CNA Financial Corp (CNA) 2006 Q3 法說會逐字稿

Welcome to the CNA Financial Corporation third quarter 2006 conference call. For opening remarks and introductions I will turn the call over to Nancy Bufalino. Please go ahead, ma'am.

Thank you, and good morning. We would like to welcome you to CNA's third quarter 2006 financial results conference call. My name is Nancy Bufalino and I have responsibility for Investor Relations at CNA. 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.

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. Forward-looking statements speak only as of today, October 31, 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. With that, I'll turn the call over to Steve Lilienthal.

Thank you, Nancy. And good morning everybody and thank you for joining us. CNA had a very good quarter, as good as any quarter since I joined the company in 2001. And while we did have help with the winds not blowing, the results were solid regardless of the lack of catastrophe activity. I trust that our discussion today will convey a very simple and very upbeat message.

In the third quarter of 2006, CNA delivered more than $280 million in net operating income for the quarter, and $800 million plus for 9 months. We delivered sub 95% combined ratios in our core property casualty operations, we delivered sub 30% expense ratios for the third consecutive quarter, we delivered double-digit ROE's for the third consecutive quarter, book value per share was up about 11% for the quarter and we're very pleased and proud to be able to pay back $1 billion to our parent Lowe's through a refinancing that improved not only our capital structure from a cost standpoint, but also from a transparency standpoint. Craig and Jim will provide more detail on each of these items in a moment.

Overall what you see in the third quarter are results of a good business well run, well-positioned, performing well, and consistently improving. A bit more on the financials. Third quarter net operating income was $283 million. Net income was $311 million. Before the impact of catastrophes, third quarter NOI was up 16%, net income up 8%. The drivers were solid performance by our core property casualty ops business, disciplined expense management and strong investment income.

Year-to-date, net operating income was $822 million, net income was $779 million. Apples-to-apples, before catastrophes and significant commutations, year-to-date net operating income was up 11% from the prior period, and net income was slightly down at 2%. The drivers of our third quarter and year-to-date operating results were essentially the same.

Turning to our core property casualty business, we reported a combined ratio of 94.5 continuing the favorable progression seen all year. By the way, our 2005 hurricane estimate continued to remain unchanged, which we feel is significant not only from a claims handling standpoint but reflects well on our data quality and our ability to estimate expected loss levels. Third quarter production was healthy, average rates were flat, retention was strong, new business at 20% of the total premium was appropriate for the market, and exactly where we told you it would be. The property casualty ops expense ratio is a clear reflection of our improved expense competitiveness, as well as our aggressive, persistent and very granular approach to expense management.

Despite anticipated market pressures we feel reasonably confident about our ability to build on this level of performance going forward. With respect to the market conditions we continued to see slow incremental movement in rates consistent with prior quarters. While the property cat market will likely remain firm we remain somewhat guarded about the rest of the market.

Still, we believe CNA is well-positioned with a highly diversified portfolio, well spread geographically, by business segment and by line of business. Steady production enhanced by strong cross-sell initiatives and solid improving margins. Our data quality, our management information, and our ability to segment and subsegment available market niches, particularly in the middle market are key parts of our strategy going forward. Our distribution is solid, appropriate, and matches well with our targeted markets. We are structured and deployed in a very efficient way to pursue our markets of choice.

In summary, CNA has performed well for the quarter and year to date. We are proud of what these results say that CNA is a company that has performed well and is positioned for consistent sustainable performance going forward. With that, let me turn the call over to Craig.

Thanks, Steve, good morning everyone. I'm pleased to be here to share our third quarter results which I see as reflective of a consistent solid performance we have been demonstrating for some time now. I would characterize our progress as both measured and measurable.

With respect to underwriting, production, cash flow, investment income, and expense management, CNA is delivering consistent steady improvement. Third quarter earnings were solid with net operating income of $283 million, and an operating ROE at a respectable 12.8%. Year-to-date, operating ROE is 12.7%. Overall, the third quarter results reflect our unwavering focus on improving CNA's profitability and earnings generating power as well as building the operating fundamentals to manage successfully through market cycles. That is our goal here.

