Good morning. My name is Chelsea, and I'll be your conference operator today. At this time, I would like to welcome everyone to the CNO DAC Accounting Change 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 the number one on your telephone keypad. If you'd like to withdraw your question, press the pound key. Thank you, Mr. Goldberg. You may begin your conference.
Thank you, operator. Good morning, and thank you for joining us on CNO Financial Group's DAC Accounting Change Conference Call. Today's presentation will be led by our Chief Executive Officer, Ed Bonach. Following the presentation, we will also have several other business leaders available for the question-and-answer period. This presentation was filed in a Form 8-K earlier this morning and is also available in the investors section of our website at www.cnoinc.com. Let me remind you that any forward-looking statements 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. Now I'd like to turn the call over to our CEO, Ed Bonach. Ed?
Thanks, Scott. Good morning, everyone, and thank you for joining us on the call today. During our third quarter 2011 earnings call, we disclosed our estimated impact of implementing the new DAC accounting standard, ASU 2010-26, which was formerly known as EITF 09-G. Our estimates have not changed. The purpose of today's call is to provide more detail and granularity on the estimated impact of implementation of this standard on CNO, more specifically, to demonstrate how each of our operating segments will be impacted quite differently by the new guidance. That said, remember that the economics and cash flows of our business remain unchanged. CNO is positioned for above-average growth, with expected sales growth of 8%-12% annually. In addition, our target market has extremely attractive demographics.
The total U.S. population of those 65 and over is expected to increase approximately 35% by 2020 and grow 80% by 2030. We have a strong capital position with a consolidated RBC of 359% and $169 million of cash and investments at the holding company as of September 30, 2011. As we have indicated in prior earnings calls, the statutory earnings power of the insurance company provides excess capital or dividend capacity in the range of $75 million-$200 million annually. Statutory financials are also unaffected by this accounting change. Finally, we feel that the company has sustainable competitive advantage in the marketplace. We have an exclusive growing distribution. Our focus is on a fast-growing, underserved market. We believe there are significant barriers to entry to our market.
Slide six is the same disclosure from our third quarter 2011 earnings call, showing the estimated impact of implementing the new accounting standard. As I mentioned at the outset, our estimates are unchanged from what was previously disclosed. Our estimates show an expected $29 million-$34 million negative impact to our annual net income in the first year of adoption, equating to $0.09-$0.12 per diluted share. In addition, we estimate the initial retrospective adoption to result in a $465 million-$510 million or a 10%-12% reduction in book value excluding AOCI, equating to $1.50-$1.70 reduction in diluted book value per share. The changes from the new pronouncement will impact GAAP financials only. Statutory and tax, along with cash generation, are unchanged.
On slide seven, you can see the 2008 through 2010 statutory earnings and cash generation of the company as contrasted with the reported pre-tax GAAP operating income results for the same period on both a pre and post-implementation basis. As a reminder, statutory income is the primary driver of dividend capacity from the insurance subsidiaries. In addition to dividends, the holding company also generates cash from interest payments on intercompany surplus notes, plus fees for investment and administrative services provided to the insurance companies that annually total approximately $140 million. As we talked about in our 3Q earnings call, we think this is important to note as statutory income mirrors cash flow, and there are some investors that seem to be moving towards valuing companies on statutory metrics.
The overall impact of implementing ASU 2010-26 on the reported pre-tax GAAP operating earnings for 2008 through 2010 is negative, as shown by the yellow bars on the right side of this slide. As you can see, as the business ages, the impact lessens. This is primarily due to the impact of fresh start accounting, which was implemented as the company came out of bankruptcy in late 2003. Because of this accounting, the age of the book of business comprising the deferred acquisition costs on the balance sheet is relatively young. Costs related to acquiring new business are significant in the first year, resulting in a higher unamortized DAC asset amount.
