CNA Financial Corp (CNA) 2007 Q2 法說會逐字稿

Good day and welcome to the CNA Financial Corporation second quarter 2007 conference call. Today's call is being recorded. At this time, I'd like to turn the conference over to Ms. Nancy Bufalino. Please go ahead, ma'am.

Thank you, Amy, and good morning. Welcome to CNA's second quarter 2007 financial results conference call. Hopefully everyone has had an opportunity to review the press release and financial supplement which were released earlier this morning and can be found on the CNA website. With us this morning to discuss our financial results are Steve Lilienthal, Chairman and CEO; Craig Mense, CFO; and Jim Lewis, President and CEO of PNC Operations. Before we get started, I'd like to advise everyone that 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. In addition, the forward-looking statements speak only as of today, July 30, 2007. CNA expressly disclaims any obligation to update or revise any forward-looking statements made during this call. This call is being recorded and webcast. During the next week the call can be accessed again on CNA's website at www.cna.com. Following the conclusion of today's prepared remarks by CNA's senior management, we will be happy to take questions from the investment community. With that, I will turn the call over to CNA's Chairman and CEO, Steve Lilienthal.

Thank you, Nancy, and good morning everybody. Welcome to our second quarter earnings call, and thank you for joining us today. Consistent with our previous calls, the second quarter was very solid for CNA and represents the continuation of our focus on the fundamentals and solid execution across the board. Some highlights -- quarterly net operating income of $318 million represents our best in more than a decade and is up 4% over the second quarter of 2006. Year to date operating income of $625 million is a 16% improvement over the same period in 2006. Net income for the quarter of $217 million was down $22 million or 9% compared to the same period prior year, reflecting net realized losses driven primarily by changing interest rate environment. Year to date net income of $513 million was up 10% over the same period in 2006. Investment income was strong for the quarter as compared to the second quarter of 2006. Book value per share of $36.85 as of June 30, '07, while down $0.49 compared to the first quarter, is still up $0.82 as compared to year end '06, where it was at $36.03. Operating return on equity of 13.2% is respectable; still a work in progress, but represents consistency with '06 and '07 year to date. I will provide some additional detail on this shortly and give you an update on run off operations.

Core property & casualty operations likewise continues to demonstrate solid underwriting and claims fundamentals, as well as a discipline that had been embedded in this business, which is our core business, for the past several years. Combined ratios of 94.7 for the quarter and 94.9 year to date represent solid results and consistency with 2006. Net written premiums for the quarter year to date are slightly down to prior year, mostly in standard lines, and is a reflection of the continued softening market conditions. Retention levels have held strong, and we have adjusted our new business levels to appropriately reflect rate deterioration, which is exactly what we said we would do. Property and casualty expense ratio continues in the sub-30 category at 29.8 for the quarter and 29.2 year to date, which is pretty much in line with the same period in 2006. Expense control and management are very important components of our operating culture, and we are cognizant of the pressure that the market will put on expense ratio going forward.

For some time now, CNA has been delivering results that reflect our determination to drive continuous improvements in the operating fundamentals and earnings power of the Company. Our second quarter and year to date results reflect our measured progress. Our core property and casualty operations combined ratio improved to just under 95%. Expense ratio at 29.8 remains competitive with our peers. Our revenue rate and retention statistics reflect our disciplined approach to the business. We continue our orderly run off of our noncore businesses. Positive cash flow continues to fuel growth and investment income and we produced a net operating income ROE of 13.2%. Overall, we continue to demonstrate our commitment to being a leading competitor in a commercial P&C 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 second quarter net operating income from continuing operations of $318 million or $1.17 per share, compared to $305 million or $1.11 per share in the prior year period. You will recall that the per share amounts for '06 include the impact of undeclared preferred stock dividends. These dividends were eliminated with the repurchase of stock from Loews last August. Net income for the quarter, which includes the impact of discontinued operations as well as realized investment gains and losses, was $217 million or $0.80 per share, compared to $239 million or $0.86 per share last year. Second quarter results in '07 include a loss of $10 million from discontinued operations versus a loss of $2 million in disc ops in '06. Year to date net operating income from continuing operations was $625 million or $2.30 per share, versus net operating income of $539 million or $1.95 per share in the first half of 2006. Year to date net income was $513 million or $1.89 per share versus $468 million or $1.68 per share for the prior year period.

