Cincinnati Financial Corp (CINF) — Q3 2017 Earnings Call Transcript

Hello. This is Dennis McDaniel from Cincinnati Financial. Thank you for joining us for our third quarter 2017 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. And the shortest route to the information is the Quarterly Results link in the navigation menu on the far left. On today's 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 given by others in the room with us, including Chairman of the Board, Ken Stecher; Chief Investment Officer, Marty Hollenbeck; and Cincinnati Insurance's Chief Insurance Officer, J.F. Scherer; Chief Claims Officer, Marty Mullen; and Senior Vice President of Accounting, Theresa Hoffer. 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 now, I'll turn over the call to Steve.

Thank you, Dennis and good morning. Thank you for joining us today to hear more about our third quarter 2017 results. While the past quarter presented challenges, we see several positives regarding future prospects from improved operating performance. First, our third quarter and nine months 2017 property casualty combined ratios stayed just at 100%, putting us in a good position to earn an underwriting profit for the sixth consecutive year, consistent with one of our primary objectives. Second, we reported a nine-month current accident year combined ratio before catastrophe losses of 91.1%. While that was 7/10 of a point higher than accident year 2016 at nine months, the higher ratio for losses of $1 million or more for claims largely contributed to that variance and we know large losses tend to vary, particularly over relatively short-term periods. We also gained confidence from internal reports and observations that our underwriters continue to obtain relatively higher renewal pricing on expiring policies that our models and judgment indicate at relatively weaker pricing. That's an ongoing result that's segmenting our portfolio of accounts through careful underwriting of risks covered by individual policies. I'll take a moment to comment on Cincinnati Re, our reinsurance assumed operation. Following a very favorable contribution to profit during the first two years since its inception, Cincinnati Re experienced a quarter of sizeable catastrophe loss effects, which happen from time to time in the reinsurance industry. That loss experience was consistent with our models and projections for significant catastrophe events. Our underwriters and analysts are experienced subject matter experts who understand how to balance qualitative and quantitative aspects of reinsurance decision-making. So far in 2017, we've assessed nearly 500 potential reinsurance transactions, declining approximately 80% of them, a rate consistent with the prior two years. History shows that the tendency for firming reinsurance premium rates following periods similar to the recent spike in industry losses translates into near-term opportunity and we are well prepared to take advantage of it. We recognize the long-term benefits of risk diversification and Cincinnati Re should continue to help diversify our business and smooth results over time. Turning to premium growth; we continue to grow premiums in a disciplined fashion for each of our churn segments. While overall premium growth for our commercial line segments slowed during the third quarter of 2017, renewal written premiums continue to rise, and we reported a combined ratio of 95.2%. Overall, commercial lines estimated average price increases were similar to the second quarter, with higher pricing for commercial auto being the notable exception. For our personal lines segment, third quarter premium growth continues at a nice pace; the personal lines combined ratio before catastrophe effects improved for both the third quarter and first nine months, partially offsetting a higher level of catastrophe losses for both periods. Estimated average premium rate increases for personal lines in total were slightly higher than in the second quarter of 2017, with personal auto average rate increases reaching the high single-digit range. Our access and surplus lines segment reported another strong quarter of underwriting profit and premium growth with a nine-month combined ratio of under 70%. Our life insurance subsidiary again made a good contribution, net income growing third quarter 2017 for life insurance earned premiums written by 5% and helping to diversify our earnings sources. Our primary measure of financial performance, the value creation ratio, was 3.1% for the third quarter and 10.3% for the first nine months of the year; we're still on pace for another year that reaches our long-term target of 10% to 13% annual average. Despite the third quarter being challenging in terms of operating results for us and the P&C industry, we continue to find opportunities every day to deliver long-term value to shareholders and outstanding service to the agencies that represent our company and their clients. Next, our Chief Financial Officer, Mike Sewell, will highlight investment results, reserve development, and other key areas of our financial performance and financial condition.