Now, I'd 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 $283 million or $1.05 per share, versus a net operating loss of $39 million or a negative $0.22 per share in a prior-year period.

Net income for the quarter, which includes the impact of discontinued operations as well as realized investment gains and losses, was $311 million or $1.15 per share, compared to net income of $6 million or a negative $0.04 per share in the prior year period. You will recall that these per share amounts include the impact of undeclared preferred stock dividends. Otherwise, this is the last quarter our announced per share results will be reduced by these dividends because of the refinancing plan we completed in August of this year.

Year-to-date, net operating income from continuing operations was $822 million or $3 per share, versus net operating income of $425 million or $1.46 per share in the first three quarters of 2005. Year-to-date, net income was $779 million or $2.83 per share, versus $481 million or $1.68 per share in the prior-year period. Property and casualty operations produced net operating income of $282 million in the third quarter versus the net operating loss of $36 million in the prior-year period. The third quarter '06 results included a $13 million impact from catastrophes versus $294 million in the prior year period.

Other than the swing in catastrophe losses, our core business benefited from strong investment income and continued positive trends in production and expenses. The after tax net prior year development was $7 million for the quarter and $15 million year-to-date. While we are pleased to see a favorable development, we view these as relatively insignificant given our $16 billion net reserve base.

With respect to life and group noncore, the $15 million net operating loss for the third quarter is within our expected range. The favorable period over period comparison was affected by a $17 million provision in the third quarter of '05 for estimated indemnification liabilities related to the sold individual life business. The corporate segment also performed at appropriate levels with net operating income of $16 million. Pretax net investment income for the quarter was $600 million, up from $500 million in the prior-year period, a 20% increase. The major drivers were improved period over period yields, a growing asset base, and a $40 million reduction in interest expense, primarily as a result of the reinsurance commutations in 2005.

Positive cash flow continues to contribute to our base of invested assets. Since the third quarter of '05, the book value of these assets has increased by $1.8 billion. We generated just under $900 million of operating cash flow in this quarter. After tax realized investment gains for the quarter were $22 million compared to realized gains of 42 million in the prior year period.

Turning to expenses, the property and casualty operations third quarter expense ratio was 28.7% which follows a second quarter expense ratio of 29.9%. Our expense ratio year-to-date is 29.4%. Overall, these ratios are a clear indication of our disciplined expense management and greatly improved competitive position, even as we continue to invest in technology, training, and other key capabilities.

We have worked and continue to work diligently to eliminate any remaining expense disadvantage. You will recall that when we started, CNA had been running expense ratios in the mid 30s. We ended 2004 with an expense ratio of 32.1%, and have consistently driven it downward. We ended 2005 at 30.5% and are now well below 30%. We continue to make sustained solid progress. And, in fact, compare favorably to our competitors. But there's more to do here.

Before turning it over to Jim, there are two other items of note. In the third quarter, we issued $750 million in debt and $500 million in equity. We used approximately $1 billion of the proceeds to retire the series H issue of preferred stock, which we sold to Lowe's in 2002. The proceeds in excess of that amount will be used to fund the repayment of $250 million in outstanding notes that mature next month.

These refinancing activities are another foundational step for us in simplifying our balance sheet and improving our capital structure. We increased our public float by approximately 30% and eliminated an expensive security. 8% dividend for the preferred versus approximately 6.3% for the newly issued debt, and one that restricted our ability to pay common dividends. So overall, the refinancing simplified our balance sheet, improved our capital management flexibility, and broadened our investor base.

In the same spirit of both simplifying and strengthening our balance sheet, we commuted another significant reinsurance treaty during the third quarter. Since 2003 total reinsurance recoverables have dropped $5.2 billion from $16.1 billion to $10.9 billion. Reinsurance recoverables as a percentage of stockholders equity have been reduced from 184% to 117% over that same time line.

Unsecured recoverables have dropped in relatively the same proportion while our bad debt allowance has significantly increased in relation to unsecured recoverables, from 5.3% to a current 6.9%. We expect to continue to work to monetize these assets and reduce our dependence on reinsurance. In summary, consistently solid performance on all fronts, operationally and financially. Measured and measurable progress. With that, I'll turn it over to Jim.

