State Auto Financial Q3 2008 Earnings Call Transcript

Nov. 3.08 | About: State Auto (STFC)

State Auto Financial (NASDAQ:STFC)

Q3 2008 Earnings Call

October 23, 2008 10:00 am ET


Robert Restrepo – Chairman, Chief Executive Officer and President

Steven English – Chief Financial Officer

James Duemey – Chief Investment Officer

Matthew Mrozek – Corporate Actuary

Cynthia Powell – Chief Accounting Officer and Treasurer


Caroline Steers - FPK

Joseph Demarino - Piper Jaffray

Elizabeth Malone - Keybanc

Edin Imsirovic - Keybanc Capital Markets

Michael Phillips - Stifel Nicolaus


Welcome to State Auto Financial third quarter earnings conference call. (Operator Instructions) At this point I would like to turn the call over to Mr. Steve English, State Auto’s Chief Financial Officer.

Steven English

Thank you, Kelly. Good morning, and welcome to our third quarter 2008 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; Corporate Actuary, Matt Mrozek; and our Chief Accounting Officer and Treasurer, Cindy Powell.

Today’s call will include prepared remarks by our CEO, Bob Restrepo, 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, 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.

Robert Restrepo

Thank you, Steve and good morning, everyone. For those of us at State Auto, 2008 is turning out to be an unfortunate and unfunny version of Groundhog Day, and it’s dominated by similar, recurring themes:

Unprecedented catastrophe events, virtually all of which are wind related;

Solid underwriting fundamentals manifested by ex-catastrophe loss ratios, which have been generally good and reasonably consistent throughout the course of the year;

Accelerating organic growth driven by excellent results in personal lines and stable results in commercial lines;

Generally flat pricing for personal lines to modest increases prospectively;

And modest declines in commercial lines pricing resulting from continued market competition throughout the quarter and the year.

Catastrophes continue to be the headline story for us. Our experience in the quarter was reasonably good up until mid-September when hurricane Ike met a descending cold front here in the Mid West.

The results were devastating wind losses, particularly in Ohio, Kentucky and Indiana, and it could wind up being the largest single catastrophic event in the history of the State of Ohio, potentially surpassing the tornado Xenia back in the 1970s.

In line with our previous announcement, in the third quarter we experienced $54.7 million of catastrophe losses counting for 19.5 loss ratio points. Year-to-date State Auto Financial corporation has incurred $166.5 million in catastrophe losses, accounting for 19.8 loss ratio points.

Although the experience by state differed from previous quarters, the net financial result was similar and devastating to our tradition of producing underwriting profits.

Personal automobile results were somewhat affected by weather and by catastrophes. The biggest impact though in the quarter was an increase in bodily injury severity resulting from large losses, largely from prior accident years.

Both the number of large losses and the individual size of each of these large losses was more significant than we’ve experienced in previous quarters.

We continue to see significant improvement in our non-standard automobile results. The actions we’ve already taken regarding priced agency mix and underwriting controls have really paid off, and we’ve returned this business to the level of profitability that we enjoyed in previous years. We think the prognosis for this line is now quite healthy.

Homeowners continues to be the story in the third quarter, as it has in each of the previous quarters this year. Our non-catastrophe non-weather experience continues to improve relative to previous trends. Third quarter saw an almost 8% point improvement.

Clearly, though, that was a drop in the ocean relative to the wind losses that we’ve experienced, primarily from Ike. We’re now adding mandatory wind and hail deductibles in 10 states, accelerating the introduction of price increases and reexamining and rethinking the proper distribution of agency locations in catastrophe-prone areas.

Production continues to accelerate in personal lines, driven by the introduction of new rating models for our custom set personal automobile program and new easy-to-use technology solutions which our agents continue to embrace.

Written premiums were up 12.8% in the quarter and 11.4% year-to-date. Excluding the pooling change impact and the withdrawal from Florida, organic growth was up 8% in the quarter and 6.6% year-to-date. We remain pleased with both the quality and quantity of new business, our strong retention and the improving sales management.

