CNA Surety Corporation Q3 2008 Earnings Call Transcript

Oct.27.08 | About: CNA Surety (SUR)

CNA Surety Corporation (NYSE:SUR)

Q3 2008 Earnings Call

October 24 2008 11 am ET

Executives

Thomas Pottle - SVP, Credit and Field Operations

John Welch - President and CEO

John Corcoran - SVP and CFO

Analysts

Kevin Barker - FBR Capital Markets

Rohan Pai - Banc of America Securities

Operator

Good day everyone and welcome to CNA Surety's third quarter 2008 earnings conference call. (Operator Instructions).

For opening remarks and introductions I would now like to turn the call over to Mr. Thomas Pottle. Please go ahead sir.

Thomas Pottle

Thank you. Good morning, everyone, and welcome to CNA Surety Corporation's third quarter conference call. With me are John Welch, President and Chief Executive Officer of CNA Surety; and John Corcoran, Chief Financial Officer.

Before we begin, I would like to preface this call with the Safe Harbor statement under the Private Securities Litigation Reform Act of 1995, which is more fully described in the press release. Throughout the discussion and subsequent question-and-answer session, forward-looking statements that are not based on historical facts may be made. These statements are based on today's market conditions and involve certain risks and uncertainties. While every attempt is made to convey accurate information regarding these forward-looking statements, no guarantees can be made that the conditions will remain and that the actual results will conform to the statements being made today.

With that understanding, I would now like to turn the call over to John Welch.

John Welch

Alright. Thanks, Tom. Good morning, everyone, and thank you for joining us once again.

As you have seen from our press release, CNA Surety posted excellent results for the quarter. We benefited from fairly steady premiums, continued expense control, a conservative investment portfolio and a reduction in reserves relating to some older accident years. At the same time, we strengthened current accident year reserves in acknowledgement of the current economic conditions.

John Corcoran will give you a further rundown of the numbers in his comments.

Now, given everything that has gone on in the financial world over the past few months, we feel pretty good about how we are prepared for this downturn. We have always attempted to manage the business to protect the downside. While we cannot manage our way out of every risk and economic circumstance, we have managed the business in a relatively conservative manner.

To-date, our investment portfolio has held up fairly well. Outside of our deferred compensation plans, we have not invested in equities. Our subprime portfolio was small in performing. Our other asset-backed investments continue to perform, and we have a large spread of risk in the municipal bond holdings.

Our unrealized loss position on the portfolio has grown, but we feel confident in our ability to hold the portfolio. And today, we feel comfortable with the performance of the entities or transactions that underlie the investments.

From an underwriting perspective, our contract surety bond of backlog per account exposures have not increased over the past five years despite the growth in the construction economy. When our per account exposures have grown beyond our comfort level, we have sought co-surety partners.

We have generally managed the exposure levels, so that expected losses could be managed within our reinsurance protection, with our capital providing the cushion should we err in these estimates.

We have also managed commercial surety exposures to much more reasonable levels and are significantly less exposed to large corporate risks than we were five or six years ago. That said, we are fully cognizant of the current economic realities and what it could mean going forward.

Towards this end, we have strengthened our credit models, which will result in a greater percentage of our book being further evaluated. We have also intensified our evaluation of the cash flow and leveraging characteristics of each client. We continue to stay close to our clients in order to understand our financial situation and their plans for how a downturn could affect their business.

Regarding premium production, we have seen a slowdown, and barring government stimulus through public works, we would expect the trend to continue into 2009. As most of you already know, financing and construction, whether it's public or private, has constricted. This will obviously play into our production numbers going forward.

We will continue, however, our efforts to find new sources of business in territories in our product mixes where we had less presence in the past.

Given everything I have mentioned to-date; I am very pleased that we have been able to significantly lower our expense ratios over the past five years. This continued focus on expense will benefit us during this period of slowing revenues.

We will continue to look for ways to operate more efficiently as we do everything we can to offset some of the market conditions. However, we are willing to live with the expense ratio increasing to some degree in order to retain our workforce. Surety is a very specialized product, and to some degree it becomes even more important to maintain your unerring talent during difficult financial times as your underwriting intensifies, particularly in the credit-sensitive products.

In conclusion, we are very pleased that we are able to report a level of profitability that favorably reflects upon the underwriting of the past few years. We also continue to maintain healthy capital and reserve positions.

Going forward, we recognize the potential difficulties ahead and we will continue to underwrite appropriately and manage our investments, reserves and capital in a manner that will allow us to not only survive, but produce profitable results and respectable returns on capital.

With that said, I will turn the call over to John Corcoran. John?

