Cincinnati Financial Corp (CINF) — Q2 2019 Earnings Call Transcript

Hello, this is Dennis McDaniel at Cincinnati Financial. Thank you for joining us for the second quarter 2019 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.

Good morning and thank you for joining us today to hear more about our second quarter results. Operating performance was very good, particularly given challenging spring weather including storms affecting the Dayton, Ohio area with insured losses that exceeded the $100 million retention level of our property catastrophe reinsurance treaty. We believe our steadily improving results reflect our proven strategy and careful execution, as we continue efforts to grow profitably over the long term. Net income for the second quarter of 2019 nearly doubled the amount from a year ago. Changes in the fair value of equity securities held at June 30th produced most of the increase. Non-GAAP operating income was up 5% and is up 23% for the first half of the year. Our 96.5% second quarter 2019 Property Casualty combined ratio was 0.7 percentage points better than a year ago. Without the effects of natural catastrophes, it was 3.6 points better. Our results benefited from efforts to diversify risks by product line and geography in recent years. That, along with various improvements over time in how we underwrite property risks, helps reduce adverse effects of catastrophic weather events in the Midwest that have tended to impact our second-quarter results. A major reason for our confidence and improved underwriting performance is progress in segmenting our business, retaining more profitable accounts, and getting better pricing on the less profitable business while walking away from opportunities when we judge profit margins to be too thin.

Great, thank you, Steve, and thanks to all of you for joining us today. Our investment income continues to climb, up 4% for the second quarter of 2019. Dividends from our equity portfolio rose 14%, as dividend rates have increased for many of our holdings. Net purchases of stocks during the second quarter totaled $75 million. Interest income from our bond portfolio was down slightly, decreasing just under 1%. The pre-tax average yield was 4.12% for the second quarter, down 16 basis points from the second quarter a year ago. Steady investment in bonds again occurred during the quarter as we made $69 million in net purchases. Although the average pre-tax yield for the total of purchased taxable and tax-exempt bonds was a little lower than in recent quarters. For the first six months of 2019, there was 6 basis points higher than the same period in 2018, and within 2 basis points of the full year 2018 purchases. Investment portfolio valuation changes for the second quarter of 2019 were favorable, both for our stock and bond portfolios. The overall net gain was $564 million before tax effects that included $366 million for our equity portfolio and $199 million for our bond portfolio. We ended the quarter with net appreciated value of more than $4 billion, including nearly $0.5 billion in our bond portfolio. Strong cash flow again contributed to investment income growth. Cash flow from operating activities generated $476 million for the first six months of 2019, up $12 million even after paying $57 million more this year in catastrophe losses. Regarding expense management, we watch our spending carefully as we make strategic business investments. The second quarter 2019 property casualty underwriting expense ratio was 0.4 percentage points higher than last year's second quarter but matched the full year 2018 period and was within a tenth of a percentage point of the average for full years 2016 through 2018. Moving next to reserves, we apply a consistent approach as we continue to aim for net amounts in the upper half of the actuarially estimated range of net loss and loss expense reserves. During the second quarter of 2019, we again experienced a healthy amount of property casualty net favorable development on prior accident years. Favorable reserve development for the quarter benefited our combined ratio by 6.4 percentage points. Of two longer-tailed lines, commercial casualty and workers compensation, they represented nearly two-thirds of the property casualty total. Other than homeowners, each of our major lines of business experienced favorable reserve development during the first half of this year. On an all-lines basis by accident year, this includes 29% for accident year 2018, 26% for accident year 2017, and 40% for 2016 and prior accident years.

Thanks, Mike. The second quarter is often a challenging one, yet we are satisfied with our overall results. The storms that crisscrossed our nation over the past few months gave our independent agents and our claims associates who work with them a chance to shine. In August, our field associates from across the country will come together in Cincinnati to celebrate the progress we are making and to attend educational opportunities and plan for the future. It's a great opportunity to reinforce our Cincinnati advantages and to learn from our associates about the opportunities they are seeing firsthand. Our strong performance for the first half of the year bodes well for the future. As always, we remain focused on executing our proven strategy, seeking profitable growth for the benefit of all stakeholders, and creating shareholder value over time. As a reminder, with Mike and me today are Steve Spray, Marty Mullen, Martin Hollenbeck, and Theresa Hopper. Natalia, please open the call for questions.

