CNA Financial’s Noisy Quarter Does Not Detract From Favorable Prospects

CNA stands out for its ability to show material improvement in a segment that appears to be peaking. CNA should continue to make progress on its accident-year margins this year and over the long term. The major driver is a shifting business mix. The highly profitable specialty segment should continue to expand, while we expect the unprofitable commercial division to contract. In addition, margin drag from noncore businesses should lessen over time. The first quarter was a speed bump on CNA’s ability to close the gap compared with peers. The current valuation of 10.4 times our 2015 EPS estimate and 0.87 times tangible book does not appear to reflect this upward potential, and therefore we recommend that investors accumulate shares.

We lowered our 2014 operating EPS estimate from $3.65 to $3.55 because of the first-quarter miss. The miss was a result of what we believe to be normal quarterly volatility—weather-related losses, lower development, and a jump in commercial auto losses. We expect earnings performance to normalize in the coming quarter. We lowered our 2015 operating EPS estimate from $3.94 to $3.83 because of a lower investment income projection.

The commercial segment underwriting ratios have been a significant drag on CNA’s profitability. The company is taking aggressive underwriting actions, implementing renewal rate increases, and nonrenewing poor-performing business. These actions have led to improvement in the commercial segment accident-year loss ratio excluding catastrophes, with the 2013 full year running at 66.1%, compared with a peak of 72% in the soft market. We expect the commercial accident-year loss ratio excluding catastrophes to improve to 65.3% in 2014 and 63.7% in 2015. Commercial auto and workers’ compensation have been two drivers of the poor performance, and these two lines will be the drivers of the year-over-year improvement over the next two years.

We forecast favorable reserve development of 1.7% of premium in 2014 and 2.2% of premium in 2015, compared with 1.7% favorable in 2013. The driver of the favorable development is the specialty segment, which has been very profitable on a historical basis. We project the commercial segment reserves to come out roughly flat. Each one point of favorable reserve development increases operating EPS by $0.17 on an annual basis.

 

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