EX-99.1 3 exhibit991.htm EXHIBIT 99.1 exhibit991.htm


Exhibit 99.1
 

 
 
ITEM 7.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF CONSOLIDATED FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

In this section, we review the consolidated financial condition of CNO Financial Group, Inc. ("CNO", formerly known as Conseco, Inc. prior to its name change in May 2010) at December 31, 2009, and the consolidated results of operations for the years ended December 31, 2009, 2008 and 2007 and, where appropriate, factors that may affect future financial performance.  CNO became the successor to Conseco, Inc., an Indiana corporation (our "Predecessor"), in connection with our bankruptcy reorganization which became effective on September 10, 2003 (the "Effective Date").  Please read this discussion in conjunction with the consolidated financial statements and notes included in this Form 10-K.

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

Our statements, trend analyses and other information contained in this report and elsewhere (such as in filings by CNO with the Securities and Exchange Commission (the "SEC"), press releases, presentations by CNO or its management or oral statements) relative to markets for CNO’s products and trends in CNO’s operations or financial results, as well as other statements, contain forward-looking statements within the meaning of the federal securities laws and the Private Securities Litigation Reform Act of 1995.  Forward-looking statements typically are identified by the use of terms such as “anticipate,” “believe,” “plan,” “estimate,” “expect,” “project,” “intend,” “may,” “will,” “would,” “contemplate,” “possible,” “attempt,” “seek,” “should,” “could,” “goal,” “target,” “on track,” “comfortable with,” “optimistic” and similar words, although some forward-looking statements are expressed differently.  You should consider statements that contain these words carefully because they describe our expectations, plans, strategies and goals and our beliefs concerning future business conditions, our results of operations, financial position, and our business outlook or they state other “forward-looking” information based on currently available information.  The “Risk Factors” in Item 1A provide examples of risks, uncertainties and events that could cause our actual results to differ materially from the expectations expressed in our forward-looking statements.  Assumptions and other important factors that could cause our actual results to differ materially from those anticipated in our forward-looking statements include, among other things:

·  
our ability to continue to satisfy the financial ratio and balance requirements and other covenants of our debt agreements;

·  
general economic, market and political conditions, including the performance and fluctuations of the financial markets which may affect our ability to raise capital or refinance existing indebtedness and the cost of doing so;

·  
our ability to generate sufficient liquidity to meet our debt service obligations and other cash needs;

·  
our ability to obtain adequate and timely rate increases on our health products, including our long-term care business;

·  
the receipt of any required regulatory approvals for dividend and surplus debenture interest payments from our insurance subsidiaries;

·  
mortality, morbidity, the increased cost and usage of health care services, persistency, the adequacy of our previous reserve estimates and other factors which may affect the profitability of our insurance products;

·  
changes in our assumptions related to deferred acquisition costs or the present value of future profits;

·  
the recoverability of our deferred tax assets and the effect of potential ownership changes and tax rate changes on its value;

·  
our assumption that the positions we take on our tax return filings, including our position that our 7.0% Convertible Senior Debentures due 2016 ("7.0% Debentures") will not be treated as stock for purposes of Section 382 of the Internal Revenue Code (the "Code") and will not trigger an ownership change, will not be successfully challenged by the Internal Revenue Service (the "IRS");

 
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·  
changes in accounting principles and the interpretation thereof;

·  
our ability to achieve anticipated expense reductions and levels of operational efficiencies including improvements in claims adjudication and continued automation and rationalization of operating systems,

·  
performance and valuation of our investments, including the impact of realized losses (including other-than-temporary impairment charges);

·  
our ability to identify products and markets in which we can  compete effectively against competitors with greater market share, higher ratings, greater financial resources and stronger brand recognition;

·  
the ultimate outcome of lawsuits filed against us and other legal and regulatory proceedings to which we are subject;

·  
our ability to complete the remediation of  the material weakness in internal controls over our actuarial reporting process and to maintain effective controls over financial reporting;

·  
our ability to continue to recruit and retain productive agents and distribution partners and customer response to new products, distribution channels and marketing initiatives;

·  
our ability to achieve eventual upgrades of the  financial strength ratings of CNO and our insurance company subsidiaries as well as the impact of rating downgrades on our business and our ability to access capital;

·  
the risk factors or uncertainties listed from time to time in our filings with the SEC;

·  
regulatory changes or actions, including those relating to regulation of the financial affairs of our insurance companies, such as the payment of dividends and surplus debenture interest to us, regulation of financial services affecting (among other things) bank sales and underwriting of insurance products, regulation of the sale, underwriting and pricing of products, and health care regulation affecting health insurance products; and

·  
changes in the Federal income tax laws and regulations which may affect or eliminate the relative tax advantages of some of our products.

Other factors and assumptions not identified above are also relevant to the forward-looking statements, and if they prove incorrect, could also cause actual results to differ materially from those projected.

All written or oral forward-looking statements attributable to us are expressly qualified in their entirety by the foregoing cautionary statement.  Our forward-looking statements speak only as of the date made.  We assume no obligation to update or to publicly announce the results of any revisions to any of the forward-looking statements to reflect actual results, future events or developments, changes in assumptions or changes in other factors affecting the forward-looking statements.

OVERVIEW

We are a holding company for a group of insurance companies operating throughout the United States that develop, market and administer health insurance, annuity, individual life insurance and other insurance products.  We focus on serving the senior and middle-income markets, which we believe are attractive, underserved, high growth markets.  We sell our products through three distribution channels: career agents, professional independent producers (some of whom sell one or more of our product lines exclusively) and direct marketing.

 
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Beginning July 1, 2010, management has changed the manner in which it disaggregates the Company’s operations for making operating decisions and assessing performance.  As a result, the Company manages its business through the following operating segments: Bankers Life, Colonial Penn and Washington National, which are defined on the basis of product distribution; Other CNO Business, comprised primarily of products we no longer sell actively; and corporate operations, comprised of holding company activities and certain noninsurance company businesses.  All prior period segment disclosures have been revised to conform to management’s current view of the Company’s operating segments.  The Company’s segments are described below:

· 
Bankers Life, which markets and distributes Medicare supplement insurance, interest-sensitive life insurance, traditional life insurance, fixed annuities and long-term care insurance products to the middle-income senior market through a dedicated field force of career agents and sales managers supported by a network of community-based branch offices.  The Bankers Life segment includes primarily the business of Bankers Life and Casualty Company ("Bankers Life").  Bankers Life also markets and distributes Medicare Advantage plans primarily through a distribution arrangement with Humana, Inc. ("Humana") and Medicare Part D prescription drug plans through a distribution and reinsurance arrangement with Coventry Health Care ("Coventry").
   
· 
Washington National, which markets and distributes supplemental health (including specified disease, accident and hospital indemnity insurance products) and traditional life insurance to middle-income consumers at home and at the worksite.  These products are marketed through Performance Matters Associates, Inc., a wholly owned subsidiary, and through independent marketing organizations and insurance agencies.  Products being marketed by Washington National are underwritten by Washington National Insurance Company ("Washington National").
   
· 
 
Colonial Penn, which markets primarily graded benefit and simplified issue life insurance directly to customers through television advertising, direct mail, the internet and telemarketing.  The Colonial Penn segment includes primarily the business of Colonial Penn Life Insurance Company ("Colonial Penn").
   
· 
Other CNO Business, which consists of blocks of interest-sensitive life insurance, traditional life insurance, annuities, long-term care insurance and other supplemental health products.  These blocks of business are not being actively marketed and were primarily issued or acquired by Conseco Life Insurance Company ("Conseco Life") and Washington National.


 
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The following summarizes our earnings for the three years ending December 31, 2009 (dollars in millions, except per share data):

   
2009
    
2008
    
2007
  
Earnings before net realized investment gains (losses), discontinued operations,
corporate interest, gain (loss) on extinguishment or modification of debt and income taxes (“EBIT” a non-GAAP financial measure) (a):
                  
  Bankers Life
   $ 278.0     $ 171.5     $ 241.8  
  Washington National
     110.9       121.1       127.7  
  Colonial Penn
     29.4       25.2       18.1  
  Other CNO Business
     (43.6 )     .2       (154.0 )
  Corporate Operations, excluding corporate interest expense
     (37.7 )     (26.7 )     (49.0 )
  EBIT
     337.0       291.3       184.6  
Corporate interest expense
     (84.7 )     (67.9 )     (80.3 )
Income before gain (loss) on extinguishment or modification of debt, net realized investment losses, taxes and discontinued operations
     252.3       223.4       104.3  
Tax expense on operating income
     87.7       86.4       35.9  
Income before gain (loss) on extinguishment or modification of debt, net realized investment losses, valuation allowance for deferred tax assets and discontinued operations 
     164.6       137.0       68.4  
Preferred stock dividends
     -       -       (14.1 )
                         
Net operating income
     164.6       137.0       54.3  
                         
Gain (loss) on extinguishment or modification of debt, net of income taxes
     (14.4 )     13.8       -  
Net realized investment losses (excluding the increase in unrealized losses on those investments transferred to an independent trust and net of related amortization and taxes and the establishment of a valuation allowance for deferred tax assets related to such losses)
     (41.5 )     (217.4 )     (79.5 )
Net income (loss) before valuation allowance for deferred tax assets and discontinued operations
     108.7       (66.6 )     (25.2 )
Valuation allowance for deferred tax assets (excluding the establishment of a valuation allowance for realized investment losses and discontinued operations)
     (23.0 )     (343.0 )     (68.0 )
Discontinued operations
     -       (722.7 )     (105.9 )
Net income (loss) applicable to common stock
   $ 85.7     $ (1,132.3 )   $ (199.1 )
Per diluted share:
                        
Net operating income
   $ .86     $ .74     $ .31  
Gain (loss) on extinguishment or modification of debt, net of income taxes
     (.08 )     .08       -  
Net realized investment losses, net of related amortization and taxes
     (.21 )     (1.18 )     (.46 )
Valuation allowance for deferred tax assets
     (.12 )     (1.86 )     (.39 )
Discontinued operations
     -       (3.91 )     (.61 )
Net income (loss)
   $ .45     $ (6.13 )   $ (1.15 )
____________
(a)  
Management believes that an analysis of EBIT provides a clearer comparison of the operating results of the Company from period to period because it excludes:  (i) corporate interest expense; (ii) gain (loss) on extinguishment or modification of debt; (iii) net realized investment gains (losses) that are unrelated to the Company’s underlying fundamentals; and (iv) discontinued operations and increases to our valuation allowance for deferred tax assets, which are unrelated to our continuing operations.  The table above reconciles the non-GAAP measure to the corresponding generally accepted accounting principles ("GAAP") measure.

 
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Our major goals for 2010 include:

·  
Continuing to improve the focus and profitability mix of sales at Washington National.

·  
Maintaining strong growth at Bankers Life.

·  
Improving earnings stability and reducing volatility.

·  
Determining that improved controls implemented in 2009 have operated for a period of time sufficient to demonstrate their effectiveness and thereby remediating our material weakness in internal controls.

·  
Continuing to actively manage our enterprise exposure to long-term care business.

·  
Improving profitability of existing lines of business or disposing of underperforming blocks of business.

CRITICAL ACCOUNTING POLICIES

The preparation of financial statements in accordance with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Management has made estimates in the past that we believed to be appropriate but were subsequently revised to reflect actual experience.  If our future experience differs materially from these estimates and assumptions, our results of operations and financial condition could be affected.

We base our estimates on historical experience and other assumptions that we believe are reasonable under the circumstances.  We continually evaluate the information used to make these estimates as our business and the economic environment change.  The use of estimates is pervasive throughout our financial statements.  The accounting policies and estimates we consider most critical are summarized below.  Additional information on our accounting policies is included in the note to our consolidated financial statements entitled “Summary of Significant Accounting Policies”.

Investments

At December 31, 2009, the carrying value of our investment portfolio was $21.5 billion.

We defer any fees received or costs incurred when we originate investments.  We amortize fees, costs, discounts and premiums as yield adjustments over the contractual lives of the investments.  We consider anticipated prepayments on structured securities when we estimate yields on such securities.  When actual prepayments differ from our estimates, the adjustment to yield is recognized as investment income (loss).

We regularly evaluate our investments for possible impairment based on current economic conditions, credit loss experience and other investee-specific circumstances and developments.  When we conclude that a decline in a security’s net realizable value is other than temporary, the decline is recognized as a realized loss and the cost basis of the security is reduced to its estimated fair value.  During the year ended December 31, 2009, writedowns of investments included $195.4 million of writedowns of investments for other than temporary declines in fair value recognized through net income.

Our evaluation of investments for impairment requires significant judgments, including: (i) the identification of potentially impaired securities; (ii) the determination of their estimated fair value; and (iii) the assessment of whether any decline in estimated fair value is other than temporary.

Our assessment of whether unrealized losses are “other than temporary” requires significant judgment.  Factors considered include: (i) the extent to which fair value is less than the cost basis; (ii) the length of time that the fair value has been less than cost; (iii) whether the unrealized loss is event-driven, credit-driven or a result of changes in market risk premium or interest rates; (iv) the near-term prospects for improvement in the issuer and/or its industry; (v) our view of the investment’s rating and whether the investment is investment-grade and/or has been downgraded since its purchase; (vi) whether the issuer is current on all payments in accordance with the contractual terms of the investment and is expected to meet all of its obligations under the terms of the investment; (vii) our ability and intent to hold the investment for a period of time sufficient to allow for any anticipated recovery; and (viii) the underlying current and prospective asset and enterprise

 
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values of the issuer and the extent to which our investment may be affected by changes in such values.  At December 31, 2009, our net accumulated other comprehensive income (loss) included gross unrealized losses on fixed maturity securities of $.9 billion, which we consider to be temporary declines in estimated fair value.

When the cost basis of a security is written down to fair value due to an other than temporary decline, we review the circumstances of that particular investment in relation to other investments in our portfolio.  If such circumstances exist with respect to other investments, those investments may also be written down to fair value.  Future events may occur, or additional or updated information may become available, which may necessitate future realized losses of securities in our portfolio.  If new information becomes available or the financial condition of the investee changes, our judgments may change resulting in the recognition of a realized investment loss at that time.  Significant realized losses on our investments could have a material adverse effect on our earnings in future periods.

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date and, therefore, represents an exit price, not an entry price.  We hold fixed maturities, equity securities, derivatives and separate account assets, which are carried at fair value.

The degree of judgment utilized in measuring the fair value of financial instruments is largely dependent on the level to which pricing is based on observable inputs.  Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our view of market assumptions in the absence of observable market information.  Financial instruments with readily available active quoted prices would be considered to have fair values based on the highest level of observable inputs, and little judgment would be utilized in measuring fair value.  Financial instruments that rarely trade would be considered to have fair value based on a lower level of observable inputs, and more judgment would be utilized in measuring fair value.

There is a three-level hierarchy for valuing assets or liabilities at fair value based on whether inputs are observable or unobservable.

·  
Level 1 – includes assets and liabilities valued using inputs that are quoted prices in active markets for identical assets or liabilities.  Our Level 1 assets include exchange traded securities and U.S. Treasury securities.

·  
Level 2 – includes assets and liabilities valued using inputs that are quoted prices for similar assets in an active market, quoted prices for identical or similar assets in a market that is not active, observable inputs, or observable inputs that can be corroborated by market data.  Level 2 assets and liabilities include those financial instruments that are valued by independent pricing services using models or other valuation methodologies.  These models are primarily industry-standard models that consider various inputs such as interest rate, credit spread, reported trades, broker/dealer quotes, issuer spreads and other inputs that are observable or derived from observable information in the marketplace or are supported by observable levels at which transactions are executed in the marketplace.  Financial instruments in this category primarily include:  certain public and private corporate fixed maturity securities; certain government or agency securities; certain mortgage and asset-backed securities; and non-exchange-traded derivatives such as call options to hedge liabilities related to our fixed index annuity products.

·  
Level 3 – includes assets and liabilities valued using unobservable inputs that are used in model-based valuations that contain management assumptions.  Level 3 assets and liabilities include those financial instruments whose fair value is estimated based on non-binding broker prices or internally developed models or methodologies utilizing significant inputs not based on, or corroborated by, readily available market information.  Financial instruments in this category include certain corporate securities (primarily private placements), certain mortgage and asset-backed securities, and other less liquid securities.  Additionally, the Company’s liabilities for embedded derivatives (including embedded derivates related to our fixed index annuity products and to a modified coinsurance arrangement) are classified in Level 3 since their values include significant unobservable inputs including actuarial assumptions.

At each reporting date, we classify assets and liabilities into the three input levels based on the lowest level of input that is significant to the measurement of fair value for each asset and liability reported at fair value.  This classification is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established, the characteristics specific to the transaction and overall market conditions.  Our assessment of the significance of a particular input to the fair value measurement and the ultimate classification of each asset and liability requires judgment.  The vast majority of our fixed maturity securities and separate account assets use Level 2 inputs for the determination of fair value.

 
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Below-investment grade securities generally have different characteristics than investment grade corporate debt securities.  Based on historical performance, likelihood of default by the borrower is significantly greater for below-investment grade securities and in many cases, severity of loss is relatively greater as such securities are often subordinated to other indebtedness of the issuer.  Also, issuers of below-investment grade securities may be more financially leveraged hence, all other things being equal, more sensitive to adverse economic conditions, such as recession or increasing interest rates.  The Company attempts to reduce the overall risk related to its investment in below-investment grade securities, as in all investments, through careful credit analysis, strict investment policy guidelines, and diversification by issuer and/or guarantor and by industry.

Our fixed maturity investments are generally purchased in the context of a long-term strategy to fund insurance liabilities, so we do not generally seek to purchase and sell such securities to generate short-term realized gains.  In certain circumstances, including those in which securities are selling at prices which exceed our view of their current fair value, and it is possible to reinvest the proceeds to better meet our long-term asset-liability objectives, we may sell certain securities.  During 2009, we sold $1.3 billion of fixed maturity investments which resulted in gross investment losses (before income taxes) of $233.9 million.  We sell securities at a loss for a number of reasons including, but not limited to: (i) changes in the investment environment; (ii) expectation that the fair value could deteriorate further; (iii) desire to reduce our exposure to an issuer or an industry; (iv) changes in credit quality; or (v) changes in expected liability cash flows.

We generally seek to balance the duration and cash flows of our invested assets with the estimated duration and cash flows of benefit payments arising from contract liabilities.  These efforts may cause us to sell investments before their maturity date and could result in the realization of net realized investment gains (losses).  When the estimated durations of assets and liabilities are similar, exposure to interest rate risk is minimized because a change in the value of assets should be largely offset by a change in the value of liabilities.  In certain circumstances, a mismatch of the durations or related cash flows of invested assets and insurance liabilities could have a significant impact on our results of operations and financial position.  See “— Quantitative and Qualitative Disclosures About Market Risks” for additional discussion of the duration of our invested assets and insurance liabilities.

For more information on our investment portfolio and our critical accounting policies related to investments, see the note to our consolidated financial statements entitled “Investments”.

Present Value of Future Profits and Deferred Acquisition Costs

In conjunction with the implementation of fresh start accounting, we eliminated the historical balances of our Predecessor’s deferred acquisition costs and the present value of future profits and replaced them with the present value of future profits as calculated on the Effective Date.

The value assigned to the right to receive future cash flows from contracts existing at the Effective Date is referred to as the present value of future profits.  We also defer renewal commissions paid in excess of ultimate commission levels related to the existing policies in this account.  The balance of this account is amortized, evaluated for recovery, and adjusted for the impact of unrealized gains (losses) in the same manner as the deferred acquisition costs described below.  We expect to amortize approximately 13 percent of the December 31, 2009 balance of the present value of future profits inforce in 2010, 11 percent in 2011, 10 percent in 2012, 9 percent in 2013 and 7 percent in 2014.

The deferred acquisition costs are those costs that vary with, and are primarily related to, producing new insurance business in the period after September 10, 2003.  For universal life or investment products, we amortize these costs using the interest rate credited to the underlying policy in relation to the estimated gross profits.  For other products, we amortize these costs using the projected investment earnings rate in relation to future anticipated premium revenue.  The present value of future profits and the deferred acquisition costs are collectively referred to as “insurance acquisition costs.”

Insurance acquisition costs are amortized to expense over the lives of the underlying policies in relation to future anticipated premiums or gross profits.  The insurance acquisition costs for policies other than universal life and investment-type products are amortized with interest (using the projected investment earnings rate) over the estimated premium-paying period of the policies, in a manner which recognizes amortization expense in proportion to each year’s premium income.  The insurance acquisition costs for universal life and investment-type products are amortized with interest (using the interest rate credited to the underlying policy) in proportion to estimated gross profits.  The interest, mortality, morbidity and persistency assumptions used to amortize insurance acquisition costs are consistent with those assumptions used to estimate liabilities for insurance products.  For universal life and investment-type products, these assumptions are reviewed on a regular basis.

 
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When actual profits or our current best estimates of future profits are different from previous estimates, we adjust cumulative amortization of insurance acquisition costs to maintain amortization expense as a constant percentage of gross profits over the entire life of the policies.

The blocks of universal life and interest-sensitive products in the Other CNO Business segment have not performed in accordance with prior estimates of future gross profits, resulting in adjustments to amortization expense over the last 3 years.  For a description of these adjustments, see “Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations – Results of Operations – Other CNO Business – Amortization Related to Operations”.

When we realize a gain or loss on investments backing our universal life or investment-type products, we adjust the amortization of insurance acquisition costs to reflect the change in estimated gross profits from the products due to the gain or loss realized and the effect on future investment yields.  We decreased amortization expense for such changes by $4.0 million, $21.5 million and $35.7 million during the years ended December 31, 2009, 2008 and 2007, respectively.  We also adjust insurance acquisition costs for the change in amortization that would have been recorded if fixed maturity securities, available for sale, had been sold at their stated aggregate fair value and the proceeds reinvested at current yields.  We include the impact of this adjustment in accumulated other comprehensive income (loss) within shareholders’ equity.  We limit the total adjustment related to unrealized losses to the total of the costs capitalized plus interest (or the total value of policies inforce recognized at the Effective Date plus interest with respect to the present value of future profits) related to insurance policies issued in a particular year (or policies inforce at the Effective Date with respect to the present value of future profits). The investment environment during the fourth quarter of 2008 resulted in significant net unrealized losses in our fixed maturity investment portfolio.  The total adjustment to accumulated other comprehensive income related to the change in deferred acquisition costs for the negative amortization that would have been recorded if fixed maturity securities, available for sale, had been sold at their stated aggregate fair value would have resulted in the balance of deferred acquisition costs exceeding the total of costs capitalized plus interest for annuity blocks of business issued in certain years.  Accordingly, the adjustment made to deferred acquisition costs produced and accumulated other comprehensive income was reduced by $206 million.  The total pre-tax impact of such adjustments on accumulated other comprehensive income (loss) was an increase of $70.5 million at December 31, 2009.

At December 31, 2009, the balance of insurance acquisition costs was $3.0 billion.  The recoverability of this amount is dependent on the future profitability of the related business.  Each year, we evaluate the recoverability of the unamortized balance of insurance acquisition costs.  These evaluations are performed to determine whether estimates of the present value of future cash flows, in combination with the related liability for insurance products, will support the unamortized balance.  These future cash flows are based on our best estimate of future premium income, less benefits and expenses.  The present value of these cash flows, plus the related balance of liabilities for insurance products, is then compared with the unamortized balance of insurance acquisition costs.  In the event of a deficiency, such amount would be charged to amortization expense.  The determination of future cash flows involves significant judgment.  Revisions to the assumptions which determine such cash flows could have a significant adverse effect on our results of operations and financial position.

The table presented below summarizes our estimates of cumulative adjustments to insurance acquisition costs resulting from hypothetical revisions to certain assumptions.  Although such hypothetical revisions are not currently required or anticipated, we believe they could occur based on past variances in experience and our expectations of the ranges of future experience that could reasonably occur.  We have assumed that revisions to assumptions resulting in the adjustments summarized below would occur equally among policy types, ages and durations within each product classification.  Any actual adjustment would be dependent on the specific policies affected and, therefore, may differ from the estimates summarized below.  In addition, the impact of actual adjustments would reflect the net effect of all changes in assumptions during the period.

 
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Estimated adjustment to
  
   
income before
  
   
income taxes based on
  
Change in assumptions
  
revisions to certain assumptions
  
   
(dollars in millions)
  
Universal life-type products (a):
      
5% increase to assumed mortality                                                                   
   $ (99.4 )
5% decrease to assumed mortality                                                                   
     101.2  
15% increase to assumed expenses                                                                   
     (22.6 )
15% decrease to assumed expenses                                                                   
     23.7  
10 basis point decrease to assumed spread                                                                   
     (24.4 )
10 basis point increase to assumed spread                                                                   
     24.2  
10% increase to assumed lapses                                                                   
     (7.5 )
10% decrease to assumed lapses                                                                   
     7.4  
         
Investment-type products:
        
20% increase to assumed surrenders                                                                   
     (52.5 )
20% decrease to assumed surrenders                                                                   
     67.2  
15% increase to assumed expenses                                                                   
     (5.8 )
15% decrease to assumed expenses                                                                   
     5.8  
10 basis point decrease to assumed spread                                                                   
     (26.7 )
10 basis point increase to assumed spread                                                                   
     27.2  
         
Other than universal life and investment-type products (b):
        
5% increase to assumed morbidity                                                                   
     (179.2 )
50 basis point decrease to investment earnings rate
     (125.7 )
____________________
(a)  
A significant portion of our universal life-type products inforce are in loss recognition status.  A favorable change in experience on such blocks may slow down future amortization; however, the current period adjustment to insurance acquisition costs would be small.  This causes the downside sensitivities above to be lower in magnitude than the upside results.
(b)  
We have excluded the effect of reasonably likely changes in mortality, lapse, surrender and expense assumptions for policies other than universal life and investment-type products.  Our estimates indicate such changes would not result in any portion of the $2.2 billion balance of unamortized insurance acquisition costs related to these policies being unrecoverable.

 
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The following summarizes the persistency of our major blocks of insurance business summarized by segment and line of business:

                   
   
Years ended December 31,
  
   
2009
    
2008
    
2007
  
Bankers Life:
                  
Medicare supplement (1)                                                                   
     85.2 %     83.7 %     83.5 %
Long-term care (1) (4)                                                                   
     87.9 %     90.4 %     91.0 %
Fixed index annuities (2)                                                                   
     87.6 %     88.0 %     87.1 %
Other annuities (2) (5)                                                                   
     87.0 %     84.3 %     84.0 %
Life (1) (6)                                                                   
     87.4 %     87.3 %     87.7 %
                         
Colonial Penn:
                        
Life (1) (6)                                                                   
     86.4 %     86.0 %     87.3 %
                         
Washington National and Other CNO Business:
                        
Medicare supplement (1) (3)                                                                   
     78.9 %     77.8 %     75.6 %
Long-term care (1) (6)                                                                   
     92.2 %     92.1 %     92.7 %
Supplemental health (1) (6)                                                                   
     89.6 %     90.3 %     91.9 %
Fixed index annuities (2) (7)                                                                   
     82.6 %     86.5 %     91.4 %
Other annuities (2) (5)                                                                   
     93.3 %     80.6 %     89.5 %
Life (1) (6)                                                                   
     92.4 %     93.4 %     93.7 %
____________
 
(1)
Based on number of inforce policies.
 
(2)
Based on the percentage of the inforce block persisting.
 
(3)
The persistency rates during 2009 are slightly higher than our expectations for this block.
 
(4)
Bankers Life has been implementing premium rate increases on certain policies in this block.  Some policyholders have chosen to lapse their policies rather than pay the increased premium rate.  Refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Bankers Life – Insurance Policy Benefits” for additional information.
 
(5)
We have noted an increase in persistency rates for other annuity products (consisting primarily of fixed rate annuity policies).  We believe this increase is related to the lack of competing investment products which would offer higher returns for consumers.
 
(6)
These persistency rates are generally in line with our expectations.
 
(7)
This block of business has experienced higher than anticipated surrenders during 2009.  The annuities which are experiencing higher surrenders have a MVA feature, which effectively reduced (or in some cases eliminated) the charges paid upon the surrender of these policies as the 10-year treasury rate dropped to historic lows.  The impact of both the historical experience and projected increased surrender activity and higher MVA benefits has reduced our expectations on the profitability of the annuity block of Other CNO Business to approximately break-even.  Refer to “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Other CNO Business – Amortization Related to Operations” for additional information.

Liabilities for Insurance Products – reserves for the future payment of long-term care policy claims

We calculate and maintain reserves for the future payment of claims to our policyholders based on actuarial assumptions.  For all our insurance products, we establish an active life reserve, a liability for due and unpaid claims, claims in the course of settlement and incurred but not reported claims.  In addition, for our health insurance business, we establish a reserve for the present value of amounts not yet due on claims.  Many factors can affect these reserves and liabilities, such as economic and social conditions, inflation, hospital and pharmaceutical costs, changes in doctrines of legal liability and extra-contractual damage awards.  Therefore, our reserves and liabilities are necessarily based on numerous estimates and assumptions as well as historical experience.  Establishing reserves is an uncertain process, and it is possible that actual claims will materially exceed our reserves and have a material adverse effect on our results of operations and financial condition.  For example, our long-term care policy claims may be paid over a long period of time and, therefore, loss estimates have a higher degree of uncertainty.  We have incurred significant losses beyond our estimates as a result of actual claim costs and persistency of our long-term care business of Senior Health Insurance Company of Pennsylvania ("Senior Health") and Washington National.  The long-term care business of Senior Health was transferred to an independent trust in 2008 and CNO no longer has any liability for this business.  Estimates of unpaid losses related to long-term care business have a higher degree of uncertainty than

 
10
 

estimates for our other products due to the range of ultimate duration of these claims and the resulting variability in their cost (in addition to the variations in the lag time in reporting claims).  We would not consider a variance of 5-10 percentage points from the initial expected loss ratio to be unusual.  As an example, an increase in the initial loss ratio of 5-10 percentage points for claims incurred in 2009 related to our long-term care business (in both our Bankers Life and Other CNO Business segments) would result in a decrease in our earnings of approximately $35 to $70 million. Our financial results depend significantly upon the extent to which our actual claims experience is consistent with the assumptions we used in determining our reserves and pricing our products.  If our assumptions with respect to future claims are incorrect, and our reserves are insufficient to cover our actual losses and expenses, we would be required to increase our liabilities, which would negatively affect our operating results.

Accounting for marketing and reinsurance agreements with Coventry

Prescription Drug Benefit

The Medicare Prescription Drug, Improvement and Modernization Act of 2003 provided for the introduction of a Prescription Drug Plan ("PDP") product.  In order to offer this product to our current and potential future policyholders without investing in management and infrastructure, we entered into a national distribution agreement with Coventry to use our career and independent agents to distribute Coventry’s prescription drug plan, Advantra Rx.  We receive a fee based on the premiums collected on plans sold through our distribution channels.  In addition, CNO has a quota-share reinsurance agreement with Coventry for CNO enrollees that provides CNO with 50 percent of net premiums and related policy benefits subject to a risk corridor.  The Part D program was effective January 1, 2006.

The following describes how we account for and report our PDP business:

Our accounting for the national distribution agreement

·  
For contracts sold prior to 2009, we recognize distribution and licensing fee income from Coventry based upon negotiated percentages of collected premiums on the underlying Medicare Part D contracts.  For contracts sold in 2009 and thereafter, we recognize distribution income based on a fixed fee per PDP contract.  This fee income is recognized over the calendar year term as premiums are collected.

·  
We also pay commissions to our agents who sell the plans on behalf of Coventry.  These payments are deferred and amortized over the remaining term of the initial enrollment period (the one-year life of the initial policy).

Our accounting for the quota-share agreement

·  
We recognize premium revenue evenly over the period of the underlying Medicare Part D contracts.

·  
We recognize policyholder benefits and ceding commission expense as incurred.

·  
We recognize risk-share premium adjustments consistent with Coventry’s risk-share agreement with the Centers for Medicare and Medicaid Services.

 
11
 


The following summarizes the pre-tax income (loss) of the PDP business (dollars in millions):

   
2009
    
2008
    
2007
  
                   
Insurance policy income                                                 
   $ 78.6     $ 67.1     $ 70.8  
Fee revenue and other                                                 
     2.8       2.6       2.4  
                         
Total revenues                                             
     81.4       69.7       73.2  
                         
Insurance policy benefits                                                 
     66.6       62.3       57.2  
Commission expense                                                 
     7.7       6.0       6.4  
Other operating expenses                                                 
     .6       2.1       1.0  
                         
Total expense                                             
     74.9       70.4       64.6  
                         
Pre-tax income (loss)                                             
   $ 6.5     $ (.7 )   $ 8.6  

Private-Fee-For-Service

CNO expanded its strategic alliance with Coventry by entering into a national distribution agreement under which our career agents began distributing Coventry’s Private-Fee-For-Service ("PFFS") plan, beginning January 1, 2007.  The Advantra Freedom product is a Medicare Advantage plan designed to provide seniors with more choices and better coverage at lower cost than original Medicare and Medicare Advantage plans offered through HMOs.  Under the agreement, we received a fee based on the number of PFFS plans sold through our distribution channels.  In addition, CNO had a quota-share reinsurance agreement with Coventry for CNO enrollees that provided CNO with a specified percentage of the net premiums and related profits.  Coventry decided to cease selling PFFS plans effective January 1, 2010.  In July 2009, we announced a strategic alliance under which we would offer Humana’s Medicare Advantage plans to our policyholders and consumers through our career agency force and will receive marketing fees based on sales.  Effective January 1, 2010, we will no longer be assuming the underwriting risk related to PFFS business.

We received distribution fees from Coventry and we paid sales commissions to our agents for these enrollments.  In addition, we received a specified percentage of the income (loss) related to this business pursuant to a quota-share agreement with Coventry.

The following summarizes our accounting and reporting practices for the PFFS business.

Our accounting for the distribution agreement

·  
We received distribution income from Coventry and other parties based on a fixed fee per PFFS contract.  This income was deferred and recognized over the remaining calendar year term of the initial enrollment period.

·  
We also paid commissions to our agents who sell the plans on behalf of Coventry and other parties.  These payments were deferred and amortized over the remaining term of the initial enrollment period (the one-year life of the initial policy).

Our accounting for the quota-share agreement

·  
We recognized revenue evenly over the period of the underlying PFFS contracts.

·  
We recognized policyholder benefits and ceding commission expense as incurred.

 
12
 

The following summarizes the pre-tax income (loss) of the PFFS business (dollars in millions):

   
2009
    
2008
    
2007
  
                   
Insurance policy income                                         
   $ 318.2     $ 228.9     $ 100.8  
Fee revenue and other                                         
     8.4       8.3       8.6  
                         
Total revenues                                     
     326.6       237.2       109.4  
                         
Insurance policy benefits                                         
     286.4       221.7       82.7  
Commission expense                                         
     12.4       8.0       4.2  
Other operating expenses                                         
     6.2       12.7       8.8  
                         
Total expense                                     
     305.0       242.4       95.7  
                         
Pre-tax income (loss)                                         
   $ 21.6     $ (5.2 )   $ 13.7  

Large Group Private-Fee-For-Service Blocks

During 2007 and 2008, CNO entered into three quota-share reinsurance agreements with Coventry related to the PFFS business written by Coventry under certain group policies.  CNO received a specified percentage of the net premiums and related profits associated with this business as long as the ceded revenue margin was less than or equal to five percent.  CNO received a specified percentage of the net premiums and related profits on the ceded margin in excess of five percent.  In order to reduce the required statutory capital associated with the assumption of this business, CNO terminated two group policy quota-share agreements as of December 31, 2008 and terminated the last agreement on June 30, 2009.  The following summarizes the premiums assumed, related expenses and pre-tax income of this business (dollars in millions):

   
2009
    
2008
    
2007
  
                   
Premiums assumed                                        
   $ 47.5     $ 313.5     $ 99.8  
                         
Policy benefits                                        
     31.8       301.1       91.2  
Commission expense                                        
     1.7       12.0       4.1  
                         
Total expenses                                        
     33.5       313.1       95.3  
                         
Pre-tax income                                        
   $ 14.0     $ .4     $ 4.5  

Income Taxes

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

Authoritative guidance requires a reduction of the carrying amount of deferred tax assets by establishing a valuation allowance if, based on the available evidence, it is more likely than not that such assets will not be realized.  We evaluate the need to establish a valuation allowance for our deferred income tax assets on an ongoing basis.  In evaluating our deferred income tax assets, we consider whether the deferred income tax assets will be realized, based on the more-likely-than-not realization threshold criterion.  The ultimate realization of our deferred income tax assets depends upon generating sufficient future taxable income during the periods in which our temporary differences become deductible and before our capital loss carryforwards and NOLs expire.  This assessment requires significant judgment.  In assessing the need for a valuation allowance, appropriate consideration is given to all positive and negative evidence related to the realization of the deferred tax assets.  This assessment considers, among other matters, the nature, frequency and severity of current and cumulative losses, forecasts of future profitability, excess appreciated asset value over the tax basis of net assets, the duration of

 
13
 

carryforward periods, our experience with operating loss and tax credit carryforwards expiring unused, and tax planning alternatives.

Concluding that a valuation allowance is not required is difficult when there has been significant negative evidence, such as cumulative losses in recent years.  We utilize a three year rolling calculation of actual income before income taxes as our primary measure of cumulative losses in recent years.  Our analysis of whether there needs to be further increases to the deferred tax valuation allowance recognizes that as of December 31, 2009, we have incurred a cumulative loss over the evaluation period, resulting from the substantial loss during 2008 primarily related to the transfer (the "Transfer") of the stock of Senior Health to Senior Health Care Oversight Trust, an independent trust (the "Independent Trust") for the exclusive benefit of Senior Health's long-term care policyholders as described in the note to these consolidated financial statements entitled “Transfer of Senior Health Insurance Company of Pennsylvania to an Independent Trust”.  As a result of the cumulative losses recognized in recent years, our evaluation of the need to increase the valuation allowance for deferred tax assets was primarily based on our historical earnings.  However, because a substantial portion of the cumulative losses for the three-year period ended December 31, 2009, relates to transactions to dispose of blocks of businesses, we have adjusted the three-year cumulative results for the income and losses from the blocks of business disposed of in the past and the business transferred as further described in the note to these financial statements entitled “Transfer of Senior Health Insurance Company of Pennsylvania to an Independent Trust”.  In addition, we have adjusted the three-year cumulative results for a significant litigation settlement and the worthlessness of certain loans made by our Predecessor.  We consider these to be non-recurring matters and have reflected our best estimates of when temporary differences will reverse over the carryforward periods.

In order to support the utilization of the tax benefits of NOLs that do not have an offsetting valuation allowance, we project future taxable income based on our historical earnings adjusted for the items described in the previous paragraph.  Based on these projections, we must generate approximately $200 million for each year through 2018 in order to utilize the tax benefits of our NOLs which expire through that date.  The taxable income requirements are substantially comprised of life insurance income, as the potential tax benefits related to our non-life NOLs are substantially offset by a valuation allowance.  Our taxable income for 2009 was $308.1 million before deductions related to the worthlessness of certain loans made by our Predecessor, and we expect our future taxable income to be adequate to utilize the remaining NOLs.  The projections of future taxable income used to support the recovery of our NOLs do not anticipate the use of any tax planning strategies that we would consider to avoid a tax benefit from expiring.

At December 31, 2009, our valuation allowance for our net deferred tax assets was $1.2 billion, as we have determined that it is more likely than not that a portion of our deferred tax assets will not be realized.  This determination was made by evaluating each component of the deferred tax asset and assessing the effects of limitations and/or interpretations on the value of such component to be fully recognized in the future.  We have also evaluated the likelihood that we will have sufficient taxable income to offset the available deferred tax assets based on evidence which we consider to be objective and verifiable. Based upon our analysis completed at December 31, 2009, we believe that we will, more likely than not, recover $1.1 billion of our deferred tax assets through reductions of our tax liabilities in future periods.

Changes in our valuation allowance are summarized as follows (dollars in millions):

Balance at December 31, 2006                                                                                  
   $ 777.8    
           
Increase in 2007                                                                               
     68.0    
Expiration of capital loss carryforwards                                                                               
     (157.6 )  
Write-off of certain state NOLs (recovery is remote)
     (15.3 )  
           
Balance at December 31, 2007                                                                                  
     672.9    
           
Increase in 2008                                                                               
     856.2  
(a)
Expiration of capital loss carryforwards                                                                               
     (209.7 )  
Write-off of capital loss carryforwards related to Senior Health
     (133.2 )  
Write-off of certain NOLs related to Senior Health
     (5.5 )  
           
Balance at December 31, 2008                                                                                  
     1,180.7    
           
Increase in 2009                                                                               
     27.8  
(b)
Expiration of capital loss carryforwards                                                                               
     (32.1 )  
           
Balance at December 31, 2009                                                                                 
   $ 1,176.4    

 
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____________________
(a)  
The $856.2 million increase to our valuation allowance during 2008 included increases of:  (i) $452 million of deferred tax assets related to Senior Health, which was transferred to an independent trust during 2008; (ii) $298 million related to our reassessment of the recovery of our deferred tax assets in accordance with GAAP, following the additional losses incurred as a result of the transaction to transfer Senior Health to an independent trust; (iii) $60 million related to the recognition of additional realized investment losses for which we are unlikely to receive any tax benefit; and (iv) $45 million related to the estimated additional future expense following the modifications to our Second Amended and Restated Credit Agreement dated as of October 10, 2006 among CNO, Bank of America, N.A. as Agent, J.P. Morgan Chase Bank, N.A. as Syndication Agent and other parties ("Senior Credit Agreement") as described in the note to these consolidated financial statements entitled “Notes Payable – Direct Corporate Obligations.”

(b)  
The $27.8 million increase to our valuation allowance during 2009 included increases of:  (i) $23.0 million related to our reassessment of the recovery of our deferred tax assets following the completion of reinsurance transactions in 2009; and (ii) $4.8 million related to the recognition of additional realized investment losses for which we are unlikely to receive any tax benefit.

Recovery of our deferred tax assets is dependent on achieving the projections of future taxable income embedded in our analysis and failure to do so would result in an increase in the valuation allowance in a future period.  Any future increase in the valuation allowance may result in additional income tax expense and reduce shareholders’ equity, and such an increase could have a significant impact upon our earnings in the future.  In addition, the use of the Company’s NOLs is dependent, in part, on whether the IRS does not take an adverse position in the future regarding the tax position we have taken in our tax returns with respect to the allocation of cancellation of indebtedness income.

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

Section 382 imposes limitations on a corporation’s ability to use its NOLs when the company undergoes an ownership change.  Future transactions and the timing of such transactions could cause an ownership change for Section 382 income tax purposes.  Such transactions may include, but are not limited to, additional repurchases or issuances of common stock (including upon conversion of our outstanding 3.5% Convertible Debentures due September 30, 2035 (the "3.5% Debentures") or 7.0% Debentures), or acquisitions or sales of shares of CNO stock by certain holders of our shares, including persons who have held, currently hold or may accumulate in the future five percent or more of our outstanding common stock for their own account.  Many of these transactions are beyond our control.  If an additional ownership change were to occur for purposes of Section 382, we would be required to calculate an annual restriction on the use of our NOLs to offset future taxable income.  The annual restriction would be calculated based upon the value of CNO’s equity at the time of such ownership change, multiplied by a federal long-term tax exempt rate (4.16 percent at December 31, 2009), and the annual restriction could effectively eliminate our ability to use a substantial portion of our NOLs to offset future taxable income.  We regularly monitor ownership change (as calculated for purposes of Section 382) and, as of December 31, 2009, we were below the 50 percent ownership change level that would trigger further impairment of our ability to utilize our NOLs.

 
15
 

As of December 31, 2009, we had $4.7 billion of federal NOLs and $1.1 billion of capital loss carryforwards, which expire as follows (dollars in millions):

Year of expiration
  
Net operating loss carryforwards (a)
  
Capital loss
    
Total loss
  
   
Life
  
Non-life
  
carryforwards
    
carryforwards
  
                             
2010
   $ -       $ .1       $ -     $ .1  
2011
     -         .1         -       .1  
2012
     -         -         63.6       63.6  
2013
     -         -         1,034.2       1,034.2  
2014
     -         -         27.3       27.3  
2018
     1,895.7  
(a)
     -         -       1,895.7  
2021
     29.6         -         -       29.6  
2022
     204.1         -         -       204.1  
2023
     -         2,058.2  
(a)
     -       2,058.2  
2024
     -         3.2         -       3.2  
2025
     -         118.8         -       118.8  
2026
     -         1.6         -       1.6  
2027
     -         216.3         -       216.3  
2028
     -         1.2         -       1.2  
2029
      -         125.8         -       125.8  
                                     
Total
   $ 2,129.4       $ 2,525.3       $ 1,125.1     $ 5,779.8  
____________________
(a)  
The allocation of the NOLs summarized above assumes the IRS does not take an adverse position in the future regarding the tax position we plan to take in our tax returns with respect to the allocation of cancellation of indebtedness income.  If the IRS disagrees with the tax position we plan to take with respect to the allocation of cancellation of indebtedness income, and their position prevails, approximately $631 million of the NOLs expiring in 2018 would be characterized as non-life NOLs.

As more fully discussed below, the Company’s interpretation of the tax law, as it relates to the application of the cancellation of indebtedness income to its NOLs, is an uncertain tax position.  Since all other life NOLs must be utilized prior to this portion of the NOL, it has not yet been utilized nor is it expected to be utilized within the next twelve months.  As a result, an uncertain tax position has not yet been taken on the Company’s tax return.

Although authoritative guidance allowed a change in accounting, the Company has chosen to continue its past accounting policy of classifying interest and penalties as income tax expense in the consolidated statement of operations.  No such amounts were recognized in 2009 or 2008.  The liability for accrued interest and penalties was not significant at December 31, 2009 or December 31, 2008.

Tax years 2006 through 2008 are open to examination by the IRS, and tax year 2002 remains open only for potential adjustments related to certain partnership investments.  The Company does not anticipate any material adjustments related to these partnership investments.  The Company’s various state income tax returns are generally open for tax years 2006 through 2008 based on the individual state statutes of limitation.

The following paragraphs describe an open matter related to the classification of our NOLs.

In July 2006, the Joint Committee of Taxation accepted the audit and the settlement which characterized $2.1 billion of the tax losses on our Predecessor’s investment in Conseco Finance Corp. as life company losses and the remaining amount as non-life losses prior to the application of the cancellation of indebtedness attribute reductions described below.  As a result of the approval of the settlement, we concluded it was appropriate to reduce our valuation allowance by $260 million in the second quarter of 2006, which was accounted for as an addition to paid-in capital.

The Code provides that any income realized as a result of the cancellation of indebtedness in bankruptcy (cancellation of debt income or “CODI”) must reduce NOLs.  We realized an estimated $2.5 billion of CODI when we emerged from bankruptcy.  Pursuant to the Company’s interpretation of the tax law, the CODI reductions were all used to reduce non-life NOLs.  However, if the IRS were to disagree with our interpretation and ultimately prevail, we believe approximately $631 million of NOLs classified as life company NOLs would be re-characterized as non-life NOLs and subject to the 35%

 
16
 

limitation discussed above.  Such a re-characterization would also extend the year of expiration as life company NOLs expire after 15 years whereas non-life NOLs expire after 20 years.  The Company does not expect the IRS to consider this issue for a number of years.

Liabilities for Insurance Products

At December 31, 2009, the total balance of our liabilities for insurance products was $24.3 billion.  These liabilities are generally payable over an extended period of time and the profitability of the related products is dependent on the pricing of the products and other factors.  Differences between our expectations when we sold these products and our actual experience could result in future losses.

We calculate and maintain reserves for the future payment of claims to our policyholders based on actuarial assumptions.  For all our insurance products, we establish an active life reserve, a liability for due and unpaid claims, claims in the course of settlement and incurred but not reported claims.  In addition, for our health insurance business, we establish a reserve for the present value of amounts not yet due on claims.  Many factors can affect these reserves and liabilities, such as economic and social conditions, inflation, hospital and pharmaceutical costs, changes in doctrines of legal liability and extra-contractual damage awards.  Therefore, our reserves and liabilities are necessarily based on numerous estimates and assumptions as well as historical experience.  Establishing reserves is an uncertain process, and it is possible that actual claims will materially exceed our reserves and have a material adverse effect on our results of operations and financial condition.  We have incurred significant losses beyond our estimates as a result of actual claim costs and persistency of our long-term care business of Senior Health and Washington National.  Our financial results depend significantly upon the extent to which our actual claims experience is consistent with the assumptions we used in determining our reserves and pricing our products.  If our assumptions with respect to future claims are incorrect, and our reserves are insufficient to cover our actual losses and expenses, we would be required to increase our liabilities, which would negatively affect our operating results.

Liabilities for insurance products are calculated using management’s best judgments, based on our past experience and standard actuarial tables, of mortality, morbidity, lapse rates, investment experience and expense levels.

Accounting for Long-term Care Premium Rate Increases

Many of our long-term care policies were subject to premium rate increases in 2006 and 2007.  In some cases, these premium rate increases were reasonably consistent with the assumptions we used to value the particular block of business at the fresh-start date.  With respect to the 2006 premium rate increases, some of our policyholders were provided an option to cease paying their premiums and receive a non-forfeiture option in the form of a paid-up policy with limited benefits.  In addition, our policyholders could choose to reduce their coverage amounts and premiums in the same proportion, when permitted by our contracts or as required by regulators.  The following describes how we account for these premium rate increases and related policyholder options:

·  
Premium rate increases – If premium rate increases reflect a change in our previous rate increase assumptions, the new assumptions are not reflected prospectively in our reserves.  Instead, the additional premium revenue resulting from the rate increase is recognized as earned and original assumptions continue to be used to determine changes to liabilities for insurance products unless a premium deficiency exists.

·  
Benefit reductions – If there is a premium rate increase on one of our long-term care policies, a policyholder may choose reduced coverage with a proportionate reduction in premium, when permitted by our contracts.  This option does not require additional underwriting.  Benefit reductions are treated as a partial lapse of coverage, and the balance of our reserves and deferred insurance acquisition costs is reduced in proportion to the reduced coverage.

·  
Non-forfeiture benefits offered in conjunction with a rate increase – In some cases, non-forfeiture benefits are offered to policyholders who wish to lapse their policies at the time of a significant rate increase.  In these cases, exercise of this option is treated as an extinguishment of the original contract and issuance of a new contract.  The balance of our reserves and deferred insurance acquisition costs are released, and a reserve for the new contract is established.

·  
Florida Order – In 2004, the Florida Office of Insurance Regulation issued an order to Washington National  regarding its home health care business in Florida.  The order required Washington National to offer a choice of three alternatives to holders of home health care policies in Florida subject to premium rate increases as follows:

 
17
 


·  
retention of their current policy with a rate increase of 50 percent in the first year and actuarially justified increases in subsequent years;

·  
receipt of a replacement policy with reduced benefits and a rate increase in the first year of 25 percent and no more than 15 percent in subsequent years; or

·  
receipt of a paid-up policy, allowing the holder to file future claims up to 100 percent of the amount of premiums paid since the inception of the policy.

Reserves for all three groups of policies under the order were prospectively adjusted using the prospective revision methodology described above, as these alternatives were required by the Florida Office of Insurance Regulation.  These policies had no insurance acquisition costs established at the Effective Date.

Some of our policyholders may receive a non-forfeiture benefit if they cease paying their premiums pursuant to their original contract (or pursuant to changes made to their original contract as a result of a litigation settlement made prior to the Effective Date or an order issued by the Florida Office of Insurance Regulation).  In these cases, exercise of this option is treated as the exercise of a policy benefit, and the reserve for premium paying benefits is reduced, and the reserve for the non-forfeiture benefit is adjusted to reflect the election of this benefit.

Liabilities for Loss Contingencies Related to Lawsuits and Our Guarantees of Bank Loans and Related Interest Loans

We are involved on an ongoing basis in arbitrations and lawsuits, including purported class actions.  The ultimate outcome of these legal matters cannot be predicted with certainty.  We recognize an estimated loss from these loss contingencies when we believe it is probable that a loss has been incurred and the amount of the loss can be reasonably estimated.  However, it is difficult to measure the actual loss that might be incurred related to litigation.  The ultimate outcome of these lawsuits could have a significant impact on our results of operations and financial position.

In conjunction with our bankruptcy reorganization in 2003, $481.3 million principal amount of bank loans made to certain former directors and employees to enable them to purchase common stock of our Predecessor were transferred to the Company.  These loans had been guaranteed by our Predecessor.  We received all rights to collect the balances due pursuant to the original terms of these loans.  In addition, we hold loans to participants for interest on the loans.  The loans and the interest loans are collectively referred to as the “D&O loans.”  We regularly evaluate the collectibility of these loans in light of the credit worthiness of the participants and the current status of various legal actions we have taken to collect the D&O loans.  At December 31, 2009, we have estimated that approximately $3.8 million of the D&O loan balance (which is included in other assets) is collectible (net of the costs of collection).  An allowance has been established to reduce the total D&O loan balance to the amount we estimated was recoverable.

Pursuant to the settlement that was reached with the Official Committee of the Trust Originated Preferred Securities (“TOPrS”) Holders and the Official Committee of Unsecured Creditors in connection with our bankruptcy reorganization in 2003, the former holders of TOPrS (issued by our Predecessor’s subsidiary trusts and eliminated in our reorganization) who did not opt out of the bankruptcy settlement will be entitled to receive 45 percent of any proceeds from the collection of certain D&O loans in an aggregate amount not to exceed $30 million.  As of December 31, 2009, we had paid $19.3 million to the former holders of TOPrS and we have established a liability of $2.7 million (which is included in other liabilities), representing our estimate of the additional amount which will be paid to the former holders of TOPrS pursuant to the settlement.

 
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RESULTS OF OPERATIONS:

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

Please read this discussion in conjunction with the consolidated financial statements and notes included in this Form 10-K.

The following tables and narratives summarize the operating results of our segments (dollars in millions):

   
2009
    
2008
    
2007
  
                   
Income (loss) before net realized investment gains (losses), net of related amortization and income taxes (a non-GAAP measure) (a):
                  
Bankers Life                                                                           
   $ 278.0     $ 171.5     $ 241.8  
Washington National                                                                           
     110.9       121.1       127.7  
Colonial Penn                                                                           
     29.4       25.2       18.1  
Other CNO Business                                                                           
     (43.6 )     .2       (154.0 )
Corporate operations                                                                           
     (144.6 )     (73.4 )     (129.3 )
                         
      230.1       244.6       104.3  
                         
Net realized investment gains (losses), net of related amortization:
                        
Bankers Life                                                                           
     (31.6 )     (100.9 )     (17.4 )
Washington National                                                                           
     (2.6 )     (16.2 )     (13.9 )
Colonial Penn                                                                           
     4.5       (1.6 )     (.2 )
Other CNO Business                                                                           
     (19.4 )     (71.4 )     (84.6 )
Corporate operations                                                                           
     (7.4 )     (50.8 )     (6.2 )
                         
      (56.5 )     (240.9 )     (122.3 )
                         
Income (loss) before income taxes and discontinued operations:
                        
Bankers Life                                                                           
     246.4       70.6       224.4  
Washington National                                                                           
     108.3       104.9       113.8  
Colonial Penn                                                                           
     33.9       23.6       17.9  
Other CNO Business                                                                           
     (63.0 )     (71.2 )     (238.6 )
Corporate operations                                                                           
     (152.0 )     (124.2 )     (135.5 )
                         
Income (loss) before income taxes and discontinued operations
   $ 173.6     $ 3.7     $ (18.0 )
____________________
(a)  
These non-GAAP measures as presented in the above table and in the following segment financial data and discussions of segment results exclude net realized investment gains (losses), net of related amortization and before income taxes.  These are considered non-GAAP financial measures.  A non-GAAP measure is a numerical measure of a company’s performance, financial position, or cash flows that excludes or includes amounts that are normally excluded or included in the most directly comparable measure calculated and presented in accordance with GAAP.

These non-GAAP financial measures of “income (loss) before net realized investment gains (losses), net of related amortization, and before income taxes” differ from “income (loss) before income taxes” as presented in our consolidated statement of operations prepared in accordance with GAAP due to the exclusion of before tax realized investment gains (losses), net of related amortization.  We measure segment performance excluding realized investment gains (losses) because we believe that this performance measure is a better indicator of the ongoing businesses and trends in our business.  Our primary investment focus is on investment income to support our liabilities for insurance products as opposed to the generation of realized investment gains (losses), and a long-term focus is necessary to maintain profitability over the life of the business.  Realized investment gains (losses) depend on market conditions and do not necessarily relate to decisions regarding the underlying business of our segments.  However, “income (loss) before net realized investment gains (losses), net of related amortization, and before income taxes” does not replace “income (loss) before income taxes” as a measure of overall profitability.  We may experience

 
19
 

realized investment gains (losses), which will affect future earnings levels since our underlying business is long-term
in nature and we need to earn the assumed interest rates on the investments backing our liabilities for insurance products to maintain the profitability of our business.  In addition, management uses this non-GAAP financial measure in its budgeting process, financial analysis of segment performance and in assessing the allocation of resources.  We believe these non-GAAP financial measures enhance an investor’s understanding of our financial performance and allows them to make more informed judgments about the Company as a whole.  These measures also highlight operating trends that might not otherwise be transparent.  The table above reconciles the non-GAAP measure to the corresponding GAAP measure.

General: CNO is the top tier holding company for a group of insurance companies operating throughout the United States that develop, market and administer health insurance, annuity, individual life insurance and other insurance products.  We distribute these products through our Bankers Life segment, which utilizes a career agency force, through our Colonial Penn segment, which utilizes direct response marketing and through our Washington National and Other CNO Business segments, which utilize professional independent producers.

 
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Bankers Life (dollars in millions)

   
2009
    
2008
    
2007
  
Premium collections:
                  
Annuities                                                                   
   $ 1,060.4     $ 1,224.1     $ 885.5  
Medicare supplement and other supplemental health
     1,711.7       1,887.0       1,546.1  
Life                                                                   
     228.8       209.4       200.0  
                         
Total collections                                                               
   $ 3,000.9     $ 3,320.5     $ 2,631.6  
                         
Average liabilities for insurance products:
                        
Annuities:
                        
Mortality based                                                               
   $ 250.9     $ 252.9     $ 281.6  
Fixed index                                                               
     1,506.3       1,203.0       787.4  
Deposit based                                                               
     4,789.9       4,464.3       4,507.4  
Health                                                                    
     4,122.1       3,880.5       3,569.7  
Life:
                        
Interest sensitive                                                               
     401.6       385.9       364.2  
Non-interest sensitive                                                               
     407.2       357.8       299.1  
                         
Total average liabilities for insurance products, net of reinsurance ceded
   $ 11,478.0     $ 10,544.4     $ 9,809.4  
                         
Revenues:
                        
Insurance policy income                                                                    
   $ 1,959.2     $ 2,109.9     $ 1,780.0  
Net investment income:
                        
General account invested assets                                                                
     643.6       617.1       578.7  
Fixed index products                                                                
     24.5       (49.4 )     (10.6 )
Other special-purpose portfolios                                                                
     10.0       (9.5 )     4.2  
Fee revenue and other income                                                                    
     10.2        11.0       12.0  
                         
Total revenues                                                               
     2,647.5       2,679.1       2,364.3  
                         
Expenses:
                        
Insurance policy benefits                                                                    
     1,667.5       1,879.9       1,480.6  
Amounts added to policyholder account balances:
                        
Annuity products and interest-sensitive life products other than fixed index products
     183.1       175.7       180.9  
Fixed index products                                                                
     54.4       34.8       23.2  
Amortization related to operations                                                                    
     267.9       234.8       264.0  
Other operating costs and expenses                                                                    
     196.6        182.4       173.8  
                         
Total benefits and expenses                                                               
     2,369.5       2,507.6       2,122.5  
                         
Income before net realized investment losses, net of related amortization and income taxes
     278.0       171.5       241.8  
                         
Net realized investment losses                                                                
     (31.4 )     (116.7 )     (19.9 )
Amortization related to net realized investment losses
     (.2 )      15.8       2.5  
                         
Net realized investment losses, net of related amortization
     (31.6 )     (100.9 )     (17.4 )
                         
Income before income taxes                                                                      
   $ 246.4     $ 70.6     $ 224.4  

(continued)

 
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(continued from previous page)


   
2009
    
2008
    
2007
  
                   
Health benefit ratios:
                  
All health lines:
                  
Insurance policy benefits                                            
   $ 1,489.4     $ 1,709.4     $ 1,298.0  
Benefit ratio (a)                                            
     87.0 %     91.3 %     84.4 %
                         
Medicare supplement:
                        
Insurance policy benefits                                            
   $ 468.8     $ 452.3     $ 433.3  
Benefit ratio (a)                                            
     70.7 %     70.8 %     67.2 %
                         
PDP and PFFS:
                        
Insurance policy benefits                                            
   $ 384.8     $ 585.1     $ 231.1  
Benefit ratio (a)                                            
     86.6 %     96.0 %     85.1 %
                         
Long-term care:
                        
Insurance policy benefits                                            
   $ 635.8     $ 672.0     $ 633.6  
Benefit ratio (a)                                            
     105.2 %     107.6 %     102.0 %
Interest-adjusted benefit ratio (b)
     67.9 %     74.0 %     70.8 %
____________________
(a)  
We calculate benefit ratios by dividing the related product’s insurance policy benefits by insurance policy income.
(b)  
We calculate the interest-adjusted benefit ratio (a non-GAAP measure) for Bankers Life’s long-term care products by dividing such product’s insurance policy benefits less interest income on the accumulated assets backing the insurance liabilities by policy income.  These are considered non-GAAP financial measures.  A non-GAAP measure is a numerical measure of a company’s performance, financial position, or cash flows that excludes or includes amounts that are normally excluded or included in the most directly comparable measure calculated and presented in accordance with GAAP.

