CNO Financial Group, Inc. quarterly report, Q2 FY2013

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

Reporting period: Three and six months ended June 30, 2013; filed August 2, 2013. The unaudited filing covers a U.S. insurance holding company serving middle-income and senior markets through Bankers Life, Washington National, Colonial Penn, Other CNO Business and corporate operations.

Financial performance and position

Metric	Q2 2013	Q2 2012	Six months 2013	Six months 2012
Total revenues	$1,081.5 million	$1,065.0 million	$2,224.1 million	$2,188.9 million
Income before taxes	$114.7 million	$104.5 million	$149.3 million	$196.8 million
Net income	$77.1 million	$65.7 million	$89.0 million	$124.8 million
Diluted EPS	$0.34	$0.24	$0.38	$0.45
Operating income, non-GAAP	$67.7 million	$54.2 million	$117.4 million	$94.8 million
Net cash from operating activities	Not separately reported	Not separately reported	$289.9 million	$239.0 million

Q2 revenue increased approximately 1.5%, while net income increased approximately 17%. The six-month revenue increase was approximately 1.6%, but net income declined approximately 29% because of debt-extinguishment costs and lower realized investment gains. Net margins were approximately 7.1% in Q2 2013 and 4.0% for the first six months, compared with approximately 6.2% and 5.7%, respectively, in the prior-year periods.

Operating trends: Six-month EBIT before excluded items increased to $209.8 million from $184.7 million. Net operating income increased to $117.4 million from $94.8 million.
Segment EBIT before excluded items: Bankers Life was $141.2 million for six months, down from $146.6 million; Washington National was $61.2 million, up from $58.6 million; Colonial Penn improved to a $4.2 million loss from a $9.2 million loss; and Other CNO Business improved to $6.2 million from a $0.4 million loss.
Balance sheet: Total assets were $33.8 billion versus $34.1 billion at December 31, 2012. Shareholders’ equity was $4.6 billion versus $5.0 billion, primarily reflecting a $499.3 million after-tax decline in other comprehensive income from unrealized investment losses.
Cash and liquidity: Unrestricted cash was $280.0 million, down from $582.5 million at year-end. Operating cash flow was $289.9 million, while investing activities used $855.8 million and financing activities provided $263.4 million.

Debt, capital and investments

Direct corporate obligations were $905.7 million at June 30, 2013, down from $1,004.2 million. The balance included $606.5 million under the Senior Secured Credit Agreement, $275.0 million of 6.375% senior secured notes and $29.2 million of 7.0% debentures.
Investment borrowings were $1.878 billion, including approximately $1.8 billion of collateralized Federal Home Loan Bank borrowings secured by investments with a fair value of $2.3 billion. Borrowings related to consolidated variable interest entities were $1.144 billion.
The company amended its Senior Secured Credit Agreement in May 2013, reducing applicable interest-rate spreads. At June 30, the six-year and four-year term loans carried rates of 3.75% and 3.00%, respectively.
Debt covenant measures remained within requirements: debt-to-total-capitalization was 19.1% versus a 27.5% maximum; interest coverage was 7.84x versus a 2.50x minimum; aggregate insurance-company capital to company-action-level RBC was 376% versus a 250% minimum; and statutory capital and surplus was $1.865 billion versus a $1.300 billion minimum.
Fixed maturities available for sale had a fair value of $23.6 billion, including $2.7 billion of below-investment-grade securities. Gross unrealized losses were $187.4 million, and management concluded the losses were not other-than-temporary as of June 30.

Material changes versus the prior comparable period

Six-month income before taxes declined $47.5 million, largely due to a $65.4 million loss on extinguishment of debt, compared with $0.7 million in the prior-year period.
The company recognized $18.5 million of net realized investment gains in the first six months, versus $54.8 million in 2012.
Six-month net investment income from policyholder, reinsurer and other special-purpose portfolios increased to $109.5 million from $48.3 million, partly reflecting fixed-index product valuation changes that were substantially offset by insurance benefit changes.
Bankers Life premium collections increased 2.5% to $1.190 billion for six months, including a 24% increase in life collections, while long-term-care collections declined 2.5%.
Washington National premium collections increased 2.5% to $302.1 million, driven by supplemental health growth, while Medicare supplement business continued to run off following the discontinuation of new sales in late 2012.
Other CNO Business premium collections declined 5.8% to $95.8 million because of policyholder redemptions, lapses and lower charges on certain interest-sensitive life products.
The company repurchased 4.4 million common shares for $50.0 million and purchased $63.8 million principal amount of 7.0% debentures for $134.2 million during the first six months. Remaining repurchase authority was $165.7 million.

Guidance, outlook, risks and unusual items

Management anticipated total 2013 securities repurchases of approximately $250 million to $300 million.
Colonial Penn expected a 2013 loss before realized investment gains and income taxes of approximately $5 million to $10 million.
Other CNO Business expected 2013 normalized earnings before specified investment and derivative items and taxes of approximately $5 million to $20 million, with volatility from thin margins and litigation.
Management expected Bankers Life’s long-term-care interest-adjusted benefit ratio to approximate normalized results from the last two quarters for the remainder of 2013. The six-month ratio was 81.5%, compared with 70.4% in 2012; excluding specified unusual items, management reported a ratio of 77.7%.
The filing recorded a $6.0 million after-tax out-of-period adjustment in the first six months for insurance benefits and amortization; none of the adjustment was recorded in Q2.
Long-term-care future loss reserves increased $10.9 million in the first six months. Management noted that a 5- to 10-percentage-point increase in the initial loss ratio for 2012 claims could have reduced earnings by approximately $35 million to $72 million.
Material risks include sustained low interest rates, investment losses and impairments, mortality and morbidity trends, long-term-care claim uncertainty, policy lapses, regulatory approval of rate increases and dividends, debt covenant compliance, tax-asset recoverability, litigation and insurance subsidiary financial-strength ratings.
Conseco Life remained materially weaker than the company’s primary insurance subsidiaries. The filing described its 2012 RBC ratio as 129%, near the company-action threshold, although management stated that the subsidiary was no longer considered in hazardous financial condition based on March 31, 2013 results.
Significant legal matters included settlements or pending proceedings involving Valulife/Valuterm and Lifetrend policies, as well as a Washington National inflation-escalation rider case. Management did not believe pending matters were probable of materially affecting consolidated results, but acknowledged that outcomes could be adverse and difficult to estimate.
Subsequent events included the July 2013 conversion-right termination for the 7.0% debentures, conversion of $25.7 million principal amount into 4.7 million shares, a July IRS settlement expected to reduce the deferred-tax valuation allowance by approximately $70 million, and an anticipated approximately $14 million tax benefit related to debenture repurchase premiums.

Investor verification checklist

Reconcile GAAP net income with non-GAAP net operating income, including the debt-extinguishment loss, derivative fair-value changes, realized investment gains and tax valuation-allowance adjustments.
Assess the sustainability of Bankers Life earnings amid rising long-term-care benefit ratios and the expected reduction in rate-action benefits.
Review liquidity available at the holding company separately from cash held by regulated insurance subsidiaries, including the need for regulatory approval of extraordinary dividends.
Monitor investment portfolio credit quality, below-investment-grade exposure, unrealized losses and potential other-than-temporary impairments.
Verify the effect of the July 2013 debenture conversions, IRS settlement and subsequent tax benefit in later filings.
Track Conseco Life’s RBC ratio, ratings, capital needs and the status of pending litigation and regulatory examinations.