Cincinnati Financial Corp (CINF) — Q3 2018 Earnings Call Transcript

Hello. This is Dennis McDaniel at Cincinnati Financial. Thank you for joining us for our third 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 Chief Investment Officer, Marty Hollenback; and Cincinnati Insurance's Chief Insurance Officer, J.F. Scherer; Chief Claims Officer, Marty Mullen; Senior Vice President of Commercial Lines, Steve Spray; and Senior Vice President of Corporate Financial, 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 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 does not reconcile to GAAP. Now, I will turn the call over to Steve.

Good morning. And thank you for joining us today to hear more about our third quarter results. Net income for the third quarter of 2018 was more than five times the same period a year ago. Approximately three quarters of the growth in net income again reflected variability related to this year's new accounting requirement for changes in the fair value of equity securities. About one eighth of the increase was from other non-recurring items generally related to taxes, and Mike will comment further on that in a moment. The remaining growth in net income largely reflects improved underwriting results despite higher catastrophe losses and is reflected by our improving property casualty combined ratio and 41% growth in non-GAAP operating income. Our 96.8% combined ratio for the third quarter of this year was 2.5 points better than a year ago. And this is the result of several factors, including ongoing benefits of diversifying our business in recent years. Our commercial line segment experienced another good quarter with a combined ratio of near 95%. Importantly, we’re seeing signs of improvement in paid loss cost trends for our commercial casualty line of business. The paid ratio for the first nine months of 2018 was almost 2 percentage points lower than the same period a year ago. While we’re currently maintaining a prudent amount of IBNR reserve for that line, particularly for accident year 2018, we are comfortable with releasing some reserves for all the accident years, largely accident years 2016 and prior. We continue to take a careful approach to growing our commercial lines business and targeting underwriting actions, slowing net written premium growth to 1% on a nine-month basis. Overall, commercial lines' estimated average price increases for the third quarter were slightly higher than the first half of 2018, including higher average pricing for our commercial casualty line of business. Our excess and surplus line segment continues to perform very well with third quarter and year-to-date combined ratios in the low 70s. It has reported 24 straight quarters of combined ratios below 100%. Excess and surplus lines' premiums are also growing at a healthy rate in the double-digit range for the third quarter and first nine months of this year. Our personal line segment in Cincinnati Re were affected by significant levels of weather-related catastrophe losses, experiencing third quarter combined ratios a little over 100%. Cincinnati Re remains profitable for the full year and inception to date. Our personal line segment continued to experience a rise in average rate increases. The third quarter 2018 average was a little higher than the second quarter with personal auto again near the high end of the high single-digit range. Both of these areas of our business continue to grow at healthy rates, and we anticipate better underwriting results in future quarters. Throughout our property-casualty operations, we continue to obtain relatively higher renewal pricing on policies where our models and judgment indicate that’s needed, as we segment accounts through careful underwriting of various risks. That segmentation is not always reflected in the average renewal price increases we report. However, when the benefits of segmentation combine with rising reported average renewal price increases as they did this quarter, it can significantly enhance our overall profitability. Our life insurance subsidiary also had an outstanding quarter, nearly doubling net income reported a year ago, along with earned premiums growing at 9%. Our primary measure of long-term financial performance, the value creation ratio, was 6.3% for the third quarter of 2018. The component of net income before investment gains or losses contributed 2.4 percentage points, an improvement of 1.1 points versus a year ago, including 0.7 points from other nonrecurring items. In addition, investment gains in our equity portfolio contributed 4.6 percentage points, offsetting a negative 0.7-point effect from the fixed maturity portfolio. Our results for the quarter were solid and included several areas of ongoing improvement in our operations. Next, our Chief Financial Officer, Mike Sewell, will highlight some important aspects of the financial performance and financial condition.

