State Auto Financial Corporation
Q1 2010 Earnings Call Transcript

Published: 29 Apr 2010

[Operator:]

Welcome to the State Auto Financial’s first quarter 2010 Earnings Call. Initially you will be in listen-only mode. Today’s call is being recorded. If you have any objections, you should disconnect at this time. (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:]

Good morning and welcome to our first quarter 2010 earnings conference call. Today I’m 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; Chief Actuarial Officer, 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 website, www.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, Bob Restrepo.

[Bob Restrepo:]

Thank you, Steve, and good morning, everyone. We had a solid first quarter and we’re pleased to report an underwriting profit, an increase in our book value to $21.65 a share and further improvement to our trailing 12-month return on equity results. We continue to work towards a double-digit ROE and a result of 4.6% demonstrates the progress we are making. For the quarter, we produced net income from operations of $0.27 a share, despite $0.11 a share for charges resulting from the recently passed Federal Healthcare Reform legislation which eliminated the tax benefit related to Medicare Part D subsidies. Our GAAP combined ratio for the quarter was 99.7%. Overall, we are pleased with the improvement we see in our personal automobile business and the solid results we produced in business insurance. Our 2010 first quarter results were also helped by a return to historical levels of catastrophe losses for the first quarter. We normally experience a 3 or 4 percentage point impact from catastrophes in the first quarter. 2008 and 2009 were outliers with excessively high catastrophe loss ratio results. Our first quarter this year result of 3.3%, is consistent with normal and expected trends. We still want to improve on underwriting performance in homeowners. Although catastrophe and large loss experience was normal relative to previous year's trends, a non-catastrophe weather related experience produced an unsatisfactory ex-catastrophe loss ratio result. We expected its bit of an anomaly and remain confident that we have the right plans in place to attain profitability in this line. This morning, I'll discuss our operating results in a bit more detail, Steve English will then comment on investment performance and the balance sheet. Our overall underwriting profitability is highly dependent on our personnel automobile business. Improved loss experience, benign pure premium loss cost trends and increased prices all contributed to better loss ratio performance. Frequency is up a bit, but pure premium trends remained in the low single-digit area. In the first quarter, we achieved a 4.3% price increase, which accounted for a third of our written premium growth in the personal auto line. Success in the homeowners' line is driven by spread of risk and price adequacy. We are making progress on both fronts. Over a third of our homeowners' growth is coming from four states where we had no presence three years ago. Almost 50% of our overall premium growth is coming from price increases, which were up over 9% and will continue to increase throughout 2010. Taking together these two drivers account for approximately 90% of our total homeowners' growth and a good leading indicator of improved loss ratio performance on both the non-catastrophe and catastrophe front Homeowners’ large loss activity is down significantly from last year, but remains slightly elevated relative to historic trends. The economy must be a factor. We have new underwriting tools and processes in place to identify prospective foreclosures and to take the appropriate underwriting actions. The most significant impact on our first quarter homeowner profitability was non-catastrophe weather events. Specifically, our non-catastrophe weather loss ratio was 10 to 15 percentage points higher than normal trends. The states of Maryland, Ohio, Pennsylvania and West Virginia were significant contributors resulting from bad winter weather and heavy snow. All in all, the weather has somewhat masked the underlying improvements we have made to our homeowners' business. We expect low double-digit price increases by the end of this year. Retention is holding up extremely well despite these price increases, which indicated that our competitors are also acting particularly in the Midwest and the Southeast. We are also making progress with our insurance to value program, and we now have mandatory wind and hail deductibles in 13 states, and will implement these deductibles in another four states over the next 12 months. A new by-peril rated homeowner product, which we call homeowners' custom fit, has performed well in the pilot state of Missouri. This year we will roll out this new product in 10 additional states. As a reminder, homeowners' custom fit increased their pricing precision by better accepting the loss potential of the homeowner through predictive modeling techniques in the property itself by accessing the loss potential for multiple perils including fire, wind, hail and water damage separately and pricing for each appropriately. This approach helps to remove subsidies, provide for better spread of risk and helps us to achieve an adequate price. We expect all these actions to reduce their ex-catastrophe loss ratios to under 50% and over time reduce the aggregate impact of catastrophes on an underwriting profitability. In business insurance, loss ratios improved on the catastrophe and non-cat basis. Catastrophe experience was 4 percentage points and on a non-cat basis we saw lower large loss activity in the commercial automobile and fire lines. Last year's first quarter results were plagued by several unusually large fires. Commercial multi-peril liability and workers' compensation loss ratio results were elevated somewhat due to an increase in large loss activity. Our experience is these lines are typically volatile, quarter to quarter, given the relatively low premium volumes. We have no reason for concern in these lines. After two quarters of modest price increases, we did see a modest reduction of less than one-half of percent this quarter for pricing. The same time pure premium trends were down in the mid single digit range driven by significantly lower frequency, offset somewhat by higher severity. We continue to view this year as a difficult one for commercial lines. We won't see the economic recovery on a premium basis until well after it actually happened. In addition, our agents throughout the country reported continuing lack of confidence among their clients regarding the economy. Those that have survived the economic downturn are conserving cash, making few investments in the future and aren't expecting much of any increase in hiring. This clearly has also had an impact on pricing. We saw an increase in competition this quarter, particularly in the middle market. We don't expect to see much relief on either the economic or pricing front until the end of the year at the earliest. Production in our business insurance lines is off a bit on a policy count basis and down 6.2% in the aggregate, resulting primarily from lower premium basis. These results are offset somewhat by the addition of our new alternative risk transfer business. Risk evaluation and design, or RED, is managing general underwriting organization, which is an affiliate of State Auto Mutual. 80% of the underwriting results of this business will be included in the results of STFC. The first program is a group of restaurants. Most of the business is casualty oriented and is included in our commercial multi-peril results. Beginning with second quarter results, we will also be including our second new program, which is also casualty oriented and will increase our commercial automobile production by approximately $30 million this year on a net written premium basis. Throughout the rest of this year, we will continue to evaluate our specialty business and determine what if any is ready to be included in our pool results next year. This is our standard practice. We don't plan to make any changes to the pool until the beginning of a new calendar year. A reminder, our specialty insurance portfolio includes admitted specialty lines, non-admitted specialty lines and a Monoline workers' compensation business. Our expense ratio results are essentially flat relative to the first quarter of last year. We continue to make excellent progress with their field and claim organization and our other initiatives. We are confident that we will begin to see the financial benefits of this later this year. At this point, they're masked somewhat for a variety of reasons. First we continue to incur implementation costs related to severance, relocation, terminated leases and enabling technology initiatives. In addition, the deferred acquisition cost accounting rules delayed the realization of some benefits that we have already achieved in our case particularly with commission reductions and better management of underwriting report expenses. Last week, the net staffing reductions that we expect from our underwriting sales and claims initiatives won't be fully realized until the end of this year or early next year. So far though, we are very much on track and we expect to see bottom-line benefits in both their expense ratio and loss ratio, beginning as we finish this year. With that, I will turn you over to Steve English.

