State Auto Financial Corporation
Q4 2019 Earnings Call Transcript

Published: 21 Feb 2020

[Operator:]

Welcome, and thank you for standing by. [Operator Instructions]. Today's call is being recorded. If you have any objections, please disconnect at this time. I would now like to turn the call over to State Auto Financial Corporation's Director of Investor Relations, Natalie Schoolcraft.

[Natalie Schoolcraft:]

Thank you, Carol. Good morning, everyone. Welcome to our fourth quarter 2019 earnings conference call. Today, I'm joined by our Chairman, President and CEO, Mike LaRocco; Senior Vice President and CFO, Steve English; Senior Vice President of Personal and Commercial Lines and Managing Director of State Auto Labs, Kim Garland; Senior Vice President of Data and Analytics, Jason Berkey; Chief Actuarial Officer, Matt Mrozek; and Chief Investment Officer, Scott Jones. After our prepared remarks, we'll open the lines for questions.Our comments today may include forward-looking statements, which, by their nature, involve a number of risk factors and uncertainties, which may affect future financial performance. Such risk factors may cause actual results to differ materially from those contained in our projections or forward-looking statements. These types of factors are discussed at the end of our press release as well as in our annual and quarterly filings with the Securities and Exchange Commission. Financial schedules containing reconciliations of certain non-GAAP measures, along with other supplemental financial information, are included as part of our press release and available on our website, stateauto.com, under the Investors section.Now I'll turn the call over to STFC's Chairman, President and CEO, Mike LaRocco.

[Michael LaRocco:]

