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CNA Surety, Inc. (NYSE:SUR)

Q4 2007 Earnings Call

February 8, 2008 11:00 am ET

Executives

Thomas A. Pottle – Senior Vice President – Credit & Field Operations & Secretary

John F. Welch – President, Chief Executive Officer

John F. Corcoran – Senior Vice President, Chief Financial Officer and Treasurer

Analysts

Randy Binner – Friedman, Billings, Ramsey & Co.

[Rohan Pie] – Bank American Securities

Peter Seuss – SuNOVA Capital

Operator

Good day everyone and welcome to CNA Surety’s fourth quarter analyst conference call. As a reminder today’s call is being recorded. For opening remarks and introductions I would like to turn the conference over to your moderator for today, Mr. Thomas Pottle, please go ahead sir.

Thomas A. Pottle

Thank you, good morning everyone and welcome to CNA Surety corporations 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 began, 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 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 F. Welch

Good morning everyone and thank you all for joining us again this quarter. We are very pleased to report on a great year for CNA Surety. During 2007 we were able to once again grow revenue, generate significant cash flow, add significantly to our IB&R reserves, decrease our expense ratio and generate a respectable return on equity. We celebrated our 10th year as a public company traded on the New York Stock Exchange, and want to thank all of our employees and business partners that have made the company what it is today.

Turning to the numbers, gross written premiums for the year totaled roughly $472 million dollars or 4.2% above prior year. Or contract growth remains strong at over 7% for the year, while our commercial surety writings were flat. For the quarter our gross written premiums were relatively flat with last year. The contract line was up around 1%, and the commercial line was relatively unchanged. We attribute the flat premium quarter to two things: first, we had very strong premium production this year in September which helped the third quarter, last year our October was very strong thus making the year-over-year comparison difficult. The timing of contract surety production can vary widely from month-to-month thus, is better viewed over a longer period. Secondly, the commercial line was affected negatively by our decision to reduce our exposure to certain long tail bonds, we felt the exposure reduction of these types of bonds was more important than the premium growth.

The loss ratio for the year moved up slightly as we accrued additional reinsurance expense, thus lowering our earned premium. This additional reinsurance cost was triggered by a contract surety loss we suffered in the fourth quarter. Our actual overall loss activity for the year, case incurred less salvage, was relatively unchanged from last year, which by the way was a very good year. However, the way the losses fell this year unfortunately, caused this additional reinsurance premium. Essentially what we had was one additional larger type loss this year but fewer smaller losses as compared to the past few years. Expense ratio for the year also improved as have been able to hold operational expenses fairly steady over the past few years. Cash flow was also very good this year as we significantly added to invested assets and for the first time in the history of our company we have exceeded $1 billion dollars in invested assets. Our collections have improved dramatically, over the past few years and we sit today with virtually no collection problems.

Turning to the overall construction market, we continued to see descent public spending, but the private spending continues to slip. The negative effects of the slumping housing markets are being felt in other areas of the construction industry. Fortunately our surety writings are still heavily dependant on the public sector and to date this has continued to be strong. 2007 will probably be one of the best years on record for the surety industry. We have not seen final numbers, but interim numbers were looking very positive. Competition continues to be strong but for the most part underwriting and pricing disciplines still exist. Combining the slowing construction market with the very profitable surety industry, I would expect premium writings will be under significant pressure over the next 12 months. Our goal will be to withstand the storm and be well positioned for the eventual market disruptions. We have many long time loyal accounts and agents, a dedicated staff and a very solid balance sheet. We are confident these three items will allow us to continue to prosper even as conditions tighten. With that I will turn the call over to John Corcoran, for some additional financial details, John.

John F. Corcoran

Good morning everyone, I will provide a few more details on our earnings, and will also provide some information on our investment portfolio. We reported net income for the fourth quarter of $21.9 million dollars or $0.49 per share compared to $21.7 million or $0.49 per share for the fourth quarter of 2006. For the year, we reported net income of $92.5 million or $2.09 per share, compared to $82.8 million or $1.89 per share for 2006. While we are pleased to report another strong year with net income growing about 12% from 2006, our fourth quarter was impacted by an accrual for an additional reinsurance premium that was related to the amount of loss exceeded to our reinsurers. This accrual lowered our net earned premium and thus adversely impacted our loss and expense ratios.