Consequently, with CNO's much younger block of business with DAC, applying these new accounting rules will result in higher expenses upfront on a relative basis, with the impact lessening as the post-2003 business matures and its contribution to earnings is more evident. I'll touch on the additional details and impacts of fresh start accounting a little later in the presentation. Turning to slide eight. This call is to cover how each of our operating segments is impacted differently by the new DAC accounting guidance. In addition, we feel it's important to understand these differences not only when assessing the performance of each of our segments, but also in assessing CNO consolidated and relative to our peers. With respect to the agenda, we will first review the background and summary of the DAC accounting changes.
We will then take you through the impacts on CNO, including additional disclosures bifurcating results between new and in-force business. As you will see, we believe that the in-force results are more indicative of business performance and long-term value. Finally, as I had mentioned earlier, we will comment on the implications of fresh start accounting on CNO. In the past, there has been diversity in industry practice relating to what costs are deferred and the underlying concepts of costs that vary with and are primarily related to new business that were not clearly defined. Under existing accounting rules, identifying acquisition costs eligible for deferral was subject to significant management judgment. The accounting and regulatory body's intent is to improve comparability across insurers, but as we will show you later in the presentation, the impacts on business segments, even within one company such as ours, can be markedly different.
The changes are primarily related to the definition of deferred acquisition costs. A company was previously able to defer costs that vary with and are primarily related to the addition of insurance contracts. Now, only costs related to successful efforts can be deferred, general overhead costs related to acquisition activities such as rent, software, administrative costs must be expensed. In addition, and of significant impact to our Colonial Penn segment, advertising costs can only be deferred if qualified pursuant to the direct response advertising criteria. We will touch on this in more detail later. Turning to slide 10. Again, this is a GAAP accounting change only, which we will be adopting retrospectively in the first quarter of 2012. There will be no change to the economics of our business, nor will this change our cash flow, statutory financials, tax position, NOL, or capital generation.
We will continue to defer most commission payments plus other costs directly related to the production of new business. However, a significant portion of direct advertising costs incurred by the Colonial Penn segment and field management costs incurred by the Bankers Life segment will be expensed as incurred. Our PVFP balance and related amortization will not be impacted by this accounting change. Slide 11 is a summary of EBIT by segment for the year ended December 31, 2010. On the left-hand side of the chart, you can see the segment results on an as-reported basis, and on the right side of the chart, you can see the segment results restated for ASU 2010-26, which is then further split between in-force and new business. Although Bankers Life has the largest dollar impact, Colonial Penn has the largest impact as a percentage of reported EBIT.
Our Washington National and other CNO business segments are not significantly impacted by this accounting change. I'd like to spend a few minutes on where and why CNO is expected to be impacted disproportionately. As I said previously, Colonial Penn will be impacted the most as a % of their segment earnings due to the significantly reduced deferral of direct advertising costs. Bankers Life has pre-reduction and will also be impacted as certain field management expenses will no longer be deferred. Under the new pronouncement, new business will strain earnings in year of issue, growth will suppress reported earnings. As CNO's sales growth has been greater than market and is expected to continue to outpace the market, we expect a disproportionate negative impact on our earnings as compared to the industry. Our fresh start accounting from 2003 will also have a disproportionate impact.
With PVFP not being impacted by ASU 2010-26, CNO will have less of a book value decrease upon adoption. The PVFP amortization will continue to have a negative impact on future earnings and returns relative to peers. Application of these accounting rules to CNO's much younger block of business with DAC will result in higher upfront on a relative basis, with the impact lessening as the business matures and its contribution to earnings is more evident. Slide 13 is a summary of the estimated impact of the implementation on the various components of our DAC balance, calculated on a pro forma basis as of September 30, 2011. Turning to slide 14. This again is a summary of the estimated impact of the implementation of the new DAC accounting rules on CNO as of September 30, 2011, on a pro forma basis.
As I said before, this is unchanged from our 3Q earnings call disclosure. The pro forma impacts are calculated based upon a number of assumptions, including sales growth, mix of business, and the level of direct advertising. Actual experience may differ from assumptions. The impact to ROE on a consolidated basis is not expected to be significant as both R and E decrease. Slide 15 is a summary of the impact with respect to the debt covenants in our senior secured credit facility. For the debt-to-capital ratio, the current covenant level is at 30%. The ratio reported at September 30, 2011, was 18%. Pro forma after the accounting change, the ratio would increase to 20%. There is no impact on the other key covenant metrics related to statutory surplus, consolidated RBC, and interest coverage.
