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EMC Insurance Group Inc. (NASDAQ:EMCI)

Q3 2009 Earnings Call Transcript

October 23, 2009 11:00 am ET

Executives

Anita Novak – Assistant Secretary, Director of IR

Bruce Kelley – President & CEO

Mark Reese – SVP, Accounting & CFO

Bill Murray – EVP and COO

Scott Jean – VP, Actuary

Kevin Hovick – SVP, Business Development

Rich Schulz – SVP, Claims

Analysts

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

Bob Barnum – Keefe, Bruyette & Woods

Operator

Greetings and welcome to the EMC Insurance Group Incorporated third quarter 2009 earnings 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 Ms. Anita Novak, Director, Investor Relations for EMC Insurance Group Incorporated. Thank you. Ms. Novak, you may now begin.

Anita Novak

Thank you, Becky. Good morning everyone, and welcome to EMC Insurance Group’s 2009 third quarter earnings call. A supplemental investor packet is available on the Investor Relations page of our Web site, which can be found at www.emcins.com/ir. A webcast for replay purposes is also available at this site until January 23, 2010. The transcript of the webcast will be available for one year.

This presentation includes some forward-looking statements about our expectations for our future performance. Actual results can differ materially from those suggested by our comments today. Additional information about factors that could affect future results is addressed in our SEC filings, including Forms S-1, 10-K, 10-Q and 8-K. Any information provided today should be read in conjunction with the 2009 third quarter earnings release with accompanying financial tables issued earlier today.

With us today are several members of EMC Insurance Group’s executive management team. They are Mr. Bruce Kelley, President and Chief Executive Officer; Mr. Bill Murray, Executive Vice President and Chief Operating Officer; Mr. Rich Schulz, Senior Vice President, Claims; Mr. Kevin Hovick, Senior Vice President and Business Development; Mr. Ray Davis, Senior Vice President, Investments and Treasurer; Mr. Scott Jean, Vice President, Actuary; Mr. Kelvin Sederburg, Vice President, Actuary; and Mr. Mark Reese, Senior Vice President and Chief Financial Officer.

At this time, it is my pleasure to introduce EMC’s Chief Executive Officer, Bruce Kelley.

Bruce Kelley

Thank you, Anita. Good morning. For the property casualty insurance sector business is proceeding despite the turmoil of current economic conditions. Our basic operations are normal. We renew existing policies, we write new business, we paid claims, we developed new products, and we compete with our peers for profitable business.

We tried various risk management strategies in the past, and we found that an emphasis on underwriting profitability is the best method for us. So we continue to market our products on that premise. We've retained post-relationships with our independent agency field force through 16 strategically located branches, growing our business organically through existing agencies, and the employment of new producers. And as of September 30, we have appointed 151 new agents and canceled 87. We maintain a financially strong balance sheet, we reserve conservatively and we invest conservatively. In a nutshell, we adhere to our corporate strategy plan whether we are encountering a soft pricing environment or a hard one. And that of course -- and that course of actions work well for us. Our objective is to emerge from the current soft market, financially sound with a profitable book of business.

Third quarter, for the most part, is right on track with our corporate objectives and expectations. Operating income was $0.24 per share and net income was $0.38 per share. Catastrophe and storm losses declined to $0.79 per share, which was again less than third quarter 2008 results but higher than company averages due to active Midwest storm patterns.

The book value of the company's stock increased 9.4% to $25.41 in third quarter and 19.2% year-to-date. Net written premiums for the third quarter increased 2.8%, which is a result of some rate increases and an increase in new business policy counts, predominantly in personal lines. Year-to-date, however, net written premiums remained flat due to competitive pricing in the first half of the year, which tends to limit our ability to grow profitably.

As we have discussed on previous calls, we have initiated a marketing strategy for personal lines, which has taken us out of some states, mostly coastal regions, and increased marketing efforts in other states, where we believe personal lines can be written profitably over the long term. Although, working off a lower base is a starting point, personal lines new business net written premiums have increased 43.1% and new business personal lines policy counts have increased 27.9%. We are generally seeing mid-single digit rate increases in most geographic locations and some double-digit increases in some areas in our personal lines. We plan to further expand this marketing strategy going forward.

