Meadowbrook Insurance Group, Inc. Q1 2009 Earnings Call Transcript

Meadowbrook Insurance Group Inc. (MIG)

Q1 2009 Earnings Call

May 5, 2009 9:00 am ET

Executives

Bob Cubbin - President and CEO

Karen Spaun - CFO

Analysts

Beth Malone - Wunderlich Securities

Ken Billingsley - Signal Hill Capital

Walter Schenker - Titan Capital

Robert Paun - Sidoti & Company

Scott Heleniak - RBC Capital Markets

Tom Spiro - Spiro Capital Management

Brian Rohman - Robeco Investment Management

Presentation

Operator

Greetings and welcome to the Meadowbrook Insurance Group Inc.'s first quarter 2009 conference call. At this time all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions) As a reminder this conference is being recorded.

It is now my pleasure to introduce your host, Karen Spaun, Chief Financial Officer for Meadowbrook Insurance Group Inc. Thank you, Ms. Spaun, you may now begin.

Karen Spaun

Thank you and welcome to Meadowbrook's first quarter 2009 Earnings Call. I will lead off today's call with a review of our financial results. Bob Cubbin, our President and CEO, will then follow with a review of our financial outlook and current market conditions. The call will conclude with a question-and-answer session.

During this call we may make certain statements relating to future results and expectations. These statements constitute forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. We, therefore, must state that actual results may differ materially from those projected and may involve risk and uncertainties that are outlined in our Forms 10-K and 10-Q that are filed with the SEC. Please note Meadowbrook undertakes no obligation to update or revise any forward-looking statement. If you have not received a copy of our earnings release, it is currently available on our website meadowbrook.com or you may give me a call, and I will be happy to fax a copy to you.

We are pleased with our 2009 first quarter results. We reported an increase in net operating income of $9.2 million to $16.3 million or $0.28 per diluted share, up from $7.1 million or $0.19 per diluted share for the first quarter of 2008. Net income increased to $13.5 million or $0.24 per diluted share for the first quarter of 2009 compared to $7.1 million or $0.19 per diluted share in the first quarter of 2008. Our first quarter 2009 net income includes an after-tax realized capital loss of $2.8 million or $0.04 per diluted share due to other than temporary impairments in the first quarter of 2009. These impairments were related to certain asset-backed securities, corporate bonds, and to a lesser extent preferred stock.

Our first quarter 2009 net income also includes amortization expense of $1.5 million or $0.03 per diluted share. This compares to amortization expense of $1.6 million or $0.04 per diluted share in 2008. The first quarter GAAP combined ratio of 87.7% reflects an improvement of 6.2 percentage points compared to the combined ratio for the first quarter of 2008, which was 93.9%. The 2009 combined ratio includes 6.5 percentage points of favorable development on prior year loss reserves, while the combined ratio for the first quarter of 2008 included 4.3 percentage points related to favorable prior year development.

Prior year development for the first quarter was $8.3 million, primarily due to favorable development in our general liability and workers' compensation lines. The loss ratio for the first quarter of 2009 improved to 58% compared to 61.7% for the first quarter of 2008. Our expense ratio for the first quarter of 2009 was 29.7% compared to 32.2% for the same period in 2008. The improvement reflects a reduction in insurance-related assessments and our ability to leverage fixed cost over a larger premium base.

During our last conference call, we suggested that we expect our year-to-date and quarterly expenses to be in the range of approximately 32% to 32.5%, and we continue to expect this will be our range of expense ratios in subsequent quarters.

For the first quarter of 2009, gross written premium grew by 76.8% to $160 million, which includes $52.1 million from our Century Insurance operations. Excluding Century, gross written premiums grew up by 19.3%.

As I mentioned earlier, our first quarter results include $2.8 million or $0.04 per diluted share of an after-tax net realized investment loss due to other than temporary impairments. Quarter-over-quarter, we have experienced a decline in other than temporary impairments. Since this became an area of focus across the industry during the last half of 2008, we've seen improvement in stabilization across many of our asset classes, most significantly municipal bonds and mortgage-backed securities.

The net unrealized gain in our portfolio has increased to $16.2 million at March 31, 2009, from a net unrealized gain of $3.8 million at December 31, 2008, and a $20 million net unrealized loss at September 30, 2008. The improvement over time in our unrealized gain loss position has contributed approximately $0.41 to our book value per share since September 30, 2008.

