized losses in a different manner, including reflecting unrealized losses in the income statement as other-than-temporary impairments. The following table summarizes the gross unrealized losses and fair value of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that such securities have been in a continuous unrealized loss position at September 30, 2004 (dollars in millions).
Less than 12 months 12 months or greater Total ---------------------- --------------------- ----------------- Fair Unrealized Fair Unrealized Fair Unrealized Description of securities value losses value losses value losses ------------------------- ----- ------ ----- ------ ----- ------ United States Treasury securities and obligations of United States government corporations and agencies........ $ 210.5 $ (2.5) $ .5 $ - $ 211.0 $ (2.5) States and political subdivisions... 161.4 (4.7) 1.7 (.1) 163.1 (4.8) Debt securities issued by foreign governments.............. 15.3 (.1) - - 15.3 (.1) Corporate securities................ 1,624.6 (27.5) 23.8 (.8) 1,648.4 (28.3) Structured securities............... 980.3 (5.3) 15.2 (.5) 995.5 (5.8) -------- ------ ----- ----- -------- ------ Total actively managed fixed maturities................. $2,992.1 $(40.1) $41.2 $(1.4) $3,033.3 $(41.5) ======== ====== ===== ===== ======== ====== Equity securities................... $3.0 $(.1) $3.0 $(.1) ==== ==== ==== ====
Based on management's current assessment of investments with unrealized losses at September 30, 2004, the Company believes the issuers of the securities will continue to meet their obligations (or with respect to equity-type securities, the investment value will recover to its cost basis). The Company has no current plans to sell these securities and has the ability to hold them to maturity. The recognition of an other-than-temporary impairment through a charge to earnings may be recognized in future periods if management later concludes that the decline in market value below the cost basis is other than temporary. Structured Securities At September 30, 2004, fixed maturity investments included $5.4 billion of structured securities (or 25 percent of all fixed maturity securities). Structured securities include mortgage-backed securities, collateralized mortgage obligations, asset-backed securities and commercial mortgage-backed securities. The yield characteristics of structured securities differ in some respects from those of traditional fixed-income securities. For example, interest and principal payments for mortgage-backed securities occur more frequently, often monthly. In addition, mortgage-backed securities are subject to risks associated with variable prepayments. Prepayment rates are influenced by a number of factors that cannot be predicted with certainty, including: the relative sensitivity of the underlying mortgages backing the assets to changes in interest rates; a variety of economic, geographic and other factors; and the repayment priority of the securities in the overall securitization structures. In general, prepayments on the underlying mortgage loans and the securities backed by these loans increase when prevailing interest rates decline significantly in absolute terms and also relative to the interest rates on such loans. The yields on mortgage-backed securities purchased at a discount to par will increase when the underlying mortgages prepay faster than expected. The yields on mortgage-backed securities purchased at a premium will decrease when 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 90 CONSECO, INC. AND SUBSIDIARIES ------------------- 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 as a result of a decrease in the annual amortization of the premium. Pursuant to fresh start reporting, we were required to mark all of our investments to market value. The current interest rate environment is much lower than when most of our investments were purchased. Accordingly, the fresh start values of our investments generally exceed the par values and the actual cost of such investments. The amount of value exceeding par is referred to as a "purchase premium" which is amortized against future income. If prepayments in any period are higher than expected, purchase premium amortization is increased. In periods of unexpectedly high prepayment activity, the increased amortization will reduce net investment income. 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 September 30, 2004 (dollars in millions):
Par Amortized Estimated value cost fair value ----- ---- ---------- Below 4 percent..................................................................... $ 196.7 $ 198.2 $ 201.3 4 percent - 5 percent............................................................... 1,415.6 1,363.2 1,381.6 5 percent - 6 percent............................................................... 1,607.2 1,599.1 1,630.7 6 percent - 7 percent............................................................... 1,731.9 1,795.0 1,821.7 7 percent - 8 percent............................................................... 323.8 339.5 343.9 8 percent and above................................................................. 43.2 46.0 47.7 -------- -------- -------- Total structured securities (a).............................................. $5,318.4 $5,341.0 $5,426.9 ======== ======== ======== - --------------- (a) Includes below-investment grade structured securities with an amortized cost and estimated fair value of $2.1 million and $2.9 million, respectively.
The amortized cost and estimated fair value of structured securities at September 30, 2004, summarized by type of security, were as follows (dollars in millions):
Estimated fair value ---------------------- Percent Amortized of fixed Type cost Amount maturities - ---- ---- ------ ---------- Pass-throughs and sequential and targeted amortization classes............ $3,084.9 $3,129.1 15% Planned amortization classes and accretion-directed bonds................. 754.8 763.3 3 Commercial mortgage-backed securities..................................... 1,466.8 1,500.4 7 Subordinated classes and mezzanine tranches............................... 33.9 33.5 - Other..................................................................... .6 .6 - -------- -------- -- Total structured securities (a).................................... $5,341.0 $5,426.9 25% ======== ======== == - -------------- (a) Includes below-investment grade structured securities with an amortized cost and estimated fair value of $2.1 million and $2.9 million, respectively.
Pass-throughs and sequential and targeted amortization classes have similar prepayment variability. Pass-throughs historically provide the best liquidity in the mortgage-backed securities market. Pass-throughs are also used frequently in the dollar roll market and can be used as the collateral when creating collateralized mortgage obligations. Sequential classes are a series of tranches that return principal to the holders in sequence. Targeted amortization classes offer slightly better structure in return of principal than sequentials when prepayment speeds are close to the speed at the time of creation. Planned amortization classes and accretion-directed bonds are some of the most stable and liquid instruments in the mortgaged-backed securities market. Planned amortization class bonds adhere to a fixed schedule of principal payments as 91 CONSECO, INC. AND SUBSIDIARIES ------------------- long as the underlying mortgage collateral experiences prepayments within a certain range. Changes in prepayment rates are first absorbed by support or companion classes. This insulates the planned amortization class from the consequences of both faster prepayments (average life shortening) and slower prepayments (average life extension). Commercial mortgage-backed securities ("CMBS") are bonds secured by commercial real estate mortgages. Commercial real estate encompasses income producing properties that are managed for economic profit. Property types include multi-family dwellings including apartments, retail centers, hotels, restaurants, hospitals, nursing homes, warehouses, and office buildings. The CMBS market generally offers higher yields, compared to similar-rated corporate bonds. Most CMBS have strong call protection features where borrowers are locked out from prepaying their mortgages for a stated period of time. If the borrower does prepay any or all of the loan, they will be required to pay prepayment penalties. Subordinated and mezzanine tranches are classes that provide credit enhancement to the senior tranches. The rating agencies require that this credit enhancement not deteriorate due to prepayments for a period of time, usually five years of complete lockout, followed by another period of time where prepayments are shared pro rata with senior tranches. Subordinated and mezzanine tranches bear a majority of the risk of loss due to property owner defaults. Subordinated bonds are generally rated "AA" or lower; we typically do not hold securities rated lower than "BB". Mortgage Loans At September 30, 2004, the mortgage loan balance was primarily comprised of commercial loans. Less than one percent of the mortgage loan balance was noncurrent at September 30, 2004. Investment Borrowings Our investment borrowings averaged approximately $529.6 million during the first nine months of 2004; $531.5 million during the one month ended September 30, 2003; and $689.1 million during the eight months ended August 31, 2003 and were collateralized by investment securities with fair values approximately equal to the loan value. The weighted average interest rates on such borrowings were 1.3 percent during the first nine months of 2004; 1.3 percent during the one month ended September 30, 2003; and 1.8 percent during the eight months ended August 31, 2003. STATUTORY INFORMATION (BASED ON NON-GAAP MEASURES) As of the date of this filing, the consolidated statutory results of our insurance subsidiaries for the nine months ended September 30, 2004, have not been finalized. The quarterly statutory financial statements of our insurance subsidiaries are expected to be filed with the respective domiciliary insurance regulators on or about November 15, 2004. Statutory accounting practices prescribed or permitted by regulatory authorities for the Company's insurance subsidiaries differ from GAAP. The consolidated statutory net income (loss) (a non-GAAP measure) of our insurance subsidiaries is expected to be approximately $(37.1) million in the first nine months of 2004 compared to $255.6 million in the same period of 2003. Included in such net income (loss) are net realized capital gains (losses), net of income taxes, of approximately $(50.8) million and $33.3 million in the first nine months of 2004 and 2003, respectively. In addition, such net income included interest expense on surplus debentures of $148.0 million and nil in the first nine months of 2004 and 2003, respectively. The Company's insurance subsidiaries expect to report the following amounts to regulatory agencies at September 30, 2004, after appropriate eliminations of intercompany accounts among such subsidiaries (dollars in millions): Statutory capital and surplus .................................. $1,552.2 Asset valuation reserve......................................... 