John Corcoran

Thanks, John. Good morning, everyone. I will go directly to our loss reserves, since that is the big story for the quarter.

Our reserve analysis completed in the third quarter indicated a significant redundancy of approximately $45 million based on June 30 data. This is consistent with our commentary over the past few quarters regarding favorable loss activity.

We decided to release $25 million of this redundancy in the third quarter. We retained the additional reserves in light of the current economic conditions.

The reserve redundancies were primarily indicated for accident years 2006 and 2005, with smaller redundancies for earlier accident years. While we are quite proud of these results, we fully understand that they benefited from the significantly better economic conditions of 2006 and prior.

Our actual loss activity in the third quarter was again favorable. In fact, it was one of the best quarters of recent memory.

About the only bad news on the loss front was some deterioration on one of the claims that we discussed in the fourth quarter of 2007. While this deterioration was ceded to reinsurers, it did cause us to incur $4.2 million of additional reinstatement premiums on the 2007 treaty.

In light of the current economic conditions, we added $5 million to our loss provision for the 2008 accident year. This results in a year-to-date loss ratio of 26.8 for the current accident year, up 1.5 points from our previous selection. This increase was not based on any specific loss activity that we have seen.

As I, said our loss activity remains very favorable. We simply believe that it is prudent and realistic to reflect the economic conditions in our loss pick. If these conditions persist or worsen, we intend to address that proactively in future loss picks.

Finally, I want to mention that we will most likely be changing the timing of our reserve review in 2009. We currently perform the most detailed analysis during the third quarter using data as of June 30, and then update that analysis for use in our yearend financials.

We believe that it would be beneficial to move the detailed analysis to the fourth quarter using data as of September 30. This way, we have more data included in the most detailed analysis, and then the amount of new data considered in the update is minimized.

Moving on to premium, our gross written premium for the quarter was down about 2.5%. This decline was concentrated in our contract business, which was down about 5% due to the slowing construction market.

Net written premium and net earned premium were down in the quarter, primarily due to the additional reinstatement premium I mentioned earlier.

The expense ratio increased to 56.2% for the quarter, up from 52.8% for the third quarter of 2007 and up from 53.3% for the second quarter of 2008. The increase was primarily caused by the additional ceded premium, which decreases the denominator of the expense ratio calculation.

We also had an increase to our accruals for incentive compensation based on our strong results. If I adjust for these items, the expense ratio would show improvement from the second quarter of this year and the third quarter of last year.

Investment income for the quarter was $11.8 million, up from $11.3 million for the third quarter of 2007 due to the increase of invested assets, which more than offset the impact of lower short-term interest rates and a higher concentration of short-term investments.

Again, our portfolio is not immune to the broader market conditions that have impacted bond values. Fortunately, our long held conservative approach has helped minimize the impacts.

Our unrealized loss position increased by about $28 million in the quarter to approximately $31 million as credit spreads widened. We do not believe that we have any specific bond holdings that require impairment.

We did take a small impairment on our equity investments. All of the equities we own are related to a non-qualified deferred compensation plan. The participants in the plan bear all of the risk associated with these investments. Any change in value of these investments creates an offsetting change in our liability to the plan participants.

Our minimal exposure to subprime home loans decreased in the quarter to about $8.5 million due to principal pay downs. Both of our subprime holdings are now paying down.

We hold approximately 52 million of Freddie Mac and Fannie Mae bonds and approximately 104 million of agency CMOs and mortgage pass-throughs. Other than the investments related to the deferred comp plan, we own no common or preferred stock.

The overall credit quality of our bond portfolio remained at AA. At quarter end, invested assets and cash totaled $1.59 billion.

Operating cash flow for the third quarter was $31 million compared to $58 million for the third quarter of 2007. I mentioned in our last call that we had a large claim payment at the beginning of the third quarter. This payment drove the decline in cash flows.

To reiterate, our net exposure on that claim had been fully reserved for a number of years. We did have substantial reinsurance on that claim, and I am pleased to report that we received full and prompt payment on all of the amounts due.

Debt outstanding remained at $31 million at quarter end. As a quick reminder, this debt has a final maturity of 2034, and we have the option to retire part or all of the debt beginning next year.

Statutory surplus grew to $530 million at quarter end, resulting in a net written premium to surplus ratio of 0.8 to 1. At quarter end, our consolidated stockholders equity increased to $722 million or $16.36 per share.

In conclusion, we had record net income for the quarter at $34.3 million or $0.78 per share. Our investment portfolio continues to weather the storm, and our capital position is the strongest it has ever been.

We will now open up the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) We'll take our first question from Randy Binner with FBR Capital Markets.

