State Auto Financial Corporation
Q3 2009 Earnings Call Transcript

Published: 22 Oct 2009

[Operator:]

Welcome to State Autos Financial’s third quarter earnings conference call. Initially you will be in a listen-only mode. (Operator Instructions) At this point, I would like to turn the call over to Mr. Steve English, State Auto’s Chief Financial Officer. Mr. English, you may proceed.

[Steve English:]

Thank you, Tom. Good morning and welcome to our third quarter 2009 earnings conference call. Today I am joined by several members of STFC’s senior management team. Our Chairman, President and CEO Bob Restrepo; Chief Operating Officer, Mark Blackburn; Chief Investment Officer Jim Duemey; Corporate Actuary, Matt Mrozek; and our Chief Accounting Officer and Treasurer, Cindy Powell. Today’s call will include prepared remarks by our CEO, Bob Restrepo and myself, after which we will open the lines for questions. Please note 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 to which I refer you. A financial packet containing reconciliations of certain non-GAAP measures, along with supplemental financial information was distributed to registered participants prior to this call, and made available to all interested parties on our website www.stateauto.com under the Investor’s Section, as an attachment to the press release. Now I’ll turn the call over to STFC’s Chairman, President and CEO, Bob Restrepo.

[Bob Restrepo:]

Thank you Steve and good morning everyone. Needless to say, we’re pleased with our improved underwriting results in the third quarter and the increase in our book value to $21 a share. Our results were driven by a number of factors including lower catastrophe experience resulting from better weather, and recoveries from our new aggregate reinsurance treaty, stable non-catastrophe loss ratio results, also a stable expense ratio, despite incurring some costs from our restructuring initiatives, strong premium growth once again driven by personal insurance, and improved investment valuations with virtually no impact form other than temporary impairments. This will be back in the black, and we think we’re well positioned from improved results going forward. This morning I’ll discuss operating highlights, and Steve will review the components of our book value growth, the details of investment income results, and the positive impact we’ve experienced from our aggregate reinsurance treaty. Catastrophe results were the lowest we’ve experienced in the third quarter, since in the past seven years; partly from favorable whether and partly from the application of the reinsurance treaty. Our Catastrophe experience for the quarter was actually 5.2% before adjusting for the reinsurance recovery from the aggregate treaty, which reduced our net cap loss ratio to 3.6%. Non-catastrophe loss ratio results were elevated a bit relative to the third quarter of last year, but relatively stable on a sequential basis. Personal automobile loss ratio results, both standard and non-standard increased as did our ex-catastrophe loss ratio for commercial multi-peril for CMP. Personal auto loss ratios were up despite flat peer premium trends. We need more price, particularly for physical damage coverage, and we’re getting it. In the third quarter we earned a 1.3% increase on our standard personal automobile book, and a 3.6% increase on our non-standard auto book, and our plan costs for somewhat higher priced increase is through the end of the next year 2010. Our ex-catastrophe property results benefited this quarter, from our return to our more normal large loss experience in both personal and business insurance. All property lines improved with the exception of CMP where we had some adverse developments on prior year losses. All-in-all, we are pleased with our loss ratio results, but need more prices to improve margins and better anticipate the longer term prognosis for higher levels of inflation, which will increase their costs for repairing cars, properties and people. As I’ve said, we’re making good progress on the pricing front. In personal auto we continue to increase prices. In the third quarter, 3.3 percentage points of our written premium growth is attributable to price increases, compared to just over 2% last quarter. We expect this percentage will continue to increase modestly, as we trial and earn out price increases, and continue to file for new increases in the mid single digit range. We’re obviously much more aggressive pricing in the homeowner’s line. In the third quarter, over 5% of our growth is directly attributable to price increases. In addition, we’ve implemented 10 state rate changes this quarter, which will increase rates going forward by over 7%, and next year plan calls for another round of net increases, aggregating to over 10 percentage points. In addition to price increases, we’ve taken several other actions to improve results in this troubled line. Mandatory win and held deductibles are now in place for a third of our operating states. An aggressive insurance to value program went live in all states this past quarter. We’ve implemented commission reductions which will take effect the first of next year, and we’ll introduce our new bi-peril homeowner product in Missouri by the end of the year. In business insurance we continue to make good progress in stabilizing our pricing, and positioning us for increases in the future. For this quarter our premium for exposure on renewing policies with flat up 0.1%. Commercial order remained quite competitive, but we’re getting increases on property, liability and bought lines, using our new predict to modeling technology which we call Quest. We’re pleased with how we can both get the price increases more surgically, and still experience relatively high levels of retention. Our goal is not just to get price increases, but to get those price increases on a retained book of profitable business. So far we’ve been able to do that with minimal disruption. Premium growth and personal insurance continued to be strong, though we expect it to moderate somewhat in the future, partly because of the economy, and partly because the year-over-year comparisons will become more challenging. Our growth is driven by price increases and new growth and expansion states. Our exposure growth in our core states of Ohio, Indiana and Kentucky is actually flat for auto and home owners, which is consistent with our strategy to diversify our business geographically. We continue to leverage our net express technology and have once again increased core activity by 60% on a year-to-date basis, utilizing both our net expressed technology and increased automated bridging solutions. Business insurance production once again declined in the third quarter. While retention is down a bit, more significant as they lower flow of new business, and the increasing impact of the economy on our premium basis. We see it most in the casualty lines. Property oriented classes are holding up reasonably well for commercial auto, liability and workers compensation, all are down as we experienced lower levels of vehicles, sales and payrolls. Since our industry is a bit of a lagging indicator for economic growth or economic retraction, we expect these trends to continue for several more quarters. On a more positive note, we implement above choice, our enhanced business owner policy this past quarter in Utah. With the ability to attract more classes such as auto service companies, contractors, restaurants and manufactures, these products strengthens our ability to write more casualty oriented risks, and it leverages our investment and physically rests our web based rating portal. Assuming a successful 90 day pilot in Utah, we will introduce the Bob (ph) choice products, into virtually all states in the first half of 2010. Expense ratio results are once again relatively flat with last year. We incurred higher levels of expenses in the quarter related to the restructuring of our field in claim operation. These expenses primarily relate to severance relocation, and duplicated rental cost as we shift geographic locations. As said in the past, these are investments in the future. We expect to see a positive impact on our expense and loss ratio result beginning next year. With that, I’ll turn you all over to Steve English.

