Cincinnati Financial Corp (CINF) — Q2 2016 Earnings Call Transcript

Hello, this is Dennis McDaniel from Cincinnati Financial. Thank you for joining us for our second quarter 2016 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 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. Second, 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. Now, I will turn the call over to Steve.

Thank you, Dennis. Good morning and thank you for joining us today to hear more about our second quarter results. We're pleased to report satisfactory operating performance despite second quarter catastrophe loss effects that were slightly higher than our long-term average. Thanks to the steady efforts of our associates to support the local independent agents who represent Cincinnati Insurance, we still managed to generate a modest underwriting profit in the second quarter, and our first half 2016 consolidated property/casualty combined ratio of 95.4% is within half a point of the first half of last year. We were encouraged by improving underwriting results before the effects of catastrophes and believe we'll see ongoing benefits from our various initiatives focused on profitability. Rising investment income and robust portfolio valuations at quarter end were another bright spot for recent performance. Higher investment income for the first half of 2016 offset a small decrease in property casualty underwriting profit leading to a 3% increase in operating income. Mike Sewell will comment further on that in a moment. First, I will highlight some important points about our insurance operations. Each of our segments continues to grow satisfactorily as we earn quality new business produced by our agencies. Pricing was generally consistent with the first quarter. However, personal auto was an exception with average renewal rate percentage increases moving from the mid-single-digit range to the high-single-digit range. We believe that improved pricing for both our personal and commercial auto, along with other initiatives, will improve our results for those lines of business. Expansion of our reinsurance assumed operation, known as Cincinnati Re, also continues to progress nicely. Cincinnati Re generated an underwriting loss of just under $1 million for the second quarter as a result of a $4 million estimated share of losses from the Fort McMurray, Canada wildfire affecting the industry, plus what we believe is appropriate reserving for a diverse portfolio of reinsurance treaties. We are also satisfied with the progress of expanding the personal lines products and services we offer to our agencies’ higher net worth clients. Nearly one quarter of the total $59 million in personal lines new business written premiums for the first six months of 2016 came from high net worth policies. We reported an underwriting profit for each of our property/casualty segments in the first half of 2016. As in most years, we anticipate the second half to be better than the first. Our commercial lines segment produced a combined ratio of just over 95% for the first half of the year, while that ratio for our excess and surplus segment was just under 75%. Our life insurance subsidiary, including income from its investment portfolio, also experienced another good quarter and first half of the year. For the first six months of 2016, earned premiums grew 11%, and net income for our life insurance subsidiary rose 10% compared with last year. Our primary measure of financial performance, the value creation ratio, was again strong at 4.6% for the second quarter and 10.5% for the first half of 2016. Generally higher valuations in securities markets augmented the contribution of our operating performance. While we are pleased with ongoing good performance, we understand the need to remain focused on underwriting profitability and growth. We will do that as we seek to continually improve performance. I will now ask our Chief Financial Officer, Mike Sewell, to share his highlights for other areas of our financial performance.

Great, thank you, Steve, and thanks for all of you for joining us today. I will open with highlights of second quarter investment results. It was another stellar quarter for investments, including 6% growth in pre-tax investment income and 7% on an after-tax basis. We also experienced increases in the fair value and unrealized gain positions of both our equity and bond portfolios. We ended the second quarter of 2016 with a net unrealized gain of nearly $2.7 billion before taxes, including more than $2 billion for our common stock portfolio that reached more than $5 billion in fair value. For our bond portfolio, interest income again grew 4% in part due to net purchases of $309 million over the past four quarters. The bond portfolio's pre-tax average yield reported at 4.64% for the second quarter and 4.65% for the first half of 2016, matching the year-ago periods. Taxable bonds purchased during the first six months of 2016 had an average pre-tax yield of 4.5%, 8 basis points higher than we experienced a year ago. Tax-exempt bonds purchased averaged 3.01%, 33 basis points lower than a year ago. Our bond portfolio's effective duration at June 30 was 4.8 years, up slightly from 4.7 years at year-end. Cash flow from operating activities continues to fuel the investment income growth. Funds generated from net operating cash flows for the first half of 2016 rose 4% compared with a year ago to $490 million and helped generate $292 million of net purchases of securities for our investment portfolio. As always, we work to carefully manage our expenses at the same time of strategically investing in our business. Our first half 2016 property/casualty underwriting expense ratio rose 0.2 percentage points compared with a year ago. Our loss reserves continue to experience favorable development as we apply a consistent approach to setting overall reserves. For the first six months of 2016, favorable reserve development benefitted our combined ratio by 5 percentage points compared with 4.4 points for the same period last year and similar to the 5.2 point rolling average for the prior four quarters. Reserve development so far in 2016 continued to be spread over most of our major lines and over recent accident years including 55% for accident year 2015 and 22% for accident year 2014. Overall reserves, including accident years 2016 and net of reinsurance, rose $229 million in the first half of 2016, including $133 million for the IBNR portion. Our capital strength, liquidity, and financial flexibility continued at healthy levels. Our capital remains ready to support future profitable growth of our insurance operations and other capital management actions such as returning capital to shareholders. As usual, I'll conclude with a summary of contributions during the second quarter to book value per share. They represent the main drivers of our value creation ratio. Property/casualty underwriting increased book value by $0.04, life insurance operations added $0.07, investment income other than life insurance and reduced by non-insurance items contributed $0.47. The change in unrealized gains at June 30 for the fixed income portfolio, net of realized gains and losses, increased book value per share by $0.72. The change in unrealized gains at June 30 for the equity portfolio, net of realized gains and losses, increased book value by $0.59, and we declared $0.48 per share in dividends to shareholders. The net effect was a book value increase of $1.41 during the second quarter to a record $42.37 per share. And now I'll turn the call back over to Steve.