Hi, good morning. My first question is regarding the catastrophe levels this quarter. I know it depends on when I start the average calculation. The long-term average cat load, I believe, for 2Q was higher than what you experienced this quarter. I know that's changed since then. You have grown into different segments and states, and you have a new treaty. So I'm trying to understand whether this quarter's cat load was materially above your kind of base case normal expectations, if you can opine?

Yes, this is Mike Sewell, and that's a great question, Mike. If I think about the second quarter cats that we had, it was 10 points for this year. When we think about cat loads, we do look at averages and that average actually was right in between a 5- and 10-year average. So, a five-year average for us was right at 10 points, if you gauge as of 12/31/18. So we actually were right on top of it. We were actually a little bit lower if you go and look at a 10-year average, but included in the 10-year average, remember back in 2011 we had our two largest cats back to back. So we were actually right in the middle on this one.

Okay. I'll check my math then, and I think I probably added more cat load for the reinsurance division. So then this would kind of be within your normal expectations was my takeaway?

I would say so, yes.

Okay. In terms of the commercial pricing environment, it sounded like in the press release that pricing hasn't shown much momentum quarter-over-quarter. I think some peers have shown a good deal of momentum. Specifically, Travelers showed over a point of momentum in their book quarter-over-quarter. Any color or thoughts there?

Yes, Mike, this is Steve Spray. You're right. Second quarter, just from our major lines of business, what we're experiencing is in commercial auto, we're still in the high single-digit range, commercial property mid-single digits, casualty low single-digit, and workers' compensation is down mid-single. Just as a reminder, I think we talked or I commented on this on the last quarter as well. I don't think the averages really tell the complete story for the way we're trying to execute with our agents, both on new business and on renewals. As an example, while we remain consistently in that high-single-digit range on the commercial auto, we're really focused on executing on segmentation. A portion of our book that the analytics indicate have less of an opportune chance for profit, or at least adequately priced business, we are getting increases far in excess of our average. Then on the business that we see is most adequately priced, we're working with our agents to really focus on retention there. And that will impact the average, but it also, if you think about it, it's improving our mix. We don't just do that in commercial auto, we take that across all major lines of business and commercial lines, new and renewal. Now to comment, I think I'd like to add a little extra color too, because we are seeing a pronounced firming, hardening -- however you would like to put it -- and it's focused in some specific areas in commercial lines. For example, habitational risks, such as apartments, condos, anything coastal, large property schedules, or large property risks. We're seeing additional firming in that. Commercial auto, of course, we're seeing that there. Commercial auto would be the area that we would track with the industry. Those other areas, we certainly have larger property risks, larger property schedules, and we have some tougher casualty, with a little coastal as well. But on a relative basis, not to the rest of the industry. So I think that's what's driving some of the muting of what you're seeing there as well. Does that make sense?

Yes, that's good color. As a follow-up to you, some of your peers have talked over the years about being more precise in determining which accounts need more or less rate. I'm just curious, at a high level, are these tools you're using to determine this proprietary to Cincinnati Financial, or is it a change in the last couple of years versus the prior decade? Or is this kind of off-the-shelf software that most of your competitors are using too?

No, I would say it's proprietary to Cincinnati Insurance. Others obviously use predictive analytics and tools as well, and theirs would be proprietary to them. We implemented this on the workers' compensation front about 9 or 10 years ago. Then our package lines, including our major package lines -- auto, general liability, property, and workers' compensation -- property followed right after the workers' compensation. I just think we are continuing to execute better and better on the segmentation across all those lines, Mike, and just really focused on it. Our underwriting teams are doing an excellent job working with our agents, and it's picked up steam over the last couple of years. I'm confident that's what we're seeing in the results.

