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CNO Financial Group, Inc. (NYSE:CNO)

Q2 2012 Earnings Call

July 26, 2012, 12:00 p.m. ET

Executives

Scott Galovic – VP IR

Edward J. Bonach – CEO

Scott R. Perry – CBO, President Bankers Life

Eric R. Johnson – CIO

Frederick J. Crawford –CFO

Analysts

Ryan Krueger – Dowling & Partners Securities, LLC

Randy Binner – Friedman, Billings, Ramsey

Paul Sarran – Evercore Partners

Chris Giovanni – Goldman Sachs

Erik Bass – JP Morgan Securities, Inc.

Sean Dragan – Macquarie

Operator

Operator

Good morning. My name is Hatty and I will be your conference operator today. At this time, I would like to welcome everyone to the CNO Financial Group’s Second Quarter 2012 Earnings Results Conference Call. (Operator Instructions)

Mr. Galovic, you may begin your conference.

Scott Galovic

Thank you, Operator, and good afternoon and thank you for joining us on CNO Financial Group’s second quarter 2012 earnings conference call. Today’s presentation will include remarks from Ed Bonach, Chief Executive Officer, Scott Perry, Chief Business Officer and President of Bankers Life, Eric Johnson, our Chief Investment Officer and Fred Crawford, Chief Financial Officer. Following the presentation, we will also have several business leaders available for the question and answer period.

During todays’ 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. The presentation is also available in the investor section of the website, and was filed in a form 8-K this morning. We expect to file our second quarter 2012 form 10-Q, and post it on our website, on or before July 30th.

Let me remind you that any forward-looking statements we make today are subject to a number of factors which may cause actual results to be materially different than those contemplated by the forward-looking statements. Today’s presentation does contain a number of non-GAAP measures, which should not be considered as substitutes for the most directly comparable GAAP measures. You will find a reconciliation of the non-GAAP measures to the corresponding GAAP measures in the appendix to the presentation.

As a reminder, effective January 1st, 2012, we adopted ASU 2010-26, which modified the definition of the types of acquisition costs that can be deferred by insurance companies. We elected to adopt a new guidance on a retrospective basis, and accordingly, all prior periods presented have been retrospectively adjusted. The new guidance impacts the timing of the recognition of profits on our business, but has no impact on cash flows, statutory financial results or the ultimate profitability of the business.

Throughout this presentation, we will be making performance comparisons and, unless otherwise specified, any comparisons made will be referring to the changes between Q2 2011 as we stated for the DAC renouncement, and Q2 2012. And now, I’d like to turn the call over to our CEO, Ed Bonach. Ed?

Edward Bonach

Thanks, Scott, and good afternoon. CNO’s core businesses continued their positive momentum and performed well during the second quarter. Investments we are making in distribution and business growth continue to yield solid sales and earnings results. We reported net operating income of $54.2 million, which was up 22% over last year. Sales grew for the fourth consecutive quarter, and were up 6% from the prior year, primarily due to the increases in the sales of life and supplemental health products. These increases were partially offset by lower annuity sales as a result of the low interest rate environment and the product adjustments that we made during the year.

Scott Perry will touch on the sales details later in the presentation. Statutory earnings for the quarter were $97 million, up 23% from the prior year. Our strong financial position and our continued generation of cash and excess capital allowed ups to continue to buy back stock at an accelerated rate. As previously announced, the board of directors approved an additional $100 million for share repurchases, removed the combined repurchase authority outstanding to $172 million as of the end of the second quarter. Also during the quarter, the board approved initiation of a dividend program, and our first dividend payment was made during the quarter. This was a significant milestone for CNO, marking the tremendous progress the company has made through some of the most challenging economic conditions in our history, and also demonstrating confidence in our current and future cash flow and financial strength.

Our key metrics of risk-based capital and debt-to-total-capital improved further during the quarter. Fred will touch on these in more detail later in the presentation.

And finally, we continued to emphasize and focus on profitable organic growth in our three core segments. Reported net operating EPS in the quarter was $.20 per share, up from $.15 per share in the prior year. To enhance the understanding of our operating results, slide seven shows our operating EPS adjusted for one notable item occurring in both this quarter and another in the year-ago. Our second quarter operating earnings and operating EPS were the highest achieved in the last two and half years.

Slide eight shows our trailing four quarters consolidated operating return on equity. Trailing four quarters’ earnings, we’re up 6%, but this is outpaced by the increase in average common shareholders equity of 10%, resulting in ROE being down slightly from the prior year. Our statutory results, free cash flow and excess capital generation provide meaningful insights on CNO’s enterprise value. As we have discussed before, our levers to improve ROE continue to be layering on profitable new business at a minimum 12% unlevered after-tax return, effectively deploying our excess capital, improving OCB margins and continuing to improve efficiencies across the enterprise. While we have made progress in growing earnings, and as important, earnings stability, we have made even more progress in restoring the balance sheet and deleveraging. Having now achieved capital ratios consistent with upgrades, we expect continued earnings growth in capital management to contribute more to increasing our ROE. It’s also worth noting the ROE convention of reporting on a trailing 12-month basis somewhat masks the run rate progress we have been making in advancing ROE. This, of course, will eventually come through as we post continued strong quarters.