In the last half of 2008, we took an action to increase the frequency of our meetings with our investment advisor. Even though our portfolio remains appropriately conservative, the additional [oversight] has been useful for us. We've been able to stay current on emerging issues that could influence the investment environment in general, which has given us the ability to anticipate changes and consider different alternatives as appropriate. We continue to focus on high-quality investments and the average S&P rating on our fixed income portfolio is AA+. Only 2% of our portfolio is allocated to equities and our allocation to commercial mortgage-backed securities is 2.3%. We continually monitor our CMBS exposure and the S&P rating on those securities remains at AAA.

The duration of our fixed income portfolio is 4.3 years compared to 4.5 years as of December 31, 2008. Our pre-tax yield is 4.4%. Our after-tax yield is 3.3%, and since the beginning of 2009 we have achieved an average pre-tax yield on new investments in debt securities of 5.3%. These new investments are primarily in investment-grade corporate bonds that have attractive spreads, strong business, and capital fundamentals. We continue to expect that we will be able to achieve average pre-tax yields in the range of 5% to 5.5% on new purchases.

For the first quarter of 2009, fee-for-service pre-tax income excluding amortization was $1.6 million compared to $2.5 million in the first quarter of 2008. For the first quarter of 2009, we reported a pre-tax margin of 5.4% compared to 10.9% for the first quarter of 2008. The decline in the margin is primarily due to variable compensation and to the anticipated lower level in net commissions and fee revenue.

As we expected revenue from managed programs declined compared to 2008. For the first quarter of 2009, revenue from managed programs and commissions were $10.2 million compared to $12 million in the first quarter of 2008.

Finally, our income tax expense for the first quarter of 2009 was 36.8% of income before taxes, which is an increase from 29.4% for the first quarter 2008. The increase reflects the impact of a valuation allowance established in 2009 for other than temporary impairments, where there are no realized gains to offset the realized losses.

Excluding the deferred tax valuations, the effective tax rate would have been 31.5%. This increase from our first quarter of 2008 reflects a relatively lower contribution of investment income to pre-tax income due to the improvement of our underwriting results in the first quarter of 2009 compared to the first quarter of 2008.

Now I will turn the call over to Bob. Bob?

Bob Cubbin

Thanks, Karen. Good morning, everyone. We're pleased with our operating results for the first quarter. Our earnings growth is a result of our long-term strategy to produce consistent returns with a balanced business model. The growth in EPS to $0.28 per share on 57.4 million shares from $0.19 per share on 37 million shares reflects our ability to quickly overcome the dilution from the shares issued in conjunction with the ProCentury merger.

As we continued to build the integrated platform, we should realize additional revenue growth. Our combined ratio in the quarter improved by 6.2 percentage points to 87.7 as favorable development on prior accident years continues and the current accident year remains at a profitable level.

Book value improves to $7.98 per share as a result of net operating income and an increase in unrealized capital gains. For the first quarter, gross written premium was $160 million including about $52.1 million from Century, but excluding the Century premium contribution premium increased by 19.3% on the historic Meadowbrook business.

The new business that we implemented in 2008 and early 2009 have gained traction, and we expect these programs to continue to contribute to growth throughout the year. For example, we have several regional workers' comp initiatives underway and we have also geographically expanded our transportation program. We're optimistic about several of our E&S initiatives and we have selectively added wind coverage to [C&P] business with fixed property exposures in the Southeast for our E&S general agency group. We are starting with Florida where Century had historically excluded wind on all fixed properties and expect a controlled rollout of the coverage offerings to other states during the second quarter.

We will closely monitor our aggregates. We've created limited but greater capacity while our net exposure per catastrophe has not increased. This initiative should help us to be more competitive in the selected markets. We're encouraged to see that rate decreases are moderating to some extent, but the market is still competitive. For our workers' compensation business rates are down about 4.8% driven primarily by mandated decreases in Florida, but the trend reflects progressively smaller rate reductions over time.

