XNYS:CNO CNO Financial Group Inc Quarterly Report 10-Q Filing - 3/31/2012

Effective Date 3/31/2012

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q
þ
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2012
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from ___ to ___ 

Commission File Number 001-31792



CNO Financial Group, Inc.


Delaware
 
75-3108137
State of Incorporation
 
IRS Employer Identification No.
 
 
 
11825 N. Pennsylvania Street
 
 
Carmel, Indiana  46032
 
(317) 817-6100
Address of principal executive offices
 
Telephone


Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days:  Yes [ X ]  No [   ]

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes [ X ]  No [   ]

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  Large accelerated filer [ X ]  Accelerated filer [   ] Non-accelerated filer [   ] Smaller reporting company [   ]

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):  Yes [   ] No [ X ]


Shares of common stock outstanding as of April 19, 2012:  239,238,945





TABLE OF CONTENTS

PART I - FINANCIAL INFORMATION
Page
 
 
 
Item 1.
Financial Statements
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 2.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Item 3.
 
 
 
Item 4.
 
 
 
PART II - OTHER INFORMATION
 
 
 
 
Item 1.
Legal Proceedings                                                                                                  
 
 
 
Item 1A.
Risk Factors                                                                                                     
 
 
 
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds                                                                                                 
 
 
 
Item 5.
Other Information                                                                                                         
 
 
 
Item 6.
Exhibits                                                                                                      


2


PART I - FINANCIAL INFORMATION

ITEM 1.
FINANCIAL STATEMENTS.

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(Dollars in millions)

ASSETS

 
March 31,
2012
 
December 31,
2011
 
(unaudited)
 
 
Investments:
 
 
 
Fixed maturities, available for sale, at fair value (amortized cost:  March 31, 2012 - $22,021.2; December 31, 2011 - $21,779.1)
$
23,777.7

 
$
23,516.0

Equity securities at fair value (cost: March 31, 2012 - $172.7; December 31, 2011 - $177.0)
176.5

 
175.1

Mortgage loans
1,546.7

 
1,602.8

Policy loans
277.8

 
279.7

Trading securities
122.3

 
91.6

Investments held by variable interest entities
564.7

 
496.3

Other invested assets
270.9

 
202.8

Total investments
26,736.6

 
26,364.3

Cash and cash equivalents - unrestricted
173.5

 
436.0

Cash and cash equivalents held by variable interest entities
65.8

 
74.4

Accrued investment income
313.6

 
288.7

Present value of future profits
675.4

 
697.7

Deferred acquisition costs
790.4

 
797.1

Reinsurance receivables
3,052.7

 
3,091.1

Income tax assets, net
819.9

 
865.4

Assets held in separate accounts
16.0

 
15.0

Other assets
402.3

 
292.2

Total assets
$
33,046.2

 
$
32,921.9



(continued on next page)











The accompanying notes are an integral part
of the consolidated financial statements.



3



CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET, continued
(Dollars in millions)

LIABILITIES AND SHAREHOLDERS' EQUITY

 
March 31,
2012
 
December 31,
2011
 
(unaudited)
 
 
Liabilities:
 
 
 
Liabilities for insurance products:
 
 
 
Interest-sensitive products
$
13,103.4

 
$
13,165.5

Traditional products
10,517.9

 
10,482.7

Claims payable and other policyholder funds
1,000.8

 
1,034.3

Liabilities related to separate accounts
16.0

 
15.0

Other liabilities
721.0

 
556.3

Investment borrowings
1,684.9

 
1,676.5

Borrowings related to variable interest entities
519.9

 
519.9

Notes payable – direct corporate obligations
799.3

 
857.9

Total liabilities
28,363.2

 
28,308.1

Commitments and Contingencies


 


Shareholders' equity:
 

 
 

Common stock ($0.01 par value, 8,000,000,000 shares authorized, shares issued and outstanding: March 31, 2012 - 239,219,445; December 31, 2011 – 241,304,503)
2.4

 
2.4

Additional paid-in capital
4,345.6

 
4,361.9

Accumulated other comprehensive income
808.0

 
781.6

Accumulated deficit
(473.0
)
 
(532.1
)
Total shareholders' equity
4,683.0

 
4,613.8

Total liabilities and shareholders' equity
$
33,046.2

 
$
32,921.9





















The accompanying notes are an integral part
of the consolidated financial statements.


4


CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF OPERATIONS
(Dollars in millions, except per share data)
(unaudited)

 
Three months ended
 
March 31,
 
2012
 
2011
Revenues:
 
 
 
Insurance policy income
$
686.3

 
$
667.2

Net investment income (loss):
 

 
 

General account assets
345.2

 
336.1

Policyholder and reinsurer accounts and other special-purpose portfolios
65.6

 
37.4

Realized investment gains (losses):
 

 
 

Net realized investment gains, excluding impairment losses
30.8

 
18.4

Other-than-temporary impairment losses:
 

 
 

Total other-than-temporary impairment losses
(7.9
)
 
(13.3
)
Portion of other-than-temporary impairment losses recognized in accumulated other comprehensive income

 

Net impairment losses recognized
(7.9
)
 
(13.3
)
Total realized gains (losses)
22.9

 
5.1

Fee revenue and other income
3.9

 
3.4

Total revenues
1,123.9

 
1,049.2

Benefits and expenses:
 

 
 

Insurance policy benefits
689.0

 
683.2

Interest expense
28.8

 
29.2

Amortization
86.6

 
94.9

Loss on extinguishment of debt
.2

 
1.4

Other operating costs and expenses
227.0

 
170.1

Total benefits and expenses
1,031.6

 
978.8

Income before income taxes
92.3

 
70.4

Income tax expense on period income
33.2

 
25.0

Net income
$
59.1

 
$
45.4

Earnings per common share:
 

 
 

Basic:
 

 
 

Weighted average shares outstanding
240,895,000

 
251,121,000

Net income
$
.25

 
$
.18

Diluted:
 

 
 

Weighted average shares outstanding
297,343,000

 
307,498,000

Net income
$
.21

 
$
.16


The accompanying notes are an integral part
of the consolidated financial statements.


5


CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF COMPREHENSIVE INCOME
(Dollars in millions)
(unaudited)

 
Three months ended
 
March 31,
 
2012
 
2011
Net income
$
59.1

 
$
45.4

Other comprehensive income, before tax:
 
 
 
Unrealized gains for the period
51.9

 
48.5

Amortization of present value of future profits and deferred acquisition costs for:
 
 
 
Unrealized gains during the period
(20.0
)
 
(7.5
)
Amount related to premium deficiencies assuming the net unrealized gains had been realized
30.3

 

Reclassification adjustments:
 
 
 
For net realized investment gains included in net income
(21.6
)
 
(8.8
)
For amortization of the present value of future profits and deferred acquisition costs related to net realized investment gains included in net income
1.1

 
.4

Unrealized gains on investments
41.7

 
32.6

Change related to deferred compensation plan
.8

 
.3

Other comprehensive income before tax
42.5

 
32.9

Income tax expense related to items of accumulated other comprehensive income
(16.1
)
 
(12.3
)
Other comprehensive income, net of tax
26.4

 
20.6

Comprehensive income
$
85.5

 
$
66.0





















The accompanying notes are an integral part
of the consolidated financial statements.



6


CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(Dollars in millions)
(unaudited)
 
Common stock and
additional
paid-in capital
 
Accumulated other
 comprehensive income
 (loss)
 
Retained earnings
 (accumulated deficit)
 
Total
Balance, December 31, 2010 (as originally reported)
$
4,426.7

 
$
238.3

 
$
(339.7
)
 
$
4,325.3

Cumulative effect of accounting change (adoption of ASU 2010-26)

 
14.4

 
(528.1
)
 
(513.7
)
Balance, December 31, 2010 (as adjusted)
4,426.7

 
252.7

 
(867.8
)
 
3,811.6

Net income

 

 
45.4

 
45.4

Change in unrealized appreciation (depreciation) of investments (net of applicable income tax expense of $10.8)

 
17.9

 

 
17.9

Change in noncredit component of impairment losses on fixed maturities, available for sale (net of applicable income tax expense of $1.5)

 
2.7

 

 
2.7

Stock option and restricted stock plans
1.9

 

 

 
1.9

Balance, March 31, 2011
$
4,428.6

 
$
273.3

 
$
(822.4
)
 
$
3,879.5

 
 
 
 
 
 
 
 
Balance, December 31, 2011 (as originally reported)
$
4,364.3

 
$
625.5

 
$
42.8

 
$
5,032.6

Cumulative effect of accounting change (adoption of ASU 2010-26)

 
156.1

 
(574.9
)
 
(418.8
)
Balance, December 31, 2011 (as adjusted)
4,364.3

 
781.6

 
(532.1
)
 
4,613.8

Net income

 

 
59.1

 
59.1

Change in unrealized appreciation (depreciation) of investments (net of applicable income tax expense of $14.3)

 
23.1

 

 
23.1

Change in noncredit component of impairment losses on fixed maturities, available for sale (net of applicable income tax expense of $1.8)

 
3.3

 

 
3.3

Cost of shares acquired
(18.9
)
 

 

 
(18.9
)
Stock option and restricted stock plans
2.6

 

 

 
2.6

Balance, March 31, 2012
$
4,348.0

 
$
808.0

 
$
(473.0
)
 
$
4,683.0






The accompanying notes are an integral part
of the consolidated financial statements.



