CNA Surety Q3 2007 Earnings Call Transcript

Oct.26.07 | About: CNA Surety (SUR)

CNA Surety Corp. (NYSE:SUR)

Q3 2007 Earnings Call

October 26, 2007 11:00 am ET

Executives

Tom Pottle - Senior Vice President of Credit and FieldOperations

John Welch - President and Chief Executive Officer

John Corcoran - Chief Financial Officer

Analysts

Randy Binner - Friedman, Billings, Ramsey

Ron Pate - Banc of America Securities

Operator

Good day everyone and welcome to CNA Surety's Third QuarterAnalyst Conference Call. As a reminder, today's call is being recorded.

For opening remarks and introductions, I would like to turnthe call to Tom Pottle. Please go ahead, sir.

Tom Pottle

Thank you. Good morning everyone and welcome to CNA SuretyCorporation's third quarter conference call. With me are John Welch, Presidentand Chief Executive Officer of CNA Surety, and John Corcoran, Chief FinancialOfficer.

Before we begin, I would like to preface this call with theSafe Harbor statement under the private securities litigation reform act of1995, which is more fully described in the press release. Throughout thediscussion and subsequent question and answer session, forward-lookingstatements that are not based on historical facts may be made.

These statements are based on today's market conditions andinvolve certain risks and uncertainties. While every attempt is made to conveyaccurate information regarding these forward-looking statements, no guaranteescan be made that the conditions will remain, and that the actual results willconform to the statements being made today.

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

John Welch

All right, thanks Tom. Thank you all for joining us againthis quarter. As some of you may know, this month we are celebrating our 10-yearanniversary as a publicly traded company, the only publicly traded SuretyCompany in the United States.

During the past 10 years, the company has made some greatstrides. When CNA Surety was created 10 years ago, we wrote roughly $270million in gross written premiums. As we move towards 2008, we are nearing $500million in gross written premiums.

Company's equity position has grown from $257 million in1997 to $636 million today. Our book value per share has risen from $5.93 in1997 to $14.44 today. All told, the company has been reporting record earnings,and is in the best financial condition in its history.

Turning to this quarter's results, we are pleased to reportrecord net income of $28 million. This brings nine months net income to nearly$17 million, which puts us in a good position to finish the year on a verystrong note.

Overall, gross written premiums increased 7% for thequarter, with contract surety leading the way with growth of 11%. Within thecontract surety line, our small contractor book has grown substantially.

Our small commercial surety book grew by nearly 3% while ourcorporate commercial segment was off by nearly 13%. Our corporate commercialbook was off due to a more competitive environment and continued underwritingdiscipline.

Our overall quarter production was strong, we tend to focuson the yearly growth rates as quarter-to-quarter comparisons can vary, giventhe timing of when construction contracts are awarded and when bonds arewritten. Our loss ratio remains fairly consistent with the prior year, withboth years being affected by similar reserve releases.

We completed our outside actuarial reserve review during thequarter, and as a result, we released $5 million of reserves dating back to2003 and prior. Beyond the reserve release, we continue with the same level ofcurrent loss provisions.

On the expense side, we continue to report nothing but goodnews as our expense ratio once again declined from 55% last year third quarterto 52.8% this quarter. Lower expense ratio was again driven by greater premium,lower reinsurance costs, and continued improvement in operating efficiencies.

Looking forward, we continue to focus on growth prospects inthe construction industry for contract surety and the overall economy for ourcommercial surety growth. Let me provide a little perspective on theconstruction economy. Through August year-to-date, according to numbers we gotfrom the census bureau, over all construction spending was down 1.7% from 2006levels.

The decrease was driven by the residential sector, which wasdown 16.5%. Public construction spending was actually up 14.7%, while privatenonresidential construction was up 15.2%. Our expectation is that the declinein the residential sector will moderate to some degree, while growth in theprivate nonresidential and public sectors will slow down some. The slowdown inthe housing sector will ripple into various other sectors of the constructioncompany over the next few years.