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

Our free cash flow is building, and slide 10 gives a snapshot of the 2011 excess capital generation and utilization at CNO. If you look at the information on the bottom of the slide, there is about $500 million that we generate annually in statutory gross income. That’s on a capital base of about $1.8 billion in our insurance companies, which equates to approximately a 30% return on statutory capital. About $155 million was kept in the insurance companies last year to support business growth and to increase RBC by over 20 points. We paid down debt by $145 million in 2011, and had approximately $90 million in holding company interest and expenses. In addition to those uses, we also repurchased $70 million of stock and added about $40 million to liquidity at the holding company. If you play that now forward to 2012, our voluntary debt repayments and RBC builder now complete, the continued strong statutory performance supports increased guidance for both insurance company dividends and share buybacks. We anticipate total-year dividend payments to the holding company in the range of $200 to 275 million during 2012, or roughly $100 to 175 million for the second half of the year, but we also anticipate repurchasing approximately $150 to 170 million of common stock during 2012, or approximately $90 to 110 million for the remainder of the year.

Our confidence in free cash flow is also evidenced by the initiation of a common stock dividend, based upon our expectation of continuing to generate strong statutory earnings and excess capital. And finally, we will continue our investments in business for additional growth, including distribution expansion and potential reinsurance recapture transactions.

So to recap, our continuing investments in distribution, growth and active management of the business inforce are yielding solid sales and earnings results. We expect to continue to generate free cash flow for reinvestment in our business, and returning capital to our shareholders through increased share repurchase activity and dividends. Our financial strength, profitability and credit profile continue to improve, as well as our generation of considerable cash flow and excess capital.

Let me now turn it over to Scott Perry to cover the results for our three quarter segments he oversees. Scott?

Scott Perry

Thanks, Ed. During the second quarter, we continued to improve performance in all three of our business segments where we are actively selling new business.

At Bankers, while total sales were down by 1%, excluding annuities, the remaining lines of business were up 11%. I will address our annuity strategy on the next slide. Our agent force continues to grow, our long term care business continues to show predictable and stable performance and our manager training program is in full gear. As of June 30th, we have hired 19 trainees and expect to hire an additional 61 this year. It is our expectation that these trainees will be ready to take over leadership of a Bankers location after approximately three years. This program will enable us to accelerate our location expansion by more than doubling the rate of locations we are able to establish through our normal, organic development process.

At Washington National, PMA sales have benefited from increased agent productivity and improvements in worksite. Washington National Independent experienced growth through increased wholesaling support and continued strong IMO recruiting. Sales at Washington National in total were up 15%.

At Colonial Penn, we have increased our investment in marketing and advertising, which, along with improvements in productivity, have produced very positive results. Sales for the quarter were up 22% over the prior year.

At Bankers, we experienced solid agent force growth of 9% during the quarter, which was driven primarily by improved veteran agent retention, which improved by 4%, and strong recruiting during the past several quarters. We finished the quarter at over 5,000 producers. The growth in agent force was especially encouraging as we battle a challenging annuity market. Annuity sales were down 35%, but overall sales were essentially flat. Regarding annuity sales, consistent with the industry trends we are seeing, fixed annuity sales are being negatively affected by the low interest rate environment. Additionally, as you may recall, in January we implemented a commission reduction to ensure that products sold meet our targeted return threshold in this low rate environment. Finally, during the quarter, in a move to stay ahead of developing sales compliance regulatory trends, we fully implemented a series of sales compliance process changes to strengthen annuity sales practices. We expect that it will take some time for agents to adapt to these new processes, and will likely in the short term cause some agents to shift their focus to other product lines. Given the current rate environment as the new norm, we believe the annuity sales levels we’ve seen in the first six months of this year are likely to be typical of what we’ll see the remainder of the year and into 2013. Sales excluding annuities were up 11%, as agents focused on other product lines within our portfolio to meet target market needs. During the quarter, we saw increases of 12% in life, 10% in short term care, 11% in med sup and 7% in long term care. Life sales benefited from two products that were modified and reintroduced during Q4 of last year. Universal Life, which increased 27%, and Single Premium Whole Life, which increased 35% during the quarter.

It is important to know that although NAP was slightly down in total, on a policy count basis sales were up 5% including annuities. This demonstrates the growth of our agent force and their resilience. In response to a challenging fixed annuity environment, our agency force has shifted focus away from higher premium per policy annuity sales to other lines. These other lines generally generate lower premium per policy, but our continuous pay products, which generate renewal income, which will be a long-term benefit to agent retention.

Besides life insurance, our new critical illness product is also being positively affected by this mix shift. Piloted late in the first quarter, critical illness has now been rolled out to about 50% of the addressable market, with favorable second quarter results. To date, it has accounted for 1.5 million in sales, of which 1 million came during the second quarter.

I would like to briefly reiterate some comments I made last quarter about the performance of our long term care business, the differences in the risk profile of the three products that make up this line, and our position in this market going forward. As I’ve reported, at Bankers, we’ve never offered group coverage. All of our business is career agent sold. We began implementing rate increases in 2006, and have increased over 50% of all of our inforce comprehensive and home healthcare policies over four rounds of adjustments. We sell to a lower price point, and we sell reduced benefit plans with shorter benefit periods and smaller daily benefits. Less than 5% of our total inforce policies, and less than 1% of our current sales, have unlimited lifetime benefits or limited pay options. Our average issue age is 67, which allows us to achieve tight asset liability matching to support reserves. Over the last six years, we’ve seen a dramatic shift in sales away from the comprehensive long term care product to a lower-risk short term care and home healthcare only coverage. The risk profile for short term care is considerably lower than a comprehensive product, in that the maximum benefit period is one year. This product now accounts for in excess of 50% of all of our long-term care sales. Finally, since 2009, we’ve been reinsuring between 25 and 75% of our new business, with a leading reinsurer. This helps reinforce our pricing standards and underwriting and claims procedures. We remain committed to offering this product to our target market, and are comfortable with the ability to continue to profitably manage the business.

