Edward J. Bonach – Chief Executive Officer
Frederick J. Crawford – Executive Vice President and Chief Financial Officer
Tom G. Gallagher – Credit Suisse Securities LLC
CNO Financial Group, Inc. (CNO) Credit Suisse Financials Forum Conference Call February 14, 2013 10:15 AM ET
Tom G. Gallagher – Credit Suisse Securities LLC
Okay we’ll get started here. I am pleased to introduce the CNO Financial executives CEO, Ed Bonach; and CFO, Fred Crawford. Under Ed’s leadership, the Company has undergone a very positive transformation and which we think has been accelerated as well since well regarded executive Fred Crawford joined the company more recently.
With that, let me turn it over to Ed.
Edward J. Bonach
Thanks, Tom and good morning everyone. Obviously forward-looking statements and some non-GAAP measures, but getting to the story, we believe we really are well positioned. We’d first of all define ourselves by the markets we serve, and that’s the middle-income market in the U.S. and primarily those 65 and over. And that’s an underserved market and fast growing now with the baby boomers having started the turn 65 last year.
The track record that we’ve got of execution hopefully is showing we’re not a one-hit vendor. We’ve been doing things over the last five, six years to position the company and continue to drive shareholder value. And in that, risk management is a key tenant of what we have been doing. We also have done refinancing and in September of last year did a re-capitalization as well. And we continue to generate a fair amount of excess capital that is in large part being returned to the shareholders in share repurchases and we initiated a dividend last year for the common shareholders.
So what really does make us a compelling value proposition and why should you be thinking of CNO in your portfolio, again it starts with, we define ourselves and are differentiated by focusing on a market. We’re not product driven. Our products are all priced quite tightly around the 12% unlevered after-tax return. We’re product agnostic. We’re serving the customers of that middle income customer.
We reached those customers with largely exclusive distribution. So, with that it’s career agents at Bankers. It is largely a Washington National, wholly-owned agency that has people also like Bankers going out, meeting with customers face-to-face in person. And then we have direct to the consumer with Colonial Penn, primarily with TV and direct mail advertising.
With that we’ve got a lot of pricing influence. We don’t have to have a product line getting pumped up and sacrifice returns because again we’re serving the customer annuities is a great example in that. We’ve maintained our pricing discipline. We have in some cases home products and some cases we reduce commissions in order to keep offering the product and getting our at least 12% return.
In the products, beyond that is that we’ve got a breath of product, pretty evenly balanced over time between life insurance annuities, which are only fixed and fixed index annuities, supplemental health, which includes medicare supplement as well as critical illness or specified disease and then long-term care.
We then have the alignment continue with our home office, back office. To serve that market, you’ve got to be geared to serve that market. You got to be focused on that customer base.
We have almost four million policyholders. We do tens of millions of transactions a year. And to do that you need to have an alignment with that home office and back office to serve that customer and then have a culture that really puts a ball around it. And that alignment is something that again we think is a sustainable competitive advantage to have that whole alignment from market distribution to the culture.
So what has that done for us? We have returned a great amount to the shareholders, 49% total return in the last year. But as time eluded in and to an introduction, it didn’t just start in the last 12 or 18 months. This started back largely in ‘06, ‘07, to where we really did reset our business mix.
Primarily what that meant is, to get out of the independent distribution of most products, like Medicare supplement and annuities, life, we didn’t have the right ability to compete there. We didn’t have either the scale or the ratings and the business we are doing was compromising returns that way. And it wasn’t focused on senior middle markets.
We also in that which is both business foundation, as well as financial foundation we de-risked the company. We sold through reinsurance $3 billion black of annuities, fixed and fixed index that was sold through independent distribution. That was largely out in this rental charge period. We did not see up side regardless of where interest rates were going to go and we're able to sell that via reinsurance in the competitive biding process, then about a year later towards the end of ’08, just over $3 billion as well of a close block of long-term care that we legally separated from by contributing it to an independent business trust in Pennsylvania, very much the kinds of businesses you are reading about in the headline meaning that a very rich lifetime benefits, inflation protection benefits, it was sold through independent distribution, all different kinds of couple of thousand product forms, and again contributed that to de-risk the Company and stabilize our base.
We have been investing in growth. We are one of the few companies to our knowledge the only company that has a growing career agent distribution force, but also growing in Washington National and Colonial Penn, and I will get back to that in a minute. And then the return to shareholders that I mentioned and have had a very good run since '09, but at the same time like I said 49% return last year.
