State Auto Financial Corporation
Q1 2012 Earnings Call Transcript

Published: 8 May 2012

[Operator:]

Welcome and thank you for standing by. At this time, participants would be on a listen-only mode until the question-and-answer portion. (Operator Instructions). Today's conference is also being recording. If you have any objections, please disconnect at this time. And now, I would now like to introduce your host for today's conference Chief Financial Officer, Steve English. Sir, you may begin.

[Steve English:]

Thank you, Mellissa. Good morning, and welcome to our first quarter 2012 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, Scott Jones; 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. Despite solid ex-catastrophe results in most lines, we're disappointed with your combined ratio of 109.4% and a modest loss of $2 million, or $0.05 a share. State Auto Financial Corporation's book value settled in at $18.16, which is an increase of $0.21 per share from our restated book value at year end. Our current book value includes a reduction of $2.49 a share for a deferred tax asset valuation allowance, which we continue to carry. The first quarter is shaping up as a relatively light catastrophe quarter for the industry and for State Auto with on significant exception. Last year tornados, wind and hail loss that had Midwest in March 2nd and 3rd, had a significant impact on our first quarter results and caused widespread damage in four of our five largest states, Kentucky, Indiana, Ohio and Tennessee. For State Auto this catastrophe was similar to the storm that devastated Tuscaloosa, Alabama last year. First it was widespread and had a high frequency of severe tornados with accompanying wind and hail. Second, they caused a much higher frequency of commercial property losses resulting in greater overall loss severity. And third, it triggered a recovery under our property catastrophe treaty. As a reminder, our attachment point under the treaty is $55 million. All-in this event which the property claim services organization, or PCS, identified identify that cat number 67 resulted in a $21.6 million loss for STFC, that are recoveries from both, our homeowners' quota share treaty and a catastrophe treaty. The quota share treaty operated as intended by minimizing the impact on our earnings and capital reducing our overall underwriting loss by $7.1 million, and producing a net benefit to our combined ratio of 1.1%. The catastrophe loss ratio improved 4.8 percentage points, but our non-cat loss ratio results were up 2.9 percentage points due to the ceded premium impact on our overall results. It also added another eight-tenth of a point to our expense ratio. Catastrophe results has generally solid quarter, it was marred only by reserve strengthening and the Specialty segment to cover run-off of a terminated commercial automobile program written by our managing general underwriting affiliate, RED. Business from this program began running off on 1 April. And, personal insurance, personal auto results remain profitable despite a higher frequency of hourly entry losses. We expect results to improve. We're getting pricing increases in excess of loss cost and retention is sound all of which will improve margins in our larger clients. Production is down a bit, primarily in our core states of Indiana, Kentucky, Ohio and Tennessee. As we've reported previously, our personal lines business is heavily cross-sold. Homeowners actually have affected personal auto production, particularly in catastrophe prone states. We've also terminated relationships with underperforming personal lines agencies in our core states. This will affect both, our retention and new business for the rest of the year. Outside of cat exposed states, personal auto production is good and we continue to diversify our geographic footprint beyond the Midwest. In homeowners, we continue to improve our ex-catastrophe results despite elevated trends of non-catastrophe weather-related losses in the quarter. We're on track to exceed our rate plan of 15% for the year. Price increase vary by state with the largest increases targeted at our most unprofitable states. Prices will increase at least 20% in most of our core states, where we've had the poorest results. We're also filing for higher mandatory wind and hail deductibles. We previously implemented $1,000 deductibles in 16 states, which account for over 75% of our wind and hail losses. We're now increasing those deductibles in 11 of our most cat-prone states to 1% of the building replacement value, subject to a maximum of a $2,500 deductible. Homeowners' results remains a difficult and long-term effort. We knew it would be a three-year fix when we began these first at the end of 2008. Giving the more severe weather patterns and elevated loss cost trends, taking another year or two to complete. The actions we're taking to increase prices and deductibles and to reduce their exposure through agency terminations will pay off over time. The homeowners quota share reinsurance treaty provides us added protection as we complete the fix. Ex-catastrophe results in our Standard Business Insurance segment were very good. We're very pleased with the improvement following last year's completion of several casualty claim initiatives. Underwriting quality remains good, prices are increasing, and the short-term impact on casualty case reserves has abated. Significantly improving results in our commercial, auto and general liability lines. Large losses are down and we're getting price increases, particularly in the middle market, where pricing is up in the 10% to 15% range. Setting aside the pooling change impact, business insurance had a solid first quarter production wise. Retention improved, new business is up and prices have turned positive. Other than RED, specialty results are good. Specialty is key to our diversification strategy to write more commercial and more casualty business. Rockhill continues to grow and produce strong underwriting profits. Commissions are up as standard markets tighten and we're getting healthy price increases. We continue to manage expenses well. The modest increase in our expense ratio is completely driven by the homeowners' quota share reinsurance treaty. With that I'll turn you over to Steve English before we open up the line for your questions.