Thanks, Craig and good morning everyone. I would agree with Steve, we are pleased with the absence of hurricanes, but even more pleased to be reporting strong consistent performance on every front. The third quarter's all about consistent ongoing execution of the same strategies we've been discussing with you for the past several years.

The building blocks should sound familiar. Portfolio diversification, focus on growing and targeted better performing segments with a big part of our growth driven by cross-sell, segmentation of our $2 billion loan market book by market niches, and careful disciplined monitoring of the quality of our business with new efficiency measures and new business paid in case loss ratios. This strategy has enabled us to achieve consistently in proven results and it positions us well to continue to improve regardless of the market.

Now let's turn to a few of our key operating metrics starting with premium. Property and casualty operations gross written premium was up approximately 6% to $2.4 billion in the third quarter and up 4% to $7 billion year-to-date. Standard lines gross written premium was up about 8% for the quarter, and 4% for the year, while specialty lines was up 3% for the quarter and 5% for the year. On a net written basis, premium growth was in a similar range, approximately 6% for PNC operations for the third quarter, and 3% for the year.

Overall, this is a picture of healthy disciplined premium growth, fueled by growth in our targeted segments. It also speaks to the benefits of our blended portfolio of standard and specialty lines. For several years now premium growth in specialty has outpaced standard. This quarter is the other way around.

While we continue to find good opportunities for profitable growth in specialty, the large property market on the standard side has become quite attractive and our underwriters are right in the middle of it. These are risks we understand and we are able to control our coastal exposures with deductible and wind storm limits. Another growth area for standard mines is small business where our new products and technology platform are making us a much more formidable competitor.

Now let's look at rate and retention. Average rate for PNC operations have been virtually flat for the past year. And we saw more of the same in the third quarter. Rates in standard lines were up slightly, while specialty lines was down slightly. Overall, this is a rate environment in which we can operate effectively. The leveling of rates has allowed us to take a measured approach to adjusting our underwriting and marketing strategy, building capabilities for future growth and farther reducing expenses.

As for retention, property and casualty operation came in at 83% in the third quarter, we have been running in this range for several quarters, with standard retention in the low '80s, specialty in the mid to high '80s. These are the targeted retention levels we've been discussing with you for some time. We finished our reunderwriting initiatives and now our retention is right where we said it would be.

On both sides of the portfolio, we're comfortable with our book of business and we're holding onto it at renewal without sacrificing rates. Our focus is on optimizing the performance of our portfolio. Better risk segmentation and pricing are a big part of this. We're making significant investments to enhance these capabilities. Now, let's turn to new business.

We wrote approximately $373 million of new business in the third quarter, this represents approximately 20% of total production. Right where we have been for the past few quarters and right where we said we'd be when rates start to moderate. Overall, our new business strategy is reflecting continued discipline in a stable to gradually softening marketplace. For instance, we tracked new business quality with a range of quantitative measures, including the spread between new and renewal loss ratios, and the spread between new business pricing and manual rates.

In addition, we continue to generate a good part of our new business by cross-sell initiatives; the sell of additional CNA products to every CNA customer. Over the past three-year cross-sell initiative produced $1.5 billion in new premium. In the third quarter, we produced approximately $149 million of cross-sell premium or 40% of new business. Year-to-date cross-sell generated $418 million of premium or 39% of new business. As we had mentioned in the past, cross-sell gives us a greater insight into the account profile, not to mention a much more efficient marketing outreach. The ability to cross-sell is a CNA advantage that many other carriers don't have and it's well ingrained in the CNA culture.

Turning to loss ratio, third quarter PNC operations net calendar year loss in LAE ratio was approximately 66%, with standard lines coming in at 69% and specialty at 61%. These ratios are in the range we have been running all year long. The 2006 net accident year loss ratios are similar to the net calendar year ratios, 65% for PNC ops; 68% for standard; 60% for specialty.

