Cincinnati Financial Corp (CINF) — Q1 2015 Earnings Call Transcript

Hello, this is Dennis McDaniel from Cincinnati Financial. Thank you for joining us for our first quarter 2015 earnings conference call. Late yesterday, we issued a news release on our results, along with our supplemental financial package, including our quarter-end investment portfolio. To find copies of any of these documents, please visit our Investor website, cinfin.com/investors. The shortest route to the information is the quarterly results link in the navigation menu on the far left. On this call, you’ll first hear from Steve Johnston, President and Chief Executive Officer; and then from Chief Financial Officer, Mike Sewell. After their prepared remarks, investors participating on the call may ask questions. At that time, some responses may be made by others in the room with us, including Cincinnati Insurance Company’s Executive Committee Chairman, Jack Schiff, Jr.; Chairman of the Board, Ken Stecher; Chief Insurance Officer for the Cincinnati Insurance Company, J.F. Scherer; Principal Accounting Officer, Eric Matthews; Chief Investment Officer, Marty Hollenbeck; and Chief Claims Officer for Cincinnati Insurance, Marty Mullen. First, please note that some of the matters to be discussed today are forward-looking. These forward-looking statements involve certain risks and uncertainties. With respect to these risks and uncertainties, we direct your attention to our news release and to our various filings with the SEC. Also, a reconciliation of non-GAAP measures was provided with the news release. Statutory accounting data is prepared in accordance with statutory accounting rules and therefore is not reconciled to GAAP. And with that, I’ll turn the call over to Steve.

Thank you, Dennis. Good morning. And thank you for joining us today to hear more about our first quarter results. The quarter included several areas of good performance, including enhancing our balance sheet strength. We see incremental progress as we steadily execute our underwriting and pricing strategies. Our investment strategy and successful portfolio management produced our seventh consecutive quarter of investment income growth. Careful underwriting and disciplined pricing, along with more favorable weather than the first three months of last year, led to a first quarter 2015 consolidated property casualty combined ratio of 97.5%. While that ratio improved by 2.8 points compared with the year ago, it did not meet our expectations. Every major line in our property casualty segments except for commercial and personal auto had loss ratios that translated into estimated combined ratios near or within the 90% to 95% range. We strengthened reserves for those auto lines of business, causing our overall combined ratio to rise above the sub 95% that we were seeking for year 2015. We believe our balance sheet is now stronger than it was at year-end. We continue to further segment our business using pricing precision and risk selection decisions that combine data models and informed underwriting judgment on a policy-by-policy basis. In the first quarter, we experienced strong retention and satisfactory renewal pricing, although premium growth continues to slow as we exercise pricing and underwriting discipline. As noted in the past, we tend to avoid drawing conclusions about trends based on a single quarter of data for certain measures, including premium growth. We continue to earn quality new business from our agencies, and we experienced a healthy pace of new business premium growth in our personal lines and excess and surplus lines segments. In addition to continuing to develop new products and services through our target markets department, we continue to make progress on expanding our current products and services aimed at high net worth policyholders offered through our personal lines insurance segment. We believe we are on track to begin offering a new suite of high net worth insurance products in the second half of this year through agents in the state of New York. Those products will include higher coverage limits than we offer today, along with other new options. In addition to growth opportunities with our agencies on a direct written premium basis, we see long-term opportunities in assumed reinsurance. Last night, we announced with a separate news release an important initial step for realizing future opportunities, hiring Jamie Hole as Managing Director, Head of Reinsurance Assumed to lead this initiative. We recognize the current challenges in the reinsurance market, and we won’t be trying to grow that business quickly; instead we’ll take our time and maintain underwriting discipline as we develop relationships and expertise that we believe will benefit the company and shareholders over the long term. Looking forward toward 2020, we’re in the early phases of establishing the vision of what’s to come. As always, that vision will include continuing to profitably grow the company with our successful agency-centered model and focusing on our value creation ratio to measure long-term value for shareholders. Over time, we expect to develop more specific objectives and plans, and we’ll communicate them at appropriate times. For the first quarter, average renewal price increases for commercial lines continued their percentages near the middle of the low single-digit range, very similar to the fourth quarter. That average includes the mitigating effect of three new policies that were not yet subject to renewal pricing during the first quarter. For smaller commercial property and commercial auto policies that renewed during the first quarter, we continue to obtain meaningful price increases. Those commercial property policies experienced percentage increases averaging in the high single-digit range; in commercial auto, average increases in the mid-single-digit range. For our personal auto policies, renewal price percentage increases averaged near the low end of the mid-single-digit range. Homeowner policies were a little higher in the same range. For our excess and surplus line segment, the first quarter 2015 average renewal price increases were also near the low end of the mid-single-digit range. That segment of our business turned in another outstanding quarter with the combined ratio of below 90% and net written premiums up 20%. Our life insurance subsidiary, including income from its investment portfolio, again contributed nicely to earnings, and again grew premiums in its largest product line, term life insurance. In conclusion, our primary measure of long-term financial performance, the value creation ratio was 1.3% for the first quarter, with operating income leading the way. We feel we are well-positioned for good overall financial performance for the remainder of 2015. I’ll now ask our Chief Financial Officer, Mike Sewell, to add his insights about our recent financial performance.