Ironically, we were pleased with our overall loss activity in 2007. Our case incurred activity which is paid losses plus or minus the change in case, reserves was substantially lower than expected. This translates to a significant increase in IB&R reserves over the year. Unfortunately the losses that we did have, hit us in such a way that the additional reinsurance premiums were triggered. I should note that the accrual is based on our current case estimates for the underlying claims. The accrual could change up or down depending on the ultimate outcome of these claims.

The loss ratio was eight tenths of a point higher for the fourth quarter, compared to the fourth quarter of 2006. We didn’t change our loss fix per say. The higher loss ratio resulted from the additional seeded premium which lowers the denominator in the loss ratio calculation. For the year the loss ratio was two tenths of a point higher in 2007 this difference resulted from slightly less favorable developments in 2007 versus 2006. The results of our updated reserve analysis using year end data showed modest improvement from the mid-year study. As we did in the third quarter we have applied a cautious view towards our reserves primarily in light of the uncertain economic times. This has resulted in our recorded reserves being slightly higher than our actuaries point estimate. The expense ratio for the fourth quarter was 54.4% down slightly from the fourth quarter of 2006, but up from the third quarter of 2007, again due to the additional seeded premium. For the year the expense ratio improved one point to 54%.

Pre tax net investment income for the quarter was $11.3 million compared to $9.9 million for the same quarter last year. For the year, investment income increased to $44.6 million from $39.3 million for 2006. These increases continue to be driven by the growth in invested assets due to strong operating cash flow and slightly higher yields. Our investment portfolio has served us well over the year. We have long noted the conservative nature of our investments and that has proved quite comforting in these volatile times. The portfolio continues to have an overall rating of AA plus. Our exposure to sub prime home loans continues to be limited to two AAA asset backed securities containing fixed rate loans originated in 2004. These securities have an aggregate value of approximately $10 million dollars and were in an unrealized loss position at year end of approximately $50,000.

Municipal bonds make up the majority of our investment portfolio. Approximately 60% of our Muni holdings are insured by one of the major bond insurers. The Muni portfolio including insurance has an average credit rating of between AA plus and AAA. Substantially all of the insured bonds have underlying ratings of at least A with an average rating of AA. There are four insured bonds totaling about $11 million dollars that have underlying credit ratings of DDD plus. There are three other insured bonds totaling about $15 million that do not have underlying ratings assigned by S&P or Moodys. Our outside investment advisors internal ratings for these issuers are AA for two of the bonds with $12 million in value and A for the other. Given the strong underlying credit quality of our insured investments, we believe that the impact of any bond insurer troubles will not be significant for us.

Operating cash flow for the fourth quarter was $38 million compared to $44 million for the fourth quarter of last year. For the year we generated operating cash flow of $129 million compared to $124 million for 2006. At year end, invested assets and cash totaled $1,250,000,000, crossing the billion dollar mark for the first time. Debt outstanding remained at $31 million at year end. Statutory surplus was $442 million at year end resulting in a net written premium to surplus ratio of 1 to 1. At year end our stockholders equity increased to $668 million or $15.13 per share. That concludes my remarks so we will now open up the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions) We will take our first question from Randy Binner at Friedman, Billings, Ramsey & Co.

Randy Binner – Friedman, Billings, Ramsey & Co.

I just wanted to dig a little bit on the reinsurance charge, and not so much on the details of what happened but what you might think the impact for the cost of reinsurance is going to be for 08 and 09. I think that there was some expectation of a more favorable rate there and maybe just in the context of the retention ratio between written and gross, could you comment on what the effect of that might be going forward?

