State Auto Financial Corporation Q2 2009 Earnings Call Transcript

| About: State Auto (STFC)

State Auto Financial Corp. (NASDAQ:STFC)

Q2 2009 Earnings Call

July 28, 2009 10:00 am ET

Executives

Steven E. English - Chief Financial Officer, Vice President

Robert P. Restrepo Jr. - Chairman of the Board, President, Chief Executive Officer

James E. Duemey - Vice President, Chief Investment Officer

Matt Mrozek – Corporate Actuary

Cynthia A. Powell – Chief Accounting Officer, Treasurer

Analysts

Joseph DeMarino - Piper Jaffray

Michael Phillips - Stifel Nicolaus & Company, Inc.

Beth Malone - Wunderlich Securities Inc.

Paul Newsome - Sandler O'Neill & Partners L.P.

Operator

Good morning ladies and gentlemen and welcome everyone to the State Auto Financial Corporation’s Second 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.

Steve English

Good morning and welcome to our second quarter 2009 earnings conference call. Today I am joined by several members of STFC’s senior management team. Our Chairman, President and CEO Bob Restrepo; Chief Investment Officer Jim Duemey; Corporate Actuary Matt Mrozek; and our Chief Accounting Officer and Treasurer Cindy Powell.

Today's call will include prepared remarks by our CEO Bob Restrepo and myself, after which we will open the lines for questions. Please note our comments today may include forward-looking statements which by their nature involve a number of risk factors and uncertainties which may affect future financial performance. Such risk factors may cause actual results to differ materially from those contained in our projections or forward-looking statements.

These 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.

Bob Restrepo

Thank you Steve and good morning everyone. Our poor underwriting results in the second quarter resulted in an operating and net income loss. Catastrophe results were a significant contributor, but we typically experience high catastrophes in the second quarter. This year catastrophes contributed 12.6% points to our loss ratio in the second quarter. Our five-year average for the second quarters 13% points and our ten-year average is 11.7 points. Poor results, but fairly typical given our historic geographic footprint.

Our non-CAT loss ratio experience deteriorated somewhat driven by non-CAT weather in the homeowner’s line and an unusually high frequency of large fire losses in both the homeowner’s and commercial fire lines. It was a tough quarter in the liability lines driven by several unusually large losses from prior accident years and one large Workers Compensation loss.

The non-CAT weather losses in homeowner’s increased our bottom line loss ratio by 2% points relative to the second quarter of last year. The large loss activity I spoke to increased our bottom line loss ratio for the same time period by approximately 4% points. Beyond this our results in personal automobile, and our other commercial line held up reasonably well.

Following my commentary on operating results Steve English will review investment results. The recovery we recorded under our new aggregate reinsurance treaty and comment on expenses.

Our standard private passenger automobile business continues to perform well and produce solid results. Pure premium trends have moderated with lower levels of both frequency and severity. We continue to file rate increases in the low single-digit range. Well over 2% points of our growth in personal auto is directly attributable to price increases.

Looking forward we expect the yield from our pricing actions to increase somewhat. Although our pure premium trends are relatively benign we are watching loss cost severity and want to strengthen margins on our largest line.

In the homeowner’s we are much more aggressive in pursuing rate changes. The catastrophe results and the recent large fire losses we’ve experienced require that we be as aggressive as regulators will allow in taking price increases. We are not alone. Results here in the Midwest are poor and have deteriorated over the past two years. We are seeing a wide array of competitors taking significant price actions, generally in the high single-digits to low double- digit area and we’re doing the same.

As I said last quarter, pricing alone will not address our chronically poor homeowner results. We now have wind and hail deductibles in place in 11 states with additional states planned for the future. We have been piloting an aggressive insurance to value program and we’ll go live in all states during the third quarter.

We recently announced commission reductions for several lines with the impact disproportionately focused on homeowners. We plan to introduce our new bi-peril homeowners’ product in Missouri by the end of the year. We have also completed an analysis of our homeowners’ risk portfolio by county in each of the 33 states in which we operate. This analysis compares our model average annual loss to total insured value and our premium volume in each county. Our goal is to identify counties where the modeled average annual loss is disproportionately greater than our insured values or our premium value. With this analysis completed we are now targeting underwriting and agency actions to address counties where the expected loss from wind or hail is disproportionately high relative to our exposure.

Lastly, the aggregate reinsurance treaty we have in place buys us the time we need to implement all of these actions and improve results.