[Steve English:]

Thank you, Bob. For the first quarter of 2010, our reported book value per share is $21.65, up 1.5% from December 31, 2009 and 12.7% from March 31, 2009. Our high quality and conservative investment portfolio continues to provide income while protecting our capital. During the quarter, investment valuations improved as the equity markets were up and interest rates were relatively unchanged with tightened spreads. Compared to a year ago, investment income in the quarter increased $2.2 million, primarily as a result of improved tips performance. The duration of the fixed income portfolio is 4.8, down slightly from December's duration of 5. Net realized gains on investments totaled $3.2 million compared to a year ago, when we reported net realized losses on investments of $11.3 million. Significantly, lower levels of other than temporary losses and current period gains on securities sold and called were the primary drivers of the improved results. The statutory capital of STFC's insurance subsidiaries now stands at $787 million, down from $797 million at December 31, 2009. This decline includes a $40 million extraordinary dividend out of State Auto National, our non-standard auto company which has been declared and recorded. Having just recently received regulatory approval for the dividend, we intend to redeploy a substantial portion of these funds into another STFC insurance subsidiary while retaining a portion of the funds to finance holding company interest. Our overall effective tax rate for the quarter was 37.3%. In this quarter's provision we recorded $4.5 million of deferred tax expense, relating to the impact of the Patient Protection and Affordable Care Act of 2010, due to its treatment of the Medicare Part D subsidy. The remaining provision is based upon an estimate of our annual effective rate. And with that we would like to open the line for any questions that you may have.

