CNO Financial Group, Inc. (NYSE:CNO)
Q2 2014 Results Earnings Conference Call
July 29, 2014 11:00 AM ET
Erik Helding - Investor Relations
Ed Bonach - Chief Executive Officer
Scott Perry - Chief Business Officer
Fred Crawford - Chief Financial Officer
Randy Binner - FBR
Chris Giovanni - Goldman Sachs
Tom Gallagher - Credit Suisse
Erik Bass - Citigroup
Humphrey Lee - UBS
Sean Dargan - Macquarie
Good morning. My name is Bradley and I will be your conference operator today. At this time I would like to welcome everyone to the Second Quarter 2014 Earnings Results Conference Call. All lines have been placed on mute to prevent any background noise. (Operator Instructions). Thank you. Mr. Erik Helding, you may begin your conference.
Good morning and thank you for joining us on CNO Financial Group’s Second Quarter 2014 Earnings Conference Call.
Today’s presentation will include remarks from Ed Bonach, Chief Executive Officer; Scott Perry, Chief Business Officer; and Fred Crawford, Chief Financial Officer. Following the presentation we will also have several other business leaders available for the question-and-answer period.
During this conference call we will be referring to information contained in yesterday’s press release. You can obtain the release by visiting the Media section of our website at www.cnoinc.com. This morning’s presentation is also available in the Investors section of our website and was filed on a Form 8-K earlier today. We expect to file our Form 10-Q and post it on our website by August 6.
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.
Throughout this presentation we will be making performance comparisons and unless otherwise specified any comparisons made will be referring to changes between second quarter 2013 and second quarter 2014.
And with that I’ll turn the call over to Ed.
Thanks, Erik, and good morning everyone. CNO posted another strong quarter and our business has performed well as we continued to deliver growth in sales, collected premiums annuity account values and earnings.
Consolidated sales were up 3% in the quarter and operating earnings per share excluding significant items increased by 28%. Our financial position remains strong and our key capital ratios are at investment grade levels. We continue to return capital to shareholders and repurchase $96 million of common stock in the quarter also we recently increased our 2014 full year guidance for securities repurchase to $350 million to $400 million.
On July 1st we successfully closed the sale of CLIC. As we’ve previously discussed the sale of CLIC is an important milestone for the company and should significantly reduce our risk profile, further sharpen management’s focus on our three core businesses and enhance the quality and stability of earnings going forward.
Our consistent performance, strong balance sheet and proactive approach to derisking our business continues to be recognized by rating agencies with S&P upgrading CNO to BB+ earlier this month, the ninth upgrade we have received since 2012.
At our investor conference last month, we highlighted some of the investments we’re making to increase agent productivity, expand our geographic footprints, introduce new products, expand our work site platform, increase back office operating efficiencies and enhance the customer experience.
They are important growth investments that should continue to enable us to drive sales growth above industry averages. While first half sales are below our full year expectations, there are several metrics supporting our confidence in attaining our sales growth guidance. Scott Perry will go into this in more detail later in the presentation. Despite the slow start, sales over the last 12 months have increased 6%, while collected premiums and annuity account values have increased 2%.
Turning to slide seven. We have had great success in increasing our operating earnings by proactively managing our imports business and continuing to invest in initiatives to drive growth. For the second quarter, operating earnings excluding significant items increased by 24% and operating earnings per share were up 28% as a result of our continued commitment to return capital to shareholders via stock buyback.
CNO’s capital generation capabilities are compelling. Since 2011, we have generated approximately $1.8 billion in capital and have been thoughtful and balanced in deploying that capital. Earlier this month, we achieved yet another milestone having bought back $1 billion in common stock and equivalents since we implemented our repurchase program in 2011. With the significant amount of excess capital at the holding company, expectations for continued strength in capital generation, financial metrics at or above investment grade standards and leverage of 17% I can assure that we are continuously monitoring the key factors that will determine the extent and timing of recapitalizing.
Let me now turn it over to Scott to discuss our segment results in more detail. Scott?
Thanks Ed. Bankers Life sales were flat in the quarter with a 13% increase in life and a 10% increase in annuities offset by overall lower sales of 15% in health which was mainly impacted by negative long-term care results. The overall agent force declined by 4% versus last year but it’s up 1% from last quarter. The agent force has been impacted by lower recruiting which was down 9% in the quarter.
Collected premiums for Bankers Life were up 2% in the quarter due mainly to increases in life and annuity products which were up 10%. Overall health premiums were down 4%, mainly due to the continued decline in mix shift in long-term care and the decline in Coventry PDP quota share premium as the program has converted to a fee only arrangement.
Embedded in our results for the quarter are trends that bode well for the long term economics of the business. With the mix shift we have seen towards life and annuity products, our average premium per policy increased by 10% and our agent productivity is up 4% in the quarter. In addition, our productive agents increased by 14% versus 2013.
While our first year agent numbers are down, the increased productivity of our veteran agents is driving improved retention levels which we expect to continue and eventually combined with recruiting results which we fully expect to revert chain historical norms will lead to a larger, more productive agency force. Finally, we opened an additional four satellite offices in the quarter and five year-to-date, bringing our total location count to 306.
Turning to Washington National. Sales were up 9% in the quarter with individual market sales up 11% and worksite sales up 3%. Supplemental health sales were up 12%, primarily driven by sales in the individual market through PMA. Supplemental health collected premiums increased by 6% and PMA producing agents rose by 17%, benefiting from improved agent retention during the quarter.
Moving on to Colonial Penn, we are pleased with the solid sales recovery that yielded 4% growth in the quarter. This growth was mainly driven by strong sales in both web and digital generated activities as well as in the new simplified issue term and whole life products.
