State Auto Financial Corporation
Q2 2011 Earnings Call Transcript

Published: 2 Aug 2011

[Operator:]

Welcome and thank you all for standing by. At this time, I would like to remind parties today’s call is being recorded. If you have any objections, you may disconnect at this time. All parties are in a listen-only mode until the question and answer session, at which time you may press star one to ask a question. At this time, I will turn the meeting over to President, Chairman and CEO, Bob Restrepo and Vice President and Chief Financial Officer, Steve English. Thank you. You may begin.

[Steven English:]

Thank you Rose. Good morning and welcome to our second quarter 2011 earnings conference call. Today, I’m joined by members of SFTC’s senior management team, our Chairman, President and CEO Bob Restrepo, Chief Investment Officer, Jim Duemey and our Chief Actuarial Officer, Matt Mrozek. 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 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 everyone. Second quarter results for both the industry and State Auto were terrible. In addition to the widely reported and previously disclosed impact of catastrophes, State Auto Financial Corporations earnings and book value were also affected by a valuation allowance we’ve established against our net deferred tax asset. This allowance reduced earnings by $115 million and our book value by $2.86 per share. The allowance was triggered by the historic and tragic impact of the spring storms throughout our operation territory. All in, State Auto Financial Corporation reported a second quarter net loss of $201.4 million or $5.01 per diluted share. Year to date, STFC has a net loss of $188.7 million or $4.70 per diluted share. Book value per share now stands at $16.77. Our GAAP combined ratio for the second quarter was 147% with catastrophe losses accounting for 44.3% of the total loss ratio of 114%. Our X catastrophe loss ratio result was higher than normal because of higher personal auto loss ratios, non-cat weather and increased, unallocated loss adjustment expenses due to higher levels of claim activity. Although catastrophe related, we historically have only classified allocated, not unallocated loss adjustment expenses as catastrophe expenses. Following my commentary on earnings and operating results, Steve English will explain the impact of the net tax deferred asset evaluation allowance on our tax and capital position going forward. In addition, he’ll recap investment income results, provide you an update on the status of our major reinsurance treaties, which we renewed effective July 1. Homeowners was obviously the primary, but not the only line affected by the spring storms. The impact of this line for both the industry and State Auto was truly historic. So far this year, I’ve been in 20 of our operating states, meeting with our agents and employees while outlining our company’s strategy. Part of my presentation discusses the impact of wind, hail, tornado and lighting losses on industry results going back to 1980. Throughout most of the ‘90’s, and the first part of this century, the industry typically reported annual losses from wind, hail, tornado and lighting of about $5 billion to $6 billion per year. In 2008, ‘09 and ‘10, experience deteriorated and the industry had approximately $10 billion in losses for the entire year. Based on my rough accounting, April alone will go down as a $10 billion month and May will probably exceed $5 billion. Given our geographic footprint, we bore our fair share of these losses. Virtually all of our states were affected by catastrophe losses for homeowners, auto physical damage, both personal and commercial and commercial property. For all these lines, both the frequency and severity of losses were unprecedented. The only states not significantly affected by the storms were on our periphery; out west in Colorado, Utah and in the Dakotas and in the east, Connecticut, Maryland and West Virginia. Despite the widespread scope of losses, almost 60% of our losses were concentrated in five states. In order of impact, they were Tennessee, Missouri, Ohio, Texas and Alabama. All in, we had almost 32,000 weather related claims in the quarter resulting from both catastrophes and non-catastrophe weather events. Over half of these were property related catastrophe losses and to give you some perspective, our previous largest loss was hurricane Ike in 2008 where we had 17,000 claims. The frequency, severity and scope of losses for this quarter exceeded anything we previously experienced. In my experience, I’d never seen so many total losses affecting homes, businesses, cars and generating maximum payouts for additional living expenses and for business interruption coverage. As I mentioned, our non-catastrophe experience in home owners also deteriorated in part because we do not allocate internal claims related costs as catastrophe loss adjustment expenses. An example is our internal claims express unit, which handles first notices of loss. We hired a significant number of part time help to support this unit and the increase in call activity. All of these expenses was embedded in our X catastrophe homeowner loss ratio. We continue to file and receive approval for double digit rating increases in our homeowners book, but the loss trend is also increasing at a double digit pace. The frequency and severity of storms over