Great, thank you Steve and thanks to all of you for joining us today. I’ll start with some analysis of investment results. The investment income grew in the first quarter, mainly from the boost for stock portfolio dividends that rose 13% for the quarter. Yields continue to slowly decline for our bond portfolio. We generated a 1% increase in interest income over the first quarter 2014, as our net purchases of bonds during the last four quarters totaled $375 million. For bond portfolios, the first quarter 2015 pretax average yield reported at 4.7% was 12 basis points lower than a year ago but only 2 basis points lower than what we reported for the fourth quarter of 2014. We now report in our 10-Q the yields for new bonds purchased during the quarter and we added a table for yields of bonds expected to be redeemed by year, for the next two to three years. You can see that taxable bonds purchased during the first quarter had an average pretax yield of 4.34%, while tax-exempt bond purchases averaged 3.13%. Our bond portfolio’s effective duration remained at the same level as last year-end at 4.4 years. Cash flow from operating activities continues to help our investment income grow. Funds generated from net operating cash flows for the first quarter of 2015 rose 67% to $215 million, contributing to $93 million of net purchases of securities for our investment portfolio. Paying $38 million less for catastrophe losses was part of the reason for the increase in operating cash flow for the first quarter of this year compared with a year ago. We’re still carefully managing expenses, and the 0.2 ratio increase for the property casualty underwriting expense ratio was also explained in our 10-Q. As noted on our fourth quarter earnings call, we think investing in our business in areas such as enhancing pricing and underwriting expertise is a good trade-off over time. A short-term increase in expense can create long-term value for investors. For example, since the first quarter of last year, we strategically invested in personal line staff additions to support high net worth market expansion and we anticipate a good return on that investment. Loss reserves are the next subject of my comments. Our approach to setting overall reserves remains consistent with the past as we aim for net amounts well into the upper half of the actuarially estimated range of net loss and loss expense reserves. In the first quarter, we strengthened reserves for our auto lines of business. For our other lines in total, the best estimate by our actuaries of ultimate loss and loss expense ratios for all accident years in aggregate was similar to our year-end estimate. The ratio for our total property casualty net favorable reserve development on prior accident years was similar to the full year 2014, benefiting the combined ratio by a little more than two points. Overall, our first quarter 2015 net favorable development was, as usual, spread over several accident years, including 30% for accident year 2014; 22% for accident year 2013; 39% for accident year 2012; and 9% for all other accident years in aggregate. Steve noted that we enhanced the strength of our balance sheet this quarter. There are many ways to assess capital strength, and we think as an important aspect is our liquidity and financial flexibility. Cash and marketable securities for our parent company rose 2% from year-end, topping $1.8 billion at the end of the first quarter. Our strong capital also positions us well to continue to grow our insurance operations. I’ll end my prepared remarks, as usual, by summarizing the contributions during the first quarter to book value per share. They represent the main drivers of our value creation ratio. Property casualty underwriting increased book value by $0.11. Life insurance operations added $0.05. Investment income, other than life insurance, and reduction by non-insurance items contributed $0.37. The change in unrealized gains at March 31st for the fixed income portfolio, net of realized gains and losses, increased book value per share by $0.19. The change in unrealized gains at March 31st for the equity portfolio, net of realized gains and losses, decreased book value by $0.18. We declared $0.46 per share in dividends to shareholders. The net effect was a book value increase of $0.08 during the first quarter to another record high of $40.22 per share. And now, I’ll turn the call back over to Steve.