With respect to combined ratio, property and casualty operation came in at just under 95%. SNA continues to perform as well as anyone out there with a third quarter '06 combined ratio of 87%, standard came in at 99%. There's room for improvement on the standard side, but we do like being the sub 100 club on both sides of our portfolio.

Going forward, we're positioning standard lines for continued improvement by investments and possible segments such as small business and manufacturing, through improved segmentation of our middle market book, better data quality and more efficient segment and claim strategy. In addition, as you heard from Craig, our expense ratios have become increasingly competitive. This is the result of several years of disciplined expense management, a mind-set that's now embedded in our operation and culture.

In summary, property and casualty operation is performing well and closing in on a very solid year. We continue to leverage a diverse portfolio growing our targeted segments, segment our risks, and monitor the quality of our business. All in all, we're well-positioned to manage in, through and around whatever we face in the market. With that, I'll now turn it to the operator for the Q&A session.

Thank you. [OPERATOR INSTRUCTIONS] And first we'll go to Jay Cohen from Merrill Lynch.

Hey, good morning.

Morning.

Two questions. First is, Craig, you mentioned you commuted another treaty, and the details may have been in the press release, I've been on conference calls all morning, so I'm wondering if you can give some details around that? How big was the commutation and secondly, what will the impact be on the investment income going forward?

Well, the treaty wasn't in the press release, Jay, so you didn't miss it. It will be in the Q when you get the Q, which we would expect to file later this week. But you might recall, we had two large corporate treaties, one of which, the largest we commuted last year, the second was what we call the CCC cover, which is a one-year treaty covering 2001.

There was no financial impact in terms of operating income for the quarter as a result of the commutation. It does -- what it will do is add simply reduced reinsurance recoverables by something slightly over $750 million, and add to our reserve base, our net reserve base by $750 million. And in terms of--.

There's no cash transfer, then?

No. And in terms of investment income going forward, or lack of expense, what you'll see is that we're now down to, I think the finite interest expense for the quarter was under $10 million and in future quarters should be running in the $5 to $6 million a quarter range. So it's going to be, we think we're down to a pretty insignificant number.

Great. I guess the next question is maybe a little bit bigger picture and I'm sure I've talked about this before or asked about it, and that is capital. Pay down the preferred, obviously you raised money to do that. So I'm looking at the statutory surplus in your PNC business and your premiums, and just based on our model, well, certainly right now I see a kind of premium-to-surplus ratio, less than 0.9 to 1, 0.89 to 1. I know that's a very crude measure of capital, I'm sure you have very sophisticated measures, but based on that very crude measure, I'm wondering what you think you should be operating at or could be operating at instead of at a relatively low level, I think?

I guess, Jay, the way I'd answer that is that we're comfortable with the capital we have today, the amount of capital we have today. We're comfortable with the structure of the capital, meaning that the debt-to-total capital ratios, our coverage ratios, in terms of earnings, et cetera, et cetera, are today. So that's point one.

Now, I agree with you that the amount, the total amount of capital may be a bit larger than we need for the ongoing operations, but it does give us some flexibility to deal with such things as a reinsurance market, property cat reinsurance market, to make sure we're not pushed into making noneconomic trade. And as we demonstrate, as we go forward and we continue to demonstrate ability to generate consistent and increasingly improved level of earnings, that will give us more flexibility and capital management. So that's really to say that's how we're thinking about it today.

So in other words if your results in 2007 look similar to the results in '06, both from a growth, profitability standpoint, then by the end of the year one would suspect you would have had certainly much more flexibility from a capital standpoint?

Yes.

Okay. Thanks a lot.

And our next question comes from Bob Glasspiegel from Langen McAlenney.

What's this with the idea of a dividend and more substantively, what are the timing as you read the Board, of when that might be feasible to consider?

Bob, this is Steve. The discussion about a dividend to common shareholders is something that we've talked about and we evaluate continuously, and it's something that is a matter of discussion with the Board.

Frankly, we would feel that it would be part of the natural evolution or position of CNA at some point to be able to pay a dividend to all common shareholders. So at this point, we really can't say much more about it, I think Craig said what he had to say about the capital structure, all I can tell you right now is it's something that we discuss and evaluate on a regular basis with the Board.

