CNO Financial Group Inc (CNO) 2012 Q2 法說會逐字稿

At this time, I would like to welcome everyone to the CNO Financial Group's second quarter 2012 earnings results conference call. (Operator Instructions). Mr. Galovic, you may begin your conference.

Thank you, Operator. Good afternoon and thank you for joining us on CNO Financial Group's second quarter 2012 earnings conference call. Today's presentation will include remarks from Ed Bonach, Chief Executive Officer, Scott Perry, Chief Business Officer and President of Bankers Life, Eric Johnson, our Chief Investment Officer and Fred Crawford, Chief Financial Officer. Following the presentation, we'll also have several other business leaders available for the question and answer period. During today's conference call, we'll be referring to information contained in yesterday's press release. You can obtain the release by visiting the media section of our website at www.CNOinc.com.

The presentation is also available in the investor section of the web site and was filed under form 8-K this morning. We expect to file our second quarter 2012 form 10-Q and post it on our website on or before July 30. Let me remind you, that any forward-looking statements we make today, are subject to a number of factors which may cause actual results to be materially different than those contemplated by the forward-looking statements. Today's presentation does contain a number of non-GAAP measures, which should not be considered as substitutes for the most directly comparable GAAP measures. You'll find a reconciliation of the non-GAAP measures to the corresponding GAAP measures in the appendix to the presentation.

As a reminder, effective January 1, 2012, we adopted ASU 2010-26, which modified the definition of the types of acquisition costs that can be deferred by insurance companies. We elected to adopt the new guidance on a retrospective basis and accordingly, all prior periods presented have been retrospectively adjusted. The new guidance impacts the timing of recognition of profits on our business, but has no impact on cash flow, statutory financial results or the ultimate profitability of the business. Throughout this presentation we'll be making performance comparisons, and unless otherwise specified, any comparisons made will be referring to the changes between 2Q 2011, as we stated for the DAC announcement, and 2Q 2012. And now, I would like to turn the call over to our CEO, Ed Bonach. Ed?

Thanks, Scott. Good afternoon. CNO's core businesses continued their positive momentum and performed well during the second quarter. Investments we're making in distribution and business growth, continued to yield solid sales and earnings results. We reported net operating income of $54.2 million, which was up 22% over last year. Sales grew for the fourth consecutive quarter and were up 6% from the prior year, primarily due to increases in the sales of life and supplemental health products.

These increases were partially offset by lower annuity sales, as a result of the low interest rate environment and the product adjustments that we made during the year. Scott Perry will touch on the details, later in the presentation. Statutory earnings for the quarter were $97 million, up 23% from the prior year. Our strong financial position and our continued generation of cash and excess capital, allowed us to continue to buy back stock at an accelerated rate. As previously announced, the board of directors approved an additional $100 million for share repurchases. Bringing the combined repurchase authority outstanding to $172 million as of the end of the second quarter. Also during the quarter, the board approved initiation of a dividend program. Our first dividend payment was made during the quarter.

This was a significant milestone for CNO. Marking the tremendous progress the Company has made through some of the most challenging economic conditions in our history, and also demonstrating confidence in our current and future cash flow and financial strength. Our key metrics of risk-based capital and debt to total capital improved further during the quarter. Fred will touch on these in more detail, later in the presentation. And finally, we continue to emphasize and focus on profitable organic growth in our three core segments.

Reported net operating EPS in the quarter was $0.20 per share, up from $0.15 per share in the prior year. To enhance the understanding of our operating results, slide 7 shows our operating EPS adjusted for one notable item occurring in both this quarter and another in the year ago. Our second quarter operating earnings and operating EPS were the highest achieved in the last two and a half years. Slide 8 shows our trailing four quarters consolidated operating return on equity. Trailing four quarters earnings were up 6%, but this is outpaced by the increase in average common shareholder's equity of 10%, resulting in ROE being down slightly from the prior year. Our statutory results free cash flow and excess capital generation provide meaningful insights on CNO's enterprise value.

As we have discussed before, our levers to improve our week continue to be layering on profitable new business at a minimum of 12% unlevered after tax return, effectively deploying our excess capital, improving OCB margins and continuing to improve efficiencies across the enterprise. While we have made progress in growing earnings, and as important, earnings stability, we have made even more progress in restoring the balance sheet and deleveraging. Having now achieved capital ratios consistent with upgrades, we expect continued earnings growth in capital management to contribute more to increasing our ROE. It is also worth noting, that our ROE convention of reporting on a trailing 12-month basis somewhat masks the run rate progress we have been making in advancing ROE. This, of course, will eventually come through as we post continued strong quarters.

Slide nine is one that we have shown in the past several quarters. The slide not only illustrates the growth of our franchise based on growth and liabilities for our three core segments, but also clearly shows that for OCB, which is primarily [closed blacked] the business, the liabilities continue to run up. With respect to our franchise, I'm very pleased with the continued improvements we have seen across our business segments. At Bankers, our agent force continues to grow and our field management training program is fully operational. Washington National sales have benefited from increased agent productivity and IMO recruiting. Our increased investment in marketing and advertising at Colonial Penn, has helped to drive that segment's sales up 22% over last year.

All in all, a very strong quarter across the board. Scott Perry will provide much more detail later, in the second quarter business review. Our free cash flow is building and slide ten gives a snapshot of the 2011 excess capital generation and utilization at CNO. If you look at the information on the bottom of the slide, there is about $500 million that we generate annually in statutory gross income. That's on a capital base of about $1.8 billion in our insurance companies, which equates to approximately a 30% return on statutory capital. About $155 million was kept in the insurance companies last year, to support business growth and to increase RBC by over 20 points. It paid down debt by $145 million in 2011, and had approximately $90 million in holding company interest and expenses. In addition to those uses, we also repurchased $70 million of stock and added about $40 million to liquidity at the holding company.

