CNA Financial Corp (CNA) 2006 Q2 法說會逐字稿

Good morning, everyone and welcome to CNA Financial Corp. second quarter 2006 financial results conference call. This call is being recorded and webcast. During the next few weeks, this call may be accessed again on CNA's website at www.CNA .com. With us this morning is Steve Lilienthal, CEO; Craig Mense, CFO; and Jim Lewis President of PNC Operations. Any statements on this call related to public securities offerings are not prospectus, and are not an offer to sell securities. During this call, there may be forward-looking statements made and references to non-GAAP financial measures.

Please see the section of the earnings release available on CNA's website headed forward-looking statements with regard to both. The forward-looking statements speak only as of today, August 1, 2006, further, CNA expressly disclaims any obligation to update or revise any forward-looking statements made during this call. There will be time for questions from the investment community following the conclusion of CNA's remarks. Members of the news media may call Charlie Boesel at 312-822-2592 or Katrina Parker at 312-822-5167 and investment analyst questions may be directed to Jack Hanrahan at 312-822-6586 or David Adams 312-822-2183. And with that I will turn the call over to Steve Lilienthal.

Thank you, operator. And good morning, everybody. And thank you for joining us today. CNA's second quarter for 2006 was a strong quarter by every measure, net income, net operating income, sub 100 combined ratios, production, expenses, cash flow, services, and the like. Return on equity for the quarter was 13.6 and is now 12% for the year to date. We are pleased with, but not satisfied with these results. There is still more to do, but we remain confident in our ability to do so.

Net operating income for the quarter was 305 million, up 12% from the 272 million in the prior year period. Net income was down -- was 239 million, down from the 290 in the same period. Key drivers were solid performance by our core property casualty operations and strong investment income. Net income for the quarter included net realized investment losses of $64 million. Last year, our second quarter earnings benefited from $115 million tax settlement offset in part by a commutations loss.

This year our second quarter earnings are the result of the fundamentals of our business. Solid operating results, strong investment income, and disciplined expense management. Year to date net operating income was up 16% to $539 million, and net income was down 1% to 468 million. Year to date results reflect the factors already mentioned.

Turning to our core property casualty operations the combined ratio was 95% for the quarter and 96 for the year. Production was healthy, retention was strong, and new business was appropriate for the market. Calendar year and accident year loss ratios in the mid-60s reflect the improved quality of our book of business. Expense ratios, 29.9 for the quarter, 29.8 for the year, are well below expense levels of the past few years. Despite continued market pressures, we feel reasonably optimistic and upbeat about the ability to sustain this level of performance. Challenges and threats abound, but things are moving in the right direction, and we are executing quite well on all fronts. A few more words about the second quarter.

In 2005, and even more so in 2006, we are seeing the continued emergence of the fundamental attributes of a winning company. Our operating platform remains stable, our distribution plant is robust, production metrics, rate retention, and new business are all showing the strength of our front line, catastrophic risk has been hedged as best possible by way of exposure reduction, and even better reinsurance purchasing and by the way our initial estimates for loss for the storms of '04 and '05 continue to hold. Several targeted growth segments are beginning to bear fruit with a few more on the horizon. Expenses continued improve, noncore businesses continued to operate in an orderly fashion, the balance sheet is stronger and more transparent, Craig will be providing a brief overview of a refinancing initiative that will help us even further financially, finite reinsurance is becoming a thing of the past and rating outlooks have improved and most recently on our AM best ratings.

In summary, it was a strong quarter -- it was a strong quarter and year to date. Not that we are declaring victory, steps remain, and we cannot ignore the impending hurricane season. Having said that we feel good about our consistently improving results, and we have the people and the strategies in place to take them to the next level. Now, let me turn the call over to Craig. Craig?

Thanks, Steve. Good morning, everyone. I'm very pleased to be reporting on our second quarter results. For the past few quarters, we have been demonstrating solid improvement in CNA's performance. You can see this continuing story in a big way in the results we are presenting today. With respect to every major driver of results, underwriting, production, claims, cash flow, investment income, and expense management, CNA had a banner quarter. The bottom line earnings were strong, and operating ROE was a very respectable 13.6%. Well above our cost of capital. Overall, the second quarter results reflect everything we have done and continue to do to make CNA a leading competitor in the commercial property casualty marketplace.