For admitted business in lines other than workers' comp, we have achieved a very slight rate increase in the first quarter of 2009. This area is also seeing the rate changes move in a positive direction. On the E&S side, on average our rates are down in a range of about 5% to 6%. E&S general liability is still competitive and the standard market continues to encroach into business that had historically been written in the E&S market.

Again, overall the market remains competitive, but we are observing a trend towards rate moderation. We also continue to work on new business arising out of the merger. One of the early opportunities that we identified was the ability to fill a surplus lines market need for one of our Meadowbrook workers' comp partners in New England.

During the first quarter, both production and quoting activity have continually improved. This should be a $4 million to $6 million operation in the intermediate term. Century's garage liability business has been able to expand geographically by taking advantage of Meadowbrook's admitted status in various markets.

Additionally, Century's standard surety business, which has been rebranded as [Star Surety], has benefited from a higher treasury listing and broader licensing. The surety team has also been able to leverage Meadowbrook's branch structure and marketing capabilities to expand its geographic reach. We have recently started a program for environmental contractors, which would not have been possible for either companies to implement independently. This is a good illustration of the type of revenue-enhancing synergy that we anticipate as a result of the merger.

We are combining specific Century products and underwriting expertise with a workers' compensation and commercial auto product from Meadowbrook to create a comprehensive solution for a specific specialty market. This should be $12 million to $15 million program over time.

Finally, our combined marketing and business development function also allow us to look at more opportunities to meet our agents' program needs in specialty markets. Our performance in the first quarter of 2009 positions us well to achieve the guidance that we have established for the remainder of the year.

Our earnings guidance range is unchanged and we continue to expect net operating income of between $46 million and $52 million or $0.80 to $0.90 per diluted share. Gross written premium is expected to be $725 million to $740 million.

As the first quarter's loss information has developed favorably, we expect that we will be able to meet or come in below our combined ratio target of 95% for the year, which should position us in the higher end of our earnings range. The profit margin on our fee-for-service business is somewhat lower than expected due to continued competitive market condition, and there is still a degree of uncertainty on pricing, but if the market stabilizes and pricing firms more quickly than it has so far that will help us.

While we don't include unidentified programs or new initiatives in our plans, to the extent that we execute on new opportunities we can enhance our performance further. Overall, we remain optimistic about our prospects for continued profitable growth.

Thank you for our interest in Meadowbrook and we will now open the call to questions.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Beth Malone from Wunderlich Securities. Please pose your question.

Beth Malone - Wunderlich Securities

Good morning and congratulations on the quarter. I've a couple of questions. On the reserve development, how much of the favorable reserve development came from the ProCentury books?

Bob Cubbin

3.73 pre-tax.

Beth Malone - Wunderlich Securities

What was the dollar amount of the reserve development from 2008 first quarter so we can compare it?

Bob Cubbin

Yes, that was $2.9 million pre-tax.

Beth Malone - Wunderlich Securities

That wouldn't have included any ProCentury? ProCentury is all this year?

Bob Cubbin

That is correct.

Beth Malone - Wunderlich Securities

Then just a question on your 15% return on equity goal that you have for the company; that would probably require a greater lever of your surplus than you currently are doing. Is that going to need a better pricing environment for you to see the opportunities to leverage your capital to get to that level?

Bob Cubbin

Absolutely. You really have to adjust your thinking when the market doesn't allow you to grow like it hasn't in 2007 and 2008. So as the market does turn over the next couple of years, we will be able to leverage the balance sheet a little bit more. So that will get us up to that 15% or 16% range. What we're really trying to do, Beth, is make sure that when the market is soft we can still deliver double-digit ROEs and then when the market is harder we can get up to that 15% or 16% range.

We really don't think it's worth taking the extra risk to either take more risk in the investment portfolio or to over-leverage the balance sheet, so that liquidity becomes an issue. So, we have been very cautious about that and I think that has served us well during this very difficult time.

Beth Malone - Wunderlich Securities

Then one last question. On the cross-selling, you are going to start offering wind risk to the Southeast; that sounds like a pretty risky category given the hurricane exposure that Florida has. What kind of expertise are you employing to be able to write this?

Bob Cubbin

The current Century book has a lot of coverages that exclude wind and that book of business will remain the way it is. We're not going to add wind protection in areas that you would find to be extremely risky. We're adding it in areas that are much less risky in order to support their GA business in general. So this is more inland and less wind exposed than the historic E&S business that Century has written.