Great. Thank you, Steve and thanks to all of you for joining us today. The third quarter of 2017 was our 17th consecutive quarter of investment income growth, rising 3% for the quarter and 2% for the first nine months. Dividend income was up 10% for the quarter and interest income was up 1%. The double-digit growth in dividend income will make for a tough comparison in 2018. Since the beginning of 2014, we've reported quarterly dividend growth ranging from 2% to 19%; such variability can result from irregular patterns for dividend payments such as special dividends that can occur anytime. For our portfolio, they tend to occur in the fourth quarter. Our equity portfolio experienced another quarter of growth in unrealized gains, up 7% for the quarter to more than $2.7 billion. The bond portfolio's pre-tax average yield was 4.43% for the third quarter of 2017, down 20 basis points from last year's third quarter. That yield decline reflects the effect of higher yielding bonds that continue to be called or that mature. While we've reported another quarter of interest income growth, the third quarter's 1% growth rate is well below the recent peak of 4% we've reported for each of the first two quarters of last year. Taxable bonds purchased during the third quarter of 2017 had an average pre-tax yield of 3.81%, and purchase tax-exempt bonds averaged 3.15% for a blended yield of 3.55% while the bond portfolio effective duration did not change. Cash flow from operating activities continued to provide funds for our investment portfolio. Funds generated from net operating cash flows for the first nine months of 2017 totaled $746 million, down $89 million or 11% from the same period a year ago. A $103 million increase in catastrophe losses and loss expenses paid this year was a key contributor to the decrease. Once again, we carefully managed expenses during the quarter while at the same time investing strategically in our business. Our third quarter and nine-month 2017 property casualty underwriting expense ratios improved somewhat from comparable 2016 periods. Moving to loss reserves, our consistent approach to setting overall reserves again resulted in net favorable development on prior accident years. For the third quarter of 2017, favorable reserve development benefited our combined ratio by 1.6 percentage points, somewhat lower than a typical quarter in recent years. Development for each of our major lines of business was favorable with the exception of auto and also commercial casualty, which is our largest line of business. Reserve development for commercial casualty was essentially flat for the third quarter of 2017, as we reported a net unfavorable amount of less than $1 million. Paid losses and loss expenses were higher than in any quarter since the beginning of 2015, in part due to an increase in large losses. On a case-incurred basis, the ratio of losses and loss expenses was approximately two percentage points better than the first half of 2017, but remains approximately four points worse than the average for the prior two years. Yet for considering these trends for commercial casualty, we maintained our consistently prudent approach of setting reserves, including IBNR reserves that resulted in basically no favorable or unfavorable prior accident year development for the quarter with a nine-month current accident year loss and loss expense ratio of approximately two percentage points higher than the full year 2016. Our commercial casualty third quarter 2017 loss and loss expense ratio of 63.2%, combined with an estimated underwriting expense ratio of 32 points or so indicates an estimated combined ratio of approximately 95%. In total, favorable reserve development for the first nine months of 2017 continued to be spread over most of our major lines of business and over several accident years, including 53% for accident year 2016, 7% for accident year 2015, 19% for accident year 2014, and 21% for 2013 and prior accident years. Regarding capital management, our approach and financial strength remain stable. We have excellent financial flexibility, including September 30 holding company cash and marketable securities that rose 16% from the year-end 2016. To conclude, I'll summarize third quarter contributions to book value per share. They've represented the main drivers to our value creation ratio. Property casualty underwriting increased book value by $0.04. Life insurance operations also added $0.04. Investment income other than life insurance and non-insurance items contributed a decrease of $0.54. The change in unrealized gains at September 30 for the fixed income portfolio, net of realized gains and losses, increased book value per share by $0.05. The change in unrealized gains at September 30 for the equity portfolio, net of realized gains and losses, increased book value per share by $0.72, and we declared $0.50 per share in dividends to shareholders. The net effect was a book value increase of $0.89 during the third quarter to a record $45.86 per share. And now I'll turn the call back over to Steve.

Thanks Mike. Before we open the call for questions, I'd like to thank our associates who work relentlessly to respond to our agents and policyholders affected by Hurricanes Harvey and Irma. With our clients' team leading the way, associates from all across the company jumped into action and helped wherever they could. Storms of this magnitude leave widespread damage in the community and widespread concern about how to get back to normal. This is when our associates shine, calming those fears, upholding the reputation of our agents, and delivering on the value of Cincinnati Insurance policies. The start of the fourth quarter didn't bring much relief to our country as communities continue to experience devastating loss from both Hurricane Nate and the California wildfires. Our hearts go out to the families and businesses, including our own policyholders, affected by these events. In terms of losses, we estimate insured losses for our company will be less than $1 million for each of these fourth quarter events. 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 Ken Stecher, J.F. Scherer, Marty Mullen, Marty Hollenbeck, and Theresa Hoffer. Jane, please open the call for questions.