Thanks, Nat, and good morning, everyone. First, I'd like to welcome Mayor and congratulate him on getting the opportunity to file the most innovative and exciting company in the P&C space. Welcome, Mayor.Next, let me update you on some internal changes we made at the beginning of the year. I asked Jason Berkey to lead our Data and Analytics area as our Chief Data Officer reporting to me. We believe that a combination of technology, data, analytics and innovative culture will be a key factor in who wins going forward. Therefore, we felt it was critical to creating this focused and centralized group. With this change, I consolidated our business lines, both personal and commercial, under Kim Garland's leadership. Kim previously led personal lines before moving to commercial lines, so his institutional knowledge will ensure a seamless transition.Now for the results. 2019 was a year that had many twists and turns, ups and downs, but ultimately, it was a successful year. We started this journey to modernize State Auto just a few years ago, and last year, we took another significant step forward. At the end of the last year, I said the turnaround of State Auto was complete. I was mostly correct. Unfortunately, there were 2 areas that we had covered early in 2019 that needed additional intention. There were some flaws in our personal auto product and our personal auto platform. While I'm disappointed that these challenges put us behind our schedule, I'm pleased that we have put fixes in place and entered 2020 prepared to compete across all our lines of business. Kim will address the product challenges in auto and what we fixed in 2019 and the changes that are coming early this year.The auto platform needed some additional work to improve both the speed and stability as well as enhancements to improve our processing of auto endorsements. The vast majority of that work was completed by the fourth quarter of last year, with just a handful of updates that will be resolved in the first quarter. Again, while these fixes were not anticipated as we entered the year, I'm pleased that we were able to make the needed adjustments. This is the benefit of having a modern digital platform.Unfortunately, the result of our misses was a year where we did not grow across auto and failed to make an underwriting profit, both unacceptable results. As a veteran of this industry and specifically auto, I'm confident we can and will bounce back from this poor year. We understand the business and now have a stable and innovative digital platform upon which we will place an appropriately competitive product.There is room for State Auto to write a significant amount of auto insurance. Our digital approach and emerging product will allow our agents to win their fair share of this competitive line. While we hit bumps across auto and failed to meet our expectations, the news was mixed but much better in homeowners. We continue to achieve a significant growth, a clear indicator of the power, again, of our digital platform and well-designed product. As our auto product comes back and becomes more competitive, whole will benefit as we anticipate an increase in multi-policy sales.Of course, growth without profit is unacceptable as well, so we consider the overall home results a disappointment. We look carefully at the results and know that we had a significant level of both cat and non-cat weather. In addition, we had a handful of fire losses, particularly in the fourth quarter. The combination resulted in a combined ratio well above our expectations. Now we do not use weather, cats or otherwise or fires as an excuse. We own the results, and we expect to return to profitability this year.Now commercial lines had an outstanding year. We have consistently expressed a belief that these lines presented a unique opportunity for State Auto. Once we exited large commercial and E&S, lines that are both unprofitable and a distraction, we knew our focus on small and middle market commercial would lead to realizing the potential in commercial lines. 2019 was our first major step in that direction.Our digital platform for commercial auto and small commercial has been embraced by our agent partners as well as newly designed products that provide better segmentation and matching of rate to risk. Our middle market success has come without the benefit of our new platform. Instead, our culture, which is the foundation of the new State Auto, properly empowered our team, resulting in gains in both efficiency and effectiveness. In the second quarter this year, we will -- we anticipate the start of the rollout of our middle market digital platform. This will allow us to be even more efficient, helping all 3 components of the combined ratio of growth, loss control and expenses.I'm especially pleased that we grew across all commercialized products other than workers' comp. We believe we can grow workers' comp, but we refuse to file the market trends where rates continue to be set at unprofitable levels. Our focus remains on underwriting, claims handling and getting the appropriate rate. That discipline will offer some growth in 2020, even with the undisciplined pricing in the market. Workers' comp will be the final line on our new platform. Once complete, our agents will be able to write the complete package for both small and midsized commercial on the same digital platform.We just launched our farm and ranch product on Connect, again, our digital platform. This is so significant because the product has a level of innovation and sophistication that is unique in the industry. Our rapid growth in this line will also be boosted as we add 8 new states, states we are currently in with the rest of our commercial lines business. As I noted in the second quarter, we will start to roll out a middle market commercial, leaving only workers' comp, which should be in the market by the end of the year.As happy as I am about our commercial growth, I'm ecstatic about the profitability. We still have lines that need attention, but the underlying loss ratios are generally performing to our expectation. We believe our products have been well-designed and are built for ongoing profitable growth. The key, as always, for consistent profitability across commercial will be our expense ratio.In an industry not known for innovation, words can't capture the pride I have in our team's technology achievement. We set out just a few years ago to modernize this 99-year-old company. Indeed, we were, at the time, a 95-year-old startup. As we enter year 5 of this journey, we have brought State Auto to the front of the industry with our digital technology and new products. The cost was not insignificant, but with the largest part of the investment now behind us, we can continue to build the scale that will lead to efficient growth.Achieving scale on our platform is key to getting a competitive expense ratio. We will continue to be disciplined about our expenses as we have been for the last few years. Even with the large investment in technology, we have been able to get some expense ratio improvement, but we are now at the point in our journey where we must prove the value of our investment with profitable growth.2019 was an incredibly challenging year, and our results did not meet our expectation. We take full responsibility for those results. However, numbers do not tell the full story. We now have our digital platform in place for the majority of our products, products that have been rebuilt with sophisticated modeling and pricing. We have stabilized and improved that platform across our largest line. This year, we will complete the rebuild of our auto product that began last year, allowing us to continue our journey to profitable growth in this key product.Finally, our unique culture continues to be the driving factor in our success. We are building on a lead team of professionals who are innovative, empowered and passionate about winning. We entered 2020 as an organization that is ready to compete and win across personal and commercial lines of insurance.And with that, I'll turn the call over to Steve.