If you play that now forward to 2012, our voluntary debt repayments and RBC build are now complete. The continued strong statutory performance supports increased guidance for both insurance company dividends and share buybacks. We anticipate total year dividend payment to the holding company, in the range of $200 million to $275 million during 2012, or roughly $100 million to $175 million for the second half of the year. We also anticipate repurchasing approximately $150 million to $170 million of common stock during 2012, or approximately $90 million to $110 million for the remainder of the year.

Our confidence in free cash flow is also evidenced by the initiation of a common stock dividend, based upon our expectation of continuing to generate strong statutory earnings and excess capital. And finally, we'll continue our investments in business for additional growth, including distribution expansion and potential reinsurance recapture transactions. So to recap, our continuing investments in distribution growth and active management of the business in force are yielding solid sales and earnings results. We expect to continue to generate free cash flow for reinvestment in our business, and returning capital to our shareholders through increased share repurchase activity and dividends. Our financial strength, profitability and credit profile continue to improve, as well as our generation of considerable cash flow and excess capital. Let me now turn it over to Scott Perry, to cover the results for our three core segments he oversees. Scott?

Thanks, Ed. During the second quarter, we continued to improve performance in all three of our business segments where we're actively selling new business. At Bankers, while total sales were down by 1%, excluding annuities, the remaining lines of business were up 11%. I will address our annuity strategy on the next slide. Our agent force continues to grow. Our long-term care business continues to show predictable and stable performance, and our manager trainee program is in full gear. As of June 30, we have hired 19 trainees and expect to hire an additional 61 this year. It is our expectation the trainees ready to take over leadership of a Bankers location after approximately three years.

This program will enable us to accelerate our location expansion, by more than doubling the rate of locations, we are able to establish through a normal organic development process. At Washington National, PMA sales have benefited from increased agent productivity and improvements in work site. Washington National Independent experienced growth through an increased wholesaling support and continued strong IMO recruiting. Sales at Washington National, in total, were up 15%. At Colonial Penn, we have increased our investment in marketing and advertising, which along with improvements and productivity, have produced very positive results. Sales for the quarter were up 22% over the prior year. At Bankers, we experienced solid agent force growth of 9% during the quarter, which was driven primarily by improved veteran agent retention, which improved by 4%. And strong recruiting during the past several quarters.

We finished the quarter at over 5,000 producers. The growth and agent force was especially encouraging as we battle a challenging annuity market. Annuity sales were down 35%, but overall sales were essentially flat. Regarding annuity sales, consistent with the industry trends we're seeing, fixed annuity sales are being negatively affected by the low interest rate environment. Additionally, as you may recall in January, we implemented a commission reduction to ensure that products sold meet our targeted return threshold in this low rate environment. Finally, during the quarter, in a move to stay ahead of developing sales compliance regulatory trends, we fully implemented a series of sales compliance process changes to strengthen annuity sales practices.

We expect that it will take some time for agents to adapt to these new processes and will likely, in the short term, cause some agents to shift their focus to other product lines. Given the current rate environment as the new norm, we believe the annuity sales levels we've seen in the first six months of in year, are likely to be typical of what we'll see the remainder of the year and into 2013. Sales excluding annuities, were up 11% as agents focused on other product lines within our portfolio to meet target market needs. During the quarter, we saw increases of 12% in life, 10% in short-term care, 11% in Med Supp and 7% in long-term care. Life sales benefited from two products that were modified and reintroduced during Q4 of last year. Universal life, which increased 27%, and single premium whole life, which increased 35% during the quarter.

It is important to note that although NAP was slightly down in total, on a policy count basis, sales were up 5% including annuities. This demonstrates the growth of our agent force and their resilience in response to a challenging, fixed annuity environment. Our agency force has shifted focus away from higher premium per policy annuity sales to other lines. These other lines generally generate lower premium per policy, but are continuous pay products which generate renewal income, which will be a long-term benefit to agent retention. Besides life insurance, our new critical illness product is also being positively affected by this mix shift. Piloted late in the first quarter, critical illness has been rolled out to about 50% of the addressable market, with favorable second quarter results. To date, has accounted for $1.5 million in sales of which $1 million came during the second quarter.

I would like to briefly reiterate some comments I made last quarter about the performance of our long-term business. The differences in the risk profile of the three products that make up this line, and our position in this market going forward. As I reported, at Bankers, we've never offered group coverage. All of our business is career agent sold. We began implementing rate increases in 2006, and have increased over 50% of all of our in force comprehensive and home healthcare policies over four rounds of adjustments. We sell to a lower price point, and we sell reduced benefit plans with shorter benefit periods and smaller daily benefits. Less than 5% of our total in force policies, and less than 1% of our current sales, have unlimited lifetime benefits or limited pay options.

Our average issue age is 67, which allows us to achieve tight asset liability matching to support reserves. Over the last six years, we've seen a dramatic shift in sales away from the comprehensive long-term care product, to a lower risk of short-term care and home healthcare only coverage. The risk profile for short-term care is considerably lower than a comprehensive product, in that the maximum benefit period is one year. This product now accounts for in excess of 50% of all of our long-term care sales. Finally, since 2009, we've been reinsuring between 25% and 75% of our new business with a leading reinsurer. This helps reinforce our pricing standards and underwriting and claims procedures. We remain committed to offering this product to our target market and are comfortable with the ability to continue to profitably manage the business.

Turning to Washington National, sales of our core supplemental health and life products increased by 18%. In the independent channel, sales continue to build momentum as we benefit from an increased focus on work site sales. Recruiting in the independent channel is also positively impacted by the additional resources, as new producing IMOs increased by 26 or 24% during the quarter. At PMA, sales were up 18%, driven by improvement and agent productivity, which was up 14% and improved cross selling of life insurance by both the consumer and work site divisions. PMA agent count is 674, which is up 3% for the quarter. As a reminder, at Washington National, both channels, PMA and Washington National Independent, sell supplemental health and life products direct to the consumer and through the work site as voluntary benefits. We've seen a continued improvement in the work site sales environment for these products sold through both channels.

