Harleysville Group Inc. Q4 2008 Earnings Call Transcript

Harleysville Group Inc. (HGIC)

Q4 2008 Earnings Call

February 20, 2009 8:00 am ET

Executives

Mark Cummins - Chief Investment Officer

Michael Browne - President and CEO

Art Chandler - Chief Financial Officer

Kevin Toth - Chief Underwriting Officer

Tom Clark - Senior Vice President of Field Operations

Allan Becker - Chief Actuary

Analysts

Mark Dwelle – RBC Capital Markets

Presentation

Operator

(Operator Instructions) Welcome to the Harleysville Group Fourth Quarter 2008 Earnings Conference Call. I would now like to turn the meeting over to Harleysville Group Chief Investment Officer, Mr. Mark Cummins.

Mark Cummins

I’d like to welcome everyone today to our fourth quarter 2008 conference call. Our complete news release and financial supplement are posted in the investor section of our website at www.HarleysvilleGroup.com. A replay of this morning’s presentation will be available on our website later today.

During this call Harleysville Group, Inc. may make remarks about future expectations, plans and prospects. These remarks constitute forward looking statements for purposes of the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995. Actual events or results may differ materially from those indicated by these forward looking statements and our fourth quarter earnings release as a result of various important factors including those discussed in the 2007 Form 10-K and the third quarter Form 10-Q which have been filed with the Securities & Exchange Commission.

You will hear us talk about operating results. Operating income is a non-GAAP financial measure defined by the company as net income excluding net after tax realized gains and losses on investments. For further definition we’ve included a chart titled reconciliation to operating income on the financial highlights page of our earnings release.

Leading off the call today will be our President and CEO Michael Browne, Art Chandler our Chief Financial Officer will follow with some highlights of our financial results, Kevin Toth, our newly appointed Chief Underwriting Officer will follow with some comments on line of business results. I will return to provide some remarks on investments and Michael Browne will then offer his closing comments. Tom Clark our Senior Vice President of Field Operations and Allan Becker our Chief Actuary also are here to help address your questions at the end of the planned remarks.

With that I’ll turn it over to Michael.

Michael Browne

This month marks my fifth anniversary as Harleysville CEO and I’m extremely proud of what we’ve accomplished during the past five years. In many ways, I think we have reinvented our company and we are now clearly a leader among large regional insurers in the marketplace. The goals we set back in 2004 were challenging but we worked very hard in the past five years to accomplish what we set out to do and those efforts have enabled us to outperform the competition during an extremely tumultuous year in 2008.

Before we look at our fourth quarter results I want to spend just a few minutes reflecting on some of the keys to our organizations success in 2008. I credit much of the success to the quality of the leadership of our management team, a group of experienced, creative and dedicated individuals that have demonstrated that they can compete effectively with anyone in the property and casualty industry. That success is reflected in our fourth quarter operating earnings of $0.87 per share which were our best operating earnings in any quarter in our company’s history.

A key reason we’ve been successful has been our diligent attention to the fundamentals of our business which include maintaining our underwriting discipline in a very competitive environment. We can’t afford to compromise on underwriting quality so we are not afraid to walk away from under priced business when necessary.

We are focused on protecting the quality and long term profitability of our business and this effort benefits greatly from our use of predictive modeling because it enables us to effectively assess risk quality and better match price to risk with the bottom line goal of competing aggressively for our agency partners best business and retaining our most profitable business.

As you know, we were one the first regional companies to use predictive modeling but we’re now to the point where we model more than 80% of our commercial line of business of both new and renewal and we believe predictive modeling is embedded in our underwriting process which we believe makes us the leader among our regional peers.

As we use tools like predictive modeling to focus on our longer term profitability we are pleased to have the continuing support of our agency partners who play a pivotal role in our success. Our agency relationships truly have differentiated us and as a result have helped us to be successful in a very difficult marketplace.