Thanks Mike. In closing our prepared remarks, I would like to mention a few other events of the quarter that show the commitment of all of our associates to keep getting a little bit better every day, keeping us on track to deliver shareholder value far into the future. First, we’ve made outstanding strides in improving our real-time download capabilities which make it easier for our agency customers to do business with us. At the recent conference, NetVU recognized those efforts by presenting us with their Quantum Award for offering superior workflow productivity. NetVU is the agent-based user group for Vertafore’s agency management system. Second, we’re working to be good stewards of all our resources, including our natural ones. Our headquarters facility recently earned the silver level certification for LEED for existing buildings, operations, and maintenance. We are one of only 40 buildings with more than 100 million square feet to earn certification in this LEED category nationally. We appreciate this opportunity to respond to your questions and also look forward to meeting in person with many of you during the remainder of the year. As a reminder, with Mike and me today are Jack Schiff, Jr., Ken Stecher, J.F. Scherer, Eric Matthews, Marty Mullen, and Marty Hollenbeck. Erica, please open the call for questions.

I know you guys don’t like to make a forecast based on one quarter but there is a real trend if we look at the homeowners’ line. You guys have grown double digits as recently as the year ago; fourth quarter was light, so was there is no growth this quarter in it, and I know you’re making a drive in that high net worth product, I guess. What’s happening there? Can you talk about that a bit?

Josh, this is J.F. Scherer. A couple of things happening there. We were taking some pretty significant increases in homeowner rates over the last several years that have moderated now. That drove a lot of the growth. We think we’ve reached great adequacy in a lot of the states. And so, we’re doing a fair amount of tweaking but nothing as drastic as we had been. We are also in the process of running off our Florida originated personal lines book of business that started last July. And so that’s contributing to an absence or it’s diluting growth in the homeowner line as well. So that will finish; we have one more quarter of that, and then beginning in the third quarter, the comparisons will be without the effect of Florida. Our new business in homeowners was up 16%; the initiative we have with the high net worth is really starting to take effect right now. So, we’re seeing a bit more business generated in the higher net worth area in both homeowner and auto for that matter. So, I think what you’ll see, without making any predictions of it, is a rebound in the growth rate in homeowners’ line.

And just philosophically, why the Florida now? I mean, three years ago, five years ago, eight years ago, I know these times someone could have made the decision to be in Florida. Currently reinsurance in Florida is probably more affordable than it’s been in a long time. What was the mathematics behind why Florida now?

We spent about the period of time that you just described trying to negotiate with the Department of Insurance for rate adequacy in our homeowner book of business. It was locally inactive, inadequate, and had gotten that way over a period of time due to really matters related to legislative reasons. For the legislator that enacted limitations preventing us from raising rates for our book of business, necessitating us to have adequate rates. It took us a lot of time to exhaust all those options, and then it was finally concluded that we were not going to be able to get adequate rate increases, so we chose to leave. There wasn’t going to be enough relief, not even close to enough relief in reinsurance costs in Florida, to cause us to believe that the risk we were taking at the rates we were allowed to charge were worth it. So, in the commercial lines area, there is low rate flexibility. Obviously, the Department of Insurance is interested in protecting the personal lines clients, whereas business clients can make their own decisions about what they pay for insurance. So, we’re still there in commercial lines; we still monitor what goes on within the state. It could very well be that based on more flexibility in the state of Florida that we could someday write more business down there. As it is right now, the only personal lines business that we’re writing in Florida is business that’s collateralized. By that, I mean, it’s originated from states outside Florida with business that we believe warrants us to take whatever risk we might take on secondary residence in Florida.

