Fred Eppinger - President & CEO
The Hanover Insurance Group, Inc. (THG) Bank Of America Merrill Lynch 2013 Insurance Conference Call February 14, 2013 2:55 PM ET
Okay last presentation of the conference. A lot of insurance over the last two days, but we are closing with an excellent speaker, I must say; and the first time speaker to our conference, we have Fred Eppinger, Head of Hanover. Fred took over Hanover I guess about 10 years ago and the amount of change in this organization over that time is really astounding and that change accelerated recently with the acquisition of Chaucer making this a global company, at least multinational anyway. Fred’s got a great story to tell. I'm going to let him tell it, I'll turn it over to Fred.
The last presentation. This is fantastic, so what I would like to do is introduce our company. There you go. And so we are 161 year old startup. And what I mean by that is that the Hanover particularly over the last nine or so years has embarked on a journey to build this world class P&C company that could deliver top quartile performance through the cycle.
Today, we find ourselves at about $5 billion in gross written premium. Its about a third, a third, a third specialty, personal lines and core commercial. If you look at the mix of the business now domestically we are about $3.8 billion gross and about $1.4 billion is out of the Lloyd’s platform and so quite a broad and diversified portfolio now.
Let me just give you a little bit of overview on what I'm going to talk about today and kind of little bit about the company. We are a very well positioned and unique institution. We have built a series of pretty distinct business positions across our businesses that have allowed us to have preferred shelf place with some of the best insurance companies, insurance agents in the country and we have positioned ourselves now to really enhance the profitability of each of those businesses now that we've built them out.
So as we sit at the end of the year, we have the best balance if you will, both geographically and line of business, as well as operating model and position in each of those businesses as we've ever had. ’12 was a transition year for us. We did finished the integration of Chaucer which is a pretty significant step for us, but on top of that we finished up about nine acquisitions and business launches since 2009 to really complete the portfolio and so we entered ’12 with some work still to be done and I'm going to talk a little bit about how we ended.
Where we find ourselves now is in a terrific position, to capitalize on the disruption that's happening in the marketplace, this is not just a turn. This is frankly a real change in the market because it’s the first churn that has been really driven not just by the cycle of insurance, its been driven by the economy, its been driven by yields, its been driven by the structural changes that's occurring which is really threatening small companies and really creating consolidation to better companies. And so we feel that we are very well positioned in each of our businesses through pricing, through our ability to actually shift to higher margin businesses, to really continue to leverage the investments we've made on our operating model, to really take advantage of this to both grow topline and the bottomline of the business.
Now, from the beginning, we set out to be a very vision-based institution. I think that people that follow this industry realize that the industry is very good. 25% of the companies make all the money and what's interesting about the industry is the folks that tend to be good, stay good. And so as a company, when we started, we were probably the one or two worst companies in this sector. We had life operation that almost put the company under in the early 2000s, because of guaranteed minimum debt benefit and so we started with a portfolio that was quite weak and wanted to set forth on a journey that created a property and casualty company that had a distinctive ability to make returns to the cycle, that really created a series of four priorities.
One is to make sure we had a differentiated product set and in the most attractive areas of the industry, and I am going to talk a little bit about that because that really is the secret in our industry is that most of the sectors even if you are outstanding or hard to make money, because there is a lot of parts of the business that under achieve over long periods of time.
The second thing was to create within those businesses a distinctive position, instead of just doing what everybody else would opportunistically go after large accounts or national accounts to create niches or segments that we tap to another operating model that allowed us to both make money, but to sustain profitability to the cycle.
The third was to create what we call value proposition that gave us preferred shelf space with the distributors of this industry. There is a lot of things going on, but there were 1,000 of the independent agents that are better than the others. They were able to sell value, they were broad in their capabilities, they have more distinctiveness. And the question is how do you get preferred shelf space in a business that has a lot of excess capacity? And so we think we've done that.
And then finally, what we wanted to be able to do is, every great company in our space takes advantage of a cycle, have and have not separate during the transition. The weak company shrink, they re-underwrite, the good companies were able to not only grow to play, they were able to cherry pick and so the question is do you have the financial strength when it occurs to capitalize on it and when we have done we believe it set ourselves up for each of those for the next two or three years.
