State Auto Financial Corporation
Q4 2017 Earnings Call Transcript

Published: 20 Feb 2018

[Operator:]

Welcome and thank you for standing by. At this time, all parties are in a listen-only mode. After the speaker’s remarks, there will be a question-and-answer session. [Operator Instructions]. Today’s call is being recorded. If you have any objections, please disconnect at this time. I’d now like to turn the call over to State Auto Financial Corporation Investor Relations and Financial Director, Tara Shull.

[Tara Shull:]

Good morning and welcome to our Fourth Quarter 2017 Earnings Conference Call. Today, I’m joined in Columbus by our Chairman, President and CEO, Mike LaRocco; Senior Vice President and CFO, Steve English; Senior Vice President of Personal Lines Jason Berkey; Senior Vice President of Commercial Lines and Managing Director of State Auto Labs, Kim Garland; 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. A financial packet containing reconciliations of certain non-GAAP measures, along with supplemental financial information, is available on our website, stateauto.com, under the Investors section as an attachment to the press release. Now, I’ll turn the call over to STFC’s Chairman, President and CEO, Mike LaRocco.

[Mike LaRocco:]

Thank you Tara and good morning everybody. Finally, I’ve been lucky to have been part of an extremely successful turnaround. I know what’s involved and the steps needed to succeed. That experience taught me to understand each part of the process, so I can measure whether and how much progress is being made. It’s clear to me we have turned the proverbial corner. The most obvious indicator, our results for 2017, especially the improvement we’ve made each quarter, culminating in a profitable fourth quarter for our continuing businesses, personal and commercial, at a 97.1% statutory combined ratio. Our full year combined ratio at 102.3% represents a 2.2% improvement over 2016 and includes an expense ratio that’s not represented of what we expect to achieve in 2018 and beyond, as it reflects a one-time change or agent bonus plan and a level of investment that we expect to abate in coming quarters and years. Of course, our overall statutory combined ratio of 107.3% includes our exited specialty operations, which, for the most part, will run off through 2017. The specialty results included 22.5 points of cat losses, primarily due to hurricanes Harvey and Irma. I’m extremely confident we’ll manage off the remainder of our specialty exposures, efficiently. We’ve made progress towards completing agreements stakesat all of our lines, except E&S property, which we began running off last November. Steve will provide more details. The fourth quarter demonstrated what we’re capable of and validates our hard work to date. Our loss ratios for personal and commercial auto lines continue to show improvement and our path to profitability in these critical lines is clear. We reduced the personal auto non-cat loss ratio by 4.2 points and the commercial non-cat loss ratio by 20.8 points from 2016. I understand we have a long way to go and must remain focused. I can assure you that will not be a problem. Our product teams continue to take the necessary rate with a targeted approach, and our claims and risk engineering team has continued to improve the handling of claims across both property and liability. Focus has been on quality and speed. The team has been rebuilt over the last few years, and we’re seeing the results in both efficiency and effectiveness. Most encouraging is seeing the growth from executing our digital strategy. Our decision to go completely digital was bold and it’s working. We set all-time records in quotes and sales in 2017. Our agents, including our new platform agents, have responded with great excitement and energy. Perhaps the most exciting part of our digital platform is that we’re just getting going. We are a very different technology company. We’ve built an internal structure that can undergo continuous improvement. Not unlike you’d see from a true tech company. We are regularly updating and improving the platform. The result is not only seeing a new business growth, but for the first time in eight years, we grew our home policies in force. Personal auto ended 2017 with four consecutive months of PIF growth. Also, we’re leveraging robotics across the company, bringing gains and productivity. We have successfully launched the new digital platform as well as new finance and human resource systems. It’s working. Now we still have a number of concerns as we close 2017 and enter 2018. Number one is ongoing improvement in our loss ratio. As I’ve already noted, we’ll continue to take rate in 2018, but it will be focused based on analysis of losses at a detailed level. In addition, while our claims handling has improved, we still believe there is further significant loss leakage we can reduce and eliminate. Our expenses will never stop being a focus. Our fourth quarter looks bad, but it’s simply a result of timing and a unique one-time impact. Agent bonus compensation increased $6.5 million compared to the fourth quarter of 2016. This was related to our decision to offer agents a transition approach in 2017. They had two bonus programs

