Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

CNA Surety Corporation (NYSE:SUR)

Q3 2009 Earnings Call

October 30, 2009 11:00 AM ET

Executives

Thomas A. Pottle - Senior Vice President, Credit and Field Operations

John F. Welch - President and Chief Executive Officer

John F. Corcoran - Senior Vice President and Chief Financial Officer

Analysts

Randy Binner - FBR Capital Markets

Operator

Good day everyone and welcome to CNA Surety's Third Quarter 2009 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 Mr. Thomas Pottle. Please go ahead, Sir.

Thomas A. 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 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 F. Welch

Alright, thanks Tom. Thank you all for joining us again this quarter.

As you could see from our press release, we posted another solid quarter despite continued challenging economic conditions. Although as expected, Surety premiums were down, our loss activity remained modest and our investment portfolio continued to improve.

Overall, gross written premiums were down 5.8% for the quarter. Contract Surety premiums declined roughly 8% while commercial Surety gross written premiums were essentially flat.

The decrease in contract Surety premiums resulted from less construction activity in the market combined with accelerated competition in the public construction sector, as traditionally private sector contractors have moved into the public construction arena. Commercial Surety premiums remained flat as a result of the general decline in the overall economy. Our premium production by month there in the quarter varied widely with no real clear trends emerging.

On the plus side, our loss activity for the quarter was once again very modest. We continue to see profitable results being reported by most of the firms we bond. In addition, the balance sheets of our clients continue to be very strong. A vast majority of firms we bond have taken significant steps to adjust overhead and restructure any debt in anticipation of declining revenues.

Backlog levels and profit margins on work are declining but firms are on working on to resize their operations to fit the current market realities. While our loss results to-date have been positive, we are acutely aware of the uncertain times we are living in and we continue to build in our reserves.

Our expense ratio increased during the quarter due to a one time charge in the information technology area. Given the current economic realities, we undertook a thorough review of our IT spending and though it was prudent to stop work on a project that was not progressing as hoped and was not critical to our revenue stream.

The decision to stop work resulted in our having to write off some previously capitalized items. There was no negative cash flow implication to the decision and this will improve cash flows going forward. Beyond the one time charge, the expenses remained well under control.

Overall while construction activity is off considerably from prior years, there does appear to some evidence of at least a leveling off of the decline. Our contextual billing index which we consider to be a leading indicator of future construction activity continues to reflect the net decrease but certain sub sectors within the index are showing positive signs.

Among sub sectors, the August reading for commercial and industrial practices are at the highest level since January of 2008. The index for residential practices principally mainly multifamily grows for the six months and eight months. The reading for institutional practices were virtually unchanged. We've also begun to see the impact of the stimulus package and expect its greatest impact would be felt over the next 12 months.

While it is difficult to feel positive about the current economic situation, we do feel well-positioned to confront the challenges. Often times it is not just what you are currently doing to confront the crisis, but rather what you've done in the past to prepare for the crisis that might come along.

Towards that end, during the past six years, we have built a strong balance sheet with the understanding that prosperity in this business comes in cycles and then we need to be able to weather the ups and the downs of any given business cycle no matter how extreme.

Our underwriting investment and reserving philosophies have all been shaped to not only preserve the value of the CNA Surety franchise, but we were well positioned to capture future opportunities as market condition exists.

And with that I'll turn the call over to John Corcoran for some additional financial details.

John?

John F. Corcoran

Thanks John. Good morning, everyone. I will provide a little more detail and the bigger items impacting our quarter.

First on loss development; we continue to enjoy very modest claim activity as has been the case in the first half of the year. Given that we now have three consecutive quarters with favorable plan activity, we believed it was appropriate to adjust our lost reserves. We focused on more mature accident years and we released a total of just under 8 million from the 2006 and prior accident years.

Our annual reserve review is in process and we will address the outcome of that review in our fourth quarter results.

We continued to book the same loss ratio of 29.3% for the current accident year. In the third quarter last year, we had almost 25 million of favorable loss development. At the same time, we increased the loss debt for the 2008 accident year so that year-to-date loss ratio was at 26.8%.

The other significant item was the impairment of capitalized IT development cost that John Welch mentioned. These impairments totaled just under 5 million and added 4.5 points to the expense ratio for the quarter.

In the third quarter of 2008, we also had a couple of significant items impact the expense ratio. If we adjust both ratios for all of these items, we end up with expense ratios of 52.2% for both third quarters of 2009 and 2008. This illustrates that core expenses remain under control.