[Steven English:]

Thanks, Mike, and good morning, everyone. As you can see from this morning's release, STFC reported net income for the 2019 fourth quarter and full year that was significantly greater than the same corresponding periods in 2018. The swing in net investment gain or loss is the primary reason as it reflects the change in unrealized gains and losses on equity securities and other invested assets in accordance with the new rules that went into effect last year. This new guidance has created the volatility it was predicted to create.On an operating basis, which excludes the impact of net investment gain or loss, STFC reported $0.29 per diluted share for the fourth quarter of 2019 compared to $0.67 in the fourth quarter of 2018. On a year-to-date basis, STFC reported $0.63 per diluted share in 2019 compared to $1.20 for all of '18. Included in these results are the ongoing personal and commercial insurance operations as well as the impact of the specialty runoff business. The lower level of operating earnings is primarily driven by underwriting results with higher combined ratios.Looking at combined ratios on a GAAP basis, comparing fourth quarter 2019 to 2018, the GAAP combined ratio of 100.4 is 5.8 points higher than the fourth quarter a year ago. Quarterly results can fluctuate, but our fourth quarter cat loss and ALAE ratio of 7.7 is 5.1 points higher than the cat ratio of 2.6 reported in the fourth quarter of 2018.Two significant items drove the higher level of cats. First, we recorded additional specialty Irma and Harvey losses in response to claim development we are seeing beyond what was expected. Loss development seems to be impacted by efforts by insureds and public adjusters representing insureds seeking damages by late reporting of claims and/or seeking additional damages beyond what we believe we owe on claims already reported. We added to these reserves in the second quarter of 2019 as well. Some of these claims are or will possibly end up being litigated. This drove the 6.6 million of cat loss for the quarter in specialty runoff. Specialty adverse development added 2 points to the quarter and 0.9 year-to-date. For the quarter and year, these cat losses are the most significant story within specialty.Second, we recorded an estimate of $16.5 million for storms in late October of 2019 impacting the Dallas-Fort Worth area. Collectively, this is $23.1 million of the $24.8 million for the quarter. Comparing fourth quarters, the non-cat loss and ALAE ratios for the fourth quarter of 2019 rose 2.3 points compared to the fourth quarter of '18, and the GAAP expense ratio declined 1.6 points when comparing the same 2 periods. On a year-to-date basis, the GAAP combined ratio of 102.7 for 2019 compares to 100.6 for '18, an increase of 2.1 points. The cat loss and ALAE ratio was up 2.2 points, the non-cat loss and ALAE ratio was up 0.9 points, while the GAAP expense ratio declined 1 point. Each successive quarter, the impact of the specialty runoff has become less and less impactful, and the focus continues to be on the adequacy of our reserve estimates.I will turn the attention into our personal and commercial segments. As can be seen from our press release disclosures on a statutory basis, our personal and commercial segments' combined ratios were 97.1 and 101.2 for the 2019 fourth quarter and year-to-date, respectively, compared to 92.8 and 98.6 for same periods of '18. Our personal segment drove the overall higher combined ratios in 2019, with quarterly and year-to-date combined ratios above 100, while our commercial segment reported improved results and combined ratios below 100 for the same periods of time. 2019 personal lines underwriting results in the quarter and for the year when compared to the same periods in 2018 were impacted by higher cat losses, ALAE ratios and higher non-cat loss and ALAE ratios. These were somewhat offset by slightly improving expense ratios. The personal lines book grew 9.1% for the year in 2019 when compared to '18.2019 commercial underwriting results were much improved, with combined ratios of 86.5 and 97.0 for the fourth quarter of '19 and full year '19, respectively, compared to 90.4 and 101.2 from the same periods a year ago. For the year, commercial lines loss and the LAE results improved 1.8 points when compared to 2018, and the expense ratio declined 2.4 points on the same basis. Commercial lines grew over 12% when compared to 2018 for both the quarter and the year. Kim Garland will provide greater product detail in his prepared remarks.To wrap up my comments on underwriting results, let's spend a few moments on prior year loss development and expenses. For the year, personal lines reported 1.7 points of net favorable development of prior year non-cat loss and ALAE reserves compared to 4.9 points a year ago. 2018 development included 2.9 points of favorable development for homeowners compared to 0.1 point of adverse development for '19. Homeowners has not aligned a business where we expect significant amounts of development as it is short-tail property. For the year, commercial lines reported 12 points of net favorable development of prior year non-cat loss and ALAE reserves compared to 10.1 points a year ago. We continue to see favorable experience emerge on workers' compensation. The absolute dollar amount of development was greater in 2019 than in 2018. But keep in mind, the book has been shrinking, so current year earned premium is less contributing to the higher ratio impact in 2019 as well. Small and middle market commercial reflected higher amounts of favorable development, while commercial auto was roughly half of what it was in 2018.On a statutory basis, the total personal and commercial lines expense ratio for the year ended December 31, 2019, at 34.4% compared to 35.6% a year ago, a reduction of 1.2 points. With overall growth of 10.2% and net written premium, the expense ratio did benefit from scale. Base commissions, though, as a percentage of net written premiums is trending down as more of our book is comprised of business written on our digital Connect platform. With lower overall underwriting profitability, associated variable compensation was less in '19 as compared to '18, and offsetting these items is the normal pressure from increased fixed costs such as wage and salary adjustments for associates. There was no material dollar change in our project-related costs, although those costs focused more on middle market, farm and ranch and workers' compensation lines of business as compared to commercial auto and small commercial in 2018. With continued rollouts of our Connect system and growth, we would expect to see the overall expense ratio continue to improve as we move forward.Moving on to investments. Net investment income was up sequentially from the third quarter of 2019 but lower than last year's fourth quarter. Year-to-date, net investment income was $80.4 million compared to $84.9 million for 2018. $3 million of the $4.5 million decrease was in fixed maturities split evenly between traditional fixed income, securities and tips. The overall fixed maturity portfolio and amortized cost declined during 2019. A contributing factor is the settlement of specialty claims and runoff. Overall, specialty reserves are down $85.2 million from December 31, 2018, and stand at $233.7 million as of December 31, 2019.And with that, I'll turn the call over to Kim.