the past several years has increased demand for building supplies, which have also been affected by the increased price of oil and play in the cost of shingles and other building material. That’s why price alone will not improve results and why we continue to act of achieving insurance to value, requiring higher deductibles, rolling our bi-para rating and pruning the agency plant. As aggressive as we’ve been with our homeowners’ remediation actions, clearly, they weren’t enough to offset the unprecedented storm activity we saw this past quarter. We’ll press for even more significant price increases going forward. In addition, we’re evaluating our presence in a number of states and geographic locations. We’ve already exited four states for personal lines; Florida, Oklahoma, and most recently, Massachusetts and Rhode Island. We’re in the process of evaluating additional states and geographic areas to determine if we need to get smaller, exit the state or reduce agency representation for personal lines. We won’t continue to allocate capital to lines or states where we can’t see a reasonable opportunity to make a profit in the near future. From a production standpoint, all our homeowners’ growth is coming from states that we’ve either expanded into or identified as profitable growth opportunities. Our core states of Ohio, Kentucky and Indiana, along with other non-targeted states, have a policy count loss close to 10% this year. I expect this decline will accelerate going forward as we update our pricing, underwriting and agency management action plans. Our farm owners business, which is embedded in other personal lines, also experienced an increase in non-catastrophe weather related losses, and also included a $1 million law suit settlement on an old case incurred in 2006. Otherwise, our non-catastrophe loss ratio continues to be good in this segment. Excluding the impact of catastrophe losses, our personal auto business continues to produce good results. Loss ratios remain a bit elevated due to large bodily injury losses as we more aggressively manage outstanding, open bodily injury and general liability cases, primarily in previous accident years. We expect the impact of this more aggressive file management on our case bases reserves to diminish over time. Increased severity in theft and increased frequency of uninsured motorists and under-insured motorist claims has also elevated our loss ratio and influenced our pricing actions going forward. Personal auto prices are up 2.5% for the quarter and 2.7% year to date. Our production results in personal auto continue to be affected by our homeowners rate underwriting and agency actions. New business is down since we’re not as competitive on an account basis or on a bundle basis, and retention is off a bit primarily due to run off from terminated agents. All of our growth in auto is coming in states identified as expansion or targets for growth. Our core and other states experienced a policy count decline of almost 7% affected by homeowner’s actions, agency terminations and the sale of our non-standard automobile business. In the business insurance segment, catastrophe and non-catastrophe weather is also the story. Our X catastrophe loss ratio results are roughly the same as last year and last quarter. Our liability loss ratios remain elevated as we continue our review of prior accident year reserves. Price per exposure results are flat in our small account oriented book. Premium rate levels on our larger accounts, which is a relatively small part of our commercial business, is seeing low single digit price increases. We’re taking steps to begin to achieve the same kind of result in our small account book over the next 18 months. Business insurance production is flat, with retention and new business levels largely unchanged. Specialty insurance was the only segment not affected by the weather. It’s also the segment that is driving State Auto Financials growth and diversification. Loss ratio results are largely unchanged with acceptable results coming from our program management and alternative risk transfer business red. Our underlying worker’s compensation results are improving, but have been affected by more active claim file management on the legacy State Auto book. We remain optimistic about our ability to grow and profit in the small, guaranteed cost worker’s compensation business. We’ve completed the integration of our claim and product management functions and have a prototype marketing plan in place with 100 agents in five states. Our strategy is to target the small account market, particularly policy sizes under $10,000. We also plan to focus our marketing efforts on four wall classifications and states with attractive regulatory climates and profitable loss ratios. Rockhill’s growth has been solid and our underwriting results are excellent. We think we’re well positioned in this specialty segment for an eventual turn in the market. In addition, the quarter demonstrated how uncorrelated our specialty business is to the kind of weather patterns that have plagued our homeowner and commercial property business for several years. We will continue to invest in our specialty segment and reduce the relative size of our property lines and its traditionally negative impact on our profitability. With that, I’ll turn you over to Steve before we open the line for your questions. Steve?

