State Auto Financial Corporation Q4 2008 Earnings Call Transcript

Feb.17.09 | About: State Auto (STFC)

State Auto Financial Corporation (NASDAQ:STFC)

Q4 2008 Earnings Call

February 17, 2009 10:00 am ET

Executives

Steven E. English – Chief Financial Officer

Robert P. Restrepo Jr. – Chairman, President, Chief Executive Officer

James Duemey – Chief Investment Officer

Matt Mrozek – Corporate Actuary

Cynthia A. Powell – Chief Accounting Officer, Treasurer

Analysts

Joseph DeMarino

Michael Phillips

Larry Greenberg

Ron Bobman

Operator

Welcome to State Auto Financial’s fourth 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. Mr. English you may proceed.

Steven E. English

Thank you [Amy]. Good morning and welcome to our fourth quarter 2008 earnings conference call. Today I’m joined by several members of STFC’s senior management team, our Chairman, CEO and President, 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 and myself, 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 type of factors are discussed at the end of our press release as well as in our annual and quarterly filing 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.

Robert P. Restrepo Jr.

Thank you Steve and good morning everyone. We finished a difficult and tumultuous 2008 with a very active quarter. The headlines are many. We produced a solid underwriting profit. We continued to experience strong growth as agents responded well to our investments in new products and new systems. We completed a series of actions to reduce headcount by as much as 7% by the end of the second quarter of this year.

We launched and completed a plan that we call “Innovate SA” which should improve our combined ratio by approximately four percentage points over the next three years. We announced the purchase of Rockhill Insurance by our parent, State Auto Mutual. We closed on this transaction last week but have no immediate plans to include it in the pool.

We put into place a new aggregate reinsurance treaty effective January 1 which will help address our earnings volatility related to high frequency, low severity weather events. And we managed to limit the loss to capital and book value despite [histor] equity investments while maintaining our competitive dividend pay-out.

There are a lot of moving pieces in the quarter. Steve English and I will do our best to brief you on each. From an underwriting perspective we had a solid quarter with a combined ratio of 96%. Our loss ratio was the primary driver and benefited from relatively mild weather and favorable catastrophe loss developments. The loss ratio fell 3.9 percentage points by release of reserves for prior quarter catastrophes. Excluding the impact of favorable catastrophe development, fourth quarter loss ratios were largely on track with trends we’ve seen throughout 2008.

In personal auto, fourth quarter weather had some impact on our loss ratios for both standard and non-standard. Property damage and physical damage frequency was up, particularly in December, affecting our loss ratios relative to the fourth quarter of last year.

In commercial lines, loss ratios also were largely in line with the previous three quarters. Exceptions were property and workers compensation. In our fire and allied lines we had an unusual frequency of large losses relative to our usual experience. Workers compensation results were affected by reinsurance, accounting adjustments and a frequency of large losses on this relatively small line. On balance we remain pleased with our loss ratio results but need price to improve results in both segments.

As I mentioned we continue to experience strong premium growth. In the quarter we grew 16.1% and for the year 12.9%. Excluding the impact of pooling changes and our withdrawal from the Florida personal lines market, which we completed at year-end, our growth was 7.6% for the quarter and 5% for the year. Organic growth was driven by personal insurance where we have 11.3% growth in the quarter and 7.7% for the year after accounting for the impact of pooling changes and the Florida withdrawal.

Personal insurance new business policy counts increased almost 40% last year. Retention remained strong and total policies in force in personal lines increased by 4.4%. Price increases are beginning to accelerate. We’ve already implemented pricing actions to increase prices by around 3%. We’re also in the process of filing additional price increases amounting to 4.5% for both auto and home in 2009.

Business insurance production was up slightly, but continues to face pricing pressures. Our policy count was up 1.8% for the year. The business insurance competitive landscape was largely unchanged at the turn of the year, but we’re hopeful we will experience a flattening out of what is now a declining price curve sometime during the second half of this year. A poor economy and a slow turn in pricing will obviously constrain our premium growth this year, particularly in commercial lines.

