Cincinnati Financial Corp (CINF) — Q3 2015 Earnings Call Transcript

Hello, this is Dennis McDaniel at Cincinnati Financial. Thank you for joining us for our third quarter 2015 earnings conference call. Late yesterday we issued a news release about 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 Investors website, cinfin.com/investors. The shortest route to the information is a quarterly results link in the navigation menu on the far left. On this call you will 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 the Cincinnati Insurance Company's Executive Committee Chairman, Jack Schiff, Jr.; Chairman of the Board, Ken Stecher; Chief Insurance Officer for Cincinnati Insurance, 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 those 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. Now I will turn the call over to Steve.

Thank you, Dennis. Good morning and thank you for joining us today to discuss our third quarter results. Overall, it was another strong quarter. Our results reflect positively on our strategy and the efforts of our associates and independent agents. We continue to benefit from executing our fundamentals while enhancing performance through various initiatives. Our underwriting programs and investment philosophy led to substantial underwriting profit and marked the ninth consecutive quarter of growth in investment income. Disciplined underwriting and pricing on each policy were slightly affected by less favorable weather-related catastrophic impacts compared to the third quarter of last year. Overall, we achieved a third quarter 2015 consolidated property casualty combined ratio of 87.8%. Our nine-month 2015 combined ratio before the impacts of catastrophes also stood at 87.8%, an improvement from both full-year 2014 and 2013. Each of our major business lines has performed well this year except for commercial auto and personal auto. We are actively improving pricing precision and other initiatives to enhance performance in our auto business over time. In late 2011, we set a long-term goal of profitably reaching $5 billion in direct written premiums by the end of 2015. It appears we may not achieve that goal this year, but we have consistently emphasized our focus on profitable growth. I am pleased with our overall underwriting profitability so far this year, and I won't be disappointed if we do not reach $5 billion in premiums until 2016. Over the past five years, our premium growth has roughly doubled that of the U.S. property and casualty industry. We continue to secure quality new business from our agencies, particularly in personal lines products and services for higher net worth clients. Of the $16 million increase in nine-month new business written premiums for our personal lines segment, nearly 20% of that came from high net worth policies. We introduced Executive Capstone, our new suite of high net worth insurance products, in New York this past September and expect these products to significantly contribute to profitable premium growth over time. We are on track with an initiative we announced in the second quarter regarding the expansion of our reinsurance assumed, referred to as Cincinnati Re. We have an experienced executive leading this effort and are assembling a small team of talented individuals to help implement our plans. We are committed to remaining disciplined during this expansion, especially in challenging reinsurance market conditions. As of September 30, we had entered into several diverse treaties. If each treaty is maintained for its full term and the premiums related to the risks we are reinsuring materialize as expected, we estimate that these treaties could generate around $30 million in premiums over the next year. The premiums, losses, and expenses recognized in the third quarter of 2015 from our reinsurance assumed program were each below $500,000, having an immaterial effect on our results for the quarter. Regarding renewal policies, as we further segment our business, we utilize pricing precision tools and informed underwriter judgment to select and retain policies at prices that we believe offer an acceptable return for the risks we accept. Overall pricing for the third quarter was comparable to the second quarter. Average renewal price increases for commercial lines continued to trend in the low single digits. This average also includes policies with three-year terms that were not up for renewal in the third quarter. For the commercial property and commercial auto policies that did renew during the third quarter, we achieved meaningful price increases, with property averaging in the mid-single-digit range and auto near the high end of the low single-digit range. Our most profitable line of business in recent quarters, workers compensation, experienced slightly negative pricing during the quarter. While the average pricing adjustment may have been negative, we continue to assess prices on a policy-by-policy basis. Certain policies identified as needing a price increase received one. The average renewal price increases for our personal auto policies were near the low end of the mid-single-digit range, while homeowner policies were slightly higher within that range. In the excess and surplus line segment, the average renewal price percentage increases for the third quarter of 2015 were around the low end of the mid-single-digit range. The NS segment continues to perform very well, delivering another quarter with a combined ratio below 80% and experiencing double-digit growth in net written premium. Our life insurance subsidiary, including income from its investment portfolio, also had a strong quarter. The growth in profit for the third quarter has pushed our nine-month life insurance results above last year's levels. Our primary measure of financial performance, the value creation ratio, is intentionally designed for the long term. We recognize that it may sometimes fall short of targets in the short term due to market volatility. We are focused on underwriting profitability and growth. Our insurance business is in excellent condition, contributing more significantly to this year's nine-month value creation than in the previous year. We have confidence in our associates, the relationships we build with independent agencies, and the ongoing benefits of our strategic initiatives aimed at continually improving performance. Lastly, I would like to express my sympathy for those affected by the flooding this fall. We dispatched a storm team of our highly trained associates to South Carolina to meet with policyholders in person and swiftly begin the recovery process. We currently estimate that our total losses from this catastrophic event will be between $4 million and $8 million. I will now pass the call to our Chief Financial Officer, Mike Sewell, to discuss other aspects of our recent financial performance.

