Fred Crawford
Management
Thank you, Jimmy, appreciate it, and Arun, thank you also for the invitation. I very much enjoy this conference because it’s a nice balance of both equity investors and fixed-income investors. And particularly as a below-investment grade issuer of debt, which we are, both those constituencies are material to the company and so I appreciate you attending. The nice thing about, I think, these days the industry is – there tends to be a lot of commonality in terms of concerns on both the equity side and on the fixed income side. They tend not to diverge these days, they tend to be orienting around the same things and so hopefully my comments will help both constituencies understand better where we’re headed as a company. Please take a look at the forward stating commentary. I’ll let you do that on your own. The outline today is really the, first slide and essentially I just want to talk a little bit about the markets we serve which are quite unique compared to most in the industry and how we serve it is relatively unique. How we deliver our products, talk a little bit about where we plan to make investments in building out their franchise, some of the earnings dynamics and then a slow and steady build through the capital and I’ll explain as we get there starting with some of the deeper tissue actuarial dynamics building up through the capital of the company and then into where we plan to go with deploying capital. So first of all, what differentiates CNO? Number one, we are exclusively targeting the middle market and whether you read Conning research or LIMRA research or more recently McKinsey studies on the industry, our own center for secured retirement which is our own research institution inside CNO, no matter where you read it, you’ll come to the following conclusion and that is the middle market is underserved, it’s under-penetrated, meaning there aren’t many companies that are focused appropriately on that market and able to deliver on it. The middle market in general is unprepared for retirement and their protection needs. They’re ill informed oftentimes and they very much appreciate face-to-face contact and discussion on buying their products and all of these dynamics set up very uniquely for our business model. We have a controlled distribution platform, which we very much like because it allows us to control, among other things, the risk return profile of the products we sell and how we sell them. We are very diverse in the way we go at the middle market. So the Bankers platform, which is what we’re more well known for, 5,000 agents that sell product in and around a 25 mile radius from the some 275 branch locations that we have. It is a very localized kitchen table, middle market sales process that’s quite unique and quite resilient over the years. We have a roll-in farm oriented distribution outlet through Washington National and a small group, a very small group worksite platform out of Washington National and then many of you know us for Colonial Penn because you see our advertisements where we have a direct writer of largely end-of-life type expense life insurance, very small face amount life insurance and a very efficient platform. So we hit the middle market in a uniquely diverse way and in a controlled way which is what we think is one of the strengths of the franchise. And then we have alignment. Look, we sell simple products that tend to be protection-oriented. They are not targeted towards the wealth market for obvious reasons. If an individual or family has $250,000 of net worth or investible money, that is at the very high-end of the client base that we serve. So this is very much, people are literally buying our products, if you can believe it, for the actual insurance component in the product as opposed to the wealth component of it. They’re looking to protect themselves. And oftentimes, what we sell is really GAAP-oriented. Our client base can’t afford the full comprehensive coverage, whether it’d be longevity risk, mortality risk, morbidity, what we provide is oftentimes GAAP. You think of it mostly as Medicare supplement business, which is well known to be GAAP insurance. But the life insurance we sell, the annuities we sell are really not comprehensively handling the risk for the client. They are providing GAAP coverage for them. And that’s important because we have a very granular business, as a result, that helps with managing the risk, and we also have a lot of volume that runs through the company which means we have to be operationally efficient. Now, we have a very strong track record of execution. The culture of CNO, and I think it’s somewhat because of what we’ve had to work our way through over the years, is we see things for what they are and we go after it. It’s really quite straightforward. And so we tend to hard target specific actions that we expect to result in benefits. One of the observations I’ve made to the team joining CNO is it’s – it’s in many ways refreshing to think of an idea in the first quarter, pitch it in the second quarter, execute it on the third quarter and see it in your stock price in the fourth quarter. There aren’t a lot of companies that actually have that type of speed, if you will, and we have somewhat of a target-rich environment over the past few years to make those kinds of decisions. But resetting the business mix, for example, included $6 billion worth of reinsurance and walled-off transactions that move us out of very risky long-tail, highly volatile long-term care business as well as exposed annuity business. And it was a very hard-targeted specific to transactions that really shifted the mix of the business. From a financial perspective, we very quickly, through free cash flow, restored the financial ratios of the company, but we’ve also improved the ratings across the board and through recapping the balance sheet, we’ve lowered our