Oct 29, 2007
Executives
TomPottle - Senior Vice President of Credit and Field Operations JohnWelch - President and Chief Executive Officer JohnCorcoran – Senior Vice President, Chief Financial Officer and Treasurer
Analysts
RandyBinner - Friedman, Billings, Ramsey & Co. RonPate - Banc of America Securities
Operator
Goodday everyone and welcome to CNA Surety's Third Quarter Analyst Conference Call.As a reminder, today's call is being recorded. Foropening remarks and introductions, I would like to turn the call to Tom Pottle.
Tom Pottle
Thankyou. Good morning everyone and welcome to CNA Surety Corporation's thirdquarter conference call.
With me are John Welch, President and Chief ExecutiveOfficer of CNA Surety, and John Corcoran, Chief Financial Officer. Beforewe begin, I would like to preface this call with the Safe Harbor statement under the Private Securities Litigation Reform Act of1995, which is more fully described in the press release.
Throughout thediscussion and subsequent question and answer session, forward-lookingstatements that are not based on historical facts may be made. These statementsare based on today's market conditions and involve certain risks anduncertainties.
While every attempt is made to convey accurate informationregarding these forward-looking statements, no guarantees can be made that theconditions will remain, and that the actual results will conform to thestatements being made today. Withthat understanding, I would now like to turn the call over to John Welch.
John Welch
ThanksTom. Thank you all for joining us again this quarter.
As some of you may know,this month we are celebrating our 10-year anniversary as a publicly tradedcompany, the only publicly traded surety company in the United States. Duringthe past 10 years, the company has made some great strides.
When CNA Surety wascreated 10 years ago, we wrote roughly $270 million in gross written premiums.As we move towards 2008, we are nearing $500 million in gross written premiums.The company's equity position has grown from $257 million in 1997 to $636million today. Our book value per share has risen from $5.93 in 1997 to $14.44today.
All told, the company has been reporting record earnings, and is in thebest financial condition in its history. Turningto this quarter's results, we are pleased to report record net income of $28million.
This brings nine months net income to nearly $71 million, which putsus in a good position to finish the year on a very strong note. Overall,gross written premiums increased 7% for the quarter, with contract suretyleading the way with growth of 11%.
Within the contract surety line, our smallcontractor book has grown substantially. Oursmall commercial surety book grew by nearly 3% while our corporate commercialsegment was off by nearly 13%.
Our corporate commercial book was off due to amore competitive environment and continued underwriting discipline. Ouroverall quarter production was strong, we tend to focus on the yearly growthrates as quarter-to-quarter comparisons can vary, given the timing of whenconstruction contracts are awarded and when bonds are written.
Our loss ratioremains fairly consistent with the prior year, with both years being affectedby similar reserve releases. Wecompleted our outside actuarial reserve review during the quarter, and as aresult, we released $5 million of reserves dating back to 2003 and prior.Beyond the reserve release, we continue with the same level of current lossprovisions.
Onthe expense side, we continue to report nothing but good news as our expenseratio once again declined from 55% last year third quarter to 52.8% thisquarter. Lower expense ratio was again driven by greater premium, lowerreinsurance costs, and continued improvement in operating efficiencies.
Lookingforward, we continue to focus on growth prospects in the construction industryfor contract surety and the overall economy for our commercial surety growth.Let me provide a little perspective on the construction economy. Through Augustyear-to-date, according to numbers we got from the census bureau, overallconstruction spending was down 1.7% from 2006 levels.
Thedecrease was driven by the residential sector, which was down 16.5%. Publicconstruction spending was actually up 14.7%, while private nonresidentialconstruction was up 15.2%.
Our expectation is that the decline in theresidential sector will moderate to some degree, while growth in the privatenonresidential and public sectors will slow down some. The slowdown in thehousing sector will ripple into various other sectors of the construction industryover the next few years.
Lookingforward, we hope to offset some of these downward pressures by selectivelyexpanding into geographic regions where we do not have a large presence or anypresence, and by putting additional emphasis on certain niches we have notfocused on for the past few years. More importantly, however, is maintainingthe credit quality of the book, and this along with exposure management willcontinue to be our top priorities.
Duringthe fourth quarter, we will be renewing our reinsurance contract given thestrength of our capital. We are in a good position to consider numerousalternatives.
We continue to believe it is important to maintain a very strongcapital position in order to provide flexibility in the reinsurance buying,liquidity for any attractive acquisitions that might come along and to cushionagainst any downturn in the construction economy and/or its creditfundamentals. Overall,we are very pleased with our current results and expect to finish the year in avery solid financial position.
