CNO Financial Group, Inc. quarterly report, Q1 FY2017

Business Context and Reporting Period

CNO Financial Group, Inc. is an insurance holding company serving middle-income pre-retiree and retired Americans through Bankers Life, Washington National, Colonial Penn, and a long-term-care block in run-off. 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 months ended March 31, 2017, compared with the three months ended March 31, 2016. The long-term-care run-off segment reflects business recaptured from Beechwood Re Ltd. effective September 30, 2016.

Key Financial Metrics

Metric	Q1 2017	Q1 2016	Change
Total revenues	$1,070.7 million	$960.4 million	11.5% increase
Income before income taxes	$96.7 million	$40.5 million	138.8% increase
Net income	$62.3 million	$45.5 million	37.0% increase
Diluted EPS	$0.36	$0.25	44.0% increase
Net margin	5.8%	4.7%	Improved
Net cash from operating activities	$141.0 million	$143.6 million	1.8% decrease
Ending unrestricted cash	$530.2 million	$635.7 million	Prior-period comparison

Insurance policy income increased to $663.8 million from $644.4 million. General-account net investment income increased to $312.0 million from $291.0 million, while income from policyholder and other special-purpose portfolios increased substantially to $75.2 million from $11.7 million. Net realized investment gains were $7.9 million versus a $0.9 million loss in the prior-year quarter.

Total benefits and expenses were $974.0 million versus $919.9 million. The implied pretax margin was approximately 9.0%, compared with 4.2% in Q1 2016. The effective tax expense on period income was $34.4 million, compared with $15.0 million; Q1 2016 also benefited from a $20.0 million deferred-tax valuation-allowance reduction that did not recur.

Operating Performance and Material Changes

Operating earnings: Pre-tax operating earnings increased to $92.9 million from $77.6 million. Net operating income increased to $59.8 million from $49.6 million.
Bankers Life: Pre-tax operating earnings rose to $89.7 million from $77.6 million. Premium collections increased 4.1% to $687.8 million, primarily from annuities. Long-term-care interest-adjusted benefit ratio improved to 72.5% from 75.3%.
Washington National: Pre-tax operating earnings declined to $23.5 million from $26.3 million. Supplemental-health claims increased, with the interest-adjusted benefit ratio rising to 60.6% from 57.7%.
Colonial Penn: The operating loss narrowed to $0.3 million from $6.8 million, helped by lower marketing costs. Premium collections increased 6.3% to $74.5 million.
Long-term care in run-off: The segment contributed $0.4 million of pre-tax operating earnings. It remains in loss-recognition status and is highly sensitive to investment-yield and actuarial assumptions.
Premium collections: Consolidated collections increased 4.9% to $940.0 million, with first-year collections up 5.1% to $345.3 million.
Equity and repurchases: Shareholders’ equity increased to $4.61 billion from $4.49 billion, supported by $107.2 million of after-tax other comprehensive income. The company repurchased 2.1 million shares for $43.0 million and declared $14.0 million of dividends, or $0.08 per share.

Debt, Liquidity, Investments, and Capital

Direct corporate obligations were $913.4 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 a revolving credit facility. The facility had $50.0 million of remaining availability and matures in May 2019.
Investment borrowings were $1.65 billion, primarily collateralized Federal Home Loan Bank borrowings. Borrowings related to consolidated variable-interest entities were $1.63 billion.
Holding companies held $137.4 million of unrestricted cash and cash equivalents, $86.6 million of fixed-income investments, and $89.6 million of equity securities. Management stated that available liquidity and expected operating cash flows should be sufficient for debt service and other obligations, but noted dependence on insurance-subsidiary distributions and regulatory approvals.
The estimated consolidated statutory risk-based capital ratio was 446%, and the company reported compliance with debt covenants, including a 19.5% debt-to-total-capital ratio for purposes of the revolving credit agreement.
Fixed maturities available for sale had a fair value of $21.38 billion, including $3.21 billion of below-investment-grade securities. Investment-grade securities represented 94.9% of the portfolio by fair value. Gross unrealized losses on fixed maturities were $134.2 million.

Guidance, Outlook, Risks, and Unusual Items

Management expected the 2017 Medicare supplement benefit ratio to be approximately 71% to 74%, Bankers Life long-term-care interest-adjusted benefit ratio to be 77% to 82% excluding reserve-related rate-increase effects, and Washington National supplemental-health interest-adjusted benefit ratio to be 58% to 61%.
Colonial Penn expected 2017 earnings before realized investment gains or losses and income taxes of $5 million to $15 million.
Management anticipated repurchasing approximately $200 million to $275 million of common stock during 2017, subject to business and market conditions and competing capital needs.
The company recognized $8.4 million of investment impairment losses in Q1 2017, including $3.2 million on fixed maturities of an energy-sector issuer and $5.2 million related to a real-estate investment.
The company has a $255.9 million valuation allowance against deferred tax assets. Failure to achieve projected taxable income, or an ownership change under Section 382, could require additional allowance charges and reduce earnings and equity.
Long-term-care risk remains material. The company indicated that a 50-basis-point reduction in the ultimate new-money-rate assumption for the run-off block could produce an estimated $10 million pretax charge. Management also discussed the possibility of future reinsurance transactions that could require a substantial ceding commission and create an initial loss.
CNO and subsidiaries are involved in litigation and regulatory examinations. A Washington National matter had jury awards of $4.7 million in compensatory damages and $6.0 million in punitive damages, subject to post-trial motions. The company also pursued arbitration and litigation related to the Beechwood Re and Platinum-related long-term-care reinsurance arrangements.
Key continuing risks include low interest rates, investment losses and impairments, mortality and morbidity experience, health claims, rate-increase approvals, reinsurer performance, policyholder surrenders, regulatory restrictions on dividends, debt covenant compliance, litigation, tax audits, and market-value volatility in fixed-index annuity derivatives.

Investor Verification Checklist

Verify the sustainability of the increase in operating earnings, particularly Bankers Life’s investment income and improved long-term-care results.
Monitor long-term-care reserve adequacy, rate increases, the run-off block’s investment-yield assumptions, and any proposed reinsurance transaction or ceding commission.
Review investment portfolio credit quality, energy-sector exposure, below-investment-grade holdings, unrealized losses, and subsequent impairment activity.
Assess holding-company liquidity, dependence on regulated-subsidiary dividends, debt maturities, revolving-credit availability, and covenant headroom.
Track deferred-tax-asset realizability, Section 382 ownership-change exposure, and the results of ongoing IRS and state tax examinations.
Follow the Beechwood Re arbitration and related litigation, the Washington National jury award, regulatory examinations, and potential guaranty-association assessments.
Reconcile management’s non-GAAP operating measures with GAAP net income and consider the effect of derivative fair-value changes and realized investment gains or losses on reported earnings.