During the quarter, we also achieved a 5% year-over-year improvement in the marketing cost to sales ratio, as a result of both improvements in our TV cost per lead as well as good progress made on our sales and lead generation diversification efforts. After a very challenging January, Colonial Penn has started to generate strong sales momentum achieving a 7% growth since February. This is very relevant since the competitive dynamics have not changed. The positive momentum is a result of multiple internal sales and productivity enhancement initiatives that were launched in February, and we expect that they will continue to generate positive results for the remainder of the year. Finally, Colonial Penn's collected premium and in-force EBIT were both up 6%. Colonial Penn continues to drive solid economic value for the company.
Turning to slide 11, our business segments are making strategic investments and overall we are pleased with the progress that those initiatives to help fuel growth in 2014 and beyond. At Bankers we completed the first phase of work on our new customer relationship management platform, which involves lead and appointment management and is now being evaluated by several pilot offices.
We also have now released new two day live classroom training course on advanced life insurance sales concept, which has been attended by over 1,000 agents and has become a regular part of our first year agent training.
At Washington National, we introduced our new critical loan with supplemental health product in the second quarter in 17 states for sales in the individual market through PMA. We are seeing strong market receptivity with policy sales exceeding expectations and higher average premium per policy as compared to the previous product offered in those states.
We're also on track to launch three new group products and an enhanced enrollment and benefit servicing platform later this year. Given the timing of product state approval and enrollment of voluntary benefits, we anticipate the impact of these developments on worksite sales to largely occur in the second half of 2015.
Colonial Penn is making strong progress on its four major initiatives. First, new term and whole life product sales are increasing and now account for close to 10% of total sales. Additionally, we continue with our web and digital efforts which are improving our marketing cost effectiveness and are a key components of our sales diversification strategy. Lastly we are capturing benefits in tele sales productivity with the full utilization of our new CRM system.
I'll now turn it over to Fred to discuss CNO's financial results. Fred?
Thanks Scott. CNO recorded another strong quarter on the earnings and capital front. If you adjust for the significant item, we recorded operating earnings of $0.32 per share. This quarter’s only significant item impacted corporate expenses and consisted of an adjustment to our agents’ deferred compensation liability of approximately $12 million. This adjustment is driven by the material drop in interest rates year-to-date and associated pension index used to value the liabilities. We take a mark-to-market approach to valuing these liabilities under GAAP and we have experienced periods of gains and losses in the past which we normalize out of our core results.
The majority of our earnings drivers performed at or better than expected, notably annuity margins overall investment results, health margins and bankers and life margins at Colonial Penn. Core capital ratios and holding company liquidity remains strong, we accelerated capital deployment activities in the quarter. We repurchased approximately $96 million of common stock and in the process we spent down some of our holding company excess capital. We closed down the CLIC transaction July 1st, raising approximately $220 million net of deal expenses, close to the $200 million after completing the recapture of the Bankers Life block from Wilton Re.
Before I leave this slide it’s worth noting that when comparing our sequential EPS development we moved back to fully diluted shares. The net loss from the sale of CLIC recognized in the first quarter required the use of basic shares in our first quarter EPS calculation.
Turning to slide 13 in our segment earnings. As discussed during our first quarter earnings call, of the roughly $5 million of residual overhead resulting from the sale of CLIC, Bankers in Washington National were each respectively allocated approximately $2 million in the quarter. Important when considering year-over-year results. Bankers EBIT benefited from continued strength in the Medicare supplement in annuity margins. While long-term care benefit ratios improved as compared to recent quarters. In terms of annuities, the combination of strength and indexed annuity sales solid persistency in spreads continue to feel strength and earnings.
Washington National posted another consistent quarter of sales and collected premium growth in their supplemental health business. However consistent with recent quarters benefit ratios were elevated. I'll touch on this in more detail in a moment.
Colonial Penn reported solid earnings and recovery and sales growth driven by cost effective marketing spend. Results also benefited from a modest shift towards direct mail which allowed us to DAC certain acquisition costs. Consistent with guidance provided at our investor conference we anticipate breakeven EBIT for the year, as we continue to actively invest in building enforce earnings and value. Corporate investment results were solid driven by favorable markets and tactical investment decisions that contributed to the strong performance.
Turning to slide 14. There were a few notable items that requite a deeper dive into the performance of our overall health margins. Again the diversity of net supplemental health, critical illness and long-term care affectively ensure a level of stability in our overall margin contribution. It would be unusual to experience favorable or unfavorable margins in all of our health lines in a given quarter, this quarter was another good example of that.
Med supp benefit ratios continued their strong trends coming in at 69% with continued growth in premium. Long-term care had a favorable quarter relative to recent experience with its interest adjusted benefit ratio dipping below 80% and better overall claims experience. It's too early to conclude that the activities, we outlined at our investor conference are having traction but we were pleased to see this improvement, note that premium continues to reduce as we run off more comprehensive and older business and replace with shorter term and more limited benefit long term care product.
As noted in our press release Washington National supplemental health performance was an area of weakness in the quarter. We have seen in recent quarters a slowing of conversion activity, meaning a policy holder who upgrades their policy resulting in a conversion and resetting of reserve patterns. This activity supported lower near-term benefit ratios, but was not favorable to the long-term economics of our business.
Together with related persistency and certain blocks of policies we see this dynamic continuing into the future and have adjusted our 2014 guidance to the 54% range for interest adjusted benefit ratios.
Turning to slide 15 and investment results while rates remain low and spreads are tight we defended new money rates by remaining tactical in our in our investment strategy. Tight ALM standards and low turnover creates a manageable flow of assets to invest allowing us to be selective and nimble in finding opportunity without sacrificing credit risk. As we did last quarter we highlight on this slide the approximate assets transferred as part of the CLIC sale overall asset levels in our core businesses continued to grow modestly. We had no impairments in the quarter and credit conditions remain very strong.