Evidence of the strength of those relationships and the trust our agents place in us has been their commitment to bring us their quality business. This is clearly reflected in their very strong retention rate we continue to see in both our commercial and our personal lines of business. Those relationships have been strengthened even further by excellent technology because it enhances the ease of which our agency partners are able to transact business with us.

We continue to roll out Access Harleysville our new commercial and personal lines policy administration systems during the year to replace a dozen existing legacy systems. As we complete the full roll out of these systems, systems that were developed with significant agent input and involvement our agents will benefit from some of the industries easiest systems to use for writing business.

As we noted in the past, much of our strategy revolves around small business due to the fact that it’s less price sensitive, generates better loss ratios and better retention levels. Not only are these new systems making it easier for our agents to write this type of business today but going forward these systems will offer much greater flexibility, expanding into new products, geographies and services quickly and effectively.

This new technology platform will position us as one of the few insurance companies free of legacy system constraints. Our agents have also told us that the quality of our claim service helps us to stand out from the competition and it is an important factor in their choosing our company for their customers.

Another key to our success has been our capital management strategy. In 2008 we put our strong cash flow and capital to work for our shareholders by again, increasing our regular cash dividend this time by 20% to an annual payout of $1.20 per share. That’s a considerable increase; in fact, our dividend is up more than 75% in just the last five years. The dividend payout reflects our strong capital position and the confidence we have in our future.

This is further evidenced by the fact that we have repurchased about 15% of our outstanding stock in the past year and a half and as you know we have just announced plans for another 3% stock buyback. All of these capital management efforts have been driven by our healthy operating results.

All of these important keys, coupled with the ongoing dedication of our employees and agents have positioned Harleysville as a formidable franchise that can compete with anyone in this industry. For that I want to personally thank our employees and our agency partners who have contributed to our success and I want to acknowledge our policy holders and our investors who continue to support us.

Before I turn the call over to Art Chandler our CFO to walk you through the details of our financial results let me touch on just a few of the most significant numbers from the fourth quarter and the full year. As I noted earlier our operating earnings per share for the quarter grew by 5% to $0.87. For the full year we reported operating earnings of $2.77 per share. When you exclude the impact of cat losses from this year and last year our underlying operating earnings per share for the year improved from 2007 which indicates that we continue to perform well in the fundamental areas of our business.

In the fourth quarter our statutory combined ratio was 98.5 meaning that we reported combined ratios below 100 in three of the four quarters of 2008. As you will recall, the second quarter was affected by cat losses primarily in the Midwest which ultimately led to our full year combined ratio of 100.7. We still outperformed the competition based on the projection by A.M. Best which is that the industry combined ratio will be 104.7 for the full year 2008.

We also produced an operating return on equity of 11.9% for the trailing 12 months which was just short of our ongoing goal of an ROE of 12% or better because I think a significant achievement in light of these outside events. It’s important to note that while many of our competitors have faced numerous problems related to their investment portfolio we built a conservative, high quality portfolio that’s designed to weather the type of difficult economic environment we currently face. Mark Cummins will provide you further details on that later in the call.

Those who have invested in our company have been rewarded with superior returns. In fact, our average annualized shareholder return over the past five years has been 15.6% which surpasses all of our regional peers, in S&L P&C index and the S&P 500 by wide margins.

With that I’m going to ask Art Chandler to provide further commentary on our fourth quarter financial results and then I’ll come back later to offer some closing comments and also to answer your questions.

Art Chandler

Starting with the first page of the supplement you will note that we had operating income of $0.87 per share in the fourth quarter of 2008 compared to $0.83 per share in the prior year’s fourth quarter. Fourth quarter included catastrophe losses of $0.07 per share compared to catastrophe losses of $0.03 per share for the fourth quarter of 2007. Year to date the operating earnings per share were $2.77 per share with cat losses accounting for a $0.77 per share impact compared to $3.17 per share for 2007 with cat losses accounting for a $0.19 per share impact.