[Steven English:]

Thank you, Bob. As Bob mentioned our book value per share increased substantially during the third quarter, fueled by continued improvement in fixed income and equity valuation. Of the $1.36 per share increase for the quarter, other comprehensive income contributed $1.16 per share. Earnings of course added $0.33 per share, while dividends reduced book value by $0.15 per share. On a statutory basis, STFC’s insurance subsidiaries, statutory surplus now stands at $762 million. Both domestic and international equity markets rose during the quarter, and fixed income security valuations improved as yields fell. We continue to hold high quality investments with no significant change in the overall ratings of our portfolio. The quarterly results included net realized gains of $3.6 million, offset by $900,000 of other than temporary impairment losses, primarily related to one large cap industrial equity security. Net investment income improved sequentially for the second quarter in a row, as we continue to invest our funds. This quarter reflected a full quarter’s income on the affiliated notes, plus improved performance of our chip bonds. Year-over-year though, net investment income continues to trail 2008 due to chips performance, lower dividend yields, and short term money rates. To update you on our cap aggregate treaty, through September 30 we estimate we have almost $101 million of qualifying claims on a group basis, after taking into consideration the 25% co-participation in the cooling impact, STFC recorded $4.9 million of seeded losses in the quarter, which reduced the net loss and loss expense ratio by 1.6 points. On a year-to-date basis STFC has recorded seeded losses of $12.5 million, reducing the net loss and loss expense ration by 1.4 points. As our estimates stand through September, $20.8 million of the $30 million limit has been used. As a reminder, the $30 million limit of which we participate 25% in, sets a top an $80 million aggregate retention. We have a $5 million franchise deductible and the aggregate covers PCS numbered caps, excluding earthquake and named storms such as hurricanes or tropical storms. Consistent with each quarter this year we have recorded taxes based upon our actual results on a year-to-date basis, rather than an estimated tax rate for the year, due to the uncertainties surrounding making a full year estimate. With that, we’d like to open up the line for any questions you may have.