7


CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(Dollars in millions)
(unaudited)

 
Three months ended
 
March 31,
 
2012
 
2011
Cash flows from operating activities:
 
 
 
Insurance policy income
$
602.5

 
$
591.6

Net investment income
306.7

 
325.2

Fee revenue and other income
3.9

 
3.4

Insurance policy benefits
(565.3
)
 
(513.9
)
Interest expense
(26.5
)
 
(16.2
)
Deferrable policy acquisition costs
(46.2
)
 
(53.2
)
Other operating costs
(193.2
)
 
(180.9
)
Taxes
(3.7
)
 
(.7
)
Net cash provided by operating activities
78.2

 
155.3

Cash flows from investing activities:
 

 
 

Sales of investments
670.3

 
1,248.1

Maturities and redemptions of investments
417.1

 
252.9

Purchases of investments
(1,305.2
)
 
(1,661.1
)
Net sales (purchases) of trading securities
7.9

 
(23.6
)
Change in cash and cash equivalents held by variable interest entities
8.6

 
(.3
)
Other
(9.8
)
 
(5.3
)
Net cash used by investing activities
(211.1
)
 
(189.3
)
Cash flows from financing activities:
 

 
 

Payments on notes payable
(59.4
)
 
(50.0
)
Issuance of common stock
.1

 

Payments to repurchase common stock
(18.9
)
 

Amounts received for deposit products
346.6

 
395.3

Withdrawals from deposit products
(406.3
)
 
(425.8
)
Issuance of investment borrowings:
 
 
 
Federal Home Loan Bank

 
67.0

Payments on investment borrowings:
 
 
 
Federal Home Loan Bank

 
(67.0
)
Related to variable interest entities and other
(.3
)
 
(32.8
)
Investment borrowings - repurchase agreements, net
8.6

 

Net cash used by financing activities
(129.6
)
 
(113.3
)
Net decrease in cash and cash equivalents
(262.5
)
 
(147.3
)
Cash and cash equivalents, beginning of period
436.0

 
571.9

Cash and cash equivalents, end of period
$
173.5

 
$
424.6


The accompanying notes are an integral part
of the consolidated financial statements.


8

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
___________________


BUSINESS AND BASIS OF PRESENTATION

The following notes should be read together with the notes to the consolidated financial statements included in our 2011 Annual Report on Form 10-K.

CNO Financial Group, Inc., a Delaware corporation (“CNO”), is a holding company for a group of insurance companies operating throughout the United States that develop, market and administer health insurance, annuity, individual life insurance and other insurance products.  CNO became the successor to Conseco, Inc., an Indiana corporation (our “Predecessor”), in connection with our bankruptcy reorganization which became effective on September 10, 2003.  The terms “CNO Financial Group, Inc.”, the “Company”, “we”, “us”, and “our” as used in these financial statements refer to CNO and its subsidiaries or, when the context requires otherwise, our Predecessor and its subsidiaries.  We focus on serving the senior and middle-income markets, which we believe are attractive, underserved, high growth markets.  We sell our products through three distribution channels: career agents, independent producers (some of whom sell one or more of our product lines exclusively) and direct marketing.

Our unaudited consolidated financial statements reflect normal recurring adjustments that, in the opinion of management, are necessary for a fair statement of our financial position, results of operations and cash flows for the periods presented.  As permitted by rules and regulations of the Securities and Exchange Commission (the “SEC”) applicable to quarterly reports on Form 10-Q, we have condensed or omitted certain information and disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”).  We have reclassified certain amounts from the prior periods to conform to the 2012 presentation.  These reclassifications have no effect on net income or shareholders’ equity.  Results for interim periods are not necessarily indicative of the results that may be expected for a full year.

As discussed in the note to the consolidated financial statements entitled "Recently Issued Accounting Standards", we have adopted the provisions of Financial Accounting Standards Update No. 2010-26 (“ASU 2010-26”), effective January 1, 2012. Pursuant to the guidance, we elected to adopt the provisions on a retrospective basis. Accordingly, all prior periods presented have been retrospectively adjusted.

The balance sheet at December 31, 2011, presented herein, has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by GAAP for complete financial statements.

When we prepare financial statements in conformity with GAAP, we are required to make estimates and assumptions that significantly affect reported amounts of various assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and revenues and expenses during the reporting periods.  For example, we use significant estimates and assumptions to calculate values for deferred acquisition costs, the present value of future profits, certain investments (including derivatives), assets and liabilities related to income taxes, liabilities for insurance products, liabilities related to litigation and guaranty fund assessment accruals.  If our future experience differs from these estimates and assumptions, our financial statements would be materially affected.

Our consolidated financial statements exclude the results of transactions between us and our consolidated affiliates, or among our consolidated affiliates.



9

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
___________________

INVESTMENTS

We classify our fixed maturity securities into one of three categories: (i) “available for sale” (which we carry at estimated fair value with any unrealized gain or loss, net of tax and related adjustments, recorded as a component of shareholders’ equity); (ii) “trading” (which we carry at estimated fair value with changes in such value recognized as net investment income (classified as investment income from policyholder and reinsurer accounts and other special-purpose portfolios)); or (iii) “held to maturity” (which we carry at amortized cost).  We had no fixed maturity securities classified as held to maturity during the periods presented in these financial statements.

The trading account includes: (i) investments purchased with the intent of selling in the near term to generate income on price changes; and (ii) investments supporting insurance liabilities (including investments backing the market strategies of our multibucket annuity products) and certain reinsurance agreements. The change in fair value of these securities is recognized in income from policyholder and reinsurer accounts and other special-purpose portfolios (a component of net investment income). Investment income from trading securities backing insurance liabilities and certain reinsurance agreements is substantially offset by the change in insurance policy benefits related to certain products and agreements.  Prior to June 30, 2011, certain of our trading securities were held to offset the income statement volatility caused by the effect of interest rate fluctuations on the value of embedded derivatives related to our fixed index annuity products.  During the second quarter of 2011, we sold this trading portfolio and invested the proceeds in higher yielding investments which were classified as available for sale. See the note entitled “Accounting for Derivatives” for further discussion regarding these embedded derivatives.  The trading account also includes certain fixed maturity securities containing embedded derivatives for which we have elected the fair value option. The change in value of these securities is recognized in realized investment gain (losses). Our trading securities totaled $122.3 million and $91.6 million at March 31, 2012 and December 31, 2011, respectively.

Accumulated other comprehensive income is primarily comprised of the net effect of unrealized appreciation (depreciation) on our investments.  These amounts, included in shareholders’ equity as of March 31, 2012 and December 31, 2011, were as follows (dollars in millions):

 
March 31,
2012
 
December 31,
2011
Net unrealized appreciation (depreciation) on fixed maturity securities, available for sale, on which an other-than-temporary impairment loss has been recognized
$
1.6

 
$
(4.4
)
Net unrealized gains (losses) on all other investments
1,757.5

 
1,733.2

Adjustment to present value of future profits (a)
(207.3
)
 
(214.8
)
Adjustment to deferred acquisition costs
(285.4
)
 
(289.3
)
Unrecognized net loss related to deferred compensation plan
(7.5
)
 
(8.3
)
Deferred income tax liabilities
(450.9
)
 
(434.8
)
Accumulated other comprehensive income
$
808.0

 
$
781.6

_________
(a)
The present value of future profits is the value assigned to the right to receive future cash flows from contracts existing at September 10, 2003 (the date our Predecessor emerged from bankruptcy).