[Steven English:]

Thank you Bob. Before I address the impact of the second quarter on our capital, I would like to first clarify the financial statement impact of the valuation allowance. Included in the investor packet this quarter, is some additional information for our tax accounts, which may be helpful as I comment. At June 30, 2011, prior to establishing the allowance, STFC’s net deferred tax assets totaled $116.9 million compared to $85.1 million at March 31, 2011 and $86.3 million at December 31, 2010. The increase in the June 30, 2011 balance, primarily related to the net operating loss carried forward, generated in the second quarter, reflecting the impact of the second quarter storm losses. In addition, prior to establishing the allowance, STFC had recorded a net Federal income tax benefit of $48.5 million for the six months period ended June 30, 2011, based upon actual results. This net income tax benefit was comprised of a current benefit of $6.8 million and a deferred benefit of $41.7 million. The current benefit relates to carrying back an AMT loss generated in the second quarter of prior years. The establishment of an allowance in the amount of $115 million was recorded as a charge to the income statement and included in income tax expense, resulting in net tax expense for the six month period of $66.5 million. As discussed in our 2010 Form 10-K, we review our deferred tax assets each period to determine if they are realizable as required by financial accounting standards boards, accounting standards codification 740 income taxes, or ASC 740. This evaluation requires us to make certain judgments and assumptions. In evaluating the ability to recover preferred tax assets, we consider all available evidence, including loss carry back potential, past operating results, existence of accumulative losses in the most recent years, projected performance of the business, future taxable income, including the ability to generate capital gains, and prudent and feasible tax planning strategies. When positive evidence outweighs the negative evidence, the assets are considered recoverable. On completion of this evaluation for our first quarter of 2011, we had concluded our deferred tax assets were recoverable as we posted earnings consistent with our business plan and strategies. However, the magnitude of the second quarter catastrophe losses from unprecedented storms experienced industry wide, which by far exceeded our projections, has resulted in an expectation that we report a loss for 2011 and have a tax loss for the current year. Considering this negative evidence, our recent losses and the volatility of our property results, we concluded a valuation allowance was required under ASC 740 as of June 30. In future periods, we will reassess our judgments and assumptions but until such time the positive evidence exceeds the negative evidence, we will maintain an allowance. Until that time, as we report earnings and generate taxable income, we do not expect to recognize any income tax expense as we utilize our NOL carry forward and release a corresponding amount of the allowance. Alternatively, any reported losses will add to our NOL and be reserved against by adding to the allowance. As we noted in our press release last week, this is a non-cash charge and does not change our view of the long term prospects for our company; not does it preclude us from actually realizing these tax benefits. The tax loss carry forward period is 20 years. As Bob noted, our book value per share is $16.77 and our GAAP equity is $674.7 million. The STFC insurance subsidiary statutory capital at June 30, 2011 is $593.4 million. I would like to add, there are similar rules relating to statutory deferred tax assets and we have also provided for an allowance on a statutory basis. This is recorded entirely as a surplus adjustment. We recognize that STFC is now more highly leveraged when looking at capital measures such as premiums to surplus ratios. Using the last 12 months of net written premium, STFC’s statutory premiums to surplus ratio is 2.4 times. However, our debt to capital ratio remains low at 14.7% and we continue to maintain comfortable, risk based capital ratios for regulatory purposes. On a group basis, our premium to surplus leverage is 1.5 and other capital measures such as A Invest, capital adequacy ratio remain strong. We are however, evaluating several possible actions to address our leverage, which may be near term in nature, as well as improve our longer term profitability. While we believe we have the right strategy surrounding products and diversification, it is clear from this quarter’s results, we need to consider additional steps. These steps may include, but are not limited to, evaluating possible reinsurance solutions, including amending our inter-company pooling agreement to reduce leverage at STFC, identifying additional operational changes to lower expenses, accelerating rate actions across all lines of business, especially homeowners, and targeting reductions in certain states by curtailing new property business, terminating existing business or taking agency action. We will be discussing these possible actions with our Board of Directors at their meeting next week. Our liquidity remains excellent, which is a testament to our conservative investment strategies. We maintain a $100 million unused line of credit, which contains typical covenants, including a required minimum GAAP equity value. As a result of our second quarter loss, our GAAP equity is below the required minimum of $702 million. Our bank group has waived this covenant violation until September 30, 2011. Given that the line of credit is due to expire within one year, we will be working with our bank group in the coming weeks and expect to negotiate a replacement line of credit extending next July’s expiration date. In speaking of investment strategies, the valuations of our investments improved overall, driven by lower interest rates and fixed income valuations. The duration of the fixed income portfolio is 4.6. Quality remains high and the trend of owning proportionately fewer municipal bonds continues. Our investment income for the quarter was significantly impacted by chips, which contributed an additional $4 million over last year’s second quarter results. The book value of our chips at June 30, 2011 was $235.3 million compared to $152.6 million at June 30, 2010. Finally, I would like to comment on our recent reinsurance renewal season. As you may recall, many of our treaties renew each year on July 1. We are in the process of evaluating our reinsurance on a group wide basis for all of our business units. Reinsurance coverage for business written by our Rockhill specialty unit continues under separate treaties. For our casualty excess of loss treaties, no significant changes were made in coverage and rates were low in the single digit range. We did make a change to our worker’s compensation reinsurance structure, consolidating all of our worker’s compensation business under one treaty, including business written by RTW. Previously, our coverage under the State Auto treaty was $8 million, in excess of a $2 million retention. The coverage is now $9 million of limit, in excess of a $1 million retention, which mirrors RTW’s expiring reinsurance structure. We continue to maintain $10 million in excess of $10 million for catastrophe worker’s compensation exposure, and that additional premium, including the additional coverage is less than $1 million on a group basis. On the property per risk treaty, we again made no significant changes to the program. Rates were up, reflecting some of the recent fire experience we have reported on in past quarters, but not materially relative to the size of our property book. For property catastrophe coverage, we added $50 million more limit such that we now have $160 million in excess of $55 million retention. We do participate at 5% in the limit. A handful of factors, including worldwide catastrophe events such as the Japan earthquake and tsunami, the release of revised catastrophe models, State Auto’s growth in the southwest and northeast, as well as adding to our coverage, impacted the renewal. I am pleased to report though, the program was completely filled before July 1. Our decision to add limit was based upon our evaluation of the latest models and considering our internal risk guidelines. With a significant increase in limit, and a hardening property catastrophe market at July 1, the seeded premium spend will increase, though less than 40 basis points relative to total premium. And with that, we would like to open the line for any questions you may have. Rose.

