State Auto Financial Corporation
Q4 2009 Earnings Call Transcript

Published: 18 Feb 2010

[Operator:]

Welcome to State Auto Financial’s fourth quarter earnings conference call. Initially you will be in a listen-only mode. Today’s call is being recorded. (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, Diane. Good morning and welcome to our fourth 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 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 me 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 Web site 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. Results continued to improve. We are pleased to report an underwriting profit for the fourth quarter and a further increase in our book value to $21.33 a share. In the quarter we produced net income from operations of $0.36 a share despite $0.24 a share of charges for reserving for the settlement of a class action claim establishing a one-time valuation allowance to the North Carolina Beach Plan and recognizing additional expenses associated with our restructuring. We overcame this and made good progress in restoring underwriting profitability by increasing prices, and introducing a host of new claim initiatives. Our GAAP combined ratio for the quarter was 98.4%, it was inflated by 2.6 points by the class action claim resolution and the restructuring expense. We continued to implement our strategy of geographic diversification, accelerated product development, a new technology, which enables both ease of doing business and pricing discipline. These actions contributed to growth, which exceeded both the economy and the industry by a wide margin. We continue to develop our Enterprise Risk Management capability particularly as it relates to geographic concentration. Our aggregate reinsurance treaties did exactly what we wanted by addressing our greatest strategic concern of high frequency, low severity wind and hail events. We continue to manage our capital effectively. We maintain a very competitive dividend although we repurchased no shares this quarter under the share repurchase program, which expired in December. Beginning 2010, we will introduce changes to the pooling arrangement between State Auto Mutual and State Auto Financial Corporation. We recently received state regulatory approval to pool our non-standard automobile business, which we call State Auto National. Previously 100% of our non-standard automobile business was reported through STFC. Going forward, 20% of this business will be shared with State Auto Mutual under our pooling agreement. This change allows us to streamline our organization and provide more consistent results reporting. In addition, we will begin pooling a new specialty business in 2010. We expect this new business to increase commercial lines net premiums by approximately $30 million this year. This morning I will discuss our operating results in more detail, Steve English will then review the components of our book value growth, provide an overview of investments, and comment on reserve developments for the year. Our fourth quarter underwriting profit was helped by inconsequential catastrophe activity in the quarter and favorable catastrophe development from prior quarters and prior year. These trends are consistent with previous years. The net impact this year was a help of 0.4 percentage points compared to a help of 3.7 percentage points in 2008. On a full-year basis, net CAT experience was 7.7%, which is close to our five-year rolling average. Results improved substantially over the past two quarters thanks to mild weather. Our net catastrophe loss ratio results were generally good in the quarter. Personal automobile, which account for over 40% of our premiums benefited from relatively flat pure premium trends and increased pricing. Auto results tended to deteriorate for us a bit at the end of the year because of the winter weather. Reported results also include an increase of approximately 5 percentage points in the quarter due to allocations of loss adjustment expenses and salvage and subrogation. Without these reallocations, our results actually improved from the fourth quarter of last year. Year to date, 2009 results are comparable to 2008. We expect the underlying improvements from personal lines profitability, personal automobile profitability to grow as we continue to get price increases in the mid-single digit range. Homeowner results were influenced negatively by 12 percentage points in the quarter and 3.2 percentage points for the year resulting from the settlement of the class action claims related to homeowner property claim handling. We are confident in our risk selection capability for personal line and our strong agency relationships. We need more price and we are getting it. For the quarter, the all end impact of rate changes on our written premium growth was about 3.5% for automobile and 7% for homeowners. The earned impact lag was about 