National Interstate Corporation Q3 2008 (Qtr 9/30/2008) Earnings Call Transcript

National Interstate Corporation (NATL)

Q3 2008 Earnings Call

October 31, 2008 10:00 am ET

Executives

David W. Michaelson – President & Chief Executive Officer

Julie A. McGraw – Chief Financial Officer, Vice President & Treasurer

Gary N. Monda – Vice President & Chief Investment Officer

Analysts

Elizabeth Malone - Keybanc Capital Markets

Mayer Shields - Stifel Nicolaus & Company

[Edin Isarvik] - Keybanc Capital Markets

Amit Kumar - Fox-Pitt Kelton

Presentation

Operator

Welcome to the National Interstate Corporation 2008 third quarter conference call. My name is [Shinqua] and I will be your coordinator for today. At this time, all participants are in a listen only mode. We will conduct a question and answer session following the company’s prepared statements. (Operator Instructions) As a reminder, this call is being recorded for replay purposes.

Your host for today’s call are Mr. David Michaelson, President and Chief Executive Officer, Ms. Julie McGraw, Vice President and Chief Financial Officer and Mr. Gary Monda, Vice President and Chief Investment Officer. I would now like to turn the call over to Ms. McGraw to begin the presentation.

Julie A. McGraw

Certain statements made during this call are not historical facts and may be considered forward-looking statements and are based on estimates, assumptions and projections which management believes are reasonable but by their nature subject to risks and uncertainties. The Private Securities Litigation Reform Act of 1995 provides a Safe Harbor for forward-looking statements.

The factors which could cause actual results to differ materially from those suggested by such forward-looking statements including, but are not limited to, those discussed or identified from time-to-time in National Interstate’s filings with the Securities & Exchange Commission including the annual report on Form 10K and quarterly reports on Form 10Q. The company does not promise to update such forward-looking statements to reflect actual results or changes in assumptions or other factors that could affect these statements.

I’ll now pass the call over to our CEO Dave Michaelson.

David W. Michaelson

Last night we released our 2008 third quarter results which reflected a net loss or $0.22 per share for the quarter. Similar to most other investors, our investment results have been adversely affected by the crisis in the financial markets that escalated in the third quarter and has continued in to October. During the third quarter we sold some investments at a loss, wrote off current holdings that were taking over by the government or have filed bankruptcy and wrote down several investments under the other than temporary impairment accounting guidelines, all of which were recorded as realized investment losses on our income statement.

To better distinguish the full impact that realized investment losses had on our performance, this quarter we began reporting net realized gains and losses from investments separate from operating results. For the 2008 third quarter we loss $0.45 per share as a result of realized investment losses which compare to a $0.01 per share loss for the 2007 third quarter and we had profits of $0.23 per share from operations in the 2008 third quarter compared to $0.53 last year.

Our decline in operating profits for both the third quarter and year-to-date reflects flat net investment income and lower underwriting profits. Our recurring investment income was relatively flat because the growth in average cash and investment assets was offset by lower yields in 2008 compared to 2007 particularly for cash and short term investments. The decline in underwriting profits for both the 2008 third quarter and year-to-date reflect a higher underwriting expense ratio and continued loss severity.

We have seen an increase in our expenses related to growth in several of our higher commissioned products. In addition, during the third quarter we had a one-time state guarantee fund charge that added approximately 1.7 points to the 2008 third quarter underwriting expense ratio. Of greater consequence is the loss severity that we experienced in the first half of 2008 which has continued in to the third quarter.

To provide some perspective on the impact that large losses had on the current year results, excluding physical damage claims that settled quickly and for lower dollar amounts, we have had approximately 16,000 claims reported to us in 2008. 11 of those 16,000 claims that were reported in 2008 have added 6.6 percentage points to our 2008 loss ratio. Excluding those 11 severe claims, our 2008 year-to-date loss ratio would have been approximately 61% which is within one to three percentage point deterioration which we had anticipated from charging lower insurance premiums on our commercial transportation business over the past several years of soft market conditions.

Clearly, several of these large high profile losses that we’ve experienced in 2008 are attributable to bad timing. We write higher limit policies and even the best risks could experience a severe loss. Many of the large losses in 2008 have occurred with long standing customers with an excellent loss history and strong safety programs. These are customers who we want to insure. However, several of the large losses have occurred with customers which at the time of the loss did not fit our preferred risk profile.

The most significant loss occurrences have been in the chartered passenger transportation product. While the losses have occurred with both large and small charter companies, we have focused our attention on the small fleet operators which represents a relatively small portion of our transportation component and has historically performed well. We are in the process of reviewing most of our large fleet charter book of business and our entire in force small fleet book of business to ensure that our high underwriting standards remain in place.

