CNA Surety Corporation Q2 2008 Earnings Call Transcript

| About: CNA Surety (SUR)

CNA Surety Corporation (NYSE:SUR)

Q2 2008 Earnings Call Transcript

July 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

Randy Binner - FBR

Rohan Pai - Banc of America Securities

Operator

Good day everyone and welcome to CNA Surety Second Quarter 2008 Earnings Call. As a reminder, today's call is being recorded. For opening remarks and introduction, I'd like to turn the call over to Mr. Thomas Pottle. Please go ahead sir.

Thomas Pottle

Thank you. Good morning everyone and welcome to the CNA Surety Corporation's second 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 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 good morning everyone, and thank you for joining us once again this quarter. As you've noted in our press release, second quarter net income grew over 10% to just over $24 million and nearly all of our reported numbers continued this positive momentum. Although premiums were down slightly expenses and loss reserves remained under control. John Corcoran will give you greater insight into the details in a few moments.

Suffices to say these are very challenging times and we are very pleased that our underwriting results and investment portfolio held up very well. Over the past five years we have purposely emphasized exposure management and expense control.

We have positioned our portfolio such that exposure to large credit values should be contained within our reinsurance limits than it was to be comfortably observed within our solid capital base. We understood that maintaining exposure discipline could limit top line growth to some degree still we were able to maintain a healthy top line due to significant Newton acquisitions and a strong construction economy.

The actions we started five years ago have already helped CNA Surety remain strong in a weakening economy. As the economy overall and the construction economy in particular continued to deteriorate, our past efforts should help us further weather the storm.

Same general comments could be made about our investment portfolio, portfolio where we have also remained conservative. This may have meant lower short-term returns, but for the long-term we are positioned with a relatively healthy portfolio going forward.

Finally our attention to expense control in the past five years should also help us as our revenues become challenged. We have kept the expenses under control through a combination of controlled headcount aided by processing efficiencies. While pressure will build on the expense front we are able to confront this pressure from a base to the lowest expense ratio we have had in many, many years.

All the items mentioned have positioned us to the slowing economy. So far the construction economy is a tale of two worlds. The residential market has contracted considerably, but has been offset for the most part by commercial building and public works.

I've had varying projections going forward, most indicating 2008 will hold up well, but 2009 will most likely see signs of deterioration as public spending and commercial building will not be able to continue, softening the fall of the residential market. The impact is already being felt in many areas we service. Although our default rates at present are very good, we could see pressure in this area over the next few years.

Even with these challenges, we feel very good about how we are positioned in the current cycle. Given our solid foundation, we can continue to seek quality new opportunities. We continue to expand in some new geographic areas, and we have had some success in the large commercial area. With our expanded capital base we have been able to grow with our customers.

While I'm not sure we can completely offset market forces with our efforts, we should at least be able to maintain a reasonable top line. Most importantly, however we will be the last ones. We feel all the work over the past five years with credit modeling and exposure management will pay off for us over the next few years. Our efforts may already be seen in our current results. As many of the credit institutions in the US are struggling badly, we continue to grow earnings.

With that overview, I'll let John cover the quarter's results. John?

John Corcoran

Thanks John. Good morning everyone. We've reported net income for the second quarter of $24.1 million or $0.54 per share compared to net income of $21.9 million or $0.50 per share for the second quarter of 2007. For the first six months of 2008, net income grew to $47 million or $1.06 per share from $42.6 million or $0.96 per share for the first six months of 2007. The 10% growth in net income for the quarter and year-to-date is driven by higher earned premium, higher investment income, a lower expense ratio and lower realized investment losses.

While we are proud to have generated strong earnings growth during this difficult economic environment, we are experiencing some pressure on the top line. Gross written premiums were down 1.3% for the quarter; this decline was focused in our traditional contract and small commercial, business which were down 2.1% and 1.5% respectively. We believe that these declines are driven by lower demand as a result of economic condition.

We were pleased however that we saw top line growth from two parts of our business that we had identified and invested in as growth opportunities, our large commercial and small contract businesses. These businesses grew by 4% and 3% respectively in the quarter and more importantly especially for the large commercial business this growth was achieved on maintaining our conservative underwriting standards.

We continue to be pleased with the level of loss activity. We again experienced very modest case incurred activity in the second quarter continuing the strong experience we enjoyed in the first quarter of 2008 and in 2007.

This low level of case incurred activity results in a strong growth in our IBNR reserves. Net IBNR reserves grew by $14 million during the quarter and $30 million year-to-date. We have begun our normal actuarial review using data through June 30th. We typically receive the results of this analysis during the third quarter.

The expense ratio declined again to 53.3% down from 54% for the second quarter of 2007 and down from 53.9% for the first quarter of 2008. This improvement continues to be driven by our ongoing focus on expense management, growth in earned premium and lower reinsurance costs.