In business insurance, underwriting results deteriorated somewhat. Weather and catastrophe experience were clearly a factor, but we also saw an increase in large losses in commercial automobile and in general liability.

In addition, workers’ compensation loss ratios were also inflated, primarily due to higher medical cost severity on older accident-year claims.

Business insurance net premiums increased 14.6% for the quarter and 12.7% year-to-date. Excluding the impact from the pooling change, organic growth for our business insurance segment was consistent with previous quarters at a positive 0.7% for the quarter and for the year.

For STFC, written premiums grew 13.5% for the quarter and 11.9% for the year. Once again, excluding the pooling change impact and the Florida withdrawal, our results for the company was 5.1% for the quarter and 4.2% year-to-date.

Pricing in personal lines is beginning to increase, with modest pricing adjustments earning out over the next three to six months in the 2 to 5% range, bearing by line and by state. Business insurance pricing remains depressed in the low to high single-digit range, depending on the line.

Prospectively, we see plenty of opportunities in the market to increase personal lines prices and get ahead of the lost development curve. In business insurance, we expect to see prices begin to bottom out, but probably not until after the 1/1 renewal season.

It’s been widely reported that should be at an inflection point for pricing, given deteriorating underwriting results, bad weather, volatile financial markets, and most importantly, declining levels of surplus in the industry. You would think that all of this should auger for changes in pricing behavior and available capacity. We’ll see.

Our expense ratio for the third quarter was inflated somewhat by the discontinuation of an inter-company catastrophe reinsurance program; also by an acceleration of ceded premium under our third party catastrophe reinsurance program as well as the purchase of additional reinsurance catastrophe coverage following Ike; and thirdly, an underestimation of the agency program in the prior year, third quarter of 2007.

We continue to maintain a high quality investment portfolio as previously disclosed. We have no direct exposure to Lehman Brothers or AIG, and no exposure to the common or preferred shares of Freddie Mac or Fannie Mae.

Our only exposure is to Freddie Mac and Fannie Mae senior debt issues and mortgage backed pools, which are now fully guaranteed by the government, and which amount to less than 4% of invested assets. At this time, we do not anticipate impairment.

Given the recent uncertainty and related volatility in the equity markets, we did take an other than temporary impairment charge totaling $5.9 million on several stocks within our equity portfolio.

Earlier this month, I wrote to our associates, agents, and retirees regarding the state of State Auto. I noted that despite the turbulence in the financial markets, and the impact on our stock and their 401(k)s, the good news for all our stakeholders is that we remain a conservative and superior manager of risk.

We routinely produce quality underwriting results, aside from the weather, thanks to our continued focus on balancing risk and rate regardless of market competition. Our reserving practices, both on individual claim cases and overall in our bulk reserves, remains on target.

Our reinsurance partners are on solid footing and we continue to seek out new M&A opportunities which we can leverage our strong capital position and exploit current opportunities to diversify.

I continue to be impressed and support our investment strategy which emphasizes capital preservation over earnings enhancements. It’s been a strategy that certainly paid off this year.

Jim Duemey, our Chief Investment Officer, has done a superior job over the years of producing good investment returns and minimizing downside risk.

We continue to have an outstanding story to tell. My predecessors at State Auto have built an outstanding business that has thrived in all sorts of financial markets.

Looking to the future, I’m confident that we continue to have the people and the plans in place to differentiate ourselves in the marketplace and emerge from this market turmoil an even stronger and more successful company.

And with that, I’ll turn it back over to you, Steve.

Steven English

Thank you, Bob. At this point, Kelly, would you please open the lines for questions.

Question-and-Answer Session


(Operator Instructions) Our first question comes from Michael Phillips - Stifel Nicolaus.

Michael Phillips - Stifel Nicolaus

Bob, a couple things. You mentioned the homeowners doing well ex cat. You mentioned auto was somehow affected by weather and cat. Any way you can help us quantify that auto piece on the cat piece? Because we look at the loss ratio you give and see it spike up quite a bit, and some of that’s weather related, but I just wonder how much?

