Oct 30, 2012
Start Time
11:02: CNO Financial Group, Inc. (NYSE:CNO) Q3 2012 Earnings Call October 30, 2012 11:00 am ET
Executives
Erik Helding – Senior Vice President, Treasury & Investor Relations Edward J. Bonach – Chief Executive Officer Scott R.
Perry – Chief Business Officer, CNO Financial President, Bankers Life and Casualty Eric R. Johnson – President Frederick J.
Crawford – Executive Vice President and Chief Financial Officer
Analysts
Randy Binner – FBR Capital Markets & Co. Mark Palmer – Btig, LLC Humphrey Lee – UBS Securities LLC
Operator
Good morning. My name is Tanya, and I will be your conference operator today.
At this time, I would like to welcome everyone to the CNO Finance Group Third Quarter 2012 Earnings Results Conference Call. All lines have been placed on mute to prevent any background noise.
After the speakers’ remarks, there will be a question-and-answer session. (Operator Instructions) Thank you.
Mr. Helding, you may begin your conference.
Erik Helding
Good morning and thank you for joining us on CNO Financial Group’s third quarter 2012 earnings conference call. Today’s presentation will include remarks from Ed Bonach, Chief Executive Officer; Scott Perry, Chief Business Officer and President of Bankers Life; Eric Johnson, Chief Investment Officer; and Fred Crawford, Chief Financial Officer.
Following the presentation, we will also have several other business leaders available for the question-and-answer period. Recognizing the disruption of Hurricane Sandy, the company is continuing with this conference call to provide management’s comments on the quarter, and to take questions.
If deemed necessary, an additional question-and-answer call may be scheduled. During this conference call, we’ll be referring to information contained in yesterday’s press release.
You can obtain the release by visiting the media section of our website at www.cnoinc.com. This afternoon’s presentation is also available on the Investors section of our website, and was filed in a Form 8-K this morning.
We expect to file our third quarter 2012 Form 10-Q and post it on our website by the end of this week. Let me remind you that any forward-looking statements that we make today are subject to a number of factors which may cause actual results to be materially different than those contemplated by the forward-looking statements.
Today’s presentation contains a number of non-GAAP measures, which should not be considered as substitutes for the most directly comparable GAAP measures. You’ll find a reconciliation of the non-GAAP measures to the corresponding GAAP measures in the appendix.
Throughout this presentation, we will be making performance comparisons, and unless otherwise specified, any comparisons made will be referring to the changes between 3Q 2011 and 3Q 2012. And now, I’d like to turn the call over to our CEO, Ed Bonach.
Ed?
Edward J. Bonach
Thanks, Eric. First and foremost, our thoughts are with everyone on the East Coast battling Hurricane Sandy, and thank you for those who have been able to call in.
Turning the corridor, management took several steps to improve the financial flexibility in go forward earnings profile of the company. As a result, we’ve recorded some one-time charges that impacted net income for the quarter.
These charges related to the recently completed recapitalization, significant progress made in reaching a Tentative Litigation Settlement in our OCB segment and an update of assumptions related to interest rate. Fred will discuss these items in greater detail later in the presentation.
Beside from these one-time items, our businesses continue to perform well with core sales and earnings building, while we will continue to invest in distribution and operations to drive future organic growth. As you can see on slide 6, CNO’s core businesses continued their positive momentum and performed well during the quarter.
Excluding the significant items, operating EPS increased to $0.26 per share in the quarter from $0.16 in the prior year. The increase in earnings reflects continued favorable trends in annuity spreads, annuity persistency and overall benefit ratios, as well as increased investment results in our corporate segment.
The recapitalization were not materially impacting third quarter operating results is expected to be accretive the EPS and ROE on a go-forward basis. While we have been largely successful in defending the overall portfolio investment yield, the persistent low interest rate environment is a challenge and asset recovery, we expect that this will be a headwind to future earnings growth.
Turning now to slide 7, during the quarter we achieved another significant milestone by completing a comprehensive recapitalization. As previously announced, we’ve raised $950 million of new debt to payout for existing senior secured debt and repurchased $200 million of the $293 million of convertible debentures in our privately negotiated transaction.