Now again, our history is interesting only because it gives you a sense of what we have done. In the first four or five years of the joinery it was all about fixing; we were about 12 hours should be taken over by the State of Massachusetts. We were have been downgraded four notches. We had a portfolio with about 12 run off businesses.
The first five years were really about getting ready to run off businesses and we were focusing on the P&C business; we were in the business we are as I said we are 161 years old with a 36 of this company on the New Stock Exchange. So we have some history to us but we had a very difficult decade and so what we did is really refocused the business. In ’09, late ’09, we have got upgrades, a second set of upgrades from all the rating agencies, I think we are the only financial service company in America that got upgrades by all the rating agencies during the financial crisis in ‘08-‘09 actually.
And after that we have been able to, we took some proceeds from the sale of the run off businesses and the new rating and set forth on creating this portfolio. So expanding beyond our portfolio to really enhancing the business portfolio, we went on a to even buying nine companies entering a couple of orders through renewal write deals and expansions to be able to create a portfolio that was much more distinctive and that’s really what we have been working on.
Now where we are in the journey is that we are pretty much settled in and what’s great about being here where we are, this year it’s really about just creating financial leverage. We have all the businesses, we have the geography in place, we have the business operating models in place and now what we are doing is working on the margin through the leverage that are available to us and so we are really in a quite good place to increase our margin and our value in a pretty significant way.
The three leverage that we are working on and we did working on that really positions us well is this better mix of business, both geography and line, more distinct strategies within the business and then finally this value proposition which is quite unique to our company, and I am going to talk a little bit about and makes us probably the most talked about company in our space because of our position with some of the better agents in the country.
So again each one of those levers are important, let me just talk about geography, when we started in ’03, the P&C business was 70% personalized to 70% in four states and they happen to be the worst force states in America, Mass, New Jersey, New York and Michigan. The fifth state was Louisiana and the sixth state was property in Florida. You cannot create a more difficult mix. By ‘08, we were still about 57% in our core four, we are now about a third, so our portfolio has now spread nicely, so our geography and spread is very even and distributed appropriately to better positions to regulatory reform but also in places that have upside both demographics in the mix of lines of business.
This is probably the most important thing, again, one of the things that people who follow the industry don't realize is that yes, the industry in total underperforms cost of capital through the cycle. But what’s even more interesting is that many of the lines of business and many of these geographies are always worst than the cost of capital. And so if you look at our entire industry, it is about 18% of the lines of business that they cost of capital over the cycle and lowest don't. So it's really quite interesting. There are a lot of reasons for that, the excess capacity mutual dominate certain states and certain lines. But if you look at the best companies, 40% of their mix are in that categories, so it’s not enough. You just can't do that, there's a lot of people that do poorly in the best line but to be world class to be top quartile it’s hard to have the worst mix and outperform.
Of the top 50 companies in the country in ’08 we had the worst mix. So, 15% of our lines of business when they are attract it and so while we outperform like our Michigan personal lines we outperformed seven points to the industry. We do it very well, but if you are going to be top quartile for the cycle its hard to have that bad of a mix, where we find ourselves today is we are now the same as the top quartile.
We are about 40% of those attractive and frankly, given what we did this year with Chaucer that we are about 43. So we have an attractive mix of business but again I say this isn't enough. There are a lot of people that do poorly in good lines and there's a lot of people that do well in poor lines.
But it was a very important part of what we try to do and so as you look at our mix today from ’08, we went to the $2.5 billion company we are about $4.5 billion today net and about $5 billion gross with this broad portfolio. In addition, and probably most importantly, in each of these businesses we've created a very distinctive approach to go to the market.
So, in small commercial we have the most distinctive operating model. We are the only ones that of the top four we are kind of top four if you will in small commercial right now. If you look at our operating model, we distribute new business underwriting that's tied to all our automation. Sure, we have all the straight through stuff and we have all the automation like everybody else does but particularly for that 25% to 50%, we distribute our new business underwriting for the stuff that's a little different which gives us an enormous advantage of what's really Main Street America.
So we have the efficiency of the renewal centers and all the automation but we've spent so much money on automation, we can have remote people that can give it to our agents’ office and take advantage instantly of opportunities. So with every one of these segments, we have a little difference. In middle market, we are an industry oriented player, almost all our businesses around industry solutions niches and segments.