Other initiatives centered on risk selection and pricing adequacy have been implemented relative to the entire charter product. Areas of focus include the financial strength and safety consciousness of the operator and the quality of the driver profile. We are pushing up rates in our higher limit policies and continue to emphasis the look of accident event recorder technology.

Our realized losses from investments were primarily caused by preferred stock that we held in Fannie Mae, Freddie Mac and Lehman as well as Lehman debt. Based on the government actions related to Fannie and Freddie and the Lehman bankruptcy, we wrote over $5.8 million in the 2008 third quarter bringing the 2008 year-to-date loss to $6.8 million related to these three companies.

Also in the 2008 third quarter we sold at a loss and had additional write downs related to several of our commercial real estate and financial institution preferred stock holdings. At the time we purchased them, the holdings that are adversely impacting our results were high quality investments and fit within our investment policy.

As a further complication, because of a limitation set forth in the Internal Revenue Code, which restrict the recoverability of capital losses, we could not recognize a tax benefit related to the realized losses from investments in the 2008 third quarter and had only a modest tax benefit for the first nine months. This meant our net income was reduced by the entire amount of the realize investment losses.

However, investment gains in subsequent periods may allow us to recognize future tax benefits on these capital losses. In addition to realized investment losses that adversely impacted income, our portfolio suffered unrealized losses during the third quarter. As of September 30, 2008 we had pre-tax unrealized losses of $9.3 million on fixed maturities, $10.7 million on equities and $7.8 million on our securities lending portfolio.

The financial holdings in our fixed income and preferred stock portfolios as well as our exchange traded funds have been the investments most affected. Overall, our non-cash investments and securities lending collateral were down a total of approximately 5% at the end of the quarter. While the bottom line results are down compared to last year, we continue to grow our top line through favorable renewal persistency and by adding new programs in our alternative risk transfer component.

The ART component is up 50.7% in the 2008 third quarter and up 29.5% for the first nine months compared to last year. The alternative risk transfer growth was the primary reason our total growth premiums written increased 7.5% for the quarter and are up 13.6% for the year. Having less impact on the total but also growing was our personal lines and commercial vehicle component. We have taken modest rate increases in our personal lines products and we continue to attract new insured to our commercial vehicle product.

Our transportation and Hawaii and Alaska components continue to hold the line in this competitive commercial insurance market. Both components are down for the quarter and year-to-date compared to 2007 reflecting our willingness to walk away from business that we feel is inappropriately priced. To summarize we have been affected by the investment market turmoil and our underwriting profits have declined further than expected. Our high proportion of quality short duration fixed income investments and our strong cash flow from operations will allow us to tolerate the impact on our capital position caused by the financial crisis.

Maintaining strong underwriting discipline relative to pricing and risk selection is key to maintaining our successful business model. Our efforts are squarely focused on addressing the few areas that are detracting from our underwriting performance. Julie, Gary and I will now answer any questions that you may have.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question comes from Elizabeth Malone – Keybanc Capital Markets.

Elizabeth Malone – Keybanc Capital Markets

Could you spend some more time explaining exactly how you’re addressing what appears to be deterioration in the quality of your book of business, in particular the charter bus business? I mean I think it’s difficult to assume that the severity that you’ve endured over the last three quarters was really statistical aberration.

David W. Michelson

As we’ve indicated, the majority of our large losses and again 11 of them contributed 6.6 loss ratio points but the majority of our large losses year-to-date have been in the passenger transportation business and many of them have been with customers that have been with us for a number of years.

That being said, we’re not pleased that we had continued severity again predominantly in just a few of our products and again with the passenger transportation focus and charter in specific that it continued into the third quarter. Given that it’s continued into the third quarter, we felt it was prudent and responsible for us to respond and respond in a pretty direct manner. So there are a number of things that we’ve done.

First of all, there has always been an emphasis on underwriting profit here. That has and will continue to be reinforced. New business risk selection has to stay on point. Renewal underwriting is something that at times when you renew an account and you’ve had it on the books for a number of years, one could make the presumption that something you wrote a few years ago is of the same quality today that it was a few years ago. But particularly in these economic times, one cannot make that presumption.

So we are drilling down on every renewal account that comes across particularly again in passenger transportation and charter within that class as if it’s a new piece of business.

We’ve also enhanced our data gathering process relative to updated information on the financial fitness and safety fitness of transportation operators on a current real-time basis so there’s a more in-depth drill down than we were already doing and that was already pretty in-depth.

