CNO Financial Group, Inc. (NYSE:CNO)
2012 Investor Day Conference Transcript
December 13, 2012 12:15 PM ET
Erik Helding - Senior Vice President, Investor Relations
Ed Bonach - Chief Executive Officer
Scott Perry - Chief Business Officer and President, Bankers Life
Mike Buckley - Senior Vice President, Sales, Bankers Life
Steve Stecher - President, Washington National
Gerardo Monroy - President, Colonial Penn
Eric Johnson - Chief Investment Officer and President, 40|86
Fred Crawford - Chief Financial Officer
Sam Profitt - Stone Harbor
Chris Giovanni - Goldman Sachs
Erik Bass - Citigroup
Randy Binner - FBR Capital Markets
Paul Sarran - Evercore
Richard Sbaschnig - Hovde Capital
Sean Dargan - Macquarie
Humphrey Lee - UBS
Ryan Krueger - Dowling
Well, good afternoon. And welcome to the CNO Financial Group 2012 Investor Day Conference. I’m Erik Helding, Senior Vice President of Investor Relations. And on behalf of the entire management team, I’d like to thank you for participating in today's event and for your interest in the company.
Today’s presentation will cover several topics that we hope will further enhance your understanding of CNO. First, Ed Bonach, our Chief Executive Officer will talk about CNO’s overall strategy, addressing the needs of our fast growing and underserved target market. How CNO differentiates itself from its competitors, and lastly, some of the strategic initiatives and milestones that the company planned on executing on over the next several years.
Next, Scott Perry, Chief Business Officer and President of Bankers Life will speak about CNO’s overall distribution and go-to-market strategy, and discuss specific areas of growth for each of the business units.
Scott will then ask Mike Buckley, Senior Vice President of Sales at Bankers Life; Steve Stecher, President of Washington National; and Gerardo Monroy, President of Colonial Penn to join him up on the stage to talk about some of the initiative and key value drivers in each of those businesses.
After a short break, Eric Johnson, our Chief Investment Officer and President of 40|86 will discuss CNO's investment portfolio and strategy. Eric will then turn it over to Fred Crawford, our Chief Financial Officer, who will cover some key financial topics. Ed will then make a few closing remarks.
At the end of each section, there will be a question-and-answer period, if any member of the audience would like to ask a question, please raise your hand and we will provide a microphone so those listening to the webcast will be able to hear.
As we have a full agenda and time is limited we will limit questions to two per person. At the conclusion of the conference, Ed, Scott, Eric and Fred will come back up to the front for a final Q&A session.
As the company greatly values the input and feedback of all of its key stakeholders, we will also conduct a brief online survey of today’s event. Additional information will be sent via e-mail in the next couple of days.
This morning the company issued a press release that provided an update on its stock repurchase program and provided 2013 guidance for dividends to the holding company and securities repurchases. Ed and Fred will cover these items in greater detail during the presentation.
You can obtain this release by visiting the Media section of our website at www.cnoinc.com. This afternoon's presentation is also available in Investors section of our website and was filed in our Form 8-K this morning.
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 contains 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.
And now, let me turn it over to Ed Bonach, our Chief Executive Officer. Ed?
Thanks, Erik, and welcome everyone. It looks like I did win the bet with the management team that if we [strong] for sponsoring a concert last night at MSG, we’d get a better turnout today. So thank you for your attendance and coming.
This is CNO's first ever Investor Day. We think it is another important demarcation in our continued growth and development. And with today, we have spoken to many of you prior to this and did obtain input and we are seeking to advance the ball of knowledge on several front and specifically on that is, okay, why is CNO a good value proposition? What about our growth? What about our continued capital deployment even beyond our press release today? How are we going to achieve our ROE goal and learn more about our unique market position and business model?
As part of that, we also think there are some key questions that you’ve got on your mind or most of you have on your mind that will try to also answer in advance the ball there too, low for long interest rates, certainly with the recent Fed comments that continues to be on everyone's mind.
What about long-term care? What about Healthcare Reform and what are we going to do and what are we doing with our OCB run-off segment? And as Erik mentioned, we’ll hopefully continue to listen to you and come back to you after for an online survey in the next few days.
So let’s with CNO, we have been focused on execution and first of all, to really reset our business mix. Get focused on the middle-income market that’s underserved and fast growing.
We also did a lot of work on setting a firm financial foundation. We've got strong capital, strong liquidity, strong earnings, strong cash flow and excess capital generation and we are returning from that or with that moving forward and in the past to invest in growth.
We have been growing faster than the marketplace. You are going to hear about investing even more in that and increasing our sales as we move forward. With that also capital and value to the shareholders and we continue to have that as a priority going forward. So I would like to propose there were no longer CNO the project, for we are now CNO a compelling value proposition.
So what does differentiate us? We think it starts with the fact that we’re defined by the market that we serve. We have a market focus very different than a lot of companies in the industry that are product focus. We’re focused on that middle-income market and largely with exclusive and direct distribution.
With that, we think that, it brings a lot of ability to do things that other companies using independent distribution, broker cannot do and you'll hear hopefully more about that too. Alignment is the key, alignment first with having distribution to go and reach that underserved target market.
Secondly, having a breath of products to go and serve the needs of that middle-income market. Having then on top of that a home office, back office that supports the distribution and our customers and wrapped all in a culture that is dedicated to serving the underserved middle-market and advancing the ball for shareholders and all of our other stakeholders.
Heard a lot about the aging the baby boomer. Heard a lot about demographics, while the markets growing. This is a way of looking at it and it is underserved. Over half the people that we end up having as customers through agents, through direct have not been called on by any type of agent or financial advisor in the last year. If you look even past that the number is not much different if you said two years or three years.
Also most people are unprepared for retirement. We know in America, we are a nation of spenders not so much savers. So the advised the product, the service we bring is pretty important to them. So, and we do have, again, through largely exclusive distribution and direct a way to reach that market.
But let me level that a little bit on what that mean, especially I’m going to focus on Bankers Career Agents. It’s very different. The agents how they work, is quite different than insurance agents and brokers that you might be familiar with.
Firs of all, these agents do mirror and they are from a social economic status the market they serve. They are middle-income largely. The also live near the customers they serve. They set up an offices that are largely leased Class B office space. They have rows of small cubicles with the telephone and a file drawer, where they are using that to make appointment, follow up on different requirements if necessary for completing an application and then going out, and they actually do meet face-to-face in the people home, across the kitchen table, you listen to their needs and try to propose solutions to meet those needs.
The other thing you won't see in these offices, you’re not going to see mahogany and marvel. Again, Class B lease office space more of factory to be able to serve the customer than get out there and serve them.
With that, let me turn here to our three core businesses. We are and have been growing in all three segments. We have been investing in those segments. But we’re stepping up that investment. We expect to invest in organic growth initiatives in these three segments over the next three years between $80 million and $85 million.
We've also invested in people and Fred Crawford obviously joined us less than a year ago, middle of the year added Bruce Baude to head IT and Operations. Why, because that helps to move the lever and continue to move us along the track to meet our objectives of growth, earnings and ROE.
So with operational efficiency, cost efficiency, that is one of the four levers that we’ve been speaking about to move us to our ultimate ROE goal. There are various things that are guiding our principal here and Bruce and his team, and working with the businesses, how are we going to approach and serve the market, that’s on the left-hand side here, that -- these are what were being guided by and how we define success in providing good service.
Along the right hand side are the areas of opportunity and we do see a distinct correlation with improve customer service, driving higher sales, higher persistency, more business growth and earnings. It also helps with the agents. We serve the customer for helping to serve the agent at the same time.
So this is a way to think of and look at our value proposition. We have this unique business model. It provides us with steady earnings, excess capital to invest and deploy, and we do have opportunities, like I said even beyond what we announced today on capital deployment and capital management.
Unlocking value in OCB is the part of our opportunity landscape here and that will also be a potential to stairstep our returns even more and more, again Fred will touch on that later. And but make no mistake about it, investing in organic growth is a priority, but at the same time, returning value to the shareholders is also a top priority.
So let me be a little more specific about what are these milestones or what does that mean. I mentioned, investing $80 million to $85 million in strategic business initiatives over the next three years. These investments we think will expand our reach, increase agent counts, increase locations, help with productivity as well as product offerings to our target market.
We expect that these will drive our sales growth from the current 6% to 8% annual sales growth to 8% to 10% and then ultimately 10% to 12%. Capital deployment is certainly a part of this in helping the shareholders, and we expect to do more in the way of returning capital to shareholder. I’ll touch on that in a little more detail here in a minute.
With -- what do we mean by accelerating the run-on and the run-off, talked already about investing and growth, that's part of the run-on and the run-off that’s OCB engineering. And we do see that as being a key part of continuing to deliver shareholder value. One might ask what about M&A. Is that in your landscape and scope, it could be but let me set expectations on that.
First of all, it’s going to be a strategic fit if we do anything, and as certainly the management team has heard, many of you have heard, even I can go out and buy hot dog stand. We don’t know anything about running hot dog stand. We know about life and health insurance and annuity serving the middle market. It’s going to be a strategic fit.
At the same time, it’s going to be of a size that make sense meaning self-financed with our stock trading below intrinsic value. We don't think it's a smart idea to go on issue stock to make an acquisition. We think our recapitalization puts a great debt structure in place for us, don't see going and levering up to go and do an acquisition. And in many ways, we don't have to.
You know about the cash generation story. Again Fred will give you more details on that. We generate a considerable amount of excess cash in capital every year that way. Talked about the customer experience and how that is going to help us in that direct correlation between customer satisfaction, sales growth, persistency and earning.
We do have as our objective by 2015 to have at least 9% ROE. Again, we’ll give you a little more color on how we get there. And we do believe that by 2015 will be investment grade.
Now the beauty is for us, we don’t need that to conduct our business. As you know, we are not in a rating sensitive part of the market and that is not why we need it. We wanted for capital markets purposes, give us additional flexibility, and we think that improves the shareholder base to for those who question why would I want to own a below-investment grade financial company.
We’re looking to increase our dividend and target at 20% payout ratio by 2015. When we initiated our dividend earlier this year that was around 1% return, very modest payout ratio but very much in line with where our companies initiate dividends. We continue to pay close attention to what the peer group does with dividends, what levels they are and we realized this 20% is at least currently, someone at the low-end of the medium range but we think that's important again going back to my earlier comments with the stock trading below intrinsic value, we would expect that we’ll continue to deploy most of our excess capital with securities buyback.
So again you’ll be hearing a lot more about these in the coming couple of hours. So with that I will open it up for a few questions here if any one has them. We’ve got again mikes. So raise your hand if you do have a question.
Say your name and company before your question. Thanks.
[Joe Dona], ING. Maybe you can or if you’re going to do this later on that’s fine. But if you can outline the past IG for us, what measures you’re targeting and how are you thinking about that?
Yeah. I do believe we will be covering that and I know asking for questions right upfront here. One, we’ve got a couple hours. My colleague is coming up is potentially going to give the answer to a lot of questions. But it hopefully is telling you that we are thinking what's on your mind and trying to address them.
Hi. [Saifudin from Guardian]. Looking at slide eight, you get sort of your opportunities. How do you guys view the various boards there in terms of -- order them in terms of priorities?
With them, we first view them as opportunistic and that we can’t necessarily predict. Slide eight, isn’t it? Okay.
The one with the circle.
So on one hand, it’s opportunistic. Capital management, we believe we've been focused on that for some time and continue to be focused on that and now how much goes into securities, buyback et cetera in part is dependent on where is our share price and where is that relative to what we believe intrinsic value as obviously at today's level, then historic levels over the last couple of years. It’s in our opinion below intrinsic value.
So we’re putting a lot of our capital management towards that. Fred will touch on this later but prior to this year, we spend a lot of time building up capital levels in the insurance companies, building up liquidity at the holding company. Good news is we got levels there that we feel are appropriate to run the business to support higher ratings and to move forward so that we actually have more capital to deploy.
Yeah. The run-off engineering that’s really something more to touch on but it's -- we needed to do something that we have been doing in OCB to stabilize that business, maximize cash flows and reduce volatility in order to have that now in mind.
And I like to say on operational efficiencies, we've been working on various aspects of that all among but we’re stepping it up, investing in Bruce coming on, looking at having more money invested in organic growth, which also helps to drive certain efficiencies. They’re all may be a long way to get to -- they are all equally important but they are going to be in different degrees of timing and dollars just because of either where we’re at, where our stocks at or where the markets at. One more over here.
Sam Profitt - Stone Harbor
Sam Profitt, Stone Harbor. Ed, I don’t want to cease upon the distinction without a difference but I do not that you’re careful to say intrinsic value. You are not saying book value. Is there a difference between the two or are you making a knot in the direction of the difficulty that spread businesses will have in a compressed yield environment. Is there more meaning there?
To me it’s almost a rhetorical question of what's intrinsic value or book value. The best representation, I would say one of the main reasons we use intrinsic value is the DAC accounting change that we had, not too long ago but that changed book values. Did intrinsic value change? No. So we’re using a term that will hopefully transcend whatever accounting regime scheme we’re under there and that's why we choose that to be economic value.
Chris Giovanni - Goldman Sachs
Thanks. Chris Giovanni, Goldman Sachs. When you -- the dividend payout ratio target of 20%, is that 20% of the capital that you generate or is that going to be based off of operating earnings?
Chris Giovanni - Goldman Sachs
Okay. And then if we go back in June, you were in event, stock was at $6, $7 and you said it screaming by. We’re sitting here today, the stock is up. How would you categorize the value proposition?
I won’t scream but I’ll talk real loudly. We think it’s a compelling value proposition. So we really do with the market position we have, the ability to grow and I go way back into my college business days. We have a business that first of all has strong cash flow generation. It is in a market where there's not a lot of competition and you’ve got the sustainable competitive advantage and you’re earning reasonable return, that is a value proposition.
And we think again going back to intrinsic value, it’s not yet reflected in our stock. So we think we have a long way to go, yet to have that, the two pads to me dedicated to continuing to unlock that and have the markets recognized.
We’ll move on here now but again as Erik said, we’ll have more time for Q&A after every session and then at the end. Thank you.