Expense ratio is unusually high for the quarter and was hurt by expenses related to the implementation of Innovate SA and the actions we took to reduce headcounts. The Innovate SA initiative engaged all of our associates at State Auto in identifying over 2,000 ideas which will reduce our expenses, improve productivity and enhance our revenues. After evaluating all the ideas, we now have game plans to implement 480 separate actions which should improve our expense ratio by at least three percentage points over the next three years beginning in 2010 and should also benefit our loss ratio by an additional point over roughly the same timeframe.

In the fourth quarter we implemented changes to our retiree healthcare program, we offered a one-time early retirement option and we completed a reduction of [enforce] staff of about 50 people. Combined with not replacing open positions last year, we will reduce our headcount by over 150 positions at the end of the second quarter this year which equates to approximately 7% of our staff.

All the ideas generated by the Innovate SA project, both large and small, will enable profitable growth; lower loss ratios; and a more competitive expense ratio. These ideas will also enable us to accelerate investments in people and technology, and maintain the solid production momentum that we’ve established.

With that I’ll turn you over to Steve English for a review of some of the most significant issues related to our balance sheet. Steve.

Steven E. English

Thank you Bob. As Bob mentioned in the fourth quarter we implemented changes to our retiree healthcare program which result in our current and future retirees sharing more of the cost of those benefits. The impact was to reduce our post-retirement benefit liability and increase other comprehensive income in the quarter by approximately $18 million net of tax.

At the same time, though, interest rates used to discount our benefit obligation and the decline in the fair value of the asset held by our pension plan worked against us. The combination of these increased our post-retirement and pension benefits liability and decreased other comprehensive income in the quarter by approximately $59 million net of tax. The net $41 million reduction in book value per share was $1.05.

During the quarter the Innovate SA initiative, the changes to our retiree healthcare program, the one-time early retirement option to eligible employees and the reduction of in force staff resulted in a charge to the income statement in the amount of $8.5 million, adding three points to the quarterly combined ratio.

Everyone is aware of the financial market turmoil that is ongoing. Our strategy of investing high quality, fixed maturity and diversified equity securities saw us through a difficult end of the year. The after tax impact of changes in fair value of investments and net realized investment losses for the quarter resulted in a small decline of approximately $3 million to our book value or equity.

Breaking this down between fixed maturities and equities, the fixed maturities portfolio contains high quality, investment grade securities made up almost entirely of triple A and double A issues; 82% are municipals, 92% of which are rated double A or better without the benefit of credit enhancement. No significant write-downs or impairments were necessary on this portion of our portfolio. We continue to have no direct exposure to sub-prime mortgages, derivatives, or credit default swaps.

Other comprehensive income increased during the quarter on fixed maturities by approximately

$30 million net of tax due to changes in fair value. Our equity portfolio contains U.S. large and small caps stocks plus international funds, classified as other investment assets and are well diversified. Unfortunately, all sectors faired poorly and other comprehensive income decreased during the quarter approximately $11 million net of tax due to changes in fair value.

Additionally, we evaluated our equity securities in light of individual circumstances; the magnitude and length of time they had been below cost; the domestic and global economic outlook; and our ability and intent to hold until recovery. For the quarter, our net realized losses on investments were $32.7 million, $29.7 million of which were other than temporary impairments. On an after tax basis this amounted to $21.7 million.

Net investment income for the quarter declined $2 million from the prior year and $3.3 million from the third quarter of 2008. This is primarily due to our investment in Treasury inflation protected securities or TIPS. As the consumer price index rises we record additional income on those funds. As the CPI declines as it did in the fourth quarter we reverse previously recognized income. This accounts for $1.2 million of the year-over-year variance and $2.3 million of the sequential quarterly variance.

At December 31, 2008 we are holding $79 million of TIPS with a fair value of $76 million and par value of $73 million. Additionally we held higher levels of cash in the fourth quarter at lower yields and relative to last year we held fewer large cap dividend paying stocks as we diversified into small cap stocks and international funds.