Good morning. So I just had a couple of questions here; in terms of the commercial casualty line, I just wanted to talk about that a bit more. So, would you say that you're seeing kind of deteriorating trends there? Does the severity seem like it's actually ticking up or do you think this is more of a temporary issue? I just wanted to get a bit more color about what's happening with that line?

Arash, we feel good about the line. As Mike went over, the profitability is holding up well. Within commercial casualty, there are a lot of parts there that are analyzed and moving in different directions but overall, I think while we do see some upward trends, we feel confident with the way that we're underwriting and executing, and are confident in terms of the continuation of the profitability in the casualty line.

So is it mostly just kind of an uptick in severity? Is that a fair characterization?

This is Mike. We've been reviewing the severity of our losses, and we've seen a few larger losses this quarter. Specifically, losses of $1 million or more were more frequent than before. While we're not observing a clear trend yet, we decided to be cautious and release some of our IBNR reserves as these losses were realized. I would say that there isn't a specific trend related to geography or the nature of these losses, but I can ask Marty Mullen to share more details about the types of large losses we've encountered.

Sure, thanks Mike. First, this third quarter, we had 28 commercial lines claims, 17 of those large claims which are categorized as $1 million or more were spread across the commercial lines. And to give you some examples, nine of those were $1 million claims in commercial auto and of the other nine losses, eight were in different states. The same with general liability; five of those large losses of over $1 million were in general liability lines and again, they were in five different states. So the claims are very diverse and spread across our pattern and I think it's just one of those quarters that we saw a significant increase in those number of claims spread across the country.

And is that 63%, I mean is that more or less like a fair run rate to assume for commercial casualty in terms of the core loss ratio?

Yes, if you look at the last few quarters, there has been a slight increase. I’d like to wait and see what happens over the next couple of quarters and observe where the large losses appear. We will continue to follow our actuaries' consistent approach in their assessments. Our loss expense ratio, which is detailed in our supplementary report, has been fluctuating between the low 50s and reaching up to 63.2%. However, let's be patient; this is a long-term matter, and we will adhere to the recommendations from our actuaries.

Sure. And just in that same kind of question, are you seeing an uptick in jury awards?

Arash, this is Marty. I think we haven't seen a trend in that regard; there are certain jurisdictions that you certainly have to be more careful in making decisions to take a case to trial, and certainly we're very cognizant of that and prudent in deciding which cases to take to trial depending on the facts and specific jurisdictions. So I think you still have to be careful in making those decisions in specific areas.

Thanks for those answers. And just my last one was; for Cincinnati Re, the 1 in 250 net PML looks like it's actually below your 1 in 100 net PML. So I just wanted to see how you guys are accomplishing that.

I think that was in the 10-K and I think it had to do with the change in the loss per change in TVAR, I'm getting kind of technical there but in terms of change in risks; so it wasn't necessarily a change in bar number.

I wanted to ask about the possible expansion of the reinsurance business and specifically what sort of metrics are you using in terms of ROE or underwriting or whatnot in terms of the volatility measures today to determine whether you want to be on a piece of business versus what you might be doing tomorrow? I'm wondering if there is any change there as well?

Good question, Paul. It will be a consistent approach. From the beginning, we've been very consistent in not focusing on growth but trying to focus on profitability, to focus on returns with each contract. For example, we did not set up a specific company for Cincinnati Re with capital that had to be used for return; we try to look at each risk individually on its merits. As I mentioned in my opening comments, we've been very disciplined in the ones that we accept and a number of measures are looked at and will continue to be looked at. Obviously, what do we estimate the expected combined ratio would be; we do look at as we're looking at lack of correlation with our regular business, we will look and try to estimate what we think the change in TVAR, the 1 in 250 year will be in combination with our already existing book in terms of the capital needed, what type of return we can get on that, and we look at rate on lines from a judgment factor. So, to me it really always comes down to the people, and we have a very experienced team there that has been hired and are confident in their ability going forward to be in an even stronger position than we are now. I think the exception to date was probably the worst quarter in memory in terms of reinsurance losses with maybe about $13 million in total inception to date, and that's something that really, with a good first quarter, we could bring it back to breakeven or near breakeven by the end of the year and be perfectly positioned I think as we move forward into next year.