[Steve English:]

Thanks, Mike, and good morning, everyone. As Mike noted, I’ll comment on the net deferred tax charge taken in the quarter, the status of exiting the overall specialty segment as well as expenses, reserve development and the level of investment gains in the quarter. Before I get into my commentary, you probably noticed a change in our release this quarter. We’ve now incorporated our investor packet into the actual release, putting everything in one place. 2018 will be a transition year as the specialty segment winds down, with the focus shifting to our continuing personal and commercial lines of business. By now, everyone is aware that the President signed the Tax Cuts and Jobs Act on the 22nd of December, reducing the overall corporate tax rate to 21% from 35%. In the quarter, we took a provisional net deferred tax charge of $36.4 million as required by the Accounting Standards to reflect the reduced tax rate. Going forward, muni bond investment income will continue to be taxed at 5.25%, dividends at 13.8% with the balanceof items at 21%. Mike commented on fourth quarter expenses, as our GAAP expense ratio was up over a year ago by 5.3 points. Year-to-date, the GAAP expense ratio was up 2.4 points. Fourth quarter added 0.7 points to the full year GAAP expense ratio. So what were the factors driving these increases? First, as a reminder, we spoke earlier in the year about the change made regarding how our specialty underwriting unit expenses were treated, and we anticipated by year-end, the impact would be to increase the GAAP expense ratio by 0.5 point. At that time, we had not made the decision to exit all specialty. We now estimate that about 0.4 points of the 2.4 point GAAP year-to-date expense ratio increase was attributable to the this change. This only impacted the specialty segment, which of course, will run off during 2018. Next, Mike spoke of agent bonus programs and the decision to transition the agents. Year-over-year, agent contingent commissions increased on a dollar-basis by $8 million, adding 0.6 of a point. As we trued up these estimates, it disproportionately impacted the fourth quarter of 2017 and contributed two points of the over five point increase in the year-over-year quarterly expense ratios. Finally, for the year, increased technology and IT costs added 1.4 points to the GAAP expense ratio. This relates to the continued build-out of the commercial lines platform as well as amortization of past capitalized costs of the new personalized platforms. For the quarter, this added 1.8 points. So to summarize, the 2.4 point increase in the 2017 year-to-date GAAP expense ratio was 0.4 points on the treatment of specialty underwriting costs, 0.6 points for agent bonus programs and 1.4 points for technology spend. To summarize the increase in the quarter’s GAAP expense ratio, the specialty underwriting cost had a negligible impact, agent bonus expense contributed two points, technology spend added 1.8 points and while not impacting the year-to-date ratios, the associate bonuses added one point to the fourth quarter of 2017 over fourth quarter 2016. The balance of any remaining variances are due to timing of expenses and quarterly written and earned-premium amounts. The runoff of the specialty segment will put additional short-term pressure on our overall expense ratio, as we work through these overhead costs. Moving on to loss reserve development. Prior year non-cat loss development in the quarter was favorable, improving the GAAP combined ratio by 3.4 points and favorable for the year 3.5 points. This compares to 2016, where we experienced for the year 2.2 points of unfavorable development of prior year non-cat loss reserves. In the quarter, we saw a more favorable personal auto development, continued favorable development in commercial lines, while E&S casualty reported adverse development, driven by general liability. While not prior year development, our fourth quarter cat losses were almost entirely driven by revised estimates for Hurricane Irma, most of which was reflected in the E&S property line of business. Before I provide an update on specialty, I did want to mention that our fourth quarter realized gains include $18.5 million, related to the sale of our small-cap portfolio. This portfolio was externally managed, and we did not feel the returns justified the cost. We have reinvested those proceeds and other small-cap focused investments using mutual funds and ETFs. For specialty, quarter-to-date net written premium is down 51% from last year, reflecting our decision to exit specialty lines. The quarterly statutory combined ratio was 130.8% up 7.1 points from a year ago, the cat loss ratio reflects reevaluated Irma losses. The non-cat loss and ALAE ratio was 63.4 points, an improvement of 12.7 points from a year ago and was spread across all three product lines. Prior year loss reserve development was adverse, as I mentioned previously. The current accident period results improved this quarter from a year ago. The expense ratio was up 14.5 points due to lower premium levels and fixed overhead expense is yet to be eliminated. Since our last call, we’ve been working toward exiting specialty. Similar to programs, we formally put E&S property into runoff last November and have since only written contractually required new business. Our E&S casualty line is principally made up of our general liability, environmental, umbrella or excess liability and distribution books. In mid-January, we announced entering into a renewal rights transaction for the environmental book. We’re in final discussions with additional parties for similar types of transactions involving each of the remaining E&S casualty businesses. At the present time, I cannot provide any further details, but our best estimate at the moment of the runoff impact is as follows

