CNO Financial Group, Inc. quarterly report, Q2 FY2016

CNO Financial Group, Inc. — 2016 Q2 Form 10-Q Summary

Business context and reporting period

CNO is a U.S. insurance holding company serving middle-income pre-retiree and retired customers through Bankers Life, Washington National and Colonial Penn. Products include health insurance, annuities, individual life insurance and related services, distributed through career agents, independent producers and direct marketing. This unaudited Form 10-Q covers the three and six months ended June 30, 2016, compared with the corresponding 2015 periods.

Financial performance and condition

Metric	Three months ended June 30	Six months ended June 30
Total revenues	$1,003.9 million, versus $959.5 million	$1,964.3 million, versus $1,937.8 million
Income before income taxes	$82.7 million, versus $72.7 million	$123.2 million, versus $155.0 million
Net income	$59.9 million, versus $46.8 million	$105.4 million, versus $99.6 million
Diluted EPS	$0.33, versus $0.24	$0.58, versus $0.50
Net operating income	$63.7 million, versus $60.8 million	$113.3 million, versus $120.9 million
Pre-tax operating earnings	$99.4 million, versus $93.8 million	$177.0 million, versus $186.8 million
Cash flow from operations	Not separately provided	$336.5 million, versus $330.4 million

Six-month net income margin was approximately 5.4%, compared with 5.1% in 2015; the six-month pre-tax margin was approximately 6.3%. The decline in pre-tax income despite higher revenue primarily reflected unfavorable fair-value changes in embedded derivative liabilities, higher expenses and the absence of the prior-year debt-extinguishment effects in the comparable operating presentation.

Assets were $32.0 billion at June 30, 2016, up from $31.1 billion at December 31, 2015. Shareholders' equity increased to $4.46 billion from $4.14 billion, primarily reflecting $375.0 million of after-tax other comprehensive income and $105.4 million of net income, partly offset by $151.0 million of share repurchases and $26.9 million of dividends.
Unrestricted cash was $437.2 million, compared with $432.3 million at year-end. Operating cash flow was $336.5 million; investing activities used $227.1 million and financing activities used $104.5 million.
Direct corporate obligations were $912.0 million, consisting principally of $325.0 million of 4.5% senior notes due 2020, $500.0 million of 5.25% senior notes due 2025 and $100.0 million drawn under the revolving credit facility. The company had $50.0 million of undrawn revolving capacity.
Corporate debt to total capital was 17.0%; debt to total capitalization under the revolving credit agreement was 20.2%, below the 30.0% covenant. Estimated consolidated statutory risk-based capital was 448%, above the 250% covenant.
Fixed maturities available for sale totaled $21.0 billion at fair value, including $2.76 billion of below-investment-grade securities. Gross unrealized losses were $147.1 million, including $40.9 million in the energy sector.

Material changes versus the prior comparable period

Second-quarter revenue increased 4.6% and net income increased 28.0%; six-month revenue increased 1.4% and net income increased 5.8%.
Six-month pre-tax operating earnings declined 5.2% to $177.0 million. Bankers Life increased to $170.9 million from $168.6 million, while Washington National declined to $47.8 million from $48.6 million, Colonial Penn's loss widened to $3.8 million from $1.7 million, and corporate operating losses increased to $37.9 million from $28.7 million.
Net realized investment gains improved to $11.7 million from a $1.2 million loss. The 2016 amount included $36.2 million of net investment-sale gains, $23.6 million of impairment losses and a $7.3 million VIE dissolution loss. The 2015 period included an $11.3 million VIE dissolution gain.
Fair-value changes in embedded derivative liabilities, net of related amortization, were a $46.0 million loss for the first six months, versus a $13.0 million gain in 2015. These changes principally relate to fixed-index annuity liabilities and are sensitive to interest rates and market performance.
The company reduced its deferred-tax-asset valuation allowance by $27.0 million, benefiting six-month net income. It had $2.4 billion of federal net operating losses, subject to utilization limitations and tax-related contingencies.
Share repurchases totaled 8.6 million shares for $151.0 million during the first six months. Remaining repurchase authorization was $304.7 million. The quarterly dividend was increased to $0.08 per share from $0.07.

Guidance, outlook, risks and unusual items

Management expected Bankers Life's Medicare supplement benefit ratio to remain between 70% and 73% for the remainder of 2016. Long-term-care interest-adjusted benefit ratio guidance was 81% to 86%, excluding reserve-related impacts of rate increases. Washington National supplemental-health interest-adjusted benefit ratio guidance was 56% to 59%.
Colonial Penn was expected to report 2016 earnings between breakeven and $6 million, with results sensitive to television advertising costs, including possible effects from the U.S. presidential campaign.
Management anticipated repurchasing approximately $275 million to $375 million of common stock during 2016, subject to business conditions and alternatives such as investment, dividends, acquisitions or reinsurance transactions.
CNO continued to pursue a strategic reduction of long-term-care exposure by approximately one-half over three to six years, potentially through reinsurance. A transaction could require a substantial ceding commission, create an initial loss and reduce liquidity or repurchase capacity.
The company highlighted persistent low interest rates, investment losses and impairments, insurance claims and morbidity experience, rate approval risk, policyholder persistency, regulatory restrictions on dividends, debt covenants, tax-asset recoverability, litigation, cyber and operational risks, and reinsurer credit risk.
A significant new risk involved Beechwood Re Ltd., which reinsures approximately $495 million of long-term-care reserves. At June 30, 2016, BRe reported approximately $591 million of trust assets supporting approximately $526.5 million of ceded liabilities, including approximately $302 million classified as Level 3. CNO began an audit focused initially on approximately $126 million of Level 3 assets after reports of possible connections to Platinum Partners. The audit was expected to be substantially completed in the third quarter of 2016; valuation adjustments or collateral shortfalls remained possible.
On August 1, 2016, after quarter-end, S&P placed the financial-strength ratings of primary insurance subsidiaries and CNO's issuer and senior secured debt ratings on Credit Watch with negative implications, citing information related to a reinsurer.
The filing states that no material changes occurred in market risks or disclosure controls. Pending accounting changes, including revenue, financial instruments, leases and expected credit losses, were under assessment and their effects were not yet clear.

Important facts investors should verify

Whether the BRe collateral and Level 3 asset valuation audit results in adjustments, additional collateral requirements or recapture of the ceded long-term-care business.
The sustainability of long-term-care reserves, rate increases, benefit ratios and the planned reduction of long-term-care exposure.
The effect of low interest rates, fixed-index annuity derivative volatility and future investment impairments on earnings, capital and accumulated other comprehensive income.
Whether insurance subsidiaries can continue making dividends to the holding company and whether holding-company liquidity remains sufficient for debt service, dividends and repurchases.
The realizability and utilization limits of deferred tax assets and federal NOLs, including the unresolved IRS position regarding the CSHI loss.
Future credit-rating actions, particularly S&P's Credit Watch review and potential effects on sales, policy surrenders, borrowing costs and access to capital.