For the quarter, voluntary work site sales, in total, were up 23%. Sales at Colonial Penn were up 22%, driven mainly by higher lead generation which was up 7%. Carryover leads from the first quarter, are also contributing to the sales growth. In addition, we are also seeing higher productivity through improved recruiting efforts, and increased training and monitoring of our telemarketing agents. As I mentioned earlier, over the past several quarters, we've increased our investment in marketing and advertising in order to generate sales growth that will benefit the Company over the long-term. Because of the new accounting principles now in place, the investments we make in this segment will no longer be deferrable, and as a result, financial results in this segment will tend to fluctuate.

We've completed a strong first half of 2012 and are optimistic looking forward. Our strategy is focused on the rapidly-growing pre and post retiree middle markets that are being fueled by the aging of the boomer generation. This market needs the simple, straightforward products that we offer to address the things they're most concerned with healthcare expenses, outliving their retirement and providing a legacy for their families. Our segments are well positioned to meet these basic needs, whether through career agents, independent agents, at the work site or direct. In all three businesses, the capital deployment initiatives we identify to accelerate organic growth, are progressing and on-going. Bankers will continue to increase the number of locations and operationallize the field manager trainee program. Both of which, will increase our ability to grow our agent force. Year-to-date, we have opened 12 new locations and expect to meet our goal of 15 for the year.

While we expect sales of annuities to continue to be a challenge in this low rate environment, we are encouraged by the overall agent force growth and our agent's ability to pivot within the portfolio. Which is evidenced by sales results of our new critical illness product and our life products. We expect this positive momentum to carry forward. At Washington National, we expect the increased focus and progress in the voluntary work site market to continue for both PMA and our independent channel, as the additional resources we've deployed continue to ramp up. We expect the strong recruiting of new IMOs to continue for the remainder of the year, with anticipation that we will see recruiting gains in the 20% range for the year.

To support geographic expansion at our PMA channel and increase sales in existing states through independents, we have introduced supplemental health and life insurance products in 15 states, plus Guam and Puerto Rico. For a total of 23 product roll-outs, covering six different products. At Colonial Penn, we will continue to invest in new lead generation activity. We expect that lead-base spending will increase sequentially slightly during Q3 and will taper off during Q4, as a result of the presidential election. Lastly, we remain on track with Colonial Penn new product launches, which are scheduled to begin in the second half of this year. And with that, I'll hand it over to Eric Johnson, who will discuss CNO's investment portfolio. Eric?

Thank you, Scott. I'm beginning with slide 18. In the second quarter, we earned investment income of $351 million, compared to $345 million in this year's first quarter. Our portfolio earn yield was 5.76%, compared to 5.4% in the prior quarter. One priority is holding down portfolio through and over to sustain portfolio yields. By way of reference, all of the things held constant. At our current level of turnover, each 100 basis point decline in new money rates, results in roughly a 3% decline in investment income. Our new money rate in the quarter was 5.25%. We allocated the bulk of this new money to high grade corporates and [RNBS].

We continue to actively match our assets nonliabilities at a line of business level, and we continue to be well within our duration matching targets in every line of business. Slide 19 lays out realized gains and losses for the trailing five quarters, sequentially. In the second quarter, we were roughly $32 million to the green. This includes $41 million in gross realized gains, partially offset by $6 million in realized losses, and $3.5 million in other than temporary impairments recognized in earnings. Going on to slide 20. Impairments remain comparatively low at $3.5 million. I would attribute this to satisfactory corporate fundamentals in the US and, more importantly, a stabilizing housing market. Going on to slide 21. Our unrealized gain increased slightly to $2.2 billion at quarter end.

This is primarily a function of lower rates quarter-over-quarter as an indicator, the ten-year treasury yield was down slightly over 56 basis points. Slide 22 illustrates our overall asset allocation, which was substantially unchanged in the quarter. Our asset quality remains good. Our invested assets were 90% investment grade at quarter end, essentially unchanged. In industrials, the relationship of upgrades to downgrades has been relatively stable. In financials, downgrades were primarily driven by sovereign credit issues and their impact on core European banks. In addition, we had slightly more than $20 million in downgrades from California redevelopment municipals. These downgrades were the result of legislative changes in California, reflecting the legal stages of the redev agencies, and the possibility of a lower degree of independence from the state's financial condition. Taken as a whole, downgrades had a 3 point impact in RBC in the quarter. Slide 23 is about investments at our holding company.

Our first priority remains liquidities to support corporate capital management strategies. Holding company cash is invested principally in money market and core plus allocations, with limited leverage. We additionally maintained a smaller allocation on leveraged equities and alternatives. At June 30, the amount of unrestricted cash to investments was $197.7 million. Net interest income for the quarter was slightly over $800,000. Gain/loss for the quarter was approximately $5.7 million. Total return for the quarter was 43 basis points. Our fixed income allocation returned 3.15%. Equity allocation returned a loss of 2.75%, consistent with the S&P index. Alternatives were down 5.94%. Going on to slide 24. Taken as a whole, news on the economy, including the US consumer confidence, our labor markets, changing US GNP expectations and European sovereign risk developments, all add up to a declining uncertainty and declining growth. The Fed's expected to keep rates low for an extended period won't answer the market's call for clarity concerning QE3.

