CNA Financial Corp. Q2 2009 Earnings Call Transcript

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 |  About: CNA Financial Corporation (CNA)
by: SA Transcripts

Operator

Welcome to the CNA Financial Corporation’s second quarter 2009 earnings conference call. Today’s call is being recorded. At this time I would like to turn the conference over to Nancy Bufalino.

Nancy Bufalino

Good morning. Welcome to the CNA’s second quarter 2009 financial results earnings call. The press release and financial supplement which were released earlier this morning and can be found on the CNA website for your reference. With us this morning are Tom Motamed, our Chairman and CEO and Craig Mense, our CFO. Tom and Craig will provide some prepared remarks about our second quarter results and then we will open it up the discussion to questions.

Before we get started, I would like to advise everyone that during this call there may be forward-looking statements made and references to non-GAAP financial measures. Please see the sections of the earnings release headed financial measures and forward-looking statements for further detail. In addition, the forward-looking statements speak only as of today, August 3, 2009. CNA expressly disclaims any obligation to update or revise any forward-looking statements made during this call. This call is being recorded and webcast. During the next week the call may be accessed again on CNA’s website at www.cna.com.

With that, I will turn the call over to CNA’s Chairman and CEO, Tom Motamed.

Thomas Motamed

Thank you Nancy. Good morning and thank you for joining us. In today’s call I will start by covering CNA’s second quarter and first half results. Our CFO, D. Craig Mense, will discuss our performance against our financial priorities and then I will come back on the line with some summary comments.

Let me start by saying we are pleased to report that CNA had a very solid second quarter. Net operating income increased 22% to $305 million or $1.02 per common share compared with $250 million or $0.93 per common share in the second quarter of 2008. The improvement was driven by a 17% increase in investment income along with steady operating performance from our core underwriting business.

Net income for the quarter was $105 million as compared with $181 million in last year’s second quarter. Book value increased 28% to $27.53. From year-end 2008 we were up 32%. For the first six months net operating income was $454 million in 2009 or $1.45 per common share compared with $471 million or $1.75 per common share in 2008. The net loss for the period was $90 million compared with net income of $368 million in the prior year.

Turning to our core property and casualty business we achieved a combined ratio in the quarter of 98.1 as compared to 97.7 in the second quarter of 2008. We have been running in this range or better for the past several years. Favorable development improved the combined ratio in the second quarter by 4.9 points versus 0.8 points last year. Catastrophe losses represented 2.9 points in both periods.

Our 2009 accident year and loss adjustment expense ratio excluding catastrophes is 68.8 compared with 67 for accident year 2008. Both ratios are our current view, evaluated as of June 30, 2009. Net written premiums were down 6.6% in the second quarter and 4.2% for the first half.

Turning to our specialty line segment, the second quarter combined ratio was 92.1 compared with 92.9 in last year. Favorable prior year development improved the 2009 ratio by 4.9 points versus unfavorable development of 0.2 points in 2008. Catastrophes added 0.4 points to the ratio in 2009 versus 0.2 points last year.

Specialties 2009 accident year loss and loss adjustment expense ratio excluding catastrophes was 67 compared with 66.9 in 2008. Again, both ratios are our current view. There was less of an impact from the credit crisis on accident year 2009 and this offset deterioration from ongoing rate decreases over the past year.

Specialty lines net written premiums declined 3% in the second quarter and in the first six months. Excluding currency fluctuation the quarterly decrease was 1% and year-to-date net written premiums were flat.

Other key production metrics reflect the positive momentum of our specialty business. The second quarter ratio of new loss business was 1.3 to 1. Year-over-year policy count at quarter end was up 1%. We retained 83.5% of the business on renewal, in line with last year. We are also encouraged that renewal rate decreases have been narrowing progressively for the past four quarters.

The average second quarter decrease in 2009 was 0.8% compared with 3.4% in the prior-year period. As for standard lines, the second quarter combined ratio was 105.5 in 2009 compared with 103.2 in 2008. Favorable prior year development had a 4.4 point impact versus 1.9 points last year. Catastrophe losses added six points to the 2009 ratio versus 5.9 points in 2008.

