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CNA Financial Corp. (NYSE:CNA)

Q3 2009 Earnings Call

November 2, 2009; 10:00 am ET

Executives

Tom Motamed - Chairman & Chief Executive Officer

Craig Mense - Chief Financial Officer

Richard Scott - Chief Investment Officer

Nancy Bufalino - Investor Relations

Analysts

Jay Cohen - Banc of America/Merrill Lynch

Robert Glasspiegel - Langen McAlenney

Dan Johnson - Citadel

Operator

[Technical Difficulties - Audio Starts Abruptly]

At the same time, standard line premiums are being pressured by declining exposures, due to depressed payrolls and revenues, as well as premium audits that are generating return premiums.

Standard lines policy count was essentially flat during the quarter. Although we are not satisfied with our top line in Standard Lines, we are pleased with our new business production. Our ratio of new to lost business was 1.1 to 1 this quarter, a slight improvement over last year’s third quarter. In Standard Lines, 81% of new business is coming from the industry segments that we outlined to you earlier this year. We continue to drive more of our business from segments that we believe have greater profit potential.

Renewal rates were essentially flat in the third quarter. In the third quarter of 2008, the average rate decrease was 5%. Third quarter retention came in at 80% compared with 81% in third quarter of 2008. We are prepared to see a decline in our retention as we push for more rates to improve profitability.

Market conditions in Standard Lines remain very competitive for new business. We continue to see aggressive pricing on accounts of all types and sizes, including catastrophe exposed locations, high value property, large casualty accounts, and small business.

Our property and casualty operations expense ratio for the quarter was 33.3% compared with 31.5% in last year’s third quarter. The increase came from lower net earned premiums as a result of negative premium growth and return premiums, as well as higher underwriting expenses and the previously mentioned assessments. Craig.

Craig Mense

Thanks, Tom. Good morning, everyone. I would like to spend the next few minutes, discussing our performance against the financial priorities that we laid out at the beginning of the year. The quarter’s highlights include net operating income of $331 million and operating return on equity of 12.2%, which approaches our target range and a very substantial improvement in CNA’s balance sheet and capital position.

The recovery in the market value of our investment portfolio, together with the third quarter net income of $263 million, increased book value to $35.38 per share, a 29% improvement from the end of the second quarter and a 69% improvement from year end 2008.

At the end of the quarter, all of our capital metrics were at or better than 2007 year end levels. We also continued to make significant progress in our efforts to reposition our investment portfolio, to reduce risk in volatility and drive more consistent performance in the future. The operating income results were fueled by strong net investment income, primarily from limited partnerships, as well as a $61 million after tax gain from the previously disclosed settlement with Willis.

Third quarter net investment income totaled $660 million, a 50% increase over the prior year period. Our fixed income results continue to reflect historically low short term rates, as well as a high level of our holdings in cash and short term investments. We benefited from another quarter of very strong performance from our limited partnership investments. Income from these investments was $145 million in the third quarter, a rate of return of approximately 8%. Year-to-date, these investments have returned 14%.

You will recall from previous discussions on these calls that we invest in LPs as an alternative to equities. We expect that overtime, our portfolio of limited partnership investments will bring us higher accumulative returns than equities with less volatility. While they represent only 5% of our total invested assets, they remain an important part of our ongoing investment strategy.

I would like to remind you of two important characteristics of our LP investments. First, they overwhelmingly represent investment in marketable securities, with the valuations driven by the fair value of the LPs’ underlying securities holdings. Only 6% of our LP holdings by value are in private equity and less than 2% in real estate. Second, approximately 90% of our LP holdings, as measured by reported values, report results on a one month lag or less. Consequently, our quarterly earnings reflect current market valuations.

Net income for the quarter was $263 million, and included after tax other than temporary impairments, recognizing earnings of $96 million, as compared to after tax OTTI losses of $380 million in the prior year period. The OTTI credit losses in the quarter were centered primarily in residential mortgage backed securities. These impairment decisions were driven by our assessment of the likely future performance of these securities, as well as intent to sell decisions consistent with our ongoing management of risk and volatility in the portfolio.

Our realized investment results for the quarter do not include the effect of the sale of 100% of our common stock holdings of Verisk Analytics, formally known as ISO. We sold these holdings in the Verisk IPO in the first week of October. As a result, we increased the fair value of our position to $370 million at third quarter end, which is reflected as an unrealized gain in our balance sheet.

