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State Auto Financial Corp. (NASDAQ:STFC)

Q1 2009 Earnings Call

April 28, 2009 10:00 am ET

Executives

Steven E. English – Chief Financial Officer

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

Mark Blackburn – Chief Operating Officer

James Duemey – Chief Investment Officer

Matt Mrozek – Corporate Actuary

Cynthia A. Powell – Chief Accounting Officer, Treasurer

Analysts

Joseph DeMarino – Piper Jaffray

Michael Phillips – Stifel Nicolaus

Paul Newsome – Sandler O'Neill & Partners

Matthew Rohrmann – Keefe, Bruyette & Woods

Operator

Welcome to the State Auto Financial first 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 English

Good morning and welcome to our first quarter 2009 earnings conference call. Today I'm joined by several members of STFC's senior management team. Our Chairman, President and CEO, Bob Restrepo, Chief Operating Officer Mark Blackburn, 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 types of factors are discussed at the end of our press release as well as in our annual and quarterly filings with the Securities and Exchange Commission to which I refer you. A financial packet containing reconciliations of certain non-GAAP measures along with supplemental financial information was distributed to registered participants prior to this call and made available to all interested parties on our website, www.stateauto.com under the investor section as an attachment to the press release.

Now I'll turn the call over to STFC's Chairman, President and CEO, Bob Restrepo.

Robert R. Restrepo

Thank you, Steve. Good morning everyone. Once again the headline for the quarter is catastrophes. Historically the first quarter has been kind to us. We thought last year's first quarter was unique when we experienced catastrophes accounting for 12.5 percentage points in our loss ratio. We were wrong. This year our catastrophe experience accounted for 15.3 percentage points in our combined ratio. Usually, over the past 10 years or so, we average 2 to 3 percentage points in the first quarter.

Unlike last year where we had a high number of storms this year two catastrophes were the primary contributors to our disappointing results. A January ice storm which shut down large parts of Indiana and Kentucky and an unusual wind storm in February which swept through the Midwest and Mid-Atlantic states, accounted for the vast majority of our catastrophe losses in the quarter.

In addition, net income results were hurt by lower investment income, a larger write down on our equity portfolio quarter-over-quarter, a higher frequency of fire losses in personal lines, and one significant fire loss here in the Columbus, Ohio area which produced a net loss to us of $2.4 million. All of this was offset somewhat by a higher income tax benefit recorded in the first quarter.

Over the next few minutes I'll provide a brief summary of operating results and Steve will discuss the balance sheet.

Catastrophe results are obviously affected the property-oriented lines of homeowners, farm owners, fire and other allied lines. Non-catastrophe loss ratio results were generally comparable to last year. Results for personal automobile, our largest line, improved somewhat despite higher levels of severity driven by increases in medical costs.

Non-catastrophe homeowners' results were hurt by an unusually large number of fire losses. We don't have enough data yet to directly correlate these losses to a poor economy, but we did experience a higher frequency of large losses in states with higher foreclosure rates. Based on what I've heard from other companies our experience is not unusual. No doubt less maintenance and possibly even arson could be contributing factors, but we really don't know yet. It's simply too early to tell.

Commercial lines results improved somewhat. We're pleased with our commercial auto, commercial multi-peril and general liability results. Our fire loss ratio was hurt by the large Columbus loss and Worker's Compensation results were higher but do vary from quarter to quarter given our relatively small premium volumes. Although non-catastrophe results were relatively stable, it's clear that we need price increases to improve results and get ahead of the loss curve.

In personal automobile we continue to experience higher levels of severity and bodily injury and [PIP] driven by medial cost inflation. Pure premium trends are up about 3.5%. In the first quarter this year we've already filed for rate increases approaching 3.5% and have actions in place to further increase prices for standard automobile for the rest of the year.

In homeowners we continue to file rate increases in the mid to high single digits, but this number varies widely by state. Price alone though will not fix our homeowners problem. In addition to the aggregate reinsurance treaty that we put in place the first of this year, we're now in the process of implementing wind and hail deductibles in 11 states, strengthening our insurance-to-value program and taking either underwriting and/or agency actions in counties where our vulnerability to wind and hail losses is the greatest.

