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Donegal Group, Inc. (NASDAQ:DGICA)

Q4 2008 Earnings Call

February 18, 2009 11:00 AM ET

Executives

Jeffrey D. Miller - Senior Vice President and Chief Financial Officer

Donald H. Nikolaus - President and Chief Executive Officer

Analysts

Joseph Demarino - Piper Jaffray

Michael Phillips - Stifel Nicolaus

Dan Schlemmer - Fox-Pitt Kelton

Operator

Good morning. My name is Britney, and I will be your conference operator today. At this time, I would like to welcome everyone to the Q4 2008 Donegal Group's Earnings Conference Call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. (Operator Instructions).

Thank you. Mr. Miller, you may begin your conference.

Jeffrey D. Miller

Thank you. Good morning, everyone and welcome to the Donegal Group earnings release conference call for the fourth quarter and year ended December 31, 2008.

I am Jeff Miller, Chief Financial Officer, and I will begin the conference call by covering financial highlights and providing commentary on the quarterly and annual financial results. I will then turn the call over to Don Nikolaus, President and Chief Executive Officer, for his comments on the quarter, as well as the business trends that we are currently experiencing.

Certain statements made in our earnings release and in this conference call are forward-looking in nature, and involve a number of risks and uncertainties. Please refer to our earnings release for more information about forward-looking statements. There were a number of factors that impacted our results for the fourth quarter of 2008. Increased claim activity affected our underwriting profitability, and conservative investment decisions resulted in lower net investment income for the quarter, as compared to the fourth quarter of 2007.

However, viewed within the context with difficult economic and market conditions, we are pleased to report a number of positive developments during the quarter.

First of all, unlike many of our peers, we incurred minimal realized investment losses, and no other than temporary impairments during the fourth quarter of 2008. The market values of our available-for-sale fixed income investments improved significantly during the fourth quarter, mainly as a result of the lower market rates.

Equity holdings represent less than 1% of our overall investments.

Our short-term money is invested primarily in U.S. Treasury securities, where we are receiving a low investment yield, but ensuring the preservation of our capital. We believe the absence of significant investment losses during the quarter, speaks to the soundness of the decisions we made throughout the year.

Our top-line growth during the quarter was attributable to the pooling agreement change and reinsurance savings that we've discussed throughout the year. In spite of the lack of organic growth, we are pleased to be able to report 11% growth in net premiums written for the quarter.

We completed the acquisition of Sheboygan Falls Insurance Company as of December 1, 2008, and the results of that subsidiary are included in our financial results from that date forward. Sheboygan Falls is a modest size Wisconsin company that wrote just under $8 million of net premiums in 2008. We look forward to growing our premium base in Wisconsin, and have already implemented many of our technology tools to assist Sheboygan Falls in acquiring premium growth, and expanding its distribution system.

One of our most significant accomplishments and one that few companies have achieved is that we ended the year with an increase to our book value.

Our stockholders equity increased 3%, and our book value per common share increased from $13.92 at December 31, 2007, to $14.29 per share at December 31, 2008.

We are pleased that in spite of the challenges that we and all in financial institutions faced in 2008, we emerged from the year at stronger financial position than we entered into it.

Turning now to the quarterly results, our net income for the fourth quarter of 2008 was $6.4 million or $0.26 per share of Class A common stock on a diluted basis, compared to $10.8 million or $0.43 per share of Class A common stock on a diluted basis for the fourth quarter of 2007.

Our total revenues for the fourth quarter of 2008 increased 10.3% to $95.8 million, driven primarily by 13.9% growth in net premiums earned to $89.1 million. As I mentioned earlier, our net premium writings increased 11% for the fourth quarter of 2008, primarily as a result of increased pooling allocations and reinsurance savings.

Personal lines writings increased 16.3%, and commercial lines writings were virtually unchanged from the fourth quarter of 2007.

Our investment income for the quarter was $5.4 million, a decrease of 7.4% from the fourth quarter of 2007. Similar to our comments during the third quarter conference call, the factors driving the decrease in our investment income were several.

