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CNA Surety Corporation (NYSE:SUR)

Q4 2009 Earnings Call Transcript

February 5, 2009 11:00 am ET

Executives

Thomas Pottle – SVP, Credit and Field Operations

John Welch – President and CEO

John Corcoran – SVP and CFO

Analysts

Ken Barker – FBR Capital Markets

DeForest Hinman – Walthausen & Company

Ron Bobman – Capital Returns

Operator

Good day everyone and welcome to CNA Surety fourth quarter and year-end 2009 analyst conference call. As a reminder, today's call is being recorded. For opening remarks and introductions, I would like to turn the call over to Thomas Pottle. Please go ahead, Sir.

Thomas Pottle

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

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

John Welch

Thanks Tom and thank you all for joining us once again this quarter.

As you have seen from the press release, we ended the year with a very strong fourth quarter, significantly bolstered by older year reserve releases. For the year, we reported net income of nearly $118 million with gross written premiums of just over $438 million. This was the fourth straight year of record profitability. For the quarter, gross written premiums were down 8.4% from prior year fourth quarter, and were down 6.2% for the full year. Contract surety gross written premiums fell 8.5% for the year to roughly $275 million. Commercial surety gross written premiums were relatively flat in the year to $133.5 million.

Like most businesses, out topline suffered during the year due to the economy. As widely reported, construction spending for the year was off considerably and the vast majority of our products depend on the help of the construction industry. With that said, we feel comfortable, we remained competitive in the market and performed well against our peers. While John Corcoran will provide additional financial details, we are pleased that expenses remained under control. Our incurred loss activity remained relatively light and our investment portfolio continued in a net unrealized gain position.

As noted, fourth quarter results were significantly aided by a reduction in our carried loss reserves. Our comprehensive reserve review indicated redundancy in some older accident years. Given the health of the economy and the weakened credit environment in general, it may appear unusual to release reserves at this time. However, as mentioned, most of the reserve releases relate to older underwriting years where most of our bond liabilities have been considerably reduced. We continue to maintain our carried reserves in the most recent years and continued to book a healthy idea in our reserve on each quarter’s premiums.

Overall, from what we can gather, the surety industry enjoyed another great year. Fortunately, underwriting has remained disciplined and rates were held fairly steady. There are pockets of increased competition as we have all faced decline in revenue, there has not been an irresponsible rush to replace lost premium. At the end of the day, we are predominantly a credit business and credit expansion is normally not a profitable way to pursue business. The tax [ph] was clearly highest in the past few years as our company struggled with considerable over leveraging.

While the underwriting discipline is held up fairly well, the construction environment where we generate a good deal of our revenue has clearly suffered. Construction spending overall through November is off 13.2% from prior year as reported by the census bureau. November year-to-date construction stocks [ph] are up 28% from prior year as reported by McGraw Hill Construction. Competition for new work is fierce and profit margins are deteriorating.

With that said, many industry publications indicate the industry has hit the bottom and there are some signs of life. Most are projecting the industry to actually reflect some growth in spending and stocks during 2010. If in fact some of these projections do come true, we may be able to stabilize revenues in the near future. More importantly however, the much-needed new work could help sustain many construction firms that will face considerable difficulties should things not improve over the next 18 months. This would obviously help our results as well as there would potentially be less defaults under our bonds.

We have also been very impressed by the timely and decisive action taken by many of the firms we bond to right size their organizations to the current market realities. When the new work returns, many of these firms will be well positioned to capitalize on new opportunities.

While it is very difficult to predict the coming year, we feel strongly that our employees and business partners understand the challenges and are very capable of helping us through these times. Additionally, we have built a very strong balance sheet over the past six years and we are well positioned financially to not only manage through a more difficult construction and credit environment but also to capitalize on new opportunities as they arrive. We have a great organization, we have built our house out of brick, so to speak, and we feel comfortable, confident that we will continue generating respectable returns.

With that, I will turn the call over to John Corcoran for some additional financial details. John?