The standard lines 2009 accident year loss and loss adjustment expense ratio excluding catastrophes was 70.8 compared with 67.2 for 2008. Both ratios are our current view. The deterioration reflects the frequency of large property losses as well as margin compression due to rate decreases over the past year.

Standard lines net written premiums decreased 10% in the second quarter and 6% in the first half. Currency fluctuations had no impact on standard lines premium. The decline in premium reflects in part the impact of the economy on exposures in all of our segments but particularly so in our construction business.

We are also encouraged by the rate trend in standard lines. Rate decreases averaged approximately 0.9%, the lowest in 11 quarters. In the second quarter of 2008 the average rate decrease was 5.1%.

As for the second quarter retention we came in at approximately 80%, slightly down from 81% in last year’s second quarter.

Overall, we are taking a more proactive stance on rate and risk quality in standard lines as well as focusing on new business in the industry segments where we believe there are greater profit margins.

Turning briefly to expenses our expense ratio was 31.5 for the quarter and year-to-date. In spite of the pressure on reduced net earned premium, these ratios are in line with the past few quarters and with our peers. Over the past few years we believe CNA has demonstrated its ability to manage expenses in a competitive environment.

In summary, CNA had another solid quarter financially and operationally. With that I will turn it over to Craig.

D. Craig Mense

Thanks Tom. Good morning everyone. Last quarter I laid out three key financial priorities for CNA. Today I would like to give you a report on our progress as outlined against those priorities. As a reminder, those priorities are: First, deliver solid operating income. Second, reduce the risk and volatility of our investment portfolio. Third, maintain a strong level of capital adequacy.

As you just heard from Tom we delivered on priority one with $305 million of operating income, a 22% increase over the prior year period and a respectable 11.4% operating ROE. These results were fueled by a significant increase investment income primarily from limited partnerships and a continued steady contribution from our core PNC businesses including their now 10th straight quarter of favorable reserve development.

Second quarter investment income totaled $675 million, a 17% increase over the year earlier period. Fixed income results were below the prior year, reflecting our decision to continue to maintain a high level of cash and short-term investments coupled with historically low short-term and long-term risk free interest rates. At the present time we are comfortable giving up income to maintain a high degree of liquidity in a still uncertain environment. Although you will likely see us put more of this cash to work over the coming months.

Income from our limited partnership investments was $165 million or a rate of return in the quarter of approximately 10%, a significant recovery in value. You will recall from our earlier discussions of our investment strategy that we invest in LPs as an alternative to equities. We expect that over time they will bring us higher cumulative returns with less volatility. Their recent performance demonstrates this point.

Last year, our LP holdings produced a return of negative 19% while the S&P 500 index returned a negative 37%. This quarter the S&P 500 index returned 16% while our LPs produced 10%. Over the last 10 years our LPs have produced an annualized compound return of 10% while the S&P 500 index produced a negative 2% return. We believe that these investments will continue to perform well over the long-term.

Two other important characteristics of our LP investments are: One, they primarily hold marketable securities with valuations driven by the fair value of the LP’s underlying security holdings; only 6% of our LP holdings are in private equity and 1% in real estate. Two, close to 90%, as measured by reported value, report results on a one month lag or less so our earnings reports reflect more current market valuations.

The $199 million net realized investment loss in the quarter included after-tax, other than temporary impairments recognized in earnings of $267 million. This compares to an OTTI loss of over $111 million in the prior year period. The OTTI credit losses in the quarter were centered in asset backed holdings, primarily residential and commercial mortgage backed securities that were affected by the current difficult economic conditions. These impairment decisions were driven by both current collateral performance and our view that fundamentals are likely to continue to deteriorate.

Additionally, OTTI losses reflect intent to sell decisions, consistent with our strategy of reducing risk and volatility in our portfolio.

We adopted the new GAAP accounting guidance on other than temporary impairments in the second quarter. In general, this change reduces impairment losses recognized in earnings because a portion of the loss, the non-credit portion, is recognized in other comprehensive income. That benefit in the quarter was largely offset by the negative impact of the securities that were written up as part of the cumulative effect adjustment required upon adoption of FAS 115-2, but were then sold at a loss or further impaired.