Slide 16 profiles our capital position. We ended the quarter with an RBC ratio of 437%, our RBC benefited from strong statutory earnings in the quarter of approximately 133 million which includes the results of CLIC. It’s worth noting that we will see reduced statutory income and a modest reduction of RBC now having sold CLIC. In addition we closed down the recapture of the recapture of the life block from Wilton Re, paying a recapture fee of $28 million and generating additional statutory income in future periods.
Leverage dropped 20 basis points in the quarter, despite more robust capital deployment. We ended the quarter with over $277 million of liquidity and investments at the holding company and we’ve sized our deployable capital at approximately $130 million. The sale of CLIC will increase holding company liquidity and excess capital in the third quarter by approximately $200 million. We provided updated share repurchase guidance during our investor conference. We repurchased a $137 million year-to-date and maintained our repurchase guidance range of $350 million to $400 million for 2014. We are in a strong capital position and remain dedicated to securing investment grade ratings over time although we believe it’s critical to unlocking additional shareholder value.
Turning to slide 17 and ROE development, our normalized operating ROE came in at the mid-8% range. We have been retaining high levels of capital in both the insurance companies and at the holding company.
When excluding the impact of OCB transactions, average equity is up nearly $270 million as compared to this time last year. This has obviously supported our ratings momentum but challenges ROE progression. In the quarter, the sale of CLIC had a muted impact on ROE given the trailing four quarter basis. In addition, recognize, you are not seeing the benefits of any reinvestment strategy on the proceeds and the life insurance recapture.
As Ed noted in his comments with strength in core capital ratios, the sale of CLIC behind us continued deleveraging, ratings improvement and favorable market conditions, we are weighing the value of recapitalizing the balance sheet. Recognizing that in some cases we are on positive outlook with the rating agencies, we are looking to drive economic value for our shareholders without sacrificing our desire to achieve investment grade ratings in time. This requires careful planning and consideration of all the variables outlined at our investor conference.
We remain focused on a few simple drivers of sustainable shareholder value: Investing back in our business to support growth; building ROE while lowering our cost of capital and related beta in our business; and effectively deploying excess capital.
And with that I’ll hand back to Ed for closing comments.
Thanks Fred. At our Investor Day last month, I highlighted some of the reasons why CNO is an attractive opportunity. First, we are market focused on the middle income market in the U.S. The middle market is large and underserved with the at or near retirement portion of that market in which we specialize growing rapidly. Our unique business model and strategic alignment of distribution, products and back office give us sustainable competitive advantage to meet the needs of the middle market. We are reinvesting in our business model to continue to drive sales growth above industry averages and to improve operating efficiency. We are generating significant amount of excess capital and have been returning a significant portion for that capital to shareholders without sacrificing growth or financial strength. We have a strong and proven track record of execution and success coupled with compelling catalysts to drive future valuation.
With that we’ll now open it up for questions. Operator?
Yes, sir. (Operator Instructions). Your first question comes from the line of Randy Binner.
Randy Binner - FBR
Good morning, thank you. I am going to try a couple on the potential for debt recap. I appreciate all your commentary on it so far. But just want to ask a couple specific ones if I can try to. The first is the on the issue of the make whole for the senior secured bond, our estimate is that it’s something like $20 million economically. And so the question is, is that $20 million a material on a money relative to all the other NPV considerations that go into this decision of how to best optimize the capital structure? Is that a big number in that analysis or is that a smaller number in that analysis?
Thanks Randy. Yes, and I think to clarify the $20 million you’re identifying is the difference between the make whole as it stands today and the call premium if you will that’s involved once we become callable in October 1st of 2015 at 104.7 or what have you. So I think what you’re saying is that, that’s the economic decision point or negative that you’re basing your approach on relative to simply waiting for October 1st of next year. The answer is it’s not insignificant. I would say that it is in fact somewhat of a driver of an NPV analysis. If you’re just looking at the economic benefit of just simply refinancing your debt structure, that make whole premium alone would make the economic outcome tight unless you did something like go offloading and bank on low floating rates for an extended period of time which would probably not be wise and definitely would not be favorable to rating agency discussions.
So if you sort of assume a natural consistency in the fixed floating mix that make whole actually wipes out any economic benefit even with our ratings progression. Keep in mind that’s in part because we refinanced our leverage loans at literally the low point in the market from an overall rate and spreads standpoint, so we don't enjoy much of an uptick there.
So then that leads you to well all the other economic considerations and non-economic considerations and really consistent with what we've been saying, what's happening is that pure refinancing economic decision which is a tough call, kind of a breakeven net negative is now starting to become more appealing as you look at other opportunities for lowering the overall cost of capital of the company by leveraging a little bit more being deleveraged. While looking at non-financial metrics like extending the maturity moving to a more covenant light structure and lowering the amortization which then freeze up additional free cash flow for redeployment at more attractive rates.
The other component of it of course that factors in as what's your view of intrinsic value of the stock and what's your view very importantly of where that goes, if that's part of the reinvestment strategy which is naturally part of recap. So the answer to your question is, it’s not insignificant, it actually very much hurts the pure economics of the debt structure, but it is very much on our radar because all of the other issues are becoming much more compelling for driving economic benefits overtime.
Randy Binner - FBR
Right, because with the stock at 17 bucks. The amount of market cap, you could potentially create. Is kind of get, in my mind it seems like you'll be a lot great than the 20 million, but here you on the refi side and I guess the other piece is, I think we've tended, always I’ve tended to talk about maybe there will be a levered portion of this recap. And you're very clear on that at the June day, you would have a more optimal leverage structure, but given the ongoing earnings here in upload, the holding company. If you were to optimize kind of cash and kind of this extra equity that’s holding ROE down would we think that some would come away from your liquidity buffer at the hold co and some might come away from your RBC and also some might come away from the lever portion of the recap, there is really kind of three buckets that could all be pulled down into whatever category you created to deploy excess capital, is that the right way of thinking is that all of those three areas could give me excess capital to manage?
