Cincinnati Financial Corp (CINF) — Q2 2018 Earnings Call Transcript

Hello. This is Dennis McDaniel at Cincinnati Financial. Thank you for joining us for our second quarter 2018 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 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 in the call may ask questions. At that time some responses may be made by others in the room with us including Chairman of the Board, Ken Stecher; Chief Investment Officer, Marty Hollenback; and Cincinnati Insurance's Chief Insurance Officer, J.F. Scherer. Also Chief Claims Officer Marty Mullen and Senior Vice President of Corporate Finance, Teresa Hopper. 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 for our various filings with the SEC. Also, a reconciliation of non-GAAP measures was provided with the news release. Statutory accounting is prepared in accordance with statutory accounting rules and therefore has not reconciled the GAAP. And now, I will turn the call over to Steve.

Good morning. And thank you for joining us today to hear more about our second quarter results. Net income for the second quarter of 2018 more than doubled the same period a year ago. While this year's new accounting requirement for changes in the fair value of equity securities represented a large portion of the increase, operating income, which is independent of that change, also rose significantly up 24%. Our 97.2% property casualty combined ratio for the second quarter of this year was 1.1 points better than a year ago and reflected benefits of diversifying our business in recent years. Our commercial lines segment experienced a combined ratio below 95%. Our excess and surplus lines segment and Cincinnati Re had excellent results, each with the second quarter 2018 combined ratio below 80%. Our life insurance subsidiary also had an excellent quarter reporting a 42% increase in net income or 31% on an operating income basis. Our personal line segment reported a down quarter reflecting reserve increases in part due to a 53% year-to-date increase in large losses of $1 million or more per claim. Our all lines accident year 2018 combined ratio before catastrophe losses is roughly 2 points higher than accident year 2017, both measured as of June 30 of the respective accident year. However, on a paid basis, the ratio is nearly the same for each of those two periods. Despite that fairly stable level of paid amounts experienced by each of our major lines of business, management's best estimate of ultimate loss and loss expense ratios and related reserves maintains a prudent amount of IBNR including elevated levels for two lines in particular, homeowner and commercial casualty. As more data becomes available, we'll adjust estimates for reserves up or down as appropriate. One of the benefits of stable paid ratios as we profitably grow our insurance business is that it increases the float, helping to fuel cash flow for our investment portfolio. Mike will elaborate on that in a moment. Consolidated premium growth was much better in the second quarter of 2018 than it was in the first quarter. Our commercial line segment rebounded from a 1% decrease in written premiums to a 5% growth in the second quarter 2018. Each of our other insurance segments experienced second quarter premium growth ranging from 5% to 7%. Importantly, our internal reports and observations suggest that this growth is healthy. Our underwriters continue to obtain relatively higher renewal pricing on businesses where our models and judgment indicate it's needed. Segmenting our portfolio of accounts through careful underwriting of risks covered by individual policies. Average pricing remained mostly steady, including overall commercial lines estimated average price increases similar to the first quarter, with commercial auto remaining in the high single-digit range. Estimated average premium rate changes for personal lines in total and for both personal auto and homeowner were somewhat higher than the first quarter of 2018. With personal auto average rate increases near the high end of the high single-digit range. As we reported in our 10-Q, effective July 1, we added a new component of reinsurance protection from catastrophe losses with an excess of loss treaty providing coverage for up to $50 million in aggregate. It includes coverage of $50 million in excess of $125 million per occurrence for combinations of business written on a direct basis and by Cincinnati Re and $25 million in excess of $32 million for catastrophe events affecting only Cincinnati Re. It also provides additional coverage for earthquakes, brush fires or wildfires in certain Western states after a per event loss retention of $10 million. Our primary measure of long-term financial performance, the value creation ratio was 1.6% for the second quarter of 2018. The component of net income before investment gains or losses contributed 1.7 percentage points, an improvement of 0.2 points versus a year ago, and investment gains in our equity portfolio contributed 1.0 percentage points enough to offset a negative 0.8 contribution from the fixed maturity portfolio. We were pleased to see a partial recovery evaluation in our equity portfolio following the downturn experienced in the first quarter of the year. We'll continue to place much of our focus on the profitable growth of our insurance business. That focus has served us well in the past and will help us create shareholder value over time. Next, our Chief Financial Officer, Mike Sewell will provide insights on a few other important elements of our financial performance and financial condition.