So what are we doing and investing in the business? We have invested in productivity tools for our agents. We're investing in recruiting. We have expanded our branch and satellite locations at bankers. We have expanded into different geographic territories at Washington National, and we have added products. The critical illness product is the bread-and-butter of Washington National, we have introduced to bankers where test marketing, simplify the issue term in whole life at Colonial Penn at we just announced, we’re introducing, I’ll say the next generation of critical illness at Washington National which will include some accident coverage as well as covering for heart, cancer and stroke.
We have achieved already benefits of that and if you exclude annuities at Bankers of course with the low interest rates, they were selling over 20% on annuity sales. We actually grew sales by 12% as you see here over the last three years, an 8% compound annual growth rate in sale.
Here is another way of looking at growing the franchise. The stacked bars are the liabilities of our three core segment. Bankers Life in the dark blue, light blue, Washington National and then Colonial Penn. At same time, you see the liabilities of our runoff businesses in our OCB or other CNO business gradually declining; that’s important in improving and part of our walk to achieving 9% ROE by the time we get to the 2015 time horizon.
What are we doing though to accelerate this run on and run off, already talked about investing in that organic growth. We’re going to step that up over the next three years and I’ll talk about that a little bit at the end in more detail. But at the same time, as we continue to work the closed blocks in OCB, put in price increases in non-guaranteed elements where we can progress with outstanding legacy litigation on these books. We are reducing the beta over the volatility in that business, we are improving the stability and cash flows of that business, which gives us more options to ultimately look at accelerating that run-off through sale of some of that or all of that business or reinsurance which is in essence of the sale of that business as well that will help potentially even accelerate our rise in ROE to even higher levels.
So with that I am going to turn it over to Fred.
Frederick J. Crawford
Thanks, Ed. This next slide really talks about our, what we would call our normalized earnings trend or in other words taking our earnings over the last few years and pulling out significant items. The classic significant items would include things like litigation reserves or the one time effect of a change in an assumption embedded in our business and reserves. And there is sometimes redundancy or deficiency in reserves where there is a one-time adjustment. We do that to then show really the more normalized earnings trends in the company and that’s what this slide shows.
You could see it’s moving very much in the right direction. I would say at the base of this growth is really the slide we just came off of that. Ed commented on and that is the role on of good well priced product and the roll off of naturally lower return product that’s in our run off businesses. That certainly is embedded in these results. But beyond that we’ve enjoyed favorable benefit ratios overall in our three key claims driven businesses of medicare supplement, long-term care and specified disease. You know this is not just sort of a lucky period of time. This comes through properly pricing and very importantly properly underwriting of the business. It also somewhat comes to having a captive distribution agency that is able to be more disciplined in what they sell as oppose to the constant worry of competing on the shelf with other products and other providers.
So all of these things come together to provide a more consistent level of performance on the underwriting side and we’ve seen that really go nicely here in the last few years. Interesting byproduct of low rates as well as absolutely a headwind for the industry and for our company as well. It has an interesting side effect and that is the annuities that are on your balance sheet, tend to stay on your balance sheet. So persistency tends to remain very high. Why for the simple reason that there is nowhere else attractive to go with that money.
That allows us to hang on to those attractive spreads for longer, and it’s really contributed to preserving a lot of the net investment income that we have in the company despite the low rate environment. We’ve also recently started to create a little bit more of revenue and earnings stream at the corporate level, something you will know, if you follow CNO. We tend to carry much more of our excess capital up at the holding company level.
We do that for financial flexibility purposes, but we also do it because of its tax advantage at the holding company level where we have a lot of non-life NOLs that we want to take advantage of overtime. That corporate investment portfolio is starting to generate real returns, which are working to move the corporate segment, which we oftentimes don’t talk about as a driver of earnings, and it’s helping to really displace a lot of otherwise with the expense running through corporate.
So that strategy is building as well. And then we’ve been deploying our free cash flow. Interestingly just in last year alone, we spent over a $0.5 billion in taking out diluted share count. We reduced our diluted share count on these results by roughly 18% last year, and we continue to deploy that capital going forward, it’s a quite provocative part of our story of course. There are headwinds out there, of course slow rates which we fight against by having solid asset liability management practices, lowering the turnover on our portfolio and being opportunistic and smart where we go with the assets.
As a result, you can see from our recent results if we’re able to tune into our earnings call here a few days ago that we’ve been able to actually achieve new money rates that are right on our plan and preserve for the most part portfolio yields holding them relatively flat. That’s again net investment income being helped up by corporate strategies, being smart with the money, good ALM, low turnover et cetera, so reasonably successful there.
There are a couple of other headwinds to make note of, one is, in particular is long-term care. The good news and as Ed talked about earlier is that we have been re-rating the product now actively for the better part of five years or so. And that has gone a long way to preserve the healthy underwriting margins that I spoke to earlier.