Thank you, Steve, and thanks to all of you for joining us today. Growth of pretax investment income of 1% for both the third quarter and first nine months of 2018 has slowed somewhat, reflecting the fact that in recent years, many of our higher yielding bonds were called prior to maturity or redeemed upon reaching maturity dates. As a comparison, our pretax investment income grew at a 2% rate for full year 2017 and at 4% in 2016. On the other hand, after-tax investment income is 12% higher so far in 2018 compared with the first nine months of 2017, continuing to contribute significantly to earnings and book value growth. Dividends from our equity portfolio continued growing nicely, up 5% during the third quarter of 2018 and 6% on a year-to-date basis. Our investment portfolio experienced overall gains for the third quarter of $381 million before tax effects. That included a $458 million increase in our equity portfolio, partially offset by a $76 million decrease from our bond portfolio. We ended the quarter with a net appreciated value of nearly $3.4 billion, including $7 million in our bond portfolio. Taking a closer look at interest income from our bond portfolio, which decreased 1% during the quarter, the pretax average yield was 4.19% for the third quarter of 2018, down 24 basis points from last year's third quarter. We continue to invest in bonds, including $324 million in net purchases during the first nine months of this year. Taxable bonds purchased during the third quarter of 2018 had an average pretax yield of 4.53%, 72 basis points higher than we purchased for last year's third quarter. Tax exempt bonds purchased averaged 3.87%, also up 72 basis points from a year ago. Cash flow from operating activities continued to provide funds for our investment portfolio, with funds generated from net operating cash flows for the first nine months of 2018 totaling $826 million, up 11% from the same period a year ago, despite 2018 income tax payments that nearly doubled the 2017 amount. Now, I'll comment on the $56 million third quarter 2018 benefit from certain nonrecurring items, of which $50 million was a result of tax accounting method changes, for which we received approval from the IRS during the quarter, as disclosed in the income tax footnote of our 10-Q filing. The largest of these tax accounting changes pertain to the valuation of our tax base for loss reserves, which had a $49 million favorable effect on our reported third quarter net income. Turning to our underwriting expense ratio, we continue to carefully manage expenses with an eye towards strategically investing in our business where we think it makes sense. Our nine-month 2018 property-casualty underwriting expense ratio rose by only one-tenth of a percentage point compared with the same period of 2017. Regarding loss reserves, once again, our consistent approach to setting overall reserves resulted in property-casualty net favorable development on prior accident years. Third quarter 2018 favorable reserve development benefited our combined ratio by 3.5 percentage points. And the nine-month 2018 benefit of 3.3 percentage points exceeded the same period last year by 0.6 percentage points. Our commercial casualty lines of business experienced $21 million of favorable reserve development during the quarter. Most of our major lines of business have experienced favorable reserve development in the first nine months of 2018. On an all-lines basis by accident year, it included 39% for accident year 2017, 20% for accident year 2016 and 41% for 2015 and prior accident years. Regarding capital management, both financial strength and financial flexibility remain in excellent shape. I'll conclude in typical fashion with a summary of third quarter contributions to book value per share, which represent the main drivers of our value creation ratio: property-casualty underwriting increased book value by $0.20; life insurance operations added $0.09; investment income other than life insurance, reduced by non-insurance items, contributed $0.92, including $0.34 from other non-recurring items; net investment gains or losses for the fixed income portfolio decreased book value per share by $0.36; net investment gains and losses for the equity portfolio increased book value by $2.22; and we declared $0.53 per share in dividends to shareholders; the net effect was a book value increase of $2.54 during the third quarter to a record high of $51.22 per share. And now, I'll turn the call back over to Steve.

Thanks, Mike. It was a good quarter, and we feel optimistic about the future. That optimism includes anticipation of meaningful contributions over time from leaders at Beaufort Underwriting Agency, the Lloyd's managing agency subsidiary of our pending acquisition of MSP Underwriting Limited that we announced earlier this month. Collectively, we aim to focus on profitable growth and providing superior service to our appointed agencies. History tells us that doing so will benefit all stakeholders at Cincinnati Financial and its affiliated companies, creating shareholder value over time. As a reminder, with Mike and me today, are J.F. Scherer, Steve Spray, Marty Mullen, Marty Hollenback, and Teresa Hopper. Michelle, please open the call for questions.

