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CNA Surety Corp. (NYSE:SUR)

Q4 2008 Earnings Call

February 6, 2009 11:00 am ET

Executives

Thomas Pottle – Senior Vice President, Credit and Field Operations

John Welch – President and Chief Executive Officer

John Corcoran – Senior Vice President and Chief Financial Officer

Analysts

Kevin Barker – FBR Capital Markets

Operator

Welcome to the CNA Surety’s fourth quarter 2008 analyst conference call. As a reminder, today’s call is being recorded. For opening remarks and introductions, I would now like to turn the call over to Thomas Pottle. Please go ahead, sir.

Thomas Pottle

Welcome to CNA Surety Corporation’s fourth quarter and year end 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 all 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 condition 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

I appreciate you all joining us once again this quarter. As you saw in our press release, we had an outstanding fourth quarter completing a record year of profitability. While the prior year loss reserve takedowns drove this year’s outstanding result, we also continue with a very modest level of current incurred loss activity.

Despite the low level of current loss activity, we continue to build the loss reserves of the more current years in anticipation of potentially more difficult times ahead. We feel very positive about the level of capital and reserves we have built in order to confront these challenging times. Gross written premiums for the quarter increased 2% with contract surety up 1.9% and commercial surety up 3.2%. The increase in commercial surety was driven by a one-time recognition of an older premium that resulted from a successful loss mitigation strategy.

For the year, gross written premiums decreased 1% with contract surety down 1.8% and commercial surety up 0.9%. Overall, given the difficult economic circumstances, we are pleased with the premium production numbers. Our production was supported by the continued spending on public construction offset to some degree by the drop off in the private market. While there are strains on public construction spending, talk of a government stimulus package including public infrastructure spending give us some encouragement going forward.

As mentioned, we experienced favorable loss development during the quarter of $20.5 million. An updated analysis of our year-end reserve position indicated continued redundancy in the older accident years. At the same time, as a result of the current economic climate, we have bolstered our 2008 IB&R reserves and will continue with the higher level of IB&R reserving in 2009. As a result of the reserve releases the past few quarters, our year-end loss ratio declined from the previous year.

Regarding reinsurance, we completed our renewal at the end of the year and we made a few changes to the structure. As a result of our significantly increased capital position and more difficult reinsurance market conditions, we decided we could absorb a higher retention level.

As such, we are now retaining the first $15 million of loss per account versus $10 last year. At the same time, we structured the program to have less possibility of incurring the reinstatement premiums during 2009. You might remember that reinstatement premiums caused our results to fluctuate over the past year.

As a result of these changes, we expect our overall reinsurance cost will decline in 2009 based on our current estimate of earned premiums. From an expense perspective, our expense ratio increased 0.3% for the quarter and 0.5% for the full year due to the impact of an increased accrual for incentive compensation based on positive results. As we have mentioned on prior calls, we will begin to see pressure on the expense ratio as premium level out or decrease and we continue with normal year-end salary adjustments.

We will need to continue to find ways to identify efficiencies within the organization in order to keep these ratios at a reasonable level. We put a good deal of work into driving the expense ratio down over the past five years and we do not want to see it return to previous levels.

With that said, we are willing to let the expense ratio slide up to a degree to protect the underwriting talent in infrastructure we have in place. Underwriting discipline is even more important in this difficult credit environment and we want to be well positioned for a turn in the economy. If the expected rebound does not occur for some time, we will obviously have to look for ways to manage our expenses in line with our revenues.

The performance of our investment portfolio continues to be one of the highlights of the year, given what has happened in the investment world. John Corcoran will provide the details, but we have suffered minimal realized losses and our earned realized loss position is quite modest. We certainly compliment our investment managers and our board for keeping us on a very conservative path.

Overall, the surety market remains fairly steady. Competition continues for good business but we have not seen deterioration in underwriting standards nor pricing. While the Surety lineup business has been very profitable for almost all carriers the past few years, the current economic circumstances have had a somewhat dampening effect on aggressive production efforts.

Like many businesses, we are very anxious to see the results of the government’s efforts to jumpstart the economy. In summary, despite the doom and gloom you read every day in the press, we actually enjoyed a record year. Our results were certainly not borne of last year’s business climate, but were the result of conservative underwriting claim handling and investing over the past number of years.

Fortunately, we positioned ourselves fairly well for the circumstances we are living with today. While we cannot totally escape the effects of this very difficult credit climate, we do feel very good about the strength of our balance sheet and are hopefully, we and our industry will be able to participate in the economy’s road to recovery.

With that, I’ll turn you over to John Corcoran for some additional financial details.