We have end-to-end solutions for things like fine arts or cultural institutions. It’s a very value-added approach to that business. If you look at personal lines, we have an account oriented value approach that's whole account is very different, kind of a near fluent approach to that $1.6 billion business for us.
So with each of these, we try to be a value-added player that picked some niches and goes after. So we are not only broader and within better lines of business, we are a little bit more distinctive and then our value proposition, and again one of the things that people don't quite understand in our business is the consolidation that has occurred to the better agents and the better agents and brokers in this country have really done a lot of acquisitions but also a lot of investment and how to deliver industry solutions.
And so what the question for us was is we had a lot of small agents you could imagine in the personal lines company in four states. We didn't have those kinds of relationships with the top 1,000. So one of the things we did is we created a very clear value proposition that gives them greater franchise value.
We have fewer appointments than any company in the top 20 in the industry. So we give much more franchise value locally. We do retail straight on things like specialty. We don't put through wholesales. We go directly and built operating models to go direct to folks to provide specialty business to retail agents and we are very big (inaudible) this local responsiveness and quick turnaround.
So that value proposition has allowed us to double our position with the best agents in the country. Today, we have $3.5 billion with 800 of the best agents in the country. That alignment of incentives is everything because what happens is through profit sharing and alignment of incentives, when you try to get price increases like in today’s environment, it is very dangerous because you can get price increases but adverse (inaudible) if you push too hard.
Well if you have your business, align with agents, we have a lot. We have profit sharing aligned. They are with you on how to get the best mix as well as the price. It's why what you have seen us do as we've been able to get more price and [held] all our retention than almost anybody during this transition.
And so for us, this whole shift to the best is big and by the way, those are the folks that are buying people. So what happens is as they buy other agents, they shift share to us. So we have a built-in ability to grow because those the same 800 that I have 3.5 million with, only have 3% share. So, our headroom with their consolidation and their (inaudible) move forward allows us to think forward in an easy way of profitably growth.
So again, this is a big part of who we try to become. Over the last five years, we’ve made good progress as far as our size and our earnings power in capital. Now, we had a very difficult couple of years. We've been weathering ‘11 and Sandy has really done a number on us but we're very proud and I want to talk a little bit about how resilient we're with something like Sandy, which is really a storm that hit our biggest concentration via zip code and we still didn’t hit our reinsurance retentions. So it tells you we've done a lot around our spread of risk but our mix has changed and since the last five years, even with all of this change and all this investment, we have consistently outperformed the kind of regional company and small company in the industry.
We are not where we need to be in top quartile. So you see is we have shifted and outperformed the regions but we consistently not at the top quartile. So given all this investment, given all this change, the number one thing we need to do now is to make sure we are outperforming and moving towards the top quartile which is why we build the portfolio we built.
So if you think about ‘12 and the transition, a lot of things happened to us because of the [troughs] we obviously grew as the troughs got integrated into the business and we have momentum, very significant momentum in our commercial business as well with all the new businesses.
And we were able to increase the dividend and move forward but Sandy was the story in a lot of way this year for the company and so as I step back, one of the most important things that our strategy has allowed us to do is aggressively attack our mix. So what I mean by that is that, in the industry today, most people will tell you that this weather is something that has to be addressed.
The volatility and the intensity of what I call (inaudible) which has gone from just few hurricanes to micro storms that are very intense have changed people’s perspective and it requires that you think about your micro concentrations of business because your micro concentrations create a marginal cost of capacity that’s quite high, if you are overly concentrated and it will cause a lot of volatility.
So what you are seeing is a lot of people working on those micro concentrations. What we did this year is we got rid of about $175 million worth of business, but because of our strategy and our partnership strategy, we are able to do that by shutting legacy agents and doing deals with people to do renewal rights and other things to sell that business or move that business up relatively rapidly, but we have done a lot of work there. We feel very good about our portfolio. We did grow a lot this year but we did get rid for 175 at the same time and we have about 75 more I would like to do, but what this does guys is, it emphasizes the importance of diversification, spread of risk and good pricing because nobody knows what these events are, and that's why you are seeing its interesting way of life you are going to see sustained pricing because of this yield. There will be sustained pricing in the system because people can see what is happening.