Our new debt structure reflects the continued strong operating performance and improved rating. We were able to significantly lower our overall average cost of debt, enhance financial flexibility and our debt maturity profile, and significantly reduce the overhang associated with convertible securities, while achieving a meaningful stair step in go-forward EPS and ROE.
The recapitalization further strengthened our balance sheet. The capital position of the company is very strong with consolidated risk-based capital of 361% and over $300 million of cash and investments at the holding company, both of which are well above management’s stated target.
Our ongoing statutory cash flow generation was largely unaffected by activity in the quarter, and we continue to execute on our capital deployment strategy. We expect statutory dividends for the holding company of $250 million to $275 million for the year, and stock buybacks to come in near the high end of the $150 million to $170 million range that we previously disclosed.
Turning now to slide 9, in addition to deploying excess capital and the stock buybacks and dividends, we are also continuing to invest in our core businesses. We are making investments and initiatives that are increasing the productivity and size of our agent force, while staying focused on profitable growth.
We are increasing direct marketing, adding new sales locations to expand our presence in under-penetrated marketplaces, along with developing and launching new products that meets the needs of our fast growing target markets. These investments are already paying us.
Consolidated sales excluding annuities are up 8% in the third quarter and were up 13% on a year-to-date basis compared to last year. Let me now turn it over to Scott Perry, our Chief Business Officer to discuss our core businesses in more detail.
Scott?
Scott R. Perry
Thanks, Ed. Sales results that Bankers were mixed for the quarter, while overall growth continues to be challenging due to the impact of the low interest rate environment on annuity sales and overall sales were down 5% year-over-year.
We were pleased with the gains that we made in growing the agent force. Through the third quarter, our agent force is grown by 7%, finishing the quarter at over 5,200.
This growth was primarily driven by improved agent retention across all agent categories, as recruiting levels were essentially flat with last year. Although annuity sales were down by 35% in the quarter, sales excluding annuities were up 5%, due to increases in life sales, which were up 4%.
Medicare supplement sales, which were up 9% and short-term care sales, which were up 8%. Earlier in the year, we introduced a new critical illness product.
Through September that new product was available for sale in 38 states. This product has been well received in the marketplace and sales through the first nine months of this year totaled $2.7 million.
One important aspect of the Bankers robust distribution model is the breath of our product offerings, which allows us to shift sales mix relatively quickly in response to customer needs, while maintaining pricing discipline. Having multiple products that meet the needs of our target market also allows agents to generate a sufficient level of income, while servicing the customer in a responsible and compliant manner.
Along with this shift, an expanded product portfolio and enhanced agent training efforts are contributing to the improvements in agent retention even as we deal with a difficult annuity sales environment. Turning to Medicare Advantage; as we have discussed in the past, Bankers partners with the leading providers to sell Medicare Advantage and PDP; we currently have relationships with Humana, United HealthCare, Aetna and Coventry.
In preparation for the 2013 Medicare Annual Election period, nearly one-third of our agent force is certified and ready to sell Medicare Advantage, as nearly twice the level of last year. We are also continuing our partnership, selling of Humana Wal-Mart Preferred Prescription Plan in Wal-Mart locations across the country.
It’s worth noting as well that although the Annual Election period is designed around Medicare Advantage sales. We typically also see an uptick in med sup activity.
This year appears to be no exception as med sup sales activity is trending positively as of last year through October. I’ll look forward to sharing the results of the Annual Election period in next quarter’s call.
Turning now to Washington National; sales for the quarter were very strong. Sales of our core supplemental health and life products increased by 9%, this was primarily driven by continued gains in our voluntary worksite distribution channel.
The investments we are making to expand our life product offering are gaining traction. Through the first nine months of this year, life sales have more than doubled to $5.2 million.
We are also pleased with our recruiting and retention results, producing agent at PMA were up 6%, and in our partner channel, new producing partners were up 6% as well. Slide 12 shows the sales results for Colonial Penn.
2012 sales at Colonial Penn continued in the third quarter with sales up 19% year-over-year. The increase in sales is due to continued investments we are making in television and direct mail advertising.