It absolutely is the right way to think about it but let me give you my editorial comments on all three. First, editorial comments on RBC. Yes, we are traveling at a high level of consolidated RBC at about 437% no question. Now as I mentioned in my comments you have to sort of pro forma for our new RBC as we roll click the legal entity off of our balance sheet and move forward we would that to drag RBC down by about 5 points, give or take that’s roughly the pro forma estimate. And then you have to kind of be aware that I give you a nice neat and tidy consolidated RBC, but the way we as managers our RBC is on a legal entity by legal entity basis. I will just give you for an example Bankers which arguably has the low for long interest rate risk and understandably the long-term care risk we run at about 380, which is a very strong RBC and perfectly adequate but quite a bit south of the notion of 437. We run Washington National higher in the mid-400s we run Colonial Penn similarly in the mid-400s and we covariance benefits that we calculate as if we were one legal entity it pops up into that 437 range. When we are working with the rating agency then frankly just watching our own risk management techniques, we have look at both measures consolidated and legal entity.
This is all by of saying as I would not count on a significant freeing up of excess capital down in the insurance companies. I think we've guided that will naturally travel down to around the 415 range. Yes, there is a little bit of excess in there, a little bit of cushion and ability to manage some additional money up, but wouldn't count on it.
When you go to liquidity, I think you haven't measured right. We talked about our deployable capital today, being about a $130 million, now you bring in net new funds of roughly $200 million after the recapture of the life block. And that somewhat sizes the type of available capital you have in liquidity and then it all comes down to leverage capacity. And that once again is a cost to capital decision, our rating agency dialog recognizing we're on positive outlook with Moody's, Fitch and A.M. Best and just good risk management, what do you think make sense.
What I tended to guide to is, I feel comfortable, we feel comfortable in the 20% range leverage, but we clearly have pushed that up at times to 22%, 23%. In fact the last recap we did, we pushed up a little north of 22%. But it was with the notion of amortizing down into something more comfortable.
What access the governor on leverage for us is not my earnings and free cash flow. The governor is on below investment grade and I'm saddled with the potential of refinancing risk, if I'm not careful. It takes absolutely nothing in terms of economic weakness in geopolitical matters to have below investment grade financial debt, gap out or even at times freeze out. And I need to be careful about what I'm putting on my balance sheet and what I'm rolling over.
One of the big ways we unlock future value down the road is by being investment grade stringing out our maturities having literally no amortization and more confidence in rolling the debt. That's when I can push leverage up a little bit higher and commensurate with our cash flow.
Randy Binner - FBR
Right and I appreciate it. And I'm now asking one more and I'll get back in the queue. Just on the covariance comment and then just also on the last piece about the kind of the broad basket of covenants you have had. Wouldn't the credit market be more likely to take an investment grade view if you will on those issues. I mean when they'll be more likely to like look at kind of give you the ability to have investment grade like covenants now? And the issue of covariance I guess that's not an investment grade issue, but aren't the credit markets more likely to take in the real benefit that covariance offers?
Well not mixing kind of covariance and market reception. Let me just speak to your question. Right now what we're seeing is relative historic tightness if you will between the relative pricing or spread between BB particularly BB plus and investment grade BBB flat or BBB minus. In fact at historical tightness which would tell you that this is an attractive time to be in that sort of that highest end of the blown investment grade range. And that's in fact contributing to why we are much more interested despite to make whole and looking at whether or not there is an economic benefit to recapitalization.
So one there is that dynamic and we need to be careful about that dynamic going away over time which it has. Interestingly historically it's been as wide as 500 basis points if you can believe that during the period credit markets. So we watch that carefully.
In terms of the structure of the transactions you are right. It is the case that we're seeing more what I call covenant light structures, light is the word used. And then it's also the case that it's possible to structure follow a provisions that allow you to gain some advantages once you do achieve investment grade.
But these are things that have been flow in market conditions, with recent geopolitical news for example we've seen a little bit of sell off in leverage loans and a little bit of widening and so forth. So these things have been flow over time, we have to be careful watch those markets. So, I agree with your comments but what it will never give us though is the ability to do those longer dated maturities and really later them out and it will not give us the confidence of being able to refinance that will and that’s the challenge.
Randy Binner - FBR
I appreciate all the commentary. Thank you.
Your next question comes from the line of Chris Giovanni.
Chris Giovanni - Goldman Sachs
Thanks so much. Good morning. I guess first question just around the sales environment and maybe bit soft sort of telegraphed at your Investor Day, a meeting to really now get kind of the top-end of those long-term targets to fall within the ‘14 target. So, I guess is that I guess based on what you guys are seeing the recovery in improvement that you guys talked about in your prepared comments, I guess how achievable are some of those targets?
Hey Chris this is Scott. Yes. I think we are thinking about guidance I mean clearly where we are sitting at this point in the year, I’d say we tend to guide for the lower end of our range. But we believe those that that is still achievable at this point. I mean, I think there is couple things worth noting, I mean at Bankers in particular one of the things that’s causing a little bit of the sluggishness is as we transition to more fully underwritten life insurance that’s a longer process time and so we actually have seen a -- our submitted business year-to-date is actually up 6% at Bankers. And we have a building inventory that is being, that has to work its way through the underwriting process and that’s going on. And that’s a change from previous periods as we see a larger percentage of our business fall into that fully underwritten category. So I think that's worth noting.
I think the second thing worth noting is Washington National is right smack on their target and kind of the higher end of their range. And Colonial Penn, well as I mentioned in my comments upfront, after January we’ve seen solid sales of 7% and we see some real positive trends there; conversion rates are strong and our lead costs, our television lead cost and clearance looks very good and we expect that to continue in the second half of the year.