Thank you, Steve, and thanks to all of you for joining us today. Second Quarter 2018 was our 20th consecutive quarter of investment income growth up 2%, including 5% for dividend income. As we reported, overall investment gains for the second quarter were favorable at $25 million before tax effects, that included a $105 million increase in our equity portfolio, partially offset by a $78 million decrease from our bond portfolio. We ended the quarter with a net appreciated value of nearly $3.1 billion including $84 million in our bond portfolio. As we highlighted last quarter, new accounting standards required that in 2018 and future years changes in fair value of equity securities will be reported as part of net income instead of other comprehensive income. And we noted that our value creation ratio was unchanged by the new accounting. The second quarter 2018 net income effect of fair value changes of equity securities was a favorable $80 million, a sharp reversal of the unfavorable $156 million we experienced in the first quarter of 2018. Drilling down a little more on interest income from our bond portfolio, the pre-tax average yield was 4.28% for the second quarter of 2018, down 14 basis points from last year's second quarter as many of our higher yielding bonds continue to be called or redeemed as they reach their maturity date. Second quarter 2018 interest income grew 1% in part due to $226 million in net purchases of bonds in the first six months of this year. Taxable bonds purchased during the second quarter 2018 had an average pre-tax yield of 4.68%, 93 basis points higher than we purchased for last year's second quarter. Tax-exempt bonds purchased just average 3.72% up 39 basis points from a year ago. Cash flow from operating activities continued to provide funds for our investment portfolio. Funds generated from net operating cash flows for the first six months of 2018 totaled $464 million, up $19 million or 4% for the same period a year ago. Turning to underwriting expense ratio, careful management of expenses continues to be a priority as is investing strategically in our business. Our second quarter 2018 property casualty underwriting expense ratio decreased by 0.5 percentage points versus the second quarter of 2017. Regarding loss reserves, our consistent approach to setting overall reserves again resulted in property casualty net favorable development on prior accident years. Second quarter 2018 favorable reserve development benefited our combined ratio by 2.6 percentage points and the six-month 2018 benefit of 3.3% matched the same period last year. Our commercial casualty line of business experienced $14 million of favorable reserve development. Most of our major lines of business have seen favorable reserve development in the first six months of 2018. On an all lines basis by accident year, it included 38% for accident year 2017, 15% for accident year 2016, and 47% for 2015 and prior accident years. In terms of capital management during the second quarter we repurchased nearly 1.6 million shares at an average price per share of $70.57. Related to that and opportunities to modestly grow our commercial leasing and financing subsidiary, we used a small portion of capacity available from our $225 million line of credit. Our financial strength and financial flexibility remain excellent. As usual, I'll conclude with a summary of second quarter contributions to book value per share. They represent the main drivers of our value creation ratio. Property casualty underwriting increased book value by $0.17. Life insurance operations added $0.10, investment income other than life insurance and reduced by non-insurance items contributed $0.39. Net investment gains and losses for the fixed income portfolio decreased book value per share by $0.38; net investment gains and losses for the equity portfolio increased book value by $0.51; and we declared $0.53 per share in dividends to shareholders. The net effect was a book value increase of $0.26 during the second quarter to $48.68 per share. Now I'll turn the call back over to Steve.

Thanks, Mike. We are encouraged by our second quarter results as we see several positive trends that are building momentum. While there is still work to be done, we have confidence in the future because of the outstanding independent agencies that represent our insurance companies and because of our capable dedicated associates who deliver excellent service daily to our agents and their clients. 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 Mullin, Marty Hollenback, and Teresa Hopper. Emily, please open the call for questions.

Thank you. So first question I had was on the workers comp side, I saw that the growth there was negative the last few quarters, but it was positive this quarter. So just wanted to see if that's something that we should expect going forward. And what drove the growth there?

Hi, Arash. This is JF. We're facing what many carriers are dealing with: the decrease in net rates has slowed our growth. As we've mentioned before, we're not aggressively pursuing workers' compensation; it comes with the package business we've acquired. Overall, we've seen positive new business growth in our commercial line segment, and workers' compensation was part of that. We're pleased with that outcome. We're not hesitant about workers' compensation, but I don't anticipate any significant changes moving forward.

And is it fair to expect that the core loss ratios there to continue being elevated year-over-year just given the pricing environment in that line of business?

Yes. It's tough to keep up with the rate decreases that we're seeing there. On the other hand, I think we continue to see improvements on our loss cost from the initiatives we have in the claims area as well as loss control. So we're comfortable with how we're doing in comp; it's actually doing fairly well for us. So we're pleased with the outcome.

Thanks. And on the commercial casualty side, it looked like the core loss ratio there was better than it's been the last two quarters and you have favorable development this quarter as well. So is that just simply a factor of the initiatives you've been taking on the underwriting side bearing fruit, and should we continue to see that type of sequential improvement?