[Jason Berkey:]

Thanks, Steve, and good morning, everyone. Our plan to improve profitability has been consistent, and each quarter, we’ll continue to update you on our progress. In this quarter, we had a continuation of favorable loss reserve development. At the same time, we continued to take targeted aggressive rate actions in personal auto and to press for claims operational improvements. Looking at our personal auto results for the quarter, the loss and ALAE ratio was 74.0 with a combined ratio of 105.5. In terms of personal auto rate activity, in 2017, we made 50 rate changes in our 28 states, with an average rate increase of 13.6%. Subject to DOI approval, we have 18 rate changes in the pipeline, with an average 9.2% rate change in the first quarter of 2018. Included in these rate changes is a 23.2% increase in our bodily injury rate. These rate changes continue to earn into our personal auto book of business. The result is that the average written premium per vehicle in December 2017 is 16.1% higher than December 2016. In recent quarters, we have discussed the operational changes in our claims organization. In this quarter, we saw loss cost trends generally improving on this front, with the exception of bodily injury. The bodily injury exiting year loss cost trend remains high. The operational changes in our claims organization take longer to affect bodily injury loss cost trends for many reasons, including the longer claim settlement period for bodily injury claims. We closely watch the rate of increase in premium versus the rate of increase of loss costs. In fourth quarter 2017, the change in 12-month rolling earned premium per vehicle of 10.1% was less than the change in the annual loss cost trend of 13.8%. Therefore, in fourth quarter of 2017, our progress in restoring personal auto profitability was less than anticipated. Rate changes that have yet to be earned will increase the change in earned premium per vehicle in the coming quarters. In addition, we anticipate additional benefits from claims operational improvements. Nonetheless, further significant bodily injury rate actions will be necessary to address the high level of loss cost trend being seen in that coverage. While improving profitability is the highest priority for the personal auto product line, as I mentioned, last quarter, we are seeing the first signs of growth. Starting in August and continuing through the fourth quarter, personal auto policies in force increased for four straight months. This is the first time PIF has grown in several years and is a very important step on the path to profitable growth. In financial terms, our personal auto performance is as follows

[Kim Garland:]

Thanks, Jason. The commercial business results are as follows

[Operator:]

[Operator Instructions] First question comes from Christopher Campbell from KBW. Your line is open.

[Christopher Campbell:]

Can you hear me?

[Mike LaRocco:]

Yes. Yes, we can.

[Christopher Campbell:]

Okay, great. Sorry about that. So first question is, current loss ratio improvement was very solid and would have been stronger without the unallocated LAE increase. Anything special driving these expenses higher?

[Steve English:]

In terms of the ULAE, you mean?

[Christopher Campbell:]

Yes.

[Steve English:]

No, that’s just a function of that – those reserves, we calculate and allocate amongst various product lines. Claim counts, a lot of things go into that, which created some noise. There’s nothing special there, just a little noise.

[Christopher Campbell:]

Okay, great. Maybe you mentioned, and I’m not sure if I missed it, is there a bit of assumptions that we should have for an operating tax rate?

[Steve English:]

So here’s how I would respond to that. In terms of the new law, I think that where – on investment income where we’re sitting today, I would estimate an effective tax rate on that somewhere around 17% or so. So that will be down about 10 points from where it is under the old tax law. Then, obviously, the operating or the non-investment income operating pieces would be at 21%, basically, it’s close enough. So depending on how you model the comp – mix between investment income and underwriting yield, that’ll blend you whatever your overall model rate would be.

[Christopher Campbell:]

Okay, great. So that would be 17% on the investment income and then 21% on operating. Is that correct?