At March 31, 2012, adjustments to the present value of future profits, deferred acquisition costs and deferred income tax assets included $(176.3) million, $(64.4) million and $86.7 million, respectively, for premium deficiencies that would exist on certain long-term health products if unrealized gains on the assets backing such products had been realized and the proceeds from our sales of such assets were invested at then current yields.


10

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
___________________

At March 31, 2012, the amortized cost, gross unrealized gains and losses, estimated fair value, other-than-temporary impairments in accumulated other comprehensive income of fixed maturities, available for sale, were as follows (dollars in millions):

 
Amortized
cost
 
Gross
unrealized
gains
 
Gross
unrealized
losses
 
Estimated
fair value
 
Other-than-
temporary
impairments
included in
accumulated other
comprehensive
income
Corporate securities
$
14,574.1

 
$
1,425.3

 
$
(77.1
)
 
$
15,922.3

 
$

United States Treasury securities and obligations of United States government corporations and agencies
286.7

 
5.5

 
(3.1
)
 
289.1

 

States and political subdivisions
1,788.2

 
203.9

 
(8.2
)
 
1,983.9

 

Debt securities issued by foreign governments
.8

 

 

 
.8

 

Asset-backed securities
1,383.0

 
48.9

 
(24.9
)
 
1,407.0

 

Collateralized debt obligations
333.1

 
2.2

 
(2.9
)
 
332.4

 

Commercial mortgage-backed securities
1,399.7

 
103.5

 
(3.9
)
 
1,499.3

 

Mortgage pass-through securities
28.5

 
1.6

 

 
30.1

 

Collateralized mortgage obligations
2,227.1

 
94.2

 
(8.5
)
 
2,312.8

 
(10.8
)
Total fixed maturities, available for sale
$
22,021.2

 
$
1,885.1

 
$
(128.6
)
 
$
23,777.7

 
$
(10.8
)

The following table sets forth the amortized cost and estimated fair value of fixed maturities, available for sale, at March 31, 2012, by contractual maturity.  Actual maturities will differ from contractual maturities because certain borrowers may have the right to call or prepay obligations with or without penalties.  In addition, structured securities (such as asset-backed securities, collateralized debt obligations, commercial mortgage-backed securities, mortgage pass-through securities and collateralized mortgage obligations, collectively referred to as “structured securities”) frequently include provisions for periodic principal payments and permit periodic unscheduled payments.

 
Amortized
cost
 
Estimated
fair
value
 
(Dollars in millions)
Due in one year or less
$
163.1

 
$
165.0

Due after one year through five years
1,443.3

 
1,542.1

Due after five years through ten years
4,534.1

 
4,901.1

Due after ten years
10,509.3

 
11,587.9

Subtotal
16,649.8

 
18,196.1

Structured securities
5,371.4

 
5,581.6

Total fixed maturities, available for sale
$
22,021.2

 
$
23,777.7


Net Realized Investment Gains (Losses)

During the first three months of 2012, we recognized net realized investment gains of $22.9 million, which were comprised of $27.4 million of net gains from the sales of investments (primarily fixed maturities) with proceeds of $.7 billion, the change in fair value of certain fixed maturity investments with embedded derivatives of $3.4 million, and $7.9 million of writedowns of investments for other than temporary declines in fair value recognized through net income.


11

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
___________________

During the first three months of 2011, we recognized net realized investment gains of $5.1 million, which were comprised of $18.4 million of net gains from the sales of investments (primarily fixed maturities) with proceeds of $1.2 billion and $13.3 million of writedowns of investments for other than temporary declines in fair value recognized through net income.

At March 31, 2012, fixed maturity securities in default or considered nonperforming had an aggregate amortized cost of $.4 million and a carrying value of $.5 million.

Our fixed maturity investments are generally purchased in the context of a long-term strategy to fund insurance liabilities, so we do not generally seek to generate short-term realized gains through the purchase and sale of such securities.  In certain circumstances, including those in which securities are selling at prices which exceed our view of their underlying economic value, or when it is possible to reinvest the proceeds to better meet our long-term asset-liability objectives, we may sell certain securities.

During the three months ended March 31, 2012, we sold $147.6 million of fixed maturity investments which resulted in gross investment losses (before income taxes) of $2.3 million.  We sell securities at a loss for a number of reasons including, but not limited to:  (i) changes in the investment environment; (ii) expectation that the market value could deteriorate further; (iii) desire to reduce our exposure to an asset class, an issuer or an industry; (iv) prospective or actual changes in credit quality; or (v) changes in expected cash flows.

There were no investments sold at a loss during the first three months of 2012 that had been continuously in an unrealized loss position exceeding 20 percent of the amortized cost basis for more than 12 months prior to the sale of the investment.

We regularly evaluate all of our investments with unrealized losses for possible impairment.  Our assessment of whether unrealized losses are “other than temporary” requires significant judgment.  Factors considered include:  (i) the extent to which fair value is less than the cost basis; (ii) the length of time that the fair value has been less than cost; (iii) whether the unrealized loss is event driven, credit-driven or a result of changes in market interest rates or risk premium; (iv) the near-term prospects for specific events, developments or circumstances likely to affect the value of the investment; (v) the investment’s rating and whether the investment is investment-grade and/or has been downgraded since its purchase; (vi) whether the issuer is current on all payments in accordance with the contractual terms of the investment and is expected to meet all of its obligations under the terms of the investment; (vii) whether we intend to sell the investment or it is more likely than not that circumstances will require us to sell the investment before recovery occurs; (viii) the underlying current and prospective asset and enterprise values of the issuer and the extent to which the recoverability of the carrying value of our investment may be affected by changes in such values; (ix) projections of, and unfavorable changes in, cash flows on structured securities including mortgage-backed and asset-backed securities; (x) our best estimate of the value of any collateral; and (xi) other objective and subjective factors.

Future events may occur, or additional information may become available, which may necessitate future realized losses in our portfolio.  Significant losses could have a material adverse effect on our consolidated financial statements in future periods.

Impairment losses on equity securities are recognized in net income.  The manner in which impairment losses on fixed maturity securities, available for sale, are recognized in the financial statements is dependent on the facts and circumstances related to the specific security.  If we intend to sell a security or it is more likely than not that we would be required to sell a security before the recovery of its amortized cost, the security is other-than-temporarily impaired and the full amount of the impairment is recognized as a loss through earnings.  If we do not expect to recover the amortized cost basis, we do not plan to sell the security, and if it is not more likely than not that we would be required to sell a security before the recovery of its amortized cost, less any current period credit loss, the recognition of the other-than-temporary impairment is bifurcated.  We recognize the credit loss portion in net income and the noncredit loss portion in accumulated other comprehensive income.

We estimate the amount of the credit loss component of a fixed maturity security impairment as the difference between amortized cost and the present value of the expected cash flows of the security.  The present value is determined using the best estimate of future cash flows discounted at the effective interest rate implicit to the security at the date of purchase or the current yield to accrete an asset-backed or floating rate security.  The methodology and assumptions for establishing the best estimate of future cash flows vary depending on the type of security.

12

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
___________________


For most structured securities, cash flow estimates are based on bond specific facts and circumstances that may include collateral characteristics, expectations of delinquency and default rates, loss severity, prepayment speeds and structural support, including excess spread, subordination and guarantees.  For corporate bonds, cash flow estimates are derived from scenario-based outcomes of expected corporate restructurings or the disposition of assets using bond specific facts and circumstances including timing, secured interest and loss severity.  The previous amortized cost basis less the impairment recognized in net income becomes the security’s new cost basis.  We accrete the new cost basis to the estimated future cash flows over the expected remaining life of the security, except when the security is in default or considered nonperforming.

The remaining noncredit impairment, which is recorded in accumulated other comprehensive income, is the difference between the security’s estimated fair value and our best estimate of future cash flows discounted at the effective interest rate prior to impairment.  The remaining noncredit impairment typically represents changes in the market interest rates, current market liquidity and risk premiums.  As of March 31, 2012, other-than-temporary impairments included in accumulated other comprehensive income of $10.8 million (before taxes and related amortization) related to structured securities.