In a related matter, the adoption of FAS 157-4 had no impact on CNA’s financial condition or results of operations. Our investment decisions continue to emphasize diversification, quality and liquidity. The effective duration of the total portfolio was 5.6 years at quarter end, up from 5.2 years at the end of the first quarter. Most of the duration increase can be attributed to closing derivative positions that had shortened the effective duration as well as selling securities at the short end of the curve.

The effective duration of assets backing our segregated portfolio to match our life like, long term liabilities was 10.5 years which is in line with portfolio targets. The effective duration of the remaining assets backing our PNC liabilities was four years, at the low end of our 4-5 year target and reflecting our overweight cash and short-term position.

Our investment portfolio’s market value reflects a sizeable recovery in the second quarter which included with earnings increased book value per common share by 28% from March 31. Our net unrealized loss position stood at $2.7 billion at quarter end, improving substantially from the $4.8 billion at the end of the first quarter and from $5.4 billion at year-end 2008. The sizeable recovery was led by corporate and municipal bonds. I would also point out that 84% of our unrealized losses at quarter end were attributable to investment grade securities.

We took advantage of the quarter’s market recovery to make substantial progress towards our objective to reduce the level of risk and volatility in our investment portfolio. During the quarter we made net purchases of $2.3 billion of investment grade corporate bonds and nearly $500 million in agency collateralized pass throughs and CMOs. We took further advantage of favorable conditions to reduce our holdings of high yield corporate bonds by over $500 million in the quarter and $750 million year-to-date.

In non-agency mortgage backed securities our position was reduced by $490 million in the quarter and $840 million year-to-date through principle payments and sales. We were also a net seller of about $1 billion in municipal bonds for reasons related to tax efficiency as well as our views on relative risk and attractiveness of the sector.

Our liquidity and cash flow continue to be major advantages. We had $5.5 billion in short-term holdings and treasuries at quarter end including approximately $450 million at the holding company. Positive cash flow from operations, maturities and principle payments from structured securities were approximately $650 million in the second quarter which were in addition to the $640 million of positive cash flows in the year’s first quarter.

This quarter’s results also reflect an improvement in our capital position. GAAP equity increased from $7.1 billion to $8.7 billion during the quarter and our regulatory capital improved as well, up 5% to $8.2 billion. We regularly evaluate our capital adequacy against regulatory, internal and ratings agency metrics. Against all these measures we believe our capital is more than sufficient to support our current ratings.

Before turning the call back over to Tom I would like to report briefly on our non-core business. Results for our life and group non-core segment were essentially flat with a second quarter net operating loss of $26 million. This quarter’s results included two unusual items; a $28 million after-tax legal accrual related to a previously held limited partnership investment which was largely offset by a favorable performance on our remaining pension deposit business. The underlying business performance is relatively constant.

The corporate segment produced second quarter net operating income of $13 million in 2009 driven by improved net investment income.

In summary, CNA had another steady quarter as measured by our progress on our key financial priorities. We remain well positioned to deliver solid operating results, we made meaningful progress towards our objective to reduce risk and volatility in our investment portfolio and we built upon already strong levels of capital adequacy.

With that I will turn it back to Tom.

Thomas Motamed

Thanks Craig. I thought it would be appropriate to update you on our progress on our operating priorities as well as our view of market conditions. In the first quarter conference call I mentioned that based on CNA’s success in construction and healthcare we would be expanding our industry specific appetite into nine additional segments. It is our belief these areas will provide us opportunities for profitable growth. To date the results are quite encouraging.

Submission activity in the U.S. for the first six months was up 28% in specialty and 21% in our core middle market segments. Although our premium trend is not in positive territory, the submission counts tell us we do have the support of our producers. We believe we are well positioned for growth over time and expect our profitability to improve since these industries tend to run at lower loss ratios.

Last quarter we also told you of our interest in building out our excess and surplus lines capabilities through our wholesale distribution system. We have initially decided to focus on four specific areas; property, casualty, programs and transportation.