With respect to book value per share, we ended the second quarter at $36.85, which is a slight decline from first quarter reflecting a decrease in our unrealized gain position driven by the changing interest rate environment. You will recall that the 10-year treasury was at 4.64 at the end of March and at 5.02 at the June valuation period. Property and casualty operations produced net operating income of $325 million in the second quarter, up from $277 million in the prior year period, a 17% increase. Our core business benefited from solid underwriting results and strong investment income. Life and group noncore produced a second quarter net operating loss of $13 million. The unfavorable period over period change was driven by a decline in results, the life settlement contracts and unfavorable development in group reinsurance which is in run off.

With respect to the corporate segment, the second quarter net operating income was $6 million versus $23 million in the prior year period. The more favorable results in '06 included a release of a restructuring accrual. Results in life and group and corporate segments can vary, but we continue to focus on managing, monitoring and controlling these legacy risks. Pretax net investment income in the second quarter was $671 million, which compares to $552 million in the prior year period. Included in those numbers is a $49 million increase in income from the trading portfolio, which is more than offset by an increase in policy holder reserves supported by that portfolio. The comparison excluding the trading portfolio was $631 million in second quarter '07, versus $561 million in '06, a 12.5% increase. Drivers include growth of our invested asset base resulting from improved cash flow, strong income from limited partnerships and reduction in interest expense primarily as a result of the reinsurance commutation. During the quarter our invested assets grew by $360 million. Net realized investment losses were $91 million after tax, which compares to losses of $64 million in the prior year period. The current quarter loss is mainly the result of interest rate related other than temporary impairments.

If you excuse me taking an aside for a second to talk about those GAAP securities accounting, you will recall that every quarter we review all securities held in a loss position and determine whether we have an intent to hold the securities until the value recovers the book value. Those securities where we are uncertain for whatever reason of our intent to hold until recovery are impaired to market value. We follow this disciplined process to maximize our flexibility to reinvest as opportunities may arise in the future. During the quarter, our other than temporary impairment losses totaled $114 million and were largely offset by gains of $75 million on derivative positions held as an economic hedge against a rise in interest rates. We also recognize approximately $50 million of realized losses on securities sold during the quarter as we acted to reposition parts of the portfolio.

Among the other than temporary impairments for the quarter was $20 million that was attributable to our investments in securities with exposures to sub-prime mortgage collateral. At June 30 our sub-prime exposure in securities held was $834 million, which is less than 2% of invested assets. Of these exposures, 94% are currently rated A or better. None of the securities was sub-prime residential mortgage collateral that were part of the recent rating agency actions are owned by CNA. In addition, we have also exposure of approximately $44 million to sub-prime collateral risks through our positions in limited partnerships and equities. These risks, like all the risks in our investment portfolio, have been and will continue to be managed closely.

I know you are interested in sensitivity of our portfolio to interest rate changes so I'd like to provide some additional information on the duration of our combined fixed income and short term portfolio. Our interest sensitive securities are generally managed to two distinct duration objectives. One of the duration objectives is established for those securities that support the property and casualty segment. This group includes 78% of all fixed income securities held, and had an effective duration of 3.5 years at the end of the quarter. The duration objective of this group is subject to change based on market views and the needs of the property and casualty segment. We have segmented a second group of dedicated asset liability portfolios to support interest sensitive liabilities such as annuities, structured settlements and long-term care reserves. This is generally part of the life and group segment. This group represents the other 22% of fixed income securities, and is managed to a target duration of 9.9 years. These investments are managed in a traditional asset liability duration approach. When combined, these two groups represent all interest sensitive investments and had a duration of five years at the end of the quarter. This information along with further discussion is also contained in our second quarter 10-Q to be filed later today.