During the fourth quarter, the after-tax sales proceeds of $240 million will be reported as a realized gain. As of September 30, our investment portfolio had a pretax net unrealized gain of $176 million. This compares to a $2.7 billion pretax net unrealized loss at the end of the second quarter, and a $5.4 billion pretax net unrealized loss at year end 2008.

This substantial improvement reflects not only the recovery of the broader financial markets, but also the work we have done to reposition our portfolio. The recovery in the value of our investment portfolio was reflected across virtually all asset classes, but was led by corporate and municipal bonds.

During the quarter, we made net purchases of $2.6 billion of investment grade corporate bonds. This asset class now represents 39% of invested assets, up from 24% at the beginning of the year. We also purchased a little more than $400 million in agency collateralized pass through and CMOS. We took advantage of continued favorable conditions to further reduce our holdings of high yield corporate bonds by over $350 million in the quarter and over $1 billion year-to-date.

In non-agencies mortgage backed securities, principal payments in sales reduced our holdings by another $400 million in the quarter and $1.3 billion year-to-date. We started the year with $6.4 billion of book value in this class. It now stands at $4.9 billion of book value, a 22% reduction. Overall, our investment decisions are consistent with the framework that we outlined to you at the beginning of the year.

We continue to manage our portfolio to align with the needs of our insurance business. The effect of duration of the overall portfolio was 6.2 years at quarter end, up from 5.6 years at the end of the second quarter. Most of the duration increase can be attributed to simple duration drift, caused by an overall lower interest rate environment.

The effect of duration of the assets backing our P&C liabilities was 4.3 years, well within our target range. The effective duration of assets matching our long duration lifelike liabilities was 11.4 years, which is also in line with portfolio targets.

Our overall investment portfolio of liquidity and substantial positive cash flow continue to be major advantages. As a reminder, we still had $4.1 billion, roughly 10% of invested assets in short term holdings at quarter end, including approximately $400 million at the holding company.

Positive cash flows from operations in the investment portfolio were approximately $1 billion in the third quarter. Included in these amounts are principal cash flows from the structured securities portfolio of approximately $500 million during the quarter, which were in line with the past few quarters and consistent with our expectations.

Turning to our capital position, GAAP equity increased from $8.7 billion to $10.8 billion during the quarter, and our regulatory capital improved as well, approximately 10% to $9 billion. We regularly evaluate our capital adequacy against regulatory internal and rating agency metrics. Against all these measures, we believe that our capital is more than sufficient to support our current ratings.

All of our key capital metrics, total capital, statutory surplus, RBC ratios, debt to capital, coverage ratios, and all rating agency capital models are at or better than year end 2007 levels. Before turning the call back over to Tom, I would like to report briefly on our non-core business.

Our life and group non-core segment produced $51 million in net operating income, driven by improved net investment income and the previously mentioned settlement with Willis. The corporate segment produced third quarter net operating income of $9 million, reflecting steady underlying performance and increased net investment income. In summary, CNA ended the quarter on a very solid financial foundation.

With that, I’ll turn it back to Tom.

Tom Motamed

Thanks, Craig. Before opening it up for questions, I’d like to take a moment to summarize our progress on our priorities to grow the top and bottom line. First, we continue to be encouraged by submission activity in our expanded set of industry segments.

During the third quarter, submission activity in the U.S. increased 32% and U.S. Specialty and 11% in Standard Lines. These positive trends tell us that our producers support us and that we are positioned for profitable growth overtime. With respect to improving profitability in Standard Lines, we told you we would be focusing on driving growth in our target industry segments. In that regard, our production metrics are encouraging.

During the third quarter 69% of our small and middle market submissions were in our target segments. In addition, our hit ratio on submissions in these segments was 19% in the third quarter as compared to 12% outside of these segments and reflecting our emphasis on only writing rate adequate business. Renewable metrics on our small and middle market business show the same focus we are retaining 81% of the renewals in our target segments as compared to 72% among less profitable risk.

Finally, I want to say a few words about expenses. We are in the process of conducting a cost benchmarking initiative that will help us identify potential cost saving opportunities and process improvements across the entire organization. Looking ahead, we expect the fourth quarter to be a continuation of the prior three quarters. Lingering problems include lack of consumer spending, a depressed housing market and increasing unemployment.