Credit spreads, on the whole, continue to grind tighter with periodic, but brief [portions], wider. Recent equity market performance has demonstrated the possibility of volatility in risky assets and low risk has outperformed. I suspect overall, nonfinancial credit quality has piqued and fundamentals may have more downside than upside from here, excluding housing and real estate. We have certainly [signing] around low new money rates for the foreseeable future. Since income is a scarce commodity that's becoming very expensive, this suggests to me that some caution is warranted. We are avoiding high data names. We still also consider mortgages cheap and including parts of the commercial mortgage market. We expect to continue to fund at levels consistent with the Company's needs and objectives. And with that, I'll turn over to Fred.

Thanks, Eric. Operating earnings for the quarter came in at $54.2 million or $0.20 per diluted share. The quarter continued our record of solid earnings and capital performance with little noise to speak of. Our book value, excluding AOCI, increased by 5% to $16.67 per share, and ROE grew by 20 basis points sequentially, to 6%. Our debt to capital ratio, excluding AOCI, came in at 16.6%, down 170 basis points from year end. A combination of retained earnings and continued debt amortization. Our consolidated statutory RBC ratio ended the period at 369%, driven by year to date statutory operating earnings of $183 million and after paying $103 million in dividends. Unrestricted cash and investments held by our non-insurance subsidiaries, ended the quarter at nearly $200 million.

This after repurchasing 5.6 million shares of the common stock at a cost of $39 million, paying out on our quarterly dividend of $5 million and paying down debt by $22 million. Turning to our segments, Bankers earnings benefited from strong annuity persistency and spreads. Offset by less favorable benefit ratios in our Medicare Supplement and long-term care businesses. While modestly elevated, benefit ratios were within our expected range. Washington National posted a very strong quarter, driven by sustained new business growth rates and favorable benefit ratios in our supplemental health product line.

I'll touch on Colonial Penn in a moment, but the segment's earnings were largely affected by a seasonal reduction of marketing spend in the period. Finally, our other CNO business segment earnings were down roughly $3 million, primarily the result of adverse mortality in the quarter. We have investigated the claims activities and seen no systemic issues in this runoff block. We did experience a concentration of larger claims, which we expect to calm down in future periods. We use slide 27 last quarter, to illustrate how DAC change impacts each of our four business segments differently.

Focusing on Colonial Penn, we required a modest profit in the period, recognizing nearly all of their marketing and advertising costs are not deferrable. For 2012, there is an added wrinkle, given we're in a presidential election year and accelerated our investment earlier in the year. This disproportionately impacted the first quarter's results. As we look out for the remainder of 2012, we expect Colonial to record roughly break even results for the second half of 2012. More specifically, we tend to have a seasonal buying pattern. So while fluctuating around break even, we expect a modest loss in Q3 followed by a modest profit in Q4. Turning to capital, we define capital generation as statutory earnings prior to taxes, surplus note interest and contractual payments made to the holding company.

That number was $0.5 billion in 2011 and on pace for a similar result in 2012. Note that in the first half of the year, we have retained nearly $80 million of capital in our insurance subsidiaries, but building our RBC ratio by 11 points year-to-date, in addition to supporting new business. With strength in RBC build and stability in statutory earnings, we have revised upward our range-bound guidance on statutory dividends for 2012. To $200 million to $250 million, or roughly $100 million to $175 million in dividends for the remainder of the year. Slide 29 carries over from the previous slide and details are sources of holding company cash flow and recurring uses of capital. Surplus note interest and contractual payments to the holding company are essentially locked in and stable sources of cash flow.

This slide really attempts to make a simple point. That our recurring source of cash are enough to cover reoccurring uses. Interest expense, holding company expenses and even scheduled amortization on our debt. This then leaves statutory dividends as truly free cash flow. You can see that our guidance on statutory dividends suggests we will most likely generate free cash flow significantly above 2011 levels. Thus our increased stock repurchase authorization and guidance for 2012. Slide 30, then looks back on 2011 free cash flow dynamics and seeks to normalize for conditions we're experiencing in 2012. The waterfall graph starts with our 2011 capital generation and defines free cash flow by pulling out capital obtained in subsidiaries and holding company recurring expenses.

As we move through 2012, we do not have the need to build RBC, which required over $100 million in capital during 2011. With the retirement of our senior help note behind us, we're no longer dedicating free cash flow to voluntary debt reduction. We're also now subject to a reduced cash flow sweep of $0.50 on every dollar of stock repurchase and common stock dividend. In short, free cash flow is finding a new level as we move through 2012 and into 2013. Recognizing understandable concern over current low interest rate environment, we want to take some time to discuss our exposure to a low for long interest rate scenario. Before we discuss the stress test, it is important to reflect on our ALM dynamics and investment results.

As you can see from the table on slide 31. We run very tight ALM matching. Within a half a year across all our product lines. This includes long-term care, where our liability duration is shorter than most players in the industry. Thus we're able to purchase assets to support this business without making an interest rate bed. We benefit from a diversified product portfolio and are focused on serving the middle market, through exclusive distribution results in both granular and stable liabilities. We have been successful in investing at new money rates in excess of our management expectations, and have slowed the turnover rates in our portfolios to preserve higher yielding assets. Disciplined, and at times, opportunistic investment strategies, together with tight ALM and reduced turnover, have all combined to defend our portfolio yields as depicted in the graph at the bottom of the slide. An obvious question is, have we moved out on the risk curve?

Our recent new money investment mix has been overweighed high yield, discounted RMBS, emerging markets and select real estate investments, balancing risk and return and consistent with where we see opportunity. We continue to maintain tight standards around all our overall asset risk collapses and have not seen any material increase in risk, as measured by C1 capital to total invested assets. The specific stress test was built off a ten-year treasury of 1.75%, and held new money rates flat for five years, then recovering slowly to an ultimate rate. This interest rate scenario is consistent with recent rating agency stress tests. The low for long rate assumption has the effect of reshaping portfolio yields, shifting down 25 basis points in year ten, and the ultimate rate down 50 basis points from current estimates. We divide the impact into two categories. The run rate earnings impact from depressed net investment income, and the potential one-time impact of adjusting GAAP and statutory reserves.