Thank you, Steve, and thank you to everyone for joining us today. First, I will discuss some key points from our third quarter investment results. Although the fair value of our equity portfolio declined by 4% during the quarter, we still ended that period with a net unrealized gain of over $1.5 billion before taxes for our common stock holdings combined. We saw continued growth in investment income, which increased by 4%. All 50 common stocks in our core portfolio raised their annual regular dividend over the period from October 2014 to September 2015, with a median dividend increase of 7.6%. In our fixed maturity portfolio, interest income rose despite a decline in average yields, partly due to net purchases of $486 million made in the first nine months of 2015. The pretax average yield for our bond portfolio in the third quarter of 2015 was 4.62%, down 14 basis points from a year ago. Taxable bonds bought during the third quarter had an average pretax yield of 4.64%, while tax-exempt bonds averaged 3.32%, both higher than last year’s figures. The effective duration for our bond portfolio as of September 30 was 4.7 years, an increase from 4.4 years at year-end, mainly due to the effects of rising interest rates on our callable bonds rather than a strategic shift. Cash flow from operating activities again supported investment income growth, with net operating cash flows for the first nine months of 2015 rising by 19% compared to last year to $755 million, which facilitated $624 million in net securities purchases for our investment portfolio. We are still carefully controlling our expenses. Although we are continuing to strategically invest in our business, the expense ratios for both the third quarter and nine months in property-casualty underwriting saw a slight rise compared to previous periods. Regarding loss reserves, I want to reaffirm that our overall approach to setting reserves remains consistent with the past. We aim for net reserves firmly within the upper half of the actuarially estimated range for net loss and loss expense reserves. For the first nine months of 2015, favorable reserve developments from prior accident years improved our combined ratio by 4.4 percentage points, which is slightly better than the 3.9 points from the same period last year and in line with what we saw in the first half of this year. While our major lines of business in commercial and personal auto have performed well this year, nearly 75% of the unfavorable reserve developments in our auto lines were attributed to accident years 2013 and 2014. In the nine months of 2015, our net favorable developments were distributed across several accident years, with 41% from accident year 2014, 21% from accident year 2013, 29% from accident year 2012, and 9% from all older accident years combined. Our capital strength remains robust, providing us with liquidity and financial flexibility. As of September 30, our parent company's cash and marketable securities totaled just over $1.8 billion, an increase of 1% from the end of last year. This strong capital is essential for the continued growth of our insurance operations and allows us to take management actions such as returning capital to shareholders. During the third quarter, we allocated $73 million for dividends to shareholders and $21 million to repurchase 400,000 additional shares at an average price of $51.74 per share. Similar to our previous share repurchases, this was a maintenance measure aimed at offsetting the issuance of shares through equity compensation plans. I will conclude my remarks as I usually do by summarizing the contributions during the third quarter to book value per share, which are the main drivers of our value creation ratio. The property-casualty underwriting contributed $0.53 to book value, while our life insurance operations added $0.07, and investment income excluding life insurance along with certain reductions from non-insurance items contributed $0.47. The change in unrealized gains as of September 30 for the fixed income portfolio, after accounting for realized gains and losses, decreased book value per share by $0.07. The change in unrealized gains for the equity portfolio decreased book value by $1.37. We declared $0.46 per share in dividends to shareholders, leading to an overall book value decrease of $0.83 during the third quarter, bringing it to $38.77 per share. Now I will turn the call back over to Steve.