Looking forward, we hope to offset some of these downwardpressures by selectively expanding into geographic regions where we do not havea large presence or any presence, and by putting additional emphasis on certainniches we have not focused on for the past few years. More importantly,however, is maintaining the credit quality of the book, and this along withexposure management will continue to be our top priorities.

During the fourth quarter, we will be renewing ourreinsurance contract given the strength of our capital. We are in a good positionto consider numerous alternatives. We continue to believe it is important tomaintain a very strong capital position in order to provide flexibility in thereinsurance buying, liquidity for any attractive acquisitions that might comealong and to cushion against any downturn in the construction economy and/orits credit fundamentals.

Overall, we are very pleased with our current results andexpect to finish the year in a very solid financial position. We believe thecompany is well positioned for the next 10 years and we look forward to beingpart of that continued success.

With that, I'll turn the call over to John Corcoran for someadditional financial details. John?

John Corcoran

Thanks, John. Good morning, everyone. I will provide a fewmore details on our record earnings. A quick note, all the earnings per shareamounts that I quote will be on a fully diluted basis.

We reported net income for the third quarter of $28 millionor $0.63 per share, compared to net income of $23.6 million or $0.54 per sharefor the third quarter of 2006. For the first nine months of 2007, we havereported net income of $70.6 million or $1.60 per share, compared to $61.1million or $1.39 per share for the first nine months of 2006.

Realized investment gains were minor in the current quarter,so net operating income was also $28 million and $0.63 per share, compared tonet operating income of $24.3 million or $0.55 per share for the third quarterof 2006.

For the first nine months of 2007, we reported net operatingincome of $71 million or $1.60 per share, compared to $61.7 million or $1.41per share for the first nine months 2006. The increase in income was driven byhigher earned premium, higher investment income and lower expense ratios.

Both the current quarter and the third quarter of 2006benefited from reserve releases of $5 million and $5.1 million respectively.John Welch covered the premium trends, so I will spend a minute on the loss andexpense ratios.

While the reserve releases were about the same dollaramount, the loss ratio impact in the current quarter was less, so we actuallysee a slightly higher loss ratio when compared to the third quarter of lastyear. However, our loss ratio selection for the current accident year remainedat the same level as the previous quarters, at about 3/10 of a point betterthan our original selection for 2006.

As John mentioned, we did receive the results of theindependent actuarial study using data as of June 30th. The study confirmedthat our loss experience has been favorable. We released reserves from accidentyears of 2003 and prior, as we believe those years are sufficiently mature andunlikely to be impacted by current economic conditions.

While the reserve study did indicate modest improvements forthe more recent accident years, we did not release any reserves for theseyears. There was nothing in the data that concerned us, we simply believe thatthe current economic conditions highlighted by the sub-prime mortgage issue andthe housing slump call for a bit of caution as we assess the more recentaccident years.

During the fourth quarter, we will update the reserveanalysis and will discuss those results during our year-end conference call.

We continue to be pleased with the improvements in theexpense ratio, which improved to 52.8% for the third quarter, compared to 54%for the second quarter of 2007, and 55% for the third quarter of 2006. Thebiggest drivers of this improvement continue to be the growth in earned premiumin part due to lower reinsurance costs and the fact that we have accomplishedthis growth with little additional expense.

Pre-tax net investment income for the quarter was $11.3million compared to $9.9 million for the same quarter last year. The increasecontinues to be driven by the growth in invested assets due to strong operatingcash flow and slightly higher yields.

Operating cash flow for the third quarter was $58 millioncompared to $43 million for the third quarter of last year. The third quarteris typically a high cash flow period for us, as we collect the premiums writtenin our heavy production months of June and July.

At quarter end, our invested assets in cash totaled $980million. The credit quality of our investment portfolio remained at AA plus.Debt outstanding remained at $31 million at quarter end. Statutory surplus was$413 million at quarter end, resulting in a net written premium to surplusratio of 1:1.