With respect to an accounting change such as ASU 2010-26, the credit agreement allows the company and the agent to negotiate in good faith to amend the impacted covenants to restore the company and the lenders to the position occupied before the change is implemented. Even without such an amendment, we still have substantial margin on the impacted covenant. Slide 16 details additional disclosures that we intend to implement and potential mitigation actions with respect to the implementation of the new accounting standard. The most important one, which I have already alluded to, is the bifurcation of results between in-force and new business. We believe that the in-force results are more indicative of business performance and long-term value, while the new business results are impacted more by the rate of sales growth, sales mix, and the level of direct advertising spend.
We intend to shift some of our annual incentive compensation to be based on in-force profitability. We will also continue to review potential business actions, such as modifying certain commission and compensation arrangements so they are directly related to the successful acquisition of new insurance contracts, as well as exploring reinsurance and other transactions. Slide 17 shows the estimated impact of the adoption of the accounting on our consolidated EBIT for the year ended December 31, 2010, broken down by line item. It's important to note that the earnings before acquisition expenses and amortization remain substantially unchanged. On the left side of the table are the results on an as-reported basis, and on the right side are the results restated for ASU 2010-26 in total, and then split between in-force and new business.
By separating the income statement between new and in-force business, you can see the impact on earnings resulting from the majority of direct marketing costs no longer being capitalized and deferred under the new accounting. Slide 18 shows the consolidated GAAP EBIT for 2008 to 2010 as restated for ASU 2010-26 and broken down by in-force versus new business results. In addition, you can also see the impact on consolidated ROE as restated for the pronouncement. The next four slides show the impact for 2008 through 2010 for each of the segments. Slide 19 is the impact of the accounting on Bankers Life. As Bankers Life has career distribution, there will be an impact going forward as certain field management expenses will no longer be deferrable. Note that Bankers Life return on allocated capital is expected to be favorably impacted.
We anticipate the implementation of the new accounting to have very little impact on Washington National's earnings, yet its ROAC is also expected to be positively impacted. Turning to slide 21 with respect to Colonial Penn, earnings after adoption of ASU 2010-26 for a direct marketing operation like Colonial Penn will be similar now to statutory earnings. In addition, you can see from the chart that we had a notable increase in earnings in 2009, which is a direct impact of reducing advertising spending to conserve cash and capital in that year. This underscores why we believe that GAAP in-force results are more indicative of business performance and value creation. The other CNO business segment will see a slight positive impact from the new accounting, as future amortization amounts will be less with no offsetting acquisition, with the segment being comprised of closed blocks of business.
As I mentioned earlier, PVFP is not impacted by ASU 2010-26. PVFP is sometimes referred to as purchase DAC and is a proxy for the DAC on business at CNO that was written prior to September 1, 2003. The table on slide 23 is intended to show the pro forma amounts if the PVFP balance and related amortization of PVFP were treated the same as DAC and were reduced by the new accounting standard proportional to the decreases in DAC and DAC amortization. Under this scenario, our book value would decrease by an additional $379 million. However, our pro forma operating earnings per share for 2010 would swing $0.15 per share positively, increasing by an estimated $0.01 per share rather than decreasing by $0.14 per share. The key message is that this is a GAAP accounting change only, and the economics of the business do not change.
There is no impact to statutory or cash flow, there's no impact on capital generation or our valuable NOL asset. However, as we hopefully demonstrated, the impact on the GAAP earnings is markedly different for each of our segments. CNO has an above-average growth potential, not only with our focus on the underserved and growing senior middle-income market, but also with our plans to invest in organic growth. We are in a strong capital position with $110 million in excess of management targets at the end of 3Q 2011, and we continue to generate significant excess capital of approximately $75 million to $200 million annually. Furthermore, we believe we have a sustainable competitive advantage. With that, I will open it up for questions. Operator?