John F. Welch

Sure, we did conclude our reinsurance renewal towards the end of 2007 and actually it was very favorable renewal. We did get a rate decrease to result in a lower base premium. So going forward into 08, I guess a couple of things to consider: one, with the savings we did generate will we try to find a way to avoid this additional reinstatement premium in the future. There’s different things you can do to even purchase things to avoid that or you might consider as well any conservative estimation in there for a reoccurrence of an additional reinstatement premium in 08, which is really hard to predict. I mean that kind of thing happens, well it’s the first time its happened since I’ve been here and I’ve been here almost five years. So when we look at our reinsurance that’s what you question, is it worth buying something to pay for that upfront to avoid that kind of event or do you just take the one in five year chance that you’ll actually incur it. So we feel pretty good where we sit right now, with the savings we got it was a very good renewal actually the terms and conditions remain the same limits wise and we were actually very happy with the renewal.

John F. Corcoran

I should note there was no new news post renewal all of this information was known at the time.

Randy Binner – Friedman, Billings, Ramsey & Co.

Ok, understood. I guess, the take away for me from that it is possible savings could be used to essentially be put back into the reinsurance agreement, so a flat assumption on that cost is probably safe, is that fair? Or will we actually see the savings?

John F. Welch

It’s safe, assuming nothing happens during the year. We’ll look at alternative ways to do something about it but you know the cost benefit of it has to be questioned usually you’re just trading dollars. We have to see if it is worth it and I’m not sure it will so then the next question is will we incur losses that will trigger something again in the next year and right now we feel pretty good that you know like I said that is happens once every four or five years.

Randy Binner – Friedman, Billings, Ramsey & Co.

You know that gets into my second question is that is this the type of thing that you would see more of in a softer economic environment because it has been about five years since we saw that. So I mean is that going to be the orientation of the program if we expect a softer economic environment in 2008.

John F. Welch

Well if you incurred you know losses as they happened to us again in the same pattern as 07 and 08, yes you would. But as John said in his comments and as I said our actual loss activity was actually very good and almost unchanged from the prior year. We had a lot less of these smaller type losses and we had one additional large one and I would say the losses that we did have in 2007, the bigger ones anyway were a little different. So we didn’t see any trend there. One of them we felt was unusual in a part of the country where we don’t do much business so you wouldn’t expect to see much and it just kind of happened. But the underlying trend actually was favorable because we had less activity as far as item count of losses. Just kind of odd we had one at the end of the year and one way at the beginning of the year and so the way they fell into one year caused that reinsurance charge.

Randy Binner – Friedman, Billings, Ramsey & Co

Okay and then just one kind of final follow up, historically when there is a softer economic environment do you see higher severity and lower frequency? Is that something that was the case in the 2002 and 2001 time frame or is there no conclusion to be drawn there?

John F. Welch

Well no in those times frames it was both quite frankly. It was severity and frequency. You know if you do a decent job at which we think we’ve done over the last few years we should avoid the severity problems that existed in the 2002 timeframe. We don’t have that kind of exposure base anymore. So yeah, you would look to more frequency probably which really hasn’t shown up yet and I don’t really expect it to show up for a while because the actual construction market is still really strong and by the time these guys actually suffer from a down trend in the construction economy they have some decent balance sheets to work through before they actually start failing. So we’re not really expecting that to happen in 08.

Randy Binner – Friedman, Billings, Ramsey & Co.

And then could you just give a little color on the work out process or the salvage, I guess salvage isn’t the right term or the work out process you have on these claims and how the process works for trying to I guess improve your chance at recovery or improve the outcome of the accrual that you’ve taken?

John F. Welch

Yes sure. I mean in all surety cases you have an indemnity agreement from the people that you wrote the bonds for, so and sometimes you have personal indemnity as well. So we then have the ability to go back and try and recover assets from them after the fact if there are any assets left. On some of the bigger corporate type, commercial type bonds you also run into and we actually benefited from this in 2007 from some bankruptcy proceeds basically out of from the bankruptcy trust [reeds]. So on the ones that we had this year that would essentially lower, let’s say that reinsurance premium that John talked about, that’s a matter of the contractors, the few that we had of that size, they do have certain claims with the owners that they’re chasing money for this reason or another reason and if their successful in recovering that money that for the most part would go to us. So there’s upside for that to come down and therefore the reinstatement premiums would come down. We’ve actually been fairly successful at that but it’s nothing we bank on and nothing we book until it happens.

