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CNA Surety Corporation (NYSE:SUR)

Q1 2008 Earnings Call Transcript

April 25, 2008 11:00 am ET

Executives

Thomas Pottle – SVP of Credit and Field Operations

John Welch – President and CEO

John Corcoran – SVP and CFO

Analysts

Kevin Barker [ph] – Friedman, Billings, Ramsey

Rohan Pai – Banc of America Securities

Operator

Please stand by. We are about to begin. Good day, everyone and welcome to CNA Surety's First Quarter 2008 Analysts Conference Call. Today's call is being recorded. For opening remarks and introductions, I'd now like to turn the call over to Mr. Thomas Pottle. Please go ahead, sir.

Thomas Pottle

Thank you. Good morning everyone and welcome to CNA Surety Corporation's first quarter conference call. With me are John Welch, President and Chief Executive Officer of CNA Surety and John Corcoran, Chief Financial Officer. Before we begin, I would like to preface this call with the Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995 which is more fully described in the press release. Throughout the discussion and subsequent question and answer session, forward-looking statements that are not based on historical facts may be made. These statements are based on today's market 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 again this quarter. As you've already noted in our press release, we recorded net income of $22.9 million for the quarter, which represents an increase in earnings of 10% over the prior year on premium volume that was relatively flat for the quarter. Our loss activity actually decreased from the prior year and we were able to continue to strengthen our IBNR position. Our investment portfolio also held up well given the volatility in the markets.

Let me provide with you a little more detail on the quarter. Overall, our gross written premiums were down 1.5% from prior year first quarter. Our January production was significantly off but we did grow 4% and 5% in February and March respectively. As we mentioned in our prior call, premium production can vary widely from month to month due to the timing of contract awards, thus it's better viewed over a longer period. As an example, our December premium was up 9.5% over the prior year while our January production was down around 9.6%. If you look at the combined four months from December to March or on a rolling 12-month average, we reflect modest growth.

That said, economic activity and construction activity in particular have slowed, and we are feeling the effects of the slowdown as we move into the second quarter. As mentioned, we had a quiet quarter in terms of losses. In fact, the incurred loss activity was below prior year. As we said last quarter, we have not seen any loss emergence but we'll continue to monitor the credit fundamentals of our portfolio. We again added to our IBNR reserves which strengthens our overall financial position.

We continue to do a good job of controlling our costs. Our expenses remain relatively stable while the expense ratio improved a point over prior year first quarter due to stronger earned premium and lower reinsurance cost. Our headcount overall has remained relatively flat over the past few years and we do not see any significant change in this area. As most of you have heard repeatedly in the news, the economy has slowed down and the construction sector, particularly housing, has helped lead the way. While public and nonresidential private construction has helped offset the slumping housing sector for the past few years, we have now begun to see a significant slowdown in those markets as well.

Public construction continues to reflect growth but the pace of that growth has slowed. Our contract surety writings are significantly tied to public construction spending, thus we have been buffeted to some degree by some of the declines in private construction. One of the primary consequences to date is the slowdown has been significantly longer bid lists in many parts of the country. Increased competition ultimately erodes bid margins, which will be felt on the bottom lines so the construction firms revive. While some firms will continue to prosper due to established market niches, others will need to consider contingency plans for falling revenues and margins.

As we move forward in managing through this cycle, it is more important than ever to continue to focus on our underwriting disciplines and exposure management. To combat the slowdown in construction economy, we are looking for new growth opportunities and have concentrated on adding resources in geographic areas and product lines where we see potential for improvement. Our primary focus, however, continues to be on the bottom line and we do not want to relax our credit standards in order to generate new volume particularly heading into a weakening economy.

Looking forward to the balance of 2008, we continue to feel good about the potential profitability of CNA Surety even with the challenges in the economy. We have a strong base of existing clients and continue to pick up quality new business. We are strengthening our workforce through (inaudible) and by adding select new hires where appropriate. Our expenses are under control, loss trends have remained favorable and our balance sheet is very solid. With a little cooperation from the economy, we remain optimistic about the balance of the year. With that said, I'll turn the call over to John Corcoran for some additional financial details. John?

John Corcoran

Thanks John. Good morning, everyone. I'll provide you with usual details on our earnings and also provide an update on our investment portfolio. We reported net income for the first quarter at $22.9 million or $0.52 per share compared to net income of $20.7 million or $0.47 cents per share for the first quarter 2007. We continue to be pleased with the level of loss activity. We experienced very modest case-incurred activity in the first quarter, continuing the strong experience we enjoyed in 2007.