Okay, great. Maybe part of that is your field underwriters have gotten more comfortable using the analytics. I don't know if you have a thought about that.

Yes, that's a great follow-up. Absolutely, the analytics, we use the tools both on new business and on renewals. I would say that both our HQ renewal underwriters and our field sales underwriters, it took time to evolve on this, get more comfortable, communicate with the agents, and work with the agents. I think our underwriting teams are doing a great job of getting out in front early and often and communicating with the agents on those risks, where we think we need to take maybe the most drastic action. So yes, I feel really good about that. We can see in the analytics too that our new business pricing has continued to improve, and it has continued to improve this year as well.

Okay, great. One last question, also then, probably for Mike. Did you say in the prepared remarks that the gap between the new money investment yield and your portfolio yield, or whatever is expiring in the portfolio, is 2 basis points?

Yes, that's right. Let me have Marty maybe give a little bit more detail on that.

Yes. Purchases of about $419 million, book yield purchase was 427. That's about, call it 3 basis points less than the prior quarter and embedded book value, so very slight.

Okay. So then it seems like you guys have less drag. If that's on a go-forward basis, it doesn't seem like you guys have much of a drag, whereas some peers have a bigger gap.

I wouldn't quite agree. We do have a drag in that. We've got a number of corporate bonds purchased 10 years ago in the aftermath of the financial crisis at very generous credit spreads, and for the last year and a half or so we've been experiencing those leaving us. So that's created some drag. We're doing our best to counter it, but there is still some drag there.

Thanks for the insights.

Good morning. Congrats on the quarter. I was looking at the paid losses relative to incurred. It looks like they've risen significantly in both the commercial lines and personal lines this year, and I was wondering if you could kind of reconcile what's underneath that, too. I mean, it looks like paid losses are pretty flat. But the incurred is down, what do you think is going on with that?

This is Steve, I'll jump in. I think there is a very steady approach to setting the reserves. If we look at the half year and its total, the paid to incurred looks pretty reasonable. I think we've added about 2.4 loss ratio points to the first half in terms of IBNR additions. One thing to consider is that we're coming out of a period that had relatively higher catastrophe losses. We're looking at this paid to incurred on a kind of a calendar year basis. We could have the emergence of claims that are being paid and also some take down in reserves, which is showing up in the favorable development column. The confidence we have in our consistent approach to setting the reserves gives us great confidence to the point on the cat payments. They were $57 million more so far this year than they were for the first half a year ago. I think that has some explanation there.

Great. Given the environment with pricing sort of outside the core business being a little bit more attractive, have you thought about putting more capital than you had previously thought into the reinsurance and voids business?

We are pleased with the way both of those are performing. One thing that we've done that was the way to do it, on the Cincinnati Re, was to not establish a separate company there. It's a part of Cincinnati Insurance, and it puts us in a position to just not have pressure to grow into a capital base, which could incentivize taking a little bit more risk to provide a return on the capital amount allocated. We have a very small but talented group. I think there's about 20 in the Cincinnati Re that are performing at a high level. It puts them in a position where they can just, on a risk-adjusted basis, look policy-by-policy. It's not at all top-down dictated, it's very much our people getting more and more opportunities. As we see in the marketplace, Cincinnati Re is just developing a reputation, getting a lot more looks, maintaining their underwriting discipline, and we can be very selective in the risks and contracts that we entertain. In terms of Cincinnati Global, our Lloyd's subsidiary, again, we're very happy with the way they're starting. They're a talented group that's been profitable 20 out of the last 24 years. We think we have sufficient capital there to execute on the business plans that they have submitted and received approval for. We will keep a close eye on that. In this instance, I don't want to show any lack of confidence in either by not saying we're going to pour more capital into them, but we think we have adequate capital in both places, and we think that both are executing at a high level.

Great. thanks. Congrats on the quarter again.