[Steve English:]

Thank you, Bob. My comments today will touch upon the impact of adopting the accounting guidance for deferred acquisition cost, investment results, the homeowner quota share treaty and taxes. Effective January 1, 2012, we have adopt retrospectively a FASB guidance accounting for cost associated with acquiring or renewing insurance contracts. Accumulative effect of this respective adoption reduced stockholders' equity by $20.5 million after tax at January 1, 2010. The impact as of December 31, 2011, was to reduce stockholders' equity by $34.5 million $26.4 million of this was a reduction of deferred policy acquisition cost, while $8.1 million relates to deferring reinsurance ceding commission received excess of DAC and classified as other liabilities. In total, the adoption of this new guidance reduced our previously reported book value per share as of December 31, 2011, of $18.81 per share by $0.86, or $17.95 per share on a restated basis. All previous periods have been restated to conform to this new account standard. As Bob mentioned, our book value per share end of the quarter at $18.16 per share, up 1.2% from year end, driven by market gains in our equity securities and other invested asset portfolios. Net investment income totaled $17.5 million for the quarter ended March 31, 2012, compared to $21 million for the same period in 2011. Lower overall levels of invested assets in 2012, due to the pooling change and quota share treaty contributed to this decline. In addition, book yields continue to be negatively impacted by call, pay down and maturities of fixed income securities. $1.1 million of the decline is attributable to CPI adjustments on our tips, which make up about 11% of our total investment portfolio. We included a new Schedule 2 in our investor packet to assist you in understanding the impact of the quota share treaty on our overall financial results. The treaty provided an overall benefit of $7.1 million to underwriting results. As you can see from Schedule 2, we ceded cat loses at a rate well in excess of our overall cat loss ratio, and we ceded non-cat loses at a rate well below our overall non-cat loss ratio. As a result, the quota share treaty results in a reduced overall cat loss ratio while resulting in an increased overall non-cat loss ratio. Similarly, as the ceding commission is lower than our expense ratio, they result in a higher overall expense ratio. All-in, our combined ratio was improved by 1.1 points due to the treaty. This quarter, you will notice, we did not provide for intraperiod income tax expense as we have done in the past two quarters since establishing the valuation allowance for net deferred asset. Presently, we believe, we will not fall into the exception under ASC 740, and it's determined that the zero effective tax rate is appropriate. As always, we will reevaluate this each reporting period throughout 2002. And with that, we would like to open the line for any questions you may have.

[Operator:]

(Operator Instructions). And our first question comes from Larry Greenberg from Langen McAlenney. Your line is open.

[Larry Greenberg:]

I'm just wondering if you could quantify the reserve strengthening, the commercial auto program and give us some indication of, I assume that's an annual run-off period on that business, and what kind of underwriting is that being booked at over the run-off?

[Bob Restrepo:]

Sure, Larry. In terms of the amount of reserves strengthening, on a dollar basis, it was about $3.6 million, so you can divide that through and see the impact. In terms of a prospective basis, we are booking the 2012 loss pick at a higher rate. We haven't historically disclosed that on a separate basis, but I can tell you that we intend to book that through the balance of the year. At a stronger rate here in 2012 to protect the balance sheet. With non-renewal at April 1st, underwritten premium reserve will run-off through the balance of the year and a little bit into the first quarter of 2013.