Now, I would like to give you a bit more detail on the financials before turning it over to Jim Lewis. Today, we reported net operating income from continuing operations of 305 million, or $1.11 versus net operating income of 272 million or $1 per share in the prior year period. Net income for the quarter which includes the impact of discontinued operations, as well as realized investment gains and losses, was 239 million, or $0.86 per share, compared to net income of 290 million, or $1.06 per share in the prior year period. You will recall that these per share amounts include the impact of undeclared preferred stock dividends.

As Steve mentioned, the period over period comparisons are even more impressive when you consider the boost in prior period results from the large tax settlement. Year to date, net operating income from continuing operations was 539 million, or $1.95 per share. Versus net operating income of 464 million, or $1.68 per share in the first half of 2005. Year to date net income was 468 million, or $1.68 per share versus 475 or $1.72 per share for the prior year period.

Property and casualty operations produced net operating income of 277 million in the second quarter, versus 181 million in the prior year period, a 53% increase. Key drivers were strong net investment income, continued positive trends in production and expenses, and minimal net prior year development. Which this quarter was a favorable 12 million, after tax, versus an unfavorable 33 million in the prior year period. With respect to life and group noncore, we were flat period over period. At 5 million in net operating income for the quarter, this segment continues to run within expected and acceptable ranges.

The Corporate segment benefited from an $8 million after-tax restructuring reserve release, and improved investment income. You will recall that the prior year period included $115 million tax benefit, and a $36 million commutation charge. The comparable operating earnings numbers are 23 million this quarter, versus 86 million in the second quarter of '05. Netting out the unusual items, this segment continues to perform at appropriate levels, if not a little better. Pre-tax net investment income for the quarter was 552 million, up from 539 million in the prior year period. The major drivers were improved period over period yields, especially short-term yields, and a $20 million reduction in interest expense, primarily as a result of the reinsurance commutations in 2005. Our invested asset base continues to grow. Our positive cash flow generated a further increase in the book value of invested assets of 143 million from first quarter to second quarter. Our book value of invested assets is increased by approximately 1.1 billion since the second quarter of 2005.

I would also mention that our reported second quarter investment income results were dampened by a $9 million loss from our trading portfolio, that is largely offset by corresponding decrease in policy holder funds reserves. After tax realized investment losses for the quarter were 64 million, compared to the realized gains of 16 million in the prior year period. The majority of the losses were the result of selling investment grade securities in a rising interest rate environment.

Turning to expenses, the property and casualty second quarter expense ratio was 29.9%, which follows a first quarter expense ratio of 29.7%. Steve Lilienthal is fond of saying two quarters does not make a trend unless it is bad. And there is some seasonality in our spending levels. While we have much more work to do, we are pleased by these unmistakable indicators of our continuously improving expense discipline and our greatly improved expense competitiveness.

Before turning it over to Jim, there is one other item of note. Earlier today, we announced our plan to retire the series H issue of preferred stock, which we sold to Lowe's in 2002. The retirement would be financed through the issuance of -- by CNA of additional debt and common stock, approximately equal proportions. We trust that you share our view that this is another positive step forward for CNA. It will eliminate a relatively expensive source for capital, simplify our balance sheet, and improve our capital structure. Further, the plan should not be dilutive to earnings per share. While our Board has authorized management to proceed with the plan, no binding commitments have been made to go forward, I would emphasize that the timing of any determination to proceed would be subject to market and other considerations. Please see our 10-Q for a further discussion of this plan. With that I will turn it over to Jim.

Good morning, everyone. Property and casualty operations continued to perform well with the second quarter combined ratio of 95%. Operationally, we continue to emphasize disciplined underwriting, retention of quality business, and controlled new business growth. As we have said before, the first step in our turn-around was to rebuild our book of business by reducing risk assumed and achieving significant rates. Now, we're building on that base steadily and profitably.

Property and casualty operations gross written premium was up approximately 3%, to 2.3 billion in the second quarter, and up 3% to 4.7 billion year to date. The underlying gross written premium was up about 2% for the quarter and 3% for the year. Our specialty lines was up 3% for the quarter, and 5% for the year. On a net written basis, premium plus was in a similar range, approximately 3% for PNC operations, for the second quarter, and 1% for the year. Overall, our premium volumes continued to reflect collective growth as opportunities present themselves. In the standard lines we like the property market, rates are favorable and we're able to control coastal exposures with higher deductible and lower win limit. In specialty we continue to see a range of opportunities to write quality business at prices we like.