If this scenario were to play out, we estimate a $5 million to $10 million impact to GAAP in statutory net income in 2013, and $15 million to $20 million in 2014. This represents a run rate net investment income impact to our current financial plan estimates for 2013 and 2014, thus compared to a recovering new money rate. We then applied the stress test scenario to our GAAP models, which produced an estimated one-time reserve strengthening and impact to intangibles of $50 million to $80 million after tax. In terms of statutory impact, we would expect reserves to be more resilient to a low for long rate environment, but see the potential for increasing asset adequacy reserves in the range of $15 million to $20 million, or 4% to 10% of RBC ratio.

Overall, a low for long rate environment represents a headwind to earnings growth rates, but does not eliminate growth. GAAP and statutory reserve adjustments, should they be necessary, are manageable when reflecting on our capital structure. We would not anticipate any significant disruption to current capital management plans. Finally, we're well positioned to both withstand capital threats and are confident in our ability to execute on our capital management plans. Our near-term capital strategy is transparent. We have a bias towards using free cash flow to repurchase stock. We're managing our ratios to ensure continued momentum in our ratings, with a goal of achieving BB debt ratings from S&P and Ba from Moody's. As our financial strength and ratings improve, we're monitoring market conditions for opportunities to lower our cost to capital. We see capital deployment in the potential for opportunistically lowering our overall cost to capital, as critical to driving ROE expansion. With that, I'll hand it back to Ed, for closing comments.

Thanks, Fred. CNO has a compelling value proposition. We have been growing and have above average growth potential, as we're defined and differentiated by our market focus on the senior and middle income market. Which is both underserved and rapidly expanding with the baby boomers now turning age 65. Our risk profile benefits from active management and the diversification of our products. With the markets we serve, mostly needing straightforward protection products. This is a product mix where a significant amount of sales convert quite quickly to cash.

We're shifting gears to increase our capital deployment. CNO's market focus, coupled with the alignment of distribution, products and home office to support our distribution, as well as our end customer, provide us a sustainable competitive advantage for CNO. We're also winning with quality people, adding another seasoned executive in Bruce Baude to our team. In summary, we believe we're well-positioned to continue to capitalize on our unique market focus and business strengths. With that, we'll now turn it to the operator to open it up for questions. Operator?

(Operator Instructions). Your first question comes from the line of Ryan Krueger, with Dowling Partners.

Hey, good afternoon. Thank you for the interest rate scenario. I had a couple of questions on that slide. Just first, on the GAAP and statutory actuarial charges, how would you expect that to emerge over the three year time period? In other words, would you expect some impact each year or would this be more back-end loaded?

Really, at the end of the day, what you're asking is at what point in time would we assess our assumptions and take a charge and that is something that's a very detailed exercise inside our Company. It starts to emerge as we're building our financial plan, because you would expect similar assumptions in financial plan that you use in the actuarial testing. I'm really not in a position to give precise timing and amounts.

That will depend on that analysis network, and really what we're seeing in the way of new money investing, what our reasonable outlook is for new money rates and then we'll make that call. So what we've done here has simply said, look, if I hand you this assumption, forget about the work you do to assess the appropriate long-term assumption, if I just hand this to you and have you install it, about what would be the range of GAAP impact? So it is important to note, that this was a stress test. This was not trying to build an assumption for purposes of recognizing in our financials. It was simply a stress test, so that you all as analysts, can get an idea of how big an impact would be under certain conditions.

Understood. I have a follow-up on the statutory side, the $20 million to $50 million. I want to make sure I fully understand what that is assuming. Should I take that to mean, that under the scenario you presented, you would assume 1.75% ten-year treasury for the next five years, then grading up over time in your statutory cash flow testing and that is what would produce the $20 million to $50 million?

No. What really happens is this. So statutory cash flow testing is somewhat prescribed. And the issue is, as each year goes by and I hand you a lower starting point, that eventually those prescribed tests are eventually going to result in outputs that caused you, as an appointed actuary, to look at the margins you have under cash flow testing under the so-called seven test. And that may cause you to think, to really feel more comfortable, building back those margins by adding asset adequacy reserves.

So as each year goes by in a low interest environment and you then conduct your prescribed test, plus all kinds of other sensitivities, what we're simply doing, as a management team, is making a practical conclusion that there would be certain lines of business within certain legal entities where it is more likely than not, that an appointed actuary would want to build back margins to gain comfort in their opinion. We estimate that to be in the range of $10 million to $50 million if this low for long market place would persist over time. That help?

Yes. That's helpful. Just one clarification. If rates continue to be low past the five-year timeframe, would that necessitate additional cash flow testing reserves or would you have already assumed at that point basically low rates?

It would have not only to do with what was happening at that time, but also what the circumstances are for potential recovery. And so at the end of the day, after all of the testing is done, prescribed or not, you still have an actuary on a statutory basis that needs to sign off on and an opinion on a per legal entity basis. And it may be that the judgement, based on that information, is such that we want more margin than less. I think it stands to reason, that if we're low for long beyond five years, you would expect there to be more pressure on adding asset adequacy reserves. I think that's a pretty straightforward comment.

Very helpful.

I feel comfortable when you're talking about -- one of the things interesting this quarter, you can see how rapidly we can build RBC when we decide to retain capital in the insurance companies, because of the power of the free cash flow. That provides me great comfort when I think I have a set of circumstances where an appointed actuary is going to want to look harder at asset adequacy reserves by a line of business.

Thanks a lot, Fred.

Yes.

Your next question comes from the line of Randy Binner, with FBR.

Hey, thanks. Couple of follow-ups also, on slide 32 with the interest rate stress test. I guess the easy question is, I assume that credits spread in this scenario would be unchanged?