So, as a result of our normal reserving process, our IBNR reserves grew by 8% during the quarter. The expense ratio also continues to improve due to our ongoing focus on expense management, growth in earned premium and lower reinsurance costs. The expense ratio for the first quarter of 2008 was 53.9% just short of a full point improvement from the first quarter of 2007. Investment income for the quarter was $11.8 million up from $10.7 million for the first quarter of 2007 due to the increase in invested assets. However, investment income was down slightly from the fourth quarter of 2007 due to the steep decline in short-term yields.

Our investment portfolio continues to perform well during these tumultuous times, but it has been completely immune from the challenges. The downgrade of FIGIC [ph] did result in corresponding downgrades to about 25 of our municipal holdings, and to one of our two holdings exposed to subprime home loans. All of the downgraded municipal bonds remain investment grade with the majority now rated in the AA range. This is evidence of the strong underlying credit of our municipal portfolio that we discussed last quarter.

The downgraded security with subprime home loans remains investment grade with a BBB rating, the other subprime holding remains AAA rated. The book value of our subprime holdings decreased slightly to $9.5 million due to paydowns in the quarter. We continue to monitor these holdings closely and do not believe that the underlying collateral performance warrants any concerns. Even with these downgrades, the portfolio continues to have an overall rating of AA+ plus.

At year end, investment assets and cash totaled $1.022 billion, down slightly from year end. This is due to $15 million receivable for our March 31st trade that did not settle until after quarter end. Operating cash flow for the first quarter was $19 million, compared to $14 million for the first quarter of last year. Debt outstanding remained at $31 million at quarter end. Statutory surplus grew to $464 million at quarter end resulting in a net written premium in the surplus ratio of one to one. At quarter end, our consolidated stockholders' equity increased to $688 million or $15.59 per share. That concludes my remarks, so we will now open up the call for your questions.

Question-and-Answer Session

Operator

Thank you. (Operator instruction) We'll go to Randy Binner of Friedman, Billings, Ramsey.

Kevin Barker – Friedman, Billings, Ramsey

Hang on guys, this is Kevin Barker [ph] on behalf of Randy Binner of FBR. Just want to ask a couple of questions concerning the –initial loss ratio was better than expected compared to prior year reserve activity. Can you give a little color on this?

John Corcoran

Sure. Our current actually in your [ph] pick was consistent with what we had used during 2007. The fourth quarter of 2007 was impacted a little bit by those reinstatement premiums we had, on reinsurance, we had some higher reinsurance costs in the fourth quarter. So, that caused the loss ratio to pick up. But the current (inaudible) rate is consistent with where we had at – in '07.

Kevin Barker – Friedman, Billings, Ramsey

Okay. Great. Also concerning the Safeco/Liberty merger activity going on, do you have any thoughts on the competitive position? Do you see this as a positive or negative for CNA?

John Corcoran

Yes, sure. Overall, our Safeco and Liberty are two good Surety competitors in the market, and I think the merger will – is a nice complement for them, and I'm sure they'll do everything they can to hang on to all their business and their people. But at the same time my experience has been in any merger that there usually is some opportunities available from displacement of people or people not being happy with certain relationships. So, we are well-positioned around the country. We have lots of branch offices all over the place, and I'm sure all our people will take every opportunity to try and grab some of the business if some would become available.

Kevin Barker – Friedman, Billings, Ramsey

Okay, great. One last question. Do you have any updates on what you're seeing out there with the soft economy, some added color around there? Do you see rates coming down or anything like that?

John Corcoran

Sure. As far as the construction economy ahead is slow as I said in my comments, and it's – fortunately the public construction sector has held up pretty well and there's still growth in it. So, like I said I think 80% of our business comes from public – our contract surety business, anyway it comes from the public construction arena. So, we're hoping that – we've continued spending in that area. The results of the surety industry have been pretty good. 2007 was a good year. Early results have shown very good result. So, the competition remains healthy. Fortunately, it hasn't gone to the point of causing significant price declines of any degree. We haven't had to compete on rate or the competition has been on terms and conditions whether it be indemnity or just the capacity you are willing to give somebody given a certain financial statement. So, we're hoping that we don't degenerate into a price competition like some of the insurance lines. It's held up pretty well to date. And I think things like the merger of Liberty and Safeco might only help support the pricing to some degree because this is one last competitor in the market. So, time will tell. It has been very profitable and when it is that profitable a lot of the management in the insurance companies want to share your line to grow more and that becomes more pressure to do that, but hopefully, if the competition remains sane. So far it has.