56.7 Interest maintenance reserve.................................... 269.4 -------- Total........................................................ $1,878.3 ========
The statutory capital and surplus shown above included investments in upstream affiliates of $52.4 million, all of which were eliminated in the consolidated financial statements prepared in accordance with GAAP. In the second quarter of 2004, $106.6 million of affiliated preferred stock held by our insurance subsidiaries was redeemed by the parent using the proceeds from the refinancing of our Previous Credit Facility. 92 CONSECO, INC. AND SUBSIDIARIES ------------------- The ability of our insurance subsidiaries to pay dividends is subject to state insurance department regulations. These regulations generally permit dividends to be paid from 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 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. No dividends were paid to the parent company in the first nine months of 2004. The National Association of Insurance Commissioners' Risk-Based Capital ("RBC") for Life and/or Health Insurers Model Act (the "Model Act") provides 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 whether there is a need for possible regulatory attention. The Model Act provides 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, AVR and certain other adjustments) to its RBC: (i) 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; (ii) 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; (iii) 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 (iv) 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 Model Act provides for an annual 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: (i) between the current year and the prior year; and (ii) 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. The 2003 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, as a result of losses on the long-term care business within the Other Business in Run-off segment, the RBC ratio of Conseco Senior was near the level which would require it to submit a comprehensive plan aimed at improving its capital position. See "-- Other Business in Run-off" for additional discussion related to an order issued by the Florida Office of Insurance Regulation regarding certain blocks of Conseco Senior's long-term care business. At September 30, 2004, the consolidated Company Action Level RBC ratio for our insurance subsidiaries exceeds the minimum risk-based capital requirement included in our Credit Facility. See the note to the consolidated financial statements entitled "Changes in Direct Corporate Obligations" for further discussion of various financial ratios and balances we are required to maintain. We calculate the consolidated RBC ratio by assuming all of the assets, liabilities, capital and surplus and other aspects of the business of our insurance subsidiaries are combined together in one insurance subsidiary, with appropriate intercompany eliminations. Our insurance subsidiaries held principal protected senior notes of three trusts which invested in fixed maturities, mortgages, preferred stock, common stock and limited partnerships. We consolidated the trusts in our financial statements prepared in accordance with GAAP at December 31, 2003. During the fourth quarter of 2003, the trusts began liquidating their portfolios, a process that was completed in the first quarter of 2004. Under statutory accounting practices, which differ from GAAP, realized capital losses of $45.9 million were recorded by the insurance subsidiaries on the fourth quarter 2003 partial redemption of the senior notes. Additional statutory realized capital losses of $94.9 million were recorded at December 31, 2003 since a decision had been made to redeem the remaining senior notes at amounts less than their amortized cost. The total statutory realized losses of $140.8 million on the senior notes were included in the interest maintenance reserve ("IMR") at December 31, 2003. The redemption of the remaining senior notes resulted in realized gains of $9.9 million in the first nine months of 2004 which were also included in the IMR. NEW ACCOUNTING STANDARDS See "Recently Issued Accounting Standards" in the notes to consolidated financial statements for a discussion of recently issued accounting standards. 93 CONSECO, INC. AND SUBSIDIARIES ------------------- ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. Our market risks, and the ways we manage them, are summarized in "Management's Discussion and Analysis of Financial Condition and Results of Operations", included in Conseco's Form 10-K for the year ended December 31, 2003. There have been no material changes in the first nine months of 2004 to such risks or our management of such risks. ITEM 4. CONTROLS AND PROCEDURES. Evaluation of Disclosure Controls and Procedures. Conseco's management, under the supervision and with the participation of the Chief Executive Officer and the Chief Financial Officer, evaluated the effectiveness of Conseco's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended). Based on this evaluation, the Chief Executive Officer and Chief Financial Officer concluded that, as of September 30, 2004, Conseco's disclosure controls and procedures were effective to ensure that information required to be disclosed by Conseco in reports that it files or submits under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. Evaluation of Internal Controls. Section 404 of the Sarbanes Oxley Act of 2002 will require us to include a report in our Form 10-K for the year ending December 31, 2004 containing an assessment of the effectiveness of our internal control structure and procedures for financial reporting as of December 31, 2004. Our external auditors are required to attest to, and report on, the assessment made by management. We are currently undergoing a comprehensive effort to test our internal controls to confirm that such controls are designed properly and operating effectively. When our testing identifies potential weaknesses, we are taking necessary remediation actions. While we anticipate being able to fully satisfy the requirements of Section 404 in a timely manner, we cannot be certain as to the timing of completion of our evaluation, testing and remediation actions or the impact of these actions on our operations. In addition, since the new rules are subject to varying interpretations, there is uncertainty regarding how compliance will be measured. Changes to Internal Controls and Procedures for Financial Reporting. There were no significant changes in Conseco's internal controls over financial reporting that occurred during the quarter ended September 30, 2004, that have materially affected, or are reasonably likely to materially affect, Conseco's internal controls over financial reporting. PART II - OTHER INFORMATION LITIGATION AND OTHER LEGAL PROCEEDINGS We are involved on an ongoing basis in lawsuits, including purported class actions, relating to our operations, including with respect to sales practices, and we and current and former officers and former directors are defendants in pending class action lawsuits asserting claims under the securities laws. The ultimate outcome of these lawsuits cannot be predicted with certainty and we have estimated the potential exposure for each of the matters and have recorded a liability if a loss is deemed probable. Securities Litigation Since we announced our intention to restructure our capital on August 9, 2002, a total of eight purported securities fraud class action lawsuits have been filed in the United States District Court for the Southern District of Indiana. The complaints name us as a defendant, along with certain of our current and former officers. These lawsuits were filed on behalf of persons or entities who purchased our Predecessor's common stock on various dates between October 24, 2001 and August 9, 2002. In each case the plaintiffs allege claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended (the "Exchange Act") and allege material omissions and dissemination of materially misleading statements regarding, among other things, the liquidity of Conseco and alleged problems in CFC's manufactured housing division, allegedly resulting in the artificial inflation of our Predecessor's stock price. On March 13, 2003, all of these cases were consolidated into one case in the United States District Court for the Southern District of Indiana, captioned Franz Schleicher, et