Great. Thanks Ed. We’re back to -- next up, Scott Perry, Chief Business Officer and President, Bankers Life, will talk about the segment growth strategy and then lead a pseudo panel discussion with his direct reports to talk about their market and distribution.
Thanks Erik. Good afternoon everybody. It’s truly a pleasure to be here to talk to you about the CNO businesses. For a long time, we spend a lot more time talking about our balance sheets and the business. It’s nice to see the interest shifting in the marketplace.
As Ed mentioned, at CNO our strategy is not about products. It’s about the market that we serve and that market is growing middle market. We have three businesses that are focused on serving this underserved market and each is uniquely positioned, focusing on different sub-segments of that market, whether that’s working Americans, people in their pre-retirement years or people already into retirement. Each is uniquely positioned as well to distribute and reach that market through control distribution, that targets a sub-segment of that demographic, with straight forward, simple, protection based, life and health products, and the right go-to-market approach.
What I mean by go-to-market approach whether that is a face-to-face visit at somebody’s home or face-to-face interaction at the worksite or direct to the consumer at the workplace, the combination of those three elements, focus, right products, the right approach, positions our business as well to profitably grow and serve their market.
Now, over the next 30 years, this market is going to see tremendous growth especially the 50 plus demographic of the market, that’s going to be fueled by the aging of the baby boomers. Each one of our businesses has strategies in place to capitalize on this tremendous market opportunity and grow sales at two to three times the traditional rate that we’ve seen the industry grow.
What I’d like to do now is just walk through each one of our business segments, talk at a high level, about some of the strategies and growth levers that are in place in the areas that we are focusing on. Let’s begin by talking about Bankers Life. Bankers is our career segment that focuses on the pre-and post-retiree segment of middle America.
At Bankers, we focus on and have three -- I’ve identified three primary growth levers, the first is expanding our agent reach. That’s essentially another way of saying growing our agency force. The second is improving our product offerings, making sure that we have the right products to meet the needs of the marketplace and that we provide those products to our agents so they can serve those needs of the customers and build their practice successfully.
And finally, we focus on building our customer relationships, essentially deepening those relationships, giving the company an opportunity to cross sell multiple products into a household, increases our customer loyalty, and results in improved product persistency down the road as well.
Now, as you can see on the slide, we have a number of initiatives that are in flight to support these growth levers. And as we think about incremental investments into the business, we tend to think more around those things that are at the core of our competencies, those things where we had experience or we’ve demonstrated -- we've been able to successfully demonstrate competency in execution, which raises the likelihood of success as we implement those initiatives.
For instance, as we think about growing our agents force or expanding our agency force, we know that there are two key elements. The first is more locations. More locations give us an opportunity to establish a foothold in a local market, that gives us that base to recruit, train and develop agents.
Another key to growing and expanding our agency force is improved productivity of our agents. We know that improved productivity leads to improved agent retention. Improved retention along with consistent recruiting leads to agency force growth.
Now, to support these key elements, we’ve recently invested in two major initiatives. The first is the management trainee program or MTP. The management trainee program is all about identifying high-caliber candidates from the outside that enter and join the company as management trainees. They come in and learn the business from the ground floor.
They enter as agents and they rapidly move through the process of being an agent into managerial ranks. And they rapidly move through the managerial ranks. And we provide them with the support and training and guidance to make that happen in about two and half to three and half years. That’s about half the time but it takes us organically to produce a management candidate within our system.
So what this is going to result in, as its going to result in a pool of management candidates that are going to emerge beginning in 2015 that will be able to staff kind of an accelerated location expansion.
We will continue to develop management candidates organically but we’re going to add to it with this accelerated addition of management training candidates through the management training program.
One of the other initiatives that we’re investing in is Top Gun. Top Gun is all about improving agent productivity, especially agent productivity of our second year agents. One of things that we experienced much like the rest of the industry is that agents enter their second year we tend to see a high attrition rate, a lot of agents discover that the business is a lot tougher and they have trouble of being productive and therefore they drop out.
So the Top Gun program targets agents that have demonstrated high propensity to be successful in this business. We provide them with additional tools, support and training to improve their productivity. So we can pull them through that second year into their third year. We know if we get them into the third and fourth year, we are going to see retention rates go up.
Over the next three years we’re going to be running about 700 to 900 agents through the Top Gun program, improving their productivity, which will also lead to improve retention and again, that combined with consistent recruiting will allow us to grow our agency force. So those are just a couple of our initiatives that I wanted to highlight within the Bankers segment.
Now let’s move to Washington National. Washington National is our agent-driven business that sells supplemental benefit plans to working families. They do that both face-to-face at -- and at in people home, as well as face-to-face at the worksite.
The key growth levers at Washington National are similar in some ways to Bankers. One, is to expand our distribution, quietly different at Washington National and at Bankers, and at Washington National this is all about expanding PMA, PMA is a wholly-owned rear agent subsidiary.
The opportunity at PMA is to expand geographically like at Bankers but it’s different in many ways. At Bankers, we’re already nationwide. At PMA we’re only effectively in about 15 or 20 markets, 15 or 20 states.
The opportunity there is to redeploy existing talent to open up new geographies and new states, and that will give us a chance and opportunity to replicate that model in multiple markets.
We need to be able to support that redeployment and expansion is making sure they have the right product and that leads us to our second key growth lever.
We are introducing a new unique and innovative product. We are going to be introducing this is in January, just around the corner. It’s called Active Care and this unique product combines the benefits of a critical illness product with hospital product and even offers the opportunity to purchase accidental coverage.
It’s unique, innovative, it fills a significant gap and early indications as we review this with our agency force has given extremely high marks, we’ve done some consumer focus groups as well. We think this product will stand the significantly benefit from some of the changes that we’re going to see in Healthcare Reform as truly as a supplemental gap filler.
One of the other levers that we are going to, that we believe will benefit our growth plans at Washington National is and improve our customer satisfaction, and our customer experience is the expansion of electronic application.
Electronic application allows our worksite customers, employers and our agents to submit business seamlessly, electronically and has that -- and that business get straight through process, that obviously improves the satisfaction level of our customers, allows our agent to get their business issued and allows them to get paid faster, that leads to higher agent satisfaction.
But more importantly, it improve its -- improves our back office efficiency, which leads to lower costs on the acquisition side and allows us to be more competitive in the marketplace.
I'd like to touch on Colonial Penn. Colonial Penn is our highly predictable direct-to-consumer marketing engine. At Colonial Penn, first and foremost, it's critical that we tightly manage our base business model.
Our base business model is what's been driving most of our double-digit growth over the last three years and that base model is our guarantee acceptance, final expense policy that sold, and it is the key to managing that model is ensuring that we’re driving strong marketing yields from the marketing spend. That’s all about managing our lead cost, making sure we are getting optimal lead generation for the programs that we’re implementing and ensuring that our inside sales force is successfully converting those leads to sale at high rate.
We’ll continue to tightly manage that base model. We will continue to offer our guarantee acceptance product and we think it’s going to help contribute to our growth. But to sustain double-digit growth, which is what our expectations are at Colonial Penn we are going to have do more. We are going to have to expand into new markets and we are going to have to expand our product offerings.
One other things that we’ll be launching in 2013 and ‘14 is to expand into the Hispanic market, obviously a significant fast growing subsegment of the middle market. We think this market is ideal for the Colonial Penn offerings.
So we will be taking our base model, the guarantee acceptance model, we will be making modifications to our marketing messaging, our collateral, some of that target, targeting that we do, the direct-mail targeting that we do and we believe we will be able to cease a larger share of the Hispanic market.
The other opportunity is to expand to slightly younger agents. Today, our guarantee acceptance product offers the maximum benefit of $25,000. The two new products that we’ll be launching this year and into next, one is a term life product, the other is a whole life product, both offer benefits up to $50,000, so two times our current benefit offering.
We believe these products which combined to make up our patriot program, we’ll appeal to a slightly younger age than our current market is, than our current product and our current strategy is appealing too.
So these two things combined. The entrance and focus on the Hispanic market. The addition of two new products that will bring us down in age slightly and in addition to continuing to tightly manage our base model will allow us to continue to deliver high double-digit growth at Colonial Penn.
Now before we go into our panel portion of our discussion. There is just a couple of topics I'd like to pause and address for you. I'm sure, if, they're probably on your list of questions or things that you’d like us to discuss. The first is our long-term care strategy.
Now, I'm not go into the financial dynamics of long-term care, Fred will cover that later in his remarks. But I did want to discuss kind of the strategic positioning and the strategic feeling that we have about this product within our market.
First and foremost, long-term care is important to our business segment at Bankers Life obviously. It's important to our segment because it’s important to our market. We believe that we are comfortable with being able to manage some of the complexities and the changing aspects of this line, largely because we see our business -- our long-term care business considerably unique and different than the rest of the industry.
So how is it different? How is it unique? Well, first of all it’s unique, because of the market that we serve. Because we serve the middle market, we tend to sell to a lower price point that means we are selling a lower risk profile product.
We tend to sell two to three year benefit periods and the rest of the industry is selling four, five, eight, 10 or lifetime benefit options. Because we tend to sell to a slightly older market, we also see an older average issue age. Our average issue age is approximately 67 years old versus an industry rate in somewhere between 58 and 59.
So what does that mean? Well, that means, the average duration of our business is in the 12 to 14 range versus an industry average that’s closer to 18 to 20. This gives us better ability to match our assets and liability.
I’ll also read different, well, 100% of our business has been and is being sold through controlled distribution. This means that we don't get selected against either at the point of sale or at the time of re-rates.
Another way we are different is, we are not in the group business at all. 100% of our business is individually underwritten. Also since 2009 over 50% of our sales have actually been short-term care. We lump it into one category called it long-term care.
But short-term care actually makes up over 50% of our business and that policy has a maximum benefit period of one year, again, significantly lowering our product risk profile. We’ve also been aggressively managing our business over the years, both our re-rate, in-force business, as well as our new business.
We began re-rating in-force business in 2006 as it was necessary. We’ve been able to implement multiple rounds of re-rates as appropriate in our -- in some blocks of business are at our third round of rate increases.
One of the reasons we’ve been able to do that is back to our controlled distribution. We weren’t held hostage by our distribution and we were competing for distribution. We were able to go to our distribution and work together to understand the importance of the long-term value of putting in these re-rates.
We've also actively been managing our new business, a product for new sales. Matter of fact beginning in the middle of 2013 we will be introducing a new product with new pricing to affect -- to reflect kind of low for long view that we have on the interest rate and our ability to generate yields.
So we’ve actively managed in-force and new business pricing, as well as making product -- underwriting modifications when necessary. We are also be introducing some underwriting modifications at the beginning of the year that will affect our new in -- exact -- our existing product, as well as our new product, that will essentially lower some of the benefit offerings and lower the maximum issue age.
So what of all these things mean? These are the things that make us different. These are the reason why we think our business will perform differently and outperform the rest of the marketplace.
Moving on to the next topic that maybe on your list and that’s Healthcare Reform, no, I’m not going to provide a tutorial and exhaust of explanation of our Healthcare Reform or the Affordable Care Act. But I did want to discuss, how Healthcare Reform affects or in fact doesn't affect the CNO company.
First of all, because the majority of our products or all of our products fall under the accepted benefit definition of the Affordable Care Act, we are not directly affected. However, because we do travel around the peripheral of healthcare and Healthcare Reform we may see side effects, indirect effects.
For instance, Medicare Advantage will see changes. We expect Medicare Advantage to be in and out of favor over the years. Well, that’s why we participate in both markets. We are a distributor of Medicare Advantage for some of the leading providers and have been for over four years.
We are Humana, one of Humana’s top distributors. We also have relationships with United and Aetna. We are also, obviously, a manufacture Medicare supplements. So if that business goes in and out of favor, we think we stand to take advantage.
Another change that we think will occur as a result of Healthcare Reform is gaps will be highlighted and expose in coverage. Our policies are well-positioned to fill those gaps. We think supplemental benefits absolutely will stand to benefit from Healthcare Reform.
And lastly, as we've seen in the past, reform creates confusion, confusion in the marketplace is an opportunity for our rear agents to go out, meet with people face-to-face, whether that’s the PMA folks or our agents at Bankers.
To meet with our customers to help them navigate through the decisions they have to make, to answer their questions, that activity leads to sales activity and sales activity usually leads to sales.
We think, overall, we’re well-positioned to stand the benefit. We will obviously monitor Healthcare Reform as it unfold but think -- we think at this point, we’re well-positioned and see it as an opportunity.
Okay. Now let’s move to the panel portion of our discussion. Before I bring our panelist up I'd like to just make a few remarks again about our franchises overall. Each one of our franchises has unique value proposition and unique distribution model. But they do share the attributes I mentioned, we focus on the middle market. We offer straightforward, simple protection products through controlled distribution methodologies.
The goal of today's panel is to give you a little deeper understanding of the approach that each businesses takes to their market and some of their differentiators in the marketplace, as well as what are the key elements or key value drivers that they look at in managing their business and ultimately to grow their business.
So why don’t we get started. Let me first, bring our first panelist up, and that’s Mike Buckley. Mike is Senior Vice President of Sale at Bankers. Mike has been in the industry for over 35 years. He served in senior sales roles with leading organizations including Prudential and American General. Mike joined Bankers in 2004 as a Territory Vice President, moved into his current role in 2009.
Next on our panel is Steve Stecher. Steve is President of Washington National. Steve has over 25 years in the business in both marketing and operational role. He joined CNO in 2004 and moved into his current position in 2008.
And finally, Gerardo Monroy, Gerardo has been in the industry since 2001. He held various positions, including Head of Marketing at Bankers and most recently he led the Bankers long-term care operations team. Gerardo moved into his current position as President of Colonial Penn in August of this year.
To get started Mike, why don’t you tell us about the Bankers value proposition, little bit about our market and about our model?
I’ll be happy too. Good afternoon all. I’m going to talk a little bit about as Scott mentioned the target market, our distribution model and the metrics that we managed to. First of all our customer base, pre and post-retirees, middle-income folks, folks that are close to retirement, getting close to Medicare decisions and folks that are in retirement. They have a modest amount of assets.