Productivity also improved in the quarter as we made several enhancements to direct mail kit, policy fulfillment packages, and reflects our cutover to a new customer relationship management system. We are on track to finish 2012 strong and are optimistic looking forward.
Our strategy is focused on the rapidly growing pre- and post-retiree middle markets that are being fueled by the aging of the boomer generation. This market needs the simple, straightforward products that we offer to address the things that they are most concerned with, healthcare expenses, outliving their retirement, and providing a legacy for their families.
Our segments are well-positioned to meet these basic needs, whether through career agents, independent agents at the worksite or direct. In all three businesses, the capital deployment initiatives we identified to accelerate organic growth are progressing and ongoing.
Bankers will continue to increase the number of locations and fully implement the Manager Trainee Program, both of which will enable us to grow our agency force. Year-to-date, we have opened 22 new locations, which is well ahead of our expectations.
While sales of annuities continue to be a challenge in this low interest rate environment, we are encouraged by overall agent force growth, and our agents ability to pivot within the portfolio as we discussed earlier. We expect this positive momentum to carry-forward.
At Washington National, we expect the increased focus and positive momentum in the voluntary worksite market to continue for both PMA and our partner channels. As the additional resources we deployed continue to ramp up, we expect a strong recruiting results to continue in the partner channel with anticipation that we will see recruiting gains of 15% or more for the year, and we continue to invest in expanding PMA’s geographic reach to increasing product availability.
We are on track for adding products in 34 states by year end. The combination of the increased product availability and placement of additional field leadership talent in 90 markets year-to-date positions PMA well for future growth.
At Colonial Penn, we will continue to invest in new lead generation activity. We do expect that lead-based spending will taper off during Q4 and then ramp back up in the first quarter of next year.
And lastly, at Colonial Penn, as I mentioned during our last call, we are still on track with our new product launch scheduled to begin in the fourth quarter. And with that, I’ll hand it over to Eric Johnson, who will discuss CNO’s investment portfolio.
Eric?
Eric R. Johnson
Thank you, Scott and good morning everyone. I’m going to slide 14; in the third quarter, we earned investment income of $349 million, compared to $351 million in the immediately preceding quarter.
Our portfolio earned yield was 5.71%, down five basis points sequentially, due to some book yield attrition from lower new money rates, as well as sequentially fewer one-time gains included in investment income. Our new money rate in the quarter was 4.71%.
We are facing yield. During the quarter, we allocated the bulk of our new money to high-grade U.S.
corporate financials, private-label RMBS and CRE loans. One important way to sustain portfolio yield is by holding down portfolio turnover.
All other things held constant at current new money rate, each percentage in annual turnover results in roughly $2.5 million decline in investment income. We continue to actively manage our assets and other liabilities at a line of business level and we continue to be well within our duration and convexity matching targets in each line of business.
Slide 15 lays out realized gains and losses for the trailing four quarters. In the third quarter, we recognized $9 million in net realized gains, $41 million in gross realized gains can be basically attributed to generally low corporate yields.
This is partially offset by $9 million in realized losses and $23 million in other than temporary impairments recognized in earnings. The credit performance of our portfolio continued to be favorable with low or no impairments across virtually all asset classes.
As you will recall late in 2011, we completed the early commutation of the year can exchange for varied interest into our underlying invested assets held by the issuer. We disclosed with the great majority of those interest prior to this quarter raising $210 million.
We reinvested our securities earning in 1.33% and into much higher yield. Our third quarter impairment of $23 million reflects our assessments of the future prospects of federal of remaining interest.
The key differences from prior quarters are higher discounting factor and in longer time horizon. The remaining carrying balance of these interests is $39 million.
Going on to slide 16, our unrealized again increased by approximately $680 million during the quarter to $2.9 billion at quarter end, primarily this is the function of higher corporate and mortgage spread. Slide 17, illustrates our overall asset allocation, which represent we unchanged in the quarter.
As I said earlier, our asset quality remains good. Our invested assets or 90% investment grade essentially unchanged from prior period.
