State Auto Financial Corporation
Q3 2010 Earnings Call Transcript

Published: 2 Nov 2010

[Operator:]

Welcome to the State Auto Financial’s Third Quarter 2010 Earnings Conference Call. Initially, you will be in 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, William [ph]. Good morning and welcome to our third 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 Actuary 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 are 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 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, good morning. The third quarter State Auto Financial Corporation reported net income of $200,000 up $21.18 book value was up from the second quarter, but remains below year-end 2009. GAAP combined ratio was higher than the third quarter this year relative to last year. In particular, our loss ratio was higher due to an increased level of catastrophe loses and an unusually high frequency of large liability losses particularly in the commercial auto line. These negative trends were offset somewhat by improving personal insurance results and a better expense ratio. Net income in the quarter was also hurt by lower levels of investment income. The STFC GAAP combined ratios for the quarter was 105.9% compared to 102.5% last year. Virtually all the difference resulted from Linden Hill catastrophe losses. Catastrophe experience was somewhat better in personal insurance, business insurance was hurt by large losses, which we define as losses in excess of $100,000 which added approximately 3 percentage points to our total combined ratio and almost 9 percentage points to our business insurance loss ratio when compared to the third quarter of last year. The lines most affected were commercial auto, fire and general liability and I’ll provide a bit more color later on in my commentary. Year-to-date STFCs GAAP combined ratio improved to 106.9% relative to last years 108.3% with modest improvements in catastrophe experience, our non-cat loss ratio and the expense ratio. From personal lines we are pleased with the continued improvement in our critical personal automobile line. Our third quarter loss ratio improved 3 point, 4 point and on a year-to-date basis 3 point, 5 points, as we earn out price increases implemented over the past year or so. In addition, improvements to our claim processes improved results in our loss adjustment expenses. All then for personal lines, we’ve seen an improvement of over a 4-point, year-to-date to our personal lines loss ratio. Personal auto premium growth has moderated somewhat but mostly because of the significant pricing and underwriting actions that we’re taking in the homeowners line. Growth in our standard auto line was up 5.2% for the quarter and 8.3% year-to-date. Most of the personal auto growth in the quarter came from price where the written premium impact was up 4.7%. The balance of the growth came from the expansion states of Arizona, Colorado, Connecticut and Texas. Policy account production and all the other things was flat. Homeowner results were hurt by higher levels of catastrophes than we usually see in the third quarter when we exclude the impact from hurricanes. Wind and hail in the Green Bay Wisconsin and Minneapolis, Saint Paul areas, disproportionately hurt our third quarter results. Excluding the impacts of catastrophes, the loss ratios in the homeowner lines are improving due to lower more normal levels of large fire losses and significantly higher levels of price increases. Net premiums in the homeowner line grew over 7.9% the quarter, but all of this was driven by price increase. As the earned premium cash was up with these written premium trends, we expect to see accelerated improvements in our ex-catastrophe homeowner’s loss ratios. In addition of the price increases we’re getting at homeowners, we’re now well into our insurance-to-value program. Based on the current run rate, we expect to recognize another 3-percentage point price increase on top of the higher levels of rates that we are now charging. Along with the deductibles we have in place, the new underwriting programs that I outlined last quarter, and more aggressive agency management actions. We also announced this past quarter, our withdrawal from the Oklahoma personal lines market, which is the small, but volatile segment of our personal lines business. We’re confident that improvement in this troubled lines will continue. Business insurance results were a disappointment in the quarter. Catastrophes took their toll but the big surprise for us was the unusually high level of large loss activity. As I said earlier large losses increased our commercial lines loss ratio by almost 9 percentage points when compared to the third quarter of last year. At commercial auto bodily injury lines was most significantly impacted. Large loss frequency increased by over 150% in the quarter and added approximately 22 points to our commercial auto loss ratios. In the fire lines, we had two very large losses in July, which increased our loss ratio by approximately 27 points for the quarter. And lastly the liability line was hurt by prior accident year, large loss developments and which hurt by approximately 30 points. All in all, we were disappointed by the unexpected loss severity particularly in the commercial auto line, which is traditionally been one of our most stable and profitable. I can tell you that our business mix and underwriting quality has not changed. We’re a bit more aggressive in bringing our loss reserves to ultimate on a case basis. But we’ve short this quarter up to simply a bad one and bad luck for a traditionally very good line. Year-to-date our total ex-catastrophe loss ratios improved about half a point with positive improvement in personal lines offset somewhat by a slight deteriorations in our overall business insurance results. Also, year-to-date catastrophe experience was slightly higher than our normal expectations, but not significantly so. Assuming a normal fourth quarter, we should come within our average annual catastrophe range of 7 to 8 points in our loss ratio. Getting back to business insurance for a minute, the premium per exposure remains largely unchanged with a minus 1% price decline for the quarter. Year-to-date pricing remains flat. We continue to see tough competition exacerbated by a difficult economy and to perhaps premium basis. Account retention has improved but new business remains negative resulting in a modest reduction in our overall policy account. For the quarter, premium production increased 25.4% and 13.3% year-to-date. Setting aside premiums from RED, business insurance premiums declined 3.6% for the quarter and 3.2% year-to-date. All of our growth in business insurance continues to be generated by our State Auto mutual affiliated RED business unit or Risk, Evaluation and Design. A bright spot in our business insurance production growth is our new BOP Choice Program. This product remains very popular with our agents, we used predict modeling techniques to assure appropriate pricing and an easy to use portal with the same positive policy and premium growth in this line and expect continued growth in the small business market as we complete the country wide rollout in Connecticut and Massachusetts. In addition, we’ll begin providing bridging solutions to our agents, which will facilitate the upload of agency-initiated transactions to our company’s system. We will also introduce policy downloads next year, which will transmit the completed transactions for all business insurance lines to our agency partners and management business. This will give our agents more reasons to use State Auto for business insurance for the future. We continue to target an expense ratio on the low 30s and we are making good progress particularly in the third quarter with a GAAP result of 32.8% a 1.4-point improvement over last years third quarter results. We now have commission rates that are inline with the market and high productivity levels in our personal lines business. We continue to streamline our business insurance operations, with the introduction of new technology over the next two years we expect to see substantial improvements in our commercial lines expense ratio complementing our already competitive personal lines and loss reduction expense ratios. All in this will improve both our expense ratio and the loss adjustment expenses embedded in our loss ratio. With that, I’ll turn you over to Steve English.