These are folks that really aren’t looking for wealth management services or to pay a fee for doing that, their assets aren’t strong enough, but they do require professional advice. They enjoy having trust in a representative that they can talk to face-to-face.
And the issues that are important to them are retirement planning, certainly Medicare planning and understanding their choices, final expenses, even a modest amount of legacy giving. And again, they prefer this kind of counsel on their own terms in their own homes, and we are willing to do that.
The products we offer are very, very straightforward. The traditional life insurance, fixed annuities, as Scott mentioned, long-term care moving even more to short-term care, Medicare supplement and Medicare Advantage plans.
I want to talk just a minute or two about our distribution model that Ed reference as really a differentiator and I believe so to. Having been in the career agent industry for over 35 years, been a part of [GAMA] organizations and committees, and LIMRA organizations, you really don’t have an appreciation for how different and how personalized Bankers, distribution model really is unless you totally visit and understand.
And some of the unique qualities, number one we have management employees. Now that’s not entirely different but it gives us control over processes, it gives us standardized procedures. It allows us to share best practices and to really execute to those practices.
From the agent’s perspective, we have independent contractors but they're captive. They are exclusive to Bankers. They use the right Bankers products or partnerships that we’ve engaged with. We’re not competing with non-proprietary product that we have control there. They offer a face-to-face counsel and with strong management oversight and we are especially gifted and trained to establish strong service relationships with our customer base and to develop new relationships. They are very, very good at that.
We have various customer access points. We use direct mail. We certainly train to referrals. We have agent participation in understanding and executing to different prospecting techniques that come up. We are especially focused on engaging our 1.4 million customers in cross-selling and showing those customers the opportunities they have to solve other needs.
And especially unique, and coming from a different perspective, is the understanding of the culture in our organization. It is very, very special and I really think you need to be involved to have an appreciation for how different it is. The culture is one of complete sharing. Our management team, the fabric of loyalty that exists between them and each other in the organization is exceptionally strong.
They participate in all committees and give all kinds of feedback on any process initiatives we have, any best practice sharing. We have a Bankers university that’s run by our management team, where 250 or so management folks gather on an annual basis in Chicago to share their ideas.
We’re competitive like all sales people are and they want to be at the top of the ranking in Bankers. But they also understand that giving back to Bankers is extremely important. And that’s a culture that I think we all in the organization, CNO, appreciate.
Just to profile a branch to build on what Ed had mentioned. Our typical branch is about 2500 to 3500 square feet. It’s in Class B space. If we have a satellite to offer that branch, that satellite typically is a 1500 foot satellite to begin with. We have a lease of as early as a year and as late as three years. So we limit our potential cost liability, if it doesn't work the way we think it should work.
We have our branch sales manager in charge of the branch. We have 143 of those. We have 275 locations, meaning the balance are smaller satellite locations and they are run by second line management that report to the branch.
Where we target those locations is important. We do a market analysis on senior population and Medicare opportunities as well as recruiting opportunities. We know that our agency force wherever they live, they write within 30 some miles of where they live. So to reach out and cover territory where we don't have facilities requires a facility.
We are strong on focusing on management development and even stronger now with the management trainee program that Scott mentioned that we’re developing to continue to fuel our satellite locations.
Talking about the key value drivers, first it was mentioned we’re laser-like focused on agency growth. And if you look at the top two graphs, you can say that there is some correlation, a strong correlation between the selling locations, we've been able to establish along with the agent count. So we’re continuing to focus on expanding locations where we have market and recruiting opportunity.
We also are focused on retention and that’s agent productivity. You can see that our recruits through the years have been pretty flat, yet our agent growth has continued. That in large part is due to our focus on new agents in terms of training them to attain certain standards early on. We have 16 centralized schools nationally where we can standardize our processes for execution and prospecting and we now have the top-gun program to help us continue to improve retention for our second year agents.
So we feel with all of that and a keen focus on prospecting and you can see the cross-selling efforts that that one graph shows very clearly and utilizing our customer base to familiarize them with new products that could meet their needs and we feel that combination of value drivers, if we stay focused on will continue our growth.
One thought I had as you were talking that I thought might be worth mentioning is the connection between the management trainee program and locations. So we’ve been able to increase our location count back to what I was talking about through the organic method. We hope to maintain that those organic -- the ability to develop organic managers but also accelerate that over the next three to five years, which will accelerate our growth rate because it will accelerate our ability and our agency force.
One other point that I think is worth noting that neither Mike nor I mentioned but control distribution also tends to provide pricing power. So all of these growth that we've experienced over than we’ve been drawing at about a CAGR of about 6% to 7% if we go back to 2007 has been with growing profitably. Through correct pricing, we make pricing changes when we need to, we can put that pricing in place without worrying about disrupting our distribution channel.
Now, I’ll turn it over to Steve to provide us an overview of the Washington National models.
Thanks Scott and good afternoon everybody. Washington National focuses on providing supplemental health and life products to middle-income working Americans. We distribute our products face-to-face in farming and rural communities, a market that’s estimated to have annual sales to be approximately $500 million.
We also target the voluntary worksite market which is where most middle-income Americans purchase their supplemental health coverage. According to Eastbridge Consulting, the market generated approximately 5.4 billion new business premium in 2011.
Washington National has a strong presence in school districts, government entities and small businesses with employees of 250 or less. Our key advantages are first, our long-term experience in the worksite market servicing over 25,000 groups with some of them being billed for over 35 years.
Second, we primarily offer individually underwritten products, which have a higher profit margin than carriers that focus on group products. Individual products also offer the consumer better portability.
And third unlike many other carriers, we offer our products with the return of premium and cash value option writers. And then finally, we offer high-quality, high touch service for our agents and our employers.
Our product line includes critical illness, cancer, heart and stroke, accident, short-term disability and life insurance company. Our products fill the gap that individuals have in their employment coverage. And we cover non-medical-related expenses such as lost wages and trips to treatment facilities.
We market our products to our wholly-owned distribution company, Performance Matters Associates, which is mentioned several times today. They sell exclusively for Washington National. We also market through long-term partners, independent partners and worksite agency that use us as our primary carrier.
Before I move on to the value drivers, I wanted to share a bit of data on the results, Washington National has been able to achieve. Washington National has averaged double-digit growth over the past five quarters, averaging 15% growth per quarter over the prior year.
That performance has been driven by additional product availability by the growth on our worksite business, the development of additional sales talent and leadership at PMA, and finally an increase in recruiting capacity. Our two key measures that we monitor to ensure that Washington National continues to grow profitably are our distribution growth and back-office efficiency.
As has been mentioned several times today, growing our producing agent count is a key driver to our success. And our new business producing independent partners grew by 29% over the past 12 months and the PMA producing agent count has grown by 6%.
The other essential element to our organization is back-office efficiency. It’s obviously a key component of being a low-cost provider. And what we've done is we've made investments in technology such as electronic app, straight-through processing, automated group billing and an award-winning website.
Wit that, our worksite applications, electronic application submission has increased from 61% in the third quarter of 2011 to 88% in the third quarter of 2012. We intend to roll this technology out to PMA's individual business in over the course of 2013 and we’re targeting an overall utilization rate of over 75%.
Our high utilization rate is key to enabling Washington National to continue the strong sales growth while minimizing any additional back-office expense. We believe that we have the product portfolio, quality back office services and the strong sales leadership talent that will enable Washington National continue its double-digit growth.
Thanks Steve. Similar to how Bankers will benefit from the boomers, I think it's pretty clear that Washington National stands to benefit in the supplemental business from healthcare reform and just the increase in the propensity and the interest in GAAP coverage, so extremely well positioned both direct to the consumer at home as well as at the worksite. I think also just the growth in small business.
The focus that Washington National on our worksite has really targeted small employers for dealing with mostly groups under 250 with volunteer -- offering voluntary benefits and obviously that's a growing segment within as well and those employers are going to look for continue ways to offer additional benefits to their employees.
Why don’t we move now to Colonial Penn. Gerardo, can you tell us a little bit about the Colonial Penn model.
Thank you, Scott. It is my pleasure to share today Colonial Penn’s target market and the uniqueness over distribution model. The Colonial Penn target market are mid-to-low mid income seniors with an average issue age of 65 years. Our customers mostly live in urban areas, close to 50% live in top 25 MSA. Two thirds of the customers are female, one third of the customers are diverse customers.
Colonial Penn customers’ needs are to receive personalized advice over the phone. Our customers need help with final expense and funeral planning. They have one simple and easy to understand products which make them ideal for over direct response model.
Our customers need basic money management support and for some bringing collections need to be tied to the time for social securities deposits are made. Due to very tight money constraints, their beneficiaries require quick claims processing at time of debt. Colonial Penn’s products are Final Expense, Term Life and Whole Life Insurance.
We have headquartered in Downtown Philadelphia. We represent the market that we serve. And as you can see from these pictures which actually are Colonial Penn Associates. When to use an integrated sales and marketing approach that relies heavily on direct response TV that are complemented by direct mail which will help offset some of the challenges of the direct response seasonality.
We’re very good at market segmentation and very efficient at reaching our target market. Through these campaigns, we generate leads that become prospects that our telesales represent these core loan to explain our product features to define coverage amount and corresponded premium that fit our customer budgets and meet.
All Colonial Penn Associates fully understand can relate to our customer needs. These provides us a competitive advantage in effectively reaching them and in engaging in phone conversations like we were at the kitchen table to our sales process and service process.
We generate approximately 60%, sorry, 60% of our new sales group, new prospect identification and the other 40% to prospect and customer reactivation to data service and lastly through our combination of test markets and to our hybrid program for our TV lead non-buyers are made available to Bankers agent.
Our Colonial Penn have several key metrics that we’d carefully use to monitor performance and they are lead generation. Colonial Penn continues to invest in lead generation with the heavy emphasis on TV or direct response TV.
Self conversion rates are substantially higher with direct sales representative involvement. Thus or heavy emphasis on phone contact rates, despite the very large increase that we have achieve in lead generation, we have been able to maintain this close to 80% contact rates throughout this year.
We connect with almost 60% of prospects within three days of the initial contact and with 80% within seven days. And after those, is actually after those seven days of 15 phone attempt, we send them premium package via mail.
The acquisition NAP ratio tends to increase when we are investing in growth, when we are investing in new products, or a new market. As you can see in 2012, we are achieving improvements in sales growth and improve direct marketing efficiency. These are mainly driven by higher response rate and higher sales conversion.
In summary, Colonial Penn has achieved double-digit growth in the last few years and we are well-positioned to continue this trend in the coming years.
Now, I’ll turn it back to you.
Thank you, Gerardo. I think it's worth pointing out and we’ve talked to some of you about this in the past that the current accounting treatment tends to blur some of the value that’s created by the investment that we’re making at Colonial Penn. But, no, the certain that the products are priced for a 12% after-tax unlevered return. We know if we are adding that business to the in-force that we’re adding long-term value and it’s going to ultimately result in increased earnings.
Just a couple of comments, before we go to question-and-answer to summarize the group, I think what we attempted to convey to you is that we think, progress the slide, that we have three well-positioned franchises that are poised to take advantage of growing market, the middle market.
All three of them have very strong execution capabilities. We are also making investments in the businesses and these investments will lead to growth and in the range of 8% to 10% as we've mentioned. That level of growth we think is sustainable and we think it will allow us to establish ourselves as a true market leader in serving the underserved middle market.
With that, I’ll open it up for questions.
Erik Bass - Citigroup
Hi. Erik Bass with Citigroup. I guess, first, Scott or Mike, if -- you have any productivity metrics you could chair for Bankers agents and how those evolve over the past few years? And maybe how much is improving productivity are you looking for that to drive and help you get to the double-digit?
Thanks, Eric. Good question. I’ll let Mike comments too, but we have a number of productivity measures at various stages of an agents development, as early as 90 days after they contract. We have a measurement called SNA and that stands for Successful New Agent with measure based upon their productivity.
And as matter of fact to your point, have we seen improvements? Absolutely, Mike and his team have done a great job in driving our SNA conversion rate up, 6 or 8 percentage points over the last couple of years.
We know that if an agent makes it to SNA, they have a might -- much more likely chance of making it to another metric that we have, our performance metric called SNA 2, which as taken after the 90, I’m sorry, after the nine month in the business.
We then measure retention after the end of their first year and we have a productive agent metric that we monitor. We are seeing improvements across all of those productivity measures. And I think the ultimate measure is we’re seeing improved retention of our agents.
Agents leave this business because they are not productive. They are not making money. That's why we loose agents. So if we are improving our retention. We know that their productivity is getting better and I think as Mike pointed out, even though our recruiting has been relatively flat. We’ve managed to grow our agency force and we feel that that’s a direct result of improve in productivity.
Yeah. I would just add that the training focus is that we have actually complement the metrics for the periods of time that Scott mentioned. The Successful New Agent metric is how many hit a certain threshold of productivity at the end of nine months and are we have at the end of three months. And we have our centralized schools targeted to not only provide product knowledge, compliance understanding, but also training skills, for sale skills and relationship building.
Moving from there, the Top Gun program, that Scott referenced, is now targeted to make sure that second year agent becomes a productive agent, a productive agent is one who actually not submits, but pays for four policies per month and we measure that very, very closely.
Our productive agent percentage has continued to increase over the last four years, which has again fueled retention. We could try to out recruit so that we could grow our agency force there, but if we don't focus on retaining them after 90 days the percentage that hits that threshold and then the percentage of productive agents will just be kind of like trading water. So our training programs absolutely complement the timing for the metrics.
Yeah. One other thing I didn’t mention, we didn’t discuss the headwinds that we are seeing in the annuity marketplace. And including annuities, sales are essentially flat but if you backout annuities we’re seeing an increase in all the other line. And we’re also seeing a significant increase in the policies per agents that are sold.
So what we’ve seen is, our agency for shift away from the fixed annuity line as that market has become tougher and to the other product lines. And so they’ve been able to offset some of the impacts of the annuity headwinds.