That's right. We more or less -- what we really did was we flat lined new money rates, okay?

Yes.

I'm expressing it in using the basis of a 175 treasury, so you could frame it in your head as to what was the basis of thinking through new money rates. Yes, it more or less flat lines, holds all else equal, if you will, in terms of spread environment.

Okay, great and then on the $50 million to $80 million for the GAAP, just to clarify that's a combination basically of both DAC and GAAP reserves?

It's GAAP, first, so it is GAAP. And it is a combination of intangibles and reserves. What happens to be the case with us, Randy, by nature of the business that we have, is it tends to be much more in the way of strengthening future loss reserves. The reason for that ,is the particular lines of business that fall under most pressure, when it comes to a low for long interest rate environment, in many cases happen to be in a lost recognition mode, whereby there isn't much in the way of DAC to start with. It has implications for the mix of DAC versus [rock low] reserve strengthening, but also the on-going income run rate as well. It is why you'll tend to find a low for long interest rate is much more of an net interest income dynamic for our Company, than it is the combination of income and DAC unlocking type work.

Okay. So by extension then, could I assume that the majority of that $50 million to $80 million would be an OCB?

There is really two pockets of business that would be more sensitive to a low for long interest rate. And that would be yes to your point, OCB interest sensitive life and also, particularly older age Bankers Life long-term care business.

Can you roughly break out those two buckets in the $50 million to the $80 million? Like how much -- if it was $80 million on the high end -- would $40 million of it be OCB?

Yes, here's the way I would describe it is this. That one of the fortunate things about Bankers long-term care, is when it comes to interest rate sensitivity, there are other margin creating activities that take place in that book naturally. For example, the selling of new business that's been priced, repriced. The rate action we're taking while not tied to interest rates, certainly still helps with overall margins when looking at reserves. And so when you take a look at the stress testing of interest rates, it would tend to be a more acute issue in OCB, and so I would probably weight it that direction overall. But don't want to be that precise. It is really the combination of the two business lines we're look at.

Understood. Just one more. On the second part of that slide that talks about the ultimate year 30, 50 basis point impact --I'm trying to understand what that is. This is how I'm understanding it. Are you trying to say that if the ten-year, as proxy for new money yield, stayed at the current level, not for five years but for 30 years, that you're basically your whole J curve would go down 50 basis points?

This is the way to understand it. So what we do physically, is we take a new money rate assumption, which under this stress test is a flat new money rate assumption for five years. No recovery in interest rates and in new money rates, followed by a slow recovery to ultimately a lower rate than we have in our current assumptions. We take that stress test new money rate and we simply install it, if you will, into the models to create a portfolio yield.

When we install that new money rate into the models, it reshapes the portfolio yield. And what this box is telling you, is how is that reshaping take place? And the way to think about it is there is a modest shift down in the early years, related to that assumption, and then it gets gradually more severe in the out years. So the portfolio J curve, so to speak, shifts down by roughly 25 basis points in year ten and 50 basis points in the ultimate year. So the way to think about it is, this was not a full J curve shift in every timeframe. This was a shaping, a reshaping of the J curve, by simply installing this assumption.

So it kind of starts to look more like a hockey stick than a J.

Really, actually, what it really does is it takes the J and basically flattens it out in the future years.

Right, okay.

-- hockey stick.

Sure. Flattens it is a better metaphor. Understood. Thank you for the responses.

Yes, you bet.

Your next question comes from the line of Paul Sarran, with Evercore Partners.

Good morning.

Good morning.

First to start, do you have any update on the Nicholas case?

Paul, we continue to be in a status of negotiation and trying to combine the two lawsuits and because we are in that process, you'll hopefully understand, that that's as much as we can and should comment on right now.

Okay. Got it. Bankers Life, life and annuity margins were described as somewhat favorable. Can you try to help us understand how they compared this quarter versus what you would expect on more of a run rate go forward basis?

On Bankers, from a margin perspective, one of the more principle drivers was really annuity margins year-over-year. And here's the dynamics at play. First, because of the low interest rate, there's good news and bad news about a low interest environment on annuities. The bad news is what Scott was talking through, which is it makes it is a very difficult sales dynamic in the market place. The good news, more particularly good news when you have exclusive distribution like CNO, is that it is often the case that persistency will do better than you expected. Quite frankly, because there's not a heck of a lot of other alternatives to go to with your money. And so as a result, we have seen pretty decent persistency above what we otherwise would plan for.

Meanwhile, we've been able to defend spreads in the business per everything Eric talked about, in terms of our most recent investment strategy and very tight ALM management around those products. So what we've seen year-over-year, is a particularly strong result in our indexed annuity business where we have assets under management in that particular line, are up over $0.5 billion year-over-year. Deferred annuities are down around $200 million. Roughly a net $300 million of increased assets under management on our entire annuity business. Meanwhile, spreads have held up nicely. We have been gradually ticking down crediting rates for all of the reasons you would expect. Expecting the low interest rate environment.

That has accumulated to serve us well, in terms of defending spreads. Meanwhile, we have been achieving pretty decent new money rates, and therefore defending portfolio yields. So as we go forward, the tight ALM management, the slowing down of turnover, being very tactical in managing assets, we all feel good about that. But clearly, the environment is such that spreads are under pressure going forward. The reality is that you do run into some layers of spread compression depending on the products we have on our books, but we're certainly doing everything we can to defend that, and thus far, successfully.

Okay. Great. Wanted to ask a question on slide 31, about the duration matching, which I appreciate the disclosures. I wanted to ask how you think about managing not duration mismatch, but convexity mismatch, with the potential for prepays and calls, and your assets and the potentials for annuities to stay on the books longer in the low interest rate environment?