cost-to-capital as well as improved our financial flexibility. And so very specific actions taken for very specific reasons and executing on it. And now today, the shift that’s taking place at CNO is we’re now back to more reliably more, and a more stable and consistent basis investing in the actual platform itself. So continuing to build out distribution products, et cetera, which turns me to the next few slides. On top of all that though, we’ve been delivering capital back to the shareholders. We, on a diluted share basis last year, okay if you include the buyout of $200 million par of convert, we bought back $535 million of diluted shares. That was $58 million shares, nearly 20% of the company. We instituted a dividend and that was after bringing the RBC up to nearly 370%, bringing leverage in and around 20%. So we have a very powerful cash flow dynamic, but the shifting has gone from repair and restore key ratios to now shifting towards investing back in the platform and returning some capital to our shareholders, if we don’t have a higher and better use for that capital. So investing in our business has started to pick up pace. And we really do it in some very simple ways and it’s delivering results. So for example, we’ve – there’s really three areas that we’re looking to invest in the franchise. One is expanding our agent force. The second is bringing more products to this unique distribution model and then the third would be geographic or segmentation of the market. So for example, at Bankers, we increased agents last year by about 6%. At PMA which is the Washington National distribution mechanism or platform, we increased by nearly 35% the agents in that business. Other independent agents through Washington National grew by 19%, so expanding the agent force in a very steady way. From a product perspective, we introduced critical illness into the Bankers distribution channel and a new life product in Colonial Penn, simplified issue life product in Colonial Penn, is a couple of examples of product expansion. And then our footprint, last year, we opened up 25 new branches at Bankers, 275 in total, expanding our footprint. The new agents that we brought on at PMA in Washington National were really also targeted towards underserved geographies, states that we currently don’t cover rural communities; we currently don’t cover from an agent perspective, so expanding the geography. And then at Colonial Penn, you might think of a direct marketer as having a unique, an odd dynamic to expand its marketplace but we are, and really what we’re doing is tapping things like the Hispanic market which is uniquely attractive market for us to tap through direct marketing of insurance. So expanding agents, expanding our footprint, bringing new products into the distribution, that’s really where we’ve oriented our spent, our investment in terms of building out the franchise. Now at the end of the day, this is somewhat of an embedded value slide in many respects. It’s very simplistic and that it’s simply showing the run-off, if you will, in our core business liabilities and the run-off of lower return and frankly more volatile liabilities. And in this balance hangs an awful lot of economic value and shareholder value. The run-on of business is important and that we’re very disciplined about the pricing of our products. I know you hear that from everybody in the industry. Our situation I think is bolstered in a couple ways. We don’t just target IRRs of 12% unlevered after-tax, which is roughly our goal across the board. But we use a measure called VNB value of new business to govern the economics of what we’re putting on our books. In other words, if you walk in to me as the Head of Distribution and you want to run a commission special to ramp up the sales, that may do very well for meeting your sales targets, but it’s going to kill your economic value once I install that in my VNB model. And so that embedded value culture permeates throughout CNO. So, managers of distribution channels understand there’s a give and take to those types of strategies and so we’re quite disciplined on it. The other is of course the captive and control distribution. We can control our own destiny when it comes to the pricing dynamics and that has proven to help us out over the years in terms of building a better looking in force of book of business. Now, key to our company of course is we’re running off blocks. We’ve rolled off nearly $5 billion as you can see on this slide of run-off blocks and these are slowly running off, so diminishing returns on the business. They’ve also proven to be volatile and one of the keys to our strategy is making sure we maximize the cash flows in these businesses and minimize the disruption or volatility such that we have options. We can hold on to the business and redeploy the cash flows elsewhere as it runs off or entertain reinsurance solutions having built a better dynamic for better pricing. Now, from an earnings perspective, a few comments I’d make. This is a normalized earnings slide and what has been normalized you see in the schedules in the back all the detail and the normalization, but I can kind of cut to the chase on it. If you look at 2012, there was two big pockets of normalized items. We took nearly $75 million of litigation and regulatory-related penalties and fines through the company throughout 2012. To me, this is a good example of the dynamic of our company these days which is we’re oftentimes needing to take one step back in order to prepare for two steps forward. And that is probably the best way I would broad brush those charges that we took throughout the year and that is working very hard to get things behind us and move the company forward as best we can. The other dynamic that ran through was interest rate-related adjustments, and so we’re trying to work very hard to recognize in our balance sheet the reality