Randy Binner – Friedman, Billings, Ramsey & Co.

Great, fair enough. A couple of quick ones, the longer duration or longer tail or rather bonds that you were talking about, is that reclamation bonds? What exactly are those?

John F. Welch

Yes you pretty much hit it on the head. That’s it.

Randy Binner – Friedman, Billings, Ramsey & Co.

So you just don’t like the tail?

John F. Welch

Basically yes, it’s been a good business obviously. I mean the coal business has been excellent the last few years. But the bonds go on, yes for one they’re big exposures and in our case we are trying to reduce some we had that we’re in excess of $100 million at one point in time, so we’ve been trying to bring those limits down just to be more within our appetite. Then secondly, they go on, and on, and on,9 and they’re hard to get off if in fact, if the industry does have trouble again.

Randy Binner – Friedman, Billings, Ramsey & Co.

Is it mostly coal?

John F. Welch

Yes.

Randy Binner – Friedman, Billings, Ramsey & Co.

So is that when they plant trees and fill the pit in?

John F. Welch

Yes.

Randy Binner – Friedman, Billings, Ramsey & Co.

Just to give it more color.

John F. Welch

They’ve got to reclaim the land essentially when they are mining it and that could be 20 from now.

Randy Binner – Friedman, Billings, Ramsey & Co.

Understood. Then just real quick for John Corcoran the yield on the investment income was good, it was surprisingly high given the overall rate environment. Can you comment on that real quick? I would think that we wouldn’t see downward pressure on that yield but any thought on that?

John F. Corcoran

No I think your observations are spot on. We’ve enjoyed high coupons in the portfolio. Those aren’t of unlimited life, those will begin to mature off and the reinvestment rates aren’t as attractive. We don’t have any big concentrations of maturities coming out anytime soon but I think your overall direction is correct.

Operator

And we’ll take our next question from [Rohan Pie] at Bank of American Securities.

[Rohan Pie] – Bank American Securities

The first question is for John Welch. I think you suggested that some of the weakness in the private residential marketplace seems to be overflowing into other areas. Could you elaborate on the comment on where you’re seeing the weakness, is on the non-residential construction that you are seeing some pressure?

John F. Welch

I mean I think the first place that we see it essentially isn’t necessarily on the bonds that we write as far as how many but the fact that some of the utility type contractors lets say that do sewers and roads and that type of things in the housing developments have moved over into the public markets and we’re seeing more bidders in the public works because of that. So that’s one effect you have and we’ve seen that around the country actually. It’s been reported to us by a number of our branches. Secondarily, you know we haven’t really seen it in the numbers as far as how the housing would result in less schools being built or retail shopping strips but a lot of the things you read is that’s probably coming. Although the last thing I read yesterday actually is educational growth in schools still looks pretty strong for a little while but eventually some of these thing will slow down if there is obviously less housing development out there but right now it’s still stable at least and growing to a little degree in 2007.

[Rohan Pie] – Bank American Securities

Alright and I guess the other question was, are you able to give us any details on the large loss in the fourth quarter and then the first quarter? What kind of losses where these? I think you said contractors but if you can just flesh out a little more?

John F. Welch

Sure the losses of any size let’s say this year were all construction related conscientious normal contractors. I think one was a road guy, one was a general and one was electrical actually and they were in various parts of the country, no particular area that caused a problem. One that I said was a bit unusual was in Hawaii, which for us why I say that is unusual is we just don’t really have a presence there. We did handle one account related to a subsidiary company of CNA that if they need some extra capacity sometimes we’ll look at so it was not in our traditional book let’s say. Another loss was the electrical firm, essentially was there was some private equity money in it and they had been trying to grow the firm essentially and it just didn’t work out for them at the end of the day. And the third, one the road guy that was of significance let’s say, you know just failed. I think the price of asphalt caused a lot of problems for us in that particular claim, there wasn’t a huge supply. I think we had one source to go to get it which probably escalated the claim beyond what you would traditionally have as well. So when we look at it overall we say, “Well you know I mean obviously we wish it didn’t happen but we are in business to have some every now and then,” and we don’t see it as any particular trend or anything wrong with the book. The electrical that did go at the end of the year was very well identified in our credit scoring modeling. We’ve been working with it trying to work with the owners of that firm to manage the company and manage our exposure down so that we wouldn’t get hurt but at the end of the day the private equity people kind of just tired out. So all in all we feel pretty good that the controls are working. We spot the accounts when they start having trouble, we start working with them and sometimes they work out and sometimes they don’t.