We believe the company is well positioned forthe next 10 years and we look forward to being part of that continued success. Withthat, I'll turn the call over to John Corcoran for some additional financialdetails.
John Corcoran
Thanks,John. Good morning, everyone.
I will provide a few more details on our recordearnings. A quick note, all the earnings per share amounts that I quote will beon a fully diluted basis.
Wereported net income for the third quarter of $28 million or $0.63 per share,compared to net income of $23.6 million or $0.54 per share for the thirdquarter of 2006. For the first nine months of 2007, we have reported net incomeof $70.6 million or $1.60 per share, compared to $61.1 million or $1.39 pershare for the first nine months of 2006.
Realizedinvestment gains were minor in the current quarter, so net operating income wasalso $28 million and $0.63 per share, compared to net operating income of $24.3million or $0.55 per share for the third quarter of 2006. Forthe first nine months of 2007, we reported net operating income of $71 millionor $1.60 per share, compared to $61.7 million or $1.41 per share for the firstnine months 2006.
The increase in income was driven by higher earned premium,higher investment income and lower expense ratios. Boththe current quarter and the third quarter of 2006 benefited from reservereleases of $5 million and $5.1 million respectively.
John Welch covered thepremium trends, so I will spend a minute on the loss and expense ratios. Whilethe reserve releases were about the same dollar amount, the loss ratio impactin the current quarter was less, so we actually see a slightly higher lossratio when compared to the third quarter of last year.
However, our loss ratioselection for the current accident year remained at the same level as theprevious quarters, at about 3/10 of a point better than our original selectionfor 2006. AsJohn mentioned, we did receive the results of the independent actuarial studyusing data as of June 30th.
The study confirmed that our loss experience hasbeen favorable. We released reserves from accident years of 2003 and prior, aswe believe those years are sufficiently mature and unlikely to be impacted bycurrent economic conditions.
Whilethe reserve study did indicate modest improvements for the more recent accidentyears, we did not release any reserves for these years. There was nothing inthe data that concerned us, we simply believe that the current economicconditions highlighted by the sub-prime mortgage issue and the housing slumpcall for a bit of caution as we assess the more recent accident years.
Duringthe fourth quarter, we will update the reserve analysis and will discuss thoseresults during our year-end conference call. Wecontinue to be pleased with the improvements in the expense ratio, whichimproved to 52.8% for the third quarter, compared to 54% for the second quarterof 2007, and 55% for the third quarter of 2006.
The biggest drivers of thisimprovement continue to be the growth in earned premium in part due to lowerreinsurance costs and the fact that we have accomplished this growth withlittle additional expense. Pre-taxnet investment income for the quarter was $11.3 million compared to $9.8 millionfor the same quarter last year.
The increase continues to be driven by thegrowth in invested assets due to strong operating cash flow and slightly higheryields. Operatingcash flow for the third quarter was $58 million compared to $43 million for thethird quarter of last year.
The third quarter is typically a high cash flowperiod for us, as we collect the premiums written in our heavy productionmonths of June and July. Atquarter end, our invested assets in cash totaled $980 million.
The credit qualityof our investment portfolio remained at AA+. Debt outstanding remained at $31million at quarter end.
Statutory surplus was $413 million at quarter end,resulting in a net written premium to surplus ratio of 1:1. Atquarter end, our consolidated stockholders equity increased to $636 million or$14.44 per share, reflecting the net income for the quarter, and a swing backinto an unrealized gain position in our investment portfolio.
Thatconcludes my remarks, so we will now open up the call for your questions.
Operator
(OperatorInstructions) Our first question will come from Randy Binner with Friedman,Billings, Ramsey & Co..
Randy Binner - Friedman, Billings, Ramsey
Onthe reserves: I think you mentioned that it was the whole $5 million was all'03 and prior. Is it possible to break out more specifically what accidentyears that applied to?
John Welch
Sure.' 03 itself was the biggest release − about $3.7 million.
'01 had about $1.5million. The rest of the years were a little movement back and forth; nothingreally material.
Randy Binner - Friedman, Billings, Ramsey
'02had an unfavorable development after a favorable development the year before,so that related to, I think, some ongoing litigation. You had mentioned thatyou think that those years are sufficiently mature, so can we infer from thatthat the '02 and '03 accident years are pretty well locked at this point?
Imean, I know they are by definition, but just maybe more color on it.
John Welch
Idon't want to over-imply the level of precision that goes on in any individualaccident year. I think collectively as a group, now, we should see smallermovements.
We're always going to see small movements back and forth; one claimdevelops worse than we expected, then another claim develops better than weexpected. Sothat could cause some blips across accident years, but in general, looking overthat group of years, yes, I think we should see those settle down.