[Steven English:]

Thank you, Bob. This morning, I would like to comment on investments, taxes and the status of our 2010 CAT aggregate treaty. For the quarter our book value per share increased $0.81 driven by improved investment evaluation principally debt to maturity, security. Our high quality bond portfolio benefited from declining interest rates and continued treasury ended the quarter at 2.51%, the duration of the portfolio is 4.2 down from 5.0 at December 31, 2009. While lower interest rates have helped bond valuation, it has created challenges in generating investment income. During the third quarter, we saw an increase in call and prepayment activity relating to our portfolio both taxable and non-taxable. New money range hover, around 2%, as we have been investing in shorter-term government agency bonds this shift in the portfolio is putting downward pressure on yield, and the amount of investment income earned. In addition, we have approximately $162.5 million of TIP bond and the related CPI adjustments have created volatility in our reported investment income. Net investment income for the third quarter of 2010, was down $2.3 million from the same period last year with TIPS accounting for nearly $700,000 this decline and the balance was yield related. Compared to the second quarter of this year, net investment income was down $1.5 million with TIPS accounting for $900,000 of the decline with the balance yield related. On a year-to-date basis net investment income was flat. The decline in yield was offset by our TIP bond, which earned $2.6 million more in 2010 than 2009. Despite the quarterly income statement volatility our TIP bonds have earned 6.6% year-to-date on a total return basis. For the nine-month ended September 30, 2010 we again recorded a tax benefit at an annual estimated effective tax rate. This is being offset by $4.5 million of deferred tax expense we reported in the first quarter this year, related to the recently enacted federal healthcare legislation and its treatment of the Medicare Part D subsidies. We expect to true up our estimate at the end of the year. We have not discussed the status of our CAT aggregate reinsurance treaty recently so I found an update with an order. As a reminder, for the second year in a row we entered into an aggregate treaty providing coverage on a group basis, once we exceed a specified retention. Non-named storms qualified for the treaty if they exceed $5 million. Our aggregate retention is $90 million and as of September 30, 2010 we have storms totaling approximately $70 million that qualify. Based upon past history it seems unlikely we will exceed our aggregate retention for 2010. Finally, the statutory surplus of STFC’s insurance subsidiaries now stands at $745 million. And with that we would like to open the lines for any questions you may have.