Thank you, Mike. As you can see, we had a lot of positive trends carrying us into the second half of the year. Our focus on incremental improvement is adding up and delivering great results that are worth noticing. In the last few months, Moody's, S&P, and Fitch have all affirmed our strong financial strength ratings, maintaining their stable outlooks. Fortune Magazine also took notice of our progress this year as we joined the ranks of the Fortune 500 in June. As we work together with our agency partners to maintain this momentum, we're confident that we will continue to produce value for shareholders in the near-term and for the long-term. 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. I also note that many of you know Eric Mathews, who we announced last call will be retiring on July 29 after nearly 40 years with the company. We thank Eric for his leadership of our accounting operations and wish him the best. Senior Vice President Theresa Hoffer will participate in future earnings conference calls instead of Eric. As a reminder, with Mike and me today, are Jack Schiff Jr., Ken Stecher; J.F. Scherer, Marty Mullen, and Marty Hollenbeck, in addition to Eric Mathews. Shannon, please open the call for questions.

Good morning everyone, another excellent quarter as usual.

Thank you, Josh.

Thank you.

I wanted to ask about the approach to reserving for personal lines compared to commercial lines. Commercial lines often show a consistent pattern of redundancy over time, while personal lines fluctuate in various directions. I understand that commercial liability, and possibly orders comp, are long-tail types, which may contribute to this difference. Considering your cautious viewpoint, why do you see these as two separate approaches?

Josh, this is Mike Sewell. That's a great question and hopefully, you mentioned whipsaw, I'm not sure I would describe it that way. We do follow a consistent approach with our actuaries, not changing how we do the reserves and look at them. But from time to time, we will have some refinements to the process as more information becomes available and so forth. I think the comment might be specifically related to the personal lines and how maybe that fluctuated a little bit from the first quarter of this year to the second quarter and how maybe the second quarter was probably a little bit more in line with 2015 and 2014. Really as we noted in our first quarter 10-Q and I think I have made some comments in there, we did have a slight refinement on our personal lines business which was really related to what we called the AOE reserves. And so there were some expenses there that we refined, moving about $9 million to $10 million worth of reserves from the personal line side to the commercial line side. Had we not made that refinement, you would have actually probably seen the personal lines prior year development in the first quarter really be flat. So because we did that, you saw some favorable development there and now in the second quarter, really what's running the temperature is personal auto as well as commercial auto when you look at prior year reserve development. So absent some refinements, I think we're fairly consistent, we are consistent in the process and I think the numbers really show that. So I don't know if Steve or anyone else has any additional comments, but that might have been a little long-winded for you.

I'll take as much information as I can get. New appointments on new agencies, to what extent when you're growing are you finding the appointments are trending in newer territories versus territories that you know well? To what extent is it possible for you to find agencies in territories that you know well that you think you can get a 30% to 40% share of the business out of? How are new additions looking these days?