[Operator:]

Thank you. (Operator Instructions) Our first question is from Paul Newsome. Your line is open.

[Paul Newsome:]

Good morning and thanks for the call folks. I actually wanted to ask about the PIP severity increase that popped up there. It looks like that’s sort of excluding catastrophe losses. Could you maybe focus a little bit more on that and just kind of what’s going on with the pieces of the medical/auto business?

[Bob Restrepo:]

Yes, and I’ll ask Paul and Matt Mrozek to embellish if you will on anything I say. But for the last year or so, I think one of the symptoms of the economy is definitely what we’re seeing in under insured and uninsured motorists. You didn’t ask about that, but it’s definitely a driver. We’re seeing more people with lower limits or more people driving without insurance and that’s definitely affected our loss trends for UM and UIM. Even before the economic difficulties in 2008, we’ve all been saying increasing medical costs really across the board, is the primary driver right now of worker’s compensation increases. It’s a big factor in bodily injury, but it’s obviously most concentrated in PIP. We’ve seen that trend for several years and we’re working hard to stay ahead of the loss curve, but we really – but the severity continues. The severity continues to increase and with all the uncertainty about the health care reform going forward, I suspect that there’s going to continue to be a lot of pressure for cost shifting out of traditional health insurance facilities or new health insurance facilities into systems like PIPS so we’re expecting the severity to continue and we’ll continue to try to stay ahead of the loss curve with our pricing actions. Matt, anything to add?

[Matt Mrozek:]

I would just add that the PIP dollars are relatively small relative to the total personal auto book, so the driver of the severity is more the bodily injury coverage, which is minus 11 and over the last year, 18 months, the total frequency has been anywhere from minus 3 to plus 1. And you see this quarter it’s minus 11, so while all the points that Bob noted on the PIP severity, that contribution is still pretty minimal.

[Paul Newsome:]

Thanks. And maybe a follow up to Steve’s capital comments. Where are you from a holding company capital perspective and do you have any thoughts on use of holding company capital dividend and other uses?

[Steven English:]

When you say where we’re at from a holding company capital position, are you really asking about liquidity at the holding capital and the need to pull capital out of the insurance subs?

[Paul Newsome:]

Yes.