While we had a few more things going on this quarter, we again reported very solid results. Net income for the third quarter was 25.5 million or $0.57 per share compared to net income of 34.3 million or $0.78 per share for the third quarter of 2008. As I noted earlier, the major driver of this decline in net income was the higher amount of favorable reserve development recognized in the third quarter of 2008.

Our investment portfolio continues to be a great story for us. We ended the quarter in an unrealized gain position of approximately 65 million. We took advantage of favorable market conditions to slightly reposition the portfolio and to take a little over $1 million of realized gains. We had no additional impairments in the quarter. The number of bonds in unrealized loss positions is down dramatically and the total unrealized loss on these securities is only about $4 million.

Investment income for the quarter was 12.5 million, up from 11.8 million for the third quarter of 2008 due to increased invested assets. However, portfolio yield continued to be adversely impacted by extremely lower short term rates. At September 30, invested assets and cash totaled 1.3 billion.

The trading activity in the quarter resulted in a slight drop in our overall credit quality from AA to AA minus. We expect to move the portfolio back to AA during the fourth quarter.

We again generated strong operating cash flow with 45 million in the current quarter compared to 31 million in the third quarter of 2008. Last year's third quarter was impacted by a large claim payment.

Debt outstanding remained at 31 million at September 30. Statutory surplus grew to 627 million at quarter end, resulting in a net written premium to surplus ratio of 0.7 to 1.

At quarter end, our consolidated stockholders' equity increased to 885 million or $19.99 per share.

With that, we can open up the call for questions.

Operator?

Question-and-Answer Session

Operator

Thank you, Mr. Corcoran. The question-and-answer session will be conducted electronically. (Operator Instructions). And we'll take our first question from Randy Binner with FBR Capital Markets.

Randy Binner - FBR Capital Markets

Hey, thank you very much. John Corcoran, I just wanted to go through some of the reserve stuff what think we could. So the timing was a little earlier and you mentioned that in your opening remarks. So, how does that position you for the kind of quarter end reserve process with overview process?

John Corcoran

Sure. As I said, that's going on right now. The third quarter activity was really more of looking at three consecutive quarters now a very favorable claim activity and it appeared to us again especially looking at the accident years in particular that we should take some action now. It was say fairly obvious.

We certainly will get a lot greater insight from the reserve review. We expect to have that in time to address any indications from that during fourth quarter.

Randy Binner - FBR Capital Markets

Okay. But -- I guess I didn't ask the question right, the reserve release this quarter was at with the kind of more related to more current periods where there was favorable development or is it still across the whole book overtime?

John Corcoran

It was actually older years. 2006, we really based that on the fact that we just aren't seeing the emergence of claims that we would have expected.

Randy Binner - FBR Capital Markets

Yeah.

John Corcoran

So, just the activity is not there. And then actually for some of the earlier years kind of going back to 2004 and older, what we really saw was favorable case incurred activity, either recoveries or reductions in case reserves. So we felt given the maturity level of those accident years that it was reasonable to at least let that favorable case activity fall through.

Randy Binner - FBR Capital Markets

And then how about 2007? Is that still too fresh to make many changes?

John Corcoran

That's where we'll look for the much more insightful information that will come out of the reserve review.

Randy Binner - FBR Capital Markets

Got it, that's really helpful. And do you know is there -- are you near the point estimate, the actuarial point estimate at it or above it or is that something you'll look at more for the year end review?

John Corcoran

Right, that'll come out of the year-end review. We'll get a fresh update of the point estimate.

Randy Binner - FBR Capital Markets

On the point, okay. So kind of similar to I guess capital adequacy, you mentioned of course so that's 0.7 to 1 premiums a surplus, may be this is one for John Welch, but the -- I mean, is there any kind of updated stock and capital management? I know you're being prudent, obviously we are in a big recession, you're a recession exposed business line. But you're releasing reserves, you're underwriting leverage, if you will, is under utilized. So do you -- is it too early to think about capital management or is that something that you could give us some color on?

John Welch

Sure Randy. I agree with you the growth of the results are good. We are situated pretty nicely from a capital and reserve standpoint. We planned it that way. We'll get to a point where we do have to look at and see is it the right level for what's going on in the economy.

But as you said at the beginning of your comments you had it rate on the head. Right now I just don't think it's the moment in time to guess that things are going to be okay and start releasing capital on the form of dividends or stock purchase or whatever. So, the Board does review it every quarter and we'll continue to talk about it but right now, it would be a bit premature

Randy Binner - FBR Capital Markets

Is there any M&A activity that is more or less kind of on the front burner given where we are on the cycle or would it'd just be an issue of you’d be wondering what you’d be buying on the reserves given where we are in the cycle?