Josh, this is J.F. In existing territories, we've always taken the approach with the relatively low number of agencies we have to really appoint as few as possible in any particular area. Now with the M&A activity that's occurring, a lot of consolidation in agencies, from time to time we would run into a case where if we needed to augment our agencies in any particular area, the group from which we can choose might be smaller, but fortunately the desire for agencies that don't represent us to have a contract with us is still high. So we rarely are turned down when we prospect for agencies. Consequently, there are a lot of agencies that don't represent us in a lot of territories. So that's not a big concern for us where we've been able to find agencies to appoint 30% to 40% of the volume in an agency is an ambitious target. We certainly want to be consequential to the agencies as you know we talk about being number one or number two after we've been in an agency for five years. But we're not seeing any lack of opportunity for us to do that; it's worked out pretty well. In newer states, particularly with what Will Van Del Heuvel is doing in the high net worth area, between the very good reputation that our agencies have earned for our company and they talk to agencies in some of these newer states for us. The door is pretty wide open for us to appoint agencies, for example in lower New York, Manhattan, Long Island. We just recently opened New Jersey, California is soon to be opened and really no shortage of agencies to appoint there. So fortunately, I think across the board, in new states and existing states we've been in pretty good shape.

And on the high net worth homeowners initiative, do you get any sense of the previous carrier? Is there any trend on where you are winning that business from?

Well, the opportunities have resolved from the consolidation of carriers in that line. Agencies, more than anything, want options they can offer to their policyholders. I just happen to see one come through this morning; it was from a direct writer that we actually wrote the business that frankly hadn't been very well attended to. But it's coming across the board actually; the direct writers write a tremendous percentage of that business. So it’s not all uncommon to see that. Then from the usual characters, we're competing pretty favorably against everybody right now. I think what's happening is that when agencies take a contract with us, they know as part of the approach we take to them that if we'll agree to appoint fewer agencies than perhaps brand X might appoint, in return for that, we ask that the agency concentrate on making the relationship with us work. We're very pleased with the number of opportunities we're getting. I think that's the most important thing. Those agencies aren't forced to put any business with us, but if they have given us the opportunities, which we're pleased they are, we're very pleased with the result.

Well, continued good luck to all of you.

Thanks, Josh.

Good morning, congratulations on the call and the earnings. I wanted to see if you could help us think about the trend in both the commercial and the personal lines of the accident year results, if you exclude the catastrophe loss, the so-called underlying combined ratio. Most folks are talking about commercial lines and at least commercial lines pricing being lower than claim cost inflation and then other mitigating efforts. And, obviously, you have a little different discussion on the personal lines side. I was wondering if you could walk through your thoughts on both of those.

Paul, this is J.F. I think in terms of the rate increases that we're getting on renewals, we're reasonably pleased with what we're seeing in auto both in private passenger and commercial autos; those are healthy and getting healthier. So we think that between the underwriting actions that we're taking in those two lines of business plus the rate increases, as you know, we've been pretty aggressive about adjusting reserves on prior years and pretty conservative this year, we think that things are going in the right direction on auto. Relative to loss cost and all the other lines, there are still a lot of initiatives that are in the works here, loss control, inspections, more specialization by line of business as well as by industry that we think and then of course the segmentation and the analytics that we're employing. We just think we're being better selectors of risk, and we're also addressing loss mitigation issues that's helping with our loss cost. So as it is right now, the improvement you're seeing in the accident year excluding catastrophes would be exactly what we would expect to have happened and we're pleased with really everything has kind of fallen in place; still a lot more to do. Frankly, we think there are a lot of improvements we can continue to make in those areas.

Do you believe the current trend we've observed over the past year or two will lead to further improvements in the underwriting combined ratio?

Paul, this is Steve and I’m clear 100% with J.F. He just nailed that answer. Maybe just putting in a little bit of qualitative terms, we are already seeing rate increases; I think segmentation, as J.F. mentioned, is working well, it is best helping some of the premiums driving. As also as J.F. mentioned in terms of the trend, if we look at it in future trend in terms of rate-making being prospective. So we’re looking now of trying to anticipate where loss trends are going in the prospective rate periods or pricing periods. The points that J.F. made about things that are going on with underwriting, especially in loss control, are making us optimistic about the future of continuing to make improvements. So I think from everything we can see in the near-term anyways, we feel pretty good about our process.

My first question is on the catastrophe preannouncement, you pointed out in the release that this quarter's catastrophe load ended up being close to the normal in terms of the 10-year historical average. I guess in my seat I was a little bit surprised it was around that historical average, given your lack of personal lines exposure in Texas. So my question is, whether your team at Cincy was surprised by the level of losses this quarter.

