CNO Financial Group, Inc. annual report, FY2012

CNO Financial Group, Inc. — FY2012 Form 10-K Summary

Business context and reporting period

CNO is a U.S. insurance holding company serving primarily senior and middle-income customers through Bankers Life, Washington National, Colonial Penn, Other CNO Business and corporate operations. Products include supplemental health, Medicare supplement, long-term care, life insurance and annuities. The filing covers the fiscal year ended December 31, 2012, with comparative information for 2011 and 2010. Fourth-quarter 2012 net income was $101.2 million, compared with $64.4 million in fourth-quarter 2011.

Key financial metrics

Metric	2012	2011	Change
Total revenues	$4,342.7 million	$4,124.6 million	5.3% increase
Income before income taxes	$155.7 million	$306.2 million	49.1% decrease
Net income	$221.0 million	$335.7 million	34.2% decrease
Diluted earnings per share	$0.83	$1.15	Decrease
Net operating income	$180.4 million	$171.5 million	5.2% increase
Operating EBIT	$350.3 million	$349.9 million	Essentially flat
Net cash from operating activities	$634.9 million	$774.8 million	18.1% decrease
Total assets	$34.1 billion	$32.9 billion	3.7% increase
Shareholders’ equity	$5.0 billion	$4.6 billion	9.4% increase
Corporate notes payable	$1,004.2 million	$857.9 million	17.1% increase

Reported net margin was approximately 5.1%; pretax margin was approximately 3.6%. The filing does not provide a single consolidated operating margin measure.

Premium collections were $3.35 billion, down from $3.58 billion. Health collections were broadly stable at $1.93 billion; annuity collections fell to $712.8 million from $1.00 billion; life collections rose to $705.7 million from $641.8 million.
Net investment income increased to $1.486 billion from $1.354 billion. Net realized investment gains increased to $81.1 million from $61.8 million, including $37.8 million of other-than-temporary impairment losses.
The investment portfolio totaled $28.0 billion, including $24.6 billion of available-for-sale fixed maturities. Approximately 90% of fixed maturities were investment grade and 10% were below investment grade.
Insurance product liabilities were $25.1 billion. The average fixed-maturity portfolio yield was 5.7%, versus an average credited or accruing rate on insurance liabilities of 4.5%.
Unrestricted cash and cash equivalents totaled $582.5 million on a consolidated basis. CNO, CDOC and other non-insurance subsidiaries held $167.3 million of unrestricted cash and cash equivalents at year-end.
Consolidated statutory capital and surplus plus asset valuation reserve was $1.783 billion. The consolidated insurance-subsidiary RBC ratio was 367%, compared with a 250% debt-covenant minimum.

Material changes versus the prior comparable period

Net income declined primarily because of a $200.2 million loss on extinguishment of debt in connection with the September 2012 recapitalization. The loss included the repurchase of $200.0 million principal amount of 7.0% Debentures, the refinancing of the 9.0% Notes and repayment of the prior senior credit agreement.
Operating performance improved modestly: operating EBIT was stable, Bankers Life EBIT increased to $300.9 million from $290.9 million, and Washington National EBIT increased to $127.1 million from $96.1 million.
Other CNO Business EBIT deteriorated to a $48.8 million loss from $15.3 million of income. The segment recorded approximately $43 million of additional future loss reserves, primarily from lower projected investment yields, and $41.5 million of litigation expense.
Bankers Life premium collections fell 8.5%, principally because annuity collections declined 28%. Bankers Life life collections increased 26%, while Medicare supplement collections increased 2.3%.
Washington National premium collections increased 0.8%, driven by supplemental health growth, but new Medicare supplement sales were discontinued in the fourth quarter of 2012.
Colonial Penn premium collections increased 7.3%, but the segment reported an $8.6 million operating loss as direct-response marketing costs increased and were generally not deferrable.
The company repurchased 21.5 million common shares for $180.2 million and initiated a quarterly common-stock dividend of $0.02 per share in the second quarter. Total 2012 dividends were $13.9 million.
Shareholders’ equity benefited from $415.8 million of after-tax other comprehensive income, primarily unrealized investment gains. Accumulated other comprehensive income increased to $1.197 billion from $781.6 million.
CNO retrospectively adopted ASU 2010-26, which reduced deferred acquisition costs and changed the timing of expense recognition but did not affect cash flows, statutory results or ultimate business profitability.