[Operator:]

(Operator Instructions) Our first question will come from Paul Newsome, please state your company name please.

[Paul Newsome:]

Good morning, it’s Paul Newsome from Sandler O'Neill & Partners. I was hoping you could revisit a little bit of the frequency up-tick that happened, in this quarter, it seems like a pretty high amount and maybe largely see that between tapping on your old business versus for the new?

[Bob Restrepo:]

Hey Paul, it’s Restrepo frequently up-tick was on a paid basis and when we look at our K plus incurred all in the pure premium trends are in the 3% to 4% range and when we look at it on a [Inaudible] rolling year basis, our pure premium trends are still less than the prices that we are charging to perform the deal. Although we’ve definitely seen an acceleration of the frequency up-tick in the personal auto line, which picked up from last quarter but again on an all line paid cost incurred basis we’re pretty comfortable that our pricing is still well ahead of the pure premium trend.

[Paul Newsome:]

Any of you this is why it happens?

[Bob Restrepo:]

Well, we’ve definitely have more intense focus in our claim processes and I think that’s probably contributed to an accelerated, acceleration of payment as we see the close claim factor, obviously an up-tick in case is a bypass to that, particularly on the bodily injury lines.

[Paul Newsome:]

Okay and then I’d also like to revisit the RED new NGA operations and just give us a couple of words as to why this growth, in this commercial market, is going to be okay?

[Steven English:]

Well, one of the reasons that we’d like to, see alternative risk transfer business and RED in particular is just less vulnerable pricing cycle and it’s not completely involved in both the less vulnerable, people that choose to enter the alternative risk transfer business really make a long-term decision about how they’re going to be buying their insurance and they opt for price stability overtime rather than shopping for the cheapest price. But these are programs that has been well established from many years, we can evaluate the profitability, the size of the business and in many cases, these programs depending on the structure that the individual insurers actually retain risk either into digitally or collectively through risk retention group or through CAT through a variety of alternative risk mechanisms. So we think overtime it’s both less vulnerable pricing cycle again they’re completely vulnerable, the less vulnerable and also complements our focus on small businesses and we’re purposefully tearing away from large single self-insured. We are looking more at programs relatively had our genius risks with the small business and casualty orientation to better balance our growth – our property business.

[Paul Newsome:]

Do you know what historically these programs has run in terms of a combined ratio?

[Bob Restrepo:]

Yes, we do. We don’t disclose it, but we do know it. And obviously we wouldn’t be accepting business that we didn’t think that’s going to contribute to underwriting profitability. These are still relatively in the tour programs so we’ve set some pretty conservative loss picks internally when we spike the business. And so far, again, this is our first full year. But so far, we’ve been pleased with a lot of development.

[Paul Newsome:]

Great, I’ll let some other folks to ask questions. Thank you very much.

[Bob Restrepo:]

Thank you.

[Operator:]

Our next question will come from Caroline Steers. Please state your company name.

[Caroline Steers:]

Hi, this is Caroline Steers and I’m from Macquarie. My first question is, just Bobby, where are you focused on growth most right now? Are there any new lines that you’re interested in getting in to? And then, just on competition, who is it that you’re seeing the most competition from right now in business insurance?