So clearly getting to that range is going to assume that we get recruiting back to norm at bankers, it also assumes the strong second half with Med Sub, especially a strong open enrollment period and then continued progress in the areas that we’ve noted that have already shown strength.
Chris Giovanni - Goldman Sachs
Okay. And then what’s causing you to capture kind of the greater portion of the fully underwritten business?
I think that’s a very kind of purposeful move that we’ve made around agent training and development. So, there has been -- and it somewhat had a negative impact on our recruiting. We’ve rolled out a number of training and promotional programs starting in the second half of last year that our managers have had to spend a great deal of their time and energy focusing on. Those are largely rolled out and the systems are now running and so we’re expecting that our management focus can return to a more balanced focus between recruiting and ongoing sales management.
Chris Giovanni - Goldman Sachs
Okay. And then at Colonial Penn, you talked about in the press release about the shift towards deferrable marketing expenses which look to reduce some of the new business stream, just wondering can you talk a little bit more about some of those shifts, something you talked about higher TV marketing conversion but sort of the sustainability of that. And given the build out of the in force, are we possibly at a point where Colonial Penn at least on a GAAP basis could be an earnings contributor as early as next year?
Well, I don’t want to get too far ahead of ourselves. But clearly, we have made a purposeful shift to drive more web and digital regeneration activity and those can be more closely related to the sale and ultimately allow for deferability. Now that is an initiative that has been going on for about 12 months in earnest, so we expect that to continue. And over time we expect more balance and a shift from heavy reliance on TV lead gen to less heavy reliance on lead gen supplemented by web and digital activity and thus an increase in deferability.
Chris, just a couple of comments on EBIT of Colonial Penn. I mean we did have a very good quarter. I would say the combination of some favorable investments results that are allocated to Colonial Penn, a little bit of favorable mortality and the deferability. Deferability was maybe a 0.5 millionish type contributor to the EBIT in the quarter that the combination of those things probably helped out earnings in the quarter by about $1 million, maybe a tick over $1 million before tax, just to give you some color on that. Again as we mentioned, we are adhering to the breakeven concept for the year. Third quarter, you should note is seasonally, a quarter where we tend to run at breakeven to a small loss then recovering to break even or a small profit in the fourth quarter and therein lies driving towards a breakeven for the year.
As we go forward, that notion of in-force earnings build should continue in a steady and predictable rate, that's where we are focused in driving economic value. But the ebb and flow of our investment in the business will really then dictate the EBIT in any particular year and that’s subject to our strategic view of whether we like what is progressing.
Chris Giovanni - Goldman Sachs
Understood. And last one Fred, just for you. Thoughts on valuation allowances, I believe the third quarter is when you do your annual review of the valuation allowance pertaining to the kind of your earnings outlook in likelihood utilizing the tax assets?
Yes, I don't want to front run our process. But what we have been saying, particularly after an extremely active year of releasing valuation allowance and generating economics last year is that we would expect the traditional annual review as prescribed under GAAP to really, really calm down in terms of valuation releases as we go forward.
We have a natural assumed level of growth rate in earnings including non-life income in our current estimate. I can’t predict for you whether or not we’ll see something, but I would suggest you my expectation would be if we did, it would be very modest in the way of adjustments.
Chris Giovanni - Goldman Sachs
Understood, very helpful. Thanks so much.
Your next question comes from the line of Tom Gallagher.
Tom Gallagher - Credit Suisse
Good morning. First question is just on Bankers and what kind of spread you’ve been earning on the indexed annuity, fixed annuity portion of that business? Fred, is there a way we can think about where spreads have been finding, what the ROE is in that business and how big of the contributor that is to the 87 million of EBIT?
Yes it's a strong contributor to Bankers EBIT for sure and has been for a while, impart because we've been growing those assets overall in our annuity block both EIA sales as well as persistency has been tracking favorable. Keep in mind Tom that the type of distribution model that we have is quite beneficial in that regard we're not on shelf space so to speak nor are we where you get competitive issues and sort of exchanges in moving money around nor are we selling into an investment oriented group of individuals.
These folks are really focused in on the protection orientation of the product as well as investment returns. And so it's a very sticky predictable high quality business. That being said to answer your question, we have been travelling in a range of about 325 to 350 basis points of spread overall when combining the products traditional fixed annuity deferred annuity and indexed annuity.
We have been traveling I think a high level of spread, this is due to some very good investment results. And somewhat to do all those -- although would say modest the low volatility environment and related option cost et cetera.
So there are some things that are allowing us to enjoy a bit wider, so I would suspect that we're at the high end of that range and would probably normalize. In fact I can't recall if I mentioned this at the investor conference, but I am happy to mention it here and that as we gave some forward projections on things like ROE build and EPS build and in those projections we have a modest calming down if you will spreads over time which we would expect to normalize.
So that gives you a little bit of color. I think our assets under management if you want to call it or account value under management is traveling around $7.8 billion when combining both products.
Tom Gallagher - Credit Suisse
Now that’s helpful, Fred. And then would that wide of a spread I am assuming that’s going to yield something like an after-tax ROA in the low 100s, does that sound reasonable or my -- would you make any adjustments to that?
Yes, I’ll let you do those calcs so only because I haven’t been tracking it that way, plus I would need to kind of think through everything I want in there and not in their relative to expense loads. So, for example that spread I mentioned is not including any sort of provision for default expectations and so forth which I would normally do when thinking about long-term ROAs I’d also have to think about distribution expense and other dynamics that we have incorporated in our spread expectation. So Tom I don’t mean to avoid the question but I would suggest that you could do some of your own calcs and come up with an idea of how that’s working.