The following table summarizes the amount of credit losses recognized in earnings on fixed maturity securities, available for sale, held at the beginning of the period, for which a portion of the other-than-temporary impairment was also recognized in accumulated other comprehensive income for the three months ended March 31, 2012 and 2011 (dollars in millions):
 
Three months ended
 
March 31,
 
2012
 
2011
Credit losses on fixed maturity securities, available for sale, beginning of period
$
(2.0
)
 
$
(6.1
)
Add:  credit losses on other-than-temporary impairments not previously recognized

 

Less:  credit losses on securities sold
.1

 
4.3

Less:  credit losses on securities impaired due to intent to sell (a)

 

Add:  credit losses on previously impaired securities

 

Less:  increases in cash flows expected on previously impaired securities

 

Credit losses on fixed maturity securities, available for sale, end of period
$
(1.9
)
 
$
(1.8
)
__________
(a)
Represents securities for which the amount previously recognized in accumulated other comprehensive income was recognized in earnings because we intend to sell the security or we more likely than not will be required to sell the security before recovery of its amortized cost basis.

Gross Unrealized Investment Losses

Our investment strategy is to maximize, over a sustained period and within acceptable parameters of quality and risk, investment income and total investment return through active investment management. Accordingly, we may sell securities at a gain or a loss to enhance the projected total return of the portfolio as market opportunities change, to reflect changing perceptions of risk, or to better match certain characteristics of our investment portfolio with the corresponding characteristics of our insurance liabilities.


13

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
___________________

The following table summarizes the gross unrealized losses and fair values of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that such securities have been in a continuous unrealized loss position, at March 31, 2012 (dollars in millions):

 
 
Less than 12 months
 
12 months or greater
 
Total
Description of securities
 
Fair
value
 
Unrealized
losses
 
Fair
value
 
Unrealized
losses
 
Fair
value
 
Unrealized
losses
United States Treasury securities and obligations of United States government corporations and agencies
 
$
195.3

 
$
(3.1
)
 
$

 
$

 
$
195.3

 
$
(3.1
)
States and political subdivisions
 
4.1

 
(.3
)
 
126.4

 
(7.9
)
 
130.5

 
(8.2
)
Corporate securities
 
1,204.7

 
(38.9
)
 
388.5

 
(38.2
)
 
1,593.2

 
(77.1
)
Asset-backed securities
 
287.7

 
(6.7
)
 
211.8

 
(18.2
)
 
499.5

 
(24.9
)
Collateralized debt obligations
 
198.5

 
(2.7
)
 
11.0

 
(.2
)
 
209.5

 
(2.9
)
Commercial mortgage-backed securities
 
89.6

 
(2.0
)
 
29.2

 
(1.9
)
 
118.8

 
(3.9
)
Mortgage pass-through securities
 
.5

 

 
2.2

 

 
2.7

 

Collateralized mortgage obligations
 
331.9

 
(6.0
)
 
63.7

 
(2.5
)
 
395.6

 
(8.5
)
Total fixed maturities, available for sale
 
$
2,312.3

 
$
(59.7
)
 
$
832.8

 
$
(68.9
)
 
$
3,145.1

 
$
(128.6
)
Equity securities
 
$
3.5

 
$
(.3
)
 
$

 
$

 
$
3.5

 
$
(.3
)

The following table summarizes the gross unrealized losses and fair values of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that such securities have been in a continuous unrealized loss position, at December 31, 2011 (dollars in millions):

 
 
Less than 12 months
 
12 months or greater
 
Total
Description of securities
 
Fair
value
 
Unrealized
losses
 
Fair
value
 
Unrealized
losses
 
Fair
value
 
Unrealized
losses
United States Treasury securities and obligations of United States government corporations and agencies
 
$
9.1

 
$

 
$
.2

 
$

 
$
9.3

 
$

States and political subdivisions
 
6.9

 
(.2
)
 
155.4

 
(13.4
)
 
162.3

 
(13.6
)
Debt securities issued by foreign governments
 
.5

 

 

 

 
.5

 

Corporate securities
 
1,394.7

 
(57.0
)
 
466.2

 
(79.9
)
 
1,860.9

 
(136.9
)
Asset-backed securities
 
437.6

 
(14.5
)
 
147.5

 
(22.2
)
 
585.1

 
(36.7
)
Collateralized debt obligations
 
268.8

 
(6.3
)
 
1.7

 

 
270.5

 
(6.3
)
Commercial mortgage-backed securities
 
168.8

 
(5.2
)
 
33.0

 
(2.7
)
 
201.8

 
(7.9
)
Mortgage pass-through securities
 
1.2

 

 
2.2

 
(.1
)
 
3.4

 
(.1
)
Collateralized mortgage obligations
 
645.0

 
(20.8
)
 
29.7

 
(.6
)
 
674.7

 
(21.4
)
Total fixed maturities, available for sale
 
$
2,932.6

 
$
(104.0
)
 
$
835.9

 
$
(118.9
)
 
$
3,768.5

 
$
(222.9
)
Equity securities
 
$
41.6

 
$
(3.0
)
 
$
.4

 
$

 
$
42.0

 
$
(3.0
)

Based on management’s current assessment of investments with unrealized losses at March 31, 2012, the Company believes the issuers of the securities will continue to meet their obligations (or with respect to equity-type securities, the

14

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
___________________

investment value will recover to its cost basis).  While we do not have the intent to sell securities with unrealized losses and it is not more likely than not that we will be required to sell securities with unrealized losses prior to their anticipated recovery, our intent on an individual security may change, based upon market or other unforeseen developments.  In such instances, if a loss is recognized from a sale subsequent to a balance sheet date due to these unexpected developments, the loss is recognized in the period in which we had the intent to sell the security before its anticipated recovery.

EARNINGS PER SHARE

A reconciliation of net income and shares used to calculate basic and diluted earnings per share is as follows (dollars in millions and shares in thousands):
 
Three months ended
 
March 31,
 
2012
 
2011
Net income for basic earnings per share
$
59.1

 
$
45.4

Add:  interest expense on 7.0% Convertible Senior Debentures due 2016 (the “7.0% Debentures”), net of income taxes
3.7

 
3.7

Net income for diluted earnings per share
$
62.8

 
$
49.1

Shares:
 

 
 

Weighted average shares outstanding for basic earnings per share
240,895

 
251,121

Effect of dilutive securities on weighted average shares:
 

 
 

7% Debentures
53,367

 
53,367

Stock option and restricted stock plans
2,582

 
2,748

Warrants
499

 
262

Dilutive potential common shares
56,448

 
56,377

Weighted average shares outstanding for diluted earnings per share
297,343

 
307,498


Basic earnings per common share is computed by dividing net income by the weighted average number of common shares outstanding for the period.  Restricted shares (including our performance shares) are not included in basic earnings per share until vested.  Diluted earnings per share reflect the potential dilution that could occur if outstanding stock options and warrants were exercised and restricted stock was vested.  The dilution from options, warrants and restricted shares is calculated using the treasury stock method.  Under this method, we assume the proceeds from the exercise of the options and warrants (or the unrecognized compensation expense with respect to restricted stock) will be used to purchase shares of our common stock at the average market price during the period, reducing the dilutive effect of the exercise of the options and warrants (or the vesting of the restricted stock). Initially, the 7.0% Debentures will be convertible into 182.1494 shares of our common stock for each $1,000 principal amount of 7.0% Debentures, which is equivalent to an initial conversion price of approximately $5.49 per share. The conversion rate is subject to adjustment following the occurrence of certain events in accordance with the terms of the 7.0% Debentures.

BUSINESS SEGMENTS

The Company manages its business through the following operating segments: Bankers Life, Washington National and Colonial Penn, which are defined on the basis of product distribution; Other CNO Business, comprised primarily of products we no longer sell actively; and corporate operations, comprised of holding company activities and certain noninsurance company businesses.  

We measure segment performance by excluding realized investment gains (losses) and fair value changes in embedded derivative liabilities because we believe that this performance measure is a better indicator of the ongoing business and trends in our business.  Our primary investment focus is on investment income to support our liabilities for insurance products as opposed to the generation of realized investment gains (losses), and a long-term focus is necessary to maintain profitability over the life of the business.

15

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
___________________


Realized investment gains (losses) and fair value changes in embedded derivative liabilities depend on market conditions and do not necessarily relate to the underlying business of our segments.  Realized investment gains (losses) and fair value changes in embedded derivative liabilities may affect future earnings levels since our underlying business is long-term in nature and changes in our investment portfolio may impact our ability to earn the assumed interest rates needed to maintain the profitability of our business.