al. v. Conseco, Inc., Gary Wendt, William Shea, Charles Chokel and James Adams, et al., Case No. 02-CV-1332 DFH-TAB. The lawsuit was stayed as to all defendants by order of the United States Bankruptcy Court for the Northern District of Illinois. The stay was lifted on October 15, 2003. The plaintiffs have filed a consolidated class action complaint with respect to the individual defendants. Our liability with respect to this lawsuit was discharged in the Plan and our obligation to 94 CONSECO, INC. AND SUBSIDIARIES ------------------- indemnify individual defendants who were not serving as one of our officers or directors on the Effective Date of the Plan is limited to $3 million in the aggregate under the Plan. Our liability to indemnify individual defendants who were serving as an officer or director on the Effective Date, of which there is one such defendant, is not limited by the Plan. A motion to dismiss was filed on behalf of defendants Shea, Wendt and Chokel and has been set for hearing on November 19, 2004. We believe this lawsuit is without merit and intend to defend it vigorously. The ultimate outcome of this lawsuit cannot be predicted with certainty. Other Litigation Collection efforts by the Company and its wholly owned subsidiary, Conseco Services, LLC ("Conseco Services"), related to the 1996-1999 director and officer loan programs have been commenced against various past board members and executives with outstanding loan balances. In addition, certain former officers and directors have sued the companies for declaratory relief concerning their liability for the loans. Currently, we are involved in litigation with Stephen C. Hilbert, James D. Massey, Dennis E. Murray, Sr., Rollin M. Dick, James S. Adams, Maxwell E. Bublitz, Ngaire E. Cuneo, David R. Decatur, Donald F. Gongaware and Bruce A. Crittenden. The specific lawsuits include: Hilbert v. Conseco, Case No. 03A 04283 (Bankr. Northern District, Illinois); Conseco Services v. Hilbert, Case No. 29C01-0310-MF-1296 (Circuit Court, Hamilton County, Indiana); Murray and Massey v. Conseco, Case No. 1:03-CV-1701-LJM-VSS (Southern District, Indiana); Conseco v. Adams, et al., Case No. 03A 04545 9 (Bankr. Northern District, Illinois); Conseco Services v. Dick, et al., Case No. 06C01-0311-CC-536 (Circuit Court, Boone County, Indiana); Stephen C. Hilbert v. Conseco, Inc. and Kroll Inc., Case No. 29D02-0312-PL-1026 (Superior Court, Hamilton County, Indiana); Crittenden v. Conseco, Case No. IP02-1823-C B/S (Southern District, Indiana); Conseco v. Dick, Case No. 04L 002811 (Circuit Court, Cook County, Illinois) Conseco Services v. Adams, Case No. 29D02-0404-CC-000376 (Superior Court, Hamilton County, Indiana); Conseco Services v. Bublitz, Case No. 29D02-0404-CC-377 (Superior Court, Hamilton County, Indiana); Conseco Services v. Cuneo, et al., Case No. 1:04-CV-0929-DFH-WTL (Southern District, Indiana); Conseco Services v. Murray., Case No. 29D02-0404-CC-381 (Superior Court, Hamilton County, Indiana); Conseco Services v. Massey, Case No. 29D01-0406-CC-477 (Superior Court, Hamilton County, Indiana); Conseco Services v. Gongaware, Case No. 29D02-0404-CC-380 (Superior Court, Hamilton County, Indiana). David Decatur filed for bankruptcy on May 12, 2004. The Company and Conseco Services believe that all amounts due under the director and officer loan programs, including all applicable interest, are valid obligations owed to the companies. As part of the Plan, we have agreed to pay 45 percent of any net proceeds recovered in connection with these lawsuits, in an aggregate amount not to exceed $30 million, to former holders of our Predecessor's trust preferred securities that did not opt out of a settlement reached with the committee representing holders of these securities. We intend to prosecute these claims to obtain the maximum recovery possible. Further, with regard to the various claims brought against the Company and Conseco Services by certain former directors and officers, we believe that these claims are without merit and intend to defend them vigorously. The ultimate outcome of the lawsuits cannot be predicted with certainty. We have reached a settlement agreement with Thomas J. Kilian. On October 20, 2004, the judge in the Conseco Services v. Hilbert case granted partial final summary judgment in favor of Conseco Services in the amount of $62.7 million plus interest. Mr. Hilbert has filed a notice of appeal. In October 2002, Roderick Russell, on behalf of himself and a class of persons similarly situated, and on behalf of the ConsecoSave Plan, filed an action in the United States District Court for the Southern District of Indiana against our Predecessor, Conseco Services and certain of our current and former officers (Roderick Russell, et al. v. Conseco, Inc., et al., Case No. 1:02-CV-1639 LJM). The purported class action consists of all individuals whose 401(k) accounts held common stock of our Predecessor at any time since April 28, 1999. The complaint alleges, among other things, breaches of fiduciary duties under ERISA by continuing to permit employees to invest in our Predecessor's common stock without full disclosure of the Company's true financial condition. This lawsuit was stayed as to all defendants by order of the Bankruptcy Court. The stay was lifted on October 15, 2003. On March 22, 2004, plaintiffs filed an amended complaint and added additional former officers as named defendants and dismissed Conseco, Inc. as a party. We filed a motion to dismiss the amended complaint on June 1, 2004. On July 30, 2004, the Russell matter was dismissed. On August 25, 2004, the plaintiffs filed a notice of appeal in the 7th Circuit Court of Appeals. On February 13, 2004, the Company's fiduciary insurance carrier, RLI Insurance Company, filed a declaratory judgment action asking the court to find no liability under its policy for the claims made in the Russell matter (RLI Insurance Company v. Conseco, Inc., Stephen Hilbert, et al., Case No. 1:04-CV-0310DFH-TAB (Southern District, Indiana)). On March 15, 2004, RLI filed an amended complaint adding Conseco Services as an additional defendant. On July 28, 2004, we filed a motion to stay the RLI matter until Russell is resolved. On September 2, 2004, RLI filed a motion for judgment on all counterclaims. On October 5, 2004, our motion to stay this matter was granted. We 95 CONSECO, INC. AND SUBSIDIARIES ------------------- believe the lawsuits are without merit and intend to defend them vigorously. The ultimate outcome of the lawsuits cannot be predicted with certainty. On June 24, 2002, the heirs of a former officer, Lawrence Inlow, commenced an action against our Predecessor, Conseco Services and two former officers in the Circuit Court of Boone County, Indiana (Inlow et al. v. Conseco, Inc., et al., Cause No. 06C01-0206-CT-244). The heirs asserted that unvested options to purchase 756,248 shares of our Predecessor's common stock should have been vested at Mr. Inlow's death. The heirs further claimed that if such options had been vested, they would have been exercised, and that the resulting shares of common stock would have been sold for a gain of approximately $30 million based upon a stock price of $58.125 per share, the highest stock price during the alleged exercise period of the options. The maximum exposure to the Company for this lawsuit was estimated to be $33 million. The heirs did not file a proof of claim with the Bankruptcy Court. A settlement agreement has been reached by all of the parties. On June 27, 2001, two suits against the Company's subsidiary, Philadelphia Life Insurance Company (now known as Conseco Life Insurance Company), both purported nationwide class actions seeking unspecified damages, were consolidated in the U.S. District Court, Middle District of Florida (In Re PLI Sales Litigation, Cause No. 01-MDL-1404), alleging among other things, fraudulent sales and a "vanishing premium" scheme. Philadelphia Life filed a motion for summary judgment against both named plaintiffs, which motion was granted in June 2002. Plaintiffs appealed to the 11th Circuit Court of Appeals. The 11th Circuit, in July 2003, affirmed in part and reversed in part, allowing two fraud counts with respect to one plaintiff to survive. The plaintiffs' request for a rehearing with respect to this decision has been denied. Philadelphia Life filed a summary judgment motion with respect to the remaining claims. This summary judgment was denied in February 2004. In March 2004, the remaining plaintiff filed a motion to substitute plaintiff, to which Philadelphia Life has objected. We expect the court to set a trial date during the June 2005 trial term. On September 27, 2004, Philadelphia Life was named in a purported nationwide class action filed by the same plaintiff's attorney seeking unspecified damages in the District Court of Clark County, Nevada (Emma Gilbertson individually and on behalf of others similarly situated v. Conseco Life Insurance Company f/k/a Philadelphia Life Insurance Company, Cause No. A492738), alleging breach of contract pertaining to notice of premium increases. Philadelphia Life believes both lawsuits are without merit and intends to defend them vigorously. The ultimate outcome of the lawsuits cannot be predicted with certainty. On December 1, 2000, the Company's former subsidiary, Manhattan National Life Insurance Company, was named in a purported nationwide class action seeking unspecified damages in the First Judicial District Court of Santa Fe, New Mexico (Robert Atencio and Theresa Atencio, for themselves and all other similarly situated v. Manhattan National Life Insurance Company, an Ohio corporation, Cause No. D-0101-CV-2000-2817), alleging among other things fraud by non-disclosure of additional charges for those policyholders paying via premium modes other than annual. We retained liability for this litigation in connection