I already mentioned our decision to increase our short-term investments holdings and shift them into U.S. Treasury securities. Secondly, we have liquidated our preferred stock holdings during the year, resulting in reductions in dividend income. And as we discussed last quarter, we used investment funds to pay off $15.5 million of trust preferred subordinated debentures in August of 2008, with a related decrease in investment income, more that offset by interest expense savings.

We have begun to invest in selected fixed income classes in early 2009. But, we are continuing to follow a very conservative path, until the investment markets stabilize.

Moving to underwriting results, our fourth quarter 2008 loss ratio was 66.8%, compared to the 58.4% loss ratio we reported for the fourth quarter of 2007.

We had an usually large number of fire losses in the fourth quarter of 2008, with three large fire claims alone adding $1.2 million to our quarterly losses.

In addition to the fire losses, we saw increased claim severity in several of our casualty lines of business. Also contributing to the higher loss ratio was approximately $2 million less favorable loss reserve development, as compared to the fourth quarter of 2007.

Our expense ratio was 30.9% for the fourth quarter of 2008, compared to 31.6% reported for the fourth quarter of 2007.

With the slight decrease attributable to a higher premium base and lower underwriting base incentive costs due to the less favorable underwriting results year-over-year. The expense ratio decreased in spite of a $1.3 million severance charge related to a reduction in force of approximately 50 full time positions across our organization.

We are continuing to implement an expense reduction program as a means of driving down our expense ratio, and in recognition of the current recessionary environment.

Our combined ratio for the fourth quarter of 2008 was 98%, compared to the unusually favorable 90.5% in the fourth quarter of 2007, with the increase reflecting the higher loss ratio in the current quarter.

Our net income for the full year 2008 was $25.5 million, down from the net income of $38.3 million for the full year 2007, reflecting the impact of increased weather claim activity, increased loss severity and less favorable prior accident year reserve development as compared to the prior year.

Earnings per share for the full year 2008 were $1.02 per share across a common stock on a diluted basis, compared to $1.53 for the full year 2007, and our combined ratio for 2008 was 97.2%, compared to 91.3% for the year earlier period.

Our pre-FAS 115 book value per share as of December 31, 2008, was $14.22, reflecting a 4% increase over the $13.64 pre-FAS 115 book value one year earlier.

At this point, I will turn the call over to our President, Don Nicholas, for his comments on the quarter. Don?

Donald H. Nikolaus

Thank you, Jeff, and good morning, everyone. Welcome to our fourth quarter earnings conference call. As a follow-up to the same that I would have discussed that the third quarter earnings conference call of the Donegal Group has continued to basically focus on some very key issues.

First of all, I'd like to talk about balance sheet strength. It became very clear in the August, September timeframe that unusual events were occurring in the investment markets. And we recognized that the integrity of the balance sheet of Donegal Group would be extremely important.

As Jeff has indicated, we are pleased to be announcing today that we have a increase in book value, which I think places us among a limited number of insurance companies that would have achieved that for the full year 2008, and also for the fourth quarter.

The fact that we have focused on balance sheet strength, and continuing to implement a conservative investment philosophy, we were also able to report today that there were no other than temporary impairments, and that our realized investment losses were limited to the modest sum of $181, 000.

Equities, as Jeff has indicated, are only representing approximately 1% of the portfolio and we do not own any preferred stocks because we had liquidated them earlier in the year. We continue to operate on a very conservative operating and underwriting strategy, because we believe in a recessionary environment.

For an insurance company it becomes very important that you are focused on the quality of your book. We certainly are very anxious to grow our premium, but probably more important what the quality of the premium is that we have on our books and that we would be writing as new business. So that we are certainly redoubling our efforts to make sure that we are writing profitable premium.

As Jeff has indicated, we have taken some steps from a standpoint of managing our expenses and took the step of reducing numbers of positions in the October, early November timeframe, because as we would have said at the third quarter earnings call, we want to be positioned for whatever the economic and financials situation that we might be presented with and that we believe that management's proactive steps in managing the expense side of the operation is extremely important.