John Corcoran

As I did last quarter, I will directly to our loss reserves since that is, again, the major story. Our year-end reserve analysis indicated further improvement. This resulted from some case reserve reduction on older cases and continued favorable loss activity. We concurred with the actuarial indications for accident years 2005 and prior as we believe that these years are sufficient developed and significantly less likely to be impacted by current economic conditions.

However, we have booked reserves that are higher than the actuarial indication for the more recent accident years in light of these economic conditions. This resulted in favorable reserve development of $20.5 million, which included some reserve strengthening for the 2007 accident year. In addition, we further increased our reserves for the 2008 accident year. Again, this was driven by economic conditions our current loss activity remains modest. In total, our net reserves at year-end are approximately 5% higher than the actuarial indication.

John Welch covered the production and expense details, so I’ll move on to investments. Investment income for the quarter was $12 million up from $11.8 million for the fourth quarter of 2007. Our overall yields were adversely impacted by very low short-term rate. Again, our portfolio was not completely immune to market dynamics, but the impact so far has been very minimal.

We did record in other than temporary impairment of approximately $1 million on a $4 million bond position, and we did take some additional impairments of equity investments associated with our deferred compensation plan. However, we remain very pleased with the performance of our portfolio. Our bond portfolio ended the year in an unrealized loss position of only $7 million, a solid improvement from the $31 million unrealized loss at September 30th.

Our minimal exposure to subprime home loans decreased by another $500,000 in the quarter to approximately $8 million due to principal pay down. At quarter end, invested assets in cash totaled $1.1 billion and our bonds portfolio retained an overall credit quality of AA.

Operating cash flow for the fourth quarter was $39 million up about a million from the fourth quarter of 2007. For the year, operating cash flow was $124 million compared to $129 million in 2007. Debt outstanding remained at $31 million at year-end with no required repayments until 2034. Statutory surplus grew to about $555 million at year-end, resulting in a net written premium, a surplus ratio of 0.8 to 1. At year-end our consolidated stockholders equity increased to $767 million or $17.37 per share.

In conclusion, we had another strong quarter and our third consecutive year with record net income. Our investment portfolio is standing tall and our capital position is again the strongest it has ever been. We will now open up the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Randy Binner – FBR Capital Markets.

Kevin Barker – FBR Capital Markets

Barker filling in for Randy Binner. I just had a couple questions concerning competitive environment with Liberty and Safeco impacts. Have you guys seen anything? I know I asked about this last quarter, but have you seen any more impact on the competitive environment lately over the last quarter?

John Welch

Not really. They are doing actually a pretty good job of consolidating the two companies, particularly in the surety area. And there really hasn’t been much movement that I’ve seen of personnel and/or business. I’m sure there’s been some but it’s not been significant enough to comment on really.

Kevin Barker – FBR Capital Markets

With construction being pulled back a little bit over the last year and with the possibility of the Obama Administration coming in and spending more on infrastructure, do you see maybe your construction rate in premiums coming down in the near-term and possibly moving up in the long-term and how are you positioning yourself for that possible impact?

John Welch

That could happen what you’re laying out. It’s going to take a while for whatever stimulus package they have in place to really get to us. So for the foreseeable future, sure, I would see things stagnating or declining and we began to see that already a little bit this year.

The infrastructure part of the stimulus package from best I could tell looks to be anywhere $70 to $80, $90 billion, which is good and it’s great and we need it, but it still is relatively a small part of the overall construction spending in a full year. It will certainly help offset some of the other things going on, but I’m not sure it’s the total answer so we need to keep looking for new opportunities, new niches, new geographic areas we can enter into to help supplement whatever might come there.

Kevin Barker – FBR Capital Markets

Where would you expect the severity to be most affected over the next several quarters? Do you expect it right now and I mean the softness, in the first quarter, or would you expect it maybe a little bit further in like the second half if the stimulus package does not – it’s probably not going to come through for quite a while? Do you expert the economic downturn to really have a stronger effect in the second half compared to the first half?

John Welch

For us, no. I think it’s already underway. There’s less spending out there by states and the federal government and I don’t know the federal government to a great degree but the states definitely are spending less and some of the other political subdivisions that you have. There are all sorts of budget problems left and right that you read about. So we’re seeing it now so I think it will continue really throughout the year. I think it might be the reverse. I think if we see any better improvement it will be towards the latter half of the year and that’s still speculative to say.

Kevin Barker – FBR Capital Markets

[Inaudible] Fidelity premiums coming down, contract premiums and commercial premiums rate in premiums also going up. Do you expect softening in the commercial and contract along with continued softening in Fidelity, or do you expect any one of those to outperform over the next couple of quarters, as far as how many premiums are written.