[Operator:]

(Operator Instructions). Our first question comes from Mike Phillips, Stifel Nicolaus. Your line is open.

[Mike Phillips:]

Bob, first of all, can you just give a little more detail on the new program going into RED next quarter, the commercial auto you talked about?

[Bob Restrepo:]

The second program is transportation related trucking. 70% of it is in the short and medium term. It's mostly small to medium size businesses. A very little of it is owner operated and it's been a program that been in place for some time and were very comfortable with the quality of the business and the quality of the results. And it's kind of typical of the kind of business that we are looking for over the short-term. The term we like programs or opportunities like that that will offer a lot or little, we are not looking to make big bets on larger organizations. We'd like to stick to our traditional profile of small-to-medium size businesses and we want to better balance our overall risk portfolio by having more commercial business and more casualty-oriented business. And then second program, it's very consistent with our strategy in the alternative risk transfer business.

[Mike Phillips:]

So it sounds like a lot like a restaurant in word, lot of high retention on the actual [conservative], is that true?

[Steve English:]

High retention?

[Mike Phillips:]

Yeah.

[Bob Restrepo:]

In this case they all vary. In this case there is some retention. It is very similar to the restaurant program, yes. The structure of the different programs can vary. In this case it was the case with the restaurant program as the reinsurance arrangement. There may be other program down the pipe that we are dealing with organizations that are grouped together as [cactus] or risk retention group. In this case, the risk from risk retention the part is obviously members, our arrangement is the reinsurer.

[Mike Phillips:]

Two quick accounting numbers type question. The other restaurant one, was that turned into your C&P line this quarter?

[Steve English:]

The restaurant program is in our C&P line, the second program you will see in our commercial automobile line.

[Mike Phillips:]

And then the [non-centered] auto drop, is it because of the point change?

[Steve English:]

Yes, essentially.

[Mike Phillips:]

Most of the drop, I guess.

[Steve English:]

Yes.

[Mike Phillips:]

I guess, Bob, can you update us on your thoughts of -- you talked a lot about your goals for improving combined ratio over the next couple of years, can you talk about how you feel if it happened and I think your goal was at the end of 2011 for about a 3 to 4 point improvement, just kind of update us on that?

[Bob Restrepo:]

It's still very comfortable with the fact that we're still working towards a 3 to 4 percentage point improvement in our existing business, our core business. That doesn't include what we are doing in specialty. It doesn't include with what we are doing with alternative risk space. And roughly speaking, we expect to see about 60% of the improvement embedded in our loss ratio, both allocated and unallocated loss adjustment expenses and roughly speaking about 1.5 on our underwriting expense ratio.

[Mike Phillips:]

Just a reminder, that's an improvement relative to what year or what kind of base?

[Bob Restrepo:]

Relative to the baseline that we had at the beginning of 2009.

[Operator:]

Our next question comes from Matt Rohrmann of KBW. Your line is open.

[Matt Rohrmann:]

Just wondered Bob, could you just quickly talk about some more color on the loss trends that you are seeing on the business insurance side.

[Bob Restrepo:]

Matt, could you repeat that. It was little fuzzy?

[Matt Rohrmann:]

I was just trying to see if you could give me a little more color on the loss trends that you had touched on earlier on the business insurance side?

