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CNA Financial Corporation at Keefe, Bruyette & Woods Insurance Conference - Final

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CRAIG MENSE, CFO, CNA FINANCIAL CORPORATION: As you've heard I'm Craig Mense. I'm the Chief Financial Officer for CNA. I joined the Company in 2004, late in 2004, and I came with the expectation that we had an opportunity to build something very special at CNA and that the work that Steve Lilienthal and group had done before my arrival had set a stage for a company that could produce consistently improving financial results. So I trust my remarks this morning will convey the sense that CNA is a smarter, leaner, faster, more efficient Company, that next it's a Company that does what it says it's going to do. I think that's an important point. We do what we say we're going to do, that's both financially and operationally and I think what you'll see is that we continue the progress that we discussed at last year's conference and finally, that we're well positioned. CNA is well positioned to continue to deliver consistently improving results and increasing shareholder value.

Now for a bit more detail on who we are and how management views our Company. We are a leading U.S. commercial lines insurers. We are actually the sixth largest P&C Company. We've been in business for more than a century and we now serve about 1 million business and professional insured. We are especially well diversified and with respect to both our products, services and our geographic presence. We are a global Company but we are primarily a U.S. operation. We have significant brand identity in the commercial lines marketplace and we have a legacy of positive loyal producer relationships. And with that said, over the years we've realigned our [inaudible] our focused on our distribution dates and we think that's allowed us to produce more and better quality business.

The Company is focused on the two defining functions of insurance operations, which is underwriting and claims payments, so we've upgraded; we've rebuilt and we've centralized controls for these core functions. At the same time we redesigned and upgraded our management information and data quality. The Company really believes in and acts on that is the lifeblood of insurance, as I am sure you would agree.

CNA's core earnings power continues to improve and that's happening through disciplined underwriting and claims practices, really relentless pursuit of expense management, favorable cash flow and its related investment income. And finally, our balance sheet and our capital position are very strong and together with our improved earnings power are reflected in strong insurance ratings and improved outlook, which we received from the major rating agencies. So overall we're well-- we think we consider ourselves very well positioned to compete successfully in the market going forward. As I said, we're the sixth largest U.S. commercial lines Company. We're seventh if you include the California State Worker's Comp Fund and I think the important thing is after you get past the first two the rest of the leaders are all clustered in the $6 to $8 billion revenue range and we think that we built a very formidable franchise in our chosen markets.

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This is particularly so on the specialty side where we are a market leader with the number one or two market position in our range of industry segment and we'll talk a little bit more about our specialty business later on in the presentation, which I think is often overlooked, what a strong franchise we have there. In standard lines we are a leading middle market player with a rapidly growing position in small business and so we like our position in the market. We think we have the scale and ability to compete with anyone, including the two lead companies on this list with whom we've fared quite well across our portfolio over time.

With respect to diversification of the product portfolio, we are split about one-third specialty and two-thirds standard lines. It's a very nice mix. We think that matches us up well against any of our competitors. As a comparison in 2002 we were about three-quarter standard and one-quarter specialty so we've grown in specialty because we've seen opportunity for both improved price and terms and we've been a better performer there over the last several years. We think this diversification is a particular strength of the Company, especially when you consider that both the standard and specialties portfolios have a strong small and middle market bias. I think that's another thing that's often overlooked relative to our specialty business. When you get inside the pie chart themselves, you'll see that we're also very nicely spread among the various product lines of coverage so that we can grow or shrink as markets conditions change. We're not overly dependent on any single product, market segment, or any particular business in order to be successful. With respect to geography CNA is equally diversified. We have strong positions in the territories where we choose to compete and we closely tailor our product strategies and appetites to match the profit potential in each territory. So the market and product strategies are designed on a central and regional basis with local execution.

Relative to distribution, I mentioned before that CNA has longstanding positive relationships to our agents and brokers. We recently completed an external survey, independent survey, of the most profitable agencies. These are the ones that we consider to be and have a tag of high performing and the important point is the majority do view CNA as a preferred market in the business segments that we've targeted for growth. And over 90% of these agencies have indicated to us they think CNA adds significant value to their agencies and we ourselves maintain a very steady significant and consistent presence through those agencies.