John Welch

I would say in the commercial area we can tend to stay a bit more steady because there’s some renewal aspect to that book of business. Whereas the contract businesses is based on new projects being led so it’s whatever the activity is in the market is what we’ll write bonds on. But I think the contract line to probably decrease a little bit more than the commercial line. The Fidelity line kind of follows the same way as the commercial line, more or less.

You might think in this environment there might be a few more Fidelity policies sold given it’s a dishonesty type coverage and this might be a time you want to have some coverage like that. But we’re relatively a smaller player in that area and that’s not going to drive our numbers one way or the other. The big ticket items are the commercial surety and the contract and we won’t write enough commercial surety to offset some of the declining contracts, but I would expect it to slow less, yes.

Kevin Barker – FBR Capital Markets

Can we consider the contract premiums to have a more consistent rate with the previous years where you’re going to have a stronger written premium in the second or third quarter? Do you expect that to continue, or like the economic effect over the next couple quarters to really hit that or to maybe cause that to come down a little bit?

John Welch

I would expect about the same just because if nothing else just that the climates of the country. You generally have more construction, obviously, in the middle of the year than you have in December and January. So I don’t see even with the stimulus package that that would change. I could be wrong but I don’t really see any significant effect there.

Kevin Barker – FBR Capital Markets

Now on to the reserve release at $20.5 million, should we expect some of that going forward to continue for further reserve releases coming out? What years specifically were these coming out of? Can you provide some color around the reserve releases?

John Corcoran

Kevin, it's John Corcoran. For the quarter the $20, $20.5 million for the quarter 2006 accident year was the big impact about $16 million, then about $7 million from 2005, a couple million from 2004 and then it kind of trails off. Actually in the older buckets the real old buckets there was a couple million. As I mentioned under my comments, within that we did strengthen 2007, again, in light of the economic condition.

Generally for the year our favorable development for the year was $45.5 million on prior years and the dynamic stayed pretty much the same, 2005, 2006 were by far the majority of those with smaller buckets in the older years.

In terms of seeing this level of development go forward, I don’t think that’s realistic in the current environment. One, the degree of caution that we’ll be looking at the more recent accident years until there is more clarity about the economic situation and a stimulus package and the help of our contractors we’ll be looking at those years conservatively.

We think the older years are accurately set now. Might there be some further improvement there, sure, if the loss activity remains modest for those years. There could be some more money there but I can’t imagine to the magnitude that we’ve seen this year.

Kevin Barker – FBR Capital Markets

You mentioned reinsurance costs declining earlier in the call, how should we look at that impact on your loss ratio going forward? Would that have a significant impact or would it really push it down?

John Corcoran

Along with the costs going down, we did take a higher retention so in essence those things will tend to offset. Now it will move the number a little bit just from the math. If you added say $5 million to losses and took $5 million out of premium, you have no bottom line impact but it does change your ratio calculation a little bit.

Kevin Barker – FBR Capital Markets

Finally one last thing on credit, noticed that your unrealized loss actually went down to $7 million that’s awesome in the fourth quarter, probably one of the worse quarters in decades. Where did you see the appreciation in unrealized loss and what specific asset classes were realized. Were you seeing it mostly in treasuries and municipals or are you seeing any deterioration in municipals? Can you just give me a little color around the unrealized loss issues?

John Corcoran

The makeup of our portfolio is 65% municipal so any significant movement is going to be driven there. We did experience very strong improvement in our muni portfolio. I believe we benefited particularly because of our very high quality bias in munis and a fairly short duration in our muni portfolio. That seemed to help us in particular and maybe more than a broader market. So that was really the driver. We don’t have a whole lot of treasures. We happened to make a couple of good buys there that did perform well but that’s not the driver. The driver is in munis.

Kevin Barker – FBR Capital Markets

Would you expect any maybe one off losses in the munis or specific municipalities that may be in trouble with some problems in their budgets? I understand as a whole that it would be appreciating and that you may see spreads starting to tighten, but overall have you seen any in like specific one off munis that are starting to deteriorate?

John Corcoran

Not really. There’s a couple that we’ve been describing in our SEC filings that are a little more complicated prepaid gas type deals in the muni portfolio. Those have been under a lot of pricing pressure but we remain very confident in the fundamentals of the deal. Short of that, again, for what credit ratings are worth, we’ve been bias towards very high quality and at least at this point don’t see anything particular in the portfolio that has us concerned.

Operator

(Operator Instructions) It appears that we have no further questions at this time. At this point, I would like to turn the program over to John Welch to conclude the program.

John Welch

We appreciate everybody joining us once again this quarter and, as always, should you have any questions please feel free to call John or myself. Thank you.

Operator

This does conclude today’s teleconference. Have a great day and you may disconnect.

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