Last quarter we also mentioned a higher frequency of large losses, particularly from fires.
We saw that trend continue in the second quarter. Although the severity was comparable to last year, the number of large losses in the second quarter increased by almost 50%. A review of the large loss activity for homeowners does not point to any specific cause and there is little evidence of fraud. While we believe the economy must be driving some of this, we can’t reliably point to any hard evidence.

The last factor affecting our homeowner results this quarter was a fairly significant increase in non-CAT weather related losses. All in all it was a dismal quarter for homeowners.

In business insurance commercial auto and commercial multi-peril results continue to be good. Our historically good results in commercial fire and liability were hurt this quarter by large losses.

In the fire line we had twice as many fires with significantly higher severity.

In liability frequency was down, but severity was significantly higher than what we experienced in the second quarter of last year.

We regularly look at all of our large loss activity and that includes losses with an incurred amount of $100,000.00 or more and it includes new losses and also large reserve adjustments on prior period losses.

Following a routine underwriting audit, that we conduct regularly for all of our large losses, in the commercial fire line we saw no occupancy related patterns and no evidence of for-profit arson.

Price competition in commercial lines continues, particularly for larger accounts. Despite this, we have been able to moderate the decline in price per exposure to the low single-digit range. In April we began deploying our new predictive modeling capability for commercial lines, which we call Quest, which covers our property, liability and bond lines. We have been experimenting with it for the past year providing guidance to underwriters, but we are not automatically applying the price changes to our renewal book. We will have this new capability completely deployed in all states by the end of August.

Although it is still early, we are pleased with the improved pricing we saw on our June renewals. Equally important our preliminary retention results seem to be unaffected by the price changes. I will be in a much better position to report more detailed findings in next quarters call.

Premium growth in the quarter was comparable to first quarter. Personalized growth continues to be exceptionally strong driven by record levels of quotes and significant growth from three new states, Texas, Arizona, and Colorado which collectively account for over 4% points of our growth in personal lines. Additionally, quote activity has increased over 60% in the last year resulting from automated bridging solutions which we continue to implement, expansion into new states, primarily in the west, and increased consumer shopping. Our geographic diversification, our products, our pricing precision, and our easy to use portals have clearly made us the go-to personal lines company among our regional company competitors.

Business insurance production declined in the quarter. Policy counts were flat but the economy has clearly taken its toll on our production results. We are looking for flat to slightly positive pricing going forward, but we expect our business insurance top line will continue to be pressured by a declining exposure base.

Expense ratio results on a year-to-date basis are flat with last year. We are incurring some expenses related to the restructuring of our field and claim operations. As I have said in the past, I don’t expect to see any expense ratio benefit this year from these restructuring actions, but do expect a positive impact on our underwriting and loss adjustment expenses beginning in 2010.

With that I will turn you back over to Steve English.

Steve English

Thank you, Bob. Consistent with the performance of the overall market during the second quarter the fair value of our investment portfolio improved and we recorded net unrealized gains net of tax of $13.5 million. Coupled with other comprehensive income from adjustments from unrecognized benefit plan obligations the result was an overall increase in stockholders equity as these offset the impact of the net loss and dividends for the quarter.

Book value per share increased and finished at $19.64 per share. The quality of the portfolio continues to be excellent, but nearly all of our fixed income securities rated AA or better. During the quarter we reported net realized gains on investments of $2.5 to $5 million. Included in that figure are impairments of $600,000.00 primarily from one large cap equity security.

Net investment income declined compared to the second quarter of 2008, yet rose sequentially from the first quarter of 2009. The decline is attributable to the impact of our treasury inflation protected securities, lower dividend yields on equities and short-term money rates. While lower compared to last year TIPs contributed to the increase in net investment income over the first quarter of 2009, as well as our investment in affiliated notes.

Consistent with our previous statements we intend to continue investing conservatively to preserve capital while generating investment income. As I mentioned the accumulated other comprehensive income was positively impacted by adjustments to unrecognized benefit plan obligation as recorded pursuant to SFAS-158.

The restructuring of our field and claim operations reduces our post retirement obligation and as such we have adjusted our pension and post retirement liabilities. This did not have, nor is expected in the future to have, a material income statement impact. The restructuring will also result in severance, relocation, and lease termination costs to be recognized from now until the end of 2010 when the reorganization is expected to be complete. We currently estimate this to total $8.8 million of which we have recognized $1 million in the second quarter of 2009.