Understood, thank you for all clarity. And look, I’ve asked this question several ways every conference call; at least somebody has. I ask it different ways. It does seem that your loss taking is more accurate now than it was maybe five years ago and something we might view that as a pejorative statement because usually you had fixed cap for favorable development, and now you're giving numbers closer to rights. I don’t know how you view all that? Do you feel that you have a better grasp on loss? Do you think the attitude has changed by giving numbers right versus giving them overestimated has changed? It feels totally different, and maybe in two years we look back at the time and laugh at it as a cycle moment, but it does feel with all the disinflationary pressure over the last few years, I’m surprised there are not more reserve releases.

I think over time, we’ve been consistent in our approach. I think we always go with the actuarial people’s best estimate of their ultimate losses. I would think that with every area of our company, I would agree that there has been improvement and they’ve gotten better at picking the ordinates. But I also agree that there is tremendous uncertainty; it will be interesting to look back in a few years and see how accurate everything has turned out to be. I just always try to stress that it’s a very consistent approach. We go with the actuary’s best estimates, and we do feel in the area that we’re trying to get a little bit more precise.

There is an awful lot being precise. Thank you for all the answers.

To start off on the assumed reinsurance discussion, I know it’s really preliminary, but I’m curious if any lines that you might target. And then it sounds like this may be more of a direct effort, but there is some mention of JLT, maybe it was implied, but will JLT play a fairly big part here? Just trying to understand the distribution nature of that effort?

I guess one thing, I would like to make one point is assumed reinsurance is not entirely new to us here at Cincinnati. Over the past year or I guess over the past 20 years, voluntary assumed reinsurance has been as high as about 2.4% of our net writings. This has largely been done through various pools and retrocessions that we’ve been involved with reinsurers and companies with whom we had long relationships. But we’ve been very passive participants, and it is my opinion that we kind of lacked expertise. Currently, we’re down to just one contract that we’re involved with. So, we feel here that we have the opportunity to bring in really some excellent talent. And with Jamie Hole, we know we have a known quantity with a long successful relationship. We are more confident that we’ll be at good deal flow from JLT over time, as well as from other entities that we’ll work with. We believe Jamie is going to establish a small team of expertise as part of Cincinnati Insurance. We’re going to execute what we describe as an allocated capital model. We are going to do our best to contract by contract to estimate the capital that would be needed for that individual policy and only move forward if we can get our fair risk-adjusted return on that policy. We recognize it’s a really tough market right now, and we’re going to be very judicious. Just look at everything, kind of to your other point, policy by policy; we don’t have a specific line of business strategy or anything like that. It’s going to be very much technically based on a policy-by-policy basis. We’re only going to look at diversifying opportunities, so obviously nothing in the Midwestern convective storm area. We believe the diversification that we may be able to achieve over time should be really helpful to us in driving up our overall risk-adjusted returns. Again, we’re going to be very careful and disciplined in putting our capital to work here.

I guess one thing I would say that among some of the other companies we cover, I think Cincinnati has a very good reputation among your peers. And I don’t think there is any doubt about your capital adequacy. So that said, I’m wondering if there would be a target for U.S. regional business outside of the Midwest or, to your point on diversification, if you’d look outside of the U.S. to get some of that diversification benefit?

We’re going to be very flexible, certainly not in the Midwest, but beyond that we’re going to be very flexible and again, policy-by-policy, contract-by-contract, look at them very closely one-by-one.

I guess bringing it a little bit closer to home here. On that incurred ratio, I noticed that that dropped pretty decently in the quarter. I wanted to check in and see if that’s the result of maybe a little bit lower weather losses or, obviously, development and some of the lines can play a part there. Just curious if any of this is stemming from a little bit higher initial asking price or just any color there would be helpful.