I know several of you have questioned our catastrophe losses over the past year or so. Is it bad luck or bad underwriting? All I can tell you is that our underwriting has not changed. Our pricing has exceeded the consumer price index for homeowners since 2004 and we've taken a variety of actions to diversify our property business and our geographic footprints. Clearly, we need to do more.

We obviously can't control the weather, but we need to do a better job responding to uncertain weather cycles. Fixing our personal property issues will require that we both increase prices and reduce retained property exposure.

Our experience in commercial multi-peril, general liability and commercial automobile has benefitted from lower levels of frequency and severity. Loss ratios for all three lines are lower this quarter than last year's first quarter. As I mentioned, fire and allied lines was hurt by the one large loss, and we did see a fairly significant increase in severity for Worker's Compensation in the quarter.

Price competition remained strong, primarily in commercial automobile and general liability where we experienced a 4% to 5% price reduction year-over-year. Worker's compensation pricing is flat and our BOP and CMP prices declined in the 1% to 2% range. This quarter we've begun to test the market by increasing prices, particularly on the smaller property-driven CMP and BOP lines where we've used our fully deployed predictive models to re-evaluate the application of credits and debits at renewal.

Premium growth continues to be driven by personal lines. Our new business quote activity in the first quarter has almost doubled relative to the first quarter of last year. This is partly a result of our new product and point of sale technology which has been very well received by our agents, but it's also due to expansion into new states.

In addition our new CustomFit product positions us very well to take advantage of higher levels of consumer shopping. Anecdotally we're hearing from our agents that they're getting a significantly increased level of re-quoting demands from their clients and we expect this trend will continue for several more quarters.

Business insurance production was flat for both policy count and premiums. It will be extremely difficult to generate any kind of measureable growth in business insurance given the current level of pricing and the impact of the economy on premium bases, such as payrolls, sales and numbers of vehicles.

Our expense ratio is down somewhat primarily resulting from higher levels of earned premium and lower accruals for agency contingent commission expense. All in all, the headline continues to be the weather and to a lesser degree a poor investment climate in the first quarter. With that I'll turn you over to Steve English.

Steve English

Our capital and book value remained flat this quarter despite the catastrophe experience Bob discussed. Our high quality fixed maturities portfolio continues to perform well and we experienced unrealized gains during the quarter despite a rise in Treasury rates. These gains offset continued declines in the equity markets and the impact of our net loss and dividends for the quarter.

Book value per share finished the quarter at $19.21, down $0.02 from year end. We did not repurchase any shares in connection with our Treasury program this quarter. We reported net realized losses for the quarter of $11.3 million including $6.4 million of impairments, all related to equity securities and principally large cap industrials.

Net investment income declined $4.1 million compared to last year's first quarter. As we discussed on our last call our investment in Treasury inflation-protected securities accounts for over half of this decline.

The remaining decline is attributable to rates on short-term money, which are lower by approximately 200 basis points since last year. We anticipate putting our cash to work in high- quality taxable fixed income securities in the coming weeks. We intend to continue investing conservatively to preserve capital while generating investment income.

Updating you on the status of our CAT aggregate reinsurance treaty, during the first quarter we had catastrophe losses in excess of $50 million on a group basis that qualified against our $80 million group aggregate. As a reminder, we entered into this treaty effective January 1, 2009, which runs through the end of this calendar year.

The treaty has a $5 million franchise deductible, per charge capped at $55 million. The limit is $30 million in excess of $80 million aggregate for the group with a 25% co-participation. The aggregate covers PCF-numbered CATs, excluding earthquake and named storms, such as hurricanes or tropical storms. We are currently working on our July 1 treaty renewals and anticipate sharing the results during our second quarter call later this summer.

During the quarter, we amended our line of credit. This was done to gain greater flexibility by eliminating the impact of accumulated other comprehensive income on equity from the financial covenants. At the same time, we reduced the line to $100 million based upon our needs and the desire to reduce associated costs.