The other thing that we simply have to respond to is rate level and specifically in the classes that are giving us problems. That for the most part has been passenger transportation, again charter and for the most part traditional or non-captive charter business. So rate levels are going to be getting pushed up.

Something else that we have recently done to mitigate to some degree the lumpiness in our results from this charter class, which is a $5 million policy limit class of business, is we’ve recently lowered our retention in the layer of loss starting at $1 million up to $5 million for our passenger transportation business. We still participate in that layer but we’ve lowered our retention in the layer from $1 million to $5 million to reduce our lumpiness in the event we have future large losses.

Then beyond risk selection and rate level we have a continuing push relative to best practices and risk management practices, and we are continuing to put out accident event recorders in as many of our insured units as we possibly can. Just over the first three quarters of this year we’ve nearly doubled the number of accident event recorders that we have installed in our policyholder units.

We are responding. We have responded. From our conversations you know that we’re a management by objective culture. This quarter does not make any of us happy and it’s one that we cannot and have not ignored, and we’re responding appropriately.

Elizabeth Malone - Keybanc Capital Markets

Do these actions suggest that an improvement could result in the fourth quarter or are these actions that take time because they have to be implemented at renewal of the contract and it will be implemented over time as those contracts come up for renewal?

David W. Michelson

As we’ve mentioned in the past, our business is lumpy. A number of the large losses that we’ve had this year in 2008 are with customers that we’ve insured for 10 years that haven’t had any large losses prior to 2008. We can’t predict when those are going to occur.

Also if there were a couple risks this year that were renewal customers where there was deterioration potentially related to economic times, possibly not, could we still have some of those accounts on the books that have a loss in the fourth quarter? The answer is of course, yes. Could we still have a few of those risks on the books that don’t pop us with a loss in the fourth quarter? The answer to that is also yes.

I can tell you that our actions are immediate and swift but as you’ve recognized we have business in force. We are doing a complete re-underwriting on much of our passenger transportation business but in some of those instances if we find any, and I can’t say whether we will or won’t, in some of those instances those accounts might have to run their course to expiration.

Others we potentially have the opportunity but it has to be within the legal restrictions that are placed upon us by state regulations to potentially get off of a risk if there has been a material change in the risk. But we have to follow the law if we’re going to take any of those kinds of actions.

Elizabeth Malone - Keybanc Capital Markets

Did you find in your analysis of the claims that there were customers whose underwriting quality had deteriorated since the last time you did an audit and that that contributed to the severity of the loss?

David W. Michelson

We have identified at least a couple where as I Monday morning quarterback and which we have to do here, there have probably been a couple risks this year where they were on the smaller fleet charter side where from the time we originally wrote them and the vision we had of what that account was at that time to the time that we had the loss, in my view there was probably deterioration. As a result we’ve enhanced our data gathering and underwriting process even on those types of accounts.

Elizabeth Malone - Keybanc Capital Markets

You mentioned in the release that top line has improved because of a new client in the ART. Is that a small bus charter company that you’ve added to your ART?

David W. Michelson

No. If you hear us mention adding an ART customer as a new product, it’s going to be a multimillion dollar big account. We added a new customer in the third quarter that was of significant size. I think we’ve used the term before, large account rental captive. We’ve got a number of other customers in that category of our ART component and it’s a large customer. It was not a small fleet customer by any means.

Operator

Our next question comes from Mayer Shields - Stifel Nicolaus & Company.

Mayer Shields - Stifel Nicolaus & Company

Is it the disproportionate number of high security losses in small fleet that lead you to focus more on that than on fleets of other sizes?

David W. Michelson

We’re going to be looking at all of our charter business but the losses that we’ve had with the larger fleet customers for the most part have been with customers that have been with us for many, many years and are the kinds of customers that we want to insure whereas the smaller fleet customers, at least from our initial analysis and again we’re re-underwriting the entire book, appear to be customers that at least in a couple instances the quality of that risk has deteriorated from the time we originally wrote it until the time we had the loss. But by no means are we not pulling back the covers on all of our passenger transportation business with a particular focus on the charter which is where we’ve really had the lumpiness in our results.

Mayer Shields - Stifel Nicolaus & Company

Can you quantify at all the increased reinsurance costs associated with bringing down your retention in the $5 million range? I’m trying to calculate the difference between gross and net premiums based on the fact that you’re lowering your retentions in the $1 million to $5 million layer.

David W. Michelson

Actually I don’t have the numbers in front of me but I would say to you that it will be approximately neutral on the net to direct relationship because what we’ve done is while we have reduced our retention in the layer above $1 million where we have the lumpiness, we have offset that reduction in retained premium with an increase in the lower layers in our retention. So when you add the layers together, we’ll be approximately in the same range on a net to direct basis.