Turning to expenses, the PC Op second quarter expense ratio of 29.8% on a par with our peers is reflective of our sustained focus on CNA's expense structure. Expense management remains critical to our cycle management strategy. We recognize that the current competitive environment will continue to pressure those ratios, and we are committed to take timely steps to sustain our improved competitive position. Finally, for anyone who did not see the particulars of last week's announcement, CNA will be paying a quarterly cash dividend on our common stock in the amount of $0.10 per share, payable on September 4 to shareholders of record on August 13. With that, I will turn it over to Jim.

Thanks, Craig (sic), and good morning everyone. Property and casualty operations performed well in the second quarter with production, loss, and expense metrics all reflecting our disciplined approach. Our core strategies have not changed. Maintaining our underwriting discipline -- that has driven risk selection and pricing, selective growth to optimize our portfolio, cross-selling to get a bigger piece of each customer's insurance dollar, and aggressive focus on expenses. Overall, these strategies continue to serve us well in navigating our way through the market cycle. Now let's turn to a few of our key operating metrics, starting with premium. Property and casualty operations gross written premiums were up approximately 4% to $2.4 billion in the second quarter and up 1% to $4.7 billion year to date. Standard lines gross written premium were up 6% for the quarter and 4% year to date while specialty lines had a 2% decrease for the quarter and 4% year to date. On a net written basis, PNC Operations premiums were down 1% for the quarter and year to date. Standard lines decreased approximately 2% for the quarter and 3% year to date while specialty lines was up 2% for the quarter and up 1% year to date. The differences between the net and gross numbers relate primarily to change in volumes in our fully seeded captive program as well as changes in our reinsurance program for specialty lines. Given the current environment, we do expect downward pressure on the top line. We are responding with an active discipline approach to the market. We won't chase business we can't make money on. We will continue to pursue small business, specialty and other attractive opportunities. And we are fully prepared to take risk management up a notch to protect the bottom line.

Now let's look at rate and retention. For the second quarter, we average rate decreases of a little over 3%, similar to our rate experience in the first quarter. Standard lines rates decreased to a little under 3% while specialty lines decreased 4% to 5%. With respect to market conditions, it's tough out there. External surveys put average rate decreases in the mid-teens. But these surveys do not reflect the profile of the business we are writing. CNA's sweet spot is a smaller and mid-size risk, which is generally less volatile, less price driven, and more [lull]. The fact is, we like our renewal book. We continue to find quality new business and we continue to benefit from investments we made in pricing tools for our underwriters, market segmentation, an agency interface that makes it easier to do business with us and value-added services that help us attract and retain high quality accounts. Speaking of retention, we have been running in the low 80s range since fourth quarter of '05, right where we said we would be once our major underwriting initiatives were completed. Standard lines retention was 82% during the second quarter, with specialty running at 83%. Overall we feel good about our retention rates. Considering the competitive pressure, retention over 80% speaks volumes about the ability of our underwriters to sell the value of CNA to customers we know and like.

Now let's turn to new business. We wrote approximately $326 million of new business in the second quarter, or approximately 18% of total production. This compares with approximately $376 million in prior year period or 20% of total production. Overall, new business is right where it should be under current market conditions, and right where we said it would be. We take a very data driven approach to new business quality. Our monitors track such indicators at new versus renewal pricing and use of discretionary price in modification. We also focus on cross-sell, which is a big deal for us in terms of generating more premium for every customer. The second quarter we generated approximately $120 million in cross-sell business or 36% of all new business. Absent cross-sell, this is quality business that otherwise would be left on the table.