From the standpoint of the growth of our distribution system, as you know from our prior calls, we believe it's extremely important to build for the future and building for the future in our business the way we distribute our products depends a lot upon the growth of the distribution system meaning the number of agencies that represent us. In the fourth quarter, we appointed 51 new agencies and for all of 2008 the total would be 245.

We believe that that boards well for the future, whether that's later in '09 or whether it's in '10 or '11, and we will continue in the year 2009 to be very proactive in seeking out quality additional agency appointments.

We have, as you all know, in early December, Sheboygan Falls Mutual Insurance Company became de-mutualized and simultaneously, Donegal Group Inc. acquired it, and basically one month's of its numbers are included in the fourth quarter numbers that were announced today.

The big story with regard to that acquisition is several-fold. One, that we have again demonstrated an ability to do an acquisition, to do a de-mutualization. It also very importantly gives us an access into the Wisconsin market which is a very excellent state in which to do business.

We have already before, even before that the de-mutualization; we began to rollout WritePro, which is our personal lines automation system. It is already live in the state of Wisconsin for their agencies. We will in '09 bring WriteBiz, which is our commercial equivalent and we would look also to bring Donegal Atlantic States commercial products to the state of Wisconsin. And so we believe that it will be going forward, a very good operating state for us.

There is always an interest in what is happening with regard to rate filings. I am pleased to tell you that we have continued to be very proactive in making additional personal lines rate filing. We have now made rate filings, or certainly by the end of next week, we will have made rate filing in 11 states. In all those 11 states, we would have made home owner rate filings, and in private passenger automobile, in most of those states we would have made rate filing.

In several states they actually would represent a second rate filing within a nine month period of time. We are seeing -- in a competitive marketplace, we are seeing competitors making rate filings in personal lines, it maybe a bit counterintuitive given the economy, but we believe that it's an appropriate action for us to be taking.

On the commercial side, I think we would all understand that our pressures on businesses because of the recessionary economy, and that can impact insurance companies, because insureds might have lower payrolls, which is the basis for premiums such as worker's comp. Sales sometimes are utilized in certain calculations for general liability.

We believe that from what we're seeing that the pricing, the competitiveness has not changed in commercial lines. It continues to be quite competitive. We don't see at this point having gotten any better. We don't see it having gotten any worse.

One other the things that we are trying to do, or some of the things we're trying to do to respond to what's happening in the marketplace. We've begun our annual agency meetings, which we do in 14 states, about 28 meetings. We started them in late January. We have been pleased by the response and the attendance. And some of the presentations that we have made have focused on delivering new products, being very concerned about customer service, and retention of existing business. We have also sort of taken the position with our agencies that the Donegal Insurance Group doesn't want to participate in the recession.

We want to do things that hopefully, counterbalance some of the negatives that the recession will put forth. We continue to position ourselves to be able to be opportunistic as circumstances present opportunities in the acquisition arena.

We continue to talk to various companies. We have nothing specific, or in anyway close to any final discussions at this point. We believe that a strong balance sheet will be very helpful, as acquisition opportunities become available, and we think that we will be in an environment in the future that provides those kind of opportunities.

At this point, I'll turn it back to Jeff, and we'll open it up for questions.

Jeffrey D. Miller

Thank you, Don. And Britney, if you could proceed with the question-and-answer period please.

Question-and-Answer Session

Operator

(Operator Instructions). Your first question comes from the line of Joseph Demarino with Piper Jaffray.

Joseph Demarino - Piper Jaffray

Thank you. Good morning. On the higher severity, you mentioned resulting, I think some fires. What type of buildings did these fires occur in? Was that personal or commercial?

Jeffrey Miller

There were actually two farm policies that had large fires in the fourth quarter, as well as a large commercial. So, the three large fires that I referred to, two of them were farm, which would fall into our personal lines segment, and then one large commercial building.

Joseph Demarino - Piper Jaffray

Okay. And I think, did you say for favorable development you did have some, but that it was $2 million less than what it had been in the prior year?