And Sandy again, we are very proud of Sandy. Hanover is (inaudible) up at the Hanover Square. This we’ll hear for 120 years if we look about to choose it, those zip codes were some of our most significant zip codes in the country. The models where they had us some like 350, we had about a $170 million.
So what we have done is we have managed our aggregations very well. We have done a great job on underwriting. We've no large losses; we have number of losses but no large losses out of it but again one-time loss over the whole thing. So for us, that's tells me that our diversification is working, we did not use our reinsurance fee and this is the second worst storm in history that hits our hometown, right.
So for me that makes me feel good about the resiliency going forwards of our earnings and where we are going. The other issue in the industry that I just want to comment on, clearly there is a severity thing in auto and again what is interesting about I think good amount of people will talk about the extra 1,000 (inaudible). For me, the team here is making sure that you get the right mix and you are getting right and so in this year of transition, while we had some issues, like everybody else we did on severity, we have got really good rate above inflation and we are reacting very quickly on top of that.
So, again as we look forward, we feel very good about our results. So with ’13 its very simple, its all about leveraging the position we built to create a world class return. We believe that's ‘11 or ’13 are through the cycle and I know that yields are going down, but we believe that in our back of business we are a little bit less tail than most and float them most. Their ability given the positions we've built over the next two years by working at three things that we are working on; one is obviously the financial performance and leverage in pricing and a little bit of operating model work we got because we built so many businesses with us we have some expense leverage that's still in front of us.
It’s continuing to look at the mix and improving our mix both to get volatility down, but also to get more margin in the book by increasing our specialty and unique niche positions. And then finally continuing to leverage this shelf space I talk about with the agents. The lead market that we compete against that you all know who they are we won't name them, that's the same businesses what we have 3% in those agents, they have close to 15% to 20%. So our head room with those really good agents is significant.
So continuing to build that shelf space as we build out the products is right in front of us. I mentioned pricing in ’13, the reason we are confident and what's happening in ’13 this is both our pricing and both our personal and commercial as well as our retention. What you can see is obviously and obviously the market’s helping. But what I like about it is that our average policy size is small in commercial, we are getting really solid and growing price increases December was better than October, January was better than December.
So we are getting very good solid price increases and our retentions are holding beautifully; even with this notion that we shed some business to reduce the volatility. So again we are in a very good position to continue to improve our mix and improve our pricing. And on expense as I said when you did so much building and buying of companies, we took what I call expense risk versus the loss risk. In our business, you don't want to get in businesses you don't understand, you want to invest in the capabilities that people, the technology before you do it. We invested a lot and so we really increased our expense ratio when we went through this process, and as we have moved forward obviously that's come down dramatically and I think over the next two years we will get another point half or two out of commercial, because we are now digesting that investment but it was the right way to do it. We took an expense risk and we didn't get in a situation where we were extending ourselves on the appetite before we knew what we were doing. So I feel very, very good about that level as well.
And then if you look at our specialty position which we worked hard to build. We are now one of the significant specialty players in the markets we are in, we are about $700 million with a good portfolio professional lines, some special industrial HPR type businesses, some program business and liability areas and marine insurers. So we built out a diverse specialty book direct to retail agents which is a really nice solid diversifier for us with high margin. Chaucer again we worked hard. We believe very strongly that Lloyd’s platform with its efficiency of capital is a great add to us. It was a specialty oriented company. This isn't really a reinsurance company, this is a Lloyd’s specialty company. There are 13 or so really very strong embedded skill sets and its about $1 billion, its performed very well for us. We made this year a $136 million pre-tax out of this portfolio.
What we love about is the skill set are strong and they are applicable to our partner agent in a number of categories in the US as well as out of the Lloyd’s platform and so we're able to leverage this platform to really provide a distinctive opportunity for our agents in places like aviation and marine in particular energy, where we are now one of the better energy providers in the country and in the world and frankly and things like platform and some of the alternative energy. So it gave us an additional set of capability that we're very excited about having in the portfolio.
