CNA Financial Corp

NYSE:CNA

Earnings Call Transcript 2019-Q2

[Operator]

Good morning, and welcome to CNA's Discussion of its 2019 Second Quarter Financial Results. CNA's second quarter earnings release, presentation and financial supplement were released this morning and are available via its Web site, www.cna.com.

Speaking today will be Dino Robusto, CNA's Chairman and Chief Executive Officer; and James Anderson, CNA's Chief Financial Officer. Following their prepared remarks, we will open the lines for question.

Today's call may include forwarding-looking statements and references to non-GAAP financial measures. Any forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from the statements made during the call. Information concerning those risks is contained in the earnings release and in CNA's most recent 10-K on file with the SEC.

In addition, the forward-looking statements speak only as of today Monday, August 5, 2019. CNA expressively disclaims any obligation to update or revise any forward-looking statements made during this call. Regarding the non-GAAP measures, reconciliations to the most comparable GAAP measures and other information have been provided in the financial supplement. This call is being recorded and webcast. During the next week, the call may be accessed on CNA's Web site.

With that, I will turn the call over to CNA's Chairman and CEO, Dino Robusto. Please go ahead, sir.

[Dino Robusto, Chairman and CEO]

Thank you, Alison. Good morning, everyone. I'm pleased to share our second quarter results with you today, a good result, reflecting strong execution across the board.

Core income for the second quarter was $294 million or $1.08 per share, up 9% over the prior-year quarter. Core return on equity was 9.9%. This result reflected improved underlying underwriting performance, continued pricing momentum, good investment performance, and continued stable performance of our run off long-term care business.

For the quarter, the P&C underlying combined ratio was 94.6% compared with last year's second quarter results of 95.3%. The underlying loss ratio of 60.8% improved a little more than a half-a-point from the prior year. The all-in combined ratio of 95.7% included 2.2 points of catastrophes and 1.1 points of favorable prior period development. Our expense ratio in the quarter was 33.4%, nearly a half-a-point better than the first quarter.

We generated robust growth in the U.S. segment with gross written premium excluding third-party captives up 10% and net written premium up 8%. Growth was particularly strong in our commercial segment, while international's net written premium was down 8% in the quarter, driven by our Lloyd Syndicate was down 23% resulting from our re-underwriting efforts that will continue throughout the year as we have previously discussed.

We continue to effectively manage the rate retention dynamic achieving higher rate increases in each business unit, and doing so with steady retentions in the U.S. In the second quarter, rate for P&C overall was 4%, up one point from the first quarter with commercial and specialty each up one point and international up two points from the first quarter. We drilled down a little more. Pushing for rate increases is the quintessential priority for us.

In our specialty business unit, rate was up 4% and up 8% outside of our professional E&O program business, which we refer to as Affinity. In our healthcare business, which has experienced higher severity trends as we have referenced on several prior calls, rate increased further to 14 points compared with 10 points in the first quarter. Public company D&O rate increases showed similar momentum, up 15 points in the second quarter compared with 11 points in the first quarter. And importantly, even in the context of the positive rate movement, specialty's overall retention was steady at 88%.

Overall commercial rate was up 5%, excluding worker's compensation and 3% all-in, each a point higher than the first quarter, while retention was steady at 85%. Commercials rate included umbrella, up 7% and commercial auto as well as property were also up 7%.

International rate was up 7% compared with 5% in the first quarter, and retention was 67%, again reflecting our re-underwriting efforts. A four points of rate overall in the second quarter exceeds our long-run loss cost trend. As mentioned before, this is a good result, but obviously needs to be sustained before we recognize any meaningful margin improvement as a result of this dynamic.

Overall in the pricing environment, I'd reinforce the comment I made last quarter. If that pricing continues to migrate from being a headwind and not a tailwind, and that change is appropriate given that the headwind period lasted several years when price changes fell below long-run lost cost trend. It is encouraging that this tailwind is also beginning to include improvement in terms and conditions beyond price in areas where it is needed most.

