State Auto Financial Corporation
Q1 2011 Earnings Call Transcript

Published: 3 May 2011

[Operator:]

Welcome to the State Auto Financial Corporation First Quarter Earnings Call. At this time, all participants will be in a listen-only mode until the question-and-answer period. (Operator Instructions) Now I’d like to introduce STFC’s Chief Financial Officer, Steve English.

[Steven E. English:]

Thank you, Angela. Good morning and welcome to our first quarter 2011 earnings conference call. Today, I’m joined by several members of STFC’s senior management team, our Chairman, President and CEO, Bob Restrepo; 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 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 reconciliation 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.

[Robert P. Restrepo Jr.:]

Thank you, Steve. Good morning everyone. First quarter results for State Auto Financial Corporation continued to show improvement in our property insurance lines, particularly homeowners. Our net income of $12.7 million was flat compared to last year’s first quarter result of $12.9 million. Net income from operations was $0.18 a share compared to $0.27 a share last year. The difference was all the loss ratio where we had higher levels of catastrophe and large liability losses, which offset strong results in personal auto and improved results in the property lines. Our GAAP combined ratio for the quarter was 103% versus 99.7% for the first quarter of 2010. Excluding the impact of catastrophes, our combined ratio was two points higher with 98.4% this quarter compared to 96.4% last year. Large liability losses accounted for the difference and were 3.5 points higher than the first quarter of last year. Expense ratio results were flat despite the addition of higher cost specialty insurance unit and moderating premium growth. Investment income was also flat with last year’s first quarter. In general, I’m somewhat pleased with the results we reported this quarter for a number of reasons. We continue to produce very strong personal auto results. Our loss ratio was hurt by an increase of large bodily injury claims from prior accident years. Compared to the first quarter of last year large lost activity increased our loss ratio by three points. Despite that we continue to get appropriate price increases consistent with the pure premium loss trend and claim actions are reducing this severity of our physical damage loss experience. We’re well positioned for continued profitability in our core personal auto line. We also continued to see significant improvements in our non-catastrophe homeowner results. The pricing, underwriting and claim actions we’ve taken over the past two years are earning out and paying off with significantly improved ex-catastrophe loss ratio results. Our first quarter represented a 4.8% point improvement over the same quarter last year. All in, we reported strong personal lines results and are well positioned for the future assuming normalized catastrophe experience. In claims, we continue to see the positive impact of new claim processes and more active file management in virtually all our insurance lines. The claim initiatives we’ve had underway for the past two years have improved our service, reduced the loss adjustment expenses, which are embedded in our loss ratio and enabled us to better manage loss ratios through indemnity payout. We have already seen a positive impact on the shorter tail lines such as auto physical damage and property, our relatively small workers compensation business has also benefited significantly. Our active file management though has hurt our short-term results in bodily injury and commercial liability. We’ve had a conservative effort underway to make sure that the case basis reserves we carry less represent what we think will be the ultimate value of the claim. This has always been our philosophy for a now more consistent and aggressive in our attempts to both recognize the ultimate value and accelerate the resolution of outstanding liability claims. Over time, this will reduce indemnity payout and associated legal expenses. Short-term, now, it increase the number not the severity of large casualty losses. We define our large losses any claim, either a new or preexisting, which carries a loss reserve estimate greater than a $100,000. I’ll discuss the impact of these changes on the relevant lines in a few minutes. Adjusting our first quarter results also showed solid profit and growth coming from our new specialty segment. Now, lets take a closer look at each of the operating segments. First, our insurance results were profitable, despite the higher levels of catastrophes and large bodily injury losses in the auto line. And auto production is moderated primarily due to the underwriting and pricing actions we’ve taken in homeowners. We continue to earn price increase at or beyond the peer premium loss trend. The pricing impact on earned premium this quarter was 4.1% compared to our peer premium trend of 2.8%. Looking ahead, we continue to get price increases. The written premium impact of price increases this past quarter was 3 percentage points. We continue to feel good about our first line of results and our ability to compete regardless of the competitor or economic environment. We’d like to see more growth in our core states, but that will be difficult though with the short-term as we complete the final stages of our homeowners’ remediation plan. We are also concerned about the increased large loss activity related to uninsured and underinsured motorist coverage. This is an expected trend during an economic downturn and we’ve anticipated that in our pricing actions. Regardless of peers watching and we will continue to do so. As I’ve mentioned we are very pleased with the progress we’re making in homeowners. Our ex-catastrophe loss ratio result was higher than the fourth quarter, which is normal for this time of year. What we are really pleased with is the substantial improvement