2 points for auto and 3 points for homeowners. As 2010 plays out, our earned impact rate changes will steadily increase and improve margins. Business insurance loss ratios were good despite continued soft [ph] pricing in a difficult economy. We saw improvements in the quarter and our non-catastrophe large loss experience particularly in the property, workers’ compensation, and general liability lines. We did manage an aggregate price increase for commercial lines of 1% for the quarter. The results primarily benefited from our ongoing underwriting discipline and negative pure premium trends. For the year, our net loss ratio improved from 2008 driven by lower catastrophe losses and improved large loss experience and general liability and commercial auto offset somewhat by the large fire losses that we experienced in the first two quarters of the year. 2010 promises to be a difficult year in commercial lines given the pricing and economic climate. We are getting more price, experiencing negative pure premium trends, and rolling out new claim initiatives, which will help us maintain results in business insurance. Expense ratio for the quarter was down relative to last year. Our current quarter and year-to-date expense ratios were impacted by internal restructuring costs while last year’s same period reflected costs associated with our innovate State Auto initiative that took place in the fourth quarter. Regarding production, our goal is always to tend to grow but to do it rationally. We define rational growth as outperforming the economy and the industry, and we did that in 2009 due entirely to our personal lines business. New business to personal lines remained steady and retention is stable. Premium growth is moderating primarily because year-over-year comparisons are more challenging, and the significant pricing actions that we are taking in homeowners has flattened our new business growth curve. Geographic diversification is the key part of our personal line strategy. For the quarter, the expansion phase of Arizona, Colorado, Connecticut and Texas accounted for 4.8% of our direct premium growth and 4% for the year. Disciplined pricing is also a critical part of our production and profit strategy. Price increases accounted for almost 30% of our personal lines growth in the quarter and 20% for the year. Taken together, over 50% of our growth is from states we were not in three years ago and from price increases. We continue to innovate our product portfolios at State Auto. In personal lines we pressed the marketing of our Prime of Life program, which targets mature households and it has been a profitable segment for us over the years. We introduced our new homeowners’ custom fit program, which includes bi-peril rating and predictive modeling pricing in Missouri and we will add ten states this year in 2010. This new product is critical to our efforts to make homeowners profitable and reduced earnings volatility. In business insurance, we introduced our new Bob Choice [ph] program in Utah last quarter and we will have the product fully deployed in 32 states later this year. Bob Choice is characterized by broader eligibility, predictive modeling, and point of sale quoting and processing. Over time, this product will not only allow us to remain competitive in the marketplace but improve our pricing precision and ease of doing business further leveraging and supporting the terrific relationships we have with their independent AC partners. The other new product initiative is in the alternative risk transfer business. As a reminder, State Auto Mutual acquired a specialty property in casualty company called Rockhill in February 2009. Since then, we have been integrating operations and identifying businesses to grow and eventually pool with the results of State Auto Financial Corporation. The first entry arrived in 2010 with a business we call Risk Evaluation and Design or RED. RED is in the alternative risk transfer business and works with commercial policyholders to retain a substantial amount of risk through a variety of vehicles such as reinsurance arrangements, captives, risk retention groups or stand-alone self-insured programs. The risks we assume here are typical of what we would write everyday in our Main Street business insurance portfolio. The only difference is the policyholder retains more risk than we traditionally see. First program we have written with RED is a restaurant program, which is almost entirely casualty. This business aligns well with our traditional risk profile and will contribute to our strategic desire to write more commercial and more casualty oriented business. We are looking at a number of other program opportunities with RED and plan to make substantial progress this year integrating Rockhill’s operations and possibly pooling more commercial specialty business next year in 2011. With that, I will turn you all over to Steve English. Steve?