Operating information by segment was as follows (dollars in millions):
 
Three months ended
 
March 31,
 
2012
 
2011
Revenues:
 
 
 
Bankers Life:
 
 
 
Insurance policy income:
 
 
 
Annuities
$
7.2

 
$
8.4

Health
334.1

 
339.8

Life
65.2

 
51.8

Net investment income (a)
234.9

 
209.6

Fee revenue and other income (a)
2.9

 
2.3

Total Bankers Life revenues
644.3

 
611.9

Washington National:
 

 
 

Insurance policy income:
 

 
 

Health
142.4

 
140.2

Life
4.3

 
4.1

Other
.7

 
1.1

Net investment income (a)
50.0

 
46.3

Fee revenue and other income (a)
.2

 
.3

Total Washington National revenues
197.6

 
192.0

Colonial Penn:
 

 
 

Insurance policy income:
 

 
 

Health
1.4

 
1.6

Life
52.0

 
48.7

Net investment income (a)
10.0

 
10.3

Fee revenue and other income (a)
.2

 
.2

Total Colonial Penn revenues
63.6

 
60.8

Other CNO Business:
 

 
 

Insurance policy income:
 

 
 

Annuities
2.5

 
2.3

Health
6.7

 
7.3

Life
69.6

 
61.3

Other
.2

 
.6

Net investment income (a)
92.7

 
94.7

Total Other CNO Business revenues
171.7

 
166.2

Corporate operations:
 

 
 

Net investment income
23.2

 
12.6

Fee and other income
.6

 
.6

Total corporate revenues
23.8

 
13.2

Total revenues
1,101.0

 
1,044.1


(continued on next page)

16

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
___________________

(continued from previous page)
 
Three months ended
 
March 31,
 
2012
 
2011
Expenses:
 
 
 
Bankers Life:
 
 
 
Insurance policy benefits
$
420.9

 
$
404.8

Amortization
56.9

 
68.5

Interest expense on investment borrowings
1.4

 
1.2

Other operating costs and expenses
94.6

 
75.2

Total Bankers Life expenses
573.8

 
549.7

Washington National:
 

 
 

Insurance policy benefits
115.7

 
112.2

Amortization
12.7

 
13.4

Interest expense on investment borrowings
.7

 

Other operating costs and expenses
43.8

 
42.1

Total Washington National expenses
172.9

 
167.7

Colonial Penn:
 

 
 

Insurance policy benefits
42.1

 
38.7

Amortization
3.7

 
4.0

Other operating costs and expenses
27.6

 
23.8

Total Colonial Penn expenses
73.4

 
66.5

Other CNO Business:
 

 
 

Insurance policy benefits
121.9

 
127.5

Amortization
7.5

 
8.6

Interest expense on investment borrowings
5.1

 
4.9

Other operating costs and expenses
39.5

 
17.8

Total Other CNO Business expenses
174.0

 
158.8

Corporate operations:
 

 
 

Interest expense on corporate debt
17.5

 
20.6

Interest expense on borrowings of variable interest entities
4.0

 
2.5

Interest expense on investment borrowings
.1

 

Loss on extinguishment of debt
.2

 
1.4

Other operating costs and expenses
21.5

 
11.2

Total corporate expenses
43.3

 
35.7

Total expenses
1,037.4

 
978.4

Income (loss) before net realized investment losses and fair value changes in embedded derivative liabilities (net of related amortization) and income taxes:
 

 
 
Bankers Life
70.5

 
62.2

Washington National
24.7

 
24.3

Colonial Penn
(9.8
)
 
(5.7
)
Other CNO Business
(2.3
)
 
7.4

Corporate operations
(19.5
)
 
(22.5
)
Income before net realized investment losses and fair value changes in embedded derivative liabilities (net of related amortization) and income taxes
$
63.6

 
$
65.7

___________________
(a)
It is not practicable to provide additional components of revenue by product or services.

17

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
___________________


A reconciliation of segment revenues and expenses to consolidated revenues and expenses is as follows (dollars in millions):

 
Three months ended
 
March 31,
 
2012
 
2011
Total segment revenues
$
1,101.0

 
$
1,044.1

Net realized investment gains
22.9

 
5.1

Consolidated revenues
$
1,123.9

 
$
1,049.2

 
 
 
 
Total segment expenses
$
1,037.4

 
$
978.4

Insurance policy benefits - fair value changes in embedded derivative liabilities
(11.6
)
 

Amortization related to fair value changes in embedded derivative liabilities
4.7

 

Amortization related to net realized investment gains
1.1

 
.4

Consolidated expenses
$
1,031.6

 
$
978.8


ACCOUNTING FOR DERIVATIVES

Our fixed index annuity products provide a guaranteed minimum rate of return and a higher potential return that is based on a percentage (the “participation rate”) of the amount of increase in the value of a particular index, such as the Standard & Poor’s 500 Index, over a specified period.  Typically, on each policy anniversary date, a new index period begins.  We are generally able to change the participation rate at the beginning of each index period during a policy year, subject to contractual minimums.  We typically buy call options (including call spreads) referenced to the applicable indices in an effort to offset or hedge potential increases to policyholder benefits resulting from increases in the particular index to which the policy’s return is linked.  We reflect changes in the estimated fair value of these options in net investment income (classified as investment income from policyholder and reinsurer accounts and other special-purpose portfolios).  Net investment gains (losses) related to fixed index products were $41.4 million and $26.7 million in the three months ended March 31, 2012 and 2011, respectively. These amounts were substantially offset by a corresponding change to insurance policy benefits.  The estimated fair value of these options was $88.6 million and $37.9 million at March 31, 2012 and December 31, 2011, respectively.  We classify these instruments as other invested assets.

The Company accounts for the options attributed to the policyholder for the estimated life of the annuity contract as embedded derivatives.  The expected future cost of options on fixed index annuity products is used to determine the value of embedded derivatives.  The Company purchases options to hedge liabilities for the next policy year on each policy anniversary date and must estimate the fair value of the forward embedded options related to the policies.  These accounting requirements often create volatility in the earnings from these products.  We record the changes in the fair values of the embedded derivatives in current earnings as a component of insurance policy benefits.  The fair value of these derivatives, which are classified as “liabilities for interest-sensitive products”, was $704.3 million at March 31, 2012 and $666.3 million at December 31, 2011. Prior to June 30, 2011, we maintained a specific block of investments in our trading securities account (which we carried at estimated fair value with changes in such value recognized as investment income from policyholder and reinsurer accounts and other special-purpose portfolios) to offset the income statement volatility caused by the effect of interest rate fluctuations on the value of embedded derivatives related to our fixed index annuity products.  During the second quarter of 2011, we sold this trading portfolio, which will result in increased volatility in future earnings since the volatility caused by the accounting requirements to record embedded options at fair value will no longer be offset.

If the counterparties for the call options we hold fail to meet their obligations, we may have to recognize a loss.  We limit our exposure to such a loss by diversifying among several counterparties believed to be strong and creditworthy.  At March 31, 2012, substantially all of our counterparties were rated “BBB+” or higher by Standard & Poor’s Corporation (“S&P”).


18

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
___________________

Certain of our reinsurance payable balances contain embedded derivatives.  Such derivatives had an estimated fair value of $3.4 million and $3.5 million at March 31, 2012 and December 31, 2011, respectively.  We record the change in the fair value of these derivatives as a component of investment income (classified as investment income from policyholder and reinsurer accounts and other special-purpose portfolios).  We maintain the investments related to these agreements in our trading securities account, which we carry at estimated fair value with changes in such value recognized as investment income (also classified as investment income from policyholder and reinsurer accounts and other special-purpose portfolios).  The change in value of these trading securities offsets the change in value of the embedded derivatives.

We purchase certain fixed maturity securities that contain embedded derivatives that are required to be bifurcated from the instrument and held at fair value on the consolidated balance sheet. For certain of these securities, we have elected the fair value option to carry the entire security at fair value with changes in fair value reported in net income for operational ease.

REINSURANCE

The cost of reinsurance ceded totaled $57.2 million and $60.4 million in the first quarters of 2012 and 2011, respectively. We deduct this cost from insurance policy income.  Reinsurance recoveries netted against insurance policy benefits totaled $61.6 million and $62.5 million in the first quarters of 2012 and 2011, respectively.

From time-to-time, we assume insurance from other companies.  Any costs associated with the assumption of insurance are amortized consistent with the method used to amortize deferred acquisition costs.  Reinsurance premiums assumed totaled $15.9 million and $20.4 million in the first quarters of 2012 and 2011, respectively.  Reinsurance premiums included amounts assumed pursuant to marketing and quota-share agreements with Coventry Health Care (“Coventry”) of $10.8 million and $14.4 million in the first quarters of 2012 and 2011, respectively.