[Bob Restrepo:]

Business insurance, our focus has been continues to be on small business. The area that we are seeing some growth is in the BOP lines as a result of our BOP Choice. And we’re really focusing on that product partly because of the attractiveness for us in the small business markets. And partly because BOP Choice allows us to enter the small business markets much more productively with the point in sales technology that we have in our agent’s office and with the rating, we don’t have to touch those transactions often as we have to do on our other line. And we’ve broadened our ability to include more casualty oriented lines such as construction, light manufacturing, restaurants to balance our traditionally property oriented business. So that’s the area, Caroline, that we’re really focused in for small business generically and also on the BOP line. I think overtime with the acquisition of Rockhill and with RTW, which is the model line workers compensation business. We think we have an opportunity to complement that the small packets business with small guaranteed cost workers compensation policy. But we want to make sure that we’ve got the claim processes in place right now. We’ve integrated RTW’s claim processes and people with State Auto’s processes and people and down the road, once we’re comfortable that we’ve got the right systems and the right people and processes in place. We think we can complement our BOP reduction with a small guaranteed workers compensation, depending on the state, not every state of all, that attractive, but most of the states we operate in has pretty reasonable regulatory climate for workers compensation.

[Caroline Steers:]

Okay, thanks. And then just quickly I know we talked about frequency, but just on the severity side it looks like the declines in severity are getting lower, is there anything that’s driving that or?

[Bob Restrepo:]

Again on a pay basis, it can hop around on a rolling 12 months basis so I think all in, I’m looking at Matt Corporate Actuary we’ve probably seen a pick on an all in basis on severity but not significant.

[Caroline Steers:]

Okay, and then finally, just on…

[Bob Restrepo:]

But that’s not in yesterdays, so I have it right.

[Caroline Steers:]

Okay, and then just quickly shifting to the investment portfolio, can you just tell me how much money or how much is actually going to be reinvested going into 2011 and 2012 and then just where you are thinking of putting that, is it in equity or more fixed income?

[Steve English:]

When you see how much it’s going to be in reinvested, this is Steve, Caroline

[Caroline Steers:]

Yeah

[Steve English:]

I am not sure what you mean by that?

[Caroline Steers:]

Is there any fixed income investment that sort of mature and then you’re reinvesting that money or?

[Steve English:]

Okay, sure well as I said in my commentary presently new money on the fixed income side is going into shorter-term government agencies, which as you are well aware the yields on those are fairly low. We are still adding somewhat to our equity positions although we are getting near our targeted allocations there. And in terms of how much is going to roll over in the coming year, I don’t think that’s a terrible significant number, I am trying remember from the schedule you’ll see in the Q and the K where it shows the run out of the fixed maturities. And I think in the next year it’s not a significant number.

[Caroline Steers:]

Okay, great. Thank you.

[Operator:]

Our next question will come from Larry Greenberg, please state your company name.

[Larry Greenberg:]

Lange and McCleany, good morning.

[Bob Restrepo:]

Good morning Larry.

[Larry Greenberg:]

Hey, Bob just want to clear, so the commercial auto loss issues are from the legacy book and you are not seeing any problems in the RED business?

[Bob Restrepo:]

No, that they’re all in the legacy standard lines business, we do large loss analysis on all these losses just to find out either lessons we can learn about how the business was underwritten or priced. And based on that analysis as well as our ongoing file audits as well as our ongoing fast checking with new business, we remain comfortable that our quality of our business is as good together. And it was a pattern particularly on the older claims where we just round up getting new information on claims and as it significantly revalued them on the case basis. And then we had a run of new claims in the third quarter that we just by nasty, I mean $1 million claims pretty good we had several full limits of claims that were highly unusual. But the underlined quality of the business the pricing, we’ve held our pricing margins we haven’t got a lot price increases, but we’ve held our margins and look at the secure premium trends overtime they tend to be negative but we really see this quarter is in operation.

[Larry Greenberg:]

Just curious, doesn’t the introduction of RED into the book, is that make you more vulnerable to large losses to the extent that your picking up, excess of some amount or maybe some self insured business?

[Bob Restrepo:]

Well, the business we have on the business right now the auto business that we have in the books right now is done on a reinsurance basis. So we are picking up everything pretty much on the first dollar basis and then going forward the next role change as we get more risk retention within the programs. But the programs we have in the books right now are reinsurance claims. So we have not seen an impact from the RED book. Actually, the net impact in the quarter was a positive form.

[Larry Greenberg:]

Okay. Did you have any cash pull over from prior periods of this year, in the quarter?

[Steve English:]

Yeah, Larry and this is Steven English. In the quarter, of the cash about 1 point of it was from cash previously 2010 cash from prior quarters.