This is Mike. Thanks for the question. We really weren't surprised because it really was falling in line when you’re looking at five-year, 10-year averages. The largest catastrophe, and maybe Marty might be able to talk about that, really was in San Antonio, Texas, and having that run-up, so we don't have personal lines there; it's only commercial lines. So that might have caught some analysts off guard a little bit having that being in there because that was running about $55 million to $56 million. There were some other ones in there that were in the, I will call it in the $15 million to $25 million range, but I was probably not surprised when we looked at the five-year, 10-year averages and so forth, but the last couple of years, we’ve had pretty good catastrophe loss ratios, and so this one being elevated a little bit. So maybe I'll turn over to Marty for some details on some of our cat losses.

Sure. Thanks, Mike. The comment on San Antonio was accurate; it's about $56 million in end-of-second-quarter loss for us, and all commercial - everything you read, San Antonio was not on the map in Texas as far as being a hail risk for the industry. There was supposed to be an area that really wasn't very prolific as far as previous hail events, and so I think it caught everybody by a little bit of a surprise to the extent that the hail storm hit San Antonio. As a result of that, I think the losses were a little greater in the industry than probably were anticipated for us. We certainly took our share of those commercial losses. That actually was twice the size of any other cat we had for the quarter. The other ones were mainly Midwestern storms related to particular hail losses over several days. So other than that, there really wasn't anything unusual in the quarter as far as those events.

Okay. That's helpful. And one follow-up, just kind of on the other hand, while catastrophes pushed up the absolute combined ratio, the accident year excluding catastrophe loss ratio was the best it's been in 10 years, if my model is right. Can you speak to why it's improved so much, so we can kind of better think about its sustainability? I don't know if there were any unusual items, or maybe cats were high and that ate up some of the non-cat weather.

Yes, Mike, this is J.F. again. Similar to what we mentioned with Josh, and I think Paul as well, I think there is momentum going right now for a variety of areas. One of the things we're very pleased with is the predictive modeling and analytics that we've employed both in personal lines and in commercial lines. That continues to get more and more refined; we're segmenting our book of business better than we have. I think we've done a good job of integrating that. It's a little more standard underwriting, as we’ve talked about in the past. Our agents have been great in cooperating with that, really for an agent to explain the science part of this to policyholders but I think we've done a good job there and agencies have come through for us. We have expanded our loss control significantly over the last five years, really the last six or seven years, we're inspecting risks that we hadn't inspected in the past. The inspections that we are making are much more in-depth than we have in the past. We're discovering things both good and bad that allow us to make more informed decisions. So we've gotten off risks that we should have gotten off of. We've said yes to risks that maybe in the past we would have thought were a little tough in terms of their industry classification. So that's working out really well. I'd say in particular in personal lines, the inspections have also afforded a lift in the area of insurance to value. So we are increasing premiums there, getting a better ratio of premium to risk for ourselves there. So it's not one thing, it's a lot of things that are working well. I don't think there’s anything particularly unique to what we're doing compared to what other companies are doing. I just think we probably executed pretty well so far in this process, and as Steve said a few minutes ago, there is still, I think a lot of optimism moving forward. We can continue to improve.

Got it. So it sounds like maybe you can remind me; I know you guys have talked in the past about kind of combined ratio goals over time. It feels like things are more momentum and things are potentially, I don't know want to put words in your mouth, going better than planned a year or two ago and is that the right way to think about things?

Sure, I think so. With the plans that we have laid out and that we've been working towards, like J.F. just mentioned, we always wanted to be I'll say in that 95 to 100 combined range but with interest rates where they're at today on the investment side, we've always been striving to be below a 95 combined and are really driving everything we can on a current accident year basis ex-cat basis; we're really having to drive it to where we're at today and to keep the momentum going.

I'll just add to that, an example would be that we're pleased with is the introduction of high net worth to our first lines book of business. That segment of personal lines in the industry has always been much more profitable for us, though we weren't writing very high net worth; I would say our book of business previous to Will Van Del Heuvel who joined the company was more mass affluent that it was high net worth. But it performed 10 points better than our middle market first lines book of business. So as you can tell from the weighting of new business and high net worth this quarter versus middle market, we're increasing the proportion of high net worth. So there have been a lot of deliberate steps that we have taken to position our book of business to perform better than the 95 to 100 that Mike mentioned.

Well, thank you, Shannon. Excellent job, and thanks for all of you for joining us today. We look forward to speaking with you again on our third quarter call. Thank you.