CNA Financial Stock: an ATM at the service of shareholders (NYSE: CNA)

AIIC in brief

CNA (CNA) is one of the largest property and casualty insurance companies in the United States. Backed by more than 120 years of experience, CNA offers a wide range of standard and specialty insurance products and services for businesses and professionals in the United States, Canada and Europe.

Source: Introducing CNA Investor Day 2021

The insurer primarily focuses on specialty and commercial lines, which account for approximately nearly 90% of total P&C insurance business.

Source: Introducing CNA Investor Day 2021

While premium growth was anemic through 2017, the company achieved net annual premium growth of around 7% from 2018 to 2020, benefiting from favorable market conditions and new business.

Source: Introducing CNA Investor Day 2021

However, the insurer remains focused on improving underwriting margins over the years. Although the insurance company has been affected by higher catastrophe costs and unexpected extreme events, such as COVID-19 in 2020, the underlying combined ratio has improved over the years for all P&C segments .

Source: Introducing CNA Investor Day 2021

The situation therefore seems idyllic, with a growing insurer, comfortable and improving margins, and prudent risk management.

CNA has a significant advantage in resisting systemic shocks: its specialty business. The insurer has made efforts to improve the overall profitability of its portfolio in recent years. But most of its margin comes from the ATM, which is the specialized business.

Operational performance driven by the specialty insurance portfolio

As I have said many times, it is better to have an insurance company that does not grow with high margins rather than an insurer that increases its revenue by 10% each year but deteriorates its underwriting performance.

The best example that comes to mind is Trupanion (TRUP), a pet insurance company that has had consistent losses for over 15 years, even though its revenue is growing at a double-digit rate. (between 20 and 30% per year).

How has CNA managed to deliver positive underwriting performance over the years? The reason is simple; CNA’s portfolio is well diversified and has a hidden gem: its specialty insurance portfolio.

It accounts for approximately one-third of total earned premiums but generates approximately 79% of net operating income. Why? Because the portfolio is well managed, highly profitable and focused on niche markets, such as surety business, the health insurance segment or alternative risks.

With an average 6-year combined ratio of around 89.05%, there’s no denying that it’s very profitable from a technical performance point of view. The combined ratio jumped in 2020 to 93.5%, but this was mainly due to the non-recurring effects of COVID-19.

Source: Financial reports (aggregated figures by the author)

For the first nine months of 2021, the combined ratio is under control, at 88.3%, i.e. a level of technical margin more in line with previous years.

The other two segments, commercial and international activities, have seen more difficult fortunes in recent years. While the 9M2021 operating performance of the international business suggests that the year could be profitable, this has not always been the case.

Between 2015 and 2020, the segment only generated technical profits in 2015 and 2016. The period 2017-2019 was a long dry period, while 2020 was penalized by the increase in claims due to COVID- 19.

Source: Financial reports (aggregated figures by the author)

If international seems to be doing better, this is not the case for commercial insurance, which has been struggling to be profitable for six years. Between 2015 and 2020, the business was never able to break even and generate revenue through its insurance portfolio. 2021 looks as bleak as other years, with a combined ratio of 106% for the first nine months of the year.

Source: Financial reports (aggregated figures by the author)

The commercial portfolio continues to be penalized by the increasing cost of natural disasters. In 9M2021, the cost of natural disasters had a negative impact of 12.6 points on claims. Over 2015-2020, the cost of disasters represented an average impact of 6.5 points, canceling out all efforts to improve profitability.

Source: Financial reports (aggregated figures by the author)

Indeed, at the same time, the underlying combined ratio improved significantly, from 98% in 2015 to 94.1% in 2020.

In other words, the losses of the commercial portfolio are mainly explained by the additional cost of natural disasters. Is this a reason not to question the underwriting and pricing policy of the insurer? No. Each insurer must ensure that the prices charged allow it to cover all costs (including large claims) and to generate an underwriting profit, as evidenced by a combined ratio below 100%.

CNA Financial is not yet in a position to do this for its commercial portfolio and should – but this remains hypothetical – succeed in being profitable for its international portfolio.

To put it simply, CNA Financial can only rely on its specialized activities to generate stable and recurring profits. This financial windfall gave him time to transform his international portfolio, reduce it, raise prices and increase underwriting initiatives if necessary.

Any investor interested in CNA Financial’s operating performance, if they were to look at just one metric, should look at the Leased Lines Combined Ratio (and how it changes over time).

And every investor should keep in mind that CNA is, for now, at the mercy of any paradigm shift that could jeopardize the profitability of its core business. Fortunately, the insurer was able to defend its specialty business.

CNA Financial: Loews’ cash cow

CNA Financial is nearly 90% owned by Loews (L).

Source: Loews presentation

In other words, CNA is at the mercy of Loews’ decisions, good or bad, in terms of capital allocation.

Loews uses CNA as a money pump; the insurer pays large dividends to its shareholders to enable Loews to invest in new businesses and actively buy back its shares.

Source: Loews presentation

Therefore, CNA’s capital allocation is perfectly clear: return as much money as possible to Loews through the payment of a regular and growing dividend, combined with a special dividend, which varies according to annual results.

Since 2012, Loews has retired more than 35% of its outstanding stock for about $6.5 billion.

Source: Loews presentation

This cannibalism was only made possible through the efforts of CNA Financial. Without the CNA Financial dividend, there would be no return to Loews shareholders through the share buyback.

Were these redemptions relevant? This is an other story. In any case, the minority shareholder of CNA must be satisfied with a hefty dividend but will never be able to influence the rules for allocating the company’s capital.

To invest or not in CNA Financial?

In my opinion, the P&C insurer will continue to make the necessary efforts to improve its technical margins and please its largest shareholder, Loews, by increasing its dividend over the years.

Investing in CNA means being compensated as a minority shareholder for accepting Loews’ decisions, good or bad.

The only possible catalyst would be delisting, but that would mean (1) CNA is undervalued and (2) Loews has no better opportunities.

This scenario could never happen since Loews de facto controls CNA. In the meantime, shareholders should benefit from a dividend that should grow over time, supported by solid technical margins.