Kevin Barker - FBR Capital Markets

Good morning, everyone. This is Kevin Barker filling in for Randy Binner. I just wanted to ask a question concerning the loss ratios. As you've guys have seen, those come down to 8%. Were you forced to take those releases from the auditors, the actuaries, and why release now considering how soft the economy has become?

John Corcoran

Well, Kevin, the release primarily is coming from older accident years that we believe are sufficiently mature and the actuarial indications are appropriate. We did retain a significant amount of additional indicated redundancy for the more current accident years based on the economic conditions.

Kevin Barker - FBR Capital Markets

Do you expect to add to that $5 million for 2008 or do you think you are right there, everything is fine?

John Corcoran

We think it's a good selection as we sit today, but we will certainly react as conditions warrant.

Kevin Barker - FBR Capital Markets

Okay. In addition, I noticed the increase in expense ratio. Should we think of that as a trend and keep it at 56% going forward considering the change in the denominator?

John Corcoran

Well, no. That change in the denominator is an unusual event. I can't say it's one-time because we did have a similar situation in the fourth quarter of '07. But we don't anticipate that being a recurring issue.

Then, again, on expense dollar side, we did have a little bit of an unusual increase related to incentive comps. So both of those things I would view as nonrecurring, non-trend altering impacts.

Kevin Barker - FBR Capital Markets

A range of around 53% would be reasonable?

John Corcoran

That sounds pretty reasonable.

Kevin Barker - FBR Capital Markets

Okay. So, considering the economic environment, are you considering holding on to the capital and possibly being conservative in the next two to four quarters on dividend payouts or maybe repurchases?

John Welch

Kevin, this is John Welch. We do look at that. We did have the Board Meeting yesterday and we look at that every quarter. But you are quite right. Given everything that's going on right now, it's probably best to retain what we have and see how it develops. The capital is pretty strong, but I'd like to keep it that way given what we see out there.

Kevin Barker - FBR Capital Markets

Yes, absolutely. Also on investment losses, the realized losses were so low, it was great in comparison to insurers so far this quarter. Have you seen investment opportunities out there and do you plan to take advantage of some of those opportunities as spreads widen?

John Corcoran

In terms of the investment portfolio, specifically?

Kevin Barker - FBR Capital Markets

Yes.

John Corcoran

We're approaching the market cautiously. Our investments are handled by Conning Asset Management who has done a great job and really positioned us very well here for these tough times, and we expect them to continue to approach the market in the same conservative fashion.

We're heavily concentrated in municipal bonds, high quality municipal bonds. That would continue to be our posture go-forward. Conning has done a great job for us so far and we fully anticipate they will continue to do that.

Kevin Barker - FBR Capital Markets

So, in other words, you're going to continue with the investment philosophy. You're not going to expand beyond the current municipals and being very conservative?

John Corcoran

I would agree.

Kevin Barker - FBR Capital Markets

Okay. Finally, one more question on the competitive environment. Are you seeing Travelers or Liberty Mutual possibly getting a little bit more aggressive on pricing competition, considering the current environment, or are you seeing that softening a little?

John Corcoran

Well, in the surety world, actually the surety world has been pretty profitable over the last few years and I would venture to guess 2008, if not equally, as profitable. So we had begun to see some additional competition. Not really from rate. The rates have held steady, but some of the underwriting conditions started to loosen a little bit and the competition started to increase.

However, with what's going on in the market, I don't know if that's going to cause people to pause a bit in what they're doing. The industry in the surety world anyways has consolidated quite a bit. There is not that many larger players in the market, and it would kind of be a shame to see us return to that kind of competition when it's really not necessary and in light of what we're looking at down the road here.

So far it hasn't happened to any great degree and we're hopeful that it doesn't.

Kevin Barker - FBR Capital Markets

Have you seen anything specifically with Liberty Mutual and SafeCo?

John Corcoran

Not really. In the surety world they've just announced, to the best of my knowledge, only the higher level positions. So, we know who is sitting in those chairs, but I haven't really heard how the field is all going to shake out yet. I think until that shakes out, you won't really know how that will go. But I'm sure they will try and hang on to pretty much what they have.

Will there be opportunities as people get dislocated? Probably, but it's yet to play out.

Kevin Barker - FBR Capital Markets

Okay. One last question finally. I just wanted to ask about with the slowdown in construction and the ability to grow the topline, do you guys have any flexibility in decreasing operating expenses and keeping the margin going forward or can you give me a little color around that?

John Corcoran

Well, first, we're trying to offset what's going on in the market by just trying to get into some areas, essentially in the surety business where, maybe, we haven't been as strong. We've opened up a few newer offices that we didn't have in the commercial surety area. We've attempted to get into a few niches we haven't been in.