These non-GAAP financial measures of “interest-adjusted benefit ratios” differ from “benefit ratios” due to the deduction of interest income on the accumulated assets backing the insurance liabilities from the product’s insurance policy benefits used to determine the ratio.  Interest income is an important factor in measuring the performance of health products that are expected to be inforce for a longer duration of time, are not subject to unilateral changes in provisions (such as non-cancelable or guaranteed renewable contracts) and require the performance of various functions and services (including insurance protection) for an extended period of time.  The net cash flows from long-term care products generally cause an accumulation of amounts in the early years of a policy (accounted for as reserve increases) that will be paid out as benefits in later policy years (accounted for as reserve decreases).  Accordingly, as the policies age, the benefit ratio will typically increase, but the increase in benefits will be partially offset by interest income earned on the accumulated assets.  The interest-adjusted benefit ratio reflects the effects of the interest income offset.  Since interest income is an important factor in measuring the performance of this product, management believes a benefit ratio that includes the effect of interest income is useful in analyzing product performance.  We utilize the interest-adjusted benefit ratio in measuring segment performance because we believe that this performance measure is a better indicator of the ongoing businesses and trends in the business.  However, the “interest-adjusted benefit ratio” does not replace the “benefit ratio” as a measure of current period benefits to current period insurance policy income.  Accordingly, management reviews both “benefit ratios” and “interest-adjusted benefit ratios” when analyzing the financial results attributable to these products.  The investment income earned on the accumulated assets backing Bankers Life’s long-term care reserves was $225.1 million, $210.1 million and $193.8 million in 2009, 2008 and 2007, respectively.

Total premium collections were $3,000.9 million in 2009, down 9.6 percent from 2008, and $3,320.5 million in 2008, up 26 percent from 2007.  Premium collections include $444.4 million, $614.0 million and $277.8 million in 2009, 2008, and 2007, respectively, of premiums collected pursuant to the quota-share agreements with Coventry described above under “Accounting for marketing and reinsurance agreements with Coventry”.  See “Premium Collections” for further analysis of Bankers Life’s premium collections.

 
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Average liabilities for insurance products, net of reinsurance ceded were $11.5 billion in 2009, up 8.9 percent from 2008, and $10.5 billion in 2008, up 7.5 percent from 2007.  The increase in such liabilities was primarily due to increases in annuity and health reserves resulting from new sales of these products.

Insurance policy income is comprised of premiums earned on policies which provide mortality or morbidity coverage and fees and other charges assessed on other policies.  Insurance policy income includes $444.3 million, $609.5 million and $271.4 million in 2009, 2008 and 2007, respectively, of premium income from the quota-share agreements with Coventry described above under “Accounting for marketing and reinsurance agreements with Coventry”.

Net investment income on general account invested assets (which excludes income on policyholder accounts) increased 4.3 percent, to $643.6 million, in 2009 and 6.6 percent, to $617.1 million, in 2008.  The average balance of general account invested assets was $11.4 billion, $10.6 billion and $10.0 billion in 2009, 2008 and 2007, respectively.  The average yield on these assets was 5.64 percent in 2009, 5.83 percent in 2008 and 5.79 percent in 2007.  The increase in general account invested assets is primarily due to sales of our annuity and health products in recent periods.  The reduction in average yield in 2009 reflects lower new money rates due to tighter credit spreads for many investments and a higher amount of short-term investments with relatively lower yields.

Net investment income related to fixed index products represents the change in the estimated fair value of options which are purchased in an effort to hedge certain potential benefits accruing to the policyholders of our fixed index products. Our fixed index products are designed so that the investment income spread earned on the related insurance liabilities is expected to be more than adequate to cover the cost of the options and other costs related to these policies.  Net investment income (losses) related to fixed index products were $38.5 million, $(67.0) million and $(11.2) million in 2009, 2008 and 2007, respectively.  Net investment income related to fixed index products also includes income (loss) on trading securities which are held to act as hedges for embedded derivates related to fixed index products.  Such trading account income (loss) was $(14.0) million, $17.6 million and $.6 million in 2009, 2008 and 2007, respectively.  Such amounts are generally offset by the corresponding charge (credit) to amounts added to policyholder account balances for fixed index products based on the change in value of the indices.  Such income and related charges fluctuate based on the value of options embedded in the segment’s fixed index annuity policyholder account balances subject to this benefit and to the performance of the index to which the returns on such products are linked.

Net investment income on other special-purpose portfolios includes the income related to Company-owned life insurance (“COLI”) which was purchased as an investment vehicle to fund the deferred compensation plan for certain agents. The COLI assets are not assets of the agent deferred compensation plan, and as a result, are accounted for outside the plan and are recorded in the consolidated balance sheet as other invested assets.  Changes in the cash surrender value (which approximates net realizable value) of the COLI assets are recorded as net investment income (loss) and totaled $7.1 million, $(9.5) million and $1.5 million in 2009, 2008 and 2007, respectively.  We also recognized death benefits of $2.9 million and $2.7 million under the COLI in 2009 and 2007, respectively.

Fee revenue and other income was $10.2 million in 2009, compared to $11.0 million in 2008 and $12.0 million in 2007.  We recognized fee income of $9.2 million, $9.9 million and $11.0 million in 2009, 2008 and 2007, respectively, pursuant to the agreements described above under “Accounting for marketing and reinsurance agreements with Coventry”.

Insurance policy benefits fluctuated as a result of the factors summarized below for benefit ratios.  Benefit ratios are calculated by dividing the related insurance product’s insurance policy benefits by insurance policy income.

The Medicare supplement business consists of both individual and group policies.  Government regulations generally require us to attain and maintain a ratio of total benefits incurred to total premiums earned (excluding changes in policy benefit reserves), after three years from the original issuance of the policy and over the lifetime of the policy, of not less than 65 percent on individual products and not less than 75 percent on group products, as determined in accordance with statutory accounting principles.  Since the insurance product liabilities we establish for Medicare supplement business are subject to significant estimates, the ultimate claim liability we incur for a particular period is likely to be different than our initial estimate.  Our insurance policy benefits reflected reserve redundancies from prior years of $7.7 million, $.5 million and $3.7 million in 2009, 2008 and 2007, respectively.  Excluding the effects of prior year claim reserve redundancies, our benefit ratios would have been 71.9 percent, 70.8 percent and 67.8 percent in 2009, 2008 and 2007, respectively.  We experienced an increase in the number of incurred claims in 2009 and 2008.

The insurance policy benefits on our PDP and PFFS business result from our quota-share reinsurance agreements with

 
23
 

Coventry as described above under “Accounting for marketing and reinsurance agreements with Coventry”.  We began assuming the PDP business on January 1, 2006 and the PFFS business on January 1, 2007.  During 2007 and 2008, we entered into new PFFS quota-share reinsurance agreements to assume a specified percentage of the business written by Coventry under three large group policies.  During 2008, we recognized a $3 million increase in insurance policy benefits due to changes in our estimates of prior period claim costs on the PFFS business we assume from Coventry.  In order to reduce the required statutory capital associated with the assumption of this business, CNO terminated two group policy quota-share agreements as of December 31, 2008 and terminated the last agreement on June 30, 2009.  Coventry has decided to cease selling PFFS plans effective January 1, 2010.  On July 22, 2009, Bankers Life announced a strategic alliance under which it will offer Humana’s Medicare Advantage plans to its policyholders and consumers nationwide through its career agency force and will receive marketing fees based on sales.  Effective January 1, 2010, the Company will no longer be assuming the underwriting risk related to PFFS business.  Insurance margins (insurance policy income less insurance policy benefits) on the PDP and PFFS business were $59.5 million, $24.4 million and $40.3 million in 2009, 2008 and 2007, respectively.  The increase in margin in 2009 is primarily due to:  (i) increases in our share of risk adjustment premium payments made by the Center for Medicare and Medical Services; and (ii) favorable reserve developments.

The net cash flows from our long-term care products generally cause an accumulation of amounts in the early years of a policy (accounted for as reserve increases) which will be paid out as benefits in later policy years (accounted for as reserve decreases).  Accordingly, as the policies age, the benefit ratio typically increases, but the increase in reserves is partially offset by investment income earned on the accumulated assets.  The benefit ratio on our entire block of long-term care business in the Bankers Life segment was 105.2 percent, 107.6 percent and 102.0 percent in 2009, 2008 and 2007, respectively.  The interest-adjusted benefit ratio on this business was 67.9 percent, 74.0 percent and 70.8 percent in 2009, 2008 and 2007, respectively.  Since the insurance product liabilities we establish for long-term care business are subject to significant estimates, the ultimate claim liability we incur for a particular period is likely to be different than our initial estimate.  Our insurance policy benefits reflected reserve redundancies (deficiencies) from prior years of $10.0 million, $(6.0) million and $(7.4) million in 2009, 2008 and 2007, respectively.  Excluding the effects of prior year claim reserve deficiencies, our benefit ratios would have been 106.9 percent, 106.7 percent and 100.8 percent in 2009, 2008 and 2007, respectively.  The benefit ratio for 2009 reflected a reduction in liabilities for insurance products of approximately $41.9 million due to our estimates of:  (i) the reduction in liabilities for policyholders choosing to lapse their policies rather than paying higher rates; (ii) the reduction in liabilities for policyholders choosing to reduce their coverages to achieve a lower cost; offset by (iii) the increase in the reserves related to waiver of premium benefits to reflect the higher premiums after the rate increase.  The aforementioned reduction in liabilities was partially offset by increased amortization of insurance intangibles of $4.7 million resulting from the increase in lapses.  When policies lapse, active life reserves for such lapsed policies are released, resulting in decreased insurance policy benefits (although such decrease is somewhat offset by additional amortization expense).

As a result of higher persistency in our long-term care block in the Bankers Life segment than assumed in the original pricing, our premium rates were too low.  Accordingly, we began a program in 2006 to seek approval from regulatory authorities for rate increases on approximately 65 percent of this block.  As an alternative to the rate increase, policyholders were offered the option:  (i) to reduce their benefits to maintain their previous premium rates; or (ii) to choose a nonforfeiture benefit equal to the sum of accumulated premiums paid less claims received.  We have received all expected regulatory approvals and have implemented these rate increases.  In addition, another round of increases was filed during the second and third quarters of 2007 on newer long-term care, home health care, and short-term care policies not included in the first round of rate increases, however, non-forfeiture benefits were only offered in accordance with the terms of the policy.  The policies in this round represent approximately 25 percent of the inforce block.  As of December 31, 2009, all such filings had been submitted for regulatory approval, and approximately 80 percent of the expected rate increases had been approved by regulators and implemented.  Finally, an additional rate increase on the 65 percent of the block that received an increase in 2006 was filed in the third quarter of 2008, however, non-forfeiture benefits were only offered in accordance with the terms of the policy.

Amounts added to policyholder account balances for annuity products and interest-sensitive life products were $183.1 million, $175.7 million and $180.9 million in 2009, 2008 and 2007, respectively.  The weighted average crediting rates for these products was 3.5 percent, 3.6 percent and 3.7 percent in 2009, 2008 and 2007, respectively.  The average liabilities of the deposit-based annuity block was $4.8 billion, $4.5 billon and $4.5 billion in 2009, 2008 and 2007, respectively.

Amounts added to fixed index products based on change in value of the indices will generally fluctuate with the corresponding related investment income accounts described above.  Such corresponding relationship did not exist in 2008 and 2007 due to a number of factors including variations in option costs and changes in the value of the trading account

 
24
 

securities which did not correspond to the changes in the value of the embedded derivatives related to these products.

Amortization related to operations includes amortization of deferred acquisition costs and the present value of future profits (collectively referred to as “amortization of insurance acquisition costs”).  Insurance acquisition costs are generally amortized either:  (i) in relation to the estimated gross profits for universal life and investment-type products; or (ii) in relation to actual and expected premium revenue for other products.  In addition, for universal life and investment-type products, we are required to adjust the total amortization recorded to date through the statement of operations if actual experience or other evidence suggests that earlier estimates of future gross profits should be revised.  Accordingly, amortization for universal life and investment-type products is dependent on the profits realized during the period and on our expectation of future profits.  For other products, we amortize insurance acquisition costs in relation to actual and expected premium revenue, and amortization is only adjusted if expected premium revenue changes or if we determine the balance of these costs is not recoverable from future profits.  Bankers Life’s amortization expense was $267.9 million, $234.8 million and $264.0 million in 2009, 2008 and 2007, respectively.  Amortization expense related to our annuity block of business increased $46.9 million in 2009, as compared to 2008, partially due to changes in our lapse assumptions.  We limit the total amortization adjustments resulting from losses on a block of business issued in a particular year to an amount which would not result in the balance of insurance acquisition costs exceeding the total of costs capitalized plus interest.  During 2009, amortization expense related to annuities decreased by $5.9 million due to this limitation.  During the first six months of 2008 and 2007, we experienced higher lapses than we anticipated on our Medicare supplement products.  These lapses reduced our estimates of future expected premium income and, accordingly, we recognized additional amortization expense of $12.2 million and $25.4 million in 2008 and 2007, respectively.  We believe such increases were partially related to competition from Medicare Advantage products.

Other operating costs and expenses in our Bankers Life segment were $196.6 million in 2009, up 7.8 percent from 2008 and were $182.4 million in 2008, up 5.0 percent from 2007.  Other operating costs and expenses include the following (dollars in millions):

   
2009
    
2008
    
2007
  
Expenses related to the marketing and quota-share agreements with Coventry
   $ 28.6     $ 40.8     $ 24.5  
Commission expense                                                                     
     18.0       20.5       20.8  
Other operating expenses                                                                     
     150.0       121.1       128.5  
                         
Total                                                                  
   $ 196.6     $ 182.4     $ 173.8  

Net realized investment losses fluctuated each period.  During 2009, net realized investment losses in this segment included $65.0 million of net gains from the sales of investments (primarily fixed maturities) and $96.4 million of writedowns of investments for other than temporary declines in fair value recognized through net income ($182.2 million, prior to the $85.8 million of impairment losses recognized through accumulated other comprehensive loss).  During 2008, net realized investment losses in this segment included $31.1 million of net losses from the sales of investments (primarily fixed maturities) and $85.6 million of writedowns of investments resulting from declines in fair value that we concluded were other than temporary.  During 2007, net realized investment losses in this segment included $4.6 million of net losses from the sales of investments (primarily fixed maturities) and $15.3 million of writedowns of investments resulting from declines in fair value that we concluded were other than temporary.

Amortization related to net realized investment losses is the increase or decrease in the amortization of insurance acquisition costs which results from realized investment gains or losses.  When we sell securities which back our universal life and investment-type products at a gain (loss) and reinvest the proceeds at a different yield, we increase (reduce) the amortization of insurance acquisition costs in order to reflect the change in estimated gross profits due to the gains (losses) realized and the resulting effect on estimated future yields.  Sales of fixed maturity investments resulted in an increase (decrease) in the amortization of insurance acquisition costs of $.2 million, $(15.8) million and $(2.5) million in 2009, 2008 and 2007, respectively.

 
25
 

Washington National (dollars in millions)

 
2009
    
2008
  
2007
  
               
Premium collections:
              
Medicare supplement and other supplemental health
 $ 566.3     $ 584.9   $ 592.7  
Life
   30.1        35.7     39.6  
                     
Total collections
 $ 596.4     $ 620.6   $ 632.3  
                     
Average liabilities for insurance products:
                    
Medicare supplement and other supplemental health
 $ 2,518.2     $ 2,510.3   $ 2,414.4  
Non-interest sensitive life
   376.7       493.0     510.3  
                     
Total average liabilities for insurance products, net of reinsurance ceded
 $ 2,894.9     $ 3,003.3   $ 2,924.7  
Revenues:
                    
Insurance policy income
 $ 597.9     $ 617.2   $ 637.7  
Net investment income:
                    
General account invested assets
   191.2       197.3     194.3  
Trading account income related to reinsurer accounts
   4.2       (6.7 )   (1.4  )
Change in value of embedded derivatives related to modified coinsurance agreements
   (6.5 )     6.7     1.4  
Fee revenue and other income
   1.5        .7      1.0  
                     
Total revenues
   788.3        815.2     833.0  
                     
Expenses:
                    
Insurance policy benefits
   467.0       473.2     481.0  
Amortization related to operations
   53.9       54.0     54.3  
Other operating costs and expenses
   156.5        166.9     170.0  
                     
Total benefits and expenses
   677.4       694.1     705.3  
                     
Income before net realized investment losses
   110.9       121.1     127.7  
                     
Net realized investment losses
   (2.6 )     (16.2 )    (13.9 ) 
                     
Income before income taxes
 $ 108.3     $ 104.9   $ 113.8  
                   
Health benefit ratios:
                  
All health lines:
                  
Insurance policy benefits                                                                      
 $ 433.2     $ 432.4    $ 439.3  
Benefit ratio (a)                                                                      
   76.2 %     74.3 % 
73.4
 % 
                     
Medicare supplement:
                    
Insurance policy benefits                                                                      
 $ 124.0     $ 139.8    $ 156.4  
Benefit ratio (a)                                                                      
   68.3 %     68.4  %
67.6
 % 
                     
Supplemental health:
                    
Insurance policy benefits                                                                      
 $ 303.4     $ 285.4    $ 279.4   
Benefit ratio (a)                                                                      
   79.5 %     77.1  %
                            77.8
 % 
Interest-adjusted benefit ratio (b)                                                                      
   46.0 %     43.3  % 
44.7
% 
                     
Other:
                    
Insurance policy benefits                                                                      
 $ 5.9     $ 7.2    $ 3.5   
Benefit ratio (a)                                                                      
   110.2 %     101.1  %
43.2
% 
____________________
(a)  
We calculate benefit ratios by dividing the related product’s insurance policy benefits by insurance policy income.
(b)  
We calculate the interest-adjusted benefit ratio (a non-GAAP measure) for Washington National’s supplemental health products by dividing such product’s insurance policy benefits less interest income on the accumulated assets backing the insurance liabilities by policy income.  These are considered non-GAAP financial measures.  A non-GAAP measure is a numerical measure of a company’s performance, financial position, or cash flows that excludes or includes amounts that are normally excluded or included in the most directly comparable measure calculated and presented in accordance with GAAP.

 
26
 


These non-GAAP financial measures of “interest-adjusted benefit ratios” differ from “benefit ratios” due to the deduction of interest income on the accumulated assets backing the insurance liabilities from the product’s insurance policy benefits used to determine the ratio.  Interest income is an important factor in measuring the performance of health products that are expected to be inforce for a longer duration of time, are not subject to unilateral changes in provisions (such as non-cancelable or guaranteed renewable contracts) and require the performance of various functions and services (including insurance protection) for an extended period of time.  The net cash flows from supplemental health products generally cause an accumulation of amounts in the early years of a policy (accounted for as reserve increases) that will be paid out as benefits in later policy years (accounted for as reserve decreases).  Accordingly, as the policies age, the benefit ratio will typically increase, but the increase in benefits will be partially offset by interest income earned on the accumulated assets.  The interest-adjusted benefit ratio reflects the effects of the interest income offset.  Since interest income is an important factor in measuring the performance of these products, management believes a benefit ratio that includes the effect of interest income is useful in analyzing product performance.  We utilize the interest-adjusted benefit ratio in measuring segment performance because we believe that this performance measure is a better indicator of the ongoing businesses and trends in the business.  However, the “interest-adjusted benefit ratio” does not replace the “benefit ratio” as a measure of current period benefits to current period insurance policy income.  Accordingly, management reviews both “benefit ratios” and “interest-adjusted benefit ratios” when analyzing the financial results attributable to these products.  The investment income earned on the accumulated assets backing the supplemental health reserves was $127.7 million, $125.2 million and $118.9 million in 2009, 2008 and 2007, respectively.

Total premium collections were $596.4 million in 2009, down 3.9 percent from 2008, and $620.6 million in 2008, down 1.9 percent from 2007.  The decrease in collected premiums was primarily due to lower sales of Medicare supplement products.  See “Premium Collections” for further analysis of fluctuations in premiums collected by product.

Average liabilities for insurance products, net of reinsurance ceded were $2.9 billion in 2009, down 3.6 percent from 2008, and $3.0 billion in 2008, up 2.7 percent from 2007.  The decrease in 2009 was primarily due to the coinsurance transaction with Wilton Reassurance Company ("Wilton Re") completed in September 2009, as further discussed in the note to the consolidated financial statements entitled “Summary of Significant Accounting Policies - Reinsurance”.

Insurance policy income is comprised of premiums earned on traditional insurance policies which provide mortality or morbidity coverage and fees and other charges assessed on other policies.  The decrease in insurance policy income is primarily due to lower income from Medicare supplement products due to lapses exceeding new sales and lower premiums from our life insurance block.  See “Premium Collections” for further analysis.

Net investment income on general account invested assets (which excludes income on policyholder and reinsurer accounts) decreased 3.1 percent, to $191.2 million, in 2009 and increased 1.5 percent, to $197.3 million, in 2008.  The average balance of general account invested assets decreased 2.9 percent in 2009, to $3.3 billion, and increased 3.0 percent in 2008, to $3.4 billion.  The average yield on these assets was 5.71 percent in 2009, 5.87 percent in 2008 and 5.97 percent in 2007.  The reduction in average yield in 2009 reflects lower new money rates due to tighter credit spreads for many investments.

Trading account income related to reinsurer accounts represents the income on trading securities which are held to act as hedges for embedded derivatives related to certain modified coinsurance agreements.  The income on our trading account securities is designed to substantially offset the change in value of embedded derivatives related to modified coinsurance agreements described below.

Change in value of embedded derivatives related to modified coinsurance agreements is described in the note to our consolidated financial statements entitled “Summary of Significant Accounting Policies - Accounting for Derivatives.” We have transferred the specific block of investments related to these agreements to our trading securities account, which we carry at estimated fair value with changes in such value recognized as trading account income.  The change in the value of the embedded derivatives has largely been offset by the change in value of the trading securities.

Insurance policy benefits were affected by a number of items as summarized below.  Benefit ratios are calculated by dividing the related insurance product’s insurance policy benefits by insurance policy income.

The benefit ratios on Washington National’s Medicare supplement products have been impacted by increases in policyholder lapses following our premium rate increase actions and competition from companies offering Medicare Advantage products.  We establish active life reserves for these policies, which are in addition to amounts required for incurred claims.  When policies lapse, active life reserves for such lapsed policies are released, resulting in decreased

 
27
 

insurance policy benefits (although such decrease is substantially offset by additional amortization expense).  In addition, the insurance product liabilities we establish for our Medicare supplement business are subject to significant estimates and the ultimate claim liability we incur for a particular period is likely to be different than our initial estimate.  Our insurance policy benefits reflected claim reserve redundancies from prior years of $4.6 million, $2.5 million and $1.0 million in 2009, 2008 and 2007, respectively.  Excluding the effects of prior year claim reserve redundancies, our benefit ratios for the Medicare supplement block would have been 70.8 percent, 69.6 percent and 68.0 percent in 2009, 2008 and 2007, respectively.  Governmental regulations generally require us to attain and maintain a ratio of total benefits incurred to total premiums earned (excluding changes in policy benefit reserves), after three years from the original issuance of the policy and over the lifetime of the policy, of not less than 65 percent on these products, as determined in accordance with statutory accounting principles.  Insurance margins (insurance policy income less insurance policy benefits) on these products were $57.6 million, $64.6 million and $74.9 million in 2009, 2008 and 2007, respectively.  Such decreases are primarily due to lower sales.

Washington National’s supplemental health products generally provide fixed or limited benefits.  For example, payments under cancer insurance policies are generally made directly to, or at the direction of, the policyholder following diagnosis of, or treatment for, a covered type of cancer.  Approximately three-fourths of our supplemental health policies inforce (based on policy count) are sold with return of premium or cash value riders.  The return of premium rider generally provides that after a policy has been inforce for a specified number of years or upon the policyholder reaching a specified age, we will pay to the policyholder, or a beneficiary under the policy, the aggregate amount of all premiums paid under the policy, without interest, less the aggregate amount of all claims incurred under the policy.  The cash value rider is similar to the return of premium rider, but also provides for payment of a graded portion of the return of premium benefit if the policy terminates before the return of premium benefit is earned.  Accordingly, the net cash flows from these products generally result in the accumulation of amounts in the early years of a policy (accounted for as reserve increases) which will be paid out as benefits in later policy years (accounted for as reserve decreases).  As the policies age, the benefit ratio will typically increase, but the increase in benefits will be partially offset by investment income earned on the accumulated assets.  The benefit ratio will fluctuate depending on the claim experience during the year.  Insurance margins (insurance policy income less insurance policy benefits) on these products were $78.2 million, $85.0 million and $79.7 million in 2009, 2008 and 2007, respectively.  The increase in the margin in 2008 includes a $12 million correction to insurance policy benefits resulting from our material control weakness remediation procedures.

The benefit ratios on Washington National’s other products are subject to fluctuations due to the smaller size of these blocks of business.

Amortization related to operations includes amortization of insurance acquisition costs.  Insurance acquisition costs are generally amortized in relation to actual and expected premium revenue, and amortization is only adjusted if expected premium revenue changes or if we determine the balance of these costs is not recoverable from future profits.  A revision to our current assumptions could result in increases or decreases to amortization expense in future periods.

Other operating costs and expenses were $156.5 million, $166.9 million and $170.0 million in 2009, 2008 and 2007, respectively.  Other operating costs and expenses include commission expense of $63.6 million, $67.5 million and $70.0 million in 2009, 2008 and 2007, respectively.

Net realized investment gains (losses) fluctuate each period.  During 2009, net realized investment losses in this segment included $25.7 million of net gains from the sales of investments (primarily fixed maturities) and $28.3 million of writedowns of investments for other than temporary declines in fair value recognized through net income ($64.4 million, prior to the $36.1 million of impairment losses recognized through accumulated other comprehensive loss).  During 2008, net realized investment losses included $3.9 million of net gains from the sales of investments (primarily fixed maturities) and $20.1 million of writedowns of investments resulting from declines in fair value that we concluded were other than temporary.  During 2007, net realized investment losses in this segment included:  (i) $10.1 million from the sales of investments (primarily fixed maturities); and (ii) $3.8 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary.  The net investment losses realized on sales of investments in 2007 were primarily recognized on securities collateralized by sub prime residential mortgage loans.  We decided to sell these securities given our evaluation regarding the potential effect of future adverse developments on the fair value of these securities.

 
28
 


Colonial Penn (dollars in millions)

   
2009
    
2008
    
2007
  
                   
Premium collections:
                  
Life                                                                          
   $ 187.3     $ 174.1     $ 113.7  
Supplemental health                                                                          
     7.5       8.9       10.4  
                         
Total collections                                                                       
   $ 194.8     $ 183.0     $ 124.1  
                         
Average liabilities for insurance products:
                        
Annuities-mortality based                                                                          
   $ 81.7     $ 85.9     $ 88.7  
Health                                                                          
     19.1       20.7       22.9  
Life:
                        
Interest sensitive                                                                   
     23.2       25.0       25.9  
Non-interest sensitive                                                                   
     569.6       562.9       558.9  
                         
Total average liabilities for insurance products, net of reinsurance ceded
   $ 693.6     $ 694.5     $ 696.4  
                         
Revenues:
                        
Insurance policy income                                                                           
   $ 196.1     $ 184.8     $ 125.8  
Net investment income:
                        
General account invested assets                                                                       
     38.7       40.1       37.8  
Trading account income related to reinsurer accounts
     -       (.5 )     (.2 )
Change in value of embedded derivative related to a modified coinsurance agreement
     -       -       .2  
Fee revenue and other income                                                                           
     .9       1.8       .7  
                         
Total revenues                                                                       
     235.7       226.2       164.3  
                         
Expenses:
                        
Insurance policy benefits                                                                           
     141.9       138.2       101.0  
Amounts added to annuity and interest-sensitive life product account balances
     1.1       1.2       1.2  
Amortization related to operations                                                                           
     33.3       32.0       20.3  
Other operating costs and expenses                                                                           
     30.0       29.6       23.7  
                         
Total benefits and expenses                                                                       
     206.3       201.0       146.2  
                         
Income before net realized investment gains (losses) and income taxes
     29.4       25.2       18.1  
Net realized investment gains (losses)                                                                        
     4.5       (1.6 )     (.2 )
                         
Income before income taxes                                                                            
   $ 33.9     $ 23.6     $ 17.9  

Reinsurance recapture:  In the fourth quarter of 2007, we completed the recapture of a block of traditional life insurance inforce that had been ceded under a coinsurance agreement with Reassure America Life Insurance Company ("REALIC").  The recapture of this block resulted in a $2.8 million gain accounted for as a reduction to insurance policy benefits.

Total premium collections increased 6.4 percent, to $194.8 million, in 2009 and 47 percent, to $183.0 million, in 2008. See “Premium Collections” for further analysis of Colonial Penn’s premium collections.

Average liabilities for insurance products, net of reinsurance ceded, did not fluctuate significantly during the three years ended December 31, 2009.

Insurance policy income is comprised of premiums earned on policies which provide mortality or morbidity coverage

 
29
 

and fees and other charges assessed on other policies.  In 2009, insurance policy income includes the recognition of a $3.4 million final distribution and commutation amount following the termination of a group insurance pool that Colonial Penn previously participated in.  The increase in the 2009 periods also reflects the growth in this segment.  The increase in 2008 reflects:  (i) the additional premiums following the recapture of the modified coinsurance agreement in the fourth quarter of 2007; and (ii) the growth in this segment.  See “Premium Collections” for further analysis.

Net investment income on general account invested assets (which excludes income on policyholder and reinsurer accounts) did not fluctuate significantly during the three years ended December 31, 2009.  The average balance of general account invested assets was $659.9 million in 2009, $676.0 million in 2008 and $660.6 million in 2007.  The average yield on these assets was 5.86 percent in 2009, 5.94 percent in 2008 and 5.72 percent in 2007.

Trading account income related to reinsurer accounts represents the income on trading securities, which were designed to act as hedges for embedded derivatives related to a modified coinsurance agreement.  The income on our trading account securities was designed to be substantially offset by the change in value of embedded derivatives related to the modified coinsurance agreement described below.  As a result of the recapture of a modified coinsurance agreement in the fourth quarter of 2007, such trading account securities were sold in the first quarter of 2008.

Change in value of embedded derivative related to a modified coinsurance agreement is described in the note to our consolidated financial statements entitled “Summary of Significant Accounting Policies - Accounting for Derivatives.” We had transferred the specific block of investments related to this agreement to our trading account, which we carried at estimated fair value with changes in such value recognized as trading account income.  The change in the value of the embedded derivative was largely offset by the change in value of the trading securities.  As a result of the recapture of the modified coinsurance agreement in the fourth quarter of 2007 (as further discussed below under insurance policy benefits), the embedded derivative related to the agreement was eliminated.

Insurance policy benefits fluctuated as a result of:  (i) the additional benefits incurred following the recapture of the modified coinsurance agreement in the fourth quarter of 2007; and (ii) the growth in this segment in recent periods.  Insurance policy benefits were reduced by $2.8 million in 2007 as a result of completing the aforementioned recapture of a block of traditional life insurance in force that had been ceded in 2002 to REALIC.  In the transaction, which had an effective date of October 1, 2007, Colonial Penn paid REALIC a recapture fee of $63 million.  Colonial Penn recaptured 100 percent of the liability for the future benefits previously ceded, and will recognize profits from the block as they emerge over time.  Colonial Penn already administered the policies that were recaptured.

Amortization related to operations includes amortization of insurance acquisition costs.  Insurance acquisition costs in the Colonial Penn segment are amortized in relation to actual and expected premium revenue, and amortization is only adjusted if expected premium revenue changes or if we determine the balance of these costs is not recoverable from future profits.  Such amounts were generally consistent with the related premium revenue and gross profits for such periods and the assumptions we made when we established the present value of future profits.  A revision to our current assumptions could result in increases or decreases to amortization expense in future periods.

Other operating costs and expenses in our Colonial Penn segment increased 1.4 percent, to $30.0 million in 2009 as compared to 2008.  Such expenses increased 25 percent, to $29.6 million, in 2008 as compared to 2007 primarily due to:  (i) the additional costs incurred following the recapture of the modified coinsurance agreement in the fourth quarter of 2007; and (ii) the growth in this segment in recent periods.  Other operating costs and expenses in our Colonial Penn segment in 2007 included $8.4 million of marketing costs associated with a pilot program involving the distribution of Coventry’s PFFS plan through our direct response distribution channel.  Such pilot program was discontinued in 2008.

Net realized investment gains (losses) fluctuated each period.  During 2009, net realized investment losses in this segment included $8.7 million of net gains from the sales of investments (primarily fixed maturities) and $4.2 million of writedowns of investments for other than temporary declines in fair value recognized through net income ($4.6 million, prior to the $.4 million of impairment losses recognized through accumulated other comprehensive loss).  During 2008, net realized investment losses in this segment included $.1 million of net gains from the sales of investments (primarily fixed maturities) and $1.7 million of writedowns of investments resulting from declines in fair value that we concluded were other than temporary.  During 2007, net realized investment gains in this segment included $.4 million of net gains from the sales of investments (primarily fixed maturities) and $.6 million of writedowns of investments resulting from declines in fair value that we concluded were other than temporary.

 
30
 


Other CNO Business (dollars in millions)

   
2009
    
2008
    
2007
  
                   
Premium collections:
                  
Annuities                                                                            
   $ 78.4     $ 129.8     $ 368.6  
Other health                                                                            
     34.1       36.9       40.7  
Life                                                                            
     210.2       234.1       247.7  
                         
Total collections                                                                          
   $ 322.7     $ 400.8     $ 657.0  
                         
Average liabilities for insurance products:
                        
Annuities:
                        
Mortality based                                                                        
   $ 215.2     $ 220.7     $ 230.3  
Fixed index                                                                        
     778.5       891.0       1,435.3  
Deposit based                                                                        
     661.5       752.6       2,337.7  
Separate accounts                                                                        
     18.2       23.6       28.4  
Other health                                                                            
     485.9       482.8       513.1  
Life:
                        
Interest sensitive                                                                        
     2,777.2       2,945.5       3,045.5  
Non-interest sensitive                                                                        
     862.7       900.8       869.9  
                         
Total average liabilities for insurance products, net of reinsurance ceded
   $ 5,799.2     $ 6,217.0     $ 8,460.2  
Revenues:
                        
Insurance policy income                                                                            
   $ 340.4     $ 341.7     $ 352.2  
Net investment income:
                        
General account invested assets                                                                        
     357.1       393.8       533.3  
Fixed index products                                                                        
     7.0       (28.4 )     (1.3 )
Trading account income related to policyholder accounts
     7.8       (10.2 )     2.8  
Other trading accounts
     -       -       (12.8 )
Fee revenue and other income                                                                            
     -       1.0       -  
                         
Total revenues                                                                          
     712.3       697.9       874.2  
                         
Expenses:
                        
Insurance policy benefits                                                                            
     376.6       349.2       371.6  
Amounts added to policyholder account balances:
                        
Annuity products and interest-sensitive life products other than fixed index products
     138.8       152.1       215.7  
Fixed index products                                                                          
     36.3       8.2       60.7  
Amortization related to operations                                                                            
     81.6       68.6       123.9  
Interest expense on investment borrowings                                                                            
     20.5       22.4       17.6  
Costs related to a litigation settlement                                                                            
     -       -       32.2  
Loss related to an annuity coinsurance transaction
     -       -       76.5  
Other operating costs and expenses                                                                            
     102.1        97.2       130.0  
                         
Total benefits and expenses                                                                          
     755.9       697.7       1,028.2  
                         
Income (loss) before net realized investment losses, net of related amortization and income taxes
     (43.6 )     .2       (154.0 )
                         
Net realized investment losses                                                                          
     (23.6 )     (77.1 )     (117.8 )
Amortization related to net realized investment losses
     4.2       5.7        33.2  
Net realized investment losses, net of related amortization
     (19.4 )     (71.4 )     (84.6 )
                         
Income (loss) before income taxes                                                                                
   $ (63.0 )   $ (71.2 )   $ (238.6 )

(continued)

 
31
 

(continued from previous page)

   
2009
    
2008
    
2007
  
                   
Health benefit ratios:
                  
All health lines:
                  
Insurance policy benefits                                                                      
   $ 62.7     $ 61.9     $ 75.6  
Benefit ratio (a)                                                                      
     178.9 %     163.6 %     180.9 %
                         
Long-term care:
                        
Insurance policy benefits                                                                      
   $ 59.9     $ 58.7     $ 72.5  
Benefit ratio (a)                                                                      
     186.7 %     169.6 %     192.4 %
Interest-adjusted benefit ratio (b)                                                                      
     107.9 %     93.5 %     128.5 %
                         
Other:
                        
Insurance policy benefits                                                                      
   $ 2.8     $ 3.2     $ 3.1  
Benefit ratio (a)                                                                      
     95.5 %     99.3 %     75.2 %
____________________
(a)  
We calculate benefit ratios by dividing the related product’s insurance policy benefits by insurance policy income.
(b)  
We calculate the interest-adjusted benefit ratio (a non-GAAP measure) for long-term care products in our Other CNO Business segment by dividing such product’s insurance policy benefits less interest income on the accumulated assets backing the insurance liabilities by policy income.  These are considered non-GAAP financial measures.  A non-GAAP measure is a numerical measure of a company’s performance, financial position, or cash flows that excludes or includes amounts that are normally excluded or included in the most directly comparable measure calculated and presented in accordance with GAAP.

These non-GAAP financial measures of “interest-adjusted benefit ratios” differ from “benefit ratios” due to the deduction of interest income on the accumulated assets backing the insurance liabilities from the product’s insurance policy benefits used to determine the ratio.  Interest income is an important factor in measuring the performance of health products that are expected to be inforce for a longer duration of time, are not subject to unilateral changes in provisions (such as non-cancelable or guaranteed renewable contracts) and require the performance of various functions and services (including insurance protection) for an extended period of time.  The net cash flows from long-term care products generally cause an accumulation of amounts in the early years of a policy (accounted for as reserve increases) that will be paid out as benefits in later policy years (accounted for as reserve decreases).  Accordingly, as the policies age, the benefit ratio will typically increase, but the increase in benefits will be partially offset by interest income earned on the accumulated assets.  The interest-adjusted benefit ratio reflects the effects of the interest income offset.  Since interest income is an important factor in measuring the performance of these products, management believes a benefit ratio that includes the effect of interest income is useful in analyzing product performance.  We utilize the interest-adjusted benefit ratio in measuring segment performance because we believe that this performance measure is a better indicator of the ongoing businesses and trends in the business.  However, the “interest-adjusted benefit ratio” does not replace the “benefit ratio” as a measure of current period benefits to current period insurance policy income.  Accordingly, management reviews both “benefit ratios” and “interest-adjusted benefit ratios” when analyzing the financial results attributable to these products.  The investment income earned on the accumulated assets backing the long-term care reserves was $25.2 million, $26.3 million and $24.1 million in 2009, 2008 and 2007, respectively.

Annuity coinsurance agreement.  On October 12, 2007, we completed a transaction to coinsure 100 percent of most of the older inforce fixed index annuity and fixed annuity business of three of our subsidiaries with REALIC.  The transaction was recorded in our financial statements on September 28, 2007, the date the parties were bound by the coinsurance agreement and all regulatory approvals had been obtained.  In the transaction, REALIC:  (i) paid a ceding commission of $76.5 million; and (ii) assumed the investment and persistency risk of these policies.  Our insurance subsidiaries ceded approximately $2.8 billion of policy and other reserves to REALIC, as well as transferred the invested assets backing these policies on October 12, 2007.  Our insurance subsidiaries remain primarily liable to the policyholders in the event REALIC does not fulfill its obligations under the agreements.  The coinsurance transaction had an effective date of January 1, 2007.

Pursuant to the terms of the annuity coinsurance agreement, the ceding commission was based on the January 1, 2007 value of the assets and liabilities related to the ceded block.  The earnings (loss) after income taxes on the business from January 1, 2007 through September 28, 2007, were included in our consolidated financial statements until the transaction was completed.  Upon completion, the earnings on this block of business were included as a component of the loss on the

 
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transaction which was recognized in the third quarter of 2007.  Such after-tax earnings (loss) include the fair value declines on invested assets transferred to the reinsurer occurring during the first three quarters of 2007.  As a result, the comparison of this segment’s operating results between periods is impacted by the coinsurance transaction.

Total premium collections were $322.7 million in 2009, down 19 percent from 2008, and $400.8 million in 2008, down 39 percent from 2007.  The decrease in collected premiums was primarily due to lower sales of fixed index annuity products.    See “Premium Collections” for further analysis of fluctuations in premiums collected by product.

Average liabilities for insurance products, net of reinsurance ceded were $5.8 billion in 2009, down 6.7 percent from 2008, and $6.2 billion in 2008, down 27 percent from 2007.  The decreases in such liabilities were primarily due to:  (i) the coinsurance transaction with Wilton Re completed in September 2009, as further discussed in the note to the consolidated financial statements entitled “Summary of Significant Accounting Policies - Reinsurance”; (ii) the annuity coinsurance transaction completed in 2007 as described above; and (iii) policyholder redemptions and lapses exceeding new sales.

Insurance policy income is comprised of premiums earned on traditional insurance policies which provide mortality or morbidity coverage and fees and other charges assessed on other policies.  The decrease in insurance policy income is primarily due to lower premiums from our life insurance block.  See “Premium Collections” for further analysis.

Net investment income on general account invested assets (which excludes income on policyholder and reinsurer accounts) decreased 9.3 percent, to $357.1 million, in 2009 and 26 percent, to $393.8 million, in 2008.  The average balance of general account invested assets decreased 6.0 percent in 2009, to $6.3 billion, and 25 percent in 2008, to $6.7 billion.  The average yield on these assets was 5.71 percent in 2009, 5.87 percent in 2008 and 5.97 percent in 2007.  The reduction in average yield in 2009 reflects lower new money rates due to tighter credit spreads for many investments.

Net investment income related to fixed index products represents the change in the estimated fair value of options which are purchased in an effort to hedge certain potential benefits accruing to the policyholders of our fixed index products.  Our fixed index products are designed so that the investment income spread earned on the related insurance liabilities is expected to be more than adequate to cover the cost of the options and other costs related to these policies.  Net investment income (losses) related to fixed index products were $12.2 million, $(37.3) million and $2.7 million in 2009, 2008 and 2007, respectively.  Such trading account income (loss) was $(5.2) million, $8.9 million and $(4.0) million in 2009, 2008 and 2007, respectively.  Such amounts were mostly offset by the corresponding charge (credit) to amounts added to policyholder account balances for fixed index products.  Such income and related charges fluctuate based on the value of options embedded in the segment’s fixed index annuity policyholder account balances subject to this benefit and to the performance of the indices to which the returns on such products are linked.

Trading account income related to policyholder accounts represents the income on investments backing the market strategies of certain annuity products which provide for different rates of cash value growth based on the experience of a particular market strategy.  The income on our trading account securities is designed to substantially offset certain amounts included in insurance policy benefits related to the aforementioned annuity products.

Net investment income on other trading accounts includes:  (i) the change in the fair value of a trading securities portfolio; and (ii) the change in fair value of interest rate swaps.  The trading securities were carried at estimated fair value with changes in such value recognized as trading income.  The change in the value of the interest rate swaps was recognized in trading income.  Prior to December 31, 2007, these fixed rate securities were sold and the associated interest rate swaps were terminated.

Insurance policy benefits were affected by a number of items as summarized below.  Benefit ratios are calculated by dividing the related insurance product’s insurance policy benefits by insurance policy income.

The long-term care policies in this segment generally provide for indemnity and non-indemnity benefits on a guaranteed renewable or non-cancellable basis.  The benefit ratio on our long-term care policies was 186.7 percent, 169.6 percent and 192.4 percent in 2009, 2008 and 2007, respectively.  Since the insurance product liabilities we establish for long-term care business are subject to significant estimates, the ultimate claim liability we incur for a particular period is likely to be different than our initial estimate.  Our insurance policy benefits reflected reserve redundancies (deficiencies) from prior years of $(2.1) million, $1.1 million and $(6.3) million in 2009, 2008 and 2007, respectively.  Excluding the effects of prior year claim reserve redundancies (deficiencies), our benefit ratios would have been 180.1 percent, 172.8 percent and 175.7 percent in 2009, 2008 and 2007, respectively.  These ratios reflect the level of incurred claims experienced in recent periods, development on claims incurred in prior periods and changes in policy income.  The prior period deficiencies have primarily resulted from the impact of paid claim experience being different than prior estimates.

 
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The net cash flows from long-term care products generally cause an accumulation of amounts in the early years of a policy (accounted for as reserve increases) which will be paid out as benefits in later policy years (accounted for as reserve decreases).  Accordingly, as the policies age, the benefit ratio will typically increase, but the increase in benefits will be partially offset by investment income earned on the assets which have accumulated.  The interest-adjusted benefit ratio for long-term care products is calculated by dividing the insurance product’s insurance policy benefits less interest income on the accumulated assets backing the insurance liabilities by insurance policy income.  The interest-adjusted benefit ratio on this business was 107.9 percent, 93.5 percent and 128.5 percent in 2009, 2008 and 2007, respectively.  Excluding the effects of prior year claim reserve redundancies (deficiencies), our interest-adjusted benefit ratios would have been 101.5 percent, 96.7 percent and 111.9 percent in 2009, 2008 and 2007, respectively.

In each quarterly period, we calculate our best estimate of claim reserves based on all of the information available to us at that time, which necessarily takes into account new experience emerging during the period.  Our actuaries estimate these claim reserves using various generally recognized actuarial methodologies which are based on informed estimates and judgments that are believed to be appropriate.  As additional experience emerges and other data become available, these estimates and judgments are reviewed and may be revised.  Significant assumptions made in estimating claim reserves for long-term care policies include expectations about the:  (i) future duration of existing claims; (ii) cost of care and benefit utilization; (iii) interest rate utilized to discount claim reserves; (iv) claims that have been incurred but not yet reported; (v) claim status on the reporting date; (vi) claims that have been closed but are expected to reopen; and (vii) correspondence that has been received that will ultimately become claims that have payments associated with them.

On July 1, 2004, the Florida Office of Insurance Regulation issued an order impacting approximately 4,800 home health care policies issued in Florida by our subsidiary, Washington National, and its predecessor companies.  Pursuant to the order, Washington National offered the following three alternatives to holders of these policies subject to rate increases as follows:

·  
retention of their current policy with a rate increase of 50 percent in the first year and actuarially justified increases in subsequent years (which is also the default election for policyholders who failed to make an election by 30 days prior to the anniversary date of their policies) (“option one”);

·  
receipt of a replacement policy with reduced benefits and a rate increase in the first year of 25 percent and no more than 15 percent in subsequent years (“option two”); or

·  
receipt of a paid-up policy, allowing the holder to file future claims up to 100 percent of the amount of premiums paid since the inception of the policy (“option three”).

Policyholders selecting option one or option two are entitled to receive a contingent non-forfeiture benefit if their policy subsequently lapses.  In addition, policyholders could change their initial election any time up to 30 days prior to the anniversary date of their policies.  We began to implement premium adjustments with respect to policyholder elections in the fourth quarter of 2005 and the implementation of these premium adjustments was completed in 2007.  We did not make any adjustments to the insurance liabilities when these elections were made.  Reserves for all three groups of policies under the order were prospectively adjusted using the prospective revision methodology described in the “Critical Accounting Policies – Accounting for Long-term Care Premium Rate Increases” in “Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations”.

The order also requires Washington National to pursue a similar course of action with respect to home health care policies in other states, subject to such actions being justified based on the experience of the business and approval by the other state insurance departments.  If we are unsuccessful in obtaining rate increases or other forms of relief in those states, or if the policy changes approved by the Florida Office of Insurance Regulation prove inadequate, our future results of operations could be adversely affected.

The benefit ratios on Other CNO Business’ other products are subject to fluctuations due to the smaller size of these blocks of business.

Amounts added to policyholder account balances for annuity products and interest-sensitive life products were $138.8 million, $152.1 million and $215.7 million in 2009, 2008 and 2007, respectively.  The decrease was primarily due to a smaller block of annuity business inforce due to:  (i) lapses exceeding new sales in recent periods; and (ii) the smaller block of business following the completion of the annuity coinsurance agreement in October 2007, as discussed above.  The weighted average crediting rates for these products were 4.1 percent, 4.2 percent and 4.1 percent in 2009, 2008 and 2007, respectively.

 
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    Amounts added to fixed index products generally fluctuate with the corresponding related investment income accounts described above.

Amortization related to operations includes amortization of insurance acquisition costs.  Insurance acquisition costs are generally amortized either: (i) in relation to the estimated gross profits for universal life and investment-type products; or (ii) in relation to actual and expected premium revenue for other products.  In addition, for universal life and investment-type products, we are required to adjust the total amortization recorded to date through the statement of operations if actual experience or other evidence suggests that earlier estimates of future gross profits should be revised.  Accordingly, amortization for universal life and investment-type products is dependent on the profits realized during the period and on our expectation of future profits.  For other products, we amortize insurance acquisition costs in relation to actual and expected premium revenue, and amortization is only adjusted if expected premium revenue changes or if we determine the balance of these costs is not recoverable from future profits.  The assumptions we use to estimate our future gross profits and premiums involve significant judgment.  A revision to our current assumptions could result in increases or decreases to amortization expense in future periods.  The decrease in amortization expense in 2008, as compared to 2007, was primarily a result of the coinsurance agreement discussed above.

The blocks of universal life and interest-sensitive products in the Other CNO Business segment have not performed in accordance with prior estimates of future gross profits, resulting in adjustments to amortization expense over the last 3 years.  We have been required to accelerate the amortization of insurance acquisition costs related to these blocks because the prior balance was not recoverable by the current estimated value of future gross profits.  These increases to amortization expense were necessary so that our insurance acquisition costs would not exceed the value of future estimated gross profits.  Because our insurance acquisition costs are now equal to the value of future estimated gross profits, these blocks are expected to generate break-even earnings in the future.  In addition, results for these blocks have and are expected to continue to exhibit increased volatility in the future, because the entire difference between our assumptions and actual experience is reflected in earnings in the period such differences occur.

During 2009, we were required to accelerate the amortization of insurance acquisition costs by approximately $25 million for the changes in three assumptions related to future profits from our universal life products in this segment.  The first change resulted in additional amortization expense of $24 million and relates to the investment earnings assumption for the entire interest-sensitive block of life insurance business.  The average yield on our general account invested assets decreased during 2009 reflecting lower new money rates.  Accordingly, the future weighted average investment earnings assumptions were reduced reflecting the lower portfolio earnings.  The second change resulted from refinements to our estimates of premium taxes expected to be incurred in the future, and resulted in a reduction to amortization expense of $8 million.  The third change resulted in additional amortization expense of $9 million and relates to the assumption of when we will ultimately increase certain non-guaranteed premium rates related to the Lifetrend insurance products.  As described in the note to the consolidated financial statements entitled “Litigation and Other Legal Proceedings – Regulatory Examinations and Fines,” we have reached a settlement in principle with the regulators regarding this issue, but we have not implemented the non-guaranteed premium rate increases pending execution of the final settlement agreement.

We were also required to accelerate the amortization of insurance acquisition costs due to changes in our assumptions related to future profits on our universal life products in this segment during 2008 and 2007.  During 2008, an analysis was performed on a universal life block of business that led to changes in our assumptions of future mortality, surrenders, premium persistency, expenses and investment income.  We recognized additional amortization expense of approximately $8 million to reflect these changes.  During 2007, we recognized additional amortization expense of $14.8 million to reflect changes in our estimates of future mortality rates.  The additional amortization expense in both 2007 and 2008 was net of planned increases to associated policyholder charges.

During 2009 and 2008, we were required to accelerate the amortization of insurance acquisition costs due to the experience of a block of fixed index annuities.  This block of business has experienced higher than anticipated surrenders and we have increased our expected surrender assumptions in future periods.  These annuities also have a MVA feature, which effectively reduced (or in some cases, eliminated) the charges paid upon the surrender of these policies in the recent periods as the 10-year treasury rate dropped.  The impact of both the historical experience and the projected increased surrender activity and higher MVA benefits has reduced our expectations on the profitability of this block to approximately break-even.  We recognized additional amortization of approximately $8.5 million in 2009 and approximately $5 million in 2008, related to the actual and expected future changes in the experience of this block.  We continue to hold insurance acquisition costs of approximately $68 million related to these products.  Results for this block are expected to exhibit increased volatility in the future, because the difference between our assumptions and actual experience will be reflected in earnings in the period such differences occur.

 
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Interest expense on investment borrowings includes $20.3 million, $21.9 million and $16.7 million of interest expense on collateralized borrowings in 2009, 2008 and 2007, respectively, as further described in the note to the consolidated financial statements entitled “Summary of Significant Accounting Policies - Investment Borrowings”.

Costs related to a litigation settlement include legal fees and estimated amounts related to a settlement during 2006 in the class action case referred to as In Re Conseco Life Insurance Company Cost of Insurance Litigation.  The costs related to the litigation settlement recognized in 2007 represent changes to our initial estimates based on the ultimate cost of the settlement.  For further information related to this case, refer to the caption entitled “Cost of Insurance Litigation” included in the note to our consolidated financial statements entitled “Commitments and Contingencies”.  A portion of the legal and other costs related to this litigation were incurred by the Corporate Operations segment to defend the non-insurance company allegations made in such lawsuits.

Loss related to an annuity coinsurance transaction resulted from the completion of a transaction to coinsure 100 percent of most of the older inforce fixed index annuity and fixed annuity business of three of our insurance subsidiaries with REALIC as further discussed above under annuity coinsurance transaction.

Other operating costs and expenses were $102.1 million, $97.2 million and $130.0 million in 2009, 2008 and 2007, respectively.  Other operating costs and expenses include commission expense of $8.0 million, $11.7 million and $12.2 million in 2009, 2008 and 2007, respectively.  These amounts fluctuate as a result of consulting and legal costs which often vary from period to period.  In 2007, we recognized expenses of $7.3 million related to the decision to abandon certain software and $3.7 million of costs related to other operational initiatives and consolidation activities.

Net realized investment gains (losses) fluctuate each period.  During 2009, net realized investment losses in this segment included $29.4 million of net gains from the sales of investments (primarily fixed maturities) and $53.0 million of writedowns of investments for other than temporary declines in fair value recognized through net income ($120.3 million, prior to the $67.3 million of impairment losses recognized through accumulated other comprehensive loss).  During 2008, net realized investment losses included $36.9 million of net losses from the sales of investments (primarily fixed maturities) and $40.2 million of writedowns of investments resulting from declines in fair value that we concluded were other than temporary.  During 2007, net realized investment losses in this segment included:  (i) $33.5 million from the sales of investments (primarily fixed maturities); (ii) $10.6 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary; and (iii) $73.7 million of writedowns of investments (which were subsequently transferred pursuant to a coinsurance agreement as further discussed in the note to the consolidated financial statements entitled “Summary of Significant Accounting Policies – Reinsurance”) as a result of our intent not to hold such investments for a period of time sufficient to allow for any anticipated recovery in value.  The net investment losses realized on sales of investments in 2007 were primarily recognized on securities collateralized by sub prime residential mortgage loans.  We decided to sell these securities given our evaluation regarding the potential effect of future adverse developments on the fair value of these securities.

Amortization related to net realized investment losses is the increase or decrease in the amortization of insurance acquisition costs which results from realized investment gains or losses.  When we sell securities which back our universal life and investment-type products at a gain (loss) and reinvest the proceeds at a different yield (or when we have the intent to sell the impaired investments before an anticipated recovery in value occurs, we increase (reduce) the amortization of insurance acquisition costs in order to reflect the change in estimated gross profits due to the gains (losses) realized and the resulting effect on estimated future yields.  Sales of fixed maturity investments resulted in a decrease in the amortization of insurance acquisition costs of $4.2 million, $5.7 million and $33.2 million in 2009, 2008 and 2007, respectively.

 
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Corporate Operations (dollars in millions)
   
2009
    
2008
    
2007
  
                   
Corporate operations:
                  
Interest expense on corporate debt                                                            
   $ (84.7 )   $ (67.9 )   $ (80.3 )
Net investment income                                                            
     1.7       4.9       6.6  
Fee revenue and other income                                                            
     2.7       4.7       9.8  
Net operating results of variable interest entity
     .8       7.2       9.2  
Costs related to a litigation settlement
     -       -       (32.2 )
Other operating costs and expenses                                                            
     (42.9 )     (43.5 )     (42.4 )
Gain (loss) on extinguishment or modification of debt 
     (22.2 )     21.2       -  
                         
Loss before net realized investment losses and income taxes
     (144.6 )     (73.4 )     (129.3 )
                         
Net realized investment losses                                                            
     (7.4 )     (50.8 )     (6.2 )
                         
Loss before income taxes                                                         
   $ (152.0 )   $ (124.2 )   $ (135.5 )

Interest expense on corporate debt has been impacted by:  (i) amendments to the Company’s credit facilities in 2009 and 2007; (ii) borrowings and repayments pursuant to our Senior Credit Agreement; (iii) the issuance in 2008 of a $125.0 million Senior Note due November 12, 2013 (the "Senior Note"); (iv) repurchases of 3.5% Debentures; (v) completion of a cash tender offer (the “Tender Offer”) for $176.5 million aggregate principal amount of the 3.5% Debentures; and (vi) the issuance of $176.5 million of 7.0% Debentures.  Such transactions are further discussed in the note to the consolidated financial statements entitled “Notes Payable – Direct Corporate Obligations”.  Our average corporate debt outstanding was $1,275.8 million, $1,219.3 million and $1,111.8 million in 2009, 2008 and 2007, respectively.  The average interest rate on our debt was 5.7 percent, 4.6 percent and 6.2 percent in 2009, 2008 and 2007, respectively.

Net investment income primarily included income earned on short-term investments, changes in the underlying value of certain investments held by the Corporate segment and miscellaneous other income and fluctuated along with the change in the amount of invested assets in this segment.

Fee revenue and other income includes:  (i) revenues we receive for managing investments for other companies; and (ii) fees received for marketing insurance products of other companies.  In 2007, our wholly owned investment management subsidiary recognized performance-based fees of $2.4 million resulting from the liquidation of two portfolios that were managed by the subsidiary.  Excluding such performance-based fees, fee revenue and other income has decreased primarily as a result of a decrease in the fair value of investments managed for others, upon which these fees are based.

Net operating results of variable interest entity represent the operating results of a variable interest entity (“VIE”).  The VIE is consolidated in accordance with GAAP.  Although we do not control this entity, we consolidate it because we are the primary beneficiary.  This entity was established to issue securities and use the proceeds to invest in loans and other permitted assets.

Costs related to a litigation settlement include legal and other costs incurred by the Corporate Operations segment to defend the non-insurance company allegations made in the class action case referred to as In Re Conseco Life Insurance Company Cost of Insurance Litigation.  Refer to the captions entitled:  (i)  “Costs related to a litigation settlement” included in the results of operations section for the Other CNO Business segment; and (ii) “Cost of Insurance Litigation” included in the note to our consolidated financial statements entitled “Commitments and Contingencies” for further information related to this case.

Other operating costs and expenses include general corporate expenses, net of amounts charged to subsidiaries for services provided by the corporate operations.  These amounts fluctuate as a result of expenses such as consulting, legal and severance costs which often vary from period to period.

Gain (loss) on extinguishment or modification of debt in 2009 consisted of expenses incurred and the write-off of unamortized discount or issuance costs totaling $22.2 million related to the following transactions:  (i) the Tender Offer; (ii)

 
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repayment of principal amounts on the Senior Credit Agreement from the proceeds from the issuance of common stock; and (iii) modifications to our Senior Credit Agreement in March 2009 and December 2009.  The gain on extinguishment of debt of $21.2 million in 2008 resulted from the repurchase of $37.0 million par value of 3.5% Debentures for $15.3 million plus accrued interest.  These transactions are further discussed in the note to the consolidated financial statements entitled “Notes Payable – Direct Corporate Obligations”.

Net realized investment losses often fluctuate each period.  During 2009, net realized investment losses in this segment included $6.1 million of net gains from the sales of investments (of which $.7 million were losses recognized by a VIE) and $13.5 million of writedowns of investments (all of which were recognized by a VIE) due to other-than-temporary declines in value.  During 2008, net realized investment losses included $36.1 million from the sale of investments ($14.1 million of such losses were recognized by a VIE) and $14.7 million of writedowns ($10.8 million of such writedowns were recognized by a VIE) of investments resulting from declines in fair value that we concluded were other than temporary due to declines in value on certain securities.  During 2007, net realized investment losses in this segment included $4.7 million from the sale of investments (primarily fixed maturities) and $1.5 million of writedowns of investments resulting from declines in fair value that we concluded were other than temporary.

PREMIUM COLLECTIONS

In accordance with GAAP, insurance policy income in our consolidated statement of operations consists of premiums earned for traditional insurance policies that have life contingencies or morbidity features.  For annuity and universal life contracts, premiums collected are not reported as revenues, but as deposits to insurance liabilities.  We recognize revenues for these products over time in the form of investment income and surrender or other charges.

Our insurance segments sell products through three primary distribution channels — career agents (our Bankers Life segment), direct marketing (our Colonial Penn segment) and independent producers (our Washington National segment). Our career agency force in the Bankers Life segment sells primarily Medicare supplement and long-term care insurance policies, Medicare Part D contracts, PFFS contracts, life insurance and annuities.  These agents visit the customer’s home, which permits one-on-one contact with potential policyholders and promotes strong personal relationships with existing policyholders.  Our direct marketing distribution channel in the Colonial Penn segment is engaged primarily in the sale of “graded benefit life” and simplified issue life insurance policies which are sold directly to the policyholder.  Our independent producer distribution channel in the Washington National segment consists of a general agency and insurance brokerage distribution system comprised of independent licensed agents doing business in all fifty states, the District of Columbia, and certain protectorates of the United States.  Independent producers are a diverse network of independent agents, insurance brokers and marketing organizations.  Our independent producer distribution channel sells primarily supplemental health and Medicare supplement insurance policies, universal life insurance and annuities.