Randy Binner - FBR Capital Markets
Thanks. Randy Binner from FBR Capital Markets. I want to talk little bit about the Active Care product and understand a little better how that differs from the existing coverage is done indemnity product, is it focused more on filling gaps from Healthcare Reform, is that what the target is?
Yeah. I’ll just make a quick comment. I’ll pass it over to Steve. It’s the uniqueness of that is that it’s a combination of those three elements, the critical illness, the hospital indemnity, but it is -- and the accident benefits. But it is an indemnity policy, it is absolutely design to fill the gaps and well-suited for filling the gaps developed, created by Healthcare Reform. Steve, do you want to?
Yeah. It was design specifically to be, if you will, kind of a cafeteria approach. So in essence, at the core there is a minimum of $5,000 critical illness component, it can go up to $100,000.
But what you allow someone to do especially in the situation where they have no healthcare coverage and they are employer, is they can add hospital indemnity component to it and if need be an accident component, it also has wellness benefits.
So one of the other things that’s very attractive is there is a re-earn and what I mean by that is, most policies that offer lump sum in terms of critical illness, which this does, its once have done and what we do is, you re-earn back a portion of that over the course of five years.
So you could actually be recovered if you, obviously are, cancer free or your heart situation improved, that’s really a unique additional benefit that bring some attractiveness.
But what we're seeing is you can sell that, we sell it both -- we will sell it in the individual market and in the worksite market. And when you're going into an employer that’s not offering very good benefits, they have high deductibles and they have an HAS, well most middle-income workers do not have enough in their HSA account to cover anything.
So if they unfortunately early in the year happen to have a severe illness. We’ve got the hospital indemnity component that can help them out, as well as they, if it depending on what the critical illness is, a lump sum benefit.
So they're finding it very attractive to be able to do a cafeteria approach with one product and it tends to be a little easier to explain them, trying to both on the heart and stroke and both on other things. So, we think its going to be, based on the study groups you had and the works with, the work we’ve done with our distribution channels we are excited about it.
Randy Binner - FBR Capital Markets
All right. And just one more, kind of revolving around the Healthcare Reform, and that’s make the commentary on Medicare Advantage, you said that you would be, there will be changes in Medicare Advantage and that, if you mean just kind of how much CMS is funding it.
Right. I was really referring to funding levels, right.
Randy Binner - FBR Capital Markets
That is funding levels move the benefit structures of the plans will change making them more or less attractive in the marketplace.
Randy Binner - FBR Capital Markets
So you can just put back and forth between…
Randy Binner - FBR Capital Markets
… you could do.
Randy Binner - FBR Capital Markets
But there is not a structural change to how…
No. No, I don’t, well…
Randy Binner - FBR Capital Markets
Medicare is the same, the supplements are same. You can just sell whatever wrapper people want at the time.
Randy Binner - FBR Capital Markets
Paul Sarran - Evercore
Yeah. Thanks. It’s Paul Sarran at Evercore. I’m hoping to ask two questions if I could. First, you talk about sales growth targets, if you hit those targets, what is the main for overall revenue growth over the next couple of years, maybe for each business?
I’m sorry, what is the?
Paul Sarran - Evercore
If you hit your sales targets…
What’s the overall revenue?
Paul Sarran - Evercore
What is the main for overall revenue growth, yeah?
Yeah. I think, Fred, can comment on that in his section overall, but it’s going to be more than what we've experienced. And a little bit of that depends upon mix shift, right. So, some of our sales growth is being generated by lower policy per premium business like short-term care. We've also seen a shift away from annuities, annuities is a high premium per policy.
So a little bit of and as we saw shifts in Medicare supplement market or shift away from the higher premium plan F or J into plan N is that becomes more appealing to the middle market.
So, you have to take into account mix shift. So as we see these 8% to 10% topline growth rates in NAP, they will translate doing increases in revenue but you have to take into account the product mix shift as well.
Paul Sarran - Evercore
I think Fred will comment on that later in his discussion as well.
Paul Sarran - Evercore
Okay. I’ll wait for that. Another question is we’ve seen more insurance companies looking at ways to move back towards the middle market, new product, new distributions. Have you seen or do you think that down the line this could present any sort of channel to any of your businesses?
Well, I’ll answer that in general and if anybody wants to add they certainly can. I would say we welcome the competition. We will monitor it closely. This is not an easy market to enter and it certainly not an easy market to enter if you have been focus on other markets.
The advantage that we believe we have is this has been a market that we’re built for. We’ve been building for this market. Meaning that, we have the infrastructure, the back office, the products and it’s taken us a long time to get there.
But we’re certainly monitoring some of with -- some of the players are doing. We certainly see, the health plans is a realistic threats. But we also feel that we have a nice head start and our strategy, we certainly monitoring them, but we’re doing less about looking over our shoulder and more about our focus is on more towards putting our foot on the accelerator and putting as much distance between us and the competition as possible.
Yeah. One point, when it comes to the worksite market, a number of companies have attempted it, but what we see is Washington National has been spending last few years, they have really trying to become a very low cost manufacturer and focus on a very small segment of the markets and that being 250 or less, in some cases 500 or less.
And you don't have a lot of the bigger players wanting to compete in that market. They stay in a 1000 above. They work with employ benefit brokers. And of course, those markets tend to be a little more upscale as well.
So they're struggling with, how do we cost effectively get to the lower end of the market, when we are competing with an organization like PMA’s worksite marketing division or our long-term partners, which are most exclusive to us and have been for 15 to 20 years.
So we have I think a cost advantage in terms of the way we go to the market and we have a unique breath and depths of products in terms of having both group and individual chassis products.
And one other things lot of these companies try to do when they go into this market going after the middle market is they come up with a lot of group products and that necessarily work for all employers. And so we've had more success with the individual products that which actually offers us a higher margin.
So I think there is somewhat of a barrier entry, because you have -- ultimately have to build tools like electronic app and group billing systems, and number of things that allow you to compete at least in the worksite market and then on the individual market for supplemental health.
There are very few carriers that know how to go after this smaller rural market, because it's very hard to go market in a large urban environment and try to pick up the middle-income Americans, it’s not cost effective.
But the way we’ve been doing this for over 25 years is going into the -- into population size as a 5000 or less, and we might grow that to 10,000. It’s just something that they, just don’t have the distribution force to do and we do. So I think that it’s somewhat of a barrier entry.
I will add, career agent perspective, I think it’s important to reflect on edge point about, who Bankers recruits are and where we come from. It's the middle market. It’s the market we serve. If you take for example our Life sales, our average Life premium per sale this year is $784.
So, in terms of career agents and brokerage agents, they are looking good, put the same effort into obtaining a sale as we do, but they are not looking for $380 commission, they are looking to maximize commission.
And that means that they have to go to a larger size sale and that means to an upscale market. So, from my perspective for them to convert from where they are as a career agency organization to where we are would be an extremely difficult task to execute.
I’ll add just basically on the Colonial Penn side, as I mentioned, the Colonial Penn Associates, actually are reflection of the market that we are serving and remember we are -- we have this engine that generate leads response and then its our telesales representative engaging and attending the conversation with somebody. And this is the first time that that somebody has been sort of been advised on product feature.
So, connection that in fact that clearly understanding of the need only happen if you really understand the market and real part of that market. So I think that really creates a very, very unique competitive advantage for Colonial Penn.
Paul Sarran - Evercore
Chris Giovanni - Goldman Sachs
Thanks. Chris Giovanni, Goldman Sachs. Question maybe for Mike. You also commented around the pressures in the fixed annuity space. Do you guys are willing to kind of just sell the business? You’re focused on margin improvement. And with that, I think there has been some frustration with the distribution in terms of one of their tools, may be opting where they wanted to be in terms of a productivity standpoint. So can you talk a little about out their shifting, some one had primarily sold fixed annuities. How they’re shifting to your new product focus and their philosophy?
Thanks Chris. I’ll let Mike answer that.
Yeah. First of all, I mean, we are somewhat retooling. We’ve done about 34% in our annuity business this year but our life has taken off like crazy. Our life -- our premium is more than half of what our total premium is and that’s been a big shift for us. We’re focused on a couple of issues in terms of the training. Number one, we've executed to taking advantage of our culture.
We’ve had people who have been very, very successful in marketing life products, do webinars for us and put on sales, presentations and demonstrations. So that we can hopefully train the folks who have moved away from the annuity market to exploit the life opportunity we have.
The second thing we've done is introduce better fact-finding tools for our agency force to uncover a broader need to move them just from focus on retirement and annuities but into eventual legacy giving and the final expenses. And lastly, we've introduced a customer-oriented concept of premium commitment, trying to determine after the fact finder what it is that people can afford. First, what they want, what they think they need and then move to affordability trying to ask them and solve for a life insurance product that would do what they wanted to do or tailor it to what they can afford to pay.
So those kind of efforts are what we've done but we've really been very fortunate in that, our management team and our agency force has been willing to contribute practices and then we videoed and go out and demonstrate and do webinars that have spread their skills to other places.
Yeah. A couple of things just to add to that and Mike’s absolutely right. So a lot of training that we got that trained out there early because we saw this coming, right. So we began to, kind of, drive home the need to shift. We saw a little bit of agent attrition real early on and then things have been stabilized quickly as some of our agent, especially our veteran agents that may have been big annuity producers shifted.
But again back to Ed’s point because our agents view their businesses, the market as well, they're not wedded to one product. We have very few agents that only sell med stuff or only sell annuities. Generally, all of our agents offer some element of our entire portfolio. And so it was a little bit easier for them to shift compared to an independent producer who is just the annuity producer, just the Meds Supp producer, something disruptive in that market. They have to do something else. They have to find another outlet. We don't have that phenomenon so we help them migrate.
We also introduced other products. Timing worked out well for the introduction of the critical illness product within the Bankers channel and that product has exceeded our expectations that have taken off and we’ve seen some level of shift to that product as well.
Richard Sbaschnig - Hovde Capital
Richard Sbaschnig from Hovde Capital. In terms of worst-case scenario, where the entitlement reform leads to the Medicare Supplement product being kind of completely on the economic to offer but having existing customers grandfathered in, what’s kind of the tail of earnings for that business for you?
That’s an excellent question to end on because it will be a good one for Fred to answer starting his section. I think from a market perspective though, you're asking about earnings. So I’ll address it from a market perspective. And we feel if that happens, one of the things that we are pursuing beyond the only fee relationships that we have with our partners, our MA partners we are pursuing a quarter share arrangement.
So that obviously a quarter share arrangement would improve the economics of Medicare advantage sales and we don't have one yet, so we certainly all three of our partners are interested in discussions.
Thank you very much to our panel. We appreciate those insights. We’ll take a short 10 minute break right now and then regather. I’ll make sure you guys get in here on time. Second half of the portion is going to be the financial portion. We’ll cover investments and the financials.
Okay. If we could have everybody take their seats. We’ll get started back up again. Next on the agenda is the investment overview section. I’d like to bring up Eric Johnson, the Chief Investment Officer and President of 40|86. Eric.
Hello, everybody and glad to be here with you this afternoon. We’re here to talk about pretty serious business, which is $24 billion, which in today’s world doesn’t sound like a lot but when you have to invest to the kind of our earnings target that we have, it’s quite a lot.
Let me give you a few key takeaways for what I’m going to tell you today. And if you just remember these few key things from what I say, I will be a success. The first one is that investing is a core competency at CNO, and I think it contributes a lot to the CNO value proposition. It’s really built on a culture of active management and very strong risk discipline that have been in place for a long time and have served the company well.
And we have been able to deliver and we’ll continue to deliver the returns built into corporate overall strategy. Our group is not just one guy standing on stage. There are 85 people with a lot of experience, a lot of broad product capabilities. We use technology very efficiently and as I said earlier we're open right into the mix that we’ve established via the company that Ed showed you earlier today.
Now, I realize that really what you want to hear about is low yield, low yield, low yield and pretty much everything else I say is just [one, one, one]. But I’m going to say a few other things and then we’ll get to the low yield, low yield, low yield and I’ll begin by showing you broad, broad share of the market today.
Obviously, in the foreseeable future, the Fed and the ECB are going to dictate low short rates. I am very sure that they really are in control of the long run of the curve as they like to be. Although I’d say they keep buying the entire short end of the agency supply and increasingly treasuries that will first fox out the curve and that pull -- it's like a very strong technical pull and maybe flat and curve a little bit.
But for the foreseeable future, obviously short rates are going to say low, and we’re not naïve about that. In the world we see today than relative value for our company is really going to equal credit compression and probably a barbell and that would be a good image to remember in terms of our investment strategy for 2013.
And obviously in the long-run, we’re actively preparing for and understand that they will come although it would be a different rate environment. When I first started working in 1983, long bond was 18%. So I’m very familiar with a very different world than one we’re in today. And I know what’s going to come again perhaps not that extreme but certainly, we’re going to see a different rate environment at some point out there.
Housing is obviously very strong. Banks are going to have some point before used to lend money which will stimulate the economy and soon or later, we will see a different world and we, as an enterprise, are not just the wallowing in low rates, we’re also preparing for that future.
So in terms of where we’re right now and what are we doing, it’s boiling it all down and trying to make it neat and simple, kind of, five basic things. We are within extremely well structured boundaries. We do understand that credit compression is kind of the trade of the day and we have modestly increased the amount of risk we’re taking but very much within limit and that’s the compression trade.
Very strong emphasis on the U.S. and as I’ll show you later on, we’re born in USA and that’s where our money is. It’s the world that I think is transitioning from a highly correlated kind of beta market to a single name market and so we’re built to analyze things from the ground up and so we’re built for that kind of market. That’s what we do, both in structured securities, also incorporate, in mortgages, everything else we do, we analyze everything from the bottom-up.
Yeah. The housing market is probably, almost certainly bottomed out though my wife still has a house for sale in Cincinnati. If anybody wants to move to Cincinnati, we have a cheap offer on a nice house and pleasant ridge and probably even rented. And I may call [black stone at Brian how, aren’t they keep] reading and we’re big on energy and our analyst there who is also our Director of Research is just as bullish as you can be.