Finally, I wanted to comment on taxes. Last year we recorded in the first quarter a tax benefit based upon an estimate of the full-year rate. In the first quarter this year, the tax benefit recorded was based upon the actual calculation as small assumption changes materially impacted estimating a full-year tax rate.

And with that, we will open it up to any questions that you may have.

Question-and-Answer Session

Operator

(Operator Instructions) Your first call comes from Joseph DeMarino – Piper Jaffray.

Joseph DeMarino – Piper Jaffray

My first question, on the reinsurance, did you say you had $50 million in losses towards your aggregate?

Steve English

Correct. That's on a group basis.

Joseph DeMarino – Piper Jaffray

Can you explain that a little bit more, because you had at least two in losses in the quarter, so how do we get to that $50 million number?

Steve English

The $50 million is on a group basis. Under the pooling agreement, the public company shares in 80% of that and so then the balance of the first quarter catastrophes would be other storms that did not qualify for the aggregate in the quarter, as well as the small amount of favorable development on prior year CATs.

Robert R. Restrepo

And the 20% that the State Auto Mutual Company picked up.

Joseph DeMarino – Piper Jaffray

On the wind and hail deductibles you mentioned that you're going to be, I guess, raising in 11 states, when does that take effect and when do you expect to see the benefits?

Robert R. Restrepo

The first state that we rolled it on was the third quarter of last year. The roll-on will be completed in the third quarter of this year and then of course, it will 12 months to apply it to each of renewal policies. So it'll play out over the next 18 months, but we're well into now.

Joseph DeMarino – Piper Jaffray

On pricing, any way to separate your growth into how much occurred from pricing improvement versus expansion of either new products or new territories?

Robert R. Restrepo

Yes, our policy counts for homeowners was up – hold on a second, yes, our policy counts for our homeowners is up slightly less than our premiums. So we still need to earn out the price increases, but let me look here – I'm sorry. Our homeowner's policy count is up less than 2% and the premium is up higher than that.

Joseph DeMarino – Piper Jaffray

What about just generally though, across your – let's say across the personal segment. How much of that growth in the quarter is attributed to pricing increases versus, I guess, expansion?

Robert R. Restrepo

For homeowners, most of it has to do with price increases. I'd say about over 80% of it has to do with price increases. And a fair amount of – I don't have the exact number with me, but I'd say the price increases for personal automobile probably account for about a third of the growth. But we can get you more precise numbers later on.

Joseph DeMarino – Piper Jaffray

And one last question, can you talk about lost trends, excluding CATs in the quarter? It seems like year-over-year is pretty much on par, but it still seems a bit higher than, I guess, 2007 and prior years. Maybe just talk about lost trends excluding CATs related to your expectations for losses in the quarter?

Robert R. Restrepo

Yes. Personal automobile – let me back into it. The lost trends for commercial automobile, general liability and a lot of our business insurance lines, pure premium trends still look very favorable for us. And I think, with the exception of Workers' Compensation where we're seeing higher medical severity, and the same theme carries over to personal lines. Our issue, from a severity standpoint, is on the medical side.

I think when I look at what's gone on with the industry in terms of fast track data provided by the Insurance Services Organization as well as other public company reports; we had trailed the severity increase that some companies were reporting two years ago. I don't know whether that's because our predominance here in the Midwest. We're not – obviously, don't have much presence on the Coast.

It may have taken a while for the medical cost curve to hit the states that we operate in, but we are now seeing a kind of severity in personal automobile that many companies were reporting 18 months to two years ago. It's moderated somewhat quarter-over-quarter, but it's still early and last year produced pure premium trend that went positive.

And we have seen that increase coming, which is why we started increasing personal automobile prices last year and we're continuing to do that as I said at the opening.

Operator

Your next question comes from Michael Phillips – Stifel Nicolaus

Michael Phillips – Stifel Nicolaus

Can you remember where you are with – you've done some restructuring in offices and specifically with the claims offices, where are you with that?

Robert R. Restrepo

The process started in the second quarter. We've, to date, closed two of the 20 claims sub-office, actually three now, three of our 20 sub-offices, but we're very early on in the process. The goal here is to have our – is really three-fold, to reduce our dependence on third-party appraisers and have more of our property and automobile adjusting done by our own staff appraisers.