[Operator:]

Our first question comes from Joe DeMarino with Piper Jaffray.

[Joe DeMarino:]

Thank you. Good afternoon or good morning. My first question, correct me if I’m wrong, but I’m looking at your balance sheet and your net loss reserves, and it looks like year-over-year your net loss reserves are fairly flat, but when I look at your net or your new risk written, it looks like it’s up some 8% year-over-year. So my question is, in a soft market that we’re in here, you’re adding additional risk, yet your reserves it seems year-over-year are flat; is anything I missing here, correct me if I’m wrong I guess, but…

[Steven English:]

Yes. I think what you are perhaps missing is the fact that 2008 we had significant property CAT claims that we’re settling, and those are running off this year.

[Joe DeMarino:]

Okay, anything else?

[Steven English:]

I don’t think there is anything else unusual in those trends.

[Joe DeMarino:]

Okay, and I guess moving on here, to the commercial aspect or commercial side, you maybe already said this, but what does your premium per exposure look like in the commercial side; is that a rate flat per exposure or are they down still?

[Bob Restrepo:]

Pricing, overall is flat, it’s up 0.1%. It varies somewhat by line. Pricing is still down somewhat in commercial automobile, pretty flat in workers compensation and we’re beginning to get price increases on a total quarter basis. Its not reflective in our results yet, but going forward we’re getting price increases in the low single digit range for our property liability and prop classes, again using our new predictive modeling technology.

[Joe DeMarino:]

Okay, do you see the declining exposures bottoming soon?

[Bob Restrepo:]

No. It may bottom in the next couple of quarters, but for the past couple of quarters we’ve been in a net deficit position in terms of our premium audit returns and we settled those up 12 months after the inception data of the policy. So as I indicated in my prepared remarks though, we’re a lagging indicator. So even if the economy turns around or stabilizes, its going to take several quarters for us to fully reflect that in our renewal premium basis, as well as in our audit results, so we continue to see negative effect on our premium basis and on our top line commercial lines for several more quarters. Anecdotally talking to our agents, we’ve spent a lot of time talking to our agents. It’s a mixed bag. There are some areas that feel that they are approaching bottom. There is other areas where they are uncertain. There is a lot of anxiety and uncertainty out there, but we definitely don’t see any pick up in our premium basis for sometime in the future.

[Joe DeMarino:]

Certainly not from new business creation I would suspect?

[Bob Restrepo:]

No, and we’re hearing anecdotally, it’s affecting annual business flow and our independent agents aren’t seeing much new business either. I think everybody is kind of battling down the hedge, so the new flow for our agents affects the new flow that we’re seeing. We are up like 1% in business insurance, and it hasn’t really affected the new flow yet in personal insurance, but clearly had an effect on our commercial lines.

[Joe DeMarino:]

Okay, thank you, and just one last question; are you concerned with inflation at all, in particular how it relates to workers comp line and if at all any loss cost there?

[Bob Restrepo:]

The answer is yes, we are concerned, we don’t expect to say it for the next year or two, but we definitely are concerned about the impact of inflation as I said on fixing cars, fixing properties, and on the medical cost related probably injury. It affects not just our workers compensation. It has an equal effect on probably injury plans that we settled for our automobile claims and for general liability. So it’s not just a workers compensation phenomenon; it’s really across the board.

[Joe DeMarino:]

Okay great. Thank you. That’s all I have.

[Operator:]

Our next question comes from Michael Phillips with Stifel Nicolaus.

[Michael Phillips:]

Thanks, good morning. Does the claim organization have any impact on your loss ratio going forward, and if so how do you quantify that?

[Bob Restrepo:]