More on our outlook, supply and demand is a real big deal right now. Both obviously in structured securities, which has been a shrinking universe by and large and will continue to be so, lay down exceedingly new issuance. But also on the corporate space, we read a lot and hear a lot about the huge volume of corporate new issue but I'm not sure we’re keeping that -- the flow of new issue is actually keeping up with the retirement coupon et cetera and new money flowing into the market.
So is this a foot-fight to get good investment out there and you know you really -- you got to work hard to stand in front of people and get their best ideas. You all, I think, know that already. And that kind of relationship management is an important part of our job because the demand is pretty high out there.
Next point, I want to make corporate credit has a pretty heady aroma right now I would say. And what I mean by that is that I think corporate credit quality is almost certainly peak and it’s going to go the other way. Fundamental learnings except at our company, credit rating trends except at our company and margins except at our company are probably going to be poor rather than better looking out a year. And it’s very hard although corporates are an important asset for us. It’s very hard to really see value there today.
And so we understand shots have to be taken selectively there and with great care. And yes we have to have yields but no, we’re not going to do anything stupid or crazy and it’s important to you to hear that because we don’t serve the policyholder or the shareholder well if we run out and do stupid stuff to get yield today that we have to pay high price for tomorrow and we’re not going to do that.
Where is our money today, kind of, shifting gear. And I would say it has three key qualities, high quality, great liquidity and a lot of earnings power in terms of book yield and I think as I get further into it in the next couple of slides, this will help tell you something about how we do business at our shop.
First thing, I’ll talk about is kind of the ratings profile. And as you can see, we are not addicted to high risk assets. We have pretty good constrains and control over, the level of risk that we take in the portfolio and where we put it.
And we, yeah, we’ve been building and learning lot of book yield over the last couple of years and pretty good new money rates, but we haven’t been pumping yield to do that, pumping risk to do that, quality have been same and we are 90% in high-grade assets.
We don't have a lot of equity on the book, don’t have a lot of private equity on the book, don’t have own real estate at all and so, as you can see we have protected the balance sheet as well as income.
Corporates as I said earlier is a big asset class for us and one other things we are very active manager, I said earlier and we very deliberately will have overweight and underweight as we see these fundamentals in relative value.
And just to give you a little bit depiction today, one of our, some of our overweight that are listed, energy as I mentioned earlier, REITS, insurance, we are an insurance company and we like insurance right now. I know this docs, there aren’t making people lot of money but we think the bonds will.
And market has got also little bit wrong REITS. We’ve done very well in REITS. I should, muni should be up there, we’ve done great in -- in particularly ABS, we have a big allocation there relative to other insurance companies and its, the book yield is fabulous, the quality is fabulous. These earnings, there are huge gains and we like that very much. We hope it comes back, call your Congressman and if you really like our company. We have some underweights. I won’t get too much into those. I did mention Europe, not something we are big heavy on right now.
Let me mention, talk about Structured Securities a little bit, we have a very strong competency here, based on really capable people and depth use of technology and we actively manage this allocation to reflect where we see value.
As you’ll the grey and blue bars there on this table on the left hand or your right hand side there. You can see we are like agency today as those rushed that in and we added substantially a non-agency over the last two, three years.
And particularly we added in below investment grade non-agency during that time, which has done great for us. And as you know now can you hardly buy them, because, if come in tremendously and it’s a real wrestling match, we were adding them when people didn’t want them, it’s done well.
And if, you can see on this next slide, the change, or the growth in our allocations below investment grade, RMBS, and as you can see, they decline since 2008, when people were selling them, we were taking them in. And it’s done well. And these bonds are very, from a capital perspective they don’t pick up whole lot of capital. Its 98% NAIC 1 capital rating, which is great, yet they have, very substantial book yields, relative to what NAIC 1 typically would have.
And as the housing market has stabilized the collateral performance has also become quite much more stable, much less volatile, the cash flows have become much more predictable, much less volatile. So we like this a lot. We are going to stay with it, probably do more.
CMBS is a little bit of a different story for us and that for us is an asset class where we’ve always had a decent size allocation at the high end of the capital stack, looking for duration, stability, a performance, and we’ve got that. We’ve got 100% investment grade, 87% AA or better, 98% NAIC 1, long-term buy and hold strategy based on property fundamentals, and that’s what we do there and we’ve done it very well.
We have -- our collateral tends to have relatively low delinquencies compared to the market, tends, this -- it’s just a cash flowed very well. This is an area like everything else in Structured Securities where we subject our investments to pretty severe stress testing and we’ll use very -- we will use market consistent value and then stress them on using extreme assumptions.
So that, we can feel comfortable and our auditors can feel comfortable, and you can feel comfortable that, they aren’t air balls here. We tend to play at the top of the stack. We don’t like to sell leverage in Structured Securities. We tend to benefit from other people selling us leverage i.e. credit -- implied credit support. So this is an area we understand well. We think we know what we are doing and up till now the cycle improvement is correct.
CLOs, very similar story and this is a significant commitment for us and so far this has been very satisfactory. It really comes in two parts.
The first part we have about 400 million of what we call owned assets, that are, tranches of CLOs of other people feel, largely we are going to be in the AA part of the stack, some small amount of AAAs, small amount mezzanine paper, it’s been a fairly stable performer for us, strong credit support, if you look at OC calculations and NAVs or CCC balances or default balances in the deals.
We’ve got a lot of protection from DOD and RDO, they are all cash flowing. We are not picking anything and feel very good about that. We probably continued to add to that allocation. There is some value there.
Also we manage CLOs, if we use the same people and same skills manage CLOs and we sponsor them and we give them names that reflect who we are, Eagle Creek, Mill Creek, [Peter] Creek, well, [Peter] Creek on the comp, but that will be our next area.
But this is an area where we leverage our competency. We make some money and we invest in our deal. We own the equity in that or at least probably chunk of it, rate book yields 10% to 12%. We like it very much. We are going to do more.
Commercial mortgage loans, very intense focus on high quality, A quality properties, if you think about it, Freddie has been doing a lot of business in here, in the 3%, 3.5% range, big multifamily buyer using the market. We want to be right above Freddie in that qualitative here.
Also high quality properties, maybe a little longer duration then they want, maybe look at us little more yields then they get, and so that. If you think about, what we are doing that’s a good model.
If you come see our campus, there are couple of new resi developments right around campus, 116 has been college. We are the wonder on that building. So, it’s a great deal. The developer is very experience and we’ll make good money on that.
Our portfolio has very limited near-term maturities, good long-term value, good DSCR on an average basis, very low delinquencies, we really high-graded it over the last three years. And the allocation is smaller than use to be, its also higher quality. And it earns great book yields well north of 6%.
We -- as I mentioned, Europe has not been big commitment for us, its still not, at some point it will be an opportunity, not yet. This is all reflected in a very low level of impairment in the last three -- particularly last two years and I would imagine it population, be giving any forward-looking guidance on that, [national set up]. Thank you, Fred.
Now here is what you all wanted to really talk about. I see my yellow lights on, so I’m going to have to get it in a little tight here. But dealing with low interest rates, which is the order of the day and we’ve been successful, by that bar chart is the new money rate trend and yeah, it’s kind of down a little bit, but it’s did, even now it’s at 4.71% and we can do that. And we’ve shown we can do that. And remember we were earning that in treasuries were tighter than they are today, I mean, treasuries were 1.30%, 1.40%, 1.50%, and outlook 0.70% for a 10 year. So we know how to do this.
And how do we do it? Well, we do with credit at the short end of the curve and quality at the long end of the curve, by really slowing down our portfolio turnover a lot. We are -- as I said earlier, we are very active manager. There are years when it makes sense for us, we will turn the portfolio over 50%, 60%, a lot, and for an insurance company that’s really a lot, as you all follow insurance know that.
I would venture to say that it will be a lot lower next year. It’s been a lot lower this year. And that add values this year. There are years when turning the portfolio helps the company that’s what we will do. They are viewers sitting on our heads helps the company that’s what we will do.
So, what’s to do with company in needs now what we want? And we have maintained our asset liability management discipline and we have strong group of people who look after that, kind of the shared commitment with actuarial department and the investment area. And that’s an area that we very deliberately muscled up over the last three years and we have very good discipline.
And we do have a modest amount of investment leverage that will -- that comes in the play to help us build income as well and that which involves borrowing from Federal Home Loan Bank, involve CLOs and these are areas that will continue sustain the next year as well.
Overall though, we’ll try very hard to avoid doing anything stupid, chasing fictitious yield and I think if we do all that, as well as we’ve done it this year, we’ll continue to fund at levels that support the company’s business plan.
I should lastly mentioned that we also have money at the holding company that we invest leveraging our skills on behalf of the company and that is really invested in support of the company’s corporate capital strategy and it has a lot of liquidity with a little bit of leverage and a targeted amount alternatives, as well as some of our CLO equity. And if you put that all together, it’s a pretty competitive yield for the company. But in a way that also as good liquidity and transparency, if there are other need for the money.
So on that note, if there are any questions, Erik said two, I’ll let you have three, if I’m a nice guy, and we will go from there. No one from the company can ask question, so, far away.
Sean Dargan - Macquarie
Sean Dargan - Macquarie
Sean Dargan from Macquarie. I have a question about the whole core investment strategy a little while back it was positive as maybe it was (inaudible) NOLs. I’m just wondering, how big can those investments, I mean, what are you thinking as, what’s your strategy there in terms of (inaudible) I’d like to ask for something else.
Sure. And let me say this and I’ll differ to Fred on some of the kind of corporate finance implications of your question. So I’ll just tackle whether as an investment person, which we are boxes much, much, more.
The -- and did you notice earlier, when Ed was talking all the investments in the company, he talked about Fred and Bruce. They must make a lot of money. He didn’t say anything about us, I notice that. But that’s, you know what that, that’s okay, that’s fine. Your new money rates going down next year, Ed.
Basically, this is, big picture, the number that, the amount of liquidity you should expect to see at the holding company at any point in time is $100 million or more, okay. And sometimes it’s a good deal more in between periods, as dividends come up and reimbursements for services come up and payouts were made on buyback the dividends or that repayment or whatever else. So it’s a very viable cash balance.
But any given -- at a snapshot in time, you expect to see at least $100 million and actually fairly liquid security. Now, how would define liquid for that conversation, would be money market, would be agencies, would be very high quality corporates, maybe all, any of those with a little bit of leverage on them, probably in repo perform, short-term repo, maybe 30 days, maybe seven days, and like that, whatever make sense for the trade.
And in addition to that $100 million, you might see as you will see right now roughly $50 million in what we call alternative, that might be CLO equity, it might be large cap mezz fund, it might be some else. That box is going to be smaller. And its not a box that we, for the sake of it look to grow per se, because that’s not going to, that’s not why the holding company liquidity is there, that’s not where the money is there.
However, when in circumstances where you have a compelling investment opportunity, our own CLO equity for example, that’s often a good place to put it, because you don’t have the RBC requirement up there. So it produces less drag on the enterprise as the capital requirement and creates more flexibility for the company.
So I know that’s a little bit of long winded answer, but we are not trying to build an investment empire at the holding company. No, we are not trying to (inaudible) up all the liquidity at the holding company. But at the same time, we are trying to make sure that we on money that is there we produce say, a satisfactory, to better satisfactory return with the balancing act.
Sean Dargan - Macquarie
I don’t think the question deserve all of that weighting, I mean, the question is not good enough. But you describe the credit barbell and I’m sure that the trading on long ended pretty subdue just as you said, I’m wondering if you could indicate, what’s the trading is like on the short end?
Yeah, Sean. Could I ask you just to amp it up a little bit, I can’t…
Sean Dargan - Macquarie
Yeah. So you were describing a credit barbell.
Sean Dargan - Macquarie
And I’m sure the trading is subdued on the long end. I’m wondering what the trading turn over is like on the short end? And have you had much need to move outside traditional conventional street bid ask, is your trades done with liquidity diminished?
Yeah. Those are -- I’m not sure my answer is going to be -- even as good as your question. So if you don’t belittle my answer, I won’t belittle your question. Let me give you an answer though.
I mean is certainly as less liquidity out there today than it was three or four or five years ago, oh God, I look back to the ‘80s, which I’m old enough to do. And you remember at what the street was like then. And, yeah, now it’s harder to get business done, no kidding.
You’ve got to work lot harder sometimes to find an offering or find a bid against what you are doing. As a electronic world hasn’t really taken complete move yet, except in very, very commoditize products, the street want to carry less inventory, but you have to work harder to get trades done. And in particularly you get off the run, I mean, that’s where you will be real sure what you are doing, plus its very expensive trade off the run.
So, I mean, I think your questions are good one and I think back, support the kind of the idea behind your question. At the short end, it’s funny. We’re not -- that is not a part of the portfolio that we’re aggressively looking around. I mean, because we’re just buying in that area, basically but for a given example. You’re buying structured securities. You’re buying for us. You are buying CLOs, ABS or something else and you’re just seasoning that out and rolling it down and a lot of what we’re buying is short end and that will be of an amortizing nature.
Any way it’d be factoring down. That also will tend to be buy and hold transactions to a greater extent. And probably if you took a kind of key rate duration chart and brought our portfolio against it and put our turnover up against it, it will be kind of in the middle of the barbell in the seven to 10 year range, not going to be a long stuff and probably not the real short stuff.
And now, if you really just got very specific about it, we’ve got a lot of commercial papers that run through as well. So we’re having right money to invest in and it will be fair to count in this calculation. That’s just going to come in and roll-off.
Humphrey Lee - UBS
Humphrey Lee from UBS. You mentioned about the asset turnover rates earlier, what are you planning to do that will be different than what you did in the past to drive that ratio down and then fiscally, is there any target that you are aiming at?
Sure. Let me say first that in past years at any time, we’re trying to do transactions that add value to the company and pretty much anytime we’re pulling trigger on something, we’re making sure that it has positive reinvestment characteristics, i.e. we’re picking up book yield or we’re picking up quality or hopefully picking up both, although that’s kind of a dream, right.