For larger property schedules, there is a broader adoption of higher deductibles, in particular for catastrophe perils. In medical professional liability, specifically aging services, higher deductibles are more readily-adopted to mitigate frequency exposures, and we are successfully tightening coverage language in tougher judicial jurisdiction.

During a headwind period, these terms and conditions tend to slowly relaxed negatively affecting the portfolio, given the simultaneous deteriorating rate environment. And at some point, the clawing backup price as well as terms and conditions begins this time around starting a few quarters ago in order to secure the risk adjusted return required, but this restorative process requires more time for both CNA and the industry, which is why I am optimistic that the environment will continue to support pricing above long-run lost cost trend.

Turning to the other elements of the quarter, new business in the U.S. was up 13% in the second quarter, which was somewhat influenced by a few large accounts we have been working on for over a year and we're successful in securing in the second quarter. As I have mentioned in the past, securing high quality sophisticated accounts can take more than one renewal cycle to win. Indeed, I have specifically referenced on prior calls when we struck out on certain larger accounts the first time around the main point here is that although new business success will fluctuate quarter-to-quarter, I am very pleased with this key tenant of our strategy, just getting an increasing access to the best business.

In addition to this tenant, on past calls, I have talked about several other vectors of success we are pursuing in order to achieve top quartile underwriting performance, including institutionalizing deeper underwriting expertise, and reenergizing relationships with our distribution partners amongst others.

Today, I want to comment on our drive to enhance our specialization approach as we are not interested in being all things to all businesses as a generalist commercial insurer. This includes prioritizing certain industry segments and exposures and bringing to bear an expert value chain of deep technical talent, tailored products and services and strengthening relationships with those agents and brokers that also seek to provide their clients. This added value solution set. This approach is a significant reason behind the long-standing performance we enjoy in our specialty business.

Our customized expert value proposition for very different businesses such as affinity, surety, warranty, and healthcare creates a meaningful competitive advantage that has allowed us to generate excellent margins over the long run. In the past year, we have accelerated the evolution of our commercial business units along the same path of enhanced specialization. We are targeting our investments and resources to those segments where we can better capitalize on our brand and expertise and where agents and brokers have told us they value our approach and would like to see an even stronger commitment by CNA.

One example of this is our construction business, our most mature industry segment where we have deep underwriting expertise, customized risk control services and specialized claims capabilities. And recently, you would have seen the announcement that we added a new head of construction Song Kim as a proven industry expert in this business and reflects our targeted investment in resources.

The same acceleration towards specialization is happening with our middle market business. Or we have previously spoken about our focus on specific industry segments like technology and professional services amongst others and we are looking to develop more specialties, such as the recently added cultural institutions.

Other areas of priority specialization within commercial or marine or small business operation and our property and casualty national accounts unit that provides targeted P&C coverages for larger clients. In this latter area, we also recently announced the addition of David Hayes, an industry expert, the head of National Accounts Casualty Unit.

Finally, our London-based operation is also migrating to a more specialized focus, where they will target similar segments and exposures building upon the expertise house within our specialty and commercial business unit. This is happening simultaneously to the re-underwriting process. So it will take time to develop and show up in the results. I'll keep in mind. Our drive towards greater specialization, like all of the tenants of our strategy to achieve sustained top quartile performance will proceed with a deep sense of urgency yet our fundamental focus and actions are guided by the fact that we are playing for the long-term.

And now turn I'll turn it over to James.

[James Anderson, CFO]

Thanks, Dino, and good morning everyone. Our property and casualty operations produce core income of $298 million in the second quarter, pre-tax underwriting profit with $72 million and underlying underwriting profit was $93 million.

Moving to each our P&C business units, specialty second quarter underlying combined ratio was 93.2% including an underlying loss ratio of 59.9%, specialty's overall combined ratio of 90.7% included 2.6 points of favorable prior period developments, Specialty's gross written premium ex-third-party captives grew a healthy 6% in the quarter.