Tom Gallagher - Credit Suisse
Understood. And then -- and your comment on the margins or the spreads coming down a bit in the future is that more of a intermediate term expectation or is there any reason to think that might happen over the next few quarters.
Yes. I would say generally we feel okay about sustainability of spreads throughout 2014 but I would expect it to start to calm down as you get into ‘15 and ‘16 to more normal levels which would be more around the low-end of the range I mentioned.
Tom Gallagher - Credit Suisse
Okay. And then shifting gears to some of the other areas within Bankers, the med is up I know the 69.5 benefit ratio result this quarter is roughly in line with your expectations, but a bit higher than it's been running at lately. And in anything particular driving that and is that should we – is the expectation still there around the 70% level going forward?
Yes, we stuck to that guidance of 70% range and feel like of course this quarter is very consistent with that. You've seen in previous quarters that we have been traveling lower than that. And really what had been going on in previous quarters, although not outside the norm we've seen these levels before is a level of redundancy in the number, where we reflect on our current, we reflect on the current performance and then pass reserving standards and make adjustments to the reserves according to how we see the pattern of performance.
Those redundancies although small and any particular quarter can contribute to a better benefit ratio or favorable benefit ratio and that's how we tended to describe it in this last few quarters as being favorable. We would describe this quarter as being essentially in alignment with our long-term expectations.
So no real deterioration if you will in terms of say claims activity or something going on that's causing deterioration it was really more about favorability in previous quarters due impart to little redundancy factors that have taken into the numbers.
Tom Gallagher - Credit Suisse
Okay. And the delta on long-term care this quarter. How you got some improvement there? And anything as you peel back the onion, was it claims, was it better NII, what was the driver there?
Yes, better claims activity. And then also slightly better persistency in nursing home inflation. As I've mentioned before Tom on previous calls, it does not take too much in the way of moment and persistency on particularly the more comprehensive product that was sold historically in past years, we bucket that in nursing home inflation, nursing home inflation is in and around a little north of $2 billion of our overall reserves and long-term care and it is the most sensitive to those dynamics. So we saw that improve just a little bit in the quarter and that will make a difference, but together and somewhat coupled with that is better claims experience.
Now what I would guard against is for the same reason when traveling at 81% I said not to worry we are sticking with our guidance, is the same reason traveling at 79%, I would say not to worry we are sticking with our guidance and that is we should expect to see quarters that are favorable and unfavorable on the margin given this business but that was the driver this quarter.
Tom Gallagher - Credit Suisse
Okay. And if I could just sneak one more in, the Washington National, the supplemental health and other what was driving the interest adjusted benefit ratio. Can you comment a bit further on the product that was a drag there and is that something that we should be just thinking about from an earnings standpoint, is there any potential balance sheet implications there?
Yes. I would not be concerned over balance sheet implications, impart because this particular business both stat and gap carries significant loss recognition testing and cash flow testing margins and relative to the product expectation. So we would not be concerned about that dynamic. This is really once again more about net favorability historically, historically meaning even previous to the quarters that we show on the slide here going back into ‘12 and early part of ‘13 where we are enjoying a level of conversion activity. And this is where we had certain incentives out there for agents to go back to policyholders, where we had previously sold them a critical illness policy and working with them to upgrade the policy based on their needs. And if the policyholder would have take these upgrades it would trigger a conversion if he will. And in doing so actuarially you reset if you will, the pattern of reserves going forward under the fresh policy. That resetting has the effect of releasing a level of reserves, even though it's not really an item that matters to what I'd call the long-term economics or life time benefit ratio if you will of the product.
It has the effect of more near term benefits in the benefit ratio and near term quarter to quarter earnings benefits. But it was not a good long-term economic approach to the business. So we then pulled back on incenting that kind of behavior, because obviously we want agents to create new households, new clients and be oriented around that, that's what we are trying to capitalize on the middle market.
That is in fact happening now which we're quite excited about, armed with a new product and incented to really drive new households. So, conversion activity has slowed and this ratio has [crept] up. And we think that's going to be sustainably at these levels, which is why we are re-guiding.
Importantly, it's not as if the product has misbehaved and now all the sudden we are not generating the returns we anticipated, when we first structured the product, it's really more returning back to the kind of policyholder behavior, we would otherwise expect in the product.
Tom Gallagher - Credit Suisse
Your next question comes from the line of Erik Bass.
Erik Bass - Citigroup
Hi, thank you. What is the timing for reviewing your GAAP interest rate assumptions for the long term care block? And if you could just talk about where new money rates are running today and what is your methodology for projecting future new money rates?
Yes. It's, first under GAAP Eric, we actually are required to take a look at what interest rates are doing in our best estimates each quarter and so we do watch what's going on. But your question is appropriate and that from a practical standpoint because you wouldn't typically on best estimate actuarial assumptions, move with every tick and tie of interest rate. You tend to make a deeper annual look at it and we tend to look at it particularly interest rate oriented look in the third quarter.
We do, do a little bit of work on assumptions in the fourth quarter as well. But historically interest rates in particular have been in the third quarter period. The timing of that has to do with really the timing of building up our log-term investment strategy to support our financial planning process. And we use that same material and that same view of the world that goes into our financial plan, goes into influencing our long-term assumptions for loss recognition testing and cash flow testing. So it tends to be third quarter. And that's where we’ve made those adjustments.
What I am seeing now and you can sort of see it in our results is that we’ve been able to achieve new money rates that are at or better than the assumption we had in place for this year. Interestingly, we’re also seeing a really decent portfolio yields overall as some of our investment strategies in past years, particularly around beaten down or discounted RMBS are starting to drive a little bit of energy in portfolio yield as well.
So we seem to be hanging in there. Now, as I mentioned at the conference and I am sure my friend Eric Johnson who is sitting next to me would say the same thing. Code yellow right, with tinge of orange on the overall investment yield for the same reason, we’re exploring or at least thinking through the dynamics of recapitalizing are the same reason why we’re challenged on the investment side.