[Kim Garland:]

Thanks, Steve, and good morning, everyone. I'll be covering both personal and commercial lines this morning. For both the fourth quarter and the entire year of 2019, it is the tale of 2 different stories. I'll start with commercial lines. 2019 was a historically good year for State Auto, which produced a 4Q '19 combined ratio of 86.5 versus 90.4 in 4Q '18 and a 4Q '19 written premium increase of 12.6% versus 4Q '18. And for the entire year of 2019, our commercial lines produced a combined ratio of 97 and a written premium increase of 12% versus 2018.The highlights of the quarter and the year for commercial lines. The commercial lines expense ratio dropped 2.4 points in 2019 from 42 to 39.6. Growth continues to strengthen with all of the commercial product lines, except workers' compensation growing in 2019. Commercial new business premiums increased 76% in 2019. Our product is currently on commercial Connect, while commercial auto and commercial umbrella gained traction in 2019, and it continued in January 2020 as we wrote $9 million of new business written premium in these products on the Connect platform. This is almost the amount of new business that we wrote for all of commercial lines in an average month in 2018.The challenges of the quarter and the year for commercial lines were the following

[Operator:]

[Operator Instructions]. Our first question today comes from Paul Newsome from Piper Sandler.

[Paul Newsome:]

A couple of related questions. First, I was hoping you could kind of give us some more detail on the auto retention situation and how you think or hope that will change in the future. And then I was hoping as well, relatedly, if you could talk about the auto insurance's market environment. Lots of concerns that it has become a very, very competitive market. And how does that make it -- has that made the challenge of trying to improve the profitability, the book more difficult? Or...

[Michael LaRocco:]

Thanks, Paul. I'll let Kim weigh in on both. I've got quite a view on the market environment that I certainly want to share as well. But I think Kim can talk about retention and some thoughts on the market.