Jeffrey Miller

Actually, in the fourth quarter of 2007, we actually had very little development. It was basically flat, and the fourth quarter 2008, we actually had $2 million of unfavorable development.

Joseph Demarino - Piper Jaffray

Okay.

Jeffrey Miller

So, the $2 million less is of about a flat base from 2007.

Joseph Demarino - Piper Jaffray

And, what lines I guess, did that occur in, and what accident years?

Jeffrey Miller

It was primarily attributable to loss severity in the 2007 accident year. And primarily in personal auto.

And I can put that into some perspective, for the full year 2008, we experienced net unfavorable development of around $2.7 million, which was 1.2% of our reserves as of the prior year end. So it's certainly within a range that we consider reasonable. And I can report that our external actuaries had confirmed earlier this week that our net reserve estimates are very close to their point estimates, and we continue to believe that our loss reserves are adequate, and even conservative estimates of our ultimate liability.

Joseph Demarino - Piper Jaffray

Okay. Thank you. And then, on the mention of the lower underwriting based incentive compensation. What exactly, what exact changes did you make to the compensation structure?

Donald Nikolaus

Basically, that refers to contingent commission programs that are available for agents as well as the bonus programs are available for all employees. So and both are focused on loss ratio and if you have a higher loss ratio, you would experience lower contingent commission payouts and there are lower incentive compensations to employees.

Joseph Demarino - Piper Jaffray

Okay, thanks. And then just lastly, what was the statutory capital number at year end?

Jeffrey Miller

Statutory capital and surplus was $324.9 million. That would include Sheboygan Falls, as fairly close to what I believe I told you at the end of third quarter and the reason that we didn't see an increase for Sheboygan Falls acquisition was that we also had dividends paid from the subsidiaries to our holding company.

Joseph Demarino - Piper Jaffray

Okay, thank you.

Jeffrey Miller

You're welcome.

Operator

Your next question comes from the line of Michael Phillips with Stifel Nicolaus.

Michael Phillips - Stifel Nicolaus

Thanks, good morning.

Jeffrey Miller

Good morning.

Michael Phillips - Stifel Nicolaus

Let me start off with just one kind of high level kind of strategic question. And then couple of other ones. First question, no surprise that we're seeing combined ratios for pretty much industry tick up '08, probably '09 as well and so we're going to see, it's likely a lot of smaller companies, impairment rates kind of tick up and some companies that don't have the well with (ph) that I think that you guys have, find yourselves in, it's dire strait. I mean we have even seen some recent companies say point out of personal lines in certain segments that means recently in last week, obviously.

I guess the question is how much do you focus on that kind of stuff in terms of a concrete strategy to say here's what other companies have done, they may be a trouble and there is some business to be had because of that and how aggressive do you become in going out after some business that might be out there on the table to get because of that?

Donald Nikolaus

Well, let me respond to that. Companies that are exiting a particular line of business, what we talked about in the -- our distribution system is books of business. There might be book of business that were with a company that either has become less competitive or in the example you gave or exiting the market. You have to be careful because there's generally a reason why somebody is exiting the market. They're not exiting it because they made too much money in it.

So you have to be careful that the quality of the book of business is what you want it to be. But we are very proactive in looking to what is called rollover books of business and what we do, however, is we have a whole process where there are specific criteria under which that have to be met in order for us to sign off on agreeing to rolling over a book of business. But it's certainly area where we look to always try to grow. We just need to be careful that we don't get carried away with what that book of business might be.

There is an old saying in our business that, you have to be careful that you don't look at the perfume of the premium versus the sort of the downside or the problems with the quality and the profitability of it. So we're very cautious about that but we're aggressive about looking to those opportunities.

Michael Phillips - Stifel Nicolaus

Well, thanks, Don, that makes great sense. Nuts and bolts question, the press release talked about and you mentioned that in your opening comment Jeff the savings from staff productions, first you said $2.3 million in '09 and subsequent. Can you breakdown how much that might be in '09?

Jeffrey Miller

It would be $2.3 million in '09 as well as in subsequent years. So that's an annual number.