In addition, we recorded net realized investment losses equal to $0.71 per share in the quarter which primarily related to the repositioning of our equity portfolio for tax planning reasons. Mark Cummins will provide more information on investments later in the call.

Including the realized net investment losses, net income was $0.16 per share in the fourth quarter and $1.44 per share for the year. The statutory combined ratio for the fourth quarter was 98.5 and included 1.3 points of catastrophe losses. The year to date combined ratio was 100.3. As a reminder, I would note that the change in the pooling percentage had a 0.4 point favorable impact on the year to date expense ratio and combined ratio. There is no impact on the fourth quarter ratios.

Adjusting for this re-pooling impact the year to date statutory combined ratio was 100.7 including 3.8 points of catastrophe losses compared to a 2007 statutory combined ratio of 96.7 that included 1.1 points of catastrophe losses.

Favorable prior development of 5.3 points was recognized in the quarter as compared to 1.3 points in the fourth quarter of 2007. This fourth quarter included 1.5 points of favorable development emanating from voluntary and involuntary pools as well as our small surety run off book. Favorable prior development was 3.5 points for all of 2008 and 2.6 points in 2007.

The underlying year to date current accident year loss ratio excluding catastrophies was up about 2 points from the result posted in 2007 due primarily to elevated non-catastrophe property experience. The year to date statutory expense ratio of 33.7 again was favorably impacted by 0.4 points as a result of the re-pooling transaction. Adjusting for the re-pooling the expense ratio of 34.1 is up 0.4 points from the result posted in 2007.

Internal expenses were flat as compared to last year which marks the third consecutive year that internal expenses were held flat. Staffing levels declined by approximately 4% over the last 12 months. Year to date operating cash flow was $197 million including $83 million associated with the pooling change.

Excluding the impact of the pool share change paid losses did increase about 12% compared to 2007 with a portion of the increase driven by higher cat loss payments and payments associated with higher non-cat property losses. However, the ratio of paid loses to incurred losses remained at a solid level of 96% on a 1% decline in earned premiums.

Pre-tax investment income increased $2.7 million or about 2% versus last year. The pooling change is the principal driver of the higher investment income.

Turning to premium production, net written premiums increased about 8% during 2008. Excluding the pool share change net written premiums declined about 5% in the quarter and 3% year to date. For commercial lines where renewal pricing was down 1.8% for the quarter and 2.9% for the year, written premiums were up about 7% including the pool share change and down about 4% excluding the pool share change.

Renewal unit retentions have remained strong. The decline of writings is mostly a function of lower new business writings in the middle market sector. Our year to date personal lines premium volume was up about 12% including the pool share change and up about 1% excluding the pool share change as compared to last year. Growth largely was price driven in the homeowner’s line as a result of insurance to value actions although strengthening unit retentions also were a positive factor.

Our balance sheet remains strong with a consolidated statutory surplus of $1.1 billion and a consolidated premium to surplus ratio of 1:1 we are well positioned to write quality business. In addition, our investment portfolio is of high quality and provides ample liquidity over and above our consistent positive operating cash flows. Our GAAP book value is $23.18 per share which is about flat compared to the end of the third quarter and debt to total capital is a conservative 16%.

During the quarter we completed our stock buyback program by purchasing 145,837 shares at an average price of $32.12 per share.

With that I’ll turn the call over to Kevin Toth.

Kevin Toth

I’ll be discussing line of business results on the last page of the financial supplement. When discussing year to date figures for both personal lines and commercial lines I’ll be referring to the results excluding the impact of the pooling change. I’ll start with commercial lines.

The total commercial lines combined ratio for the fourth quarter was 98.4% versus 97.5% for the fourth quarter of last year. For the full year our commercial lines combined ratio was 100.9% which compares to 97.5% at year end 2007. Cat activity contributed 2.9 points to our overall combined ratio compared to 0.7 points in 2007.