See the note entitled “Accounting for Derivatives” for a discussion of the derivative embedded in the payable related to certain modified coinsurance agreements.

INCOME TAXES

The components of income tax expense were as follows (dollars in millions):

 
Three months ended
 
March 31,
 
2012
 
2011
Current tax expense
$
3.3

 
$
3.1

Deferred tax provision
29.9

 
21.9

Total income tax expense
$
33.2

 
$
25.0


A reconciliation of the U.S. statutory corporate tax rate to the effective rate reflected in the consolidated statement of operations is as follows:
 

Three months ended

March 31,
 
2012
 
2011
U.S. statutory corporate rate
35.0
 %
 
35.0
 %
Other nondeductible benefits
1.2

 
(1.0
)
State taxes
1.1

 
.7

Provision for tax issues, tax credits and other
(1.3
)
 
.8

Effective tax rate
36.0
 %
 
35.5
 %


19

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
___________________

The components of the Company’s income tax assets and liabilities were as follows (dollars in millions):
 
March 31,
2012
 
December 31,
2011
Deferred tax assets:
 
 
 
Net federal operating loss carryforwards attributable to:
 
 
 
Life insurance subsidiaries
$
545.1

 
$
583.0

Non-life companies
863.6

 
862.2

Net state operating loss carryforwards
16.6

 
16.8

Tax credits
34.8

 
32.6

Capital loss carryforwards
331.1

 
342.3

Deductible temporary differences:
 

 
 

Insurance liabilities
764.8

 
744.4

Other
46.8

 
64.8

Gross deferred tax assets
2,602.8

 
2,646.1

Deferred tax liabilities:
 

 
 

Investments
(25.8
)
 
(24.2
)
Present value of future profits and deferred acquisition costs
(348.4
)
 
(363.7
)
Unrealized appreciation on investments
(450.9
)
 
(434.8
)
Gross deferred tax liabilities
(825.1
)
 
(822.7
)
Net deferred tax assets before valuation allowance
1,777.7

 
1,823.4

Valuation allowance
(938.4
)
 
(938.4
)
Net deferred tax assets
839.3

 
885.0

Current income taxes accrued
(19.4
)
 
(19.6
)
Income tax assets, net
$
819.9

 
$
865.4


Our income tax expense includes deferred income taxes arising from temporary differences between the financial reporting and tax bases of assets and liabilities, capital loss carryforwards and net operating loss carryforwards (“NOLs”). Deferred tax assets and liabilities are measured using enacted tax rates expected to apply in the years in which temporary differences are expected to be recovered or paid.  The effect of a change in tax rates on deferred tax assets and liabilities is recognized in earnings in the period when the changes are enacted.

A reduction of the net carrying amount of deferred tax assets by establishing a valuation allowance is required if, based on the available evidence, it is more likely than not that such assets will not be realized. In assessing the need for a valuation allowance, all available evidence, both positive and negative, shall be considered to determine whether, based on the weight of that evidence, a valuation allowance for deferred tax assets is needed. This assessment requires significant judgment and considers, among other matters, the nature, frequency and severity of current and cumulative losses, forecasts of future profitability, the duration of carryforward periods, our experience with operating loss and tax credit carryforwards expiring unused, and tax planning strategies. We evaluate the need to establish a valuation allowance for our deferred income tax assets on an ongoing basis. The realization of our deferred income tax assets depends upon generating sufficient future taxable income during the periods in which our temporary differences become deductible and before our capital loss carryforwards and NOLs expire.

Recovery of our deferred tax assets is dependent on achieving the future taxable income used in our deferred tax valuation model and failure to do so would result in an increase in the valuation allowance in a future period.  Any future increase in the valuation allowance may result in additional income tax expense and reduce shareholders’ equity, and such an increase could have a significant impact upon our earnings in the future.  In addition, the use of the Company’s NOLs is dependent, in part, on whether the Internal Revenue Service (the “IRS”) takes an adverse position in the future regarding the tax position we have taken in our tax returns with respect to the allocation of cancellation of indebtedness income ("CODI") resulting from the bankruptcy of our Predecessor and the classification of the loss we recognized as a result of the transfer of

20

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
___________________

the stock of Senior Health Insurance Company of Pennsylvania (“Senior Health”) to Senior Health Care Oversight Trust, an independent trust (the “Independent Trust”).

The Internal Revenue Code (the “Code”) limits the extent to which losses realized by a non-life entity (or entities) may offset income from a life insurance company (or companies) to the lesser of:  (i) 35 percent of the income of the life insurance company; or (ii) 35 percent of the total loss of the non-life entities (including NOLs of the non-life entities).  There is no similar limitation on the extent to which losses realized by a life insurance entity (or entities) may offset income from a non-life entity (or entities).

Section 382 of the Code imposes limitations on a corporation’s ability to use its NOLs when the company undergoes an ownership change.  Future transactions and the timing of such transactions could cause an ownership change for Section 382 income tax purposes.  Such transactions may include, but are not limited to, additional repurchases or issuances of common stock (including upon conversion of our outstanding 7.0% Debentures), or acquisitions or sales of shares of CNO stock by certain holders of our shares, including persons who have held, currently hold or may accumulate in the future five percent or more of our outstanding common stock for their own account.  Many of these transactions are beyond our control.  If an additional ownership change were to occur for purposes of Section 382, we would be required to calculate an annual restriction on the use of our NOLs to offset future taxable income.  The annual restriction would be calculated based upon the value of CNO’s equity at the time of such ownership change, multiplied by a federal long-term tax exempt rate (3.47 percent at March 31, 2012), and the annual restriction could effectively eliminate our ability to use a substantial portion of our NOLs to offset future taxable income.  We regularly monitor ownership change (as calculated for purposes of Section 382) and, as of March 31, 2012, we were below the 50 percent ownership change level that would trigger further impairment of our ability to utilize our NOLs.

As of March 31, 2012, we had $4.0 billion of federal NOLs and $.9 billion of capital loss carryforwards, which expire as follows (dollars in millions):

Year of expiration
 
Net operating loss carryforwards (a)
 
Capital loss
 
Total loss
 
 
Life
 
Non-life
 
carryforwards
 
carryforwards
2013
 
$

 
 
 
$

 
 
 
$
908.3

 
(b)
 
$
908.3

2014
 

 
 
 

 
 
 
28.7

 
 
 
28.7

2015
 

 
 
 

 
 
 
8.9

 
 
 
8.9

2018
 
1,323.8

 
(a)
 

 
 
 

 
 
 
1,323.8

2021
 
29.6

 
 
 

 
 
 

 
 
 
29.6

2022
 
204.1

 
 
 

 
 
 

 
 
 
204.1

2023
 

 
(b)
 
1,975.2

 
(a)
 

 
 
 
1,975.2

2024
 

 
 
 
3.2

 
 
 

 
 
 
3.2

2025
 

 
 
 
118.8

 
 
 

 
 
 
118.8

2027
 

 
 
 
216.8

 
 
 

 
 
 
216.8

2028
 

 
 
 
.5

 
 
 

 
 
 
.5

2029
 

 
 
 
148.8

 
 
 

 
 
 
148.8

2031
 

 
 
 
4.0

 
 
 

 
 
 
4.0

Total
 
$
1,557.5

 
 
 
$
2,467.3

 
 
 
$
945.9

 
 
 
$
4,970.7

 
_________________________
(a)
The allocation of the NOLs summarized above assumes the IRS does not take an adverse position in the future regarding the tax position we plan to take in our tax returns with respect to the allocation of CODI.  If the IRS disagrees with the tax position we plan to take with respect to the allocation of CODI, and their position prevails, approximately $631 million of the NOLs expiring in 2018 would be characterized as non-life NOLs.
(b)
Capital loss carryforwards expiring in 2013 include a $742 million loss on our investment in Senior Health which was worthless when it was transferred to the Independent Trust in 2008. Due to uncertainties in the Code, we have reflected this loss as an ordinary loss in our tax return. If classifying this loss as ordinary is ultimately determined to

21

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
___________________

be correct, capital loss carryforwards expiring in 2013 would decrease and life NOLs expiring in 2023 would increase by $742 million.

We had deferred tax assets related to NOLs for state income taxes of $16.6 million and $16.8 million at March 31, 2012 and December 31, 2011, respectively.  The related state NOLs are available to offset future state taxable income in certain states through 2019.