Turning to Washington National, sales of our core supplemental health and life products increased by 18%. In the independent channel, sales continue to build momentum as we benefit from an increased focus on worksite sales. Recruiting in the independent channel was also positively impacted by the additional resources, as new producing IMOs increased by 26, or 24%, during the quarter. At PMA, sales were up 18%, driven by improvement in agent productivity, which was up 14%, and improved cross-selling of life insurance by both the consumer and worksite divisions. PMA agent count is 674, which is up 3% for the quarter. As a reminder, at Washington National, both channels, PMA and Washington National Independent, sell supplemental health and life products direct to the consumer and through the worksite as voluntary benefits. We’ve seen a continued improvement in the worksite sales environment for these products sold through both channels. For the quarter, voluntary worksite sales in total were up 23%.

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

We’ve completed a strong first half of 2012, and are optimistic looking forward. Our strategy is focused on the rapidly growing pre- and post-retiree middle markets that are being fueled by the aging of the Boomer generation. This market needs the simple, straightforward products that we offer to address the things they’re most concerned with – healthcare expenses, outliving their retirement and providing a legacy for their families. Our segments are well-positioned to meet these basic needs, whether through career agents, independent agents at the worksite or direct.

In all three businesses, the capital deployment initiatives we identified to accelerate organic growth are progressing and ongoing. Bankers will continue to increase the number of locations, and operationalize the field manager trainee program, both of which will increase our ability to grow our agent force. Year-to-date, we have opened 12 new locations, and expect to meet our goal of 15 for the year. While we expect sales of annuities to continue to be a challenge in this low rate environment, we are encouraged by the overall agent force growth, and our agents’ ability to pivot within the portfolio, which is evidenced by sales results of our new critical illness product and our life products. We expect this positive momentum to carry forward.

At Washington National, we expect the increased focus and progress in the voluntary worksite market to continue for both PMA and our Independent channel, as the additional resources we deployed continue to ramp up. We expect the strong recruiting of new IMOs to continue for the remainder of the year, with anticipation that we will see recruiting gains in the 20% range for eth year. To support geographic expansion at our PMA channel and increase sales in existing states through Independent, we have introduced supplemental health and life insurance products in 15 states plus Guam and Puerto Rico, for a total of 23 product rollouts covering six different products.

At Colonial Penn, we will continue to invest in new lead generation activity. We expect that lead-based spending will increase sequentially slightly during Q3, and will taper off during Q4 as a result of the presidential election. Lastly, we remain on track with colonial Penn new product launches, which are scheduled to begin in the second half of this year.

And with that, I will hand it over to Eric Johnson, who will discuss CNO’s investment portfolio. Eric?

Eric Johnson

Thank you, Scott. I’m beginning with slide 18. In the second quarter, we earned investment income of 351 million, compared to 345 million in this year’s first quarter. Our portfolio earned yield was 5.76% compared to 5.64% in the prior quarter. [inaudible] is holding down portfolio turnover to sustain portfolio yield. By way of reference, all other things held constant and our current level of portfolio turnover, each 100 basis point decline in new money rates results in roughly a 3% decline in investment income.

Our new money rate in the quarter was 5.25%. We allocated the bulk of this new money to high-grade corporates and [inaudible]. We continue to actively match our assets and other and our liabilities at a line of business level, and we continue to be well within our duration matching targets in every line of business.

Slide 19 lays out real-life gains and losses for the trailing five quarters sequentially. In the second quarter, we were roughly 32 million into the green. This includes 41 million in gross realized gain, partially offset by 6 million in realized losses and 3.5 million in others and temporary impairments recognized in earnings.

Going on to slide 20. Impairments remain comparatively low, at $3.5 million. I’d attribute this to satisfactory corporate fundamentals in the U.S., and more importantly, a stabilizing housing market.

Going on to slide 21. Our unrealized gain increased slightly, to 2.2 billion at quarter-end. This is primarily a function of lower rates; quarter-over-quarter as an indicator, the 10-year treasury yield was down slightly over 56 basis points.

Slide 22 illustrates our overall asset allocation, which was substantially unchanged in the quarter. Our asset quality remains good. Our invested assets were 90% investment grade a quarter-end, essentially unchanged. In industrials, the relationship of upgrades to downgrades has been relatively stable. In financials, downgrades were primarily driven by sovereign credit issues and their impact on core European banks. In addition, we had slightly more than 20 million in downgrades from California Redevelopment Municipal. These downgrades were the result of legislative changes in California reflected in the legal status of the redef agencies, and the possibility of a lower degree of independence from the state’s financial condition. Taken as a whole, boundaries had a three-point impact on RBC in the quarter.

Slide 23 is about investments in our holding company. Our first priority remains liquidity to support corporate capital management strategy. Holding company is invested principally in money market and core plus allocations, with limited leverage. We additionally maintain a smaller allocation to unleveraged equities and alternatives. At June 30th, the amount of unrestricted cash investments was 197.7 million. Net interest income for the quarter was slightly over $800,000. Gain loss for the quarter was approximately $5.7 million. Total return for the quarter was 43 basis points. Our fixed income allocation returned 3.15%. Our equity allocation returned a loss of 2.75%, consistent with the S&D index, and alternatives were down 5.94%.