with the sale of Manhattan National Life in June 2002. We believe this lawsuit is without merit and intend to defend it vigorously. The ultimate outcome of the lawsuit cannot be predicted with certainty. On December 19, 2001, four of the Company's subsidiaries were named in a purported nationwide class action seeking unspecified damages in the District Court of Adams County, Colorado (Jose Medina and others similarly situated v. Conseco Annuity Assurance Company, Conseco Life Insurance Company, Bankers National Life Insurance Company and Bankers Life and Casualty Company, Cause No. 01-CV-2465), alleging among other things breach of contract regarding alleged non-disclosure of additional charges for those policy holders paying via premium modes other than annual. On July 14 and 15, 2003 the plaintiff's motion for class certification was heard and the court took the matter under advisement. On November 10, 2003, the court denied the motion for class certification. On January 26, 2004, the plaintiff appealed the trial court's ruling denying class certification. All further proceedings have been stayed pending the outcome of the appeal. The defendants believe this lawsuit is without merit and intend to defend it vigorously. The ultimate outcome of the lawsuit cannot be predicted with certainty. The Company and its subsidiaries, Conseco Life Insurance Company and Bankers Life and Casualty Company, have been named in purported class actions and an individual lawsuit alleging, among other things, breach of contract with regard to a change made in the way monthly deductions are calculated for insurance coverage. Many of these nationwide purported class action lawsuits were filed in Federal courts across the United States. The Judicial Panel on Multidistrict Litigation consolidated these lawsuits into the case now referred to as In Re Conseco Life Insurance Co. Cost of Insurance Litigation, Cause No. MDL 1610 (Central District, California). Other nationwide purported class actions and an individual lawsuit are filed in Illinois, Indiana and California state courts. The case filed in Illinois state court is Barry A. Feinberg, Trustee of the Linda Leventhal Irrevocable Trust, individually and on behalf of all other persons and entities similarly situated v. Conseco Life Insurance Company, f/k/a Massachusetts General Life Insurance Company, Case No. 04CH17937 (Circuit Court, Cook 96 CONSECO, INC. AND SUBSIDIARIES ------------------- County, Illinois). Those cases filed in Indiana state courts have been consolidated into the case now referred to as Alene P. Mangelson, et al. v. Conseco Life Insurance Company, Cause No. 29D01-0403-PL-211 (Superior Court, Hamilton County, Indiana). Those cases filed in California state courts are as follows: Stephen Hook, an individual, on behalf of himself and all others similarly situated v. Conseco Life Insurance Company and Bankers Life and Casualty Company and Does 1 through 10, Case No. CGC-04-428872 (Superior Court, San Francisco County, California); Michael S. Kuhn, on behalf of himself and all others similarly situated v. Conseco Life Insurance Company and Does 1 through 100, Case No. 03-416786 (Superior Court, San Francisco County, California); Sidney H. Levine and Judith A. Levine v. Conseco Life Insurance Company, Mark Peters Insurance Services, Inc., Hon. John Garamendi (in his capacity as Insurance Commissioner for the State of California) and Does 1 through 10, Case 04 CV 125 LAB (BLM) (Superior Court, San Diego County, California); Steven Rose, on Behalf of Himself and All Others Similarly Situated, and on Behalf of the General Public for the State of California v. Conseco Life Insurance Company, Case No. GIC 827178 (Superior Court, San Diego County, California); Alfonso Tamayo, individually and on behalf of all others similarly situated and on behalf of the General Public v. Conseco Life Insurance Co., Inc., an Indiana Corp., successor to Philadelphia Life Insurance Co. and formerly doing business as Massachusetts General Life Insurance Company, Case No 04-431660 (Superior Court, San Francisco County, California). We have filed a motion with the Judicial Council of California requesting consolidation of all the California state court cases. We believe these lawsuits are without merit and intend to defend them vigorously. The ultimate outcome of the lawsuits cannot be predicted with certainty. On February 7, 2003, the Company's subsidiary, Conseco Life Insurance Company, was named in a purported Texas statewide class action seeking unspecified damages in the County Court of Cameron County, Texas (Lawrence Onderdonk and Yolanda Carrizales v. Conseco Life Insurance Company, and Pete Ramirez, III Cause No. 2003-CCL-102-C). On February 12, 2004, the complaint was amended to allege a purported nationwide class and to name Conseco Services as an additional defendant. On March 5, 2004, the complaint was amended a second time naming additional plaintiffs. The purported class consists of all former Massachusetts General Flexible Premium Adjustable Life Insurance Policy policyholders who were converted to Conseco Life Flexible Premium Adjustable Life Insurance Policies and whose accumulated values in the Massachusetts General policies were applied to first year premiums on the Conseco Life policies. The complaint alleged, among other things, civil conspiracy to convert the accumulated cash values of the plaintiffs and the class, and the violation of insurance laws nationwide. The parties have reached a settlement agreement on a class wide basis. On October 14, 2004, the judge signed an order preliminarily approving the settlement. The hearing for final approval is set for January 31, 2005. On December 30, 2002 and December 31, 2002, four suits were filed in various Mississippi counties against Conseco Life Insurance Company (Kathie Allen, et al. v. Conseco Life Insurance Company, et al., Circuit Court of Jones County, Mississippi, Cause No. 2002-448-CV12; Anthony Cascio, et al. v. Conseco Life Insurance Company, et al, Circuit Court of LeFlore County, Mississippi, Cause No. CV-2002-0242-CICI; William Garrard, et al. v. Conseco Life Insurance Company, et al., Circuit Court of Sunflower County, Mississippi, Cause No. CV-2002-0753-CRL; and William Weaver, et al. v. Conseco Life Insurance Company, et al., Circuit Court of LeFlore County, Mississippi, Cause No. CV-2002-0238-CICI) alleging, among other things, a "vanishing premium" scheme. In August 2004, the parties agreed to a settlement of these four suits. On September 21, 1999, Conseco Health Insurance Company ("Conseco Health"), Conseco Services, Performance Matters Associates (one of our subsidiaries), and a subsidiary officer were named in an action seeking damages in the United States District Court for the Northern District of Alabama (Danny McFarlin; Tennessee Capitol Associates, Inc.; Neal Nielsen; Group Marketing Services, Inc.; Eleanor D. Newman; Dick Manley; Commonwealth General Group, Inc.; Robert E. Taylor; Benefits of America Limited, Inc.; and Daniel Smith v. Conseco, Inc.; Conseco Services, LLC.; Conseco Health Insurance f/k/a Capitol American Life Insurance Company; Consolidated Marketing Group; Suncoast Fringe Benefits, Inc.; Performance Matters Associates, Inc.; Christopher L. Weaver; Jim Hobbs, Mike Foster and David King; Cause No: 99-CV-2282-S) alleging among other things fraud, tortious interference with business and contractual relations, conspiracy, breach of contract, unjust enrichment, extortion and interstate travel in aid of extortion under the Racketeer Influenced and Corrupt Organization Act ("RICO") and mail/wire fraud under RICO. The case concerns the consolidation of plaintiffs' independent marketing organizations under a wholly owned subsidiary of Conseco. In May 2003, the Court dismissed the tortious interference claim as to Conseco Health, the breach of contract claims as to all defendants other than Conseco Health, and the extortion-related RICO claims as to all defendants on summary judgment. The case was on appeal to the 11th Circuit Court of Appeals but was recently remanded to the district court and is currently set for trial in March 2005. Conseco believes the lawsuit is without merit and intends to defend it vigorously. The ultimate outcome of the lawsuit cannot be predicted with certainty. 97 CONSECO, INC. AND SUBSIDIARIES ------------------- In addition, the Company and its subsidiaries are involved on an ongoing basis in other arbitrations and lawsuits, including purported class actions, related to their operations. The ultimate outcome of all of these other legal matters pending against the Company or its subsidiaries cannot be predicted, and, although such lawsuits are not expected individually to have a material adverse effect on the Company, such lawsuits could have, in the aggregate, a material adverse effect on the Company's consolidated financial condition, cash flows or results of operations. Other Proceedings On September 18, 2003, the Company received a grand jury subpoena from the U.S. District Court for the Southern District of Indiana in connection with a Department of Justice investigation requiring production of documents relating to the valuation of interest-only securities held by CFC, our Predecessor's former finance subsidiary, contemporaneous earnings estimates for the Predecessor, certain personnel records and other accounting and financial disclosure records for the period June 1, 1998 to June 30, 2000. The Company has subsequently received follow-up grand jury document subpoenas concerning other matters. All of these follow-up requests have been limited to the time period prior to the December 17, 2002 bankruptcy filing. The Company has been advised by the Department of Justice that neither it nor any of its current directors or employees are subjects or targets of this investigation. The Company is cooperating fully with the Department of Justice investigation. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. At the Company's annual meeting on August 24, 2004, the shareholders elected Debra J. Perry, Philip R. Roberts and Michael T. Tokarz to serve as directors for terms ending in 2005. Directors whose class was not up for election and whose term of office continued after the meeting are R. Glenn Hilliard, Neal Schneider, Michael Shannon and John G. Turner. The results of the voting were as follows (there were no broker non-votes):