It’s harder for those calculation to make sense today. It’s that simple. So in essence, the calculation is the stop sign because you can’t reinvest at decent break-even yields given what rate they have done over the last three years. So we have a pretty good discipline around that decision process and that discipline tells us no right now. That sitting on our hand is -- this is the better trade to make very often today and protect your book yield. Don’t turn it over. Now, there will come times again in the future where that calculation will drive us the other way. So the disciplined approach will kind of gives us the answer. In some way, it’s just a risk intake and we just do the answer that arithmetic gives. All right. Thank you very much.
Thanks Eric. Sorry. I had to cut it off. Eric will be back up after Fred’s remark. So if you have another question for him, you can ask him at that time. So without further ado, Fred Crawford, Chief Financial Officer.
Thank you, Erik. Good afternoon. It’s good to see all again. I had -- this is an absolute true story. I think I told a couple of you this during lunch but it’s a true story. I was getting into Starbucks coffee this morning just right across the street, up across Vanderbilt and I ran into an old colleague of mine that I worked with back at my previous employer and she was one of the financial -- members of the financial team at LinkedIn and helped me in countless numbers of annual investor conferences. Many of you in this room attended them, whether they be in Philadelphia or more recently in New York.
So she said, Fred, Fred, and I won’t use her name and I said what are you doing here and she said, well, now, I work for ING now and I’m in town, just working just couple of blocks away. What are you doing? And I said well I'm here for our annual investor conference and her immediate response was oh God, you’re back doing that again with a tone of when you’re going to make something of your life and do something productive.
And so -- but let me just assure you that I couldn't be more excited to obviously having joined CNO and it's interesting. I'm still in this period of time. I had been here now, coming on 11 months, little north of 10 months. That officially means I need to have a grip, a full fundamental grip on the financials of the company, so there are no excuses.
But I’m also and still that mode of being able to make observations. Look, this is my read. This is what I see going on as I look at the condition of the company. And so the tone I want to take on this slides is very consistent with CFO slides at investor conferences. We have them packed full of data and it’s good data. It’s helpful.
I think it does advance the ball in a number of areas and hopefully it advances the ball in areas that you have been most interested in and we’ve been on the road with you. We just got done doing a recap and so from a creditor’s perspective and from an investor’s perspective, we should fundamentally have a handle of what's on your mind.
And what we tried to do is create information that advances that ball for you, brings a little more transparency as to what we think. Having said that, I do not want to go drilling down into every number that appears in every slide, we have them printed and we have them webcast. We have them for you. So you can look at them and follow up with us. What I do want to do is make some observations and really answer the question so what's the point.
So let’s go through these slides and what I want to start with is what are -- what's our strategy financially. What do we orient it around? Well, we have an absolute desire to build organic ROE. But importantly and I'll touch on this later, there are opportunities for stairstep. There are leverage points where we can kick that organic ROE into another gear. You just witnessed that notion of a stairstep in the recap we did in the third quarter. That’s the type of transaction, the type of step I'm talking about when I say kicking up organic ROE.
The second thing is stability is as important as growth. For this company, when it comes to things like better utilizing our tax assets, creating a lower cost of capital for the company and therefore a better stock price movement, improving the ratings of the company and a quest for investment grade, stability, reliability, okay, lessen the way of surprises or vulnerability in our business model is as important as pure earnings growth. That we are focused on making decisions that also address beta and stability in the company.
We have an economic value orientation and what do I mean by that. We're oriented around capital generation, free cash flow, economic value, that’s what motivates us. When we make decisions, it’s around that the universe. We have a measure called value of new business or VNB which is effectively an embedded value measure on the new business we put on our books.
That’s a great example. And by the way, that is also tied to our compensation. It’s not just a neat sort of exercise that we have in the company. And that puts an exclamation point on the notion of being tied to economic value drive ways.
We have a balanced approach to redeploying our capital. I have an audience here of creditors and equity investors. Okay. I am not shading the story of the direction of a creditor or shading the story to direction of an equity owner. We have one story and the story is balance. And it just so happens that that same strategy and financial story does as good for our spreads and our ratings as it does for our stock price.
And then, I would say we have a very good orientation around risk management, just now observation. We have a CEO who is an actuary and grew up through actuarial and reinsurance ranks. Including him, we have four actuaries on our board, one of whom was the former Chief Actuary and CFO of UNAM who chairs our audit and risk committee. When we use words like risk return trade-off, value of new business, stress testing, cash flow testing, this is not French to our Board. Okay
This is understood. This is in a very detailed real way. So our risk management is not only comprehensive but it’s quite sophisticated, I assure you. Now, what’s first level sell, what’s the condition of earnings are at the company.
We’ve got some tailwinds and headwinds not surprisingly. From a tailwind perspective, benefit ratios across the company, across our underwriting businesses have been generally favorable. Favorable in the sense of also having some redundancies from time to time that have helped to boost earnings quarter to quarter.
We have seen annuity margins do very well. So we’ve been quite proactive in not only retaining a good amount of spread business on our books but also working the crediting rates to drive as much net investment income as we can despite the low interest rate environment. And interestingly and Eric just talked to you about it, we have an emerging earnings stream at the corporate level with the use of excess capital and also leveraging 40|86 skills for driving a little bit of an earnings engine at the corporate segment level.
Many of you watching our corporate segment reporting are seeing very slowly but surely that what is normally understood to be an expense category virtually every company in our peer group, we are working to mitigate that to some degree through a real good legitimate stream of earnings coming out of corporate activity, corporate investment activity.
Headwinds are what you really understand. That is obviously the low interest rate environment as the headwinds. We have a natural run-off nature to our business. I think that's a good kind of a headwind and that what’s running off the books is generally lower return, also tends to be characterized by volatility.
So while we may be running often and lowering the earnings growth rate with that run-off, we’re also running off beta as well. So don’t lose sight of that and then obviously a natural headwind but a good kind of headwinds as we’re investing more proactively in the business.
So the point or one of the points of the first half of the session this afternoon was we are back investing in our platform. We have the capital, cash flow and opportunity to invest back in it. That’s naturally under new GAAP accounting, in particular, going in a way a little bit in the shorthand but with CBAs and benefits that play out of as we go to three year’s planning cycle.
Now, don’t forget we are per share story, right. So we brought the end of period share count down by 20% since 2010. So we’re an earnings per share story or a cash flow per share story or an embedded value if one takes some of the parts point of view to Colonial Penn and tax assets, embedded value per share story. And as Ed mentioned earlier, we’re about ready to start down the road being a dividend per share story.
So let’s now talk about the earnings drivers. We don’t give earnings guidance but we do give guidance on what the key earnings drivers are. And let’s start with Bankers Med Supp and Washington National Supplemental Health. The punch line here is this is about a $1.2 billion of collected premium a year.
And the general read on these businesses is that we expect them to be stable, modestly growing and contributing to an earnings growth rate as we go forward. Now, Bankers Med Supp has enjoyed a history, more recent history of redundant reserve releases. So when you look at the benefit ratios of Bankers Med Supp, be careful to understand that you need to adjust or normalize those for what we call out in our press release as being reserve redundancies that we -- that pumped up the earnings.
So the normalized benefit ratio in Med Sup is really between 70% to 73% and our outlook for this business is around 71% benefit ratios persistency improving. Now, I will try to -- I think about four times already this morning, you deferred questions to the CFO’s dialogue and so I'll try to hit them as I get to them.
But the question was, how do I think about Med Supp run-off if you were not to be selling it. We have -- our persistency in this business tends to be around 85%. The notion of how fast or slow something would runoff would be very difficult to judge, know a couple things the captive nature of our distribution platform typically results and in fact has proven out the result in better persistency than you see elsewhere.
In fact, many of the healthcare providers that sell through us Medicare Advantage do so because of their favorable persistency in dynamics. And then also note of course if you are grandfathering a block of business and no longer being offered, you would expect that persistency to be particularly good.
But nevertheless that’s the persistency of the business in a way to think about it. Now, Washington National Supplemental Health is simply going to be driven by what Steve talked about earlier. We’re expanding geographies, we’re introducing new product. Worksite is growing and we expect the premium -- collected premium to follow accordingly.
We have seen benefit ratios come down in the business and would expect them to fall right into the normalized range about 50% or so interest adjusted benefit ratios.
Long-term care. Scott spent some time with you earlier on the strategy of long-term care. I’m going to take a slightly different and obviously more financial approach but let’s just first level set for a second. And that’s the top half of the slide. And the level setting as we think about our long-term care of financial stability story as being essentially in four bucket.
The bucket number one is don't lose sight of the fact that we divested of in 2008 roughly $3 billion of particularly highly volatile, long-term care business. And it was not for free that we did that. We took the related GAAP financial charges associated with running that business off but it has been in fact reduced substantially what otherwise would normally have been built up in the traditional long-term care block of business a player that had been in the long-term care business for years and years.
In another words, we’ve gotten that behind us and it fundamentally changes the makeup of the long-term care business we have in our books. The second bucket is we have a small but $0.5 billion worth of reserves, about $500 million of reserve, small block in OCB that where our future loss reserve has been put up at the time we put it in run-off to reflect the potential for ongoing poor performance in that book. So think of it as having recognized the poor performance in the run-off and establish the future loss reserves on that business.
That creates a more stable go-forward outcome as you release those reserves to reflect the performance of the business. That leaves us them with Bankers’ long-term care. And there is really two categories, two buckets to think about there. And that is first roughly 70% or so of the reserves relate to business from 2002 and prior were interestingly about 80% of the economic benefits we have driven from the re-rating process or more or else attacking that portion of the business.
And this is where we've done in some cases two and even three rounds of rate increases on those particular reserves. The newer business we have on our books is characterized by having been freshly priced and much shorter in duration as Scott mentioned.
So what’s the point, the point is, is that the result of the divestiture of the business, the establishment of the future loss reserve on the run-off block, the four rounds of rate action since 2006 concentrated on business that is older and therefore much more susceptible to volatility and the shorter duration new business all puts us in a position where you naturally have a more stable, dynamic going forward than you might normally see in the marketplace among most long-term care players.
So what’s our outlook? Our outlook is that we would expect premiums to start to come down, Why? Because we are in fact growing shorter-term product that is at a lesser premium. That shouldn’t be confused with having given up economic value that's driven by selling a product.
Question earlier was how should I think about revenue. Revenue will be weighed down by the shift in business but remember that is a lower premium on lesser benefits and so what you lose in the way of a premium dollar, you gain in the way of a claim expense, right. And so the economics remains somewhat similar to what we’re looking at.
And then we do expect benefit ratios declined modestly but only because it’s a natural aging of the long-term care block of business having completed many rounds of rate increases and that now slowing down. You would expect persistency and really more lapse rate voluntary lapse rate to find a new level and that what’s happening in the benefit ratio.
Turning to spreads, but first start with net investment income. Once again remember the history. We reinsured a $3 billion annuity block of business that was outside of surrender charge, had high crediting rates and minimum crediting rates back in 2007. I just got down talk into you about another $3 billion long-term care transaction, realize that we entered into two substantial derivatives to protect our balance sheet back in 2007 and 2008. That lowered the reserve that are sensitive to low interest rates by $6 billion, that was a positioning move by the company, recognizing we could have concentrated in the interest rate risk among other risks.
We have very tight ALM’s standard. We have disclosed on our ALM but we routinely run within a couple tense of the year across all our blocks of business including long-term care where the duration is shorter, more in the 13 to 14 year and we run tight durations there as well within a half a year. And then we slowed the turnover rates down into the -- answer to the turnover question you see it here in dollars, bringing that turnover rate down. Actually on our run rate bases the turnover rates is fully a third of what it was a couple years ago.
What that does is, buy us time. It doesn’t solve the problem completely but it buys time. It’s slow the bleed of portfolio yields and allows you to take the following actions, one adjust the pricing on your new business, go at crediting rates more actively and engage in corporate investment strategies that drive net investment income outside of the spread business.
What’s our outlook? Our outlook is that we would expect portfolio yields to decline around 7 to 10 basis points based on the portfolio. However, with the retention and growth in assets under management, we’re anticipating a neutral net investment income and income output for 2013. Spreads down, assets up, net investment income neutral.
Now, a common question we get on the road is look first I find it very hard in your industry to really understand the true risk of low interest rates. It hard -- it’s hard to model that. It’s a bit opaque, this is the word we hear and we get that. It is a quiet complicated exercise. The other question we’ll get is how back and bad get spread when we think about low-interest rates.
So what we chose to do here today is isolate a couple of key pressure points when it comes to low for long interest rates. And so we have isolated interest-sensitive life reserves in our run-off block and Bankers long-term care. Interest-sensitive life reserves is about $2.3 billion in reserves and you just get down seeing what the Bankers long-term care reserves are. If you carve about all the slices about $3.7 or so $3.8 billion of reserves.
And the new money rate expectation over the long run is critical to establishing the reserves for this business. It’s not surprisingly precisely where you have seen sensitivity or earnings issues for the company when adjusting our interest rates. So what this chart attempts to do is if you focusing on the bottom left hand side, let me step you through it. That blue line was the old new money rate assumption we had embedded in the reserve calculation for interest-sensitive life and Bankers long-term care.
This was prior to the third quarter and it had roughly a nearly 5% new money rate traveling on up to just north of 7% and then staying steady there out. In the third quarter, if you remember, we reduced that to bring the new money rate down to 475 and shifted the entire curve by 50 basis points, the result of which was about a $28 million after tax earnings charge.
We then went further and said let us give you a stress test. Let’s hold new money rates flat for five years, have them then recover backup to that long-term new money rate assumption and what does that result in. And that resulted in about a $20 million to $50 million after tax GAAP hit and statutory asset adequacy reserves of $20 million to $50 million.
By the way, why the range? The range is because as you get lower for longer you now bring not only interest-sensitive life into the equation but you start to gradually bring the long-term care Bankers into the equation, that's why the range.
Bankers long-term care has much more resiliency because it’s not in the runoff. It's freshening it’s block of business with new business and the rate actions since 2006 while not addressing interest rates have gone a long way to help support margins in the business.
Now, how bad can things get. Well, let’s go further. Let’s drop the new money rate by 50 basis points to 4.25%. Let’s hold that flat indefinitely what’s the charge. On a GAAP basis after tax $100 million to $125 million, statutory asset adequacy reserves estimated at $75 million to $100 million, let’s put this in perspective.