Going on to slide 24. Taken as a whole, news in the economy, including U.S. consumer confidence in our labor market, changing U.S. GNP expectations and European sovereign risk developments all add to declining uncertainty and declining growth. The feds expect us to keep rates low for an extended period long after the market’s call for clarity concerning QE3. Credit spreads on the whole continue to grind tighter, with periodic [inaudible] wider. Recent equity market performance has demonstrated the possibility of volatility in risky assets, and low risk has outperformed. I suspect overall non-financial credit quality has peaked and fundamentals may have more downsides and upsides from here, excluding housing and real estate. We are certainly planning around low new money rates for the foreseeable future. Since income is a scarce commodity, it is becoming very expensive. This suggests to me that some caution is warranted. We are avoiding high beta names. We still also consider mortgages cheap, including parts of the commercial mortgage market. We expect to continue to fund at levels consistent with the company’s needs and objectives. And with that, I will turn it over to Fred.

Fred Crawford

Thanks, Eric. Operating earnings for the quarter came in at 54.2 million, or $.20 per diluted share. The quarter continued our record of solid earnings and capital performance, with little noise to speak of. Our book value, excluding AOCI, increased by 5% to $16.67 per share, and ROE grew by 20 basis points sequentially to 6%. Our debt-to-capital ratio, excluding AOCI, came in at 16.6%, down 170 basis points from year-end, a combination of retained earnings and continue debt amortization. Our consolidated statutory RBC ratio ended the period at 369%, driven by year-to-date statutory operating earnings of 183 million, and after paying 103 million in dividends. Unrestricted cash and investments held by our non-insurance subsidiaries ended the quarter at nearly $200 million, this after repurchasing 5.6 million shares of our common stock at a cost of $39 million, paying out on our quarterly dividend of $5 million, and paying down debt by $22 million.

Turning to our segments, Bankers’ earnings benefited from strong annuity persistency in spreads, offset by less favorable benefit ratios in our Medicare supplement and long term care businesses. While modestly elevated, benefit ratios were within our expected range. Washington National posted a very strong quarter, driven by sustained new business growth rates and favorable benefit ratios in our supplemental health product line. I’ll touch on Colonial Penn in a moment, but the segment’s earnings were largely affected by a seasonal reduction of marketing spend in the period.

Finally, our other CNO business segment earnings were down roughly $3 million, primarily the result of adverse mortality in the quarter. We have investigated the claims activities and seen no systemic issues in this runoff block. We did experience a concentration of larger claims, which we expect to calm down in future periods.

We used slide 27 last quarter to illustrate how DAC change impacts each of our four business segments differently. Focusing on Colonial Penn, we recorded a modest profit in the period, recognizing nearly all of their marketing and advertising costs are not deferrable. For 2012, there is an added wrinkle, given that we are in a presidential election year and it accelerated our investment earlier in the year. This disproportionately impacted the first quarter’s results.

As we look out for the remainder of 2012, we expect Colonial to record roughly break-even results for the second half of 2012. More specifically, we tend to have a seasonal buying pattern, so while fluctuating around break-even, we expect a modest loss in Q3 followed by a modest profit in Q4.

Turning to capital, we define capital generation as statutory earnings prior to taxes, surplus note interest and contractual payments made to the holding company. That number was $.5 billion in 2011, and on pace for a similar result in 2012. Note that in the first half of the year, we have retained nearly $80 million of capital in our insurance subsidiaries, building our RBC ratio by 11 points year-to-date, in addition to supporting new business. With strength in RBC build and stability in statutory earnings, we have revised upward our range bound guidance on statutory dividends for 2012 to $200 to 250 million, or roughly 100 to 175 million in dividends for the remainder of the year.

Slide 29 carries over from the previous slide and details our sources of holding company cash flow and recurring uses of capital. Surplus note interest and contractual payments to the holding company are essentially locked in and stable sources of cash flow. This slide really attempts to make a simple point, that our recurring sources of cash are enough to cover recurring uses, interest expense, holding company expenses and even scheduled amortization on our debt. This then leaves statutory dividends as truly free cash flow. You can see that our guidance on statutory dividends suggests we will most likely generate free cash flow significantly above 2011 levels. Thus, our increased stock repurchase authorization and guidance for 2012.

Slide 30 then looks back on 2011 free cash flow dynamics and seeks to normalize for conditions we’re experiencing in 2012. The waterfall graph starts with our 2011 capital generation and defines free cash flow by pulling out capital retained and insurance subsidiaries, and holding company recurring expenses. As we move through 2012, we do not have the need to build RBC, which required over $100 million in capital during 2011. With the retirement of our senior health note behind us, we are no longer dedicating free cash flow to voluntary debt reduction. We are also now subject to a reduced cash flow sweep of $.50 on every dollar of stock repurchase and common stock dividend. In short, free cash flow is finding a new level as we move through 2012 and into 2013.

Recognizing understandable concern over current low interest rate environment, we want to take some time to discuss our exposure to a low for long interest rate scenario. Before we discuss the stress test, it’s important to reflect on our ALM dynamics and investment results. As you can see from the table on slide 31, we run very tight ALM matching, within a half a year across all our product lines. This includes long term care, where our liability duration is shorter than most players in the industry, thus we’re able to purchase assets to support this business without making an interest rate bet. We benefit from a diversified product portfolio and our focus on serving the middle market through exclusive distribution results in both granular and stable liabilities.

We have been successful in investing at new money rates in excess of our management expectations and have slowed the turnover rates in our portfolios to preserve higher-yielding assets. Disciplined and at times opportunistic investment strategies, together with tight ALM and reduced turnover, have all combined to defend our portfolio yield as depicted in the graph at the bottom of the slide. An obvious question is have we moved out on the risk curve. Our recent new money investment mix has been overweight high-yield, discounted RNBS, emerging markets and select commercial real estate investments, balancing risk and return and consistent with where we see opportunity. We continue to maintain tight standards around all our overall asset risk classes, and have not seen any material increase in risk as measured by C1 capital to total invested assets.