Our commercial segments underlying combined ratio was 94.9% in the quarter, the underlying loss ratio of 61.7% included a little less than a half a point of onetime costs related to the actions taken within our claim department that I mentioned last quarter as some of the costs continued into April.

The second quarter overall combined ratio for commercial was 99.7% including approximately five points of catastrophe losses and a minimal amount of favorable reserve development. Commercial's gross written premium ex-third-party captives grew 13% in the quarter. The underlying combined ratio for our International segment was 97.4% in the second quarter. The all-in combined ratio was 97.5% with a minimal amount of catastrophe losses or prior period development affecting the results.

Our P&C expense ratio of 33.4% is representative of our current annual run rate. Let me take a minute to talk about our prior period development in the quarter. Specialty is 2.6 points of favorable prior period development was primarily an accident years 2017 and prior, driven by surety, affinity and warranty and partially offset by healthcare being slightly adverse.

Commercial had a minimal amount of net favorable reserve development as favorable development in workers compensation and property was offset by unfavorable umbrella and the normal unwinding of our discounted workers compensation claim reserves.

In the businesses where we had adverse development namely healthcare and to a lesser extent umbrella, we continue to see aggressive cleanup attorney actions leading to higher severity outcomes as a result, we've been taking more aggressive underwriting actions with regard to pricing and terms and conditions to improve the margins on those businesses.

As Dino mentioned, our execution to date has been very encouraging. Our Life & Group segment produced $7 million of core income in the quarter. Long-term care morbidity experience continues to be consistent with our reserve assumptions while persistency was a driver of the positive results.

Our corporate segment produced a core loss of $11 million in the second quarter. Pre-tax net investment income was $515 million in the second quarter compared with $506 million in the prior year quarter. Our limited partnership and common equity portfolios produced pre-tax income of $43 million, a 2.1% return and in line with the prior year quarter. Pre-tax income from our fixed income portfolio was $465 million slightly higher than the prior year quarter.

The pre-tax effective yield on the fixed income portfolio was 4.8% in the quarter in line with prior periods; fixed income assets that support our P&C liabilities at an effective duration of 4.1 years at quarter end in line with portfolio targets. The effective duration of the fixed income assets that support our Life & Group liabilities was 8.9 years at quarter-end. Our balance sheet continues to be extremely strong at quarter-end shareholder's equity was $12.1 billion or $44.52 per share up 6% in the quarter as our unrealized gain position increased to $3.6 billion due to the decline in interest rates.

Shareholder's equity excluding accumulated other comprehensive income was $12 billion or $44.08 per share an increase of 5% from year-end 2018 when adjusted for the $2.70 of dividends per share paid during the first two quarters. In the second quarter, operating cash flow was $227 million. We continue to maintain a very conservative capital structure. All of our capital adequacy and credit metrics are well above our internal targets and current ratings.

In May, we issued $500 million of senior debt at a rate of 3.9% with proceeds used to redeem $500 million of 5 and 7-8 notes due in August of 2020. The deal was significantly oversubscribed and came in at spreads comparable to our peers rated a notch higher than our current ratings. And on the subject of ratings, we are pleased that Fitch upgraded our financial strength rating to A+ and A.M. Best upgraded our issuer credit rating to A+ during the quarter providing further validation of the strength of our balance sheet and then momentum of our business. Finally, we are pleased to announce our quarter dividend of $0.35 per share.

With that, I will turn it back to Dino.

[Dino Robusto, Chairman and CEO]

Thanks James. Before we move to the question-and-answer portion of the call, let me leave you with some overarching thoughts on the quarter. Core income for the second quarter was $294 million bringing the first-half core income to $612 million, the highest level in 12 years. Our 2019 second quarter core return on equity is 9.95. Our underlying P&C loss ratio was 60.8% for the quarter and 60.7% year-to-date.