Thanks, Mike. In closing our prepared remarks, I would like to share some other positive news we received during the quarter. While we don't seek accolades, it is nice when we're recognized for our efforts. Forbes has again ranked Cincinnati Financial Corporation among America's 50 most trustworthy financial companies in 2015. This marks the fifth consecutive time Forbes has recognized Cincinnati Financial for openness and integrity in accounting, governance, and management. As we head into the last quarter of the year, we're committed to maintaining the momentum we have created so far in 2015. We're confident that Cincinnati Financial is on the right track to deliver shareholder value far into the future. 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. Nick, would you please open the call for questions?

I wanted to get a little detail on your entry into the New York market and the appetite for high net worth homeowner's products there given incumbent carriers and whatnot.

We began our efforts in New York by appointing several agencies, totaling 14, including 12 in the New York City/Long Island area and two nearby. Our goal is to maintain a relatively small number of appointments. We are looking to offer Coverage A limits up to $50 million, although I don't expect high volume at this level. However, we do have a strong appetite that reflects the expertise that Will Van Den Heuvel has brought to the Company, along with his growing team. Our marketing team is actively in the region, and we have also recruited professionals who have previously worked with Will to lead our risk control, appraisal, and valuation units there. Additionally, we have a specialist in Cincinnati focused on high net worth clients and have trained 100 of our field claims representatives in that area. We believe we are well-equipped to deliver the level of claims service that sets us apart nationally. We have made a solid start, and while we are not aiming for rapid expansion, the interest from agencies in partnering with us has been very positive.

What about the source of business? Are you gaining that business from established companies? Many high net worth writers mention there are numerous opportunities to attract clients from the general market, specifically those not being catered to by high net worth specialists. New York is a fairly sophisticated buyer's market. What does the marketplace look like there?

Well, we're getting business. The agencies we have appointed have pretty much all been high net worth specialist agencies. So we're writing business in some cases from within their agencies; we have helped them write new accounts and have written some accounts that have previously been written by some of the major players in that area. But as you mention, an awful lot of that marketplace, the majority of that marketplace is currently being served by carriers that don't specialize in the high net worth area. And we're seeing some business not only in New York City and that area but also around the country from carriers that would not be in those top five carriers that everyone speaks of when it comes to mind.

In terms of the current accident picks in commercial casualty, it's clearly been an excellent quarter with a significant improvement in the loss ratio. When evaluating that business, what portion is allocated to IBNR and what portion is allocated to case? As you adjust your new loss pick, how do you approach that? Where does the data come from that provides the most accurate estimate?

Yes, Josh, this is Steve. And basically we look at it in terms of estimating and making our actuaries do the best estimate of the ultimate accident year for each accident year. And they will use a variety of techniques for commercial casualty. In particular they are going to use a multiple regression technique on paid losses which would take any variability and claims reserve setting and so forth out of the equation, although they do also look at incurred methods, Bornhuetter-Ferguson methods and so forth. But there is an emphasis there on the paid losses and regressing along three different ways, the accident year, the report year, and the calendar year. So, I think in answer to the question, the main point is to try the best, the actuaries try their best to pick the appropriate accident year ultimate; then they would subtract off the paids and the case reserves to arrive at the indicated IBNR.