John Welch

Well you certainly have to be careful. But right now, there is really not -- there is not a lot out there that I've seen for sale really. I haven't seen the companies come into the business or leave the business. We are just not seeing much be available for sale but with that set, we would be interested if we could find something that seem to fit and be more of a kind of complimentary to our business.

Randy Binner - FBR Capital Markets

Right I mean that's still the ideal use of any quarter-on-quarter excess capital, right?

John Welch

Definitely. We would like to do that if we could but as I said there's hasn’t been anything that we've seen.

Randy Binner - FBR Capital Markets

Okay. I mean if then if you did some tuck in it would it be more likely to be on the commercial side?

John Welch

Yeah, if you could find one. There is not a lot that companies that would be like what we have (inaudible) as a Western Surety franchise, but if we could find something like that certainly that would be of interest.

In contrast it would be more -- that's really hard to tell. I mean you could always look even outside the U.S. there are some surety markets outside the U.S. that are possibility. Inside the U.S. there's some areas where we are not so strong and if they happen to fit,and some company came along in a complementary area where we're not strong, that might be of interest. But, really right now, I don't see anything really available.

Randy Binner - FBR Capital Markets

Okay, and then back to couple of income statement items. The IT program that's discontinued, can you give us a little more color on what that was?

John Welch

Sure. We were -- we've been working on a project for a few years and essentially we just took a look at it. It was more of an IT player where we were looking to move some things up, our mainframe essentially. And so, we are working on a program to do some of that and it was just kind of dragging on longer than we had anticipated. So, we took a good look at it, brought in actually some outside consultants to also take a look at it.

And just reviewing what it would take us to get over the finish line, if we could get it over the finish line, we just thought the risk was a bit greater than we wanted take, particularly in a time when we are trying to conserve as much money as we can. So, we just said, since this isn’t critical to our revenue stream, let's just stop it.

It doesn't mean some day we might go back and try and tackle that again. But, right now just, given the path we are on, we weren’t going to continue on that path. We would probably go a different path to tackle it in the future.

Randy Binner - FBR Capital Markets

But, I'm interpreting that, it's backend stuff rather than maybe something the underwriters use or something that's helpful for client management. Is that right?

John Welch

Right, yeah.

Randy Binner - FBR Capital Markets

Okay, got you.

John Welch

But, for administrative functions than underwriting functions and that's really where we put right now where we put our emphasis on the IT efforts and our expense is more of pretty much on a revenue driven type process.

I mean we recently completed and are introducing a product, we call bONdLINE which is an internet based way to access us to get the small commercial bonds out of. And we have an old bONdLINE product, this is an upgrade and we are really excited about it. We think it's going be very successful for us. And we just want to concentrate more on those kinds of things that can help us generate revenue.

Randy Binner - FBR Capital Markets

Okay, let me just ask one more and I’ll jump back in the que. Just on the investment income. The yields are little bit lower which is a common theme among insurance companies and I guess there was also some mention of trying to get the portfolio back to AA.

So, John Corcoran, I'm just curious just curious kind of how you view the yield going forward, new money yields, what you would be buying to get the portfolio back up. If muni are seeming a little tight on spread right now? If just any color on that and if you could kind of quantify how you see the yield potentially recovering?

John Corcoran

Sure, the biggest driver of the yield is has been the short term rates and I've mentioned in my comments, we did do a little bit of portfolio repositioning in the quarter.

So, that caused us to have a little more money than typical in the short term as we went through that repositioning. And that will continue in the fourth quarter. In terms of driving the credit rating of the portfolio backup, we'll be probably looking at agencies, pass through agencies CMO type of things.

You're right; we're just de-emphasizing slightly the muni purchases on a new money basis thinking that those prices seem a little bit rich right now, but our overall philosophy the portfolio remains the same is we're looking to maximize income but with a very, very, very high quality bias.

And I think the last year here is really pouring out the value of that strategy for us. So, we'll carefully look for, what we think a good values on high quality issuers if that means that we keep a little more money than short term than might be otherwise optimal so be it.

We'd rather do that than stretch for a yield basically. So we've been, as I said we've been extremely pleased with the performance of the portfolio and we'll continue in our very conservative track.

John Welch

I think the reason principally for the decrease from the AA was we moved up to some commercial mortgage backed bonds substantially that which were highly rated but we just weren't just comfortable with that sector. So felt it was prudent to move out. There was very strong recovery in that sector and we saw the opportunity to reduce our exposure there at very, very minimum cost.

Randy Binner - FBR Capital Markets

Got you. Okay great. I'll let some others, I will re-queue.

Operator

(Operator Instructions) And we'll go next to Roger Brown with Brown & Brown.

Unidentified Analyst

Good morning. I just wanted to ask about your reinsurance and how the reinsurance market looks.