[Steven English:]

We actually have very good liquidity at the moment at the holding company. When we sold State Auto National last year, we had taken some capital out of that company and then the sales proceeds from the sale were all retained at the holding company. We had contributed some of that back down into the insurance subs, but kept enough liquidity to certainly get us through this year and into next year. In regards to dividend policy, we review that annually in the fall and certainly as we have discussions with our Board here next week in regards to capital, we’ll be discussing it as well.

[Paul Newsome:]

Great. Terrific. I’ll let some other folks ask questions.

[Bob Restrepo:]

Thanks Paul.

[Operator:]

Thank you. The next question is from Matt Rohrmann. Your line is open.

[Matt Rohrmann:]

Bob, Steve, good morning.

[Bob Restrepo:]

Good morning.

[Matt Rohrmann:]

Bob, I’m sorry, could you just tell me again the states you said that were the top five in losses. I know you said Tennessee, Missouri.

[Bob Restrepo:]

Tennessee was the largest. Missouri was number two and then our two largest personal line states were next in order Ohio and Texas and then Alabama was probably next to Missouri, more devastated than any state in the spring. That was the fifth state. And they collectively were just under 60% of our total loss dollars.

[Matt Rohrmann:]

Okay, great. And Bob, I know you’ve talked about various initiatives in place and those potentially be put in place. Could you talk more about within each of your states, any sort of change in looking at the concentration of business being written or any policy changes for your agents?

[Bob Restrepo:]

Yeah, we really going back two years as part of our enterprise risk management review, we modeled the frequency and severity of wind and hail as best as we could, given the state of the art with the models in all the states, and we identified several areas where we thought that our total insured value was high relative to the return rate of wind and hail events. Minneapolis/St. Paul was tops on the list. Louisville, Kentucky was another area and we were also thought we were out of whack in northwestern Arkansas. We had very large agents there at the time. And those are the areas that stood out and all the other areas we felt we had for the most part, an appropriate balance between our exposure and our expectation of wind and hail losses. So in the areas that we did have an imbalance, we terminated agencies and of course those states, we also imposed mandatory wind deductibles, but the big action was really to reduce our representation in the area and we focused on agents that were either small, didn’t have a broad based relationship with us, were over concentrated in property, under concentrated in automobile and the casualty lines or where felt there really wasn’t a strong enough relationship to remain patient. So what we particularly, in the Minneapolis/St. Paul area in Minnesota, we significantly reduced our presence and to a lesser degree, in Louisville and northern Arkansas.

[Matt Rohrmann:]

Okay. Great. And then of the potential initiatives you had mentioned in terms of talking to the Board about, any guess or ability to prioritize those or kind of be potentially a mix of all four goals?

[Bob Restrepo:]

We’re going to lay out all the options and evaluate and communicate the pros and cons of each and then we will make our recommendations. I think it would be premature right now for me to get ahead of my Board and be real specific. I think Steve was appropriately specific about both the scope and the type of options we’re considering. As it affects homeowners, it’s really accelerating a lot of what we have been doing and looking for areas where maybe traditionally we have been more optimistic than we’ve gotten over the last three years. As I’ve said in the past, I don’t know whether this is the new normal or not, but we’ve had three and a half years of exceptionally high catastrophe losses, particularly as it relates to wind and hail. So in the absence of anything different, we have to assume that something has fundamentally changed and as aggressive as we have been, it hasn’t been enough, so we’re going to have to look at both accelerating existing actions as well as considering new ones.

[Matt Rohrmann:]

Okay. And last question, Steve, I just wanted to double check it. What was it again, the net impact to equity once you’ve put through the valuation allowance and NOL’s and all those adjustments? Was it $67 million? I didn’t catch that. I apologize.

[Steven English:]

No, the impact of the allowance was $115 million, which is the book value. It was $2.86.

[Matt Rohrmann:]

Okay. And then were there other adjustments you said in terms of NOL’s and things like that?

[Steven English:]

Well, no I didn’t mention that other than when you walk through, if you look at the schedule we provided in the supplement, you can see what the numbers would have looked like prior to the allowance, which prior to the allowance, we would have booked additional deferred tax benefit associated with second quarter losses, and that would have been booked as a NOL carry forward.

[Matt Rohrmann:]

Oh, okay.

[Steven English:]

In fact we did book it that way, but then the allowance provided for after you do that initial booking.