Insurance companies do two things, as I've said before, that separate them from any other business. We underwrite, meaning we assume risk for money, and we pay claims. So over the past few years CNA has demonstrated I believe a very significant level of improvement in both of these core functions. We've managed our portfolio by shifting our mix of business to control volatility, to increase diversification and to optimize returns. We've also managed down our catastrophe exposure. We've taken a very disciplined and measured, but most importantly, profit based approach to new and renewal business as the market began to soften, and I think this work is evident in our disciplined approach to the marketplace you can see on the rate and retention stats in this slide. Since the peak of the hard market a few years ago as rates have drifted gradually downward quarter-by-quarter our new business writings have changed, although in 2005 or so we did see some leveling in the rate environment, in 2005. This gradual softening has allowed us to adjust our underwriting and marketing strategies as well as our expenses on an incremental basis.

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With respect to retention you can see that in 2004 our retention overall was in the 73% range. If you split it out between standard and specialty, which you can't see here, actually in 2004 our standard retention was in the high 60s as we will continue to work through underwriting initiatives and workers compensation, residential construction and some E&S programs and the silica exposure, which we felt to be problematic into the future. With this work done, retention rebounded nicely to 83% at the end of '05 and into '06, which we view as a very normal appropriate level for this stage of the market and for our current standard portfolio. So we're even more pleased with our current historic and specialty lines retentions were a bit higher than our standard lines retentions. So in short, we are very comfortable with our book of business that we have at CNA right now and we're holding on to it at renewal without unnecessarily sacrificing rates. The book-- the other important point here is the book is increasingly well segmented and priced accordingly. We are making some very important investments in our ability to segment risks and have matched pricing for that. We think that's an important ability going forward.

With respect to new business, our writings and our strategies reflect continued discipline in our changing marketplace. In the robust conditions in '02 and '03 our new business writings were in the vicinity of 25% of our total production and, as market conditions softened, we brought that down to the low 20s in '04 and '05. This is exactly what we said we would do in response to the softening market conditions. We feathered back our new business writings because we didn't want to reintroduce the same problems we had removed from the book a few years ago. I would also mention that starting in '02 we began a massive effort to cross sell so that if we sold the package to a mid sized customer we also wanted a shot at selling the umbrellas, specialty and international coverages. CNA in the past has been very much of a mono line market player. In '03 we started tracking cross sell volumes seriously and since then cross sell has produced 1.6 billion in new business so this represents approximately 28% of our new business during that period. And again, it's an important point because now that we are selling in a gradually softening marketplace, we're both reducing our new business writings as well as making sure we are selling to customers that we know. The ability to cross sell we thin is a particular CNA advantage that many other carriers don't have, many speak about but don't necessarily have. And it's something that we have built into our culture so we want to make sure that we sell as much of our product portfolio as we want to to each and every customer. This is one of the major advantages to our diversified portfolio and our enterprise wide distribution strategy.

Relative to CAT risk, we think our underwriting discipline is also very well evident in our management of catastrophe risk. We've mitigated this risk through disciplined exposure management and well-designed reinsurance programs. In 2005, which witnessed the most destructive hurricane season on record, our losses had an after tax impact of $334 million, which is really a modest percentage of our book value and actually about roughly equal to what our earnings were last quarter. So our losses were very manageable and well within the tolerances and the expectations that we set for ourselves and this was not fortuitous. It's a reflection of several years of very deliberate reductions of our coastal exposures, a sound reinsurance program and our highly professional claims staff on the ground. Hence in 2006 we actually bought increased reinsurance limits. We didn't change our retention and we again bought a second event treaty that was very valuable to us in 2005. I would like to point out that our initial hurricane loss estimates for '04 and '05 continue to hold, haven't changed since our initial estimates that we published at the time of the hurricane, and I would emphasize also that our loss estimates were well below the external estimates generated at the time of these losses. I think all of those speak to how well CNA has been positioned against the coastal exposures and how well designed the reinsurance programs have been.

