CNO Financial Group, Inc. quarterly report, Q3 FY2011

CNO Financial Group, Inc. — Q3 2011 Form 10-Q Summary

Business context and reporting period

CNO is a U.S. insurance holding company focused on senior and middle-income markets. Its principal segments are Bankers Life, Washington National, Colonial Penn, Other CNO Business and corporate operations. Products include health insurance, annuities, individual life insurance and related products distributed through career agents, independent producers and direct marketing.

This unaudited filing covers the three and nine months ended September 30, 2011, compared with the corresponding 2010 periods. The company had 243.25 million common shares outstanding at September 30, 2011.

Key financial metrics

Metric	Q3 2011	Q3 2010	9M 2011	9M 2010
Total revenues	$992.3 million	$1,052.5 million	$3,073.5 million	$3,008.1 million
Income before taxes	$87.5 million	$77.3 million	$263.3 million	$182.2 million
Net income	$196.0 million	$49.4 million	$309.4 million	$116.4 million
Diluted EPS	$0.66	$0.17	$1.05	$0.42
Net cash from operating activities	Not provided for quarter	Not provided for quarter	$562.2 million	$524.6 million

Reported net margin was approximately 19.8% in Q3 and 10.1% for the first nine months; these figures were materially affected by a $143.0 million reduction in the deferred-tax-asset valuation allowance.
Excluding that tax benefit, net income was $53.0 million in Q3 and $166.4 million for the first nine months. Management’s net operating income was $46.5 million and $155.9 million, respectively.
Net realized investment gains were $30.6 million in Q3 and $38.6 million for the first nine months, versus $3.6 million and a $18.0 million loss in the comparable 2010 periods.
Other-than-temporary impairment losses recognized in earnings were $2.9 million in Q3 and $26.3 million for the first nine months, down from $22.8 million and $72.7 million, respectively.
Shareholders’ equity increased to $4.949 billion from $4.325 billion at December 31, 2010, primarily reflecting net income and a $355.8 million increase in accumulated other comprehensive income from investment appreciation, partly offset by $55.7 million of share repurchases.
Total assets were $32.926 billion, including $25.835 billion of investments. Unrestricted cash was $461.9 million versus $571.9 million at year-end 2010.

Material changes versus the prior comparable periods

Nine-month revenue increased 2.2%, while Q3 revenue declined 5.7%, primarily reflecting lower investment income from policyholder and special-purpose portfolios and investment-related volatility.
Nine-month income before tax increased 44.5%, and net income increased substantially because of improved operating results, lower impairment losses, favorable realized investment results and the $143.0 million tax valuation allowance release.
Management’s segment earnings before investment gains, embedded-derivative fair-value changes and taxes increased to $244.0 million for the first nine months from $200.7 million. Bankers Life improved to $240.0 million from $212.7 million; Washington National declined to $70.0 million from $75.9 million; Other CNO Business improved to $13.9 million from a $17.5 million loss.
Bankers Life’s Q3 operating earnings declined to $91.4 million from $95.5 million, partly due to unfavorable fixed-index annuity derivative effects and higher amortization. Its nine-month results benefited from rate actions and improved long-term-care experience.
Other CNO Business improved because of lower benefits, amortization and operating costs, but its long-term-care benefit ratio remained elevated at 223.1% for the first nine months, or 127.1% after interest adjustment.
Corporate operations became more unfavorable, with a nine-month pretax loss of $102.2 million versus $95.2 million, including an $8.9 million Q3 charge related to actuarial assumption changes for agent deferred compensation and retirement benefits.
The company sold its trading portfolio used to offset fixed-index annuity embedded-derivative volatility during Q2 2011. Management expects greater future earnings volatility as a result.

