CNO Financial Group, Inc. annual report, FY2013

CNO Financial Group, Inc. — 2013 Form 10-K Summary

Reporting period: Fiscal year ended December 31, 2013; quarterly information is unaudited. CNO is a U.S. insurance holding company serving middle-income pre-retirees and retirees through Bankers Life, Washington National, Colonial Penn, Other CNO Business and corporate operations. Products include health insurance, long-term care, annuities and life insurance.

Financial performance and condition

Metric	2013	2012	Change
Total revenues	$4,476.1 million	$4,342.7 million	+3.1%
Insurance policy income	$2,744.7 million	$2,755.4 million	-0.4%
Net investment income	$1,664.0 million	$1,486.4 million	+12.0%
Income before taxes	$304.8 million	$155.7 million	+95.7%
Net income	$478.0 million	$221.0 million	+116.3%
Diluted EPS	$2.06	$0.83	+148.2%
Net operating income	$270.0 million	$180.4 million	+49.8%
Net cash from operations	$720.4 million	$634.9 million	+13.5%
Total assets	$34.8 billion	$34.1 billion	+1.9%
Shareholders’ equity	$5.0 billion	$5.0 billion	-1.9%

Net income margin was approximately 10.7% of reported revenue, compared with approximately 5.1% in 2012. The improvement was substantially influenced by tax benefits and lower debt-extinguishment losses, rather than solely by underlying insurance operations.

Total premium collections increased to $3.455 billion from $3.349 billion in 2012 and $3.578 billion in 2011.
Premium collections by major category were health $1.942 billion, annuities $748.7 million and life $764.4 million.
Operating EBIT, a non-GAAP measure, increased to $462.9 million from $350.3 million. Segment EBIT increased at Bankers Life to $310.5 million, but declined at Washington National to $120.8 million. Colonial Penn remained unprofitable at $(12.5) million.
Bankers Life premium collections increased 3.5% to $2.430 billion, supported by life and fixed-index annuity sales. Washington National collections increased 3.1% to $609.1 million, while Colonial Penn collections increased 6.9% to $231.7 million.
Bankers Life long-term-care benefit ratio deteriorated to 129.3% from 117.6%; its interest-adjusted benefit ratio was 80.6%. Other CNO Business long-term-care benefit ratio remained severely adverse at 245.7%.
The investment portfolio totaled $27.2 billion, including $23.2 billion of fixed maturities. Approximately 88% of fixed maturities were investment grade and 12% were below investment grade.
Net realized investment gains declined to $33.4 million from $81.1 million. Other-than-temporary impairment losses recognized in earnings declined to $11.6 million from $37.8 million.
Other comprehensive income declined by $465.6 million after tax, primarily because rising interest rates reduced unrealized investment gains. Accumulated other comprehensive income fell to $731.8 million from $1.197 billion.

Cash flow, debt and liquidity

Operating cash flow was $720.4 million. Investing activities used $602.5 million, primarily reflecting net investment purchases. Financing activities used $1.4 million.
Unrestricted cash and cash equivalents were $699.0 million consolidated; CNO, CDOC and other non-insurance subsidiaries held $133.5 million of unrestricted cash and cash equivalents at year-end.
Direct corporate obligations totaled $856.4 million, consisting principally of $581.5 million under the Senior Secured Credit Agreement, $275.0 million of 6.375% senior secured notes due 2020 and $3.5 million of 7.0% debentures.
Scheduled direct corporate principal payments total $59.4 million in 2014, $79.3 million in 2015, $64.0 million in 2016, $4.2 million in 2017, $378.1 million in 2018 and $275.0 million thereafter. Including interest, management identified approximately $98 million of 2014 debt-service cash requirements.
Insurance subsidiaries had $1.9 billion of collateralized Federal Home Loan Bank borrowings, secured by investments with a fair value of $2.4 billion. Consolidated investment borrowings were $1.9 billion.
Debt covenant measures were within requirements at year-end: debt-to-total-capitalization ratio 17.0% versus a maximum of 27.5%; interest coverage 8.53x versus a minimum of 2.50x; consolidated insurance-company RBC ratio 410% versus a minimum of 250%; and statutory capital and surplus $1.946 billion versus a minimum of $1.300 billion.
Insurance subsidiaries paid $236.8 million of extraordinary dividends in 2013. Future distributions require regulatory approval because immediate insurance subsidiaries had negative earned surplus.