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With respect to financial results, CNA is improving steadily. In 2005 what I view as strong underlying results were offset by the $334 million impact of catastrophes and they were further masked by a $259 million after tax impact of several significant reinsurance commutations. In 2006 we're on track to a very good year. Every major driver of results, underwriting, production, claims, cash flow, investment income and expense management is contributing to improved earnings. Year-to-date results are very solid. Operating income through six months was 539 million. That's a 16% increase over the comparable 2005 period and a 42% increase over the comparable 2004 period. This comes to well within an improved ROE of 12%. Really the sequential improvement is even more evident if you look at the standalone second quarter results when we recorded 305 million of operating earnings, the combined ratio and property casualty business was 95.2%. The expense ratio was 29.9%. We had a 40% growth in core investment income and we produced an operating ROE of 13.6%. Now these overall trends were driven primarily by continuously improving earnings power of the core P&C businesses that is coupled with a wall managed and orderly run off of our non-core businesses.

In the past we've given investors who have looked for an indication of what we could expect from the life group and you can see a breakout here of P&C as well as life group and corporate non-core, the expectation of that life group would swing somewhere between a 20 million quarterly loss to 20 million gain, which I think that you should expect. That's still our expectation. Remember that we are very respectful of the businesses of what's in debt in these runoff segments. We do have a large long-term care book in the life and group segment and the corporate segment houses our CNA [REIT] runoff as well as our asbestos pollution and mass tort exposure so not to overemphasize the volatility inherent there but just to tell you how respectful we are and how important we think that is to manage those things well so we understand well what's in bed there and are mindful of it. We have a professional group who is managing those, managing the run up of those businesses and we are managing it as if it is a business.

With respect to core Property and Casualty operations, our performance, we view it as solid and it's consistently improving. Since 2002 we shifted our mix of business towards our more profitable segment. As is said, one of the major shifts was to change from the specialty portfolio, which used to make up a quarter of the business to now making up a third of the business as well as inside those businesses where we're much less reliant on workers compensation, which used to be a very large product mix. The $300 million drop in premiums in 2004 reflects the pullback and problem areas that I mentioned before in standard lines. The drop would have been more pronounced but at the same time we were growing strongly on the more profitable specialty side of the portfolio and we were significantly improving overall levels of rate. This positive impact of that shift is evident in our improving combined ratios and as shown here before the impact of commutations and catastrophes. Really I would say it's kind of before the impact of the significant commutations we had in the fourth quarter of 2005. We had some smaller commutations earlier in the year. Overall the specialty business is performing as well as anyone out there and our standard lines business is making steady progress against our expectations for much improved long-term earnings power.

On the expense side, which is something that we spent significant time on, we have significantly improved our expense ratio since 2003. The cumulative change in dollars spend, which is better than 18%, also speaks to the discipline around expenses. It's not just on ratio. And expense management is something that you can expect us to work very, very aggressively in the future. While we very much have improved our expense competitiveness, and actually I think we've in the second quarter of '06 we actually compare favorably to some of our competitors, our major competitors, and that's a point that seems to be overlooked. We're not where we want to be and you should expect us to continue to grind down on these numbers. So this is kind of a story that maybe will be kind of eliminating in the future but until recently CNA's earning's power was fairly significantly dampened by the interest expenses associated with finite reinsurance treaties. In 2005 we completed several significant commutations of those treaties and these treaties where these commutations which where negotiated on favorable economic terms have eliminated a significant earnings drag and will continue to improve our financial results.

We reduced the anticipated finite interest expense by 76 million in '06 and 64 million in '07. We modified reinsurance recoverables and we added to our invested asset base, not to mention the fact that we significantly improved the transparency of our balance sheet. As I mentioned before, investment income was very much a key contributor to improved earnings. The favorable trend that you see here is being driven by improved period-over-period yield, especially short-term yields and reduced interest expense as a result of the commutations that I mentioned before.

Just as importantly though that we continued to generate positive growth operating cash flows and add to our invested asset base. Our book value of invested assets has increased by approximately 1.1 billion since the second quarter of '05. These-- the cost in net investment income, contribution to earnings, the year-over-year change in the first quarter of '06 was 29% and in the second quarter of '06 was 40% increase, as I mentioned before.