Submission activity is encouraging, up 41% in casualty and transportation and up 20% for property in the first six months. We believe we have the knowledge and expertise to underwrite and price these risks for a profit with the added benefit of freedom from [form] and rate.

We also advised you of our plans to open five new offices in the U.S. and to build out our capabilities in Europe and Canada. We continue to proceed on schedule with the implementation of our branch and zone network. We are also encouraged by our ability to attract quality people into our field operations as we build out our capabilities at the point of sale.

Along with improving our ability to grow comes the need to improve our profitability. We are delighted with the performance and market position of our specialty business. We believe it has a very strong franchise. However, we do need to upgrade our performance in standard lines. Recently we made two significant management changes.

First, Mike Coyne, who made important contributions in CNA’s finance area, has assumed responsibility for our small business portfolio. Under Mike’s leadership the unit has already made significant inroads on risk selection, pricing and process improvement.

Second, just last week we announced that Bob Lindemann would be joining CNA as the President of Standard Lines. Bob’s 33 years of experience in commercial underwriting and claims as well as his external focus make him preeminently qualified to improve our performance and market standing.

I would be remiss if I did not spend a minute on expense management. We will be looking at our expenses across the company with an eye towards identifying cost reduction opportunities. We will approach this by looking to simplify, improve and eliminate those processes that do not provide value. I can assure you that disciplined expense management remains a key priority in our overall strategy.

Lastly, let me comment on the market place. The market continues to be competitive but then after 32 years in the business I do not know when it was not competitive. In specialty, competition remains pervasive and strong across virtually all our business units. As I said earlier, rate decreases continue to moderate. The trend of increasing rates and decreasing supply continues in financial institutions but in most other areas intense competition is the norm.

In healthcare we are seeing institutional business shift from established domestic carriers to new markets in London and Bermuda. In professional liability new capacity continues to enter the market. Other challenging areas include large law firms and public company [D&O]. In standard lines, rate decreases have also continued to moderate. However, we are seeing significant competition on the new business side especially from the national carriers with the package line being the most competitive. We are even seeing aggressive pricing on higher hazard accounts, notably in construction.

Overall, we do not see a turn in the market for some time. The culprit is the exposure declines across almost all industry segments and plentiful capacity. Although rates continue to moderate, premiums will continue to be under pressure. Rate improvement will favorably impact loss ratios over time but the decline in written premiums will put pressure on expense ratios. Therefore, we believe our strategies of broader appetite and geographic expansion will help us through the current soft cycle until there is improvement in the economy.

With that we will take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) The first question comes from the line of Jay Cohen – BAS/MIL.

Jay Cohen – BAS/MIL

I have a couple of questions. First, you mentioned I guess in the specialty business credit crisis claims being less than what you had seen last year. I’m wondering if you can expand on that. What are the trends you are seeing?

Thomas Motamed

I think if you look at the credit crisis and the decline in the stock market last year we believe that a lot of the litigation or the lawsuits occurred in 2008. The fact is, the market has rebounded to a degree and clearly when stock prices go down you do see shareholder lawsuits. The stock market goes up and there is less to sue about. I think that is what we are seeing and I think if you go back to some of the other conference calls some of our competitors would have suggested the same thing. They are not seeing a lot of activity in 2009 and that the worst of it is probably behind us when those suits were filed contemporaneous with the credit crisis.

Jay Cohen – BAS/MIL

I guess the other assumption is you are booking because of that for that business a lower action year loss ratio because of the lower claims?

Thomas Motamed

We are taking that into consideration.

Jay Cohen – BAS/MIL

When you talk about rate, premium rates and renewal rates is it pure rate or does exposure play a role there?

Thomas Motamed

Rate only. Not exposure. For us, rate and exposure equals price. So we only talk about rate.

Jay Cohen – BAS/MIL

At least one other company that I can recall, Travelers, talked about their average renewal rates being up modestly in the second quarter. I know you don’t have access to all their data but what would be a reasonable explanation for why they would be seeing somewhat of a different trend than you?

Thomas Motamed

I don’t know their numbers and I am not going to refer to anybody else’s numbers but our rates have been improving but we are not over flat yet. We are slightly under flat. I think what you are seeing with some of the other markets is they might be a little bit ahead of us in pushing rate. Therefore if they say they are positive you would have to go back and look at some of their prior quarters to really look at their rate trend line. I think they are probably in positive territory because they started pushing rates a little harder, a little sooner.

