CNO Financial Group, Inc. quarterly report, Q2 FY2010

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

Business context and reporting period

CNO Financial Group, formerly Conseco, Inc., is a U.S. insurance holding company serving primarily senior and middle-income customers through Bankers Life, Colonial Penn and Conseco Insurance Group. Products include supplemental health insurance, annuities, individual life insurance and other insurance products. The filing covers the quarter and six months ended June 30, 2010, with comparisons to the corresponding 2009 periods.

Key financial metrics

Metric	Q2 2010	Q2 2009	Six months 2010	Six months 2009
Total revenues	$953.2 million	$1,095.6 million	$1,955.6 million	$2,165.1 million
Income before taxes	$51.8 million	$49.6 million	$104.9 million	$91.8 million
Net income	$33.1 million	$27.6 million	$67.0 million	$52.1 million
Diluted EPS	$0.12	$0.15	$0.25	$0.28
Net cash from operating activities	Not separately provided	Not separately provided	$346.0 million	$269.2 million

Six-month net income increased approximately 29%, despite a roughly 10% decline in revenue. The improvement primarily reflected lower benefits and expenses, lower impairment losses and lower amortization.
Approximate net margins were 3.5% in Q2 2010 versus 2.5% in Q2 2009, and 3.4% for the first six months of 2010 versus 2.4% in the prior-year period.
Management’s non-GAAP EBIT increased to $89.7 million in Q2 2010 from $86.7 million and to $168.9 million for the first six months from $159.0 million. Net operating income increased to $44.9 million for Q2 and $83.1 million year to date, versus $40.8 million and $78.3 million, respectively.
Total assets were $31.2 billion at June 30, 2010, compared with $30.3 billion at December 31, 2009. Shareholders’ equity increased to $4.18 billion from $3.53 billion, aided substantially by a $583.1 million improvement in accumulated other comprehensive income.
Unrestricted cash and cash equivalents were $323.7 million at June 30, 2010, down from $523.4 million at year-end 2009. Including cash held by variable interest entities, cash was $337.2 million.
Operating cash flow was $346.0 million. Investing activities used $498.4 million, principally because investment purchases exceeded sales and maturities. Financing activities used $47.3 million.
Direct corporate notes payable totaled $1.03 billion. Investment borrowings were $454.2 million, borrowings related to variable interest entities were $449.7 million, and total liabilities were $27.0 billion.
At June 30, 2010, the Senior Credit Agreement covenants included a 318% aggregate risk-based capital ratio, 21% debt-to-total-capitalization ratio and 1.76-to-1 interest coverage ratio. The company reported compliance with these requirements.

Material changes versus the prior comparable period

Total revenue declined 13% in Q2 and 10% for the first six months. The largest factor was the absence of significant PFFS business following Coventry’s decision to cease selling those plans effective January 1, 2010.
Bankers Life premium collections declined 12% in Q2 and 16% year to date, primarily because prior-year collections included PFFS premiums. Bankers Life operating income before realized investment losses increased to $64.0 million in Q2 and $117.2 million year to date.
Conseco Insurance Group premium collections declined 13% in Q2 and 11% year to date, primarily due to lower annuity and life sales and the 2009 Wilton Re coinsurance transaction. Segment operating income increased to $29.9 million in Q2 and $55.6 million year to date.
Colonial Penn operating income declined to $7.6 million in Q2 and $12.9 million year to date, compared with $11.0 million and $16.1 million, respectively.
Net realized investment losses were $21.6 million for the first six months of 2010 versus $23.2 million in 2009. Other-than-temporary impairment losses recognized in earnings fell to $48.2 million from $128.6 million.
Operating cash flow improved by $76.8 million year over year, while ending cash declined because investment purchases and other financing uses exceeded operating cash generation.
The company repurchased $116.5 million of 3.5% convertible debentures in February and May 2010 and issued an equivalent principal amount of 7.0% convertible debentures. The transactions resulted in $2.7 million of debt extinguishment losses and a $4.0 million after-tax beneficial conversion feature recorded in additional paid-in capital.
Effective January 1, 2010, CNO adopted new variable-interest-entity consolidation guidance. The adoption increased reported assets by $275.1 million, liabilities by $291.0 million and reduced shareholders’ equity by $15.9 million at adoption.

Outlook, commentary, risks and unusual items

The filing does not provide formal earnings or revenue guidance. Management expects to reorganize Conseco Insurance Group later in 2010 into Washington National and Other CNO Business segments.
Management expects approximately $170.0 million of extraordinary dividends from insurance subsidiaries during the twelve months ending June 30, 2011, subject to regulatory approval, plus $48.7 million of surplus-debenture interest. It also expects to contribute approximately $140.0 million to insurance subsidiaries.
Projected holding-company sources for the next twelve months were $278.1 million versus projected uses of $304.6 million, implying a projected $26.5 million decrease in cash. Management nevertheless believes available cash and expected operating sources will be sufficient to meet obligations, while warning that regulatory, market and operating conditions could impair liquidity.
Long-term-care claims remain a major operating risk. Bankers Life’s interest-adjusted long-term-care benefit ratio increased to 73.6% for the first six months from 67.5%; Conseco Insurance Group’s ratio declined to 112.2% from 117.7%, but remained above 100%.
The investment portfolio included $19.94 billion of actively managed fixed maturities, with $386.9 million of gross unrealized losses and $1.80 billion of below-investment-grade amortized cost. Management noted that further impairment losses could materially affect future earnings.
Deferred tax assets totaled $768.8 million net of a $1.18 billion valuation allowance. Realization depends on future taxable income, and an additional valuation allowance could reduce earnings and equity. The company also had approximately $4.6 billion of federal NOLs and $1.1 billion of capital-loss carryforwards.
The company disclosed numerous litigation and regulatory matters, including class actions involving securities, cost-of-insurance practices, annuity sales and policy administration. Management does not currently expect existing litigation to have a material adverse effect, but acknowledged that adverse outcomes could exceed established reserves.
A regulatory settlement finalized in June 2010 concerning Lifetrend policies requires a $10 million policyholder fund and a $1 million assessment; the financial impact had been accrued in 2009.
Out-of-period adjustments reduced net income by $2.7 million in Q2 and $3.0 million for the first six months. Management considered the errors immaterial to the reported periods and prior periods.
Management concluded that disclosure controls and internal control over financial reporting were not effective because of a material weakness in the actuarial reporting process for certain Conseco Insurance Group policies. Remediation was expected by year-end 2010, but no assurance was given regarding timing.

Important facts for investors to verify

Whether expected extraordinary dividends and surplus-debenture interest payments receive required insurance-regulatory approvals.
Progress in remediating the actuarial reporting material weakness and whether future filings identify related corrections.
Long-term-care claims trends, reserve adequacy, approved rate increases and policy lapses.
Future investment impairments, especially in below-investment-grade, mortgage-backed, asset-backed and commercial mortgage exposures.
Holding-company liquidity after debt service, capital contributions and required principal payments, including $602.1 million scheduled for 2013.
Realization of deferred tax assets and the potential effect of IRS positions or ownership changes under Section 382.
Developments in material litigation, regulatory proceedings and the company’s financial-strength ratings.