Investment income for the quarter was $11.7 million up from $10.8 million for the second quarter of 2007, due to the increase in invested assets which more than offset the impact of lower short-term interest rates.

Our investment portfolio was again impacted by down grades of bond insurers and back an MBIA lost their AAA ratings during the quarter and FIGIC was further downgraded. These actions impacted about 40 of our Municipal bond holdings and one of our two holdings with exposure to sub-prime home loans. These securities are now rated at the higher of the bond insurers rating or the bond issuers underlying rating.

As we have said in the past all of our Municipal holdings have strong underlying rating and all remain investment grades and average AA rating. The downgraded security with sub-prime home loans is now rated below investment grade by S&P and investment grade by Moody's. The other sub-prime holdings remains AAA rated.

The book value of our sub-prime holdings again decreased slightly to $9.2 million due to pay-downs in the quarter. These downgrades did cause the overall credit rating of our portfolio to drop from AA+ to AA.

We hold approximately 53 million of Freddie Mac and Fannie Mae bonds and approximately 90 million of the Agency CMO and Mortgage Pass-Throughs. We hold no preferred or common equity of Fannie or Freddie.

At quarter end, invested assets and cash totaled $1.57 billion up about 3% from year end. Operating cash flow for the second quarter was $35 million compared to $19 million for the second quarter of last year. For the first six months of 2008 operating cash-flow was $54 million compared to $33 million for 2007.

I should note that we did payoff a large claim in early July. The payment was approximately $49 million on a bond that was written in 1999. We've had our net retention fully reserved in this case since 2003. Subsequent to our payment we've billed our reinsurance for approximately $25 million of recoverables related to this claim.

We've had been holding funds in short-term investment at June 30, in preparation for this payment. That outstanding remained at $31 million at quarter end. At June 30th, our bank credit facility expired; we had not drawn on that facility for sometime and choose not to renew it.

Statutory surplus grew to $485 million at quarter end, resulting in a net written premium to surplus ratio of 0.9 to 1. At quarter end our consolidated stockholders equity increased to $704 million or $15.95 per share.

That concludes my remarks. So, we will now open up the call for your questions.

Question-and-Answer Session

Operator

(Operator Instructions).And we will go first to Randy Binner from FBR

Randy Binner - FBR

Hi, everyone. John Corcoran, I just want to follow-up on one of those last pieces, you mentioned that the claim was paid in July and so there wouldn't be any unusual. I am unframed from that there is no unusual loss ratio effect for the third quarter and did that impact to some extent the lower investment yield we saw in the second quarter?

John Corcoran

Correct. The only impact of this claim payment would be cash and we positioned the portfolio with a higher short-term component in preparation for the payment. And with short term rates being down, that did push our yield down a little bit. As I said this claim has been -- we started net retention and this claim was fully reserved back in 2003 in older bonds and just finishing up the case.

Randy Binner - FBR

Okay and then with the re-insurers, have you been in contact with them already, are there any re-insurers counter party that have lower ratings?

John Corcoran

Yes we have in contact and we expect no issues associated with recoverables.

Randy Binner - FBR

Okay. That's great and then I guess mentioning statutory capital and this is probably may be more of a question for John Welch. So your premiums surplus is coming down its actually 0.88 times now. You let the bank facility go. I would argue there is some excess capital in the organization and there is no capital returns. Also John you mentioned at the top of the conversation that you expect to be able to whether the economic storm because you do have that capital base. So, can you just walk us through how you think of returning capital to shareholders versus needing to keep it for potentially economic issues?

John Welch

Yeah, we are happy to have the good results and we do discuss the capital management every quarter with the Board. We realize that the topic, that as we continue to do well, we need to address. I guess we've just been stalled down a little bit over the last number of quarters. Looking forward while everything does look positive for us and we feel very good that we've controlled the exposure base of the company and we have tools in place to monitor things.

You know, you hate to be too presumptuous that you are going to outsmart the whole market and avoid some credit issues. I would hope we don't and I think the way we manage the portfolio, any single failure isn't going to hurt us like it might of five or six years ago. So, I guess the question remains to be seen is how deep this problem goes in the economy and if it went real deep I guess you could have a frequency issue not a severity issue but a frequency issue that could cause you some difficulty.

So, I guess we're just being cautious as much as anything, really, and we may think we're smart and have everything under control, but you know it's kind of way to save money for an unforeseen event. You don't know what you don't know. I guess these things -- hopefully we see some better economic indicators I think, and if we continue to have these results this is going to have to be given some more consideration.

Randy Binner - FBR

Okay, fair enough and then just one other question. I think the stock has definitely, has a tendency to trade more to tangible book than stated GAAP book value recently given. Can you just give us maybe some color on or review of what the quality in your opinion is of those intangibles and how they came on, and just provide us with more of that story to understand the difference, there is a pretty big difference. I have 15.95 for state of booking, 12.81 for intangibles. So, just some color on the difference between that would be helpful.