Tax years 2008 through 2010 are open to examination by the IRS.  The Company’s various state income tax returns are generally open for tax years 2008 through 2010 based on the individual state statutes of limitation. Generally, for tax years which generate net operating losses, capital losses or tax credit carryforwards, the statute of limitations does not close until the expiration of the statute of limitations for the tax year in which such carryforwards are utilized.

NOTES PAYABLE - DIRECT CORPORATE OBLIGATIONS

The following notes payable were direct corporate obligations of the Company as of March 31, 2012 and December 31, 2011 (dollars in millions):

 
March 31,
2012
 
December 31,
2011
7.0% Debentures
$
293.0

 
$
293.0

Senior Secured Credit Agreement (as defined below)
245.8

 
255.2

9.0% Senior Secured Notes due January 2018 (the “9.0% Senior Secured Notes”)
275.0

 
275.0

Senior Health Note due November 12, 2013 (the “Senior Health Note”)

 
50.0

Unamortized discount on 7.0% Debentures
(12.4
)
 
(12.9
)
Unamortized discount on Senior Secured Credit Agreement
(2.1
)
 
(2.4
)
Direct corporate obligations
$
799.3

 
$
857.9


In March 2012, we amended our senior secured term loan facility maturing on September 30, 2016 (the "Senior Secured Credit Agreement"). The changes to the Senior Secured Credit Agreement included:

(i)
a change in the definition of “Total Capitalization” (used to calculate compliance with the Debt to Total Capitalization Ratio covenant) to provide that any change to the Company's shareholders' equity resulting from the adoption by the Company of ASU 2010-26, related to the accounting for deferred acquisition costs, shall be disregarded for the purpose of such covenant to the extent the Company going forward quantifies the impact of ASU 2010-26 for each fiscal quarter or fiscal year and the cumulative impact since its adoption; and

(ii)
an increase in the cap on investments in “Capital Stock” (as defined in the amended credit agreement) from 1 percent to 3 percent.

In March 2012, as required under the terms of the Senior Secured Credit Agreement, we made a mandatory prepayment of $9.4 million due to our repurchase of $18.9 million of our common stock in the first quarter of 2012. As a result of the repayment, we recognized a loss on the extinguishment of debt totaling $.2 million representing the write-off of unamortized discount and issuance costs associated with the Senior Secured Credit Agreement.

In March 2012, we also paid in full the remaining $50.0 million principal balance on the Senior Health Note, which had been scheduled to mature in November 2013. The repayment in full of the Senior Health Note removes the previous restriction on our ability to pay cash dividends on our common stock.


22

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
___________________

The Senior Secured Credit Agreement requires the Company to maintain:  (i) a debt to total capitalization ratio of not more than 30 percent (such ratio, calculated in accordance with the Senior Secured Credit Agreement, was 16.1 percent at March 31, 2012); (ii) an interest coverage ratio of not less than 2.00 to 1.00 for each rolling four quarters (such ratio was 5.13 to 1.00 for the rolling four quarters ended March 31, 2012); (iii) an aggregate ratio of total adjusted capital to company action level risk-based capital for the Company’s insurance subsidiaries of not less than 250 percent (such ratio was 360 percent at March 31, 2012); and (iv) a combined statutory capital and surplus for the Company’s insurance subsidiaries of at least $1,200.0 million (combined statutory capital and surplus at March 31, 2012, was $1,793.2 million). The Company is in compliance with all debt covenants as of March 31, 2012.

The scheduled repayment of our direct corporate obligations was as follows at March 31, 2012 (dollars in millions):

Year ending March 31,
 
2013
$
33.8

2014
60.0

2015
77.5

2016
74.5

2017
293.0

Thereafter
275.0

 
$
813.8


We may prepay, in whole or in part, the Senior Secured Credit Agreement, together with any accrued and unpaid interest, with prior notice but without premium or penalty in minimum amounts of $1.0 million or any multiple thereof.

Mandatory prepayments of the Senior Secured Credit Agreement will be required in an amount equal to: (i) 100 percent of the net cash proceeds from certain asset sales or casualty events; (ii) 100 percent of the net cash proceeds received by the Company or any of its subsidiaries from certain debt issuances; (iii) 50 percent of the net cash proceeds received from certain equity issuances; and (iv) 100 percent of the amount of certain restricted payments made (including any common stock dividends and share repurchases) as defined in the Senior Secured Credit Agreement provided that if, as of the end of the fiscal quarter immediately preceding such restricted payment, the debt to total capitalization ratio is: (i) equal to or less than 17.5 percent, but greater than 12.5 percent, the prepayment requirement shall be reduced by one-half; or (ii) equal to or less than 12.5 percent, the prepayment requirement shall not apply.

Notwithstanding the foregoing, no mandatory prepayments pursuant to items (i) or (iii) in the preceding paragraph shall be required if: (x) the debt to total capitalization ratio is equal or less than 20 percent; and (y) either (A) the financial strength rating of certain insurance subsidiaries is equal or better than A- (stable) from A.M. Best Company ("A.M. Best") or (B) the Senior Secured Credit Agreement is rated equal or better than BBB- (stable) from S&P and Baa3 (stable) by Moody's Investor Services, Inc. ("Moody's").

The 9.0% Senior Secured Notes were issued pursuant to an Indenture, dated as of December 21, 2010 (the “Indenture”), by and among the Company, the Subsidiary Guarantors and Wilmington Trust FSB, as trustee and collateral agent (“Wilmington”). The Indenture contains covenants that, among other things, limit (subject to certain exceptions) the Company's ability and the ability of the Company's Restricted Subsidiaries (as defined in the Indenture) to:

incur or guarantee additional indebtedness or issue preferred stock;
pay dividends or make other distributions to shareholders;
purchase or redeem capital stock or subordinated indebtedness;
make certain investments;
create liens;
incur restrictions on the Company's ability and the ability of the Restricted Subsidiaries to pay dividends or make
other payments to the Company;
sell assets, including capital stock of the Company's subsidiaries;
consolidate or merge with or into other companies or transfer all or substantially all of the Company's assets; and
engage in transactions with affiliates.

23

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
___________________


Under the Indenture, the Company can make Restricted Payments (as such term is defined in the Indenture) up to a calculated limit, provided that the Company's pro forma risk-based capital ratio exceeds 225% after giving effect to the Restricted Payment and certain other conditions are met. Restricted Payments include, among other items, stock repurchases, common stock dividends and investments in excess of $75 million made at the holding company level that are other than cash and cash equivalents. The limit of Restricted Payments permitted under the Indenture is the sum of (x) 50% of the Company's “Consolidated Net Income” (as defined in the Indenture) for the period (taken as one accounting period) from January 1, 2011 to the end of the Company's most recently ended fiscal quarter for which financial statements are available at the time of such Restricted Payment and (y) certain other amounts. Based on the Company's Consolidated Net Income through March 31, 2012, the Company could make additional Restricted Payments under this Indenture covenant of approximately $121 million.

INVESTMENT BORROWINGS

Three of the Company’s insurance subsidiaries (Conseco Life Insurance Company (“Conseco Life”), Washington National Insurance Company and Bankers Life and Casualty Company ("Bankers Life")) are members of the Federal Home Loan Bank (“FHLB”).  As members of the FHLB, Conseco Life, Washington National Insurance Company and Bankers Life have the ability to borrow on a collateralized basis from the FHLB.  Conseco Life, Washington National Insurance Company and Bankers Life are required to hold certain minimum amounts of FHLB common stock as a condition of membership in the FHLB, and additional amounts based on the amount of the borrowings.  At March 31, 2012, the carrying value of the FHLB common stock was $82.5 million.  As of March 31, 2012, collateralized borrowings from the FHLB totaled $1.7 billion and the proceeds were used to purchase fixed maturity securities.  The borrowings are classified as investment borrowings in the accompanying consolidated balance sheet.  The borrowings are collateralized by investments with an estimated fair value of $2.1 billion at March 31, 2012, which are maintained in a custodial account for the benefit of the FHLB.  Such investments are classified as fixed maturities, available for sale, in our consolidated balance sheet.  Interest expense of $7.2 million and $6.0 million in the first three months of 2012 and 2011, respectively, was recognized related to the borrowings.