Our capital position remains strong despite a difficult 2008. Book value per share only decreased 3.6% in the fourth quarter which speaks to our overall conservative risk management strategies. With a debt to capital ratio below 14% and well capitalized insurance subsidiaries with capital levels exceeding seven times the required statutory risk-based capital, STFC is well positioned heading into 2009.

To further protect our capital and provide added protection from high frequency, low severity weather we entered into an aggregate cap reinsurance treaty effective January 1, 2009, and running through the end of the year. Our new aggregate treaty has a $5 million franchise deductible per occurrence, capped at $55 million. The limit is $30 million in excess of an $80 million aggregate for the State Auto Group with a 25% co-participation. The aggregate covers PCS numbered caps, excluding earthquake and named storms such as hurricanes or tropical storms.

Once a qualifying event exceeds the $5 million franchise deductible, the entire amount is applied towards the $80 million aggregate. We were pleased to be able to put this in place as part of our risk management strategy. As a reminder, our existing property CAT treaty renews July 1 and as we discussed on the last call we extended our coverage from $80 million in excess of $55 million to $100 million in excess of $55 million for the State Auto Group.

With that, I will turn it back to you Bob.

Robert P. Restrepo Jr.

Thanks Steve. I think as you all can see there were a lot of moving parts in our fourth quarter results. I feel confident that we’re well positioned to succeed in an uncertain business environment. Our loss ratios are holding up well, prices are increasing in personal lines, organic growth remains strong and we’re taking actions to reduce our expense ratio. Our financial strength is unquestioned and we have the capital and liquidity required to invest in our business and succeed in the future.

With that, I’ll open it up to any questions that anybody has.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Joseph DeMarino.

Joseph DeMarino

What investments caused the impairments or write-downs in the quarter?

Steven E. English

The investments – the write-downs were primarily from our large cap stock portfolio and the international funds. And collectively they made up 95% of the $29 million.

Joseph DeMarino

And what is the criteria for realizing a write-down?

Steven E. English

Our general guideline is once a security is 15% below cost we put it on a watch list. Once it is 20% below cost and has been there for nine months we have to have a compelling story as to not consider an impairment.

Joseph DeMarino

And of your portfolio right now, what amount of what portion is 20% below cost?

Steven E. English

Very little. We’ve pretty much cleaned house.

Joseph DeMarino

On pricing can you kind of provide more details on renewal pricing versus new business?

Robert P. Restrepo Jr.

Yes. Renewal pricing is on a price per exposure continues to be down in the mid single-digit range. It varies by line. It’s not down as much in workers compensation. It tends to be down a little bit more on the liability line. But in the aggregate on commercial lines it’s price per exposure is down mid single digits.

Joseph DeMarino

And on the expense ratio, what would be a good run rate going forward from here? When do you expect to achieve the reduction in –

Robert P. Restrepo Jr.

Yes, we expect the reduction to begin in 2010. I think the run rate that we’ve been experiencing over the last several years in the 33 of 34 range is probably where we’re going to finish this year. We’re in the process of restructuring our personal lines, commercial lines and claim operations so we expect that we may incur – we don’t know yet, but we may expect we might incur some additional severance costs in 2009. And we’ll also be incurring some relocation costs as people move to the new locations.

And the third area is that some of the improvement in expenses and improvement in productivity require some technology investments that we’ll be making this year. So the cost to implement these ideas, we still have additional costs that we’ll be incurring in 2009. But beginning in 2010 that’s when we expect to see a lower expense ratio.

Joseph DeMarino

And then lastly on your own reinsurance that you purchased, what was the pricing experience like there?

Steven E. English

We typically don’t disclose the price of the reinsurance.

Operator

Your next question comes from Michael Phillips.

Michael Phillips

Talk about a little bit about the Innovate SA for a second, you know, it looks like ‘010 three points on the expense ratio, a point on the loss ratio. Focus on that loss ratio piece for a second. You know we’ve had for a little while now and continue going to have it looks like personal injuries that are pretty favorable. Commercial lines may be starting to turn, who knows, I’m not going to make a prediction on that but is that point improvement there irrespective of what happens in the pricing market?