So you think within the next six months it's possible?

I think we discuss that on a consistent and a regular basis with the Board, Bob, and I don't think we really can say anything more than that.

Okay. Question two, premium growth, slight acceleration, I know there might be some artificial numbers, and Jim your commentaries seem to imply your strategy is to be sort of muted and not have your foot on the gas pedal at this point in the cycle. But in general, is this a time to be growing in commercial lines or are we soon at the point where we know we're going to be contracted?

--commercial lines as long as you're growing in the segments that are performing well. And as we look at growing in our overall commercial lines operation, we've looked at every one of our businesses, identified the top performer businesses from an ROE perspective, those are the businesses that we're making investments in and those are the places that we're growing. For example, small business, small business we're actually up 12% over prior year for the quarter.

We've made a big investment in technology. We've come out with a realtime quote system that makes it much easier for our agents to do business with us. As a matter of fact, it actually positions us not equal to but ahead of the competition. And we just recently received the 2006 award from Applied for our leadership and innovation in developing this system. What this does, rather than the agent having to do double key-in, they can go in through their agency management system, AMS or Applied and access our system and then get a quote realtime without the duplication that occurs.

We've also invested in the product and significantly in the resources. Large property is a significant growth opportunity for us right now. We're getting rates in large property in the third quarter of around 28%, our growth in the quarter was 59% over prior. And here's one where at the same time that we're growing large property, we're reducing our total insured values on the coast at the same time. So we actually are getting more rate for less exposure. And then the last piece is our specialty portfolio. With combined ratios that consistently run in the 80s, we're growing our overall specialty portfolio 5% year-to-date, and there are still opportunities to grow that.

I think as you look at us now and into the future, and you hear us talk about growth it will be in targeted segments, it will be in small middle market-type businesses. We found that those businesses have performed much better than when you're starting to look at anything large that's a Fortune 500. So large businesses are opportunistic, our portfolio has really shifted to small and middle which are less price sensitive than what we're seeing on the large side.

So I think this is clearly a good opportunity and good time to grow, it's still a healthy marketplace. And when I look at my book now for four quarters, I've got [Inaudible] that are flat for four consistent quarters on a $9 billion portfolio. So I'd say it's still attractive.

Okay, last question, on the life, you said it was sort of in line with what you were looking for, and there wasn't any commentary, it was below sort of the first half run rate, I know that bounces around and there's runoff issues in that, and maybe I had a bad model, but was there anything funny in the quarter that sort of penalized the third quarter versus the first half?

I'm sorry, Bob, are you talking about the life group?

Yes, sir.

No, there wasn't. And remember last quarter we indicated to you there was a one-time good guy that--.

Right.

--where we thought the kind of run rate was.

So $15 million is a sort of reasonable run rate of a loss for that business, is that what you're saying?

Small loss to a -- I think that what we said before is that kind of the pattern of that business is probably a $40 million swing from like a small to $20 million gain, I think we've had in the past to a $20 million or so loss, that's kind of where we've been in general patterns and that's about where we are. So it runs, it does run generally, you would expect a small loss.

Okay. With no good guys, you're going to get a $15 million loss? I mean, that's not unusual. So, that's right on.

Around that range, yes.

Okay. Thank you very much.

Hey, Bob, this is Steve. I just wanted to pick up on some of Jim's comments and echo Jim's opinions that we can grow the business, it will be careful, it will be cautious and it will be very focused, but just to kind of tell you a little bit of the how's, I mentioned in my remarks that CNA enjoys the luxury or at least the advantage of being a very, very diversified commercial insurer and we've diversified by line and by business segment and geography. The portfolio is and has been very stable for some time now. I mean, everything is staffed and deployed so we're not going through any enormous organizational change or aspirational things that are out there.

Our retention levels have hit and it will stay at what we feel are appropriate targeted level, our new business is at targeted levels, exactly where we said it would be and we get the advantage of an updraft from the cross-sell initiative, which has been a huge advantage for us over the past couple of years. So I just wanted to come right in and echo Jim's remarks. We do think that it's a business that can grow despite some of the pressures in the market. I think we enjoy some competitive advantages that others don't have.