[Kim Garland:]

So I think retention is going to be a combination of a couple of things. So I think on the first side of retention, it's sort of things that we do ourselves. So I mentioned, I think, when we look at rates at both ends of the spectrum, I think we are probably priced a little bit high on the preferred end of the spectrum and a little bit inadequate on the sort of higher risk end of the spectrum. And so as rates are stable or down in preferred, that should help preferred auto versus the retention. Also, Mike mentioned that we have brought greater stability to the platform, and I think greater stability is going to help our agents sort of -- their renewals be less -- have less systems-related issues. And so that should help our retention also. I think a third aspect of it is, last year, we mentioned we had stopped writing a bunch of 1-month down payment, and that business had very low retentions. And so the fact that we aren't writing that business anymore is going to help the retention of a book as a whole. And so there are a lot of things. If we think about each of these markets, I'll call them preferred standard, nonstandard individually, those things should help retention levels in those markets individually.But one of the things I mentioned was because of some operational issues and sort of prices being lower than they needed to be at the higher end risk of the spectrum, we probably attracted a bit more of that business than we were expecting, and that type of business just has general lower retention levels. And so I think what you will see over the coming year is a shift more and writing more preferred business, which just brings a higher retention level. And so as that mix changes, that will be as important a driver as the individual sort of things that we are working on.When I think about sort of the state of the market, again, it's -- we look at -- I think when we set rates, we look at both what our actuarial indications are and both the competitive position in the market. And I think while we have seen the market getting more competitive, when we go market by market, I think we believe that we can put rates in the market, especially in the preferred, ultra preferred end, that are both adequate and competitive. And so we think even though personal auto is always competitive, and it continues to get more competitive, that we will be in good position there. I think what we will see is, at the higher end of the spectrum, we will take the rate that we need to take. And so we may not be competitive on some of the standard or better nonstandard risks, and that part is fine with us.

[Michael LaRocco:]

Yes. And Paul, just to add some commentary. I mean, it's very clear that companies that are spending between $1 billion and $2 billion advertising, and there's a handful of them, they're going to win their fair share of the marketplace. And those advertising dollars, obviously, are driving customers to their site, and they are able to close those opportunities. So it would be foolish not to suggest that there's going to continue to be some level of consolidation towards the top of the market, particularly with a handful, and I truly mean just a handful, of companies that are pushing into that space.The thing that's interesting about the auto market is that it's extraordinarily inefficient. And what I mean by that is that if you go out, I'm sure you've done this, and get 5, 6, 7 quotes, the range of rates that will come back to you would be surprising. And they're not always the companies that are spending those $1 billion and $2 billion to drive those opportunities. So there is opportunity for more than just a handful of companies to consolidate.Now do I believe the old line mutuals and the old line regionals are dead men walking and are not going to be able to compete successfully? 100%. Because you have to have some core things. You've got to have a very efficient system to make the process seamless if you're selling through an independent agent. And you've got to have enough efficiency in there that you can have, at least a competitive rate because your expense ratio reflects that.The other thing that's a misunderstanding about the market is that independent agents are either walking away from auto -- and by the way, a lot of those regionals and small mutuals are trying to switch to become commercial underwriters because they're literally not seeing a future in auto, which creates more opportunity for those tweener companies like State Auto. But the other misconception about it is that agents are just kind of accepting this change and not adjusting themselves. We have a significant number of our agents who are what we would call digital agents or at least a portion of their business is that they go -- they set up online search engines, and they are driving customers to their website. They get the advantage of kind of having that local presence. And they are doing quite well in that space. And what they're really looking for are partners like State Auto that have also a digital presence.And so the combination of the inefficiency of the market, the bottom dwellers who will start exiting creates opportunities in that space for companies that have a level of innovation around their platform and their products, especially with things like telematics and some of the other changes that our team has been launching and will continue to launch into 2020.So we're actually all in on auto. I know some of you who look at the market from the outside don't agree with that. But we have a very strong feeling that we can win more than our fair share of that business, and we'll continue to pursue it.

[Operator:]

[Operator Instructions]. Our next question comes from Meyer Shields from KBW.

