Good morning. My name is Stephanie, I will be your conference operator today. At this time, I would like to welcome everyone to the Cincinnati Financial Third Quarter 2014 Earnings Conference Call. All lines have been placed on mute to avoid any background noise. After the speakers remark, there will be a question and answer session. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. If you would like to withdraw your question, press the pound key. Thank you. Dennis McDaniel, Investor Relations Officer, you may begin your conference.
Hello, this is Dennis McDaniel from Cincinnati Financial. Thank you for joining us for our third quarter 2014 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. On this call, you'll first hear from Steve Johnston, President and Chief Executive Officer, then from Chief Financial Officer, Mike Sewell. After their prepared remarks, investors participating on the call may ask questions. At that time, some responses may be made by others in the room with us, including Cincinnati Insurance Company's Executive Committee Chairman, Jack Schiff Jr., Chairman of the Board, Ken Stecher, Chief Insurance Officer for The Cincinnati Insurance Company, J.F.
Scherer, Principal Accounting Officer, Eric Mathews, Chief Investment Officer, Marty Hollenbeck, and Chief Claims Officer for Cincinnati Insurance, Marty Mullen. Please note that some of the matters to be discussed today are forward-looking. These forward-looking statements involve certain risks and uncertainties. With respect to these risks and uncertainties, we direct your attention to our news release and to our various filings with the SEC. Also, a reconciliation of non-GAAP measures was provided with the news release. Statutory accounting data is prepared in accordance with statutory accounting rules and therefore is not reconciled to GAAP. I now turn the call over to Steve.
Good morning, thank you for joining us today as we discuss our third quarter results. We reported strong operating performance reflecting steady execution in our underwriting and pricing, an assist from relatively favorable weather patterns in our sixth consecutive quarter of investment income growth. We worked to improve on our first half combined ratio before catastrophe losses, kept our average renewal price increases essentially in line with the first half of 2014, have reported nine months loss reserve development on prior accident years consistent with full year 2013. I'm quite pleased with how we've maintained pricing discipline in 2014 and continue to further segment our book of business. Our pricing precision and risk selection actions, which bring together data models and underwriting judgment on a policy-by-policy basis, are the keys to improving underwriting results.
We feel we are in a good position to continue driving long-term underwriting profit, benefiting from the local presence of our field underwriters who make those decisions for all of our commercial new business. Their decisions are informed by analytics and risk inspection data from our ongoing inspection program, as well as the insights of our agents. Our nine months net written premium growth is still ahead of what has been reported for the industry. However, net written premium growth slowed in the third quarter, as expected, despite steady renewal pricing and steady retention. Last quarter on this call, we provided a reminder that in the third quarter of 2013, we reported 16% net written premium growth for our largest property casualty insurance segment, and that it would be a challenge to report year-over-year growth for that segment in this year's third quarter.
I'll comment further on growth by segment in a moment. Looking longer term, we continue to appoint agencies in areas where we are underrepresented, taking care to preserve established agency relationships in the franchise value they enjoy. In the first nine months of 2014, we appointed 75 new agencies. Those agencies, as well as others appointed in recent years, continue to give us the opportunity to increase our market share within their agencies as we learn to match each other's underwriting appetite and earn their trust. We feel confident that our agent-focused business model will drive long-term premium growth just as it has for more than 60 years. Our appointed agencies are terrific in helping us retain profitable accounts as our policy retention has remained steady in 2014. For the third quarter, average renewal price increases for Commercial Lines were near the high end of the low single-digit range.
That average includes the muting effect of three-year policies that were not yet subject to renewal pricing during the third quarter. For smaller commercial property and commercial auto policies that renewed, we've been seeking and getting price increases higher than the average of our total commercialized renewals. Those commercial property policies experienced another quarter of increases averaging near the upper end of the high single-digit range, and commercial auto averaged increases in the mid single-digit range. For both our Personal Lines and Excess and Surplus Lines segments, third quarter 2014 renewal price increases averaged in the mid single-digit range. Looking at net written premiums for our Commercial Lines segment, we reported a 2% decrease for the quarter, running into a tough growth comparative. The decrease was from both new business premiums and what we report as other written premiums.