Robert Restrepo.

Two points in the loss ratio.

Michael Phillips - Stifel Nicolaus

Okay. Thanks. And a numbers question here. You might have said this. If you did, I apologize, I didn’t hear it. Organic growth in commercial lines, 0.5%?

Robert Restrepo


Michael Phillips - Stifel Nicolaus

Okay, and then the first question on auto. The loss ratio ex cat, obviously impacted by more weather claims that just didn’t make the cat threshold; any way you could help us quantify that please?

Robert Restrepo

The big change that we saw this quarter relative to what we see is higher incidents of large losses that affected our [personal] on the field line. Just to give you an example we had 13 losses over $250,000, which is higher than usual, both the size and the frequency, and 12 of those were 2007 or prior losses.

We also had a higher incidence of large losses in our commercial automobile general liability business, and as I mentioned in my opening comments, we increased customer reserves on prior accident years for worker’s compensation almost exclusively related to increases in medical costs.

Michael Phillips - Stifel Nicolaus

Trying to understand what’s happened there. Is that the adjuster was looking at that and maybe, I’m picking a number, $5,000 per claim and then they say ‘oh gee it’s no longer $5,000 it’s $250,000.’ Is it a big jump or was it $100,000 and then $250,000, and some of these got over $250,000 over time? Or was it more of a big jump?

Robert Restrepo

It’s a timing issue. These things work out over time it’s just we had an unusual concentration of them and, in the third quarter we regularly review all of our outstanding claims.

But often times we’re at the mercy of a doctor sending us bills and we had a uptick in several cases where we reassessed what we thought the ultimate liability would be for medical costs for several people that were seriously injured in automobile loses.

But it’s a timing issue; we didn’t see anything that we thought was untoward; we just had a spike this quarter.

Michael Phillips - Stifel Nicolaus

Okay, great. Thanks Bob.


Our next question comes from Edin Imsirovic - Keybanc Capital Markets.

Edin Imsirovic - Keybanc Capital Markets

I was wondering if you could give us an update on your efforts to obtain how you get reinsurance coverage for the wind and hail events? And I believe on the last conference call you mentioned that it may be in effect on January 1, 2009 and I was wondering if that’s still the case?

Robert Restrepo

We are hopeful but, two things. We are continuing discussions, ongoing discussions with several reinsurers regarding aggregate reinsurance cover as we’ve discussed in the past and I was frankly more optimistic six months ago than I am right now given the weather that we’ve seen in the Midwest and also given what we believe is going to happen in the property reinsurance markets.

As you’ve seen with reinsurers as well as primary companies reporting financial results in the third quarter, not a good year for any of us relating to weather. That, my guess, is going to make us much more difficult to get the kind of solution we want, if nothing else just from a cost benefit standpoint going forward. Matt Mrozek is here with us and he’s on point with this and I’ll ask Matt, if you can add any color to that.

Matthew Mrozek

Just that we’ve looked at aggregate cover for a couple of years now. Historically it’s not been a cost effective purchase. This year we are more hopeful with the changes in the reassurance market we’ve come to some coverage that made sense from a cost standpoint, again is bottled into the changing reinsurance market right now may or may not make that a possibility. That’s something we continue to assess.

Edin Imsirovic - Keybanc Capital Markets

Okay, thank you. And just one last question. Just given how the investment markets have behaved lately, are you making any significant changes to your portfolio? Do you see any opportunities in terms of new investments?

Robert Restrepo

We’ve not changed our asset allocations which has emphasized municipal bonds and within our STFC portfolio just fixed income in general. I’ll ask Jim Duemey to comment on any significant changes he sees going forward, particularly the equity.

James Duemey

I’d to like to think that are opportunities to, at some point, increase our equity portfolio but the primary emphasis will be on the income side primarily with municipal bonds. So really not much change going forward.