[Larry Greenberg:]

Okay, and is there any reason that you can give that would lend confidence that this reserve strengthening in the first quarter got everything that you need to get there?

[Bob Restrepo:]

Well, at the end of, well, not at the end of. Probably two-thirds through the 2011 year, we made some significant underwriting actions within that program, ultimately decided that it made sense to terminate the program, so we had already shared amount of business in some of the problematic areas had increased prices and we believe at this point that by providing at the higher loss picks, we're accomplishing what you are asking about, but I can't say for sure that we've caught at all, but that's certainly our intent.

[Larry Greenberg:]

Okay. And if we back though, the $3.6 million of strengthening and looked at the adjusted loss ratio, I mean, is that a reasonable level that we should be assuming going forward, or is there anything? May I know if there is some other program in RED?

[Bob Restrepo:]

No. That would be a reasonable approach given the magnitude of that particular program to the total.

[Larry Greenberg:]

Okay. And then RED's volume was up in the quarter. I mean, what's going on there?

[Bob Restrepo:]

Yeah. That is somewhat of a, I don't know what the right word is. When we started RED, some of the business was reported on a one-month lag and we have now, for those programs, we've recognized that lag in 2012, so that truck program was one of them. And since it's terminated, at April 1st, we've caught up on that lag here in the first quarter, so some of that growth is due to that accounting change.

[Larry Greenberg:]

So, you don't think there was any last minute efforts to…

[Bob Restrepo:]

Get in the door?

[Larry Greenberg:]

Yeah.

[Bob Restrepo:]

No.

[Larry Greenberg:]

Okay. And then just finally, the unallocated loss adjustment ratio in the quarter, is that a good run rate for what we should be using over the balance of the year?

[Bob Restrepo:]

Yes. It is, and I point out you can see perhaps some of our disclosures that the -- because of the mechanics, the quota share that's about a point higher than what it would normally run. Obviously, since the quota share is in place, that's a good representative number.

[Steve English:]

Okay. Well, thank you, Mellissa. And, we want to thank all of you for participating in our conference call and.

[Operator:]

Sir, we do have one question.

[Steve English:]

Okay. Please.

[Operator:]

The question comes from Paul Newsome, Sandler O'Neill. Your line is open.

[Paul Newsome:]

Sorry. To extend the call, but just could you guys, folks remind us of some of the underlying efforts to reduce the cat losses, and I would like to know specifically what we saw this quarter that in your view extend to the couple of years. What are those kinds of factors?

[Bob Restrepo:]