John Corcoran

Thanks John. Good morning everyone. Since the reserve activity is the major financial issue for the quarter, I will start there.

Our comprehensive reserve review was completed in the fourth quarter using data as of September 30. We also performed a roll-forward analysis based on year-end data, which essentially confirmed the indications from the comprehensive review. The review indicated a substantial redundancy in total and significant redundancies for accident years 2004 through 2009. The primary drivers were a low level of reported losses, particularly more severe losses, favorable outcomes on open cases, and strong indemnification recoveries.

While we were obviously pleased with the outcome of the review, we remain cautious about the indications for the most recent accident years. We believe that the actuarial methodologies may not fully reflect the significant change in economic conditions that have occurred over the last several years. As a result, we chose to accept the actuarial indications for accident years 2007 and prior. This resulted in the favorable reserve development of $46.3 million for the quarter.

For the 2008 and 2009 accident years, we chose to maintain our original estimate of ultimate losses for these years. In other words, we did not take any development for 2008 and continued to put 2009 at the same level we had throughout the year. These estimates were based on an analysis of our experience in past periods of challenging economic condition. Therefore our carried reserves at December 31 are approximately $32 million higher than the actuarial indication.

So with a big boost from the reserve release, we reported net income for the fourth quarter of $49.3 million or $1.11 per share compared to $29.1 million or $0.66 per share for the fourth quarter of 2008. Reserve releases represented $0.68 and $0.30 per share for the fourth quarters of 2009 and 2008 respectively. For the full year, we reported net income of almost $118 million or $2.65 per diluted share compared to $110 million or $2.49 per diluted share for 2008. For the year, reserve releases represented $0.79 per share for 2009 and $0.67 per share for 2008.

The expense ratio increased to 58% in the fourth quarter as additional incentive compensation accruals added 3.5 points. The expense ratio for the fourth quarter of 2009 was 54.7% and also included 1.5 points related to an additional incentive comp.

Investment income for the quarter was $13 million, up from $12 million for the fourth quarter of 2008 due to higher invested assets. Our overall yields continued to be impacted by very low short-term rates and lower reinvestment rates. Our portfolio performed extremely well during 2009. We ended the year in a pretax unrealized gain position of $47 million compared to a pretax unrealized loss of $7 million at year-end 2008. We also recorded a bit over $1 million of realized gains for the year, which was net of very modest impairment losses. At year-end, invested assets and cash totaled $1.3 billion and our bond portfolio retained an overall credit rating of AA-.

We enjoyed a very strong cash flow in 2009. Operating cash flow was $158 million with $48 million of that in the fourth quarter. Operating cash flow for 2008 was $124 million. Debt outstanding remained at $31 million at year-end. Statutory surplus grew to about $680 million at year-end resulting in a net written premium to surplus ratio of 0.6 to 1. At year-end, our consolidated stockholders’ equity increased to $923 million or $20.85 per share.

In conclusion, we had our fourth consecutive year of record net income. Our investment portfolio remained strong and highly liquid and we continued to reserve prudently given current conditions. With that, we will now open up the call for your questions.

Question-and-Answer Session

Operator

(Operator instructions) Our first question comes from Randy Binner at FBR Capital Markets.

Ken Barker – FBR Capital Markets

Good morning, this is Ken Barker filling in for Randy Binner. I will just do a quick run through on the core number from the reported, I get $0.68 of reserved releases this quarter, $0.05 for higher comp and then on top of the $0.07 for software development impairments. So core number of about $0.55, am I looking at that correctly or would I add anything else in there?

John Corcoran

No, actually the IT impairment was a third quarter item.

Ken Barker – FBR Capital Markets

Okay, it is more like $0.47.

John Corcoran

$0.47, $0.48 sounds about right.

Ken Barker – FBR Capital Markets

Yes, right around there, okay and then one thing on the investment, on the reserve releases, you were saying it is mostly related 2004, 2007 development, I noticed you had more in 2007, you are starting to see some more clarity there in 2007 reserves, I was wondering if you could give me a little more color on that and some of that later accident years.