U.S. net written premium grew 8%. We achieved 4 points of rate in the quarter, one point higher than the first quarter. And we are optimistic that the rate environment will continue to be a tailwind.

With that, we will be glad to take your questions.

[Operator]

Thank you, sir. [Operator instructions] We will take our first question from Josh Shanker with Deutsche Bank. Please go ahead.

[Josh Shanker, Deutsche Bank]

Yes. Good morning, everyone.

[Dino Robusto, Chairman and CEO]

Good morning.

[James Anderson, CFO]

Good morning.

[Josh Shanker, Deutsche Bank]

Two questions, the first one, you have said that pricing is ahead of lost cost. In an aggregate, your commercial pricing is up 3, but I guess up 5, excluding worker's comp. Historically long-term loss cost trends for the industry sat around 4% or 5%. In the past 10 years, the economy has been more sluggish than the long-term. So, it's probably been less than that, but when we talk about pricing up, 3% in total, 5% ex-worker's comp, is that comfortably ahead of long-term loss cost trends? I mean it just seems to me that is about the long-term lost cost trend, maybe you can give me some color on that.

[James Anderson, CFO]

Yes, Josh, let me see if I can give you a little bit of context here. So, when we look at our long-run loss cost trends, you have to keep in mind that it's reflective of our -- the makeup of our portfolio. We have a significant component of our portfolio in our, what we refer to as our Affinity business that has a lower than normal long-run loss cost trends, actually, it's around 1%. So when we look in aggregate at our portfolio loss cost trend, it's about 2.5s point when we factor in that 1 point what's about between 50% and 20% of our portfolio. So when we look at our overall rates, in Q1, our overall rate was 3%. So that was higher than that long-run loss cost trend. And in this quarter, the overall P&C rate was 4%. So, both quarters being ahead of that 2.5 point loss cost trend. So hopefully that gives a little bit of…

[Josh Shanker, Deutsche Bank]

Yes, that's very helpful. Thank you. And can you shed some perspective on the Child Victims Act in New York? And how you are thinking about it? How the industry should be thinking about it? And what it means for states outside of New York?

[James Anderson, CFO]

Sure. So we have been following this legislation that's issue for quite some time. It's not new. We have been considering the potential impact to our reserves all along, and that consideration continues to be part of how we think about overall reserve position. Now remember, our claim department has been handling these types of claims for years. So we are well positioned to deal with whatever may come. Or, we have to wait and see how much new claim activity is generated from New York and any of the other states as a result of these statutes. Let me just say as I sit here today, I feel really good about our overall reserve strength.

[Josh Shanker, Deutsche Bank]

In your initial reserves that you had set let's say prior to the beginning of this year when the law changed, did you have reserves up for a assumption that there was a probability that the statute of the limitations will be waived?

[Dino Robusto, Chairman and CEO]

Look, I'm not going to get into the specifics on how we would split IBNR into different buckets, but I just will reiterate what I said. We've been factoring this into our thinking over time.

[Josh Shanker, Deutsche Bank]

Okay, thank you very much.

[Operator]

We will now take the next question from the line of Gary Ransom from Dowling & Partners.

[Gary Ransom, Dowling & Partners]

Yes, good morning. I wanted to ask a little bit about expenses. The expense ratio in specialty was up about a point and split more or less equally between acquisition and underwriting. And then when I look at commercial, the other underwriting expense ratio is up a little bit there too. I just wondered if you can give us a sense of what's going on and especially in light of the various expense initiatives you have underway.

[James Anderson, CFO]

Sure, Gary. On specialty, specifically we did in the quarter have a couple of one-time adjustments to our acquisition costs. So we would expect that not to reoccur going forward. With regard to the underwriting side and this would be in terms of both specialty and commercial, one of the things that we're seeing is we've shown good growth on a gross premium basis. It's been a little bit less on a net premium written basis, and then even less as there's a lag as that premium written earns. Though one of the things you're seeing there is just earned net written premium being a little lower and lagging what we've been doing more recently. So, when we think forward on our expense ratio we would expect to see some improvement there.

