An analysis of CNO’s debt and liabilities

Update:  If you read this article prior to 11:20pm EST, please re-read it.  I had a major data loss in the upload that I did not recognize and as a consequence the bulk of the article was deleted. 

I have been asked by several readers to assess the severity and impact of Conseco’s (CNO) debt.  I am much obliged to do so.  But let me forewarn all readers that assessing the debt of an insurance company is risky business (pun intended).  Insurance companies buy and sell risk and as a consequence virtually all of their policies expose them to future liability.

Let’s start simple. An insurance company receives payments from its clients for a service (life insurance, mortgage insurance, mortgages themselves) The actuaries at the insurance company determine based on probabilistic theories how much these services should cost.  If an insurance company just ‘sat’ on the money they collected in order to keep it safe in the event of massive payouts (let’s say invested soley in Treasury Bills), they couldn’t stay in business.  In order to compensate for their low rate of return on their collected revenue, their premiums for service would have to extraordinarily high and as a consequence they would price themselves out of business.  So instead, they invest this money, in a variety of ways not unlike an investment bank would.  Additionally, as most publically traded companies do, they have a certain amount of secured debt (true ‘debt’ . . think bonds).

Most of you didn’t need to read that paragraph, maybe some of you did.  But even if it was ‘below’ you, it serves as a good starting point to assess the debts or potential debts of an insurance company. 

Let’s boil down that basic paragraph to identify the sources of liabilities and debt that an insurance company is expected to have:  secured debt (true debt – bonds, notes), liability stemming from policies they have written, mortgages they hold and investments that are linked to ‘risky’ assets (such as mortgage securities).

Let’s take a look at CNO’s numbers:

Secured debt (direct corporate debt):  $1.2 billion dollars

Cash on hand:  $1.2 billion dollars. 

This is a very stable condition. 

The metric that is often used to determine a company’s ability to pay its debts is the interest coverage ratio which is 3:1 for CNO. (Which compares the net income (before taxes) with the annual interest expenses).  This is a very stable ratio for CNO.

Let’s next consider the amount of liability that CNO is exposed to due to their insurance contracts.  CNO has approximately $23 billion dollars of liability associated with their insurance contracts.  Theoretically, if all of these needed to be paid, CNO would be bankrupt.  But, of course, this is the same for every insurance company on the planet.  The key to an insurance company’s profitability lies in two key factors:  1. that their revenue exceeds the amount of benefits paid out each year.  2. that they invest their revenue wisely to ensure they maintain a large buffer to safety in unpredictable economic times.  

Let’s look at last quarter for CNO.  They received $1.069  billion dollars in revenue and paid out $1.027 billion dollars in insurance benefits.  This resulted in a pre-tax income of $42 million dollars.  After taxes, the net income was $24.5.  Divide this profit 184 million ways for each share and we get 13 cents profit per share.  Repeat this process quarter after quarter and you have a successful insurance company. 

At first glance, it appears as if the difference between payouts in benefits and revenue is slim.  It is.  For CNO, it is 4%.  Let’s compare that performance with a larger company that is currently trading near its book value. 

I selected Prudential (who looks like they will reject TARP funds).  In the same quarter (1st quarter of this year), Prudential earned $8.563 billion dollars in revenue and paid out $8.551 billion dollars in insurance payouts and benefits.  This resulted in a pre-tax income of $12 million dollars and then after taxes and some creative accounting net income of $5 million dollars attibutable to shareholders (they report an income of $14 milion but for a variety of reasons only $5 million dollars of that is attributable to shareholders) for an income of 1 cent per share.  Prudential’s margin here is .1% (compared to the 4% we calculated for CNO)

So after all the number crunching, I think it is clear that CNO’s financial structure regarding its insurance policies is sound and no different than the titans of the industry (and in the case of Prudential, arguably better)

Now there is the topic of exposure to the credit and mortgage ‘crisis’.  CNO is exposed to $2 billion dollars of mortgages and has close to $3 billion dollars of mortgage backed securities as investments.  To address the latter first, CNO has placed a ‘fair value’ on the $3 billion of investments at $2 billion to be conservative and as a result reducing their held assets by 5%.  As a side note, they did not have to do this, but it is clear to me that they are trying to protect themselves from future economic and credit hardships.

As far as their $3 billion dollars in mortgage loans, the company reported that as of 31 March 2009, the company had $7.6 million dollars in mortgage loans that were currently 90 days or more delinquent.  This is .2% of the value of their currently held loans, with the national foreclosure rate hovering around 2% (on the high side), it is clear that CNO is not likely to suffer from past poor lending practices.

There is much more analysis that could be done here (such as looking at their regional exposures and their debt structures) but I think the numbers presented speak for themselves here.  CNO’s debt and liability structure is healthy and although not without some risk, in-line or above the industry average.

Aimee and I are leaving to watch a performance of Mama Mia in Honolulu tonight.  Have a great weekend.

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