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 Financial Group third quarter 2012 earnings results conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star, then number 1 on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you. Mr. Helding, you may begin your conference.
Good morning. 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 Frederick 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 investor 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'll be making performance comparisons, unless otherwise specified, any comparisons made will be referring to changes between 3Q 2011 and 3Q 2012.
Now I would like to turn the call over to our CEO, Ed Bonach. Ed?
Thanks, Erik. 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. During the quarter, management took several steps to improve the financial flexibility and go-forward earnings profile of the company. As a result, we 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 rates. Fred will discuss these items in greater detail later in the presentation. Aside from these one-time items, our businesses continue to perform well with core sales and earnings building while we continue to invest in distribution and operations to drive future organic growth.
As you can see on slide six, CNO's core businesses continued their positive momentum and performed well during the quarter. Excluding 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, while not materially impacting third-quarter operating results, is expected to be accretive to 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 absent recovery, we expect that this will be a headwind to future earnings growth. Turning now to slide seven. During the quarter, we achieved another significant milestone by completing a comprehensive recapitalization.
As previously announced, we raised $950 million in new debt to pay off our existing senior secured debt and repurchase $200 of the $293 million of convertible debentures in a privately negotiated transaction. Our new debt structure reflects continued strong operating performance and improved ratings. 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 stairstep 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 targets.
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 to the holding company of $250 million-$275 million for the year and stock buybacks to come in near the high end of the $150 million-$170 million range that we previously disclosed. Turning now to slide nine. In addition to deploying excess capital into stock buybacks and dividends, we are also continuing to invest in our core businesses. We are making investments in 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 meet the needs of our fast-growing target market. These investments are already paying off.
Consolidated sales, excluding annuities, are up 8% in the third quarter and are 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?
Thanks, Ed. Sales results at 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 has 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 breadth of our product offerings, which allows us to shift sales mix relatively quickly in response to customer needs while maintaining pricing disciplines. 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, UnitedHealthcare, 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. That's nearly twice the level of last year. We are also continuing our partnership selling of Humana Walmart-Preferred Rx Plan in Walmart 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 MedSup activity. This year appears to be no exception, as MedSup sales activity is trending positively ahead of last year through October. I 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 agents 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 kits, 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 work site 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. 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 channel as the additional resources we've deployed continue to ramp up. We expect strong recruiting results to continue in the partner channel, with anticipation that we will see recruiting gains of 15% or more for the year.
We continue to invest in expanding PMA's geographic reach through increasing product availability. We are on track for adding products in 34 states by year-end. The combination of increased product availability and placement of additional field leadership talent in nine key markets year-to-date positions PMA well for future growth. At Colonial Penn, we will continue to invest in new lead generation activity, do expect that lead-based spending will taper off during Q4 and then ramp back up in the first quarter of next year. 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. With that, I'll hand it over to Eric Johnson, who will discuss CNO's investment portfolio. Eric?
Thank you, Scott, and good morning, everyone. 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 aren't chasing yield. During the quarter, we allocated the bulk of our new money to high-grade U.S. corporates, financials, private label RMBS, and CRE loans. One important way we sustain portfolio yield is by holding down portfolio turnover. All of other things held constant at current new money rates, each percentage in annual turnover results in roughly $2.5 million decline in investment income.
We continue to actively match our assets and our liabilities at a line of business level. 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 was 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 impairment across virtually all asset classes. As you will recall, late in 2011, we completed the early commutation of a GIC in exchange for varying interests in the underlying invested assets held by the issuer.
We disposed of the great majority of those interests prior to this quarter, raising $210 million to be reinvested out of securities earning 1.33% and into much higher yields. Our third quarter impairment of $23 million reflects our assessment of the future prospects of several of the remaining interests. The key differences from prior quarters are a higher discounting factor and a longer time horizon. The remaining carrying balance of these interests is $39 million. Going on to slide 16. Our unrealized gain increased by approximately $680 million during the quarter to $2.9 billion at quarter end. Primarily, this is a function of tighter corporate mortgage spreads. Slide 17 illustrates our overall asset allocation, which was substantially unchanged in the quarter. As I said earlier, our asset quality remains good. Our invested assets are 90% investment grade, essentially unchanged from prior periods.