Edin Imsirovic - Keybanc Capital Markets

Okay, thank you.


Our next question from Elizabeth Malone - Keybanc.

Elizabeth Malone - Keybanc

Just a couple of questions; on the pricing in the auto market, that looks like it has improved. Can you identify why pricing is a little bit better than we’re seeing in the general property casualty environment right now; is it typically a leader?

Robert Restrepo

I think it’s a just inherently a more disciplined market; there were fewer big players; they are more disciplined. Large well known companies particularly the stock companies have analytics; we all have the analytics now. We have much better handle on our business than let’s say we had back in the 90s, predictive modeling allows us to refund much more quickly with price increases even in the absence of rate increases.

The market has been changing in personal automobile because of deteriorating accident year trends for the past year or so. We’ve lagged a bit behind because our accident year trends have remained terrific, very good. But we are seeing a pure premium trends that are on the positive side so it’s time for us to join the pack and get the kind of rate increases we need to preserve our margins.

Elizabeth Malone - Keybanc

Okay, and then another question on M&A opportunities; you’ve spoken quite a bit about your interest in expanding through mergers and acquisitions in past conference calls and I wondered given market conditions and what’s happened with some investments, does that provide more opportunities and would you need to raise capital or debt in order to make an acquisition?

Robert Restrepo

Of course it depends. I’ll answer the second question first; our financing needs would obviously be depended upon the size of the opportunity. Until we actually disclose that we’ve completed the transaction, it’s kind of hard for me to respond to that.

On your first question, yes, we continue to see opportunities regardless of what’s happened in the market. We’ve have ongoing discussions with a couple of prospective partners and we’re optimistic that over the next couple of quarters one of them will actually wind up being a successful new partner to State Auto.

Elizabeth Malone - Keybanc

In terms of what you’re looking for, is it really more a product expansion or geographic expansion?

Robert Restrepo

It’s primarily right now product expansion. We’d really like to diversify our product portfolio particularly in the commercial specialty area.

Elizabeth Malone - Keybanc

Okay. Thank you.


Our next question comes from Joseph Demarino - Piper Jaffray.

Joseph Demarino - Piper Jaffray

What primarily drove the increase in both personal and business segment in net premiums written? What do you attribute the growth to?

Robert Restrepo

Let me talk about personal lines first. Number one, most importantly, it’s very stable retention. We’ve always had good retention. We’ve been primarily a total account writer and that contributes to excellent retention ratios over the years. Those have continued.

The second issue is we have a lot more pricing flexibility now with our custom set. We’re introducing the second version of it and that’s allowed us not only to broaden our underwriting appetite, but to preserve the margins by getting the pricing precision we need.

And the third thing and probably the most important change over the past two years is the point of sale technology that we’ve introduced. We’ve talked in the past about our net express technology which allows our agents to rate, quote and issue policies in their office.

But we’ve augmented that with new bridging technology, and new bridging solutions that make it even easier for agents to deal with us from their agency management systems.

So we’ve seen our quotation activity triple over the past two years. What hasn’t changed is the percentage of quotes that we actually write, which is good for us because that means we’re not being overly aggressive in the market place.

Our hit ratio is about one out of four. It was one out of four two years ago and it’s still one out of four. What’s changed is our ability to generate more activity. As our head of sales says ‘the more at bats you have, the more hits you have.’ We’ve have lots more at bats over the last two years, and we continue to roll out new bridging solutions and we like our run rate.

Let me just respond quickly to business insurance. Early in the third quarter we rolled out what we call BizExpress, which is our point of sale technology for commercial automobile.

As we saw with our BOP line when we rolled this capability out last year, we again had a significant uptick in activity. And the more activity you get the more opportunities you have to quote new business, the more opportunities you have to write business. We have really not a pricing issue as much as an ease of doing business issue.

We have our business owner product and our commercial auto product supported by that technology and workers compensation will come early next year.