Now let's look at rates. For the second quarter, average rates and standard lines were flat while specialty lines was up slightly. We are achieving significant rate increases in large property. Overall, though, the rate environment has been stable for the past year or so. I would also say that our underwriters continue to be very vigilant with regards to appropriate rates, terms, and conditions.

Turning to retention, we have been running in the low 80s now for three consecutive quarters, likewise we would expect to see a strong stable book of business. I would remind you that in '04 our average retentions were in the low 70s as underwriting initiatives played out. A big driver of improvement has been standard lines. Today, we have a much less quality standard lines book of business, and our underwriters are doing a good job of hanging on to the risk we want without sacrificing rate. Meanwhile specialty lines continues to shine with retention in the mid to high 80s.

Now let's turn to new business. We wrote approximately 375 million of new business in the second quarter. This represents approximately 20% of total production. Right about where we should be under current market conditions. We dialed back on new business over the past few years due to market conditions. That being said, we have some proven capabilities for bringing in the new business we want. You have heard us talk about focus on selling more of our products to every customer. Over the past three years, cross-sell initiatives produced 1.5 billion in new premium that might otherwise have been left on the table. We built on this momentum in the second quarter, with an additional 165 million of cross-sell premium, approximately 44% of total new business written.

We like cross-sell business for a number of reasons. When we sell more coverages to our customers, we are leveraging the full range of our product portfolio. But also, deprives our competitors of a foothold into the account. The net effect is improved retention, greater underwriting insight in the account risk profile and a much more efficient market and outreach. In addition to cross sell we continue to monitor our new business metrics. For instance we watched the spread between new and renewal price. We also tracked the spread between paid and case lost ratios for new business and renewal business. Quantitative measures like this are at the heart of a controlled selective new business strategy.

Now, let's turn to our loss ratios. For the second quarter, the property and casualty net calendar year loss ratio was approximately 65%. A 5-point improvement over the prior year period. The improvement was largely driven by our prior year development, favorable this year, versus unfavorable last year. In addition, second quarter '05 results included the impact of a loss in the surety line of business. The same drivers are evident in the standard accident lines second quarter loss ratios, which came in at about 68 and 61 respectively. And on a net accident year basis, we recorded loss ratios of 65% for P&C operations, 68 for standard lines, and 60 for specialty lines. Overall our loss ratios are consistent with disciplined risk selection, pricing, and claims practices.

Turning to combined ratios, property and casualty operation came in at approximately 95%. The best combined ratio we have reported since we formed P&C operations as a business segment in 2001. A big driver here was specialty lines, where our combined ratio has consistently run into the 90 range or better. Equally important, though, is the steady improvement in the performance of our standard lines. This combined ratio improved 4 points coming in at 99%. In addition, as you heard from Craig, our expense initiatives continue to make a difference. Our expense ratio ran just under 30% for the quarter, and year to date.

As Steve said, we're not declaring victory here but we're encouraged by our continued progress. The summary of property and casualty operations is moving along well, stable rates, strong retention, appropriate new business, expense initiatives that are showing in our results, now, more than ever, CNA is positioned to win in the commercial lines marketplace. With that, I will turn it back to the operator.

Thank you, Mr. Lewis. [OPERATOR INSTRUCTIONS] We will take our first question today from Jay Cohen within Merrill Lynch.

Two questions. The first is within the property, casualty, and investment income, X-ing out the partnership income, and the impact of the financial reinsurance commutation, that kind of underlying number, mostly I guess from the fixed income portfolio, anything unusual there? Is that just mainly a reflection of the higher interest rates that you've seen?

It's just that, Jay. It is mainly a reflection of the increased asset base, and interest rates, particularly the improvement in short term.

Great. And then the next question has to do with the repaying of the series H notes. I was a little surprised that are you going to be issuing equity to help fund this, given that from my standpoint, you look fairly well capitalized, at least within your property casualty business with a premium to surplus ratio kind of comfortably below 1 to 1. And I did the math and you're right, it doesn't look like there is any dilution to earnings from your actions, but had you used just internal funds, it seems to me it would be nicely accretive to earnings. And I'm wondering, why you are issuing equity for this, when you seem to have ample capabilities to just use internal funds.

