CNO Financial Group, Inc. quarterly report, Q1 FY2012

CNO Financial Group, Inc. — Form 10-Q Summary

Business context and reporting period

CNO is a U.S. insurance holding company serving senior and middle-income markets through Bankers Life, Washington National, Colonial Penn, Other CNO Business and corporate operations. Products include health insurance, annuities, individual life insurance and related products distributed through career agents, independent producers and direct marketing. This filing covers the three months ended March 31, 2012, compared with the three months ended March 31, 2011; balance-sheet comparisons are to December 31, 2011.

Financial condition and operating results

Metric	Q1 2012	Q1 2011	Change
Total revenues	$1,123.9 million	$1,049.2 million	+7.1%
Income before taxes	$92.3 million	$70.4 million	+31.1%
Net income	$59.1 million	$45.4 million	+30.2%
Diluted earnings per share	$0.21	$0.16	+31.3%
Net cash from operating activities	$78.2 million	$155.3 million	Down $77.1 million

Net margin was approximately 5.3%, compared with 4.3% in Q1 2011; pretax margin was approximately 8.2%, compared with 6.7%.
Insurance policy income increased to $686.3 million from $667.2 million. Net investment income increased to $410.8 million from $373.5 million, and net realized investment gains increased to $22.9 million from $5.1 million.
Total assets were $33.05 billion at March 31, 2012, versus $32.92 billion at December 31, 2011. Shareholders’ equity increased to $4.68 billion from $4.61 billion, helped by $59.1 million of net income and $26.4 million of after-tax other comprehensive income.
Unrestricted cash and cash equivalents declined to $173.5 million from $436.0 million. Cash flow was affected by $211.1 million used in investing activities and $129.6 million used in financing activities.
Direct corporate obligations were $799.3 million, including $293.0 million of 7.0% debentures, $245.8 million under the senior secured credit agreement and $275.0 million of 9.0% senior secured notes. Investment borrowings were $1.68 billion, primarily collateralized Federal Home Loan Bank borrowings; VIE borrowings were $519.9 million.
Debt and capital metrics remained within covenants: corporate debt to total capital was 14.6%; debt-to-total-capitalization under the credit agreement was 16.1%; interest coverage was 5.13x; and insurance-company total adjusted capital to company action level risk-based capital was 360%.

Material changes versus the prior comparable period

Bankers Life EBIT increased to $70.5 million from $62.2 million, supported by growth in the in-force block, higher investment income and lower amortization. Premium collections declined 5.2% to $584.3 million, primarily because annuity and long-term-care collections decreased.
Washington National EBIT was broadly stable at $24.7 million versus $24.3 million. Supplemental-health benefit performance weakened, while investment income increased.
Colonial Penn’s operating loss widened to $9.8 million from $5.7 million, reflecting adverse mortality and higher marketing expenses.
Other CNO Business moved to a $2.3 million EBIT loss from $7.4 million of EBIT, primarily because of a $20.5 million litigation-related charge. This charge related to a tentative settlement concerning cost-of-insurance increases on certain universal-life policies.
Corporate operations improved to a $19.5 million pretax operating loss from $22.5 million, mainly because of lower corporate interest expense, but included a $6.8 million charge related to relocating Bankers Life’s primary office.
The Company recorded approximately $10 million of pretax expense for a settlement with state securities regulators involving Bankers Life and BLC Financial Services. The settlement provided for approximately $9.9 million of payments among the states, plus certain investigation, licensing and registration costs.
The Company adopted ASU 2010-26 retrospectively, reducing deferred acquisition costs and shareholders’ equity and changing the timing and classification of expenses. Management stated that the adoption did not affect cash flows, statutory financial results or ultimate profitability.
The Company repurchased approximately 2.4 million shares for $18.9 million and had $111.3 million of remaining repurchase authorization at March 31, 2012. It also repaid the remaining $50.0 million Senior Health Note, removing a prior restriction on cash dividends.

Outlook, commentary, risks and unusual items

The filing provides no quantitative earnings or revenue guidance. Management expects approximately $35 million of additional long-term-care rate increases after required state approvals; approximately $28 million had been approved by March 31, 2012.
Management expects insurance-company cash flows from premiums and investment income to meet operating obligations, but holding-company liquidity depends on dividends, distributions and other payments from subsidiaries, many of which require regulatory approval. Holding-company and noninsurance subsidiaries had $39.3 million of unrestricted cash and cash equivalents, $84.5 million of fixed-income investments and $48.1 million of equity securities and other invested assets.
Key operating risks include low interest rates, investment valuation and impairment losses, mortality and morbidity, long-term-care claims and reserve estimates, policy lapses and surrenders, inability to obtain health-insurance rate increases, insurance-company ratings, regulatory restrictions on dividends, debt covenant compliance, litigation and the recoverability of deferred tax assets.
The fixed-maturity portfolio had $23.78 billion of fair value, including $2.33 billion of below-investment-grade securities and $5.58 billion of structured securities. Gross unrealized losses on fixed maturities were $128.6 million; management did not consider these securities other-than-temporarily impaired at quarter-end, but acknowledged that future events could require additional losses.
Fixed-index annuity accounting creates earnings volatility because embedded derivatives are measured at fair value. The related liability was $704.3 million at March 31, 2012, and the Company no longer held the former trading portfolio that had offset some interest-rate-related volatility.
Pending litigation includes cost-of-insurance class actions, long-term-care matters, securities litigation and other regulatory proceedings. The tentative cost-of-insurance settlement remained subject to court approval, and the Company stated that its recorded liability could be insufficient if implementation costs exceed estimates.
Federal tax matters remain significant: deferred tax assets totaled $1.78 billion before a $938.4 million valuation allowance, and the Company reported approximately $4.0 billion of federal NOLs and $0.9 billion of capital-loss carryforwards. IRS challenges, ownership changes under Section 382 or insufficient future taxable income could reduce their value.

Important facts for investors to verify

Reconcile the improvement in GAAP net income with higher realized investment gains, fair-value changes in embedded derivatives and unusual litigation and relocation charges.
Assess recurring operating earnings separately from investment gains and derivative-related volatility, including the decline in consolidated EBIT from $88.2 million to $83.1 million.
Monitor long-term-care benefit ratios, reserve development, approved and pending rate increases, and policyholder lapse behavior.
Evaluate liquidity after the substantial decline in unrestricted cash and confirm the availability and timing of dividends from regulated insurance subsidiaries.
Review debt maturities, collateralized FHLB borrowings, debt covenants and the effect of future share repurchases or dividends on mandatory prepayments.
Track the court approval and ultimate cost of the tentative cost-of-insurance settlement and the outcome of related class actions and regulatory proceedings.
Reassess investment-credit exposure, below-investment-grade securities, structured securities, unrealized losses and potential future impairment charges.
Verify the sustainability and realizability of deferred tax assets and NOLs, including the unresolved tax positions concerning cancellation-of-indebtedness income and Senior Health.