The relationship of upgrades and downgrades in corporate states have been relatively stable with no net impact to RBC. Moving on to slide 18, which is about investments at our holding company, our first priority there remains liquidity to support corporate capital management.
Holding company cash has invested principally in money market and core plus allocations, which limits its leverage. We additionally maintain a smaller allocation to unleverage the equity and alternatives.
The amount of unrestricted cash and investments held at September 30 was $313 million. Net and investment income for the quarter was approximately $1 million.
Gain loss for the quarter was approximately $6 million. Total return for the quarter was 3.3%.
Our fixed allocation returned 3.4%. Our equity allocation returned 6.35% consistent with the S&D index, and alternatives returned to modest gains.
Moving on to slide 19, taking as a whole news on U.S. economy including consumer confidence, the labor market housing, and inflation trends all others are slow, but persisting well.
The fairly excited strategic rate for an extended period, credit spreads on the whole seem, likely to continue to grind tighter with some likelihood of periodic of free purchase wider. It would be industry certain valuations in fixed income as stress and insufficient as demand for subsidiary to save assets compared to value.
Overall non-financial credit quality has gone – has exceeded and corporate fundamentals seem to have more downside than upside from here. Sales for here and now compression seems likely, and we are funding around loan money rates for the foreseeable future.
Net income is a scarce commodity is becoming expensive and this suggests, do caution is more, and so we are avoiding high data names and excess leverage in terms of financing. We still continue to consider residential and commercial mortgages cheap.
We expect this to continue to fund at levels consistent with the company’s needs and objectives. And with that, I will turn it to Fred.
Frederick J. Crawford
Thanks, Eric, and good morning, everyone. This was a quarter of significant management action, which resulted in a number of notable items impacting both operating earnings and net income.
In terms of operating earnings, we concluded our review of long-term interest rate assumptions and took a more significant charge in the quarter. I’ll provide more color on this later in my comments.
As Ed noted, we have made progress on the OCB litigation front, mediation tox advanced to a point of agreement in principle on the material economic elements of a settlement. This is the contingent loss reserve recognizing that while we know enough to estimate the financial impact we are still working to certain non-economic items.
Impacting net income was the previously disclosed charge associated with our recapitalization. In addition, stability and our normalized earnings and steady capital gains supported a release of our deferred tax valuation allowance.
There was very little disruption to core capital generation, cash flow dynamics and deployment plans when considering the various earnings items in the quarter. When looking at normalized segment results, our underlying fundamentals continue to support growth in core earnings.
As detailed in our press release, if you normalize for significant items in the quarter, we posted $0.26 per share. Bankers earnings reflect earned premium growth coupled with favorable med sup benefit ratios.
Bankers continues to enjoy strong annuity persistency and spreads somewhat offsetting pressure on portfolio yields. For long-term care business experienced modestly elevated benefit ratios still within our expected range.
We have been enjoying favorable benefit ratios as a result of active re-rating our long-term care in force. But as that rate activity slows, we naturally see persistency returned to more normal levels.
We expect to see interest adjusted loss ratios remain in the mid 70% range. Washington National posted another very strong quarter driven by favorable benefit ratios in our supplemental health product line.
Colonial Penn’s results were impacted by seasonal marketing spend consistent with our guidance last quarter, we expect a modest profit in the fourth quarter. Corporate results benefited from overall investment performance and trading strategies.
Year-over-year results were significantly impacted by a favorable swing in the COLI investment, which increased by $14 million versus the prior year. Taken as a whole, it’s fair to characterize normalized results as coming in favorable to our expectation for the quarter.
Turning to interest rates, we completed our review of long-term rate assumptions taking a $28 million after-tax charge in our OCB segment, specifically increasing future loss reserves on our interest-sensitive life business. We have been successful in defending new money rates and have slowed the turnover rate in our portfolios to preserve higher yielding assets.
However, conditions are more challenging and Fed appears determined to keep rates lower for longer.
If this scenario were to play out, we estimate the annual impact to GAAP and statutory net income to be $10 million to $15 million in 2013, and $25 million to $30 million in 2014. This represents the annual impact to net investment income as compared to 2012 levels, simply reflecting the natural bleed in portfolio yields if new money rates remain flat.