Commercial lines pricing remains quite competitive. While we are seeing some firming in the workers’ compensation line of business, overall, new business net written premium for commercial lines have increased approximately 8.7% as compared to 2008, and new business commercial lines policy counts have increased 6.8%.

Across all lines of business, net written premiums on new business for the nine months ended September 30, has increased approximately 11.5% as compared to 2008, and policy counts on new business have increased 14%.

We continued to expand our Safety Groups, Target Markets, and Choice Specialty Markets, all of these programs currently both incurred to earned ratios in the low mid-40 percentile and comprised approximately 43.8% of our commercial lines written premium.

The company continues to experience retention levels higher than industry averages and consistent with our expectation. Commercial lines retention is approximately 86% and personal lines retention is approximately 87%. Commercial retention to slightly lower than the past four years, but demonstrates the ongoing competitiveness of the commercial lines marketplace and our willingness to walk away from underpriced business. Frequency was down slightly in the third quarter 2009; severity is also down when non-storm shock claims are excluded. The company has experienced three non-storm shock claims in 2009 compared to zero in 2008. As explanation, we consider a non-storm shock claim to be a very large claim outside the usual rental [ph] business.

With that, I’ll turn the discussion over to Mark Reese, Chief Financial Officer for additional discussion with regard to our financial result. Mark?

Mark Reese

Thank you, Bruce. Let me start by stating that our most recent actuarial analysis of reserves indicates a level of adequacy consistent with other recent evaluations. Since [ph] management strives to maintain a reasonably consistent level of reserve adequacy at each quarterly reporting date, the financial impact resulting from development of prior accident years is in effect being offset by the establishment of equally adequate reserves on current accident year claims. For this reason, management believes the composition of the company's underwriting results between the current and prior accident years creates potential form of misinterpretation, and in any event is not relevant to an understanding of the company's results of operations.

Operating income for the third quarter was $3.2 million, which is a significant increase from the $295,000 loss reported in the third quarter of 2008. Operating income for the third quarter of 2009 reflects a higher than normal level of catastrophe and storm losses and a moderate but steady decline in overall premium rate levels.

Operating income for the first nine months of 2009 was $20.9 million, compared to $8.6 million in 2008. The company has historically reported catastrophe and storm losses net of development experienced on prior year’s catastrophe and storm losses. This has not had a material impact on the reported amount, because development associated with prior year's catastrophe and storm losses has historically been relatively small.

During 2009, however, the company has experienced a larger amount of favorable development related to the record amount of catastrophe and storm losses incurred in 2008. As a result, the company is changing its reporting of catastrophe and storm losses to include only current accident year events. Any maturing amount of development experienced on prior accident year catastrophe and storm losses will be reported separately. This change in reporting does not have any impact on the reported amounts of operating income or net income. It only affects the reported amounts of catastrophe and storm losses.

Catastrophe and storm losses totaled $0.79 per share in the third quarter compared to $0.97 per share in 2008. For the first nine months of 2009, catastrophe and storm losses totaled $1.52 per share compared to a record $2.41 per share in 2008. The company experienced favorable development on prior year's catastrophe and storm losses of $0.04 per share for the three months ended September 30, 2009, compared to $0.01 per share for the same period in 2008.

For the nine months ended September 30, 2009 favorable development on prior year’s catastrophe and storm losses totaled $0.15 per share compared to $0.07 per share for the same period in 2008. Reserves associated with catastrophe and storm losses are event specific, and are initially established based on non-exposures and estimates of loss frequency and severity. As actual loss information is reported, management is better able to project the ultimate costs of the loss event. Changes in the projected ultimate costs of our prior accident year loss event is reported as development, and this development has an impact on the company's results of operations because the total amount of the companies carried reserves has changed.

Large losses, which we define as losses greater than $250,000, excluding catastrophe and storm losses, amounted to $0.40 per share and $1.35 per share for the third quarter and first nine months of 2009 respectively, compared to $0.59 per share and $1.17 per share for the third quarter and first nine months of 2008.

Net income for the third quarter totaled $5.1 million compared to a net loss of $9.5 million in 2008. For the first nine months of 2009, net income totaled $17.8 million compared to $2.2 million loss in 2008. Other than temporary investment impairment losses totaled $611,000 in the third quarter and $17.1 million in the first nine months of 2009. This compares to $9.7 million in the third quarter and $21.7 million in the first nine months of 2008.