Thanks a lot, Steve.

[OPERATOR INSTRUCTIONS] Next we'll hear from Gary Ransom from Fox-Pitt Kelton.

Good morning, I had a question on the standard commercial, with decline rates, it's under a hundred, but just a little bit under a hundred, it sounded like you'd like to get that lower. I just wondered what, where your -- where you expect that to come from and I guess I'm looking out over a longer period of time, three or four years, hopefully you can improve that business' position against wherever the market might be going. And are there other long-term initiatives that you're targeting there?

As we look at this, I think clearly we can improve our combined ratio in standard lines. One, I mentioned earlier is by mix of business, targeting specifically where we're growing our book of business. We're growing more so that our mix changes that our higher performing ROE businesses become a much larger piece of the overall standard lines, that improves our book, that's why the emphasis in standard lines is on small business, it's on large property, it's on manufacturing.

We've done a lot of work on subsegment in our overall book of business within manufacturing on an overall class of business basis, geographic basis, size of premium basis so we now know the classes that we want to target and we've having success there. We're doing the same thing with the retail services side of our book. So we will take our $2 billion middle market book and we will actually look for the most profitable niches in that particular book of business and that's where we're going to focus our growth and also all of our resources.

Does that imply that there's some underperforming segments buried in there that you should be backing off from more quickly?

No. We've gone through the reunderwriting of this total portfolio. I'm not at this point looking to jettison any part of the portfolio.

There are parts of the portfolio that are much more attractive and are already producing ROEs in excess of 15%. Those are the ones we're going to focus the resources on to really grow even more of those segments. The others are still performing fine, it's just that they're not at the double-digit level that we'd like them to be, but none of them that we would say we should exit. We've gone through and done that, we've got a book that we're comfortable with regardless of the market.

The other thing that helps us is we've got a better debtor quality today, so we can respond much or quickly to issues that are occurring in our marketplace. We do measure what's happening with pricing. We look at what's going on with our new and renewal pricing and the spread that we see between that. This isn't something new, we've been doing it since 2000.

And right now for our new business there's only a spread of two points in the paid and case loss ratio, evaluated at nine months. And when we look at our underwriters making the right decisions on the quality of business, we also monitor renewal efficiency. And we've been monitoring this since 2000. To really see what's the loss ratio for the business we're getting off, versus the business that we're keeping, the business that we're keeping is 19 points better than what we're getting off of.

I think the other opportunities that we have is really looking at a closer analysis of our claims expenses, our ULAE and ALAE, I think there's opportunities there. We have also made investments in our claims organization. We've got an express center, which is an operation that's set up to really service our small low-touch business and our small claims. It's going to be a much more cost-effective model, it's already in place, that will ultimately drive our expenses down as far as our claims handling for small business and also the lower end of middle market. And I think the other piece of it is we've got to continue the aggressive expense management that we've already done.

Even though we've made good progress, we're still not happy with where we are and we will continue to push the expense side of the pedal, especially as we continue in a marketplace where rates are moderating. As we look at expenses, we monitor everything. We look at it based on the bottom line impact versus the expense and what are we going to get for it. And that's the culture we're creating here, those are the elements that I think that are going to help us to improve our results.

All right. Thank you for that answer.

[OPERATOR INSTRUCTIONS] And I'm showing there are no more questions at this time. I'd like to turn it over to today's speakers for any additional or closing remarks.

Thank you, and that you all for joining us today. Once again I call your attention to the disclosure 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 November 7. You can access the replay by dialing (888)203-1112 or (719)457-0820 for international callers, using pass code 874-2359.

The call will also be archived later in the day for replay on the Investor Relations section of CNA's website. For further information, members of the news media may call Charlie Boesel at (312)822-2592 or Katrina Parker at (312)822-5167. Investor analyst questions may be directed to Jack Hanrahan at (312)822-6586, David Adams, at (312)822-2183 or myself at (312)822-7757. All these can be found on the news release. And then thank you again and we appreciate your participation in today's call.

And thank you, that does conclude today's conference, we thank everyone for joining and have a great day.