[Rohan Pie] – Bank American Securities

Yes John we haven’t heard from any other surety writer yet of large loss activity. Were these dollar accounts that you were the only surety on?

John F. Corcoran

Yes. Generally yes, we don’t co-surety a ton of business or share surety much either but these were ours and when we’re talking big there not that big. I think the biggest think you have here is $20 million gross, $10 million net so it’s not really a jumbo thing. So you might not even hear that from other surety’s quite frankly because that probably wouldn’t hit the radar screen for some people.

John F. Welch

And Rohan I would note other than the additional seeded premium these claims weren’t particularly noteworthy for us. It was only because it triggered that additional seeded premium that they seem maybe more indicative than they really are.

Rohan Pie - Bank of American Securities

Okay. Thanks and just the other two questions I have are on the reserve, there was slight adverse reserve development this quarter not much but just a little surprising maybe given your reserve position. Was there anything that we should be thinking about that?

John F. Welch

No I mean were talking about thousands of dollars right?

[Rohan Pie] – Bank American Securities

Right.

John F. Welch

t just as we work through the mechanics of lining up the reserves in the accident years you’ll get a little bit of spillage here and there and there’s absolutely nothing to be drawn from that.

[Rohan Pie] – Bank American Securities

Okay and what was IB&R at the end of the quarter?

John F. Welch

$206 million that’s net basis.

[Rohan Pie] – Bank American Securities

And how did that compare to the end of the third quarter if you can just remind us?

John F. Welch

Third quarter was $197 so about $9 million up.

[Rohan Pie] – Bank American Securities

For the year?

John F. Welch

For the year we were up about $47.

Operator

And we will go next to Peter Seuss at SuNOVA Capital.

Peter Seuss – SuNOVA Capital

So I just had a couple of quick questions for you and I apologize if I missed this but you mentioned that you expect premiums to be under pressure for the next 12 months. Were you talking about the industry or you guys specifically or both?

John F. Welch

No. I would think both. We’re pretty much in the same boat. Like I said the results have been very, very good for the surety industry so that usually leads to more competition and while I haven’t seen the pressure on the pricing yet it’s just something we’re looking at that could happen. And then, you know were looking out at everything you hear in the construction economy and also in just the financial world that there becomes less bond issuance being had at there, you know to be able to build certain things you could end up with some slow down. It’s not that we know it but we’re just kind of projecting that that could be a possibility. It just seems from the economic times that we’re in it that it would seem to follow.

Peter Seuss – SuNOVA Capital

Gotcha. And also just on the pricing this is I’m sure a question you’ve gotten before, but just the implications of higher commodity costs on both your loss fix and pricing it. Do you guys fully factor in you know where like copper is trading now? Or do you kind of take more of a longer term average just wondering what your philosophy is towards that?

John F. Welch

Well when we write the bonds and we did particularly I would say in 2006, we get a big benefit from that because our premiums are based on contract amounts and the contract amounts grew quite a bit because of exactly what you’re talking about. And so we kind of have the money in the bank so to speak to be able to pay for the higher costs claims when they in fact do happen. That’s really just kind of how it works. With any luck some of the prices have moderated actually since 2006 and so if you hit it right your claim might actually be even a little bit less. But you’re right copper is still up there but some of the others, the wall boards gone down I know because of housing and so there’s a mixture of it and I would say it was less price escalation in 07 for sure than 06.

Peter Seuss – SuNOVA Capital

So pretty much when you write the contract wherever those commodities are trading you kind of factor it in at that time but then if the price goes down it’s kind of a benefit because you have some cushion in the premiums that you’ve booked.