I'll begin with the E&S segment. While it may not be the largest, the results have been outstanding. I'm interested in hearing more about what this segment is focused on. I have always believed that, over time, the combined ratio would improve compared to the total commercial, but it appears to remain exceptional. Could you provide additional insight into what's happening there?

Mike, this is J.F. Scherer. The book is primarily focused on casualty rather than property; we don’t underwrite coastal property in the E&S company. Our appetite spans from small special event policies to substantial products liability coverages. I believe one reason for our success is that our offerings are typically linked to standard property and casualty accounts. Approximately 45% of the E&S policies we write are part of packages with Cincinnati Insurance Company. The premiums and losses from E&S are accounted for in our agents' profit-sharing, so they are meticulous about what they place with us. Additionally, our claims team, which also manages the standard business, oversees E&S policies. Altogether, this means we are attracting more selectively chosen business. We are taking a measured approach to growing CSU and expect our agencies to write about $3 billion in the E&S business, aiming to finish the year with CSU around $250 million. We see plenty of opportunities without having to aggressively pursue new business in the same areas we are currently writing. We feel secure in focusing on the casualty side and do not anticipate expanding into coastal property. Moreover, the management of CSU, particularly Don Doyle and his team, excel in their review and promotion processes.

If we can switch gears to personal lines, could you discuss both home and auto? It seems that auto-focused insurers are feeling more optimistic, and pricing is decreasing in that sector, while some commercial-focused personal lines providers are still working to improve their mix. Additionally, in homeowners insurance, certain carriers have mentioned some negative trends related to underwriting. Could you please elaborate on these lines of business?

Well, we’re feeling pretty good about private passenger auto; we think that the rate increases, the analytics that we're applying, are setting things in a good direction there. We have been taking some fairly significant rate increases as we've disclosed in the upper single-digit range. On homeowners, notwithstanding the fact that the results don't look as good, we're pretty optimistic about the direction that we're heading there. High net worth continues to grow at a nice clip. Historically, high net worth has been more profitable compared to middle market and we think that the team that Will Van Den Heuvel assembled in that area consists of a great number of professionals with many years of experience in the high net worth space, which will produce results that’ll be very favorable. We are seeing the negative trends that many other carriers have talked about. Our rate increases in homeowners are mid-single digits and we see that strengthening over the next couple of years. In addition to rate increases, we'll continue doing what we have been doing relative to inspections and loss control associated with our homeowner book of business. We are seeing and have seen larger claims in the homeowner area. Those tend to be pretty volatile. Right now, based on what we've seen, we’re maintaining a prudent level of reserving, which you would expect out of us on that homeowner line. We have confidence that we think things will level out and that those results will get much better.

And lastly, if we can focus on commercial liability, looks like commercial auto has been improving. But maybe you could talk more broadly about loss costs, and on the commercial liability side, some carriers are saying that they’re seeing an uptick in liability inflation along with just broader inflation. Although, it does seem like maybe commercial auto is getting a lot better and offsetting that. So just trying to get a sense for margins, because pricing still seems like it's steady low single digits. And wondering how you’re seeing lost cost inflation.

I think we have seen some of those trends. I'd like to think we got out a bit early on it and have been addressing it here over a period of time. You'll recall that we have had periods where we’ve shown some adverse development on that line as we've reacted to seeing some of the trends. I think we have moved to take action in terms of both rate and prudent underwriting, and now are showing a couple of quarters in a row where we've had some favorable development on that. I think it's still prudent that we treat the current accident quarter with due caution as we've seen this trend. But I do think we are on top of it, addressing that appropriately with both rate and prudent underwriting action.