That GAAP charge is about 50 basis points of leverage. I’m reducing my leverage by over 100 basis points a year to natural amortization of my debt. That asset adequacy reserves measure is about 15 to 20 points of RBC.
Right, this morning I guided on statutory dividend capacity to the holding company. Think of that as our free cash flow of $250 million to $300 million. Let’s takes the low end of that $250 million.
Okay. I have free cash flow equivalent to 50 points of RBC each year. Look this is a headwind. This is, in fact, eating into available capital and free cash flow. But this is a manageable dynamic for us to work our way through particularly given the diversity in our business mix. Not good for the business, not helpful but something we can mange our way through if necessary.
Let’s change gears a bit, talk about three topics. Three topics that are really some of the parts type topics. One is Colonial Penn. So first of all understand Colonial Penn is very, very uniquely economic for us to be investing and why is that? One it’s a unique franchise that aligned with our middle-market and you just learned about that with Gerardo this morning. But it’s also predictable; mortality based low beta cash flows.
Our industry needs more of that, right. That’s what we like. That’s a nice type of business to put in your books. It’s a nice balance of risk to have on your books. It’s also fairly low execution risk to invest in it. Once you have the formula, once you have the franchise in the engine that Gerardo talk to you about, feeding it is relatively low execution risk growth.
Many, many, many products in our industry if it grows like a weed, it may be a weed. Right, this is not their type of business. It’s really hard to screw up low face amount mortality based life insurance.
So how do we think about the economic value of it? Well, we did a calculation. So you know we use value of new business which is an embedded value calculation when we put new business on. We did something very straightforward and that is we appraised effectively the in-force dynamics of the business.
If you take a present value of distributive earnings plus the VNB or economic value added over a five-year period from the product you expect to put on plus a little bit of value for franchise but I emphasize that’s a variable that’s difficult to estimate the value of. But clearly there is franchise value there. We would estimate that calculation results in roughly a five to six time in-force EBIT valuation.
Interestingly, if you go back to pre-DAC calculations and look at what the allocated capital to this business is, okay, falls in right around $230 million, interestingly think of it as one-time’s book. So sort of a smell test if you will, to this notion of appraising the cash flows. And that was done at a 10% or 12% discount rate. So a way for you to think about the value that we’re building in that business and plopping that over our shares outstanding.
OCB, one of the things that attracted me to CNO was OCB in putting a shining a light on your challenges. Now, I've had people say, Fred that makes you a population of one, as to what attracted you to the company and but I really mean it. And that is one of the things I was very impressed with is back a number of years ago this segment was formed and it was formed and collected all the challenging blocks of business in the company to put a considered effort around managing it, and the goal is very simple, let stabilize the cash flows and grow them where possible, minimize volatility and surprises. And in doing so open up options to maximize these cash flows either by hanging onto them and redeploying or exercising reinsurance transactions.
What we’re doing on this slide is shining a harder light on it, let’s bring a little more transparency into it because we find there is confusion at times as to what is actually in this OCB of yours. In fact we run into a number of people who believe it’s a big long-term care block, which is obviously not the case.
And so here is the pie chart breakdown and the run-off of reserves in OCB. If you look at on the left-hand side, we give you some characteristics of the earnings and cash flow. And so interestingly if you were to sum it up in a punch line, effectively traditional life annuities and even long-term care in a modest loss position represent relatively stable net profitable businesses, and really the volatility and where the game is being played so to speak in terms of management attention and dynamics is on interest sensitive life.
And of course, interest sensitive life is sensitive to changes, and interest rates as you see and we talked about, but it's also sensitive to where we have been addressing non-guaranteed elements in a prudent way and where we have gone down the road to take action and settling litigation, such there is more clarity around go forward plan.
The strategy here again maximize cash flows, minimize volatility and we will in fact explore reinsurance, where it makes sense economically for the company. But it doesn't make sense in doing that if you still have the volatility or if you believe there is more work that can be done on the in-force blocks before one would entertain reinsurance.
Our tax asset is another important component of the story, very simply maximizing life insurance income and non-life income is the way to generate as much value out of these tax assets as we can.
But note that we also are engaged in other types of activities. For example, we’re working with the IRS on disputed items. This would be the categorization of past losses or gains, which have implications for our assets.
We also are exploring strategies to better utilize capital loss carry-forwards before they expire. Importantly, we have valuation allowance up for the downside of these decisions. In other words, there is not a negative surprise embedded in our balance sheet only upside if we were to resolve these things.
Economically, we value these assets at between $560 million and $600 million, depending on the discount rate you want to use I’d argue these are not particularly risky cash flows to create thus the lower discount rate.
If we were to get a favorable outcome with some of these items in working with the service, it could mean as much as $170 million of additional present value to the company.
Now be careful. I have valuation allowances up because it is indeed a challenge to work through these disputed items. Before you go running off and plopping them into our valuations. But, no, that we are working actively on it and we have of course disclosed actually a quite bit of detail on these items in our 10-Q.
Now capital, as you know we exercised the recapitalization here in the third quarter. It was quite compelling. It says a lot about the financial health of the company to reduce your cost of debt by over 200 basis points.
We’re tiring 17% together with our repurchased guidance this year, 17% of your diluted shares outstanding, and through your capital policies and greater financial flexibility driving upgrades and positive outlook from the rating agencies.
So, once again deferred question, question was, what do you think about me making it to investment grade, I think was the question from the audience. And let me give you, my point of view on that.
First, we’re dialing in financial ratios that we believe to be investment grade in nature, and that's not just simply because we’re trying to drive investment grade ratings. But it's actually the right way to be running the company.
So when we talk about leverage of 20%, free cash flow coverage are better than five times which I would argue is as strong as you will see in the industry, RBC of 350 recognizing the short and long-term mix in our business. We believe these are ratios that are consistent with the lower end of investment grade when looking at senior debt ratings.
But what’s the challenge? The challenge is we have a higher bar to jump over in terms of stability, improving out the stability of the model, the resiliency of the model. Also to be quite honest with you, the word long-term care doesn't do too much for your ratings or your stock price.
And as you know today, we spent quite a bit of time talking about and we’re talking about it because it is an absolute challenging business to run profitably consistently over a long period of time we get that. But as we talked about today, we’re very different in our makeup, but we've got to improve that out to all of you here and that’s management challenges and that includes rating agencies as well.
And then there is a growing recognition of do we or don’t we have the market presence to push this business model forward and that something we’re also working on with the rating agencies. It’s a good question. And it's one that hopefully you have more a feel of today from listening to Scott and the panel and others.
So very good capital plan and note the free deployable capital. Cash flow is one of the critical investment parameters of the company. We've reached the milestone RBC wise and so we’re no longer retaining capital and the insurance companies to build RBC, nor are we needing the voluntarily reduce debt because it being reduced normally. And so, leverage is in good shape.
And we are not looking to build additional liquidity at the holding company. We've got over $300 million at the holding company. And we would argue $150 million of that readily deployable, okay.
So question, deferred question, what about building an investment portfolio at the holding company, let me just tell you what our plan is. Our plan is no, okay. Our plan is, we’ve got about $50 million investment portfolio at the holding company and that's where we expected to remain. And we’ve got $100 million of additional fixed income and liquidity that is there for risk management purposes, ready liquidity. We have over $300 million at the holding company sell for that $150 million of deployable capital.
What’s interesting is, we may be one of the few companies in the industry that actually guides on free cash flow. And how should you think about it. Well, effectively, our statutory dividend guidance to the holding company is more or less free cash flow guidance.
Why do I say that? Because we were sending a $140 million a year up to the holding company in the form of contract payments through 40|86 and other service non-life entities, as well as surplus note income.
That $140 million covers my corporate expenses in lump sum, covers my interest expense on holding company debt and covers my schedule debt service that leaves me with the dividend capacity up to the holding company.
And then the issue becomes what you’re doing with it? In the pie chart on the right, there is a snapshot of historically how we’ve balanced the use of that free cash flow. I would expect that pie chart to be substantially similar as we go forward with a couple outlook comments.
You saw our press release this morning. It stands to reason that the portion called stock buyback is likely to be larger portion of the pie. We’d expect the dividend to gradually be a larger portion. We won't be going through additional financing costs this year. And we don't have voluntary debt payments that we’re going to execute on it’s more the scheduled amortization and suites.
But you should continue to see that balance. Once again we’ve got creditors in the room. We’ve got rating agencies in the room. We’ve got equity investors in the room. This pie chart is balanced for a reason. We want to get to investment grade. We want to drive the cost-to-capital down when the share price up. We’re going to take a balanced approach to it.
So, finally, in closing, ROE and shareholder building. So this is not aspirational, this is our financial plan. We just got done, working with our board and working internally to create a complex and calculated financial plan. This 9% ROE that’s being built off of a normalized 2012 is coming off of our financial plan.
We've rounded for ease of execution but by and large we find it somewhat equal weighted between business growth and capital deployment held back not surprisingly by a low interest rate environment.
But what it doesn't include is non-organic stairsteps. In other words this is an organic ROE build what else can management be attacking overtime. While one is the run-on, run-off of business, as Ed mentioned earlier. And certainly solutions around OCB and where that heads is a principle point of that. But don't lose sight of the non-organic ability to run-on business as well.
Recapitalization, The Sequel, this 9% ROE in 2015 is on leverage between 16% and 17%. If I have improved my ratings and I’m delever down to 16% and the markets are cooperating, there is going to be a sequel to the movie we showed last quarter.
And then operating effectiveness. Look we have a lot of the key building blocks in place. We have an underserved middle market. We have a product set that is simple and meet those needs. We have a very unique delivery mechanism. There is no question, if you’re listening at all today, you’ll walk away saying look, the combined delivery mechanism of Bankers, Washington National and Colonial Penn is unique, and uniquely aligned with the middle market.
However if caught on to it, yes, indeed, middle and back office needs to be efficient, effective, and we’re naturally complicated or complex, because we once upon a time were built up through acquisition.
Not surprising a fair amount of that complexity is actually zeroed in around OCB. Although there’s levers to be pulled there but they need to be done in the right way and don't lose sight the fact that we are in fact pulling some of those levers as we speak. We've been actively engaged at looking to simplify the platform where we can, some of that spend coming through our numbers today.
So with that, what I want to do is conclude there and bring Ed back up and Scott back up and Eric, and we’ll open it up to questions really anywhere across the company. Obviously, I'll take any financial questions you’ve got as well.
Again, [Mark Clony], Fred a couple of questions on your presentation. On your GAAP and statutory stress tests numbers, were the price increases factored into that…
… or is that steady state you don’t adjust…
… your book of business at all.
Yeah. Yeah. And it’s really a static test, okay. So couple things to know about that page is I zeroed in on what I would call the pressure point and really more acute capital reserve impact items, okay. And so, it is specifically those two categories the reserve interest sensitive life and long-term care that are more acutely exposed to changing your new money rate.
And we did not play around with, but here is the drop down box of four or five -- clinical management actions that will somehow mitigate. It was at the flat out calculations. You dropped that new money rate in, you run your models, what is it telling you?
Now, remember asset adequacy reserve or cash flow testing that that is a slightly more judgmental approach right. That is your appointed actuary on a legal entity by legal entity basis assessing the margins and realize you can carry some margins over to other within the confines of life or health business to make the judgment costs to what will I need to do to shift money from capital to reserves to support my opinion at the end of year.
Don’t lose side effect then in already low environment coming off a 2011, we passed all of the so-called New York 7 cash flow testing tests across all legal entities, okay. So we enter 2012 now cash flow testing and soon 2013 in another year, in a reasonably good position.
But the reason we have assets coming in or that statutory impact is because look, judgmentally, what my point actuary is saying is coming and saying, I suspect we’ll need to do some bolstering of reserves on these two product categories, if you hand me this stress test.
Thank you. And on your last chart, you gave us 2012 and 2015, but couple years…
… in between some of us may not make it through to get to 2015.
Help us a little bit and how we should think about the slope of the improvement…
And whether it’s going to be sort of incremental…
… share or…
I mean, I’ll…
… some headwinds…
… that put you behind the lift.
Yeah. I mean, let me give you a little bit of color, but let me just say that at the onset that we have enough math majors in this room that if I give you the explicit path I think you can back your way into a nice neat earnings guidance, suggested story right.
And so, look the first know that what I said is serious. This is in fact in our financial plan. Look, we may have one assumption cooperate with us and one assumption not. But what this is not is an aspirational bar chart. This is what the plan is, we may succeed, we may fail, but it is in fact the plan and it’s organic.
The path of it is, not surprisingly, Ed was up here, talking about $80 million of investment over the time period going forward over the next few years. And so you would expect that there is a level of investment followed by return, okay.
So there is a bit of sloping going on and so yeah, is it a linear path, the answer is no, we wouldn't intended to be linear, but should you see natural year-over-year progression, yeah, you should…
So if we…
… its not a hockey stick.
So if you’re ahead or behind the curve a year from now, I mean would you likely less that or…
I don’t think I need to tell you. I think it will be right there in the numbers. And look, if we’re doing our job disclosure wise, your models ought to be reasonably accurate. And so, we will be giving you the building blocks as best we can, but we’re reluctant to go down the earnings guidance route.
Thank you, Fred.
Chris Giovanni - Goldman Sachs
Chris Giovanni, Goldman Sachs. The ROE walk that you provided. So the, I guess, the stairsteps that, I think you categorize on the right-hand side of the chart, none of those are factored into the 9%.
Chris Giovanni - Goldman Sachs
ROE, okay. And then when we think about the stairstep that we just saw from the recap that added 40 basis points…
Chris Giovanni - Goldman Sachs
…or so to the ROE.
Chris Giovanni - Goldman Sachs
Is that the magnitude of stairsteps we should expect from kind of these three drivers that you talk about on the right-hand side or is that stairstep big of step.
Yeah. I’m honestly as we sit here today. My ability to put range bound ideas around what the order of magnitude around that could be, would be difficult to do with any sort of, I wouldn’t want to pin myself to that. But from a recapitalization standpoint that type of dynamic should not be viewed as unusual in terms of pure ROE benefit from a recapitalization.