I do think that, again, we go with our actuarial best estimate. I think they have been very prudent in the way they’ve gone about things. I think with a couple of lines, the auto lines, while we’ve had favorable development overall and again building on 26 years of favorable development, we hadn’t had a couple of lines; the auto lines had some adverse development. I thank particularly here in the first quarter it is a situation where when you see some adverse development and now you’re making the initial pick on just one quarter; the first quarter of a new accident year, you certainly don’t want to step into the same situation that we were in before. I think that being prudent in the picks that they are making through the current accident quarter, particularly on those auto lines given what we’ve seen.

Would it be fair to say on the auto lines, but you’re kind of responding to some of the same trends in your comments, trying to make sure that it doesn’t re-emerge for this year? Or has there been anything incremental that has emerged since the year-end review where from a loss cost side you have to maybe take another step back?

I think it would be more of the former.

And then just one last one if I can speak to it a little bit. The press release noted sort of the $5 billion goal. There has been some conversation about a 2020 plan, looking out a little bit further out. I’m curious if you guys would be prepared to talk about growth plans looking further out in reconciling that to the pace of the ’15 goal and the expectations where we are today.

We said that 2015 goal several years ago, and I think it’s a really good goal and it has spurred us forward. One thing that we’ve always made perfectly clear is that we are only going to do it if we can do it profitably. I think it has been beneficial. If you look back, just recently the A.M. Best in one of their best rankings in March put out the new list of companies with U.S. net written premiums, and we moved up to 22nd. Over this period, we started at year-end 2010 as the 26th largest writer based on U.S. net written premiums. Each year, we’ve moved up one position from 26th to 25th to 24th to 23rd to 14th, and down to 22nd. I think setting and the work that goes into setting these plans is very important. We have stressed that we are only going to do it if we can do it profitably. We’re glad to say that over that period of time, other than catastrophic events in 2011, we’ve been able to maintain sub 100 combined ratios and we're looking good about that again here for 2015. So, it’s been a good goal; I think it’s going to come down to the wire, so we are hedging a little bit as we make our disclosures. But I think it’s really good to set out ambitious challenging goals that are achievable, while always keeping our focus on the need for profitable growth. We’ll do the same thing as we move into our planning for the 2020 goal. At this point, I might ask J.F. if he had any other input he’d like to add to that.

I think Steve has summed it up pretty well. We still think we have tremendous potential. When we get around to setting projections for 2020, we will certainly be ambitious. We’re still in 39 states; our penetration rate in those states is still relatively low; the number of agencies we have is still relatively low, at sub 1500 agencies. We think we have tremendous opportunities within those agencies, as they write over $30 billion in premiums within those agencies that we don’t write. But really, as Steve said, we’ve done so much in the area of fortifying our profitability through analytics, modeling, loss control, inspections, special services, and specialization and underwriting target markets. Notwithstanding the fact that $5 billion might be a little short this year, we’re certainly not pessimistic about how we can look at 2020 and beyond; we feel actually pretty good about that.

Just wondering if you could touch on the expense ratio. I don’t know if you had any kind of estimation or is this a good kind of quarterly run rate to use for what it might be for the full year? Might it be up a little bit? I know you mentioned some of the initiatives. Is your expectation this? And is most of the increase, you talked about strategic investments; is that mostly personal lines and technology or is there anything else in this?

This is Mike. There’s probably a lot of different strategic investments that we’re making. For a run rate for the rest of the year, it’s going to be a combination of our investments, how much we’re spending, and the growth of the premiums. Some of the investments that are in there, I mentioned were related to our high net worth homeowners and so forth. But we’re investing probably more; we’ve got more inspectors, and we started a customer care center that’s going to be ramping up this year. Our target markets, the focus that we have, IT as you mentioned, and we’ve been adding more actuaries to be able to better segment the business and price adequately, etc. So, you’ve really got a combination of a lot of investments. We’ve been watching our existing costs and really just trying to control those. So, we’re still controlling those. But you can only squeeze so much out, and so with the investments that we’re making. As you look at the first quarter compared to the first quarter of the prior year, with our combined ratio being a little bit better, our profitability there; there is also just a slight uptick that’s related to our profit-sharing or contingent commissions for agents. So, it’s a combination of all that; you saw a little bit of an uptake; let’s wait to see how the rest of the year pans out. But we’re not really changing our direction on increasing expenses overall; still controlling them, but with strategic investments and growth in premiums.