Secondly, we've been working very closely with our reinsurance partners since the capacity to do this is really coming from them. So we have not increased our net exposure to catastrophes at all while we are being able to expand our capacity. The reinsurers also provide us with a number of tools to allow us to track the aggregations and to be careful in the selected areas that we are moving into.

This is a very targeted, focused initiative, and it's not intended to be an extremely large part of what we are doing. It's not unsupported wind, by the way. It's with their package policies, so its business that has very good historic loss ratios and that they would have written had they had the reinsurance capacity in the past. So it's a very limited, very select, and very targeted focused addition.

Operator

Our next question is coming from Ken Billingsley from Signal Hill Capital. Please pose your question.

Ken Billingsley - Signal Hill Capital

Just to follow up on Beth's question on the wind business, so essentially are you fronting this on behalf of the reinsurers and you're just collecting the fee or do you have capital at risk as well?

Bob Cubbin

We do have capital at risk, Ken, we are keeping the net, but we are not increasing our overall catastrophe loss on a net basis. So it's not really fronting, but in the event of a large catastrophe we do have limited exposure. We're taking the risk on the package side, we're taking the risk on the non-wind side, and if the specific loss that we suffer does not exceed our cash retention then we would be retaining that exposure. So it's not fronted but we're taking a limited amount of risk on any one loss.

Ken Billingsley - Signal Hill Capital

Is there still a two county exclusion like in the old Century business?

Bob Cubbin

Yes.

Ken Billingsley - Signal Hill Capital

Okay, so even in Florida it's still two counties away from the --?

Bob Cubbin

That is correct.

Ken Billingsley - Signal Hill Capital

On your releases, I want to a few questions about workers' comp, because we have seen a few numbers on the workers' comp from different companies; some focused primarily in the industry and others it's a tangible part of what they do and they have had bad numbers. How is your workers' comp business shaping up and were there any reserve releases in your workers' comp book?

Bob Cubbin

We like workers' comp. We have, obviously, a strong track record in that line of business. We did have some favorable development in workers' comp in the quarter. The exposures that we have, again, remain on the small average premium side. It tends to be specialty focused and geographically specific for us. We are expanding our workers' comp writings during 2009 in some selected states that we think are very attractive with partners who have proven track records.

So, yes, we have seen favorable development on the workers' comp. We see current accident years' performing very well and it's a line of business that we expect to see expansion during 2009 and 2010.

Ken Billingsley - Signal Hill Capital

On the investment side are you increasing your duration? It looked like it was increasing through '08 and then it's a little bit lower now in the first quarter of '09.

Karen Spaun

We're really comfortable with the duration as it is right now. It will fluctuate slightly up and down somewhat based on our cash needs and some seasonality of those cash flows.

Ken Billingsley - Signal Hill Capital

What would you say the duration of the liabilities are?

Karen Spaun

The duration of the liabilities are somewhere around 3.0 to 1.

Ken Billingsley - Signal Hill Capital

So your asset duration is a little bit higher than --?

Karen Spaun

Not really, because if you look at the size of the assets versus the size of the liabilities our liabilities are slightly longer than our assets.

Operator

(Operator Instructions). Our next question is coming from Walter Schenker from Titan Capital.

Walter Schenker - Titan Capital

Goof morning. Where do we stand on the existing covenants, the balance sheet, the equity, and the ability to buy back stock since we still traded at 20%-plus below book and one way to get higher ROE would be to buy back some of the stock below book?

Karen Spaun

Walter, we are well within our covenants from a compliance point of view. We continue to look at our covenants. We continue to look at our cash flows needs and liquidity needs over the near and longer terms as we look at share repurchases and other uses of capital. We do have a lot of opportunities for growth, as Bob was saying, and we feel that the use of our capital in those opportunities is beneficial for us.

Bob Cubbin

Walter, as we said last quarter as well, we do have an authorization to repurchase an additional 2.2 million shares, and as we manage our capital position throughout 2009 that is definitely one of the areas that we look at and discuss in terms of what our capital needs are and where we can best put that capital to use.