So I suspect that sort of range bound in and around the territory. The operational effectiveness issue is really going to depend on a number of things and quite honestly it's a bit early for us to be putting any sort of estimates around that. That's why we have not put it in any sort of organic plan, until it’s baked, it aren’t in the plan.
And so that is going to be under development but we know enough about our platform and of course, we’ve brought on a new executive who came out of an industry where the fundamental value proposition of the business. He was CEO of was efficient operating administrative platforms. That was the calling card of the business. And so we've got some leadership around it. We are building expertise around it. We know there's opportunity, but we’re not at a position to size it.
And then the run-on and run-off, the only thing I would say is about this, when thinking about OCB, for example just understand that there are some natural rules of engagement, this is not CNO thing. This is actually what you tend to see when you see reinsurance driven transactions that that seek to accelerate the run-off in the current period.
You typically find that there is a gap charge of some kind, okay, relatively neutral to positive on a pure capital or say statutory basis. And then it's really all about what -- how does this change the trajectory or the thought process on the go forward numbers.
Did it reduce volatility and exchange for reduced growth rates? Were you able to redeploy that capital in the way that’s particularly attractive? But from day one you tend to have a boost in ROE but it drop in book value. And so the issue becomes, have you done something to improve the quality of your ROE as you go forward. Therefore, driving a better book value multiple on it, right.
That will generically be the equation that gets set up and looking at reinsurance. The $3 billion annuity deal we did in 2007 and the $3 billion long-term care deal that was done in 2008 had those types of precise dynamics surrounding it.
Chris Giovanni - Goldman Sachs
Okay. And can you just comment a little bit about how you’re thinking about the possibilities for the OCB block. You’ve broke down some of these are very earnings generative today? So how are you thinking about the possibility once we get through some type of -- what could it be?
Yeah. I think there is sort of this built-up anticipation that that these steps need to take place and then when will do ex. I mean, we are in constant communication with the reinsurance markets, looking for where they’re may or may not be a shareholder advantage or a financial risk advantage that is attractive for both parties to execute on, both within and outside of OCB.
So realize that the communication lines with that marketplace on various blocks of business, has always been in place. But we’re not in a position to do is talk about how something might get packaged, both how will get packaged or when it will get package.
And the reason is because that has a lot to do with not only progress we’re making but also the appetite on the other side among reinsurers. You'll typically find reinsurers have a very specific desire to go after a specific type of risks, because they have a lever they’re pulling on their balance sheet.
Sometimes it’s in administrative platform, motivation, sometimes they’re long more ship mortality, and want to get longer assets, sometimes long assets, want to get longer mortality, there is other dynamics right that come into play.
So right now, we’re not in a position to give, a precise roadmap other than to know by reducing volatility and maximizing cash flows, we open up more options, right. We create more interested parties and we create greater dynamics for what maybe -- maybe -- we maybe able to execute on, if, it's in our best economic interest.
Let me add a little bit to that is why the earlier question I got about the different opportunities, how would we rank them and weight them, very difficult, but there again, it’s more let's talk about our approach to be opportunistic to maximize shareholder value in that process. And it is -- I realize them answering in some ways in a rhetorical way, but go back to the breakdown of OCB, the different slices of that pie.
There is a fairly good sized slice of that that traditional life an annuity making money on a consistent basis. Now it will be a declining stream of income of course and it’s a run-off block. But there generally are a lot of interested buyers, reinsures for that.
The question is, pursuing something on that now, is that optimizing the valuable of OCB and CNO, half the answer, but that’s the question we’re trying to answer and say, we get an economic value of act for that, does that enhance or diminish the economic value of the remaining parts of OCB. It may or may not and that is the decision framework the we’re trying to go through as we consider different alternatives with OCB to accelerate the run-off.
Ryan Krueger - Dowling
Ryan Krueger with Dowling. I had a follow-up on OCB low end topic. How do you think about the interplay between a potential transaction and the potential additional recap opportunity in 2015? The reason I asked is because Fred you mentioned that, I agree that, obtain an OCB transaction would probably reduce GAAP equity, which would also increase your leverage, I think you think about that?
Yeah. I mean the way we think about it is. One, when you go into a fresh debt capital structure create a level of capacity, cushion and flexibility to execute on transactions that maybe GAAP negative, but capital risk management go forward valuation positive.
And so I like the fact that we are naturally delevering over time, because you're naturally introducing a level of greater flexibility and greater capacity to make those kinds of moves if necessary.
The other reason you want that room is because we’re living in an environment right now, where you have more acutely dangerous GAAP charges than you do statutory. But the simple reason that GAAP reserves and intangibles are often times predicated on best estimates as opposed to a severe stress test or cushion or pads. And so you want to have that room and flexibility.
And so understand that when we put in place the recapitalization we structured covenants. We created a good amount of financial flexibility not just because that's of course what every company wants, but we want to have the flexibility to execute on smart economic decisions that may or may not be your period GAAP friendly, that’s how we think about it.
Ryan Krueger - Dowling
If OCB were separated, do you think you could run the company at a higher leverage ratio?
Well, that’s, think about it, if one views OCB the businesses in there as more as having more capital volatility, it being the higher beta area of the company, then what you may give up in the way of a kick up in leverage, frankly a modest kick up in leverage from a reinsurance deal. You may gain in fact in an ability to have more consistency cash flows and earnings allowing you to have that additional leverage. So it very well could end up being in a corporate finance trade-off if you.
Ryan Krueger - Dowling
Okay. Then on the low rate scenario on the severe stress test, the amount wasted is that a 10-year timeframe, because I said indefinitely, but I assume it’s not, not forever?
Yeah. It’s basically plugging the new money rate into the long duration model of the products, long-term care and interest-sensitive life. So it actually strings out for several years, better than 20 going on 30 years of assumption.
Ryan Krueger - Dowling
All right. And just one last quick one, that share repurchases up to 50 to 300, does that include the $93 million of remaining converts?
Yeah. The way we think about it is, in part because the converts are so far into the money. That we really have what we would call, common stock equity and equity like equivalents of which the convertible when include in that.
So we are really in different. We’re agnostic as to where we deploy the excess capital. It’s a matter of being smart, opportunistic and assessing the relative economic trade-offs are going for one or the other.
But it's about driving diluted share count down, doing it within the band of we've got a quest to have a good solid capital structure and drive our costs to capital down and drive our ratings up.
Randy Binner - FBR Capital Markets
Thanks. Randy Binner from FBR. A couple more kind of clarification questions on the low for loan stress scenario. I guess one, I'm still not clear, I think it would be good for everyone to be clear on the timing of when that GAAP and statutory reserve impact comes on?
Yeah. The, well, here is the -- it sort of unclear for a reason, but let me give you some color on it, okay. So, GAAP, right, what is the trigger for doing something related to either the moderate or severe stress testing GAAP? The trigger is when it becomes in fact your best estimate.
So, for example, this year, when we brought the curve down, it was predicated on a couple very straightforward things. It was a Fed who said we’re bound and determined to keep rates lower for longer and it was an investment strategy specifically put in the play that said we are not going to do better than this new money rate, okay. And those two things kept the scale towards, hey, we’re going to adopt this new curve, right.
So what we’re going to do and in fact it's not even a management judgment issue, it’s what’s prescribed under GAAP accounting is each quarter, we make that same assessment. Now from a practical perspective, it tends to be annual in the industry and the reason for that is because one quarter does not make a best estimate.
So each year we take a very deep dive into, Eric, what are you doing with the assets and/or by the way having 40!86 is like having an economic department as well, what are you seeing in the estimates that are going on in the market, that action like yesterday and discussion what that may mean for a long-term rates, and that plays into our annual review. But the day you changed that best estimate is a day you take that charge.
Asset adequacy reserves and the statutory side of it, I would argue is a more gradual dynamic. In fact, interestingly we actually added, we didn’t talk about it, because it's not -- it’s a rounding error at best.
But we actually added $4 million of asset adequacy reserves, particular part of the business in the third quarter. Of course means nothing to our financial ratios but what it tells you is that that the appointed actuary is putting forth his or her opinion. They take that very seriously.
They triangulate into the right amount of reserves by a series of studies including the so called New York 7. And then they make that adequacy judgment call and that's why it's not uncommon for those actuaries to come into my office and say we would be more comfortable, if we could add some asset support to these areas and these areas and support of my opinion.
So we’ll tend to be more gradual. It’s not something typically where you wake. In fact I would be disappointed if any came, a bunch of our actuarial staff in my office in any given year and said, we’ve run the numbers and we need a $100 million. That’s not really the way it’s going to play out, right. As each year goes by in a low interest rate environment, you’re wanting to add a bolster to the some of that.
Randy Binner - FBR Capital Markets
Okay. And, so whether or not it's rapid under GAAP or gradual under stat, those would be the cumulative loss estimates out to 2022. So that’s an intentional kind of 10-year look, right?
Yeah. That that graph was really just meant to say, I didn’t want to drive you nuts by stringing out of…
Randy Binner - FBR Capital Markets
… 30 year graph, so that was PowerPoint mechanics.
Randy Binner - FBR Capital Markets
Okay. But it’s a cumulative number across the period, it’s not every year?
Right. Yeah. That’s right. Yeah.
Randy Binner - FBR Capital Markets
Okay. And then net investment income was not covered here.
Randy Binner - FBR Capital Markets
I don't think…
Randy Binner - FBR Capital Markets
… and so in the moderate stress test which is pretty inline with reality.
Randy Binner - FBR Capital Markets
… you lose $15 million, $30 million and then $60 million in each successive years, so it’s going to linear.
Randy Binner - FBR Capital Markets
Are there similar numbers you can share?
Randy Binner - FBR Capital Markets
For the more severe one or should we just kind of like incrementally...
Well, one, you have portfolio yields. You have turnover rates. You have an ability to model that. But what I tried to cover it was really on the slide prior, right. Really to say don't lose sight of the fact that $10 billion of my reserves are spread based where I’m taking action on crediting rates in the face of a bleeding portfolio yield.
Don’t lose sight of the fact that I’m in fact still intending on growing some assets under management, in particular to CNO it's been indexed annuity growth rates, which not only build assets but build assets with greater flexibility on the crediting rate side.
And don't lose sight that I’m building out investment strategies things like FHLB spread business. CLO business that drives both asset management fees, as well as spread income.
Alternative investment portfolio, which granted, we don't have a very big one, but we are building one and it’s at the holding company level and it expected to perform. That those types of dynamics go a ways to offsetting what otherwise would be a pure static modeling of your portfolio yields doing this, multiplied by a static assets, here is you know earnings rate.
So what we did in the third quarter is we said look, let’s go a few years out with this notion of a moderate stress test to show you how that believe it work if, I froze assets at the 2012 level.
So I didn't go, there were these tests, because I just want more acutely say look, here's a two blocks of business, here is what happens if I plug it in the model, this is sort of your balance sheet dynamics, which is I think in part the concern in the marketplace.
We have time for one more question.
Sean Dargan - Macquarie
Sean Dargan from Macquarie again. It sounds like you want to cap the size of the holding portfolio and I know Ed is not interested in running hot dog stand. So is there anything you would consider buying and switch you could the non-life NOL?
Yeah. To my earlier comments about M&A got to set our strategy, you think of not to say this is going to be or not be what we would acquire, but we have done that in the past PMA, wholly-owned distributor exclusive to us, that is a non-life company distribution, reaching the market that we serve. I would venture to guess there are other PMA type organizations out there.
So there are non-life types of entities that do fit with our strategy and also are in that sizing where we can self-finance it that way. But those are the screens. That to the strategy, be able to pay for it out of available funds and cash flows.
And in that though, we are not saying if must or must not be a life or a non-life entity. It’s going to be one or the other, but it’s not that one has preference it. What again opportunistically and strategically would make any sense.
What amount of tax benefit, we could drive, right. The -- give you an idea everyone percentage, if you take a growth rate of our earnings, the GAAP requirement is 5% growth rate for five years then flat in establishing your valuation allowance.
If you take a growth rate and just assume into perpetuity a growth rate of 5%, every 1 percentage point move in that growth rate equates to about an additional $50 million of net NOL value created.
And maybe on a present value basis something in the $15 million range. I think about that for a second, why would it ever make sense for us to do a risky less than strategic acquisition to create that kind of value.
So look it factors in to our thinking. It's an absolute piece of the puzzle that we bring to the table that is our tax position. But it’s never going to argue over and above does this thing actually makes sense to drive by the earnings in value.
So and sorry, we have to cut it off, but as you probably no one expect several of us will be still around here and we have hopefully demonstrated in the past and expect to continue it going forward to be available to you -- to meet with you in a proactive way to answer your questions.
So, hopefully, we did deliver on our objectives and you understand more now about our value proposition and why you should be owning CNO. Something we didn’t talk about, but I think is also very important is, we’re not a static, we don't have variable business and we don’t have business that gets impacted by AG 38.
So other factors that differentiate us we believe in a very positive way from a shareholder standpoint. We do believe that we are uniquely positioned. We do have that sustainable competitive advantage that does have barriers to entry as we’ve talked about. And we are focused on and committed to serving that fast-growing underserved middle-income market and hopefully you’ve got a better idea of how we do reach and serve that market, and add value to the enterprise.
So, with that, that unique market focus, we really do believe does drive value. It also coupled with our growth investments, positioned us, as we talked about to increase our sales growth rate from that 6% to 8% annually to 8% to 10%, and then to 10% to 12% annual growth, while not lowing down our deployment of capital and returning it to shareholders while we are also delevering at the same time.
We do intend on continuing our track record of execution. And it’s great to see so many of you that have been following, investing and lending to the company for several years that, hopefully we built up credibility by earning it through that execution and we’re committed to keep doing that and achieving this strategic milestone.
I believe, we really have turned another chapter and hopefully, you agree to that we are no longer CNO the project. We do believe we are CNO a compelling value proposition. And to the question earlier about at six or seven, we were screaming by don't put this in an acronym, but we’re shout out by. So, for that shout out, thank you for your interest and your support at CNO.
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