Randy Binner - Friedman, Billings, Ramsey
Okay.And so, now that would imply that '03 would be back to par. That's great.
Oneother question, just maybe a little bit more color on what happened with thecommercial line, the weakness there. And I know that that's trended down a bit sequentiallyand year-over-year.
I mean is there a trend going on there? Is it competition?
Whatexactly is making that happen?
John Welch
Sure.Let me first distinguish between our small commercial book and our corporatecommercial book. Thecorporate commercial book overall was relatively small, and that's the areathat had decreased, I think, on a yearly basis; we might do $30 million give ortake, and so that's the area that was impacted.
Thesmall commercial business continues to grow, and the core segments of thatprobably are rated more or less 3% The smaller corporate book, what's reallybeen impacted there is a couple of things. One,we had emphasized it for a lot of years, and only got really more back into it,let's say, within the last year.
And so we're in a position of trying to go outthere and drum up production after having told everybody we didn't want to bein it for a long time. So it's been a little bit slow, and we've done it at atime when the market started to get a little more competitive, and we haven'treally been willing to play at some of the terms.
Andthen you combine that with the fact that some of the bonds in that sector hadto deal with, like mortgage broker business for example, and there's lessdemand for that. So, some of that's gone.
Some of the decrease was related toreclamation bond exposure where it's a “long-tail” exposure − that we're notcrazy about, so, we manage that a little more carefully, and so, we’ve kind ofmoved some of that off the books. Then the contractor clients themselves whohappen to need small commercial bonds at times have had less demand in the lastquarter for whatever reason.
Butoverall we're not really concerned about that because when we restructure thiscorporate commercial segment of our business, we essentially broaden it to morethan just commercial surety bonds. We're having that group basically go afterbusiness that traditionally might have been considered contract bond.
It'sactually contract bond but for non-construction clients. They would be some ofthe larger companies like a General Electric, some people like that that youdon't generally think need performance bonds but that actually do.
Andwe haven't been a big player in that, and so we've had the people focusing onthat, and so some of the production they're actually generating is showing upin contract, and you're not seeing it in commercial. So we're pleased with theunit, even though those numbers don't look so good at the moment, but we expectthey will swing back.
Randy Binner - Friedman, Billings, Ramsey
Okay.The top line was very good in contract with 11%. Was there any lumpiness inthere, or big contracts that came through in the quarter that made that seem alittle outsized, relative to the go-forward trend?
John Welch
Yes,maybe a little bit. We alluded to it a little bit.
It's difficult to predictwhen construction contracts are going to get awarded and when we're going tobond them. And we saw actually a very good September compared to the prioryear.
Andour October last year was very strong, and we're waiting to see how Octoberturns out this year, but we are somewhat thinking maybe we flipped months.September was strong this year, and October was strong last year, and it mightbe the reverse this year. Butso far October is turning pretty good, but, yes, I think it was a particularlystrong quarter, I would say that.
It's hard to predict, but I would think itwould be hard to match that same number in the fourth quarter.
Randy Binner - Friedman, Billings, Ramsey
Yes,seasonally that would imply that, but also the rate was also high.
John Welch
Iwould agree with that.
Randy Binner - Friedman, Billings, Ramsey
Thanks.I'll drop back and see if anyone else has questions. Thank you.
John Welch
ThanksRandy.
Operator
(OperatorInstructions) We'll go next to Ron Pate with Banc of America Securities.
Ron Pate - Banc of AmericaSecurities
Justthe first question is following the external actuarial reserves study, if youcan just tell us how the point estimate from the external actuaries comparedwith your own.
John Welch
Sure.As of 6-30, our booked reserves were $7.5 million higher than the actuarialestimate. But I remember that's at June 30th, when the study is performed.
Ron Pate - Banc of AmericaSecurities
Right.Now, your overall aspect has remained the same. If you can just quickly tell uswhether each of the individual lines, the aspect stayed the same, and if youcan just remind us what they are.
John Welch
Sure.They have stayed the same. Contracts, we've generally said, very slightly below30; the large commercial the lower to mid-30s, and the small commercial in thehigher teens.
That stayed pretty constant now for certainly through '07, justslightly better than we had in '06. And that's really more driven by theimpact, again, of lower reinsurance costs than anything else.
Ron Pate - Banc of AmericaSecurities
Okay.Now, this is a separate question. Are you noticing any increased publicspending related to the infrastructure projects following the bridge collapsein Minnesota?
Has that affected the overall trend?
John Welch
Iwould say, I think it will. We know of a particular big program in Missouri, where they're putting a whole program of bridgesout for bid all over the state.