Relative to net operating income and the results of the last several quarters, I believe these results reflect again, as I said, our fundamental improvement in our operations. We did have some significant items to absorb in the third and fourth quarters of '05, most notably the hurricane losses in the third quarter as well as in the fourth, and in addition to our reserves and our reinsurance runoffs in the fourth quarter of '05. The second quarter of '05 did have a favorable tax settlement included in those numbers, so adjusting for those events our quarterly NOI has been trending upward. The underlying NOI has been trending upward from the $200 million range to approximately $300 million range today. That's also reflected in the improved operating ROE and again, the drivers here are solid performance by P&C, reduced expenses, improved investment income and steady runoffs.

In addition to improving the operating earnings, we've also acted to improve both the quality of the earnings and the quality of the balance sheet. We get a number of questions about reinsurance recoverables and I would tell you we are in a much stronger position today than we were a few years ago relative to reinsurance recoverables. Reinsurance recoverables today are down by more than $4 billion from 2003 and if you look at the unsecured portion, you'll see that there unsecured recoverables are down in roughly the same proportion even though at the same time our bad debt allowance has actually consistently increased in relation to unsecured recoverables. So not only are we working hard to monetize these assets and reduce our dependence on reinsurance, but we're also working hard to strengthen the balance sheet.

I'm sure that you're also all aware that we executed a refinancing plan in the last month and that plan was really aimed at further simplifying our balance sheet and improving our capital structure for the long term. So if I can give you kind of a brief overview of what we did there, we raised approximately 1.25 billion in early August, 500 million from the issuance of common equity and 750 in senior debt. The uses of that, we used approximately 1 billion of those proceeds to retire the Series H preferred stock, which we sold to [Loews Corporation] in 2002. Now that preferred stock had a face value of 750 million and had an 8% dividend so it was calculated on both the face value plus the amount of undeclared and accumulated dividends. So the proceeds in excess of the amount used to retire the Series H will be used to fund the repayment of 250 in outstanding notes that mature in November of this year. So turning to the impact of the plan, the issuance of the debt and equity increased our June 30th debt to total capital ratio by a little less than 5 points to 20.5. Now I've adjusted these for the repayment, the scheduled November repayment, so it would be a little above that at this point in time but I think the important point to make here is that the 20.5% is at the low end of the range of our peer companies and it's in line with our comfort level, so we're very comfortable with this total capital, total debt to capital ratio.

Our balance sheet is very strong. You can see the total capital remained consistent but the equity component, if you consider the preferred as an equity component, is slightly reduced and we think we're slightly more efficient. We also increased the float of the stock by approximately 30% and we did in addition to eliminating a very expensive security and it's one that would have become more expensive with time. It was also a security that restricted our ability to pay common dividends so overall the refinancing has improved our capital management flexibility and broadened our investor base.

Relative to financial ratings, the rating agencies have responded to our improved financial performance. Over the last eighteen months each of the four major rating agencies has changed the outlook on our P&C to stable, some negative. We're actually eliminating all the conversation points that we used to have in our investor calls I think and they used to ask about what we were doing. We've finalized what we're doing with Series H and when the rating agencies were going to give us a stable outlook.

As I said also most importantly we're very pleased by the market's response to our improved performance. Year-to-date you can see the stock has begun to reflect the improved earnings fundamentals. Since the end of '05 the change in the CNA stock is up about 6.5%. And just so you know, the numbers on these slides are updated to September 1st and if you did get a copy of the handout you should know that the numbers in the handouts and that graph were actually prepared in mid-August so this is a little more up to date. The closing price last night would have taken us up 6.5% since January 1 and it's compared to the S&P Insurance Index, which is down a little less than 1%. So you can see underneath there just what the improvement has been and EPS, operating ROE as well as price to book. So things are headed in the right direction.

In summary, I guess you know we view CNA as a leading commercial U.S. insurance organization and we think we're very well positioned to compete in the market going forward. Now we have a strong capital position. We have consistently improving financial results. We have a strong brand identity. We think we have incorporated a very high degree of expense discipline and we think we've also demonstrated a very good track record of mitigating catastrophe risk. Overall we view CNA as well diversified, we think well managed, and we are focused on P&C, on commercial P&C. So that's who we are. I appreciate your interest in us and I'll stop now and be happy to take questions.

UNIDENTIFIED PARTICIPANT: [Inaudible question].