The specific stress test was built off a 10-year treasury of 1.75%, and held new money rates flat for five years, then recovering slowly to an ultimate rate. This interest rate scenario is consistent with recent rating agency stress tests. The low for long rate assumption has the effect of reshaping portfolio yield, shifting down 25 basis points in year 10, and the ultimate rate down 50 basis points from current estimates. We divide the impact into two categories, the run rate earnings impact from depressed net investment income, and the potential one-time impact of adjusting GAAP and statutory reserves. If this scenario were to play out, we estimate a $5 to 10 million impact to GAAP and statutory net income in 2013, and 15 to 20 million in 2014. This represents a run rate net investment income impact to our current financial plan estimates for 2013 and 2014, thus compared to a recovering new money rate.

We then applied the stress test scenario to our GAAP models, which produced an estimated one-time reserve strengthening and impact to intangibles of $50 to 80 million after tax. In terms of statutory impact, we would expect reserves to be more resilient to a low for long rate environment, but see the potential for increasing asset adequacy reserves in the range of $20 to 50 million or roughly 4 to 10 percentage points of RBC ratio.

Overall, a low for long rate environment represents a headwind to earnings growth rates, but does not eliminate growth. GAAP and statutory reserve adjustments, should they be necessary, are manageable when reflecting on our capital structure, and we would not anticipate any significant disruption to current capital management plans.

Finally, we are well positioned to both withstand capital threats and are confident in our ability to execute on our capital management plans. Our near-term capital strategy is transparent. We have a bias towards using free cash flow to repurchase stock, we are managing our ratios to ensure continued momentum in our ratings, with the goal of achieving double D debt ratings from S&P, and BA from Moody’s.

As our financial strength and ratings improve, we are monitoring market conditions for opportunities to lower our cost to capital. We see capital deployment and the potential for opportunistically lowering our overall cost to capital as critical to driving ROE expansion. And with that, I’ll hand back to Ed for closing comments.

Edward Bonach

Thanks, Fred. CNO has a compelling value proposition. We have been growing and have above-average growth potential, as we are defined and differentiated by our market focus on the senior and middle-income market, which is both underserved and rapidly expanding with the Baby Boomers now turning age 65. Our risk profile benefits from active management and the diversification of our products, with the markets we serve mostly needing straightforward protection products. This is a product mix where a significant amount of sales convert quite quickly to cash. We are shifting gears to increase our capital deployment. CNO’s market focus, coupled with the alignment of distribution, products and home office to support our distribution, as well as our end customer, provides a sustainable competitive advantage for CNO. We are also winning with quality people, adding another seasoned executive in Bruce Boddy to our team.

In summary, we believe we’re well-positioned to continue to capitalize on our unique market focus and business strengths. And with that, I will now turn it to the operator to open it up for questions. Operator?

Question-and-Answer Session

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

Ryan Krueger – Dowling & Partners Securities, LLC

Hey, good afternoon. Thank you for the interest rate scenario, I have a couple of questions on that slide. First, on the gap and statutoriactual charges, how would you expect that to emerge over the three year time period? I guess, in other words, would you expect some impact each year, or would it just be more back end loaded?

Frederick J. Crawford

Really, at the end of the day, what you’re asking is, you know, at what point in time would we assess our assumptions and take a charge, and that is something that is very detailed exercise inside our company. It starts to emerge as we are building our financial plan because you would expect similar assumptions and financial plan that you use in the actuarial testing. And so, I am really not in the position to give precise timing and amounts – that will depend on that anlaysis network, and really, what we are seeing in the way of new money investing, what are reasonable outlook is for new money rates, and then we will make that call. So, what we have done here is simply said, look, if I hand you – if I hand you this assumption – you know, forget about the work you do to assess the appropriate long term assumption. If I just hand this to you, and have you install it, about what would be the range of gap impact? So, it’s important to know that this was a stress test, this was not trying to build an assumption for purposes of recognizing in our financials, it was simply a stress test so you all, as analyst, can get an understanding of how big an impact would be under certain conditions.

Ryan Krueger – Dowling & Partners Securities, LLC

Okay, understood. I guess, I have a follow up on the statutory side, the 20 to 50 million.

Frederick J. Crawford

Yes.

Ryan Krueger – Dowling & Partners Securities, LLC

I want to make sure that I fully understand what that is assuming. Is that – should I take that to mean that under the scenario that you presented, that you would assume 2.75%, 10 year treasury for the next five years, then grading up over time in your statutory cash flow testing, and that is what would produce the 20 to50 million?

Frederick J. Crawford

No, what it really – what really happens is this. So, statutory cash flow testing is somewhat prescribed, and the issue is as each year goes by, and I hand you a lower starting point, that eventually, those prescribed tests are eventually going to result in out puts that cause you as an appointed actuary to look at the margins you have under cash flow testing under the so called seven test. And that may cause you to thing to really feel more comfortable building back those margins by adding asset equity reserves. So, as each year goes by in a low interest environment, and you then conduct your prescribed test, plus all kinds of other sensitivities, what we are simply doing is, as a management team, is making a practical conclusion that there be certain lines of business within certain legal entities where it is more likely than not that an appointed actuary would want to build back margins to gain comfort in their opinion. We estimate that to be in the range of $10 to $15 million if this sort of low for long market place would persist over time. Does that help?