Yeah, sure, this is Eric Johnson. The durations that you see on the page -- I don't have it in front of me, but I believe they're effective durations. First off, so we're modeling in on the asset side of prepayment assumptions with respect to a whole host of asset classes, could be RMBS, CMBS, ABS, corporate, commercial mortgage, et cetera. We're modeling in prepayment assumptions that we think are market consistent and reasonable. And we threw them up and check them quite frequently, more frequently every quarter. So that we feel we have estimates of future cash flows and durations that are reasonable. And I think historically, we've been pretty much on the -- reasonably on the screws, with respect to real cash generated as it compares to what we thought we generate in the portfolio over periods of time. We do look at it retrospectively to see what were we off and if so, why?

So obviously, we're receiving -- our actuarial is producing quite elaborate estimates on the liability side, on the reserve side, with respect to the complexity of the reserves. We do have policies which you don't see necessarily on this page, but which we manage toward around convexity management basically. So that we understand that in different forward-looking interest rate scenarios, what are the potential effects? Not just on the high level statistics, but kind of looking at actual line of business, the line of business cash flows. So, I think this is an area we're very much on top of and have not, to date, proven to be a source of volatility in earnings or GAAP earnings or in cash activity in the Companies.

Okay. Thanks.

You're welcome.

Your next question comes from the line of Chris Giovanni, with Goldman Sachs.

Thanks so much. Good afternoon. I guess first question just on the operating expenses was in Washington National, they seem to be running maybe $2 million to $3 million low. Sorry, if I missed commentary on the call. What took place there and is this a sustainable level?

Yeah. It is a good question and let me just square it for you. First. When looking sequentially at the expense line, we did have some litigation-related reserve activity that took place in the first quarter that did increase the expenses there. At the end of the day, we didn't call it out because there was a mix of other items taking place, plus it wasn't outside, the overall expenses were not outside the expected range. We were elevated due to that particular item in the first quarter. When looking at last year's same quarter, we had merger-related expenses.

Now the term merger, used to describe having combined certain statutory legal entities for efficiencies and so forth, but in the process of doing that, there are certain one-time costs that you have to undertake to get that done properly. And we took much of that cost through in the second quarter of 2011. So from a comparability standpoint, it looks as if expenses dropped down, but you did have some noise in there. All by way of saying, Chris, is that lost in all of this is the fact that Washington National has been proactively looking to manage expenses down and keep control of it, despite the growth rates that they're experiencing. So I would view their expense level here in this quarter, as not outside our expectations.

Okay. That's helpful and then the $200 million to $275 million that you talked about in terms of dividend capacity to the parent, that's free to use for buyback dividends and debt payments, right? There isn't any interest expense that's tied up within that $200 million to $275 million number.

The way to think about it, is that number -- that is a number that is after all surplus note interest payments made to the holding company and it is after contractual payments made up to the holding company. It is strictly the dividend. What I try to describe, and sort of that three slide build-up, was it happens to be the case as a Company that we really cover our holding company fixed or recurring expenses through those contractual surplus note payments and contractual payments.

So if, for example, in 2011 when we ran $135 million to $140 million up to the holding company, in the way of surplus note interest and contractual payments, that fully covered all of our holding company debt interest expense. Our holding company expenses, and even went towards covering some of our actual debt amortization itself. So as we move through 2012, not only do we have an increasing statutory dividend range of $200 million to $275 million, but we're also seeing things moderate on the uses side. Meaning, we're seeing of course interest expense come down, and you can see that in our numbers as we continue to pay down debt. We have a much different cash flow suite dynamic, where we were living for much of 2011 in a dollar for dollar sweep on repurchase, now it is $0.50 on the dollar. We have a bit less in the way of mandatory amortization in total in 2012. And so all of those dynamics are boding well for free cash flow and hopefully that I helps.

Yes, it does. As you move through into 2013, the $500 million in capital generation, you guys pointed to in 2011 and then again, the [up trimming] of the dividends this year. Is there any reason that those aren't sustainable levels, as we look out over the next couple of years?

Well, I mean clearly, obviously our goal is to create a stable and building capital generation environment. So a lot of different things can go on in terms of capital generation, and honestly, good and bad. The bad is very evident in terms of whether you start running into credit-related risk, as you've seen in our disclosures, while we view interest rates as a headwind, it still is a headwind into both statutory income numbers as well, so we have to watch interest rates.

But overall, when thinking about the threats to that, I don't -- right now, we're certainly trying to manage to reduce those threats and our -- you should think of our guidance on stat dividends as the confidence level we have in being able to execute on that run rate of capital generation. We wouldn't guide on statutory dividend ranges, particularly increased ranges. Guide on increased share repurchase and initiate a common stock dividend, if we didn't have a level of confidence in the range-bound risk profile of our capital generating model.

Okay. That's helpful. Lastly, this really points to -- going to be sniffing 12.5%, which is the next level of, sort of, the interest rates sweeps. Probably early next year. Should we be thinking about another sort of stair step up from a capital management standpoint in 2013? Without putting sort of numbers around it. But theoretically, is that the way we should be looking at it?

Let's step back a bit. My view of this notion of a stair step, or finding, or accelerating the ROE run rate of the Company, has actually less to do with reaching a milestone of 12.5% and being able to have, let's say, freer to have that capital. To me it is a bit more dynamic than that. We're a Company that has really switched gears in terms of cash flow dynamics, financial strength dynamics and capital strength. And as a result, we're seeing positive ratings momentum as a Company, and that offers up the opportunity for us to think about where we can be opportunistic on lowering our cost to capital, looking at our debt structure, which is relatively expensive. Because it is a hangover, if you will, from the financial crisis period of time.

As we start to build that kind of momentum in financial strength and ratings, and pending market conditions, that's more what I view as an opportunity for stair step. That's what I'm trying to say, when I say I believe our plan is transparent in that respect. These are management's goals. It is not so much we're on a quest to drive leverage down to 12.5%, because what you may gain in the way of freedom around free cash flow, you're hurting in the way of cost of capital.