No other management actions to mitigate the impact are included in the stress test. We then applied the stress scenario to our GAAP models, which produced an estimated one-time reserve strengthening and impact to intangibles of $20 million to $50 million after-tax.
Lower than our lost stress test recognizing our third quarter charge, the statutory impact range we previously disclosed was unchanged. Overall, a low for long rate environment represents a headwind to earnings, but is manageable from a capital planning perspective.
We traditionally review our deferred tax valuation allowance once a year in the third quarter and concert with our financial planning process. Stable on building earnings support release of the valuation allowance on assets related to non-life NOLs.
Our approach has not changed. We look back three years and calculate the average normalized annual earnings then assume a 5% growth rate for five years and flat thereafter.
The release reflects our improved performance and the view of stability going forward. In addition, the same low rate supplying pressure to our earnings has delivered a reliable level of capital gains this year, supporting or lowering of the valuation allowance on tax assets derived from past capital loses.
Overall, we identified a reduction to our deferred tax valuation allowance of $155 million of which $143 million was recognized this quarter, and approximately $12 million will be recognized in the fourth quarter of this year. We now have settled into our post recapitalization capital structure.
We ended the quarter with RBC ratio of 361%. This is particularly strong recognizing the OCB litigation reserve was $40 million on a statutory basis, impairments of $23 million, and insurance company dividends of $95 million during the quarter.
Leverage settled in at 21%, and we expect this to gradually reduce in time as we naturally amortize debt. Our new debt prepayment suite provision require as we pay down our debt $0.33 for every dollar used to repurchase stock or pay on common stock dividends.
The requirement increases to dollar for dollar if leverage rises above 22.5% and falls away completely as long as leverage remains below 17.5%. We ended the quarter with over $300 million in liquidity at the holding company.
We would size our deployable capital at a $150 million and expect to come in at the high-end of our previous guidance for 2012 stock repurchase. We define capital generation is statutory earnings prior to surplus note interest and contractual payments made to the holding company.
That number was $0.5 billion in 2011 and on pace for a similar result in 2012. Capital generation and amounts moved up to the holding company are converging.
This is the result of no longer needing to build RBC, so any retained capital primarily supports business growth. With strength in RBC and stability and statutory earnings, we have refined our statutory dividend guidance now expecting dividends in a $250 million to $275 million range for 2012.
Slide 26 profiled our 2012 year-to-date free cash flow dynamics. The waterfall graph starts with the same capital generation numbers on the previous slide and defines free cash flow by pulling out capital retained in the insurance subsidiaries and holding company reoccurring expenses.
Again our business model demands relatively little capital to support growth. Here is showing roughly $45 million in capital retained in the business thus far in 2012.
We were able to modestly lower our interest expense via the recapitalization despite upsizing the transaction by $50 million. As noted earlier, we structured in greater flexibility in a reduced cash flow suite, scheduled amortization of a debt is roughly $55 million annually excluding any prepayments.
In short, free cash flow is finding a new level as we moved to 2012 and into 2013. And with that, I’ll hand it back to Ed for some closing comments.
Ed?
Edward J. Bonach
Thanks, Fred. CNO represents a compelling value proposition.
We have been growing and have above-average growth potential as we are defined and differentiated by our market focus on the senior and middle-income markets, which is both underserved and rapidly expanding with the Baby Boomers, turning age 65. Our risk profile benefits from active management and the diversification of our products; with the markets we serve mostly meeting the straightforward protection products.
This is a product mix, where a significant amount of sales to convert quickly to cash. We are shifting gears to increase our capital deployment, and our recently completed recapitalization has increased our financial flexibility as well as lowering our cost to capital.
CNO’s market focus, coupled with the alignment of distribution to reach that market products and home office support to our distribution, as well as the end customer, provide a sustainable competitive advantage. Lastly, I’m pleased to announce that the company will be hosting an Investor Day Conference in New York City on Thursday, December 13.
Invitations will be sent out and additional details will be posted to our website in the coming week. And now, we’ll open it up for your questions.