Jay, it is Craig, again. And that's just -- I would prefer really not to comment on that at this point and just to let that is the plan to issue some combination roughly equal proportions of stock and debt.

Did you consider not issuing equity?

We consider a range of options, and we think -- as we're disclosing to you, we're disclosing to you the current plan as it stands.

I guess just one, not to overdo this one, but were the rating agencies a constraint in this regard at all, in your selection?

No, Jay, we had a conversation with all of the rating agencies, and they were very receptive to our plan.

But had you -- did they cause you to raise the equity basically?

No.

Okay. Thanks.

Our next question will come from Bob Glasspiegel with Langen McAlenney.

I'm sort of excited about the preferred announcement and I'm going to come after yeah's questions a little bit differently. You say it is nondilutive. I mean I actually calculate $0.05 accretion from it, and if you're saying you're going to force your nondilutive, maybe it means your earnings estimate is a whole lot higher for '06 and '07 than what I'm using. So would you quarrel with modest accretion as a possibility?

No.

And it seems to me, the key is, are the rating agencies fired up about this. And you can get an upgrade, rather than are you doing this defensively. I view this as sort of an offensive transaction. Am I crazy to think of about it in that way? And are the rating agencies likely to be, respond positive to this?

Bob, we had discussions with all four rating agencies as I mentioned before. The entire plan was received very positively, in the spirit of it, and then in the structure of it. They understood exactly what we were about and where we were going with it. This was not done defensively. It was done quite frankly, as a very natural act in the evolution of the Company, this is where we're at, and I think what we said about it this morning is about all we can say about it, until we get a little further on here. But at the end of the day, it was received quite well, we don't speculate about ratings upgrades, the fact of the matter is we've had outlooks taken up by three of the four rating agencies and they feel good about our quarter, and they feel good about our capital plan.

You said it wasn't done defensively. You're saying it was done offensively? I mean it was done--.

It wasn't done defensively. It was done as a very natural act in the evolution of this company.

Okay. And releasing reserves of, I don't know how many quarters it has been, have you gone back to check when CNA had a quarter of reserve release, but my guess is that you would not start releasing reserves until you had a very strong comfort level that the base was solid. Is that a fair characterization?

We've take a very conservative approach with respect to our reserve position, and so I guess I would just leave it at that.

Okay. And your general commentary of the market is not bad, not good? Is that a fair?

I think, Bob, that we would characterize it as pretty steady. It softened obviously from where it has been over the past -- if you kind of go year-over-year, or year over two years ago, obviously, market conditions have softened, but kind of softened gradually, and I would say to a certain extent may have even flattened out a little bit in '06. We are very grateful that the market hasn't cliffed, or hasn't softened in a much, much more aggressive way because it allows us to move and shift our portfolio in a very logical, rational way and allows us to kind of manage our expense structure in a very logical and rational way currently with the production side. I don't know, Jim, if you want to add anything to that.

I would consider this really a rational market. When you look at where our rate levels have been, they have been consistently flat now for three consecutive quarters. And the only place where we're seeing a significant uptick in the rates is in the large property, especially anything that is involved in any coastal area. Outside of that, the rates have been very stable, and I think the competition is very rational, the only place where we see any increased competition is not so much the nationals, but with the regional companies, as they move outside of their appetite and start driving large or middle market business. But all in all, we're very comfortable to where this marketplace is, and this is a healthy marketplace to compete in.

Thank you very much.

[OPERATOR INSTRUCTION] We will now hear from John Lambers with Chesapeake Partners.

Hi, what was -- I don't know if you said this before, and I missed it, but what was the quarter end book value?

It's 31.05, adjusted for comprehensive income. 31.05.

Thank you.

[OPERATOR INSTRUCTIONS]

Operator, are you going to poll the group one more time.

We will take a question from Stephen Petersen with Citadel Investment Group.

I'm sorry. I guess my question was answered and I was going to just follow up. My only question for Mr. Lewis is, I mean, I'm all set, thank you very much.

We have a follow-up question from Jay Cohen with Merrill Lynch.