of low-for-long interest rates and so we adjusted our assumptions and took charges through that. We think that sets the stage for a higher-quality book value and one that is realistic to the current environment, but also from a litigation perspective, it’s about moving forward as a company. Now, you take those out and you get this chart and this chart is quite robust. But realize in 2012, we benefited from few things. We have very good benefit ratios across our Med-supp business across our long-term care business relative to our expectations going forward. So for example, in Bankers Medicare supplement, we travel that around a 69% benefit ratio last year. We would otherwise forecast around 71% as an outlook. Every one percentage point change in the benefit ratio is about $7 million of EBIT. Long-term care, we ran at a little north of 71% benefit ratio last year, but we are expecting that long-term care benefit ratio to climb up into the mid-70s, about 75% as rate action slow across the industry and with CNO and every one percentage point of long-term care, benefit ratio is about $5 million of EBIT annually. So as a result, you could see we benefited throughout 2012 from net favorable benefit ratios across the board. Supplemental health, which is in Washington National came in really as expected, right around an interest adjusted 50% benefit ratio which is about what we performed in 2012 and about what we would expect. We also benefited from good persistency and spreads in annuities. This is really the positive end of a low-interest rate environment. There’s simply nowhere else to go if you’re an investor in a fixed annuity these days. You have a very low crediting rate because the industry and CNO has been very proactive in bringing those crediting rates down in a dropping rate environment. But still even with those crediting rates coming down, there is not really attractive alternatives for you as an investor. And remember, our client base is buying the annuity for longevity insurance, right? It’s not just about wealth management or asset accumulation or a tax play with our particular investor base. So it’s very sticky business to start with and we’ve enjoyed that and expect to continue to enjoy that type of earnings stream. And all of this in the face of the obvious, which is low-for-long rates do eat at us and so do the natural run-off nature of our block. But overall, we’ve been able to defend that through good asset-liability management and actually favorable corporate investment results throughout the year. Now before I leave this slide, the one thing I do want to note particularly for our investors and analysts that are listening in, and that is don’t forget about the first quarter being very seasonal for our business. It’s very, very much the norm that we would expect a seasonal low point in Bankers earnings in the first quarter, typically in the neighborhood of 20% to 30% reduction in EBIT coming off the fourth quarter. And we’ve also talked about Colonial Penn having a seasonal component to their results because we tend to accelerate the advertising spend at Colonial Penn in the first quarter. So, we are guiding to $5 million to $10 million loss for all of 2013 at Colonial Penn, but the majority of that loss tends to be experienced in the first quarter. So remember that seasonality and the pattern of our earnings as we go through the year and give our outlooks. Now to build the capital that I mentioned earlier and so, from my perspective and the years in the industry and watching the capital dynamics of insurance companies, to me, it’s a mistake to run to the ratios and feel just automatically comfortable. For me, you need to start in the engine room and the engine room is, on a GAAP basis, the loss recognition testing that takes place each year that really is the GAAP testing of your intangibles and the quality of your reserves. And then, of course, cash flow testing, which is the statutory testing of your reserves. And so, what we decided to do this year is bring you inside this study on a GAAP and stat basis. This slide is complicated but I can make it fairly simple for you. On a GAAP basis, which would be the left-hand side of the slide, our margins remain very good. Now, they have been deteriorating by virtue of the low interest rate environment but are bolstered by putting new freshly priced business on the books. So it helps to really make the point of how important it is to have a new business generating engine as part of maintaining margins on a GAAP basis. But realize that our company as well as the rest of the industry benefits tremendously from the fact that we have written down a substantial portion of the intangibles by adopting the new GAAP guidance on DAC. And so for example, CNO wrote down $900 million pre-tax of intangibles and so withstand for a reason that those intangibles test out better. They’re more recoverable, obviously on a loss recognition testing basis as you go forward. But overall, we’ve been able to maintain margins. What we get hurt by in low interest rates, we get helped by in new business. Similar story on cash flow testing on the right side, only it’s done differently, cash flow testing is done on a legal entity basis. And in our case, and particularly because of the conservative nature of reserving on a statutory basis, we pass all of these standard scenarios, each legal entity passed the standard scenarios without the need to put up asset adequacy reserves on a cash flow testing basis. And as importantly, the margins in that testing remain relatively neutral for the year. Now, a couple of things to be mindful off, right. One is how cash flow testing works? Cash flow testing is not a run-the-test, fail-the-test, put-up assets. It’s not that simple. It’s oftentimes run the test, assess the margins. Now, you as an appointed actuary, before you sign off on those reserves to the