Net written premiums increased 1.1% to $304.6 million in the first nine months of the year. The reinsurance segment reported an increase of 6.7%, while the property and casualty insurance segment was relatively flat. In the property and casualty insurance segment, commercial lines of business declined 1.3%, while personal lines of business increased 8.3%. For the first nine months of 2009, new business premium was up 11.7%, reflecting a 40% increase in personal lines and a 9.1% increase in commercial lines. The increase in personal lines is distorted somewhat by a change from six months auto policies to annual auto policies, and we estimate the impact of this change to be approximately 9 percentage points.

Investment income decreased 3.6% to $11.8 million in the third quarter and 2.6% to $35.3 million in the first nine months of 2009. This decline in investment income is attributed to a high level of call activity experienced on the company's US Government Agency securities during the first half of 2009 as a result of the low interest rate environment, a decline in yield on short-term investments, and the elimination of dividends on the Freddie Mac and Fannie Mae preferred stocks in 2008. As of September 30, the majority of the proceeds received from the called securities have been reinvested.

The total rate of return on our equity portfolio for the first nine months of 2009 was 16.77%, which is less than the 19.26% total return generated by the S&P 500. During the third quarter, our equity portfolio returned 13.61% compared to 15.61% for the S&P 500. The current annualized yield on our bond portfolio is 5.31%, and the effective duration is 5.68 years which is up from 5.36 years at June 30.

The net book value of the company’s stock at September 30 was $25.41 per share, an increase of 19.2% from $21.32 per share at December 31, 2008.

Consolidated assets totaled $1.2 billion, including $1 billion in the investment portfolio. And stockholders’ equity was $334.3 million, an increase of 18.2% from year-end 2008.

Based on actual results, for the first nine months of 2009 and our expectation for the remainder of the year, we are reaffirming our 2009 annual operating income guidance range of $1.80 to $2.05 per share, which is based on a projected GAAP combined ratio of 103.5%.

As previously reported, the company sold 100% of its investment in Verisk Analytics Inc., common stock in connection with that company's initial public offering on October 7, and expects to record an after-tax realized gain on the sale of approximately $14.6 million or $1.10 per share in the fourth quarter. Management decided to sell all of its Verisk stock to reduce the potential volatility of its equity portfolio and also to generate tax gain that can be used to offset tax losses that will be recognized upon the disposition of the company’s holdings of other than temporarily impaired securities as the company rebalances its equity portfolio.

In 2008, the company's Board of Directors authorized a stock repurchase plan totaling $25 million. The program does not have an expiration date and the timing in terms of the purchases is determined by management based on market condition and the applicable rules of the SEC. As of October 10, 736,133 shares have been repurchased at a cost of approximately $17.9 million, leaving approximately $7.1 million available for the purchase of additional shares.

At this time, I would like to open the phones for questions.

Question-and-Answer Session

Operator

(Operator instructions) Thank you. Our first question is coming from Paul Newsome of Sandler O'Neill & Partners.

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

Hello folks, thank you for the call.

Bruce Kelley

Good morning, Paul.

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

I wanted to touch a little bit on these new business efforts. And maybe you could (inaudible) into the context of -- obviously the absolute returns on underwriting business don’t meet the hurdle of underwriting profits. How do we know that increasing profitability is into equity sales at this time, which appears to be at the bottom of the soft market, use -- the right strategy is actually going to improve underwriting profits. In particular, for example, I was struck by the fact that you are going to one year policies from six year policies. Typically, that’s an increase in terms of – maybe you are losing in terms of conditions. Is that sort of counter to trying to improve profitability?

Bruce Kelley

Thanks, Paul for your question. I appreciate you're looking at our marketing. I’ll turn the question over to Bill Murray, our Chief Operating Officer.

Bill Murray

Good morning, Paul.

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

Good morning.

Bill Murray

I think I'll address this pretty much from a personal lines standpoint, if that's okay, because that seems to be where our year-over-year comparisons suggest that we are writing quite a bit of new business. I would like to begin by saying that commercial lines continues to be profit center in our marketing plan. But personal lines continues to be an important part of the marketing plan in some of our branches. Our overall strategy for personal lines is to write less where personal lines hasn’t been growing and an important part of branch plans, and where it can, therefore, hurt you.