Now let's turn to our loss ratio. For the second quarter, the property and casualty net calendar year loss ratio was approximately 65%, very close to where we were in the prior year period. We benefited from approximately 1 point of favorable net development, which is detailed on pages 6 and 8 of our financial supplement. Standard and specialty lines second quarter loss ratios were 67% and 61% respectively, again very close to the prior year period. On a net accident year basis, the 2007 loss ratio for property and casualty operations, standard lines and specialty lines are approximately 66%, 69% and 61% respectively. Each of these ratios is up approximately 2 points from 2006, which reflects the pressure on rates. The accident year loss ratios I just mentioned are all evaluated as of second quarter of '07. Obviously protecting our loss ratio is imperative, and I've already mentioned a few of our strategies. I would also add that in standard lines, we are doing a complete review of our claims operations to optimize outcomes and control expenses. In addition, we continue to refine our predictive modeling tool which has given our middle market underwriters a very quantitative view of risk quality.

Turning to combined ratios, property and casualty operation came in at approximately 95%, 0.5 point better than second quarter '06, and consistent with the improved levels of performance we have reported for the past year or so. Specialty lines continues to perform well in the second quarter with a combined of 87%, standard lines came in at approximately 99%, better than in the past but no means an end state at this point. In addition, as you heard from Steve and Craig, pressure on the top line underscores the importance of our continued focus on expense management.

In summary, property and casualty operation is performing well in the face of tougher market conditions. Stable premium volume, strong retention, appropriate new business, respectable loss ratios and competitive expense levels. Now our challenge is to keep it going and carry our momentum into 2008. With that, I will turn it back to the operator.

Thank you. The question and answer session will be conducted electronically. (OPERATOR INSTRUCTIONS) We will go first to Bob Glasspiegel with Langen McAlenney.

I was wondering if you could give us a little color on realized losses in the quarter, where they came from -- first question, and then I have a follow up.

Well, as I said $114 million came from impairments and $50 million -- I'm talking about the realized losses of $50 million were mainly government as we sold government and kind of an equal proportion of sales of asset backs and munis.

The impairment piece was for what?

The impairment piece was kind of across the board. The answer I was giving you was the $50 million on losses.

Right. How were you taking impairments? Where did that come up from?

Let us take a minute here, Bob, and we will work out the percentages for you exactly. But the majority -- as I said, the majority of those were interest rate related impairments across the board the fixed income portfolio.

Related to the fact that the interest rates went up in the second quarter?

As I said, interest rates went up 38 basis points.

Right. Well treasuries have obviously rallied strongly and I know you don't have a portfolio full of treasuries. But is there sort of an offset in the third quarter we should be thinking in terms of?

Well, right, we are down to, as I said -- at the June valuation, and this is just a ten-year, so we are going to be invested more than just that -- but at the end of the second quarter which is what all these unrealized, these losses were taken against, the ten-year was at 5.02 and it's at 4.78 today. So, yes, you should expect a change in the unrealized gain position upwards.

Okay. I will have to follow up with you but you took an impairment charge last quarter then you get a sort of rally this quarter --

Not this the quarter, I think the rally was --

Third quarter, I'm saying.

The third quarter and these results are as of June.

I know. I'm just saying you are taking an impairment charge in the second quarter for something that's other than temporary, and then within the next month they've been reversed, it's -- I'm just surprised that it was a realized change, given that it was unrealized in the portfolio. But I will follow it up later with you because I am confused on that.

Maybe I should go back to my remarks -- this is Craig, again, on the disciplined process that we follow relative to securities and security evaluations. You'll recall that any -- the GAAP accounting rules are [Day 1, Dollar 1] decline in market value, unless you intend -- unless you assert a positive intention to hold. So those changes are going to show through either realized or unrealized and we quite honestly would prefer to see -- we want to maintain our flexibility future and liquidity future. So you are going to see the difference in one, the economic changes is going to come through one place or the other. So for us you see a little bit more coming through realized and unrealized. We choose to maintain more flexibility.

I don't want to belabor this -- I do have a number of follow ups on that. But I will get you later. Do you have more disclosure on CDOs and the vintages of your sub-prime?

So, sure. You want me to just talk more about what that $834 million is made up of?