It’s an excellent question, Mike. It definitely has an impact on our loss ratio results, both in terms of the expenses relative to adjudicating claims, and also the speed and quality with which we settle claims. A big focus on the initiatives that we’ve had underway for the last year, so that we call innovate or innovate state auto has been on the claim areas. There is also a big impact on our underwriting sales organization as well. So we’ve really been looking in our claim operation for how we can reduce their dependence on third party appraisers which costs more, and also contribute to leakages. When you look back, you could settle that claim for somewhat less, and when you depend on third party appraisers, there is always some leakage. So we have initiatives underway to significantly reduce their dependence on third party appraisers for our day-to-day property and automobile insurance claims, and we’re bringing in-house as much of the CAT work and large property work as we can. We’re also tightening up our oversight of automobile appraisers for centralizing that. We also are rapidly building out what we call a house council. Our biggest single claim expense is legal expense. We want to bring more of those expenses in-house and our cost profile is significantly less. We’re expanding from 14 offices over the next 18 months. We’re about half way through that build out cycle, but expect to complete it next year. We have a whole host, if I talk for another 15 minutes, a whole host of claim initiatives under way and when we talk about the three to four point improvements in our combined ratio going forward as the result of the (Inaudible), about 60% of this minimum will come from improvements in our claim operations.

[Michael Phillips:]

Okay, I guess it’s my impression that a lot of that three to four points is the expense ratio side, is that correct?

[Bob Restrepo:]

It’s a mixture of expenses and loss ratio improvement. Much of the expense, in fact virtually all the expense related to settling claims is embedded in the loss ratio. So we look at it both as under writing our general acquisition or commission or premium tax expense, but we also look at the loss adjustment expenses embedded in the loss ratio. So I say it’s going to improve that loss ratio. I’m talking about the expenses related to our loss.

[Michael Phillips:]

Okay, good. Any sense do you have Bob, either for your own self or just for your competitors, how the change may kind of the investment horizon has impacted or might impact the speed at which we’ll see a turn in the industry rates.

[Bob Restrepo:]

Well it happened. Partly we’ve had a recovery, we didn’t follow it far, so we didn’t come back as much with the book value improvements we saw this year, but my guess is we’re kind of early on in the earnings cycle, but my guess is we’re going of hear a lots of positive investment, results and lots of book value improvements over the next couple of weeks. Now how that translates to pricing philosophy, I’ve not started. I can’t say that what we see in the industry, what we certainly see internally, particularly well in personal and commercial, but particularly in commercial lines is that despite fairly of the nine peer premium trends, the impact of several years of price discounts is really eroding margins, and it’s contributing to deteriorating acts at near trends. So sooner or later that’s got to play out, and sooner or later people have to respond to actually near trends that are performing sub standards, and the response to it maybe not as aggressively as we’ve seen back earlier this decade, but definitely response with tighter terms and conditions and more aggressive and increases in pricing. I think regardless of investments, most people who run operating entities within insurance companies are looking at their accident new results. When they are down, they got to figure out some way to respond to them regardless of what goes on in the investment world.

[Michael Phillips:]

Okay, that’s helpful. I mean it sounds like at least from your own book of business, any more positive investment horizon, it doesn’t change your rate actions that you’ve….

[Bob Restrepo:]

No, it doesn’t. What changes their rate needs is looking at the actual near trends and when they are above their targets.

[Michael Phillips:]

Okay good, thanks. Finally one personal auto on the growth, you quantified it, I think you said about 3.2 or just over that was from rate; can you quantify at all, how much of the personal auto growth was from new entry states versus the kind of the core states?

[Bob Restrepo:]

About 35% of our growth, and this was consistent with what we reported last year, was from expansion states, and we are trying expansion states we were in three to four years ago; Texas, Colorado, Arizona, Connecticut.

[Michael Phillips:]

Okay, when you say 35%, so when I look at that 16.5 personal auto that would have been flattish without those… I missed anything else?

[Bob Restrepo:]

And I haven’t done the math here, but my guess is it’s like five to six points.

[Michael Phillips:]

Okay. Alright, thank you very much.

[Operator:]

Our next question comes from Paul Newsome with Sandler O’Neill & Partners.

[Paul Newsome:]

Hi. I’m sorry, I got myself a little confused on the pricing, and I dropped in a little late, but if you look at your book in total, I know you are trying to achieve it, but where are you at on a total basis from a price perspective for sort of an area piece of your book? I apologies if I’m making you repeat that.

[Bob Restrepo:]

No, no that’s okay. From a personal automobile standpoint, in the quarter we had a written premium impact of 3.3%. While obviously earned is lagging behind that, we earned 1.3%. We had a written impact in homeowners of excess of 5%, and in the quarter for all in, for commercial line it was flat up 0.1%, and that’s again written premium impact, not earned impact.