As Bob stated, our catastrophe results for the second quarter are consistent with past experience. Last quarter we reported catastrophe losses in excess of $50 million on a group basis that qualified against our $80 million group aggregate treaty. With second quarter storm activity we have almost $93 million of qualifying claims, which after consideration of the 25% co-participation and cooling impact resulted in SGFC recording a $7.6 million reduction in losses in the second quarter. This leaves approximately $17 million of the original $30 million group limit. As a reminder, the aggregate covers PCS numbered caps excluding earthquake and named storms such as hurricanes or tropical storms.

Year-to-date our expense ratio of 33.4 points is essentially flat with the same period in 2008. The ratios on a quarterly basis, for both first and second quarter comparison, are impacted by timing and estimate of contingent compensation plans primarily our contingent commission expense.

Finally, I would like to report we successfully renewed all of our reinsurance treaties on July 1, 2009. Pricing for property, catastrophe, and [PURUS} treaties increased reflecting the impact of reinsurer’s recent loss experience in investment results. Casualty pricing continued to be soft. Overall we were able to fill our programs with no overall significant increase in costs or material changes in coverage or terms.

With that, Ed, we would like to open the call up to any questions.

Question-and-Answer Session

Operator

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

Joseph DeMarino - Piper Jaffray

My first question is on the deterioration in the Workman’s Comp loss ratio. Would you say that is driven by higher severity and if so is that affecting prior accident years?

Bob Restrepo

Joe that was, if I remember right, a current accident year loss and it was one large loss. It is a small line and on a quarter-to-quarter basis very much influences if we have a significant loss, which we did this quarter. Beyond that the trends from a frequency and severity standpoint are largely unchanged.

Joseph DeMarino - Piper Jaffray

Okay and then what are your assumptions, or estimates, for inflation going forward and how does that factor into your reserving methodology?

Bob Restrepo

I will ask Matt Mrozek to comment on it, but our short-term prognosis for inflation is relatively unchanged, but clearly the actions we are seeing on the federal level give us a fair bit of concern about inflation and the impact on our investment portfolio as well as our reserving practices and our pricing practices. I don’t necessarily expect to see that happening in 2010, but beyond 2010 we definitely have concerns regarding the impact of inflation on pricing, reserving, as well as investment yields.

Matt, I will ask you to talk briefly about just how we assess inflation from a reserve perspective.

Matt Mrozek

As Bob said, we are conscientious about the expectation for inflation. Certainly keeping a close eye to the extent we start to see anything that does come through, but right now I would say our trends are not reflecting an up tick in inflation. Whether, as Bob said, reserving or from a pricing standpoint monitoring it very closely, expecting that there may well be increased pressure going forward in the next year and in 2011.

Bob Restrepo

Joe, I will add to that. From a pricing standpoint we are looking to get more conservative. We are in the process now of assessing different ranges of inflation and the impact on building supplies, on medical costs, and on car repairs. We probably haven’t seen significant inflation since the 80’s and early 90’s, but it tends to have a disproportionately higher impact on things that we pay for as far as the claims settlement process. So, we are trying to anticipate that in our pricing assumptions, but we are just in the middle of that right now.

Joseph DeMarino - Piper Jaffray

Thank you, that is helpful. Then I just have one other question for now. Aside from the aggregate CAT reinsurance program, what reinsurance programs do you have for non-CAT storm losses?

Bob Restrepo

We have our three primary treaties are a property to risk treaty, a casualty per risk treaty and then our standard catastrophe treaty which attaches at a $55 million loss.

Joseph DeMarino - Piper Jaffray

So did the non-CAT storms from this quarter, were those helped by that?

Bob Restrepo

No. They were all on our nickel.

Joseph DeMarino - Piper Jaffray

Okay, thank you.

Operator

Your next question comes from Michael Phillips from Stifel Nicolaus & Company, Inc.

Michael Phillips - Stifel Nicolaus & Company, Inc.

Bob, if I recap what I think of your deductible plans you are doing in homeowners, correct me if I am wrong, it is kind of two phases. You have in the eleventh stage you have the mandatory dollar amount deductibles that are now in place and I think you are rolling out the percent of deductibles starting next year, is that correct?

Bob Restrepo

Yes, Mike. Our plan is to adopt $1,000.00 wind and hail deductibles in states that account for a disproportionate amount of our wind and hail losses over the past many years. But, when we introduced our new products our bi-peril rated products where we actually price for each peril wind, hail, fire, water separately we will be including percentage deductibles either 1% or 2%. We have those deductibles in place now in Texas. They have been in place in Texas industry wide for at least ten years; Oklahoma and other states where percentage deductible are in vogue. What we have seen over the past, definitely the last two years, we have seen the wind and hail line move further north and be more frequent earlier in the year. So, we think it is prudent to start applying solutions that have been in place in Texas and Oklahoma for many years further north.