Speaking a little about the national advertising campaign you launched during the quarter, what are your expectations for its impact on that part of the business as you increase your high net worth efforts in 2015 and 2016?

Scott, this is J.F. Have you seen the ad? No? Well, maybe we need to run it more often. This is actually the first time we've done any national TV ads. The ad will be running for two weeks on, two weeks off, through September. It’s being aired on CNN and Fox News across various shows on Fox News. There is a demographic on those cable channels that we are targeting, particularly a slightly higher net worth audience and business owners. We're not trying to compete with major advertisers. Instead, we aim to showcase the value of an agent and the key role they play in their relationship with our company. Alongside this, we have significantly increased our digital advertising. While the TV ad will contribute to this effort, digital advertising will be the primary focus. Although the general public is one audience for this ad, we also want our agents to engage with it. Having Cincinnati Insurance Company on a national scale builds confidence, especially as we expand out west into areas where Cincinnati Insurance hasn’t been active before. Reaching potential customers in those regions, including New York City for personal lines business, is valuable. This is part of a larger initiative that encompasses our agencies, digital efforts, and national outreach. You can expect consistency in this approach, but not a significant increase. We’ve been measuring the impact both qualitatively and quantitatively and have observed increased website activity during the weeks the ad runs. Notably, the agent tab that visitors click has seen a significant uptick during the ad broadcasts. We believe this strategy is already proving effective.

The next question is about the commercial and personal auto reserve strengthening. Was there no significant change in the first quarter regarding the severity or frequency of the claims? Can you provide any specific comments on what might have influenced that?

I would like to emphasize what we have already stated. Over the long term, we have observed trends in paid losses that have prompted us to strengthen reserves for the auto lines from previous years. This, along with our current observations, is guiding the actuaries to make careful initial selections for the first accident quarter of 2015.

I was hoping you could talk about the continued distribution expansion with a little bit more detail, just to kind of give us an update?

Paul, we’ve been appointing agencies about 100 new relationships a year over the last five or six years. We’ll probably continue expanding at that particular pace. As you know, there still continues to be a lot of M&A activity and consolidation of agencies. In some cases, it works to our benefit where the combined agencies create more opportunity for us in a community and some cases, it creates disruption, causing our premium activities to go down a little bit. We continue to look at new appointments, whether they be in Ohio. I don’t think you’re going to see much of an increase beyond about 100 new agency appointments. You will see some personal lines only appointments associated with high net worth specialists. We could end up appointing 500 agencies over the next five years; with the kind of consolidation occurring; maybe only net out 150 or 200 increases. But it is our plan to continue to appoint more agencies.

A follow-up, if I understood correctly from one of the previous questions, it sounded like the increases in the accident year ex-catastrophe loss ratios in personal and commercial were primarily due to what you’re seeing in both commercial and personal auto. And if that’s correct, along the same lines, I know you guys talked about non-catastrophe weather-related losses being lower than a year ago levels. I was curious if there were other items that may have been unusually elevated, like personal auto losses between $1 million to $5 million or maybe other items?

No, I don’t think there are a whole lot of other items; I think you touched on them with the personal and the commercial auto. I think there is a bit of an elevation in the commercial casualty. But I think you’ve pretty much hit on what we’re seeing in the quarter.

And so then, if I think about the pricing in personal auto and in commercial lines, I mean are you guys getting enough price to improve margins on a go-forward basis?

I think, we’re Mike. Time will only tell but I think from what I see, not only in pricing but what we’re doing on the underwriting side of things, when we really team up with it, when the claims, we have got every area of the company contributing towards improvement. I think we’re still on a trajectory of improvement here.

Thank you, Erica, and thanks to all of you for joining us today. We hope to see some of you this Saturday at our Annual Shareholders Meeting at the Cincinnati Art Museum. If you can’t make it, please listen to our webcast; that meeting is available at cinfin.com/investors. If not, we look forward to seeing you again at the second quarter call if not before. Thank you. Have a great day.