Ryan Krueger – Dowling & Partners Securities, LLC

Yes, that’s helpful, I guess just on clarification – if rates continue to be low past the five year time frame, would that necessitate additional TASO testing reserves, or would you already assume at that point basically, low rates for everybody [inaudible]?

Frederick J. Crawford

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

Ryan Krueger – Dowling & Partners Securities, LLC

Very helpful.

Frederick J. Crawford

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

Ryan Krueger – Dowling & Partners Securities, LLC

Thanks a lot, Fred.

Frederick J. Crawford

Yes.

Operator

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

Randy Binner – Friedman, Billings, Ramsey

Hey, thanks. A couple of follow ups also on slide 32, at the interest rate stress test – I guess, just the easy question is, I assume that credit spreads in this scenario would be unchanged?

Edward Bonach

Yes, that is right, we more or less – what we did is really – what we really did was we flat lined the money rates. Okay?

Randy Binner – Friedman, Billings, Ramsey

Yes.

Edward Bonach

And I’m expressing it using the basis of a 175 treasury so you can sort of frame it in your head as to what was the basis of thinking through your new money rates. But yes, it more or less flat lines – you know, holds all else equal if you will in terms of spread environment.

Randy Binner – Friedman, Billings, Ramsey

Okay, great, and then on the 50/80 on the gap, just to clarify, that is a combination basically of both DAC and GAP reserves?

Edward Bonach

It’s GAP, and – first, it’s not [inaudible], so it is GAP, and it is a combination of intangibles and reserves. Now, what happens to be the case with us Randy, just by nature of the business that we have, is it tends to be much more in the way of strengthening future loss reserves, and the reason for that is the particular lines of business that fall under most pressure when it comes to a low for long interest rate environment, in many cases happen to be in a loss recognition mode where by there, there isn’t much in the way of DAC to start with. That has actually implications for not only the mix of DAC versus ROTHLA reserve strengthening, but also the ongoing income run rate as well – it is why you will tend to find a low for long interest rate is much more of a net interest income dynamic for our company than it is a combination of income and DAC and LOC type work.

Randy Binner – Friedman, Billings, Ramsey

Okay, so by extension then, could I assume that the majority of that 50/80 would be an OCB?

Edward Bonach

There’s really two pockets of business that would be more sensitive to a low for long interest rate, and that would be yes to you your point – OCB interest is sensitive life and also a particularly older age bankers life long term care business.

Randy Binner – Friedman, Billings, Ramsey

Can you roughly break out those two buckets in the 50 to the 80?

Edward Bonach

You know…

Randy Binner – Friedman, Billings, Ramsey

Like how much – how much if it was 80 on the high, and would half of – you know, would 40 of it be OCB and 40 LCT?

Edward Bonach

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

Randy Binner – Friedman, Billings, Ramsey

Understood, and then just one more – and so, on the second part of that slide, that talks about the ultimate year 30, 50 basis point impact…

Edward Bonach

Yes.

Randy Binner – Friedman, Billings, Ramsey

I guess I’m just trying to understand what that is, and this is how I’m understanding it – is that – are you trying to say that there – if a 10 year as proxy for new money yields stay at the current level, not for 5 years, but for 30 years that year, basically your whole [inaudible] would go down 50 basis points, is that what the intention there is?

Edward Bonach

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

Randy Binner – Friedman, Billings, Ramsey

Okay.

Edward Bonach

When we install that new money rate into the models, it re-shapes the portfolio yield, and what this box is telling you is how is that re-shaping take place, and the way to think about is there is a modest shift down in the early years related to that assumption, and then it gets gradually more sever in the out years so that the portfolio [inaudible], so to speak, shifts down by roughly 25 basis points in year 10, and 50 basis points in the ultimate year. So, the way to think about it is this was not a full j-curve shift in every time frame, this was a shaping, a re-shaping of the j-curve by simply installing this assumption.

Randy Binner – Friedman, Billings, Ramsey

So, it kind of starts to look like a hockey stick instead of a J?

Edward Bonach

Really, what it really does is it takes the J and it basically flattens it out in the future years. So, it becomes kind of a hockey stick.

Randy Binner – Friedman, Billings, Ramsey

Yes, okay, sure, it flattens it is a better metaphor. Understood, thank you for the responses.

Edward Bonach

Yes, you bet.

Operator

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

Paul Sarran – Evercore Partners

Good morning. First to start, do you have any update on U. Nicholas case?

Edward Bonach

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

Paul Sarran – Evercore Partners

Okay, got it. Banker's Life and Annuity margins were described as favorable. Can you try to help us understand how they compared this quarter versus what you would expect on more of a run rate go forward basis?

Edward Bonach

So on Banker's from a margin perspective, one of the more principled drivers was really annuity margins year-over-year. And here's the dynamics at play.

First because of the low interest rate, there's good news and bad news about a low interest rate environment on annuities. The bad news is what Scott was talking through, which is a mix of a very difficult sales dynamic in the marketplace. The good news, but more particularly good news when you have exclusive distribution like CNO is that it's often the case that persistency will do better than you expected quite frankly because there's not a heck of a lot of other alternatives to go to with your money.

And so as a result, we've seen pretty decent persistency above what we otherwise would plan for. Meanwhile, we've been able to defend spreads in the business per everything Eric talked about in terms of our most recent investment strategy and very tight ALN management around those products.

So what we've seen year-over-year is a particularly strong result in out index annuity business where we have assets under management in that particular line are up over $.5 billion year-over-year. Deferred annuities are down around $200 million. So roughly a net $300 million of increased assets under management on our entire annuity business.