And whether that's inclusive of CDOs or are there CDOs on top of that.

No, that's everything. So of that $834, just to break it -- 82% of that is asset backs, 14% is CDOs, and 4% CMOs. I'm sure you'd also like to know vintage year of the $834 million. '06 is a little bit more than 26%; '05, 27%; '04, 23%; and very little in '07. Then relative to ratings: '06 88% are A or better; in '05 94% are A or better, in '04 99% are A. or better.

Okay. I'll go back to the queue. Thank you very much.

Welcome.

We'll go next to Jay Cohen with Merrill Lynch.

Yes, I had also a question on the mortgages which you mostly answered. If you could just -- one more set of details would be helpful and that is, you initially mentioned a certain percentage was A or better. If you could break it down AAA, AA, A that would be helpful, if you have it.

Well, I can quickly give you -- in terms of vintage year that in '06 over of course 80% are AA and better. In '05 76% A or better. We can go back and then figure out the remainder if you need it.

In '05 76% was AA or better?

Yes.

Okay. This is a good place to start. That's good. Thank you.

We will take the next question from Dan Johnson with Citadel Investment Group.

Thank you very much. I do have a portfolio question, but I feel that we ought to at least ask an operating question before that.

Good idea.

I'm sorry, I will get to the portfolio question. But the standard lines gross written was, I think it was up -- and I'm sorry if I have the wrong number here, up about 6%.

That is correct.

And I know we talked a little bit about some changes in retention, but I thought that was more on the specialty lines. Can you put a little more color around that growth in standard, please?

What's driving the overall change between the gross and the net is that we have a very large cell phone captive that's a fully seeded captive itself that's driving that difference in the premium. That's why when you look at it on a net basis you'll see that the standard lines is down. If you [kind of] normalized that captive program for the second quarter, the overall written premium would have been flat.

Got it. So that's -- most of that premium is then just being seeded out?

Most of that premium has been seeded out and what you then see is more of a reflection of new business. 18% of our book is actually new business, down from the 20% second quarter of a year ago. And then you're also seeing the increased pressure from a rate standpoint.

Is that, that cell phone program, was that new this quarter?

No, this is a program that we've had in place for well in excess of five years.

And was it just that this quarter it generated -- because obviously we have an increase in gross and a decrease in net, but I was even just looking at the fairly large increase in the gross in the quarter versus the prior couple of quarters.

What you are also seeing is this is a program that we've had for multiple years, but you're also seeing that this program is growing. So it actually had growth in the second quarter compared to the rest of the book.

And I think you had said earlier in response to my question that most of that 6% growth is actually due to the growth in the cell phone program.

That is correct.

Then on to the portfolio question. After looking at the Ks and the Qs, I'd love it if you could give us a little bit more detailed disclosure around the overall asset backed portfolio. In the first quarter, it was about $12.6 billion. I know we don't have it sliced that way in the supplement, or at least it doesn't appear that way. Can you give us an update on where that portfolio is? Obviously you've highlighted the sub-prime components, which are obviously a minority of it but if you could tell us a little bit else, what fits under your definition of asset backed, please?

Sure. We have approximately $10.8 billion in our total definition of asset backs down, so we have decreased the investment -- we sold some asset backs. You will see when you see the Q. We've sold asset backs, sold governments and reinvested mainly in munis.

The same thing you were doing in the first quarter but just continued, it looked like.

Yes. What you see us do is basically take advantage of the liquidity that we have in the portfolio and we have plenty of cash in treasuries that selectively add in areas where we feel like we have confidence as spreads widen.

Of that remaining roughly $11 billion asset back, can you sort of walk through what's in there, what sort of classes did you invest in?

Mortgage backs represent $1.4 billion, CMOs are a little over $6 billion, asset backs and commercial mortgage backs are $2.7 billion, EDOs are $600 million.

You said CDOs are $600 million? And the underlying asset that's in that?

Hold on one second.

Thank you.

It's mainly -- the majority of it is commercial real estate, there's residential security, there's commercial real estate in there, a number of different things.