As we previously reported, the third quarter of 2013 included a higher than usual estimate for premiums of policies in effect, but not yet processed at that time or business in the pipeline. That contributed to the decrease reported in this year's third quarter. Commercial new business written premiums slowed compared with the year-ago third quarter, when we reported they were at record high. Our growth rate this year also reflects our pricing and underwriting discipline. As expected, Personal Lines new business was affected when we implemented higher pricing and underwriting profitability actions, including greater pricing precision and changes in policy terms, such as more use of actual cash value coverage for older roofs. Our Excess and Surplus Lines in new business premiums continues to show strong growth as we add field representatives to provide service and convey our value proposition to agents and their clients.
That segment of our business is having an outstanding year, with nine-month net written premiums up 21% and a combined ratio below 80%. Our life insurance subsidiary, including income from its investment portfolio, produced another quarter of earnings and premium growth. The profit of that subsidiary tends to vary in quarters where we make changes in interest rate or other actuarial assumptions for our universal life products, known as unlocking effects, and this was one of those quarters. Term life insurance, our main life insurance product, continues to grow profitably. The results from this overall very strong quarter are demonstrated by our primary measure of long-term financial performance, the value creation ratio, or VCR. At nine months, our VCR stands at 8.4%, more than three-quarters toward our target of an annual ratio averaging 10%-13%.
I'll now ask our Chief Financial Officer, Mike Sewell, to add his insights about our recent financial performance.
Great. Thank you, Steve, and thanks to all of you for joining us today. Several key measures help explain our overall investment results. First, our third quarter 2014 results again benefited from our equity investing strategy. Dividend income from our stock portfolio was up 17% for the quarter and 16% for the first nine months of this year. In our core portfolio of 50 common stocks, all 50 improved their annual regular dividend over the 12-month period of October 2013 through September 2014. The median dividend increase for those stocks was a little over 9%. Yields for our bond portfolio declined from a year ago. The third quarter 2014 pre-tax average yield, reported at 4.76%, was 15 basis points lower, while the measure on a nine-month basis was 19 basis points lower.
Taxable bonds, representing nearly 70% of our bond portfolio, had a pre-tax yield of approximately 5.23% at the end of the third quarter of 2014. The average yield for new taxable bonds purchased during the quarter was 4.41%. For the same period, our tax-exempt bond portfolio yield was 3.81%, and purchases during the quarter yielded 3.22%. Our bond portfolio's effective duration remained at 4.4 years at the end of the third quarter, just under 4.5 years reported at year-end. Cash flow from operating activities continues to help grow investment income. Funds generated from net operating cash flows were $633 million for the first nine months of 2014, contributing to $342 million of net purchases of securities for our investment portfolio. We continue to carefully manage expenses, helping to reduce the third quarter and nine-month underwriting expense ratio by more than a point compared to a year ago.
Along with very selective underwriting and disciplined pricing, the improved expense ratio resulted in a third quarter 2014 combined ratio of 91%, moving the nine-month ratio below 100%. That nine-month ratio, at 97.3, included losses and loss expenses from catastrophes and non-catastrophe weather that were 3.4 points higher than a year ago. Reserve development on prior accident years, fairly steady in recent quarters, was another important component of the nine-month combined ratio. We seek to follow a consistent approach in setting loss and loss expense reserves, aiming to remain well in the upper half of the actuarially estimated range. For the first nine months of 2014, favorable development on prior accident years at 3.9% was basically in line with the 4.1% full year 2013 ratio.
Our nine-month 2014 net favorable development was again spread over several accident years, including 71% for accident years 2013 and 2012 in the aggregate, and 29% for all older accident years. Our financial strength and liquidity are both in excellent shape. We repurchased 300,000 additional shares during the third quarter of 2014 at an average cost of $46.09 per share. Similar to our first quarter repurchase of 150,000 shares, it was a maintenance type action intended to partially offset issuance of shares through equity compensation plans. Cash and marketable securities at the parent company rose to almost $1.8 billion at the end of the third quarter, up 16% from the year-end 2013. Our property casualty premiums to surplus ratio remained at 0.9 to one, providing plenty of capital to support continued growth of our insurance business.
I'll conclude my prepared comments by summarizing the contributions during the third quarter to book value per share. Property casualty underwriting increased book value by $0.37. Life insurance operations added $0.04. Investment income other than life insurance and reduced by non-insurance items contributed $0.48. The change in unrealized gains at September 30th for the fixed income portfolio, net of realized gains and losses, decreased book value per share by $0.24. The change in unrealized gains at September 30th for the equity portfolio, net of realized gains and losses, increased book value by $0.03. We declared $0.44 per share in dividends to shareholders. The net effect was a book value increase of $0.24 during the third quarter to $39.01 per share. Now I'll turn the call back over to Steve.