As Art noted, although pricing improved in the fourth quarter, market conditions continue to be competitive in commercial lines. We continue to exercise underwriting discipline and we are walking away from business that is under priced. At the same time, predictive modeling continues to be highly effective in allowing us to direct price changes to risks based on both risk quality and expected profitability. Our policy retention continues to remain very strong.

Commercial auto continued to perform well during 2008. The fourth quarter combined ratio was 87.5% versus 97.5% in the fourth quarter of last year. The full year result was 93.1% versus 94.7% in 2007. Prior year development was 9.4 points for the full year versus 5.1 points in 2007. Claim frequency in commercial auto liability continues to show a favorable decreasing trend for both bodily injury and property damage counts and severity is in line with our expectations.

Our commercial multi-peril combined ratio finished the fourth quarter at 105.2% versus the 95.9% we posted in the fourth quarter of 2007. For the full year, we finished 104.5% versus 97.8% for 2007. Cats contributed 0.7 points in the fourth quarter and 3.9 points for the full year. Favorable prior year development was negligible at 0.3% for the full year versus 0.7% in 2007. As we reported last quarter, property experience was elevated in 2008; this was primarily due to weather related events.

Our workers compensation combined ratio for the fourth quarter was 112.8% versus 112.2% for the fourth quarter of last year. For the full year, the combined ratio was 112.9% versus 112.2% for 2007. We recognized 1.3 points of favorable development for the full year. The more recent accident years are running off better that expected. Workers comp is a long tailed line but this is encouraging and I’m confident that our approach to this line will continue to position us for improving results.

I’d like to make note of our growth in other commercial lines. As you know, that line item is a combination of several miscellaneous commercial products including inland marine. As we advised you last year we are placing much greater emphasis on inland marine because of its historical profitability. It’s not surprising then that much of the 7.6% premium growth in other commercial in 2008 can be attributed to inland marine. We continue to view inland marine as an opportunity to both broaden and diversify our commercial portfolio in a line that has performed well over time.

Personal lines net written premium grew 3.3% compared to last years fourth quarter and 1.2% for the full year. That growth was driven by states that we targeted. In those states direct written premium was up 2.4% and policy counts were up 0.9%. New business units increased by 2.4% versus 2007 and policy retention which has been consistently strong continues to improve.

Personal lines delivered a combined ratio of 99% in the quarter versus 91.5% for the fourth quarter 2007. Cat activity contributed 3.4 points to the combined ratio for the quarter and 7.7 points for the full year. Favorable development was 4 points for the full year versus 6.6 points in 2007.

The personal auto combined ratio for the fourth quarter was 102.4% a 4.3 point improvement over the fourth quarter of last year. For the full year, the combined ratio was 96.1% a 3.6 point improvement over 2007. Favorable development was 9.8% for the full year versus 8.1% last year. Similar to commercial auto, liability claim frequency continues its steady decline. Written premiums for personal auto were up by about a point for the quarter and down by about the same amount for the full year.

Turning to homeowners, the homeowners combined ratio for the fourth quarter was 100.9% versus 76.3% for the fourth quarter of last year. For the full year, the combined ratio was 105.8% versus 86.8% for 2007. The second quarter catastrophic weather events had a significant impact on our homeowner’s results contributing 15.7 points to the full year combined ratio versus 5.8 points in 2007. Favorable development was about a point for the full year versus 6.4 points in 2007. Homeowner’s premiums grew 3.1% in the quarter and 2.1% for the full year.

In a year marked by continued price competition, unprecedented catastrophic events and disruption in the financial markets, we’re pleased with our strong underlying performance. Our relentless focus on underwriting discipline and our use of predictive modeling gives us the tools to responsibly select and price risks and differentiate ourselves from our peers.

At this point I’ll turn the call over to Mark Cummins to comment on investments.