Operator?
Operator
(Operator instructions) Your first question comes from the line of Randy Binner of FBR.
Randy Binner – FBR Capital Markets & Co.
It was a pretty large increase of $21 million, it was $20 million initially I think. And so, I guess my question is how much closer does this get you to settle in that issue around, rate increases and other settlement activity?
And what might this mean for other potential litigation in OCB?
Edward J. Bonach
Yeah, thanks, Randy, this is Ed. First of all, this is a broader settlement, in that it does bring together three different cases class action suites, the so-called U1, U2 and Nicklas.
So that gives rise to the additional amount that we have set up. We have reached as Fred indicated agreement on the significant economic terms.
So, with that, we do believe that the significant impact is booked now into our financials on an economic basis. There is still our items that we need to workout on the process of this settlement and some of the timing and details and, but it does represent a significant step towards resolving not only this, but continuing to manage the OCB business in the way that it was intended.
Randy Binner – FBR Capital Markets & Co.
And I guess just a kind of helped someone is not as close to the legal situation like myself and kind of what others, I mean can you kind of frame this in the context of OCB meaning is there any other significant, now that you brought these three cases together. Is there any other kind of significant pending litigation?
And is there anything in the settlement that is kind of favorable from a present perspective for you to continue to re-rate other pieces of OCB?
Edward J. Bonach
On your first question, the answer is no. We do not have any current other significant outstanding litigation on OCB.
And on your second question, we had the ability that has been confirmed in different ways to implement non-guaranteed element changes including the multi-state regulatory settlement. So that we expect that this is another step and confirmation that we have that rate in ability to execute on [MGE] changes were warrants.
Randy Binner – FBR Capital Markets & Co.
Great, thank you for the responses.
Operator
Your next question comes from the line of Mark Palmer.
Mark Palmer – Btig, LLC
Could you please comment on the reports that we’re in The Wall Street Journal this week that state regulators had voted to compel insures to hold more capital against their mortgage debt holdings and how that may impact CNO?
Edward J. Bonach
Yeah, good morning. There are chance Mark, and I can do that.
The general for sales on the call, who may not maybe over the general approach of the NAIC here into reevaluate the different projections for future path of home price appreciation that are used to determine NAIC value for RMBS and also CMBS in a separate methodology, such that different they’re re-weighting the scenario such that more conservative scenarios in terms of an averaging process, let’s see to have a greater weight in the averaging process. Parenthetically, the underlying cash flow projections for the security are actually year-over-year, slightly improved due to a year of favorable performance.
So net-net there will be relatively small effects on NAIC ratings of RBC requirements related to those. In terms of our portfolio, a lot of would be probably inappropriate to give you a specific number going forward, and this would be a projection.
I would think it would be not noticeable, but not material, the number of RBC point impact largely, because RMBS portfolio is basically a no-loss portfolio to a great extent in which case we are waiting on the future path as of really no impact. That same thing is true of our CMBS portfolio, the two taking together, the aggregates are RBC effective not going to be, it will be noticeable, but not significant.
Scott R. Perry
Yeah, and I would just tell you Mark, from my perspective, it’s a threat to emphasize Eric’s comments. There is a drag relate to this, should it go through as it’s being discussed, but it’s not to a point to where it alters our capital planning in anyway.
Mark Palmer – Btig, LLC
Very good. Thank you.
Operator
Your next question comes from the line of Humphrey Lee with UBS.
Humphrey Lee – UBS Securities LLC
So how much new money do you have to come down further before another charge on the interest expenses life book, and then as well I think from the slide you mentioned that OBC right now is adequate, the same thing. So how much would new money you have to come down before you would consider another strengthening?
Edward J. Bonach
I think and you are breaking up a little bit Humphrey, it could be related to some of the poor connections we might have. But I think your question was what would rates have to do in the future to give rise to a further charge?
We obviously, importantly, this new assumption that we’ve layered is what we would characterize is the best estimate. In other words it was attempting to look very realistically at what we believe the Fed is doing, what current rates and importantly spreads.