Spreads are in and rates are low certainly year-to-date. And so we have to be very tactical to maintain these yields as we go forward. But so far through the first half of this year, we’ve been hanging in there with our assumptions.
Erik Bass - Citigroup
Okay, thank you. And then I guess if I could maybe circle back to your response to Randy’s question and I guess kind of a nuance in terms of how are you talking about the view of the rating agencies and wanting to certainly preserve the kind of long-term upward bias in your ratings progression towards investment grade. Am I interpreting it right? It sounds like you are a little bit less a convicted around that being the governor in terms of the timing of the potential recap given some of the other factors you’re looking at. And then you mentioned the upgrade from S&P but they obviously moved to a stable outlook and provided several targets for you to achieve which all look achievable but will take time. So I guess maybe how do you think about that variable?
Sure, I mean I break it into really two comments, one is sort of a longer term perspective on it on investment grade which is I don’t fundamentally believe that the ratios we’re operating at, the pure credit ratios we’re operating at are somehow holding us back from getting to investment grade. I think if you were to look at the combination of our RBC, our leverage, our cash flow coverage which has to be among the best in the industry and the credit conditions that we have been producing in the general account, you have to sort of conclude I would hope that we are safely in the investment grade category on those ratios, particularly when you realize we don’t do anything synthetically on our RBC like the use of captives and letters of credit and securitization; we don’t have hybrid securities in our capital structure that are debt but get equity credit. We don’t have any of that kind of stuff. What you see is what you get and I think that bodes well for our ratios.
So it’s not really about dialing in ratios, which means it’s really about franchise progress, stability, growth, certainly calming down and building a fence if you will around the risks profile of long-term care. It has to do with those dynamics in my view in terms of driving towards investment grade. So why would I hold up the efficient use of capital or the efficient capital structure for a rating agency outcome if it has more to do with franchise dynamics and risk profile of that business.
So that’s my long-term point of view. And I think we’re going to find rating agencies that are going to naturally want to take that much more time when we’re making the move to investment grade that would be to me understandable that they would take some time and some deep thought as they move that direction.
The more near-term issue to be careful about, so in other words, that's not holding a spec. The near-term issue to be careful about is that we're on positive outlook with some of these agencies. And you have to think about that for a second, you have an agency that sometime in the last six months has made the proactive move to put you on positive outlook with an intention that your capital structure is going to be managed in the certain way and if so, they will make a move on your rating and some measurable timeline, typically something like a year.
And so that just means by definition, we have to be careful to really work actively with the agencies all of them, even if not on positive outlook, but particularly for those that have a sound outlook to make sure that they understand, we are settling into ratios that remain very consistent with an otherwise strong investment-grade company. And that's really what I mean by deep consideration and working with the agencies, just that nuance of being on positive and not really warning to cause disruption in that progress.
Erik Bass - Citigroup
Got it. Thank you.
Your next question comes from the line of Humphrey Lee.
Humphrey Lee - UBS
Thank you, good morning. Just wanted to follow up on the Washington National supplemental health product, what percentage of the block has digital conversion and the return on premium feature and what is the average – life cycle for this product? Just kind of were to get a sense of how much it’s kind of elevated and the ratio for this?
At my fingertips I don’t have the percentage of the block if you will that has been subject to conversion activity albeit I know that once upon a time when looking at our new sales in a particular period let’s say pulled back to the 2010-2011 time period we would have as much as little more than 30% of our sales related to just conversion activity, more recently because of the adjustments we have made that I think sub 10% in terms of it’s contribution of sales, these are approximate figures. So I can answer that way in terms of the recent years and the amount of that activity taking place, I can’t really answer just simply don’t have the data in front of me on the percentage of the block.
What you do your second though is interesting to understand and that is that this dynamic is taking place on critical illness products supplemental health product with a return of premium feature and it’s typically the case on return to premium that there is a maturity data at which time that return of premium you now become eligible to take advantage of that return of premium dynamic and that is quite a long duration I am going to look to my partners here, but I believe it’s in the 20 year category I am getting nodding heads so around 20 years or so. And so what you have going on here is not just a slowing down or conversion activity, but very likely a slowing down of that activity and therefore more persistency on products that are reaching those dates closer to that maturity date. And as you could expect, as you reach closer to return of premium, your reserve start to accelerate and build in readiness if you will for that maturity date.
So, that's kind of the dynamic that's happening. When we talk about persistency in certain blocks of business, it's literally the vintage of those policies, keeping closer to those anniversary dates where the reserve build starts to naturally pick up a little bit more steam as we get closer. If those policies persist more, you'll see some elevated reserving and therefore weighing down on a benefit ratio.
This is again, over the life time of the policy, this isn't necessarily a problem and that, it was anticipated that if you offer a feature like this, this should be the dynamic of the policyholder behavior. So, it's less about return dynamics and more about the near term quarter to quarter earnings dynamic.
Humphrey Lee - UBS
Alright. This is helpful. Shifting to I want to push on sales a little bit, I think that was being comfortable with achieving the low end of the target. I mean the sales growth target for 2014. But when I'm looking at Bankers and loan yield, it seems like if you want to get to the low end of the target, you probably have to throw roughly 10% year-over-year for the second half of the year. So as Scott mentioned at there, in a pipeline there is some kind of policy underwritten, but not probably I mean in the pipeline that have been released underwritten. So that could be some pickup in the second half of the year. But kind of in general are there any initiatives that you are planning to do with on how do you pick that to their close to 10% in the second half of the year?
Yes. I think the two things that are going on, one I alluded to the real very positive trends that we're seeing at Colonial Penn that we just expect to continue. So we have more spend planned for the second half of the year and we are experiencing rates that would bode well for that spend. The other thing we're seeing is pickup in conversion rates and converting those leads to sales.