Is there any other line I should be aware of besides commercial auto, like general liability and similar areas?

No, we feel pretty good about the book in total. And again, the commercial auto, I think we’re making progress there with the accident year ex-caps starting to move in the correct direction.

I really want to follow up on Mike’s question. Steve, can you talk a little bit about the internal analytical capabilities that you have to anticipate maybe macroeconomic changes that would impact commercial claim frequency?

Yes, I think it's the whole team. It starts with claims. We have local claims representatives led by Marty Mullen here that are out working from their homes in the communities with the agents. So, I think we get some pretty early intelligence of what's going on street level from our claims people. That’s brought here in the home office where we have a robust process, oversight committee that has every department in the Company represented. We do have predictive models on the analytic side, very much segmented by the book. In fact, we can look at every single policy in terms of how we feel it is priced relative to where we think it should be priced. We take action at a very granular rate in terms of encouraging keeping those that have the highest profit potential and working with those that don't in terms of what we can do on the underwriting side, the loss control side, pricing, and also working with the agent. So, it's a very holistic approach that we use. And we do have, specific to your question, the analytics in place and the predictive models in place that allow us to do this at a very granular level.

And I think we're clearly seeing it in results. Maybe a more specific question; we're hearing some chatter about better funded law firms maybe impacting overall casualty claim frequency severity or both. Is that something that you're seeing?

Meyer, we haven’t really experienced that phenomenon or trend across our casualty book other than past history. It's been pretty stable in that event.

Just a couple of questions, some prior people covered a few of them. I just want to drill down on the loss cost a little bit. One of your competitors commented fairly extensively this morning about workers' comp and some of the pressure they were seeing there with the high employment and a lot of new workers in the workforce. Just wondering what your experience has been so far and how that compares with their commentary?

I didn't hear that commentary or know about it, but we can share our observations. Workers' compensation remains favorable, particularly in terms of loss cost trends. We're seeing recognition of this alongside increased competition on the premium side, where there is healthy competition due to its profitability. If we were to comment on the impact of full employment and the need to secure workers, it would likely be more evident in commercial auto. We carefully monitor driver qualifications in commercial automobile insurance. While we also pay close attention to this in workers' comp, we haven't observed the same trends in workers' compensation as we have in auto.

And Mark, this is J.F. I would add that what we are noticing most and monitoring closely, which appears to be impacting our business, is the significant decrease in base rate loss costs by NCCI; those reductions have been quite pronounced. We have historically been somewhat concerned that these declines lag behind current trends, so we try to offset them to some extent. I also concur with Steve that one key feedback we receive from policy agents and their policyholders is the frustration in finding qualified workers. The market for workers' comp is quite competitive, with many carriers offering commission bonuses to agencies. We are satisfied with our workers' comp portfolio. Compared to several other carriers, we tend to take a more cautious approach, not pessimistically but with caution.

And then as you look at your written premium growth, more so than earned, because that’s been a natural lag. I mean you commented on the rate environment and the pricing environment rather. What proportion of your premium growth would you say is really being derived from just a better economy and more exposure unit growth and more, I should say, workers and etcetera?

I think it's pretty much a 50-50 split because we're seeing rates in the low single-digit range and premium growth also in that range, along with an increase in economic activity. So, the last time I checked, it was basically a 50-50 split.

And one other question just related to the tax rate in the quarter. There were a few moving pieces between the realized gains and special items and so forth. Would you share the effective tax rate on operating income for the quarter or approximation at any rate?