Mayer Shields - Stifel Nicolaus & Company

When we see the acquisition cost ratio rise, I’m assuming that that is inherently offset by lower loss ratio expectations. Is that fair?

David W. Michelson

That is fair. We have combined ratio targets here for every product. We’re a product management organization and we have targets that we’re supposed to hit. If there is a product that has a higher acquisition cost, then by its very nature that product based upon its financial objectives should have an appropriately lower loss ratio target.

Mayer Shields - Stifel Nicolaus & Company

The turmoil at AIG probably affects everybody but can you talk a little bit about whether you’re seeing increased client demand from current AIG customers and so on?

David W. Michelson

We have not seen a tremendous amount. Will they have an impact on the market? Potentially and possibly. AIG is a very big company that does a lot of very interesting classes, most of which we don’t do. There are a few classes that they do that we are in but it’s not like we’re running up against them every day or every hour of every day. So I would have to say that, could it have a modest impact on our sales capabilities going down the road? Possibly but I don’t see it having a significant or material impact on our future sales opportunities.

Operator

Our next question comes from [Edin Isarvik] - Keybanc Capital Markets.

[Edin Isarvik] - Keybanc Capital Markets

I was wondering if you could give us a little color on competition in your transportation and Alaska and Hawaii segments, specifically if the level of competition is about the same you saw in the second quarter or if it actually accelerated from the second quarter?

David W. Michelson

Specifically in Hawaii and Alaska; is that your question?

[Edin Isarvik] - Keybanc Capital Markets

Right. Just on transportation Alaska and Hawaii segments. Obviously they experienced competition in the third quarter, and I was just wondering if the competition has accelerated since the second quarter sequentially or is it about the same?

David W. Michelson

I would characterize it about the same. The reason why I say that is we do a lot of measurement here and that includes rate level change, it includes new business ratios, renewal retention ratios, etc. In our overall rate levels in our non-captive transportation business have been down modest single-digit year-over-year ’07 versus ’08 and that stayed consistent by quarter. Also our new business hit ratios are lower this year than last year and again the gap between ’07 and ’08 is about the same quarter-by-quarter as well as retention ratios.

So all of those things to me indicate that quarter-to-quarter and year-to-year the story is about the same out in the Hawaii/Alaska component as well as the transportation component. I’m not seeing material shifts quarter-to-quarter.

[Edin Isarvik] - Keybanc Capital Markets

On your commercial vehicle products, is the premium volume becoming a more meaningful part of the specialty personal lines and do you see opportunities in expanding this line of business beyond the current states of Ohio, Texas and California?

David W. Michelson

It’s becoming meaningful in that the numbers are starting to add up but you grow this business a policy at a time which means a couple thousand dollars at a time. So it does take time to build up momentum but we are starting to see some traction in the three states that we’re in right now, and we do have expectations that out in the future that we will be expanding it. I can’t really specify which states or the number of states because whatever state we do it in we’re going to do it right, but we do have expectations that there will be some expansion of that commercial vehicle product.

[Edin Isarvik] - Keybanc Capital Markets

Did you have any meaningful reserve developments in this quarter?

David W. Michelson

No. Actually we had very modest but some favorable development. Julie can speak to that.

Julie A. McGraw

It was $300,000 this quarter and I believe a year ago it was $400,000 so nothing material.

David W. Michelson

And we had about the same amount of favorable development in the second quarter as well in the same general range.

Operator

Our next question comes from Amit Kumar - Fox-Pitt Kelton.

Amit Kumar - Fox-Pitt Kelton

Going back to the previous question on the reserve development, I know you have talked about looking back at your underwriting practices. I am wondering if you could comment on the level of reserves and is there going to be some sort of a ground up reserve review going forward?

David W. Michelson

From a reserving standpoint if you were to look at our loss development patterns over our history, and this goes back now stretching over 18 years, you will find a very, very narrow band of development up or down and generally favorably relative to where the incurred losses are projected to be at the end of that accident year out to where it ultimately develops to. We do a pretty good job here getting reserves up as fast as are appropriate based upon what we learn about the claim.

When you have a catastrophic claim where it becomes clear earlier on in the evolution of that claim that you’re at fault and the injuries are severe, you clearly put up the reserve to a larger amount and faster than a claim where liability is questionable and the injuries are not as severe. We’re comfortable with our reserving practices; we’re comfortable with how our reserves have developed over time, and the narrow band of development around the original accident year projection.