Yes, good morning, everybody. I don't know I'm connected, hello?

Yes, good morning Josh, can you hear?

Good, good. Got it. I'm glad you are there. I just wanted to hear, I mean the workers' comp reserve releases continue to be quite excellent, and I expect that they will be in the future for the industry. I was hoping you could give us some color on what years you're seeing excellent reserve releasing trends in the workers' comp book, and whether you've touched upon the recent years at all?

Yes, Josh, this is Mike. For the year-to-date on the workers' comp, we had $42 million in favorable development. So thinking about that and looking at our details, it's actually kind of spread evenly throughout the year. For accident year 2018, it was $6 million, for accident year 2017 it was $9 million, for accident year 2016 it was $9 million, and then for accident years 2015 and prior, it's $18 million. So it's that kind of evenly over the most recent accident years.

And in terms of your forward writings, to what extent is the pricing that you guys are putting in place a function of regulatory requirement? To what extent are you taking those profitabilities yourself and saying that you can offer better prices to your customers?

Yes, I think -- Josh, this is Steve Spray. It's hard to ignore the base rate declines that are coming through from the state rating bureaus, and that's putting pressure on the accident year results for sure. But we've seen the loss trends be benign. We're an open market for work comp. I couldn't -- we couldn't be more pleased with the way we're managing work comp. I mean underwriting, risk selection, pricing, loss control, claims -- everybody hitting on all cylinders there. So we're open for business, but that line can be volatile. It can be variable as everybody knows. So we're just watching that closely and want to grow it. As we see these base rate declines come through, again, we're using the tools that we have, both the art and the science of it, and we're trying to mitigate those base rate reductions running through our book as much as possible.

Terrific. And one more if I can. I'm wondering if you could give any color -- I know obviously you give great detail. On the personal lines and net premium growth rate, is there any way to segregate your traditional business growth rate from your high-net-worth homeowners' growth rate? And if you can talk about a few geographies where you found recent success in the high-net-worth homeowners' business outside the, I guess, the New York Metro area, I'd love to hear about it.

Yes. Our high-net-worth, we are really pleased with the progress there, and that just continues month after month. Our high-net-worth is growing. It's obviously on the coasts is the main areas where that business is and where it's going, but we're seeing growth across our entire agency footprint. I would tell you our middle market business, the growth there has been under more pressure than the high-net-worth due to necessary rate actions we're taking. That's putting pressure on new business retention as well. But we think it's appropriate, we need it. We're targeting it by state, and some of our larger states need the most action -- Michigan, Kentucky, Georgia are three states, to name three of the larger ones that we're taking very aggressive rate action, which is needed and prudent, but it's putting pressure on both the new business retention and written premium in the whole book.

Would it be wrong to say that high-net-worth homeowner policy count growth continues to be in the healthy double digits for you?

Yes.

That'd be correct. Would it be wrong to say, is that correct?

That would be correct.

Yes. Okay, thank you.

Thank you, Josh.

Good morning. I was wondering what lines are driving the reinsurance growth?

The reinsurance growth would be Cincinnati Re.

Well, specifically like what types of business are you?

Yes, on a very ground-up basis, it is about, I think for the year, 42% property right now. Let me check that number, it's 40% property. Year-to-date, the rest would be in our casualty and specialty. That is varied over time, but as we go through various times of the year, we are getting a lot of great looks at some of the property business here in the second quarter. We were a little bit higher on the property this quarter. But if we look inception-to-date, it's a very balanced portfolio of 35% in property and the other 65% in casualty and specialty buckets. So again, there's a very much ground-up contract-by-contract emphasis on where we grow.

Thank you. I appreciate that. On the Lloyd's, can you just give a little color on what you're seeing in the pricing and market environments there? I think there was one insurer who just recently mentioned that they're seeing some E&S business bouncing from Lloyd's back into the US CNS market, and are you seeing that as well?