[Steve English:]

Thank you Bob. As Bob noted, our book value per share increased to finish the year at $21.33 per share, a 10.9% increase over last year, and up from $21 per share at September 30, 2009. Book value growth for the year was driven by the rebound in the investment market, both as it relates to investments directly on our balance sheet as well as investments held by our pension plan. Throughout 2009, we stayed the course with our risk and capital management strategies to grow statutory surplus, preserve capital, generate income, and maintain liquidity. Accumulated other comprehensive income increased $94.7 million or $2.37 per share with a $1.76 per share coming from investments on our balance sheet and the balance attributable to improved valuations within our pension plan. Earnings added another $0.26 per share for the year offset by our $0.60 per share dividend. STFC’s insurance subsidiaries statutory surplus now stands at $796.7 million, an increase of 8% from last year. For the quarter, equity markets rose across all sectors in which we invest. The bond values declined as interest rates rose. As a result, during the quarter, we recorded net unrealized losses on investments totalling $0.17 per share. This was offset by the revaluation of our pension obligations, which increased book value per share by $0.28. The quality of our fixed income portfolio remains quite strong with over 97% rated A or higher. The duration of our fixed maturity investment shortened from 6.3 to 5 during 2009 with nearly half of our portfolio invested in tax-exempt bonds this result in a longer duration. Our strategy has been to reduce our concentration of tax-exempt bonds, which comprised almost 75% of the portfolio last year. In addition, we have about 6% of the portfolio invested in TIF bonds as a hedge against inflation. Reported net realized gains for the quarter were negligible but included write downs for other than temporarily impaired securities in the amount of $1.1 million. This included one large cap security in the energy sector, which accounted for $900,000. Net investment income improved over the fourth quarter of 2008 and was essentially flat with the third quarter of this year. Compared to the fourth quarter a year ago, net investment income reflected a full quarter’s income on the affiliated notes plus improved performance of our TIP bonds. For the entire year though, net investment income was lower than 2008 due to TIF’s performance, lower dividend yields, and short-term money rates. Direct (inaudible) on our CAT aggregate tree through September 30, we estimated a total of $101 million of qualifying claims on a group basis. At December our revised estimates resulted in one storm no longer exceeding the $5 million franchise deductible. We now have an estimated $93.7 million of qualifying claims again on a group basis. After taking into consideration our $80 million retention, the 25% co-participation, and the pooling impact, STFC recorded $8.2 million of seeded losses for the year, which reduced the net loss expense ratio by seven tenths of a point. For the quarter, we reversed $4.3 million of seeded losses, which was offset by favorable development of prior year and prior quarter CAT losses resulting in net CAT benefit of $1.3 million or $0.04 of a point. We have renewed the contract for 2010 with the same $30 million group limit. We did increase the $80 million aggregate retention to $90 million. The contract continues with a $5 million franchise deductible, 25% co-participation, and as a reminder covers PCS numbered caps, excluding earthquake and named storms such as hurricanes or tropical storms. To wrap up, I would like to cover our accident years’ development for 2009. In total, STFC recorded $56.2 million of favorable prior year development or 4.8 loss ratio points. $10.9 million related to 2008 and prior CATs or nine-tenth of a loss ratio point. This compares to $27.3 million or 2.4 points in 2008 with $6.4 million related to prior CATs or six-tenths of a loss ratio point. Of the $45.3 million non-CAT development in 2009, $10.9 million relates to loss adjustment expenses, $9.5 million relates to auto liability, personal and commercial combined, and $8.3 million relates to other and product liability, with the balance spread across several lines of business. In general, the development was driven by better-than-expected severity primarily from accident year 2008. With that, we would like to open up the lines to any questions that you may have.

[Operator:]

Thank you. (Operator instructions) One moment please for our first question, it is from Paul Newsome with Sandler O'Neill. Go ahead sir.

[Paul Newsome:]

Good morning, sorry if I missed this because I got on the call a little bit late, was there something unusual with the tax structure this quarter, and how should we think about the effective tax rate going forward?

[Steve English:]

Sure Paul. No, there was not anything unusual other than the mix of investment income relative to underwriting income. The investment income is effectively taxed just shy of 15% and that is a combination of the result of the level of tax-exempts we have. So, on a go-forward basis, you should look to tax your investment income at that rate and the balance at 35.

[Paul Newsome:]

And then a secondary question that is unrelated, from a pricing perspective, maybe you could just go into some detail as to what you think you need perspectively from a pricing perspective?

[Bob Restrepo:]

Industry wise, I will talk about homeowners, the exhibit A for price increase needs, I have seen industry data that indicates that homeowners in general is at least 20% to 25% underpriced. Our experience in Mid West would lead to indicate that using last year’s trends not what we have put in place during 2009 but where we started in 2008 that we are at least under priced and we expect to make that up, fill that gap in over the next two years. And we started in 2009, we expect that the earned impact and written impact will increase in 2010 and will continue into 2011. We are always obviously subject to regulatory review and in some cases approval. We also want to minimize regulatory reaction and disruption. So we are not looking to get it all in one year but we are looking to get it, and it will take us probably another 18 months to recover.

[Paul Newsome:]

Great. Thank you, I will let some other folks to ask questions.

[Operator:]

Thank you. Our next question then comes from Vincent D'Agostino with Stifel Nicolaus. Go ahead.

[Vincent D'Agostino:]

Good morning everyone. Just curious if there was anything that helped change your mind on bringing Rockhill into the pool earlier than previously expected, and then I just have a few follow-ups please.

[Bob Restrepo:]

Yes Vincent, we are not bringing in all of Rockhill. We are bringing in actually a new part of Rockhill that was being discussed during our acquisition, and as I said in my prepared comments, it was a class of business that we write everyday, in fact it is an eligible class as part of our new business owner product (inaudible) of the restaurant business and it is casualty oriented. The property business, by and large, is going to be placed in London, and it was the team of people that we felt very comfortable with, had a proven track record in this industry, and the program itself was in an existing book of business. So we were able to look at it, we knew exactly what the profit impact is going to be, what the premium impact was going to be, it was a mature book of business, so we felt very comfortable bringing that in. Now, the rest of the business at Rockhill that is both a mix of admitted and non-admitted business is profitable on the specialty commercial side, but we wanted another year or so to make sure that the reserves are adequate. We have every reason to believe they are more than adequate but we wanted to make sure that we had another year of seasoning before we made a decision to bring in part or all of that business.