At this time, I would like to remind everyone, to ask a question, press star, then the number one on your telephone keypad. We'll pause for just a moment to compile the Q&A roster. Your first question comes out of Randy Binner with FBR.
Hey. Thanks for the call. Just a couple quick ones. I guess, as it relates to debt to capital, as you mentioned in the comments that it pushes out kind of the time horizon when you get to better levels on debt to cap, that does have an effect on buybacks. The buffer that you mentioned in the relative to the covenant holders is fine. Can you kind of characterize for folks how big a priority it would be for you to go back and try to renegotiate that? Because it would be better for shareholders if you moved to $0.50 on the dollar instead of $1 for $1 on buybacks versus debt paydown.
Yeah, Randy. Thanks. We would expect to approach the lenders and have those good faith discussions and have both parties step back to the same position that we were prior to the implementation of this accounting change. That said, again, this will only start to impact our debt to cap come first quarter of 2012 reported earnings. The 20% that was noted in the call was a pro forma 3Q 2011 number. Where our debt to cap will be come first quarter of 2012 is yet to be determined.
Right. I guess in particular, I'm thinking about the 17.5 level, where the capital return metrics would change. That's good to know that you'll be engaging them there. Then I guess just on the in-force data, that will be helpful in modeling out returns. It'll be important that that's at the segment level. Do you know if you're planning to enhance your in-force result disclosure in the financial supplement and for the business segment level? Is that the plan?
Yes, the plan is to report segment earnings at least for Colonial Penn and Bankers on the in-force and new business split. Given that we're doing it for those two, we most likely will do that for Washington National and OCB. Although OCB, of course, has no new business. To have it consistent between the four segments, that is our intention. As I've mentioned as well, that will help to support our move to have some of our incentive compensation be tied to in-force profitability results.
Okay, understood. Just to be clear, ideally, it would be in the sup, the financial supplement, so everyone can work it into their live model. That's all I have. Thanks.
Well, I'll say we will determine that. In what we would be reporting in our earnings call, much like we did here, the expectation would be that when we talk about the segment earnings, we will talk about total earnings and show in the calls and those disclosures what the contribution was from in-force and what the strain was from new business.
Understood. Thank you.
Your next question comes out of Eric Bass with JP Morgan.
Hi, good morning. Just had a question on, looks like the impact on operating EPS is expected to be lower in 2012 than in 2010. I would expect your sales production will probably be higher in at least most segments. Is the decline due more to kind of the lower PVFP amortization, or is something else driving that?
It is more, Eric, the fact that the in-force business sold since 2003 that has DAC will have aged and matured another year and had a larger contribution to earnings, so less of a negative impact. It's really the business Contribute more to reported earnings in that scenario.
Okay, thanks.
Again, if you would like to ask a question, press star and the number 1 on your telephone keypad. Your next question comes from Thomas Gallagher with Evercore.
Hi, thanks. You mentioned reinsurance as a possible mitigant to the accounting change. Can you give an example of what you're looking at here and why you think that reinsurance, which is largely an economic transaction, is the right response to the stat accounting change, which is purely a change to accounting? Thanks.
Yeah. Thanks, Thomas. Sorry, I'm not intending to say that reinsurance is the right response. You're absolutely correct. It's an economic transaction. As I somewhat touched on, even in the third quarter earnings call, is that if there are doubters among us that even though GAAP reported earnings on Colonial Penn are negligible under the retrospective adoption and expectations here with ASU 2010-26, that we will be able to demonstrate it, if necessary, by entering into an economic transaction to show that there really is value here, even though GAAP reported earnings are plus/minus zero. I'm not advocating that. It's not in the long-term value creation interest of the company or shareholders to do that. I bring it up more as a, I'll say, an underscoring of, yeah, this is GAAP accounting only. It's not changing the economics.
Okay, thanks.
Again, if you would like to ask a question, press star, then the number one on your telephone keypad.
Agreed. Well, thank you, everyone, for participating in the call, and happy holidays.
This concludes today's conference call. You may now disconnect.