Agents, insurance brokers and marketing companies who market our products and prospective purchasers of our products use the financial strength ratings of our insurance subsidiaries as an important factor in determining whether to market or purchase.  Ratings have the most impact on our annuity, interest-sensitive life insurance and long-term care products.  The current financial strength ratings of our primary insurance subsidiaries from A.M. Best Company ("A.M. Best"), Standard & Poor's Corporation ("S&P") and Moody's Investor Services, Inc. ("Moody’s") are “B (Fair)”, “BB-” and “Ba2”, respectively.  For a description of these ratings and additional information on our ratings, see “Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations — Liquidity for Insurance Operations.”

We set premium rates on our health insurance policies based on facts and circumstances known at the time we issue the policies using assumptions about numerous variables, including the actuarial probability of a policyholder incurring a claim, the probable size of the claim, and the interest rate earned on our investment of premiums.  We also consider historical claims information, industry statistics, the rates of our competitors and other factors.  If our actual claims experience is less favorable than we anticipated and we are unable to raise our premium rates, our financial results may be adversely affected.  We generally cannot raise our health insurance premiums in any state until we obtain the approval of the state insurance regulator.  We review the adequacy of our premium rates regularly and file for rate increases on our products when we believe such rates are too low.  It is likely that we will not be able to obtain approval for all requested premium rate increases. If such requests are denied in one or more states, our net income may decrease.  If such requests are approved, increased premium rates may reduce the volume of our new sales and may cause existing policyholders to lapse their policies.  If the healthier policyholders allow their policies to lapse, this would reduce our premium income and profitability in the future.

 
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Total premium collections were as follows:

Bankers Life (dollars in millions)

   
2009
    
2008
    
2007
  
Premiums collected by product:
                  
                   
Annuities:
                  
Fixed index (first-year)                                                                
   $ 350.1     $ 522.8     $ 437.4  
                         
Other fixed (first-year)                                                                
     707.0       697.8       445.3  
Other fixed (renewal)                                                                
     3.3       3.5       2.8  
Subtotal - other fixed annuities                                                              
     710.3       701.3       448.1  
                         
Total annuities                                                          
     1,060.4       1,224.1       885.5  
                         
Health:
                        
Medicare supplement (first-year)                                                                
     91.7       81.3       82.5  
Medicare supplement (renewal)                                                                
     562.0       555.3       553.6  
Subtotal - Medicare supplement                                                              
      653.7       636.6       636.1  
Long-term care (first-year)                                                                
     17.7       42.7       47.0  
Long-term care (renewal)                                                                
     583.9       583.0       575.4  
Subtotal - long-term care                                                              
     601.6       625.7       622.4  
PDP and PFFS (first year)                                                                
     96.0       353.3       206.4  
PDP and PFFS (renewal)                                                                
     348.4       260.7       71.4  
Subtotal – PDP and PFFS                                                              
     444.4       614.0       277.8  
Other health (first-year)                                                                
     2.7       2.1       .9  
Other health (renewal)                                                                
     9.3       8.6       8.9  
Subtotal - other health                                                              
     12.0       10.7       9.8  
                         
Total health                                                              
     1,711.7       1,887.0       1,546.1  
                         
Life insurance:
                        
First-year                                                                
     82.6       80.7       89.2  
Renewal                                                                
     146.2       128.7       110.8  
                         
Total life insurance                                                              
     228.8       209.4       200.0  
                         
Collections on insurance products:
                        
                         
Total first-year premium collections on insurance products
     1,347.8       1,780.7       1,308.7  
Total renewal premium collections on insurance products
     1,653.1       1,539.8       1,322.9  
                         
Total collections on insurance products                                                                
   $ 3,000.9     $ 3,320.5     $ 2,631.6  


 
39
 

Annuities in this segment include fixed index and other fixed annuities sold to the senior market.  Annuity collections in this segment decreased 13 percent, to $1,060.4 million, in 2009 and increased 38 percent to $1,224.1 million, in 2008.  The change in mix of premium collections between our fixed index products and our fixed annuity products has fluctuated due to volatility in the financial markets in recent periods.  In addition, premium collections from Bankers Life’s fixed annuity products decreased in the fourth quarter of 2009 as continuing decreases in new money interest rates resulted in a reduction to the bonus on our bonus interest annuity.  A new product, which will provide more flexibility in setting the bonus interest rate is expected to launch in early 2010.

Health products include Medicare supplement, Medicare Part D contracts, PFFS contracts, long-term care and other insurance products.  Our profits on health policies depend on the overall level of sales, the length of time the business remains inforce, investment yields, claims experience and expense management.

Collected premiums on Medicare supplement policies in the Bankers Life segment increased 2.7 percent, to $653.7 million, in 2009 and .1 percent, to $636.6 million, in 2008.  

Premiums collected on Bankers Life’s long-term care policies decreased 3.9 percent, to $601.6 million, in 2009 and increased .5 percent, to $625.7 million, in 2008.  The decrease in 2009 was primarily attributable to a long-term care reinsurance agreement pursuant to which we are reinsuring 70 percent of Bankers Life’s new 2009 long-term care business.  Under the reinsurance agreement, the amount reinsured decreases to 50 percent in the first quarter of 2010 and to 25 percent thereafter.

Premiums collected on PDP and PFFS business relate to various quota-share reinsurance agreements with Coventry.  Effective May 1, 2008 and July 1, 2007, we entered into new PFFS quota-share reinsurance agreements with Coventry.  In order to reduce the required statutory capital associated with the assumption of group PFFS business, we terminated two group policy quota-share agreements as of December 31, 2008 and terminated the last agreement on June 30, 2009.  Fluctuations in first-year and renewal premiums are generally due to the timing of the contracts we entered into with Coventry.  Coventry has decided to cease selling PFFS plans effective January 1, 2010.  On July 22, 2009, the Company announced a strategic alliance under which the Bankers Life segment will offer Humana’s Medicare Advantage plans to its policyholders and consumers nationwide through its career agency force and will receive marketing fees based on sales.  Effective January 1, 2010, the Company will no longer be assuming the underwriting risk related to PFFS business.
These agreements are described in “Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations - Critical Accounting Policies”.

Other health products relate to collected premiums on other health products which we no longer actively market.

Life products in this segment are sold primarily to the senior market through our career agents.  Life premiums collected in this segment increased 9.3 percent, to $228.8 million, in 2009 and 4.7 percent, to $209.4 million, in 2008.  Collected premiums have been impacted by higher persistency.

 
40
 

Washington National (dollars in millions)

   
2009
    
2008
    
2007
  
Premiums collected by product:
                  
                   
Health:
                  
Medicare supplement (first-year)                                                        
   $ 7.2     $ 9.6     $ 19.4  
Medicare supplement (renewal)                                                        
     170.6       194.2       206.5  
Subtotal - Medicare supplement                                                      
     177.8       203.8       225.9  
Supplemental health (first-year)                                                        
     45.4       39.4       31.4  
Supplemental health (renewal)                                                        
     337.9       335.2       327.8  
Subtotal – supplemental health                                                      
     383.3       374.6       359.2  
Other health (first-year)                                                        
     -       .1       .3  
Other health (renewal)                                                        
     5.2       6.4       7.3  
Subtotal – other health                                                      
     5.2       6.5       7.6  
                         
Total health                                                      
     566.3       584.9       592.7  
                         
Life insurance:
                        
First-year                                                        
     .8       .6       .5  
Renewal                                                        
     29.3       35.1       39.1  
                         
Total life insurance                                                      
     30.1       35.7       39.6  
                         
Collections on insurance products:
                        
                         
Total first-year premium collections on insurance products
     53.4       49.7       51.6  
Total renewal premium collections on insurance products
     543.0       570.9       580.7  
                         
Total collections on insurance products
   $ 596.4     $ 620.6     $ 632.3  

Health products in the Washington National segment include Medicare supplement, supplemental health and other insurance products.  Our profits on health policies depend on the overall level of sales, the length of time the business remains inforce, investment yields, claim experience and expense management.

Collected premiums on Medicare supplement policies in the Washington National segment decreased 13 percent, to $177.8 million, in 2009 and 9.8 percent, to $203.8 million, in 2008.  We have experienced lower sales and higher lapses of these products due to premium rate increases implemented in recent periods and competition from companies offering Medicare Advantage products.

Premiums collected on supplemental health products (including specified disease, accident and hospital indemnity insurance products) increased 2.3 percent, to $383.3 million, in 2009 and 4.3 percent, to $374.6 million, in 2008.  Such increases reflect higher new sales in each year and a slight improvement in persistency in 2009 and 2008.
 
    Life products in the Washington National segment are primarily traditional life products.  Life premiums collected decreased 16 percent, to $30.1 million, in 2009 and 9.8 percent, to $35.7 million, in 2008.  The decrease in 2009 is partially due to the completion of the coinsurance transaction with Wilton Re in the third quarter of 2009.

 
41
 


Colonial Penn (dollars in millions)

   
2009
    
2008
    
2007
  
Premiums collected by product:
                  
                   
Life insurance:
                  
First-year                                                                               
   $ 33.0     $ 35.0     $ 28.7  
Renewal                                                                               
     154.3       139.1       85.0  
                         
Total life insurance                                                                            
     187.3       174.1       113.7  
                         
Health (all of which are renewal premiums):
                        
Medicare supplement                                                                               
     7.0       8.1       9.4  
Other health                                                                               
     .5       .8       1.0  
                         
Total health                                                                            
     7.5       8.9       10.4  
                         
Collections on insurance products:
                        
                         
Total first-year premium collections on insurance products
     33.0       35.0       28.7  
Total renewal premium collections on insurance products
     161.8       148.0       95.4  
                         
Total collections on insurance products                                                                            
   $ 194.8     $ 183.0     $ 124.1  

Life products in this segment are sold primarily to the senior market.  Life premiums collected in this segment increased 7.6 percent, to $187.3 million, in 2009 and 53 percent, to $174.1 million, in 2008.  Graded benefit life products sold through our direct response marketing channel accounted for $180.5 million, $168.5 million and $108.8 million of collected premiums in 2009, 2008 and 2007, respectively.  In 2009, renewal premiums for our life insurance products include the receipt of a $3.4 million final distribution and commutation payment following the termination of a group insurance pool that Colonial Penn previously participated in.  Also, collected premiums have been impacted by the recapture in the fourth quarter of 2007 of a block of traditional life insurance inforce that had been ceded in 2002 to REALIC.

Health products include Medicare supplement and other insurance products.  Our profits on health policies depend on the overall level of sales, the length of time the business remains inforce, investment yields, claims experience and expense management.  Premiums collected on these products have decreased as we do not currently market these products through this segment.

 
42
 
 
 
Other CNO Business (dollars in millions)
   
2009
    
2008
    
2007
  
Premiums collected by product:
                  
                   
Annuities:
                  
Fixed index (first-year)                                                        
   $ 71.0     $ 116.1     $ 336.4  
Fixed index (renewal)                                                        
     5.6       7.6       8.2  
Subtotal – fixed index annuities                                                      
     76.6       123.7       344.6  
Other fixed (first-year)                                                        
     .8       3.8       18.0  
Other fixed (renewal)                                                        
     1.0       2.3       6.0  
Subtotal - other fixed annuities                                                      
     1.8       6.1       24.0  
                         
Total annuities                                                   
     78.4       129.8       368.6  
                         
Health:
                        
Long-term care (all of which are renewal)
     31.4       33.7       36.7  
Other health (all of which are renewal)
     2.7       3.2       4.0  
                         
Total health                                                      
     34.1       36.9       40.7  
                         
Life insurance:
                        
First-year                                                        
     2.2       3.7       4.2  
Renewal                                                        
     208.0       230.4       243.5  
                         
Total life insurance                                                      
     210.2       234.1       247.7  
                         
Collections on insurance products:
                        
                         
Total first-year premium collections on insurance products
     74.0       123.6       358.6  
Total renewal premium collections on insurance products
     248.7       277.2       298.4  
                         
Total collections on insurance products
   $ 322.7     $ 400.8     $ 657.0  

Annuities in this segment include fixed index and other fixed annuities.  We are no longer actively pursuing sales of annuity products in this segment.  Total annuity collected premiums in this segment decreased 40 percent, to $78.4 million, in 2009 and 65 percent, to $129.8 million, in 2008.

Our fixed index annuities have guaranteed minimum cash surrender values, but have potentially higher returns based on a percentage of the change in one of several equity market indices during each year of their term.  We purchase options in an effort to hedge increases to policyholder benefits resulting from increases in the indices.  Collected premiums for these products decreased 38 percent, to $76.6 million, in 2009 and 64 percent, to $123.7 million, in 2008.  During the second half of 2007, we changed the pricing of specific products and we no longer emphasized the sale of certain products resulting in a decrease in collected premiums.

Annuity premiums on fixed products were $1.8 million, $6.1 million and $24.0 million in 2009, 2008 and 2007, respectively.  Such decreases are primarily due to a focus on the sale of more profitable products.

Health products in the Other CNO Business segment include long-term care and other insurance products.  Our profits on health policies depend on the overall level of sales, the length of time the business remains inforce, investment yields, claim experience and expense management.

The long-term care premiums in this segment relate to blocks of business that we no longer market or underwrite.  As a result, we expect this segment’s long-term care premiums to continue to decline, reflecting additional policy lapses in the future, partially offset by premium rate increases.

 
43
 


Life products in the Other CNO Business segment include primarily universal life products.  Life premiums collected decreased 10 percent, to $210.2 million, in 2009 and 5.5 percent, to $234.1 million, in 2008.  The decrease in 2009 is partially due to the completion of the coinsurance transaction with Wilton Re in the third quarter of 2009.

INVESTMENTS

Our investment strategy is to: (i) maintain a predominately investment-grade fixed income portfolio; (ii) provide liquidity to meet our cash obligations to policyholders and others; and (iii) generate stable and predictable investment income through active investment management.  Consistent with this strategy, investments in fixed maturity securities, mortgage loans and policy loans made up 97 percent of our $21.5 billion investment portfolio at December 31, 2009.  The remainder of the invested assets was trading securities, equity securities and other invested assets.

The following table summarizes the composition of our investment portfolio as of December 31, 2009 (dollars in millions):

   
Carrying
    
Percent of
  
   
value
    
total investments
  
             
Fixed maturities, available for sale
   $ 18,528.4       86 %
Equity securities                                                  
     31.0       -  
Mortgage loans                                                  
     1,965.5       9  
Policy loans                                                  
     295.2       2  
Trading securities                                                  
     293.3       1  
Securities lending collateral                                                  
     180.0       1  
Partnership investments                                                  
     22.0       -  
Other invested assets                                                  
     214.8       1  
                 
Total investments
   $ 21,530.2       100 %

Insurance statutes regulate the types of investments that our insurance subsidiaries are permitted to make and limit the amount of funds that may be used for any one type of investment.  In light of these statutes and regulations and our business and investment strategy, we generally seek to invest in United States government and government-agency securities and corporate securities rated investment grade by established nationally recognized rating organizations or in securities of comparable investment quality, if not rated.

 
44
 


The following table summarizes the carrying value of our fixed maturity securities, available for sale, by category as of December 31, 2009 (dollars in millions):

                     
Percent of
  
               
Gross
    
gross
  
         
Percent of
    
unrealized
    
unrealized
  
   
Carrying value
    
fixed maturities
    
losses
    
losses
  
                         
Collateralized mortgage obligations
   $ 2,015.2       10.9 %   $ (185.1 )     21.3 %
Utilities                                                         
     1,928.8       10.4       (32.1 )     3.7  
Energy/pipelines                                                         
     1,687.1       9.1       (19.9 )     2.3  
Healthcare/pharmaceuticals                                                         
     1,420.9       7.7       (23.1 )     2.7  
Food/beverage                                                         
     1,247.5       6.7       (16.9 )     1.9  
States and political subdivisions                                                         
     853.6       4.6       (80.5 )     9.3  
Banks                                                         
     848.6       4.6       (97.6 )     11.2  
Insurance                                                         
     845.8       4.6       (63.0 )     7.2  
Cable/media                                                         
     792.9       4.3       (22.0 )     2.5  
Commercial mortgage-backed securities
     766.0       4.1       (109.5 )     12.6  
Capital goods                                                         
     689.0       3.7       (12.0 )     1.4  
Aerospace/defense                                                         
     563.2       3.0       (10.9 )     1.2  
Telecom                                                         
     547.7       2.9       (12.3 )     1.4  
Real estate/REITs                                                         
     542.4       2.9       (27.6 )     3.2  
Transportation                                                         
     473.9       2.6       (4.9 )     .6  
Building materials                                                         
     344.6       1.9       (7.6 )     .9  
Consumer products                                                         
     283.1       1.5       (5.7 )     .6  
Technology                                                         
     282.1       1.5       (9.6 )     1.1  
U.S. Treasury and Obligations                                                         
     269.6       1.5       (3.5 )     .4  
Chemicals                                                         
     214.1       1.2       (3.9 )     .4  
Entertainment/hotels                                                         
     198.9       1.1       (6.2 )     .7  
Asset-backed securities                                                         
     192.1       1.0       (54.6 )     6.3  
Other                                                         
     1,521.3       8.2       (61.6 )     7.1  
                                 
Total fixed maturities, available for sale
   $ 18,528.4       100.0 %   $ (870.1 )     100.0 %

Our fixed maturity securities consist predominantly of publicly traded securities.  We classify securities issued in the Rule 144A market as publicly traded.  Securities not publicly traded comprise approximately 13 percent of our total fixed maturity securities portfolio.

Fair Value of Investments

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date and, therefore, represents an exit price, not an entry price.  We hold fixed maturities, equity securities, derivatives and separate account assets, which are carried at fair value.

The degree of judgment utilized in measuring the fair value of financial instruments is largely dependent on the level to which pricing is based on observable inputs.  Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our view of market assumptions in the absence of observable market information.  Financial instruments with readily available active quoted prices would be considered to have fair values based on the highest level of observable inputs, and little judgment would be utilized in measuring fair value.  Financial instruments that rarely trade would be considered to have fair value based on a lower level of observable inputs, and more judgment would be utilized in measuring fair value.

There is a three-level hierarchy for valuing assets or liabilities at fair value based on whether inputs are observable or unobservable.

·  
Level 1 – includes assets and liabilities valued using inputs that are quoted prices in active markets for identical assets or liabilities.  Our Level 1 assets include exchange traded securities and U.S. Treasury securities.

 
45
 


·  
Level 2 – includes assets and liabilities valued using inputs that are quoted prices for similar assets in an active market, quoted prices for identical or similar assets in a market that is not active, observable inputs, or observable inputs that can be corroborated by market data.  Level 2 assets and liabilities include those financial instruments that are valued by independent pricing services using models or other valuation methodologies.  These models are primarily industry-standard models that consider various inputs such as interest rate, credit spread, reported trades, broker/dealer quotes, issuer spreads and other inputs that are observable or derived from observable information in the marketplace or are supported by observable levels at which transactions are executed in the marketplace.  Financial instruments in this category primarily include:  certain public and private corporate fixed maturity securities; certain government or agency securities; certain mortgage and asset-backed securities; and non-exchange-traded derivatives such as call options to hedge liabilities related to our fixed index annuity products.

·  
Level 3 – includes assets and liabilities valued using unobservable inputs that are used in model-based valuations that contain management assumptions.  Level 3 assets and liabilities include those financial instruments whose fair value is estimated based on non-binding broker prices or internally developed models or methodologies utilizing significant inputs not based on, or corroborated by, readily available market information.  Financial instruments in this category include certain corporate securities (primarily private placements), certain mortgage and asset-backed securities, and other less liquid securities.  Additionally, the Company’s liabilities for embedded derivatives (including embedded derivates related to our fixed index annuity products and to a modified coinsurance arrangement) are classified in Level 3 since their values include significant unobservable inputs including actuarial assumptions.

At each reporting date, we classify assets and liabilities into the three input levels based on the lowest level of input that is significant to the measurement of fair value for each asset and liability reported at fair value.  This classification is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established, the characteristics specific to the transaction and overall market conditions.  Our assessment of the significance of a particular input to the fair value measurement and the ultimate classification of each asset and liability requires judgment.

The vast majority of our fixed maturity securities and separate account assets use Level 2 inputs for the determination of fair value.  These fair values are obtained primarily from independent pricing services, which use Level 2 inputs for the determination of fair value.  Substantially all of our Level 2 fixed maturity securities and separate account assets were valued from independent pricing services.  Third party pricing services normally derive the security prices through recently reported trades for identical or similar securities making adjustments through the reporting date based upon available market observable information.  If there are no recently reported trades, the third party pricing services may use matrix or model processes to develop a security price where future cash flow expectations are developed and discounted at an estimated risk-adjusted market rate.  The number of prices obtained is dependent on the Company’s analysis of such prices as further described below.

For securities that are not priced by pricing services and may not be reliably priced using pricing models, we obtain broker quotes.  These broker quotes are non-binding and represent an exit price, but assumptions used to establish the fair value may not be observable and therefore represent Level 3 inputs.  Approximately 6 percent and 1 percent of our Level 3 fixed maturity securities were valued using broker quotes or independent pricing services, respectively.  The remaining Level 3 fixed maturity investments do not have readily determinable market prices and/or observable inputs.  For these securities, we use internally developed valuations.  Key assumptions used to determine fair value for these securities may include risk-free rates, risk premiums, performance of underlying collateral and other factors involving significant assumptions which may not be reflective of an active market.  For certain investments, we use a matrix or model process to develop a security price where future cash flow expectations are developed and discounted at an estimated market rate.  The pricing matrix utilizes a spread level to determine the market price for a security.  The credit spread generally incorporates the issuer’s credit rating and other factors relating to the issuer’s industry and the security’s maturity.  In some instances, issuer-specific spread adjustments, which can be positive or negative, are made based upon internal analysis of security specifics such as liquidity, deal size and time to maturity.

Privately placed securities comprise approximately 79 percent of our fixed maturities, available for sale, classified as Level 3.  Privately placed securities are classified as Level 3 when their valuation is based on internal valuation models which rely on significant inputs that are not observable in the market.  Our model applies spreads above the risk-free rate which are determined based on comparison to securities with similar ratings, maturities and industries that are rated by independent third party rating agencies.  Our process also considers the ratings assigned by the National Association of Insurance Commissioners ("NAIC") to the Level 3 securities on an annual basis.  Each quarter, a review is performed to determine the reasonableness of the initial valuations

 
46
 

from the model.  If an initial valuation appears unreasonable based on our knowledge of a security and current market conditions, we make appropriate adjustments to our valuation inputs.  The remaining securities classified as Level 3 are primarily valued based on non-binding broker quotes or internally developed models using estimated future cash flows.

For certain Level 3 assets, we have increased our default assumptions based on our review of the underlying collateral.  The changes in our assumptions resulted in lower cash flow estimates for some of our subordinated tranches and have resulted in such securities being impaired.  The default rate we expect to experience related to the collateral underlying the subordinated tranches increased from 1.7 percent to 7.6 percent for the experience expected in 2009; from .8 percent to 3.2 percent for 2010; and from .8 percent to 1.5 percent for each year subsequent to 2010.  However, the changes in assumptions did not change our cash flow estimates for the non-subordinated tranches within our Level 3 investments.  We recognized other-than-temporary impairments on securities classified as Level 3 investments of $26.7 million (including $16.1 million of impairment losses recognized through accumulated other comprehensive loss) during 2009.

As the Company is responsible for the determination of fair value, we perform monthly quantitative and qualitative analysis on the prices received from third parties to determine whether the prices are reasonable estimates of fair value.  The Company’s analysis includes:  (i) a review of the methodology used by third party pricing services; (ii) a comparison of pricing services’ valuation to other pricing services’ valuations for the same security; (iii) a review of month to month price fluctuations; (iv) a review to ensure valuations are not unreasonably stale; and (v) back testing to compare actual purchase and sale transactions with valuations received from third parties.  As a result of such procedures, the Company may conclude the prices received from third parties are not reflective of current market conditions.  In those instances, we may request additional pricing quotes or apply internally developed valuations.  However, the number of instances is insignificant and the aggregate change in value of such investments is not materially different from the original prices received.

The categorization of the fair value measurements of our investments priced by independent pricing services was based upon the Company’s judgment of the inputs or methodologies used by the independent pricing services to value different asset classes.  Such inputs include:  benchmark yields, reported trades, broker dealer quotes, issuer spreads, benchmark securities, bids, offers and reference data.  The Company categorizes such fair value measurements based upon asset classes and the underlying observable or unobservable inputs used to value such investments.

The classification of fair value measurements for derivative instruments, including embedded derivatives requiring bifurcation, is determined based on the consideration of several inputs including closing exchange or over-the-counter market price quotations; time value and volatility factors underlying options; market interest rates; and non-performance risk.  For certain embedded derivatives, we may use actuarial assumptions in the determination of fair value.

The categorization of fair value measurements, by input level, for our fixed maturity securities, equity securities, trading securities, certain other invested assets and assets held in separate accounts at December 31, 2009 is as follows (dollars in millions):

   
Quoted prices
                        
   
in active
    
Significant
                  
   
markets for
    
other
      
Significant
          
   
identical assets
    
observable
      
unobservable
          
   
or liabilities
    
inputs
      
inputs
          
   
(Level 1)
    
(Level 2)
      
(Level 3)
      
Total
  
                             
Assets:
                            
Fixed maturities, available for sale
   $ 56.5     $ 16,074.0       $ 2,397.9       $ 18,528.4  
Equity securities
     .1       -         30.9         31.0  
Trading securities
     4.3       285.3         3.7         293.3  
Securities lending collateral
     -       97.2         36.6         133.8  
Other invested assets
     -       192.6  
(a)
     2.4  
(b)
     195.0  
Assets held in separate accounts
     -       17.3         -         17.3  
_____________
(a)  
Includes company-owned life insurance and derivatives.
(b)  
Includes equity-like holdings in special-purpose entities.

 
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The following table presents additional information about assets measured at fair value on a recurring basis and for which we have utilized significant unobservable (Level 3) inputs to determine fair value for the year ended December 31, 2009 (dollars in millions):

                               
                               
                               
   
Actively
                          
   
managed
                
Securities
    
Other
  
   
fixed
    
Equity
    
Trading
    
lending
    
invested
  
   
maturities
    
securities
    
securities
    
collateral
    
assets
  
                               
Assets:
                              
Beginning balance as of
December 31, 2008                                       
   $ 1,876.1     $ 32.4     $ 2.7     $ 48.1     $ 2.3  
Purchases, sales, issuances and settlements, net
     199.1       (.3 )     -       (17.1 )     -  
Total realized and unrealized gains (losses):
                                        
    Included in net loss
     (15.2 )     -       1.0       (.9 )     (3.4 )
Included in other comprehensive income (loss)
     327.5       (1.2 )     -       (9.4 )     3.5  
Transfers into  Level 3
     32.2       -       -       20.4       -  
Transfers out of Level 3 (a)
     (21.8 )     -       -       (4.5 )     -  
                                         
Ending balance as of December 31, 2009
   $ 2,397.9     $ 30.9     $ 3.7     $ 36.6     $ 2.4  
                                         
Amount of total gains (losses) for the year ended December 31, 2009 included in our net loss relating to assets and liabilities still held as
of the reporting date                                      
   $ (3.9 )   $ -     $ 1.0     $ (.9 )   $ (3.4 )
___________
 
(a)
Transfers out of Level 3 are reported as having occurred at the beginning of the period.
 
    At December 31, 2009, 86 percent of our Level 3 fixed maturities, available for sale, were investment grade and 94 percent of our Level 3 fixed maturities, available for sale, consisted of corporate securities.

Realized and unrealized investment gains and losses presented in the preceding table represent gains and losses during the time the applicable financial instruments were classified as Level 3.

Realized and unrealized gains (losses) on Level 3 assets are primarily reported in either net investment income for policyholder and reinsurer accounts and other special purpose portfolios, net realized investment gains (losses) or insurance policy benefits within the consolidated statement of operations or other comprehensive income (loss) within shareholders’ equity based on the appropriate accounting treatment for the instrument.

Purchases, sales, issuances and settlements, net, represent the activity that occurred during the period that results in a change of the asset or liability but does not represent changes in fair value for the instruments held at the beginning of the period.  Such activity primarily consists of purchases and sales of fixed maturity, equity and trading securities and purchases and settlements of derivative instruments.

We review the fair value hierarchy classifications each reporting period.  Transfers in and/or (out) of Level 3 in 2009 were primarily due to changes in the observability of the valuation attributes resulting in a reclassification of certain financial assets or liabilities.  Such reclassifications are reported as transfers in and out of Level 3 at the beginning fair value for the reporting period in which the changes occur.

 
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Investment ratings are assigned the second lowest rating by a nationally recognized statistical rating organization (primarily Moody’s, S&P or Fitch Ratings (“Fitch”)), or if not rated by such firms, the rating assigned by the NAIC.  NAIC designations of “1” or “2” include fixed maturities generally rated investment grade (rated “Baa3” or higher by Moody’s or rated “BBB-” or higher by S&P and Fitch.  NAIC designations of “3” through “6” are referred to as below investment grade (which generally are rated “Ba1” or lower by Moody’s or rated “BB+” or lower by S&P and Fitch).  References to investment grade or below investment grade throughout our consolidated financial statements are based on such nationally recognized statistical ratings.  The following table sets forth fixed maturity investments at December 31, 2009, classified by ratings (dollars in millions):

           
Estimated fair value
  
                 
Percent of
  
     
Amortized
          
fixed
  
Investment rating
    
cost
    
Amount
    
maturities
  
                     
AAA
     $ 2,764.7     $ 2,700.9       15 %
AA
       1,270.2       1,230.3       7  
A          5,619.3       5,555.4       30  
BBB+
       2,295.2       2,297.9       12  
BBB
       2,952.3       2,916.7       16  
BBB-
       2,314.0       2,304.1       12  
                             
Investment grade
       17,215.7       17,005.3       92  
                             
BB+
       210.6       183.1       1  
BB
       257.2       226.9       1  
BB-
       550.7       504.0       3  
B+ and below
       763.8       609.1       3  
                             
Below-investment grade (a)
       1,782.3       1,523.1       8  
                             
Total fixed maturity securities
     $ 18,998.0     $ 18,528.4       100 %
_________
(a)  
Below-investment grade fixed maturity securities with an amortized cost of $284.7 million and an estimated fair value of $262.3 million are held by a VIE that we are required to consolidate.  These fixed maturity securities are legally isolated and are not available to the Company.  The liabilities of such VIE will be satisfied from the cash flows generated by these securities and are not obligations of the Company.  Refer to the note to the consolidated financial statements entitled “Investment in a Variable Interest Entity” concerning the Company’s investment in the VIE.

The following table summarizes investment yields earned over the past three years on the general account invested assets of our insurance subsidiaries.  General account investments exclude the value of options (dollars in millions).

   
2009
    
2008
    
2007
  
                   
Weighted average general account invested assets as defined:
                  
As reported
   $ 20,196.7     $ 19,597.9     $ 22,469.2  
Excluding unrealized appreciation (depreciation) (a)
     21,667.7       21,323.3       22,835.4  
Net investment income on general account invested assets
     1,230.6       1,249.9       1,344.1  
                         
Yields earned:
                        
As reported
     6.09 %     6.38 %     5.98 %
Excluding unrealized appreciation (depreciation) (a)
     5.68 %     5.86 %     5.89 %
                         
____________________
 
(a)
Excludes the effect of reporting fixed maturities at fair value as described in the note to our consolidated financial statements entitled “Investments”.

Although investment income is a significant component of total revenues, the profitability of certain of our insurance products is determined primarily by the spreads between the interest rates we earn and the rates we credit or accrue to our

 
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insurance liabilities.  At December 31, 2009 and 2008, the average yield, computed on the cost basis of our fixed maturity portfolio, was 5.7 percent and 6.0 percent, respectively, and the average interest rate credited or accruing to our total insurance liabilities (excluding interest rate bonuses for the first policy year only and excluding the effect of credited rates attributable to variable or fixed index products) was 4.5 percent and 4.5 percent, respectively.

Fixed Maturities, Available for Sale

Our fixed maturity portfolio at December 31, 2009, included primarily debt securities of the United States government, various corporations, and structured securities.  Asset-backed securities, collateralized debt obligations, commercial mortgage-backed securities, mortgage pass-through securities and collateralized mortgage obligations are collectively referred to as “structured securities”.

At December 31, 2009, our fixed maturity portfolio had $400.5 million of unrealized gains and $870.1 million of unrealized losses, for a net unrealized loss of $469.6 million.  Estimated fair values of fixed maturity investments were determined based on estimates from: (i) nationally recognized pricing services (85 percent of the portfolio); (ii) broker-dealer market makers (3 percent of the portfolio); and (iii) internally developed methods (12 percent of the portfolio).

At December 31, 2009, approximately 7.1 percent of our invested assets (8.2 percent of fixed maturity investments) were fixed maturities rated below-investment grade.  Our level of investments in below-investment-grade fixed maturities could change if market conditions change.  Below-investment grade corporate debt securities have different characteristics than investment grade corporate debt securities.  Based on historical performance, probability of default by the borrower is significantly greater for below-investment grade securities and in many cases severity of loss is relatively greater as such securities are often subordinated to other indebtedness of the issuer.  Also, issuers of below-investment grade securities frequently have higher levels of debt relative to investment-grade issuers, hence, all other things being equal, are more sensitive to adverse economic conditions, such as recession or increasing interest rates.  The Company attempts to reduce the overall risk related to its investment in below-investment grade securities, as in all investments, through careful credit analysis, strict investment policy guidelines, and diversification by issuer and/or guarantor and by industry.  At December 31, 2009, our below-investment-grade fixed maturity investments had an amortized cost of $1,782.3 million and an estimated fair value of $1,523.1 million.

We continually evaluate the creditworthiness of each issuer whose securities we hold.  We pay special attention to large investments and to those securities whose fair values have declined materially for reasons other than changes in interest rates or other general market conditions.  We evaluate the realizable value of the investment, the specific condition of the issuer and the issuer’s ability to comply with the material terms of the security.  We review the recent operational results and financial position of the issuer, information about its industry, information about factors affecting the issuer’s performance and other information.  40|86 Advisors, Inc. ("40|86 Advisors", a registered investment advisor and wholly owned subsidiary of CNO) employs experienced securities analysts in a variety of specialty areas who compile and review such data.  If evidence does not exist to support a realizable value equal to or greater than the amortized cost of the investment, and such decline in fair value is determined to be other than temporary, we reduce the amortized cost to its fair value, which becomes the new cost basis.  We report the amount of the reduction as a realized loss. We recognize any recovery of such reductions as investment income over the remaining life of the investment (but only to the extent our current valuations indicate such amounts will ultimately be collected), or upon the repayment of the investment.  During 2009, we recognized net realized investment losses of $60.5 million, which were comprised of $134.9 million of net gains from the sales of investments (primarily fixed maturities) with proceeds of $10.7 billion and $195.4 million of writedowns of investments for other than temporary declines in fair value recognized through net income ($385.0 million, prior to the $189.6 million of impairment losses recognized through other comprehensive loss).  Our investment portfolio is subject to the risks of further declines in realizable value.  However, we attempt to mitigate this risk through the diversification and active management of our portfolio.

Our investment strategy is to maximize, over a sustained period and within acceptable parameters of risk, investment income and total investment return through active investment management.  Accordingly, we may sell securities at a gain or a loss to enhance the total return of the portfolio as market opportunities change or to better match certain characteristics of our investment portfolio with the corresponding characteristics of our insurance liabilities.  While we do not have the intent to sell securities with unrealized losses and it is not more likely than not that we will be required to sell securities with unrealized losses prior to their anticipated recovery, we may sell securities at a loss in the future because of actual or expected changes in our view of the particular investment, its industry, its type or the general investment environment.

As of December 31, 2009, we had investments in substantive default (i.e., in default due to nonpayment of interest or principal) that had an estimated fair value of $39.8 million.  40|86 Advisors employs experienced professionals to manage

 
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non-performing and impaired investments.  There were no other fixed maturity investments about which we had serious doubts as to the recoverability of the carrying value of the investment.

When a security defaults or securities (other than structured securities) are other-than-temporarily impaired, our policy is to discontinue the accrual of interest and eliminate all previous interest accruals, if we determine that such amounts will not be ultimately realized in full.  Investment income forgone on nonperforming investments was $6.7 million, $.9 and nil for the years ended December 31, 2009, 2008 and 2007, respectively.

At December 31, 2009, fixed maturity investments included structured securities with an estimated fair value of $3.1 billion (or 17 percent of all fixed maturity securities).  The yield characteristics of structured securities differ in some respects from those of traditional fixed-income securities.  For example, interest and principal payments on structured securities may occur more frequently, often monthly.  In many instances, we are subject to the risk that the amount and timing of principal and interest payments may vary from expectations.  For example, prepayments may occur at the option of the issuer and prepayment rates are influenced by a number of factors that cannot be predicted with certainty, including: the relative sensitivity of the underlying assets backing the security to changes in interest rates; a variety of economic, geographic and other factors; and various security-specific structural considerations (for example, the repayment priority of a given security in a securitization structure).

In general, the rate of prepayments on structured securities increases when prevailing interest rates decline significantly in absolute terms and also relative to the interest rates on the underlying assets.  The yields recognized on structured securities purchased at a discount to par will increase (relative to the stated rate) when the underlying assets prepay faster than expected.  The yield recognized on structured securities purchased at a premium will decrease (relative to the stated rate) when the underlying assets prepay faster than expected.  When interest rates decline, the proceeds from prepayments may be reinvested at lower rates than we were earning on the prepaid securities.  When interest rates increase, prepayments may decrease.  When this occurs, the average maturity and duration of the structured securities increase, which decreases the yield on structured securities purchased at a discount because the discount is realized as income at a slower rate, and it increases the yield on those purchased at a premium because of a decrease in the annual amortization of the premium.

For structured securities included in fixed maturities, available for sale, that were purchased at a discount or premium, we recognize investment income using an effective yield based on anticipated future prepayments and the estimated final maturity of the securities.  Actual prepayment experience is periodically reviewed and effective yields are recalculated when differences arise between the prepayments originally anticipated and the actual prepayments received and currently anticipated.  For credit sensitive mortgage-backed and asset-backed securities, and for securities that can be prepaid or settled in a way that we would not recover substantially all of our investment, the effective yield is recalculated on a prospective basis.  Under this method, the amortized cost basis in the security is not immediately adjusted and a new yield is applied prospectively.  For all other structured and asset-backed securities, the effective yield is recalculated when changes in assumptions are made, and reflected in our income on a retrospective basis.  Under this method, the amortized cost basis of the investment in the securities is adjusted to the amount that would have existed had the new effective yield been applied since the acquisition of the securities.  Such adjustments were not significant in 2009.

 
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The following table sets forth the par value, amortized cost and estimated fair value of structured securities, summarized by interest rates on the underlying collateral at December 31, 2009 (dollars in millions):

   
Par
    
Amortized
    
Estimated
  
   
value
    
cost
    
fair value
  
                   
Below 4 percent                                                        
   $ 102.4     $ 84.1     $ 84.7  
4 percent – 5 percent                                                        
     571.8       561.4       539.1  
5 percent – 6 percent                                                        
     2,083.2       2,058.5       1,867.9  
6 percent – 7 percent                                                        
     589.3       567.9       482.3  
7 percent – 8 percent                                                        
     129.8       126.8       90.9  
8 percent and above                                                        
     49.9       49.7        43.8  
                         
Total structured securities                                                     
   $ 3,526.4     $ 3,448.4     $ 3,108.7  


The amortized cost and estimated fair value of structured securities at December 31, 2009, summarized by type of security, were as follows (dollars in millions):

         
Estimated fair value
  
               
Percent
  
   
Amortized
          
of fixed
  
Type
  
cost
    
Amount
    
maturities
  
                   
Pass-throughs, sequential and equivalent securities
   $ 1,425.9     $ 1,361.1       7.4 %
Planned amortization classes, target amortization classes and accretion-directed bonds
     759.3       649.8       3.5  
Commercial mortgage-backed securities                                                                 
     869.3       766.0       4.1  
Asset-backed securities                                                                 
     245.0       192.1       1.0  
Collateralized debt obligations                                                                 
     96.9       92.8       .5  
Other                                                                 
     52.0       46.9       .3  
                         
Total structured securities                                                                 
   $ 3,448.4     $ 3,108.7       16.8 %

Pass-throughs, sequentials and equivalent securities have unique prepayment variability characteristics.  Pass-through securities typically return principal to the holders based on cash payments from the underlying mortgage obligations.  Sequential securities return principal to tranche holders in a detailed hierarchy.  Planned amortization classes, targeted amortization classes and accretion-directed bonds adhere to fixed schedules of principal payments as long as the underlying mortgage loans experience prepayments within certain estimated ranges.  Changes in prepayment rates are first absorbed by support or companion classes insulating the timing of receipt of cash flows from the consequences of both faster prepayments (average life shortening) and slower prepayments (average life extension).

Commercial mortgage-backed securities are secured by commercial real estate mortgages, generally income producing properties that are managed for profit.  Property types include multi-family dwellings including apartments, retail centers, hotels, restaurants, hospitals, nursing homes, warehouses, and office buildings.  Most commercial mortgage-backed securities have call protection features whereby underlying borrowers may not prepay their mortgages for stated periods of time without incurring prepayment penalties.

During 2009, we sold $1.3 billion of fixed maturity investments which resulted in gross investment losses (before income taxes) of $233.9 million.  We sell securities at a loss for a number of reasons including, but not limited to:  (i) changes in the investment environment; (ii) expectation that the fair value could deteriorate further; (iii) desire to reduce our exposure to an asset class, an issuer or an industry; (iv) changes in credit quality; or (v) changes in expected liability cash flows.  As discussed in the notes to our consolidated financial statements, the realization of gains and losses affects the timing of the amortization of insurance acquisition costs related to universal life and investment products.

 
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Other Investments

At December 31, 2009, we held commercial mortgage loan investments with a carrying value of $1,965.5 million (or 9 percent of total invested assets) and a fair value of $1,756.8 million.  Noncurrent commercial mortgage loans were insignificant at December 31, 2009.  During 2009, we recognized $40.9 million of writedowns of commercial mortgage loans resulting from declines in fair value that we concluded were other than temporary.  During 2008, we recognized $5.8 million of writedowns of commercial mortgage loans for other-than-temporary declines in fair value and recognized losses of $22.1 million from the liquidation of several delinquent commercial mortgage loans.  Realized losses on commercial mortgage loans were not significant in 2007.  We had no allowance for loss on mortgage loans at both December 31, 2009 and 2008.  Approximately 7 percent, 7 percent, 7 percent, 6 percent and 6 percent of the mortgage loan balance were on properties located in Indiana, Minnesota, Ohio, California and Arizona, respectively.  No other state comprised greater than five percent of the mortgage loan balance.

The following table shows the distribution of our commercial mortgage loan portfolio by property type as of December 31, 2009 (dollars in millions):

   
Number of
    
Carrying
  
   
loans
    
value
  
             
Retail                                                   
     341     $ 797.7  
Office building                                                   
     174       758.0  
Industrial                                                   
     70       298.3  
Multi-family                                                   
     38       94.5  
Other                                                   
     6        17.0  
                 
Total commercial mortgage loans
     629     $ 1,965.5  

The following table shows our commercial mortgage loan portfolio by loan size as of December 31, 2009 (dollars in millions):

   
Number
    
Carrying
  
   
of loans
    
value
  
             
Under $5 million                                                   
     523     $ 1,030.6  
$5 million but less than $10 million
     83       559.7  
$10 million but less than $20 million
     15       197.0  
Over $20 million                                                   
     8       178.2  
                 
Total commercial mortgage loans
     629     $ 1,965.5  


The following table summarizes the distribution of maturities of our commercial mortgage loans as of December 31, 2009 (dollars in millions):

   
Number
    
Carrying
  
   
of loans
    
value
  
             
2010                                                      
     12     $ 52.2  
2011                                                      
     19       74.7  
2012                                                      
     22       48.3  
2013                                                      
     26       158.0  
2014                                                      
     27       93.5  
after 2014                                                      
     523       1,538.8  
                 
Total commercial mortgage loans
     629     $ 1,965.5  


 
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The following table provides the weighted average loan-to-value ratio for our outstanding mortgage loans as of December 31, 2009 (dollars in millions):

             
         
Estimated fair
  
Loan-to-value ratio (a)
  
Carrying value
    
value
  
             
Less than 60%                                                                             
   $ 694.8     $ 668.5  
60% to 70%                                                                             
     736.8       622.2  
70% to 80%                                                                             
     407.4       353.7  
80% to 90%                                                                             
     28.0       24.2  
Greater than 90%                                                                             
     98.5       88.2  
                 
Total                                                                       
   $ 1,965.5     $ 1,756.8  
__________
(a)  
Loan-to-value ratios are calculated as the ratio of:  (i) the carrying value of the commercial mortgage loans; to (ii) the estimated fair value of the underlying commercial property.

At December 31, 2009, we held $293.3 million of trading securities.  We carry trading securities at estimated fair value; changes in fair value are reflected in the statement of operations.  Our trading securities are held to act as hedges for embedded derivatives related to our fixed index annuity products and certain modified coinsurance agreements.  See the note to the consolidated financial statements entitled “Summary of Significant Accounting Policies - Accounting for Derivatives” for further discussion regarding the embedded derivatives and the trading accounts.  In addition, the trading account includes investments backing the market strategies of our multibucket annuity products.

Other invested assets also include options backing our fixed index products, futures, credit default swaps, forward contracts and certain nontraditional investments, including investments in limited partnerships, promissory notes and real estate investments held for sale.

The Company participates in a securities lending program whereby certain fixed maturity securities from our investment portfolio are loaned to third parties via a lending agent for a short period of time.  We maintain ownership of the loaned securities.  We require collateral equal to 102 percent of the fair value of the loaned securities.  The collateral is invested by the lending agent in accordance with our guidelines.  The fair value of the loaned securities is monitored on a daily basis with additional collateral obtained as necessary.  Under the terms of the securities lending program, the lending agent indemnifies the Company against borrower defaults.  As of December 31, 2009 and 2008, the fair value of the loaned securities was $178.5 million and $389.3 million, respectively.  As of December 31, 2009 and 2008, the Company had received collateral of $185.7 million and $408.8 million, respectively.  Income generated from the program, net of expenses is recorded as net investment income and totaled $1.2 million, $2.4 million and $1.3 million in 2009, 2008 and 2007, respectively.

 
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CONSOLIDATED FINANCIAL CONDITION

Changes in the Consolidated Balance Sheet

Changes in our consolidated balance sheet between December 31, 2009 and December 31, 2008, primarily reflect:  (i) our net income for 2009; (ii) changes in the fair value of actively managed fixed maturity securities, available for sale; and (iii) the issuances of common stock and the changes to corporate notes payable as further described in the notes to the consolidated financial statements entitled “Notes Payable – Direct Corporate Obligations” and “Shareholders’ Equity”.

In accordance with GAAP, we record our fixed maturity securities, available for sale, equity securities and certain other invested assets at estimated fair value with any unrealized gain or loss (excluding impairment losses, which are recognized through earnings), net of tax and related adjustments, recorded as a component of shareholders’ equity.  At December 31, 2009, we decreased the carrying value of such investments by $.5 billion as a result of this fair value adjustment.

Our capital structure as of December 31, 2009 and 2008 was as follows (dollars in millions):

   
2009
    
2008
  
Total capital:
            
Corporate notes payable                                                       
   $ 1,037.4     $ 1,311.5  
                 
Shareholders’ equity:
                
Common stock                                                    
     2.5       1.9  
Additional paid-in capital                                                    
     4,408.8       4,104.0  
Accumulated other comprehensive loss
     (264.3 )     (1,770.7 )
Accumulated deficit                                                    
     (614.6 )     (705.2 )
                 
Total shareholders’ equity                                                
     3,532.4       1,630.0  
                 
Total capital                                                
   $ 4,569.8     $ 2,941.5  

The following table summarizes certain financial ratios as of and for the years ended December 31, 2009 and 2008:

   
2009
    
2008
  
             
Book value per common share                                                                                
   $ 14.09     $ 8.82  
Book value per common share, excluding accumulated other comprehensive income (loss) (a)
     15.14       18.41  
                 
Ratio of earnings to fixed charges                                                                                
     1.38 X     1.01 X
                 
Debt to total capital ratios:
                
Corporate debt to total capital (b)                                                                                
     23 %     45 %
Corporate debt to total capital, excluding accumulated other comprehensive income (loss) (a)
     21 %     28 %
____________________
(a)  
This non-GAAP measure differs from the corresponding GAAP measure presented immediately above, because accumulated other comprehensive income (loss) has been excluded from the value of capital used to determine this measure.  Management believes this non-GAAP measure is useful because it removes the volatility that arises from changes in accumulated other comprehensive income (loss).  Such volatility is often caused by changes in the estimated fair value of our investment portfolio resulting from changes in general market interest rates rather than the business decisions made by management.  However, this measure does not replace the corresponding GAAP measure.

(b)  
Such ratio differs from the debt to total capitalization ratio required by our Senior Credit Agreement, primarily because the credit agreement ratio excludes accumulated other comprehensive income (loss) from total capital.

 
55
 

Contractual Obligations

The Company’s significant contractual obligations as of December 31, 2009, were as follows (dollars in millions):

         
Payment due in
  
   
Total
    
2010
       2011-2012       2013-2014    
Thereafter
  
                                   
Insurance liabilities (a)                                                       
   $ 53,441.6     $ 3,563.9     $ 6,921.1     $ 6,341.0     $ 36,615.6  
Notes payable (b)                                                       
     1,358.4       153.7       260.1       670.4       274.2  
Investment borrowings (c)                                                       
     831.4       28.6       159.6       43.3       599.9  
Postretirement plans (d)                                                       
     155.3       4.1       8.8       10.0       132.4  
Operating leases and certain other
                                        
contractual commitments (e)                                                   
     205.8       41.0       63.3       41.3       60.2  
                                         
Total                                               
   $ 55,992.5     $ 3,791.3     $ 7,412.9     $ 7,106.0     $ 37,682.3  
____________________
 
(a)
These cash flows represent our estimates of the payments we expect to make to our policyholders, without consideration of future premiums or reinsurance recoveries.  These estimates are based on numerous assumptions (depending on the product type) related to mortality, morbidity, lapses, withdrawals, future premiums, future deposits, interest rates on investments, credited rates, expenses and other factors which affect our future payments.  The cash flows presented are undiscounted for interest.  As a result, total outflows for all years exceed the corresponding liabilities of $24.3 billion included in our consolidated balance sheet as of December 31, 2009.  As such payments are based on numerous assumptions, the actual payments may vary significantly from the amounts shown.

In estimating the payments we expect to make to our policyholders, we considered the following:

·  
For products such as immediate annuities and structured settlement annuities without life contingencies, the payment obligation is fixed and determinable based on the terms of the policy.

·  
For products such as universal life, ordinary life, long-term care, supplemental health and fixed rate annuities, the future payments are not due until the occurrence of an insurable event (such as death or disability) or a triggering event (such as a surrender or partial withdrawal).  We estimated these payments using actuarial models based on historical experience and our expectation of the future payment patterns.

·  
For short-term insurance products such as Medicare supplement insurance, the future payments relate only to amounts necessary to settle all outstanding claims, including those that have been incurred but not reported as of the balance sheet date.  We estimated these payments based on our historical experience and our expectation of future payment patterns.

·  
The average interest rate we assumed would be credited to our total insurance liabilities (excluding interest rate bonuses for the first policy year only and excluding the effect of credited rates attributable to variable or fixed index products) over the term of the contracts was 4.5 percent.

(b)  
Includes projected interest payments based on market rates, as applicable, as of December 31, 2009 and reflects the repurchase of $64 million aggregate principal amount of the 3.5% Debentures and the issuance of $64 million aggregate principal amount of the 7.0% Debentures in February 2010 as further discussed in the note to the consolidated financial statements entitled “Subsequent Events”.  Refer to the note to the consolidated financial statements entitled “Notes Payable – Direct Corporate Obligations” for additional information on notes payable.

(c)  
These borrowings primarily represent: (i) the securities issued by a VIE and include projected interest payments based on market rates, as applicable, as of December 31, 2009; and (ii) collateralized borrowings from the Federal Home Loan Bank of Indianapolis (“FHLBI”).

(d)  
Includes benefits expected to be paid pursuant to our deferred compensation plan and postretirement plans based on numerous actuarial assumptions and interest credited at 5.75 percent.

(e)  
Refer to the notes to the consolidated financial statements entitled “Commitments and Contingencies” for additional information on operating leases and certain other contractual commitments.

 
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It is possible that the ultimate outcomes of various uncertainties could affect our liquidity in future periods.  For example, the following events could have a material adverse effect on our cash flows:

·  
An adverse decision in pending or future litigation.

·  
An inability to obtain rate increases on certain of our insurance products.

·  
Worse than anticipated claims experience.

·  
Lower than expected dividends and/or surplus debenture interest payments from our insurance subsidiaries (resulting from inadequate earnings or capital or regulatory requirements).

·  
An inability to meet and/or maintain the covenants in our Senior Credit Agreement.

·  
A significant increase in policy surrender levels.

·  
A significant increase in investment defaults.

·  
An inability of our reinsurers to meet their financial obligations.

While we seek to balance the duration and cash flows of our invested assets with the estimated duration and cash flows of benefit payments arising from contract liabilities, there could be significant variations in the timing of such cash flows.  Although we believe our current estimates properly project future claim experience, if these estimates prove to be wrong, and our experience worsens (as it did in some prior periods), our future liquidity could be adversely affected.

Liquidity for Insurance Operations

Our insurance companies generally receive adequate cash flows from premium collections and investment income to meet their obligations.  Life insurance and annuity liabilities are generally long-term in nature.  Policyholders may, however, withdraw funds or surrender their policies, subject to any applicable penalty provisions.  We seek to balance the duration of our invested assets with the estimated duration of benefit payments arising from contract liabilities.

One of the Company’s subsidiaries (Conseco Life) is a member of the FHLBI.  As a member of the FHLBI, Conseco Life has the ability to borrow on a collateralized basis from FHLBI.  Conseco Life is required to hold a certain minimum amount of FHLBI common stock as a requirement of membership in the FHLBI, and additional amounts based on the amount of collateralized borrowings.  At December 31, 2009, the carrying value of the FHLBI common stock was $22.5 million.  Collateralized borrowings totaled $450.0 million as of December 31, 2009, and the proceeds were used to purchase fixed maturity securities.  The borrowings are classified as investment borrowings in the accompanying consolidated balance sheet. The borrowings are collateralized by investments with an estimated fair value of $508.2 million at December 31, 2009, which are maintained in a custodial account for the benefit of the FHLBI.  The following summarizes the terms of the borrowings (dollars in millions):

Amount
  
Maturity
  
Interest rate
borrowed
  
date
  
at December 31, 2009
         
$ 54.0  
May 2012
  
Variable rate – .267%
  37.0  
July 2012
  
Fixed rate – 5.540%
  13.0  
July 2012
  
Variable rate – .344%
  146.0  
November 2015
  
Fixed rate – 5.300%
  100.0  
November 2015
  
Fixed rate – 4.890%
  100.0  
December 2015
  
Fixed rate – 4.710%

State laws generally give state insurance regulatory agencies broad authority to protect policyholders in their jurisdictions.  Regulators have used this authority in the past to restrict the ability of our insurance subsidiaries to pay any dividends or other amounts without prior approval.  We cannot be assured that the regulators will not seek to assert greater supervision and control over our insurance subsidiaries’ businesses and financial affairs.

 
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During 2009, the financial statements of three of our subsidiaries prepared in accordance with statutory accounting practices prescribed or permitted by regulatory authorities reflected asset adequacy or premium deficiency reserves.  Total asset adequacy and premium deficiency reserves for Washington National, Conseco Life and Bankers Conseco Life Insurance Company were $79.1 million, $257.1 million and $21.2 million, respectively at December 31, 2009.  Due to differences between statutory and GAAP insurance liabilities, we were not required to recognize a similar premium deficiency reserve in our consolidated financial statements prepared in accordance with GAAP.  The determination of the need for and amount of asset adequacy reserves is subject to numerous actuarial assumptions, including the Company’s ability to change nonguaranteed elements related to certain products consistent with contract provisions.

Financial Strength Ratings of our Insurance Subsidiaries

Financial strength ratings provided by A.M. Best, S&P and Moody’s are the rating agency’s opinions of the ability of our insurance subsidiaries to repay policyholder claims and obligations when due.

On October 16, 2009, A.M. Best affirmed the financial strength rating of “B” of our primary insurance subsidiaries and the ratings outlook as negative.  Also, A.M. Best removed the ratings from under review with negative implications.  On March 4, 2009, A.M. Best downgraded the financial strength ratings of our primary insurance subsidiaries to “B” from “B+” and such ratings had been placed under review with negative implications.  The “B” rating is assigned to companies that have a fair ability, in A.M. Best’s opinion, to meet their current obligations to policyholders, but are financially vulnerable to adverse changes in underwriting and economic conditions.  A.M. Best ratings for the industry currently range from “A++ (Superior)” to “F (In Liquidation)” and some companies are not rated.  An “A++” rating indicates a superior ability to meet ongoing obligations to policyholders.  A.M. Best has sixteen possible ratings.  There are six ratings above our “B” rating and nine ratings that are below our rating.

On October 14, 2009, S&P affirmed the financial strength rating of “BB-” of our primary insurance subsidiaries and revised the outlook to stable from credit watch with negative implications.  On March 2, 2009, S&P had placed the financial strength ratings of our primary insurance subsidiaries on credit watch with negative implications.  On February 26, 2009, S&P downgraded the financial strength ratings of our primary insurance subsidiaries to “BB-” from “BB+” and the outlook remained negative for our primary insurance subsidiaries.   A “stable” designation means that a rating is not likely to change.  S&P financial strength ratings range from “AAA” to “R” and some companies are not rated.  Rating categories from “BB” to “CCC” are classified as “vulnerable”, and pluses and minuses show the relative standing within a category.  In S&P’s view, an insurer rated “BB” has marginal financial security characteristics and although positive attributes exist, adverse business conditions could lead to an insufficient ability to meet financial commitments.  S&P has twenty-one possible ratings.  There are twelve ratings above our “BB-” rating and eight ratings that are below our rating.

On October 14, 2009, Moody’s affirmed the financial strength rating of “Ba2” of our primary insurance subsidiaries and revised the outlook to positive from negative.  On March 3, 2009, Moody’s downgraded the financial strength ratings of our primary insurance subsidiaries to “Ba2” from “Ba1” and the outlook remained negative for our primary insurance subsidiaries.  Moody’s financial strength ratings range from “Aaa” to “C”.  Rating categories from “Aaa” to “Baa” are classified as “secure” by Moody’s and rating categories from “Ba” to “C” are considered “vulnerable” and these ratings may be supplemented with numbers “1”, “2”, or “3” to show relative standing within a category.  In Moody’s view, an insurer rated “Ba2” offers questionable financial security and, often, the ability of these companies to meet policyholders’ obligations may be very moderate and thereby not well safeguarded in the future.  Moody’s has twenty-one possible ratings.  There are eleven ratings above our “Ba2” rating and nine ratings that are below our rating.

In light of the difficulties experienced recently by many financial institutions, including insurance companies, rating agencies have increased the frequency and scope of their credit reviews and requested additional information from the companies that they rate, including us.  They may also adjust upward the capital and other requirements employed in the rating agency models for maintenance of certain ratings levels.  We cannot predict what actions rating agencies may take, or what actions we may take in response.  Accordingly, further downgrades and outlook revisions related to us or the life insurance industry may occur in the future at any time and without notice by any rating agency.  These could increase policy surrenders and withdrawals, adversely affect relationships with our distribution channels, reduce new sales, reduce our ability to borrow and increase our future borrowing costs.

 
58
 


Liquidity of the Holding Companies

Availability and Sources and Uses of Holding Company Liquidity; Limitations on Ability of Insurance Subsidiaries to Make Dividend and Surplus Debenture Interest Payments to the Holding Companies

At December 31, 2009, CNO, CDOC, Inc. ("CDOC", our wholly owned subsidiary and a guarantor under the Senior Credit Agreement) and our other non-insurance subsidiaries held unrestricted cash of $146 million.  CNO and CDOC are holding companies with no business operations of their own; they depend on their operating subsidiaries for cash to make principal and interest payments on debt, and to pay administrative expenses and income taxes.  CNO and CDOC receive cash from insurance subsidiaries, consisting of dividends and distributions, interest payments on surplus debentures and tax-sharing payments, as well as cash from non-insurance subsidiaries consisting of dividends, distributions, loans and advances.  The principal non-insurance subsidiaries that provide cash to CNO and CDOC are 40|86 Advisors, which receives fees from the insurance subsidiaries for investment services, and CNO Services, LLC which receives fees from the insurance subsidiaries for providing administrative services.  The agreements between our insurance subsidiaries and CNO Services, LLC and 40|86 Advisors, respectively, were previously approved by the domestic insurance regulator for each insurance company, and any payments thereunder do not require further regulatory approval.

A deterioration in the financial condition, earnings or cash flow of the material subsidiaries of CNO or CDOC for any reason could hinder such subsidiaries’ ability to pay cash dividends or other disbursements to CNO and/or CDOC, which, in turn, would limit CNO’s ability to meet debt service requirements and satisfy other financial obligations.  In addition, we may choose to retain capital in our insurance subsidiaries or to contribute additional capital to our insurance subsidiaries to strengthen their surplus, and these decisions could limit the amount available at our top tier insurance subsidiaries to pay dividends to the holding companies.  In the past, we have made capital contributions to our insurance subsidiaries to meet debt covenants and minimum capital levels required by certain regulators and it is possible we will be required to do so in the future.  We did not make any contributions to our insurance subsidiaries in 2009, however, a $29.4 million capital contribution was accrued at December 31, 2009, and paid in February 2010.  