As we’ve indicated before we’re not in the reserve releasing business. We don’t do that. It’s not a practice of ours. But we are comfortable with the soundness of our loss reserves.

Julie A. McGraw

Even given the severe losses we’ve had this year, each quarter our reserves are analyzed by independent actuaries and we are still within that narrow band that Dave referred to.

Amit Kumar - Fox-Pitt Kelton

In terms of these losses and the trends we have seen in the past few quarters, are those trends widespread amongst your competitors too or is this more of an aberration related to your book?

David W. Michelson

Over the last several years there have been a number of rather severe charter bus losses in this country; I don’t have the exact number but significant numbers of them over the last five years. I would say that back in ’07, ’06, ’05 given that we’re the largest writer of passenger transportation business in the country, we got a disproportionate lesser share of the large losses back in ’05, ’06, ’07. We’ve gotten them this year.

If you analyze it over a five-year period, I don’t know if we’ve gotten our proportionate share. I’d like to think that we’ve gotten a little less than our proportionate share based upon our underwriting practices, but clearly in ’08 we’ve gotten some. But in ’05, ’06 and ’07 we didn’t get very many and companies that we compete against did.

Amit Kumar - Fox-Pitt Kelton

What’s the target of premium to surplus level and maybe you could just talk about what’s your comfort with the excess capital level?

Julie A. McGraw

Currently if you look at 9/30 on a consolidated basis we’re about 1.2 to 1 ratio. We’re projecting at year end to be no higher than 1.5 to 1. Obviously there’s some excess surplus sitting in there and we feel that we’d be comfortable writing up to 2 to 1, maybe 2.5 to 1. Obviously we want to write in a comfortable position to not impact our rating with AM.

Amit Kumar - Fox-Pitt Kelton

I think previously you mentioned guidance of 15% plus inflation as the ROE target. Do you still have comfort with that number?

David W. Michelson

That is our long-term annual objective to be at 15% plus inflation. I think if you were to look at our ROE through nine months and look at what we would need to accomplish in the fourth quarter, given that what I indicated before we’re not in the reserve releasing business, achieving our annual objective of 15% plus inflation for 2008 would be exceedingly challenging at best.

Operator

Our next question comes from Mayer Shields - Stifel Nicolaus & Company.

Mayer Shields - Stifel Nicolaus & Company

I think Dave you said that the loss ratio had gone to 61% excluding the large claims compared to 2007. Can you give us any idea or a sense of the magnitude of what 2008 decreases imply for the 2009 loss ratio?

David W. Michelson

In terms of the rate decreases that will roll through in terms of earned premium, I think we’re looking at less than 2 points, maybe in the 1.5 point range all other things being equal.

Mayer Shields - Stifel Nicolaus & Company

Do you have any way you can disclose in terms of loss cost inflation? Again the normalized run rate, not the catastrophic losses?

David W. Michelson

What we have seen over the last several years and I think it’s continued into this year is at least on the transportation business we have seen a steady, very gradual decline in accident frequencies coupled with a steady and gradual increase in loss severities, these large losses off to the side, so that from a pure premium standpoint what at least we’re experiencing is approximately flat pure premiums in our transportation business.

Over on the personal line side, we analyze those products on a state-by-state line of business basis. We do put our rate revisions in and we get what we get and we write what we write. But on the commercial transportation side I would say approximately flat on the pure premium excluding those large losses that you alluded to.

Mayer Shields - Stifel Nicolaus & Company

With the economy continuing to weaken, are you seeing any decrease in demand on the limousine business?

David W. Michelson

The limousine business for us is, while we’re in it and we’ve been in it consistently since 1989, it is not a big part of our overall premium. It’s been a class of business for some reason that a number of the larger property and casualty companies have liked over the years, so specialty programs crop up where a company will do limo only but they won’t do charter, school, transit and airport shuttle. So as a result over the years with it always having been a competitive slice of the passenger business, we’ve not built up a really big book of it. If it has fallen off for us, and I can’t say that it has, it would be really immaterial relative to our overall direct written premium.

Operator

There are no further questions in the queue. I would like to turn the call back over to management for closing remarks.

David W. Michelson

We’re maneuvering through some unusual and unexpected events. However as we have noted in prior calls, National Interstate is in an objective driven company. Our people are expected to maintain high standards and have the ability to do so. Achieving a return on equity of 15% plus inflation for our shareholders remains our number one business objective. Thank you for participating in our third quarter conference call and for your interest in National Interstate.

Operator

Thank you for your participation in today’s conference. This concludes the presentation. You may now disconnect. Good day.

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