Thanks, Mike. In closing our prepared remarks, I'll mention the biannual commercial producer survey results recently provided by Flaspöhler Research Group. Independent insurance agents again ranked Cincinnati Insurance very well. Current Cincinnati agents named us best overall, easiest to do business with, and the carrier they'd most likely recommend to a colleague. Agents who don't currently represent Cincinnati named us their most desired appointment. Our associates in Cincinnati and across the country work hard every day to meet the needs of those agent customers and their clients, engaging fully and responding in person. Survey results like this one confirm we're building the strong relationships that differentiate our company and bode well for future profitable growth. 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 Jack Schiff Jr., Ken Stecher, J.F. Scherer, Eric Matthews, Marty Mullen, and Marty Hollenbeck. Stephanie, please open the call for questions.
At this time, I would like to remind everyone, in order to ask a question, please press star, then the number one on your telephone keypad. We'll pause for a moment to compile the Q&A roster. Your first question comes from Joshua Shanker with Deutsche Bank. Your line is open.
Good morning, everyone.
Good morning, Josh.
Hi there. You guys know I've been out to Cincinnati three or four times. I've been to some of your sales meetings. I've traveled with some of your employees. You cut $20 million out of expenses in 2Q and another $10 million out year-over-year in 3Q. I mean, you guys never spent a dime that was unnecessary to my mind. We're trying to figure out where these expense cuts are coming from.
Hey, Josh, this is Mike Sewell, that's a great question, and that's a great lead in because I love talking about this. You know what? To begin with, it's not because spending is down. We continue to invest in the operations, as you've heard in some of your various meetings and probably some of the other things we'll be talking about, we are increasing spending, but we're investing in certain places. Overall, what we're trying to do is we're trying to control the increase in that spending to make sure that it's at a lower increase in rate than the growth of premiums. To begin with, that's the foundation of what we're doing. One of the other items that is in there is we have taken some action, J.F.
might hit on a little bit later on certain of our homeowner policies where we did decrease the commission rates from 20% to 15%. Just really across the board with items like that, we've got an expense committee that new expenditures have to go through. We've got a, I'll call it a headcount committee, associate committee, where we really watch the increases, again, they're planned increases. That is through our annual planning budgeting process. It's a team effort that everyone has put together, but the main reason is we're controlling the increase at a slower increase than what premiums are going up
Okay. Exactly when does it start? You'll want to do it forever, I assume. I don't know if that's possible. Is there a target for completion or when you know that you're working at the right pace?
Our target kind of all along has been to get us to around a 30%. I don't know how much better you could really get than that because you need to spend money to be able to reduce losses and LAE and other things. As J.F. will say, we're not an expense company. We have to continue to invest in the field, invest in IT, the technology to become more efficient. There's a lot of needs that are out there, and we're placing our bets in those areas. Probably getting much below 30% will probably be a challenge.
Josh, I appreciate your comments. We like to say, the only time we let loose of a nickel is when we want to get a tighter grip on it.
Well, I can concur. I've seen how you guys operate. The other question, I know you went through a couple items, like the three-year policy issue and whatnot. It just seems to me that compared to 2Q, there is a sea change in the growth outlook. Particularly you see it on the new business premium. You're just walking away from new business, it looks like, as far as I can tell. Is there anything in the third quarter that is dramatically different from your market outlook three months ago that is causing you to put on the brakes?
We might touch on this in a few different points. Maybe I'll let Mike just give a review first on the business in the pipeline, so to speak. Then J.F. will probably touch on the environment.
Sure. Yeah, that'd be great. As Steve mentioned, but also as we indicated in our second quarter conference call, we knew that headwinds were coming during this quarter. At times it can be difficult to judge one quarter of written premium growth without thinking of the entire year. There could be seasonality, timing of large policies written versus typical small commercial policy, or other effects that can cause a premium spike or dip in a given quarter. In the prior year, third quarter, we experienced a written premium spike that was then offset by a written premium dip in the fourth quarter. I think last quarter I mentioned, if you looked at, and you could still see it on page 17 of our supplemental financial data, you'll be able to see it there.