The following summarizes the legal ownership structure of CNO’s primary subsidiaries at December 31, 2009:

 
Org Chart
 
 

 
59
 

The ability of our insurance subsidiaries to pay dividends is subject to state insurance department regulations and is based on the financial statements of our insurance subsidiaries prepared in accordance with statutory accounting practices prescribed or permitted by regulatory authorities, which differ from GAAP.  These regulations generally permit dividends to be paid from statutory earned surplus of the insurance company for any 12-month period in amounts equal to the greater of (or in a few states, the lesser of):  (i) statutory net gain from operations or net income for the prior year; or (ii) 10 percent of statutory capital and surplus as of the end of the preceding year (excluded from this calculation would be the $61.2 million of additional surplus recognized due to temporary modifications in statutory prescribed practices related to certain deferred tax assets).  These types of dividends are referred to as “ordinary dividends”. Any dividends in excess of these levels require the approval of the director or commissioner of the applicable state insurance department.  These types of dividends are referred to as “extraordinary dividends”.  Each of the direct insurance subsidiaries of CDOC had negative earned surplus at December 31, 2009 as summarized below (dollars in millions):

   
Earned surplus
    
Subsidiary of CDOC
  
(deficit) (a)
  
Additional information
         
Conseco Life Insurance Company of Texas ("Conseco Life of Texas")                                           
   $ (1,195.1 )
(b)
Washington National                                           
     (1,183.2 )
(c)
Conseco Health Insurance Company                                          
     (6.2 )  
 
______________

 
(a)
As calculated pursuant to the state insurance department of each company’s domiciliary state.
 
(b)
During 2008, Conseco Life of Texas transferred the ownership of Senior Health, Washington National and Conseco Health to CDOC.  As a result of this transaction, the $1,574.7 million of accumulated unrealized losses of Conseco Life of Texas’ former subsidiaries were realized by Conseco Life of Texas, reducing its earned surplus to $(1,206.4) million at December 31, 2008, pursuant to the manner earned surplus is calculated under the regulations of the Texas Department of Insurance.
 
(c)
Pursuant to the regulations of the Illinois Division of Insurance, the accumulated earnings and losses of Washington National’s subsidiaries are reflected in the earned surplus of Washington National.  Conseco Life, a subsidiary of Washington National, incurred aggregate costs in excess of $265 million during the three years ended December 31, 2007 related to litigation regarding a change made in 2003 and 2004 in the manner cost of insurance charges are calculated for certain life insurance policies.  In addition, significant dividend payments have been made from Washington National and its subsidiaries in the past which have increased its earned deficit, including payments made following significant reductions in the business of Washington National and its subsidiaries pursuant to a reinsurance transaction completed in 2007.

As described above, any current dividend payments from the subsidiaries of CDOC would be considered extraordinary dividends and therefore require the approval of the director or commissioner of the applicable state insurance department.  During the next twelve months, we are expecting our insurance subsidiaries to pay approximately $105 million of extraordinary dividends to CDOC (subject to approval by the applicable state insurance department).  Although we believe the dividends we are expecting to pay during the twelve months ending December 31, 2010, are consistent with payments that have been approved by insurance regulators in prior years, there can be no assurance that such payments will be approved or that the financial condition of our insurance subsidiaries will not change, making future approvals less likely. In addition, we are expecting Conseco Life of Texas to pay interest on surplus debentures of $49 million in the next twelve months, which will not require additional approval provided the risk-based capital ("RBC") ratio of Conseco Life of Texas exceeds 100 percent (but will require prior written notice to the Texas state insurance department).  Dividends and other payments from our non-insurance subsidiaries, including 40|86 Advisors and CNO Services, LLC, to CNO or CDOC do not require approval by any regulatory authority or other third party.  However, insurance regulators may prohibit payments by our insurance subsidiaries to parent companies if they determine that such payments could be adverse to our policyholders or contractholders.

 
60
 


The insurance subsidiaries of CDOC receive funds to pay dividends primarily from:  (i) the earnings of their direct businesses; (ii) tax sharing payments received from subsidiaries (if applicable); and (iii) dividends received from subsidiaries (if applicable).  At December 31, 2009, these subsidiaries had earned surplus (deficit) as summarized below (dollars in millions):

   
Earned surplus
    
Subsidiary of CDOC
  
(deficit) (a)
  
Additional information
         
Subsidiaries of Conseco Life of Texas:
        
Bankers Life and Casualty Company
   $ 109.0  
(b)
Colonial Penn                                                        
     (228.7 )
(c)
           
Subsidiaries of Washington National:
          
Conseco Insurance Company                                                        
     (6.6 )
(d)
Conseco Life                                                        
     (401.8 )
(e)

 
__________

 
(a)
As calculated pursuant to the state insurance department of each company’s domiciliary state.
 
(b)
Bankers Life and Casualty Company’s ability to pay ordinary dividends is currently limited to its statutory net income in 2009 of $86.7 million.
 
(c)
For tax planning purposes, Colonial Penn paid dividends to its parent of $150 million during 2006.  In addition, Colonial Penn issued a surplus debenture to CDOC in exchange for $160 million of cash.  The 2006 dividend payment reduced Colonial Penn’s earned surplus by $150 million (even though total capital and surplus increased by $10 million after the issuance of the surplus debenture).  In 2007, Colonial Penn recaptured a block of traditional life business previously ceded to an unaffiliated insurer in 2002.  The Company’s earned surplus was reduced by $63 million as a result of the fee paid to recapture this business.
 
(d)
Conseco Insurance Company will not be able to pay ordinary dividends until its future earnings result in a positive earned surplus balance.
 
(e)
We have no plans for Conseco Life to pay dividends to Washington National at any time in the foreseeable future.

In assessing CNO’s current financial position and operating plans for the future, management made significant judgments and estimates with respect to the potential financial and liquidity effects of CNO’s risks and uncertainties, including but not limited to:

·  
the receipt of any required approvals for dividend payments and surplus debenture interest payments from our insurance subsidiaries by the director or commissioner of the applicable state insurance departments when required and our ability to make such payments;

·  
the potential adverse effects on CNO’s businesses from downgrades by rating agencies;

·  
our ability to achieve our operating plan;

·  
the potential for future declines in the bond and commercial mortgage loan markets and the potential for further significant recognition of other-than-temporary impairments;

·  
the potential need to provide additional capital to our insurance subsidiaries;

·  
our ability to continue to achieve compliance with our loan covenants including the financial ratios we are required to maintain;

·  
the potential loss of key personnel that could impair our ability to achieve our operating plan;

·  
the potential impact of an ownership change or a decrease in our operating earnings on the valuation allowance related to our deferred tax assets;

 
61
 


·  
the potential impact on the RBC ratio of our insurance subsidiaries if regulators do not modify the calculation of the required capital for commercial mortgages based on the use of the MEAF in a manner that results in a capital requirement that is the same or similar to the requirement calculated pursuant to temporary modifications effective for 2009;

·  
the potential impact on the RBC ratio of our insurance subsidiaries if regulators do not modify the calculation of the required capital for investments in RMBS in a manner that results in a capital requirement that is the same or similar to the requirement calculated pursuant to temporary modifications effective for 2009; and

·  
the potential impact on certain of CNO’s insurance subsidiaries if regulators do not allow us to continue to recognize certain deferred tax assets pursuant to temporary modifications in statutory prescribed practices.

CNO has significant indebtedness which will require over $218 million in cash to service in the next twelve months (assuming the holders of our 3.5% Debentures require the Company to repurchase their 3.5% Debentures on September 30, 2010 pursuant to their put right).   Achievement of our operating and capital plans is a critical factor in having sufficient income and liquidity to meet our debt service requirements for the next twelve months and other holding company obligations and failure to do so would have material adverse consequences for the Company.  These items are discussed further below.

The principal payments on our direct corporate obligations (including payments required under the Senior Credit Agreement, the Senior Health Note, the 3.5% Debentures and the 7.0% Debentures) are as follows (dollars in millions):

2010                                     
   $ 141.5  
(a)
2011                                     
     60.0    
2012                                     
     65.0    
2013                                     
     602.1    
2016                                     
     176.5    
           
    $ 1,045.1    
_____________
 
(a)
Includes $116.5 million of the 3.5% Debentures.  The holders of our 3.5% Debentures have the right to require the Company to repurchase their 3.5% Debentures for cash on September 30, 2010.  This amount assumes that all remaining holders of our 3.5% Debentures exercise that right.  In February 2010, as further discussed in the note to the consolidated financial statements entitled “Subsequent Events”, we repurchased $64 million of the 3.5% Debentures and issued $64 million of the 7.0% Debentures.


 
62
 

The following summarizes the projected sources and uses of cash of CDOC and CNO during the twelve months ending December 31, 2010 (dollars in millions):

   
From our operations or surplus debenture interest payments
    
From extraordinary dividends requiring approval and expected capital contributions
    
Related to previously announced capital transactions
    
Total
  
Sources of holding company cash:
                        
Dividends from our insurance subsidiaries:
                        
Conseco Life of Texas                                                        
   $ -     $ 75.0     $ -     $ 75.0  
Washington National                                                        
     -       20.0       -       20.0  
Conseco Health                                                        
     -       10.0       -       10.0  
Surplus debenture interest                                                           
     48.8       -       -       48.8  
Proceeds from issuance of 7.0% Debentures (b)
     -       -       110.3       110.3  
Administrative services and investment management fees
     60.0       -       -       60.0  
                                 
Total sources of cash expected to be available to service our debt and other obligations
     108.8       105.0       110.3       324.1  
                                 
Uses of holding company cash:
                                
Debt service commitments of CNO:
                                
Estimated interest payments                                                        
     76.6       -       -       76.6  
Scheduled principal payments under the Senior Note
     25.0       -       -       25.0  
Capital contributions to our insurance subsidiaries
     29.4       85.0       -       114.4  
Repurchase of 3.5% Debentures (c)
     -       -       116.5       116.5  
Corporate expense and other                                                           
     36.9       -       -       36.9  
                                 
Total expected uses of cash                                                        
     167.9       85.0       116.5       369.4  
                                 
Net expected increase (decrease) in cash
     (59.1 )   $ 20.0     $ (6.2 )     (45.3 )
Cash balance, beginning of year (a)                                                           
     146.1                       146.1  
                                 
Projected cash balance, end of year (a)
   $ 87.0                     $ 100.8  

_________
(a)  
Includes cash balances of our other non-insurance subsidiaries, which are available to CDOC or CNO.
(b)  
Amount includes the issuance, in February 2010, of $64.0 million of 7.0% Debentures.  We received aggregate net proceeds of $61.4 million (after taking into account the discounted offering price less the initial purchaser’s discounts and commissions).  The remaining amount represents the 7.0% Debentures that are expected to be issued on the date that the remaining 3.5% Debentures are repurchased.
(c)  
Amount includes the repurchase, in February 2010, of $64.0 million of 3.5% Debentures.  The remaining amount represents the 3.5% Debentures that will be repurchased later in 2010.

In connection with the Transfer further discussed in the note to the consolidated financial statements entitled “Transfer of Senior Health Insurance Company of Pennsylvania to an Independent Trust”, the Company issued a $125.0 million Senior Note due November 12, 2013 payable to Senior Health.  The Senior Note has a 6 percent interest rate and requires annual principal payments of $25.0 million.  Such amounts are expected to be funded by the Company’s operating activities.  CNO agreed that it would not pay cash dividends on its common stock while any portion of the Senior Note remained outstanding.

 
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Senior Credit Agreement

On March 30, 2009, we completed Amendment No. 2 to our Senior Credit Agreement, which provided for, among other things:  (i) additional margins between our current financial status and certain financial covenant requirements through June 30, 2010; (ii) higher interest rates and the payment of a fee; (iii) new restrictions on the ability of the Company to incur additional indebtedness; and (iv) the ability of the lender to appoint a financial advisor at the Company’s expense.

Pursuant to its amended terms, the applicable interest rate on the Senior Credit Agreement (based on either a Eurodollar or base rate) was increased.  The Eurodollar rate was equal to LIBOR plus 4 percent with a minimum LIBOR rate of 2.5 percent (such rate was previously LIBOR plus 2 percent with no minimum rate).  The base rate was equal to 2.5 percent plus the greater of:  (i) the Federal funds rate plus .50 percent; or (ii) Bank of America’s prime rate.  In addition, the amended agreement required the Company to pay a fee equal to 1 percent of the outstanding principal balance under the Senior Credit Agreement, which fee was added to the principal balance outstanding and was payable at the maturity of the facility.  This 1 percent fee was reported as non-cash interest expense.

The modifications to the Senior Credit Agreement also placed new restrictions on the ability of the Company to incur additional indebtedness.  The amendment:  (i) deleted the provision that allowed the Company to borrow up to an additional $330 million under the Senior Credit Agreement (the lenders under the facility having had no obligation to lend any amount under that provision); (ii) reduced the amount of secured indebtedness that the Company can incur from $75 million to $2.5 million; and (iii) limited the ability of the Company to incur additional unsecured indebtedness, except as provided below, to $25 million, and eliminated the provision that would have allowed the Company to incur additional unsecured indebtedness to the extent that principal payments were made on existing unsecured indebtedness.

The Company was permitted to issue unsecured indebtedness that is used solely to pay the holders of the 3.5% Debentures, provided that such indebtedness:  (i) had a maturity date that is no earlier than October 10, 2014; (ii) contained covenants and events of default that are no more restrictive than those in the Senior Credit Agreement; (iii) did not contain any covenants or events of default based on maintenance of the Company’s financial condition; (iv) did not amortize; and (v) did not have a put date or otherwise be callable prior to April 10, 2014, and provided that the amount of such unsecured indebtedness incurred under this provision did not exceed the $293 million of 3.5% Debentures outstanding on March 30, 2009; and provided further that the amount of cash interest payable annually on any new issuance of such indebtedness, together with the cash interest payable on the outstanding 3.5% Debentures, did not exceed twice the amount of cash interest currently payable on the outstanding 3.5% Debentures.

The amendment prohibited the Company from redeeming or purchasing the 3.5% Debentures with cash from sources other than those described in the previous paragraph.  The amendment permitted the Company to amend, modify or refinance the Convertible Indebtedness so long as such new indebtedness complied with the restrictions set forth in the previous paragraph.

In addition, pursuant to the terms of the amended credit agreement, the agent (acting on behalf of the lenders) has the right to appoint a financial advisor at the Company’s expense to, among other things, review financial projections and other financial information prepared by or on behalf of the Company, perform valuations of the assets of the Company and take other actions as are customary or reasonable for an advisor acting in such capacity.  A financial advisor has been appointed by the agent and has been reviewing the Company.

On December 22, 2009, the Company entered into Amendment No. 3 to our Senior Credit Agreement, which provides for, among other things:

 
(i)
the minimum risk-based capital ratio requirement will remain at 200% through December 31, 2010 and will increase to 225% for 2011 and 250% for 2012 (the risk-based capital requirement was previously scheduled to return to 250% after June 30, 2010);

 
(ii)
the required minimum level of statutory capital and surplus will remain at $1.1 billion through December 31, 2010 and will increase to $1.2 billion for 2011 and $1.3 billion for 2012 (the required minimum level of statutory capital and surplus was previously scheduled to return to $1.27 billion after June 30, 2010);

 
(iii)
the interest coverage ratio requirement will remain at 1.50 through December 31, 2010 and will increase to 1.75 for 2011 and 2.00 for 2012 (the interest coverage ratio requirement was previously scheduled to return to 2.00 after June 30, 2010); and

 
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(iv)
the debt to total capital ratio requirement will remain at 32.5% though December 31, 2009 and will decrease to 30% thereafter (the debt to total capital ratio requirement was previously scheduled to return to 30% after June 30, 2010).

The Company also agreed to pay $150 million of the first $200 million of net proceeds from its public offering of common stock (as further discussed below) to the lenders and, in addition, to pay 50% of any net proceeds in excess of $200 million from the offering.  The credit facility previously required the Company to pay 50% of the net proceeds of any equity issuance to the lenders.

The amendment modifies the Company’s principal repayment schedule to eliminate any principal payments in 2010 and provides for principal payments of $35 million in 2011, $40 million in 2012 and $40 million in 2013.  The Company was previously required to make principal repayments equal to 1% of the initial principal balance each year, subject to certain adjustments, and to make additional principal repayments from excess cash flow.

The amendment also provides that the 1% payment in kind, or PIK, interest that has accrued since March 30, 2009 as an addition to the principal balance under the Senior Credit Agreement will be replaced with a payment of an equal amount of cash interest.  The amount of accrued PIK interest ($6.3 million) was paid in cash when the amendment became effective.  The deletion of the 1% PIK interest and the payment of an equal amount of cash interest will not impact reported interest expense.

On November 13, 2009, we repaid $36.8 million of outstanding principal on the Senior Credit Agreement from the proceeds of the issuance of common stock and warrants to Paulson & Co. Inc. ("Paulson").  On December 22, 2009, the Company repaid $161.4 million of outstanding principal on the Senior Credit Agreement from proceeds of an equity offering.  These transactions are further discussed in the note to the consolidated financial statements entitled “Shareholders’ Equity.”

During 2009, we made scheduled principal payments totaling $5.3 million on our Senior Credit Agreement.  Also, during 2009, we made a mandatory prepayment of $1.2 million based on the Company’s excess cash flows at December 31, 2008 as defined in the Senior Credit Agreement.  

In accordance with Amendment No. 3 to our Senior Credit Agreement, the amounts outstanding under the Senior Credit Agreement bear interest, payable at least quarterly, based on either a Eurodollar rate or a base rate.  The Eurodollar rate is equal to LIBOR plus 5 percent with a minimum LIBOR rate of 2.5 percent.  The base rate is equal to 4 percent plus the greater of:  (i) the Federal funds rate plus .50 percent; or (ii) Bank of America’s prime rate.  Under the terms of the Senior Credit Agreement, if the Company’s senior secured long-term debt is rated at least “Ba2” by Moody’s and “BB” by S&P, in each case with a stable outlook, the margins on the Eurodollar rate or the base rate would each be reduced by .25 percent.  At December 31, 2009, the interest rate on our Senior Credit Agreement was 7.5 percent.

Pursuant to the Senior Credit Agreement, as long as the debt to total capitalization ratio (as defined in the Senior Credit Agreement) is greater than 20 percent and certain insurance subsidiaries (as defined in the Senior Credit Agreement) have financial strength ratings of less than A- from A.M. Best, the Company is required to make mandatory prepayments with all or a portion of the proceeds from the following transactions or events including:  (i) the issuance of certain indebtedness; (ii) certain equity issuances; and (iii) certain asset sales or casualty events.  The Company may make optional prepayments at any time in minimum amounts of $3.0 million or any multiple of $1.0 million in excess thereof.

 
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The following chart summarizes:  (i) the most significant financial ratios and balances we must maintain pursuant to our Senior Credit Agreement; (ii) the current ratios and balances as of December 31, 2009; and (iii) the margins for adverse developments before such ratio or balance requirement is not met (dollars in millions):

     
Balance or
    
     
ratio as of
  
Margin for adverse
 
Covenant under the
  
December 31,
  
development from
 
Senior Credit Agreement
  
2009
  
December 31, 2009 levels
           
Aggregate risk-based capital ratio
Greater than or equal to 200% from March 31, 2009 through December 31, 2010; greater than or equal to 225% from March 31, 2011 through December 31, 2011; and thereafter, greater than 250%.
     309%  
Reduction to total adjusted capital (defined as combined statutory capital and surplus plus the asset valuation reserve and 50 percent of the balance of the provision of policyholder dividends) of approximately $507 million, or an increase to required risk-based capital of approximately $253 million.
             
Combined statutory capital and surplus
Greater than $1,100 from March 31, 2009 through December 31, 2010; greater than $1,200 million from March 31, 2011 through December 31, 2011; and thereafter, $1,300 million.
  
$1,439 million
  
Reduction to combined statutory capital and surplus of approximately $339 million.
             
Debt to total capitalization ratio
Not more than 32.5% from March 31, 2009 through December 31, 2009 and thereafter, not more than 30%.
     21.6%  
Reduction to shareholders’ equity of approximately $1,620 million or additional debt of $780 million.
             
Interest coverage ratio
Greater than or equal to 1.50 to 1 for rolling four quarters from March 31, 2009 through December 31, 2010; greater than or equal to 1.75 to 1 for rolling four quarters from March 31, 2011 through December 31, 2011; and thereafter, 2.00 to 1.
  
2.38 to 1
  
Reduction in cash flows to the holding company of approximately $58 million.

The Senior Credit Agreement included an $80.0 million revolving credit facility that could be used for general corporate purposes and that would mature on June 22, 2009.  In October 2008, the Company borrowed $75.0 million under the revolving credit facility to assure the future availability of this additional liquidity given our concerns with the ability of certain financial institutions to be able to provide funding in the future.  In December 2008, we repaid $20.0 million of the revolving facility and reduced the maximum amount available under the revolving facility to $60.0 million.  At December 31, 2008, there was $55.0 million outstanding under the revolving facility.  In April 2009, we repaid the remaining $55.0 million that was outstanding under the revolving facility portion of our Senior Credit Agreement.  The Company paid a commitment fee equal to .50 percent of the unused portion of the revolving credit facility on an annualized basis.  The revolving credit facility interest was based on either a Eurodollar rate or a base rate in the same manner as described above for the Senior Credit Agreement.

The Senior Credit Agreement prohibits or restricts, among other things:  (i) the payment of cash dividends on our common stock; (ii) the repurchase of our common stock; (iii) the issuance of additional debt or capital stock; (iv) liens; (v)

 
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certain asset dispositions; (vi) affiliate transactions; (vii) certain investment activities; (viii) change in business; and (ix) prepayment of indebtedness (other than the Senior Credit Agreement).  The obligations under our Senior Credit Agreement are guaranteed by CNO’s current and future domestic subsidiaries, other than:  (i) its insurance companies; (ii) subsidiaries of the insurance companies; or (iii) certain immaterial subsidiaries as defined in the Senior Credit Agreement.  This guarantee was secured by granting liens on substantially all the assets of the guarantors, including the capital stock of Conseco Life of Texas, Washington National and Conseco Health.

3.5% Debentures

On November 13, 2009, we completed the Tender Offer for $176.5 million aggregate principal amount of the 3.5% Debentures.  The aggregate consideration for the 3.5% Debentures accepted by us in the Tender Offer, plus accrued and unpaid interest thereon, was $177.2 million.  Following the settlement of the Tender Offer, there is $116.5 million aggregate principal amount of the 3.5% Debentures outstanding.

On or after October 5, 2010, the Company may redeem for cash all or a portion of the 3.5% Debentures at any time at a redemption price equal to 100 percent of the accreted principal amount of the 3.5% Debentures plus accrued and unpaid interest.  Holders may require the Company to repurchase in cash all or any portion of the 3.5% Debentures on September 30, 2010 at a repurchase price equal to 100 percent of the accreted principal amount of the 3.5% Debentures to be repurchased, plus accrued and unpaid interest.

As further discussed in the note to the consolidated financial statements entitled “Subsequent Events”, we repurchased $64 million aggregate principal amount of the 3.5% Debentures in February 2010.

7.0% Debentures

On November 13, 2009, we issued $176.5 million aggregate principal amount of our 7.0% Debentures in the initial closing of our private offering of 7.0% Debentures to Morgan Stanley & Co. Incorporated ("Morgan Stanley"), as the initial purchaser of the 7.0% Debentures.  The net proceeds from the initial closing of the offering of our 7.0% Debentures, after deducting the initial purchaser’s discounts and commissions and  before other offering expenses, totaled $172.0 million.  The Company used the net proceeds to fund a substantial portion of the consideration payable in connection with the Tender Offer for the 3.5% Debentures.  We expect to issue additional 7.0% Debentures, and Morgan Stanley, as the initial purchaser, is required to purchase these additional 7.0% Debentures, subject to the satisfaction of certain conditions, on the following dates:

·  
the settlement date of any subsequent tender offers we make for outstanding 3.5% Debentures that expire before October 5, 2010;

·  
the settlement date of any privately negotiated transactions that settle before October 5, 2010;

·  
September 30, 2010, the date on which we may be required by holders of the 3.5% Debentures, if any, to repurchase such 3.5% Debentures; and

·  
October 5, 2010, if we elect to redeem any 3.5% Debentures that remain outstanding on such date.

The net proceeds from any subsequent closings of the 7.0% Debentures offering will be used to fund a substantial portion of the aggregate consideration payable for 3.5% Debentures that we may repurchase or redeem in accordance with the terms of the 3.5% Debentures.

The 7.0% Debentures rank equally in right of payment with all of the Company’s unsecured and unsubordinated obligations including the 3.5% Debentures.  The 7.0% Debentures are governed by an Indenture dated as of October 16, 2009 (the “7.0% Indenture”) between the Company and The Bank of New York Mellon Trust Company, N.A., as trustee.  The 7.0% Debentures bear interest at a rate of 7.0% per annum, payable semi-annually on June 30 and December 30 of each year, commencing on the interest payment date immediately succeeding the issuance date of such series; provided, however, that if the issuance date of a series of 7.0% Debentures is after the close of business on the interest record for such interest payment date, the first interest payment date will instead be the second interest payment date immediately succeeding the issuance date of such series.  The 7.0% Debentures will mature on December 30, 2016, unless earlier converted.  The 7.0% Debentures may not be redeemed at the Company’s election prior to the stated maturity date and the holders may not require the Company to repurchase the 7.0% Debentures at any time.  The 7.0% Debentures are not convertible prior to June 30, 2013, except under limited circumstances.  Commencing on June 30, 2013, the 7.0% Debentures will be convertible into shares of

 
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our common stock at the option of the holder at any time, subject to certain exceptions and subject to our right to terminate such conversion rights under certain circumstances relating to the sale price of our common stock.  If the holders elect to convert their 7.0% Debentures upon the occurrence of certain changes of control of CNO or certain other events, we will be required, under certain circumstances, to increase the conversion rate for such holders of the 7.0% Debentures who convert in connection with such events.  Initially, the 7.0% Debentures will be convertible into 182.1494 shares of our common stock for each $1,000 principal amount of 7.0% Debentures, which is equivalent to an initial conversion price of approximately $5.49 per share.  The conversion rate is subject to adjustment following the occurrence of certain events in accordance with the terms of the 7.0% Indenture.

Except as specified in the 7.0% Indenture, if an event of default (as defined in the 7.0% Indenture), other than an event of default relating to certain events of bankruptcy, insolvency or reorganization of the Company or any Significant Subsidiary (as defined in the 7.0% Indenture), occurs and is continuing, the trustee or holders of more than 50% in principal amount of the outstanding 7.0% Debentures may declare the principal of and accrued but unpaid interest on all of the 7.0% Debentures to be due and payable.  If an event of default relating to certain events of bankruptcy, insolvency or reorganization of the Company or any Significant Subsidiary occurs, the principal of, and accrued but unpaid interest on all the 7.0% Debentures will become immediately due and payable without any declaration or other act on the part of the trustee or any holders.  The following are events of default with respect to the 7.0% Debentures:

·  
default in payment of any interest due and payable on the 7.0% Debentures and such default continues unremedied for 30 days;

·  
default in payment of principal of the 7.0% Debentures when the same becomes due and payable, whether at maturity, upon declaration of acceleration or otherwise;

·  
default by the Company or any of the Company’s subsidiaries under any instrument or instruments evidencing indebtedness (other than the 7.0% Debentures) having an outstanding principal amount exceeding $50.0 million (or its equivalent in any other currency or currencies) that has caused the holders thereof to declare such indebtedness to be due and payable prior to its stated maturity;

·  
default in payment of indebtedness (other than in respect of swap contracts) for money borrowed by the Company or any of the Company’s subsidiaries in an aggregate principal amount exceeding $50.0 million (or its equivalent in any other currency or currencies) when such indebtedness becomes due and payable at final maturity;

·  
a final judgment for a payment exceeding $50.0 million (excluding any amounts covered by insurance) rendered against the Company or any of the Company’s subsidiaries, which judgment is not vacated, discharged or stayed within 30 days after (1) the date on which the right to appeal thereof has expired if no such appeal has commenced, or (2) the date on which all rights to appeal have been extinguished;

·  
default in the Company’s performance of any other covenants or agreements in respect of the 7.0% Debentures contained in the 7.0% Indenture or the 7.0% Debentures for 60 days (or (1) solely in the case of the reporting covenant and, if applicable, the covenant set forth in Section 314(a) of the Trust Indenture Act of 1939, as amended, 120 days and (2) solely in the case of the Company’s failure to comply with its obligations to convert 7% Debentures or perform its covenant to reserve and list the common stock issuable upon conversion, 30 days) after written notice to the Company by the trustee or to the Company and the trustee by the holders of at least 25% in aggregate principal amount of all series of 7.0% Debentures then outstanding (acting together as a single class);

·  
the occurrence of a change of control after written notice is received by the Company not later than 90 days following the occurrence of such change of control (or with respect to any change of control that occurs prior to the issuance of the first series of 7.0% Debentures, 90 days following the issuance date of such first series of 7.0% Debentures), to the Company by the trustee or to the Company and the trustee by the holders of at least 10% in aggregate principal amount of all series of 7.0% Debentures then outstanding (acting together as a single class); or

·  
certain events of bankruptcy, insolvency and reorganization of the Company or one of the Company’s “significant subsidiaries” (as defined in Rule 1-02(w) of Regulation S-X under the Securities Act).

The 7.0% Indenture provides that on and after the date of the 7.0% Indenture, the Company may not:  (i) consolidate with or merge into any other person or sell, convey, lease or transfer the Company’s consolidated properties and assets substantially as an entirety to any other person in any one transaction or series of related transactions; or (ii) permit any

 
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person to consolidate with or merge into the Company, unless:

·  
if the Company is not the surviving person, then the surviving person formed by such consolidation or into which the Company is merged or the person to which the Company’s properties and assets are so sold, conveyed, leased or transferred shall be a corporation or limited liability company organized and existing under the laws of the United States of America, any State thereof or the District of Columbia; provided that the surviving person (if not the Company) shall execute and deliver to the trustee a supplemental indenture expressly assuming all of the Company’s obligations with respect to the 7.0% Debentures, including, among other things, the payment when due of the principal of and interest on the 7.0% Debentures and the performance of each of the Company’s other covenants under the 7.0% Indenture; and

·  
immediately after giving effect to such transaction, no default or event of default with respect to the 7.0% Debentures has occurred and is continuing.

Upon any such consolidation, merger or transfer, the surviving person (if not the Company) shall succeed to, and may exercise every right and power of, the Company under the 7.0% Indenture.

On November 17, 2009, two investment funds managed by Paulson purchased $120.5 million aggregate principal amount of 7.0% Debentures from Morgan Stanley, and other purchasers purchased the remaining $56.0 million aggregate principal amount of 7.0% Debentures from Morgan Stanley.  We have been informed by Morgan Stanley that the two funds managed by Paulson have entered into agreements with Morgan Stanley to purchase up to a total of $79.5 million additional aggregate principal amount of 7.0% Debentures, and other purchasers have agreed to purchase up to the remaining $37.0 million aggregate principal amount of 7.0% Debentures.

Holders of the 3.5% Debentures that remain outstanding have the right to require us to repurchase their debentures for cash on September 30, 2010.  If any 3.5% Debentures remain outstanding after September 30, 2010, we will have the right to redeem such debentures on October 5, 2010 for cash.  As of December 31, 2009, there are $116.5 million in aggregate principal amount of 3.5% Debentures outstanding.  We have commitments from Morgan Stanley to purchase an additional aggregate principal amount of 7.0% Debentures equal to the aggregate principal amount of 3.5% Debentures: (i) that we may purchase pursuant to any subsequent tender offer that expires before October 5, 2010; (ii) that we may purchase in privately negotiated transactions that settle before October 5, 2010; (iii) that holders thereof require us to repurchase on September 30, 2010; or (iv) for any 3.5% Debentures that remain outstanding on October 5, 2010 that we elect to redeem.

As further discussed in the note to the consolidated financial statements entitled “Subsequent Events”, we issued $64 million aggregate principal amount of the 7.0% Debentures in February 2010.

Outlook

We believe that the existing cash available to the holding company, the cash flows to be generated from operations and the other transactions summarized above will be sufficient to allow us to meet our debt obligations through the next twelve months.  However, our cash flow is affected by a variety of factors, many of which are outside of our control, including insurance regulatory issues, competition, financial markets and other general business conditions.  We cannot provide assurance that we will possess sufficient income and liquidity to meet all of our debt service requirements and other holding company obligations.  For additional discussion regarding the liquidity and other risks that we face, see “Risk Factors”.

MARKET-SENSITIVE INSTRUMENTS AND RISK MANAGEMENT

Our spread-based insurance business is subject to several inherent risks arising from movements in interest rates, especially if we fail to anticipate or respond to such movements.  First, interest rate changes can cause compression of our net spread between interest earned on investments and interest credited on customer deposits, thereby adversely affecting our results.  Second, if interest rate changes produce an unanticipated increase in surrenders of our spread-based products, we may be forced to sell investment assets at a loss in order to fund such surrenders.  Many of our products include surrender charges, market interest rate adjustments or other features to encourage persistency; however at December 31, 2009, approximately 20 percent of our total insurance liabilities, or approximately $5.0 billion, could be surrendered by the policyholder without penalty.  Finally, changes in interest rates can have significant effects on the performance of our structured securities portfolio as a result of changes in the prepayment rate of the loans underlying such securities.  We follow asset/liability strategies that are designed to mitigate the effect of interest rate changes on our profitability.  However,

 
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there can be no assurance that management will be successful in implementing such strategies and achieving adequate investment spreads.

We seek to invest our available funds in a manner that will fund future obligations to policyholders, subject to appropriate risk considerations.  We seek to meet this objective through investments that:  (i) have similar cash flow characteristics with the liabilities they support; (ii) are diversified among industries, issuers and geographic locations; and (iii) are predominantly investment-grade fixed maturity securities.

Our investment strategy is to maximize, over a sustained period and within acceptable parameters of risk, investment income and total investment return through active investment management.  Accordingly, our entire portfolio of fixed maturity securities is available to be sold in response to:  (i) changes in market interest rates; (ii) changes in relative values of individual securities and asset sectors; (iii) changes in prepayment risks; (iv) changes in credit quality outlook for certain securities; (v) liquidity needs; and (vi) other factors.  From time to time, we invest in securities for trading purposes, although such investments are a relatively small portion of our total portfolio.

The profitability of many of our products depends on the spread between the interest earned on investments and the rates credited on our insurance liabilities.  In addition, changes in competition and other factors, including the level of surrenders and withdrawals, may limit our ability to adjust or to maintain crediting rates at levels necessary to avoid narrowing of spreads under certain market conditions.  As of December 31, 2009, approximately 41 percent of our insurance liabilities had interest rates that may be reset annually; 41 percent had a fixed explicit interest rate for the duration of the contract; 13 percent had credited rates which approximate the income earned by the Company; and the remainder had no explicit interest rates.  At December 31, 2009, the average yield, computed on the cost basis of our fixed maturity portfolio, was 5.7 percent, and the average interest rate credited or accruing to our total insurance liabilities (excluding interest rate bonuses for the first policy year only and excluding the effect of credited rates attributable to variable or fixed index products) was 4.5 percent.

We use computer models to simulate the cash flows expected from our existing insurance business under various interest rate scenarios.  These simulations help us to measure the potential gain or loss in fair value of our interest rate-sensitive financial instruments and to manage the relationship between the duration of our assets and the expected duration of our liabilities.  When the estimated durations of assets and liabilities are similar, a change in the value of assets should be largely offset by a change in the value of liabilities.  At December 31, 2009, the adjusted modified duration of our fixed maturity investments (as modified to reflect payments and potential calls) was approximately 9.0 years and the duration of our insurance liabilities was approximately 8.1 years.  We estimate that our fixed maturity securities and short-term investments (net of corresponding changes in insurance acquisition costs) would decline in fair value by approximately $455 million if interest rates were to increase by 10 percent from their levels at December 31, 2009.  This compares to a decline in fair value of $185 million based on amounts and rates at December 31, 2008.  Our computer simulated calculations include numerous assumptions, require significant estimates and assume an immediate change in interest rates without any management of the investment portfolio in reaction to such change.  Consequently, potential changes in value of our financial instruments indicated by the simulations will likely be different from the actual changes experienced under given interest rate scenarios, and the differences may be material.  Because we actively manage our investments and liabilities, our net exposure to interest rates can vary over time.

We are subject to the risk that our investments will decline in value.  This has occurred in the past and may occur again.  During 2009, we recognized net realized investment losses of $60.5 million, which were comprised of $134.9 million of net gains from the sales of investments (primarily fixed maturities) and $195.4 million of writedowns of investments for other than temporary declines in fair value recognized through net income ($385.0 million, prior to the $189.6 million of impairment losses recognized through other comprehensive loss).  During 2008, we recognized net realized investment losses of $262.4 million, which were comprised of:  (i) $100.1 million of net losses from the sales of investments (primarily fixed maturities) and; (ii) $162.3 million of writedowns of investments for other than temporary declines in fair value.  During 2007, we recognized net realized investment losses of $158.0 million, which were comprised of:  (i) $52.5 million of net losses from the sales of investments (primarily fixed maturities); (ii) $31.8 million of writedowns of investments for other than temporary declines in the fair value; and (iii) $73.7 million of writedowns of investments (which were subsequently transferred pursuant to a coinsurance agreement as further discussed in the note to the consolidated financial statements entitled “Summary of Significant Accounting Policies”) as a result of our intent not to hold such investments for a period of time sufficient to allow for any anticipated recovery in value.

The Company is subject to risk resulting from fluctuations in market prices of our equity securities. In general, these investments have more year-to-year price variability than our fixed maturity investments.  However, returns over longer time

 
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frames have been consistently higher.  We manage this risk by limiting our equity securities to a relatively small portion of our total investments.

Our investment in options backing our equity-linked products is closely matched with our obligation to fixed index annuity holders.  Fair value changes associated with that investment are substantially offset by an increase or decrease in the amounts added to policyholder account balances for fixed index products.

Inflation

Inflation rates may impact the financial statements and operating results in several areas.  Inflation influences interest rates, which in turn impact the fair value of the investment portfolio and yields on new investments.  Inflation also impacts a portion of our insurance policy benefits affected by increased medical coverage costs.  Operating expenses, including payrolls, are impacted to a certain degree by the inflation rate.

RESULTS OF DISCONTINUED OPERATIONS.

As further discussed in the note to the consolidated financial statements entitled “Transfer of Senior Health Insurance Company of Pennsylvania to an Independent Trust”, the long-term care business of Senior Health is reflected as a discontinued operation in all periods presented.  As a result, the comparison of the 2008 operating results to prior periods is impacted by the Transfer.  The following summarizes the operating results of our discontinued operations (dollars in millions):

   
2008
    
2007
  
             
Premium collections (all of which are renewal premiums):
            
Long-term care                                                                             
   $ 225.9     $ 269.1  
                 
Average liabilities for insurance products, net of reinsurance ceded:
                
Long-term care                                                                             
   $ 2,881.2     $ 2,903.8  
                 
Revenues:
                
Insurance policy income                                                                             
   $ 227.9     $ 271.6  
Net investment income on general account
                
invested assets                                                                           
     156.9       166.8  
                 
Total revenues                                                                        
     384.8       438.4  
                 
Expenses:
                
Insurance policy benefits                                                                             
     311.2       517.8  
Amortization related to operations                                                                             
     16.7       22.5  
Gain on reinsurance recapture                                                                             
     (29.7 )     -  
Loss on Transfer and transaction expenses                                                                             
     363.6       -  
Other operating costs and expenses                                                                             
     54.0       63.7  
                 
Total benefits and expenses                                                                        
     715.8       604.0  
                 
Income (loss) before net realized investment
                
gains (losses) and income taxes                                                                             
     (331.0 )     (165.6 )
                 
Net realized investment gains (losses)                                                                             
     (380.1 )     2.6  
                 
Income (loss) before income taxes                                                                                
   $ (711.1 )   $ (163.0 )
                 
Health benefit ratios:
                
Insurance policy benefits                                                                             
   $ 311.2     $ 517.8  
Benefit ratio (a)                                                                             
     136.6 %     190.6 %
Interest-adjusted benefit ratio (b)
     67.7 %     129.2 %


 
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____________________
(a)  
We calculate benefit ratios by dividing the related product’s insurance policy benefits by insurance policy income.
(b)  
We calculate the interest-adjusted benefit ratio (a non-GAAP measure) for long-term care products by dividing such product’s insurance policy benefits less interest income on the accumulated assets backing the insurance liabilities by policy income.  These are considered non-GAAP financial measures.  A non-GAAP measure is a numerical measure of a company’s performance, financial position, or cash flows that excludes or includes amounts that are normally excluded or included in the most directly comparable measure calculated and presented in accordance with GAAP.

These non-GAAP financial measures of “interest-adjusted benefit ratios” differ from “benefit ratios” due to the deduction of interest income on the accumulated assets backing the insurance liabilities from the product’s insurance policy benefits used to determine the ratio.  Interest income is an important factor in measuring the performance of health products that are expected to be inforce for a longer duration of time, are not subject to unilateral changes in provisions (such as non-cancelable or guaranteed renewable contracts) and require the performance of various functions and services (including insurance protection) for an extended period of time.  The net cash flows from long-term care products generally cause an accumulation of amounts in the early years of a policy (accounted for as reserve increases) that will be paid out as benefits in later policy years (accounted for as reserve decreases).  Accordingly, as the policies age, the benefit ratio will typically increase, but the increase in benefits will be partially offset by interest income earned on the accumulated assets.  The interest-adjusted benefit ratio reflects the effects of the interest income offset.  Since interest income is an important factor in measuring the performance of this product, management believes a benefit ratio that includes the effect of interest income is useful in analyzing product performance.  We utilize the interest-adjusted benefit ratio in measuring segment performance because we believe that this performance measure is a better indicator of the ongoing businesses and trends in the business.  However, the “interest-adjusted benefit ratio” does not replace the “benefit ratio” as a measure of current period benefits to current period insurance policy income.  Accordingly, management reviews both “benefit ratios” and “interest-adjusted benefit ratios” when analyzing the financial results attributable to these products.  The investment income earned on the accumulated assets backing long-term care reserves in our discontinued operations was $156.9 million and $166.8 million in 2008 and 2007, respectively.

Total premium collections were $225.9 million in 2008, down 16 percent from 2007.  We ceased marketing this long-term care business in 2003.  Accordingly, collected premiums have decreased over time as policies lapsed, partially offset by premium rate increases.

Average liabilities for insurance products, net of reinsurance ceded were approximately $2.9 billion in both 2008 and 2007.

Insurance policy income is comprised of premiums earned on these long-term care policies.

Net investment income on general account invested assets decreased 5.9 percent, to $156.9 million, in 2008.  The average balance of general account invested assets was $2.5 billion and $2.9 billion in 2008 and 2007, respectively.  The average yield on these assets was 6.22 percent and 5.73 percent in 2008 and 2007, respectively.  The increase in yield in 2008 reflects the decrease in the cost basis of investments as a result of the recognition of other-than-temporary impairments as further discussed below under net realized investment gains (losses).

Insurance policy benefits fluctuated primarily as a result of the factors summarized below.

Insurance policy benefits were $311.2 million in 2008 and $517.8 million in 2007.

The benefit ratio on this block of business was 136.6 percent and 190.6 percent in 2008 and 2007, respectively.  Benefit ratios are calculated by dividing the product’s insurance policy benefits by insurance policy income.  Since the insurance product liabilities we establish for long-term care business are subject to significant estimates, the ultimate claim liability we incur for a particular period is likely to be different than our initial estimate.  Our insurance policy benefits reflected reserve deficiencies from prior years of $21.8 million and $123.8 million in 2008 and 2007, respectively.  Excluding the effects of prior year claim reserve deficiencies, our benefit ratios would have been 127.0 percent and 145.0 percent in 2008 and 2007, respectively.  These ratios reflect the significantly higher level of incurred claims experienced in 2007 resulting in increases in reserves for future benefits as discussed below, adverse development on claims incurred in prior periods as discussed below, and decreases in policy income.  The prior period deficiencies have resulted from the impact of paid claim experience being different than prior estimates, changes in actuarial assumptions and refinements to claimant data used to determine claim reserves.

 
72
 


The net cash flows from long-term care products generally cause an accumulation of amounts in the early years of a policy (accounted for as reserve increases) which will be paid out as benefits in later policy years (accounted for as reserve decreases).  Accordingly, as the policies age, the benefit ratio will typically increase, but the increase in benefits will be partially offset by investment income earned on the assets which have accumulated.  The interest-adjusted benefit ratio for long-term care products is calculated by dividing the insurance product’s insurance policy benefits less interest income on the accumulated assets backing the insurance liabilities by insurance policy income.  The interest-adjusted benefit ratio on this business was 67.7 percent and 129.2 percent in 2008 and 2007, respectively.  Excluding the effects of prior year claim reserve deficiencies, our interest-adjusted benefit ratios would have been 58.1 percent and 83.6 percent in 2008 and 2007, respectively.

This long-term care business was primarily issued by Senior Health prior to its acquisition by our Predecessor in 1996.  The loss experience on these products has been worse than we originally expected.  Although we anticipated a higher level of benefits to be paid on these products as the policies aged, the paid claims have exceeded our expectations.  In addition, there has been an increase in the incidence and duration of claims in recent periods. This adverse experience is reflected in the higher insurance policy benefits experienced in 2008 and 2007.

In each quarterly period, we calculated our best estimate of claim reserves based on all of the information available to us at that time, which necessarily takes into account new experience emerging during the period.  Our actuaries estimated these claim reserves using various generally recognized actuarial methodologies which are based on informed estimates and judgments that are believed to be appropriate.  Additionally, an external actuarial firm provided consulting services which involved a review of the Company’s judgments and estimates for claim reserves on this long-term care block of business on a periodic basis.  As additional experience emerges and other data become available, these estimates and judgments are reviewed and may be revised.  Significant assumptions made in estimating claim reserves for long-term care policies include expectations about the:  (i) future duration of existing claims; (ii) cost of care and benefit utilization; (iii) interest rate utilized to discount claim reserves; (iv) claims that have been incurred but not yet reported; (v) claim status on the reporting date; (vi) claims that have been closed but are expected to reopen; and (vii) correspondence that has been received that will ultimately become claims that have payments associated with them.

During the second quarter of 2007, we increased claim liabilities for this long-term care insurance block by $108 million as a result of changes in our estimates of claim reserves incurred in prior periods.  Approximately $18 million of this increase related to claims with incurrence dates in the first quarter of 2007 and $90 million related to claims with incurrence dates prior to 2007.

The $108 million increase in estimates of claims incurred in prior periods included $100 million of adjustments related to updates to our reserve assumptions and methodologies to reflect emerging trends in our claim experience.  The following assumption changes primarily contributed to the $100 million adjustment:

·  
We increased our reserves by $32 million for changes to our assumptions regarding the future duration of existing claims.  We updated these assumptions to reflect our current expectation that policyholders will receive benefits for a longer period based on changing trends in the duration of our claims.

·  
We increased our reserves by $31 million related to a block of long-term care policies originally sold by Transport Life Insurance Company (“Transport”) and acquired by our Predecessor.  We estimate claim reserves for this block of business using an aggregate paid loss development method, which uses historical payment patterns to project ultimate losses for all the claims in a given incurral period.  We refined our loss development assumptions by developing separate assumption tables for claimants with and without lifetime benefit periods and for claimants with and without inflationary benefits, since this block’s recent loss experience has been extremely sensitive to the mix of its business.  This adjustment further improved the estimate that was made during the first quarter of 2007, which is described in further detail below.  This adjustment relates to our assumption of future duration of existing claims.

·  
We increased our claim reserves by $22 million to better reflect fluctuations in claim inventories related to certain blocks of business.  This increase relates to our estimate of claim status on the reporting date.

·  
We increased our claim reserves by $15 million for our estimate of incurred but not reported claims, reflecting recent experience and the impact of the other adjustments on waiver of premium reserves.

 
73
 

During the first quarter of 2007, we recorded a pre-tax adjustment that increased policy benefits for the Transport block by $22 million.  We found that our previous claim estimates on this block were deficient because claims on policies with lifetime benefits and inflation benefits had increased significantly in recent periods.  Since the policies with these benefits will have longer average claim payout periods than similar policies without such benefits, a shift in the mix of claimants can have a significant impact on incurred claims that is not immediately reflected using a completion factor methodology.  We improved our methodologies to address this and other shortcomings of the aggregate loss development methodology, which resulted in the pre-tax adjustment.

We had been aggressively seeking actuarially justified rate increases and pursuing other actions on our long-term care policies.  During the third quarter of 2006, we began a new program to file requests for rate increases on various long-term care products of Senior Health as we believed the existing rates were too low to fund expected future benefits.  These filings were expected to be the first of three rounds of rate increase filings for many of the same policies, and in some cases we requested three years of successive rate increases.  We chose to request a series of smaller rate increases, rather than a single large increase, to limit the impact on a policyholder’s premiums in any single year.  The effects of the first round of rate filings were partially realized in our premium revenue.  In the second quarter of 2007, we began filing requests for the second round of rate increases on many of the same policies.  The full effect of all three rounds of rate increases was not expected to be fully realized until 2011.

On April 20, 2004, the Florida Office of Insurance Regulation issued an order to Senior Health, that affected approximately 12,600 home health care policies issued in Florida by Senior Health and its predecessor companies.  Pursuant to the order, Senior Health offered the following three alternatives to holders of these policies subject to rate increases as follows:

·  
retention of their current policy with a rate increase of 50 percent in the first year and actuarially justified increases in subsequent years (which is also the default election for policyholders who failed to make an election by 30 days prior to the anniversary date of their policies) (“option one”);

·  
receipt of a replacement policy with reduced benefits and a rate increase in the first year of 25 percent and no more than 15 percent in subsequent years (“option two”); or

·  
receipt of a paid-up policy, allowing the holder to file future claims up to 100 percent of the amount of premiums paid since the inception of the policy (“option three”).

Policyholders selecting option one or option two are entitled to receive a contingent non-forfeiture benefit if their policy subsequently lapses.  In addition, policyholders could change their initial election any time up to 30 days prior to the anniversary date of their policies.  We began to implement premium adjustments with respect to policyholder elections in the fourth quarter of 2005 and the implementation of these premium adjustments was completed in 2007.  We did not make any adjustments to the insurance liabilities when these elections were made.  Reserves for all three groups of policies under the order were prospectively adjusted using the prospective revision methodology described in the “Critical Accounting Policies – Accounting for Long-term Care Premium Rate Increases” in “Management’s Discussion and Analysis of Consolidated Financial Condition and Results of Operations”.

Amortization related to operations includes amortization of insurance acquisition costs.  Fluctuations in amortization of insurance acquisition costs generally correspond with changes in lapse experience.

Gain on reinsurance recapture resulted from the recapture of a block of previously reinsured long-term care business in the third quarter of 2008.  Such business was included in the Transfer.

Loss on Transfer and transaction expenses relates to the loss on the transfer of Senior Health to an independent trust as further discussed in the note to the consolidated financial statements entitled “Transfer of Senior Health Insurance Company of Pennsylvania to an Independent Trust”.

Other operating costs and expenses were $54.0 million in 2008 and $63.7 million in 2007.  Other operating costs and expenses, excluding commission expenses, for this segment were $29.7 million in 2008 and $34.7 million in 2007.

Net realized investment gains (losses) fluctuated each period.  During 2008, net realized investment losses included $.4 million of net gains from the sales of investments (primarily fixed maturities) and $380.5 million of writedowns of investments (which were transferred to the Independent Trust) as a result of our intent not to hold such investments for a period of time sufficient to allow for a full recovery in value.  During 2007, net realized investment gains included $3.8

 
74
 

million from the sales of investments (primarily fixed maturities), and $1.2 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary.


ITEM 8.               CONSOLIDATED FINANCIAL STATEMENTS.


Index to Consolidated Financial Statements
   
 
Page
   
Report of Independent Registered Public Accounting Firm                                                                                                                                     
76
   
Consolidated Balance Sheet at December 31, 2009 and 2008                                                                                                                                     
78
   
Consolidated Statement of Operations for the years ended December 31, 2009, 2008 and 2007
80
   
Consolidated Statement of Shareholders’ Equity for the years ended December 31, 2009, 2008 and 2007
81
   
Consolidated Statement of Cash Flows for the years ended December 31, 2009, 2008 and 2007
83
   
Notes to Consolidated Financial Statements                                                                                                                                     
84


 
75
 
 

Report of Independent Registered Public Accounting Firm



To the Shareholders and Board of Directors Conseco, Inc. (now known as CNO Financial Group, Inc. as a result of its name change effective May 11, 2010):

In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Conseco Inc. (now known as CNO Financial Group, Inc. as a result of its name change effective May 11, 2010) and its subsidiaries at December 31, 2009 and 2008, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2009 in conformity with accounting principles generally accepted in the United States of America. Also in our opinion, the Company did not maintain, in all material respects, effective internal control over financial reporting as of December 31, 2009, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) because a material weakness in internal control over financial reporting related to the accounting and disclosure of insurance policy benefits and the liabilities for insurance products existed as of that date. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis.  The material weakness referred to above is described in Management’s Report on Internal Control Over Financial Reporting (not presented herein) appearing under Item 9A of the Company's 2009 Annual Report on Form 10-K. We considered this material weakness in determining the nature, timing, and extent of audit tests applied in our audit of the 2009 consolidated financial statements, and our opinion regarding the effectiveness of the Company’s internal control over financial reporting does not affect our opinion on those consolidated financial statements. The Company's management is responsible for these financial statements, for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting included in management's report referred to above.  Our responsibility is to express opinions on these financial statements and on the Company's internal control over financial reporting based on our integrated audits. We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation.  Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.

As discussed in Note 4 to the consolidated financial statements, the Company retrospectively adjusted its historical consolidated financial statements to reflect the adoption of a new accounting standard effective January 1, 2009 regarding the accounting for convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement).  Also, as discussed in Note 4 to the consolidated financial statements, the Company changed the manner in which it accounts for the non-credit portion of other-than-temporary impairments of fixed maturity securities.

As discussed in Note 1 to the consolidated financial statements, the Company retrospectively adjusted its historical consolidated financial statements to reflect the split of the former Conseco Insurance Group segment into two new segments - Washington National and Other CNO Business.



 
76
 



A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (i) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (ii) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (iii) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.

Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.


/s/ PricewaterhouseCoopers LLP



Indianapolis, Indiana
March 3, 2010, except with respect to our opinion on the consolidated financial statements insofar as it relates to the effects of the change in the composition of reportable segments discussed in Note 1, as to which the date is December 1, 2010.


 

 
77
 

 



CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEET
December 31, 2009 and 2008
(Dollars in millions)


ASSETS


   
2009
    
2008
  
             
Investments:
            
Fixed maturities, available for sale, at fair value (amortized cost:
2009 - $18,998.0; 2008 - $18,276.3)                                                                                                     
   $ 18,528.4     $ 15,277.0  
Equity securities at fair value (cost: 2009 - $30.7; 2008 - $31.0)
     31.0       32.4  
Mortgage loans                                                                                                           
     1,965.5       2,159.4  
Policy loans                                                                                                           
     295.2       363.5  
Trading securities                                                                                                           
     293.3       326.5  
Securities lending collateral                                                                                                           
     180.0       393.7  
Other invested assets                                                                                                           
      236.8       95.0  
                 
Total investments                                                                                                        
     21,530.2       18,647.5  
                 
Cash and cash equivalents - unrestricted                                                                                                               
     523.4       894.5  
Cash and cash equivalents - restricted                                                                                                               
     3.4       4.8  
Accrued investment income                                                                                                               
     309.0       298.7  
Present value of future profits                                                                                                               
     1,175.9       1,477.8  
Deferred acquisition costs                                                                                                               
     1,790.9       1,812.6  
Reinsurance receivables                                                                                                               
     3,559.0       3,284.8  
Income tax assets, net                                                                                                               
     1,124.0       2,047.7  
Assets held in separate accounts                                                                                                               
     17.3       18.2  
Other assets                                                                                                               
     310.7       276.7  
                 
Total assets                                                                                                        
   $ 30,343.8     $ 28,763.3  

(continued on next page)




















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

 
78
 


CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEET (Continued)
December 31, 2009 and 2008
(Dollars in millions)


LIABILITIES AND SHAREHOLDERS’ EQUITY


   
2009
    
2008
  
Liabilities:
            
Liabilities for insurance products:
            
Interest-sensitive products                                                                                                        
   $ 13,219.2     $ 13,332.8  
Traditional products                                                                                                        
     10,063.5       9,828.7  
Claims payable and other policyholder funds                                                                                                        
     994.0       1,008.4  
Liabilities related to separate accounts                                                                                                        
     17.3       18.2  
Other liabilities                                                                                                           
     610.4       457.4  
Investment borrowings                                                                                                           
     683.9       767.5  
Securities lending payable                                                                                                           
     185.7       408.8  
Notes payable – direct corporate obligations                                                                                                           
     1,037.4       1,311.5  
                 
Total liabilities                                                                                                    
     26,811.4       27,133.3  
                 
Commitments and Contingencies (Note 9)
                
                 
Shareholders' equity:
                
Common stock ($0.01 par value, 8,000,000,000 shares authorized,
shares issued and outstanding:  2009 – 250,786,216; 2008 – 184,753,758)
     2.5        1.9  
Additional paid-in capital                                                                                                           
     4,408.8       4,104.0  
Accumulated other comprehensive loss                                                                                                           
     (264.3 )     (1,770.7 )
Accumulated deficit                                                                                                           
     (614.6 )     (705.2 )
                 
Total shareholders' equity                                                                                                    
     3,532.4       1,630.0  
Total liabilities and shareholders' equity                                                                                                    
   $ 30,343.8     $ 28,763.3  





















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

 
79
 


CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF OPERATIONS
for the years ended December 31, 2009, 2008 and 2007
(Dollars in millions, except per share data)
   
2009
    
2008
    
2007
  
Revenues:
                  
Insurance policy income
   $ 3,093.6     $ 3,253.6     $ 2,895.7  
Net investment income (loss):
                        
General account assets
     1,232.3       1,254.5       1,350.5  
Policyholder and reinsurer accounts and other special- purpose portfolios
     60.4       (75.7 )     19.3  
Realized investment gains (losses):
                        
Net realized investment gains (losses), excluding impairment losses
     134.9       (100.1 )     (52.5 )
Other-than-temporary impairment losses:
                        
Total other-than-temporary impairment losses
     (385.0 )     (162.3 )     (105.5 )
Other-than-temporary impairment losses recognized
in other comprehensive loss
     189.6       -       -  
Net impairment losses recognized
     (195.4 )     (162.3 )     (105.5 )
Total realized gains (losses)                                                                                       
     (60.5 )     (262.4 )     (158.0 )
Fee revenue and other income                                                                                       
      15.6       19.7       23.8  
                         
Total revenues                                                                                   
     4,341.4       4,189.7       4,131.3  
                         
Benefits and expenses:
                        
Insurance policy benefits
     3,066.7       3,212.5       2,915.9  
Interest expense
     117.9       106.5       125.3  
Amortization
     432.7       367.9       426.8  
(Gain) loss on extinguishment or modification of debt
     22.2       (21.2 )     -  
Costs related to a litigation settlement
     -       -       64.4  
Loss related to an annuity coinsurance transaction
     -       -       76.5  
Other operating costs and expenses
     528.3       520.3       540.4  
                         
Total benefits and expenses                                                                                   
     4,167.8       4,186.0       4,149.3  
                         
Income (loss) before income taxes and discontinued operations
     173.6       3.7       (18.0 )
                         
Income tax expense (benefit):
                        
Tax expense (benefit) on period income                                                                                       
     60.1       9.4       (6.9 )
Valuation allowance for deferred tax assets                                                                                       
     27.8       403.9       68.0  
                         
Income (loss) before discontinued operations
     85.7       (409.6 )     (79.1 )
                         
Discontinued operations, net of income taxes                                                                                         
     -       (722.7 )     (105.9 )
                         
Net income (loss)                                                                                     
     85.7       (1,132.3 )     (185.0 )
                         
Preferred stock dividends                                                                                         
     -       -       14.1  
                         
Net income (loss) applicable to common stock
   $ 85.7     $ (1,132.3 )   $ (199.1 )
                         
Earnings (loss) per common share:
                        
Basic:
                        
Weighted average shares outstanding                                                                                   
     188,365,000       184,704,000       173,374,000  
                         
Income (loss) before discontinued operations
   $ .45     $ (2.22 )   $ (.54 )
Discontinued operations                                                                                   
     -       (3.91 )     (.61 )
Net income (loss)                                                                               
   $ .45     $ (6.13 )   $ (1.15 )
                         
Diluted:
                        
Weighted average shares outstanding                                                                                   
     193,340,000       184,704,000       173,374,000  
                         
Income (loss) before discontinued operations
   $ .45     $ (2.22 )   $ (.54 )
Discontinued operations                                                                                   
     -       (3.91 )     (.61 )
Net income (loss)                                                                               
   $ .45     $ (6.13 )   $ (1.15 )

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

 
80
 

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(Dollars in millions)

               
Accumulated
    
Retained
        
         
Common stock
    
other
    
earnings
        
   
Preferred
    
and additional
    
comprehensive
    
(accumulated
        
   
stock
    
paid-in capital
    
loss
    
deficit)
    
Total
  
                               
Balance, December 31, 2006
   $ 667.8     $ 3,497.5     $ (72.6 )   $ 628.9     $ 4,721.6  
Comprehensive loss, net of tax:
                                        
Net loss
     -       -       -       (185.0 )     (185.0 )
Change in unrealized appreciation (depreciation) of investments (net of applicable income tax benefit of $113.0)
     -       -       (202.4 )     -       (202.4 )
                                         
Total comprehensive loss
                                     (387.4 )
                                         
Cost of shares acquired
     -       (87.2 )     -       -       (87.2 )
Stock option and restricted stock plans
     -       14.4       -       -       14.4  
Change in unrecognized net loss related to deferred compensation plan (net of applicable income tax expense of $.9 million)
     -       -       1.7       -       1.7  
Reduction of tax liabilities related to various contingencies recognized at the fresh-start date in conjunction with adoption of authoritative guidance
     -       6.0       -       -       6.0  
Cumulative effect of accounting change pursuant to authoritative guidance
     -       -       -       (2.7 )     (2.7 )
Conversion of preferred stock into common shares
     (667.8 )     667.8       -       -       -  
Dividends on preferred stock
     -       -       -       (14.1 )     (14.1 )
                                         
Balance, December 31, 2007
     -       4,098.5       (273.3 )     427.1       4,252.3  

(continued on following page)
















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

 
81
 

CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY (Continued)
(Dollars in millions)

               
Accumulated
    
Retained
        
         
Common stock
    
other
    
earnings
        
   
Preferred
    
and additional
    
comprehensive
    
(accumulated
        
   
stock
    
paid-in capital
    
loss
    
deficit)
    
Total
  
                               
Balance, December 31, 2007 (carried forward from prior page)
   $ -     $ 4,098.5     $ (273.3 )   $ 427.1     $ 4,252.3  
Comprehensive loss, net of tax:
                                        
Net loss
     -       -       -       (1,132.3 )     (1,132.3 )
    Change in unrealized appreciation (depreciation) of investments (net of applicable income tax benefit of $833.9)
     -       -       (1,496.9 )     -       (1,496.9 )
    Change in unrecognized net loss related to deferred compensation plan (net of applicable income tax benefit of $.2 million)
     -       -       (.5 )     -       (.5 )
                                         
Total comprehensive loss
     -                               (2,629.7 )
                                         
Stock option and restricted stock plans
     -       7.4       -       -       7.4  
                                         
Balance, December 31, 2008                                               
     -       4,105.9       (1,770.7 )     (705.2 )     1,630.0  
                                         
Comprehensive loss, net of tax:
                                        
   Net income
     -       -       -       85.7       85.7  
   Change in unrealized appreciation (depreciation) of investments (net of applicable income tax expense of $879.6)
     -       -       1,576.5       -       1,576.5  
   Noncredit component of impairment losses on fixed maturities, available for sale (net of applicable income tax benefit of $36.4)
     -       -       (65.2 )     -       (65.2 )
                                         
Total comprehensive loss
     -                               1,597.0  
                                         
Issuance of common stock, net
     -       296.3       -       -       296.3  
Stock option and restricted stock plans
     -       9.1       -       -       9.1  
Effect of reclassifying noncredit component of previously recognized impairment losses on fixed maturities, available for sale (net of applicable income tax benefit of $2.6)
     -       -       (4.9 )     4.9       -  
                                         
Balance, December 31, 2009                                               
   $ -     $ 4,411.3     $ (264.3 )   $ (614.6 )   $ 3,532.4  





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

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CASH FLOWS
for the years ended December 31, 2009, 2008 and 2007
 (Dollars in millions)

   
2009
    
2008
    
2007
  
Cash flows from operating activities:
                  
Insurance policy income
   $ 2,747.1     $ 3,140.7     $ 2,818.0  
Net investment income
     1,167.3       1,339.6       1,610.0  
Fee revenue and other income
     15.6       19.7       23.8  
Net sales (purchases) of trading securities
     32.3       346.5       (114.3 )
Insurance policy benefits
     (2,298.8 )     (2,722.3 )     (2,339.6 )
Interest expense
     (109.0 )     (95.4 )     (114.7 )
Policy acquisition costs
     (407.5 )     (459.1 )     (545.9 )
Other operating costs
     (495.8 )     (587.0 )     (631.3 )
Taxes
     (7.2 )     4.1       (2.7 )
                         
Net cash provided by operating activities
     644.0       986.8       703.3  
                         
Cash flows from investing activities:
                        
Sales of investments
     10,709.6       6,832.7       7,192.9  
Maturities and redemptions of investments
     917.3       695.1       948.4  
Purchases of investments
     (12,540.4 )     (8,193.7 )     (9,248.7 )
Change in restricted cash
     1.4       16.3       2.9  
Change in cash held by discontinued operations
     -       45.6       (30.9 )
Other
     (10.6 )     (25.8 )     (24.2 )
                         
Net cash used by investing activities                                                                                     
     (922.7 )     (629.8 )     (1,159.6 )
                         
Cash flows from financing activities:
                        
Issuance of notes payable, net
     172.0       75.0       200.0  
Issuance of common stock
     296.3       -       3.4  
Payments to repurchase common stock
     -       -       (87.2 )
Payments on notes payable
     (461.2 )     (44.0 )     (7.8 )
Expenses related to debt modification and extinguishment of debt
     (14.7 )     -       -  
Amounts received for deposit products
     1,668.9       1,863.4       1,852.2  
Withdrawals from deposit products
     (1,670.1 )     (1,573.3 )     (1,989.3 )
Investment borrowings
     (83.6 )     (145.5 )     494.7  
Dividends paid on preferred stock
     -       -       (19.0 )
                         
Net cash provided (used) by financing activities
     (92.4 )     175.6       447.0  
                         
Net increase (decrease) in cash and cash equivalents
     (371.1 )     532.6       (9.3 )
                         
Cash and cash equivalents, beginning of year                                                                                             
     894.5       361.9       371.2  
                         
Cash and cash equivalents, end of year                                                                                             
   $ 523.4     $ 894.5     $ 361.9  
                         
                         








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

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________


1.       DESCRIPTION OF BUSINESS

CNO Financial Group, Inc., a Delaware corporation (“CNO”), (formerly known as Conseco, Inc. prior to its name change in May 2010) is a holding company for a group of insurance companies operating throughout the United States that develop, market and administer health insurance, annuity, individual life insurance and other insurance products.  CNO became the successor to Conseco, Inc., an Indiana corporation (our “Predecessor”), in connection with our bankruptcy reorganization which became effective on September 10, 2003 (the “Effective Date”).  The terms “CNO Financial Group, Inc.”, the “Company”, “we”, “us”, and “our” as used in this report refer to CNO and its subsidiaries or, when the context requires otherwise, our Predecessor and its subsidiaries.  We focus on serving the senior and middle-income markets, which we believe are attractive, underserved, high growth markets.  We sell our products through three distribution channels: career agents, professional independent producers (some of whom sell one or more of our product lines exclusively) and direct marketing.