Robert P. Restrepo Jr.

Yes it is. It primarily comes from changes in our claims processes. Over the years we’ve been for several reasons very dependent upon third party appraisers. And third party appraisers, particularly for property and automobile claims, cost us more from a loss adjustment expense standpoint. So when we do reviews of claims handled by third parties the payoff tends to be slightly higher.

So we have several actions in place to actually in some parts of the country increase staff, but we’ll save dollars on the loss adjustment expense side and also we think be able to better manage our pay out using our own staff. That’s primarily going to relate to first party claims; automobile, property damage, physical damage and [while] automobile, physical damage and real property.

Michael Phillips

Talk about I guess personal lines for just a second. I think for at least the last couple of calls we’ve talked about pretty favorable but modest to favorable rate changes and you folks talked specifically about your better pricing and segmentation systems that you’ve been rolling out. And so I guess you hear all that and still somewhat surprised I guess to see the – I guess first off applaud the better disclosure that you guys gave this quarter. Love that, [ex-cat] and [cat] loss ratios and all that. So that’s nice to see.

But now looking at those ex-cat loss ratios by the line and looking at deterioration in year-over-year, ’07 versus ’08 for personal lines we’re still up quite a bit, almost five points in ’08 ex-cat and kind of hard to see how that might change going into ’09 and ‘010. I mean, I guess I have one more thing. I hear you with the rate changes at about 4.5% for personal lines, I believe. But we’re still seeing trends that are a little above that, too, so if you could just comment on that.

Robert P. Restrepo Jr.

Number one your observation is accurate. Two we’ve got to earn out those price increases. That takes a while. And three as I indicated in my prepared comments our filed rate increase is going forward or higher in 2009 than they have been in ’08 and that’s definitely a reflection of pure premium trends which are higher than they have been in past years. So we definitely need more price and we’re accelerating our efforts to get more price.

Michael Phillips

And then I mean the same story in commercial lines; it’s just slightly worse though. You know almost ten points higher in ’08 ex-cat, so again not going to get the rate there probably. So any other ways we’re going to see operational improvements there in ’09?

Robert P. Restrepo Jr.

Well, we are looking to begin to get some more prices but we’re not going to get enough to make up – we’re not going to get enough to fix the problem clearly in 2009. Part of it’s market conditions. We’re still for most of the lines still producing good results, albeit not as good as they have been the last couple of years.

Michael Phillips

I don’t know if you guys don’t disclose it or don’t have it or by line reserve development by quarter?

Robert P. Restrepo Jr.

We typically only disclose development on an annual basis not by quarter as we’ve discussed in the past.

Michael Phillips

And is that just because that’s what you want to disclose or you just don’t have it on a quarterly basis? Help me understand that.

Robert P. Restrepo Jr.

That’s just the way we’ve always done it, Michael, and that’s something that we’ll be evaluating to have more transparency, fuller disclosure in the future. But that’s just the way we’ve always done it, which isn’t necessarily best reason but that’s –

Operator

Your next question comes from Larry Greenberg.

Larry Greenberg

Just a couple of points of clarification. On the expense ratio, are the headcount reductions part of Innovate SA or would that be additive benefit to the expense ratio?

Robert P. Restrepo Jr.

They are part of it and they come from really three broad actions. One is moving our personal lines operation from ten locations to two. And also reflects the big investments in personal line we’ve made in technology. We just simply don’t need as many people to support our personal lines operation going forward.

The second is moving from about ten or 11 locations to five locations in commercial lines. And also we’re combining our underwriting and marketing operation for our middle market with our standard lines. And then three, we’re regionalizing our casualty adjusting processes and closing almost 20 sub-offices over the next couple of years.

Larry Greenberg

And the numbers you gave on the TIPS are those numbers just what was reversed from previous quarters? Or is that the total impact of TIPS versus those comparable quarters?