On a consolidated basis, written premiums for the third quarter of 2013 was $1,031 million, followed by a fourth quarter 2013 of $908 million. The average of those two periods is consistent with the first two individual quarters of 2013. As we entered the third quarter of 2014 for written premiums, it was going to be a challenge to have a double-digit growth when compared to the prior period. All this being said, you won't see this movement in earned premiums as written premiums are earned over time, which can take the spikes and the dips out. With that, maybe as a background, maybe J.F., you can-
Yeah, Josh, just let me give a little color on the new business and what happened. I guess one of the things I would say was that 2014 hasn't been a bad year. 2013 was a really great year. The story on new business decline in commercial lines has really been more about workers' compensation. The overwhelming amount of the decline is in that particular area, and in particular in large workers' compensation accounts. We're relatively conservative when it comes to writing comp. Notwithstanding the fact that our results are good, we don't have any intentions of getting aggressive on comp. It seems that what we've run into in the marketplace, though, are some carriers that are more so than they were last year. It's not discouraging for us to be down in the comp area.
We're still competitive, it still complements the package business that we write. If you take a look at overall package business for us, it's about where it was last year. It's down just a little, but not much. Once again, the comparatives were tough. The casualty line, for example, last year-to-date, was up 23%, just to give you an idea. We were going up against a tough comparison. Property was up 18%. Workers' comp last year was up 41%. As we look at our new business, it's more a case that we're having, we believe, a good year this year. Next year, we're optimistic that we can improve on where we'll end up this year. I don't view that anything's particularly broke on the commercial line side.
Having said that, greater use of loss control and analytics is causing us to segment not only our current book of business but also the new business that we're writing. Given the fact that in the marketplace, business is more adequately priced this year, therefore it's more competitive to be able to write new business. We're consequently walking away from some accounts that maybe last year were a little easier to compete for. Hope that helps a little bit.
It does. Now we're months into the fourth quarter. Do you expect that your fourth quarter outlook will amend some of the unusual items and growth will probably be stronger in 4Q than it was in 3Q?
Yeah. Josh, it's Mike. I think you will see some effect from that because, like I said in my comments, a little bit of a spike
Third quarter last year, down a little bit fourth quarter on average. There probably will be some positive effect, but we're going to wait to see it before we call it out.
That's absolutely fine. Thank you very much.
Your next question comes from Scott Heleniak with RBC. Please go ahead.
Yes, good morning.
Good morning.
First question I had was just on, you mentioned just the comment about workers' compensation. Are you seeing more signs that carriers are being more aggressive in some of the other lines as it related to workers' compensation? In other words, more carriers that have a higher appetite for writing some of the classes that you're competing in, compared to last year? Change in the competitive environment there?
Scott, this is J.F. I think somewhat of a change in the competitive environment has to do with all large business. It's simply drawing a bit more of a crowd. On the workers' compensation side, our appetite in terms of class of business is unchanged. We have seen simply more aggressive pricing on larger accounts. Frankly, it's kind of surprising. I would think that if there was going to be more aggressive pricing, it would be on non-workers' compensation lines. That's simply what we saw, at least so far this year.
Okay. Nothing out of the ordinary as far as different lines, but just the account size.
Yes.
Okay. Just on commercial, the reserve releases looks like they were pretty good, except you had some additions in the commercial auto book. I know you mentioned the mid-single digit price increases. I wonder if you could talk about just how you've kind of repositioned that book. I know it's been a tough line for a lot of competitors over the past couple of years. What have you been doing to reposition that, and do you feel like you're kind of almost where you want to be now or getting closer?
Scott, J.F. again, on the commercial auto side. I mentioned this, I think, on the last call about kind of insurance 101 on what we're trying to accomplish. We are seeing mid-single digit increases in commercial auto, and I would anticipate, given that the whole industry's kind of having a tough time in that line, that we'll continue to be able to price that, even maybe modestly increase that. A lot of the other areas that we're working on tend to be either loss control oriented or simply classification of vehicles much better.
I know this sounds like it would be elementary, but it's amazing how books of business over a period of time can be misclassified and that the gross vehicle weight, for example, which is an important factor in rating commercial auto, it isn't accurate, or the cost new on vehicle aren't accurate, which that skews your physical damage results. We're integrating third party vendors into our systems that'll give underwriters more immediate and more precise information about the characteristics of the vehicles. We're doing the same with MVR information that allow us more information about the drivers. I don't know that there's a holy grail associated with the improvement of commercial auto other than the modest increases that we're getting right now and just simply being better underwriters, being more thorough and being more exact about knowing what we write.