While rates may improve, exposure growth will be under pressure and will not improve until the underlying economic environment improves. Against this backdrop, we continue to believe that focusing our appetite on specific industry segments, shifting our mix of business and expanding our geographic reach will help us manage through this cycle until there is improvement in the underlying economy.

With that, we will take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Jay Cohen - Banc of America/Merrill Lynch.

Jay Cohen - Banc of America/Merrill Lynch

Can you just quantify and describe those assessments? Where do those come from and how much were they?

Craig Mense

So, it some from the Department of Labor and some from New York Second Injury Fund in total, they are about little less than $20 million.

Jay Cohen - Banc of America/Merrill Lynch

Is this something that should be one time in nature or could it continuing?

Craig Mense

It should be one time in nature.

Jay Cohen - Banc of America/Merrill Lynch

Next question, maybe for you, Craig, on the capital side. So, obviously you had a great recover in the equity position. Your capital looks to be at or better than it was in the end of 2007 and I guess it was about that time, I forget the exact timing, where the company acknowledged it had excess capital and began to pay a dividend. Can you talk about your flexibility now versus then, having just lived through the credit crisis whether it’s on your own metrics, whether it’s from the rating agencies? That, be helpful.

Craig Mense

You obviously recognize it, so we’d be certainly more cautious this time having lived through what we did. It’s nice to be in a position to begin to think about the financial flexibility we have. As I said, last call, we think one of the most important things that we can do for this company is position it to get an increase from the rating agencies, obviously, the first step would be to get the outlook changed. So, as we think about things, we’re those are kind of that’s really what’s front and center in mind of what we would do or might do, if that answers your question.

Jay Cohen - Banc of America/Merrill Lynch

Then just on that topic really quickly, what were the terms of the preferred from low’s as far as the maturity of that if there was any?

Craig Mense

There was not a maturity. It’s 10% preferred dividend. There’s an automatic reset in 2013, which at that time it goes to 700 over whatever the 10 year treasury is.

Jay Cohen - Banc of America/Merrill Lynch

Then the last question, maybe a bigger picture one on the new business, which is encouraging to see, but I guess, we continue to hear a constant drumbeat from everyone in the industry that new business is very competitive and when you see a company that is increasing its new business, it is a bit of a red flag in this environment. How do we get comfortable with your new business generation, given that backdrop?

Tom Motamed

I think the answer, Jay, you have to start with when you look at these 10 industry segments that we’re focused on, how they are performing as a part of the total book. We believe, based on our analysis, that they are running somewhere between 12 to 14 points better than the rest of the Standard Lines portfolio and we believe that the pricing is coming in at that area on new business. So we are being select. I mean, you only write 19% of what comes in, in your core. You’re writing 12% outside of the core and we know the core business outperforms the non-core.

So we continue to watch those metrics closely, but we believe it’s shifting the book to become more profitable over time without dropping prices to get it and getting rates up to flat is a considerable improvement from earlier this year. So we’re hopefully not giving away a lot on the renewal book and we’re going to be pushing rates into the positive domain going forward.

Operator

Your next question comes from Robert Glasspiegel - Langen McAlenney.

Robert Glasspiegel - Langen McAlenney

I guess the rating agencies had questions regarding your portfolio dropping below cost. I know that you’re at or above cost. What sort of dialogue do you have with them? Does this sort of take care of their concerns there or what more do they want to see to take the negative outlooks off?

Craig Mense

Bob, I’d say that I mean, the reason they put the negative outlooks on were concerns about asset values. So I would hope that this recovery would address it. I think just like we said we’re being cautious and I guess whether we like it or not, I’m sure they’re being cautious in the actions and things they take and I think the key thing for us. The future is really improving the things that Tom said. So it is improving our competitive position and the overall underwriting results for the place.

Robert Glasspiegel - Langen McAlenney

How much further do you have to go in repositioning the portfolio? I mean, at what point do you think it’s where you want it?

Craig Mense

Richard Scott is here with us. Let me say a couple of things and then I’ll ask him if he wants to elaborate. I’d say that if you look at the investment grade portion, both corporates and munis, I think it’s now something less than 60%, like 57%. So we have some room to continue to add there and we’ll keep working the structured side of the portfolio. Do you want to elaborate on that, Richard?