And then as we think about the balance sheet, again, my point is that during the cycle, during the transition, this is the time we want to take advantage of the opportunities and you got to come with a strong balance sheet and we feel terrific about it. We have mostly short tailed lines, we have lot of liquidity and our debt ratios are in a very good place and we've always been very conservative on the investment portfolio. We're not one of the companies that I don’t try to believe a Warren Buffet portfolio is very boring and we're glad it is and we believe that we have a nice set of embedded yield like everybody else. We see new money going down but not a lot of portfolio turns every year. So we feel like it has some stability to it and we feel very, very good about our balance sheet right now.
So as I look forward, we're very excited about the next couple of years. We believe that we built something very lasting, very distinctive, but our goal has to be, is now to leverage that platform effectively, to make sure we're getting the pricing that we are continuing to work the mix that we continue to reduce the volatility in our mix by the combination of all those and to make sure that despite the headwinds in our industry with the yield that we are able to continue to move forward in top quartile ROEs and I think this been our outlook. We are comfortable with our outlook with a significant improvement this year and a significant improvement of following year as we build on this momentum that we have in the business.
Again as far as any of the book value measures we end the year at, it’s actually the highest book value we’ve had per share of 161 this is the history of the company partly held by the yields. But we feel like we are in a good place. We have obviously increased our dividend every year with the company was troubled they had reduced the dividend and I have credibly established those and we feel very, very good, we think it’s an important part of what we provide to the shareholders. Part of the turnaround what we have done while we have during this turnaround is we have as I mentioned a lot of run off businesses that we either shut down or shut down and sold and we were able to take the proceeds of that every time that I felt that we had excess capital during that we have given backlog $800 million to our shareholders during this turnaround in the form of either dividends or share buybacks.
So we tried all along the way not just invest in the company which was the most important thing, but to also anytime we had the excess capital to be able to make sure that we were being thoughtful returning to shareholders during this time frame. So again as I close as the last presenter of this conference, that’s a lot of insurance by the way. The investment pieces; what’s interesting about our company as I said because of 161 is altogether (inaudible) we are actually young. We are new to a lot of people, we have made a lot of changes in a business that doesn’t like a lot of changes, and what we have done in a very thoughtful way and a very deliberate way everyday for nine years is to build a platform and the portfolio that can sustained returns through the cycle.
And what we have been able to do even to the financial crisis, even during the worst weather in history is continue to move this company forward with the portfolio that allows us to say we are going to be able to do that, and so over the next two, three years we believe to this portfolio and this unique value proposition and distribution setup, that we are able to continually improve our returns and get to what we consider top quartile returns through the cycle and we believe we control the leverage now, now that we have the portfolio, now that we have the position with the agents, now we have the ability to get the price in the mix.
We believe we are good stock to hold and obviously our valuation because of all the things we have done and the uncertainty that comes with that is that a place that it is also very attractive as well. So we think we are probably one of the most interesting story in our industry for the next two, three, four years and we think we are in the great place to move forward.
So with that, thank you. And I guess we can take questions.
I do have some questions. You talked about the agents and the quality agents offices at year end and selectivity which was you’ve chosen your agents, what are you rank in those agencies, if I said rough percentage of your agencies are you top three or top five where that stand?
Yeah, that notion is kind of a very important notion because of agents as well. Now, agents have to place most of the business and so there's a pecking order of who is their partner and who is not your partner. And its why this has been such a deliberate strategy to do this from a top and a principle down and to make sure we position ourselves with the best in the country.
So, the way I would answer that is if you went to all 1,000 of our top agents and you said are we one of the most important three agents they have, it will be a 100%. If you ask them who their most important market was for the next five years to those 1,000 guys, 95% would say we are the most important market.
If you ask if we are the biggest and a lot of those agents say [Barney, Barney], because it’s a $700 million agency. There is probably three other folks significantly better than us. We are now $30 million with us. Those other businesses that they’ve had for 40 years to get to that level. With us they have been with us for seven. We know more about their business. They know more about us and the upside together is greater than their lead markets.
So what I can tell you very, very confidently is that they think about us differently. If you look at that 1,000 agents, most of those agents we do not only just planning with, we do multi-year planning with. If you look at my tie, I have spent probably a day and a hundred of those agents to present to all their employees. We are very unique animals. So, we don't just do it the way other people do it. We actually choose those partners to have franchise value with and then have a whole strategy with them to get to the most important position in their market.