Yes, maybe a bigger picture question on the underwriting side. The pricing environment has been -- on the standard side, has been fairly flat for the last year. And it looks like your accident year loss ratio is roughly even with a year ago. Which sort of suggests that the claims environment has been pretty benign and accommodating. We obviously have heard that in the personal lines business for some time, but based on your results, and Chub and St. Paul Travelers, and Hartford, it looks like you guys are benefiting from an absence of any claims inflation. And I'm wondering if you can talk about what you think is behind that.

This is Mike Fusco. Certainly embodied in our numbers is a claim of inflation going from year to year. And rate certainly is not quite keeping up with that. So I think you're right, that the '05 to '06 actually our loss ratios are a small uptick up, relatively flat, and it is a tribute to Jim's portfolio optimization work and trying to write the volume in the right areas.

Jay, this is Steve. I think you've heard us talk about in the past, but we have shifted out of a lot of the large cap business, whether it be particularly in the risk management casualty area and some of our specialty businesses, we've shifted out of the higher end businesses that are much, much more impacted by severity trends than are some of the businesses that we've been investing and growing out right now. So while frequency rates have -- while severity rates have moved up a bit, there has been a nice drop in frequency and we've taken advantage of that because we've shifted our portfolio into a more frequency driven business all the while saying we do have presence in the larger marketplace but much, much less than we used to.

What do you think is behind the drop in frequency, because you're not the only ones seeing it.

No.

Do you no he what is behind it, what you have thought about, what are the macro factors that are causing that drop in frequency?

I would like to think, Jay, that it has something to do with the risk selection that we're making and our claims management ability.

Thanks, Steve.

Seth Glasser with Barclays Capital has the next question.

Yes, good morning. Just curious regarding the debt component of the preferred stock buyback. Curious as to whether you're envisioning that as a public bond offering? Whether it would be some kind of a private financing and what the potential maturity or duration of that debt might be?

We'd prefer not really to comment on that, on the financing and if you read -- if you look at the press release related to the financing, disclosed most of the details, and the market conditions will determine and decisions about maturities and other things so we prefer not to comment on that at this time.

Fair enough.

Ryan O'Connell with Citigroup has our next question.

Thanks. This is just to get a little bit more color on what has been going on with cash flow from operating activities, and year-over-year, it is down about 500 million. Now, I know last year, you got about 340, when you commuted the reinsurance contract, but I was wondering if there were any other unusual items in the operating cash flow.

Are you looking at--?

I'm looking at page 3 of your supplement.

The supplement?

Yes, so in round numbers it went from about 800 last year down to about 300 this year in terms of operating cash flow.

And the majority of that is related to the commutation.

So nothing else unusual going on.

Further questions, operator?

We will hear from Gary Ransom with Fox-Pitt Kelton.

Yes, good morning. I had a question on pricing. And just not so much about what the overall rates are moving, but if you were making any progress, or changes in how you're segmenting the market, in terms of the commercial line? I mean a little bit behind this question is they've made -- so much progress has been made in personal lines, but some of the same concepts are applicable in terms of predictive modeling and the like and the commercial lines. Are you doing anything there, any particular segments where you think you might -- you've made some progress?

On the predictive modeling side, we already used predictive modeling for our small business arena, and we are -- roughly about a year ago, we implemented predictive modeling for our middle market segment. And we're using that as we're looking at setting our prices and then geographic territories. On the overall small business side, because we've had it in place for a couple of years, it has really proven to us that it has had a significant impact on improving the loss ratio. On the middle market side, we feel comfortable that it is going to assist, but it has just been too early. It has only been a year of having that data.

The other thing that we're doing on segment, in the overall book, is that we've been working towards portfolio optimization within our standard line portfolio. And that is is really to grow the more profitable segments within that book. And as you see our growth in the second quarter, and also year to date, I think it is reflective of those actions where we are growing property business, we're growing in our middle market, especially in manufacturing and technology segments, we're also growing in small business. Right now, small business only represents about 10% of our book. But we want to get -- take our current volume of small business, and double the size of our small business portfolio. We've made a significant investment in the small business arena. Our overall specialty lines portfolio, I think, has been segmented for some time, performing very nicely with combines of 90 or better and that's a place where we're still continuing to invest in the growth of the future.

Are there any particular initiatives in that area that might be coming on next year or so?