Richard Scott

No, I think that’s a fair summary. I mean, as a practical matter we view the non-agency residential portfolio as being a portfolio that will continue to shrink overtime and the alternative asset classes are primarily going to be investment grade asset classes, munis, corporates, and potentially some agency structure, depending on market opportunities.

Robert Glasspiegel - Langen McAlenney

Just one last clarification, the three points of current accident in your development was total company or total property/casualty?

Craig Mense

No, that was Standard Lines.

Richard Scott

Standard Lines.

Robert Glasspiegel - Langen McAlenney

Did specialty have any?

Craig Mense

A small amount, a little bit. We did strengthen the current action and year in Specialty, but marginally.

Robert Glasspiegel - Langen McAlenney

You said that was auto and comp, just to make sure I got that right?

Craig Mense

Yes.

Robert Glasspiegel - Langen McAlenney

Any in particular you saw there that drove it or…

Tom Motamed

The more severity in ‘08 and ‘07 accident years

Operator

Your next question comes from Dan Johnson - Citadel.

Dan Johnson - Citadel

I was originally going to ask about the expenses, but that sounds like it’s maybe more of a discussion for next quarter. Maybe I missed the timing on that. Do you think we’ll have something to talk about by next earnings call?

Tom Motamed

Yes, we will report to you in the future as to our cost benchmarking initiative.

Dan Johnson - Citadel

Sorry to be picky, but when you say future, is next quarter a reasonable timeframe?

Tom Motamed

That’s the future, yes.

Dan Johnson - Citadel

Certainly, over the last couple of months, we’ve seen press releases on people hired. Would you mind just taking a walk through some of the more senior folks who’ve been hired what they’re going to be doing?

Tom Motamed

Yes. As we announced early in the year, we are going to increase, I’ll say, the quality of talent here at CNA. We have hired Bob Lindemann to run all of Standard Lines that would include small business, middle market, large accounts Bob’s been in the business probably about 35 years and a real professional. So, as our Standard Lines, as we pointed out, it’s not performing to our satisfaction, we’ve made a change there.

Also on the small business, we have moved internally, a fellow, Mike Coyne, from the Finance area to run our small business portfolio. So that would be the changes in Standard Lines. We have also hired an executive by the name of Tim Szerlong to run all of our branch operations. That’s a new position to CNA. He probably has 35 years in the business as well and he’ll be responsible for driving execution at the point of sale. So I think that would be the key people.

Dan Johnson - Citadel

Tim and Bob came from where?

Tom Motamed

Bob came from Zurich North America; Tim came from Chubb.

Operator

Your final question comes from Jay Cohen - Banc of America/Merrill Lynch.

Jay Cohen - Banc of America/Merrill Lynch

Increase in severity you were seeing in those two lines of business. Can you talk about the frequency side of the coin?

Tom Motamed

Frequency is down in, I believe, every line of business with the exception of property, it is up mid-single digits.

Jay Cohen - Banc of America/Merrill Lynch

I guess not enough to offset that increase in severity you’re seeing?

Tom Motamed

Repeat that, Jay?

Jay Cohen - Banc of America/Merrill Lynch

Since you did sort of take a more cautious view on the accident year loss ratio, at least in those several lines of business, it sounds as if the frequency, the improved frequency is not enough to offset the increased severity that you are seeing from the more recent accident years.

Tom Motamed

Overall, we continue to see favorable frequency trends. In other words, new arising activity is going down. So that’s all figured in there with the severity. We don’t look at one item exclusively and adjust; we’d look at all aspects. So, that’s built-in, but what we do like is the decline in frequency. Typically, when frequency goes up, severity ultimately goes up as well. So we’re hopeful that there’ll be less severity in the book over time.

In the meantime, we have adjusted our 2009 accident year based on what we saw in ‘07 and ‘08. So we think we’re ahead of the curve; we’re not going to deal with this down the road, hopefully.

Operator

We have no further questions. I’d like to turn the call back over to Ms. Bufalino.

Nancy Bufalino

Thank you, Carrie and thank you all for joining us today. Once again, I call your attention to the disclosure concerning forward-looking statements and non-GAAP measures. A taped replay of today’s call will be available until November 9. Please see the earnings release for replay details. Thanks, everyone. Have a good day.

Operator

Ladies and gentlemen that does conclude today’s conference. We thank you for your participation.

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Source: CNA Financial Corp. Q3 2009 Earnings Call Transcript
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