Kevin Barker – Friedman, Billings, Ramsey

Okay. Do you expect to increase your recruiting efforts as a result of this merger, or it's tough to tell right now?

John Corcoran

Tough to tell. It's only been two day. So, I really don't know. Sure, we certainly entertain talking to people where we would happen to have needs should they become available. But really it's way too early to tell.

Kevin Barker – Friedman, Billings, Ramsey

Yes. That's it for me right now. Thank you.

John Corcoran

Okay, thanks

Operator

And that is star one to ask a question. We'll go to Rohan Pai of Banc of America.

Rohan Pai – Banc of America Securities

Hi, Good morning John. In your opening remarks, you've said that incurred loss activity was actually down from 2007. There's been some press reports in recent weeks where's we've seen increased disputes between sureties and some subdivision contractors. Have you seen that kind of activity increase at this point?

John Corcoran

Not for us, no, it's been relatively quiet. I mean, as I said probably in some other calls, our strategy had been and continues to be to fairly well concentrate on the largest of home builders in the country. The top ten other 12 let's say. And to date, none of them have gone into bankruptcy or anything. So we really haven't had to claim activity to speak of. There's been some regional failures around the country and fortunately, we stay away from those. I think we had a teeny bit on the one but we haven't had any claims on it. So really we just don't have the experience yet. I've seen some of what you're talking about. Even talking around the industry was some of the defaults of either had happened or hasn't been a great amount of claim activity, but we'll see. The housing market obviously doesn't seem to be getting any better at all, and this will be somewhat of a learning exercise to see how some of these play out as far as some of the regional guys go. So, right now, so far, we don't have that experience as far as CNA Surety goes.

Rohan Pai – Banc of America Securities

And any view on how the contractors are faring today maybe relative to the first quarter of 2007? What is the strength of their balance sheet, their cash flows and things that many of your – maybe home builders versus commercial clientele [ph]? Are they still unhealthy or do you see increased signs of stress?

John Corcoran

No, actually, let's separate the two from home builders from the regular construction clients, the road builders, the general contractors, the electrical guys, all those guys. Really, we're continuing to see near record levels of profitability in these companies. I mean their backlogs are still very healthy. Doug Hinkle and I, Chief Underwriter, we travel around a lot, visit with lot of clients, and generally we hearing is the bid list are longer, there's more competition, and so it's getting harder to get work at the margins they had gotten the past few years. But they have healthy backlogs right now. So, you're really talking more of them trying to fill up a backlog for 2009. And that's going to be the question mark, 2009, 2010. But with that said, their balance sheets are very strong, their cash flows are good. This is a generalization. But in general what we see is that, we'll see into '09 if the backlogs start declining, they still have very healthy balance sheets to get to that as well. So, we think that'll be a little while there.

On the home building, you probably know as much about as we do. You fairly follow them all. And it's a matter of cash flow generation from them and negotiation with the bancs to a great degree because the volume (inaudible) there and as the volume has gone down, they had to renegotiate lending terms and whatnot. But they do most of the ones we bond anyway, the larger ones have generated a decent cash flow activity still because they haven't been following the cash they generate back into new land acquisitions. So they seem to have the ability to meet the current payments at least for most of them that we watch and have been able to negotiate terms to extend out some of the debt and that cause themselves to have to trip every quarter. But it bears a lot of watching. There's no kidding anybody. It's a very, very difficult time, but again, I think I've mentioned before we have attempted to keep our exposures pretty much on all of them in line with our reinsurance capacities and our capital base. I mean, a problem for us in one of those home builders is no worse than a general contractor and electrical going broke. I mean we keep the same relative amount of exposure or less really in some case with them as we do on other types of clients. So, even in the worst case scenario here, we are hoping we've the managed the exposure such that it wouldn't dent us too horribly.

Rohan Pai – Banc of America Securities

And could you just remind us I know you said IBNR grew but could you remind what the – where IBNR stands at the end of the first quarter?

John Corcoran

Sure. At a net basis, IBNR is up $223 million up over $16 million in the quarter.

Rohan Pai – Banc of America Securities

These are the questions I had. Thank you.

John Corcoran

Thanks.

Operator

As a final reminder, that is star one if you would like to pose a question at this time. And no one else is in the queue. I'll turn the conference over to Mr. John Welch for any additional remarks.

John Welch

Okay. Great. Thank you all again for joining us this quarter, and as always, if you have any questions, please do not hesitate to contact John Corcoran or myself. Thank you.

Operator

And that concludes today's conference call. We thank you for your participation. You may disconnect at this time.

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