state regulator, do you or don’t you feel comfortable with the reserves? And so it’s not uncommon for an actuary to come into my office and say, we passed all the tests but I would feel more comfortable in our margins if we would add a little bit to asset adequacy reserves. So for example, we added $5 million to our asset adequacy reserves. It’s a knit when it comes to managing our capital, but it’s an important lesson to understand how it actually works. On the GAAP side, it’s a little more cliff like, in that you will have much more sensitivity to the adjustment of an assumption, which is why you see an interest rate assumption adjustment for CNO resulted in a $43 million pre-tax hit to earnings in the third quarter of 2012. It’s much more acute, much less gradual than it is on a cash flow testing basis. So for CNO, what’s it all about? Well if you go down to the bottom part of the chart, you’ll quickly conclude it’s about long-term care in Bankers and it’s about interest-sensitive life in our run-off business. In other words, all of the other lines of business on both a GAAP and statutory basis are quite comfortable from a margin perspective, but you need to remain focused as the management team remains focused on those two lines of business that together are roughly $7 billion of our $22 billion of reserves. So what do we do? We stress test it. So your next question is great, you’ve told me that those are the more vulnerable areas of your loss recognition and cash flow testing, help me with the numbers? And so, not surprisingly, the interest rate stress testing we’ve done is focused entirely on the Bankers’ long-term care and OCB interest-sensitive life. Our run-off block, interest-sensitive life because that is where the game is being played for those of you that are concerned about GAAP or statutory capital dynamics. And so this stress test was done in two forms. A moderate stress test which takes new money rates, holds them flat throughout the year and then gradually has them recover and that’s the green here on this chart. And we held that flat for five years low-for-long than recovering. But then we did a severe test and said, well how about we drop it by another 50 basis points indefinitely? And that would be the grey bar and the grey boxes here. And let’s just focus on the severe stress test to understand how bad that can get and so under the severe stress test, you’re talking about roughly $100 million on average event, both GAAP and stat. And as a CFO, what does that make me do? If I’m concerned about low for long rates, if I think there is the possibility or probability for rates remaining low for an extended period of time, in a practical – from a practical approach, what I’m looking at is, hey, I probably want another percentage point of leverage in the bag. Okay, so if I am targeting 20% leverage, I probably want to be more comfortable at 19% or at least find my way towards the high-teens so that I’ve got easy cushion to absorb any GAAP-related hits to my balance sheet. Then from an RBC perspective, it’s about 25 points of RBC, okay and so, look, I should probably think about my excess capital for defending low for long interest rates. It’s about 25 points of RBC. And that’s the way I very simplistically think about it as we go through capital planning. Now on our capital strategy, we therefore target ratios that we think set us up. We certainly believe set us up for ratings upgrades and eventually investment grade. We target 20% leverage and realize that I am delevering. I am a below investment grade company which means I’m required to amortize my debt. I routinely amortize about a percentage point per year. And so, if I’m coming out of the gate at 21% after our recapitalization last year, I’m clipping off a little over 1% or so of that leverage each year. I’m going to climb into the high teens from 2014. And that’s a good dynamic if I have a level of uncertainty out there related to, for example, low-for-long rates or the return of a credit cycle, which will return at some point in time. I target 350% RBC. Not surprisingly, I’m running at nearly 370%, remember my cushion comment. What do I want to be holding in the way of excess RBC as I’m making my way through a tail event related to interest rates? So I’m running at about nearly 20 points of excess RBC over my target. And then I want holding company liquidity of $150 million and we ended the year at about $300 million. And so not surprisingly, we announced a tender for the remaining converts, which if 100% successful would be about a $200 million check towards reducing diluted shares. Now, we don’t know exactly how successful that tender will be. We will not know until the final date of the tender which is coming up here on March 27, but we need to be prepared for it to be 100% successful and if it is, that would be the down payment, if you will, on the excess capital we have at the holding company. Investment grade is not important to run our business. And we’ve proven that. But if you’re a $2.5 billion financial service company, being below investment grade is no way to go through life and so we have counterparties, we are fluid, we have fluid dollars and money is moving in and out of the company. We need to drive our ratings up over time, and so we’re dialing our ratios in and dialing in our business mix and business strategy to bring stability and consistency and move towards investment grade over time. Finally, cash flow and free cash flow. So on the left hand slide, this depicts the free cash flow dynamics from last year. And they’re quite robust. Realize, we benefit to the tune of $80 million to $100 million annually related to tax benefits that we have. We have significant tax assets and those come into the stock price through free cash flow and the deployment of that excess capital. But we are a real strong cash flow generator and we would expect in 