For Withheld --- -------- Debra J. Perry........................................... 129,310,726 1,769,475 Philip R. Roberts........................................ 129,294,770 1,785,431 Michael T. Tokarz........................................ 129,735,183 1,345,018
At the annual meeting, the shareholders also ratified the appointment of PricewaterhouseCoopers LLP as the Company's auditors for 2004 as follows:
For Against Abstain --- ------ ------- 128,168,245 2,854,722 57,235
ITEM 6. EXHIBITS. 10.15 Employment Agreement dated as of July 19, 2004 between Conseco Services, LLC, and Dewette Ingham. 12.1 Computation of Ratio of Earnings to Fixed Charges and Preferred Dividends. 31.1 Certification Pursuant to the Securities Exchange Act Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification Pursuant to the Securities Exchange Act Rule 13a-14(a)/15d-14(a), as Adopted Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 32.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 98 CONSECO, INC. AND SUBSIDIARIES ------------------- SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CONSECO, INC. Dated: November 9, 2004 By: /s/ Eugene M. Bullis ------------------------------- Eugene M. Bullis Executive Vice President and Chief Financial Officer (authorized officer and principal financial officer) 99 EX-10 2 exhibit1015.txt EXHIBIT 10.15 Exhibit 10.15 EMPLOYMENT AGREEMENT This EMPLOYMENT AGREEMENT, dated as of the 19th day of July, 2004, is between Conseco Services, LLC, an Indiana limited liability company ("Company"), and Dewette Ingham ("Executive"). WHEREAS, Executive has managerial and professional experience that are of value to the Company. WHEREAS, the Company desires to have the benefit and advantage of the services of Executive to assist the Company and Conseco, Inc. ("Conseco") upon the terms and conditions set forth herein. NOW, THEREFORE, in consideration of the foregoing and the mutual covenants contained herein, the receipt and sufficiency of which are hereby acknowledged, the parties agree as follows: 1. Employment. The Company hereby employs Executive and Executive hereby accepts employment upon the terms and conditions hereinafter set forth. 2. Term. The effective date of this agreement (the "Agreement") shall be the date set forth above (the "Effective Date"). Subject to the provisions for termination as provided in Section 10 hereof, the term of Executive's employment under this Agreement shall be the period beginning on the Effective Date and ending on June 30, 2005. The term of this Agreement shall be automatically renewed for successive one-year terms on July 1, 2005 and each succeeding July 1 unless either party elects not to renew this Agreement by serving written notice of such election not to renew on the other party at least 90 days prior to such July 1. As used in this Agreement, the "Term" is the period ending on June 30, 2005 or, if this Agreement has been renewed, the one-year period relating to the last renewal. The Term shall end upon the termination of Executive's employment with the Company. 3. Duties. During the Term, Executive shall be engaged by the Company in the capacity of Executive Vice President, Human Resources of the Company and shall work at the Company's office in Chicago, Illinois. Executive shall report to the President of Conseco regarding the performance of his duties. 4. Extent of Services. During the Term, subject to the direction and control of the President of the Company, Executive shall have the power and authority commensurate with his executive status and necessary to perform his duties hereunder. Executive shall devote his entire employable time, attention and best efforts to the business of the Company and, during the Term, shall not, without the consent of the Company, be actively engaged in any other business activity, whether or not such business activity is pursued for gain, profit or other pecuniary advantage; provided, however, that, subject to Section 9 hereof, this shall not be construed as preventing Executive from serving on boards of professional, community, civic, education, charitable and corporate organizations on which he presently serves or may choose to serve or investing his assets in such form or manner as will not require any services on the part of Executive in the operation of the affairs of the companies in which such investments are made (to the extent not in violation of the nonsolicitation provisions of Section 9 hereof); provided, however, that corporate organizations shall be limited to those which Executive presently serves, if any, as listed on Exhibit A and such others as mutually agreed upon by Executive and the Company. 5. Compensation. During the Term: (a) As compensation for services hereunder rendered during the Term hereof, Executive shall receive a minimum base salary ("Base Salary") of Two Hundred Fifty Thousand Dollars ($250,000) per year payable in equal installments in accordance with the Company's payroll procedure for its salaried executives. Salary payments and other payments under this Agreement shall be subject to withholding of taxes and other appropriate and customary amounts. Executive may receive increases in his Base Salary from time to time, based upon his performance. (b) In addition to Base Salary, Executive will have an opportunity to earn a bonus each year as determined by the President and/or the Board of Directors of the Company (the "Board") or the Compensation Committee thereof, with a target annual bonus equal to 75% of Executive's Base Salary (the "Target Bonus") and a maximum annual bonus of 150% of his Base Salary with respect to any calendar year, with such bonus payable at such time that other similar payments are made to other Company executives. For purposes of clarification, annual executive bonuses are generally paid in March of the year following the year with respect to which such bonuses are payable, if Executive remains employed with the Company through such date or as otherwise payable under Section 11 of this Agreement. The Target Bonuses will be based on financial and other objective targets that the President believes are reasonably attainable at the time that they are set. The Target Bonus for any partial year of employment shall be prorated. (c) Subject to approval by the Human Resources and Compensation Committee of the Board, Executive will receive an award of options to purchase 15,000 shares of common stock with an exercise price equal to the fair market value on the date of the grant and an award of 10,000 shares of restricted stock. The options will vest over a 4-year period beginning on the date of the grant of the equity awards (the "Grant Date"), with one-fourth vesting on each anniversary of the Grant Date. Fifty percent (50%) of the restricted stock will vest on the second anniversary of the Grant Date, with the other fifty percent (50%) vesting on the third anniversary of the Grant Date. Executive shall also be eligible to participate in and receive future grants under any stock option or equity-based program offered by Conseco to executives of similar title and responsibility, if any, subject to the discretion of the Board. 6. Fringe Benefits. During the Term: (a) Executive shall be entitled to participate in such existing executive benefit plans and insurance programs offered by the Company, or which it may adopt from time to time, for its executive management or supervisory personnel generally, in accordance with the eligibility requirements for participation therein. Nothing herein shall be construed so as to prevent the Company from modifying or terminating any executive benefit plans or programs, or executive fringe benefits, that it may adopt from time to time. 2 (b) Executive shall be entitled to four weeks of vacation with pay each year. (c) Executive may incur reasonable expenses for promoting the Company's business, including expenses for entertainment, travel, and similar items. The Company shall reimburse Executive for all such reasonable expenses upon Executive's periodic presentation of an itemized account of such expenditures. The Company agrees to pay Executive an additional amount to cover the incremental additional income taxes incurred by Executive, if any, with respect to payment or reimbursement of any reasonable business expenses pursuant to this subsection (c). (d) The Company shall reimburse Executive for relocation expenses as follows: (i) Up to two (2) visits by spouse for house hunting. (ii) Moving of household goods from Atlanta, Georgia (not to exceed $50,000 in aggregate). (iii) Selling commission on sale of home in Georgia. (iv) Tax gross-up on any taxable income arising from this Section 6 (d). 