Michael Phillips - Stifel Nicolaus & Company, Inc.

Have you had a chance to look at where this quarter’s CAT losses in homeowners would have been had those percent deductibles been in place already?

Bob Restrepo

It probably would have helped our homeowner results, but not in a significant way, maybe a point or two. It would have helped, it’s a big line for us, but it all depends obviously on where the bad weather happens. We had some rather large states for us, Indiana for example, Kentucky where we didn’t have the same kind of wind and hail experience that we traditionally experience. It tended to be in smaller volume states. So the impact was disproportionately lower. But, over time we expect it to have a several point improvement in our loss ratio with the $1,000.00 deductibles. Obviously it is a lot more significant when we go the percentage deductibles.

Michael Phillips - Stifel Nicolaus & Company, Inc.

Okay great, thank you. Just to make sure I still have this one right too, on your expense ratio reduction plan you are still looking at three to four points by 2011 not 2010, is that correct?

Bob Restrepo

That is correct.

Operator

Your next question comes from Beth Malone from Wunderlich Securities Inc.

Beth Malone - Wunderlich Securities Inc.

On the fire losses is there a correlation between higher fire losses and the possibility that insured’s are cutting corners on maintenance and other servicing that creates a greater risk? Do you have a way to underwrite that from a financial perspective? Would that make a difference?

Bob Restrepo

That is an excellent question, Beth. We have been trying to connect the dots and as part of the large loss analysis we have gone back and looked at people that were behind in their mortgages; was their credit scoring affected in any way, were they having personal problems. The short answer to all of those questions is no. Of all of the large losses we saw in the first and second quarter we saw one instance where somebody was behind in their mortgage or suffered a deteriorating credit score, or was going through personal problems and that was all the same person. We haven’t been able to really connect the dots at all.

The only correlation we can see is that we tend to have in the homeowners line a higher frequency of large losses in states with higher foreclosure rates. But, we do business in a lot of states like Ohio with higher than average foreclosure rates, so I am not sure that it is disproportionate relative to our mix.

Beth Malone - Wunderlich Securities Inc.

Okay and then on the weather related losses, not just the CATs, do you think that if pricing were a little bit less competitive, where you would be able to get better pricing, would you see less weather related loss? Like back if we look back when pricing was much more favorable a couple of years ago, would there have been less weather related losses? I mean is there any correlation between the prices that you’re charging and the losses you are incurring?

Bob Restrepo

Clearly if we had more price as it earns out we would have bigger denominator to absorb the losses that we suffer in the numerator. But, homeowners particularly in the Midwest has been a historically competitive line. Competitors have tried to protect a very profitable personal automobile business by doing what they had to do on the homeowner business. It has been a bit of a loss leader.

I think we have all learned the hard way that you can’t have one line subsidize another. So, we are really pricing homeowners on its own merits and we have been doing that for the last couple of years regardless of its impact on personal automobiles. The line needs more price for catastrophe, weather, and non-weather related events.

Beth Malone - Wunderlich Securities Inc.

Okay, thank you.

Operator

Your next question comes from Paul Newsome from Sandler O'Neill & Partners L.P.

Paul Newsome - Sandler O'Neill & Partners L.P.

To what extent could some of the issues within some of these property lines be due to relative uses with the insurance scoring?

Bob Restrepo

I am not sure I understand your question, Paul.

Paul Newsome - Sandler O'Neill & Partners L.P.

Well, you have some competitors who have been doing some experiments with credit scoring in home insurance using credit scoring insurance scoring. I know you have done some of that, but my sense is that you are maybe average or a little bit below average in developing the system

Bob Restrepo

I understand. No, we have had insurance scoring in place for homeowners for quite a few years now. So, I think we are very competitive in terms of our capabilities regarding credit scoring. What some carriers have done and what we will do with our new bi-peril rating is introduce predictive modeling, which is obviously more sophisticated and will give us more pricing precision than a typical credit scored product.

We have been using credit scoring for some time in homeowners, but we expect our pricing precision to get much better with the new product which will not only be bi-peril rated, but it will also use predictive modeling techniques.

Paul Newsome - Sandler O'Neill & Partners L.P.

I am also curious as to why you are not trying to push a little bit more rate in commercial as well. I mean it sounds like you have the strategy down for home, but it is not as profitable as you would like it as well. Could you talk a little bit about the pros and cons of what is going on there?