[Steve English:]

Correct. Correct

[Christopher Campbell:]

Okay, great. So just to kind of switching to commercial. The second quarter in a row of kind of year-over-year worker’s comp core loss ratios. Just kind of curious a little bit bigger but the deeper there. That’s what we have expected with a lot of rate reductions that this might have started to weaken a little bit. Any color you could provide there would be great.

[Mike LaRocco:]

Well, I’ll start and Kim may want to clean this up. Well, this is Mike. We’re really a very focused Worker’s Comp organization. We kind of deal both in the really small stuff and really big stuff but where we play is kind of the much more traditional four wall type of risk. So that’s kind of number one, as we are really disciplined around the risk that we will write with workers compensation, and quite frankly, overtime, our appetite for workers comp will pretty much follow our appetite for BOP. Secondly, we have made really, really clear why we want to be profitable and growing organization, when it comes to workers compensation, whatever emphasis we have on profit overgrowth across all of our lines of business, there’s an extra emphasis on the profit side of workers compensation. So there has been pressure on workers comp rates. But we just refuse to run down that rabbit hole. It doesn’t mean we won’t make mistakes and there won’t be problems but we have a very disciplined group of folks in our Worker’s Comp team. And then the third thing I would say is that we have a strong belief in our claims and risk engineering team around workers comp, while we’re trying to get better across the rest of the organization. I think in the space of workers compensation, this group, which focuses on returning the work focuses on a lot of nurse involvement, is really industry leading group. And I think when you put those three factors together, we’re very bullish on our ability to be disciplined in workers compensation.

[Kim Garland:]

Yes, at the risk of repeating a little bit, I think our workers comp team, there’s sort of multiple disciplines in there that I think I really, really good at what they do, right? Mike talked about our claims group, and we really are excited about what we do around claims. Also underwriting – our underwriting group is both very experienced and very strong and is kind of no-nonsense in a space where you want them to be no-nonsense. And we also have a lot of, sort of, analytical actuarial talent in that. And when any insurance business that has all disciplines with good folks in it, you’ve got a shot at doing well in that. And then, I think Mike mentioned most important one, right?. The biggest risk maybe to outline a business is human nature. Can you maintain discipline while everybody else around you loses there’s? And we talk about that a lot internally.

[Christopher Campbell:]

Well great, thanks for that color, it’s very helpful. And then just one final one on the investment portfolio. So the media allocation has been declining and that’s been partly offset by increased corporates and Agency MBS. So just kind of two questions on that. How are you thinking about the muni allocation, given tax changes and then also on the corporate side as you’re starting to see credit spreads tighten, how are you thinking about your increased credit exposure on the corporate side as well?

[Scott Jones:]

This is Scott. I’ll start with the new muni piece first, definitely, with the tax law change and the value proposition for individuals and institutions has changed in regard to municipal bonds. So I think it’s going to be a little bit how the remark market response to that in terms of pricing. I think, in general, probably across P&C company, as you probably see a little bit of a decline in muni holdings, we always evaluate munis versus what’s available on the taxable market. And at times, there’s opportunities there and at times there is not. So we’ll continue to be with that, we going forward. In regards to the corporate market, I agree with you, corporate credit spreads are tighter now than they’ve been historically. But we still see strengthen the economy in general and in earnings growth amongst companies. So we don’t really have any concerns there, but obviously, the buying opportunities in the credit market are probably less than they were a year ago.

[Christopher Campbell:]

Great. That’s very help. Thanks for all the answers and best of luck in 2018.

[Mike LaRocco:]

Thanks, Chris.

[Operator:]

[Operator Instructions] Your next question comes from Larry Greenberg from Janney. Your line is open.

[Larry Greenberg:]

Good morning and thank you. Steve, you rattled off a number of expense ratio impacts at a much quicker rate than I was able to write them down. And I’m wondering, if may be looking at it a little bit differently. If you could just talk about the two major ongoing segments personal and commercial, and give us some sort of baseline expense ratio for where we are today. And, obviously, as detailed as you could get would be appreciated. But just directionally, over the next 12 months, what we should be looking for?