2013 that the dynamics around our cash flow will remain substantially similar to what we experienced in 2012. So as you move from left to right here, you drive towards free cash flow. The capital generation we define as the earnings before interest and taxes statutory and before, of course, dividends up to the holding company and before contractual payments we make to the holding company which would be the $158 million dark blue bar on the far-left side. We ran about $423 million up to the holding company last year and with that money we paid interest of $64 million. We would expect the interest expense to be traveling in the mid-50s this year, having recapped the balance sheet. We run at about $20 million or so of holding company net expenses and that should remain roughly consistent. It fluctuates between $20 million and perhaps as high as $30 million on a net basis at the holding company and that leaves an amount of money to buy back stock and reduce debt and realize that when we do buy back stock, we are required to sweep $0.33 on the dollar to pay down our debt. I like that discipline. If I’m going to call up a bunch of stock buyback, I need to have somewhat equal balance in managing my leverage in the process and I think that’s not a bad discipline to have. The second is I need to amortize my debt. So I have $55 million of debt amortization that’s actually scheduled. So as I mentioned earlier, I’m de-levering automatically as part of the dynamics of being below investment grade. So as you move to the right-hand side, I can see here that the colors didn’t show up very well. At least it looks like it, but I would expect the mix to be generally the same in terms of what we – how we use our excess capital. Mix meaning, it will be debt reduction, share buyback as we’ve guided and we’ve guided between $250 million and $300 million of share buyback. As we’ve signaled, we will gradually expect to increase the dividend over time. That is a Board decision and you will learn about it as we learn about it, but the intention overtime is to drive towards a more competitive payout ratio. We’ve signaled something in the 20% payout ratio dynamic. And then, things like the financing cost and so forth will come down, we expect because that was largely related to the recapitalization. So overall, I would expect that we will continue to invest roughly the $72 million to maybe a little north of that back into our business in terms of retaining. That would be that light blue bar on the left hand side, that’s retained in the insurance companies to build and support new business. And then, we’ll tick up when it comes to share buyback over last year per our guidance. Debt reduction will come down a little bit because we have less of the sweep than we have historically, a little more financial flexibility. And then we will gradually look to – go at the common stock dividend over time. So in conclusion, we have a fairly transparent, we hope, plan. Our plan is pretty straight forward, okay. We want to invest in the franchise and here we talk about investing $85 million over three years and this will not be a surprise to you, where are we investing? We’re investing in building out the agent force, expanding the geography and branches, introducing new products into the system, being more consistent in throttling up on our investment in Colonial Penn. Colonial Penn is a wonderful franchise, but it has been the victim of on-again, off-again investment over the years, because we’ve had to retain capital over the years. But now we’re in a position to be more consistent in investing in our direct model, so building out the franchise. The second major area of our strategy is around operations. If you walk into a middle-market company with 4 million policy holders, many of whom are on claim because the average age of our policyholders is 70-plus in some cases. You are going to expect a highly efficient, highly effective middle and back office operating system and that is not what we currently have. Why? It’s pretty simple. It’s because we grew through a great number of acquisitions in the early days of this company and we are still working our way through the complexities in the operational dynamics of getting more streamlined, and it’s both a defensive issue in terms of expenses and an offensive issue in terms of better capitalizing on the middle market that we serve and so that is a critical part of the initiative. We brought a new executive in who knows how to create and execute on the plan and that’s going to be a piece of our story as we move forward. We want to continue to build out the ratings of the company as I mentioned earlier and we will continue to balance the use of excess capital similar to way you’ve seen before. I think it is fair to say that we’re now in a position to look at non-organic opportunities but I would caution, in other words, code for M&A and I would caution on that and the caution would be this, I bring three primary screens to the table before I even look at a property. One is it needs to be middle-market focused. Two is, it needs to be captive or controlled distribution, and three is it needs to be less rating-sensitive. You bring just those screens and you’re automatically into a targeted, impactful list, if you will, of possible targets, right. I mean, it’s going to be very refined, very targeted and it’s going need to be special to make sense for us. But we’re in a position to start to look and that’s a nice position to be in. So with that, why don’t I move to your questions? Question-and-Answer Session Jimmy Bhullar – JP Morgan: Maybe I’ll ask one to start with. On long-term care, we’ve seen a lot of companies either get out of the product or take charges, take drastic price actions, so what’s your comfort level with your on – on long-term care block and what are some of the things you’re doing to improve the margins there?