Spreads as much as treasury these days are doing and likely be going forward and then working with Eric and this team on what the investment strategy is going to be going forward. And so this is not meant to be an aggressive or conservative assumption, it’s meant to be a best estimate.
As a result we’ll continue to review it typically each year. I say that, we are required to watch this assumption each quarter and review it, but it stands to reason that making an adjustment to new money projects that rollout better than 20 years into the future is something that you want to see a level of permanency in the terms of change of rates and rates trajectory before you would go and make an immediate adjustment.
I think if new money rates travel, for example, below our assumption, you would tend to see some level of incremental adjustment each year similar to the $13 million pre-tax we’ve been taking in previous years if there were to be a wholesale shift in the view of long-term new money rates, we would take that sort of shifting approach to the curve, the new money curve and it would be a larger number. But there is really no way for me to give you an answer to say, hey, if rates do this, we will definitely make a move.
It has everything to do what the investment strategies are at that time, what the prospects for rate recovery or lack that are going forward, and so it’s hard to determine that. We provided you a stress test, however, so that you could at least as an investor, size what an environment of flat for longer five years would mean to our GAAP results.
That’s the purpose of the stress test. It’s both our own capital management exercises.
And then giving a little bit of a window, should you want to do your own sensitivity work.
Humphrey Lee – UBS Securities LLC
Okay, got it. And then in terms of the earlier part of the presentation, you mentioned that some of the cap rates being redeployed to the businesses for growth.
Can you quantify that how much you’re investing to the businesses and what is the impact to earning?
Edward J. Bonach
Yeah, let me start to answer that. This is Ed.
From the waterfall chart that Fred covered, we’re in the $45 million range of all-in capital needed to support our business growth. The vast majority of that is capital to support the sales as opposed to investments into expanding distribution et cetera.
Actually the amount of investments of hard dollars for the expansion is modest relative to that $45 million is more human capital that were needing to invest. They are coupled with the financial capital.
Now what we expect to achieve by that is two-fold in increasing rate of sales to where we would expect over time another 1% to 2% growth. So we’re taking 6% to 8% or any 10% of annual growth in new annualized premium.
And we’re also very I’d say, focused and committed to maintaining pricing discipline that means that we would expect to get at least 12% unlevered after-tax returns on that business. So that will emerge then over the life of the products that are being put on the books.
Humphrey Lee – UBS Securities LLC
Okay. But I guess my question is more related to how this does it flows through to the income statement, because when I’m looking at for example for Bankers, the other operating expenses lines seems a little bit higher this quarter.
And my understanding is some of that can be attributed to kind of some project, or infrastructure build, so I’m just kind of from the ongoing basis how much of a drag would kind of project, or infrastructure build would attract earnings in the near-term
Edward J. Bonach
No, from the operating expenses, there is some additional expense that way for the expansion of locations, the dreaming that we are doing in the top gun program, the field management training program recruiting. But it is basically expenses rolling largely in line with the growth of business inforce, which the number as Scott alluded to the number of policies that we’re selling continues to grow and the policies inforce continues to grow.
Humphrey Lee – UBS Securities LLC
Okay, thanks.
Operator
(Operator Instructions) The next question comes from the line of Randy Binner with FBR.
Randy Binner – FBR Capital Markets & Co.
I just wanted to cleanup a little bit on the stress test. And I just wanted to clarify that the new stress test, not the kind of OCB charge in the quarter, but the output of that impact on earnings was a worse than it was in the second quarter, is that correct, is it a little bit worse?
Frederick J. Crawford
Yes, it was than what we had done in the previous stress test. The previous stress test had, first was assuming a new money rate that was closer to 5% and holding that flat for five years, this is a lower new money rate, and then again holding it for five years.
So it does have a bit more of a drag, very importantly is how we approach this Randy. And that is, we are freezing if you will assets and more or less assuming that in doing so, more or less assuming that new assets coming in are roughly equal to any assets that are leaving.
And then applying a normal turnover rate or what I expect the turnover rate would be and then refinancing at that lower new money rate. So really what these numbers are when you look at 2013 and 2014 is, they are really simply reflecting, freezing your net investment income as of 2012, and then applying the natural bleed in portfolio yield to that number.