Bob Restrepo

Right. What we have been doing, again sticking with the new predictive modeling theme, our new capability that we call Quest utilizes predictive modeling techniques for commercial lines. By the end of next month we will have it deployed in all states for property, liability, and loss. What Quest does is it breaks down the perspective loss potential into deciles from most attractive to least attractive and it surcharges for less attractive risks after we have run it through the model. We have got that deployed in some of our larger states like Ohio and Kentucky we had that in place in April for June renewals. As I mentioned in my prepared comments, we were pretty pleased with the results in our ability to get some modest price increases, but also have those price increases stick. It is one thing to charge and another thing to earn it, and we need to get the policies renewed in order to experience the benefit from the increases.

Clearly loss is the line where we had the greatest price need. Our other lines, particularly the casualty lines, still have negative pure premium trends. But, our margin has shrunk because of the pricing that we have had to give up the last couple of years and so we are looking to deploy Quest on all of our products, but it is going to have a disproportionately significant benefit on property liability, loss and on smaller accounts. One month doesn’t make a trend, but we feel pretty good about the first month results.

Paul Newsome - Sandler O'Neill & Partners L.P.

Would you be willing to start shrinking? One of the things that makes you stand out relative to a number of your peers is your top line is still growing.

Bob Restrepo

Yes, but not in commercial lines. In commercial lines our net written premium growth this quarter is down 5%. Our policy count is flat. There are two reasons we saw a drop off in retention particularly in construction related risks. We are not a big contractors market, but it is fruitful. We have a pretty broad selection of risks, but construction in our multi-peril line is about 20% and it’s a higher percentage in our commercial automobile line, it is close to 40% of our commercial automobile business. So, we have lost not only exposures, we have also lost policy count since the beginning of the year as policy holders either cut back on their exposures or just simply went out of business.

Our retention then on some lines is down 5% largely businesses going out of business. We are not seeing the top line growth in commercial lines that we are obviously seeing in personal lines.

Operator

Your next question comes from Joseph DeMarino from Piper Jaffray.

Joseph DeMarino - Piper Jaffray

I have two quick follow up questions. My first is what is your statutory capital level currently?

Bob Restrepo

It is $725 million.

Joseph DeMarino - Piper Jaffray

Thanks and then on the benefits of change in benefit obligation that you mentioned can you repeat how that flows through the income statement and for what time period?

Bob Restrepo

Yes, it did not flow through the income statement; it only went through other comprehensive income.

Joseph DeMarino - Piper Jaffray

Oh okay and that is how it is going to be going forward?

Bob Restrepo

Yes. The reductions in the projected benefits are recorded as a reduction in unrecognized actuarial gains and losses. So, it will not go through the income statement.

Joseph DeMarino - Piper Jaffray

Okay, thank you.

Operator

Your last question comes from Michael Phillips from Stifel Nicolaus.

Michael Phillips - Stifel Nicolaus

I have one follow question. Just turning to personal auto for a second Bob, you are taking the mid single-digit rate increases there probably a little bit higher than inflationary trends there in that line for now, but if I look at your personal auto results in ’08 and the first half of ’09 they are up quite a bit from the loss ratio for ’07. Does that mean you are comfortable with where you are now or would you like to see that improve in personal auto?

Bob Restrepo

No, we need to improve our margins. We are producing some line ratios in personal automobile at the 96% range which is what we targeted for, for an acceptable return on price, but we are seeing modest increase in pure premium trends and as I mentioned earlier, we are also concerned about inflation and we would like to improve our margins. We are looking right now at targeting the combined ratios that start lower than our current 96 just because we are very uncertain about inflationary trends.

We are also concerned about positive pure premium trends which we have not seen up until about a year ago.

The third thing is I think the competitive landscape is going to allow us to take those rate changes without comparing our retention. Companies are out there looking at pure premium trend increases and I have to believe they are also concerned about the impact of inflation and are taking modest price increases whether they need it or not. So that is going to give us the competitive room to do things.

Michael Phillips - Stifel Nicolaus

So does that mean the low to mid single-digit rate increases are kind of on the low end of what you will take going forward?

Bob Restrepo

I think low to mid single would definitely address. I will be in a better position to address it next quarter, but we are rethinking our pricing assumptions based on the changes in inflation, changes in pure premium trends and changes in competition.

Michael Phillips - Stifel Nicolaus

Okay, thank you Bob.

Bob Restrepo

We want to thank all of your 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 third quarter earnings call which is currently scheduled for October 22, 2009. Thank you and have a nice day.

Operator

At this time that concludes this conference (Operator Instructions) and thank you for your attendance.

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