Beginning July 1, 2010, management changed the manner in which it disaggregates the Company’s operations for making operating decisions and assessing performance.  As a result, the Company manages its business through the following operating segments: Bankers Life, Colonial Penn and Washington National, which are defined on the basis of product distribution; Other CNO Business, comprised primarily of products we no longer sell actively; and corporate operations, comprised of holding company activities and certain noninsurance company businesses.  All prior period segment disclosures have been revised to conform to management’s current view of the Company’s operating segments.  Such revisions impacted the following footnotes in the consolidated financial statements:  Footnote 1 – Description of Business; and Footnote 15 – Business Segments.  Our segments are described below.

·  
Bankers Life, which markets and distributes Medicare supplement insurance, interest-sensitive life insurance, traditional life insurance, fixed annuities and long-term care insurance products to the middle-income senior market through a dedicated field force of career agents and sales managers supported by a network of community-based branch offices.  The Bankers Life segment includes primarily the business of Bankers Life and Casualty Company (“Bankers Life”).  Bankers Life also markets and distributes Medicare Advantage plans primarily through a distribution arrangement with Humana, Inc. (“Humana”) and Medicare Part D prescription drug plans through a distribution and reinsurance arrangement with Coventry Health Care (“Coventry”).
 
·  
Washington National, which markets and distributes supplemental health (including specified disease, accident and hospital indemnity insurance products) and traditional life insurance to middle-income consumers at home and at the worksite.  These products are marketed through Performance Matters Associates, Inc., a wholly owned subsidiary, and through independent marketing organizations and insurance agencies.  Products being marketed by Washington National are underwritten by Washington National Insurance Company (“Washington National”), Conseco Insurance Company and Conseco Health Insurance Company (“Conseco Health”).
 
·  
Colonial Penn, which markets primarily graded benefit and simplified issue life insurance directly to customers through television advertising, direct mail, the internet and telemarketing.  The Colonial Penn segment includes primarily the business of Colonial Penn Life Insurance Company (“Colonial Penn”).
 
·  
Other CNO Business, which consists of blocks of interest-sensitive life insurance, traditional life insurance, annuities, long-term care insurance and other supplemental health products.  These blocks of business are not being actively marketed and were primarily issued or acquired by Conseco Life Insurance Company (“Conseco Life”) and Washington National.
 



 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



 
2.
TRANSFER OF SENIOR HEALTH INSURANCE COMPANY OF PENNSYLVANIA TO AN INDEPENDENT TRUST

On November 12, 2008, CNO and CDOC, Inc. (“CDOC”), a wholly owned subsidiary of CNO (and together with CNO, the “CNO Parties”), completed the transfer (the “Transfer”) of the stock of Senior Health Insurance Company of Pennsylvania (“Senior Health”) to Senior Health Care Oversight Trust, an independent trust (the “Independent Trust”) for the exclusive benefit of Senior Health’s long-term care policyholders.  Consummation of the transaction was subject to the approval of the Pennsylvania Insurance Department.

In connection with the Transfer, the Company entered into a $125.0 million Senior Note due November 12, 2013 (the “Senior Note”), payable to Senior Health.  The note has a five-year maturity date; a 6 percent interest rate; and requires annual principal payments of $25.0 million.  As a condition of the order from the Pennsylvania Insurance Department approving the Transfer, CNO agreed that it would not pay cash dividends on its common stock while any portion of the $125.0 million note remained outstanding.

CNO recorded accounting charges totaling $1.0 billion related to the transaction, comprised of Senior Health’s equity (as calculated in accordance with generally accepted accounting principles), an additional valuation allowance for deferred tax assets, the capital contribution to Senior Health and the Independent Trust and transaction expenses.  The accounting charges are summarized as follows (dollars in millions):

         
Recognition of unrealized losses on investments transferred to the Independent Trust
   $ 380.5  
(a)
           
Gain on reinsurance recapture, net of tax                                                                                                    
     (19.3 )  
           
Increase to deferred tax valuation allowance based on recent results which have had a significant impact on taxable income and the effects of the transaction
     298.0    
           
Write-off of remaining shareholder’s equity of Senior Health                                                                                                    
     159.2  
(a)
           
Additional capital contribution and transaction expenses                                                                                                    
     204.4  
(a)
           
Total charges                                                                                                    
   $ 1,022.8    
_________________
 
(a)
Amount is before the potential tax benefit.  A deferred tax valuation allowance was established for all future potential tax benefits generated by these charges since management had concluded that it is more likely than not that such tax benefits would not be utilized to offset future taxable income.


 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



As a result of the Transfer, Senior Health’s long-term care business is presented as a discontinued operation for all periods presented.  The operating results from the discontinued operations are as follows (dollars in millions):

   
2008
    
2007
  
             
Revenues:
            
Insurance policy income                                                                                 
   $ 227.9     $ 271.6  
Net investment income                                                                                 
     156.9       166.8  
Net realized investment gains (losses)                                                                                 
     (380.1 )     2.6  
                 
Total revenues                                                                             
     4.7       441.0  
                 
Benefits and expenses:
                
Insurance policy benefits                                                                                 
     311.2       517.8  
Amortization                                                                                 
     16.7       22.5  
Gain on reinsurance recapture (a)                                                                                 
     (29.7 )     -  
Loss on Transfer and transaction expenses                                                                                 
     363.6       -  
Other operating costs and expenses                                                                                 
     54.0       63.7  
                 
Total benefits and expenses                                                                             
     715.8       604.0  
                 
Income (loss) before income taxes                                                                             
     (711.1 )     (163.0 )
                 
Income tax expense (benefit):
                
                 
Tax expense (benefit) on period income                                                                                 
     (440.7 )     (57.1 )
                 
Valuation allowance for deferred tax assets                                                                                 
      452.3       -  
                 
Net income (loss) from discontinued operations                                                                             
   $ (722.7 )   $ (105.9 )

_______________
(a)  
In the third quarter of 2008, Senior Health recaptured a block of previously reinsured long-term care business which was included in the business transferred to the Independent Trust.


 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



 
3.
BASIS OF PRESENTATION

We prepare our financial statements in accordance with accounting principles generally accepted in the United States of America (“GAAP”).  We follow the accounting standards established by the Financial Accounting Standards Board (“FASB”) and the Securities and Exchange Commission (the “SEC”).

The accompanying financial statements include the accounts of the Company and its subsidiaries.  Our consolidated financial statements exclude the results of material transactions between us and our consolidated affiliates, or among our consolidated affiliates.

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

4.         SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

The following summary explains the significant accounting policies we use to prepare our financial statements.

Investments

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

Equity securities include investments in common stock and non-redeemable preferred stock.  We carry these investments at estimated fair value.  We record any unrealized gain or loss, net of tax and related adjustments, as a component of shareholders’ equity.  When declines in value considered to be other than temporary occur, we reduce the amortized cost to estimated fair value and recognize a loss in the statement of operations.

Mortgage loans held in our investment portfolio are carried at amortized unpaid balances, net of provisions for estimated losses.  Interest income is accrued on the principal amount of the loan based on the loan’s contractual interest rate.  Payment terms specified for mortgage loans may include a prepayment penalty for unscheduled payoff of the investment.  Prepayment penalties are recognized as investment income when received.

Policy loans are stated at current unpaid principal balances.

Certain of our trading securities are held in an effort to offset the portion of the income statement volatility caused by the effect of interest rate fluctuations on the value of certain embedded derivatives related to our fixed index annuity products and certain modified coinsurance agreements.  See the sections of this note entitled “Accounting for Derivatives” and “Investment Borrowings” for further discussion regarding embedded derivatives and the trading accounts.  In addition, the trading account includes investments backing the market strategies of our multibucket annuity products.  The change in fair value of these securities, which is recognized currently in income from policyholder and reinsurer accounts and other special-purpose portfolios (a component of investment income), is substantially offset by the change in insurance policy benefits for these products.  Our trading securities totaled $293.3 million and $326.5 million at December 31, 2009 and 2008, respectively.

Securities lending collateral primarily consists of fixed maturities, equity securities and cash and cash equivalents.  We carry these investments at estimated fair value.  We record any unrealized gain or loss, net of tax, as a component of shareholders’ equity.

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



Other invested assets include:  (i) certain call options purchased in an effort to hedge the effects of certain policyholder benefits related to our fixed index annuity and life insurance products; and (ii) certain non-traditional investments.  We carry the call options at estimated fair value as further described in the section of this note entitled “Accounting for Derivatives”.  Non-traditional investments include investments in certain limited partnerships, which are accounted for using the equity method, and promissory notes, which are accounted for using the cost method.

We defer any fees received or costs incurred when we originate investments.  We amortize fees, costs, discounts and premiums as yield adjustments over the contractual lives of the investments without anticipation of prepayments.  We consider anticipated prepayments on mortgage-backed securities in determining estimated future yields on such securities.

When we sell a security (other than trading securities), we report the difference between the sale proceeds and amortized cost (determined based on specific identification) as a realized investment gain or loss.

We regularly evaluate our investments for possible impairment.  When we conclude that a decline in a security's net realizable value is other than temporary, the decline is recognized as a realized loss and the cost basis of the security is reduced to its estimated fair value.

Cash and Cash Equivalents

Cash and cash equivalents include commercial paper, invested cash and other investments purchased with original maturities of less than three months.  We carry them at amortized cost, which approximates estimated fair value.

Deferred Acquisition Costs

The costs that vary with, and are primarily related to, producing new insurance business subsequent to September 10, 2003 are referred to as deferred acquisition costs.  For universal life or investment products, we amortize these costs in relation to the estimated gross profits using the interest rate credited to the underlying policies.  For other products, we amortize these costs in relation to future anticipated premium revenue using the projected investment earnings rate.

When we realize a gain or loss on investments backing our universal life or investment-type products, we adjust the amortization to reflect the change in estimated gross profits from the products due to the gain or loss realized and the effect on future investment yields.  We also adjust deferred acquisition costs for the change in amortization that would have been recorded if our fixed maturity securities, available for sale, had been sold at their stated aggregate fair value and the proceeds reinvested at current yields.  We limit the total adjustment related to the impact of unrealized losses to the total of costs capitalized plus interest related to insurance policies issued in a particular year.  We include the impact of this adjustment in accumulated other comprehensive income within shareholders’ equity.

The investment environment during the fourth quarter of 2008 resulted in significant net unrealized losses in our fixed maturity investment portfolio.  The total adjustment to accumulated other comprehensive income related to the change in deferred acquisition costs for the negative amortization that would have been recorded if the fixed maturity securities had been sold at their stated aggregate fair value would have resulted in the balance of deferred acquisition costs exceeding the total of costs capitalized plus interest for annuity blocks of business issued in certain years.  Accordingly, the adjustment made to deferred acquisition costs and accumulated other comprehensive income was reduced by $206 million.

As of January 1, 2007, we adopted authoritative guidance on accounting by insurance enterprises for deferred acquisition costs on internal replacements of insurance and investment contracts.  As a result of the authoritative guidance, if an internal replacement modification substantially changes a contract, then the deferred acquisition costs are written off immediately through the consolidated statement of operations and any new definable cost associated with the new replacement are deferred as deferred acquisition costs.  If a contract modification does not substantially change the contract, the amortization of the deferred acquisition costs on the original contract will continue and any acquisition costs associated with the related modification are immediately expensed.

We regularly evaluate the recoverability of the unamortized balance of the deferred acquisition costs.  We consider estimated future gross profits or future premiums, expected mortality or morbidity, interest earned and credited rates, persistency and expenses in determining whether the balance is recoverable.  If we determine a portion of the unamortized

 
88
 
CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________


balance is not recoverable, it is charged to amortization expense.  In certain cases, the unamortized balance of the deferred acquisition costs may not be deficient in the aggregate, but our estimates of future earnings indicate that profits would be recognized in early periods and losses in later periods.  In this case, we increase the amortization of the deferred acquisition costs over the period of profits, by an amount necessary to offset losses that are expected to be recognized in the later years.

Present Value of Future Profits

The value assigned to the right to receive future cash flows from contracts existing at September 10, 2003 is referred to as the present value of future profits.  We also defer renewal commissions paid in excess of ultimate commission levels related to the existing policies in this account.  The balance of this account is amortized and evaluated for recovery in the same manner as described above for deferred acquisition costs.  We also adjust the present value of future profits for the change in amortization that would have been recorded if the fixed maturity securities, available for sale, had been sold at their stated aggregate fair value and the proceeds reinvested at current yields, similar to the manner described above for deferred acquisition costs.  We limit the total adjustment related to the impact of unrealized losses to the total present value of future profits plus interest.

The discount rate we used to determine the present value of future profits was 12 percent.

The Company expects to amortize the balance of the present value of future profits as of December 31, 2009 as follows:  13 percent in 2010, 11 percent in 2011, 10 percent in 2012, 9 percent in 2013 and 7 percent in 2014.

Assets Held in Separate Accounts

Separate accounts are funds on which investment income and gains or losses accrue directly to certain policyholders.  The assets of these accounts are legally segregated.  They are not subject to the claims that may arise out of any other business of CNO.  We report separate account assets at fair value; the underlying investment risks are assumed by the contractholders.  We record the related liabilities at amounts equal to the separate account assets.  We record the fees earned for administrative and contractholder services performed for the separate accounts in insurance policy income.

Recognition of Insurance Policy Income and Related Benefits and Expenses on Insurance Contracts

For universal life and investment contracts that do not involve significant mortality or morbidity risk, the amounts collected from policyholders are considered deposits and are not included in revenue.  Revenues for these contracts consist of charges for policy administration, cost of insurance charges and surrender charges assessed against policyholders’ account balances.  Such revenues are recognized when the service or coverage is provided, or when the policy is surrendered.

We establish liabilities for investment and universal life products equal to the accumulated policy account values, which include an accumulation of deposit payments plus credited interest, less withdrawals and the amounts assessed against the policyholder through the end of the period.  Sales inducements provided to the policyholders of these products are recognized as liabilities over the period that the contract must remain in force to qualify for the inducement.  The options attributed to the policyholder related to our fixed index annuity products are accounted for as embedded derivatives as described in the section of this note entitled “Accounting for Derivatives”.

Traditional life and the majority of our accident and health products (including long-term care, Medicare supplement and supplemental health products) are long duration insurance contracts.  Premiums on these products are recognized as revenues when due from the policyholders.

We also have a small block of short duration accident and health products.  Premiums on these products are recognized as revenue over the premium coverage period.

 
89
 
CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



We establish liabilities for traditional life, accident and health insurance, and life contingent payment annuity products using mortality tables in general use in the United States, which are modified to reflect the Company’s actual experience when appropriate.  We establish liabilities for accident and health insurance products using morbidity tables based on the Company’s actual or expected experience.  These reserves are computed at amounts that, with additions from estimated future premiums received and with interest on such reserves at estimated future rates, are expected to be sufficient to meet our obligations under the terms of the policy.  Liabilities for future policy benefits are computed on a net-level premium method based upon assumptions as to future claim costs, investment yields, mortality, morbidity, withdrawals, policy dividends and maintenance expenses determined when the policies were issued (or with respect to policies inforce at August 31, 2003, the Company’s best estimate of such assumptions on the Effective Date).  We make an additional provision to allow for potential adverse deviation for some of our assumptions.  Once established, assumptions on these products are generally not changed unless a premium deficiency exists.  In that case, a premium deficiency reserve is recognized and the future pattern of reserve changes are modified to reflect the relationship of premiums to benefits based on the current best estimate of future claim costs, investment yields, mortality, morbidity, withdrawals, policy dividends and maintenance expenses, determined without an additional provision for potential adverse deviation.

We establish claim reserves based on our estimate of the loss to be incurred on reported claims plus estimates of incurred but unreported claims based on our past experience.

Accounting for Long-term Care Premium Rate Increases

Many of our long-term care policies were subject to premium rate increases in the three years ending December 31, 2009.  In some cases, these premium rate increases were materially consistent with the assumptions we used to value the particular block of business at the fresh-start date.  With respect to the 2006 premium rate increases, some of our policyholders were provided an option to cease paying their premiums and receive a non-forfeiture option in the form of a paid-up policy with limited benefits.  In addition, our policyholders could choose to reduce their coverage amounts and premiums in the same proportion, when permitted by our contracts or as required by regulators.  The following describes how we account for these policyholder options:

·  
Premium rate increases – If premium rate increases reflect a change in our previous rate increase assumptions, the new assumptions are not reflected prospectively in our reserves.  Instead, the additional premium revenue resulting from the rate increase is recognized as earned and original assumptions continue to be used to determine changes to liabilities for insurance products unless a premium deficiency exists.

·  
Benefit reductions – A policyholder may choose reduced coverage with a proportionate reduction in premium, when permitted by our contracts.  This option does not require additional underwriting.  Benefit reductions are treated as a partial lapse of coverage, and the balance of our reserves and deferred insurance acquisition costs is reduced in proportion to the reduced coverage.

·  
Non-forfeiture benefits offered in conjunction with a rate increase – In some cases, non-forfeiture benefits are offered to policyholders who wish to lapse their policies at the time of a significant rate increase.  In these cases, exercise of this option is treated as an extinguishment of the original contract and issuance of a new contract.  The balance of our reserves and deferred insurance acquisition costs are released, and a reserve for the new contract is established.

·  
Florida Order – In 2004, the Florida Office of Insurance Regulation issued an order to Washington National, regarding home health care business in Florida.  The order required Washington National to offer a choice of three alternatives to holders of home health care policies in Florida subject to premium rate increases as follows:

·  
retention of their current policy with a rate increase of 50 percent in the first year and actuarially justified increases in subsequent years;
 
·  
receipt of a replacement policy with reduced benefits and a rate increase in the first year of 25 percent and no more than 15 percent in subsequent years; or
 
·  
receipt of a paid-up policy, allowing the holder to file future claims up to 100 percent of the amount of premiums paid since the inception of the policy.
 

 
90
 
CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



 
Reserves for all three groups of policies under the order were prospectively adjusted using a prospective revision methodology, as these alternatives were required by the Florida Office of Insurance Regulation.  These policies had no insurance acquisition costs established at the Effective Date.

Some of our policyholders may receive a non-forfeiture benefit if they cease paying their premiums pursuant to their original contract (or pursuant to changes made to their original contract as a result of a litigation settlement made prior to the Effective Date or an order issued by the Florida Office of Insurance Regulation).  In these cases, exercise of this option is treated as the exercise of a policy benefit, and the reserve for premium paying benefits is reduced, and the reserve for the non-forfeiture benefit is adjusted to reflect the election of this benefit.

Accounting for marketing and reinsurance agreements with Coventry

Prescription Drug Benefit

The Medicare Prescription Drug, Improvement and Modernization Act of 2003 provided for the introduction of a prescription drug benefit (“PDP”).  In order to offer this product to our current and potential future policyholders without investing in management and infrastructure, we entered into a national distribution agreement with Coventry to use our career and independent agents to distribute Coventry’s prescription drug plan, Advantra Rx.  We receive a fee based on the premiums collected on plans sold through our distribution channels.  In addition, CNO has a quota-share reinsurance agreement with Coventry for CNO enrollees that provides CNO with 50 percent of net premiums and related policy benefits subject to a risk corridor.  The Part D program was effective January 1, 2006.

The following describes how we account for and report our PDP business:

Our accounting for the national distribution agreement

·  
For contracts sold prior to 2009, we recognize distribution and licensing fee income from Coventry based upon negotiated percentages of collected premiums on the underlying Medicare Part D contracts.  For contracts sold in 2009 and thereafter, we recognize distribution income based on a fixed fee per PDP contract.  This fee income is recognized over the calendar year term as premiums are collected.

·  
We also pay commissions to our agents who sell the plans on behalf of Coventry.  These payments are deferred and amortized over the remaining term of the initial enrollment period (the one-year life of the initial policy).

Our accounting for the quota-share agreement

·  
We recognize premium revenue evenly over the period of the underlying Medicare Part D contracts.

·  
We recognize policyholder benefits and ceding commission expense as incurred.

·  
We recognize risk-share premium adjustments consistent with Coventry’s risk-share agreement with the Centers for Medicare and Medicaid Services.

Private-Fee-For-Service

CNO expanded its strategic alliance with Coventry by entering into a national distribution agreement under which our career agents began distributing Coventry’s Private-Fee-For-Service (“PFFS”) plan, beginning January 1, 2007.  The Advantra Freedom product is a Medicare Advantage plan designed to provide seniors with more choices and better coverage at lower cost than original Medicare and Medicare Advantage plans offered through HMOs.  Under the agreement, we received a fee based on the number of PFFS plans sold through our distribution channels.  In addition, CNO had a quota-share reinsurance agreement with Coventry for CNO enrollees that provided CNO with a specified percentage of the net premiums and related profits.  Coventry decided to cease selling PFFS plans effective January 1, 2010.  In July 2009, we announced a strategic alliance under which we would offer Humana’s Medicare Advantage plans to our policyholders and consumers through our career agency force and will receive marketing fees based on sales.  Effective January 1, 2010, we will no longer be assuming the underwriting risk related to PFFS business.

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



We received distribution fees from Coventry and we paid sales commissions to our agents for these enrollments.  In addition, we received a specified percentage of the income (loss) related to this business pursuant to a quota-share agreement with Coventry.

The following summarizes our accounting and reporting practices for the PFFS business.

Our accounting for the distribution agreement

·  
We received distribution income from Coventry and other parties based on a fixed fee per PFFS contract.  This income was deferred and recognized over the remaining calendar year term of the initial enrollment period.

·  
We also paid commissions to our agents who sell the plans on behalf of Coventry and other parties.  These payments were deferred and amortized over the remaining term of the initial enrollment period (the one-year life of the initial policy).

Our accounting for the quota-share agreement

·  
We recognized revenue evenly over the period of the underlying PFFS contracts.

·  
We recognized policyholder benefits and ceding commission expense as incurred.

Large Group Private-Fee-For-Service Blocks

During 2007 and 2008, CNO entered into three quota-share reinsurance agreements with Coventry related to the PFFS business written by Coventry under two large group policies.  CNO received a specified percentage of the net premiums and related profits associated with this business as long as the ceded revenue margin (as defined in the quota-share reinsurance agreements) was less than or equal to five percent.  CNO also received a specified percentage of the net premiums and related profits on the ceded margin in excess of five percent.  In order to reduce the required statutory capital associated with the assumption of this business, CNO terminated two group policy quota-share agreements as of December 31, 2008 and terminated the last agreement on June 30, 2009.  Premiums assumed through these reinsurance agreements totaled $47.5 million in 2009.  The income before income taxes related to the assumed business was $14.0 million during the year ended December 31, 2009.

Reinsurance

In the normal course of business, we seek to limit our loss exposure on any single insured or to certain groups of policies by ceding reinsurance to other insurance enterprises.  We currently retain no more than $.8 million of mortality risk on any one policy.  We diversify the risk of reinsurance loss by using a number of reinsurers that have strong claims-paying ratings.  In each case, the ceding CNO subsidiary is directly liable for claims reinsured in the event the assuming company is unable to pay.

The cost of reinsurance on life and health coverages is recognized over the life of the reinsured policies using assumptions consistent with those used to account for the underlying policy.  The cost of reinsurance ceded totaled $179.4 million, $164.0 million and $202.4 million in 2009, 2008 and 2007, respectively.  We deduct this cost from insurance policy income.  Reinsurance recoveries netted against insurance policy benefits totaled $477.2 million, $536.3 million and $354.0 million in 2009, 2008 and 2007, respectively.

From time-to-time, we assume insurance from other companies.  Any costs associated with the assumption of insurance are amortized consistent with the method used to amortize deferred acquisition costs described above.  Reinsurance premiums assumed totaled $475.5 million, $641.0 million and $307.8 million in 2009, 2008 and 2007, respectively. Reinsurance premiums included amounts assumed pursuant to marketing and quota-share agreements with Coventry of $444.3 million, $609.5 million and $271.4 million in 2009, 2008 and 2007, respectively.  Such premiums assumed included group policy quota-share agreements whereby we assumed:  (i) a specified percentage of the PFFS business written by Coventry under a large group policy effective July 1, 2007 (which was terminated on June 30, 2009); and (ii) a specified percentage of the PFFS business written by Coventry under another large group policy effective May 1, 2008 (which was terminated on December 31, 2008).

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



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

On October 12, 2007, we completed a transaction to coinsure 100 percent of most of the older inforce fixed index annuity and fixed annuity business of three of our insurance subsidiaries with Reassure America Life Insurance Company (“REALIC”), a subsidiary of Swiss Re Life & Health America Inc.  The transaction was recorded in our financial statements on September 28, 2007, the date the parties were bound by the coinsurance agreement and all regulatory approvals had been obtained.  In the transaction, REALIC:  (i) paid a ceding commission of $76.5 million; and (ii) assumed the investment and persistency risk of these policies.  Our insurance subsidiaries ceded approximately $2.8 billion of policy and other reserves to REALIC, as well as transferred the invested assets backing these policies on October 12, 2007.  Our insurance subsidiaries remain primarily liable to the policyholders in the event REALIC does not fulfill its obligations under the agreements.  Accordingly, our insurance liabilities continue to include the amounts ceded for these policies, which is offset by a corresponding amount in reinsurance receivables.  The coinsurance transaction had an effective date of January 1, 2007.

Pursuant to the terms of the annuity coinsurance agreement, the ceding commission was based on the January 1, 2007 value of the assets and liabilities related to the ceded block.  The earnings (loss) after income taxes on the business from January 1, 2007 through September 28, 2007, resulted in increases (decreases) to the loss calculated as of January 1, 2007.  Such after-tax earnings (loss) include the fair value declines on invested assets transferred to the reinsurer occurring during the first three quarters of 2007.

The following summarizes the profits and losses recognized on this business in 2007 (dollars in millions):

   
2007
    
         
Net earnings on the block before tax                                                                                             
   $ 17.0    
           
Realized investment losses, net of amortization of insurance intangibles
     (40.6 )  
           
Loss related to the annuity coinsurance transaction                                                                                             
     (76.5 )
(a)
           
Net loss before income taxes                                                                                             
   $ (100.1 )  
____________
(a)  
Amount represents the net loss before income taxes recognized on the annuity coinsurance transaction during 2007, including the earnings and losses on the block during that period and the loss recognized upon completion of the transaction.  The following summarizes the components of the loss before income taxes (dollars in millions):

Assets received (transferred)
      
Investments                                                                   
   $ (2,560.8 )
Accrued investment income                                                                   
     (28.7 )
Present value of future profits                                                                   
     (198.9 )
Deferred acquisition costs                                                                   
     (20.5 )
Reinsurance receivables                                                                   
     2,764.3  
Other                                                                   
     (31.9 )
         
Net loss before income taxes                                                                 
   $ (76.5 )

In 2007, we completed the recapture of a block of traditional life insurance in force that had been ceded in 2002 to REALIC.  In the transaction, which had an effective date of October 1, 2007, Colonial Penn paid REALIC a recapture fee of $63 million.  The recapture of this block resulted in a $2.8 million gain accounted for as a reduction to insurance policy benefits.  Colonial Penn recaptured 100 percent of the liability for the future benefits previously ceded, and will recognize profits from the block as they emerge over time.  Colonial Penn already administers the policies that were recaptured.

In 2008, Bankers Life entered into a reinsurance agreement, as amended, pursuant to which it ceded 70 percent of its new 2008 and 2009 long-term care business, excluding certain business sold in the state of Florida.  The amount reinsured decreases to 50 percent in the first quarter of 2010 and to 25 percent thereafter.  The pre-tax impact of this reinsurance agreement was not significant in 2008.

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



In September 2009, we completed a transaction under which Washington National and Conseco Insurance Company coinsured, with an effective date of January 1, 2009, about 104,000 non-core life insurance policies in the Other CNO Business segment with Wilton Reassurance Company (“Wilton Re”).  In the transaction, Wilton Re paid a ceding commission of $55.8 million and will coinsure and administer 100 percent of these policies.  The CNO insurance companies transferred to Wilton Re $401.6 million in cash and policy loans and $457.4 million of policy and other reserves.  Most of the policies involved in the transaction were issued by companies prior to their acquisition by CNO.  Approximately 70 percent of the policies being coinsured are from Washington National; the remainder are from Conseco Insurance Company.  We recorded a deferred gain of approximately $26 million in 2009 which will be recognized over the remaining life of the block of insurance policies coinsured with Wilton Re. We also increased our deferred tax valuation allowance by $20 million in 2009 as a result of reassessing the recovery of our deferred tax assets upon completion of the transaction.

In November 2009, we entered into a transaction under which Bankers Life coinsured, with an effective date of October 1, 2009, about 234,000 life insurance policies with Wilton Re.  In the transaction, Wilton Re paid a ceding commission of $44 million and will 50% coinsure these policies, which will continue to be administered by Bankers Life.  In the transaction, Bankers Life transferred to Wilton Re $73 million in investment securities and policy loans and $117 million of policy and other reserves.  As a result of the transaction, we recorded an increase to our deferred tax valuation allowance of $18 million in 2009, as a result of reassessing the recovery of our deferred tax assets upon completion of the transaction.  We also recorded a pre-tax deferred cost of reinsurance of $32 million, which, in accordance with GAAP, will be amortized over the life of the block.

Income Taxes

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

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

At December 31, 2009, our valuation allowance for our net deferred tax assets was $1.2 billion as we have determined that it is more likely than not that a portion of our deferred tax assets will not be realized.  This determination was made by evaluating each component of the deferred tax asset and assessing the effects of limitations and/or interpretations on the value of such component to be fully recognized in the future.

Investment Borrowings

One of the Company’s insurance subsidiaries (Conseco Life) is a member of the Federal Home Loan Bank of Indianapolis (“FHLBI”).  As a member of the FHLBI, Conseco Life has the ability to borrow on a collateralized basis from FHLBI.  Conseco Life is required to hold a certain minimum amount of FHLBI common stock as a requirement of membership in the FHLBI, and additional amounts based on the amount of the borrowings.  At December 31, 2009, the carrying value of the FHLBI common stock was $22.5 million.  Collateralized borrowings from the FHLBI totaled $450.0 million as of December 31, 2009, and the proceeds were used to purchase fixed maturity securities.  The borrowings are classified as investment borrowings in the accompanying consolidated balance sheet.  The borrowings are collateralized by investments with an estimated fair value of $508.2 million at December 31, 2009, which are maintained in a custodial account for the benefit of the FHLBI.  Such investments are classified as fixed maturities, available for sale, in our

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________


consolidated balance sheet.  Conseco Life recognized interest expense of $20.3 million, $21.9 million and $16.7 million in 2009, 2008 and 2007, respectively, related to the borrowings.

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

Amount
  
Maturity
  
Interest rate
borrowed
  
date
  
at December 31, 2009
         
$ 54.0  
May 2012
  
Variable rate – .267%
  37.0  
July 2012
  
Fixed rate – 5.540%
  13.0  
July 2012
  
Variable rate – .344%
  146.0  
November 2015
  
Fixed rate – 5.300%
  100.0  
November 2015
  
Fixed rate – 4.890%
  100.0  
December 2015
  
Fixed rate – 4.710%

The variable rate borrowings are pre-payable on each interest reset date without penalty.  The fixed rate borrowings are pre-payable subject to payment of a yield maintenance fee based on current market interest rates.  At December 31, 2009, the aggregate fee to prepay all fixed rate borrowings was $43.8 million.

At December 31, 2009, investment borrowings consisted of:  (i) collateralized borrowings from the FHLBI of $450.0 million; (ii) $229.1 million of securities issued to other entities by a variable interest entity (“VIE”) which is consolidated in our financial statements as further discussed in the note to the consolidated financial statements entitled “Investment in a Variable Interest Entity”; and (iii) other borrowings of $4.8 million.

At December 31, 2008, investment borrowings consisted of:  (i) collateralized borrowings of $450.0 million; (ii) $311.7 million of securities issued to other entities by a VIE which is consolidated in our financial statements; and (iii) other borrowings of $5.8 million.

Accounting for Derivatives

Our fixed index annuity products provide a guaranteed base rate of return and a higher potential return that is based on a percentage (the “participation rate”) of the amount of increase in the value of a particular index, such as the Standard & Poor’s 500 Index, over a specified period.  Typically, on each policy anniversary date, a new index period begins.  We are generally able to change the participation rate at the beginning of each index period during a policy year, subject to contractual minimums.  We typically buy call options or call spreads referenced to the applicable indices in an effort to hedge potential increases to policyholder benefits resulting from increases in the particular index to which the product’s return is linked.  We reflect changes in the estimated fair value of these options in net investment income (classified as investment income from policyholder and reinsurer accounts and other special-purpose portfolios).  Net investment gains (losses) related to fixed index products were $50.7 million, $(104.3) million and $(8.5) million during 2009, 2008 and 2007, respectively. These amounts were substantially offset by a corresponding charge to insurance policy benefits.  The estimated fair value of these options was $114.9 million and $17.6 million at December 31, 2009 and 2008, respectively.  We classify these instruments as other invested assets.

The Company accounts for the options attributed to the policyholder for the estimated life of the annuity contract as embedded derivatives.  The expected future cost of options on fixed index annuity products is used to determine the value of embedded derivatives.  While the Company does not purchase options to hedge liabilities which may arise after the current policy anniversary date, the Company must value the related forward embedded options in the policies at fair value.  These accounting requirements often create volatility in the earnings from these products.  We record the changes in the fair values of the embedded derivatives in current earnings as a component of policyholder benefits.  Effective January 1, 2008, we adopted authoritative guidance related to fair value measurements which required us to value the embedded derivatives reflecting a hypothetical market perspective for fair value measurement.  We recorded a charge of $1.8 million to net income (after the effects of the amortization of the present value of future profits and deferred acquisition costs (collectively referred to as “amortization of insurance acquisition costs”) and income taxes), attributable to changes in the fair value of the embedded derivatives as a result of adopting such guidance.  The fair value of these derivatives, which are classified as “liabilities for interest-sensitive products”, was $494.4 million and $430.6 million at December 31, 2009 and 2008, respectively.  We maintain a specific block of investments in our trading securities account, which we carry at estimated fair value with changes in such value recognized as investment income (classified as investment income from policyholder and

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________


reinsurer accounts and other special-purpose portfolios).  The change in value of these trading securities attributable to interest fluctuations is intended to offset a portion of the change in the value of the embedded derivative.

If the counterparties for the derivatives we hold fail to meet their obligations, we may have to recognize a loss.  We limit our exposure to such a loss by diversifying among several counterparties believed to be strong and creditworthy.  At December 31, 2009, all of our counterparties were rated “A-” or higher by Standard & Poor’s Corporation (“S&P”).

Certain of our reinsurance payable balances contain embedded derivatives.  Such derivatives had an estimated fair value of $1.6 million and $6.6 million at December 31, 2009 and 2008, respectively.  We record the change in the fair value of these derivatives as a component of investment income (classified as investment income from policyholder and reinsurer accounts and other special-purpose portfolios).  We maintain a specific block of investments related to these agreements in our trading securities account, which we carry at estimated fair value with changes in such value recognized as investment income (also classified as investment income from policyholder and reinsurer accounts and other special-purpose portfolios).  The change in value of these trading securities attributable to interest fluctuations is intended to offset the change in value of the embedded derivatives.  However, differences will occur as corporate spreads change.

Multibucket Annuity Product

The Company’s multibucket annuity is an annuity product that credits interest based on the experience of a particular market strategy.  Policyholders allocate their annuity premium payments to several different market strategies based on different asset classes within the Company’s investment portfolio.  Interest is credited to this product based on the market return of the given strategy, less management fees, and funds may be moved between different strategies.  The Company guarantees a minimum return of premium plus approximately 3 percent per annum over the life of the contract.  The investments backing the market strategies of these products are designated by the Company as trading securities.  The change in the fair value of these securities is recognized as investment income (classified as income from policyholder and reinsurer accounts and other special-purpose portfolios), which is substantially offset by the change in insurance policy benefits for these products.  As of December 31, 2009, we hold insurance liabilities of $70.6 million related to multibucket annuity products.

Stock Based Compensation

Prior to January 1, 2006, we measured compensation cost for our stock option plans using the intrinsic value method.  Under this method, compensation cost was recorded when the quoted market price at the grant date exceeded the amount an employee had to pay to acquire the stock.  When the Company issued employee stock options with an exercise price equal to or greater than the market price of our stock on the grant date, no compensation cost was recorded.  Authoritative guidance required disclosures of the pro forma effects of using the fair value method of accounting for stock options.

In December 2004, the FASB issued authoritative guidance which provided additional guidance on accounting for share-based payments and required all such awards to be measured at fair value with the related compensation cost recognized in the statement of operations over the related service period.  CNO implemented the guidance using the modified prospective method on January 1, 2006.  Under this method, the Company began recognizing compensation cost for all awards granted on or after January 1, 2006.  In addition, we are required to recognize compensation cost over the remaining requisite service period for the portion of outstanding awards that were not vested as of January 1, 2006 and were not previously expensed on a pro forma basis pursuant to the guidance.  The guidance also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow rather than as an operating cash flow, as previously required.  During 2009 and 2008, we did not capitalize any stock-based compensation expense as deferred acquisition costs or any other asset category.

Fair Value Measurements

Effective January 1, 2008, we adopted authoritative guidance which clarifies a number of considerations with respect to fair value measurement objectives for financial reporting and expands disclosures about the use of fair value measurements.  The guidance is intended to increase consistency and comparability among fair value estimates used in financial reporting and the disclosure requirements are intended to provide users of financial statements with the ability to assess the reliability of an entity’s fair value measurements.  The initial adoption of the guidance resulted in a charge of $1.8 million to net income (after the effects of the amortization of insurance acquisition costs and income taxes) in the first quarter of 2008, attributable to changes in the liability for the embedded derivatives associated with our fixed index annuity products.  The change resulted from the incorporation of risk margins into the estimated fair value calculation for this liability.

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



Definition of Fair Value

Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date and, therefore, represents an exit price, not an entry price.  We hold fixed maturities, equity securities, derivatives, separate account assets and embedded derivatives, which are carried at fair value.

The degree of judgment utilized in measuring the fair value of financial instruments is largely dependent on the level to which pricing is based on observable inputs.  Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect our view of market assumptions in the absence of observable market information.  Financial instruments with readily available active quoted prices would be considered to have fair values based on the highest level of observable inputs, and little judgment would be utilized in measuring fair value.  Financial instruments that rarely trade would be considered to have fair value based on a lower level of observable inputs, and more judgment would be utilized in measuring fair value.

Valuation Hierarchy

There is a three-level hierarchy for valuing assets or liabilities at fair value based on whether inputs are observable or unobservable.

·  
Level 1 – includes assets and liabilities valued using inputs that are quoted prices in active markets for identical assets or liabilities.  Our Level 1 assets include exchange traded securities and U.S. Treasury securities.

·  
Level 2 – includes assets and liabilities valued using inputs that are quoted prices for similar assets in an active market, quoted prices for identical or similar assets in a market that is not active, observable inputs, or observable inputs that can be corroborated by market data.  Level 2 assets and liabilities include those financial instruments that are valued by independent pricing services using models or other valuation methodologies.  These models are primarily industry-standard models that consider various inputs such as interest rate, credit spread, reported trades, broker/dealer quotes, issuer spreads and other inputs that are observable or derived from observable information in the marketplace or are supported by observable levels at which transactions are executed in the marketplace.  Financial instruments in this category primarily include:  certain public and private corporate fixed maturity securities; certain government or agency securities; certain mortgage and asset-backed securities; and non-exchange-traded derivatives such as call options to hedge liabilities related to our fixed index annuity products.

·  
Level 3 – includes assets and liabilities valued using unobservable inputs that are used in model-based valuations that contain management assumptions.  Level 3 assets and liabilities include those financial instruments whose fair value is estimated based on non-binding broker prices or internally developed models or methodologies utilizing significant inputs not based on, or corroborated by, readily available market information.  Financial instruments in this category include certain corporate securities (primarily private placements), certain mortgage and asset-backed securities, and other less liquid securities.  Additionally, the Company’s liabilities for embedded derivatives (including embedded derivates related to our fixed index annuity products and to a modified coinsurance arrangement) are classified in Level 3 since their values include significant unobservable inputs including actuarial assumptions.

At each reporting date, we classify assets and liabilities into the three input levels based on the lowest level of input that is significant to the measurement of fair value for each asset and liability reported at fair value.  This classification is impacted by a number of factors, including the type of financial instrument, whether the financial instrument is new to the market and not yet established, the characteristics specific to the transaction and overall market conditions.  Our assessment of the significance of a particular input to the fair value measurement and the ultimate classification of each asset and liability requires judgment.

The vast majority of our fixed maturity securities and separate account assets use Level 2 inputs for the determination of fair value.  These fair values are obtained primarily from independent pricing services, which use Level 2 inputs for the determination of fair value.  Substantially all of our Level 2 fixed maturity securities and separate account assets were valued from independent pricing services.  Third party pricing services normally derive the security prices through recently reported trades for identical or similar securities making adjustments through the reporting date based upon available market

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________


observable information.  If there are no recently reported trades, the third party pricing services may use matrix or model processes to develop a security price where future cash flow expectations are developed and discounted at an estimated risk-adjusted market rate.  The number of prices obtained is dependent on the Company’s analysis of such prices as further described below.

For securities that are not priced by pricing services and may not be reliably priced using pricing models, we obtain broker quotes.  These broker quotes are non-binding and represent an exit price, but assumptions used to establish the fair value may not be observable and therefore represent Level 3 inputs.  Approximately 6 percent and 1 percent of our Level 3 fixed maturity securities were valued using broker quotes or independent pricing services, respectively.  The remaining Level 3 fixed maturity investments do not have readily determinable market prices and/or observable inputs.  For these securities, we use internally developed valuations.  Key assumptions used to determine fair value for these securities may include risk-free rates, risk premiums, performance of underlying collateral and other factors involving significant assumptions which may not be reflective of an active market.  For certain investments, we use a matrix or model process to develop a security price where future cash flow expectations are developed and discounted at an estimated market rate.  The pricing matrix utilizes a spread level to determine the market price for a security.  The credit spread generally incorporates the issuer’s credit rating and other factors relating to the issuer’s industry and the security’s maturity.  In some instances, issuer-specific spread adjustments, which can be positive or negative, are made based upon internal analysis of security specifics such as liquidity, deal size and time to maturity.

Privately placed securities comprise approximately 79 percent of our fixed maturities, available for sale, classified as Level 3.  Privately placed securities are classified as Level 3 when their valuation is based on internal valuation models which rely on significant inputs that are not observable in the market.  Our model applies spreads above the risk-free rate which are determined based on comparison to securities with similar ratings, maturities and industries that are rated by independent third party rating agencies.  Our process also considers the ratings assigned by the National Association of Insurance Commissioners (the “NAIC”) to the Level 3 securities on an annual basis.  Each quarter, a review is performed to determine the reasonableness of the initial valuations from the model.  If an initial valuation appears unreasonable based on our knowledge of a security and current market conditions, we make appropriate adjustments to our valuation inputs.  The remaining securities classified as Level 3 are primarily valued based on internally developed models using estimated future cash flows.  

For certain Level 3 assets, we have increased our default assumptions based on our review of the underlying collateral. The changes in our assumptions resulted in lower cash flow estimates for some of our subordinated tranches and have resulted in such securities being impaired.  The default rate we expect to experience related to the collateral underlying the subordinated tranches increased from 1.7 percent to 7.6 percent for the experience expected in 2009; from .8 percent to 3.2 percent for 2010; and from .8 percent to 1.5 percent for each year subsequent to 2010.  However, the changes in assumptions did not change our cash flow estimates for the non-subordinated tranches within our Level 3 investments.  We recognized other-than-temporary impairments on securities classified as Level 3 investments of $26.7 million (including $16.1 million of impairment losses recognized through accumulated other comprehensive loss) during 2009.

As the Company is responsible for the determination of fair value, we perform monthly quantitative and qualitative analysis on the prices received from third parties to determine whether the prices are reasonable estimates of fair value.  The Company’s analysis includes:  (i) a review of the methodology used by third party pricing services; (ii) a comparison of pricing services’ valuation to other pricing services’ valuations for the same security; (iii) a review of month to month price fluctuations; (iv) a review to ensure valuations are not unreasonably stale; and (v) back testing to compare actual purchase and sale transactions with valuations received from third parties.  As a result of such procedures, the Company may conclude the prices received from third parties are not reflective of current market conditions.  In those instances, we may request additional pricing quotes or apply internally developed valuations.  However, the number of instances is insignificant and the aggregate change in value of such investments is not materially different from the original prices received.

The categorization of the fair value measurements of our investments priced by independent pricing services was based upon the Company’s judgment of the inputs or methodologies used by the independent pricing services to value different asset classes.  Such inputs include:  benchmark yields, reported trades, broker dealer quotes, issuer spreads, benchmark securities, bids, offers and reference data.  The Company categorizes such fair value measurements based upon asset classes and the underlying observable or unobservable inputs used to value such investments.

The classification of fair value measurements for derivative instruments, including embedded derivatives requiring bifurcation, is determined based on the consideration of several inputs including closing exchange or over-the-counter market

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
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price quotations; time value and volatility factors underlying options; market interest rates; and non-performance risk.  For certain embedded derivatives, we may use actuarial assumptions in the determination of fair value.

The categorization of fair value measurements, by input level, for our fixed maturity securities, equity securities, trading securities, certain other invested assets, assets held in separate accounts and embedded derivative instruments included in liabilities for insurance products at December 31, 2009 is as follows (dollars in millions):

   
Quoted prices
                        
   
in active
    
Significant
                  
   
markets for
    
other
      
Significant
          
   
identical assets
    
observable
      
unobservable
          
   
or liabilities
    
inputs
      
inputs
          
   
(Level 1)
    
(Level 2)
      
(Level 3)
      
Total
  
                             
Assets:
                            
Fixed maturities, available for sale
   $ 56.5     $ 16,074.0       $ 2,397.9       $ 18,528.4  
Equity securities
     .1       -         30.9         31.0  
Trading securities
     4.3       285.3         3.7         293.3  
Securities lending collateral
     -       97.2         36.6         133.8  
Other invested assets
     -       192.6  
(a)
     2.4  
(b)
     195.0  
Assets held in separate accounts
     -       17.3         -         17.3  
                                     
Liabilities:
                                    
Liabilities for insurance products:
                                    
Interest-sensitive products                                             
     -       -         496.0  
(c)
     496.0  
_____________
(a)  
Includes company-owned life insurance and derivatives.
(b)  
Includes equity-like holdings in special-purpose entities.
(c)  
Includes $494.4 million of embedded derivatives associated with our fixed index annuity products and $1.6 million of embedded derivatives associated with a modified coinsurance agreement.

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



The categorization of fair value measurements, by input level, for our fixed maturity securities, equity securities, trading securities, certain other invested assets, assets held in separate accounts and embedded derivative instruments included in liabilities for insurance products at December 31, 2008 is as follows (dollars in millions):

   
Quoted prices
                        
   
in active
    
Significant
                  
   
markets for
    
other
      
Significant
          
   
identical assets
    
observable
      
unobservable
          
   
or liabilities
    
inputs
      
inputs
          
   
(Level 1)
    
(Level 2)
      
(Level 3)
      
Total
  
                             
Assets:
                            
Fixed maturities, available for sale
   $ 74.9     $ 13,326.0       $ 1,876.1       $ 15,277.0  
Equity securities                                               
     -       -         32.4         32.4  
Trading securities                                               
     8.8       315.0         2.7         326.5  
Securities lending collateral
     -       170.3         48.1         218.4  
Other invested assets
     -       55.9  
(a)
     2.3  
(b)
     58.2  
Assets held in separate accounts
     -       18.2         -         18.2  
                                     
Liabilities:
                                    
Liabilities for insurance products:
                                    
Interest-sensitive products
     -       -         437.2  
(c)
     437.2  
_____________
 
(a)
Includes company-owned life insurance and derivatives.
 
(b)
Includes equity-like holdings in special-purpose entities.
 
(c)
Includes $430.6 million of embedded derivatives associated with our fixed index annuity products and $6.6 million of embedded derivatives associated with a modified coinsurance agreement.

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



The following table presents additional information about assets and liabilities measured at fair value on a recurring basis and for which we have utilized significant unobservable (Level 3) inputs to determine fair value for the year ended December 31, 2009 (dollars in millions):

                                 
Embedded
  
                                 
derivative
  
                                 
instruments
  
   
Fixed
                            
included in
  
   
maturities,
                
Securities
    
Other
    
liabilities for
  
   
available
    
Equity
    
Trading
    
lending
    
invested
    
insurance
  
   
for sale
    
securities
    
securities
    
collateral
    
assets
    
products
  
                                     
Assets:
                                    
Beginning balance as of December 31, 2008
   $ 1,876.1     $ 32.4     $ 2.7     $ 48.1     $ 2.3     $ (437.2 )
Purchases, sales, issuances and settlements, net
     199.1       (.3 )     -       (17.1 )     -       (63.8 )
Total realized and unrealized gains (losses):
                                                
Included in net loss
     (15.2 )     -       1.0       (.9 )     (3.4 )     5.0  
Included in other comprehensive income (loss)
     327.5       (1.2 )     -       (9.4 )     3.5       -  
Transfers into Level 3
     32.2       -       -       20.4       -       -  
Transfers out of Level 3 (a)
     (21.8 )     -       -       (4.5 )     -       -  
                                                 
Ending balance as of December 31, 2009
   $ 2,397.9     $ 30.9     $ 3.7     $ 36.6     $ 2.4     $ (496.0 )
                                                 
Amount of total gains (losses) for the year ended December 31, 2009 included in our net loss relating to assets and liabilities still held as of the reporting date
   $ (3.9 )   $ -     $ 1.0     $ (.9 )   $ (3.4 )   $ 7.3  
___________
 
(a)
Transfers out of Level 3 are reported as having occurred at the beginning of the period.


 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



The following table presents additional information about assets and liabilities measured at fair value on a recurring basis and for which we have utilized significant unobservable (Level 3) inputs to determine fair value for the year ended December 31, 2008 (dollars in millions):

                                 
Embedded
  
                                 
derivative
  
                                 
instruments
  
   
Fixed
                            
included in
  
   
maturities,
                
Securities
    
Other
    
liabilities for
  
   
available
    
Equity
    
Trading
    
lending
    
invested
    
insurance
  
   
for sale
    
securities
    
securities
    
collateral
    
assets
    
products
  
                                     
Assets:
                                    
Beginning balance as of December 31, 2007 
   $ 1,753.3     $ 34.5     $ 11.8     $ 105.7     $ 4.3     $ (354.6 )
Purchases, sales, issuances and settlements, net
     465.4       (3.0 )     (6.3 )     (18.7 )     (1.4 )     (10.6 )
Total realized and unrealized gains (losses):
                                                
Included in net loss
     (18.9 )     -       (2.3 )     -       .9       (72.0 )
Included in other comprehensive income (loss)
     (247.9 )     .9       -       (2.6 )     (1.5 )     -  
Transfers into Level 3
     33.4       -       -       -       -       -  
Transfers out of Level 3 (a)
     (109.2 )     -       (.5 )     (36.3 )     -       -  
                                                 
Ending balance as of December 31, 2008
   $ 1,876.1     $ 32.4     $ 2.7     $ 48.1     $ 2.3     $ (437.2 )
                                                 
Amount of total gains (losses) for the year ended December 31, 2008 included in our net loss relating to assets and liabilities still held as of the reporting date
   $ (5.6 )   $ -     $ (1.6 )   $ -     $ .9     $ (72.0 )
___________
 
(a)
Transfers out of Level 3 are reported as having occurred at the beginning of the period.

At December 31, 2009, 86 percent of our Level 3 fixed maturities, available for sale, were investment grade and 94 percent of our Level 3 fixed maturities, available for sale, consisted of corporate securities.

Realized and unrealized investment gains and losses presented in the preceding tables represent gains and losses during the time the applicable financial instruments were classified as Level 3.

Realized and unrealized gains (losses) on Level 3 assets are primarily reported in either net investment income for policyholder and reinsurer accounts and other special purpose portfolios, net realized investment gains (losses) or insurance policy benefits within the consolidated statement of operations or other comprehensive income (loss) within shareholders’ equity based on the appropriate accounting treatment for the instrument.

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



Purchases, sales, issuances and settlements, net, represent the activity that occurred during the period that results in a change of the asset or liability but does not represent changes in fair value for the instruments held at the beginning of the period.  Such activity primarily consists of purchases and sales of fixed maturity, equity and trading securities, purchases and settlements of derivative instruments, and changes to embedded derivative instruments related to insurance products resulting from the issuance of new contracts, or changes to existing contracts.

We review the fair value hierarchy classifications each reporting period.  Transfers in and/or (out) of Level 3 in 2009 were primarily due to changes in the observability of the valuation attributes resulting in a reclassification of certain financial assets or liabilities.  Such reclassifications are reported as transfers in and out of Level 3 at the beginning fair value for the reporting period in which the changes occur.

The amount presented for gains (losses) included in our net loss for assets and liabilities still held as of the reporting date primarily represents impairments for fixed maturities, available for sale, changes in fair value of trading securities and certain derivatives and changes in fair value of embedded derivative instruments included in liabilities for insurance products that exist as of the reporting date.

We use the following methods and assumptions to determine the estimated fair values of other financial instruments:

Cash and cash equivalents.  The carrying amount for these instruments approximates their estimated fair value.

Mortgage loans and policy loans.  We discount future expected cash flows for loans included in our investment portfolio based on interest rates currently being offered for similar loans to borrowers with similar credit ratings.  We aggregate loans with similar characteristics in our calculations.  The fair value of policy loans approximates their carrying value.

Other invested assets.  We use quoted market prices, where available.  When quotes are not available, we estimate the fair value based on discounted future expected cash flows or independent transactions which establish a value for our investment.

Insurance liabilities for interest-sensitive products.  We discount future expected cash flows based on interest rates currently being offered for similar contracts with similar maturities.

Investment borrowings and notes payable.  For publicly traded debt, we use current fair values.  For other notes, we use discounted cash flow analyses based on our current incremental borrowing rates for similar types of borrowing arrangements.

 
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Notes to Consolidated Financial Statements
__________________



The estimated fair values of our financial instruments at December 31, 2009 and 2008, were as follows (dollars in millions):

   
2009
    
2008
  
   
Carrying
    
Fair
    
Carrying
    
Fair
  
   
Amount
    
Value
    
Amount
    
Value
  
                         
Financial assets:
                        
Fixed maturities, available for sale
   $ 18,528.4     $ 18,528.4     $ 15,277.0     $ 15,277.0  
Equity securities                                                
     31.0       31.0       32.4       32.4  
Mortgage loans                                                
     1,965.5       1,756.8       2,159.4       2,122.1  
Policy loans                                                
     295.2       295.2       363.5       363.5  
Trading securities                                                
     293.3       293.3       326.5       326.5  
Securities lending collateral                                                
     180.0       180.0       393.7       393.7  
Other invested assets                                                
     236.8       236.8       95.0       95.0  
Cash and cash equivalents                                                
     526.8       526.8       899.3       899.3  
                                 
Financial liabilities:
                                
Insurance liabilities for interest-sensitive products (a)
   $ 13,219.2     $ 13,219.2     $ 13,332.8     $ 13,332.8  
Investment borrowings                                                
     683.9       683.9       767.5       767.5  
Notes payable – direct corporate obligations
     1,037.4       1,041.7       1,311.5       777.3  
____________________
(a)  
The estimated fair value of insurance liabilities for interest-sensitive products was approximately equal to its carrying value at December 31, 2009 and 2008.  This was because interest rates credited on the vast majority of account balances approximate current rates paid on similar products and because these rates are not generally guaranteed beyond one year.