Steven E. English

Those were the net deltas between the quarters. So in the third quarter this year we had TIP income. In the fourth quarter we reversed TIP income causing that quarterly variance.

Larry Greenberg

And have you changed your overall TIP exposure?

Robert P. Restrepo Jr.

We have not sold anything since year-end. So the –

Steven E. English

The amount that I disclosed that we held at year-end we still hold today.

Larry Greenberg

Had you owned more of that going into the fourth quarter?

Robert P. Restrepo Jr.

No.

Larry Greenberg

And Bob can you just talk about what you’re seeing on the M&A front and a possible pipeline and any paying out there that you’re sensing might be changing the appetite of potential sellers?

Robert P. Restrepo Jr.

Well, there’s two things that I think given the way values are right now, it’s a pretty big leap between where a company is currently valued and what the take-out price would be. So I think that’s really a distance center for sellers to really step up right now since the timing is bad. I think a lot of buyers are wondering if this is the right time to jump in as well. In terms of our activities, we are more focused right now on the smaller mutual insurance companies. The acquisition we just completed on the mutual side with Rockhill, we’re focused on making sure that we properly integrate that, take advantage of the cross marketing opportunities.

And down the road evaluate what if any pooling changes would come as a result of Rockhill. But that’s probably a couple of years off. So for us we continue to be focused on mutual insurance companies looking for affiliation opportunities. But I just think the overall environment for M&A is not as good as it was a few years ago.

Larry Greenberg

Do you in your area where you focus on on the mutual side - have those companies experienced meaningful capital reductions from the financial crisis on a relative basis versus the rest of the world?

Robert P. Restrepo Jr.

Yes. I can’t really talk to the world in general. Mutual companies tend to be more invested in equities, some significantly. And so there are some mutual companies that have lost financial strength ratings with that and then invested the primary ones for mutual insurance companies. And the underwriting results are deteriorating. But the big hit for a lot of these mutual companies has been to their equity portfolios.

Operator

Your next question comes from Ron Bobman.

Ron Bobman

I just had a question about your investment impairment [testing]. You outlined it – I don’t know if it was in Q&A or prepared remarks, but in any event I was wondering those thresholds whether the 15% or the 20%, I guess the 20% in particular, is that on a continuous basis that the particular security has to have reached 20% and stayed there for nine months continuously or at a quarter end, at a month end? Could you explain that?

Steven E. English

Sure. This is Steve English. The general rule of thumb is yes, it has to be continuously under 20%. So if we have something that recovers you know say up to 10%, you know we might not impair that. However with this year-end and with all that’s going on, we also took into consideration the magnitude of the drop in values and the outlooks. So like I said in the prepared remarks earlier, that’s a – it’s a guideline. It’s not a [right] line.

Ron Bobman

And did you impair anything that was solely on the watch list but didn’t breach the 20% threshold?

Steven E. English

No, we did not.

Operator

Your next question comes from Joseph DeMarino.

Joseph DeMarino

What was the statutory capital number at year-end?

Steven E. English

Let me look that up.

Joseph DeMarino

While you’re looking that up my other question was what are you doing with new cash? How are you investing it?

Steven E. English

For new cash, you know we held higher levels here in the fourth quarter. Obviously did that with the market turmoil and the fact that with the high levels of cat claims that are paid by the mutual company and then billed to the public company, we knew that money would be flowing back to State Auto Mutual. And that is why you see that the affiliate with perma due from to a due to at the end of the year here.

Additionally we need to keep roughly $25 million or so at the holding company level for it’s dividends and interest expense and the like, the balance of which - we’ll be meeting here with our investment committee in the next week or two and look to re-deploy that cash. We’ll be looking to put it into some municipals and in select corporates and equities.

The statutory surplus was $737 million.

Operator

Gentlemen at this time I’m showing no further questions.

Steven E. English

Okay, well thank you Amy. 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 first quarter earnings call which is currently scheduled for April 28, 2009. Thank you and have a nice day.

Operator

This does conclude today’s conference call. Thank you for your participation. You may disconnect.

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