relative to the first quarter of last year. We think the ex-catastrophe loss ratio is the best measure for evaluating the impact of the rate actions, the detectable increases, insurance value program, our use of analytics and the claim initiatives all of which were put in place over the past two years and are now paying off. We are not ready to declare victory yet, but I think that fixes in and will take another 12 to 18 months to fully earn out the results of these actions and enable us to produce profits in this historically troubled line. Virtually all our homeowners’ growth came from price increases and we already have another double-digit price increase in the works for this year. By the end of the 2011, we’ll have increased prices by close to 30% since the beginning of 2009. Our new custom fit homeowner product will institutionalize the improvements we’ve made by giving us more sophisticated pricing for each property peril and introducing the kind of predict the modeling capability that has produced such good results for us in personal auto. In business insurance the large loss impact was felt in our commercial auto business but was most significant in our general liability line. Large losses added almost 33 points to the liability line and 22 points to commercial auto. We reviewed all our large losses by individual policy line of business from state policy inception date and accident year. We are not seeing any change in the quality or mix of our business or our underwriting process. It’s the number of large losses that's increasing not the severity and the majority of large losses are coming from prior accident years. As I mentioned earlier, this is an expected outcome from more aggressive file management and will ultimately produce lower loss ratios driven by lower indemnity settlements and lower legal expenses. In the short term now we’re paying a price, which at this point will not be totally offset by IBNR reserve take downs. We expect the impact of this more active claim file management to level out in the coming quarters. Commercialized production is improving and the multi-peril line as there are new BOP Choice Program continues to do well. Production in the other commercial lines is stabilizing. Price per exposure remains flat. This year we introduced a new reporting segment, specialty insurance, which includes the results of RED, Rockhill and the workers compensation units. Our goal is to better highlight our efforts to diversify and bounce our portfolio with more commercial and more casualty oriented business. In addition, we want to enhance financial reporting transparency, we’ll report production results by unit. The RED unit is the managing general underwriter, which is majority owned by our parent State Auto Mutual and which markets to the program and alternative risk transfer markets. The Rockhill unit markets products in the excess of surplus business and includes the result from our small surety business. The workers compensation unit includes business written on a modeling or account basis by both RTW, our modeling worker compensation subsidiary and State Auto. RED continues to experience strong results and maintains a focus on the small-business market. The theme for all our specialty business is small-business. We like lots of little accounts. As an example, a good portion of what we write RED will be issued on above form. Small business is also the focus for Rockhill where we had a solid underwriting profit in the quarter. We're starting to see some changes in the excess of surplus market. Our submission activity has increased fairly significantly beginning in March particularly in the property and environmental liability lines. We’re not only seeing growth opportunity, but also good opportunities to increase prices. We also seem to in the early stages of a hardening market for workers’ compensation. Our focus here is also on small accounts particularly in the $1,000 to $10,000 range. We think we’re well positioned because of our new claims capability, which we acquired with Rockhill and RTW and the distribution outlooks we now have with both retail and wholesale agents and brokers. Specialty is the developing story for us, but our strategy remains focused on underwriting a predictable risk profile, diversifying our business mix, and adding products that our agent really care about, complementing and reinforcing their trust in State Auto as a preeminent retail company. Before I turn you over to Steven English, I’d like to briefly comment on the announcement we made yesterday regarding the terrible weather we experienced last month. In April, we had five separate catastrophes triggering widespread damage from tornadoes, wind, and hail. These storms are fairly unique because they affected so many states and the claim severity appears to be more significant than what we usually see in the spring. It will be weeks before we can come up with a loss estimate that has any degree of confidence or certainty. As of now, we do know that our experience in April will exceed possibly by good measure what we normally experience in the second quarter for both catastrophes and non-catastrophe weather related claims. Prior to this year, our five-year average catastrophe loss ratio was 18 points or about $50 million in losses. Whatever estimate we come up with, we’ll exceed that amount. We are working hard to come up with an estimate at the earliest possible date, but our primary focus right now is to take care of our policyholders and claimants. Until we complete our surveys, begin making more payment and set additional reserves, we simply aren’t in a position to give you a definitive estimate. We can tell you with some confidence though that the ultimate loss we have experienced for the five catastrophes in April will well exceed our five-year average catastrophe loss ratio and may exceed what we typically see for non-catastrophe weather related losses in the second quarter. And with that, I’ll turn you over to Steve.