Now again, some of those will only do three of our businesses, they might only have specialty. They might only have personnel. So each one has a different portfolio based on what they are good at. But I can very confidently say where we are today with those. Now there was another 300 that are emerging.
So we've said to each other, we want to be franchise partners, we have a good start but we are on the process and then there's all this criteria to get there and there's all these touch points to get there but again there's no company in America that knows their agents better than we do.
We know their portfolio. We know what they are good at. We know what they are not good at. It’s just a different approach. Most companies of our size would have four to five times more agents than we do. So it’s a whole different kettle of fish than having a lot of agents. We have to build them well because we have short.
The other question I had had to do with your reinsurance retention, I mean here's the Sandy one of the biggest storms to ever hit the US and it didn't hit your retention and maybe retention is a little too high?
So that's a great question. So we are a unique company in that we have, a concentration on what we buy are cat, is really the Northeast and obviously you worry about the top end as much as you worry at the bottom end. The Northeast because of its infrequency, we buy up to two, we retain up to 200. Now when I say infrequency, I didn't realize that 30 years if I took this job, we didn't happen knowing one Hurricane, we had two, so in the last two years so maybe infrequency is not the same anymore.
But in any cost benefit it would be very hard for us to buy down because it’s so infrequent right to sort of pace this and by the way you know we hit it well, we did well 170 domestically. So to buy down to a 100, it would be very hard, you would have to have one every year really to make that cost effective but it is unique. That makes us unique. If you were in Florida where you had a frequency, right. You would think about that different, but it’s a very Northeast centric issue for us.
My last question had to do with the specialty is this in general? Do you have the specialty products now that satisfy your agents needs because there’s a chance to buy you more product capability, I am sure that it match perfectly with what your agents need but are you where you need to be?
Yeah. That’s a great question. So part of the reason I went out and bought some of these companies or built some of these is we did a profile of our partners and where they were investing and where they had dedicated resources like whether it was LPL and architects and engineers. What we did in healthcare is very specific to what we saw from agents. There is obviously lots of other things we don’t do. There is lots of things. But what we wanted to do was the kind of specialty we wanted was smaller face value, things that each of our, not each, but many of our agents had that we can go direct retail and provide it. And so what you see us do is smaller architect and smaller (inaudible) lawyers.
What we're doing in HPI which is poly-protected risk, industrial risk, with the industrial risk that were about 100,000 range that all our agents had a lot of that and they needed it, our marine is dedicated to the kind of business that you see, kind of under the five brokers and so, we like what we have. We like what our portfolio. Is there other opportunities? Sure.
We don’t have as much specialty auto for instance that we could easily have, but I don’t feel we have the skill set to do that. I feel that’s something that I need more capabilities and claims and driver education etcetera to do well. So we think it's well matched, but there is other things we could do and we think the upside of it, just as the businesses we're in is quite good. So for instance in DNL, we don’t do publicly, no we don’t do Fortune 500 financial services anything. We do not for profit. Right, that’s the kind of stuff we specialized in. Our agents have lots of that, but we have just chosen to not do the other. So I like where we are but there is other opportunities overtime I would say. Any other question.
Just quick one on capital return, I noticed there was about 75 million in the last few years. As we are starting to get into this harvest phase now that you are talking
About, is that consistent with that this year or is that ever chance of moving higher this year?
Again the way we think about capital as I say it’s a combination whether a dividend or share buybacks or whatever. Obviously the last two years earnings were very reduced because of weather and so even though our share price is attracted to do that obviously that option was less attracted to do more. As we go forward we kind of look at three things.
We look at the ability to deploy that capital for high return businesses and build up business; we look at returning how would we return if we have excess capital for the shareholders; and then within that we say what’s the best way to do it and we always consider that as one of the options. And what has happened historically is when I have had a lot of excess the share buyback has always made sense because of where our price was and where I put the alternatives were.
As we look forward, I don’t see a lot significant increase in share buybacks until we get our earnings to a higher level and we obviously have lots of business opportunities that we are considering. But it is part of the portfolio that we always look at and we are going to constantly look at it, but I don’t think it’s going to jump up a lot this year and change dramatically given where we are for earnings. Thank you very much.
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