And obviously the other numbers you gave us earlier on are in this segment as well?

Right. I think the important thing also to keep in mind is that -- in the CDOs represents about 20% of that, the sub-prime exposure we talked to you earlier and we don't have any CDO squares, okay, we don't have any of that exposure. And we don't have any direct exposure to second lien home mortgages.

Understood. All right. Well, thank you very much for answering the question.

(OPERATOR INSTRUCTIONS) We'll go next to Charlie Gates with Credit Suisse.

Good morning. Could you comment as to what portion of these securities have been downgraded in recent months?

Well, none of the securities that we hold in sub-prime were subject to the downgrade from any of the rating agencies this last quarter. We did have a number of CDOs, about half a dozen, approximately $40 million of market value now that were marked down over the course of the quarter, resulting in about a less than $25 million reduction.

In your schedule you showed securities for companies such as First Franklin, Fremont, Long Beach, NovaStar -- are those pretty much gone?

Ask that again, Charlie.

At year end you showed in your Schedule D -- which I compliment you for putting it on your webpage -- securities for, excuse me, mortgage backed securities from Bear Stearns, First Franklin, Fremont, Long Beach. Would those securities pretty much be gone or what is the treatment there?

Some of those are gone but we don't usually comment on individual transaction investments, Charlie.

My final question -- excluding mortgage backed securities, what is the approximate investment at June 30 in noninvestment grade securities?

About 7% and you have to also keep in mind when you look at it -- about a third of that total number is high quality -- actually it's 8%. And about a third of that number is high quality bank loans. So if you look at historically, we're actually under historical values percentages held in high yield.

My final question -- what would be a high quality bank loan which would be noninvestment grade, what would be an example of that?

A credit facility put together for any customer, a revolving credit facility and credit line could be double-plus rated and other things.

Thank you.

(OPERATOR INSTRUCTIONS) We'll go next to Gary Ransom with Fox-Pitt Kelton.

Good morning, I thought I would try an operating question, too. If you could comment on the underlying loss trends that you're seeing? We've heard other companies talk about it perhaps getting a bit worse in certain lines. I just wonder if you could tell us what you've been seeing in that area.

Sure, Gary, it's Mike Fusco. Generally for the standard lines we haven't seen things get worse. We're looking certainly at some frequency improvements in the 2 to 3% range varying by line of insurance and severity normal inflation changes aggregating to probably on a loss ratio basis a 3% trend. For specialty lines much more driven by -- these are very much more lower frequency lines and we are looking at the severity there. So we are still seeing some frequency improvements and monitoring the severity in specialty lines. It doesn't quite follow a simple pattern like comp and property.

Are there any areas or lines or segments that you're particularly worried about or showed anything of any dramatic changes in the recent past?

I haven't seen dramatic changes in the trend points in these lines but we certainly watch the high-volatile lines very carefully.

All right. Thank you very much.

And we'll take a followup from Bob Glasspiegel with Langen McAlenney.

There's only modest prior year development in the quarter and I was wondering if you could give us color on what was wiggling this quarter?

I think you will see -- you saw in the press release and you saw in the supplement that we had a little bit of favorable development overall in the quarter, driven particularly by recent years property non-cat. That's been the primary plus for us this quarter.

And anything important environmental on the margin we saw, asbestos this quarter?

No, we continue to monitor asbestos pollution (inaudible) on a quarter by quarter basis, but we will complete our full year annual review on this in the fourth quarter.

Thank you.

At this time we have no further questions in the queue. I would like to turn the call back over to the speakers for any additional or closing remarks.

I think we are good, Amy and just want to thank you all for joining us today. Once again I call your attention to the disclosures concerning forward-looking statements and non-GAAP measures in the earnings release. A replay of today's call will be available for one week and immediately following until August 7. Please see the earnings release for replay details. We appreciate your participation on today's call and thank you for joining us.

Thank you. That does conclude today's call. You may disconnect at this time.