But as that level of rate action slows, you naturally see persistency pick-up, and as persistency picks up our lapse rate start to reduce. You’ll naturally see a claim in the benefit ratio. I would characterize this as more a normal claim or expected claim in the benefit ratio and while we guided to it being a little higher as we go to 2013 than we’ve experienced historically.
Moving to the next slide, I’m going to dive into the engine room a little bit before I just get to the ratios, because these engine room comments are actually more important for the long-term help of the company. And by engine room I mean the product risk management and then cash flow testing results in the next slide.
So very, very important to understand about CNO is the mix of our product has everything to do with the successful cash flow that we’re generating as a company. We sell basic products and what I mean by that, is they tend not to carry secondary guarantees that require complex hedging strategies to execute on or where there is questions about, what future policyholder behavior may mean for the liabilities, we have established and the profitability of the product.
These tend to be tail type events that we can measure with more accuracy, which allows us the price with greater accuracy, and feel more confident in the 12% aftertax IRRs that Ed mentioned earlier. It’s not just about what the IRR is in our industry, it’s the level of confidence around it that matters, and that’s everything to do with the nature of the products and how exotically are or not.
We sell predominantly protection products. In protection products unlike certain wealth products benefit from the law of large numbers, just like insurance is suppose to do. The problem with wealth products as they often times get more difficult to manage the larger they get.
So a very good product set and very good product mix. We also have a nice balance of short duration and long duration meaning we have product that turns the cash flow very quickly, like med sub for example and we have longer duration products that naturally meet the risk management needs of our client based. That mix helps with the nice balance of statutory income to GAAP income, and ready cash flows, which we can redeploy in our business more actively, and which access a nice defensive tool, if we go through a credit cycle we can replenish that capital quickly, with free cash and capital built from these types of product mix.
We have a unique long-term care proposition and if were to sum it up in just a couple of quick statements, it would be quite simple. One is that it is a shorter benefit period buying largely than you would normally see in the industry far shorter. The duration in the portfolio is around 13 years, which is nearly half of what might normally see for our liability duration in long-term care, because our benefit periods are shorter. Once again also more predictable to price and less risk associated with it. We are able to ask the liability match for that same reason, which is important and we have been actively re-rating, which supports the older versions of product, that need more support given the experience we’ve had in that business and help with the profitability.
And finally as Ed mentioned we carved off the nasty stuff several years ago and don’t have that type of exposure as we go forward. All in all before put a product out of the door, we do an embedded value or appraisal of the product and this is actually part of the compensation of our distribution.
So if you are a distribution leader and you want to sell more product, and you walked into my office or into Ed’s office and say I have got a great idea, we are going to run a special, we are going to pump up the commissions and we are going to get a little bit more aggressive on the benefit and we are going to really do a great job on sales this year, that is going to immediately come out of the appraised value of the cash flows of what you are selling and you are going to for every dollar you make on sales, you are going to hit on the value of new business that discipline is enormously important to making sure that we are hearing to the returns that we put in our products.
Cash flow testing, this is a complicated slide, but we’ve been getting feedback from investors take me inside cash flow testing a little bit more, because we don’t understand it, so here is the results from this years loss recognition and cash flow testing. Loss recognition testing on the left hand side is a GAAP exercise and very simply the story is margins are there, they are larger than they have been historically in part because with the data counting we wrote down a number of intangibles across the industry. So, by nature you tend to have a well supported balance sheet on a GAAP basis, when it comes to this testing. But new business coming in also helps the margins obviously low interest rates have taken away from margins.
On a cash flow testing on the right hand side, all of our legal entities passed all of the standard scenarios requiring no additional assets by virtue of their legal entity testing. That’s a very important statement it means all the cash flow testing came out just fine. But there were winners and losers as you drill down into products. We did add a little bit of reserve to an interest-sensitive block that can run off but it was de minimis $5 million which is a rounding air in our capital management.
The bottom end of the slide really makes a simple point even though it looks a little complicated. It basically says that when it comes to cash flow testing and the adequacy of our reserves, you don’t have to worry about traditional life, you don’t have to worry about Medicare supplement, you don’t worry about interest-sensitive annuities or annuities in general. But there are two lines of business to pay careful attention to and that’s bankers long-term care business, because of the lower rate environment and interest-sensitive life also predominantly because of the lower interest rate environment and adjustments we’ve made to non-guaranteed elements.