At quarter end, our consolidated stockholders equityincreased to $636 million or $14.44 per share, reflecting the net income forthe quarter, and a swing back into an unrealized gain position in ourinvestment portfolio.

That concludes my remarks, so we will now open up the callfor your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question will come fromRandy Binner with Friedman Billings Ramsey.

Randy Binner - Friedman, Billings, Ramsey

Hi, good morning, everyone.

John Welch

Hi, Ron.

Randy Binner - Friedman, Billings, Ramsey

Just -- yeah, on the reserves. Yeah, I think you mentionedthat it was the whole $5 million was all '03 and prior. Is it possible to breakout more specifically what accident years that applied to?

John Welch

Sure. '03 itself was the biggest reduction or -- right, thebiggest release about $3.7 million.

Randy Binner - Friedman, Billings, Ramsey

Okay.

John Welch

'01 had about a million and a half. And then really the restof the years were a little movement back and forth nothing really material.

Randy Binner - Friedman, Billings, Ramsey

Okay. So, the '02 last year there was, '02 had anunfavorable development after a favorable development the year before, so thatrelated to, I think, some ongoing litigation. Is that, I mean, I guess you hadmentioned that you think that those years are sufficiently mature, so can weinfer from that that the '02 and '03 accident years are pretty well locked atthis point?

John Welch

Well, I think…

Randy Binner - Friedman, Billings, Ramsey

I mean, I know they are by definition, but just maybe morecolor on it.

John Welch

Well, I think, I don't want to over-imply the level ofprecision that goes on in any individual accident year. I think collectively asa group, now, we should see smaller movements. We're always going to see smallmovements back and forth, one claim develops worse than we developed thenanother claim develops better than we expected.

So that could cause some blips across accident years, butkind of in general, looking over that group of years, yes, I think we shouldsee those settle down.

Randy Binner - Friedman, Billings, Ramsey

Okay. And so, now that would imply that '03 would be kind ofback to par. That's great.

One other question, just maybe a little bit more color onwhat happened with the commercial line, the weakness there. And I know thatthat's trended down a bit. Sequentially, and year-over-year, I mean is there atrend going on there, is it competition, or is it -- what exactly is makingthat happen?

John Welch

Sure. Let me first distinguish between our small commercialbook and our corporate commercial book.

Randy Binner - Friedman, Billings, Ramsey

Okay.

John Welch

The corporate commercial book overall was relatively small,and that's the area that had decreased, I think, on a yearly basis, we might do$30 million more and give or take, and so that's the area that was impacted.

The small commercial business continues to grow, and thecore segments of that, probably are rated more or less 3% The smaller corporatebook, what's really been impacted there is a couple of things.

One, we had kind of the emphasized it for a lot of years,and only got really more back into it, let's say within the last year.

And so we're in a position of trying to, go out there anddrum up production after having told everybody we didn't want to be in it for along time. So it's been a little bit slow, and we've done it at a time when themarket started to get a little more competitive, and we haven't really beenwilling to play at some of the terms.

And then you combine that with the fact that some of thebonds in that sector had to deal with, like, mortgage broker business forexample, and there's less demand for that.

So, some of that's gone. Some of the decrease was related toreclamation bond exposure where it's kind of an exposure long tail that we'renot crazy about, so, we manage that a little more carefully, and so, we’ve kindof moved some of that off the books.

And then the contractor clients themselves who happen toneed small commercial bonds at times have had less demand in the last quarterfor whatever reason.

But overall we're not really concerned about that becausewhen we restructure this corporate commercial segment of our business, weessentially broaden it to more than just commercial surety bonds. We're havingthat group basically go after business that traditionally might have beenconsidered contract bond.

It's actually contract bond, but for non-constructionclients. They would be some of the larger companies, like a General Electric,some people like that that you don't generally think need performance bondsactually do.

And we haven't in a big player in that, and so we've had thepeople focusing on that, and so some of the production they're actuallygenerating is showing up in contract, and you're not seeing it in commercial.So we're pleased with the unit, even though those numbers don't look so good atthe moment, but we expect they will swing back.