We do have that in our arsenal to utilize, but we are going to do that carefully as right now going out to raise equity if a great opportunity came up, would be very difficult. Raising debt right now would be very difficult. So we are trying to preserve capital at this point in time for, as Karen said, longer-term use and deployment in the insurance operations. But buybacks are definitely something that we'll look at and examine on a regular basis.

Walter Schenker - Titan Capital

Albeit a great opportunity six months into a massive acquisition for you, which seems to be going well, one might question whether or not you want to take on a significant opportunity this quickly?

Bob Cubbin

I'm talking about new business, new programs that are in our traditional insurance company growth side, not another acquisition of any magnitude.

Okay, thanks.

Operator

Our next question is coming from Robert Paun from Sidoti & Company.

Robert Paun - Sidoti & Company

Karen, I think I missed it. Do you have the effective tax rate in the quarter?

Karen Spaun

The effective tax rate was 36.8%, but that includes a deferred tax valuation allowance. So if you exclude that the effective tax rate for the quarter was 31.5%.

Robert Paun - Sidoti & Company

Can we look at that 31.5% as a rate going forward?

Karen Spaun

Yes, that is pretty fair. It fluctuates based on the contribution of net investment income to underwriting income. As you know underwriting income is taxed at 35% and the investment income is based on your mix of tax exempts.

Robert Paun - Sidoti & Company

Bob, in your prepared comments you talked about the minor rate declines that you are experiencing. Is that for all lines of business?

Bob Cubbin

No, on lines other than comp on the admitted side we have actually seen rate increases, just slight rate increases. On the comp side, we've seen the amount of rate decrease decline. So you are not seeing the same kind of decline that you did last year, but that remains at about 4.8% primarily driven by -- I think it was about a 19% decrease in Florida. So I think that was a driver of that.

In some states, we actually are seeing some increases in comp. On the E&S business, we still see some declines in pricing. They are down between 5% and 6% depending on the line, so the general liability line has been competitive, but it's still performing very well from a loss experience standpoint because Century is walking away from business if it isn't priced for profitability. So that is why they did see about a 3% year-over-year decline in net premium volume.

Operator

Our next question is coming from Scott Heleniak from RBC Capital Markets.

Scott Heleniak - RBC Capital Markets

Just a couple of quick questions, the first is the question on the ProCentury acquisition. I guess it has been about nine months or so since you closed it. Do you feel like you have achieved all the cost savings that you can from this or will there be more to come? How are you looking at that so far? Are we on track?

Bob Cubbin

I think, we're pretty much on track. We've restructured some of what they do. They have done some restructuring themselves, so we do have the ability to continue to leverage fixed costs of the two integrated platform. So we don't expect to see additional cost savings in terms of personnel or salaries and benefits and that sort of thing, but we do expect to see benefits from leveraging the fixed costs.

We continue to jointly market our reinsurance, so there could be some benefits to having a larger amount of premium volume in the reinsurance marketplace. We do have the ability to increase some of our retentions if that becomes appropriate or if our analysis shows that increasing that would make sense from a pricing standpoint. So I think the primary benefit going forward that we will see will be the leveraging of fixed costs.

Scott Heleniak - RBC Capital Markets

Along those lines, one of the areas that you just mentioned too and you have mentioned before is the cost savings from reinsurance. Can you talk about the renewals and any changes to the treaty in pricing versus last year through savings?

Bob Cubbin

We're seeing some savings in certain classes of the business, but I would say for the most part it has been fairly flat year-over-year. I don't think there has been any dramatic changes to our pricing, which is good, because as you know every reinsurer out there is saying that they are driving rates up, but our business that we cede to the reinsurers has been profitable so I think we have some leverage in that relationship; some trading relationship that has been good for both sides.

One of the things that we have tried to have as a philosophy, both at the primary pricing level but also at the reinsurance level is that we're not trying to be the lowest priced in the soft market and we're not going to be the highest priced in the hard market. We would like to have a more consistent pattern with all of our partners, whether it's the policyholder or a reinsurer.

So we don't push them to the limit in the soft market and when the market firms we don't expect to be likewise pushed higher on prices. That philosophy and approach has worked fairly well for us and we will continue doing that.

Scott Heleniak - RBC Capital Markets

Then the last question is the big amount of programs you [figures of] 18 or so, and you mentioned a couple this year as well. Are you comfortable with where you are right now? Do you expect additional programs or is that enough to keep you busy for the year?