Sales Inducements

Certain of our annuity products offer sales inducements to contract holders in the form of enhanced crediting rates or bonus payments in the initial period of the contract.  Certain of our life insurance products offer persistency bonuses credited to the contract holders balance after the policy has been outstanding for a specified period of time.  These enhanced rates and persistency bonuses are considered sales inducements in accordance with GAAP.  Such amounts are deferred and amortized in the same manner as deferred acquisition costs.  Sales inducements deferred totaled $28.4 million, $47.1 million and $52.4 million in 2009, 2008 and 2007, respectively.  Amounts amortized totaled $30.2 million, $16.7 million and $18.4 million in 2009, 2008 and 2007, respectively.  The unamortized balance of deferred sales inducements was $177.6 million and $179.4 million at December 31, 2009 and 2008, respectively.  The balance of insurance liabilities for persistency bonus benefits was $136.2 million and $195.9 million at December 31, 2009 and 2008, respectively.

Out-of-Period Adjustments

We recorded the net effects of certain out-of-period adjustments which decreased our net income by $2.7 million (or one cent per diluted share) in 2009.  We evaluated these errors taking into account both qualitative and quantitative factors and considered the impact of these errors in relation to 2009, as well as the materiality to the periods in which they originated.  The impact of correcting these errors in prior years was not significant to any individual period.   Management believes these errors are immaterial to the consolidated annual financial statements.

Recently Issued Accounting Standards

Pending Accounting Standards

In January 2010, the FASB issued authoritative guidance which requires new disclosures and clarifies existing disclosure requirements related to fair value.  An entity will be required to disclose significant transfers in and out of Levels 1 and 2 of the fair value hierarchy, and separately present information related to purchases, sales, issuances and settlements in the reconciliation of fair value measurements classified as Level 3.  In addition, the guidance amends the fair value disclosure

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________


requirement for pension and postretirement benefit plan assets to require this disclosure at the investment class level.  The guidance will be effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures related to purchases, sales, issuances and settlements for Level 3 fair value measurements, which are effective for reporting periods beginning after December 15, 2010.  We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.

In June 2009, the FASB issued authoritative guidance that requires an entity to perform a qualitative analysis to determine whether a primary beneficiary interest is held in a VIE.  Under the new qualitative model, the primary beneficiary must have both the power to direct the activities of the VIE and the obligation to absorb either losses or gains that could be significant to the VIE.  The guidance also requires ongoing reassessments to determine whether a primary beneficiary interest is held and additional disclosures, including the financial statement effects of the entity’s involvement with VIEs.  The guidance will be effective as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period, and for interim and annual reporting periods thereafter.  Earlier application is prohibited.  The Company is in the process of evaluating the impact the guidance will have on its consolidated financial statements.

In June 2009, the FASB issued authoritative guidance that is intended to improve the relevance, representational faithfulness, and comparability of the information that a reporting entity provides in its financial statements about a transfer of financial assets; the effects of a transfer on its financial position, financial performance, and cash flows; and a transferor’s continuing involvement, if any, in transferred financial assets.  The guidance must be applied as of the beginning of each reporting entity’s first annual reporting period that begins after November 15, 2009, for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter.  Earlier application is prohibited.  The guidance must be applied to transfers occurring on or after the effective date.  Additionally, on or after the effective date, the concept of a qualifying special-purpose entity is no longer relevant for accounting purposes.  Therefore, formerly qualifying special-purpose entities (as defined under previous accounting standards) should be evaluated for consolidation by reporting entities on and after the effective date in accordance with the applicable consolidation guidance.  If the evaluation on the effective date results in consolidation, the reporting entity should apply the transition guidance provided in the pronouncement that requires consolidation.  We do not expect the adoption of this guidance to have a material impact on our consolidated financial statements.

Adopted Accounting Standards

In June 2009, the FASB issued “The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles” which established the FASB Accounting Standards Codification (“Codification”) as the single source of authoritative accounting principles in the preparation of financial statements in conformity with GAAP. Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants.  The FASB will no longer issue new standards in the form of Statements, FASB Staff Positions or Emerging Issues Task Force Abstracts; instead the FASB will issue Accounting Standards Updates.  Accounting Standards Updates will not be authoritative in their own right as they will only serve to update the Codification.  These changes and the Codification itself do not change GAAP. Codification was effective for financial statements issued for interim and annual periods ending after September 15, 2009.  Other than the manner in which new accounting guidance is referenced, the adoption of Codification had no impact on our consolidated financial statements.

In May 2009, the FASB issued authoritative guidance that established general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued or are available to be issued.  In particular, the guidance sets forth:  (i) the period after the balance sheet date during which management of a reporting entity should evaluate events or transactions that may occur for potential recognition or disclosure in the financial statements; (ii) the circumstances under which an entity should recognize events or transactions occurring after the balance sheet date in its financial statements; and (iii) the disclosures that an entity should make about events or transactions that occurred after the balance sheet date.  The requirements of the guidance are applied on a prospective basis to interim or annual financial periods ending after June 15, 2009.  The adoption of this guidance did not have a material affect on our consolidated financial statements.

On April 9, 2009, the FASB issued authoritative guidance regarding the recognition and presentation of an other-than-temporary impairment and requires additional disclosures.  The recognition provision within this guidance applies only to fixed maturity investments that are subject to the other-than-temporary impairments.  If an entity intends to sell or if it is more likely than not that it will be required to sell an impaired security prior to recovery of its cost basis, the security is other-

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________


than-temporarily impaired and the full amount of the impairment is recognized as a loss through earnings.  Otherwise, losses on securities which are other-than-temporarily impaired are separated into:  (i) the portion of loss which represents the credit loss; and (ii) the portion which is due to other factors.  The credit loss portion is recognized as a loss through earnings while the loss due to other factors is recognized in other comprehensive loss, net of taxes and related amortization.  The guidance requires a cumulative effect adjustment to accumulated deficit and a corresponding adjustment to accumulated other comprehensive loss to reclassify the non-credit portion of previously other-than-temporarily impaired securities which were held at the beginning of the period of adoption and for which we do not intend to sell and it is more likely than not that we will not be required to sell such securities before recovery of the amortized cost basis.  The guidance is effective for interim and annual periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009.  We adopted the guidance effective January 1, 2009.  The cumulative effect of adopting this guidance was a $4.9 million net decrease to accumulated deficit and a corresponding increase to accumulated other comprehensive loss.

On April 9, 2009, the FASB issued authoritative guidance which provided additional guidance on estimating fair value when the volume and level of activity for an asset or liability have significantly decreased in relation to normal market activity for the asset or liability and clarifies that the use of multiple valuation techniques may be appropriate.  The guidance also discusses circumstances that may indicate a transaction is not orderly.  The guidance re-emphasizes that fair value continues to be the exit price in an orderly market.  Further, this guidance requires additional disclosures about fair value measurement in annual and interim reporting periods.  The guidance is effective for interim and annual reporting periods ending after June 15, 2009 with early adoption permitted.  We adopted the guidance effective for the period ending March 31, 2009, and this guidance did not have a material effect on our consolidated financial statements.

On April 9, 2009, the FASB issued authoritative guidance which requires that the fair value of financial instruments be disclosed in an entity’s financial statements in both interim and annual periods.  The guidance also requires disclosure of methods and assumptions used to estimate fair values.  The guidance is effective for interim reporting periods ending after June 15, 2009, with early adoption permitted for periods ending after March 15, 2009.  We adopted the guidance for the quarter ended June 30, 2009, which did not have a material effect on our consolidated balance sheet or statement of operations.

In May 2008, the FASB issued authoritative guidance that specifies that issuers of convertible debt instruments that may be settled in cash upon conversion (including partial cash settlement) should separately account for the liability and equity components in a manner that will reflect the entity’s nonconvertible debt borrowing rate when interest cost is recognized in subsequent periods.  The guidance is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years.  The guidance was applied retrospectively to all periods presented unless instruments were not outstanding during any period included in the financial statements.  In October 2009, the Company reissued its financial statements as December 31, 2008 and 2007, and for the three years ended December 31, 2008, to reflect the adoption of this authoritative guidance on a retrospective basis.  The adoption of the guidance affected the accounting for our 3.5% Convertible Debentures due September 30, 2035 (the “3.5% Debentures”).  Upon adoption of the guidance, the effective interest rate on our 3.5% Debentures increased to 7.4 percent, which resulted in the recognition of a $45 million discount to these notes with the offsetting after tax amount recorded to paid-in capital.  Such discount is amortized as interest expense over the remaining life of the 3.5% Debentures.

Amounts related to the 3.5% Debentures are reflected in our consolidated balance sheet at December 31, 2009 and 2008, as follows (dollars in millions):

   
December 31,
  
   
2009
    
2008
  
             
Increase to additional paid-in capital                                                              
   $ 28.0     $ 28.0  
                 
Par value of 3.5% Debentures                                                              
   $ 116.5     $ 293.0  
Unamortized discount                                                              
     (3.3 )     (18.3 )
                 
Carrying value of 3.5% Debentures                                                          
   $ 113.2     $ 274.7  










 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



Interest expense related to the 3.5% Debentures includes the following at December 31, 2009, 2008 and 2007 (dollars in millions):

   
2009
    
2008
    
2007
  
                   
Contractual interest expense                                                              
   $ 9.4     $ 11.3     $ 11.5  
Amortization of discount                                                              
     9.4       9.5       8.9  
Amortization of debt issue costs                                                              
     1.1       1.3       1.3  
                         
Total interest expense                                                          
   $ 19.9     $ 22.1     $ 21.7  

 
In January 2009, the FASB issued authoritative guidance which amended certain impairment guidance by removing the exclusive reliance upon market participant assumptions about future cash flows when evaluating the impairment of certain securities.  The guidance permits the use of reasonable management judgment of the probability that the holder will be unable to collect all amounts due.  The guidance is effective prospectively for interim and annual reporting periods ending after December 15, 2008.  The Company adopted the guidance on December 31, 2008 and the adoption did not have a material effect on our consolidated financial statements.

In March 2008, the FASB issued authoritative guidance regarding whether unvested share based payment awards that contain non-forfeitable rights to dividends or dividend equivalents (whether paid or unpaid) are to be treated as participating securities prior to vesting and, therefore, must be included in the earnings allocation in calculating earnings per share under the two-class method.  The guidance is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those years and requires retrospective application.  Our adoption of the guidance did not have a material effect on our earnings per share calculations due to the immateriality of unvested restricted shares that are considered to be participating securities.

In March 2008, the FASB issued authoritative guidance which required enhanced disclosures about an entity’s derivative and hedging activities.  The guidance is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008.  The adoption of the guidance did not have a material effect on our consolidated financial statements.

In December 2007, the FASB issued authoritative guidance which establishes new standards governing the accounting for and reporting of noncontrolling interests (previously referred to as minority interests).  The guidance establishes reporting requirements which include, among other things, that noncontrolling interests be reflected as a separate component of equity, not as a liability.  It also requires that the interests of the parent and the noncontrolling interest be clearly identifiable.  Additionally, increases and decreases in a parent’s ownership interest that leave control intact shall be reflected as equity transactions, rather than step acquisitions or dilution gains or losses.  The guidance is effective for fiscal years beginning on or after December 15, 2008.  The initial adoption of this guidance had no effect on our consolidated financial statements.

In December 2007, the FASB issued authoritative guidance which requires the acquiring entity in a business combination to recognize all assets acquired and liabilities assumed in a transaction at the acquisition date fair value, with certain exceptions.  Additionally, the guidance requires changes to the accounting treatment of acquisition related items, including, among other items, transaction costs, contingent consideration, restructuring costs, indemnification assets and tax benefits.  The guidance also provides for a substantial number of new disclosure requirements.  The guidance is effective for business combinations initiated on or after the first annual reporting period beginning after December 15, 2008.  We expect that the guidance will have an effect on our accounting for business combinations, if any, that are made in the future.  In addition, the guidance changes the previous requirement that reductions in a valuation allowance for deferred tax assets established in conjunction with the implementation of fresh-start accounting be recognized as a direct increase to additional paid-in capital.  Instead, the revised standard requires that any such reduction be reported as a decrease to income tax expense through the consolidated statement of operations.  Accordingly, any reductions to our valuation allowance for deferred tax assets will be reported as a decrease to income tax expense, after the effective date of the guidance.

In December 2008, the FASB issued authoritative guidance which required public entities to provide additional disclosures about transferors’ continuing involvements with transferred financial assets and to provide additional disclosures about their involvement with VIEs.  The guidance was effective for financial statements issued for fiscal years and interim periods ending after December 15, 2008.  We adopted the guidance on December 31, 2008 and it did not have a material

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________


effect on our consolidated financial statements.

In February 2007, the FASB issued authoritative guidance which allows entities to choose to measure many financial instruments and certain other items, including insurance contracts, at fair value (on an instrument-by-instrument basis) that are not currently required to be measured at fair value.  The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions.  We adopted the guidance on January 1, 2008.  We did not elect the fair value option for any of our financial assets or liabilities.

In April 2007, FASB issued authoritative guidance which allows fair value amounts recognized for collateral to be offset against fair value amounts recognized for derivative instruments that are executed with the same counterparty under certain circumstances.  The guidance also requires an entity to disclose the accounting policy decision to offset, or not to offset, fair value amounts.  We do not, and have not previously, offset the fair value amounts recognized for derivatives with the amounts recognized as collateral.  All collateral is maintained in a tri-party custodial account.  At December 31, 2008, $11.4 million of derivative liabilities had been offset against derivative assets executed with the same counterparty under master netting arrangements.  There were no such derivative liabilities offset against derivative assets at December 31, 2009.  We adopted the guidance on January 1, 2008, and it did not have a material effect on our consolidated financial statements.

 
5.
INVESTMENTS

At December 31, 2009, the amortized cost and estimated fair value of fixed maturities, available for sale, and equity securities were as follows (dollars in millions):

         
Gross
    
Gross
    
Estimated
  
   
Amortized
    
unrealized
    
unrealized
    
fair
  
   
cost
    
gains
    
losses
    
value
  
Investment grade (a):
                        
Corporate securities
   $ 13,069.8     $ 371.9     $ (315.4 )   $ 13,126.3  
United States Treasury securities and obligations of United States government corporations and agencies
     268.5       4.6       (3.5 )     269.6  
States and political subdivisions
     924.2       3.0       (78.4 )     848.8  
Debt securities issued by foreign governments
     4.8       .3       -       5.1  
Asset-backed securities
     154.1       1.7       (17.9 )     137.9  
Collateralized debt obligations
     84.1       1.2       (.6 )     84.7  
Commercial mortgage-backed securities
     867.7       6.2       (108.2 )     765.7  
Mortgage pass-through securities
     41.1       1.6       (.1 )     42.6  
Collateralized mortgage obligations
     1,801.4       4.2       (81.0 )     1,724.6  
                                 
Total investment grade fixed maturities, available for sale
     17,215.7       394.7       (605.1 )     17,005.3  
                                 
Below-investment grade (a):
                                
Corporate securities
     1,275.4       5.8       (116.1 )     1,165.1  
States and political subdivisions
     6.9       -       (2.1 )     4.8  
Asset-backed securities
     90.9       -       (36.7 )     54.2  
Collateralized debt obligations
     12.8       -       (4.7 )     8.1  
Commercial mortgage-backed securities
     1.6       -       (1.3 )     .3  
Collateralized mortgage obligations
     394.7       -       (104.1 )     290.6  
                                 
Total below-investment grade fixed maturities, available for sale
     1,782.3       5.8       (265.0 )     1,523.1  
                                 
Total fixed maturities, available for sale                                                                           
   $ 18,998.0     $ 400.5     $ (870.1 )   $ 18,528.4  
                                 
Equity securities                                                                               
   $ 30.7     $ .8     $ (.5 )   $ 31.0  


 
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Notes to Consolidated Financial Statements
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_______________
 
(a)
Investment ratings – Investment ratings are assigned the second lowest rating by a nationally recognized statistical rating organization (Moody’s Investor Services, Inc. (“Moody’s”), S&P or Fitch Ratings (“Fitch”)), or if not rated by such firms, the rating assigned by the NAIC.  NAIC designations of “1” or “2” include fixed maturities generally rated investment grade (rated “Baa3” or higher by Moody’s or rated “BBB-” or higher by S&P and Fitch.  NAIC designations of “3” through “6” are referred to as below investment grade (which generally are rated “Ba1” or lower by Moody’s or rated “BB+” or lower by S&P and Fitch).  References to investment grade or below investment grade throughout our consolidated financial statements are determined as described above.

At December 31, 2008, the amortized cost and estimated fair value of fixed maturities, available for sale, and equity securities were as follows (dollars in millions):

         
Gross
    
Gross
    
Estimated
  
   
Amortized
    
unrealized
    
unrealized
    
fair
  
   
cost
    
gains
    
losses
    
value
  
Investment grade:
                        
Corporate securities
   $ 11,963.9     $ 76.5     $ (1,819.2 )   $ 10,221.2  
United States Treasury securities and obligations of United States government corporations and agencies
     122.3       8.7       (.4 )     130.6  
States and political subdivisions
     427.4       .4       (52.2 )     375.6  
Debt securities issued by foreign governments
     6.2       .1       (.8 )     5.5  
Asset-backed securities
     291.3       -       (87.6 )     203.7  
Collateralized debt obligations
     122.5       .3       (31.1 )     91.7  
Commercial mortgage-backed securities
     808.9       .7       (263.1 )     546.5  
Mortgage pass-through securities
     75.0       1.4       (.1 )     76.3  
Collateralized mortgage obligations
     2,901.5       59.0       (533.7 )     2,426.8  
                                 
Total investment grade fixed maturities, available for sale
     16,719.0       147.1       (2,788.2 )     14,077.9  
                                 
Below-investment grade:
                                
Corporate securities
     1,498.1       21.4       (367.4 )     1,152.1  
States and political subdivisions
     8.6       -       (1.6 )     7.0  
Debt securities issued by foreign governments
     4.2       -       (1.1 )     3.1  
Collateralized debt obligations
     11.8       -       (6.9 )     4.9  
Commercial mortgage-backed securities
     23.3       -       (2.6 )     20.7  
Collateralized mortgage obligations
     11.3       -       -       11.3  
                                 
Total below-investment grade fixed maturities, available for sale
     1,557.3       21.4       (379.6 )     1,199.1  
                                 
Total fixed maturities, available for sale                                                                           
   $ 18,276.3     $ 168.5     $ (3,167.8 )   $ 15,277.0  
                                 
Equity securities                                                                               
   $ 31.0     $ 1.5     $ (.1 )   $ 32.4  


 
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At December 31, 2009, the amortized cost, gross unrealized gains and losses, other-than-temporary impairments in other comprehensive loss and estimated fair value of fixed maturities, available for sale, were as follows (dollars in millions):

                           
Other-than-
                           
temporary
                           
impairments
         
Gross
    
Gross
          
included in other
   
Amortized
    
unrealized
    
unrealized
    
Estimated
    
comprehensive
   
cost
    
gains
    
losses
    
fair value
    
loss
                             
Corporate securities
   $ 14,345.2     $ 377.7     $ (431.5 )   $ 14,291.4     $ -  
United States Treasury securities and obligations of United States government corporations and agencies
     268.5       4.6       (3.5 )     269.6       -  
States and political subdivisions
     931.1       3.0       (80.5 )     853.6       -  
Debt securities issued by foreign governments
     4.8       .3       -       5.1       -  
Asset-backed securities
     245.0       1.7       (54.6 )     192.1       (35.1 )
Collateralized debt obligations
     96.9       1.2       (5.3 )     92.8       -  
Commercial mortgage-backed securities
     869.3       6.2       (109.5 )     766.0       (1.4 )
Mortgage pass-through securities
     41.1       1.6       (.1 )     42.6       -  
Collateralized mortgage obligations
     2,196.1       4.2       (185.1 )     2,015.2       (132.4 )
                                         
Total fixed maturities, available for sale
   $ 18,998.0     $ 400.5     $ (870.1 )   $ 18,528.4     $ (168.9 )

Accumulated other comprehensive loss is primarily comprised of the net effect of unrealized appreciation (depreciation) on our investments.  These amounts, included in shareholders’ equity as of December 31, 2009 and 2008 were as follows (dollars in millions):

   
2009
    
2008
  
             
Net unrealized depreciation on fixed maturity securities, available for sale, on
which an other-than-temporary impairment loss has been recognized
   $ (133.5 )   $ -  
Net unrealized losses on all other investments                                                                                                             
     (339.9 )     (3,015.9 )
Adjustment to the present value of future profits                                                                                                             
     10.7       111.0  
Adjustment to deferred acquisition costs                                                                                                             
     59.8       154.8  
Unrecognized net loss related to deferred compensation plan                                                                                                             
     (8.2 )     (8.0 )
Deferred income tax asset                                                                                                             
     146.8       987.4  
                 
Accumulated other comprehensive loss                                                                                                     
   $ (264.3 )   $ (1,770.7 )

 
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Notes to Consolidated Financial Statements
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Concentration of Fixed Maturity Securities, Available for Sale

The following table summarizes the carrying values of our fixed maturity securities, available for sale, by category as of December 31, 2009 (dollars in millions):

                     
Percent of
  
               
Gross
    
gross
  
         
Percent of
    
unrealized
    
unrealized
  
   
Carrying value
    
fixed maturities
    
losses
    
losses
  
                         
Collateralized mortgage obligations
   $ 2,015.2       10.9 %   $ (185.1 )     21.3 %
Utilities                                                         
     1,928.8       10.4       (32.1 )     3.7  
Energy/pipelines                                                         
     1,687.1       9.1       (19.9 )     2.3  
Healthcare/pharmaceuticals                                                         
     1,420.9       7.7       (23.1 )     2.7  
Food/beverage                                                         
     1,247.5       6.7       (16.9 )     1.9  
States and political subdivisions                                                         
     853.6       4.6       (80.5 )     9.3  
Banks                                                         
     848.6       4.6       (97.6 )     11.2  
Insurance                                                         
     845.8       4.6       (63.0 )     7.2  
Cable/media                                                         
     792.9       4.3       (22.0 )     2.5  
Commercial mortgage-backed securities
     766.0       4.1       (109.5 )     12.6  
Capital goods                                                         
     689.0       3.7       (12.0 )     1.4  
Aerospace/defense                                                         
     563.2       3.0       (10.9 )     1.2  
Telecom                                                         
     547.7       2.9       (12.3 )     1.4  
Real estate/REITs                                                         
     542.4       2.9       (27.6 )     3.2  
Transportation                                                         
     473.9       2.6       (4.9 )     .6  
Building materials                                                         
     344.6       1.9       (7.6 )     .9  
Consumer products                                                         
     283.1       1.5       (5.7 )     .6  
Technology                                                         
     282.1       1.5       (9.6 )     1.1  
U.S. Treasury and Obligations                                                         
     269.6       1.5       (3.5 )     .4  
Chemicals                                                         
     214.1       1.2       (3.9 )     .4  
Entertainment/hotels                                                         
     198.9       1.1       (6.2 )     .7  
Asset-backed securities                                                         
     192.1       1.0       (54.6 )     6.3  
Other                                                         
     1,521.3       8.2       (61.6 )     7.1  
                                 
Total fixed maturities, available for sale
   $ 18,528.4       100.0 %   $ (870.1 )     100.0 %

Below-Investment Grade Securities

At December 31, 2009, the amortized cost of the Company’s below-investment grade fixed maturity securities was $1,782.3 million, or 9 percent of the Company’s fixed maturity portfolio.  The estimated fair value of the below-investment grade portfolio was $1,523.1 million, or 85 percent of the amortized cost.

Below-investment grade fixed maturity securities with an amortized cost of $284.7 million and an estimated fair value of $262.3 million are held by a VIE that we are required to consolidate.  These fixed maturity securities are legally isolated and are not available to the Company.  The liabilities of such VIE will be satisfied from the cash flows generated by these securities and are not obligations of the Company.  Refer to the note to the consolidated financial statements entitled “Investment in a Variable Interest Entity” concerning the Company’s investment in the VIE.

Below-investment grade corporate debt securities have different characteristics than investment grade corporate debt securities.  Based on historical performance, probability of default by the borrower is significantly greater for below-investment grade corporate debt securities and in many cases severity of loss is relatively greater as such securities are generally unsecured and often subordinated to other indebtedness of the issuer.  Also, issuers of below-investment grade corporate debt securities frequently have higher levels of debt relative to investment-grade issuers, hence, all other things being equal, are more sensitive to adverse economic conditions, such as recession or increasing interest rates.  The Company attempts to reduce the overall risk related to its investment in below-investment grade securities, as in all investments, through careful credit analysis, strict investment policy guidelines, and diversification by issuer and/or guarantor and by industry.

 
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Contractual Maturity

The following table sets forth the amortized cost and estimated fair value of fixed maturities, available for sale, at December 31, 2009, by contractual maturity.  Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.  Asset-backed securities, collateralized debt obligations, commercial mortgage-backed securities, mortgage pass-through securities and collateralized mortgage obligations are collectively referred to as “structured securities”.  Many of the structured securities shown below provide for periodic payments throughout their lives (dollars in millions):

         
Estimated
  
   
Amortized
    
fair
  
   
cost
    
value
  
             
Due in one year or less                                                               
   $ 76.9     $ 77.4  
Due after one year through five years                                                               
     1,357.9       1,359.2  
Due after five years through ten years                                                               
     4,874.1       4,932.4  
Due after ten years                                                               
     9,240.7        9,050.7  
                 
Subtotal                                                           
     15,549.6       15,419.7  
                 
Structured securities                                                               
     3,448.4       3,108.7  
                 
Total fixed maturities, available for sale
   $ 18,998.0     $ 18,528.4  

Net Investment Income

Net investment income consisted of the following (dollars in millions):

   
2009
    
2008
    
2007
  
                   
Fixed maturities                                                                           
   $ 1,083.7     $ 1,094.4     $ 1,194.9  
Trading income related to policyholder and reinsurer accounts and other special-purpose portfolios
     9.7       28.6       27.8  
Equity securities                                                                           
     1.5       1.4       1.6  
Mortgage loans                                                                           
     130.8       126.1       109.3  
Policy loans                                                                           
     21.2       23.6       26.5  
Options related to fixed index products:
                        
Option income (loss)                                                                        
     (63.0 )     (71.9 )     43.8  
Change in value of options                                                                        
     113.7       (32.4 )     (52.3 )
Other invested assets                                                                           
     11.4       13.8       10.8  
Cash and cash equivalents                                                                           
     1.1       11.9       24.0  
                         
Gross investment income                                                                       
     1,310.1       1,195.5       1,386.4  
Less investment expenses                                                                           
     17.4       16.7       16.6  
                         
Net investment income                                                                       
   $ 1,292.7     $ 1,178.8     $ 1,369.8  

The estimated fair value of fixed maturity investments and mortgage loans not accruing investment income totaled $39.8 million and $15.5 million at December 31, 2009 and 2008, respectively.

 
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Net Realized Investment Gains (Losses)

The following table sets forth the net realized investment gains (losses) for the periods indicated (dollars in millions):

   
2009
    
2008
    
2007
  
                   
Fixed maturity securities, available for sale:
                  
Realized gains on sale                                                                                     
   $ 367.9     $ 110.3     $ 81.9  
Realized losses on sale                                                                                     
     (233.9 )     (177.3 )     (124.7 )
Impairments:
                        
Total other-than-temporary impairment losses                                                                                   
     (337.8 )     (152.7 )     (98.3 )
Other-than-temporary impairment losses recognized in other
comprehensive loss                                                                                
      188.3        -       -  
                         
Net impairment losses recognized                                                                               
     (149.5 )     (152.7 )     (98.3 )
                         
Net realized investment losses from fixed maturities
     (15.5 )     (219.7 )     (141.1 )
                         
Equity securities                                                                                         
     -       -       (5.0 )
Commercial mortgage loans                                                                                         
     (13.5 )     (19.7 )     (.2 )
Other-than-temporary declines in fair value of mortgage loans and other invested assets
     (45.9 )     (9.6 )     (7.2 )
Other                                                                                         
     14.4       (13.4 )     (4.5 )
                         
Net realized investment losses                                                                               
   $ (60.5 )   $ (262.4 )   $ (158.0 )

During 2009, we recognized net realized investment losses of $60.5 million, which were comprised of $134.9 million of net gains from the sales of investments (primarily fixed maturities) with proceeds of $10.7 billion and $195.4 million of writedowns of investments for other than temporary declines in fair value recognized through net income ($385.0 million, prior to the $189.6 million of impairment losses recognized through other comprehensive loss).

During 2008, we recognized net realized investment losses of $262.4 million, which were comprised of:  (i) $100.1 million of net losses from the sales of investments (primarily fixed maturities); and (ii) $162.3 million of writedowns of investments for other than temporary declines in fair value (no single investment accounted for more than $10 million of such writedowns).  During 2007, net realized investment losses included:  (i) $52.5 million of net losses from the sales of investments (primarily fixed maturities); (ii) $31.8 million of writedowns of investments for other than temporary declines in fair value (no single investment accounted for more than $5.0 million of such writedowns); and (iii) $73.7 million of writedowns of investments (which were subsequently transferred pursuant to a coinsurance agreement as further discussed in the note to the consolidated financial statements entitled “Summary of Significant Accounting Policies - Reinsurance”) as a result of our intent not to hold such investments for a period of time sufficient to allow for any anticipated recovery in value.

At December 31, 2009, fixed maturity securities in default as to the payment of principal or interest had an aggregate amortized cost of $15.0 million and a carrying value of $15.7 million.  We also had mortgage loans with an aggregate carrying value of $24.1 million that were in the process of foreclosure at December 31, 2009.

During 2009, the $195.4 million of other-than-temporary impairments we recorded in earnings included:  (i) $83.6 million of losses related to mortgage-backed and asset-backed securities, primarily reflecting changes related to the performance of the underlying assets and, for certain securities, changes in our intent regarding continuing to hold the securities; (ii) $40.9 million of losses related to commercial mortgage loans reflecting our concerns regarding the issuers’ ability to continue to make contractual payments related to these loans and our estimate of the value of the underlying properties; (iii) $13.8 million of losses related to securities issued by a large commercial lender that recently filed bankruptcy; and (iv) $57.1 million of additional losses primarily related to various corporate securities following unforeseen issue-specific events or conditions and shifts in risks or uncertainty of the issuer.

During 2009, the $233.9 million of realized losses on sales of $1.3 billion of fixed maturity securities, available for sale, included:  (i) $178.3 million of losses related to the sales of mortgage-backed securities and asset-backed securities;

 
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(ii) $11.3 million of losses related to the sale of securities issued by providers of financial guarantees and mortgage insurance; and (iii) $44.3 million of additional losses primarily related to various corporate securities.  Securities are generally sold at a loss following unforeseen issue-specific events or conditions and shifts in risks or uncertainty of certain securities.  These reasons include but are not limited to:  (i) changes in the investment environment; (ii) expectation that the fair value could deteriorate further; (iii) desire to reduce our exposure to an asset class, an issuer or an industry; (iv) changes in credit quality; or (v) changes in expected liability cash flows.

During 2008, the $162.3 million of other-than-temporary impairments we recorded included:  (i) $54.0 million of losses related to mortgage-backed and asset-backed securities, primarily reflecting changes related to the performance of the underlying assets and, for certain securities, changes in our intent regarding continuing to hold the securities; (ii) $20.7 million of losses related to securities issued by a large investment bank and a financial institution which filed for bankruptcy; (iii) $11.8 million of losses related to securities issued by casino gaming companies which have significant debt obligations which were expected to be difficult to refinance in the current investment environment; (iv) $11.0 million related to securities issued by publishers of telephone directories which are experiencing financial difficulties; and (v) $64.8 million of additional losses primarily related to various corporate securities following unforeseen issue-specific events or conditions and shifts in risks or uncertainty of the issuer.

During 2008, the $177.3 million of losses on sales of fixed maturity securities, available for sale, included:  (i) $55.5 million of losses related to the sales of mortgage-backed securities and asset-backed securities; (ii) $47.0 million of losses related to the sales of securities issued by two large investment banks and a large financial institution which filed for bankruptcy protection; and (iii) $74.8 million of additional losses primarily related to various corporate securities.  Securities are generally sold at a loss following unforeseen issue-specific events or conditions and shifts in risks or uncertainty of certain securities.  These reasons include, but are not limited to:  (i) changes in the investment environment; (ii) expectation that the fair value could deteriorate further; (iii) desire to reduce our exposure to an asset class, an issuer or an industry; (iv) changes in credit quality; or (v) changes in expected liability cash flows.

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

The following summarizes the investments sold at a loss during 2009 which had been continuously in an unrealized loss position exceeding 20 percent of the amortized cost basis prior to the sale for the period indicated (dollars in millions):

         
At date of sale
  
   
Number of
    
Amortized
  
Fair
  
Period
  
issuers
    
cost
  
value
  
                 
Less than 6 months prior to sale                                                               
     8     $ 29.6     $ 22.7  
Greater than or equal to 6 and less than 12 months prior to sale
     26       130.9       77.3  
Greater than 12 months                                                               
     43       224.7       109.4  
                         
      77     $ 385.2     $ 209.4  

During the first quarter of 2009, we adopted newly issued authoritative guidance, which changes the recognition and presentation of other-than-temporary impairments.  Refer to the note to the consolidated financial statements entitled “Summary of Significant Accounting Policies - Adopted Accounting Standards” for additional information.  The recognition provisions within this guidance apply only to our fixed maturity investments.

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

 
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Notes to Consolidated Financial Statements
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amortized cost, less any current period credit loss, the recognition of the other-than-temporary impairment is bifurcated.  We recognize the credit loss portion in net income and the noncredit loss portion in other comprehensive loss.  Prior to 2009, such other-than-temporary impairments were recognized in their entirety through earnings and the amount recognized was the difference between amortized cost and estimated fair value.

We estimate the amount of the credit loss component of a fixed maturity security impairment as the difference between amortized cost and the present value of the expected cash flows of the security.  The present value is determined using the best estimate of future cash flows discounted at the effective interest rate implicit to the security at the date of purchase or the current yield to accrete an asset-backed or floating rate security.  The methodology and assumptions for establishing the best estimate of future cash flows vary depending on the type of security.  The asset-backed securities cash flow estimates are based on bond specific facts and circumstances that may include collateral characteristics, expectations of delinquency and default rates, loss severity, prepayment speeds and structural support, including subordination and guarantees.  The corporate bond cash flow estimates are derived from scenario-based outcomes of expected corporate restructurings or the disposition of assets using bond specific facts and circumstances including timing, secured interest and loss severity.  The remaining non-credit impairment, which is recorded in accumulated other comprehensive income (loss), is the difference between the security’s estimated fair value and our best estimate of future cash flows discounted at the effective interest rate prior to impairment.  The remaining non-credit impairment typically represents changes in the market interest rates, current market liquidity and risk premiums.  The previous amortized cost basis less the impairment recognized in net income becomes the security’s new cost basis.  We accrete the new cost basis to the estimated future cash flows over the expected remaining life of the security.  As of December 31, 2009, other-than-temporary impairments included in accumulated other comprehensive loss of $170.2 million (before taxes and related amortization) primarily relate to asset-backed securities (including collateralized debt obligations and collateralized mortgage obligations).

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

Future events may occur, or additional information may become available, which may necessitate future realized losses of securities in our portfolio.  Significant losses in the estimated fair values of our investments could have a material adverse effect on our earnings in future periods.

The following table summarizes the amount of credit losses recognized in earnings on fixed maturity securities, available for sale, held at the beginning of the period, for which a portion of the other-than-temporary impairment was also recognized in other comprehensive loss for the year ended December 31, 2009 (dollars in millions):

   
Year ended
  
   
December 31,
  
   
2009
  
       
Credit losses on fixed maturity securities, available for sale, beginning of year
   $ (.6 )
Add:  credit losses on other-than-temporary impairments not previously recognized
     (20.7 )
Less:  credit losses on securities sold
     5.4  
Less:  credit losses on securities impaired due to intent to sell
     -  
Add:  credit losses on previously impaired securities
     (11.3 )
Less:  increases in cash flows expected on previously impaired securities
     -  
         
Credit losses on fixed maturity securities, available for sale, end of year                                                                                                                       
   $ (27.2 )


 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
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Investments with Unrealized Losses

The following table sets forth the amortized cost and estimated fair value of those fixed maturities, available for sale, with unrealized losses at December 31, 2009, by contractual maturity.  Actual maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.  Many of the structured securities shown below provide for periodic payments throughout their lives (dollars in millions):

         
Estimated
  
   
Amortized
    
fair
  
   
cost
    
value
  
             
Due in one year or less                                                                             
   $ 6.7     $ 6.6  
Due after one year through five years                                                                             
     549.1       514.2  
Due after five years through ten years                                                                             
     2,021.4       1,923.1  
Due after ten years                                                                             
     5,389.1       5,006.9  
                 
Subtotal                                                                       
     7,966.3       7,450.8  
                 
Structured securities                                                                             
     2,763.2       2,408.6  
                 
Total                                                                       
   $ 10,729.5     $ 9,859.4  

The following summarizes the investments in our portfolio rated below-investment grade which have been continuously in an unrealized loss position exceeding 20 percent of the cost basis for the period indicated as of December 31, 2009 (dollars in millions):

   
Number
    
Cost
    
Unrealized
    
Estimated
  
Period
  
of issuers
    
basis
    
loss
    
fair value
  
                         
Less than 6 months                                             
     8     $ 29.6     $ (6.4 )   $ 23.2  
Greater than or equal to 6 months and less than 12 months
     5       31.3       (10.5 )     20.8  
Greater than 12 months                                             
     46       496.4       (157.6 )     338.8  
                                 
      59     $ 557.3     $ (174.5 )   $ 382.8  


 
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Notes to Consolidated Financial Statements
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The following table summarizes the gross unrealized losses of our fixed maturity securities, available for sale, by category and ratings category as of December 31, 2009 (dollars in millions):

               
Below investment grade
    
Total gross
  
   
Investment grade
          
B+ and
    
unrealized
  
   
AAA/AA/A
    
BBB
    
BB
    
below
    
losses
  
                               
Collateralized mortgage obligations
   $ 73.4     $ 7.6     $ 22.2     $ 81.9     $ 185.1  
Commercial mortgage-backed securities
     63.0       45.2       -       1.3       109.5  
Banks                                                    
     44.7       37.9       15.0       -       97.6  
States and political subdivisions                                                    
     43.0       35.4       1.8       .3       80.5  
Insurance                                                    
     28.0       30.3       2.0       2.7       63.0  
Asset-backed securities                                                    
     9.6       8.3       5.7       31.0       54.6  
Utilities                                                    
     14.1       12.6       .5       4.9       32.1  
Real estate/REITs                                                    
     .7       17.4       9.3       .2       27.6  
Healthcare/pharmaceuticals                                                    
     14.8       5.5       .8       2.0       23.1  
Cable/media                                                    
     1.7       11.3       2.2       6.8       22.0  
Energy/pipelines                                                    
     1.0       16.4       1.8       .7       19.9  
Food/beverage                                                    
     4.1       10.3       1.2       1.3       16.9  
Telecom                                                    
     8.0       .8       3.2       .3       12.3  
Capital goods                                                    
     6.6       4.1       -       1.3       12.0  
Aerospace/defense                                                    
     5.3       4.2       .1       1.3       10.9  
Technology                                                    
     5.5       3.0       .3       .8       9.6  
Paper                                                    
     -       1.1       7.2       .3       8.6  
Building materials                                                    
     -       1.0       6.2       .4       7.6  
Entertainment/hotels                                                    
     -       3.3       2.0       .9       6.2  
Consumer products                                                    
     .7       3.6       -       1.4       5.7  
Collateralized debt obligations                                                    
     .4       .2       -       4.7       5.3  
Transportation                                                    
     1.6       2.5       .5       .3       4.9  
Retail                                                    
     .7       .3       2.0       1.5       4.5  
Chemicals                                                    
     -       1.9       .3       1.7       3.9  
U.S. Treasury and Obligations                                                    
     3.5       -       -       -       3.5  
Brokerage                                                    
     2.6       .6       -       .1       3.3  
Textiles                                                    
     2.4       -       -       .7       3.1  
Gaming                                                    
     -       -       -       3.0       3.0  
Metals and mining                                                    
     .1       1.0       -       .2       1.3  
Autos                                                    
     .1       -       -       .8       .9  
Mortgage pass-through securities
     .1       -       -       -       .1  
Other                                                    
     1.0       2.6       24.4       3.5       31.5  
                                         
Total fixed maturities, available for sale 
   $ 336.7     $ 268.4     $ 108.7     $ 156.3     $ 870.1  

We held six below-investment grade collateralized mortgage obligations (backed by residential mortgage loans) that had a cost basis of $215.3 million, an estimated fair value of $152.3 million and unrealized losses of $63.0 million at December 31, 2009.  We also held three asset-backed securities (backed primarily by home equity loans) that had a cost basis of $43.9 million, an estimated fair value of $21.2 million and unrealized losses of $22.7 million at December 31, 2009.  These securities were subject to total other-than-temporary impairment losses of $143.4 million in 2009, including $129.5 million recognized in other comprehensive loss and $13.9 million recognized in net income.  As of December 31, 2009, these securities had been in an unrealized loss position exceeding 20 percent of cost for over one year and were rated from BB to CC.  All of these securities are senior tranches in their respective securitization structures.  We believe the declines in fair value are largely due to widening credit spreads and increased premium for liquidity.  Based on our estimates for the performance of the underlying collateral, and our related estimate of future cash flows expected to be collected from each of the securities, discounted at the security’s original effective rate, the recoverable amount is equal to the security’s cost basis at December 31, 2009.

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



Our investment strategy is to maximize, over a sustained period and within acceptable parameters of risk, investment income and total investment return through active investment management.  Accordingly, we may sell securities at a gain or a loss to enhance the total return of the portfolio as market opportunities change or to better match certain characteristics of our investment portfolio with the corresponding characteristics of our insurance liabilities.  While we do not have the intent to sell securities with unrealized losses and it is not more likely than not that we will be required to sell securities with unrealized losses prior to their anticipated recovery, we may sell securities at a loss in the future because of actual or expected changes in our view of the particular investment, its industry, its type or the general investment environment.

The following table summarizes the gross unrealized losses and fair values of our investments with unrealized losses that were not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that such securities had been in a continuous unrealized loss position, at December 31, 2009 (dollars in millions):

   
Less than 12 months
    
12 months or greater
    
Total
  
   
Fair
    
Unrealized
    
Fair
    
Unrealized
    
Fair
    
Unrealized
  
Description of securities
  
value
    
losses
    
value
    
losses
    
value
    
losses
  
                                     
United States Treasury securities and obligations of United States government corporations and agencies
   $ 157.6     $ (3.5 )   $ -     $ -     $ 157.6     $ (3.5 )
States and political subdivisions
     375.1       (18.0 )     291.5       (62.5 )     666.6       (80.5 )
Debt securities issued by foreign governments
     -       -       -       -       -       -  
Corporate securities                                   
     3,707.1       (109.0 )     2,919.5       (322.5 )     6,626.6       (431.5 )
Asset-backed securities
     7.2       (.3 )     133.1       (54.3 )     140.3       (54.6 )
Collateralized debt obligations
     34.5       (.6 )     5.7       (4.7 )     40.2       (5.3 )
Commercial mortgage-backed securities
     211.5       (4.3 )     250.8       (105.2 )     462.3       (109.5 )
Mortgage pass-through securities
     -       -       4.2       (.1 )     4.2       (.1 )
Collateralized mortgage obligations
     1,301.3       (41.6 )     460.3       (143.5 )     1,761.6       (185.1 )
                                                 
Total fixed maturities, available for sale
   $ 5,794.3     $ (177.3 )   $ 4,065.1     $ (692.8 )   $ 9,859.4     $ (870.1 )


 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________


The following table summarizes the gross unrealized losses and fair values of our investments with unrealized losses that are not deemed to be other-than-temporarily impaired, aggregated by investment category and length of time that such securities have been in a continuous unrealized loss position, at December 31, 2008 (dollars in millions):

   
Less than 12 months
    
12 months or greater
    
Total
  
   
Fair
    
Unrealized
    
Fair
    
Unrealized
    
Fair
    
Unrealized
  
Description of securities
  
value
    
losses
    
value
    
losses
    
value
    
losses
  
                                     
United States Treasury securities and obligations of United States government corporations and agencies
   $ 25.5     $ (.3 )   $ 1.9     $ (.1 )   $ 27.4     $ (.4 )
States and political subdivisions
     200.7       (27.4 )     148.8       (26.4 )     349.5       (53.8 )
Debt securities issued by foreign governments
     1.4       -       6.2       (1.9 )     7.6       (1.9 )
Corporate securities                                           
     5,125.7       (787.9 )     4,311.1       (1,398.7 )     9,436.8       (2,186.6 )
Asset-backed securities                                           
     61.8       (12.5 )     141.9       (75.1 )     203.7       (87.6 )
Collateralized debt obligations
     54.9       (11.4 )     28.8       (26.6 )     83.7       (38.0 )
Commercial mortgage-backed securities
     137.1       (27.3 )     416.6       (238.4 )     553.7       (265.7 )
Mortgage pass-through securities
     13.7       (.1 )     .3       -       14.0       (.1 )
Collateralized mortgage obligations
     522.2       (117.6 )     547.8       (416.1 )     1,070.0       (533.7 )
                                                 
Total fixed maturities, available for sale
   $ 6,143.0     $ (984.5 )   $ 5,603.4     $ (2,183.3 )   $ 11,746.4     $ (3,167.8 )

Based on management’s current assessment of investments with unrealized losses at December 31, 2009, the Company believes the issuers of the securities will continue to meet their obligations (or with respect to equity-type securities, the investment value will recover to its cost basis).  While we do not have the intent to sell securities with unrealized losses and it is not more likely than not that we will be required to sell securities with unrealized losses prior to their anticipated recovery, our intent on an individual security may change, based upon market or other unforeseen developments.  In such instances, we sell securities in the ordinary course of managing our portfolio to meet diversification, credit quality, yield, duration and liquidity requirements.  If a loss is recognized from a sale subsequent to a balance sheet date due to these unexpected developments, the loss is recognized in the period in which we had the intent to sell the securities before their anticipated recovery.

Structured Securities

At December 31, 2009, fixed maturity investments included structured securities with an estimated fair value of $3.1 billion (or 17 percent of all fixed maturity securities).  The yield characteristics of structured securities differ in some respects from those of traditional fixed-income securities.  For example, interest and principal payments on structured securities may occur more frequently, often monthly.  In many instances, we are subject to the risk that the amount and timing of principal and interest payments may vary from expectations.  For example, prepayments may occur at the option of the issuer and prepayment rates are influenced by a number of factors that cannot be predicted with certainty, including:  the relative sensitivity of the underlying assets backing the security to changes in interest rates; a variety of economic, geographic and other factors; and various security-specific structural considerations (for example, the repayment priority of a given security in a securitization structure).

In general, the rate of prepayments on structured securities increases when prevailing interest rates decline significantly in absolute terms and also relative to the interest rates on the underlying assets.  The yields recognized on structured securities purchased at a discount to par will increase (relative to the stated rate) when the underlying assets prepay faster than expected.  The yields recognized on structured securities purchased at a premium will decrease (relative to the stated rate) when the underlying assets prepay faster than expected.  When interest rates decline, the proceeds from prepayments may be reinvested at lower rates than we were earning on the prepaid securities.  When interest rates increase, prepayments may decrease.  When this occurs, the average maturity and duration of the structured securities increase, which decreases the yield on structured securities purchased at a discount because the discount is realized as income at a slower rate, and it increases the yield on those purchased at a premium because of a decrease in the annual amortization of the premium.

 
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Notes to Consolidated Financial Statements
__________________


For structured securities included in fixed maturities, available for sale, that were purchased at a discount or premium, we recognize investment income using an effective yield based on anticipated future prepayments and the estimated final maturity of the securities.  Actual prepayment experience is periodically reviewed and effective yields are recalculated when differences arise between the prepayments originally anticipated and the actual prepayments received and currently anticipated.  For credit sensitive mortgage-backed and asset-backed securities, and for securities that can be prepaid or settled in a way that we would not recover substantially all of our investment, the effective yield is recalculated on a prospective basis.  Under this method, the amortized cost basis in the security is not immediately adjusted and a new yield is applied prospectively.  For all other structured and asset-backed securities, the effective yield is recalculated when changes in assumptions are made, and reflected in our income on a retrospective basis.  Under this method, the amortized cost basis of the investment in the securities is adjusted to the amount that would have existed had the new effective yield been applied since the acquisition of the securities.  Such adjustments were not significant in 2009.

The following table sets forth the par value, amortized cost and estimated fair value of structured securities, summarized by interest rates on the underlying collateral, at December 31, 2009 (dollars in millions):

   
Par
    
Amortized
    
Estimated
  
   
value
    
cost
    
fair value
  
                   
Below 4 percent                                                        
   $ 102.4     $ 84.1     $ 84.7  
4 percent – 5 percent                                                        
     571.8       561.4       539.1  
5 percent – 6 percent                                                        
     2,083.2       2,058.5       1,867.9  
6 percent – 7 percent                                                        
     589.3       567.9       482.3  
7 percent – 8 percent                                                        
     129.8       126.8       90.9  
8 percent and above                                                        
     49.9       49.7        43.8  
                         
Total structured securities                                                     
   $ 3,526.4     $ 3,448.4     $ 3,108.7  

The amortized cost and estimated fair value of structured securities at December 31, 2009, summarized by type of security, were as follows (dollars in millions):

         
Estimated fair value
  
               
Percent
  
   
Amortized
          
of fixed
  
Type
  
cost
    
Amount
    
maturities
  
                   
Pass-throughs, sequential and equivalent securities
   $ 1,425.9     $ 1,361.1       7.4 %
Planned amortization classes, target amortization classes and accretion-directed bonds
     759.3       649.8       3.5  
Commercial mortgage-backed securities                                                                 
     869.3       766.0       4.1  
Asset-backed securities                                                                 
     245.0       192.1       1.0  
Collateralized debt obligations                                                                 
     96.9       92.8       .5  
Other                                                                 
     52.0       46.9       .3  
                         
Total structured securities                                                                 
   $ 3,448.4     $ 3,108.7       16.8 %

Pass-throughs, sequentials and equivalent securities have unique prepayment variability characteristics.  Pass-through securities typically return principal to the holders based on cash payments from the underlying mortgage obligations.  Sequential securities return principal to tranche holders in a detailed hierarchy.  Planned amortization classes, targeted amortization classes and accretion-directed bonds adhere to fixed schedules of principal payments as long as the underlying mortgage loans experience prepayments within certain estimated ranges.  Changes in prepayment rates are first absorbed by support or companion classes insulating the timing of receipt of cash flows from the consequences of both faster prepayments (average life shortening) and slower prepayments (average life extension).

Commercial mortgage-backed securities are secured by commercial real estate mortgages, generally income producing properties that are managed for profit.  Property types include multi-family dwellings including apartments, retail centers, hotels, restaurants, hospitals, nursing homes, warehouses, and office buildings.  Most commercial mortgage-backed securities have call protection features whereby underlying borrowers may not prepay their mortgages for stated periods of time

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________


without incurring prepayment penalties.

Commercial Mortgage Loans

At December 31, 2009, the mortgage loan balance was primarily comprised of commercial loans.  Approximately 7 percent, 7 percent, 7 percent, 6 percent and 6 percent of the mortgage loan balance were on properties located in Indiana, Minnesota, Ohio, California and Arizona, respectively.  No other state comprised greater than 5 percent of the mortgage loan balance.  Less than one percent of the commercial mortgage loan balance was noncurrent at December 31, 2009.  We had no allowance for losses on mortgage loans at both December 31, 2009 and 2008.

Securities Lending

The Company participates in a securities lending program whereby certain fixed maturity securities from our investment portfolio are loaned to third parties via a lending agent for a short period of time.  We maintain ownership of the loaned securities.  We require collateral equal to 102 percent of the fair value of the loaned securities.  The collateral is invested by the lending agent in accordance with our guidelines.  The fair value of the loaned securities is monitored on a daily basis with additional collateral obtained as necessary.  Under the terms of the securities lending program, the lending agent indemnifies the Company against borrower defaults.  As of December 31, 2009 and 2008, the fair value of the loaned securities was $178.5 million and $389.3 million, respectively.  As of December 31, 2009 and 2008, the Company had received collateral of $185.7 million and $408.8 million, respectively.  Income generated from the program, net of expenses is recorded as net investment income and totaled $1.2 million, $2.4 million and $1.3 million in 2009, 2008 and 2007, respectively.

Other Investment Disclosures

Life insurance companies are required to maintain certain investments on deposit with state regulatory authorities.  Such assets had aggregate carrying values of $83.3 million and $76.2 million at December 31, 2009 and 2008, respectively.

CNO had no fixed maturity investments that were in excess of 10 percent of shareholders’ equity at December 31, 2009 and one fixed maturity investment, with an amortized cost of $283.7 million and an estimated fair value of $305.0 million, that was in excess of 10 percent of shareholders’ equity at December 31, 2008 (other than investments issued or guaranteed by the United States government or a United States government agency).

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
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6.       LIABILITIES FOR INSURANCE PRODUCTS

These liabilities consisted of the following (dollars in millions):

               
Interest
              
   
Withdrawal
    
Mortality
    
rate
              
   
assumption
    
assumption
    
assumption
    
2009
    
2008
  
                               
Future policy benefits:
                              
Interest-sensitive products:
                              
Investment contracts                                                    
     N/A       N/A    
(c)
     $ 9,676.1     $ 9,612.9  
Universal life contracts                                                    
     N/A       N/A       N/A       3,543.1       3,719.9  
                                         
Total interest-sensitive products
                             13,219.2       13,332.8  
                                         
Traditional products:
                                        
Traditional life insurance contracts
  
Company
experience
    
(a)
       5%       2,325.4       2,300.2  
                                         
Limited-payment annuities                                                    
  
Company
experience,
if applicable
    
(b)
       4%       892.8       917.2  
                                         
Individual and group accident and health
  
Company
experience
    
Company
experience
       6%       6,845.3       6,611.3  
                                         
Total traditional products                                                
                             10,063.5       9,828.7  
                                         
Claims payable and other policyholder funds
     N/A       N/A       N/A       994.0       1,008.4  
Liabilities related to separate accounts
     N/A       N/A       N/A       17.3       18.2  
                                         
Total                                                     
                           $ 24,294.0     $ 24,188.1  
____________________
 
(a)
Principally, modifications of the 1965 - 70 and 1975 - 80 Basic, Select and Ultimate Tables.
 
(b)
Principally, the 1984 United States Population Table and the NAIC 1983 Individual Annuitant Mortality Table.
 
(c)
In 2009 and 2008, all of this liability represented account balances where future benefits are not guaranteed.

The Company establishes reserves for insurance policy benefits based on assumptions as to investment yields, mortality, morbidity, withdrawals, lapses and maintenance expenses.  These reserves include amounts for estimated future payment of claims based on actuarial assumptions.  The balance is based on the Company’s best estimate of the future policyholder benefits to be incurred on this business, given recent and expected future changes in experience.

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



Changes in the unpaid claims reserve (included in claims payable) and disabled life reserves related to accident and health insurance (included in individual and group accident and health liabilities) were as follows (dollars in millions):

   
2009
    
2008
    
2007
  
                   
Balance, beginning of the year                                                                        
   $ 1,341.3     $ 1,247.7     $ 1,129.0  
                         
Incurred claims (net of reinsurance) related to:
                        
Current year                                                                      
     1,616.8       1,729.3       1,559.0  
Prior years (a)                                                                      
     (32.3 )     (25.9 )     (18.8 )
                         
Total incurred                                                                  
     1,584.5       1,703.4       1,540.2  
                         
Interest on claim reserves                                                                        
     69.3       61.4       56.7  
                         
Paid claims (net of reinsurance) related to:
                        
Current year                                                                      
     910.7       1,001.1       900.9  
Prior years                                                                      
     691.6       609.5       541.9  
                         
Total paid                                                                  
     1,602.3       1,610.6       1,442.8  
                         
Net change in balance for reinsurance assumed and ceded
     51.2       (60.6 )     (35.4 )
                         
Balance, end of the year                                                                        
   $ 1,444.0     $ 1,341.3     $ 1,247.7  
___________
 
(a)
The reserves and liabilities we establish are necessarily based on estimates, assumptions and prior years’ statistics.  Such amounts will fluctuate based upon the estimation procedures used to determine the amount of unpaid losses.  It is possible that actual claims will exceed our reserves and have a material adverse effect on our results of operations and financial condition.

7.      INCOME TAXES

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

   
2009
    
2008
    
2007
  
                   
Current tax expense                                                                       
   $ 9.3     $ 3.8     $ 2.7  
Deferred tax provision (benefit)                                                                       
     50.8       5.6       (9.6 )
                         
Income tax expense (benefit) on period income
     60.1       9.4       (6.9 )
                         
Valuation allowance                                                                       
     27.8       403.9       68.0  
                         
Total income tax expense                                                                
   $ 87.9     $ 413.3     $ 61.1  


 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



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

   
2009
    
2008
    
2007
  
                   
U.S. statutory corporate rate                                                         
     35.0 %     35.0 %     (35.0 )%
Valuation allowance                                                         
     16.0       10,916.2       377.8  
Other nondeductible expenses                                                         
     (1.4 )     125.9       (3.3 )
State taxes                                                         
     1.0       78.0       (5.7 )
Provision for tax issues, tax credits and other
     -       15.2       5.6  
                         
Effective tax rate                                                       
     50.6 %     11,170.3 %     339.4 %

The components of the Company’s income tax assets and liabilities were as follows (dollars in millions):

   
2009
    
2008
  
Deferred tax assets:
            
Net federal operating loss carryforwards attributable to:
            
Life insurance subsidiaries                                                                                         
   $ 745.3     $ 840.7  
Non-life companies                                                                                         
     883.9       835.4  
Net state operating loss carryforwards                                                                                             
     19.1       20.3  
Tax credits                                                                                             
     18.5       13.7  
Capital loss carryforwards                                                                                             
     393.8       406.0  
Deductible temporary differences:
                
Insurance liabilities                                                                                           
     782.1       789.9  
Unrealized depreciation of investments                                                                                           
     146.8       987.4  
Reserve for loss on loan guarantees                                                                                           
     1.9       68.2  
Other                                                                                           
     42.1       25.1  
                 
Gross deferred tax assets                                                                                        
     3,033.5       3,986.7  
                 
Deferred tax liabilities:
                
Investments                                                                                             
     (38.1 )     (17.7 )
Present value of future profits and deferred acquisition costs
     (694.0 )     (739.1 )
                 
Gross deferred tax liabilities                                                                                         
     (732.1 )     (756.8 )
                 
Net deferred tax assets before valuation allowance                                                                                         
     2,301.4       3,229.9  
                 
Valuation allowance                                                                                                 
     (1,176.4 )     (1,180.7 )
                 
Net deferred tax assets                                                                                         
     1,125.0       2,049.2  
                 
Current income taxes accrued                                                                                                 
     (1.0 )     (1.5 )
                 
Income tax assets, net                                                                                         
   $ 1,124.0     $ 2,047.7  

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

A reduction of the carrying amount of deferred tax assets by establishing a valuation allowance is required if, based on the available evidence, it is more likely than not that such assets will not be realized.  We evaluate the need to establish a valuation allowance for our deferred income tax assets on an ongoing basis.  In evaluating our deferred income tax assets, we

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________


consider whether the deferred income tax assets will be realized, based on the more-likely-than-not realization threshold criterion.  The ultimate realization of our deferred income tax assets depends upon generating sufficient future taxable income during the periods in which our temporary differences become deductible and before our capital loss carryforwards and NOLs expire.  This assessment requires significant judgment.  In assessing the need for a valuation allowance, appropriate consideration is given to all positive and negative evidence related to the realization of the deferred tax assets.  This assessment considers, among other matters, the nature, frequency and severity of current and cumulative losses, forecasts of future profitability, excess appreciated asset value over the tax basis of net assets, the duration of carryforward periods, our experience with operating loss and tax credit carryforwards expiring unused, and tax planning alternatives.

Concluding that a valuation allowance is not required is difficult when there has been significant negative evidence, such as cumulative losses in recent years.  We utilize a three year rolling calculation of actual income before income taxes as our primary measure of cumulative losses in recent years.  Our analysis of whether there needs to be further increases to the deferred tax valuation allowance recognizes that as of December 31, 2009, we have incurred a cumulative loss over the evaluation period, resulting from the substantial loss during 2008 primarily related to the Transfer of Senior Health to an independent trust as described in the note to these consolidated financial statements entitled “Transfer of Senior Health Insurance Company of Pennsylvania to an Independent Trust”.  As a result of the cumulative losses recognized in recent years, our evaluation of the need to increase the valuation allowance for deferred tax assets was primarily based on our historical earnings.  However, because a substantial portion of the cumulative losses for the three-year period ended December 31, 2009, relates to transactions to dispose of blocks of businesses, we have adjusted the three-year cumulative results for the income and losses from the blocks of business disposed of in the past and the business transferred as further described in the note to these financial statements entitled “Transfer of Senior Health Insurance Company of Pennsylvania to an Independent Trust”.  In addition, we have adjusted the three-year cumulative results for a significant litigation settlement, which we consider to be a non-recurring matter and have reflected our best estimates of how temporary differences will reverse over the carryforward periods.

At December 31, 2009, our valuation allowance for our net deferred tax assets was $1.2 billion, as we have determined that it is more likely than not that a portion of our deferred tax assets will not be realized.  This determination was made by evaluating each component of the deferred tax asset and assessing the effects of limitations and/or interpretations on the value of such component to be fully recognized in the future.  We have also evaluated the likelihood that we will have sufficient taxable income to offset the available deferred tax assets based on evidence which we consider to be objective and verifiable. Based upon our analysis completed at December 31, 2009, we believe that we will, more likely than not, recover $1.1 billion of our deferred tax assets through reductions of our tax liabilities in future periods.