John Welch

Sure Roger. We talked with most of the reinsurers actually during this quarter and then third quarter they normally come through and review our operations which they did. And we've since then put together a package of information for them which most of them should have in their hands, if not all of them. And we're asking for pretty much essentially the same terms. I mean we'll look at different retention levels. We'll look at different structures of the program to see if there is anyway to optimize what we're buying.

Right now, it's a little hard to say where it's going. There is not an abundance of reinsurers in the surety world, but there is decent capacity and the results have been very good. Our results continue to be very good with them. And our exposures are down as well. So, given that exposures are down, the experience is good. You would hope we would be treated fairly at the renewal. But time will tell, we'll know in a couple of months -- month and a half maybe.

Unidentified Analyst

It appears that the results in between 2009 and 2008 was that there was a substantial decrease in reinsurance expenses, is that correct?

John Corcoran

Reinsurance costs are down, part of the issues in the third quarter of 2008 we did have about 4 million of the reinstatement premium that was additional ceded premiums that were related to reinsured losses. So we have the absence of that in the third quarter which does make a pretty considerable different.

John Welch

Yeah the overall treaty cost just apples to apples, was a little less except it was driven primarily that we took a little higher retention this year.

Unidentified Analyst

Okay. Thank you.

John Welch

Thanks Roger.

Operator

And we will move next to Randy Binner with FBR Capital Markets.

Randy Binner - FBR Capital Markets

Hey thanks. I'm sorry, could you remind me as of when the reinsurance, the new reinsurance surety will kick in?

John Welch

Yeah, it's 1/1.

Randy Binner - FBR Capital Markets

It's 1/1, okay, thanks. I guess just moving I think most of the procedural items are taken care of. I just -- I'll be interested in more commentary, just I know obviously there's macro-economic challenges. But you mentioned the architectural billings leading indicator, so that would seem to be more construction bonds related?

John Welch

Right.

Randy Binner - FBR Capital Markets

So, where -- I guess that's all, that's easy for all of us to kind of visualize. Where are you cycle life of the commercial trends, just kind of in general and then there is the fidelity which has issues. But I'm just curious kind of where your feel for where you are and the trend of those products from a macro-economic perspective?

John Welch

Well, our commercial surety book does have an element of construction in it, a lot of license bonds that we write are actually for contractors. But they have lot of the kind of bonds in there too. It's been a remarkably steady. I mean we are not -- we're more or less laid down little bit in the small commercial area. That shall -- we see they're more going kind of the economy goes, because really we write bonds across a wide part of the economy in all kinds of businesses quite frankly.

So as the economy improves, we would expect that to improve. We were helped a little bit this year by -- a new product that was -- new bond that was acquired essentially in the market and that generated some premium for us; that helped a bit. But I think that will pick up, probably a little quicker than the construction area, it's gone down less and so it will probably go up a little bit more and won't ratchet up like contract -- with one contract line it catches up. But we think we can hold the line and hopefully start moving back into a little bit of growth in that area actually.

Randy Binner - FBR Capital Markets

On commercial.

John Welch

On commercial, yeah contract, it's hard to say. I mean you can read most of the things that are published. It's still -- there are signs of life I guess in the construction market but it's still pretty difficult. And –they’re not going to say that it’s because of the overall volumes of public construction that seems to be pretty decent but a lot of it is, you have a lot, lot of bidders. You have a lot of competition, lot of people that were in the private market that there is not a lot of private work going on any more, even from the residential markets that have tried to move into the public arena, particularly in the infrastructure type areas.

So while there may be a decent amount of work, there is a whole lot of more people bidding on it. And so your chances of getting in and bonding it are a little bit less. That's going to take a while for that to correct itself and through the things that's been out. And hopefully at the same time work will start increasing. The stimulus package will start kicking in a little bit better. States still have to get a little bit healthier to kind in their spending but it's going to be a slow recovery although some of the articles I've been reading lately have suggested actually some decent growth into next year. But it's hard to tell, we'll have to wait and see.

Randy Binner - FBR Capital Markets

Fair enough. Thank you.

John Welch

All right. Thanks Randy.

Operator

(Operator Instructions) And it appears that there are no further questions at this time. I'll turn the call over to Mr. Welch for any additional or closing remarks.

John Welch

All right, again thank you all for joining us again this quarter. And if you have any questions, please don't hesitate to call John Corcoran or myself. Thank you.

Operator

Ladies and gentlemen, that does conclude today's conference. We thank you for your participation and hope you have a great day.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: CNA Surety Corporation Q3 2009 Earnings Call Transcript
This Transcript
All Transcripts