[Vincent D'Agostino:]

Okay, that is most helpful. Then, it is possible to break up the 2.6 points from the restructuring charges and from the class action between the two?

[Steve English:]

Sure. On the class action that was in the quarter had an effect of 2.4% on the combined ratio year to date 0.6%, and then, on the restructuring in the quarter, it had two-tenth of a percent effect in four-tenths on the year.

[Vincent D'Agostino:]

Great, thank you. And then just lastly, just some frequency (inaudible) question, just kind of curious, the slight uptake that we are seeing on the collision frequency certainly makes sense with somewhat of a return to normal driving trends. But is there anything that you can speak to in terms of the offset and stark [ph] difference in BI frequency and severity that we are seeing in the last two quarters?

[Bob Restrepo:]

I will ask Matt Mrozek, our corporate actuary to comment on that Vince.

[Vincent D'Agostino:]

Okay, thank you.

[Matt Mrozek:]

The exhibit that is shared shows the rolling 12 month change in frequency of severities well, and the severity between BI and the (inaudible) gets a little wider on a rolling 12-month basis than what we would see as current trends and the severity also shows up in industry data, there is some ISO data that shows a bit of additional frequency on the physical damage side relative to the BI. So, in looking at that frequency, the negative 8.6% for bodily injury, if current trends are probably more in the single-digit negative likewise on the increased frequency for physical damage in the 5% to 10% range on exhibit, current trends are more in the 2% to 3% range. So there is some disparity, again driving trends may well be contributing to that, but I do not think the underlying trend difference is as wide as what is reflected in the rolling 12-month change.

[Vincent D'Agostino:]

Is there anything geographic that is causing the comp to jump up to the 9.5 reported in the quarter?

[Matt Mrozek:]

No, nothing geographic, and this is a rolling 12 months so you do not have the same effect of a heavy recent quarter that should be somewhat normalized using a rolling 12.

[Vincent D'Agostino:]

Perfect. Thank you so much, that was all my questions.

[Operator:]

Thank you. At this time, there are no further questions. (Operator instructions) Our next question comes from Paul Newsome again with Sandler O'Neill. Go ahead.

[Paul Newsome:]

Great. Follow-up on capital and buybacks, if you could talk a little bit about how you feel about your current capital position and what sort of potential is there for stock repurchases?

[Steve English:]

Sure Paul. I would say it is a moment when we look at various leverage ratios, you know, RBCs, BCAR, those types of capital adequacy type measurements, we continue to want to retain that A+ ratings, so we are very careful [ph] in the amount of capital we have. We believe at this point with some of our business plans in bringing in this new RED business as well as other potential business from Rockhill at the moment there is no plans to renew or institute an additional share purchase program.

[Paul Newsome:]

Is it true of the mutual period as well, are they considering stock repurchases, and is there, I assume just from my cursory look that their capital position is a lot better than their subsidiary.

[Matt Mrozek:]

Are you asking is the mutual company going to change its ownership level in the public company or are you asking something about the mutual company’s capital structure by itself? Because you cannot buy, there is no stock to be repurchased as a mutual company.

[Paul Newsome:]

No, by the public company.

[Matt Mrozek:]

No, at this point in time, there is no plans to change the relative ownership.

[Paul Newsome:]

Okay, thanks.

[Operator:]

Our next question comes from Matt Rohrmann with KBW. Go ahead and ask your question.

[Matt Rohrmann:]

Bob and Steve good morning.

[Bob Restrepo:]

Hi Mat.

[Steve English:]

Good morning.

[Matt Rohrmann:]

Just two questions, first on the RED segment, will that change the reporting at all, will that be its own line or how would that be lumped into the business?

[Bob Restrepo:]

It will be reported in on a line of business basis and you will probably see most of it pop up in the liability line.

[Steve English:]

Although at some point, based on size, we may down the road have to break that out separately.

[Bob Restrepo:]

But you are not going to see any change in that business for sure.

[Matt Rohrmann:]

Okay great, and then Steve, I just want to double check on what you said on the reinsurance plan, basically just the aggregate limit moved from $80 million to $90 million and other than that it is pretty much same terms and conditions as previously talked about.

[Steve English:]

Exactly.

[Matt Rohrmann:]

Alright, great, thanks a lot guys.

[Operator:]

At this time, there are no further questions.

[Steve English:]

Okay, well, thank you Diane. We want to thank all of you 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 April 29, 2010. Thank you and have a nice day.