Since the end of 2008. 2008 included Ike, and it also included unusually heavy first quarter wind and hail losses, but we saw in the pure premium trend, primarily driven by the cost of repairing, replacing building, so we saw real spike relative to normal trends. That wasn't anticipated in our pricing, but we had normally expected the inflation related to building supplies and labor to be in the low single digit that went up to the high single digit, so actually 10%, and the term we use is that it was Ike and it stated those levels for each of the last three years. It's been running 8% to 10%, primarily driven by a surge in demand for building supplies and also exacerbated by the price of oil, which obviously affects the cost of shingles and siding, so we've accelerated our price increases, but we weren't able to get the margin improvement, because the pure premium trends were much higher than what we had ordinarily seen. One thing we did in our pricing is, rather than look at 20 years of history, we've increasingly shortened our experience base to produce that we use to determine price increase to five years to recognize a change in weather patterns that we've not seen over the last 15 or 20 years, but obviously we've seen over the last five years. We've really accelerated our recognition of these increased loss costs in our pricing going forward and we've continued to do that. The second thing is that in order to ensure regulatory approval of our rate increases, we often cap those rate increases to 20% to 25% with the idea that we would get the marginal increase the following years, so we've removed those caps over the last 18 months, and just frankly let everything flow through, so those increases continue to earn out we expect to see margin improvement. And on a direct basis, we are seeing it now where we are getting significant improvements in our ex-catastrophe homeowners' margin. The second thing is as you know is really deductibles, sharing more of the risk with the policyholder. We started out with $1,000 deductibles. We're ahead of the market and that's obviously affected in a significant way. Retention and most significantly new business in the core states in Midwest and the Southeast, but we've rolled on those deductibles often ahead. And, as I mentioned in my prepared remarks that we are now increasing those deductibles from a $1,000 to 1% of what we call coverage A, and coverage A is the real property value, replacement cost value of the home. Percentage deductibles have been in play for some time for earthquake, sometime for hurricane along costal exposed area. They've existed for some time in places like Texas and Oklahoma and Kansas that have experienced catastrophes for a long period of time, but they're relatively new here in the Midwest, so we're definitely ahead of the market and that's definitely going to affect our production going forward. The third big thing that we don't see as much in our current results, but we're starting to see in April and we'll see for the rest of the year is the impact of agency terminations. We've been sending our representation, sending they are heard and geographic areas where we felt we didn't have good balance between our total insured values and our allocated annual allocated loss expectations within specific areas, so areas like Minneapolis/St. Paul global Northeastern Arkansas, we've terminated agencies going back several years. The frequency and severity of storms in places like Huntsville, Alabama and Tennessee, almost everywhere in Tennessee, Kentucky, parts of Ohio and Indiana really caused this to further accelerate those agency terminations, so they all took place last year. It takes at least six months between the time you act on the termination and when it becomes effective and the business starts rolling off, so we've seen some effect of that late last year in the first quarter, but the impact of those exposure reductions is going to accelerate throughout the rest of this year. We are in the third year of completing an insurance-to-value program. We've gotten healthy price increase from that. Our annualized run rate is in excess of 3% of a price increase there, and we have institutionalized our pricing sophistication with our by paroles product, which is now in place with all of our cat exposed areas. As you will remember, the paroles pricing really assesses the risk of the each payroll rather than lumping them together, whether it'd be fire or wind or hail or tornados or liability and several other steps, water damage. I think there's about 13 paroles that we priced for separately, so that allows us to get more pricing precision, particularly in areas, geographic areas that are more exposed to wind, hail and tornados, which has been our biggest problem, so we're getting significant price increases well in excess of the 20% in parts of state that seem to have the greatest exposure to wind, hail and tornados.

[Paul Newsome:]

Do you think you are technically or correctly priced on your new business?

[Bob Restrepo:]

Yes.

[Operator:]

Once again we have Larry Greenberg for question.

[Larry Greenberg:]

Yes. Just following up on RED. My memory me sears me the commercial auto program was about half of the volume of RED. Did you just talk about how the other business is doing within RED?

[Bob Restrepo:]

Yeah. I'll ask Steve to comment on it again. Because, one, we can comment on the other business, which Steve will say on balance is performing much better than the transportation program, but secondly what we've taken some restructuring actions and that we'll skinny down the size of RED and the impact on the overall book and it will allow us to more effectively integrate it with that Rockhill operations, which has a different management team and has been significantly more profitable than our RED program.

[Steve English:]

Larry, we've not been pleased with the underwriting results and truck program being half of the book materially impacts the results of that overall book. The second largest program is a restaurant program, which is approximately. This is a group number, but approximately about 50 million or so in premium. That program has actually over the -- we're into our third year, I believe, on that program, and over the three year cycle has actually performed well. Now, we did at the end of 2011, see a slight uptick in that program, so that's being addressed. But as Bob mentioned, we have made a decision to change management and that is now effective and we are reorganizing that organization and it will be integrated (Inaudible) as part of the overall strategy in the specialty segment and we're going to right size the goals of that book of business given the results in our current capital base.

[Operator:]

And, sir with that I'm showing no further question.

[Steve English:]

Well, thank you Mellissa. As I said a moment ago, we would like to thank all of you for participating in our conference call and for your continued interest and support of State Auto Financial Corporation, and we look forward to speaking with you again on our second quarter call, which is currently scheduled for the 2nd of August, 2012. Thank you. And, everyone, have a good day.

[Operator:]

Thank you. And this does conclude today's conference. All parties may disconnect.