CRAIG MENSE: We have not actively I would tell you. I mean some of those are actually fairly complicated because many of those businesses are actually they're if you did it you had to do it through a reinsurance transaction. You would probably add some additional credit risk if you did it. At this point in time we are focused on managing them ourselves and managing them well so there's nothing active going on today in terms of trying to shed the runoff businesses. Yes?

UNIDENTIFIED PARTICIPANT: [Inaudible question].

CRAIG MENSE: Yes. We actually-- our retention, our catastrophe, our property CAT retention is 200 million. It was 200 in '05. It remains 200 million in '06 so we didn't change retention. In the past we had bought a 300 million ex 2 CAT layer. This year we added another layer of 200 million, so we now have about a 500 million over that 200 million retention and we also bought a second event cover, which we thought-- which we bought last year for the first time so it could be very fortuitous and I think a lot of people even though they didn't give us a lot of credit for the timing and thought that went into that, that second event cover in '05 actually reduced our CAT losses by over $100 million and we were able to buy similar second event treaty in '06. So all those things are really tied to what we're doing relative to our own exposure management so we do just in addition to doing probabilistic modeling and you haven't heard us talk a lot about how the models didn't work or it did work that we spent a bunch of time on deterministing modeling as well as probabilistic modeling and we haven't forgotten to overlook everything with a heavy dose of common sense. There is such a thing as too much of a good thing and too much exposure in places so we really-- we actually look at every 25 mile segment up and down the coast and around in the Gulf to look at what our package of values are there and try to corporately manage those catastrophe reinsurance lines with what those aggregates are. I think that is something that many of you don't hear a lot of but at the end of the day you can spend as much time as you want looking at models but if you don't just kind of step back and try to infuse a little bit of that with common sense, you wouldn't necessarily do very well. I don't think investors really appreciate the excuse that the models didn't tell us what we need to know.

UNIDENTIFIED PARTICIPANT: [Inaudible question].

CRAIG MENSE: Well I think the big point, or what I'd point you to look at really, is the consistent improvement and part of it is the starting point in terms of where we come from with that standard line. I can't really speak to how optimistic or ambitious competitors are to what they're reporting accident into this year. I can tell you that we think that we're reserving prudently in terms of where we see this current accident year. Part of that is very much an expense story. If you looked at our standard lines expense ratios relative to competitors, you'd see they still look pretty significant and disadvantaged in expenses and the other part of that is continuing to improve our mix there. I think there is sort of a mix story. If you recast standard lines we just started making an investment a year or so ago in small business. Our small business ratings and standard are about 10% of our business and for some of our larger competitors could range anywhere from 25% to 50% so there's a pretty significant upside there and there's significant upside as we're beginning to build out our middle market competence and capacity so I think there is an expense story there. There's a shift towards where we are in the product portfolio and mix of business with competitors and then after that it's a little bit more difficult to tell what's underneath in terms of accident years combined so I would think that in the first quarter our combined and standard were over 100. Last quarter they actually came down over [3] points to under two ninety nine nine so under 100 in standard and we'll continue to kind of grind down on that portfolio, again, through those three tactics, expense, portfolios [inaudible] and just underlying prudence and pricing.

What I want to-- not to get ahead of ourselves now but it was very important for us to be able to-- the Series H refinancing was a pretty significant event for us. It was very important for us to simplify the balance sheet. We thought that was-- you know, I think we've said that in terms of saving what I thought was important for capital management and I thought the very first that we needed to do was to eliminate the finite treaty, which we've faithfully done. The second step was for a refinance of Series H, which we've now done, and what the Series H did in addition to being very expensive and a pretty ugly piece of paper, it also presented us from paying common dividends. We don't have any current intentions but it is something that we will-- we would expect to revisit in the first quarter of '07 or at the end of the year.

UNIDENTIFIED PARTICIPANT: [Inaudible question].

CRAIG MENSE: Well the cost is up; actually the cost in '06 was up pretty significantly over '05. I don't know if I remember exactly what it was in dollar terms but something on the order of $35 to $40 million. Those are pretax numbers in terms of costs. The percentage increase is probably more in the 200% range in terms of what we were paying before and we've been very diligent about making sure we are capable of passing on those costs to primary customers so it's property market spend in terms of where the risks really are as how supported improved pricing.

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