24

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
___________________

The following summarizes the terms of the borrowings (dollars in millions):

Amount
 
Maturity
 
Interest rate at
borrowed
 
date
 
March 31, 2012
$
100.0

 
October 2013
 
Variable rate – 0.572%
100.0

 
November 2013
 
Variable rate – 0.583%
67.0

 
February 2014
 
Fixed rate – 1.830%
50.0

 
August 2014
 
Variable rate – 0.633%
100.0

 
September 2015
 
Variable rate – 0.853%
150.0

 
October 2015
 
Variable rate – 0.592%
100.0

 
November 2015
 
Fixed rate – 4.890%
146.0

 
November 2015
 
Fixed rate – 5.300%
100.0

 
December 2015
 
Fixed rate – 4.710%
100.0

 
June 2016
 
Variable rate – 0.682%
75.0

 
June 2016
 
Variable rate – 0.630%
75.0

 
August 2016
 
Variable rate – 0.701%
100.0

 
October 2016
 
Variable rate – 0.761%
50.0

 
November 2016
 
Variable rate – 0.750%
50.0

 
November 2016
 
Variable rate – 0.712%
100.0

 
June 2017
 
Variable rate – 0.763%
50.0

 
August 2017
 
Variable rate – 0.703%
100.0

 
October 2017
 
Variable rate – 1.002%
37.0

 
November 2017
 
Fixed rate – 3.750%
$
1,650.0

 
 
 
 

The variable rate borrowings are pre-payable on each interest reset date without penalty.  The fixed rate borrowings are pre-payable subject to payment of a yield maintenance fee based on current market interest rates.  At March 31, 2012, the aggregate fee to prepay all fixed rate borrowings was $52.4 million.

As part of our investment strategy, we may enter into repurchase agreements to increase our investment return. We account for these transactions as collateralized borrowings, where the amount borrowed is equal to the sales price of the underlying securities. Repurchase agreements involve a sale of securities and an agreement to repurchase the same securities at a later date at an agreed-upon price. Such borrowings totaled $33.4 million at March 31, 2012. The borrowings mature as follows: $29.4 million - within 30 days; and $4.0 million - between 30 and 90 days. These borrowings were collateralized by investment securities (primarily collateralized mortgage obligations) with fair values approximately equal to the loan value. The primary risks associated with short-term collateralized borrowings are: (i) a substantial decline in the market value of the margined security; and (ii) that a counterparty may be unable to perform under the terms of the contract or be unwilling to extend such financing in future periods especially if the liquidity or value of the margined security has declined. Exposure is limited to any depreciation in value of the related securities.

At March 31, 2012, investment borrowings consisted of:  (i) collateralized borrowings from the FHLB of $1.7 billion; (ii) repurchase agreements of $33.4 million; and (iii) other borrowings of $1.4 million.

At December 31, 2011, investment borrowings consisted of:  (i) collateralized borrowings from the FHLB of $1.7 billion; (ii) repurchase agreements of $24.8 million; and (iii) other borrowings of $1.7 million.



25

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
___________________

CHANGES IN COMMON STOCK

Changes in the number of shares of common stock outstanding were as follows (shares in thousands):

Balance, December 31, 2011
241,305

 
 
Treasury stock purchased and retired
(2,437
)
 
 
Stock options exercised
30

 
 
Restricted stock vested
321

 
(a)
Balance, March 31, 2012
239,219

 
 
________
(a)
Such amount was reduced by 142 thousand shares which were tendered to the Company for the payment of federal and state taxes owed on the vesting of restricted stock.

In May 2011, the Company announced a common share repurchase program of up to $100.0 million of the Company's outstanding common stock. In February 2012, the Company announced that its board of directors had approved an additional $100.0 million to repurchase the Company's outstanding common stock. In the first three months of 2012, we repurchased 2.4 million shares of common stock for $18.9 million pursuant to the program. The Company has remaining repurchase authority of $111.3 million as of March 31, 2012.

SALES INDUCEMENTS

Certain of our annuity products offer sales inducements to contract holders in the form of enhanced crediting rates or bonus payments in the initial period of the contract.  Certain of our life insurance products offer persistency bonuses credited to the contract holders balance after the policy has been outstanding for a specified period of time.  These enhanced rates and persistency bonuses are considered sales inducements in accordance with GAAP.  Such amounts are deferred and amortized in the same manner as deferred acquisition costs.  Sales inducements deferred totaled $.9 million and $4.1 million during the three months ended March 31, 2012 and 2011, respectively.  Amounts amortized totaled $7.3 million and $8.1 million during the three months ended March 31, 2012 and 2011, respectively.  The unamortized balance of deferred sales inducements at March 31, 2012 and December 31, 2011 was $142.8 million and $149.2 million, respectively.  The balance of insurance liabilities for persistency bonus benefits was $43.4 million and $50.0 million at March 31, 2012 and December 31, 2011, respectively.

RECENTLY ISSUED ACCOUNTING STANDARDS

Accounting Standard Adopted on a Retrospective Basis

In October 2010, the Financial Accounting Standards Board ("FASB") issued authoritative guidance that modified the definition of the types of costs incurred by insurance entities that could be capitalized in the acquisition of new and renewal contracts.  The guidance impacts the timing of GAAP reported financial results, but has no impact on cash flows, statutory financial results or the ultimate profitability of the business.

The guidance specifies that an insurance entity shall only capitalize incremental direct costs related to the successful acquisition of new or renewal insurance contracts.  The guidance also states that advertising costs should be included in deferred acquisition costs only if the capitalization criteria in the direct-response advertising guidance is met.  The guidance was effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2011. As permitted by the guidance, we elected to apply the provisions on a retrospective basis. The guidance reduced the balance of deferred acquisition costs, its amortization and the amount of costs capitalized. We are able to defer most commission payments, plus other costs directly related to the production of new business. The change did not impact the balance of the present value of future profits. Therefore, in contrast to the reduction in amortization of deferred acquisition costs, there was no change in the amortization of the present value of future profits.


26

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
___________________

The adoption of ASU 2010-26 had the following impact on our consolidated balance sheet and consolidated statement of operations as of and for the three months ended March 31, 2012 (dollars in millions, except per share amounts):

 
March 31, 2012
 
Amounts prior to adoption of ASU 2010-26
 
Effect of adoption of ASU 2010-26
 
As reported
Deferred acquisition costs
$
1,580.4

 
$
(790.0
)
 
$
790.4

Income tax assets, net
525.0

 
294.9

 
819.9

Other assets
426.2

 
(23.9
)
 
402.3

Total assets
33,565.2

 
(519.0
)
 
33,046.2

 
 
 
 
 
 
Other liabilities
713.2

 
7.8

 
721.0

Total liabilities
28,355.4

 
7.8

 
28,363.2

 
 
 
 
 
 
Accumulated other comprehensive income
749.5

 
58.5

 
808.0

Retained earnings (accumulated deficit)
112.3

 
(585.3
)
 
(473.0
)
Total shareholders' equity
5,209.8

 
(526.8
)
 
4,683.0

Total liabilities and shareholders' equity
33,565.2

 
(519.0
)
 
33,046.2


 
Three months ended
 
March 31, 2012
 
Amounts prior to adoption of ASU 2010-26
 
Effect of adoption of ASU 2010-26
 
As reported
Amortization
$
131.8

 
$
(45.2
)
 
$
86.6

Other operating costs and expenses
165.5

 
61.5

 
227.0

Total benefits and expenses
1,015.3

 
16.3

 
1,031.6

Income before income taxes
108.6

 
(16.3
)
 
92.3

Tax expense on period income
39.1

 
(5.9
)
 
33.2

Net income
69.5

 
(10.4
)
 
59.1

 
 
 
 
 
 
Earnings per common share:
 
 
 
 
 
  Basic:
 
 
 
 
 
    Net income
$
.29

 
$
(.04
)
 
$
.25

  Diluted:
 
 
 
 
 
    Net income
.25

 
(.04
)
 
.21



27

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(unaudited)
___________________

The adoption of ASU 2010-26 affected prior period information as follows (dollars in millions, except per share amounts):

 
December 31, 2011
 
As originally reported
 
Effect of adoption of ASU 2010-26
 
As adjusted
Deferred acquisition costs
$
1,418.1

 
$
(621.0
)
 
$
797.1

Income tax assets, net
630.5

 
234.9

 
865.4

Other assets
316.9

 
(24.7
)
 
292.2

Total assets
33,332.7

 
(410.8
)
 
32,921.9

 
 
 
 
 
 
Other liabilities
548.3

 
8.0

 
556.3

Total liabilities
28,300.1