[Gary Ransom, Dowling & Partners]

Okay, that's helpful. And just wanted to shift to loss trends, thanks for that, it is description of the long-term trends but one of the concerns in the market today is whether those trends themselves are accelerating even as the rate is accelerating. And I'm wondering if you are thinking about that or how you're thinking about the potential risk involved in the two and a half suddenly becomes three and a half or four.

[James Anderson, CFO]

Yes, we remember that two and a half is our long run loss cost trends. And so when we look at our portfolio, we do it on a very granular basis and we have parts of that portfolio, healthcare as an example where that loss cost trend today is getting close to double-digits and so clearly when you're seeing rate increases for example in healthcare of 14% in the quarter, that's being offset by an increased loss cost trends in that business. And on the flip side, as I mentioned Affinity and Surety, they have been getting rate increases and not seeing loss cost trends. So, there is a lot of things happening underneath the covers there and we're monitoring it closely and there's a heavy correlation where we're getting rate versus what's happening with the short term loss costs.

[Gary Ransom, Dowling & Partners]

Okay, and just maybe one last question on worker's comp, there's some signs of change there meaning maybe rates are bottoming and few places starting to go up. Do you have any thoughts on those trends?

[James Anderson, CFO]

I think from a rate perspective that is what we're seeing, so we're starting to see rate flattening a bit maybe starting to get less negative than it has been. So certainly, we're seeing that. I mean just to put it in the context of loss cost trends there, we're also starting to see frequency flatten a bit even if severity has maintained a quite a benign spot.

[Gary Ransom, Dowling & Partners]

Okay, that's helpful. Thank you very much.

[James Anderson, CFO]

You bet.

[Operator]

We will move on to the next question from Meyer Shields from KBW. Please go ahead.

[Meyer Shields, KBW]

Great, thanks. Two C&A questions and then one big picture industry question if I can. First I was hoping you could talk us through how much of the commercial specialization effort. How much can that accomplish in terms of closing the combined ratio gap between the two segments?

[James Anderson, CFO]

I mean look it's clearly showed itself to be very, very effective within specialty and ultimately over the last two and a half years that I've been here, we focused on a host of different underwriting priorities that I've talked to you about and one of the other things clearly I've become comfortable with in understanding is those segments where we really have some competitive advantage, and the competitive advantages really across the supply chain. We have good underwriting, we have good capacity, risk control, claims and so what we want to do is to now funnel more of the investment in resources into those specific areas and we de-prioritize the ones with less advantage. And you clearly saw that happening with the decisions we made on some of the property and other segments within our underlying -- our international business.

Now is really the time, everything is done methodically, it was done methodically over the last 2.5 years. And so, we have to get the certain initiatives, whether it was institutionalizing more of the underwriting culture, building those distribution relationships, enhancing our talent. And now is the time and the opportunity for us to really prioritize the specialization, what additional efforts and investments and some resources. And I think this is just when you add this tenant this vector of success to the other ones, I think it's just going to support our glide path to stop cortile performance because ultimately, it's when you have a competitive advantage of specialization really across the value chain that you can sustain profitability. And I think you see it even within an area like James just referenced of healthcare, where it is challenged some of those claims trends, but our market leader position having been in it for 20 years, we have the clout to be able to execute the new terms and conditions and the pricing that we need for us to stay in that marketplace and continue to see profitability overtime, so difficult for me to pin down exactly what the marginal gain is going to be.

Look, when you think about top cortile performance for us. You know, we're at 94.6, we're a couple three points away from that. And we think there's a little bit on the loss ratio, in particular as you execute some of the continued rate in terms and conditions. And there's some on the expense ratio that James just referenced. But for long-term sustainability, it's going to come from having a value proposition that is important that transcends price. And so, that's sort of the best way I can describe it Meyer.