Jay Cohen – BAS/MIL

Is there a more concerted effort at CNA to push for higher rates? Has there been a change this quarter?

Thomas Motamed

Yes. We have been pushing rates since early in the first quarter. That does take time to grasp or take hold. Right now we are looking at accounts that have effective dates of September or October so there is always a lag. When we started pushing in the first quarter it really wasn’t going to have an impact until the second quarter. It has, retentions went down slightly, and that is always a cause and effect. If you push rates, retention tends to go down a little bit.

Operator

The next question comes from the line of Daniel Johnson - Citadel Investment Group.

Daniel Johnson - Citadel Investment Group

On standard lines, can you talk about what you are seeing in casualty accident loss ratios? I think maybe it is better to talk about maybe the first half of the year versus maybe first half of last year, quarterly noise. Then I have another one on the standard lines.

Thomas Motamed

Why don’t you give us the second one first?

Daniel Johnson - Citadel Investment Group

The overall premium this quarter if you have any additional thoughts. Sequentially it was down reasonably a bit more. Whether you thought that was your pricing actions driving that.

Thomas Motamed

There are probably several stories here. The first is what we call business insurance or the small business, we have been retooling. We have been pushing rate. We have been adjusting the mix of business. When we have done that it has taken its toll on pricing. Clearly what we are trying to do is improve our profitability before we grow it in that small business area. Some of the actions we are taking resulted in price declines or lack of growth. So that was a big driver in the small business. In the middle market we are pushing rate much harder. We are also moving more towards the core segments where we believe there is greater profitability. As we did that we have run off some of the non-core business. That has had an effect as well.

Pricing is tough. It is one thing to get our rates up on the renewal book but new business is pretty tough on a pricing argument. Your other question was on the casualty book?

Daniel Johnson - Citadel Investment Group

Are we seeing improvement or degradation I guess on casualty?

Thomas Motamed

On casualty I would say we are seeing approximately 2-3 point deterioration in the current accident year versus 2008. It is really due to the rate decreases we took back in 2008. It is really a margin compression issue. The good news is frequency trends are favorable in casualty.

Daniel Johnson - Citadel Investment Group

Was that casualty comment a loss ratio or a combined ratio comment?

Thomas Motamed

Loss.

Daniel Johnson - Citadel Investment Group

Finally on the investment portfolio outside of the limited partnerships can we talk about more fixed income components of the portfolio? Where are average yields now on amortized costs and where are we putting new money to work today?

D. Craig Mense

Our average book yield as we ended the quarter was a little bit over 5.5. We have been putting new money to work in corporate as we said. Our net purchases of corporate were over $2.3 billion this quarter and we also still maintain, as I said, a very significant position in cash and short-term which I think you would also expect us to start to put to work over the coming months.

Daniel Johnson - Citadel Investment Group

In the quarter the money that was put to work, what sort of average yields?

Richard Scott

The yields have generally been on the taxables between the 5-6% range for the shorter maturity, 5-10 year maturity stuff. Long maturities have been higher but it is a smaller part of the portfolio.

Operator

The next question comes from the line of Ray Wicklander – Tradewinds Global Investors.

Ray Wicklander – Tradewinds Global Investors

Would you please discuss the benefit of lower performance fee accrual in the limited partnership portfolio? Also when we might start to see performance fees kick in for a lot of the funds that are below the high water mark?

D. Craig Mense

I’m sorry, ask that again. Lower performance fee accrual?

Ray Wicklander – Tradewinds Global Investors

Just presuming that based on last year’s performance on the LP portfolio that a lot are not paying performance fees. I just wanted to know if that 10% return, what that would be if performance fees were fully factored in.

D. Craig Mense

I think it is the same. We have been in these investments for some time. We are not paying the same two and twenty things you would have expected because of the length of time and our knowledge and relationship with these folks and these investors.

Ray Wicklander – Tradewinds Global Investors

So there is no performance fee at all for that portfolio?