Okay. That's helpful.

Your next question comes from the line of Erik Bass, with JPMorgan.

Hi, thank you. First just a follow-up on Fred, one of your last comments you were making. Maybe if you can talk a little bit about you're thinking about the capital structure longer term?

Sure.

With the improved cash flow that you could support a higher leverage than what you have. And I guess sort of related to that, would you consider refinancing the bank debt to get those prepayment requirements or eliminate them?

Yeah, the way I would answer that, Erik is this. First, management targets on what's the appropriate capital structure. We've talked about wanting to manage the Company at or above 350% risk-based capital. You've seen more recently, we're managing in the 360% this quarter, a bit higher than we otherwise would dial in. The reason we manage it a bit higher iswe try not to run it to the edge. We want to have some level of excess and comfort, because both the numerator and denominator, most particularly the denominator can swing around on you in RBC. Our fundamental view is that a consolidated RBC for our Company for the kind of businesses we're in, the diversity of the business mix and mix of short and long tail business, is something in the 350% RBC range is a quite nice and we're running north of that.

From a holding company leverage perspective, I think if you were to sit down and look at the industry and realize that we don't have anything that is pumping -- pushing down our leverage, for example, hybrid-type securities that get quasi equity treatment. The debt we have is straight debt. What we tend to think about is running in a range of 20% leverage on the high side. High teens, more or less where we're at now, is a very comfortable level as well. But clearly, as our cash flow continues to be solid, our confidence level grows each quarter, and over the last few years in capital generation and cash flow dynamics, that is allowing us to think about leverage levels that are more customary to drive an attractive cost to capital. For me, I think the right blend is something in that 20% range.

And I think historically, we've talked about 15% to 20%, with the high side of that being dependent on what we see in the way of market conditions. The low side of that would be arguably inefficient. But would only be, because we're seeing something in the dynamics of the market place that would suggest us to drive it down that low. Something in the way of a risk profile, which at the moment we don't see those conditions. So that would be my color around leverage. One of the things that we need to be mindful of in our capital structure is one, by virtue of having amortizing debt and cash flow sweeps and posting good quarters, we can't help but continue to delever as a Company. Somewhat formulaic, as opposed to it being a management decision, and so that's a dynamic that's taking place. We also have a convertible structure on our balance sheet.

That certainly has a stock price continues to respond, it is looking a lot less like debt. That dynamic is something that we think about. We've talked to you all as investors about that optionality in our capital structure, as we enter into the future years here. So those are the things that we're thinking about. Your question on would you ever consider -- look, I would expect my team to be watching the market place and working actively with bankers and capital markets professionals, for when there is ever an opportunity for us to advance the ball in the way of cost to capital and shareholder value. So we never stop doing the math. What I would tell you, is that because we're progressing so quickly, so nicely, we have to be that much more vigilant on understanding what market conditions are and whether we have an opportunity.

Great. That's helpful color. And just one other follow-up. You have mentioned on-going expense efficiency and other leverage terms. Is there anything -- any specific opportunities you can point to or provide any quantification of what has the magnitude of benefit out there?

Yeah, Eric. This is Ed. As far as other measures, certainly we've mentioned before the use of space, office space and moved the Chicago location twice in the last four years, and saved in each move roughly $1 million a year each in run rate expenses. So we'll continue to look at things like that. At the same time, the addition of Bruce Baude to combine IT and operations is expected to increase our momentum that we've got there on efficiencies. While still meeting our business needs and serving the customers. We think we can get an acceleration of the efficiencies there. But as far as specific numbers, we're not ready at this time, to provide anything more specific.

Okay. Thank you very much.

Your next question comes from the line of Sean Dargan, with Macquarie.

Thanks. I guess Fred's comment that you're monitoring markets for opportunities to lower the cost of capital, piqued my interest. Are there other opportunities besides swapping out debt for what you can issue in the Capital Markets with the better rating? Are there other avenues you can pursue that you think would lower your cost of capital?

You know, one of the things -- let's just talk at a high level generically, about where we're at and what our dynamics would be. What our goal here is first, let's get to a ratings level that offers us an opportunity to find ways to attractively look at refinancing our capital structure. And that's a very natural thing for us to be doing. Our basic strategy is we think that is a more attractive opportunity at a notch or so higher. As you know, we're on review for positive -- for upgrade with Moody's. We do continue in serious dialogue with Moody's and S&P, it is that time of year. Actually it's the review time of year. We think there's more positive pressure to our ratings, than stable or negative certainly. And you can see that in our results. But the rating agencies are the rating agencies. They've got a lot of things they assess.

They've got a process. We work proactively with them. As they do their work and as we hope we can continue to be on the path of ratings upgrades, there is an opportunity for us to go into lower coupon structures. There is also opportunity for us to look for where we can gain more financial flexibility about those structures. When we talk to the capital markets professionals, they will tell us that that is, somewhat, the sweet spot of the market. Now, market conditions can also dictate issues, right? I think something every company needs to be mindful of right now, and I'm sure is mindful of. There is likely to be more windows of opportunity than there are steady state long duration opportunities. That's because of what we're seeing in Europe. So every week conditions tend to move around a bit. I think most company treasury departments, no matter whether they're below investment grade or investment grade, they're constantly looking for where there may be those windows of opportunity to lower the cost of capital. That's what we're doing.

Sean, I would also add continuing to produce quarters, like we did again here in the second quarter, is a way to reduce our cost to capital by reducing the beta or reducing the volatility associated with CNO.

Thank you.

There are no questions at this time. Would you like to make closing remarks?

Yes, thank you, operator. Want to thank everyone for their continued interest in CNO.

This concludes today's conference call. You may now disconnect.