Yes. We're pretty pleased with how things are going in commercial casualty. The loss activity we've seen has been a bit more in the umbrella area; some large claims, most of those claims have been associated with commercial auto. So what we're spending a lot of time doing in addition to increasing rates on the commercial auto line itself is being a lot more careful about the underwriting side of things relative to scrutiny of drivers and more loss control activity in the commercial auto area. We think that that will pay off over time.

Thanks. Just the last question you mentioned in the prepared remarks on the homeowner side, can you just go into a bit more detail about the trends there and what drove the core loss ratio and the reserve development?

Well, once again, in homeowners, severity is the issue there. We've just seen an increase in the dollar value of the $1 million and higher claims that we have. We've taken a look at all of the claims that have occurred, reviewed them, and done a post-mortem on all of it. There's a lot of variability in these large claims. For example, in looking back at the full year 2015, million dollar plus claims doubled over '14 and then '16 was down 73%. So as we take a look at what's going on there, I would say first of all, quite pleased with the initiatives we've got going in homeowners: our entry into high net worth; the severity of the claims that we're seeing doesn't worry us. We've just experienced a little elevated levels of that here of late. But all in all, looking forward, we're pleased with how things are going. We think all the initiatives, including rate increases and better inspection protocols, will continue to pay off for us.

Thanks. Are the claims over $1 million related to high net worth policies? If so, could you explain the profitability of the high net worth book compared to the standard homeowner's book?

When we discuss this, we are considering both aspects. We have observed a rise in high net worth claims, primarily related to fire losses. We are also writing more high net worth policies for more valuable homes. In the first quarter, there was a $12 million increase in large claims, with only 20% from high net worth. These figures can vary significantly. The performance of new high net worth business in several newer states is progressing as we anticipated, so there are no major concerns at this time. We are aware of some variability and are keeping an eye on it. Consequently, we will adopt a cautious approach to reserving, ensuring that losses align with our expectations. We maintain a prudent and conservative stance regarding reserving, and we will continue this practice as we assess how the situation develops.

And what's the premiums in force currently for high net worth?

On the homeowner side, its direct written premium through 6 months is about 83 million.

Okay. Great. Thank you for the answers.

Thank you.

Oh, sorry about that. Good morning everyone.

Good morning.

Just a quick question first on capital management. So you guys had some buybacks in the quarter you do those from time to time. Can we expect to see those more frequently? I know that's obviously depending on what happens with the stock, but how are you looking at those now versus in the past and how you weigh that up with uses of capital including special dividends over time?

Hey, this is Mike. Buying back shares is a way of returning capital to shareholders. So far in 2018, we’ve repurchased nearly 1.8 million shares. Looking back to 2017, we bought around 1 million shares, and the year before that, just under 600 thousand, then about a million the year prior. We’ve generally aimed to maintain around a million shares annually. This year, it’s been a bit higher, but not significantly. Our decisions depend on the timing and current circumstances. We have the flexibility to act opportunistically based on the share price. On average, we’ve been buying back about a million shares each year, and we’ll continue to monitor and take action when it makes sense based on the price.

Okay. And any thoughts on how you weigh that versus special dividends which you've done from time to time? Is there any underlying factor behind that as to when you declare those?

There are a couple of uses for our capital that you mentioned: dividends and buybacks. We consider dividends every quarter as it is a decision made by the board. It is discussed during board meetings, and we have had a special dividend for the last three years. We refer to it as a special dividend for a reason; it is unique but is actively discussed at board meetings, depending on the company's performance and our future outlook.

I have a question about personalized pricing. You mentioned it improved in Q2 compared to Q1. I would like to know if that improvement applies to both homeowners and auto insurance. Also, do you expect this trend to accelerate in the second half of the year? Some companies are reporting a slowdown in rates, but it seems like you are experiencing the opposite.

As far as our rate increases are concerned, we would anticipate that the increases that we've been talking about will continue on both in home and auto and for that matter in commercial auto as well. Commercial auto is at the upper end of the single-digit range and that's in the second quarter that's on top of a similar type of rate increase in the second quarter last year. So we're pretty comfortable with our strategy and rate increases. Their sticking, our retention continues to be in the areas that we wanted to be in. So we're pleased with the strategy there.

Okay, my last question is about the improvement in the expense ratio for the quarter. I know that in Q1 there was an impact from higher deferred acquisition costs, and you mentioned that you expected the expense ratio to be around the low 30s. It appears to have improved a bit this quarter, so I'm curious if you have any insights on how that might progress for the rest of the year.

You're exactly right. I mentioned in the first quarter that we thought it would be close to a 31.1, which is where we ended up in 2017. We typically don't provide a lot of guidance, but I think that's a fair estimate if you're building out your models. This quarter was slightly lower at 30.5. Some of that is due to the timing of our expenditures as we continue to invest in various areas like IT, innovation, and predictive modeling. I could see it remaining around that figure, perhaps a bit lower, but I wouldn't assume that 30.5 indicates the next two quarters will be similar.