Randy Binner - Friedman, Billings, Ramsey

Okay. And just one more, and I'll get into the queue. Thetop line was very good in contract with 11%. Was there any lumpiness in there,or big contracts that came through in the quarter that made that seem a littleoutsized, relative to the go forward trend?

John Welch

Yeah, maybe a little bit. We kind of alluded to it a littlebit. It's difficult to predict when construction contracts are going to getawarded and when we're going to bond them. And we saw actually a very goodSeptember compared to the prior year.

And our October last year was -- was very strong, and we'rewaiting to see how October turns out this year, but we are somewhat thinkingmaybe we flipped months. September was strong last year -- or this year, andOctober was strong last year, and it might be the reverse this year.

Randy Binner - Friedman, Billings, Ramsey

Okay.

John Welch

But so far October is turning pretty good, but, yes, I thinkit was a particularly strong quarter, I would say that. I wouldn't -- it's hardto predict, but I would think it would be hard to match that same number in thefourth quarter.

Randy Binner - Friedman, Billings, Ramsey

Yeah. Yeah, seasonally that would imply that, but also therate was also high.

John Welch

I would agree with that.

Randy Binner - Friedman, Billings, Ramsey

Okay, well great. Thanks. I'll drop back and see if anyoneelse has questions. Thank you.

John Welch

Thanks Randy.

Operator

(Operator Instructions) We'll go next to Ron Pate (ph) withBanc of America Securities.

Ron Pate - Banc of America Securities

Hey, good morning. Just the first question is following theexternal actuarial reserves study, if you can just tell us how the pointestimate from the external actuaries compared with your own.

John Welch

Sure. As of 6-30, we were -- our booked reserves were $7.5million higher than the actuarial estimate. But I remember that's last at June30th, when the study is performed.

Ron Pate - Banc of America Securities

Right, right. Now, your overall aspect has remained thesame. If you can just quickly tell us how -- whether each of the individuallines, the aspect stayed the same, and if you can just remind us what they are.

John Welch

Sure. They have stayed the same. Contracts, we've generallysaid, very slightly below 30, the large commercial kind of the lower tomid-30s, and the small commercial in the higher teens. That stayed prettyconstant now for the last certainly through '07, just slightly better than wehad in '06. And that's really more driven by the impact, again, of lowerreinsurance costs than anything else.

Ron Pate - Banc of America Securities

Okay. Now, this is a separate question. Are you noticing anyincreased public spending related to the -- I guess the infrastructure projectsfollowing the bridge collapse in Minnesota? Has that affected the overalltrend?

John Welch

I would say, actually dollars on -- probably being bid yet,probably not yet, but, yeah, I think it will. We know of a particular bigprogram in Missouri, where they're putting a whole program of bridges out forbid all over the state.

So, yeah, we think there will be continued emphasis. That'sprobably a bright spot. We think despite the housing situation, we think publicspending has continued strong. Right now I haven't seen anything that wouldsuggest it wouldn't continue.

Ron Pate - Banc of America Securities

And then, I think you had eluded, John, in your initialcomments about linkage from the private housing, I mean, the privateconstruction. The residential construction probably going into the commercialconstruction on the growth prospect side.

What loss experience are you seeing on the residential?Maybe not on your own book, because I think you guys have a very small book,but industry wide, has there been in a need deterioration and the credit trendon the housing side and do you think it could go into the -- are you worried aboutit spreading into the commercial side?

John Welch

I thick there's two different points here, essentially. Ithink as far as the trouble in the housing market spilling into the rest of theconstruction industry, yeah, in my opinion, I think it will, to some degree,because as there's less developments in housing developments, you just needless schools, less shopping centers. Less retail. I mean it just kind offollows.

The secondary aspect that could cause you a problem down theroad is that a lot of the guys that did that type of work, particularly in theinfrastructure, the sewers, roads, that type of thing, it's fairly easy forthem to transition over rent back into some of the public work and give thoseguys more competition, which then eventually leads to lower margins on theirincome statements.