Debt, liquidity and capital

Direct corporate obligations declined to $871.2 million from $998.5 million at year-end. Investment borrowings increased to $1.509 billion from $1.204 billion, primarily collateralized FHLB borrowings used to purchase fixed-maturity securities. VIE borrowings were $405.6 million.
The company made $105.7 million of Senior Secured Credit Agreement prepayments, including $55.7 million required because of share repurchases, and paid $25.0 million early on the Senior Health Note.
Corporate debt represented 15.0% of total capital, down from 18.8%. The credit-agreement debt-to-total-capital ratio was 18.0%, against a 30% maximum; interest coverage was 4.5x against a 2.0x minimum.
At the holding-company level, cash and cash equivalents were $54.9 million, fixed-income investments were $66.0 million, and equity securities and other invested assets totaled $48.0 million. Management stated that available liquidity, operating cash flow and anticipated insurance-subsidiary dividends should meet obligations, but noted that regulatory approvals and subsidiary performance could restrict those funds.
The insurance subsidiaries’ consolidated risk-based-capital ratio was 359%, compared with the company’s stated 350% target. Extraordinary dividends of $165.4 million were paid to CDOC during the first nine months.
Operating activities provided $562.2 million, but investing activities used $829.1 million, producing a $110.0 million decline in cash and cash equivalents to $461.9 million.

Guidance, outlook, risks and unusual items

The filing provides no formal earnings or revenue guidance. Management expects approximately $37 million of long-term-care rate increases at Bankers Life after all state approvals; approximately $22 million had been approved by September 30, 2011.
Low interest rates remain a significant risk because they may reduce investment income, product spreads, sales, deferred-acquisition-cost recoverability and insurance reserves. The company recorded an approximately $13 million pretax reduction in Other CNO Business earnings in Q3, primarily from lower projected investment yields and higher future-loss reserves.
The company recorded a $3.9 million after-tax out-of-period adjustment that reduced net income by approximately one cent per diluted share. Management concluded the error was immaterial to current and prior periods.
A pending accounting change for insurance acquisition costs is expected to reduce book value by 10% to 12%, or $460 million to $510 million, equivalent to $1.50 to $1.70 per diluted share. Management estimated a $22 million to $27 million reduction in nine-month 2011 earnings had the guidance been effective.
Deferred tax assets remain dependent on future taxable income. The company released $143.0 million of valuation allowance after concluding that $917 million of deferred tax assets were more likely than not realizable; failure to meet projections could require future charges.
Material risks include investment impairments, below-investment-grade and structured-security exposure, insurance claims and reserve assumptions, regulatory restrictions on dividends and rate increases, litigation and regulatory proceedings, financial-strength ratings, debt covenants, reinsurance and derivative-counterparty exposure.
Pending litigation includes class actions involving life-insurance cost-of-insurance charges, long-term-care benefits and sales practices. Management does not currently expect probable losses, after existing provisions, to materially affect consolidated results, but states that outcomes and potential losses generally cannot be estimated reliably.
S&P upgraded the primary insurance subsidiaries’ financial-strength ratings to BB+ with a stable outlook in August 2011. A.M. Best ratings were B+ for primary subsidiaries other than Conseco Life, which was rated B-; Moody’s ratings were Ba1.

Important facts for investors to verify

Separate recurring operating performance from the $143.0 million tax valuation allowance release, realized investment gains and derivative fair-value effects.
Track long-term-care claims, benefit ratios, reserve adequacy and the timing and scope of approved rate increases.
Assess the effect of sustained low interest rates on investment yields, product spreads, reserves, deferred acquisition costs and present value of future profits.
Review the pending acquisition-cost accounting change and its expected $460 million to $510 million book-value reduction.
Monitor holding-company liquidity, insurance-subsidiary dividend approvals, RBC ratios and compliance with debt covenants.
Evaluate investment portfolio credit quality, including $1.836 billion of below-investment-grade fixed maturities at fair value, $239.6 million of unrealized fixed-maturity losses and $4.9 billion of structured securities.
Consider increased earnings volatility after the sale of the trading portfolio that previously offset fixed-index annuity embedded-derivative movements.