D. Craig Mense

Of course there is. I’m just saying it is not significant. Those are net numbers we report. That 10% isn’t driven by a reduction in fees.

Operator

The next question comes from the line of Robert Glasspiegel - Langen McAlenney.

Robert Glasspiegel - Langen McAlenney

I appreciate the historical limited partnership numbers. Maybe if we could get that for the total portfolio at some point that would be a great addition to the conference call. On your topical assets you are cutting back on, RMBS and high yields in particular, what percent in the quarter were sales versus maturities in the reduction? Ballpark?

D. Craig Mense

You want to talk about the structured?

Robert Glasspiegel - Langen McAlenney

You talked about your quality and you went through 3-4 asset classes you cut back on in the quarter. I just want to know if it is more maturities that you are just not putting back in or outright sales?

D. Craig Mense

On the structured I would say, we will let Richard expand here, on the structured part of the portfolio the majority are sales and most are prepayments, as we said in securities. So about a little over $550 million of structured pay down. So that is what is driving those numbers in that direction. On the bank loans, high yield below investment grade portfolio they were mainly sales.

Richard do you want to elaborate?

Richard Scott

I would concur on that. The predominance of sales in the corporate side has been out of the bank loan portfolio and has generally been focused on what I would call low coupon, high dollar price pieces where we felt that the capital costs associated with holding those pieces was not compensated by the return. In the mortgage backed space the bulk of the reduction has been through pay down.

Robert Glasspiegel - Langen McAlenney

My perception was you had a relatively short portfolio with your structured and we were going to know within a year or two if those matured or paid off or not. Do you have a rough feel for what the maturities or potential pay downs are for the rest of the year and looking out to 2010?

Richard Scott

We have estimated this year pay downs running ballpark $500 million a quarter. That includes $550 million in the second if I remember. Or thereabouts.

Robert Glasspiegel - Langen McAlenney

That includes retirement too?

Richard Scott

That is principle.

D. Craig Mense

What Richard was talking about there was just on the structure. So on the structured we said last quarter we saw about $1.8 billion for the full year. As Richard said, the first two quarters were running well above that but still our expectations are $500 million a quarter going forward for the rest of this year.

Robert Glasspiegel - Langen McAlenney

Next year?

D. Craig Mense

I don’t have that number for you for next year right now. I would imagine it would be somewhat less.

Robert Glasspiegel - Langen McAlenney

What is the denominator on this? Which page on the supplement?

D. Craig Mense

All of the structured. All of the asset backed.

Robert Glasspiegel - Langen McAlenney

I was wondering, you talked a little bit about Bob coming over from Zurich. Is he bringing agency relationships? Just general blocking and tackling? I’ m not familiar with his background.

Thomas Motamed

Bob has, as I mentioned 33 years in the business and significant underwriting roles. He does have significant agency contacts. I have gotten plenty of emails from agents saying they are glad to see Bob at CNA and look forward to working with him. He has the internal piece well covered and he has the external piece well covered. We are expecting we will see improvement both on the profit side and growth side. I have known of Bob for many years. He is a very, very solid guy. We are delighted to have somebody of his caliber join us.

Robert Glasspiegel - Langen McAlenney

If you execute your plan, how far away are we before you can start to think about paying down the loans preferred again?

D. Craig Mense

I don’t know. That is a bit too much speculation. We don’t have any current plan there. That would depend on the capital markets and their reaction to us. We are in no particular hurry to do it. Also where we stand with the rating agencies would factor into that consideration. You recall we still have a negative outlook from Best and Moody’s. We would like to see those things change. We will do it at a time when we think it would be appropriate and advantageous for all of our shareholders.

Operator

We have no further questions at this time. I would like to turn the conference back to Nancy Bufalino for any addition or closing comments.

Nancy Bufalino

Thank you all for joining us today. Once again I call your attention to the disclosures concerning forward-looking statements and non-GAAP measures. A replay of today’s conference call will be available for one week immediately following the call until August 10th. You can see the replay details in our earnings release. Thanks again for joining us this morning.

Operator

That does conclude today’s presentation. Thank you for your presentation and have a great day.

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