[Bob Restrepo:]

I think it's very much related to the economic downturn. We are just saying, particularly in the casualty line, a lot of policyholders who are parking cars in the garage taking a lot of policy, they are not driving as much. There is not as much business activity from an appointment standpoint, which affects frequency and workers' compensation and so the overall sales are down and hence just overall business activity. That things maybe picking up and I am hearing and [reading] that in a retail space, some people are starting to spend dollars, so maybe we'll start seeing a pick-up of things like slip and falls, but we just haven’t seen it. So there has been increasing cost of repairing buildings and cars and people continues to increase, but in the aggregate I just think the economic climate is such that lower business activity has translated into lower frequency, not going to stay like that forever, but that's in the track we have seen for the last 12 months.

[Matt Rohrmann:]

Steve, just two numbers, were there any share or was there moves in the quarter?

[Steve English:]

In the terms of share repurchase you mean?

[Matt Rohrmann:]

Yeah, that's correct.

[Steve English:]

That program has now expired. So there is no authorization and in terms of reserve shifts, we still are holding the same level of reserves as we measure it in terms of the confidence level and I would tell you that even though we typically annually disclose development that the development is along the consistent lines with what we saw in the prior year.

[Operator:]

Your next question comes from Caroline Steers with Macquarie.

[Caroline Steers:]

What was the rate increase in homeowners that you had mentioned?

[Bob Restrepo:]

The price increases, Caroline, is what we have filed for. This is what we have actually booked, as part of written premium for homeowners was over 9%.

[Caroline Steers:]

On advertising spend, how much do you usually spend on advertising? Do you expect that to change at all this year versus last in personal auto?

[Bob Restrepo:]

Our advertising spend is not material. In fact, it's not even material from a budgeting standpoint, it doesn’t register and one of the things we will be looking at with our Board over the next 12 months or so is just how do we position ourselves from branding and advertisement going forward. But we don’t expect any significant change to our currently exceedingly low advertising spend over the next year and half.

[Caroline Steers:]

Finally, on commercial lines, if you could just comment on around the difference between new and renewal business right now in terms of pricing? That would be great. Thanks.

[Bob Restrepo:]

It’s not substantial different, which is one of the reasons that new business flow is fairly anemic right now. Some of it is the economy and some of it is the fact that we won’t go as low as some of our competitors will be and attracting new business from [open to reach] but it clearly had an impact in our new business, which is down fairly significantly, particularly, when you compare it to the what we have been able to accomplish on the personal lines. So, it’s roughly comparable renewals as well as new business.

[Operator:]

Our next question comes from Matt Rohrmann from KBW.

[Matt Rohrmann:]

I just have one follow-up. Bob, just want to get your thoughts on, if you have been seeing anything new in the M&A market and if you guys expand through your RED programs in to the auto segment, maybe other specialty lines down the road do those type of companies become more attracted to you?

[Bob Restrepo:]

First of all, there is still some activity out there. There are companies that are “exploring strategic options and looking for respective buyers and partners”, but right now I think we are seeing more exploring than actual activity. We are frankly pretty cautious right now and our focus is really exploiting and leveraging the investment that we have made last year in the Rockhill Insurance Group, which is really three very different sizes of opportunities. The specialty business, the workers’ compensation business and alternative risk transfer business. So, our focus in primarily on that, M&A opportunities that we see most attractive to us would compliment our growing presence in that space and so we are open to managing general agency and managing general underwriter opportunity, which are more distribution investments, where we are can also assume some risk. There are less risky. There are less expensive. So, we shifted our focus more to that end than what we have been doing over the past several years we just looking to acquire or affiliate with insurance companies. Still open to that, but our focus is more on how we can build out the distribution to support what we are doing in a specialty insurance space.

[Operator:]

I’m showing no more questions in queue.

[Steve English:]

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 second quarter call, which is currently scheduled for July 29, 2010. Thank you, and have a good day.

[Operator:]

This does conclude today’s conference call. We thank you for your participation and you may disconnect at this time.