We're doing that, and that's where we think we're going to get the biggest lift for our book.
Okay. That's a good answer. The last one I had was just, over the past couple of years, a lot of business has come back to the E&S market from the standard markets. Are you seeing signs that that's starting to turn the other way, where a lot of that business is starting to, maybe some of it's starting to come out and go back into the standard markets? Or is that-
What we're seeing is, once again, it's interesting it's in the larger account area, we have seen a lot of pressure on the larger six-figure, high five-figure premium E&S accounts that are going back into the standard market. As you can tell from our results, though, we're very pleased with how things are going with our company. We continue to have a very conservative appetite. From our standpoint, we would anticipate we're going to be able to continue to grow, simply because we've yet to penetrate our agents' book of business that they already write on the E&S side, we think we've got a good model to do that. There's no question that it's not a mass exodus, we are seeing a lot of pressure on larger accounts going back to the standard market.
I think it's worth, though, noting on our book of business, given our conservative appetite, probably a lot of what we write in the E&S market on that larger scale would be the kinds of accounts that would teeter back and forth because we just don't have an aggressive appetite for risk on our book of business on the E&S side. At least in our company, that's what we see occurring.
Okay. What is the average premium size now for the typical E&S account?
It would be $5,000, $6,000 in premium.
Okay. That's helpful. Thanks.
Yeah.
Your next question comes from Mike Zaremski with Balyasny. Your line is open.
Hey, gentlemen.
Morning, Mike.
A couple follow-ups. First on workers' compensation, I think you guys talked about competition. Is that broad-based competition or maybe it's just a monoline carrier or a large carrier, or maybe it's just certain classes of workers' compensation?
I wouldn't call it necessarily by class, I would say it's somewhat isolated. We have seen a little more activity by monoline carriers and then also a few of the big guys. One of the things last year that happened that was at Liberty Mutual got rid of an awful lot of workers' compensation last year, put a lot in the marketplace. I think that probably between then and now, which my understanding is that they're more comfortable that they've done what they needed to do. I think that's one of the things that may have contributed a little bit to the higher writings of new business in comp last year. There was just a lot being shopped. As a general statement, I would say that it's not broad-based in the sense that everyone's going after comp.
It's just on the larger policies, we're seeing a few carriers be more aggressive.
Got it. On commercial auto again, what's driving the further prior year reserve additions? I guess, are you guys surprised that you're not getting or are you asking for double-digit rate increases in commercial auto given all the reserve developments over the last couple of years?
Well, Mike, this is Steve. I think we're just taking a close look at those reserves. I think our overall reserving is very consistent, but we don't like to see adverse development, so we want to take corrective action when we see it, do the right things, feel comfortable with what we're doing. Now, in terms of the rate increases, I think that is prospective in nature. We're more looking at the current accident year, factoring in the non-rate activity that we're taking, the actions we're taking to keep the loss cost trends heading in a more favorable direction. Basically staying prospective with our rating, trying to look at where we think loss costs will be next year, set an appropriate rate for next year's position, and then of course, really work on segmenting that business, looking at policy by policy, risk by risk.
We feel comfortable with where we are in getting the mid-single-digit rate.
Got it. Lastly, I believe it was this past January, you guys announced a new hire to lead a kind of the, maybe I'll call it the high-net-worth personal lines product. Would you guys expect that to be a material contributor to 2015 premium levels? Thanks.
Yes. Will van den Heuvel, who previously had run AIG Private Client, became head of personal lines for us. Yes, we are going to emphasize higher net worth into our book of business. I would not say, though, in 2015, that segment will be up and running and contributing significantly to the book of business in 2015. It'll be introduced. About 10% of what we write right now is high net worth, and consequently, it will ramp up. As far as a material contribution, I'd look for 2016.
Particularly in the earned premium, of course.
Got it. Thanks for the color.
Thanks, Mike.
Again, if you would like to ask a question, please press star, then the number one on your telephone keypad. There are no further questions at this time. Steven Johnston, I turn the call back over to yourself.
Thank you, Stephanie, and thanks to all of you for joining us today. We look forward to speaking with you again at our fourth quarter call. Thank you.
Thank you. This concludes today's conference call. You may now disconnect.