For the effective tax rate for, I want to say traditional operating income, you could think about that almost as 21%. But also included in operating income is investment income. The effective tax rate on that is about 16%. So, when you think about operating income, what’s the mix? Do you have more underwriting income that would drive it towards 21%? If you have less underwriting income, it will probably push it towards the 16%. The operating income effective tax rate for this quarter might look a little bit lower than normal. We filed our tax return right at the beginning of the fourth quarter. We had it prepared right at the end of the third quarter waiting for a couple of items to wrap up. So, you have some time, some book to tax adjustments. Some of those adjustments from what we recorded at the end of 2017, we’re making those adjustments and we made them right there towards the end of the third quarter. In this case, it had a positive effect; it actually brought our effective tax rate down for operating income. But I would say absent non-recurring items, investment gains and losses, book tax adjustments, you’re probably going to look at a normal run rate that might be in the 17% with a normal maybe mixture of underwriting income to investment income. As we keep improving, it will start to go closer to 21% as the combined ratio comes down and gets better.

I had two topics I was interested in, and this management teams garnered a well-deserved great amount of respect, and the personal lines initiative on the high-end homeowners, as well as the E&S business, are both doing wonderfully at their current state. I’m curious to know, putting that as a backdrop, the Lloyd's Syndicate, and I know it's still well away for closing. But what are the synergies behind it? Could you just talk about that? And I’m sorry and I don’t recall if you had a call immediately following the announcement that you've spent too much time on our call. But would you talk about the synergies on the Lloyd's syndicate please.

We did have a call, and so we can make that transcript available to you. But we see it as a bolt-on, really non-transformative acquisition; we see them on a standalone basis. So in terms of cost synergies, we don't see a tremendous amount there. We do see, as we picked up in terms of Cincinnati Re, synergies in terms of expertise, being able to handle larger, more complex risks. We are also looking for ways that our agents can participate and we can be more deeply involved with our agents in providing them with all the products and services that they require.

I didn't quite understand your point, so there are complex risks out there and reinsurance opportunities that Cincinnati Re hasn't been able to pursue due to a lack of expertise. Are you suggesting that the Lloyd's Syndicate might be able to underwrite those risks?

No, that wasn't the point I was trying to make. Let me try it again. I was probably not clear enough. As we grow as a company overall in terms of expertise, we have added to that throughout the company as you mentioned, whether in excess and surplus lines or high net worth. We have done some what we’re calling target markets, which are niche opportunities. We've done so in what we’re calling key accounts, which is larger properties, all of this is on the direct Cincinnati paper. Then, we have Cincinnati Re that writes reinsurance and has brought a lot of talent to the table; in terms of the modeling of catastrophe risk, the handling of different types of complex risks that they can share, the expertise of their underwriters with the underwriters that we have on the direct side. Similarly with Beaufort, Beaufort doesn't do reinsurance; they write larger properties in the D&F market, about 60% probably, another 30% or so in the binder and some aviation. We see the opportunity for that type of knowledge and expertise to also be helpful to our underwriters, as well as potential opportunities that our agents can submit business to a large syndicate with those types of skills.

Switching topics, it's still early in the commercial auto sector. You mentioned a couple of quarters of favorable development in that area, if I understood you correctly. Please correct me if I'm wrong. I'm curious if you're noticing an actual decrease or stabilization in the number of claims, or if it's simply the cumulative effect of increased rates outpacing the trends in loss costs. I'm trying to distinguish between the rate changes and the actual frequency of incidents leading to claims.

I think the first thing, the comment about a couple of quarters of favorable development had to do with commercial casualty and not commercial automobile. As we switch to commercial automobile and jump in if I am not hearing the question right; but as I heard it, you are asking about rate in terms of how it's doing relative to loss cost trends. But we do feel that as we look at lost cost trends, we look very much into the future and in the ratemaking process in terms of a trend being prospective and where we think the lost costs will be in the prospective rate in policy period that we’re making the rates for. All the activity we do in terms of claims, underwriting, loss control, and so forth, we think it has been helping to dampen the loss cost trends. What we do with the analytic side and the pricing side has helped to get us rate that we feel is moving ahead of the lost cost trends. That is why we are seeing the ex-cat loss ratios moving down a bit from where they had been, both quarter-over-quarter and on a year-to-date basis for the commercial auto.