Joseph Demarino - Piper Jaffray

Great, thanks. Did you say pricing in the personal side was up 2 to 5%?

Robert Restrepo

Prospectively. It’s been flat retrospectively, but we have filed rates and implemented rates and on a prospective basis, it should earn out in the 2 to 5% range depending upon lines [inaudible].

Joseph Demarino - Piper Jaffray

Okay, got it. First of all do you have much overlapping business with AIG and if so can you quantify or tell me about some impact you’ve seen from that?

Robert Restrepo

The short answer is no. We really don’t have any direct competition with AIG. I’ll start with our biggest line, personal automobile; most of AIG’s personal automobile business is the oldest on the market right now is direct response business, and we are obviously 100% independent agencies.

They have a small independent agency business that we don’t really compete with or in a very small way. They have some non-standard automobile products that represent a competitor in our non-standard auto line. We may get some business from there.

Commercial lines, if we had a specialty business we would be benefiting it, but in our standard lines we really don’t run up against AIG much.

Joseph Demarino - Piper Jaffray

Okay, thanks. And then one last question, what stocks in particular caused the OTCI impairments?

Robert Restrepo

It’s kind of across the board in terms of industries.

James Duemey

They were primarily in our consumer discretionary, industrial, and one [inaudible]. Pretty much across the board, just like the market.

Joseph Demarino - Piper Jaffray

Individual stocks though, not ETFs? Do you have ETFs?

James Duemey

No. We have no ETFs. They’re all individual stocks.

Joseph Demarino - Piper Jaffray

Okay. Thanks.


Our next question comes from Caroline Steers - FPK.

Caroline Steers - FPK

I just have two quick questions. One is if you could comment on the buy back and when you expect that to start up again? And then, you noted a bottoming out on [inaudible] and commercial pricing, and I’m wondering if there are any lines in particular that you would expect to be hardening first?

Robert Restrepo

Regarding the stock repurchase plan. It’s still open and we have always said that the highest priority use of our capital is for M&A. That remains our highest priority. We are also looking for opportunities to buy back our stock, but given all the volatility in the financial markets, as I said given the opportunities we’ve seen in the M&A market, we thought the most prudent use of our capital was to keep it and not buy back the stock.

We’ll be evaluating that on an ongoing basis. What makes the most sense going forward. But certainly during the third quarter for those two reasons: the volatility in the markets and the M&A opportunities, we didn’t make any repurchases. If those conditions persist, then my guess is our actions will persist. Or our lack of action will persist.

The second question, in terms of the pricing bottoming out. The biggest single indicator that I’ve seen over my career that drives pricing behavior is capacity and surplus growth.

What we’re seeing now is shrinking capacity driven by shrinking surplus growth and I think that’s going to have the biggest impact immediately on property oriented lines because of the bad weather, and a lot of the activity this year really hasn’t hurt the reinsurers, it’s hit the primary companies because it’s been more of a frequency issue than a severity issue. Ike and Gustav corrected that.

Now the pain is more broadly spread. My guess is that’s going to affect the reinsurance markets in the property lines first. Generally the first line to turn on the more liability oriented lines is commercial automobile. We haven’t seen that yet, but generally speaking commercial automobile experience is the first to deteriorate, and it’s the one that’s easier to fix, because it’s a more homogeneous risk than let’s say a general liability book business.

We’re not much into specialty lines right now, but I’ve read lots of talk about specialty lines like D&O. Given all the market turmoil, energy risks given the storm, that’s really not part of our product portfolio right now.

Where we see the biggest opportunity almost immediately is in the property lines for commercial lines, and my guess is that commercial automobile will follow. Workers compensation, because it’s so state regulated, seems to operate on it’s own cycle if you will.

Caroline Steers - FPK

Okay. Great. Thanks.


There are no further questions at this time.

Steven English

Thank you, Kelly. 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 year-end earnings call, which is currently scheduled for February 17, 2009. Thank you, and have a nice day.


Thank you for participating in today’s conference call. You may disconnect at this time.

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