[Larry Greenberg:]

Okay, great. And the liability development that you would had some of that earlier this year, was there any similarities there, any relationship or is it just?

[Steve English:]

Both fire accident year business has been on books for a while and we have more frequent large slot reviews we definitely have an emphasis on getting the ultimate clicker. But when we went back and looked at the file as you look into anything accelerated that we are just we would revalue the claims based on new information that was developed by our claim adjusters. It didn’t result from the changing claim process, despite the fact where we are having more frequent large loss disputes.

[Larry Greenberg:]

Okay. And then finally, can you just give us a few thoughts on what the personal auto environment might look like going out the next year?

[Bob Restrepo:]

Just globally?

[Larry Greenberg:]

Yes.

[Bob Restrepo:]

Yeah, I think we continue to see less demand. But we have something that we monitor that all companies call symbol drift, which is really the value, the aggregate value of the car and I’ve been in the business for a long time, I don’t remember the last time I saw a negative symbol drift. Generally people are trading up and then the aggregate using positive symbol drift, you see negative. I don’t see that changing and they’ve flatten out that’s similar to what we’ve seen in commercial lines, we just don’t see a lot of demand out there. Now from a price adequacy standpoint, as you know the first along the field market is very disciplined. And both the, particularly that’s the large automobile carriers are very disciplined in their pricing and we think it’s a very rational market. We’re not seeing the premium basis increasing, which has contributed to top line growth and we don’t see that this year, we’re not expecting to see much of it next year.

[Larry Greenberg:]

So, do you think, I don’t know if you just answered this question, but do you think prices next year will keep up with or exceed loss plus growth?

[Bob Restrepo:]

Yes, I do. I think it’s arguably the most disciplined rational market out there and I continue to expect to see small price increases in the low to mid-single digit ranges that will stay ahead of the pure payment curve.

[Larry Greenberg:]

Great. Thanks very much.

[Operator:]

Our next question comes from [Sameer Kher]. Please state your company name.

[Sameer Kher:]

Calling from Capital Returns. Good morning guys.

[Bob Restrepo:]

Good morning.

[Sameer Kher:]

I was hoping you can tell us a little bit about any exposure you guys had to the Midwest storms in October and how significant they were to you and what states were actually worst hit?

[Bob Restrepo:]

We did have some exposure, but it’s not significant, as much left than we feared. And it was largely in Northern, Minnesota, Wisconsin some of the states that we had issues with in the third quarter. There was a separate catastrophe in Texas, which is now a fairly large state for us, but our aggregate, there was a tornado in one County of Texas and a couple of counties in east Texas that really didn’t hurt us that much. So in the aggregate, we’ve had three catastrophes in October so far, no one is most terrible significant in the aggregate necessarily significant.

[Sameer Kher:]

Okay. And if you could just remind us about your normalized CAT loss ratio assumed in your placing?

[Bob Restrepo:]

Varied by line, but in the aggregate it comes about 7.5%, obviously much more weighted to be as much as 25% or more in homeowners and that’s probably the most significant impact.

[Sameer Kher:]

Great, thank you.

[Operator:]

The next question comes from Matt Rohrmann. Please state your company name.

[Matt Rohrmann:]

KBW. Bob and Steve good morning.

[Bob Restrepo:]

Good morning Matt.

[Steve English:]

Good morning Matt.

[Matt Rohrmann:]

Just I wanted to double check with you, I know Oklahoma as you said we’re trying from that market its not a big state because how much business had you written in the sense is year-to-date?

[Bob Restrepo:]

It was less than $5 million.

[Matt Rohrmann:]

And then Bobby, you said overall pricing was down about 1%, is that correct?

[Bob Restrepo:]

That’s in the quarter, year-to-date flat in commercial lines.

[Matt Rohrmann:]

Okay, great. Thanks guys.

[Operator:]

(Operator instructions)

[Steve English:]

Okay well, thank you Lou [ph] and 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 fourth quarter earnings call, which is currently scheduled for February 17th, 2011. Thank you. Have a good day.

[Operator:]

Thank you. This will conclude today’s call. You may all go ahead and disconnect. Copyright policy