7. Disability. If Executive shall become physically or mentally disabled during the Term to the extent that his ability to perform his duties and services hereunder is materially and adversely impaired, his Base Salary, bonus and other compensation provided herein shall continue while he remains employed by the Company; provided, that if such disability (as confirmed by competent medical evidence) continues for at least six (6) consecutive months, the Company may terminate Executive's employment hereunder, in which case the Company immediately shall pay Executive a cash payment equal to his annual Base Salary as provided in Section 5(a) hereof to the extent earned but unpaid as of the date of termination. However, any options or restricted stock held by Executive on the date of termination shall vest only through the date of termination according to the normal vesting schedule applicable to such options or restricted stock and Executive shall not receive any accelerated or additional vesting of such stock or options due to termination under this Section 7 on or after such date. No payments or vesting under this paragraph will be made if such disability arose primarily from (a) chronic use of intoxicants, drugs or narcotics (other than drugs prescribed to Executive by a physician and used by Executive for their intended purpose for which they had been prescribed) or (b) intentionally self-inflicted injury or intentionally self-induced illness. 8. Disclosure of Information. Executive acknowledges that in and as a result of his employment with the Company, he has been and will be making use of, acquiring and/or adding to confidential information of the Company and its affiliates of a special and unique nature and value. As a material inducement to the Company to enter into this Agreement and to pay to Executive the compensation stated in Section 5, as well as any additional benefits stated herein, Executive covenants and agrees that he shall not, at any time while he is employed by the Company or at any time thereafter, directly or indirectly, divulge or disclose for any purpose whatsoever, any confidential information (whether or not specifically labeled or identified as 3 "confidential information"), in any form or medium, that has been obtained by or disclosed to him as a result of his employment with the Company and which the Company or any of its affiliates has taken appropriate steps to safeguard, except to the extent that such confidential information (a) becomes a matter of public record or is published in a newspaper, magazine or other periodical available to the general public, other than as a result of any act or omission of Executive, (b) is required to be disclosed by any law, regulation or order of any court or regulatory commission, department or agency, in which event Executive shall give prompt notice of such requirement to the Company to enable the Company to seek an appropriate protective order or confidential treatment, or (c) must be disclosed to enable Executive properly to perform his duties under this Agreement. Upon the termination of Executive's employment, Executive shall return such information (in whatever form) obtained from or belonging to the Company or any of its affiliates which he may have in his possession or control. 9. Covenants Against Solicitation. Executive acknowledges that the services he is to render to the Company and its affiliates are of a special and unusual character, with a unique value to the Company and its affiliates, the loss of which cannot adequately be compensated by damages or an action at law. In view of the unique value to the Company and its affiliates of the services of Executive for which the Company has contracted hereunder, because of the confidential information to be obtained by, or disclosed to, Executive as set forth in Section 8 above, and as a material inducement to the Company to enter into this Agreement and to pay to Executive the compensation stated in Section 5 hereof, as well as any additional benefits stated herein, and other good and valuable consideration, Executive covenants and agrees that throughout the period Executive remains employed or compensated hereunder and for one year thereafter, Executive shall not, directly or indirectly, anywhere in the United States of America (i) solicit or attempt to convert to other insurance carriers or other corporations, persons or other entities providing these same or similar products or services provided by the Company and its affiliates, any customers or policyholders of the Company or any of its affiliates or (ii) solicit for employment or employ any employee of the Company or any of its affiliates. Should any particular covenant or provision of this Section 9 be held unreasonable or contrary to public policy for any reason, including, without limitation, the time period, geographical area, or scope of activity covered by any restrictive covenant or provision, the Company and Executive acknowledge and agree that such covenant or provision shall automatically be deemed modified such that the contested covenant or provision shall have the closest effect permitted by applicable law to the original form and shall be given effect and enforced as so modified to whatever extent would be reasonable and enforceable under applicable law. 10. Termination. (a) Either the Company or Executive may terminate his employment at any time for any reason upon written notice to the other. The Company may terminate Executive's employment for Just Cause pursuant to Section 10(b) below or in a Control Termination pursuant to Section 10(c) below. Executive's employment shall also terminate (i) upon the death of Executive or (ii) after disability of Executive pursuant to Section 7 hereof. (b) The Company may terminate Executive's employment at any time for Just Cause. For purposes of this Agreement, "Just Cause" shall mean: (i) (A) a material breach by Executive of this Agreement, (B) a material breach of Executive's duty of 4 loyalty to the Company or its affiliates, or (C) willful malfeasance or fraud or dishonesty of a substantial nature in performing Executive's services on behalf of the Company or its affiliates, which in each case is willful and deliberate on Executive's part and committed in bad faith or without reasonable belief that such breach or action is in the best interests of the Company or its affiliates; (ii) Executive's use of alcohol or drugs (other than drugs prescribed to Executive by a physician and used by Executive for their intended purposes for which they had been prescribed) or other repeated conduct which materially and repeatedly interferes with the performance of his duties hereunder, which materially compromises the integrity or the reputation of the Company or its affiliates, or which results in other substantial economic harm to the Company or its affiliates; (iii) Executive's conviction by a court of law, admission that he is guilty, or entry of a plea of nolo contendere with regard to a felony or other crime involving moral turpitude; (iv) Executive's unscheduled absence from his employment duties other than as a result of illness or disability, for whatever cause, for a period of more than ten (10) consecutive days, without consent from the Company prior to the expiration of the ten (10) day period; or (v) Executive's failure to take action or to abstain from taking action, as directed in writing by a member of the board or a higher ranking executive of the Company or Conseco, where such failure continues after Executive has been given written notice of such failure and at least five (5) business days thereafter to cure such failure. No termination shall be deemed to be a termination by the Company for Just Cause if the termination is as a result of Executive refusing to act in a manner that would be a violation of applicable law or where Executive acts (or refrains from taking action) in good faith in accordance with directions of a member of the Board or higher ranking executive but was unable to attain the desired results because such results were inherently unreasonable or unattainable. (c) The Company may terminate Executive's employment in a Control Termination. A "Control Termination" shall mean any termination by the Company (or its successor) of Executive's employment for any reason within six months in anticipation of or within two years following a Change in Control of the Company. The term "Change in Control" shall mean the occurrence of any of the following: (i) the acquisition (other than an acquisition in connection with a "Non-Control Transaction") by any "person" (as such term is used in Sections 13(d) and 14(d) of the Securities Exchange Act of 1934, as amended (the "1934 Act")) of "beneficial ownership" (as such term is defined in Rule 13d-3 promulgated under the 1934 Act), directly or indirectly, of securities of the Company or its Ultimate Parent representing 51% or more of the combined voting power of the then outstanding securities of the Company or its Ultimate Parent entitled to vote generally with respect to the election of the board of directors of the Company or its Ultimate Parent; or (ii) as a result of or in connection with a tender or exchange offer or contest for election of directors, individual board members of the Company (identified as of the date of commencement of such tender or exchange offer, or 5 the commencement of such election contest, as the case may be) cease to constitute at least a majority of the board of directors of the Company; or (iii) the consummation of a merger, consolidation or reorganization with or into the Company unless (x) the stockholders of the Company immediately before such transaction beneficially own, directly or indirectly, immediately following such transaction securities representing 51% or more of the combined voting power of the then outstanding securities entitled to vote generally with respect to the election of the board of directors of the Company (or its successor) or, if applicable, the Ultimate Parent and (y) individual board members of the Company (identified as of the date that a binding agreement providing for such transaction is signed) constitute at least a majority of the board of directors of the Company (or its successor) or, if applicable, the Ultimate Parent (a transaction to which clauses (x) and (y) apply, a "Non-Control Transaction"). For purposes of this Agreement, "Ultimate Parent" shall mean the parent corporation (or if there is more than one parent corporation, the ultimate parent corporation) that, following a transaction, directly or indirectly beneficially owns a majority of the voting power of the outstanding securities entitled to vote with respect to the election of the board of directors of the Company (or its successor). (d) Upon termination of Executive's employment with the Company for any reason (whether voluntary or involuntary), Executive shall be deemed to have voluntarily resigned from all positions that Executive may then hold with the Company and any of its affiliates; provided that such deemed resignation shall not adversely affect Executive's rights to compensation or benefits under Section 11 of this Agreement and shall not affect the determination of whether Executive's termination was for Just Cause. 