Mark Cummins

We have a great story to tell regarding our investment portfolio, especially considering these unprecedented times. We’ve built our investment portfolio to withstand this type of unpredictable worse case environment. It takes years to build a quality portfolio and when the tough times arrive it’s too late to reallocate your holdings. We have no need to restructure ours.

We’ve always managed our investments to support our insurance operations and that means providing after tax net investment income while maintaining a conservative high quality portfolio and providing cash flow to avoid selling in illiquid markets. As a result, we are extremely well positioned.

Before I provide my typical review of the investment portfolio I’d like to comment on the net realized loss of $30.8 million or $0.71 per share on the fourth quarter 2008. As I communicated on the third quarter call, this loss is primarily the result of a tax planning strategy we executed to take advantage of the collapse in the equity markets. We decided to sell our equity securities and carry back the losses offsetting them against previously realized gains.

This tax strategy was available as of the result of the significant declines in the equity markets during the fourth quarter. The tax sales will result in a $15.2 million tax refund. Also included in the realized net losses in the fourth quarter of 2008 are impairments on our fixed maturity holdings of $1.8 million pre-tax which represents less than one tenth of 1% of our invested assets.

Our market value to amortized value on the fixed maturity portfolio was 101.3 at 12/31/08. Said another way, we have $28.2 million of unrealized gains at 12/31/08 in our fixed maturity portfolio. Our duration of 3.6 years at December 31, 2008 was down from four years at the end of 2007. Our investment portfolio remains very high quality with 94% of our fixed maturities rated ‘A’ or better and 78% rated ‘AA’ or better. Our average credit ratings are Aa2 by Moody’s and AA+ by S&P.

After tax investment income was up 4% in the fourth quarter and up 5% for the full year. This was impacted by the $160.6 million of cash used for share repurchases during 2007 and 2008 but benefited from our pooling change that we’ve discussed previously. Pre-tax yield excluding short term investments was 4.8% down from 4.94% a year ago. Our after tax yield was 3.53% versus 3.56% last year. In 2009 we expect investment income to be relatively flat.

Due to our tax position we will continue to purchase primarily tax exempt securities in our fixed maturities portfolio. This is one of the more attractive times in history to buy tax exempts. We like it not only due to after tax yield but because of their strong credit quality.

Regarding equity securities, I mentioned on the last call that we would be adding $25 million to equities. We added $12.5 million in the fourth quarter of 2008 which brought our exposure to a conservative 16.8% of surplus at 12/31/08. Additionally, in January we completed this allocation adding $12.5 million to equities.

Looking ahead, we expect to add another $25 million in the first quarter 2009. This would bring equity exposure into the low 20% range to surplus. It should be noted that we run a sensitivity analysis on our equity portfolio so simulate a 50% market correction to make sure that we can afford the risk of owning equities. We are very comfortable with our equity exposure and continue to use broad based equity index products.

Our liquidity position remains very strong, the maturity ladder on our fixed maturity portfolio including investment income amounts to approximately $350 to $400 million per year over the next four years and predictable cash flow no matter what the environment.

As a final note, the key factors in this unprecedented environment continue to be liquidity, asset quality and capital. We’ve positioned our investment portfolio to provide for these in support of our insurance operations.

With that I’ll turn it back to Michael.

Michael Browne

Before opening the call to your questions let me provide just a brief summary. First, despite the continuing turbulence in the financial markets and the soft insurance marketplace we reported strong fourth quarter 2008 operating results which include operating earnings of $0.87 per share and a combined ratio of 98.5 coupled with an operating return on equity for the trailing 12 months of 11.9%.

You may recall that at the beginning of this call that I referred to our company as a leader among large regional insurance companies. We have achieved this position through our consistent and relentless execution of the basics of the business. That includes a sophisticated commercial lines underwriting approach which features predictive modeling, innovative technology that supports ease of doing business for our agents, high quality claim service, conservative investment management, a proactive capital management strategy and ongoing strong relationships with our agency partners. All supported by what we call the good people to know at Harleysville.