[Paul Newsome:]

Okay, because I guess the concern is obviously even with the return to a better weather environment, you still could use a fair amount of rate. I mean what is your thought in terms of decelerating that effort?

[Bob Restrepo:]

Personal lines, I’ll talk about that. Those efforts have been underway and we feel very comfortable that we’re going to get ahead of that. For personal automobile, we’re charging rates that are in excess of what are loss development is right now. What we got to do is we need a year to earn that out. Homeowners were charging rates that anticipate our five year CAD average in addition to our non-cash experience. We think, again, if those are announced by the end of next year, we’ll have an earned premium increased that will accommodate that loss development. Commercial lines is a more complicated story. We’ve got different lines, and we also have a situation where our peer premium trends are still negative. Now there is exceptions to that as severity and property put large losses during the first two quarters as elevated, but on balance their peer premium trends are still negative. But as I said, we’ve had since 2004, prices have been in decline for us as well as for the industry, and no matter how the peer premium trends are trending, we need more price to respond to the margin compression and also to anticipate inflation down the road.

[Paul Newsome:]

Could you give us an update as to some of the properties that are sitting at the mutual parent company, and any thoughts on when if and if they are going to be coming down into the pool?

[Bob Restrepo:]

Specifically, I think you are talk about Rock Hill, a specialty company.

[Paul Newsome:]

Yes.

[Bob Restrepo:]

Well, we have been giving that a lot of thought Paul, and I think we’re going to be in a much better position, either at the end of next quarter’s call or early next year to spell out a much more specific strategy of how that acquisition, which we just completed in July, will affect or not affect the pool going forward, but we’re not in a position right now to kind of tick and tie the business that are going to be in pool of businesses. We won’t be in the pool, but over the next six months which should be.

[Paul Newsome:]

With regard to that’s just the case it doesn’t look like it’s going to be next year, because you don’t recall the pool resets at January 1?

[Bob Restrepo:]

Not really. If we wanted to make a change, it hasn’t been our practice, and the account around here would prefer that it be, but other than that, there is no reason that we could make a change that wasn’t at year end.

[Paul Newsome:]

Thank you.

[Operator:]

At this time there are no further questions in queue. We just had one more question coming in the queue, I’m sorry. Our last question is from Mike Phillips with Stifel Nicolaus.

[Mike Phillips:]

Thanks, yes two quick follow-ups. If anything to make on that pretty nice drop off in the severity for BI, is it one quarter normally or well it’s kind of a pretty big drop, what happened there?

[Bob Restrepo:]

Yes, I’m looking to Matt Mrozek, our Corporate Actuary.

[Matt Mrozek:]

On that rolling twelve month basis, if you had recalled last year to the middle of ‘08, we had some increased severity, which at the time were just a couple of quarters, but since that’s in the comparative, we’re seeing this relative decrease flowing through in this current trend. It has more to do with how high we were on the BI severity, Q2 and Q3 in 2008. Overall current trends are much closer to flat for BI severity.

[Mike Phillips:]

Okay good, that’s helpful, and then last one Bob; you talked about how Rockhill might give you the ability to look at other acquisitions through Rockhill, and maybe and MGI type acquisition or something. If you’ve been looking at those how does that market look in terms of possible acquisitions going forward. Is it still something you’ll look at, are the prices still too hard or how does that look?

[Bob Restrepo:]

Yes, we’ll continue to look at MGA, MGU opportunities. Where we’ve been more successful is really hiring people, teams of people and then providing them the capital to start up businesses. So in the past year we’ve hired teams of people to enter the healthcare market in Rockhill, and by healthcare that’s not professional liability, its general liability in some property, but our focus is on casually. General liability related to healthcare institutions like Assisted Living facilities or medical clinics, not hospitals. We’ve also been building out environmental liability business, we’ve entered the DNO business by hiring an excellent group of underwriters, and we’re also looking at building out an alternative risk transfer of business as well by again hiring a terrific team of people.

[Mike Phillips:]

Okay, thanks Bob.

[Operator:]

At this time there are no further questions in queue.

[Bob Restrepo:]

Okay, well thank you Tom. We want to thank all of your 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 fourth quarter earnings call, which is currently scheduled for February 18, 2010. Thank you and have a nice day.