Secondly, to move our property adjusters closer to the point-of-service by having them operate out of their residences. We're very early on in that process, but we have moved in that direction with three of our smaller of the 20 offices. And then we're also regionalizing our casualty claim adjusting, partly to rationalize the expense of middle management supervision and partly to get better line-of-sight control over the casualty files. That process will not be completed until the end of next year, but we're on track so far.

Michael Phillips – Stifel Nicolaus

As you do that shuffling around and changing for the claims offices, how do you keep your hands around any kind of disruption that might actually take place in terms of the case reserves that are initially –

Robert R. Restrepo

That's a very good question. Obviously, the issue relates to casualty claim handling and when you have a new pair of eyes on a claim file, in the aggregate you can expect that the case reserves are going to go up. We anticipate that that – Matt Mrozek is here. We've anticipated that when we review our IBNR reserves.

Probably the area that we're most sensitive to is on the automobile lines, bodily injury. And we've made use of a third-party software for almost 10 years now to help us adjust those files. And if the files exceed a certain amount, usually $100,000, then they're reviewed by a second pair of eyes, the position that we call a claim examiner, and those claim examiners have not been affected by this change. So we feel both with the software we have in place with the expectation that we are going to see some increases in case basis reserves that we've accommodated that in our IBNR reserving.

And then the third that the most serious cases, the larger losses, the ones that exceed $100,000 and those are the ones that really pushed severity and could push disruption in our claim reserving trends. The folks that review those files have not changed. So we feel pretty comfortable that we've got the right controls in place to minimize volatility on the case reserves.

Michael Phillips – Stifel Nicolaus

I guess kind of a corollary to that is your thoughts on the impact going forward of inflation, especially with regards to these liability lines and Worker's Comp. as well.

Robert R. Restrepo

We're monitoring it. Obviously we may be seeing, I don't know, some early stages of inflation in medical cost care. That's really across the board for us, particularly in the personal automobile and Worker's Compensation line. We are pricing for inflation in our homeowners rates, although the most recent data would say we're seeing some disinflationary trends both in labor and building material, but that's not reflected yet in our upgrading factors for homeowners.

So we're still looking at insurance-to-value based on the data that we had 6 to 12 months ago, although from what we're seeing and talking to our claim folks unit costs are declining just because of the economy and because of the lack of construction activity.

And those are the two primary drivers for us, is medical cost inflation and property-related claim expenses. We're not seeing the same kind of severity in terms of fixing cars that we've seen maybe in the past. The two big inflationary trends have been building materials and labor and medical costs and we've been monitoring those and pricing for those.

Michael Phillips – Stifel Nicolaus

Okay, I guess just lastly just in personal auto, I hear you with the medical inflation there on the [BI], but even this quarter for you guys and I think we've seen it across the board for everybody, if loss trends have kind of improved maybe because of the economy and driving patterns or whatever you want to call it there.

But do you see because of that – and I think a lot of carriers are seeing a little bit better trends in auto maybe because of the economy, but is there any pressure on the sense of okay, we'll take single digit rate increases to maybe kind of let off because of this?

Robert R. Restrepo

We're not doing it and again, Michael, as I said at the outset our pure premium trends increase lagged relative to the industry. So we want to make sure we're ahead of it and in most states the kind of price increases we're talking about in the low to mid single digits, we think we can sell and frankly, given our new business production, given the fact that even though we take a rate increase in the 3% to 5% rate, the way we apply it through our predictive models can vary widely.

We feel very good about our production trends and our strength in the market and the ability to kind of get the rates that we need to improve our already very acceptable margins in personal automobile.

Operator

Our next question comes from Paul Newsome – Sandler O'Neill.

Paul Newsome – Sandler O'Neill & Partners

Could you remind me how you define catastrophe losses in your definition? Do you use the ISO definition or do you use your own?

Robert R. Restrepo

No, we use the ISO definition from the property claim services and if I remember right they haven't changed it. It's still got to be an industry event that they estimate to be at least $25 million.