Changes in our valuation allowance are summarized as follows (dollars in millions):

Balance at December 31, 2006                                                                                  
   $ 777.8    
           
Increase in 2007                                                                               
     68.0    
Expiration of capital loss carryforwards                                                                               
     (157.6 )  
Write-off of certain state NOLs (recovery is remote)
     (15.3 )  
           
Balance at December 31, 2007                                                                                  
     672.9    
           
Increase in 2008                                                                               
     856.2  
(a)
Expiration of capital loss carryforwards                                                                               
     (209.7 )  
Write-off of capital loss carryforwards related to Senior Health
     (133.2 )  
Write-off of certain NOLs related to Senior Health
     (5.5 )  
           
Balance at December 31, 2008                                                                                  
     1,180.7    
           
Increase in 2009                                                                               
     27.8  
(b)
Expiration of capital loss carryforwards                                                                               
     (32.1 )  
           
Balance at December 31, 2009                                                                                 
   $ 1,176.4    


 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________


____________________
(a)  
The $856.2 million increase to our valuation allowance during 2008 included increases of:  (i) $452 million of deferred tax assets related to Senior Health, which was transferred to an independent trust during 2008; (ii) $298 million related to our reassessment of the recovery of our deferred tax assets in accordance with GAAP, following the additional losses incurred as a result of the transaction to transfer Senior Health to an independent trust; (iii) $60 million related to the recognition of additional realized investment losses for which we are unlikely to receive any tax benefit; and (iv) $45 million related to the estimated additional future expense following the modifications to our Senior Credit Agreement as described in the note to these consolidated financial statements entitled “Notes Payable - Direct Corporate Obligations.”

(b)  
The $27.8 million increase to our valuation allowance during 2009 included increases of:  (i) $23.0 million related to our reassessment of the recovery of our deferred tax assets following the completion of reinsurance transactions in 2009; and (ii) $4.8 million related to the recognition of additional realized investment losses for which we are unlikely to receive any tax benefit.

Recovery of our deferred tax assets is dependent on achieving the projections of future taxable income embedded in our analysis and failure to do so would result in an increase in the valuation allowance in a future period.  Any future increase in the valuation allowance may result in additional income tax expense and reduce shareholders’ equity, and such an increase could have a significant impact upon our earnings in the future.  In addition, the use of the Company’s NOLs is dependent, in part, on whether the Internal Revenue Service (the “IRS”) does not take an adverse position in the future regarding the tax position we have taken in our tax returns with respect to the allocation of cancellation of indebtedness income.

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

Section 382 imposes limitations on a corporation’s ability to use its NOLs when the company undergoes an ownership change.  Future transactions and the timing of such transactions could cause an ownership change for Section 382 income tax purposes.  Such transactions may include, but are not limited to, additional repurchases or issuances of common stock (including upon conversion of our outstanding 3.5% Debentures or 7.0% Debentures), or acquisitions or sales of shares of CNO stock by certain holders of our shares, including persons who have held, currently hold or may accumulate in the future five percent or more of our outstanding common stock for their own account.  Many of these transactions are beyond our control.  If an additional ownership change were to occur for purposes of Section 382, we would be required to calculate an annual restriction on the use of our NOLs to offset future taxable income.  The annual restriction would be calculated based upon the value of CNO’s equity at the time of such ownership change, multiplied by a federal long-term tax exempt rate (4.16 percent at December 31, 2009), and the annual restriction could effectively eliminate our ability to use a substantial portion of our NOLs to offset future taxable income.  We regularly monitor ownership change (as calculated for purposes of Section 382) and, as of December 31, 2009, we were below the 50 percent ownership change level that would trigger further impairment of our ability to utilize our NOLs.

On January 20, 2009, the Company’s Board of Directors adopted a Section 382 Rights Agreement which is designed to protect shareholder value by preserving the value of our tax assets primarily associated with tax NOLs under Section 382.  The Section 382 Rights Agreement was adopted to reduce the likelihood of this occurring by deterring the acquisition of stock that would create “5 percent shareholders” as defined in Section 382.

Under the Section 382 Rights Agreement, one right was distributed for each share of our common stock outstanding as of the close of business on January 30, 2009.  Effective January 20, 2009, if any person or group (subject to certain exemptions) becomes a “5 percent shareholder” of CNO without the approval of the Board of Directors, there would be a triggering event causing significant dilution in the voting power and economic ownership of that person or group.  Existing shareholders who currently are “5 percent shareholders” will trigger a dilutive event only if they acquire additional shares exceeding one percent of our outstanding shares without prior approval from the Board of Directors.

The Section 382 Rights Agreement will continue in effect until January 20, 2012, unless earlier terminated or redeemed by the Board of Directors.  The Company’s Audit Committee will review our NOLs on an annual basis and will recommend amending or terminating the Section 382 Rights Agreement based on its review.  The Section 382 Rights

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________


Agreement was approved by a vote at the annual meeting of shareholders on May 12, 2009.

As of December 31, 2009, we had $4.7 billion of federal NOLs and $1.1 billion of capital loss carryforwards, which expire as follows (dollars in millions):

Year of expiration
  
Net operating loss carryforwards (a)
  
Capital loss
    
Total loss
  
   
Life
  
Non-life
  
carryforwards
    
carryforwards
  
                             
2010
   $ -       $ .1       $ -     $ .1  
2011
     -         .1         -       .1  
2012
     -         -         63.6       63.6  
2013
     -         -         1,034.2       1,034.2  
2014
     -         -         27.3       27.3  
2018
     1,895.7  
(a)
     -         -       1,895.7  
2021
     29.6         -         -       29.6  
2022
     204.1         -         -       204.1  
2023
     -         2,058.2  
(a)
     -       2,058.2  
2024
     -         3.2         -       3.2  
2025
     -         118.8         -       118.8  
2026
     -         1.6         -       1.6  
2027
     -         216.3         -       216.3  
2028
     -         1.2         -       1.2  
2029
      -         125.8         -       125.8  
                                     
Total
   $ 2,129.4       $ 2,525.3       $ 1,125.1     $ 5,779.8  
____________________
(a)  
The allocation of the NOLs summarized above assumes the IRS does not take an adverse position in the future regarding the tax position we plan to take in our tax returns with respect to the allocation of cancellation of indebtedness income.  If the IRS disagrees with the tax position we plan to take with respect to the allocation of cancellation of indebtedness income, and their position prevails, approximately $631 million of the NOLs expiring in 2018 would be characterized as non-life NOLs.

We had deferred tax assets related to NOLs for state income taxes of $19.1 million and $20.3 million at December 31, 2009 and 2008, respectively.  The related state NOLs are available to offset future state taxable income in certain states through 2015.

As more fully discussed below, the Company’s interpretation of the tax law, as it relates to the application of the cancellation of indebtedness income to its NOLs, is an uncertain tax position.  Since all other life NOLs must be utilized prior to this portion of the NOL, it has not yet been utilized nor is it expected to be utilized within the next twelve months.  As a result, an uncertain tax position has not yet been taken on the Company’s tax return.

Although authoritative guidance allowed a change in accounting, the Company has chosen to continue its past accounting policy of classifying interest and penalties as income tax expense in the consolidated statement of operations.  No such amounts were recognized in 2009 or 2008.  The liability for accrued interest and penalties was not significant at December 31, 2009 or December 31, 2008.

Tax years 2006 through 2008 are open to examination by the IRS, and tax year 2002 remains open only for potential adjustments related to certain partnership investments.  The Company does not anticipate any material adjustments related to these partnership investments.  The Company’s various state income tax returns are generally open for tax years 2006 through 2008 based on the individual state statutes of limitation.

The following paragraphs describe an open matter related to the classification of our NOLs.

In July 2006, the Joint Committee of Taxation accepted the audit and the settlement which characterized $2.1 billion of the tax losses on our Predecessor’s investment in Conseco Finance Corp. as life company losses and the remaining amount as non-life losses prior to the application of the cancellation of indebtedness attribute reductions described below.  As a result of the approval of the settlement, we concluded it was appropriate to reduce our valuation allowance by $260 million in the

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________


second quarter of 2006, which was accounted for as an addition to paid-in capital.

The Code provides that any income realized as a result of the cancellation of indebtedness in bankruptcy (cancellation of debt income or “CODI”) must reduce NOLs.  We realized an estimated $2.5 billion of CODI when we emerged from bankruptcy.  Pursuant to the Company’s interpretation of the tax law, the CODI reductions were all used to reduce non-life NOLs.  However, if the IRS were to disagree with our interpretation and ultimately prevail, we believe $631 million of NOLs classified as life company NOLs would be re-characterized as non-life NOLs and subject to the 35% limitation discussed above.  Such a re-characterization would also extend the year of expiration as life company NOLs expire after 15 years whereas non-life NOLs expire after 20 years.  The Company does not expect the IRS to consider this issue for a number of years.

In accordance with GAAP, we are precluded from recognizing the tax benefits of any tax windfall upon the exercise of a stock option or the vesting of restricted stock unless such deduction resulted in actual cash savings to the Company.  Because of the Company’s NOLs, no cash savings have occurred.  NOL carryforwards of $2.3 million related to deductions for stock options and restricted stock will be reflected in additional paid-in capital if realized.

8.       NOTES PAYABLE - DIRECT CORPORATE OBLIGATIONS

The following notes payable were direct corporate obligations of the Company as of December 31, 2009 and 2008 (dollars in millions):

   
2009
    
2008
  
             
3.5% Debentures                                                                      
   $ 116.5     $ 293.0  
7.0% Debentures                                                                      
     176.5       -  
Secured credit agreement                                                                      
     652.1       911.8  
6% Senior Note                                                                      
     100.0       125.0  
Unamortized discount on 3.5% Debentures                                                                      
     (3.3 )     (18.3 )
Unamortized discount on 7.0% Debentures                                                                      
     (4.4 )     -  
                 
Direct corporate obligations                                                                  
   $ 1,037.4     $ 1,311.5  

3.5% Debentures

In August 2005, we completed the private offering of $330 million of 3.5% Debentures.  The terms of the 3.5% Debentures are governed by an indenture dated as of August 15, 2005 between the Company and The Bank of New York Trust Company, N.A., as trustee (the “3.5% Indenture”).  During 2008, we repurchased $37.0 million par value of such 3.5% Debentures for $15.3 million plus accrued interest.  On November 13, 2009, we completed a cash tender offer (the “Tender Offer”) for $176.5 million aggregate principal amount of the 3.5% Debentures.  The aggregate consideration for the 3.5% Debentures accepted by us in the Tender Offer, plus accrued and unpaid interest thereon, was $177.2 million.  Following the settlement of the Tender Offer, there is $116.5 million aggregate principal amount of the 3.5% Debentures outstanding.  At December 31, 2009 and 2008, unamortized issuance costs (classified as other assets) related to the 3.5% Debentures were $.4 million and $2.1 million, respectively, and are amortized as an increase to interest expense through September 30, 2010, which is the earliest date the 3.5% Debenture holders may require the Company to repurchase them.

The 3.5% Debentures are senior, unsecured obligations and bear interest at a rate of 3.5 percent per year, payable semi-annually, beginning on March 31, 2006 and ending on September 30, 2010.  Thereafter, the principal balance of the 3.5% Debentures will accrete at a rate that provides holders with an aggregate yield to maturity of 3.50 percent, computed on a semi-annual, bond-equivalent basis.  Beginning with the six-month interest period commencing September 30, 2010, the Company will pay contingent interest on the 3.5% Debentures if the average trading price per 3.5% Debenture for the five trading day period immediately preceding the six-month interest period equals or exceeds a certain level, as described in the 3.5% Indenture.

Upon the occurrence of certain specified events, the 3.5% Debentures will be convertible, at the option of the holders, into cash or, under certain circumstances, cash and shares of the Company’s common stock at an initial conversion price of approximately $26.66 per share.  The number of shares to be received by a converting holder is subject to adjustment for certain dilutive events.  The amount of cash to be received upon conversion is equal to the lesser of: (i) the accreted principal

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________


amount of the converting 3.5% Debenture; or (ii) the conversion value of such 3.5% Debentures (as calculated in accordance with the 3.5% Indenture).

On or after October 5, 2010, the Company may redeem for cash all or a portion of the 3.5% Debentures at any time at a redemption price equal to 100 percent of the accreted principal amount of the 3.5% Debentures plus accrued and unpaid interest, including additional interest and contingent interest, if any, to the redemption date.  Holders may require the Company to repurchase in cash all or any portion of the 3.5% Debentures on September 30, 2010, 2015, 2020, 2025 and 2030 at a repurchase price equal to 100 percent of the accreted principal amount of the 3.5% Debentures to be repurchased, plus accrued and unpaid interest, including additional interest and contingent interest, if any, to the applicable repurchase date.

If an event of default occurs and is continuing with respect to the 3.5% Debentures, either the trustee or the holders of at least 25 percent of the aggregate accreted principal amount of the 3.5% Debentures then outstanding may declare the accreted principal amount, plus accrued and unpaid interest, including additional interest and contingent interest, if any, on the 3.5% Debentures to be due and payable immediately.  If an event of default relating to certain events of bankruptcy, insolvency or reorganization occurs, the accreted principal amount plus accrued and unpaid interest, including additional interest and contingent interest, if any, on the 3.5% Debentures will become immediately due and payable.  The following are events of default with respect to the 3.5% Debentures:

·  
default for 30 days in payment of any interest, contingent interest or additional interest due and payable on the 3.5% Debentures;

·  
default in payment of accreted principal of the 3.5% Debentures at maturity, upon redemption, upon repurchase or following a fundamental change, when the same becomes due and payable;

·  
default by the Company or any of its subsidiaries in the payment of principal, interest or premium when due under any other instruments of indebtedness having an aggregate outstanding principal amount of $50.0 million (or its equivalent in any other currency or currencies) or more following a specified period for cure;

·  
default in the Company’s conversion obligations upon exercise of a holder’s conversion right, following a specified period for cure;

·  
default in the Company’s obligations to give notice of the occurrence of a fundamental change within the time required to give such notice;

·  
acceleration of any of the Company’s indebtedness or the indebtedness of any of its subsidiaries under any instrument or instruments evidencing indebtedness (other than the 3.5% Debentures) having an aggregate outstanding principal amount of $50.0 million (or its equivalent in any other currency or currencies) or more, subject to certain exceptions; and

·  
certain events of bankruptcy, insolvency and reorganization of the Company or any of its subsidiaries.

As further discussed in the note to the consolidated financial statements entitled “Subsequent Events”, we repurchased $64 million aggregate principal amount of the 3.5% Debentures in February 2010.

7.0% Debentures

On November 13, 2009, we issued $176.5 million aggregate principal amount of our 7.0% Convertible Senior Debentures due 2016 (the “7.0% Debentures”) in the initial closing of our private offering of 7.0% Debentures to Morgan Stanley & Co. Incorporated (“Morgan Stanley”), as the initial purchaser of the 7.0% Debentures.  The net proceeds from the initial closing of the offering of our 7.0% Debentures, after deducting the initial purchaser’s discounts and commissions and  before other offering expenses, totaled $172.0 million.  The Company used the net proceeds to fund a substantial portion of the consideration payable in connection with the Tender Offer for the 3.5% Debentures.  At December 31, 2009, unamortized issuance costs (classified as other assets) related to the 7.0% Debentures were $2.1 million, and are amortized as an increase to interest expense over the term of the 7.0% Debentures.  We expect to issue additional 7.0% Debentures, and Morgan Stanley, as the initial purchaser, is required to purchase these additional 7.0% Debentures, subject to the satisfaction of certain conditions, on the following dates:

 
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·  
the settlement date of any subsequent tender offers we make for outstanding 3.5% Debentures that expire before October 5, 2010;

·  
the settlement date of any privately negotiated transactions that settle before October 5, 2010;

·  
September 30, 2010, the date on which we may be required by holders of the 3.5% Debentures, if any, to repurchase such 3.5% Debentures; and

·  
October 5, 2010, if we elect to redeem any 3.5% Debentures that remain outstanding on such date.

The net proceeds from any subsequent closings of the 7.0% Debentures offering will be used to fund a substantial portion of the aggregate consideration payable for 3.5% Debentures that we may repurchase or redeem in accordance with the terms of the 3.5% Debentures.

The 7.0% Debentures rank equally in right of payment with all of the Company’s unsecured and unsubordinated obligations including the 3.5% Debentures.  The 7.0% Debentures are governed by an Indenture dated as of October 16, 2009 (the “7.0% Indenture”) between the Company and The Bank of New York Mellon Trust Company, N.A., as trustee.  The 7.0% Debentures bear interest at a rate of 7.0% per annum, payable semi-annually on June 30 and December 30 of each year, commencing on the interest payment date immediately succeeding the issuance date of such series; provided, however, that if the issuance date of a series of 7.0% Debentures is after the close of business on the interest record for such interest payment date, the first interest payment date will instead be the second interest payment date immediately succeeding the issuance date of such series.  The 7.0% Debentures will mature on December 30, 2016, unless earlier converted.  The 7.0% Debentures may not be redeemed at the Company’s election prior to the stated maturity date and the holders may not require the Company to repurchase the 7.0% Debentures at any time.  The 7.0% Debentures are not convertible prior to June 30, 2013, except under limited circumstances.  Commencing on June 30, 2013, the 7.0% Debentures will be convertible into shares of our common stock at the option of the holder at any time, subject to certain exceptions and subject to our right to terminate such conversion rights under certain circumstances relating to the sale price of our common stock.  If the holders elect to convert their 7.0% Debentures upon the occurrence of certain changes of control of CNO or certain other events, we will be required, under certain circumstances, to increase the conversion rate for such holders of the 7.0% Debentures who convert in connection with such events.  Initially, the 7.0% Debentures will be convertible into 182.1494 shares of our common stock for each $1,000 principal amount of 7.0% Debentures, which is equivalent to an initial conversion price of approximately $5.49 per share.  The conversion rate is subject to adjustment following the occurrence of certain events in accordance with the terms of the 7.0% Indenture.

Except as specified in the 7.0% Indenture, if an event of default (as defined in the 7.0% Indenture), other than an event of default relating to certain events of bankruptcy, insolvency or reorganization of the Company or any Significant Subsidiary (as defined in the 7.0% Indenture), occurs and is continuing, the trustee or holders of more than 50% in principal amount of the outstanding 7.0% Debentures may declare the principal of and accrued but unpaid interest on all of the 7.0% Debentures to be due and payable.  If an event of default relating to certain events of bankruptcy, insolvency or reorganization of the Company or any Significant Subsidiary occurs, the principal of, and accrued but unpaid interest on all the 7.0% Debentures will become immediately due and payable without any declaration or other act on the part of the trustee or any holders.  The following are events of default with respect to the 7.0% Debentures:

·  
default in payment of any interest due and payable on the 7.0% Debentures and such default continues unremedied for 30 days;

·  
default in payment of principal of the 7.0% Debentures when the same becomes due and payable, whether at maturity, upon declaration of acceleration or otherwise;

·  
default by the Company or any of the Company’s subsidiaries under any instrument or instruments evidencing indebtedness (other than the 7.0% Debentures) having an outstanding principal amount exceeding $50.0 million (or its equivalent in any other currency or currencies) that has caused the holders thereof to declare such indebtedness to be due and payable prior to its stated maturity;

·  
default in payment of indebtedness (other than in respect of swap contracts) for money borrowed by the Company or

 
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Notes to Consolidated Financial Statements
__________________


any of the Company’s subsidiaries in an aggregate principal amount exceeding $50.0 million (or its equivalent in any other currency or currencies) when such indebtedness becomes due and payable at final maturity;

·  
a final judgment for a payment exceeding $50.0 million (excluding any amounts covered by insurance) rendered against the Company or any of the Company’s subsidiaries, which judgment is not vacated, discharged or stayed within 30 days after (1) the date on which the right to appeal thereof has expired if no such appeal has commenced, or (2) the date on which all rights to appeal have been extinguished;

·  
default in the Company’s performance of any other covenants or agreements in respect of the 7.0% Debentures contained in the 7.0% Indenture or the 7.0% Debentures for 60 days (or (1) solely in the case of the reporting covenant and, if applicable, the covenant set forth in Section 314(a) of the Trust Indenture Act of 1939, as amended, 120 days and (2) solely in the case of the Company’s failure to comply with its obligations to convert 7% Debentures or perform its covenant to reserve and list the common stock issuable upon conversion, 30 days) after written notice to the Company by the trustee or to the Company and the trustee by the holders of at least 25% in aggregate principal amount of all series of 7.0% Debentures then outstanding (acting together as a single class);

·  
the occurrence of a change of control after written notice is received by the Company not later than 90 days following the occurrence of such change of control (or with respect to any change of control that occurs prior to the issuance of the first series of 7.0% Debentures, 90 days following the issuance date of such first series of 7.0% Debentures), to the Company by the trustee or to the Company and the trustee by the holders of at least 10% in aggregate principal amount of all series of 7.0% Debentures then outstanding (acting together as a single class); or

·  
certain events of bankruptcy, insolvency and reorganization of the Company or one of the Company’s “significant subsidiaries” (as defined in Rule 1-02(w) of Regulation S-X under the Securities Act).

The 7.0% Indenture provides that on and after the date of the 7.0% Indenture, the Company may not:  (i) consolidate with or merge into any other person or sell, convey, lease or transfer the Company’s consolidated properties and assets substantially as an entirety to any other person in any one transaction or series of related transactions; or (ii) permit any person to consolidate with or merge into the Company, unless:

·  
if the Company is not the surviving person, then the surviving person formed by such consolidation or into which the Company is merged or the person to which the Company’s properties and assets are so sold, conveyed, leased or transferred shall be a corporation or limited liability company organized and existing under the laws of the United States of America, any State thereof or the District of Columbia; provided that the surviving person (if not the Company) shall execute and deliver to the trustee a supplemental indenture expressly assuming all of the Company’s obligations with respect to the 7.0% Debentures, including, among other things, the payment when due of the principal of and interest on the 7.0% Debentures and the performance of each of the Company’s other covenants under the 7.0% Indenture; and

·  
immediately after giving effect to such transaction, no default or event of default with respect to the 7.0% Debentures has occurred and is continuing.

Upon any such consolidation, merger or transfer, the surviving person (if not the Company) shall succeed to, and may exercise every right and power of, the Company under the 7.0% Indenture.

On November 17, 2009, two investment funds managed by Paulson & Co. Inc. (“Paulson”) purchased $120.5 million aggregate principal amount of 7.0% Debentures from Morgan Stanley, and other purchasers purchased the remaining $56.0 million aggregate principal amount of 7.0% Debentures from Morgan Stanley.  We have been informed by Morgan Stanley that the two funds managed by Paulson have entered into agreements with Morgan Stanley to purchase up to a total of $79.5 million additional aggregate principal amount of 7.0% Debentures, and other purchasers have agreed to purchase up to the remaining $37.0 million aggregate principal amount of 7.0% Debentures.

Holders of the 3.5% Debentures that remain outstanding have the right to require us to repurchase their debentures for cash on September 30, 2010.  If any 3.5% Debentures remain outstanding after September 30, 2010, we will have the right to redeem such debentures on October 5, 2010 for cash.  As of December 31, 2009, there are $116.5 million in aggregate principal amount of 3.5% Debentures outstanding.  We have commitments from Morgan Stanley to purchase an additional

 
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Notes to Consolidated Financial Statements
__________________


aggregate principal amount of 7.0% Debentures equal to the aggregate principal amount of 3.5% Debentures: (i) that we may purchase pursuant to any subsequent tender offer that expires before October 5, 2010; (ii) that we may purchase in privately negotiated transactions that settle before October 5, 2010; (iii) that holders thereof require us to repurchase on September 30, 2010; or (iv) for any 3.5% Debentures that remain outstanding on October 5, 2010 that we elect to redeem.

In accordance with GAAP, we are required to consider on each issuance date whether the debentures issued on such date are issued with a beneficial conversion feature.  A beneficial conversion feature will exist if the debentures may be convertible into common stock at an effective conversion price (calculated by dividing the proceeds from the issuance of 7.0% Debentures issued on that date (per $1,000 principal amount of debentures) by the then effective conversion rate) that is lower than the market price of a share of common stock on the date when all significant terms, including the quantity and timing of the issuance, are known.  When a beneficial conversion feature exists, we are required to separately recognize the beneficial conversion feature at issuance by allocating a portion of the proceeds to the intrinsic value of that feature.  The value of the beneficial conversion feature is recorded, net of taxes, as an increase to additional paid-in capital.

If a beneficial conversion feature exists on the actual date(s) of issuance, a discount equal to the intrinsic value of the beneficial conversion feature will be recorded against the carrying value of the 7.0% Debentures.  Such discount will be amortized from the actual date(s) of issuance to the stated maturity date of the 7.0% Debentures using the effective interest method.  Accordingly, the interest expense we recognize related to the 7.0% Debentures will be dependent upon whether a beneficial conversion feature exists on the actual date(s) of issuance and the amount by which the market price(s) of our common stock exceeds the effective conversion price on such actual date(s) of issuance.

On November 13, 2009, the market price of our common stock was $5.33 (the closing market price on November 12, 2009).  Because this amount was less than the effective conversion price of $5.35 on that date, a beneficial conversion feature did not exist with respect to the 7.0% Debentures issued on that date.  We cannot predict the subsequent date(s) of issuance or the market price of a share of our common stock on such date(s) of issuance, and accordingly, we cannot predict whether a beneficial conversion feature will exist on such date(s) of issuance and, if so, what value(s) would be recorded.

As further discussed in the note to the consolidated financial statements entitled “Subsequent Events”, we issued $64 million aggregate principal amount of the 7.0% Debentures in February 2010.  There was no beneficial conversion feature associated with the 7.0% Debentures issued in February 2010.

Senior Credit Agreement

On March 30, 2009, we completed Amendment No. 2 to our Second Amended and Restated Credit Agreement dated as of October 10, 2006 among CNO, Bank of America, N.A. as Agent, J.P. Morgan Chase Bank, N.A., as Syndication Agent and other parties (the “Senior Credit Agreement”), which provided for, among other things:  (i) additional margins between our current financial status and certain financial covenant requirements through June 30, 2010; (ii) higher interest rates and the payment of a fee; (iii) new restrictions on the ability of the Company to incur additional indebtedness; and (iv) the ability of the lender to appoint a financial advisor at the Company’s expense.

Pursuant to its amended terms, the applicable interest rate on the Senior Credit Agreement (based on either a Eurodollar or base rate) was increased.  The Eurodollar rate was equal to LIBOR plus 4 percent with a minimum LIBOR rate of 2.5 percent (such rate was previously LIBOR plus 2 percent with no minimum rate).  The base rate was equal to 2.5 percent plus the greater of:  (i) the Federal funds rate plus .50 percent; or (ii) Bank of America’s prime rate.  In addition, the amended agreement required the Company to pay a fee equal to 1 percent of the outstanding principal balance under the Senior Credit Agreement, which fee was added to the principal balance outstanding and was payable at the maturity of the facility.  This 1 percent fee was reported as non-cash interest expense.

The modifications to the Senior Credit Agreement also placed new restrictions on the ability of the Company to incur additional indebtedness.  The amendment:  (i) deleted the provision that allowed the Company to borrow up to an additional $330 million under the Senior Credit Agreement (the lenders under the facility having had no obligation to lend any amount under that provision); (ii) reduced the amount of secured indebtedness that the Company can incur from $75 million to $2.5 million; and (iii) limited the ability of the Company to incur additional unsecured indebtedness, except as provided below, to $25 million, and eliminated the provision that would have allowed the Company to incur additional unsecured indebtedness to the extent that principal payments were made on existing unsecured indebtedness.

 
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Notes to Consolidated Financial Statements
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The Company was permitted to issue unsecured indebtedness that is used solely to pay the holders of the 3.5% Debentures, provided that such indebtedness:  (i) had a maturity date that is no earlier than October 10, 2014; (ii) contained covenants and events of default that are no more restrictive than those in the Senior Credit Agreement; (iii) did not contain
any covenants or events of default based on maintenance of the Company’s financial condition; (iv) did not amortize; and (v) did not have a put date or otherwise be callable prior to April 10, 2014, and provided that the amount of such unsecured indebtedness incurred under this provision did not exceed the $293 million of 3.5% Debentures outstanding on March 30, 2009; and provided further that the amount of cash interest payable annually on any new issuance of such indebtedness, together with the cash interest payable on the outstanding 3.5% Debentures, did not exceed twice the amount of cash interest currently payable on the outstanding 3.5% Debentures.

The amendment prohibited the Company from redeeming or purchasing the 3.5% Debentures with cash from sources other than those described in the previous paragraph.  The amendment permitted the Company to amend, modify or refinance the Convertible Indebtedness so long as such new indebtedness complied with the restrictions set forth in the previous paragraph.

In addition, pursuant to the terms of the amended credit agreement, the agent (acting on behalf of the lenders) has the right to appoint a financial advisor at the Company’s expense to, among other things, review financial projections and other financial information prepared by or on behalf of the Company, perform valuations of the assets of the Company and take other actions as are customary or reasonable for an advisor acting in such capacity.  A financial advisor has been appointed by the agent and has been reviewing the Company.

On December 22, 2009, the Company entered into Amendment No. 3 to our Senior Credit Agreement, which provides for, among other things:

 
(i)
the minimum risk-based capital ratio requirement will remain at 200% through December 31, 2010 and will increase to 225% for 2011 and 250% for 2012 (the risk-based capital requirement was previously scheduled to return to 250% after June 30, 2010);

 
(ii)
the required minimum level of statutory capital and surplus will remain at $1.1 billion through December 31, 2010 and will increase to $1.2 billion for 2011 and $1.3 billion for 2012 (the required minimum level of statutory capital and surplus was previously scheduled to return to $1.27 billion after June 30, 2010);

 
(iii)
the interest coverage ratio requirement will remain at 1.50 through December 31, 2010 and will increase to 1.75 for 2011 and 2.00 for 2012 (the interest coverage ratio requirement was previously scheduled to return to 2.00 after June 30, 2010); and

 
(iv)
the debt to total capital ratio requirement will remain at 32.5% though December 31, 2009 and will decrease to 30% thereafter (the debt to total capital ratio requirement was previously scheduled to return to 30% after June 30, 2010).

The Company also agreed to pay $150 million of the first $200 million of net proceeds from its public offering of common stock (as further discussed below) to the lenders and, in addition, to pay 50% of any net proceeds in excess of $200 million from the offering.  The credit facility previously required the Company to pay 50% of the net proceeds of any equity issuance to the lenders.

The amendment modifies the Company’s principal repayment schedule to eliminate any principal payments in 2010 and provides for principal payments of $35 million in 2011, $40 million in 2012 and $40 million in 2013.  There were no changes to the maturity date of October 10, 2013.  The Company was previously required to make principal repayments equal to 1% of the initial principal balance each year, subject to certain adjustments, and to make additional principal repayments from excess cash flow.

The amendment also provides that the 1% payment in kind, or PIK, interest that has accrued since March 30, 2009 as an addition to the principal balance under the Senior Credit Agreement will be replaced with a payment of an equal amount of cash interest.  The amount of accrued PIK interest ($6.3 million) was paid in cash when the amendment became effective.  The deletion of the 1% PIK interest and the payment of an equal amount of cash interest will not impact reported interest expense.

 
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Notes to Consolidated Financial Statements
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On November 13, 2009, we repaid $36.8 million of outstanding principal on the Senior Credit Agreement from the proceeds of the issuance of common stock and warrants to Paulson.  On December 22, 2009, the Company repaid $161.4 million of outstanding principal on the Senior Credit Agreement from proceeds of an equity offering.  Such transactions are further discussed in the note to the consolidated financial statements entitled “Shareholders’ Equity.”

During 2009, 2008 and 2007, we made scheduled principal payments totaling $5.3 million, $8.7 million and $7.8 million, respectively, on our Senior Credit Agreement.  Also, during 2009, we made a mandatory prepayment of $1.2 million based on the Company’s excess cash flows at December 31, 2008 as defined in the Senior Credit Agreement.  There were $5.4 million and $5.8 million of unamortized issuance costs (classified as other assets) related to our Senior Credit Agreement at December 31, 2009 and 2008, respectively.

In accordance with Amendment No. 3 to our Senior Credit Agreement, the amounts outstanding under the Senior Credit Agreement bear interest, payable at least quarterly, based on either a Eurodollar rate or a base rate.  The Eurodollar rate is equal to LIBOR plus 5 percent with a minimum LIBOR rate of 2.5 percent.  The base rate is equal to 4 percent plus the greater of:  (i) the Federal funds rate plus .50 percent; or (ii) Bank of America’s prime rate.  Under the terms of the Senior Credit Agreement, if the Company’s senior secured long-term debt is rated at least “Ba2” by Moody’s and “BB” by S&P, in each case with a stable outlook, the margins on the Eurodollar rate or the base rate would each be reduced by .25 percent.  At December 31, 2009, the interest rate on our Senior Credit Agreement was 7.5 percent.

Pursuant to the Senior Credit Agreement, as long as the debt to total capitalization ratio (as defined in the Senior Credit Agreement) is greater than 20 percent and certain insurance subsidiaries (as defined in the Senior Credit Agreement) have financial strength ratings of less than A- from A.M. Best Company, the Company is required to make mandatory prepayments with all or a portion of the proceeds from the following transactions or events including:  (i) the issuance of certain indebtedness; (ii) certain equity issuances; and (iii) certain asset sales or casualty events.  The Company may make optional prepayments at any time in minimum amounts of $3.0 million or any multiple of $1.0 million in excess thereof.

 
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Notes to Consolidated Financial Statements
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The following chart summarizes:  (i) the most significant financial ratios and balances we must maintain pursuant to our Senior Credit Agreement; (ii) the current ratios and balances as of December 31, 2009; and (iii) the margins for adverse developments before such ratio or balance requirement is not met (dollars in millions):

     
Balance or
    
     
ratio as of
  
Margin for adverse
 
Covenant under the
  
December 31,
  
development from
 
Senior Credit Agreement
  
2009
  
December 31, 2009 levels
           
Aggregate risk-based capital ratio
Greater than or equal to 200% from March 31, 2009 through December 31, 2010; greater than or equal to 225% from March 31, 2011 through December 31, 2011; and thereafter, greater than 250%.
     309%  
Reduction to total adjusted capital (defined as combined statutory capital and surplus plus the asset valuation reserve and 50 percent of the balance of the provision of policyholder dividends) of approximately $507 million, or an increase to required risk-based capital of approximately $253 million.
             
Combined statutory capital and surplus
Greater than $1,100 from March 31, 2009 through December 31, 2010; greater than $1,200 million from March 31, 2011 through December 31, 2011; and thereafter, $1,300 million.
  
$1,439 million
  
Reduction to combined statutory capital and surplus of approximately $339 million.
             
Debt to total capitalization ratio
Not more than 32.5% from March 31, 2009 through December 31, 2009 and thereafter, not more than 30%.
     21.6%  
Reduction to shareholders’ equity of approximately $1,620 million or additional debt of $780 million.
             
Interest coverage ratio
Greater than or equal to 1.50 to 1 for rolling four quarters from March 31, 2009 through December 31, 2010; greater than or equal to 1.75 to 1 for rolling four quarters from March 31, 2011 through December 31, 2011; and thereafter, 2.00 to 1.
  
2.38 to 1
  
Reduction in cash flows to the holding company of approximately $58 million.

The Senior Credit Agreement included an $80.0 million revolving credit facility that could be used for general corporate purposes and that would mature on June 22, 2009.  In October 2008, the Company borrowed $75.0 million under the revolving credit facility to assure the future availability of this additional liquidity given our concerns with the ability of certain financial institutions to be able to provide funding in the future.  In December 2008, we repaid $20.0 million of the revolving facility and reduced the maximum amount available under the revolving facility to $60.0 million.  At December 31, 2008, there was $55.0 million outstanding under the revolving facility.  In April 2009, we repaid the remaining $55.0 million that was outstanding under the revolving facility portion of our Senior Credit Agreement.  The Company paid a commitment fee equal to .50 percent of the unused portion of the revolving credit facility on an annualized basis.  The revolving credit facility interest was based on either a Eurodollar rate or a base rate in the same manner as described above for the Senior Credit Agreement.

The Senior Credit Agreement prohibits or restricts, among other things:  (i) the payment of cash dividends on our

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
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common stock; (ii) the repurchase of our common stock; (iii) the issuance of additional debt or capital stock; (iv) liens; (v) certain asset dispositions; (vi) affiliate transactions; (vii) certain investment activities; (viii) change in business; and (ix) prepayment of indebtedness (other than the Senior Credit Agreement).  The obligations under our Senior Credit Agreement are guaranteed by CNO’s current and future domestic subsidiaries, other than:  (i) its insurance companies; (ii) subsidiaries of the insurance companies; or (iii) certain immaterial subsidiaries as defined in the Senior Credit Agreement.  This guarantee was secured by granting liens on substantially all the assets of the guarantors, including the capital stock of Conseco Life Insurance Company of Texas, Washington National and Conseco Health.

Senior Note

In connection with the Transfer, the Company issued the Senior Note payable to Senior Health.  The Senior Note is unsecured and bears interest at a rate of 6.00 percent per year payable quarterly, beginning on March 15, 2009.  We are required to make annual principal payments of $25.0 million beginning on November 12, 2009.  The Company made a $25.0 million scheduled payment on the Senior Note in 2009.  The Company may redeem the Senior Note, in whole or in part, at any time by giving the holder 30 days notice (unless a shorter notice is satisfactory to the holder).  The redemption amount is equal to the principal amount redeemed plus any accrued and unpaid interest thereon.  Any outstanding amount under the Senior Note will be due and payable immediately if an event of default (as defined in the Senior Note) occurs and continues without remedy.  As a condition of the order from the Pennsylvania Insurance Department approving the Transfer, we agreed that we would not pay cash dividends on our common stock while any portion of the Senior Note remained outstanding.

Gain (Loss) on Extinguishment or Modification of Debt

In 2009, we recognized an aggregate loss on the extinguishment or modification of debt totaling $22.2 million resulting from expenses incurred and the write-off of unamortized discount or issuance costs related to the following transactions which are described above:  (i) the Tender Offer; (ii) repayment of principal amounts on the Senior Credit Agreement from the issuance of common stock; and (iii) modifications to our Senior Credit Agreement in March 2009 and December 2009.

In 2008, we repurchased $37.0 million par value of the 3.5% Debentures for $15.3 million plus accrued interest and recognized a gain on the extinguishment of debt of $21.2 million related to such repurchases.

Scheduled Debt Repayments

The scheduled repayment of our direct corporate obligations is as follows (dollars in millions):

2010                                                                         
   $ 141.5  
(a)
2011                                                                         
     60.0    
2012                                                                         
     65.0    
2013                                                                         
     602.1    
2016                                                                         
     176.5    
           
    $ 1,045.1    
_____________
 
(a)
Includes $116.5 million of the 3.5% Debentures.  The holders of our 3.5% Debentures have the right to require the Company to repurchase their 3.5% Debentures for cash on September 30, 2010.  This amount assumes that all remaining holders of our 3.5% Debentures exercise that right.  In February 2010, as further discussed in the note to the consolidated financial statements entitled “Subsequent Events”, we repurchased $64 million of the 3.5% Debentures and issued $64 million of the 7.0% Debentures.

 
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Notes to Consolidated Financial Statements
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  9.  
COMMITMENTS AND CONTINGENCIES

 
    Litigation

Legal Proceedings

The Company and its subsidiaries are involved in various legal actions in the normal course of business, in which claims for compensatory and punitive damages are asserted, some for substantial amounts.  Some of the pending matters have been filed as purported class actions and some actions have been filed in certain jurisdictions that permit punitive damage awards that are disproportionate to the actual damages incurred.  Although there can be no assurances, at the present time the Company does not anticipate that the ultimate liability from either pending or threatened legal actions, after consideration of existing loss provisions, will have a material adverse effect on the financial condition, operating results or cash flows of the Company.  The amounts sought in certain of these actions are often large or indeterminate and the ultimate outcome of certain actions is difficult to predict.  In the event of an adverse outcome in one or more of these matters, the ultimate liability may be in excess of the liabilities we have established and could have a material adverse effect on our business, financial condition, results of operations and cash flows.  In addition, the resolution of pending or future litigation may involve modifications to the terms of outstanding insurance policies, which could adversely affect the future profitability of the related insurance policies.

In the cases described below, we have disclosed any specific dollar amounts sought in the complaints.  In our experience, monetary demands in complaints bear little relation to the ultimate loss, if any, to the Company.  However, for the reasons stated above, it is not possible to make meaningful estimates of the amount or range of loss that could result from some of these matters at this time.  The Company reviews these matters on an ongoing basis and when assessing reasonably possible and probable outcomes, the Company bases its decisions on its assessment of the ultimate outcome following all appeals.

Securities Litigation

After our Predecessor announced its intention to restructure on August 9, 2002, eight purported securities fraud class action lawsuits were filed in the United States District Court for the Southern District of Indiana.  The complaints named us as a defendant, along with certain of our former officers.  These lawsuits were filed on behalf of persons or entities who purchased our Predecessor’s common stock on various dates between October 24, 2001 and August 9, 2002.  The plaintiffs allege claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended, and allege material omissions and dissemination of materially misleading statements regarding, among other things, the liquidity of our Predecessor and alleged problems in Conseco Finance Corp.’s manufactured housing division, allegedly resulting in the artificial inflation of our Predecessor’s stock price.  These cases were consolidated into one case in the United States District Court for the Southern District of Indiana, captioned Franz Schleicher, et al. v. Conseco, Inc., Gary Wendt, William Shea, Charles Chokel and James Adams, et al., Case No. 02-CV-1332 DFH-TAB.  The complaint seeks an unspecified amount of damages.  The plaintiffs filed an amended consolidated class action complaint with respect to the individual defendants on December 8, 2003.  Our liability with respect to this lawsuit was discharged in our Predecessor’s plan of reorganization and our obligation to indemnify individual defendants who were not serving as an officer or director on the Effective Date is limited to $3 million in the aggregate under such plan.  Our liability to indemnify individual defendants who were serving as an officer or director on the Effective Date, of which there is one such defendant, is not limited by such plan.  Our current estimate of the maximum loss that we could reasonably incur on this case is approximately $2.0 million.  A motion to dismiss was filed on behalf of defendants Shea, Wendt and Chokel and on July 14, 2005, this matter was dismissed.  Plaintiffs filed a second amended complaint on August 24, 2005.  Plaintiffs filed their motion for class certification on May 2, 2008, and on March 20, 2009 the court granted that motion.  On April 24, 2009, certain defendants initiated a request to appeal the class certification ruling to the U.S. Circuit Court of Appeals which was adopted by the 7th Circuit.  Oral argument on the appeal was held on September 22, 2009, and the matter was taken under advisement.  We believe this lawsuit is without merit and intend to defend it vigorously; however, the ultimate outcome cannot be predicted with certainty.  We do not believe that our potential loss related to the individual defendant who served as an officer on the Effective Date is material.

On August 6, 2009, a purported class action complaint was filed in the United States District Court for the Southern District of New York, Plumbers and Pipefitters Local Union No. 719 Pension Trust Fund, on behalf of itself and all others similarly situated v. Conseco, Inc., et al., Case No. 09-CIV-6966, on behalf of purchasers of our common stock during the period from August 4, 2005 to March 17, 2008 (the “Class Period”).  The complaint charges CNO and certain of its officers

 
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and directors with violations of the Securities Exchange Act of 1934.  The complaint alleges that, during the Class Period, the defendants issued numerous statements regarding the Company’s financial performance. As alleged in the complaint, these statements were materially false and misleading because the defendants misrepresented and/or failed to disclose the following adverse facts, among others: (i) that the Company was reporting materially inaccurate revenue figures; (ii) that the Company’s reported financial results were materially misstated and did not present the true operating performance of the Company; (iii) that the Company’s shareholders’ equity was materially overstated during the Class Period, including the overstatement of shareholders’ equity by $20.6 million at December 31, 2006; and (iv) as a result of the foregoing, the defendants lacked a reasonable basis for their positive statements about the Company, its corporate governance practices, its prospects and earnings growth.  On January 12, 2010, plaintiffs filed an amended complaint.  We believe the action is without merit and intend to defend it vigorously.  The ultimate outcome of the action cannot be predicted with certainty.

    Cost of Insurance Litigation

The Company and certain subsidiaries, including principally Conseco Life, have been named in numerous purported class action and individual lawsuits alleging, among other things, breach of contract, fraud and misrepresentation with regard to a change made in 2003 and 2004 in the way cost of insurance charges are calculated for life insurance policies sold primarily under the names “Lifestyle” and “Lifetime”.  Approximately 86,500 of these policies were subject to the change, which resulted in increased monthly charges to the policyholders’ accounts.  Many of the purported class action lawsuits were filed in Federal courts across the United States.  In June 2004, the Judicial Panel on Multidistrict Litigation consolidated these lawsuits into the action now referred to as In Re Conseco Life Insurance Co. Cost of Insurance Litigation, Cause No. MDL 1610 (Central District, California).  In September 2004, plaintiffs in the multi-district action filed an amended consolidated complaint and, at that time, added CNO Financial Group, Inc. as a defendant.  The amended complaint sought unspecified compensatory, punitive and exemplary damages as well as an injunction that would require the Company to reinstate the prior method of calculating cost of insurance charges and refund any increased charges that resulted from the change.  On April 26, 2005, the Judge in the multi-district action certified a nationwide class on the claims for breach of contract and injunctive relief.  On April 27, 2005, the Judge issued an order certifying a statewide California class for injunctive and restitutionary relief pursuant to California Business and Professions Code Section 17200 and breach of the duty of good faith and fair dealing, but denied certification on the claims for fraud and intentional misrepresentation and fraudulent concealment.  The Company announced on August 1, 2006, that it had reached a proposed settlement of this case.  Under the settlement, inforce policyholders were given an option to choose a form of policy benefit enhancement and certain former policyholders will share in a settlement fund by either receiving cash or electing to reinstate their policies with enhanced benefits.  The settlement was subject to court review and approval, a fairness hearing, notice to all class members, election of options by the class members, implementation of the settlement and other conditions.  The Court entered final judgment in the case on July 5, 2007.  We previously recognized costs related to this litigation totaling $267.2 million (none of which was recognized in 2009 or 2008).

Two lawsuits are pending in Hawaii captioned AE Ventures for Archie Murakami, et al. v. Conseco, Inc., Conseco Life Insurance Company; and Doe Defendants 1-100, Case No. CV05-00594 and Clifford S. Arakaki et al. v. Conseco Life Insurance Company, Doe Defendants 1-100, Case No. CV05-00026 (United States District Court, District of Hawaii).  These suits involve an aggregate of approximately 700 plaintiffs all of whom purport to have opted out of the In Re Conseco Life Insurance Co. Cost of Insurance Litigation multi-district action.  The complaints allege nondisclosure, breach of fiduciary duty, violations of HRS 480 (unfair and/or deceptive business practices), declaratory and injunctive relief, insurance bad faith, punitive damages, and seeks to impose alter ego liability.  Trial has been set for August 20, 2010.  A settlement in principle has been reached.  The court entered a 90 day stay of the case pending finalization of the settlement.  The ultimate outcome of these lawsuits cannot be predicted with certainty and an adverse outcome could exceed the amount we have accrued and could have a material adverse impact on the Company’s consolidated financial condition, cash flows or results of operations.

Agent Litigation

On December 17, 2003, a complaint was filed in the 19th Judicial District Court, Parish of East Baton Rouge, Louisiana, Southern Capitol Enterprises, Inc. and F. David Tutt v. Conseco Services, LLC and Conseco Health Insurance Company, Case No. 515105. Plaintiffs are a former Conseco Health agency and its principal that allege in the complaint that they were damaged by Conseco Health’s termination of their Executive Marketing Agreement (“EMA”) and Business Continuation Plan (“BCP”).  Plaintiffs sought a declaratory judgment declaring the parties’ rights and obligations under plaintiffs’ EMA and BCP including definitions of terms within those contracts.  Plaintiffs also demanded a full accounting of

 
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all commissions allegedly due and a preliminary injunction stopping CNO from reducing or stopping commission payments during the pendency of this action.  At Conseco Health’s request, the case was removed to the United States District Court for the Middle District of Louisiana, Case No. 04CV40-D-M1.  On September 30, 2004, Mr. Tutt filed a separate complaint for breach of contract and damages against defendants in federal court which includes claims for: (1) breach of the EMA and BCP; (2) tortuous interference with the EMA and BCP; (3) unjust enrichment related to the EMA and BCP; and (4) requests an accounting of back commissions under the EMA and BCP.  The court consolidated the two cases on October 20, 2004.  Plaintiff later filed an amended and restated complaint for damages on March 15, 2006, which added our subsidiary, Performance Matters Associates, Inc., as a defendant.  Mr. Tutt’s motion for partial summary judgment, which sought to invalidate the non-competition and non-solicitation provisions in the EMA and the non-competition provision of the BCP, was granted by the court on December 15, 2004.  The court did not decide the issue of the BCP's continued validity.  After that issue was tried in April 2007, the court ruled that the BCP was valid and enforceable.  The court further ruled that the issues of breach of contract relating to plaintiffs’ exclusive rights and due to improper commission payments, breach of the duty of good faith and fair dealing as to the EMA and plaintiffs’ single business enterprise theory remain to be tried to a jury.  We believe the action is without merit, and intend to defend it vigorously.  The ultimate outcome of the action cannot be predicted with certainty.

On January 16, 2008, a purported class action was filed in the Superior Court of the State of California for the County of Alameda, Robin Fletcher individually, and on behalf of all others similarly situated vs. Bankers Life and Casualty Company, and Does 1 through 100, Case No. RG08366328.  In her original complaint, plaintiff alleged nonpayment by Bankers Life of overtime wages, failure to provide meal and rest periods, failure to reimburse expenses, and failure to provide accurate wage statements to its sales representatives in the State of California for the time period January 16, 2004 to present.  Additionally, the complaint alleges failure to pay wages on termination and unfair business practices.  On October 7, 2008, the plaintiff filed a first amended complaint which changes the proposed scope of the putative class from all agents in California for the subject time period to all agents at a single branch office in Alameda, California.  This would reduce the putative class from hundreds of members to approximately 100 members.  The class certification motion has not yet been filed, but the court set such motion for hearing on April 16, 2010.  We believe the action is without merit and we intend to defend the case vigorously.  The ultimate outcome of the action cannot be predicted with certainty.

Other Litigation

On November 17, 2005, a complaint was filed in the United States District Court for the Northern District of California, Robert H. Hansen, an individual, and on behalf of all others similarly situated v. Conseco Insurance Company, an Illinois corporation f/k/a Conseco Annuity Assurance Company, Cause No. C0504726.  Plaintiff in this putative class action purchased an annuity in 2000 and is claiming relief on behalf of the proposed national class for alleged violations of the Racketeer Influenced and Corrupt Organizations Act; elder abuse; unlawful, deceptive and unfair business practices; unlawful, deceptive and misleading advertising; breach of fiduciary duty; aiding and abetting of breach of fiduciary duty; and unjust enrichment and imposition of constructive trust.  On January 27, 2006, a similar complaint was filed in the same court entitled Friou P. Jones, on Behalf of Himself and All Others Similarly Situated v. Conseco Insurance Company, an Illinois company f/k/a Conseco Annuity Assurance Company, Cause No. C06-00537.  Mr. Jones had purchased an annuity in 2003.  Each case alleged that the annuity sold was inappropriate and that the annuity products in question are inherently unsuitable for seniors age 65 and older.  On March 3, 2006 a first amended complaint was filed in the Hansen case adding causes of action for fraudulent concealment and breach of the duty of good faith and fair dealing.  In an order dated April 14, 2006, the court consolidated the two cases under the original Hansen cause number and retitled the consolidated action:  In re Conseco Insurance Co. Annuity Marketing & Sales Practices Litig.  A motion to dismiss the amended complaint was granted in part and denied in part, and the plaintiffs filed a second amended complaint on April 27, 2007, which has added as defendants CNO Services, LLC and Conseco Marketing, LLC.  The court has not yet made a determination whether the case should go forward as a class action, and we intend to oppose any form of class action treatment of these claims.  We believe the action is without merit, and intend to defend it vigorously.  The ultimate outcome of the action cannot be predicted with certainty.

On September 24, 2004, a purported statewide class action was filed in the 18th Judicial District Court, Parish of Iberville, Louisiana, Diana Doiron, Individually And On Behalf of All Others Similarly Situated v. Conseco Health Insurance Company, Case No. 61,534.  In her complaint, plaintiff claims that she was damaged due to Conseco Health’s failure to pay claims made under her cancer policy, and seeks compensatory and statutory damages in an unspecified amount along with declaratory and injunctive relief.  Conseco Health Insurance Company caused the case to be removed to the United States District Court for the Middle District of Louisiana on November 3, 2004, and it was assigned Case No. 04-784-D-M2.  An order was issued on February 15, 2007 granting plaintiff’s motion for class certification.  The order certified two sub-classes,

 
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identifying them as the radiation treatment sub-class and the chemotherapy treatment sub-class.  We appealed the certification order to the 5th Circuit Court of Appeals, and by order entered May 28, 2008, the 5th Circuit Court of Appeals vacated the certification order and remanded to the District Court for redefinition of the sub-classes.  On April 7, 2009, the District Court entered an order denying recertification of the proposed classes.  The parties have agreed to settle this case, subject to court approval.  The settlement of this case will not have a significant impact on our business, financial condition, results of operations or cash flows.

On August 7, 2006, an action was filed in the United States District Court for the Southern District of New York, Sheldon H. Solow v. Conseco, Inc. and Carmel Fifth, LLC, Case No. 06-CV-5988 (BSJ).  The plaintiff alleges breach of duty to hold a fair auction, fraud, promissory estoppel, unjust enrichment and a declaratory judgment with respect to the sale by defendants of the GM Building in New York City in 2003.  The plaintiff was a losing bidder on the building.  In the complaint, the plaintiff seeks damages of $35 million on the unjust enrichment count and damages in an amount to be determined at trial on the remaining counts.  Defendants filed a motion to dismiss the complaint on September 18, 2006.  On January 11, 2008, the court ruled on the motion to dismiss, granting the motion with respect to the unjust enrichment and declaratory judgment counts, and denying the motion with respect to the remaining three counts.  On December 9, 2009, the court granted the Company’s motion for summary judgment and dismissed the case.  On December 22, 2009, the plaintiff filed a motion to alter judgment and for reconsideration.  On January 5, 2010, the Company filed its response in opposition to this motion.  On January 7, 2010, the plaintiff filed a notice of appeal.  The Company believes the action is without merit and intends to defend it vigorously.  The ultimate outcome of the action cannot be predicted with certainty.

On March 4, 2008, a complaint was filed in the United States District Court for the Central District of California, Celedonia X. Yue, M. D. on behalf of the class of all others similarly situated, and on behalf of the General Public v. Conseco Life Insurance Company, successor to Philadelphia Life Insurance Company and formerly known as Massachusetts General Life Insurance Company, Cause No. CV08-01506 CAS.  Plaintiff in this putative class action owns a Valulife universal life policy insuring the life of Ruth S. Yue originally issued by Massachusetts General Life Insurance Company in 1995.  Plaintiff is claiming breach of contract on behalf of the proposed national class and seeks injunctive and restitutionary relief pursuant to California Business & Professions Code Section 17200 and declaratory relief.  The putative class consists of all owners of Valulife and Valuterm universal life insurance policies issued by either Massachusetts General or Philadelphia Life and that were later acquired and serviced by Conseco Life.  Plaintiff alleges that members of the class will be damaged by increases in the cost of insurance that are set to take place in the twenty first policy year of Valulife and Valuterm policies. No such increases have yet been applied to the subject policies, and none is scheduled to take effect until 2011 when the oldest of these policies reaches its twenty-first anniversary.  Plaintiff filed a motion for certification of the class and on December 7, 2009, the court granted that motion.  The case is set for trial commencing July 6, 2010.  We believe the action is without merit, and intend to defend it vigorously.  The ultimate outcome of the action cannot be predicted with certainty.

On June 4, 2008, a purported class action complaint was filed in the Cook County Illinois Circuit Court Chancery Division, Sheldon Langendorf, et. al. individually and on behalf of themselves and all others similarly situated v. Conseco Senior Health Insurance Company, and Conseco, Inc., et. al. Case No. 08CH20571.  Plaintiff is claiming breach of contract and consumer fraud and seeks a declaratory judgment, claiming that Senior Health (formerly Conseco Senior Health Insurance Company prior to its name change in October 2008) and other affiliated companies routinely and improperly refuse to accept Medicare explanations of benefits as documentation in support of proofs of claim on individual hospital indemnity and other policies of health insurance.  Senior Health subsequently removed the action to the U.S. District Court for the Northern District of Illinois, where it is now pending as Case No. 08-CV-3914.  By stipulation of the parties, CNO Financial Group, Inc. was dismissed as a party on September 29, 2008.  Senior Health filed a motion to dismiss and/or for summary judgment on August 22, 2008, which the court granted in part and denied in part by entry dated December 18, 2008, dismissing the claim for Illinois statutory consumer fraud.  We agreed to assume liability for this litigation in connection with the separation of Senior Health.  The parties have agreed to settle this case, subject to court approval.  On August 6, 2009, the court granted preliminary approval of the settlement.  Final order and judgment approving settlement was entered on November 18, 2009.  The settlement of this case will not have a significant impact on our business, financial condition, results of operations or cash flows.

On December 8, 2008, a purported class action was filed in the U.S. District Court for the Southern District of Florida, Sydelle Ruderman individually and on behalf of all other similarly situated v. Washington National Insurance Company, Case No. 08-23401-CIV-Cohn/Selzer. In the complaint, plaintiff alleges that the inflation escalation rider on her policy of long-term care insurance operates to increase the policy’s lifetime maximum benefit, and that Washington National breached the contract by stopping her benefits when they reached the lifetime maximum.  The Company takes the position that the

 
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inflation escalator only affects the per day maximum benefit.  The court has scheduled a jury trial on January 25, 2010.  Plaintiffs filed their motion for class certification, and the motion has been fully briefed by both sides.  The court has not yet ruled on the motion or set it for hearing.  Additional parties have asked the court to allow them to intervene in the action, and the existing parties opposed their motion.  On January 5, 2010, the court granted the motion to intervene and granted the plaintiff’s motion for class certification.  The case is set for trial commencing on June 7, 2010.  We believe the action is without merit, and intend to defend it vigorously.  The ultimate outcome of the action cannot be predicted with certainty.

On December 24, 2008, a purported class action was filed in the U.S. District Court for the Northern District of California, Cedric Brady, et. al. individually and on behalf of all other similarly situated v. Conseco, Inc. and Conseco Life Insurance Company Case No. 3:08-cv-05746.  In their complaint, plaintiffs allege that Conseco Life and Conseco, Inc. committed breach of contract and insurance bad faith and violated various consumer protection statutes in the administration of various interest sensitive whole life products sold primarily under the name “Lifetrend” by requiring the payment of additional cash amounts to maintain the policies in force.  On April 23, 2009, the plaintiffs filed an amended complaint adding the additional counts of breach of fiduciary duty, fraud, negligent misrepresentation, conversion and declaratory relief.  On May 29, 2009, Conseco, Inc. and Conseco Life filed a motion to dismiss the amended complaint.  On July 29, 2009, the court granted in part and denied in part the motion to dismiss.  The court dismissed the allegations that Conseco Life violated various consumer protection statutes, the breach of fiduciary duty count, and dismissed Conseco, Inc. for lack of personal jurisdiction.  On October 15, 2009, Conseco Life filed a motion with the Judicial Panel on Multidistrict Litigation (“MDL”), seeking the establishment of an MDL proceeding consolidating this case and the McFarland case described below into a single action.  On February 3, 2010, the Judicial Panel on MDL ordered this case be consolidated for pretrial proceedings.  The Company believes the action is without merit and intends to defend it vigorously.  The ultimate outcome of the action cannot be predicted with certainty.

On July 2, 2009, a purported class action was filed in the U.S. District Court for the Middle District of Florida, Bill W. McFarland, and all those similarly situated v. Conseco Life Insurance Company, Case No. 3:09-cv-598-J-32MCR.  In his complaint, plaintiff alleges that Conseco Life committed breach of contract and has been unjustly enriched in the administration of various interest sensitive whole life products sold primarily under the name “Lifetrend.”  The plaintiff seeks declaratory and injunctive relief, compensatory damages, punitive damages and attorney fees.  Plaintiff filed a motion for class certification on October 6, 2009.  On October 15, 2009, Conseco Life filed a motion with the Judicial Panel on Multidistrict Litigation, seeking the establishment of an MDL proceeding consolidating this case and the Brady case described above into a single action in the Northern District of California Federal Court.  On February 3, 2010, the Judicial Panel on MDL ordered this case be consolidated for pretrial proceedings in the Northern District of California Federal Court.  The Company believes the action is without merit and intends to defend it vigorously.  The ultimate outcome of the action cannot be predicted with certainty.

On January 26, 2009, a purported class action complaint was filed in the United States District Court for the Northern District of Illinois, Samuel Rowe and Estella Rowe, individually and on behalf of themselves and all others similarly situated v. Bankers Life & Casualty Company and Bankers Life Insurance Company of Illinois, Case No. 09CV491.  The plaintiffs are alleging violation of California Business and Professions Code Sections 17200 et seq. and 17500 et seq., breach of common law fiduciary duty, breach of implied covenant of good faith and fair dealing, negligent misrepresentation and violation of California Welfare and Institutions Code Section 15600 on behalf of the proposed national class and seek injunctive relief, compensatory damages, punitive damages and attorney fees.  The plaintiff alleges that the defendants used an improper and misleading sales and marketing approach to seniors that fails to disclose all facts, misuses consumers’ confidential financial information, uses misleading sales and marketing materials, promotes deferred annuities that are fundamentally inferior and less valuable than readily available alternative investment products and fails to adequately disclose other principal risks including maturity dates, surrender penalties and other restrictions which limit access to annuity proceeds to a date beyond the applicants actuarial life expectancy.  Plaintiffs have amended their complaint attempting to convert this from a California only class action to a national class action.  In addition, the amended complaint adds causes of action under the Racketeer Influenced and Corrupt Organization Act (“RICO”); aiding and abetting breach of fiduciary duty and for unjust enrichment.  They dropped their claim that Bankers made negligent misrepresentations.  On November 20, 2009, Bankers Life filed a motion to dismiss the plaintiff’s RICO claims.  The plaintiffs’ opening brief on class certification is due by May 31, 2010.  We believe the action is without merit, and intend to defend it vigorously.  The ultimate outcome of the action cannot be predicted with certainty.