Material changes and unusual items

In December 2013, CNO ceded $495 million of Other CNO long-term-care reserves under 100% coinsurance agreements with Beechwood Re Ltd. The transaction generated a $98.4 million pretax loss, including a $96.9 million premium-deficiency reserve and transaction costs. Trust collateral is subject to 7% overcollateralization and periodic true-up provisions.
Coventry notified CNO of termination of the PDP quota-share reinsurance agreement in August 2013. No PDP business was recognized in the third and fourth quarters; related pretax income fell to $1.3 million from $10.4 million.
CNO recognized a $65.4 million loss on extinguishment of debt, substantially lower than $200.2 million in 2012, following repurchases of 7.0% debentures and amendments to the credit agreement.
A $472.1 million reduction in the deferred-tax-asset valuation allowance was recorded in 2013, producing a $301.5 million benefit from the valuation allowance and other tax items. Net deferred tax assets were $1.173 billion, with a remaining valuation allowance of $294.8 million.
The 2013 quarterly results were uneven: net income was $11.9 million in the first quarter, $77.1 million in the second, $283.0 million in the third and $106.0 million in the fourth. The third quarter benefited significantly from tax-related items.
Out-of-period adjustments reduced 2013 net income by $7.6 million, or approximately $0.03 per diluted share; management considered the adjustments immaterial to prior periods and the consolidated financial statements.
CNO repurchased 8.9 million common shares for $118.4 million and paid $24.4 million of dividends in 2013. Remaining securities-repurchase authority was $397.4 million.

Guidance, outlook and management commentary

Management targeted at least 6% sales growth in 2014 and continued progress toward a 9% operating return on equity goal by 2015.
Management expected to repurchase approximately $225 million to $300 million of securities in 2014, absent compelling alternatives, and to make further progress toward a 20% dividend payout ratio by 2015.
Management expected 2014 Bankers Life Medicare supplement benefit ratios of approximately 70% and interest-adjusted long-term-care benefit ratios of approximately 79%. Washington National expected an interest-adjusted supplemental-health benefit ratio of approximately 52%.
Colonial Penn expected to report a 2014 loss before realized investment gains and taxes of approximately $5 million because direct-response advertising costs are generally not deferred.
Management stated that existing holding-company cash, operating cash flows and other transactions were expected to support debt service and corporate obligations, but acknowledged that liquidity depends on regulatory approvals, subsidiary dividends, investment performance, claims, surrenders and debt-covenant compliance.

Principal risks and contingencies

Low interest rates may compress investment spreads, reduce net investment income and increase reserves or acquisition-cost amortization. The filing estimates a $60 million pretax charge from an immediate and permanent 10-basis-point spread reduction on interest-sensitive life and annuity products.
Long-term-care claims, persistency and mortality have exceeded historical pricing assumptions. Required rate increases may be delayed or denied by regulators, while approved increases may cause lapses and adverse policyholder selection.
Approximately 29% of insurance liabilities, or $7.2 billion, could be surrendered without penalty. Higher surrenders could require asset sales at losses and reduce liquidity.
Insurance subsidiaries are subject to extensive state regulation, including restrictions on dividends, rate increases, reserves, market conduct and risk-based capital.
CNO’s corporate debt is below investment grade and structurally subordinated to insurance-subsidiary liabilities. Covenant breaches could accelerate debt and potentially create a liquidity shortfall.
Investment risks include rising rates, credit deterioration, structured-security prepayments, below-investment-grade securities, mortgage exposure and valuation uncertainty. The filing reports $1.7 billion of net unrealized investment losses during 2013, primarily from rising rates.
Reinsurance credit risk is material: reinsurance receivables were $3.4 billion, and the ten largest reinsurers represented 93% of ceded life insurance in force. The Beechwood Re transaction involves a relatively new, non-licensed Cayman Islands reinsurer, although trust collateral was provided.
Pending litigation and regulatory examinations include a nationwide Lifetrend class action and a multistate unclaimed-property examination involving 38 states and the District of Columbia. The company cannot reliably estimate potential losses beyond recorded amounts.
CNO had approximately $3.5 billion of federal NOLs. A future Section 382 ownership change could materially restrict their use and reduce deferred tax assets.

Important facts for investors to verify

Separate recurring operating earnings from the $301.5 million tax-related benefit, the $98.4 million reinsurance loss, realized investment gains, embedded-derivative changes and debt-extinguishment loss.
Assess whether Bankers Life long-term-care claims, persistency and benefit ratios are stabilizing and whether future rate increases will receive regulatory approval.
Review the collateral, counterparty strength and performance of the Beechwood Re coinsurance arrangement and the associated $495 million ceded reserves.
Monitor holding-company cash, extraordinary-dividend approvals, debt maturities and compliance with the Senior Secured Credit Agreement and 6.375% Notes covenants.
Evaluate the sensitivity of investment spreads, unrealized gains, statutory capital and RBC ratios to changes in interest rates and credit markets.
Confirm the realizability of the $1.173 billion net deferred tax asset, the $294.8 million valuation allowance and the continuing IRS uncertainty over certain loss classifications.
Review litigation, regulatory examinations, rate filings and reinsurance recoverables for developments that could exceed recorded reserves or restrict operations.