John Corcoran

Sure, that is exactly what is going on. The 2007 year has now reached 36 months of maturity and that tends to be the period where the accident year experienced start standing on its own and is less influenced by loss ratio expectation. So, really based on the lack of loss emergence for 2007, there was a significant redundancy there. And then, the years prior to that it is – some additional clarity again, the lack of loss activity and as we get into the older years, we are also seeing either case reserve reductions, better outcomes than we had expected on individual cases or strong recoveries from prior loss activity.

Ken Barker – FBR Capital Markets

Okay. So, would you consider most of the reserve development primarily from 2007 or is it earlier accident years?

John Corcoran

2007 was by far the largest, that was about $26 million, 2006 was about $7 million, 2005 was about $9 million, 2004 was about $4 million and then the older years are small dollars, a little bit (inaudible) before.

Ken Barker – FBR Capital Markets

So for 2008, you are going to start looking at that and trying to get an assessment there probably at the end of this year?

John Corcoran

Right. At the end of 2010, 2008 will be at that 36-month maturity level and again that is typically when it starts to stand on its own.

Ken Barker – FBR Capital Markets

Okay. Now the core expense ratio with the compounded and the processed [ph] comp is 58%, when I look at that it is like a core number probably consisting of 53%, 54% give or take.

John Corcoran

Yes I think for the year, the core number that I have is 53%, 54%, that takes up the incentive comp and the IT impairment. So that is a full year number.

Ken Barker – FBR Capital Markets

Okay, that makes sense. One other thing on investment yields. You saw some inflation in your investment yields this quarter compared to last quarter, are you starting to see the portfolio turnover and maybe hit bottom where you could start reinvesting higher, greater, larger portfolio combined with better yields starting to coming out or you are seeing the yields still sustained fairly low, close to just about 4%. Would you expect a little more inflation in investment yield going forward or how would I look at that?

John Corcoran

I think what we are seeing currently and kind of through the fourth quarter was difficulty finding the yield that we wanted given our quality buyers. So I think we will continue with quality being our strongest driver. So if nothing changes in the interest rate environment, it may be difficult to keep those yields up. Your guess is as good as mine I guess in terms of the overall interest rate environment and what we will see if and how that plays out.

Ken Barker – FBR Capital Markets

Yes, especially the way it is a couple of days. As far as a M&A environment and what you see out there, is there any progress or anything you are seeing out there or anything you are considering as far as the M&A buyer and maybe just provide a little bit color on what is going on there?

John Welch

Yes sure, this is John Welch, I can speak about it a little bit. Really over the last few years, we really have not seen much activity either people, or even coming into the industry, anything, so in the last year I would say only quite a whiff of a couple of small things that could be available. So there is not a lot of activity but we keep our eyes open, we are certainly in a position to be able to do something if we want to financially. So there was something that fit our organization, something more of a bolt-on type possibility that we consider there.

Ken Barker – FBR Capital Markets

Okay is it something – maybe the level of competition out there, it is really pushing people to hole out or hesitate or possibly looking at acquisitions?

John Welch

Well, the business has been good. I do not think anybody has looked into getting rid of their Surety business. Generally what we have seen when some things have come off, it is either a big insurance company merger that might result in that but other than that it is usually smaller companies where there is some continuity issue or where there is an owner that is going to be retiring and just wants to take it out of the business potentially and cash in on its work. So we have not – there are a few of those but that is really about all I have seen.

Ken Barker – FBR Capital Markets

One more question with the inventory buildup and positive GDP and just some of these unemployment numbers, are you seeing just macro economically just a little bit more inflation in construction spending or maybe some other signals that maybe signal some recovery in the surety business and maybe more premiums written, is there anything you see out there just macro economically, any color you can provide?