So, but that's just beginning, and, you know, that takes awhile for it to work its way through the system. The private market has been sostrong, and they have made a lot of money, so they have pretty healthy balancesheets, so even more competition is going to take a while for that to workthrough and result in actual bankruptcies at the end of the day.

As regards the homeowners sector, the housing sector, youknow, you read the papers. I mean, it's been pretty dramatic decrease in thatmarket, and you know, all the surety companies have bonding in that sector, andreally to date, no, there hasn't been any significant losses that I've heardof.

There was a recent bankruptcy of a Chicago firm in the lastweek or so, and the thing about the bonding in the housing sector that makes itdifficult to determine what will result is a lot of the bonds are basicallyjust to guarantee the improvements of the development. They don't guarantee thebuilding of the houses or anything like that. It's just that they put throughinfrastructure in, and most of the time it's put in kind of up front.

So you're not really certain that even if some of these guysfail, what kind of losses you'll have. This is not certain ability to dowhoever will want you to finish out any further phrasal (ph) they want becausethey don't really want you to maintain -- they don't want to have to maintainthe road, not for a development that isn't theirs.

So it's kind of hard to tell. Yeah, it's an industry that'sgot a lot of troubles. We fortunately are focused on the top end of that, thebiggest national builders, and we've managed our exposures at least internallyhere to be in line with our reinsurance parameters, and also our capital.

So it's something to keep an eye on, and, you know, it's --it's going to be -- its going to be a little rough road for those guys. It'sbeen a rough '07 and '08. I done think is going to be any better, so we'rekeeping our eye on them, but we do feel good about how we've managed ourexposure so far.

Ron Pate - Banc of America Securities

Great. And I guess the last question if I may for JohnCorcoran. The premium to surplus is at 1.1 times. What level of premium tosurplus are you willing tolerate before you think you need to increase capitalmanagement?

John Corcoran

Well be I don't think that ratio and itself is going to bethe driver for us. I think we're taking a much more broader view of theeconomic conditions, certainly take some comfort in the fact that we'reproviding good returns on the capital currently, so I think we have to look atall of those issues, you know, especially kind of the economic conditions thatwe see and then we'll address capital as we go.

Ron Pate - Banc of America Securities

Okay. Thanks for the answers. And then Good quarter.

John Welch

Thanks. Good to have you back.

Operator

Once again, that's star one if you would like to ask aquestion. We'll pause for just a moment. We'll take follow-up question fromRandy Binner.

Randy Binner - Friedman, Billings, Ramsey

Hi again. John Corcoran, just real quick on the investmentyield. I notice that this quarter we saw just sequentially a little dip down. Igot about 4.62% as the investment yield for the quarter in my model. Is there-- are you seeing anything in the portfolio as far as lower yields and a lowerenvironment, or, you know, is there any story behind that sequential decreasein yield?

John Corcoran

Probably, a little bit more of a concentration in short-termduring the quarter.

Randy Binner - Friedman, Billings, Ramsey

Okay.

John Corcoran

But certainly, you know, as I'm sure you follow the broadermarket, you know the treasury yields obviously are down. You know, there's abig flight to quality issue, and some of the credit spreads have widened, but Ithink, we say generally the new money rates are a little lower than they havebeen the past.

Randy Binner - Friedman, Billings, Ramsey

Yeah. That's interesting. I mean for you -- well there yougo, you're 67% maybe so I guess that whatever spread widening opportunity yougot is somewhat hampered by the lower absolute return?

John Corcoran

Right. Think that's fair.

Randy Binner - Friedman, Billings, Ramsey

Okay. Thanks for the color. Good quarter. Thank you.

John Welch

Thanks, Randy.

Operator

We have no other questions at this time. I would like toturn it took our presenters for any addition or closing remarks.

John Welch

Okay. I again, that'll about wrap it up. If you could haveany questions, please do not hesitate to contact John Corcoran or myself. Thankyou.

Operator

That does conclude our call. We would like to thank everyonefor your participation. Have a great day.

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