[Meyer Shields, KBW]

Yes. That's very helpful. Thank you. Can -- I think maybe a question for James, I was hoping you could talk a little bit about why we lost trend and affinity is as low as it is?

[James Anderson, CFO]

Why it is?

[Meyer Shields, KBW]

Yes.

[James Anderson, CFO]

Well, listen, we've been in that business for a long time. It is a very homogeneous business with lots of small accounts. And we have a competitive advantage and we have very strong relationships with our partners in that business. And great data, we've been able to service clients well over time. And so, I think all those kinds of give a fundamental advantage to us. And I don't think there's much more to it than that.

[Dino Robusto, Chairman and CEO]

Yes. And so, with that competitive advantage, you can sustain the pricing and the terms and conditions you need to be able to keep it profitable, just as James says indicating.

[Meyer Shields, KBW]

Right now, I understand all that. And it's clearly showing up. I was just wondering what is it about the business the business set that produces such well lost trends.

[Dino Robusto, Chairman and CEO]

I don't know if there's any other magic to it, Meyer besides that.

[Meyer Shields, KBW]

Okay, no, I can say our expertise would do it. And then, big picture question, it's sort of a follow-on Gary's question; we've had a lot of really strong profits and rate reductions and workers compensation at some point in time, or is that going to conflict with normalizing lost trends that the industry is not anticipating?

[James Anderson, CFO]

Well, we not -- that is always, that's always going to be the question is, can the industry and frankly for us, more importantly, are we making sure that we see any inflection points that come whether it be in frequency or severity, so that we can ensure that we're getting appropriate price when that happens?

[Meyer Shields, KBW]

Okay. Thank you very much.

[James Anderson, CFO]

You bet.

[Operator]

[Operator Instructions] We'll take the next question from Jay Cohen from Bank of America Securities.

[Jay Cohen, Bank of America Merrill Lynch]

Yes, thank you. Just to switch gears a little bit, I wanted to hear more about the persistency in a long-term care block, which was favorable this quarter. Is that something that just jumps around? Or is this something that you see as maybe being more sustainable?

[James Anderson, CFO]

Jay, thanks for the question on long-term care. With regard to persistency, that is -- that's not something I would put in the camp of something you can count on for a long period of time, it's really closely aligned to us getting rate increases in different states. And seeing policyholders make choices, whether they decide to last the policy, whether they decide to reduce their benefits and maintain their current rates or actually pay the rate increases. So what we've seen over the last couple of years is people actually lapsing into what we would call non-forfeiture status, meaning they are going to take a smaller benefit and not take the rate increase or actually stop paying premium altogether. So we wouldn't expect that to stay at a high-level forever, but we're certainly happy to see for now.

[Jay Cohen, Bank of America Merrill Lynch]

And what are the average price increases you're achieving now probably varies quite a bit by state by product, but can you give us a sense of what they are?

[James Anderson, CFO]

It is a wide range by state. I mean, we are getting, in some cases, very high double-digit rates. And when I say high, I mean, in some cases that approaches 100%, all the way down to things like 10%. So you get very different outcomes, depending on the state, depending on whether it's the first-rate increase for that the policyholder is seeing or whether it's the second or third. So it's a pretty broad range. But I will tell you just overall, regulators have been much more receptive to giving us rate increases, as well as the rest of the industry, as they realize that they need carriers who write this business to be able to at least break even.

[Jay Cohen, Bank of America Merrill Lynch]

Yes. All right, thanks. That's very helpful, James. Thank you.

[James Anderson, CFO]

You bet.

[Operator]

It appears there are no further questions at this time. I'd like to turn the call back to Dino Robusto for any additional or closing remarks.

[Dino Robusto, Chairman and CEO]

So, that's great. Thank you, everyone, and we'll see you in another quarter.

[Operator]

Ladies and gentlemen, this concludes today's call. Thank you very much for your participation. You may now disconnect.