John Welch

I would say any price pressure from any commodity issues, I really do not see it and even if there was the competition is so fierce that I really have not seen pricing go up in the bidding at all, so I do not see any great possibility there in the near future. There is talk of the administration of whether there would be a second stimulus plan that is I guess a possibility. I will say that I think a bulk of the last stimulus plan subsidy will be spent probably in this year, so that should help. I think it will be a greater spend than it was in the last year, the best I can tell from what I have read. Unfortunately the states as you know are not particularly healthy, so construction spending might be off there are the (inaudible) funds that can contribute even to what the Federal government could give could be off. So it is going to be a challenge, but again, most of the publications I read, whether it is McGraw Hill or the AGC, some of the things they put out, some of the people are figuring it has hit bottom and there will be some level of growth in the residential and non-residential probably not much in the private commercial market quite frankly but still in public spending and possibly maybe the home building a little bit.

Ken Barker – FBR Capital Markets

So is it fair to say that the stimulus has not really inflated into the stage and it is more hoarding cash in order to get your budgets down, really not seeing any construction order –

John Welch

There has been construction, I mean we can identify definite construction jobs that have been the result of the stimulus package, certainly a lot of resurfacing, I think what you have not seen to a great extent is the jumbo jobs that might have come out of that but I guess there are some of those too that are still working. Not everything could have been shown already quite frankly but the only thing that could have been shown already is good resurfacing [ph] jobs have gone away, so some of it has lagged but I think why probably people have not seen the big jump in the numbers is that all the rest of the construction market other than that has suffered. So if you do (inaudible) it certainly would be worse.

Ken Barker – FBR Capital Markets

Right, so is it fair to say a slight decrease in premiums from that one particular client, was it attributable to that or is affected by some of the macro economic movements?

John Corcoran

Are you referring to the commercial premium?

Ken Barker – FBR Capital Markets

Yes.

John Corcoran

We had an unusual item in the fourth quarter of 2008, that one?

Ken Barker – FBR Capital Markets

That one, yes.

John Corcoran

No, that was a particular claim workout situation that turned out very well for us and actually allowed us to recognize a number of years of past premiums that we had not recorded due to collection concerns.

Ken Barker – FBR Capital Markets

Okay, so it is prior years. Okay, I will jump back into queue. Thank you very much.

Operator

Our next question comes from DeForest Hinman at Walthausen & Company.

DeForest Hinman – Walthausen & Company

Hi, can you talk a little bit about some of the claims activity and severity levels that you are seeing and some more of the new-term business, and I have a few more as well.

John Welch

Sure. Really, right now, there has been an absence of claim activity. Our claim activity has been probably more on the smaller round, some smaller contracts, some of the smaller commercial bonds, motor vehicle dealer bonds, we are really running probably at almost historical low loss ratios as far as the construction surety bonding goes. We are just kind of like a lot of people waiting to see – we do lag, we said there is another call, so we do expect our result and the losses to lag the rest of the economy because the firms we bond obviously have balance sheets that they have built up over the last number of years and they have backlog going into the difficult cycle.

So it takes a while for their backlog to start running off and getting replaced with less profitable backlog and then beyond that they have resources to spend before so they would [ph] not turn into loss for us. So I think with us and with the rest of the industry, what I can see with a few exceptions, people are still enjoying the very good loss result. We are just kind of positioning ourselves for maybe some worst times if things do not improve.

DeForest Hinman – Walthausen & Company

Okay, that being said, it looks like we are kind of reserving for the more current year losses in 2009 I think was around 29% somewhere in there. Does that change going into 2010, can you help me understand that?

John Welch

I think we are going to maintain consistency there. We feel pretty good about it. I think as John said earlier, I do not remember if he said, but if he did not, we can always kind of base those laws picks based on the experience we had and probably for the last and more difficult construction and funding environment. So we think that is a decent place to start and we are going to keep it at that for now.

DeForest Hinman – Walthausen & Company

And where do we stand in terms of portfolio duration at this time?

John Welch

The duration is about 4.7 for our long-term holdings.

DeForest Hinman – Walthausen & Company

Okay and can you offer us a little bit more color on your investment strategy going forward either in terms of how you want to position the portfolio, what do you think is an attractive asset class at this time in terms of – as you will get some maturities at this point?

