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CNA Financial Corp (NYSE:CNA)
Q2 2019 Earnings Call
Aug 5, 2019, 10:00 a.m. ET

Contents:

  • Prepared Remarks
  • Questions and Answers
  • Call Participants

Prepared Remarks:

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 website 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 line for questions. Today's call may include forward-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 expressly 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 website.

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

Dino E. Robusto -- Chief Executive Officer

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 0.5 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 0.5 point better than the first quarter. We generated robust growth in the US segments 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's Syndicate, which was down 23% resulting from our reunderwriting 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 it's steady retentions in the US. In the second quarter, rate for P&C overall was 4% up 1 point from the first quarter with commercial and specialty each up 1 point and international up 2 points from the first quarter. I may drill down a little more pushing for rate increases is a 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 workers' compensation in 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 reunderwriting efforts. The 4 points of rate overall in the second quarter exceeds our long-run loss cost trends. 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 quarter, which is that pricing continues to migrate from being a headwind and now a tailwind, and that change is appropriate given that the headwind period lasted several years when price changes fell below long-run loss cost trend. It is encouraging at this tailwind is also beginning to include improvements in terms and conditions beyond price in areas where it is needed most. The larger property schedules, there is a broader adoption, a 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 jurisdictions. During a headwind period these terms and conditions tend to be 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 condition 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 loss cost trends.

Turning to the other elements of the quarter, new business in the US was up 13% in the second quarter, which was influenced by a few large accounts we have been working on for over a year and we were successful in securing in the second quarter. As I have mentioned in the past, securing high quality sophisticated accounts and 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 tenet of our strategy to getting 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 among 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 [Indecipherable] 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 that the long-standing performance we enjoy in our Specialty business. Our customized expert value proposition were 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 unit along the same path of enhanced specialization. We are targeting our investments in resources to those segments where we can better capitalize on our brand and expertise and were 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 are 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 and we added a new Head of Construction, Song Kim, who is a proven industry expert in this business, and reflects our targeted investment and resources.

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

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

Finally, our London-based operation is also migrating to a more specialized focus, where they will target similar segments in exposures building upon the expertise house within our Specialty and Commercial business unit. This is happening simultaneously through the reunderwriting process. So, it will take time to develop and show up in the results.

Now keep in mind, our drive toward greater specialization like all of the tenants of our strategy to achieve sustained top quartile performance will proceed with a deep sense of urgency at our fundamental focus and actions, our guided by the fact that we are playing for the long-term.

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

James Anderson -- Executive Vice President and Chief Financial Officer

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

Moving to each of our P&C business unit, Specialty's 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 development. Specialty's gross written premium ex-third party captives grew a healthy 6% in the quarter.

Our Commercial segment's underlying combined ratio was 94.9% in the quarter. The underlying loss ratio of 61.7% included a little less than 0.5 point of one-time costs related to the actions taken within our claim department and 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 5 points of catastrophe losses and a minimal amount of favorable reserve development. Commercial's gross written premium ex-third party captive 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's 2.6 points of favorable prior period development was primarily in 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 in the normal unwinding or 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 outcome. 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 and 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 the 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 of 8.9 years at quarter-end. Our balance sheet continues to be extremely strong. At quarter end, shareholders' 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 to the decline in interest rates. Shareholders' 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 using -- used to redeem $500 million of 5 and 7, 8 [Phonetic] notes due in August of 2020. The deal was significantly oversubscribed, it came in at spreads comparable to our peers' rate it a notch higher than our current ratings.

And on the subject to ratings, we were pleased that Fitch upgraded our financial strength rating A plus and, and that's upgraded our issuer credit rating to A plus during the quarter, providing further validation of the strength of our balance sheet in the momentum of our business.

Finally, we're pleased to announce our quarterly dividend of $0.35 per share.

With that, I'll turn it back to Dino.

Dino E. Robusto -- Chief Executive Officer

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 the $612 million, the highest level in 12 years. Our 2019 second quarter core return on equity is 9.9%. Our underlying P&C loss ratio was 60.8% for the quarter and 60.7% year-to-date. US net written premium grew 8%, we achieved 4 points of rate in the quarter, 1 point higher than the first quarter, and we are optimistic at the rate environment will continue to be a tailwind.

With that, we'll be glad to take your questions.

Questions and Answers:

Operator

[Operator Instructions]. We will take the first question from Josh Shanker from Deutsche Bank. Please go ahead.

Josh Shanker -- Deutsche Bank -- Analyst

Hi. Good morning, everyone.

Dino E. Robusto -- Chief Executive Officer

Good morning.

James Anderson -- Executive Vice President and Chief Financial Officer

Good morning.

Josh Shanker -- Deutsche Bank -- Analyst

My two questions. The first one, you've said that pricing is ahead of loss cost in an aggregate, your commercial pricing is up 3%, but I guess up 5% excluding workers' comp. Historically, long-term [Phonetic] loss cost trends for the industry's facts around 4%, 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-workers' comp, is that comfortably ahead of long-term loss cost trends. I mean, it just seems to me that's about, that is about the long-term loss cost trend, maybe you can give me some color on that.

Dino E. Robusto -- Chief Executive Officer

Yeah. 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, were actually it's around 1%. So when we look in aggregate our portfolio loss cost trend, it's about 2.5 points when you factor in that 1 point on what's about between 15% and 20% of our portfolio. So when we look at our overall rates in Q1, our overall rate was 3% again, so that was higher than that long-run loss cost trends. And then in this quarter, the overall P&C rate was 4%. So both quarters being ahead of that 2.5 point loss cost trends. So hopefully, it's a little bit of [Indecipherable].