And then this continued trend in -- of pick up on the term in Whole Life. So we expect those positive trends that are driving sales in the 8% range in the last few months here in the quarter to continue the second half of the year at Colonial Penn combined with the additional spend we have planned that's why we're feeling pretty confident about our ability to get to that range.
At Bankers I would point to two things. One is we're confident that the open enrollment season will have a positive impact on both obviously our Medicare advantage activity which allows us to open a lot of new households. And then Medicare supplement activity tends to file strong in the second half of the year. We had a relatively soft half Med Sup activity in the first half and we expect that to reverse. I think secondly I think the recruiting activity we expect to pick up and help generate a positive open enrollment. Most of the decline that we saw or actually all of the decline that we saw and the softness in the Medicare supplement came from first year agent production. Actually two plus year agent production was up quarter-over-quarter. So which expect as recruiting gets back historic norms that Med Sup will benefit and then Med Sup up will also benefit and then Med Sup will also benefit from the annual and election periods.
Humphrey Lee - UBS
Okay. That’s very helpful. Just one last question on the operating earnings was very strong this quarter. Was there anything special happening, I mean how should we think about on a run rate basis?
Yes. There were some special things happening in statutory earnings, statutory earnings of $133 million would be quite elevated from what we would normally experience even in a strong quarter. And there is a few basic things going on. One is Bankers statutory earnings benefited somewhat from movement in the equity markets including equity markets and volatility. I have mentioned this in the past, we experienced this in a quarter maybe a little over a year ago or so once before and that is there is a difference under statutory accounting and the accounting for index annuities on the options versus the benefits and the accounting for it. And in other words, the liability is accounted for -- under one methodology and the asset under another. And because of that difference in approach, you can have noise in your financial statements if the market moves more sharply.
With the S&P up around 4.7 or so percent in the quarter alone and volatility moving around, we benefited -- Bankers earnings benefited overall by the markets about $10 million, again this largely driven by statutory accounting dynamics, not necessarily carrying through to our GAAP results for Bankers. So I would take $10 million out of that.
In addition then and equally as important is we had various unusual items or one-time items including items that were part of preparing for the sale of CLIC and the accounting, if you will for various internal reinsurance transactions that serve to pump, if you will the actual reported statutory earnings in the period by about $12 million. There is an offsetting entry that runs through capital, but it just has the optical illusion pumping of your statutory earnings up a little higher.
So I would place the normalized statutory earnings at closer to the $110 million in the quarter. Now you need to do one more step which is back to my comments, my prepared comments on the call and that is you actually have to remove the actual earnings of the legal entity that we’ve sold to Wilton Re as we go forward. And we again put that in and around the $10 million territory and therefore we would say pro forma normalized earnings is more in that $100 million range. Hopefully that’s helpful.
Humphrey Lee - UBS
Got it. Thanks.
Your final question comes from the line of Sean Dargan.
Sean Dargan - Macquarie
Thanks, good afternoon. Just going back to Bankers LTC, the rate of year-over-year decline in earned premiums is a little greater or has been a little greater than the 4% that was guided to. How should we think about that trending over the rest of the year?
Best I can tell Sean is that it’s going to trend similar to the way it has been. As I mentioned in my prepared remarks and this has been going on for a while now. As we simply have more comprehensive product rolling off, the combination of voluntary persistency which is quite low and then mortality which is a more meaningful component to our run-off given the average age of our policy holders tends to be quite a bit elevated compared to the industry.
And so, we have a natural rolling off of more comprehensive product. And what we’re putting on our books is shorter term and therefore less premium per policy product. Also of note of course is as we’ve said, we are relatively weaker year-over-year in the sale of long-term care insurance even the short-term care category and that has a lot to do with the just simply the challenging market dynamics of selling long-term care business that meets our return expectations.
So it’s the combination of those two things that maybe causing a bit more a tick up abd run off of premium but it’s really the same story.
Sean Dargan - Macquarie
Got it. And as we think about the noise in the corporate segment regarding the fair value of liabilities is the if we got an uptick in interest would the impact be roughly the same as it was this quarter on the way down or how should we think about that?
Not too far off but I can give you -- not too far off from a magnitude perspective but let me up or down but let me give you some color on what we are doing here. We take a what’s called a fair value approach to the liability, I use the term mark-to-market but it’s really more technically a fair value approach. We use the natural Citigroup pension index to establish a corridor, that corridor tends to be in and around 60 or 70 basis points wide, where we watch that index and how that index is moving, how that corridor moves relative to our valuation rate.
And so think of it think way, each quarter we mark-to-market if you will or update that corridor and if we fall outside of it up or down, we will make an economic adjustment or a fair value adjustment to the liability. The reason I walked you though that is that you should not anticipate that every 10 basis points of move in the treasury, and therefore presuming 10 basis points move in the index is somehow going to result in a gain or loss in any given quarter. We set it up so as to not be overly noisy, yet still be consistent with what we believe GAAP and the FASB and others expect you to do on these liabilities which is be more fair value oriented.
So we more conventionally look at this annually. That's really when we look at it hard and at year end typically as part of fourth quarter review. But what we have is a corridor that says, hey, it's in the interim however rates move to a point of busting to corridor then we really need to move more quickly to adjust our liability which we believe is what GAAP and FASB wants to do. That's what happen 50 basis points drop in the treasury, the index dropped accordingly, it busted outside the corridor and we marked to market.
Sean Dargan - Macquarie
Okay, great. Thank you.
And there are no further questions at this time.
Thanks operator and thanks for all the questions and thanks everyone on the call for your interest in CNO Financial Group.
Ladies and gentlemen, this does conclude today's conference call. You may now disconnect.
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