We generate, to give you some sizing to sort of put it in perspective, we generate $1.3 billion or so of net investment income each year, so over the course of two years $2.6 billion just if you were to freeze it. And so when looking at these numbers, these being on an after-tax basis, it’s an absolute headwind to earnings.
But we still are able to defend overall portfolio yields through our ALM work and through managing the turnover down as Eric as highlighted before.
Randy Binner – FBR Capital Markets & Co.
Okay, that’s helpful. But I mean kind the rule of my guess is that the tax change by 25 basis points on the front-end, and so the delta in the output could be away I thinking about, so…?
Edward J. Bonach
Yeah, in the previous, we tried to simplify things because we’re upon doing the previous stress test, we found that there was a times of level of confusion as to what was done, not uncommon, I think in the industry, people approaching it differently. And what we were really doing in that previous stress test as we are also incorporating kind of where we see the financial plan go as it relates to assets.
And so you had an influencing effect if you will on what the plan assumption is, was for assets and what the plan assumption is for recovering rates as compared to the stress test. So here we just simplified and said, look, we’re not going to try to include other variables that could be confusing or simply going to say, look, what would you expect the portfolio yield to be today if new money rates stayed where they are, not including any other what I would call financial plan dynamics as we go forward.
Randy Binner – FBR Capital Markets & Co.
Okay. I think that’s easier for all of us in the outside.
Edward J. Bonach
Yeah.
Randy Binner – FBR Capital Markets & Co.
And then with long-term care at Bankers, any more affected by the new methodology versus the old methodology? I think the old methodology was predominately OCB, but also affected Bankers LTC?
Edward J. Bonach
Yeah.
Randy Binner – FBR Capital Markets & Co.
How close is Bankers LTC getting in that past hours, the other has the hours pleasantly surprised that CEO was not impacted by the other test?
Edward J. Bonach
Yeah, that’s very good question Randy. So one of the things you’ll notice in the slide we prepared is we had a comment Bankers LTC reserves remain adequate, but pressured if rates remain low, which I think is somewhat of an obvious statement.
But to make your point, first we don’t have necessarily separate methodologies for separate businesses. We have a methodology of basically creating what the new money curve should look like.
The methodology being looking at our investment strategies, looking at the marketplace, capital market dynamics, the Fed and so forth. And then we applied that test to our interest sensitive life in OCB and also applied it to the other interest sensitive business, most notably Bankers long-term care.
So the idea of adjusting that assumption does have an effect on long-term care. But it’s just that it really have the affect of squeezing the margin in the loss recognition testing process.
But not breaking it if you will to a point where you need to increase your GAAP reserves. What is important though to know and there is a reason for that, we’ve said this for a while.
The reason why interest-sensitive life in OCB is a bit more susceptible, because it’s not enjoying new business generation with better margins, it doesn’t have some of the same dynamics that the long-term care business does, long-term care refresh ins by bringing in new business. The active rate efforts over the years have done a lot to contribute margin if you will as we do this testing.
But low interest rates and this new assumption applied to Bankers Life long-term care still had an impact, squeeze the margin. So the way to think about it is the risk environment related to low for long rates on Bankers long-term care is elevated by a virtue of this change and assumption, but it wasn’t to a point to where we had to increase GAAP reserves.
Randy Binner – FBR Capital Markets & Co.
Okay, got it. That’s helpful.
And then just the housekeeping matters on the new cash flow suite, does that apply to the four-year facility first, the six-year facility first, because they both get on hit equally, because they appear to be kind of a pre-pursuit?
Frederick J. Crawford
Yeah, it will tend to go with the priority towards the shorter-term facility then ultimately applying to the long-term facility.
Randy Binner – FBR Capital Markets & Co.
So, sorry, we have a timing delay, but just you ease up the short-term first and then you would go to the longer.
Frederick J. Crawford
That’s right.
Randy Binner – FBR Capital Markets & Co.
Very good. Thank you.
Operator
There are no further questions at this time.
Edward J. Bonach
So thank you, operator, and thank you, everyone, for your interest in CNO financial.