Meanwhile, spreads have held up nicely. We have been gradually ticking down crediting rates for all the reasons you would expect expecting the low interest rate environment. And that has accumulated to serve us well in terms of defending spreads.

And then meanwhile, we have been achieving pretty decent new money rates and therefore defending portfolio yields.

So as we go forward, the tight ANL management, the slowing down of turnover, being tactical in managing assets, we all feel good about that. But clearly, the environment is such that spreads are under pressure going forward. And the reality is that you do run into some layers of spread compression depending on the products we have on our books. But we are certainly doing everything we can to defend that, thus far successfully.

Paul Sarran – Evercore Partners

Okay, great. I wanted to ask a question on slide 31 about the duration match, which I appreciate the disclosures. I wanted to ask how you think about managing not duration mismatch, but convexity mismatch with the potential for pre-pays and calls in your assets and the potential for annuities to stay on the books longer in a low interest rate environment.

Eric R. Johnson

Yes, sure, this is Eric Johnson. The durations that you see on the page, I don’t have it in front of me, but I believe they're effective durations first off. So that we are modeling in on the asset sides of pre-payment assumptions with respect to whole asset classes could be RNBS, CMBS, ABS, callables, corporates, commercial mortgage, et cetera. So we're modeling in pre-payment assumptions that we think are market assistant and reasonable. And we true them up and check them every, quite frequently, and more frequently in every quarter.

And so that we feel we have estimates of future cash flows and have durations that are reasonable. And I think historically, we've been pretty much reasonably on the screws with respect to real cash generated compared to what we thought we'd generate in the portfolio over periods of time. And we do look at it retrospectively to see where we're offering so why.

And so obviously, we're receiving, our actuarial is producing quite elaborate estimates on the liability side on the reserve side with respect to the convexity of the reserves. And we do have policies, which you don’t see necessarily on this page, but which we manage toward around convexity management basically so that we understand that in different forward-looking straight scenarios, what is the potential effects not just on kind of the high level statistic, but kind of looking at actual line of business cash flows.

So yes, I think this a scenario we are very much on top of. And it has not to date proven to be a source of volatility in earnings or in GAAP earnings or in cash activity in the companies.

Paul Sarran – Evercore Partners

Okay. Thanks.

Eric R. Johnson

You're welcome.

Operator

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

Chris Giovanni – Goldman Sachs

Thanks so much. Good afternoon. I guess first question just on the operating expenses within Washington National. They seem to be running maybe $2 to $3 million lower, and sorry if I missed comment here in the call. What took place there and is this a sustainable level?

Edward Bonach

Yes, it's a good question, and let me just square it for you.

First, when looking sequentially at the expense line, we did have some litigation related reserve activity that took place in the first quarter that did increase the expenses there. At the end of the day, we didn’t call it out because there was a mix of other items taking place plus it wasn’t outside the overall expenses. We're not outside an expected range. But we were elevated due to that particular item in the first quarter.

When looking at last year's same quarter, we had merger related expenses. Now merger used to describe having combined certain statutory legal entities for efficiencies and so forth. But in the process of doing that, there are certain onetime costs that you have to undertake to get that done properly. And we took much of that cost through in the second quarter of 2011.

So from a comparability standpoint, it looks as if expenses dropped down, but you did have some noise in there. All by way of saying, Chris is that lost in all of this is the fact that Washington National has been proactively looking to manage expenses down and keep control of it despite the growth rates that they're experiencing.

And so I would view their expense level here in this quarter as not outside our expectations.

Chris Giovanni – Goldman Sachs

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

Edward Bonach

Well, so the way to think about it is that number is simply, that is a number that is after all surplus note interest payments made to the holding company. And it's after contractual payments made up to the holding company. It is strictly the dividend.

What I try to describe and sort of at three slide buildup was it happens to be the case as a company that we really cover our holding company fixed recurring expenses through those contractuals, surplus note payments, and contractual payments.

So if for example in 2011, we ran $135 to $140 million or so up to the holding company in the way of surplus note interest and contractual payments, that fully covered all of our holding company debt interest expense, our holding company expenses, and even went towards covering some of our actual debt amortization itself.

So as we move through 2012, not only do we have an increasing statutory dividend range of 200 to 275, but we're also seeing things moderate on the usage side. Meaning, we're seeing of course interest expense come down, and you can see that in our numbers as we continue to pay down debt. We have a much different cash flow sweep dynamic where we were living for much of 2011 in a dollar for dollar sweep on repurchase notes. Now it's $.50 on the $1.

We have a bit less in the way of mandatory amortization in total in 2012. And so all of those dynamics are boding well for free cash flow. Hopefully, that helps.

Chris Giovanni – Goldman Sachs

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

Edward Bonach

I mean clearly obviously our goal is to create a stable and building capital generation environment. And so a lot of different things can go on in terms of capital generation. And honestly, good and bad.

The bad is very evident in terms of whether you start running into credit related risk. As you've seen in our disclosure, while we view interest rates as a headwind, it still is a headwind of both statutory income numbers as well, so we have to watch interest rates.

But overall, when thinking about the threats to that, I don’t, right now, we certainly are trying to manage to reduce those threats. And you should think of our guidance on stack dividends as the confidence level we have in being able to execute on that run rate of capital generation.

We wouldn’t guide on statutory dividend ranges, particularly increased ranges, guide on increased share repurchase and initiate a common stock dividend if we didn’t have a level of confidence in the range bound risk profile of our capital generating model.