Josh Shanker -- Deutsche Bank -- Analyst

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

Dino E. Robusto -- Chief Executive Officer

Sure. So we've been following this legislation that this issue for quite some time. It's not new. We've been considering the potential impact to our reserves all along. And that really -- that consideration continues to be part of how we think about our overall reserve position. Now remember our claim department has been handling these types of claims for years. So we're 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 for many 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 -- Analyst

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

Dino E. Robusto -- Chief Executive Officer

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 -- Analyst

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 -- Analyst

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 was up a little bit there too. I was just wondering if you can give us a sense of what's going on and especially in light of the various expense initiatives you have under way.

Dino E. Robusto -- Chief Executive Officer

Sure. Gary. On the 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 is a lag, is that premium written earns. So one of the things you're seeing there is just earned -- net written premium being a little lower in the 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 -- Analyst

Okay. That's helpful. And just I wanted to shift to loss trends. Thanks for that 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 2.5 points [Phonetic] suddenly becomes 3.5 points or 4 points?

James Anderson -- Executive Vice President and Chief Financial Officer

Yeah. You remember that 2.5 points is our long-run loss cost trend. 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 increase 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 is a heavy correlation where we're getting rate versus what's happening with the short-term loss cost trends.

Gary Ransom -- Dowling & Partners -- Analyst

Right. Okay. And just maybe one last question on workers' comp. There is some signs of change there, meaning maybe [Phonetic] rates are bottoming in the few places starting to go up. Do you have any thoughts on those trends?

Dino E. Robusto -- Chief Executive Officer

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, but even this severity has maintained a quite a benign spot.

Gary Ransom -- Dowling & Partners -- Analyst

Okay. That's helpful. Thank you very much.

Dino E. Robusto -- Chief Executive Officer

You bet.

Operator

We move onto the next question from Meyer Shields from KBW. Please go ahead.

Meyer Shields -- Keefe, Bruyette, & Woods, Inc. -- Analyst

Great. Thanks. Two CNA 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 accomplished in terms of closing the combined ratio gap between the two segments?

Dino E. Robusto -- Chief Executive Officer

I mean, look, it's clearly showed itself to be very, very effective within Specialty and ultimately over the last 2.5 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 become comfortable with an understanding is those segments where we really have some competitive advantage and the competitive advantage is 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 -- into those specific areas and we deprioritized 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 it's really the time, everything is done methodically, was done methodically over the last 2.5 years. And so, we have to get to certain initiatives, whether it was institutionalizing more of the underwriting culture building those distribution relationships, enhancing our talent and now -- now is the time and the opportunity for us to really prioritize the specialization with additional efforts some 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 top quartile 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 challenge 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 over time.

So difficult for me to pin down exactly what the marginal gain is going to be. Look, when you think about top quartile performance for us, we're at 94.6%, were a couple of 3 points away, from that and we think there is a little bit on the loss ratio in particular, as you execute some of these continued rate in terms and conditions and there is 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 -- Keefe, Bruyette, & Woods, Inc. -- Analyst

No, that's very helpful. Thank you. Can -- I think maybe the question for James, I was hoping you could talk a little bit about why the loss trend in affinity is as low as it is?

James Anderson -- Executive Vice President and Chief Financial Officer

Why it is?

Meyer Shields -- Keefe, Bruyette, & Woods, Inc. -- Analyst

Yes.

James Anderson -- Executive Vice President and Chief Financial Officer

Well, listen, we've been in that business for a long time, it is a very homogeneous business with lots of smaller 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 kind of give a fundamental advantage to us. And I don't think there's much more to it than that.

Dino E. Robusto -- Chief Executive Officer

Yeah. 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 as indicated.

Meyer Shields -- Keefe, Bruyette, & Woods, Inc. -- Analyst

Right, now, I understand all that. And it's clearly showing up. I was just wondering what is it about the business that trends that producers such low loss trends.

James Anderson -- Executive Vice President and Chief Financial Officer

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

Meyer Shields -- Keefe, Bruyette, & Woods, Inc. -- Analyst

Okay. No, [Indecipherable] I can see how expertise are doing. 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 kind of conflict with normalizing loss trends that the industry is not anticipating?

James Anderson -- Executive Vice President and Chief Financial Officer

Well, I mean, that is -- 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'd be in frequency or severity. So that -- sure we're getting appropriate price when that happen.

Meyer Shields -- Keefe, Bruyette, & Woods, Inc. -- Analyst

Okay. Thank you very much.

James Anderson -- Executive Vice President and Chief Financial Officer

You bet.

Operator

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

Jay Cohen -- Bank of America Securities -- Analyst

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

James Anderson -- Executive Vice President and Chief Financial Officer

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 comment for a long period of time. Is really closely aligned to us getting rate increases in different state and seeing policyholders make choices whether they decide to left 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're 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 Securities -- Analyst

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 -- Executive Vice President and Chief Financial Officer

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 approach a 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 that a policyholders 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 raise this business to be able to at least breakeven.

Jay Cohen -- Bank of America Securities -- Analyst

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

James Anderson -- Executive Vice President and Chief Financial Officer

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 E. Robusto -- Chief Executive Officer

No, that's great. Thank you everyone and we'll see you in another quarter.

Operator

[Operator Closing Remarks]

Duration: 35 minutes

Call participants:

Dino E. Robusto -- Chief Executive Officer

James Anderson -- Executive Vice President and Chief Financial Officer

Josh Shanker -- Deutsche Bank -- Analyst

Gary Ransom -- Dowling & Partners -- Analyst

Meyer Shields -- Keefe, Bruyette, & Woods, Inc. -- Analyst

Jay Cohen -- Bank of America Securities -- Analyst

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