So when you then turn to what is the sensitivity, so Fred show me the numbers. How do I get comfortable with how vulnerable is this? We did that in the form of our interest rate stress test. In other words, at the end of the day, it’s about these two lines of business and it’s about interest rates predominantly when it comes to – for the balance sheet and that’s why our stress testing was disclosed to help you get comfortable with how bad, bad can get. And if you recall those numbers, there are quite manageable from both a leverage perspective and a statutory RBC perspective for the company given the strength of our cash flow.
So the capital story for the company is best summed up by this slide. We adhere to very strict policies that we believe establish the company to reach investment grade overtime. Leverage at 20%, risk based capital of 350%, call liquidity of $300 million currently but a policy of $150 million. If you break that down as to where we ended the year, we ended the year with leverage of little under 21%. Why I am not worried about that, because I amortized my dept. so I’ll be claiming down below 20% naturally through the amortization of debt that’s naturally scheduled on a payment perspective. Risk-based capital ended at 367%, every 1 percentage point of RBC is $5 million of capital, that suggest we have an $85 million of room over our policy down in the insurance companies. I like that not because I intend to necessarily release it to the holding company for more at offers and nice cushion as I sit here watching interest rate environment unfold and the inevitable credit cycle that will come back in some version someday.
So I like a little bit of excess there. And then holding company liquidity of $300 million suggest the $150 million are readily available capital and therein lies our announcement of redeeming the convert. So very simply our announcement during the earnings call on redeeming the convertible securities, we don’t have an idea of how successful that’s going to be of course, we’ve dealt in premium that we believe to be fair for all parties involved and then we’ll see how it plays out. But if it were, for example, to be a 100% successful, it would be roughly a $195 million down payment towards our repurchase guidance of $250 million to $300 million.
We like taking down the convertible as a method of reducing diluted shares, because it is paid more financially flexible mechanism to do in part, it accelerates EPS and ROE. On the flexibility side of it, paying down the convert does not trigger any sweet provisions in terms of sweeping down in our debt.
So it allows a little more flexibility. It also is not included in the build over a basket that we have that actually defines capacity and our ability to repurchase stock. So we create more flexibility by taking down diluted shares in the form of paying tendering for the convert, so we like that aspect of it.
And then before turning over to Ed, this is really one of the primary value drivers of the company and it’s cash flow generation. And so, on the left-hand side of the slide on that left-hand bar we define cash flow generation very simply as statutory income before interest paid to the holding company on surplus notes and before contractual payments to both our assets manager and an administrative platform for servicing the business. Those contract payments and surplus note interest payments are represented by the dark blue bar or the $158 million last year, which is very important about that dark blue bars is the fact that it covers our interest expense nearly 3 times before you even get to statutory dividends.
Statutory dividends last year were $265 million, we have guided this year to between $250 million and $300 million, which by definition suggests the company to be comfortable in the rolling forward of its cash flow dynamics in 2013. And then we retain a bit of capital to support business growth, what's really interesting about that retention of capital is how small it is.
We can grow our business without a tremendous amount of capital and that's because both our distribution platform as well as the mix of products back to that slide are not particularly capital-intensive to support our growth engine as a company. So, a nice healthy position to be in. The use of that cash flow would be on the right-hand side, a mix very similar to last year where we would buy back stock, pay down some debt and obviously we're committed to building a common stock dividend over time. So with that let me hand back to Ed for closing comments.
Edward J. Bonach
Thanks Fred, the objectives that we have, we've touched on a lot of them here in both our remarks. But if you look on the left hand side, in the next year or so one of our objective is to really continue to grow sales, we expect our consolidated new annualized premium sales to grow by at least 6% here in 2013, we’re going to continue to expand distribution and add to our product portfolio. Fred mentioned the operational side in part because of the history of a lot of acquisitions in the past, but we’ve invested there with bringing in an executive that is over IT and operations that has had a career running business process outsourcing companies, so we had to do it in a way to meet customer needs and at the same time do it in an efficient way. And at the same time, we think we can continue to grow EPS, improve our ROE, the tender does help us to accelerate our pays there.
And as far as ratings, we are BBB rated right now with a positive outlook from S&P. We obviously had a good 2012, good fourth quarter, that was one of the things that they indicated. They wanted to see in order to be looking at upgrading less and get to this (4B) territory. And unless we forget, while the industry in general was getting downgraded over 2012 still, we recapped, we produced earnings and got upgrades from three of the four agencies with the fourth being S&P putting a positive outlook on us.
And we’re committed to the guidance we gave of $250 million to $300 million of securities we purchases in 2013. Now, looking out a few more years to 2015, we are planning to invest $80 million to $85 million to continue to grow our distribution and extend our reach to serve that underserved metal income market.