Chris Giovanni – Goldman Sachs

Okay, that's helpful. And then just lastly then, I guess this really points to I mean we're going to be sniffing sort of 12.5%, which is the next level of sort of the interest rates sweeps probably early next year. So should we be thinking about another sort of stair step up from a capital management standpoint in 2013 without putting sort of numbers around it? But theoretically, is that the way we should be looking at it?

Edward Bonach

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

And so as we start to build that kind of momentum in financial strength and ratings, and pending market conditions, that's more what I view as an opportunity for a stair step. That's what I'm trying to say when I say I believe our plan is transparent in that respect that these are management's goals.

It's not so much we're on a quest to drive leverage down to 12.5% because what you may gain in the way of freedom around free cash flow, you're hurting in the way of cost of capital.

Chris Giovanni – Goldman Sachs

Okay, that's helpful.

Operator

Your next question comes of line of Erik Bass with JP Morgan.

Erik Bass – JP Morgan Securities, Inc.

Hi, thank you. I guess first just

Operator

Your next question comes from the line of Erik Bass with JP Morgan.

Erik Bass – JP Morgan Securities, Inc.

Hi, thank you. First, just to follow up on, Fred,kind of your last comments; you were making – maybe if you could talk a little bit how you’re thinking about the capital structure longer term. with the improved cash flow that you could support a higher leverage than what you have? And, I guess, sort of related to that would you consider refinancing the back debt to kind of get those repayment requirements or eliminate them?

Frederick Crawford

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

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

For me, I think the right blend is something in that 20% range, and I think historically we’ve talked about 15 to 20% with the high side of that being dependent on what we see on the way of market conditions. The low side of that would be arguably inefficient, but would only be because we are seeing something in the dynamics of the marketplace that would suggest us to drive it down that low. Something in the way of a risk profile, which at the moment we don’t see those conditions. So that would be my collar around leverage.

So, one of the things that we need to be mindful of in our capital structure is: One, by virtue of having advertising debt and cash flow sweeps, and posting good quarters, we can’t help but continue to deliver as a company. It is somewhat formulaic as opposed to it being a management decision. And so, that’s the dynamic that’s taking place.

We also have a convertible structure on our balance sheet that certainly as the stock price continues to respond, it’s looking a lot less like debt. And so that dynamic is something that we think about, and we’ve talked to you all as investors about that optionality in our capital structure, as we enter into future years here.

So, those are the things that we’re thinking about. Your question on “would you ever consider”. Look, I would expect my team to be watching the marketplace and working actively with bankers and capital markets professionals for when there is ever an opportunity for us to advance the ball in the way of cost to capital and shareholder value. So, we never stop doing that. What I would tell you is that, because we’re progressing so quickly, so nicely, we have to be that much more vigilant on understanding what market conditions are, and whether we have an opportunity.

Erik Bass – JP Morgan Securities, Inc.

Great, that’s helpful collar. And just one other follow up, you have mentioned ongoing expense efficiency, other leverage (inaudible). I was wondering, is there any specific opportunities to point to, or kind of provide any quantification of what – kind of the magnitude of benefit out there?

Edward Bonach

Yes Eric, this is Ed. As far as other measures, certainly we’ve mentioned before the use of space, office space and moved the Chicago location twice in the last four years, and saved in each move roughly a million dollars a year each in run-rate expenses. So, we’ll continue to look at things like that.

At the same time, you know, the addition of Bruce (inaudible) to combine IT and operations, is expected also to increase our momentum that we’ve got there on efficiencies while still meeting our business needs and serving the customers, we think we can get an acceleration of the efficiencies there. But, as far as specific numbers, we’re not ready yet at this time to provide anything more specific.

Erik Bass – JP Morgan Securities, Inc.

Okay, thank you very much.

Operator

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

Sean Dragan – Macquarie

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

Fredrick Crawford

What I would say is, let’s just talk at a high level just generically about kind of where we’re at and what our dynamics would be. What our goal here is, is first let’s get to a ratings level that offers us an opportunity to find ways to attractively look at refinancing our capital structure. And that’s a very natural thing for us to be doing. Our basic strategy is, we think that is a more attractive opportunity at a (inaudible) As you know, we’re on review for positive – for upgrade with Moody’s. We do continue in serious dialog with Moody’s and S&P. It’s that time of year actually, to the review time of year. We think there’s more positive pressure to our ratings than stable or negative certainly. And you can see that in our results.

But the ratings agencies are the rating agencies, they’ve got a lot of things that they assess. They’ve have a process and we need to just work proactively with them. But as they do their work, and as we hope, we continue to be on the path of ratings upgrades, there’s an opportunity for us to go into lower coupon structures. There’s also opportunity for us to look for where we can gain more financial flexibility about those structures. And so, when we talk to the capital markets professionals, they will tell us that that is somewhat the sweet spot of the market.

Now, market conditions can also dictate issues, right. I think something every company needs to be mindful of right now, and I’m sure is mindful of, is that there’s likely to be more windows of opportunity then there are just study state long duration opportunities. And that’s because of what we’re seeing in Europe. So every week conditions tend to move around a bit. And so, I think most company treasury departments no matter whether they are below investment grade or investment grade, they are constantly looking for where there are maybe those windows of opportunity to lower the cost of capital, and that is what we’re doing.

Edward Bonach

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

Sean Dragan – Macquarie

Thank you.

Operator

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

Edward Bonach

Yes, thank you operator, and I want to thank everyone for their continued interest in CNO.

Operator

This conclude todays’ conference call. You may now disconnect.

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