It has been a firming market. I would say it's been a firming market both in what we see with our CSU in terms of excess and surplus lines. Also, what we're seeing in the Lloyd's market is firming that is welcome. We're seeing it from some of the bigger carriers in the United States as well in terms of firming. So I think it's just overall, especially given the experience over the last couple of years, it's definitely been a firming market and we're seeing it in our Cincinnati Global underwriters and Lloyd's as well.

I appreciate the tie-up. Thanks.

Hey, thanks. One follow-up on the high-net-worth space. Just curious, do you feel, do you have any sense of whether the high-net-worth marketplace is growing or whether you're mostly taking share? Also, do you have a sense of whether your pricing is similar to that of peers, or are you kind of taking share because it's less price-sensitive and more of the relationships with the agents, if that makes sense?

Yes, I'll take the first. This is Steve Johnston, I'll take the first quick shot at it and turn it over to Steve Spray. We're seeing growth in both areas, and I think not only from what you would think of as the traditional high-net-worth carriers, but also much of the business is written from standard carriers that the clients have been with for many years, and I think they see the value that we bring in terms of upgrading coverage and expertise in handling the higher-net-worth policies. I think a lot of the growth can come from that area, both the traditional and the non-traditional.

Yes, I would, I would just add, Mike, as well that as far as the pricing goes, we feel like we have an excellent value there with the agents, and we feel like our pricing is in there with the marketplace. It's more of a value play for us, and the claims service that we provide, the broad coverage we have, the services that we provide. We've just been well received. Our strategy and our model has been received really well by all of our agencies.

Yes, thanks again.

Thanks, Mike.

Hi, thanks and good morning. Maybe just a couple of quick follow-ups. So the first is on the commercial auto discussion. I was looking at the supplement. The current AYLRs look to be trending in the right direction. Can you just refresh us on that discussion because your numbers are getting better, however, Travelers had more noise in this quarter. So I'm trying to figure out what exactly is going on in the book?

I mean, this is Steve Spray again. Yes, every quarter that goes by, we get even more confident that we were out ahead of this commercial auto, the trends that we've seen. For us, it's severity. I think it's severity for the industry. Our frequency has been good and trending even more positively. The macro things in the marketplace, so those macro effects, haven't gone away. These include distracted driving, an improving economy, increased miles driven, and I think we all can see the construction that goes on in the infrastructure of the highway system. So all that's leading to the severity. But I think we -- again, we were out ahead of this. We've worked with our agents, starting back probably about 2 years ago, maybe a little longer than that, of really focusing on segmenting the book. We've got the pricing in a good spot. We still have room for improvement. There is still a runway there. The market's going to allow us to continue to improve, but we feel really good about where we are with commercial auto right now. As a matter of fact, we are looking for opportunities inside our agencies as this market is firming. We think we can help our agents write some new business, well underwritten at more adequate prices than we've seen in the past several years.

You know, related to that answer, we've been reading more and more about the oversupply of I guess big rigs, falling freight rates, et cetera. How does that factor into your book? I know you talked about the driver issue and the overall economy, but how does that oversupply of big rigs and freight rates impact your book?

Yes, I don't think it -- it doesn't really apply to us. I mean, not that we don't have some of that business with our agencies, but we've just -- we've never been a big transportation market for long-haul trucking and such. But I can -- that kind of goes to the question earlier, too. That market, when we do see those risks presented to us, you can understand why that market is as firm or hard as it is, that segment of the market.

Yes, fair point. It's been a challenge for a long time. The other question I had was the discussion on child victims exposure, and I don't recall you mentioning in the opening remarks. Can you remind us what exposure you may or may not have to those claims?

I assume you're talking about New York and some of the things we've seen here with the diocese and so forth. Marty Mullen may want to chime in here a little bit on that.

Sure. Thank you, Amit. This is Marty Mullen. That really won't be a very big factor for us with Cincinnati in New York as we wrote very little of that back 20 or 25 years ago in New York, which I think you're referring to the statute of limitation change for these claims. We really weren't in New York at that time, back -- I think this mainly pertains to the '80s and mid-'90s. So our exposure as a result of those changes in the statutes should have very little impact on us.