Some related question; I think hard markets are primarily created by changes in perceived risk that changes underwriting methods, whether they'd be terms and conditions or pricing or whatnot? But there is usually something out there that says I need to change how I do my underwriting prospectively. Is there anything on the horizon from your perspective that would make you change how you think about your underwriting? And if so, doesn't that mean that there won't be a hard market? If not, if there are not going to be changes in underwriting standards, wouldn't that preclude a hard market?

Well, I think that as we look going forward, the same approaches will be used as I just went over. I do think it has been a wakeup call in terms of appreciation of risk. We had three hurricanes, two earthquakes; now we've had a fourth storm, Hurricane Nate; and we've got wildfires; and I think there is just a little bit of renewed appreciation of what can happen all at the same time. And I think also it's been a long time since there was an event in Florida, things have changed over that period in terms of what we're seeing with assignment of benefits and the recognition of what that can bring, different players settling claims and maybe a better appreciation of the degree of adjustors that are available to settle the claims and what that means. So I think that there is kind of a wakeup call in terms of everybody understanding or being reminded of the type of risk that's out there. But I do say in terms of our approach, it's going to be very consistent with what we have done, but we will recognize these factors.

Great, thank you very much.

Good morning. Just a question, a follow-up on reinsurance; it sounds like pricing is probably going to improve there, that's at least what everyone is kind of talking about. So just wondering how that might change your appetite. I know you mentioned some comments on the call about that and specifically, your appetite for property reinsurance. I know the book has been sort of 50% property versus casualty, but if you could talk about some of the growth you might see there if we do see better pricing in your appetite.

To the disciplined approach, we started out with a balanced focus, but now we are more oriented towards casualty insurance rather than property. Recently, casualty lines account for over 50% of our focus. We'll evaluate potential opportunities based on factors such as diversification and correlation, ensuring we understand the risks both quantitatively and qualitatively, all while feeling no pressure to grow. It will be interesting to see how the market firming occurs; I'm confident that firming will happen. It will be interesting to see how broadly the firming applies to contracts with losses compared to those without. We are curious about the duration of this firming given the available capital and how it may shift from property to casualty. There are many uncertainties, but I agree with the general consensus that we will definitely experience firming in the short to mid-term.

Currently, for 2017 year-to-date, the property is 38%, casualty is 53%, and specialty is 9%.

Okay, great. And then just switching to the high-net-worth personal lines unit; can you talk about where that is tracking versus your expectations and which you're expecting in 2018? Do you expect to continue to roll that out to new states or kind of just working on penetrating where you are mostly?

Scott, this is JF. Things have gone according to plan and we are satisfied with our progress. In personal lines, we increased new business by 34% this year, and high-net-worth saw a significant jump of almost 90%. California is performing well, and we are happy with the reception we've received there. Massachusetts has just launched, and Washington State went live in August. We are now active in key regions for high-net-worth clients including Long Island, New York, Westchester County, New Jersey, Massachusetts, Texas, and California. We plan to expand into additional states that are likely to have secondary residences, such as Colorado, Montana, Wyoming, and Hawaii. In terms of our infrastructure, we are operating effectively; for instance, as Steve mentioned, we did not incur many wildfire losses. Although we had some exposure in those areas, we've implemented wildfire defense services to protect individual homes specifically, which we're pleased with. Our reputation as a company with agencies has allowed us to penetrate the market effectively; we have established good relationships with the agencies we wish to collaborate with, despite the limited number of appointments. Many agencies are interested in working with us, but we are focused on our initial partnerships. Overall, we are happy with the incoming premiums and the quality of the business we are acquiring. It has been an excellent start.

Okay, that's helpful. That's all I have, thanks. Good luck.

Thanks.

Thank you, Jane, and thanks to all of you for joining us today. We look forward to speaking with you again on our fourth-quarter call. Thank you and have a great day.