[Meyer Shields:]

Great. I wanted to push auto for a second. When you talk about managing the books differently, does that encompass handling the claims differently? And can you talk about your capabilities on either end of the spectrum?

[Michael LaRocco:]

Yes. The core answer to your question is no. In other words, we have this very clear view in our claims organization that we want to be fast, we want to be fair, we want to be friendly and make the process good. Now, is there a change? There possibly could be. So for example, you may see folks as they're in, as Kim call it, the better nonstandard or the standard. There may be a different time of day when things happen and you've got to be thinking more differently about spreading your availability of your claims adjusters on a more 24 by 7 basis, and by the way, we're not there yet. You have to be understanding of that change. You have to be more responsive to those types of issues. So I think our care organization is built to handle the claims-related issues.The bigger issue is that when you're thinking about the business, you have to be better at handling billing. You have to be better at handling service. You might have a different number of endorsements that are happening. You may have a different type of payment-related issues that could be happening. But most importantly, you've got to be very thoughtful about your pricing, because on the business that's in that space, your retention is never going to be as high as in the preferred space. So I think Paul asked about that, and I thought Kim gave an appropriate answer. So you can't -- on the preferred business, you may be willing to understand there could be some type of new business penalty for year 1 and be sure it's anticipating the business to be with you for a long period of time. When you get into that middle space and the nonstandard space, you need to price that business for profitability from day 1. And so getting those range right and getting that process in place is really where more of the issue that Kim is relating to in terms of steps that we've taken.And so if you don't mind, I'll just add 1 more thing there, I may be going too far in answering your question, I apologize. But this is -- this auto product, like the other ones we had, this was a start-up product in 2016 when we launched it. The reason I say that is people know that our auto performance prior to '15 had not had a really good history and we had shrunk a lot of that business. So we build a new product, and the evolution of that product, we just took another step forward across '18 and '19. And it's unfortunate that we have these -- quite frankly, these bumps in terms of performance. But this is an evolutionary process, and this company is adjusting that. So I really like your question because it really goes to the heart of the matter. Whether it's on the claims side or whether it's on billing or whether it's on issuance or whether it's on rate setting, we've got to be sure we understand how to approach that business effectively. And I think we put in place the steps to do that. So sorry if that was a long answer for you.

[Meyer Shields:]

No, that was a phenomenal answer. Second question, given, let's say, the fourth quarter is above expectations, could [indiscernible] non-cat weather losses, how are you thinking about reinsurance purchases for 2020?

[Michael LaRocco:]

Yes. I'll let Steve weigh in on this. We -- I think the biggest issue is kind of private Texas homeowners. Is that fair, Steve?

[Steven English:]

Yes. That's fair, Mike. Meyer, presently on the -- we have a property cat treaty -- or, sorry, retention on a group basis, so we always have to be careful to clarify that, is $75 million. We're just now entering our marketing efforts and have already had some initial discussions with our broker as to what's going on with that marketplace and some potential changes. We're not quite through all that analysis yet. But I think the real question is, when we look at Dallas-Fort Worth, is it going to have an impact on like what I'll call tail risks? So it might cause us to take a look at maybe adding a bit on top. But the real question is, right now, are we properly priced and put in a cat load into that business so that over the long haul, we're going to make money? I mean, you're going to have years where up and down results because weather is just that unpredictable. So I don't foresee massive changes in our reinsurance buying or structured, but it is likely we'll probably add. And, I guess, that's [indiscernible].

[Michael LaRocco:]

Yes, I agree.

[Operator:]

And we have no one else in queue at this time. I'll turn the call back to Natalie Schoolcraft for some closing remarks.

[Natalie Schoolcraft:]

Thanks, everyone, for your questions, for participating in our conference call and for your continued interest in and support of State Auto Financial Corporation. We look forward to speaking with you again on our first quarter earnings call, which is currently scheduled for Wednesday, May 6, 2020. Thank you, and have a wonderful day.