The relationship of upgrades to downgrades in corporate space has been relatively stable with no net impact to RBC. Going 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 is invested principally in money market and core plus allocations with limited leverage. We additionally maintain a smaller allocation to unleveraged equities and alternatives. The amount of unrestricted cash and investments held at September 30th was $313 million. Net 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 3.44%. Our equity allocation returned 6.35%, consistent with the S&P Index. Alternatives returned a modest gain. Going on to slide 19.
Taken as a whole, news on the U.S. economy, including consumer confidence, labor market, housing, and inflation trends, all adds to slow but persistent growth. The Fed expects to keep rates low for an extended period. Credit spreads on the whole seem likely to continue to grind tighter, with some likelihood of periodic but brief searches wider. It would be easy to see certain valuations in fixed income as stretched and insufficient as demand for substitutes for safe assets compresses value. I suspect overall, non-financial credit quality has gone past its peak, and corporate fundamentals seem to have more downside than upside from here. Still, for here and now, compression seems likely, and we are planning around low new money rates for the foreseeable future. Since income is a scarce commodity, it's becoming expensive, and this suggests due caution is warranted.
We're avoiding high beta names and excess leverage in terms of financing. We still consider residential and commercial mortgage as cheap. We expect to continue to fund at levels consistent with the company's needs and objectives. With that, I will turn it to Fred.
Thanks, Eric, 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 talks advanced to a point of agreement in principle on the material economic elements of a settlement. This is a contingent loss reserve recognizing that while we know enough to estimate the financial impact, we are still working through certain non-economic items. Impacting net income was the previously disclosed charge associated with our recapitalization. In addition, stability in 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 MedSup benefit ratios. Bankers continues to enjoy strong annuity persistency and spreads, somewhat offsetting pressure on portfolio yields. Our 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 of our long-term care in-force, but as that rate activity slows, we naturally see persistency return 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 our 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.
Conditions are more challenging, the Fed appears determined to keep rates lower for longer. We adjusted our assumptions by lowering our new money rate to 4.75% and lowered our long-term rate expectation by 50 basis points. This shifting of our new money curve resulted in a large charge, larger than what we have experienced in past years. We also updated our stress test to reflect lower new money rates, again, holding flat for five years, then recovering slowly to a lower ultimate rate. This approach is consistent with rating agency stress testing standards. 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 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 last 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 in concert with our financial planning process. Stable and building earnings support a 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, assume a 5% growth rate for five years and flat thereafter. In addition, the same low rates applying pressure to our earnings has delivered a reliable level of capital gains this year, supporting a lowering of the valuation allowance on tax assets derived 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%. We expect this to gradually reduce in time as we naturally amortize debt. Our new debt prepayment sweep provision requires 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 $150 million and expect to come in at the high end of our previous guidance for 2012 stock repurchase.
We define capital generation as statutory earnings prior to surplus note interest and contractual payments made to the holding company. That number was a half a billion dollars 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 a result of no longer needing to build RBC. Any retained capital primarily supports business growth. With strength in RBC and stability in statutory earnings, we have refined our statutory dividend guidance, now expecting dividends in the $250 million-$275 million range for 2012. Slide 26 profiles 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 recurring expenses.
Again, our business model demands relatively little capital to support growth, here 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 and a reduced cash flow sweep. Scheduled amortization of the debt is roughly $55 million annually, excluding any prepayments. In short, free cash flow is finding a new level as we move through 2012 and into 2013. With that, I'll hand it back to Ed for some closing comments. Ed?
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 market, 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 needing straightforward protection products, this is a product mix where a significant amount of sales convert quickly to cash. We are shifting gears to increase our capital deployment. Our recently completed recapitalization has increased our financial flexibility, as well as lowering our cost of 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 consumer, provide a sustainable competitive advantage.
I'm pleased to announce that the company will be hosting an investor day conference in New York City on Thursday, December 13th. Invitations will be sent out, additional details will be posted to our website in the coming weeks. Now we'll open it up for your questions. Operator?
At this time, I would like to remind everyone, in order to ask a question, press star, then the number 1 on your telephone keypad. We'll pause for just a moment to compile the Q&A roster. Your first question comes from the line of Randy Binner of FBR.
You know, it was a pretty large increase. It was $21 million. It was $20 million initially, I think. I guess my question is, how much closer does this get you to settling that issue around rate increases and other settlement activity? What might this mean for other potential litigation in OCB?