John F. Welch

More or less.

Peter Sues – Sanova Capital

But if they go up do you kind of hedge that out in any way or no?

John F. Welch

No.

Peter Sues – Sanova Capital

Okay. Then also I was just wondering if you could somewhat quantify your exposure to subdivision surety bonds or anything else that’s really directly related to residential homebuilders?

John F. Welch

Sure.

Peter Sues – Sanova Capital

That’s a question I’m sure you have gotten many times.

John F. Welch

Yes we participate in the subdivision market and we participate on - our strategy has essentially been over the past number of years to concentrate for the most part on the top 10, 12 builders in the country. We have some exposure to some of the regional builders but really it’s very minimal compared to our overall book, the bulk of our exposure would be in the top 10 or 12. Our philosophy there essentially, and the way we’ve been handling per risk basis isn’t any different than how we would handle a regular general contractor, we try and not take any more exposure essentially that in the event of a problem the probable maximum, loss wouldn’t exceed what we could withstand under our reinsurance limits. So it’s really just a matter of managing our aggregate exposures. To date, we really haven’t with the failures that have occurred around the country and there’s been a number of them, more on a regional basis, we’ve had very, very little activity at all, we’ve fortunately missed some of those.

Peter Sues – Sanova Capital

Gotcha. So is there any way you could quantify it better though, for example what percent of your IB&R is related to those types of bonds?

John F. Welch

Well the IB&R really doesn’t get put together that way but quantifying it in our overall book I would say you know it’s less than 1% of our accounts. It’s probably less than, you know it was about 3% of our premium and therefore pretty much of our exposure. So relatively speaking it’s not a big portion of our book. You know when I said we try and write these accounts to our reinsurance limits, we generally carry 90/10 reinsurance limits so you know we like to keep our exposures under $100 million which in our retention under our treaty is $10 million plus a 5% of the $90 million so you’re essentially a $14.5 million retention on a $100 million problem. So you can kind of quantify it that way. I mean if you had one of these big guys go broke that’s essentially what we would hope, we would expect it to cost really, at the worst case scenario.

A lot of times you’ve got to remember about these kind of bonds there not like a traditional contract bond. As a developer might have some troubles the land is still valuable, there’s possibilities to unload it which some of the big builders have done, like Lennar had a big sale of land not to long ago. There’s people that usually might take it off your hands and the bonds really just kind of sit there and the new owner takes the responsibility essentially. A lot of times you know it depends on whether the villages that even want the subdivisions completed on out. So the loss of activity on that type of bond historically has been excellent actually. I mean if you went back over a 20 year period it’s no more than 20% over that time period. So I know we’re in a little more difficult time period than we’ve had over the last 20 years but again it’s how you manage the exposure per account.

Peter Sues – Sanova Capital

Right and that goes back to you saying it’s not really a severity concern but more of a frequency concern?

John F. Welch

Yes. I would say if you mange the exposures right, I mean if you took billions of dollars of it you got a problem. But per account if you keep your exposures managed, yeah you’re right.

Peter Sues – Sanova Capital

And just to confirm so that 3% of premiums and the kind of exposures is that just for subdivision surety or is there another kind of surety that you know, I probably don’t know the terminology, that would also tie directly to the home builders or you know other residential?

John F. Welch

It’s primarily what we play in is the subdivision bonds and that relates to that. There is another kind of bond where you basically, the developer has to post a bond if they want to use the customer’s deposits essentially so if they went broke you’d have to repay that. We haven’t really participated in any significant degree on that type of bond so ours is 99% or more really just sub-division bonds.

Operator

(Operator Instructions) It would appear that we have no further questions in the queue. Mr. Welch I would like to turn the conference back over to you for any additional or closing remarks.

John F. Welch

Okay thanks again for your participation in the questions and as usual if you have any further questions please do not hesitate to contact John Corcoran or myself. Thank you.

Operator

This does conclude today’s presentation. We thank everyone for their participation. You may disconnect your lines at any time.

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Source: CNA Surety F4Q07 (Quarter End 12/31/2007) Earnings Conference Call Transcript
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