[Steve English:]

Okay. So as you know, we don’t normally give that type of detailed guidance, but I’ll try to be responsive to your question, Larry. In regards to some of the factors that impacted 2016 versus 2017 , I mentioned the ROM effect, which is what we call the specialty underwriting cost item, treatment of those costs, so you can kind of throw that off the table, right? Because that does not affect personal and commercial lines. In terms of the agent bonus plan, I would say, I think, on a dollar-basis, I said it was about $8 million up year-over-year. A lot of that was driven by our decision to give the agents a choice or a transition period as we move from the old plan to the new plan. So I would expect a significant portion of that delta to go away in 2018. In terms of IT costs, I think those, in my comments and in his comments, that 2018, again, will be a technology investment year, as we complete commercial lines and then you start to see, come online some of the amortization cost related to what we’ve already capitalized on the books. So that really won’t be a delta in 2018. I think you’d start to see that start to truly come down, beginning in 2019. If you look at the disclosures for – and bifurcated between specialty and personal and commercial for 2017 and look at those numbers and think about 2018, from a ratio perspective, I would anticipate that the specialty expense ratio is obviously going to go up because there’s going to be a trailing effect in terms of the relationship of how quickly we can move the cost off the books relative to the decline in earned premium. And then looking at the personal and commercial side, that’s where you’ll see the full benefit of the agent bonus issue as well as to putting on that much growth that we can put on as Connect, which is what we call our new system, comes online for not only personal but commercial.

[Mike LaRocco:]

Yes. And Larry, this is Mike. I would just toss in a couple of broader thoughts on this because I think you’re thinking about it the right way in a sense that everything about what we’ve done over 2.5 years is about the turnaround and basically, creating a very different organization going forward. And I think the thing I would say about 2017 and going into 2018 is that a lot of noise is going away. And it’s frustrating on these calls to always have to be talking about explaining the impact of all the various changes, and you never get a perfectly clean situation because it’s always "stuff" that happens. But a lot of noise has gone away. We have now become a technology driven organization. We’ve become a very focused organization without specialty, without program business, without large commercial, without trucking businesses, without the healthcare business. We are a home, auto, small commercial, mid-market commercial, farm and ranch and workers’ comp company. That’s who we are. And I think that, as you look at the expenses as we talk about, there were certain things in 2017 that we needed to do and they were the right things to do. 2018 will – should be the last of the significant amount of technology dollar spend. Then you get kind of into a run rate. We’ll have to overcome some of the corporate overhead dollars that were applied to specialty but our view of the future is really very significant because when you look at the cost to run a Connect, a digital platform versus legacy cost, again, we have a very bullish view of the future. And that’s – people have to see one year to two years for us to make a lot of sense. People that do, I think it’s very positive. It is certainly for us. But I hope that makes some sense. It’s understanding where we were in 2015 and where we’re going right now because all of our expense dollars for legacy and Connect are all in the numbers now. And of course, that will emerge differently over time. So I hope that helps a little bit.

[Larry Greenberg:]

Yes, I mean, just listening to you guys, I mean, the delta on the bonuses go away but does – I mean, where we are today continues and the level of IT cost today while may be it doesn’t go higher, it’s still there for 2018. So am I hearing that – really any expense ratio leverage is going to come from top line growth. Am I hearing that correctly?

[Mike LaRocco:]

I think they’re certainly going to be that impact. I think – we have a – without talking about our specific targets, we have a fairly positive view of our ability to grow in 2018 as our retention hopefully, flattens out and stabilizes, maybe even get some bit better over time. And then of course, the top line, as we continue to roll out. But there’s other things that are happening. Kim, I think, mentioned the Straight Through Processing. There’s a lot of nontechnology changes we’re making inside of our organization, in places like commercial and things like we’re doing with the robotics that are working on nontechnology investments to drive down our expenses across the organization. But specifically, to your question, we anticipate the biggest potential lift will be from the growth that we’ll experience in 2018.

[Larry Greenberg:]

Great. Thanks.

[Operator:]

[Operator Instructions] I have no further questions at this time. I’ll turn the call back over to the presenters for closing remarks.

[Tara Shull:]

Thanks for your questions. We want to thank all of you for participating in our conference call and for your continued interest 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 Tuesday, May 8, 2018. Thank you, and have a good day.

[Operator:]

Thank you, everyone. This will conclude today’s conference call. You may now disconnect.