Paul Newsome – Sandler O'Neill & Partners

And then perhaps you could talk a little bit about your view of your own pricing models, particularly in home insurance versus the competitors to the extent to which you're using credit scoring in both the auto and home lines at this point?

Robert R. Restrepo

We feel very good about our ability to compete on personal automobile. We're in our second generation pricing model and preparing to roll out our third generation. There are some that are out there with fourth generation, but we feel very good about our pricing precision. Every generation gets better. We can slice and dice better. We can identify loss trends better.

There's some areas that are embedded in our price increases, particularly in the physical damage area for our new CustomFit product where we think we can get more rate and probably need more rate. But on balance we feel very good about our ability to compete with anybody in the personal automobile marketplace.

We've got work to do on homeowners. We're competitive in our ability to price around credit, but we need to do a better job applying the same kind of predictive modeling and the pricing precision that we have with automobiles into our homeowner product. And we'll be rolling that out with our new bi-peril yet unnamed homeowner product that we'll be putting in place the fourth quarter of this year.

So this time next year I expect our pricing precision around predictive modeling and our ability to more precisely price for the specific peril will be much more robust than it is today.

Operator

Our next question comes from Joseph DeMarino – Piper Jaffray.

Joseph DeMarino – Piper Jaffray

Just a few follow-ups, do you have any exposure to the recent storms in the Midwest, I think it was Kansas, Oklahoma, Iowa?

Robert R. Restrepo

What we had – I think there's only been one PCS numbered catastrophe that was significant enough. In fact I know because I just looked at it before I walked in here that hit us this quarter. And it had to do with the tornado that hit Arkansas, but the loss was not material enough for us to comment on it.

Joseph DeMarino – Piper Jaffray

And then maybe if you could just give a little more detail, your personal thoughts on the possible arson that seems to be – resulted in the increased number of fires you guys had?

Robert R. Restrepo

Yes, Joseph, we look at – all of us look at every loss above $100,000 and we have not had one instance yet that we have proven to be arson. Now we have had fires that – a small number of fires – that we are under investigation for potential arson, but that's our standard practice if we have any doubt at all we bring in an arson investigator.

But to date, certainly for any of the losses that have occurred over the last six months I can't remember one instance that we have definitively – looking at Mark Blackburn and he's shaking his head agreeing – that we have not had one instance where we've definitively identified a case of arson.

Joseph DeMarino – Piper Jaffray

And then one last question, do you know your statutory capital at the end of the quarter?

Steve English

Yes, it's $714 million.

Operator

Our next question is from Matt Rohrmann – KBW.

Matthew Rohrmann – Keefe, Bruyette & Woods

Gentlemen, good morning; two quick numbers questions, first, Steve, any material reserve development in the quarter either way?

Steve English

Well, as you know, Matt, we don't comment on that except at the end of the year.

Matthew Rohrmann – Keefe, Bruyette & Woods

Okay, so but even nothing of material nature movement there regardless?

Steve English

The only thing I can tell you is that on the catastrophe reserves we did have $3.3 million of favorable development that's inside that CAT number.

Matthew Rohrmann – Keefe, Bruyette & Woods

And then for non-CAT weather, Bob, can you give us any color on that? I mean how much weather do you think was kind of outside the norm beyond the CAT detail you already provided?

Robert R. Restrepo

Really nothing. I'm looking at Matt Mrozek, our actuary, and he's shaking his head no; nothing unusual. As I mentioned our Worker's Compensation numbers kind of bounced up and down because it is a very small line. It could be very vulnerable to one or two losses and we've had one or two where we had to increase our medial cost reserves because a person was more seriously injured than we thought. But other than that, for as unstable as the weather was, all the non-CAT trends were pretty stable.

Operator

(Operator Instructions).

Steve English

Well, hearing none, thank you, [Christina]. We want to thank all of you for participating in our conference call and for your continued interest in and support of State Auto Financial Corporation. We look forward to speaking with you again on our second earnings call, which is currently scheduled for July 28, 2009. Thank you, and have a nice day.

Operator

This concludes today's conference call. You may disconnect at this time.

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Source: State Auto Financial Corp. Q1 2009 Earnings Call Transcript

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