So, yeah, we think there will be continuedemphasis. That's probably a bright spot.
We think despite the housingsituation, we think public spending has continued strong. Right now I haven'tseen anything that would suggest it wouldn't continue.
Ron Pate - Banc of AmericaSecurities
Andthen, I think you had eluded, John, in your initial comments about linkage fromthe private construction, the residential construction probably going into thecommercial construction on the growth prospect side. Whatloss experience are you seeing on the residential?
Maybe not on your own book,because I think you have a very small book, but industry wide, has there beenin a need deterioration and the credit trend on the housing side and are youworried about it spreading into the commercial side?
John Welch
Ithick there's two different points here, essentially. I think as far as thetrouble in the housing market spilling into the rest of the constructionindustry, yes, in my opinion, I think it will to some degree, because asthere's less developments in housing developments, you just need less schools,less shopping centers − less retail.
I mean it just kind of follows. Thesecondary aspect that could cause you a problem down the road is that a lot ofthe guys that did that type of work, particularly in the infrastructure, thesewers, roads, that type of thing, it's fairly easy for them to transition overback into some of the public work and give them more competition, which theneventually leads to lower margins on their income statements.
So,but that's just beginning, and, you know, that takes a while for it to work itsway through the system. The private market has been so strong, and they havemade a lot of money, so they have pretty healthy balance sheets, so even morecompetition is going to take a while for that to work through and result inactual bankruptcies at the end of the day.
Asregards the housing sector, you know, you read the papers. I mean, it's beenpretty dramatic decrease in that market, and you know, all the surety companieshave bonding in that sector, and really to date, no, there hasn't been anysignificant losses that I've heard of.
Therewas a recent bankruptcy of a Chicago firm in the last week or so, and the thing aboutthe bonding in the housing sector that makes it difficult to determine whatwill result is a lot of the bonds are basically just to guarantee theimprovements of the development. They don't guarantee the building of thehouses or anything like that.
It's just that they put through infrastructurein, and most of the time it's put in kind of upfront. So you're not reallycertain that even if some of them fail, what kind of losses you'll have.
Yes,it's an industry that's got a lot of troubles. We fortunately are focused onthe top end of that, the biggest national builders, and we've managed ourexposures at least internally here to be in line with our reinsuranceparameters, and also our capital.
Soit's something to keep an eye on, and, you know, –it’s going to be a littlerough road for them. It's been a rough '07, and '08 I done think is going to beany better, so we're keeping our eye on them, but we do feel good about howwe've managed our exposure so far.
Ron Pate - Banc of AmericaSecurities
Great.And I guess the last question if I may for John Corcoran. The premium tosurplus is at 1.1 times.
What level of premium to surplus are you willing to toleratebefore you think you need to increase capital management?
John Corcoran
Idon't think that ratio in and of itself is going to be the driver for us. I thinkwe're taking a much more broader view of the economic conditions; certainlytake some comfort in the fact that we're providing good returns on the capitalcurrently, so I think we have to look at all of those issues, you know,especially the economic conditions that we see and then we'll address capitalas we go.
Ron Pate - Banc of AmericaSecurities
Okay.Thanks for the answers. And good quarter.
John Welch
Thanks.Good to have you back.
Operator
We'lltake follow-up question from Randy Binner.
Randy Binner - Friedman, Billings, Ramsey
Hiagain. John Corcoran, just real quick on the investment yield.
I notice thatthis quarter we saw just sequentially a little dip down. I got about 4.62% asthe investment yield for the quarter in my model.
Are you seeing anything inthe portfolio as far as lower yields and a lower environment, or is there anystory behind that sequential decrease in yield? JohnCorcoran Probablya little bit more of a concentration in short-term during the quarter.
As I'msure you follow the broader market, you know the treasury yields obviously aredown. There's a big flight to quality issue, and some of the credit spreadshave widened, but I think, we say generally the new money rates are a littlelower than they have been in the past.
Randy Binner - Friedman, Billings, Ramsey
That'sinteresting. You're 67% maybe so I guess that whatever spread wideningopportunity you got is somewhat hampered by the lower absolute return?
John Corcoran
Right.I think that's fair.
Randy Binner - Friedman, Billings, Ramsey
Okay.Thanks for the color. Good quarter.
Thank you.
John Welch
Thanks,Randy.
Operator
Wehave no other questions at this time. I would like to turn it back to ourpresenters for any additional or closing remarks.
John Welch
Okay.If you have any questions, please do not hesitate to contact John Corcoran ormyself. Thank you.
Operator
Thatdoes conclude our call. We would like to thank everyone for your participation.Have a great day.