All right. Fair enough. That's helpful. Thanks a lot.

Thank you.

Hi, good morning.

Good morning, Mike.

Regarding the reinsurance program you mentioned, I haven't reviewed the 10-Q yet, so there may be relevant information there. However, how should we consider its potential impact on the income statement, especially if you believe it might have a significant effect in the near future?

We have two relatively new businesses that we're expanding with Cincinnati Re in our high net worth home segment, and we're confident in the management of both enterprises. As a business grows, the premium volume increases, starting from a smaller base, which can lead to some variability in results. We are pleased with both organizations. In our analysis of Cincinnati Re, as disclosed in our 10-K, we anticipate that there could be an event where the two combined exceed $100 million. We have been underwriting Cincinnati Re in a diversified manner regarding catastrophic losses alongside Cincinnati Standard. However, in lower return periods, these amounts could accumulate. For instance, last year's hurricanes did not present any unexpected behaviors, and we were satisfied with the outcomes. In one example, our 10-K reported a $52 million loss, with $33 million attributed to the standard CIC Cincinnati Insurance and $19 million to Cincinnati Re. Our modeling shows that a one in 100-year event for the combined businesses could result in a $173 million loss, with Cincinnati Re's marginal contribution at $77 million. For a one in 250-year event, the total could rise to $413 million, with a marginal contribution from Cincinnati Re at $80 million, illustrating the diversifying effect. To manage this volatility in lower return periods, we decided an aggregate cover would be beneficial. We purchased part A of a $50 million aggregate with a $50 million excess of $125 for the combination of Cincinnati Standard and Cincinnati Re, which we believe is a prudent approach. Additionally, we recognized that smaller amounts from Cincinnati Re could also accumulate, so we procured an aggregate for Cincinnati Re specifically at $25 million excess of $32 million. Furthermore, on the high net worth side regarding personalized coverage, we considered earthquakes in California and the wildfires we've been experiencing, thus including a third part of the agreement for $50 million excess of $10 million per occurrence for earthquakes, wildfires, and brush fires in certain states out west—California, Oregon, Washington, and Nevada. The total aggregate is $50 million across these three coverage parts. We believed the pricing, slightly over $7 million for the complete cover, was reasonable, reflecting good risk management and effective handling of the volatility that could stem from the ramp-up of these two new businesses, which we are very confident in.

That's very helpful information. Can you provide some insights on commercial auto? I believe the reserves have trended negatively, while last quarter they were more stable. Is there anything significant that has changed?

I think we're continuing to feel good about the progress we're making in commercial auto. In terms of sequentially, the accident quarter improved a bit. It's also down a little bit from where it was the same quarter a year ago. On the current accident year basis, we did see some adverse development of 3.3 points on the prior accident years this time. And just the way we do reserves when we've seen some of this adverse development and as we reflect it we're cautious there and I think prudent in the pick of the current accident year's ultimate loss ratio and that would go for commercial auto and homeowners as JF described. So I think we're taking a prudent approach to the selection of our current accident year picks. But I think we're also confident when we see rates coming in the high single-digit range; all the work that's being done by our people in terms of mitigating the loss trend we feel we're ahead of the game there and are optimistic about the prospects for future improvement in the commercial auto.

Okay. Great. Lastly, I would like to ask about the broader pricing environment, perhaps distinguishing between personalized lines and commercial. Are you surprised by the apparent pricing power that seems to exceed some expectations in the industry? From my perspective, given the results, many participants seem to be doing fairly well. This cycle feels different; it appears that carriers are managing to maintain healthy retention levels while effectively implementing pricing increases at a reasonable rate, excluding workers' comp. I'm interested to know if you believe there have been significant changes this cycle compared to previous ones.

I believe we have improved our skills in underwriting, claim handling, and pricing. This is very much based on each individual risk and policy. Consequently, averages may not accurately reflect the entire picture of what's happening with risks in our underwriting, pricing, and claims processes. We focus on understanding potential risks to mitigate them as effectively as possible, benefiting us, the agents, and their clients. Our goal is to find ways to manage potential risks and to price them correctly on a risk-by-risk basis using our predictive models, underwriting judgment, applications, and traditional cost control measures. Analyzing risks at such a detailed level provides a more accurate price over time.

Okay. Understood. It appears that it will lead to more stable results over time, but we will see. Thank you for the clarification.

Thank you.

Thank you, Emily. And thanks to all of you for joining us today. We look forward to speaking with you again on our third quarter call. Have a great day.