[Steven E. English:]

Thank you, Bob. I will make some brief comments regarding book value per share and investment plus highlight the impact of pooling change had on our first quarter financial statements. For the first quarter of 2011, our reported booked value per share is $21.54, up 1.5% from December 31, 2010. Quarterly earnings, our shareholder dividends and net unrealized gains from our investment portfolio all played a part in the net increase. During the quarter, equity market and valuations were up while interest rates rose slightly. Our municipal bonds as a percentage of total fixed maturities now stand at approximately 45%, down from 49% at year-end. Credit quality remains strong with no major shifts in types of bonds or state concentrations. The overall duration of the portfolio was 4.9. The pooling change did result in $149.8 million of net cash in investments being transferred to STFC’s balance sheet. Investment income in the quarter was $21 million, up slightly from a year ago. Our pretax annualized yield was 3.5%, down from 3.7% in the prior year. We continue to invest in accordance with our target allocations, we did recognize $8.2 million of net realized gains in the quarter primarily from the sale of equity securities, which had met our price targets or our outlook for the security changed. The statutory capital of STFC’s insurance subsidiaries stands at $802 million, up from $783 million at December 31, 2010. In addition to the impact on reserves and assets, the pooling change accounted for 8% of the growth in net written premium in the quarter excluding the impact of the one-time transfer premium reserve. This equates to $24.1 million of premium, $13.9 million of which is classified as Rockhill premium and $10.2 million of workers’ compensation premium, both of which are reported as part of our specialty segment. And with that we would like to open the line for any questions you may have. Angela, we’re ready for questions.

[Operator:]

Thank you. (Operator Instructions) First question comes from Matt Rohrmann.

[Matthew Rohrmann:]

Bob, Steve, good morning.

[Robert P. Restrepo Jr.:]

Good morning, Matt.

[Steven E. English:]

Good morning, Matt.

[Matthew Rohrmann:]

A couple of questions. First, I just wanted to verify from my understanding of the reinsurance program you guys have, given that its five cats in the quarter, that won’t go into any layers of the catastrophic program, is that correct?

[Steven E. English:]

Correct. Yeah. But that’s our estimate right now, Matt.

[Matthew Rohrmann:]

Okay. And then I guess Bob I know the specialty lines are newer relative to some of the core lines for State Auto, how much growth do you see there outside of bringing on other premium within the pooling changes and things like that?

[Robert P. Restrepo Jr.:]

Yeah, I think, Matt, most of our growth in the commercial lines area will come from specialty for the foreseeable future. As I mentioned, our standard business insurance results are stabilizing, we are experiencing good results with their BOP product. And I think as the economy continues its slow recovery, we’ll see some increase in exposure basis and which will give us hopefully stabilized growth, hopefully some positive growth. But the real growth story for us will be in the specialty markets where we continue to feel very good about our growth and profit potential in the alternative risk and the program management segment through RED. As the economy recovers and we deploy our new product capability and the workers’ compensation market, addressing the small market, we see good growth opportunities there. And as I mentioned, we’re in the early stages of what appears to be a bit of a market shift in the excess surplus lines and we also see some potential good growth and profit opportunities there. So whatever we see in specialty for the next year or two, we’ll certainly outstrip what we hope will be a stabilizing pricing in the business insurance market and hopefully some modest increases in the standard lines going forward.

[Matthew Rohrmann:]

Okay, great. And then just a last question. Steven, in terms of non-cat whether that was included in the first quarter, was there a number that you could provide there?

[Steven E. English:]

No, we don’t have a number for that.

[Matthew Rohrmann:]

Okay, all right. Thanks guys.

[Steven E. English:]

Thank you.

[Operator:]

Next question comes from Paul Newsome.

[Paul Newsome:]

Good morning guys.

[Robert P. Restrepo Jr.:]

Good morning, Paul.

[Paul Newsome:]

I was wondering if you could update a little bit on your capital position and how you feel that capital, premiums in surplus is little bit higher than most of the companies I cover and the dividend is sort of just getting paid with operating earnings at this point. How do you think about your current capital position and the use of capital and then of course now you are also growing, so if you could kind of combine those issues together and a comment that would be fabulous?

[Robert P. Restrepo Jr.:]

Certainly, Paul. When we look at our capital and look at it on a total group basis some of the metrics we look at of course is how the rating agencies view our capital, so we look at Standard and Poor’s capital adequacy, we look at CAR capital. All those measures are certainly very strong and are supportive of our rating. In terms of capital management action for the foreseeable future, we have no plans to alter the dividend, we have no plans for sort of treasury stock type program, principally for the reasons you’ve just mentioned which is we are growing and we are looking to deploy that capital against written premium. Clearly, we need to start to report profits and add to the capital base.

[Paul Newsome:]

Well, I assume buyback will be pretty minimal with the growth?

[Robert P. Restrepo Jr.:]

Correct. There is no discussion at this point in time to institute a buyback.

[Paul Newsome:]

All right, thank you very much.

[Operator:]

(Operator Instructions) No further questions.

[Robert P. Restrepo Jr.:]

Okay, well, thank you, Angela. We want to thank all of you for participating in our conference call, for your continued interest in and support of State Auto Financial Corporation. We look forward to speaking with you again on our second quarter earnings call, which is currently scheduled for August 2, 2011. Thank you and everyone have a good day.

[Operator:]

This concludes today’s conference. You may disconnect at this time.