In addition, the Company and its subsidiaries are involved on an ongoing basis in other lawsuits, including purported class actions, related to their operations.  The ultimate outcome of all of these other legal matters pending against the

 
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Company or its subsidiaries cannot be predicted, and, although such lawsuits are not expected individually to have a material adverse effect on the Company, such lawsuits could have, in the aggregate, a material adverse effect on the Company’s consolidated financial condition, cash flows or results of operations.

Director and Officer Loan Program Litigation

The Company and CNO Services, LLC have settled all litigation related to the 1996-1999 director and officer loan programs.  As part of our Predecessor’s plan of reorganization, we are required to pay 45 percent of any net proceeds recovered in connection with these lawsuits, in an aggregate amount not to exceed $30 million, to former holders of our Predecessor’s trust preferred securities that did not opt out of a settlement reached with the committee representing holders of these securities.  As of December 31, 2009, we had paid $19.3 million to the former holders of trust preferred securities under this arrangement.  At December 31, 2009, we estimated that approximately $3.8 million, net of collection costs, of the remaining amounts due under the loan program will be collected (amounts that remain to be collected from borrowers with whom we have settled), of which $2.7 million will be paid to the former holders of our Predecessor’s trust preferred securities.

Regulatory Examinations and Fines

Insurance companies face significant risks related to regulatory investigations and actions.  Regulatory investigations generally result from matters related to sales or underwriting practices, payment of contingent or other sales commissions, claim payments and procedures, product design, product disclosure, additional premium charges for premiums paid on a periodic basis, denial or delay of benefits, charging excessive or impermissible fees on products, changing the way cost of insurance charges are calculated for certain life insurance products or recommending unsuitable products to customers.  We are, in the ordinary course of our business, subject to various examinations, inquiries and information requests from state, federal and other authorities.  The ultimate outcome of these regulatory actions cannot be predicted with certainty.  In the event of an unfavorable outcome in one or more of these matters, the ultimate liability may be in excess of liabilities we have established and we could suffer significant reputational harm as a result of these matters, which could also have a material adverse effect on our business, financial condition, results of operations or cash flows.

The states of Pennsylvania, Illinois, Texas, Florida and Indiana led a multistate examination of the long-term care claims administration and complaint handling practices of Senior Health and Bankers Life, as well as the sales and marketing practices of Bankers Life.  This examination commenced in July 2007 and on May 7, 2008, we announced a settlement among the state insurance regulators and Senior Health and Bankers Life.  This examination covered the years 2005, 2006 and 2007.  More than 40 states are parties to the settlement, which included a Senior Health fine of up to $2.3 million, with up to an additional $10 million payable in the event the process improvements and benchmarks, on the part of either Senior Health and/or Bankers Life, are not met over an 18 month period for Bankers Life or a two-and-a-half year period for Senior Health, which time started with the settlement.  The process improvement plan is being monitored by the lead states.

In late October 2008, Conseco Life mailed notice to approximately 12,000 holders of its “Lifetrend” life insurance products to inform them of:  (i) changes to certain “non-guaranteed elements” (“NGEs”) of their policies; and (ii) the fact that certain policyholders who were not paying premiums may have failed to receive a notice that their policy was underfunded and that additional premiums were required in order for the policyholders to maintain their guaranteed cash values.  In December 2008, Conseco Life mailed notice to approximately 16,000 holders of its CIUL3+ universal life policies to inform them of an increase in certain NGEs with respect to their policies.  Prior to or around the time that the notices were sent, Conseco Life had informed the insurance regulators in a number of states, including among others Indiana, Iowa and Florida, of these matters and the planned communication with the impacted policyholders.  Conseco Life received a cease and desist order from the Iowa Department of Insurance dated December 9, 2008, directing that it cease any further activity with respect to the matters that had been communicated in the notice to the Lifetrend policyholders.  In December 2008, in response to communications received from certain regulators and policyholders, Conseco Life unilaterally agreed to enter into a nationwide temporary moratorium through March 31, 2009 with regard to the proposed Lifetrend changes.  We agreed to extend that moratorium to June 30, 2009.  In addition, Conseco Life entered into a stipulation and standstill with the Iowa Department of Insurance pursuant to which Conseco Life also agreed to take no further action with respect to the Lifetrend and CIUL3+ policyholders in Iowa.

On December 22, 2008, Conseco Life also received an order to show cause relating to the Lifetrend changes from the Florida Office of Insurance Regulation (“OIR”), and Conseco Life entered into an agreement in January 2009 with the Florida OIR preserving Conseco Life’s right to a hearing while Conseco Life and the Florida OIR engaged in settlement

 
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discussions regarding the Lifetrend and CIUL3+ policies.  In January 2009, the Florida OIR commenced a market conduct examination involving Conseco Life.  After working with various state insurance regulators to review the terms of the Lifetrend and CIUL3+ policies, Conseco Life has reached a settlement in principle with the regulators regarding these issues. During this process, we have been allowed to move forward with implementing the NGE changes in its CIUL3+ policies while the regulators continued their review.  We have also resumed the administration of its Lifetrend policies with administrative changes in place but, at this time, it has not implemented the NGE changes pending execution of the final settlement agreement with the regulators.  The ultimate outcome of these regulatory proceedings cannot be predicted with certainty.

Guaranty Fund Assessments

The balance sheet at December 31, 2009, included: (i) accruals of $22.1 million, representing our estimate of all known assessments that will be levied against the Company’s insurance subsidiaries by various state guaranty associations based on premiums written through December 31, 2009; and (ii) receivables of $16.9 million that we estimate will be recovered through a reduction in future premium taxes as a result of such assessments.  At December 31, 2008, such guaranty fund assessment accruals were $9.5 million and such receivables were $5.9 million.  These estimates are subject to change when the associations determine more precisely the losses that have occurred and how such losses will be allocated among the insurance companies.  We recognized expense for such assessments of $.3 million, $3.1 million and $1.1 million in 2009, 2008 and 2007, respectively.

Guarantees

We hold bank loans made to certain former directors and employees to enable them to purchase common stock of our Predecessor.  These loans, with a principal amount of $481.3 million, had been guaranteed by our Predecessor.  We received all rights to collect the balances due pursuant to the original terms of these loans.  In addition, we hold loans to participants for interest on the loans.  The loans and the interest loans are collectively referred to as the “D&O loans.”  We regularly evaluate the collectibility of these loans in light of the credit worthiness of the participants and the current status of various legal actions we have taken to collect the D&O loans.  At December 31, 2009, we have estimated that approximately $3.8 million of the D&O loan balance (which is included in other assets) is collectible (net of the costs of collection).  An allowance has been established to reduce the total D&O loan balance to the amount we estimated was recoverable.

Pursuant to the settlement that was reached with the Official Committee of the Trust Originated Preferred Securities (“TOPrS”) Holders and the Official Committee of Unsecured Creditors in the Plan, the former holders of TOPrS (issued by our Predecessor’s subsidiary trusts and eliminated in our reorganization) who did not opt out of the bankruptcy settlement, will be entitled to receive 45 percent of any net proceeds from the collection of certain D&O loans in an aggregate amount not to exceed $30 million.  As of December 31, 2009, we had paid $19.3 million to the former holders of TOPrS and we have established a liability of $2.7 million (which is included in other liabilities), representing our estimate of the amount which will be paid to the former holders of TOPrS pursuant to the settlement.

In accordance with the terms of the employment agreements of two of the Company’s former chief executive officers, certain wholly-owned subsidiaries of the Company are the guarantors of the former executives’ nonqualified supplemental retirement benefits.  The liability for such benefits was $22.0 million at both December 31, 2009 and 2008 and is included in the caption “Other liabilities” in the consolidated balance sheet.

 
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Leases and Certain Other Long-Term Commitments

The Company rents office space, equipment and computer software under noncancellable operating lease agreements.  In addition, the Company has entered into certain sponsorship agreements which require future payments.  Total expense pursuant to these lease and sponsorship agreements was $42.3 million, $44.1 million and $44.8 million in 2009, 2008 and 2007, respectively.  Future required minimum payments as of December 31, 2009, were as follows (dollars in millions):

2010                                                                                               
   $ 41.0  
2011                                                                                               
     34.1  
2012                                                                                               
     29.2  
2013                                                                                               
     23.6  
2014                                                                                               
     17.7  
Thereafter                                                                                               
     60.2  
         
Total                                                                                         
   $ 205.8  

    10.  
OTHER DISCLOSURES

Agent Deferred Compensation Plan

For our agent deferred compensation plan and postretirement plans, it is our policy to immediately recognize changes in the actuarial benefit obligation resulting from either actual experience being different than expected or from changes in actuarial assumptions.

One of our insurance subsidiaries has a noncontributory, unfunded deferred compensation plan for qualifying members of its career agency force.  Benefits are based on years of service and career earnings.  The actuarial measurement date of this deferred compensation plan is December 31.  The liability recognized in the consolidated balance sheet for the agents’ deferred compensation plan was $106.3 million and $99.3 million at December 31, 2009 and 2008, respectively.  Costs incurred on this plan were $11.9 million, $7.7 million and $5.8 million during 2009, 2008 and 2007, respectively (including the recognition of gains (losses) of $(3.3) million, $.6 million and $3.3 million in 2009, 2008 and 2007, respectively, resulting from actual experience being different than expected or from changes in actuarial assumptions).  The estimated net loss for the agent deferred compensation plan that will be amortized from accumulated other comprehensive income into the net periodic benefit cost during 2010 is $.4 million.  In 2006, we purchased Company-owned life insurance (“COLI”) as an investment vehicle to fund the agent deferred compensation plan.  The COLI assets are not assets of the agent deferred compensation plan, and as a result, are accounted for outside the plan and are recorded in the consolidated balance sheet as other invested assets.  The carrying value of the COLI assets was $78.0 million and $51.2 million at December 31, 2009 and 2008, respectively.  Changes in the cash surrender value (which approximates net realizable value) of the COLI assets are recorded as net investment income.

We used the following assumptions for the deferred compensation plan to calculate:

   
2009
    
2008
  
             
Benefit obligations:
            
Discount rate
     5.75 %     6.03 %
                 
Net periodic cost:
                
Discount rate
     6.03 %     6.02 %


 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



The discount rate is based on the yield of a hypothetical portfolio of high quality debt instruments which could effectively settle plan benefits on a present value basis as of the measurement date.  At December 31, 2009, for our deferred compensation plan for qualifying members of our career agency force, we assumed a 5 percent annual increase in compensation until the participant’s normal retirement date (age 65 and completion of five years of service).

The benefits expected to be paid pursuant to our agent deferred compensation plan as of December 31, 2009 were as follows (dollars in millions):

2010                                                   
   $ 4.1  
2011                                                   
     4.3  
2012                                                   
     4.5  
2013                                                   
     4.6  
2014                                                   
     5.4  
2015 – 2019                                                   
     34.0  

The Company has qualified defined contribution plans for which substantially all employees are eligible.  Company contributions, which match certain voluntary employee contributions to the plan, totaled $4.2 million, $4.4 million and $4.2 million in 2009, 2008 and 2007, respectively.  Employer matching contributions are discretionary.

Reclassification Adjustments Included in Comprehensive Income (Loss)

The changes in unrealized appreciation (depreciation) included in comprehensive income (loss) are net of reclassification adjustments for after-tax net gains (losses) from the sale of investments included in net income (loss) of approximately $(593) million, $(19) million and $(4) million for the years ended December 31, 2009, 2008 and 2007, respectively.

 
11.
SHAREHOLDERS’ EQUITY

In December 2009, we completed the public offering, including underwriter over-allotments, of 49.5 million shares of our common stock at an offering price of $4.75 per share.  The net proceeds to the Company from the offering, after deducting underwriting commissions and discounts and offering expenses totaled $222.7 million.  The Company used $161.4 million of the net proceeds from the offering to reduce its indebtedness under its Senior Credit Agreement and the remaining net proceeds were used for general corporate purposes.

In November 2009, we completed the private sale of 16.4 million shares of our common stock and warrants to purchase 5.0 million shares of our common stock to Paulson on behalf of several investment funds and accounts managed by Paulson. The net proceeds to the Company from the private placement, after deducting financial advisory fees and other offering expenses, totaled $73.6 million.  The Company used $36.8 million of the net proceeds from the private placement to reduce its indebtedness under its Senior Credit Agreement and used $10.5 million to fund the portion of the settlement of the Tender Offer that was not funded by the issuance of the 7.0% Debentures, as further described in the note to the consolidated financial statements entitled “Notes Payable – Direct Corporate Obligations”.  The remaining proceeds will be used:

·  
to pay the portion of the purchase price, repurchase price or redemption price of the 3.5% Debentures that are (i) tendered in any subsequent issuer tender offer for the 3.5% Debentures, (ii) repurchased by us in privately negotiated transactions that settle before October 5, 2010; (iii) repurchased by us as required by the holders thereof on September 30, 2010 or (iv) redeemed by us on October 5, 2010 respectively; and

·  
for general corporate purposes.

In November 2009, concurrently with the completion of the private placement of our common stock and warrants, we entered into an investor rights agreement with Paulson, pursuant to which we granted to Paulson, among other things, certain registration rights with respect to certain securities and certain preemptive rights, and Paulson agreed to, among other things, certain restrictions on transfer of certain securities, certain voting limitations and certain standstill provisions.

The warrants have an exercise price of $6.50 per share of common stock, subject to customary anti-dilution adjustments. Prior to June 30, 2013, the warrants are not exercisable, except under limited circumstances. Commencing on June 30, 2013, the warrants will be exercisable for shares of our common stock at the option of the holder at any time, subject

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________


to certain exceptions. The warrants expire on December 30, 2016.

Prior to completing the private placement with Paulson, our board of directors deemed Paulson an “Exempted Entity” and therefore not an “Acquiring Person” for purposes of our Section 382 Rights Agreement, with respect to the 16.4 million shares of common stock, any shares of common stock issued upon exercise of the warrants, any common stock issued upon conversion of the 7.0% Debentures owned by Paulson, as well as the shares of common stock Paulson owned prior to the private placement.  See the note to the consolidated financial statements entitled “Income Taxes” for more information on the Section 382 Rights Agreement.

In the second quarter of 2004, we completed the public offerings, including underwriter over-allotments, of 50.6 million shares of our common stock at an offering price of $18.25 per share and 27.6 million shares of our 5.5 percent Class B mandatorily convertible preferred stock (the “Preferred Stock”) at an offering price of $25 per share.  In May 2007, all of our Preferred Stock was converted into shares of CNO common stock in accordance with the terms of issuance.  Under those terms, each of the 27.6 million shares of Preferred Stock outstanding was converted into 1.3699 shares of common stock.  As a result of the conversion, our common shares outstanding increased by 37.8 million.

Pursuant to the Plan, we issued warrants to purchase 6.0 million shares of our common stock (the “Series A Warrants”) entitling the holders to purchase shares of CNO common stock at a price of $27.60 per share.  The Series A Warrants expired on September 10, 2008.

In December 2006, the Company’s board of directors authorized a common share repurchase program of up to $150 million.  In May 2007, the Company’s board of directors increased the authorized common share repurchase program to a maximum of $350 million.  With respect to $25 million of the program, the Company entered into an accelerated share buy back agreement (“ASB”) to repurchase 1.2 million shares.  The initial price paid per share as part of the ASB transaction was $20.12.  The repurchased shares were subject to a settlement price adjustment based upon the difference between:  (i) the volume weighted average price of CNO common stock (as defined in the ASB); and (ii) $20.12.  The settlement price adjustment was calculated to be $.3 million and was paid to the Company.  The Company recognized a reduction in common stock and additional paid-in capital of $24.7 million in the first quarter of 2007 related to the ASB transaction.

During 2007, the Company repurchased an additional 4.5 million shares of its common stock for $62.5 million.  No repurchases were made in 2009 or 2008.

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

   
2009
    
2008
      
2007
    
                       
Balance, beginning of year                                                                               
     184,754       184,652         152,165    
Issuance of common stock                                                                           
     65,900       -         -    
Treasury stock purchased and retired                                                                           
     -       -         (5,699 )  
Conversion of preferred stock into common shares
     -       -         37,809    
Stock options exercised                                                                           
     -       -         207    
Shares issued under employee benefit compensation plans
     132       102  
(a)
     177  
(a)
Other                                                                           
     -        -         (7 )  
                             
                             
Balance, end of year                                                                               
     250,786       184,754         184,652    
____________________
(a)  
In 2008 and 2007, such amounts were reduced by 16 thousand shares and 24 thousand shares, respectively, which were tendered for the payment of federal and state taxes owned on the issuance of restricted stock.

The Company has a long-term incentive plan which permits the grant of CNO incentive or non-qualified stock options, restricted stock awards, stock appreciation rights, performance shares or units and certain other equity-based awards to certain directors, officers and employees of the Company and certain other individuals who perform services for the Company.  In April 2009, the shareholders of the Company approved an increase in the number of shares authorized to be issued under the plan to a maximum of 25.8 million shares from 10 million shares.  As of December 31, 2009, 12.6 million

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________


shares remained available for issuance under the plan.  Our stock option awards are generally granted with an exercise price equal to the market price of the Company’s stock on the date of grant.  For options granted in 2006 and prior years, our stock option awards generally vest on a graded basis over a four year service term and expire ten years from the date of grant.  Our stock option awards granted since 2006 generally vest on a graded basis over a three year service term and expire five years from the date of grant.  The vesting periods for our restricted stock awards range from immediate vesting to a period of four years.

A summary of the Company’s stock option activity and related information for 2009 is presented below (shares in thousands; dollars in millions, except per share amounts):

         
Weighted
  
Weighted
      
         
average
  
average
  
Aggregate
  
         
exercise
  
remaining
  
intrinsic
  
   
Shares
    
price
  
life
  
value
  
                     
Outstanding at the beginning of the year
     5,864     $ 16.94          
                         
Options granted                                                           
     3,219       2.64          
                         
Exercised                                                           
     -       -       $ -  
                           
Forfeited or terminated                                                           
     (523 )     15.52            
                           
Outstanding at the end of the year                                                           
     8,560       11.65  
4.1 years
   $ 31.6  
                           
Options exercisable at the end of the year
     2,992          
4.4 years
   $ 19.4  
                           
Available for future grant                                                           
     12,565                    

A summary of the Company’s stock option activity and related information for 2008 is presented below (shares in thousands; dollars in millions, except per share amounts):

         
Weighted
  
Weighted
      
         
average
  
average
  
Aggregate
  
         
exercise
  
remaining
  
intrinsic
  
   
Shares
    
price
  
life
  
value
  
                     
Outstanding at the beginning of the year
     4,828     $ 19.82          
                         
Options granted                                                           
     1,863       10.27          
                         
Exercised                                                           
     -       -       $ -  
                           
Forfeited or terminated                                                           
     (827 )     18.69            
                           
Outstanding at the end of the year                                                           
     5,864       16.94  
4.8 years
   $ 27.9  
                           
Options exercisable at the end of the year
     2,412          
5.5 years
   $ 16.6  
                           
Available for future grant                                                           
     1,154                    

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



A summary of the Company’s stock option activity and related information for 2007 is presented below (shares in thousands; dollars in millions, except per share amounts):

         
Weighted
  
Weighted
      
         
average
  
average
  
Aggregate
  
         
exercise
  
remaining
  
intrinsic
  
   
Shares
    
price
  
life
  
value
  
                     
Outstanding at the beginning of the year
     4,217     $ 20.76          
                         
Options granted                                                           
     1,671       17.37          
                         
Exercised                                                           
     (207 )     16.31       $ 1.3  
                           
Forfeited or terminated                                                           
     (853 )     20.54            
                           
Outstanding at the end of the year                                                           
     4,828       19.82  
5.9 years
   $ 28.1  
                           
Options exercisable at the end of the year
     2,462          
6.0 years
   $ 16.6  
                           
Available for future grant 
     2,794                    

We recognized compensation expense related to stock options totaling $6.9 million ($4.5 million after income taxes) in 2009, $6.0 million ($3.9 million after income taxes) in 2008 and $7.4 million ($4.8 million after income taxes) in 2007.  Compensation expense related to stock options reduced both basic and diluted earnings (loss) per share by 2 cents, 2 cents and 3 cents in 2009, 2008 and 2007, respectively.  At December 31, 2009, the unrecognized compensation expense for non-vested stock options totaled $8.7 million which is expected to be recognized over a weighted average period of 1.7 years.  Cash received from the exercise of stock options was nil, nil and $3.4 million during 2009, 2008 and 2007, respectively.

The fair value of each stock option grant is estimated on the date of grant using the Black-Scholes option valuation model with the following weighted average assumptions:

   
2009 Grants
    
2008 Grants
    
2007 Grants
  
                   
Weighted average risk-free interest rates
     1.6 %     2.5 %     4.4 %
Weighted average dividend yields                                                            
     0.0 %     0.0 %     0.0 %
Volatility factors                                                            
     108 %     24 %     22 %
Weighted average expected life                                                            
  
3.8 years
    
3.7 years
    
3.7 years
  
Weighted average fair value per share
   $ 1.89     $ 2.25     $ 4.22  

The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant.  The dividend yield is based on the Company’s history and expectation of dividend payouts.  Volatility factors are based on the weekly historical volatility of the Company’s common stock equal to the expected life of the option or since our emergence from bankruptcy in September 2003.  The expected life is based on the average of the graded vesting period and the contractual terms of the option.

The exercise price was equal to the market price of our stock for all options granted in 2009, 2008 and 2007.

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________



The following table summarizes information about stock options outstanding at December 31, 2009 (shares in thousands):

     
Options outstanding
    
Options exercisable
  
     
Number
    
Remaining
    
Average exercise
    
Number
    
Average exercise
  
Range of exercise prices
    
outstanding
    
life (in years)
    
price
    
exercisable
    
price
  
                                 
$ 1.13       697       4.3     $ 1.13       -     $ -  
$ 2.24 - $3.11       2,482       4.4       3.04       -       -  
$ 5.26 - $5.39       29       4.8       5.28       -       -  
$ 8.91 - $12.96       1,615       3.3       10.57       15       12.96  
$ 14.78 - $21.67       3,234       3.9       19.34       2,598       19.63  
$ 22.42 - $25.45       503       6.4       23.18       379       23.18  
                                             
          8,560                       2,992          

During 2009, 2008 and 2007, the Company granted .8 million, .1 million and .1 million restricted shares, respectively, of CNO common stock to certain directors, officers and employees of the Company at a weighted average fair value of $1.67 per share, $9.75 per share and $18.39 per share, respectively.  The fair value of such grants totaled $1.4 million, $.8 million and $1.7 million in 2009, 2008 and 2007, respectively.  Such amounts are recognized as compensation expense over the vesting period of the restricted stock.  A summary of the Company’s non-vested restricted stock activity for 2009 is presented below (shares in thousands):

         
Weighted
  
         
average
  
         
grant date
  
   
Shares
    
fair value
  
             
Non-vested shares, beginning of year                                                                                   
     70     $ 14.41  
Granted                                                                               
     820       1.67  
Vested                                                                               
     (132 )     5.67  
Forfeited                                                                               
     (10 )     1.12  
                 
Non-vested shares, end of year                                                                                   
     748       2.15  

At December 31, 2009, the unrecognized compensation expense for non-vested restricted stock totaled $1.1 million which is expected to be recognized over a weighted average period of 1.9 years.  At December 31, 2008, the unrecognized compensation expense for non-vested restricted stock totaled $.6 million.  We recognized compensation expense related to restricted stock awards totaling $.9 million, $1.4 million and $3.2 million in 2009, 2008 and 2007, respectively.  The fair value of restricted stock that vested during 2009, 2008 and 2007 was $.8 million, $1.9 million and $3.9 million, respectively.

Authoritative guidance also requires us to estimate the amount of unvested stock-based awards that will be forfeited in future periods and reduce the amount of compensation expense recognized over the applicable service period to reflect this estimate. We periodically evaluate our forfeiture assumptions to more accurately reflect our actual forfeiture experience.

The Company does not currently recognize tax benefits resulting from tax deductions in excess of the compensation expense recognized because of NOLs which are available to offset future taxable income.

As further discussed in the footnote to the consolidated financial statements entitled “Income Taxes”, the Company’s Board of Directors adopted the Section 382 Rights Agreement on January 20, 2009, which is designed to protect shareholder value by preserving the value of our tax assets primarily associated with NOLs.  As a result, the Company declared a dividend of one preferred share purchase right (a “Right”) for each outstanding share of common stock.  The dividend was payable on January 30, 2009, to the shareholders of record as of the close of business on that date.  Each Right entitles the shareholder to purchase from the Company one one-thousandth of a share of Series A Junior Participating Preferred Stock, par value $.01 per share (the “Junior Preferred Stock”) of the Company at a price of $20.00 per one one-thousandth of a share of Junior Preferred Stock.  The description and terms of the Rights are set forth in the Section 382 Rights Agreement.  The Rights would become exercisable in the event any person or group (subject to certain exemptions) becomes a “5 percent

 
149
 
CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________


shareholder” of CNO without the approval of the Board of Directors or an existing shareholder who is currently a “5 percent shareholder” acquires additional shares exceeding one percent of our outstanding shares without prior approval from the Board of Directors.

A reconciliation of net income (loss) and shares used to calculate basic and diluted earnings (loss) per share is as follows (dollars in millions and shares in thousands):

   
2009
    
2008
    
2007
  
                   
Income (loss) before discontinued operations
   $ 85.7     $ (409.6 )   $ (79.1 )
Discontinued operations
     -       (722.7 )     (105.9 )
                         
Net income (loss)
     85.7       (1,132.3 )     (185.0 )
Preferred stock dividends
     -       -       (14.1 )
                         
Net income (loss) applicable to common stock for basic earnings per share
     85.7       (1,132.3 )     (199.1 )
                         
Add:  interest expense on 7.0% Debentures, net of income taxes
     1.1       -       -  
Net income (loss) applicable to common stock for diluted earnings per share
   $ 86.8     $ (1,132.3 )   $ (199.1 )
                         
Shares:
                        
Weighted average shares outstanding for basic earnings per share
     188,365       184,704       173,374  
                         
Effect of dilutive securities on weighted average shares:
                        
7% Debentures
     4,281       -       -  
Stock option and restricted stock plans
     694        -       -  
                         
Dilutive potential common shares
     4,975        -        -  
                         
Weighted average shares outstanding for diluted earnings per share
     193,340       184,704       173,374  

There were no dilutive common stock equivalents during 2008 or 2007 because of the net loss recognized by the Company during such period.  Therefore, all potentially dilutive shares are excluded in the weighted average shares outstanding for diluted earnings per share, and the preferred stock dividends on the Class B mandatorily convertible preferred stock (related to the period prior to their conversion) are not added back to net income (loss) applicable to common stock.

The following summarizes the equivalent common shares for securities that were not included in the computation of diluted earnings per share, because doing so would have been antidilutive in such periods (shares in thousands).

   
2008
    
2007
  
             
Equivalent common shares that were antidilutive during the year:
            
Class B mandatorily convertible preferred stock                                                                              
     -       14,334  
Stock option and restricted stock plans                                                                              
     32       144  
                 
Antidilutive equivalent common shares                                                                            
     32       14,478  

In August 2005, we completed the private offering of the 3.5% Debentures.  In future periods, our diluted shares outstanding may include incremental shares issuable upon conversion of all or part of such 3.5% Debentures.  Since the remaining outstanding principal amount of the 3.5% Debentures can only be redeemed for cash, it has no impact on the diluted earnings per share calculation.  In accordance with the conversion feature of these 3.5% Debentures, we may be required to pay a stock premium along with redeeming the accreted principal amount for cash, if our common stock reaches a certain market price.  We will include the dilutive effect of our 3.5% Debentures in the calculation of diluted earnings per share when the impact is dilutive.  During 2009, 2008 and 2007, the conversion feature of the 3.5% Debentures did not have a dilutive effect because the weighted average market price of our common stock did not exceed the initial conversion price

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
__________________


of $26.66.  Therefore, the 3.5% Debentures had no effect on our diluted shares outstanding or our diluted earnings per share in 2009, 2008 or 2007.

Basic earnings (loss) per common share is computed by dividing net income (loss) applicable to common stock by the weighted average number of common shares outstanding for the period.  Restricted shares (including our performance shares) are not included in basic earnings (loss) per share until vested.  Diluted earnings (loss) per share reflect the potential dilution that could occur if outstanding stock options were exercised and restricted stock was vested.  The dilution from options and restricted shares is calculated using the treasury stock method.  Under this method, we assume the proceeds from the exercise of the options (or the unrecognized compensation expense with respect to restricted stock) will be used to purchase shares of our common stock at the average market price during the period, reducing the dilutive effect of the exercise of the options (or the vesting of the restricted stock).

In 2009, 2008 and 2007, the Company granted performance shares totaling 620,225, 645,100 and 420,900, respectively, pursuant to its long-term incentive plan to certain officers of the Company.  The criteria for payment related to a portion of such awards is based upon the cumulative return on the Company’s stock with dividends reinvested (“total shareholder return”) compared to the total shareholder return of a group of CNO’s peers (represented by the companies comprising the Standard & Poor’s Life and Health Index and the Russell 3000 Health and Life Index) over a three year performance measurement period.  If the Company’s results are below the 50th percentile of the comparison group, no portion of the award is earned.  If the Company’s results are equal to or greater than the 75th percentile, then the maximum award is earned.  The criteria for payment of the remaining performance shares is based upon the Company’s operating return on equity, as defined in the award agreement.  If the Company’s operating return on equity is less than 10.0 percent, no portion of the award is earned.  If the Company’s operating return on equity is equal to or greater than 12.0 percent, then the maximum award is earned.  Unless antidilutive, the diluted weighted average shares outstanding would reflect the number of performance shares expected to be issued, using the treasury stock method.

A summary of the Company’s performance shares is presented below (shares in thousands):

   
Total shareholder
    
Operating return
  
   
return award
    
on equity award
  
             
Granted in 2007                                                          
     253       168  
Forfeited                                                          
     (35 )     (22 )
                 
Awards outstanding at December 31, 2007
     218       146  
                 
Granted in 2008                                                          
     387       258  
Forfeited                                                          
     (54 )     (37 )
                 
Awards outstanding at December 31, 2008
     551       367  
                 
Granted in 2009                                                          
     -       620  
Forfeited                                                          
     (220 )     (162 )
                 
Awards outstanding at December 31, 2009
     331       825  

The grant date fair value of the total shareholder return awards was $1.6 million and $1.7 million in 2008 and 2007, respectively.  The grant date fair value of the operating return on equity awards was $1.9 million, $2.7 million and $3.0 million in 2009, 2008 and 2007, respectively.  We recognized compensation expense of $1.3 million, $.1 million and $1.1 million in 2009, 2008 and 2007, respectively, related to the performance shares.

 
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12.       OTHER OPERATING STATEMENT DATA

Insurance policy income consisted of the following (dollars in millions):

   
2009
    
2008
    
2007
  
Traditional products:
                  
Direct premiums collected                                                                        
   $ 4,128.1     $ 4,313.5     $ 4,291.4  
Reinsurance assumed                                                                        
     476.5       642.8       314.0  
Reinsurance ceded                                                                        
     (185.7 )     (164.3 )     (199.8 )
                         
Premiums collected, net of reinsurance                                                                   
     4,418.9       4,792.0       4,405.6  
                         
Change in unearned premiums                                                                        
     (2.1 )     (13.5 )     (2.1 )
Less premiums on universal life and products without mortality and morbidity risk which are recorded as
additions to insurance liabilities                                                                     
     (1,668.9 )     (1,863.5 )     (1,852.2 )
Premiums on traditional products with mortality or morbidity risk
     2,747.9       2,915.0       2,551.3  
Fees and surrender charges on interest-sensitive products
     345.7       338.6       344.4  
                         
Insurance policy income                                                                   
   $ 3,093.6     $ 3,253.6     $ 2,895.7  

The four states with the largest shares of 2009 collected premiums were Florida (7.6 percent), California (6.9 percent), Pennsylvania (6.4 percent) and Texas (6.1 percent).  No other state accounted for more than five percent of total collected premiums.

Other operating costs and expenses were as follows (dollars in millions):

   
2009
    
2008
    
2007
  
                   
Commission expense                                                             
   $ 114.3     $ 128.2     $ 118.3  
Salaries and wages                                                             
     173.5       160.5       169.3  
Other                                                             
     240.5       231.6       252.8  
                         
Total other operating costs and expenses
   $ 528.3     $ 520.3     $ 540.4  

Changes in the present value of future profits were as follows (dollars in millions):

   
2009
    
2008
    
2007
  
                   
Balance, beginning of year                                                                               
   $ 1,477.8     $ 1,573.6     $ 1,964.8  
Additional acquisition expense
     -       -       1.9  
Amortization
     (177.5 )     (187.3 )     (246.2 )
Cumulative effect of accounting change related to the adoption of authoritative guidance
     -       -       (2.6 )
Effect of reinsurance transactions
     (24.1 )     -       (134.9 )
Amounts related to fair value adjustment of actively managed fixed maturities 
     (100.3 )     92.7       (9.4 )
Other
     -       (1.2 )     -  
                         
Balance, end of year                                                                               
   $ 1,175.9     $ 1,477.8     $ 1,573.6  

 
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__________________



Based on current conditions and assumptions as to future events on all policies inforce, the Company expects to amortize approximately 13 percent of the December 31, 2009 balance of the present value of future profits in 2010, 11 percent in 2011, 10 percent in 2012, 9 percent in 2013 and 7 percent in 2014.  The discount rate used to determine the amortization of the present value of future profits averaged approximately 5 percent in the years ended December 31, 2009, 2008 and 2007.

In accordance with authoritative guidance, we are required to amortize the present value of future profits in relation to estimated gross profits for universal life products and investment-type products.  Such guidance also requires that estimates of expected gross profits used as a basis for amortization be evaluated regularly, and that the total amortization recorded to date be adjusted by a charge or credit to the statement of operations, if actual experience or other evidence suggests that earlier estimates should be revised.

Changes in deferred acquisition costs were as follows (dollars in millions):

   
2009
    
2008
    
2007
  
                   
Balance, beginning of year                                                                                                 
   $ 1,812.6     $ 1,423.0     $ 1,106.7  
Additions                                                                                             
     407.5       459.1       487.6  
Amortization                                                                                             
     (255.2 )     (180.6 )     (180.6 )
Cumulative effect of accounting change related to the adoption of authoritative guidance 
     -       -       (1.6 )
Effect of reinsurance transactions                                                                                             
     (79.0 )     -       (19.3 )
Amounts related to fair value adjustment of fixed maturities, available for sale
     (95.0 )     111.1       30.2  
                         
Balance, end of year                                                                                                 
   $ 1,790.9     $ 1,812.6     $ 1,423.0  

 
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13.       CONSOLIDATED STATEMENT OF CASH FLOWS

The following disclosures supplement our consolidated statement of cash flows (dollars in millions):

Non-cash items not reflected in the investing and financing activities sections of the consolidated statement of cash flows (dollars in millions):

   
2009
    
2008
    
2007
  
                   
Stock option and restricted stock plans                                                                      
   $ 9.1     $ 7.4     $ 11.0  
Conversion of preferred stock into common shares
     -       -       667.8  
Reduction of tax liabilities related to various contingencies recognized at the fresh-start date 
     -       -       6.0  
Change in securities lending collateral                                                                      
     223.1       51.6       408.3  
Change in securities lending payable                                                                      
     (223.1 )     (51.6 )     (408.3 )

The following reconciles net income to net cash provided by operating activities (dollars in millions):

   
2009
    
2008
    
2007
  
Cash flows from operating activities:
                  
Net income (loss)
   $ 85.7     $ (1,132.3 )   $ (185.0 )
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
                        
Amortization and depreciation
     460.9       420.7       491.2  
Income taxes
     80.7       429.0       1.3  
Insurance liabilities
     421.4       460.6       744.8  
Accrual and amortization of investment income
     (125.4 )     3.9       73.4  
Deferral of policy acquisition costs
     (407.5 )     (459.1 )     (545.9 )
Net realized investment losses
     60.5       642.5       155.4  
(Gain) loss on extinguishment of debt
     22.2       (21.2 )     -  
Net sales (purchases) of trading securities
     32.3       346.5       (114.3 )
Loss related to an annuity coinsurance transaction
     -       -       76.5  
Loss on Transfer
     -       319.9       -  
Gain on reinsurance recapture
     -       (29.7 )     -  
Other
     13.2       6.0       5.9  
                         
Net cash provided by operating activities                                                                                   
   $ 644.0     $ 986.8     $ 703.3  

Our consolidated statement of cash flows for 2008 and 2007 combines the cash flows from discontinued operations with the cash flows from continuing operations within each major category (operating, investing and financing) of the cash flow statement.

At December 31, 2009, restricted cash and cash equivalents consisted of $3.4 million held by a VIE.

At December 31, 2008, restricted cash and cash equivalents consisted of $4.8 million held by a VIE.


 
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__________________



14.       STATUTORY INFORMATION (BASED ON NON-GAAP MEASURES)

Statutory accounting practices prescribed or permitted by regulatory authorities for the Company’s insurance subsidiaries differ from GAAP.  The Company’s insurance subsidiaries reported the following amounts to regulatory agencies, after appropriate elimination of intercompany accounts among such subsidiaries (dollars in millions):

   
2009
    
2008
  
             
Statutory capital and surplus                                                       
   $ 1,410.7     $ 1,311.5  
Asset valuation reserve                                                       
     28.2       55.0  
Interest maintenance reserve                                                       
     290.6       147.7  
                 
Total                                                       
   $ 1,729.5     $ 1,514.2  

Statutory capital and surplus included investments in upstream affiliates of $52.4 million and $52.2 million at December 31, 2009 and 2008, respectively, which were eliminated in the consolidated financial statements prepared in accordance with GAAP.

Statutory earnings build the capital required by ratings agencies and regulators.  Statutory earnings, fees and interest paid by the insurance companies to the parent company create the “cash flow capacity” the parent company needs to meet its obligations, including debt service.  The consolidated statutory net income (loss) (a non-GAAP measure) of our insurance subsidiaries was $77.5 million, $(96.9) million and $(321.3) million in 2009, 2008 and 2007, respectively.  Included in such net income (loss) were net realized capital losses, net of income taxes, of $186.5 million, $217.1 million and $38.5 million in 2009, 2008 and 2007, respectively.  In addition, such net income (loss) included pre-tax amounts for fees and interest to CNO or its non-life subsidiaries totaling $137.1 million, $139.6 million and $162.8 million in 2009, 2008 and 2007, respectively.

Insurance regulators may prohibit the payment of dividends or other payments by our insurance subsidiaries to parent companies if they determine that such payment could be adverse to our policyholders or contract holders.  Otherwise, the ability of our insurance subsidiaries to pay dividends is subject to state insurance department regulations.  Insurance regulations generally permit dividends to be paid from statutory earned surplus of the insurance company without regulatory approval for any 12-month period in amounts equal to the greater of (or in a few states, the lesser of): (i) statutory net gain from operations or statutory net income for the prior year; or (ii) 10 percent of statutory capital and surplus as of the end of the preceding year, excluding $61.2 million of additional surplus recognized due to temporary modifications in statutory prescribed practices related to certain deferred tax assets.  This type of dividend is referred to as “ordinary dividends”.  Any dividends in excess of these levels require the approval of the director or commissioner of the applicable state insurance department.  This type of dividend is referred to as “extraordinary dividends”.  During 2009, our insurance subsidiaries paid cash dividends of $35.0 million to CDOC (which is the immediate parent of Washington National, Conseco Health and Conseco Life Insurance Company of Texas).

Each of the immediate subsidiaries of CDOC have negative earned surplus at December 31, 2009.  Accordingly, any dividend payments from these subsidiaries require the approval of the director or commissioner of the applicable state insurance department.  During 2010, we are expecting our insurance subsidiaries to pay approximately $105 million of extraordinary dividends to CDOC (subject to approval by the applicable state insurance department).  In addition, we are expecting our insurance subsidiaries to pay interest on surplus debentures of $49 million in 2010, which will not require additional approval provided the risk-based capital (“RBC”) ratio of Conseco Life Insurance Company of Texas exceeds 100 percent (but will require prior written notice to the Texas state insurance department).  Dividends and other payments from our non-insurance subsidiaries to CNO or CDOC do not require approval by any regulatory authority or other third party.  Also, during 2009, CDOC made no capital contributions to our insurance subsidiaries, however, a $29.4 million capital contribution was accrued at December 31, 2009, and paid in February 2010.

In accordance with an order from the Florida Office of Insurance Regulation, Washington National may not distribute funds to any affiliate or shareholder without prior notice to the Florida Office of Insurance Regulation.  In addition, the RBC and other capital requirements described below can also limit, in certain circumstances, the ability of our insurance subsidiaries to pay dividends.

RBC requirements provide a tool for insurance regulators to determine the levels of statutory capital and surplus an

 
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insurer must maintain in relation to its insurance and investment risks and the need for possible regulatory attention.  The RBC requirements provide four levels of regulatory attention, varying with the ratio of the insurance company’s total adjusted capital (defined as the total of its statutory capital and surplus, AVR and certain other adjustments) to its RBC (as measured on December 31 of each year) as follows:  (i) if a company’s total adjusted capital is less than 100 percent but greater than or equal to 75 percent of its RBC, the company must submit a comprehensive plan to the regulatory authority proposing corrective actions aimed at improving its capital position (the “Company Action Level”); (ii) if a company’s total adjusted capital is less than 75 percent but greater than or equal to 50 percent of its RBC, the regulatory authority will perform a special examination of the company and issue an order specifying the corrective actions that must be taken; (iii) if a company’s total adjusted capital is less than 50 percent but greater than or equal to 35 percent of its RBC, the regulatory authority may take any action it deems necessary, including placing the company under regulatory control; and (iv) if a company’s total adjusted capital is less than 35 percent of its RBC, the regulatory authority must place the company under its control.  In addition, the RBC requirements provide for a trend test if a company’s total adjusted capital is between 100 percent and 125 percent of its RBC at the end of the year.  The trend test calculates the greater of the decrease in the margin of total adjusted capital over RBC:  (i) between the current year and the prior year; and (ii) for the average of the last 3 years.  It assumes that such decrease could occur again in the coming year.  Any company whose trended total adjusted capital is less than 95 percent of its RBC would trigger a requirement to submit a comprehensive plan as described above for the Company Action Level.

In addition to the RBC requirements, certain states have established minimum capital requirements for insurance companies licensed to do business in their state.  These additional requirements generally have not had a significant impact on the Company’s insurance subsidiaries, but the capital requirements in Florida have caused Conseco Health to maintain a higher level of capital and surplus than it would otherwise maintain and have thus limited its ability to pay dividends.

In addition, although we are under no obligation to do so, we may elect to contribute additional capital to strengthen the surplus of certain insurance subsidiaries.  Any election regarding the contribution of additional capital to our insurance subsidiaries could affect the ability of our insurance subsidiaries to pay dividends to the holding company.  The ability of our insurance subsidiaries to pay dividends is also impacted by various criteria established by rating agencies to maintain or receive higher ratings and by the capital levels that we target for our insurance subsidiaries.

During 2009, the financial statements of three of our subsidiaries prepared in accordance with statutory accounting practices prescribed or permitted by regulatory authorities reflected asset adequacy or premium deficiency reserves.  Total asset adequacy and premium deficiency reserves for Washington National, Conseco Life and Bankers Conseco Life Insurance Company were $79.1 million, $257.1 million and $21.2 million, respectively at December 31, 2009.  The determination of the need for and amount of asset adequacy reserves is subject to numerous actuarial assumptions, including the Company’s ability to change nonguaranteed elements related to certain products consistent with contract provisions.

At December 31, 2009, the consolidated RBC ratio of our insurance subsidiaries exceeded the minimum RBC requirement included in our Senior Credit Agreement.  See the note to the consolidated financial statements entitled “Notes Payable - Direct Corporate Obligations” for further discussion of various financial ratios and balances we are required to maintain.  We calculate the consolidated RBC ratio by assuming all of the assets, liabilities, capital and surplus and other aspects of the business of our insurance subsidiaries are combined together in one insurance subsidiary, with appropriate intercompany eliminations.

15.  
BUSINESS SEGMENTS

Beginning July 1, 2010, management changed the manner in which it disaggregates the Company’s operations for making operating decisions and assessing performance.  As a result, the Company manages its business through the following operating segments: Bankers Life, Colonial Penn and Washington National, which are defined on the basis of product distribution; Other CNO Business, comprised primarily of products we no longer sell actively; and corporate operations, comprised of holding company activities and certain noninsurance company businesses.  All prior period segment disclosures have been revised to conform to management’s current view of the Company’s operating segments.

We measure segment performance by excluding realized investment gains (losses) because we believe that this performance measure is a better indicator of the ongoing business and trends in our business.  Our primary investment focus is on investment income to support our liabilities for insurance products as opposed to the generation of realized investment gains (losses), and a long-term focus is necessary to maintain profitability over the life of the business.  Realized investment gains (losses) depend on market conditions and do not necessarily relate to the underlying business of our segments.

 
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Realized investment gains (losses) may affect future earnings levels since our underlying business is long-term in nature and changes in our investment portfolio may impact our ability to earn the assumed interest rates needed to maintain the profitability of our business.
 
Operating information by segment was as follows (dollars in millions):

   
2009
    
2008
    
2007
  
                   
Revenues:
                  
Bankers Life:
                  
Insurance policy income:
                  
Annuities
   $ 41.4     $ 49.2     $ 67.6  
Health
     1,711.7       1,872.9       1,537.0  
Life
     206.1       187.8       175.4  
Net investment income (a)
     678.1       558.2       572.3  
Fee revenue and other income (a)
     10.2        11.0        12.0  
                         
Total Bankers Life revenues
     2,647.5       2,679.1       2,364.3  
                         
Washington National:
                        
Insurance policy income:
                        
Health
     563.2       574.8       590.4  
Life
     29.4       35.3       39.2  
Other
     5.3       7.1       8.1  
Net investment income (a)
     188.9       197.3       194.3  
Fee revenue and other income (a)
     1.5       .7        1.0  
                         
Total Washington National revenues
     788.3        815.2       833.0  
                         
Colonial Penn:
                        
Insurance policy income:
                        
Health
     8.1       9.5       10.8  
Life
     188.0       175.3       115.0  
Net investment income (a)
     38.7       39.6       37.8  
Fee revenue and other income (a)
     .9       1.8        .7  
                         
Total Colonial Penn revenues
     235.7        226.2       164.3  
                         
Other CNO Business:
                        
Insurance policy income:
                        
Annuities
     29.5       14.1       14.3  
Health
     32.1       34.6       37.7  
Life
     275.8       289.7       296.1  
Other
     3.0       3.3       4.1  
Net investment income (a)
     371.9       355.2       522.0  
Fee revenue and other income (a)
      -       1.0        -  
                         
Total Other CNO Business revenues
     712.3       697.9       874.2  
                         
Corporate operations:
                        
Net investment income
     15.1       28.5       43.4  
Fee and other income
     3.0        5.2        10.1  
                         
Total corporate revenues
     18.1        33.7       53.5  
                         
Total revenues
     4,401.9       4,452.1       4,289.3  

(continued on next page)


 
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(continued from previous page)

   
2009
    
2008
    
2007
  
Expenses:
                  
Bankers Life:
                  
Insurance policy benefits
   $ 1,905.0     $ 2,090.4     $ 1,684.7  
Amortization
     267.9       234.8       264.0  
Other operating costs and expenses
     196.6       182.4       173.8  
                         
Total Bankers Life expenses
     2,369.5       2,507.6       2,122.5  
                         
Washington National:
                        
Insurance policy benefits
     467.0       473.2       481.0  
Amortization
     53.9       54.0       54.3  
Other operating costs and expenses
     156.5       166.9       170.0  
                         
Total Washington National expenses
     677.4       694.1       705.3  
                         
Colonial Penn:
                        
Insurance policy benefits
     143.0       139.4       102.2  
Amortization
     33.3       32.0       20.3  
Other operating costs and expenses
     30.0       29.6       23.7  
                         
Total Colonial Penn expenses
     206.3       201.0       146.2  
                         
Other CNO Business:
                        
Insurance policy benefits
     551.7       509.5       648.0  
Amortization
     81.6       68.6       123.9  
Interest expense on investment borrowings
     20.5       22.4       17.6  
Costs related to a litigation settlement
     -       -       32.2  
Loss related to an annuity coinsurance agreement
     -       -       76.5  
Other operating costs and expenses
     102.1       97.2       130.0  
                         
Total Other CNO Business expenses
     755.9       697.7       1,028.2  
                         
Corporate operations:
                        
Interest expense on corporate debt
     84.7       67.9       80.3  
Interest expense on variable interest entity
     12.7       16.2       27.4  
Costs related to a litigation settlement
     -       -       32.2  
Other operating costs and expenses
     43.1       44.2       42.9  
(Gain) loss on extinguishment or modification of debt
     22.2       (21.2 )     -  
                         
Total corporate expenses
     162.7       107.1       182.8  
                         
Total expenses
     4,171.8       4,207.5       4,185.0  
                         
Income (loss) before net realized investment losses (net of related amortization), income taxes and discontinued operations:
                        
Bankers Life
     278.0       171.5       241.8  
Washington National
     110.9       121.1       127.7  
Colonial Penn
     29.4       25.2       18.1  
Other CNO Business
     (43.6 )     .2       (154.0 )
Corporate operations
     (144.6 )     (73.4 )     (129.3 )
                         
Income before net realized investment losses (net of related amortization), income taxes and discontinued operations
   $ 230.1     $ 244.6     $ 104.3  
                         
___________________
(a)
It is not practicable to provide additional components of revenue by product or services.
 
 

 
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A reconciliation of segment revenues and expenses to consolidated revenues and expenses is as follows (dollars in millions):
   
2009
    
2008
    
2007
  
                   
Total segment revenues                                                                    
   $ 4,401.9     $ 4,452.1     $ 4,289.3  
Net realized investment losses                                                                    
     (60.5 )     (262.4 )     (158.0 )
                         
Consolidated revenues                                                               
   $ 4,341.4     $ 4,189.7     $ 4,131.3  
                         
Total segment expenses                                                                    
   $ 4,171.8     $ 4,207.5     $ 4,185.0  
Amortization related to net realized investment losses
     (4.0 )     (21.5 )     (35.7 )
                         
Consolidated expenses                                                               
   $ 4,167.8     $ 4,186.0     $ 4,149.3  

Segment balance sheet information was as follows (dollars in millions):

   
2009
    
2008
  
Assets:
            
Bankers Life                                                                                
   $ 14,503.8     $ 12,864.0  
Washington National                                                                                
     4,070.7       3,779.5  
Colonial Penn                                                                                
     971.4       925.7  
Other CNO Business                                                                                
     9,254.6       9,545.4  
Corporate operations                                                                                
     1,543.3       1,648.7  
                 
Total assets                                                                            
   $ 30,343.8     $ 28,763.3  
                 
Liabilities:
                
Bankers Life                                                                                
   $ 12,832.4     $ 12,061.9  
Washington National                                                                                
     3,325.0       3,326.6  
Colonial Penn                                                                                
     763.3       760.3  
Other CNO Business                                                                                
     8,564.2       9,283.8  
Corporate operations                                                                                
     1,326.5       1,700.7  
                 
Total liabilities                                                                            
   $ 26,811.4     $ 27,133.3  

The following table presents selected financial information of our segments (dollars in millions):

   
Present
    
Deferred
        
   
value of
    
acquisition
    
Insurance
  
Segment
  
future profits
    
costs
    
liabilities
  
                   
2009
                  
Bankers Life                                              
   $ 569.5     $ 1,179.1     $ 12,384.8  
Washington National                                              
     455.1       185.4       3,117.2  
Colonial Penn                                              
     92.4       199.8       713.8  
Other CNO Business                                              
     58.9       226.6       8,078.2  
                         
Total                                              
   $ 1,175.9     $ 1,790.9     $ 24,294.0  
                         
2008
                        
Bankers Life                                              
   $ 761.7     $ 1,216.2     $ 11,622.3  
Washington National                                              
     491.8       159.7       3,106.4  
Colonial Penn                                              
     105.3       174.8       708.9  
Other CNO Business                                              
     119.0       261.9       8,750.5  
                         
Total                                              
   $ 1,477.8     $ 1,812.6     $ 24,188.1  


 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
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16.       QUARTERLY FINANCIAL DATA (UNAUDITED)

We compute earnings per common share for each quarter independently of earnings per share for the year.  The sum of the quarterly earnings per share may not equal the earnings per share for the year because of: (i) transactions affecting the weighted average number of shares outstanding in each quarter; and (ii) the uneven distribution of earnings during the year.  Quarterly financial data (unaudited) were as follows (dollars in millions, except per share data).

2009
  
1st Qtr.
    
2nd Qtr.
    
3rd Qtr.
    
4th Qtr.
  
                         
Revenues                                                                             
   $ 1,069.5     $ 1,095.6     $ 1,118.6     $ 1,057.7  
                                 
Income before income taxes                                                                             
   $ 42.2     $ 49.6     $ 64.1     $ 17.7  
Income tax expense (benefit)                                                                             
     17.7       22.0       48.7       (.5 )
                                 
Net income                                                                             
   $ 24.5     $ 27.6     $ 15.4     $ 18.2  
                                 
Income per common share:
                                
Basic:
                                
Net income                                                                        
   $ .13     $ .15     $ .08     $ .09  
                                 
Diluted:
                                
Net income                                                                        
   $ .13     $ .15     $ .08     $ .09  


2008
  
1st Qtr.
    
2nd Qtr.
    
3rd Qtr.
    
4th Qtr. (a)
  
                         
Revenues                                                                              
   $ 1,027.5     $ 1,094.7     $ 1,021.9     $ 1,045.6  
                                 
Income (loss) before income taxes and discontinued operations
   $ (11.9 )   $ 16.1     $ 5.7     $ (6.2 )
Income tax expense (benefit)                                                                              
     (4.2 )     306.3       31.6       79.6  
                                 
Loss before discontinued operations                                                                              
     (7.7 )     (290.2 )     (25.9 )     (85.8 )
Income (loss) from discontinued operations, net of tax
     .5       (198.3 )     (157.4 )     (367.5 )
                                 
Net loss                                                                              
   $ (7.2 )   $ (488.5 )   $ (183.3 )   $ (453.3 )
                                 
Loss per common share:
                                
Basic:
                                
Loss before discontinued operations                                                                         
   $ (.04 )   $ (1.57 )   $ (.14 )   $ (.46 )
Discontinued operations                                                                         
     -       (1.08 )     (.85 )     (1.99 )
                                 
Net loss                                                                      
   $ (.04 )   $ (2.65 )   $ (.99 )   $ (2.45 )
                                 
Diluted:
                                
Loss before discontinued operations                                                                         
   $ (.04 )   $ (1.57 )   $ (.14 )   $ (.46 )
Discontinued operations                                                                         
      -       (1.08 )     (.85 )     (1.99 )
                                 
Net loss                                                                      
   $ (.04 )   $ (2.65 )   $ (.99 )   $ (2.45 )
_____________
(a)  
In the fourth quarter of 2008, our net loss reflected the following: (i) losses from discontinued operations of $367.5 million primarily related to losses and transaction costs associated with the Transfer; and (ii) net realized investment losses of $93.0 million.

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
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17.
INVESTMENT IN A VARIABLE INTEREST ENTITY

The Company has an investment in a special purpose entity that is a variable interest entity.  The following is description of our significant investment in a variable interest entity:

Fall Creek CLO Ltd.

Fall Creek CLO Ltd. (“Fall Creek”) is a collateralized loan trust that was established to issue securities and use the proceeds to invest in loans and other permitted investments.  The assets held by the trust are legally isolated and are not available to the Company.  The liabilities of Fall Creek are expected to be satisfied from the cash flows generated by the underlying loans, not from the assets of the Company.  The investment borrowings were issued pursuant to an indenture between Fall Creek and a trustee.  The investment borrowings of Fall Creek may become due and payable if certain threshold ratios (based on the entity’s leverage and the fair value of its assets) are not met for a specified period of time.  During the first quarter of 2008, such threshold ratio was not met and the indenture was amended.  As a result of the amendment, Fall Creek sold assets of $90 million (which resulted in net realized investment losses of $11.2 million), and paid down investment borrowings of $88.0 million.  Pursuant to the amendment, we committed to provide additional capital to Fall Creek for up to $25 million (under defined circumstances), all of which was contributed in 2008.  In addition, the indenture was amended and restated in November 2008, to change certain terms related to the investment borrowings, cease future reinvesting activities of Fall Creek, provide for an additional investment in Fall Creek and remove the provision related to threshold ratios.  In conjunction with the amendment and restatement of the indenture, Fall Creek repaid $17.5 million of investment borrowings and the Company purchased: (i) $25.2 million of borrowings previously held by others; and (ii) $9.7 million of newly issued borrowings of Fall Creek.  Repayment of the remaining principal balance of the investment borrowings of Fall Creek is based on available cash flows from the assets and such borrowings mature in 2017.  Repayments totaling $82.4 million were made in 2009 and a $10.0 million repayment was made in December 2008 based on such excess cash flows.  The Company has no further commitments to Fall Creek.  The carrying value of our investment in Fall Creek was $72.5 million and $83.5 million at December 31, 2009 and 2008, respectively.  The following tables provide supplemental information about the assets, liabilities, revenues and expenses of Fall Creek which have been consolidated in accordance with authoritative guidance, after giving effect to the elimination of our investment in Fall Creek and investment management fees earned by a subsidiary of the Company (dollars in millions):

   
December 31,
  
   
2009
    
2008
  
Assets:
            
Fixed maturities                                                                                            
   $ 268.0     $ 269.7  
Cash and cash equivalents – restricted                                                                                            
     3.4       4.8  
Accrued investment income                                                                                            
     1.2       2.8  
Other assets                                                                                            
     8.0       7.2  
                 
Total assets                                                                                        
   $ 280.6     $ 284.5  
                 
Liabilities:
                
Other liabilities                                                                                            
   $ 7.4     $ 7.8  
Investment borrowings due to others                                                                                            
     224.1       306.5  
Investment borrowings due to the Company                                                                                            
     81.9       81.9  
                 
Total liabilities                                                                                        
      313.4        396.2  
                 
Equity (deficit):
                
Capital provided by the Company                                                                                            
     16.6       16.6  
Capital provided by others                                                                                            
     3.8       3.8  
Accumulated other comprehensive loss                                                                                            
     (22.5 )     (118.4 )
Accumulated deficit                                                                                            
     (30.7 )     (13.7 )
                 
Total equity (deficit)                                                                                        
     (32.8 )     (111.7 )
                 
Total liabilities and equity (deficit)                                                                                        
   $ 280.6     $ 284.5  

 
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CNO FINANCIAL GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
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Years ended
  
   
December 31,
  
   
2009
    
2008
    
2007
  
Revenues:
                  
Net investment income – deposit accounts                                                                                            
   $ 13.4     $ 23.6     $ 36.8  
Fee revenue and other income                                                                                            
     .3       .5       .3  
                         
Total revenues                                                                                        
     13.7       24.1       37.1  
                         
Expenses:
                        
Interest expense                                                                                            
     12.7       16.2       27.4  
Other operating expenses                                                                                            
     .2       .7       .5  
                         
Total expenses                                                                                        
     12.9       16.9       27.9  
                         
Income (loss) before net realized investment losses and income taxes  
      .8        7.2        9.2  
                         
Net realized investment losses                                                                                            
     (14.2 )     (24.9 )     (.4 )
                         
Income (loss) before income taxes                                                                                        
   $ (13.4 )   $ (17.7 )   $ 8.8  

During 2009, net realized investment losses included:  (i) $.7 million of net losses from the sales of investments; and (ii) $13.5 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary.  During 2008, net realized investment losses included:  (i) $14.1 million of net losses from the sales of investments; and (ii) $10.8 million of writedowns of investments resulting from declines in fair values that we concluded were other than temporary.

18.       SUBSEQUENT EVENTS

In February 2010, we repurchased $64 million aggregate principal amount of our 3.5% Debentures in a privately-negotiated transaction.  In connection with the repurchase of the 3.5% Debentures, we completed a second closing of $64 million aggregate principal amount of our 7.0% Debentures as part of our previously-announced private offering of 7.0% Debentures.  The first closing of $176.5 million of the 7.0% Debentures was completed on November 13, 2009, upon settlement of a tender offer for the 3.5% Debentures.

The purchase price for the $64 million of 3.5% Debentures was equal to 100 percent of the aggregate principal amount plus accrued and unpaid interest.  As a result of the repurchase, we expect to realize a loss on the extinguishment of debt of approximately $2 million, representing the write-off of unamortized discount and issuance costs associated with 3.5% Debentures that were repurchased.

The issuance of the $64 million of 7.0% Debentures was made pursuant to the purchase agreement that we entered into in October 2009 relating to the private offering of up to $293 million of 7.0% Debentures.  We received aggregate net proceeds of approximately $61.4 million in the second closing of the 7.0% Debentures (after taking into account the discounted offering price less the initial purchaser’s discounts and commissions, but before expenses).  An aggregate of $52.5 million of the 3.5% Debentures remain outstanding.






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