We do feel that we’ll accelerate the growth of our company and the run on, at the same time as I mentioned that with what we’re doing in our OCB segment, stabilizing that, improving the economics and cash flows, we think that it does give us the possibility to accelerate the run off through some type of reinsurance or sale transaction.
Enhancing the customer experience, you could say any business, it’s important to do that, but ours is, we think even more important, because we really do have so much information and control of that customer experience with largely exclusive distribution and focused on that metal income market, we can really use that to improve our persistency with customers, improve our ability to have referrals from that customer, and serve their extended families and households as well.
I think all of this using just organic growth and pricing discipline, we can get at least to a 9% ROE by the end of 2015. That does not factor in any accelerated run off transaction with OCB and does not include any type of non-organic acquisition which certainly we can entertain, but at the same time we’re focused on our core business, if we did an acquisition, it would number one need to fit into that quarter. Number two, our stock even though it’s had a nice run up in the $11 range, our book value excluding AOCI is north of $17, if you further exclude the economic value of our NOL, we’re still in that $15 range. It does not make sense for us to issue stock to go and acquire something. So that sizes it into something that we would have to self finance most likely out of our free cash flow.
And yeah, we do think with the credit metrics we have, the financial performance that by 2015 to be investment grade is very realistic and achievable and we have that as a goal primarily for the capital market flexibility. Another beauty of our business is it is not rating sensitive. We can continue to grow at an outpaced rate relative to the rest of the industry in spite of our ravings and with the investments that we’re making and expecting to make over the next three years, we believe that our sales growth should get to the high-single digit, low-double digit sustainable run rate in sales, so in that 8-12% range.
And as we announced in our December Investor Conference, we are looking to increase our payout ratio for common shareholder dividend to that 20% range hereby 2015. So with that, I’ll turn it back to Tom here for any Q&A.
Thanks, we have about five minutes of the Q&A. I’ll just kick it off with cash flow question. So Fred, if I have the numbers correct from that slide I believe it was $265 million of statutory earnings, $158 million of fees that are additive if I think about cash flow that’s fine toward the holding company and only $70 million or so, that needs to be retained in the subs to support business growth. I guess what strikes me is, $72 million is a relatively low number, certainly versus peers, who and it might just be your business mix it’s a lot less capital. And if all of those numbers add up, when we think out over the next several years, what is the amount, if it kind of get through all the covert buyouts, and whatnot and you get to kind of the steady state of leverage. How much if I add just very simply common dividends plus buybacks because your business model support, if you kind of pro forma that right now. How much could you do? When would do on an annual basis?
Edward J. Bonach
Yeah, I think just the way I would describe it is and we talked about this a little bit on our call is, right now, our outlook for 2013 is relatively stable capital conditions meaning, we would expect a repeat of these types of dynamics that you’re seeing in this the bar chart that was described on the cash flow. We’ve gone further to actually guide on that by guiding on statutory dividends of $250 million to $300 million, last year’s statutory dividend is being $265 million. So that suggest there to be a level of expected growth of things cooperate in that capital generation of free cash flow.
We think a kick up in the modest amount of capital held back to support growth in the business is actually a good kind of negative to that story. We obviously are hopeful, we could see more vibrancy come back into the annuity market, it’s an important product, it’s a profitable product for us, and it is a more capital intensive product. But what’s an interesting byproduct of the low rate environment and the re-pricing that has gone on in the industry to reflect the low rates. As low rate – rate intensive products also happen to be acid intensive, which also happen to be capital intensive, and so, you are naturally finding shorter duration products, getting more vibrancy than longer duration and it is contributing to somewhat to the denominator in RBC, in other words the required capital is not kicking up and soaking up your earnings, and not allowing your dividend as much.
Embedded in our ROE target of 9% by 2015 is the assumption of there being a relatively steady pace of capital creation and redeployment. We haven’t and we’d be reluctant to guide beyond 2013 on those dynamics for obvious reasons. I’d characterize the threats if you will as being really two-fold. One is low for long interest rates where we’ve really identified you how big that threat could be if you hold rates flat for the next five years or even if you drop them 50 basis points and hold them flat.
We outlined, in fact it is in the appendix of this presentation that you all have, but it’s really a repeat of the stress test that we did. That’s one threat. The other threat, of course, is the degree to which our credit market, or credit cycle comes back in. And that’s difficult to predict, but obviously, what I’m telling you is that embedded in the 9% ROE is active capital management consistent with the kind of capital generation we’ve enjoyed here this past year and expect to enjoy in 2013. But it’s also requiring some level of cooperation in the marketplace.
Tom G. Gallagher – Credit Suisse Securities LLC
We have time for one last quick question if there is one. Okay. Thanks a lot, guys. Appreciate it
Edward J. Bonach
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