John Corcoran

I'll take that Randy its John Corcoran. The goodwill and some other intangibles were born of the formation of CNA Surety and really relate to what we call the small commercial book or the former Western Surety book. We would say given that that those that goodwill and intangibles is very strong. That's a business that produces very strong profitability at very low volatility it's just a franchise that we're frankly thrilled to have and we think easily supports the goodwill values.

Randy Binner - FBR

Great, thank you.

Operator

(Operator Instructions) Our next question comes from Rohan Pai from Banc of America.

Rohan Pai - Banc of America Securities

Hi, good morning. First question for John Welch, I guess we were slightly surprised that you are growing the large commercial book. If you can just tell us where these opportunities are and how the business differs hopefully from the kind of business that caused problems in 2001, 2002?

John Welch

Sure Rohan. We about a year ago, I'd say, a little more and a year ago, really we decided we'd get back into the game a little bit and the line has been very profitable since people changed the underwriting approach probably three, four years ago now actually. If you look at that line of business even over a 20-30 year period, it's probably more profitable than the contract business actually.

So, I think it was more a matter of doing it the right way and so we decided to try and find some talent that we thought could make a difference, we thought we did find an individual that could lead the direction and his strategy essentially has ended up telling nicely would the way we think here as well and that is essentially to keep the -- again as I said earlier the exposures controlled, that's a big key.

Our exposure base these days probably for a single risk is four to five times less really than we took on back when we were having difficulties. We also are not entertaining certain types of bonds that I'd say the industry almost really just kind of created to create demand those things are kind of gone by the waste side; nobody is really right now including ourselves anymore.

So I think between just low on your exposure base for risk and staying away from more or less these demand instruments that we really didn't exactly know what we were probably doing way back when I think we can stay controlled. He's got, his mandate is some commercial, but he also writes in that unit now we're also writing some, its not reported in the public numbers but as unit reports he also writes some contract business related to the larger corporate accounts as well. So he's not just having to be focused on one area and having to meet a budget of a certain number and we think that helps as well for him to have the right approach and attitude towards the business.

So far, while it looks like its nice growth and its nice to report, again remember it's a pretty small percentage of our portfolio overall and so its probably not going to drive our numbers greatly one way or the other.

Rohan Pai - Banc of America Securities

Thanks for that and I guess if you can -- these new opportunities any of that coming from the Liberty Mutual [fiscal] merger?

John Welch

Not yet. That's still yet to unfold pretty much, we do see possibilities there though quite frankly, because they were both decent players, significant players in the commercial area and as they look at their aggregations as a combined company I would imagine -- I don't know but I would imagine they might decide to bring in some other partners on some of those risks if they are not comfortable with their aggregations. So we do think that's a possibility, but so far no.

Rohan Pai - Banc of America Securities

Okay, and John if you can just give us an update on what you're seeing in the marketplace outside of your own book, maybe just the health of contractors, the health maybe in small commercial large commercial. Have there been any defaults and how do you assess it relative to a quarter ago?

John Welch

Well, we have been kind of watching the results kind of roll in for the quarter and just trying to see at least from a top line how everybody else is faring, we saw Travelers and Sheldon and their results, they were down a bit as well. So we were actually comforted a bit that our decrease wasn't something we are doing, but more of an overall economic situation. We did notice some surprise, some losses and some other results that weren't really aware of.

Overall, the industry actually is continuing very profitability. I mean year end 2007, I think the Surety Association reported roughly a credit loss ratio of around 19%. So still and that was on top of 11% a year before. So still very strong and 2008 no short of what [Chub] reported earlier today or yesterday, I haven't heard of any other significant problem. There has been concern in the homebuilding industry and how that would affect the surety industry. But so far that's talking with reinsures that's yet really to cause any significant problem.

In the small commercial, that continues to be pretty competitive, loss trends are really not much different than they have been. Large commercial we talked about already. So, overall, it's still pretty good, the competitiveness is increasing because of those positive loss results. Everybody wants to ride a little more surety business, so it hasn't really reduced pricing to any degree yet, but we are watching it because again I think as revenues contract, everybody is going to want to try and get some more and they see this is a profitable line and that's when things start to deteriorate. So, we're going to have to maintain our discipline and try and first hang on to what we got and then hopefully find some new opportunities as well.

Rohan Pai - Banc of America Securities

Thanks for the detailed answers.

John Welch

Okay, thanks Rohan.

Operator

It appears we have no further questions at this time. Mr. Welch, I will turn the call back over to you sir for any additional or closing remarks.

John Welch

Okay, great. Thanks for joining us and should you have any further questions, please do not hesitate to contact John Corcoran or myself. Thank you.

Operator

Ladies and gentlemen that does concludes today's conference we thank you for your participation and hope you have a great day.

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