Bob Cubbin

No, we would expect and are working as we speak on new program opportunities. We just don't put them in our expectations or our pledges, but we continue to work on new programs and we will be continually adding new business. We do see a very high retention ratio on our program side, so that helps us to grow without having to take on untried business that is outside of our area of expertise.

So we will definitely stick to what we know, but we do expect to see growth, as I mentioned, in the workers' compensation line, in the areas that we're working on jointly with Century and some other initiatives in the E&O and special liability lines that we've had very good experience on.

Scott Heleniak - RBC Capital Markets

Are you jointly marketing most of the new programs with ProCentury? Or are you still planning to introduce those separately? Is that the goal to kind of do them together or --?

Bob Cubbin

Century is more of a product-driven company because of their general agency distribution system. That side of their business is generally driven by product as opposed to program, but they do have a specialty program side as well. So we are utilizing the talent and expertise from both companies to market and review and analyze any new programs that come in.

We're going to see new programs at Century, new products at Century, and we're going to see new programs at Meadowbrook, but our marketing teams and our executive teams work together to identify the best way to write that new business whether it's E&S or admitted?

Operator

Our next question is coming from Tom Spiro from Spiro Capital Management.

Tom Spiro - Spiro Capital Management

Bob, I was just curious as the unemployment rate goes up are you seeing any interesting consequences in the workers' comp book, if there are exposures or some other interesting consequences?

Bob Cubbin

Yes, we have been monitoring that and there has actually been a lot of studies done on the correlation between recessionary economies and lower employment, but there really haven't materialized in our book of business any significant impact as of this time. We don't have a lot of manufacturing or construction exposures in our work comp book and those two areas have a significantly higher unemployment rate than you do across all of the economy. We do have a lot of agricultural. We have a lot of service industries, municipalities, and that sort of thing, and they haven't really been as impacted by the unemployment and recessionary pressures as of yet.

There are also indications that the frequency of losses do go down as your less experienced employees are laid off or their jobs go away, because you are left with people who have more experience and are more mature, and have more seniority and therefore, experience tells us has a lower frequency of loss. So you do see that. I think people come back to work more quickly, because they want to be valued as an employee. But at the same time, return-to-work programs can be negatively impacted because there really is no temporary or light-duty work for people to do.

On balance, I would say that we have not seen the kind of impact that you might see if you write large average premium size. We tend to write smaller, kind of mom-and-pop operations, so we do think that our book of business has a little less impact. We're monitoring, for example, the premium audits, and so far most of the premium audits are still coming back with additional premium, so that hasn't indicated the exposure base dropping too dramatically, but it's something that we watch and that we managed, and we are careful about. It's part of our day-to-day operational attention.

Operator

Our next question is coming from Brian Rohman from Robeco Investment Management.

Brian Rohman - Robeco Investment Management

I guess these are interrelated questions and related to the question you previously answered. If I heard you correctly you had about 19% organic growth in the quarter absent the ProCentury acquisition. Where is it coming from and also what is the impact of several large workers' comp writers out there having financial troubles?

Bob Cubbin

The answer to the first question is it's coming from many different lines. Workers' comp continues to grow for us. I'd say that is probably the area that has been growing the most. We do have initiatives underway to continue to grow that line, as I mentioned, with a focus in the agricultural and foodservices area, one. But also a geographic expansion through some GA relationships we have on the work comp side. Other lines also show some growth. The transportation business has been expanded geographically from California office, so we see some growth there. What was his other question?

Brian Rohman - Robeco Investment Management

The impact of the distress of several large competitors, especially in workers' comp?

Bob Cubbin

Sure. We will probably see some residual benefit from that. There is a little bit less competition, I would say, in certain segments. The excess work comp business I think should be benefited in the future if risk managers and self-insured groups decide that they don't want to continue their excess coverage's with the carriers who are having financial difficulty, but overall we have not seen any dramatic impact of that as of yet.

Operator

Thank you. At this time we have no further questions. I would like to turn the call over to the speakers for any closing comments.

Bob Cubbin

Thank you. We appreciate your interest and if you have any further questions we would be happy to try to respond to them. Thanks again.

Operator

Thank you. This does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation.

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