11. Payments Following Termination. (a) In the event Executive's employment is terminated by the Company for Just Cause as so defined, or if Executive voluntarily resigns, then the Company immediately shall pay Executive a cash payment of his Base Salary as provided in Section 5(a) hereof that was earned but unpaid as of the date of termination. Any options or restricted stock held by Executive on the date of termination shall vest only through the date of termination according to the normal vesting schedule applicable to such options or restricted stock, and Executive shall not receive any accelerated or additional vesting of such stock or options on or after such date. (b) In the event Executive's employment is terminated by the death of Executive, then the Company shall pay Executive's estate a cash lump sum equal to the sum of (i) the remaining payments of Base Salary described in Section 5(a) that would have been payable to Executive through the date of death plus (ii) a pro-rata portion of the Target Bonus for the year in which his death occurs plus the Target Bonus for the preceding year if his death occurs after year-end but before such bonuses are paid. Any options or restricted stock held by Executive on the date of termination shall vest only through the date of termination according to the normal vesting schedule applicable to 6 such options or restricted stock, and Executive shall not receive any accelerated or additional vesting of such stock or options on or after such date. (c) In the event that Executive is terminated by the Company without Just Cause, then the Company shall pay Executive (i) on a basis consistent with the timing of the Company's normal payroll processing, the remaining payments of Base Salary described in Section 5(a) that would have been payable to Executive through the date of his termination of employment, (ii) his Base Salary and Target Bonus (in the form of salary continuation on a pro-rata basis with or without medical and dental benefits, at the Executive's election and cost) for the 12-month period following his termination of employment and (iii) a cash lump sum equal to a pro-rata portion of the Target Bonus for the year in which the date of termination occurs plus the Target Bonus for the preceding year if termination occurs after year-end but before such bonuses are paid. Salary continuation pursuant to the preceding sentence will cease if Executive obtains other employment (including self-employment) during such 12-month period. Any options or restricted stock held by Executive on the date of termination shall vest only through the date of termination according to the normal vesting schedule applicable to such options or restricted stock, and Executive shall not receive any accelerated or additional vesting of such stock or options on or after such date. (d) In the event that Executive is terminated by the Company (or its successor) in a Control Termination as so defined, then the Company shall pay Executive (i) on a basis consistent with the timing of the Company's normal payroll processing, the remaining payments of Base Salary described in Section 5(a) that would have been payable to Executive through the date of his termination of employment, (ii) his Base Salary and Target Bonus (in the form of salary continuation on a pro-rata basis with or without medical and dental benefits, at the Executive's election and cost) for the 12-month period following his termination of employment and (iii) a cash lump sum equal to a pro-rata portion of the Target bonus for the year in which the date of termination occurs plus the Target Bonus for the preceding year if termination occurs after year-end but before such bonuses are paid. Salary continuation pursuant to the preceding sentence will cease if Executive obtains other employment (including self-employment) during such 12-month period. To the extent that Executive is terminated in a Control Termination that occurs in anticipation of a Change in Control, any options or restricted stock held by Executive shall fully vest, retroactive to the date of termination, upon the occurrence of the Change in Control. (e) Notwithstanding anything to the contrary, in the event that Executive's employment terminates, the Company shall pay to Executive, in accordance with its standard payroll practice, Executive's accrued vacation. (f) Notwithstanding anything to the contrary, payment of severance under this Agreement is conditioned upon the execution by Executive of a separation and release agreement in a form acceptable to the Company and the observation of such waiting or revocation periods, if any, before and after execution of agreement by Executive as are required by law, such as, for example, the waiting or revocation periods required for a waiver and release to be effective with respect to claims under the Age Discrimination in 7 Employment Act, provided that the Company delivers to Executive such agreement with seven days of the date of his termination. 12. Change in Control. In the event of a Change in Control, Executive will be entitled to the full vesting of any options and restricted stock held by Executive on the date of such Change in Control. 13. Character of Termination Payments. The amounts payable to Executive upon any termination of his employment shall be considered severance pay in consideration of past services rendered on behalf of the Company and his continued service from the date hereof to the date he becomes entitled to such payments and shall be the sole amount of severance pay to which Executive is entitled from the Company and its affiliates upon termination of his employment during the term. Executive shall have no duty to mitigate his damages by seeking other employment. 14. Representations of the Parties. (a) The Company represents and warrants to Executive that (i) this Agreement has been duly authorized, executed and delivered by the Company and constitutes a valid and binding obligation of the Company; and (ii) the employment of Executive on the terms and conditions contained in this Agreement will not conflict with, result in a breach or violation of, constitute a default under, or result in the creation or imposition of any lien, charge or encumbrance upon any property or assets of the Company pursuant to: (A) the certificate of formation, (B) the terms of any indenture, contract, lease, mortgage, deed of trust, note, loan agreement or other agreement, obligation, condition, covenant or instrument to which the Company is a party or bound or to which its property is subject, or (C) any statute, law, rule, regulation, judgment, order or decree applicable to the Company, or any regulatory body, administrative agency, governmental body, arbitrator or other authority having jurisdiction over the Company. (b) Executive represents and warrants to the Company that: (i) this Agreement has been duly executed and delivered by Executive and constitutes a valid and binding obligation of Executive; and (ii) neither the execution of this Agreement by Executive nor his employment by the Company on the terms and conditions contained herein will conflict with, result in a breach or violation of, or constitute a default under any agreement, obligation, condition, covenant or instrument to which Executive is a party or bound or to which his property is subject, or any statute, law, rule, regulation, judgment, order or decree applicable to Executive of any court, regulatory body, administrative agency, governmental body, arbitrator or other authority having jurisdiction over Executive or any of his property. 15. Arbitration of Disputes; Injunctive Relief. (a) Except as provided in subsection (b) below, any controversy or claim arising out of or relating to this Agreement or the breach thereof, shall be settled by binding arbitration in the City of Indianapolis, Indiana, in accordance with the laws of the State of Indiana by three arbitrators, one of whom shall be appointed by the Company, one by Executive, and the third of whom shall be appointed by the first two arbitrators. If 8 the first two arbitrators cannot agree on the appointment of a third arbitrator, then the third arbitrator shall be appointed by the Chief Judge of the United States District Court for the Southern District of Indiana. The arbitration shall be conducted in accordance with the rules of the American Arbitration Association, except with respect to the selection of arbitrators, which shall be as provided in this Section. Judgment upon the award rendered by the arbitrators may be entered in any court having jurisdiction thereof. Each party shall pay its own costs and expenses incurred in connection with the enforcement of this Agreement, regardless of the final outcome. (b) Executive acknowledges that a breach or threatened breach by Executive of Sections 8 or 9 of this Agreement will give rise to irreparable injury to the Company and that money damages will not be adequate relief for such injury. Notwithstanding paragraph (a) above, the Company and Executive agree that the Company may seek and obtain injunctive relief, including, without limitation, temporary restraining orders, preliminary injunctions and/or permanent injunctions, in a court of proper jurisdiction to restrain or prohibit a breach or threatened breach of Section 8 or 9 of this Agreement. Nothing herein shall be construed as prohibiting the Company from pursuing any other remedies available to the Company for such breach or threatened breach, including the recovery of damages from Executive. 