So, do you attribute all the improvement to rate getting ahead of lost cost trend? It's not a reduction in claims frequency; maybe it's a stabilization. Would you talk about claims frequency and severity trends inside of lost costs?

So I’ll try to do it in two pieces. When we talk about lost cost trend being prospective, what will the lost cost be in the prospective periods that the rates are being made? That's where all what you would consider traditional underwriting comes into play, whether it be loss control, better classifications, better claims handling, looking at the MVRs, just everything that you would do, and the art of underwriting, we think has a dampening effect on the lost cost trends that will be experienced in the prospective policy period. Then we set the rates to be gaining ground on that lost cost trend using effective models and all the technology that we have, and so those are the two levers. We see the traditional art of underwriting is impactful to the loss cost trends.

Can we talk a little about the geography of new appointments and where you’re seeing the most growth in agencies? Also, when you think about the cohorts of agents that you appointed over the last five years. I know that long-term you have a goal of trying to get maybe as much as 30% or 40% of the volume within an agency. Is the take-up rate on new appointments, are they sending proportions of their business to you at the same pace of growth that you've seen in past appointment years?

As far as the geography of the appointments is concerned, we have appointed a lot of agencies for high net worth in California, New Jersey, and Massachusetts, where we’re not active in commercial lines. Now, at some point, we will be active there and many of those appointments will be converted to commercial lines agencies as well. But there has been a fair number of appointments there. As far as other appointments throughout the country, we are active now in downstate New York, Long Island. So we're making a few more agency appointments there for commercial lines. But typically, we are seeing a fairly broad cross-section around the country where we have agencies. It would fall in two categories; sometimes when M&A activity produces sales of agencies in a certain area, that can create a little bit of a disruptive effect; sometimes producers leave; sometimes we appoint the producers that leave, so we maintain a longer-term relationship that we had; then we also supplement by appointing the agencies that have not been as productive as they used to be. I wouldn’t say that there’s any particular state right now or any particular geography in the country that is outpacing any other. We still make new appointments in Ohio, for example. So we take a look at every single territory, and if we’re not getting the activity level we need, we go back to the existing agents and hope that we can write more business with them. If that's not the case, we appoint more agencies. As far as the productivity we’re getting out of new agencies, it continues to be very good. Hoping to write 30% or 40% of agents' book of business might be a little on the aggressive side. Particularly in some of the newer agencies that we're appointing, they are very, very large agencies. The consolidation and M&A activity have produced very large agencies. So while we may not necessarily aspire to 30% to 40%, we continue to aspire to be the most significant contributor. I think that’s the best way I would describe that the most significant contributor to that agency's success over the long term.

And Josh, this is Steve, just to throw some stats in there. Agencies that we've appointed since the beginning of 2017 have contributed $16 million or about 10% of the total new business written premiums over that period of time. In terms of new appointments, there have been 120 new agency appointments here in the first nine months of 2018, including 54 that mark only our personalized products, which are targeted towards the high net worth.

And when you think about one of those high net worth-only agencies, I imagine the same doesn’t apply that you’re hoping to be the most important contributor. What is the goal of a successful high net worth agency?

That's the same. It may take some time. We’re certainly younger at it than some of the other folks that are out there. But the agencies that we’re doing business with are agencies that have done business with Will Van Den Heuvel for 25 years. We think we’re bringing a good product to the market. We’re seeing tremendous receptivity on the part of some of those agencies. So, I guess just as I mentioned on the commercial line side or my overall comments, we have no interest whatsoever in being a fringe player or a bid player in any agency we do business with. We will make a meaningful contribution to their success, or we don't think that the relationship is worth pursuing.

Thank you all for joining us. Thank you, Michelle, for moderating the call. We look forward to seeing you again soon on our next year-end call. Thank you very much. Have a great day.