The one that we are probably closest to is in the middle market side, where we are coming out with a new product and we will be targeting additional classes of business, within SIC codes within the middle markets. What we want to do is get to more rather than just being a generalist, but to also provide more dedicated focus, and more expertise of our underwriters and also products that go after specific industry segments and the first for the manufacture and technology, soon to be followed by the real estate business itself, retail business, and others. And the specialty portfolio, we're continuing to build out the things that we already do, and we're actually going to be building out and complementing the same arenas that we're in. We're not going to go outside of the current businesses that we're in. We're just now expanding what we do in those businesses.

Thank you very much.

Gary, this is Steve Lilienthal. I just wanted to add something to Jim's comments. We segmented our commercial portfolio a couple of years ago, probably about three years ago and we think we segmented it appropriately, and what we try to do is to keep that segmentation stable so that we can do accurate and appropriate year-over-year analysis and we're not constantly trying to shift and adjust our management information to figure out where we're at, it also allows you to do that. So we did in fact segment it, it is a very highly segmented book. The specialty book has been segmented for years and we just pretty much left that alone. Secondly when we have a new area or a new segment that we're moving into, you have heard us talk a lot about small business and Jim just alluded to manufacturing and technology and real estate, we start off with those, as a clean segment, and then you will hear us talk about it on these calls. So you can follow these things as we make progress quarter to quarter and year-over-year. So A, we're segmented, B, we keep it steady so you can compare it and we can compare it, and then the new ones, we clearly identify and then we track them and we will talk about them on this call.

Thank you. That's helpful.

We have another follow-up question from Jay Cohen with Merrill Lynch.

Yes, I guess maybe getting back to my original question, not to knock the capital actions you're taking, it seems very appropriate, but it does kind of leave me with a question of capital going forward. Even if you don't grow too much, and have you an ROE in the low teens, it seems that your premiums to surplus ratio could be as low as 80% by year end '07. According to our model. And obviously not the most liquid stocks. It is hard to buy back your stock, but it seems that it leaves you in a little bit of a bind from a capital standpoint. So what's the planning from a capital standpoint as far as how you would deal with an excess position presuming that I'm indeed right and that an 80% premiums to surplus ratio would suggest excess capital.

Just to go back, we're very comfortable and we conceived the plan with a lot of thought about what our capital position was, where we were with total debt to capital ratios, where our coverage ratios were and all of those things. So we're very mindful of that and we're comfortable with where we're landing today on all of that. So we don't have any other capital plans, nor do we feel like we're particularly constrained or lack flexibility. As a matter of fact, the refinancing of the age that would improve our flexibility in terms of what we could do with capital management going further and as you recall one of the significant impediments that it does remove is our ability to pay dividends to common shareholders.

Great. Thank you very much.

[OPERATOR INSTRUCTIONS] And we have a follow-up question from Bob Glasspiegel with Langen McAlenney.

My last comment begs the question whether management is prepared to go to the Board with the consideration of a cash dividend?

I think, Jay, that -- or Bob, that Craig answered that question, I think this arrangement allows us to consider paying dividends to all common shareholders.

So it is something you would be in favor of just directionally, Steve?

I think we would like to be in a position to do so. Just to be clear, Bob there are no--.

I know you haven't done it yet. I understand that. I'm just asking where your biases might be, Steve, as a CEO, where you're going to have some influence on that decision? I know it is not your decision. But you're saying you're positively disposed to the CNA being the dividend payer sooner rather than later.

I think we would like to be in a position to have that discussion.

Okay. Thank you.

And there are no further questions at this time. I will turn the conference over to Mr. Lilienthal for any additional or closing remarks.

Well, operator thank you. Thank you all for joining us today. And I guess this will close out our second quarter conference call. And I think you've already got instructions if there are any follow-up questions as to where you can make those calls. Thank you very much for joining us, and see you next quarter. Thank you.

Thank you. Once again I call your attention to the disclosures concerning forward-looking statements in the earnings release, and as previously stated, at the start of today's call. Please note that a taped replay of today's conference call will be available for one week immediately following this call, until August 8. You can access the replay by dialing 888-203-1112. Or 719-457-0820 for international callers, utilizing pass code 2049827. The call will also be archived later in the day for replay on the Investor Relations pages of CNA's website. Thank you for joining us this morning. We appreciate your participation in today's call.