16. Notices. Any notice required or permitted to be given under this Agreement shall be sufficient if in writing and if sent by registered mail to his residence, in the case of Executive, or to the business office of its General Counsel, in the case of the Company. 17. Waiver of Breach and Severability. The waiver by either party of a breach of any provision of this Agreement by the other party shall not operate or be construed as a waiver of any subsequent breach by either party. In the event any provision of this Agreement is found to be invalid or unenforceable, it may be severed from the Agreement, and the remaining provisions of the Agreement shall continue to be binding and effective. 18. Entire Agreement. Other than any equity award agreements entered into pursuant to the Conseco, Inc. 2003 Long-Term Equity Incentive Plan, this instrument contains the entire agreement of the parties and, as of the Effective Date, supersedes all other obligations of the Company and its affiliates under other agreements or otherwise. This Agreement may not be changed orally, but only by an instrument in writing signed by the party against whom enforcement of any waiver, change, modification, extension or discharge is sought. 19. Binding Agreement and Governing Law; Assignment Limited. This Agreement shall be binding upon and shall inure to the benefit of the parties and their lawful successors in interest (including, without limitation, Executive's estate, heirs and personal representatives) and, except for issues or matters as to which federal law is applicable, shall be construed in accordance with and governed by the laws of the State of Indiana. This Agreement is personal to each of the parties hereto, and neither party may assign or delegate any of its rights or obligations hereunder without the prior written consent of the other. 20. Indemnification. If Executive was or is made a party or is threatened to be made a party to or is otherwise involved (including involvement as a witness) in any action, suit or proceeding, whether civil, criminal, administrative or investigative (a "Proceeding"), by reason of the fact that he or she is or was an officer or employee of the Company or any of its affiliates, 9 Executive shall be indemnified and held harmless by the Company to the fullest extent authorized by the Delaware General Corporation Law, as the same exists or may hereafter be amended (but, in the case of any such amendment, only to the extent that such amendment permits the Company to provide broader indemnification rights than permitted prior thereto), against all expense, liability and loss (including attorneys' fees, judgments, fines, excise taxes or penalties and amounts paid in settlement) reasonably incurred or suffered by Executive in connection therewith and such indemnification shall continue as to Executive if he ceases to be an officer or employee and shall inure to the benefit of Executive's heirs, executors and administrators; provided, however, that the Company shall indemnify Executive in connection with a proceeding (or part thereof) initiated by Executive only if such Proceeding (or part thereof) was authorized by the Board of Directors of the Company. The right to indemnification conferred in this paragraph shall include the obligation of the Company to pay the expenses incurred in defending any such proceeding in advance of its final disposition (an "Advance of Expenses"); provided, however, that, if and to the extent that the Delaware General Corporation Law requires, an Advance of Expenses incurred by Executive in his capacity as an officer or employee shall be made only upon delivery to the Company of an undertaking, by or on behalf of Executive, to repay all amounts so advanced if it shall ultimately be determined by final judicial decision from which there is no further right to appeal that Executive is not entitled to be indemnified for such expenses under this paragraph or otherwise. 21. No Third Party Beneficiaries. The terms and provisions of this Agreement are intended solely for the benefit of each party hereto and their respective successors or permitted assigns, and it is not intended to confer third-party beneficiary rights upon any other person. 22. Counterparts. This Agreement may be executed in counterparts, each of which shall be deemed to be an original, but all of which together shall constitute one and the same instrument. 10 IN WITNESS WHEREOF, the parties have executed this Agreement as of the date first above written, effective as of the Effective Date. COMPANY: CONSECO SERVICES, LLC By:/s/William J. Shea ----------------------------------- Name: William J. Shea Its: President and Chief Executive Officer CONSECO, INC. By:/s/William J. Shea ----------------------------------- Name: William J. Shea Its: President and Chief Executive Officer EXECUTIVE: /s/Dewette Ingham -------------------------------------- Dewette Ingham 11 EX-12 3 exhibit121.txt EXHIBIT 12.1 Exhibit 12.1 Computation of Ratio of Earnings to Fixed Charges and Preferred Dividends (Dollars in millions)
Successor --------- Nine months ended September 30, 2004 ---- Pretax income from operations: Net income....................................................................................... $208.4 Add income tax expense........................................................................... 115.7 ------ Pretax income from operations................................................................. 324.1 ------ Add fixed charges: Interest expense................................................................................. 59.9 Interest expense on investment borrowings........................................................ 5.2 Interest added to policyholder account balances ................................................. 306.0 Portion of rental (a)............................................................................ 9.6 ------ Fixed charges................................................................................. 380.7 ------ Adjusted earnings............................................................................. $704.8 ====== Ratio of earnings to fixed charges........................................................ 1.85x ===== Fixed charges...................................................................................... $380.7 Add dividends on preferred stock (divided by the ratio of net income to pretax income)................................................................................ 87.1 ------ Fixed charges plus preferred dividends........................................................ $467.8 ====== Adjusted earnings............................................................................. $704.8 ====== Ratio of earnings to fixed charges and preferred dividends................................ 1.51x ===== - -------------------- (a) Interest portion of rental is estimated to be 33 percent.
EX-31 4 exhibit311.txt EXHIBIT 31.1 Exhibit 31.1 CERTIFICATION I, William S. Kirsch, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Conseco, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: November 9, 2004 /s/William S. Kirsch - -------------------------------- William S. Kirsch, President and Chief Executive Officer EX-31 5 exhibit312.txt EXHIBIT 31.2 Exhibit 31.2 CERTIFICATION I, Eugene M. Bullis, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Conseco, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have: (a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared; (c) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and (d) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions): (a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and (b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: November 9, 2004 /s/Eugene M. Bullis - ------------------------------------------ Eugene M. Bullis, Executive Vice President and Chief Financial Officer EX-32 6 exhibit321.txt EXHIBIT 32.1 Exhibit 32.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Conseco, Inc. (the "Company") on Form 10-Q for the period ending September 30, 2004 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, William S. Kirsch, President and Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that to my actual knowledge: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/William S. Kirsch - ------------------------------------- William S. Kirsch President and Chief Executive Officer November 9, 2004 A signed original of this written statement required by Section 906 has been provided to Conseco, Inc. and will be retained by Conseco, Inc. and furnished to the Securities and Exchange Commission upon request. EX-32 7 exhibit322.txt EXHIBIT 32.2 Exhibit 32.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Conseco, Inc. (the "Company") on Form 10-Q for the period ending September 30, 2004 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Eugene M. Bullis, Executive Vice President and Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that to my actual knowledge: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/Eugene M. Bullis - ---------------------------------------------------- Eugene M. Bullis Executive Vice President and Chief Financial Officer November 9, 2004 A signed original of this written statement required by Section 906 has been provided to Conseco, Inc. and will be retained by Conseco, Inc. and furnished to the Securities and Exchange Commission upon request. -----END PRIVACY-ENHANCED MESSAGE-----