As I explained at the beginning of the call and as I said when I became CEO just about five years ago we have transformed our company into one of the leading large regional insurers in the marketplace and that has been affirmed recently by two important sources. A.M. Best and our agents. A.M. Best underscored that point when they recently affirmed our ratings and our positive outlook noting that our operating performance “continued to improve relative to our peers in the industry and compared favorably to both.” They also said “they believe our efforts have resulted in positive signs in recent years and that the fruits of our efforts are likely to be increasingly apparent in the upcoming years.”

In my travels I’ve also heard similar remarks from our agency partners. For instance, I recently met with a group of our leading agents in New York State. During that meeting a number of them relayed to me that they felt that despite what they see as a very difficult insurance marketplace that we are simply doing the best job of any insurance company out there. They said that we are their leading carrier and they told me that we’re doing things the right way.

Bottom line, they said Harleysville has a very strong franchise value and they expressed great confidence in our company and our people. That certainly is very encouraging for me to hear and I think comments like that are a true testament to our entire organization.

Let me just conclude this portion of the call with an important point you’ve heard me make consistently over the last few years and that is we will not compromise underwriting quality chasing near term growth goals. Instead, underwriting discipline will prevail and we will use tools like predictive modeling to protect our profitability in this market.

We will work closely with our agency partners and we will remain disciplined despite the current market conditions as we focus on our goal of maintaining a long term underwriting profit, a 12% operating return on equity and continued improvement in our performance that will serve to differentiate us throughout 2009 and beyond.

With that let’s open the call to your questions. We’re ready to take questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Mark Dwelle – RBC Capital Markets

Mark Dwelle – RBC Capital Markets

You had given the total favorable reserve development for the quarter, did you have the split on that between what portion was commercial lines and what portion was personal lines.

Art Chandler

In the fourth quarter there were 5.9 points of favorable development in commercial lines and 2.3 points favorable development in personal lines.

Mark Dwelle – RBC Capital Markets

Another quick numbers question related to, Mark had given the average pre-tax yield; I just couldn’t write that fast.

Mark Cummins

3.53% versus 3.56%.

Mark Dwelle – RBC Capital Markets

Those are the after tax.

Mark Cummins

Pre-tax 4.80% down from 4.94%.

Mark Dwelle – RBC Capital Markets

One of the initiatives to be completed in the fourth quarter was the full roll out of access Harleysville, was that finalized in the quarter or are there still a few locations left.

Michael Browne

Essentially where we are is that the commercial line system is rolled out to all of our states except for three states where we still have regulatory approval pending. It’s been completed except for three states where we’ve got to get regulatory authorities to give their final signoff. On the personal lines this system it’s been rolled out to all our states except for two where regulatory approval is still pending.

Mark Dwelle – RBC Capital Markets

What sort of regulatory approval is required?

Michael Browne

There are products involved here so products have got to be approved by the insurance department. Some states, I don’t want to get into a discussion about states versus federal regulations but as you know, some states can be a little difficult in getting products approved.

Mark Dwelle – RBC Capital Markets

It’s clear the economy is playing a role in insurance buying. Maybe you could comment a little bit on how that’s playing out across your markets the degree to which it’s impacting volumes and so forth.

Michael Browne

I think it’s certainly a part of what we’re seeing. Certainly the economy is impacting payrolls and sales of businesses and its part of overall market conditions. That helps to put pressure on the top line. It’s hard to isolate it but it’s certainly a factor.

Operator

At this time there are no further questions from the phone. I’d like to turn the call back to Mr. Cummins for closing remarks.

Mark Cummins

Thank you very much everybody for calling in and we look forward to talking to you at the end of the first quarter.

Operator

This concludes today’s conference. Thank you for joining. You may disconnect at this time.

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