John Welch

Sure. Probably the biggest change that we have seen in the portfolio is a de-emphasis I guess of our municipal holdings, for the longest time that hovered at 60% or above of the portfolio. We are not quite as attractive to that sector right now, so it has worked its way down by about 55%, not a huge change but significant for us given our historical portfolio make up. Right now we are seeing what we believe the best opportunity is to be in investment credit corporate. So that is where we are focusing. So on the agency mortgage products, corporate is probably where we are seeing what we believe to be the best opportunity.

DeForest Hinman – Walthausen & Company

And is that more on the shorter round of the yield curve or are we looking to move further out?

John Welch

No, we are staying relatively short. Our duration has been on the shorter end of our long-term target for quite a while and that has worked out well for us.

DeForest Hinman – Walthausen & Company

Okay and then finally can you help me think about the priorities with the free cash flow. I know the business is somewhat held so there is not a lot of flow out there, but we have had this nice increase since statutory surplus in this continued free cash flow, the company has not paid dividend and we historically have not bought back stock. So what do we do with the free cash flow?

John Corcoran

Essentially, we are still maintaining it obviously. We have built a good balance sheet and are really in good shape, this is somewhat unprecedented times, we are not really sure what to expect out of this current market environment, things are very good, I think we are well situated and we should have enough capital but I think we will need to wait still a little bit longer to see how this plays out because as I said before, we lag a little bit and we have not hit that lag yet, and when we do we will see how that plays out and then if we make it through this, then I think we got to look pretty hard at. In the meantime, I would say if an acquisition came off or something like that, we would consider something like that. We are obviously also internally trying to use some of the resources we have to find new opportunities, to try and create better returns, despite holding the capital, our returns on the equity have been good. That has been obviously started to deteriorate as we continued to hold capital. So we are going to have to keep looking at that each quarter and have those discussions with the board.

Operator

(Operator instructions) Our next question comes from Ron Bobman at Capital Returns..

Ron Bobman – Capital Returns

Hi, congrats on everything, great underwriting results.

John Welch

Thanks Ron.

Ron Bobman – Capital Returns

I had a question about capital as well, and could you quantify your estimate of excess capital that you are carrying and were there any stock buybacks in the quarter? I am sorry if I missed it, I did not see it in the summary press release.

John Welch

No, there were not any stock buybacks, so you did miss that. As far as how much is enough – how much excess, I guess there is a lot of different ways to look at it whether it is the (inaudible) view or how we consider modelling view, it is difficult to say what that is. We think it is an appropriate level at the moment. So I guess it depends on what –

Ron Bobman – Capital Returns

You don’t believe you have excess capital that is beyond and it is not necessary to sort of deal with volatility or worse case deterioration underwriting or severity of losses – you sort of think you are adequately capitalized given the opportunities and risks to hand kind of thing.

John Corcoran

Yes, we do. We run models in the same order, we have a one in a hundred-year event, one in a thousand-year event, that type of thing and when we run the models, our capital stands up to those results that come out of that modeling. It is not an overabundance of capital that we just had a melt down but we are well capitalized. I think it is obvious, we held on to it for a number of years and again we are happy we have it quite frankly right now going into this cycle and we will see where we go after the next couple of years.

Ron Bobman – Capital Returns

And is there a buyback authorization at least?

John Corcoran

No, not currently.

Ron Bobman – Capital Returns

And when is the last time you bought back stock, any time in the recent history?

John Corcoran

I have been here coming up on seven years and nothing in my time.

Ron Bobman – Capital Returns

Okay. Thanks a lot and best of luck. I hope the great results continue.

John Corcoran

Thanks Ron.

Ron Bobman – Capital Returns

You are welcome.

Operator

It appears that there are no other questions in the queue, I will turn the call back over to Mr John Welch for any closing remarks.

John Welch

Okay, we appreciate everybody joining us once again, and as always should you have any questions, please do not hesitate to contact John Corcoran or myself. Thank you.

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