So we're trying to offset it, but I don't know if we can outrun what's going on in the market in the construction world. So with that said, sure, there's always ways to reduce expense. As I mentioned in my comments, we would rather not at this point. The surety underwriting talent is hard to come by and it takes awhile to train.

So, once you have it in place, we'd like to keep it, particularly during these times when we probably have to intensify our analysis of the business as opposed to get rid of people and then lose sight of it, because the loss ratio is going to kill us quicker than the expense ratio.

Quite frankly, I'd rather pay attention to the loss ratio and keep that under control, while trying to find every efficiency we can in expenses. But if that drifts up a little bit, I think I'd be willing to sacrifice that as opposed to relaxing efforts to keep the loss ratio in control.

Kevin Barker - FBR Capital Markets

Okay, great. I appreciate your time and congratulations on a great quarter.

John Welch

Thank you.

John Corcoran

Thanks.

Operator

(Operator Instructions). We'll take our next question from Rohan Pai with Banc of America Securities.

Rohan Pai - Banc of America Securities

Hi. Good morning. I guess looking into next year, assuming that if the reinsurers keep their pricing in terms and conditions the same, would you look to change your principle retention or any terms in your reinsurance contracts?

John Corcoran

Well, we are actually looking at it. We have a 10 million retention with 5 million up the (inaudible) right now. We would look at some increments. The first layer is the $10 million to $25 million layer. I guess we can look at retaining any portion of that. I guess it will depend on the pricing to some extent.

As I heard in one of the other calls, reinsurance, really, I don't know that it's providing great capital, considering that we've been very profitable. So, I think it's a cost.

We have the IBNR reserves, I think, to be able to consider a higher retention, let's say, and we do have the capital to consider a higher retention. So we'll look at it, but, as of this point, we just really don't know. We've met with all of the reinsurers. They haven't given us any proposals yet. We should have that over the next month I would say.

Rohan Pai - Banc of America Securities

John, I was actually thinking that heading into 2009 in a weaker economic environment, that it makes possibly more sense if you're getting cheaper reinsurance capacity. Given that the cost of other capital is pretty high, it probably makes sense to lower retentions?

John Corcoran

Well, I don't think we'd lower it from 10. Really, we're just trading dollars, quite frankly, on the layers. What we're paying them is pretty much what we have in losses for the most part. So I'm not sure we get too much of a benefit out of it. Actually, I haven't seen any benefit out of it. It helps to smooth perhaps some volatility. It can do that.

10 is pretty good. I can't imagine we would go lower than that really, quite frankly.

Rohan Pai - Banc of America Securities

Okay. I guess the other question, if you can just give us a little more color on the loss environment outside your own book on the contractor side, especially are you seeing increased signs of stress or defaults that might not be reflected on your book, but might be happening out there?

John Corcoran

No. Really, quite frankly, it's the opposite. I mean, right now we have a lot of clients, obviously, in the construction business. We visit a lot of them. We obviously have the financial statements. The balance sheets are probably as strong as they've been. The balance sheets are very strong and the backlogs actually for the most part, other than when you talk about the residential contractors because we don't have a lot of those, but when you talk about the public world, they are still very strong.

Their concern really is more, one, can they replace this backlog, and if they do, can they replace it at the margins that they have on the current backlog. Answers to both are probably no. They'll probably struggle into '09 a little bit and '10, but they have the balance sheets to do it.

The wildcard, I think, for our business to some degree is, you hear and read a lot about perhaps a way to jumpstart a little bit, the economy is a public works spending. If that happens, that certainly would benefit us actually.

So right now, short of one loss, we saw for a competitor in New York City of some decent size and a couple of subdivision things we saw in California, to not any great degree actually, we just haven't seen the loss activity at all. That was pretty much confirmed by all the reinsurers that marched through here over the last month or so.

We're not here with blinders on. We see what's going on and we see the financing drying up left and right, even in the municipal markets when you're trying to float bond issues. So, if that continues, that has to result in less work.

Rohan Pai - Banc of America Securities

Right.

John Corcoran

Right now, they have the balance sheets to see it through for awhile.

Rohan Pai - Banc of America Securities

Okay. I think those are the only questions that I had.

John Corcoran

Thanks, Rohan.

John Welch

Okay. Thanks, Rohan.

Rohan Pai - Banc of America Securities

Thank you.

Operator

At this time, there are no additional questions in queue. Mr. Welch, I'd like to turn things back over to you for any additional or closing remarks.

John Welch

Okay. Again, thank you for joining us. If you have any questions, please contact John or myself. Thank you.

Operator

That does conclude today's teleconference. Thank you all for your participation and have a great day.

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