Michael Phillips - Stifel Nicolaus

Okay, good. And that is all I have for now. Thank you.

Jeffrey Miller

You're welcome.

Operator

Your next question comes from the line of Dan Schlemmer with FPK.

Dan Schlemmer - Fox-Pitt Kelton

Yes, hi, good morning. Sort of a follow-up on that last question with the personal reductions. Can you give a little more background on, I mean are you talking about claims people or are you talking about overhead or marketing, etcetera, where the cuts are coming from?

Donald Nikolaus

They, basically, are coming from various departments, including the fact that we have accelerated the centralization of certain functions into our home office facility because we have a number of branches and some of those relate to companies over the years that we have acquired.

So, some of it is the elimination of positions in regional offices and simply having the function centralized. Also, some of it comes from the fact that with a very aggressive program of automating function that we have been able to reduce the need for a certain number of personnel that may have done data entry work with positions like that.

It also included a few claims people. We also consolidated some marketing positions in that. We had some overlap between marketing people from one of our subsidiaries, calling on agents in the same state as we would have had calling on that same locality from the home office area. So it's a broad area. We've looked at all aspects of the operation and basically was able to downsize without, in any way in our judgment, adversely affecting our service levels or our aggressiveness in the marketplace or our ability to appropriately service claims.

Dan Schlemmer - Fox-Pitt Kelton

Great, thank you. Separately, the OTTI, I know you didn't take any impairments on the quarter, we're -- obviously are seeing a fair amount of that across the industry. And there is a fair amount of judgment as to when or whether you are taking impairment. Can you give us any background on how you guys make the determination that an impairment -- how you would make the determination that an impairment is appropriate or what kind of thresholds you might use?

Jeffrey Miller

Certainly, I can give you some color on that. Obviously, there are very specific accounting rules that dictate what constitutes an impairment and when it is other than temporary. But as you indicated, there is some level of judgment involved in that. And because we liquidated the majority of our equity holdings, we had very few equity holdings left, as we mentioned they're less than 1% of our investments and those equity holdings were held out again at the end of the year.

So the criteria that we use is we generally look at anything that is less than 20% of cost, unless if there is a decline of more than 20%. So that the holding value is less than 80% of cost, then that is obviously one that we look very closely at is to see if the near term prospects of recovery are reasonable and if they are not, then we write them down.

On the bonds side, we clearly because of the nature of our investment portfolio and the high quality of the holdings of any bonds there that are marginal, we clearly have the ability and intent to hold them to maturity. So therefore, the credit worthiness of the issuer is generally the criteria that we would use to determine if a write-down is appropriate.

Does that answer your question?

Dan Schlemmer - Fox-Pitt Kelton

Yeah, absolutely. Thank you. Last question, just real quick, talking about Sheboygan, in the comments you said Wisconsin's an excellent state to do business in. I am just curious whether you can clearly tell us what you meant by that, if you are talking about from a regulatory standpoint or competitive standpoint or other?

Donald Nikolaus

Oh yes, I'd be happy to do that. I would say from our view of it, it has a profile from a demographic standpoint. There are a lot of small towns and small cities. We like that. Also, from the standpoint of the regulatory environment, we think it's a favorable regulatory environment from an insurance company's viewpoint. It's fair, but it's reasonable. And also it's a state in which independent agency companies, because there's a number -- fair number of them balance out there.

There is a strong independent agency base. So what that tells us is that there are strong opportunities for independent type companies such as ourselves to expand a distribution system in that state. And generally, companies are profitable in this state which would be a important criteria.

Dan Schlemmer - Fox-Pitt Kelton

Very helpful. Thank you.

Operator

(Operator Instructions). At this time there are no further questions, sir.

Jeffrey Miller

Okay. We certainly thank everyone for their participation on our conference call this morning. Certainly, the year 2008 was not with lot of challenges. We look forward to 2009 and the opportunities that it might present. Thank you very much and have a nice day.

Donald Nikolaus

Thank you, everybody.

Operator

This concludes today's conference call. You may now disconnect.

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