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 suits, the so-called U1, U2, and Nichols. That gives rise to the additional amount that we have set up. We have reached, as Fred indicated, agreement on the significant economic terms. With that, we do believe that the significant impact is booked now into our financials on an economic basis. There still are items that we need to work out on the process of the settlement and some of the timing and details. 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.
I guess just to kind of help someone who's not as close to the legal situation like myself and probably a lot of others. Can you kind of frame this in the context of OCB? Meaning, now that you've brought these three cases together, is there any other kind of significant pending litigation? Is there anything in this settlement that is kind of favorable from a precedent perspective for you to continue to rerate other pieces of OCB?
On your first question, the answer is no. We do not have any current other significant outstanding litigation on OCB. On your second question, we have had the ability that has been confirmed to implement non-guaranteed element changes, including multi-state regulatory settlements, so that we expect that this is another step in confirmation that we have that right and ability to execute on NGE changes where warranted.
Great. Thank you for your responses.
Your next question comes from the line of Mark Palmer.
Could you please comment on the reports that were in The Wall Street Journal this week that state regulators had voted to compel insurers to hold more capital against their mortgage-backed holdings, and how that may impact CNO?
Yes. Good morning. This is Eric Johnson. I can do that. For those on the call who may be less familiar with it, the general approach of the NAIC here is to reevaluate the different projections for future paths of home price appreciation that are used to determine NAIC values for RMBS and also CMBS in a separate methodology. They're reweighting the scenario such that more conservative scenarios, in terms of an averaging process, will 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. Net net, there will be a relatively small effect on NAIC ratings, RBC requirements related to those. In terms of our portfolio, while it would be probably inappropriate to give you a specific number going forward since this would be a projection.
I would think it would be noticeable, but not material, the number of RBC points impact. Largely because our MBS portfolio is basically a no-loss portfolio to the great extent, in which case, the weighting of future paths is of really no impact. That same thing is true of our CMBS portfolio. The two taken together, the aggregate RBC effect will be noticeable but not significant.
Yeah, I would just tell you, Mark, from my perspective, this is Fred. To emphasize Eric's comments, there is a drag related to this should it go through as it's being discussed. It's not to a point to where it alters our capital planning in any way.
Very good. Thank you.
Your next question comes from the line of Humphrey Lee with UBS.
Just strengthening. How much new money you have to come down further before another charge on the interest-sensitive life book? As well, I think from the slide you mentioned that for LTC right now it is adequate. The same thing. How much would new money you have to come down before you would consider another strengthening?
I think, you are breaking up a little bit, Humphrey. It could be related to some of the poor connections we might have. I think your question was what would rates have to do in the future to give rise to a further charge? Importantly, this new assumption that we layered in is what we would characterize as a 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 as much as Treasuries these days are doing and likely do going forward. Then working with Eric and his team on what the investment strategy is going to be going forward. This is not meant to be an aggressive or conservative assumption. It is meant to be a best estimate.
Continue to review it typically each year. I say that we are required to watch this assumption each quarter and review it. It stands to reason that making an adjustment to new money projections that roll out 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 rate 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 new money curve, and it'd be a larger number.
There's 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 with what the investment strategies are at that time, what the prospects for rate recovery or lack thereof are going forward. 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 is both our own capital management exercise and then giving you a little bit of a window should you want to do your own sensitivity work.
Okay. Got it. In terms of the earlier part of the presentation mentioned that some of the capital is being redeployed to the businesses for growth. Can you quantify that, how much you're investing into the businesses and what is the impact to earnings?
Yeah. Let me start to answer that, Humphrey. 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 amounts of investments of hard dollars for the expansion is modest relative to that $45 million. It's more human capital that we're needing to invest there coupled with the financial capital. Now, what we expect to achieve by that is twofold. An increasing rate of sales to where we would expect, over time, another 1%-2% growth. Taking 6%-8% or 8%-10% annual growth in new annualized premium.
While we're also very, I'll 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 sold that will emerge then over the life of the products that are being put on the books.
Okay. I guess my question is more related to how does it flow through to the income statement? Because when I'm looking at, for example, for Bankers, the other operating expenses line seems a little bit higher this quarter, and my understanding is some of that can be attributed to some project or infrastructure build. I'm just kind of, on an ongoing basis, how much of a drag would that kind of project or infrastructure build would drag earnings in the near term?