Guidance, outlook, commentary, risks and unusual items

Management’s 2013 objectives include increasing operating earnings per share, growing sales profitably, improving investment income and operating efficiency, managing long-term care profitability, improving ratings and deploying excess capital.
Management expected 2013 total dividends from insurance subsidiaries of approximately $250 million to $300 million, subject to regulatory approval. It also anticipated repurchasing approximately $250 million to $300 million of securities during 2013.
Management expected Colonial Penn to report a 2013 operating loss of approximately $5 million to $10 million, based on its advertising plan. Other CNO Business normalized 2013 earnings were expected to be $5 million to $20 million, with continued volatility and litigation activity.
For 2013, management expected a Bankers Life Medicare supplement benefit ratio of approximately 71%, a Bankers Life long-term-care interest-adjusted benefit ratio of approximately 75% and a Washington National supplemental-health interest-adjusted benefit ratio of approximately 50%.
Low interest rates are a central risk. They may reduce investment yields, compress spreads, increase reserve requirements and reduce annuity sales. Approximately 26% of insurance liabilities, or $6.5 billion, could be surrendered without penalty.
Long-term care remains a significant risk. Bankers Life’s 2012 benefit ratio was 117.6%, while Other CNO Business had a 247.0% benefit ratio and a 137.6% interest-adjusted benefit ratio. Regulatory approval of rate increases may be insufficient or delayed.
Conseco Life had a weak statutory capital position and an RBC ratio near the level that could require a corrective-action plan under applicable or proposed requirements. The company reported a statutory surplus deficiency under one regulatory test but did not expect material regulatory action based on discussions at filing.
Holding-company liquidity depends on dividends, surplus-debenture interest and service payments from insurance subsidiaries. Because several subsidiaries had negative earned surplus, future dividends may require regulatory approval.
Debt service obligations were approximately $110 million in 2013 based on principal and interest requirements. The company’s debt agreements contain restrictive covenants; a covenant default could accelerate debt and create a liquidity shortfall.
Pending litigation includes class actions involving Conseco Life’s cost-of-insurance charges and Lifetrend policies. A proposed nationwide settlement was filed in January 2013, but final approval remained subject to court proceedings. CNO recorded approximately $41 million of 2012 charges related to the cost-of-insurance matters.
The company reduced its deferred-tax-asset valuation allowance by $171.5 million in 2012, producing a significant tax benefit. Net deferred tax assets were $742.6 million after a $766.9 million valuation allowance. Future profitability, IRS positions and Section 382 ownership changes could materially affect realizability.
A material weakness related to the calculation of certain other-comprehensive-income adjustments identified at September 30, 2012 was reported as remediated at December 31, 2012. The independent auditor issued an unqualified opinion on the financial statements and internal control over financial reporting.
On February 11, 2013, CNO commenced a tender offer for the remaining $93.0 million principal amount of 7.0% Debentures. The offer was scheduled to expire March 27, 2013, unless extended or terminated earlier.

Most important facts for an investor to verify

Whether Conseco Life’s RBC position and statutory surplus improve sufficiently to avoid corrective-action requirements and preserve upstream dividends.
The final outcome and total cost of the proposed cost-of-insurance and Lifetrend litigation settlements.
Actual 2013 operating earnings, long-term-care claims experience and the success of approved or pending premium-rate increases.
Whether low interest rates further compress investment spreads or require additional reserve strengthening and acquisition-cost amortization.
Compliance with debt covenants, scheduled debt service and the availability of holding-company liquidity after dividends, repurchases and capital contributions.
The sustainability of the $171.5 million deferred-tax valuation-allowance reduction and the effect of IRS challenges or a Section 382 ownership change.
The composition, valuation and credit performance of the $28.0 billion investment portfolio, including below-investment-grade, structured-security and variable-interest-entity exposures.
The effect of ASU 2010-26 and other accounting estimates on comparability of reported earnings and book value.