[Matt Rohrmann:]

Okay. Got you. And then I guess it’s – you’re going to be looking at a zero tax rate for at least the rest of this year and likely into next year as well.

[Steven English:]

Correct.

[Matt Rohrmann:]

Okay. All right. Thank you very much guys.

[Bob Restrepo:]

Thank you.

[Operator:]

Thank you. The next is from Larry Greenburg. Your line is open.

[Larry Greenburg:]

Hi, good morning. Just following up on the last comment on the tax rate, so that would be both a statutory and a GAAP tax rate at zero, because you’ll just offset any GAAP tax with the valuation allowance. Is that correct?

[Steven English:]

That is correct on a GAAP basis. On statutory Larry, it’s a little different only because you’re deferred taxes don’t go through your income statement. Only your current taxes do. Of course, we’re in a tax NOL position, so the only caveat to that on a statutory basis might be that there’s some sort of quirky AMT thing that blows through.

[Larry Greenburg:]

Okay. Okay. And was there anything unusual in investment income this quarter? Was that just the impact of the unearned premium catching up to invested assets?

[Steven English:]

No, the unusual item was the magnitude of which our TIPS VON’s contributed to investment income. Year over year the TIPS added $4 million in addition to what we had last year, on a year over year basis.

[Larry Greenburg:]

Okay. And that – so that’s a onetime thing. I mean obviously.

[Steven English:]

Well the TIPS bonds of course adjust quarterly depending on how the CPI moves.

[Larry Greenburg:]

Right.

[Steven English:]

And so there’s always a lag. So this quarter’s movement in CIP will show up in next quarters tipping income.

[Larry Greenburg:]

Okay. Okay. Fair. And then I don’t know if there’s a way to do this, but I mean can you give us some idea – I mean let’s say that the last three year’s weather turns out to be unusual and we’re back to a different environment. Can you give us an idea of how quickly it’s possible that the valuation allowance could reverse or begin to reverse?

[Steven English:]

Well under that standard, you’re required to evaluate positive and negative evidence and the positive evidence, in our case, the homeowner’s actions, rate increases, these sorts of things. Negative evidence, certainly the losses we’ve reported, the volatility. And under the standard, there are four sources of income that you look to, to support recoverability of a DTA and those are whether or not you have taxable income in the past that you can carry back losses against, the reversal of your existing DTL’s, which we certainly took into account in our evaluation. The third source is tax planning strategies. The fourth source is projected future taxable income, which of course is the least objective under the standard. And so we can’t predict when the allowance will be lifted, but we need to produce taxable income in order to make that case under the standard.

[Larry Greenburg:]

Okay, but I mean if you did produce taxable income for the next couple of quarters, can it start to reverse at year end or would that – are we talking six quarters before we could even think about that?

[Steven English:]

Yeah, so let’s break that down into two pieces, Larry. Let’s – certainly in saying the third and fourth quarters, if book income and taxable income is generated, to the extent it is, we will utilize the NOL and to the extent there was an allowance against that tax NOL, we’ll release that portion of the allowance.

[Larry Greenburg:]

Right.

[Steven English:]

So if you think in the near term, the allowance will move up and down as the corresponding deferred items move up and down.

[Larry Greenburg:]

Right.

[Steven English:]

So but then at some point, when we feel that the positive evidence once again outweighs the negative evidence, at that point, whatever is sitting there as an allowance will be eliminated in totality.

[Larry Greenburg:]

So it’s kind of an all or nothing thing for the balance sheet piece of it.

[Steven English:]

Correct.

[Larry Greenburg:]

Not the ongoing quarterly piece.

[Steven English:]

Correct.

[Larry Greenburg:]

Okay. I mean would – I mean I know it depends on a level of profitability, but I mean is it conceivable that a couple of quarters of decent profitability could provide the evidence necessary to remove the allowance?

[Steven English:]

Well that’s extremely difficult to say because of the judgment involved, but I would say it will take more than two quarters of profitability to overcome the presumption that the negative evidence outweighs the positive.

[Larry Greenburg:]

Okay. And then finally, and kind of another mushy question. As Bob, you’ve laid out target profitability objectives and they involve leverage ratios and obviously combined ratio targets. But just for your internal conversations, and I guess external conversations, when you think about those leverage ratios, I mean do you – do you still think about them excluding the deferred tax valuation allowance or do you now start thinking about those leverage targets kind of on an as reported balance sheet, if that’s clear.