Got it. And then the only final question is maybe a broader question, the discussion on social inflation and jury awards and sort of plaintiff awards have been climbing a bit. Any thoughts on that and have your thought process changed, let's say, over the past few quarters?

This is Marty, again. That's not the -- in our experience, it's a jurisdictional issue and it's very specific to the type of claim, the type of defendants that you might have, and the actual details of the incident. Our experienced claims staff that's been with Cincinnati -- we promote from within, so we have what we feel is a culture within Cincinnati to just recognize those types of situations where severity may play an impact in certain jurisdictions over another. It certainly is impacting the industry, but you just have to take it on a case-by-case basis and be aware of the potentials for an adverse verdict.

Got it. That's very helpful. I'll stop here. Thanks for the answers, and good luck for the future.

So number one, I want to tell you, to thank all of you for what you've done, because through ownership of your company I've changed people's lives and allowed them to do things they never dreamed of. You never hear much about that in our society, but I do, and I want to say thank you for what you've done. A couple of questions now, the taxes on the dividend income and equities, could you tell me how it's done now? Is there a certain percentage that's free and a certain percentage that's taxed at 21%?

Fred, I'll start out. This is Steve Johnston. I'll turn it over to Mike Sewell. First off, and I thank you for your initial comments. They're very much appreciated. When we look at the tax rate for the dividends received deduction, it was changed a bit by the new tax reform and Jobs Creation Act. It really didn't affect the overall tax rate for the dividends because the rate came down, but the parts that could be offset there went up a little bit, and the overall effective tax rate for the dividends we receive remained pretty much unchanged. So Mike might have more specifics.

Yes, yes, no, it's. Yes, Fred, that was a great observation. It really hasn't changed between the different subsidiaries, if you will. For the life insurance company, there are no dividends received deductions. For that reason, you will still have a 21% rate there. We don't hold any stocks where we get dividend income in the life company. For the property casualty companies, you do get partial dividends received deduction, so our effective tax rate on dividend income there would be about 13%. The non-insurance subsidiaries, which would be like the parent company or CFCI, again, we do get dividends received deduction. The effective tax rate there is about 10.5%. So there still are benefits for holding that. There were also a few changes on the tax-exempt interest, but if I think about it in total related to our investment income, whether it's interest income or dividend income, our effective tax yield or effective tax rate would be about 16%. If you add that on top of the non-investment income, so through operations, gains and losses, which will come in at 21, our effective tax rate will probably be in the 17% or 18% range, if you have the same mix. This quarter, our effective tax rate was around 19%, a little bit higher, but that was primarily because of the movement of unrealized gains and losses on our equity portfolio and our bond portfolio, which skewed a little bit more towards the 21%.

It used to be there was a percentage of the dividend income that was exempt from taxes, like 60%, and then that remaining 40% was taxed at 35%. Is that formula still in use, but just a different range and different structure?

That's right. That effective tax rate, when you blend it all out, has stayed pretty much unchanged from before the tax reform to after, it's down just a little bit.

Yes, the other question I have is on your defective book value. Your deferred tax liability has increased. Does that reduce your book value?

Well, yes, yes. The reason that's going up is because our unrealized gains on our equity portfolio, if that goes up by $1, your deferred tax liability in that case is going to go up 21%. That is an offset to the asset that increased. So it is offsetting that. And so that's a good thing that that liability is growing because the asset is growing on the other side.

It could be $3 a share that’s taken off book value. I am just rambling with my math here.

Yes, another way of looking at it is we carry on the balance sheet the equities, net of their tax liability. As the overall total value goes up, the liability goes up, and as Mike mentioned, it's a good thing because looking at it all out it's very positive.

Well, hey, thanks for making my life. You guys and gals and everybody in your company deserves a pat on the back because you've been terrific. So I just want to say thanks again.

Thank you, Fred. We really appreciate your comments, and your questions were excellent.

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