Well, if I am getting too specific with the next question I completely understand. How far is the current ultimate pick for 2014 comparing cash with where you are picking 2015 today?

A few questions. Let me start with just clarifying a couple of numbers. In your opening remarks you said that the high net worth products were 20%, that is of the personal lines new business, not of all new business, right?

That is correct.

Okay, so that sort of $6 million-ish for about one month worth of work?

Yes, I want to emphasize what J.F. mentioned. We launched the Capstone high net worth product in New York in September. Additionally, we have introduced four endorsements to our Executive Classic, which is our existing high-end homeowners product, to enhance it. We are also selling the high net worth product through our current agencies across the country, and that growth will be included as part of the new business for high net worth.

Mark, this is J.F. I want to highlight what Steve mentioned. Since Will joined the Company, we've informed all our agencies nationwide that we are more open to the high net worth segment. Previously, about 10% of our written business was high net worth, which I would consider more mass affluent, with Coverage A limits of $2 million or less. When we refer to high net worth, we mean Coverage A of $1 million or more. We are still seeing significant activity in the $1 million to $3 million range. The feedback we’re receiving from agencies that already represent us for personal lines has improved.

Okay, so just to paraphrase what you said, it would be a mistake to assume that the $6 million is all New York area. Some of it is New York certainly, but it is also the rest of the Cincinnati map is in that total via the endorsement of the existing product?

A small percentage would be New York.

Okay, that was my first question and you actually answered my other question related to high net worth on where the limits tend to kick in. The second question I had, in your opening remarks, Steve, you mentioned the Cincinnati Re and I think you said $30 million of premium, was that right?

Yes, that was correct and we might want to just amplify a little bit in terms of how we're booking the premium and I will turn it over to Mike to maybe touch on that.

Yes, that would be great. Hey, Mark, it is Mike. Currently, Cincinnati Re has six contracts or treaties that generally last 12 to 18 months. While the premiums may not always be known from the start, we estimate that we will receive $32 million over these periods compared to the $15 million reported at the end of the second quarter, effectively doubling that amount. However, the figures we've reported in the third quarter financials aren't material just yet. When we write a contract, we might know the full premium or we may have to wait until the cedent fully cedes the risk to us. For instance, in the case of workers compensation in California, we might not determine the final premium until we know how much the cedent ultimately writes and cedes to us. Therefore, it can be challenging to provide projections for future written or earned numbers. Nonetheless, what we've communicated is that we intend to proceed cautiously as we develop this business, only taking on risks that offer superior returns that enhance our value creation ratio. Congratulations to the team for a strong start, and we will have more updates in future quarters.

And Mark, this is Steve. And kind of the intention on the disclosure here is that we're being our usual prudent self when it comes to booking revenue, but we also want to let you know that we have six contracts out there that have the potential of ultimately producing $30 million in written premium. So we could have losses; we're being cautious on both sides I think.

Most of that was exactly what I was going to ask. The two other little bits related to that and again this is really more just a disclosure and where I find it. I assume all of this is currently being reported up through the commercial lines unit and that those amounts are also showing up in the new business written premiums totals.

That is another great question, Mark and I probably should have touched on that. We're doing this similar to the way we did our E&S business when it was a start-up. So currently it is in other for our segment business. So you won't necessarily see it in there. When it gets to be larger it will actually be reflected as its own segment within the Q. So it's in other right now, so you really can't see it because it's so small. So again, we expect it to grow and then at some point it will be material enough to break out as its own segment. So you will soon see commercial lines, personal lines, E&S, Cincinnati Re assumed life investments and then you will end up with other. So that is the way we're expecting it to go.

I have a final question regarding the commercial lines unit, which performed exceptionally well this quarter from both an accident and non-accident year perspective. I noticed in the press release you mentioned a nine-month improvement related to non-catastrophe weather and large claim losses. Do those comments also apply to the quarterly improvement?