No. From the operating expenses, there is some additional expense definitely for the expansion of locations, the training that we're doing in the Top Gun program, the field management training program, recruiting. It is basically expenses growing largely in line with the growth of business in force, which the number, as Scott alluded to, the number of policies that we're selling continues to grow, and the policies in force continues to grow.
Okay, thanks.
If you would like to ask a question, press star then the number one on your telephone keypad. The next question comes from the line of Randy Binner with FBR.
I just wanted to clean up a little bit on the stress test. I just wanted to clarify that the new stress test, so not the kind of OCB charge in the quarter, but that the output of that impact on earnings was worse than it was in the second quarter. Is that correct? It was a little bit worse.
Yes, it was, than what we had done in the previous stress test. The previous stress test 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. Then again, holding it for five years. It does have a bit more of a drag. Very importantly is how we approached this, Randy, and that is, we're freezing, if you will, assets and more or less assuming that new assets coming in are roughly equal to any assets that are leaving. Then applying a normal turnover rate or what our expected turnover rate would be, and then refinancing at that lower new money rate.
Really what these numbers are when you look at 2013 and 2014, is they're really simply reflecting freezing your net investment income as of 2012, then applying the natural bleed in portfolio yield to that number. To give you some sizing to sort of put it in perspective, we generate about $1.3 billion or so of net investment income each year. Over the course of two years, $2.6 billion, just if you were to freeze it. When looking at these numbers, these being on an after-tax basis, it's an absolute headwind to earnings. We still are able to defend overall portfolio yields through our ALM work and through managing the turnover down as Eric has highlighted before.
Okay, that's helpful. The rule of thumb, I guess, is that the test changed by 25 basis points on the front end, and so the delta in the output could be a way of thinking about.
Yeah. We tried to simplify things because upon doing the previous stress test, we found that there was at times a level of confusion as to what was done. Not uncommon, I think, in the industry. People approaching it differently. What we were really doing in that previous stress test is we were also incorporating kind of where we see the financial plan go as it relates to assets. You had an influencing effect, if you will, on what the plan assumption was for assets and what the plan assumption is for recovering rates as compared to the stress test. Here we just simplified it and said, look, we're not going to try to include other variables that could be confusing. We're simply going to say, look, what would you expect the portfolio yield bleed 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.
Okay. Yeah, I think that's easier for all of us on the outside.
Yeah.
Was long-term care at Bankers any more affected by the new methodology versus the old methodology? I think the old methodology was predominantly OCB, but also affected Bankers LTC.
Yeah.
How close is Bankers LTC getting in that test or the other testing? I was pleasantly surprised to see it was not impacted by-
Yeah
the other test.
Yeah, absolutely. It's a very good question, Randy. One of the things you'll notice in the slide we prepared is we made a comment. Bankers LTC reserves remain adequate but pressured if rates remain low, which I think is somewhat of an obvious statement. 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. We applied that test to our interest sensitive life and OCB, and also applied it to the other interest sensitive business, most notably Bankers Long-Term Care.
The idea of adjusting that assumption does have an effect on long-term care, but it's just that it really has the effect of squeezing the margin in the loss recognition testing process, but not breaking it, if you will, to a point to where you need to increase your GAAP reserves. What is important though to note. There's a reason for that. We've said this for a while. The reason why interest sensitive life and OCB is a bit more susceptible is 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 refreshens 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.
Low interest rates and this new assumption applied to Bankers Life Long-Term Care still had an impact, squeezed the margin. The way to think about it is the risk environment related to low for long rates on Bankers Long-Term Care is elevated by virtue of this change in assumption. It wasn't to a point to where we had to increase GAAP reserves.
Okay, got it. That's helpful. Then just a housekeeping matter is on the new cash flow sweep. Does it apply to the four-year facility first, the six-year facility first, or do they both get hit equally? They appear to be kind of a pari passu .
Yeah. It will tend to go with a priority towards the shorter-term facility, then ultimately applying to the long-term facility.
Sorry, we have a timing delay. Just so you use up the short term first, and then it would go to the longer.
That's right.
All right. Very good. Thank you.
There are no further questions at this time.
Thank you, operator, and thank you, everyone for your interest in CNO Financial.