[Steven English:]

Larry, let me take that one. We will think about that on the statutory side, including the valuation allowance, and the reason for that is because rating agencies and regulators will view it that way. Does that make sense?

[Larry Greenburg:]

Yeah, it does. I mean obviously taking the book value make your objectives a lot easier to attain.

[Steven English:]

That is true and just as this quarter experienced a rather large charge, at that time when we determine the positive evidence outweighs the negative evidence and the allowance comes back in; there will be a pop in the other direction.

[Bob Restrepo:]

Yeah, and we’re not talking out of both sides of our mouth when I say this, but Steve says from a financial and from a regulatory standpoint, yes, it definitely affects our outlook for the future. From an operating standpoint, we’re not adjusting our pricing targets or our profit targets to lower the ROE bar. So we’re assuming that at some point in time, that valuation allowance will go away and we’ll back in more normal times. And so the way we run the business has nothing to do with the valuation allowance.

[Larry Greenburg:]

Great. And then lastly, on the expense ratio, were there any reversal of bonus accruals or anything like that that impacted the expense ratio?

[Steven English:]

No. Nothing significant.

[Larry Greenburg:]

Great. Thanks very much.

[Operator:]

Thank you. The next is from Paul Newsome. Your line is open.

[Paul Newsome:]

Thank you. I wanted to ask a little bit about the loss ratio in specialty and what kind of returns you’re targeting because I think I saw something along the 75/76 level and if I sort of add in another sort of normal expense ratio, I think that’s a combined ratio that’s north of 100. But you mentioned you thought you were making adequate returns there. Maybe you could walk through the economics of that.

[Bob Restrepo:]

Yes, we’re making adequate returns for where we are right now, but we’re not at our targets. Our target is really to reduce combined ratios in the mid ‘90’s and one of the things we’re working through right now is really achieving sufficient scale in the businesses and also addressing some internal processing and technology issues that really inflates their – really across the board, inflates their expense ratio. So the biggest single issue that we have in terms of achieving their targets are the expense ratios that are embedded in both our Red business, our Rockhill business and to some degree, our workman’s compensation business. Beyond that, for the most part, we’re pretty pleased with the loss ratio performance with Red, very pleased with the loss ratio performance in Rockhill and we’re not achieving our targets in workman’s compensation. We have – we’re ahead of where we thought we would be with RTW, but as I mentioned in my prepared remarks, our legacy workman’s compensation book for State Auto is higher than our expectations, largely due to really addressing some older cases and making sure that we have appropriate case reserves. And the impact of the case reserve actions appropriately, isn’t fully reflected in the bulk reserves yet. So it’s a work in progress. Our biggest single short term issue is the expense ratio in the businesses and the legacy State worker’s compensation loss ratio is higher than both run rate and our expectations would be.

[Paul Newsome:]

So when you mean the expense ratio, you don’t mean the (inaudible). You mean the loss adjustment expense ratio?

[Bob Restrepo:]

I mean the operating expense ratio.

[Paul Newsome:]

Okay, but the loss ratio seems quite high too. Is that also NLE scale issue or is it also...?

[Bob Restrepo:]

That influences it, yes. Definitely in the worker’s compensation line and we also – we have very conservative loss picks. These are fairly new businesses to us. Red is growing rapidly. Rockhill is growing pretty aggressively. RTW, we just bought a couple of years ago, so we’re maintaining pretty conservative loss picks and I think – and again, that’s appropriate, but that also contributes to what we’re booking.

[Paul Newsome:]

That certainly makes sense. Is there a time frame for getting the specialty business to your targets at this point?

[Bob Restrepo:]

Within the next 18 months for sure.

[Paul Newsome:]

Terrific. Thank you.

[Operator:]

(Operator Instructions)

[Steven English:]

Okay, well thank you Rose and we want to thank all of you for participating in our conference call and for your continued interest and support of State Auto Financial Corporation. We look forward to speaking with you again on our third quarter call, which is currently scheduled for November 1, 2011. Thanks everyone and have a great day.

[Operator:]

Thank you. This concludes today’s conference. Thank you for joining. You can disconnect at this time.