This is Steve. I believe they do. I think the quarter and the year have been pretty consistent over time.

What I'm really asking is that while this is obviously good news, there may be some mean reversion in future quarters where the situation could shift back against us.

I want to ensure I am expressing this correctly. We aimed to focus closely on the core ex-cat accident year, and we believe we're making steady incremental progress. It's not significant, but we are persistently working on it, and there will be some fluctuations due to large losses and similar factors. However, we feel that with the initiatives we've implemented, we still have room for further incremental improvement. I would emphasize these comments in relation to the nine-month data as it shows less variability.

Okay. And then last question, Mike. You had mentioned the buybacks, those were all bus quarter, right? There wasn't anything incremental this quarter this quarter.

Actually there was incremental this quarter. So, it is by coincidence maybe. There was 400,000 shares in the second quarter and also an additional 400,000 shares in the third quarter. So year to date we have purchased back 800,000 shares for a total price of just a little over $41 million. So it is kind of averaging in the low $51 per share.

My first question is about the E&S business, which had an outstanding quarter with an underlying accident year of about 82%. This seems to be one of the best performances ever. Is there anything unusual about this? Was it simply a lack of property events or a change in the mix? I'm interested in understanding what contributed to this performance.

Ian, this is J.F. Our mix hasn't changed significantly; it remains around 15% property, so we have a strong casualty portfolio. A noteworthy point in E&S is the increasing pressure on larger accounts, which are mostly moving to the standard market, intensifying competition. The team managing E&S has done an excellent job ensuring we remain thorough in our underwriting practices. We have a solid opportunity within our agencies, which generate approximately $2.5 billion in E&S business, and our model is distinctive, offering a strong alternative for these agencies. This allows us to be selective about our writing. From the outset, Don has emphasized that in this business, there are times when we may need to be more stringent, although I don't believe we're at that stage yet. Nevertheless, we have managed to continue growing, evidenced by 61 consecutive months of rate increases, which supports our results. Overall, nothing has changed significantly that would lead to a drastic drop in our loss ratio. We continue to believe we are strong fundamental underwriters.

Before I move on to Mike, I have a question about commercial auto. Can you share any insights on where you are experiencing pressure in the book? Is it related to local vans, the construction sector, or perhaps long-haul operations? I'm interested in any specific areas that you think are noteworthy.

Yes, there isn't a clear issue with commercial auto that I can identify. It's a matter of severity rather than frequency. We're observing that as the economy improves, many new employees are becoming drivers. Unfortunately, some of these newer drivers may be a bit too inexperienced for the large trucks they are operating, which we often realize only after incidents occur. The American Truckers Association noted a driver shortage, increasing from 38,000 at the end of 2014 to an expected 48,000 by the end of this year. We're working on better verifying driving records and experience as well as matching vehicles to appropriate drivers. In Ohio, which is typically our top-performing state, we are facing challenges. There's a noticeable increase in the number of fatalities on Ohio highways this year. Anecdotally, we believe distracted driving also plays a role; there are cases where accidents occur without skid marks, potentially caused by drivers texting or talking on their phones. The industry is looking into various factors contributing to these issues, and it's clear that it's not just one problem but many.

And just related, does it put any pressure on the comp book for certain types of customers? Meaning if I have a business that has a lot of delivery vans or something and obviously if someone gets in an accident on the job I assume there is a comp payout too. So does that create any inflation pressure on comp as well?

It could very well and something we're paying attention to. When our loss control folks go out, they are on the lookout for that type of thing. We haven't seen it in our comp book yet, but we're looking for it.

Yes, you know the picks really haven't moved a whole lot. We look at it every quarter; the actuaries perform a thorough review during the quarter. So I would say it has been fairly flat from quarter to quarter, but it is a thorough review each quarter when they are looking at the picks.

Well, thank you, Nick and thanks to all of you for joining us today. We look forward to speaking with you again on our fourth quarter call. Have a great day.