We intend and have intended to write more of personal lines business where according to history and according to other studies, personal lines can be written profitably over the longer term. And we took on some studies and made some changes here within the last several years to enable us to do that, including studies of rates, product, and ease of doing business from an agent standpoint. We've been pretty successful in several of those states but, as Bruce has mentioned in his earlier comments, some of the numbers that we are looking at, both in terms of premium and in count, have pretty low starting points.

Actually growth is pretty much keeping with the plans that we had established with some of these states where we think we can do business successfully. But we are certainly monitoring the exposures that we are adding to our book of business; and especially, the rates in those states where it seems that we have lately been able to get some pretty good rate increases. Some of this business that we've been writing will actually tend to add to our Midwestern exposures, but actually if we have done this correctly from a rating standpoint we should be able to achieve a better spread of risk in those states where we are writing more business than we have before.

So it's actually a part of our strategy, we believe that it is a well conceived strategy, unless of course you have too unusually high Midwestern storm seasons as we had in 2008 and in 2009. But again, it's a long-term strategy and it is one we had continued to monitor carefully.

You also had a question as far as –

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

So what are you saying is that these are personal lines products that are being sold largely in new areas or – and that’s why it’s – you would expect profitability better than what you are currently having? Or are they simply a renewed effort in the same area. I was a little bit confused there.

Bill Murray

It would be a renewed effort in areas where we have traditionally written our personal lines business generally successfully in the past.

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

And today you're not successful? You doesn’t make an underwrite profit right, so are you trying a new business at a profitable level or not?

Bill Murray

Well, we continue to monitor the pricing levels that we have and we will follow some of those indications from our actuaries. And we have been successful in making some personal lines rate filings recently, and like I said, we will continue to monitor that going forward. But these are not new areas; these are in states where we have written business. But in the past, we may be have had some agencies that have been more successful with us than others, and if they have used us, they’ve used us pretty frequently. So we have had high concentrations of business even on a state business. And by redefining our pricing, we should be able to get better spread of risk within states even those in the Midwest.

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

And then a separate question, I just want to make sure is this management's view that the third quarter was typically worse than normal catastrophe quarter for yourself and/or the industry?

Scott Jean

This is Scott Jean, Actuary. For the industry, I would say, that's probably a fairly normal catastrophe year. For us, because we are heavier in the Midwest, we did have a higher catastrophe ratio during the third quarter. The catastrophe ratio for the third quarter was almost six points higher than we had expected it to be. So I'm just giving you an idea of what catastrophe looks like for us compared to what we had expected.

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

What's the possibility that this is not necessarily pure cat, but more a reflection of pricing, because – obviously a lot of recoveries in that reports aren’t clear yet. But those that have actually reported extremely light third quarter, maybe one of the lightest on record. So it would appears that the industry is having an absolutely wonderful quarter. What's the chance that this is – we are picking up something that maybe deferent than truly catastrophe loss.

Mark Reese

From our perspective, the total amount of catastrophe losses has been higher in 2008, 2009. In addition, we have analyzed catastrophe losses on an equivalent [ph] earned premium basis also, meaning that we adjust cat earned premiums to 2009 rate level for comparisons sake, and 2008, 2009 were still very historically high when adjusted and looking at it from that perspective.

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

We are just talking about the quarter?

Mark Reese

Yes.

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

Okay, great. Thank you very much.

Operator

(Operator instructions) Our next question is coming from Bob Barnum of Keefe, Bruyette & Woods.

Bob Barnum – Keefe, Bruyette & Woods

Hi, good morning. Trying go along the same thing, we are talking about market conditions; can you give us an idea, has there been any change in competition, has anybody been pulling out or alternatively being getting more aggressive, any new players?

Bruce Kelley

One thing I would comment on before I turn it over to Kevin Hovick would be that we are an independent agency company and we are competing with direct writers. And we are seeing that the ability to compete with the -- our ability to compete with direct writers has been enhanced by the technology and the fact that the independent agents have access to a number of different companies. The industry has been stressed by the catastrophes we've had in the last several years, so we've been able to demonstrate a good claim service. We have been able to demonstrate our improved technology, and then there is better pricing. So we're really able to have a better impact in competing with other companies, specifically. Direct writing companies aren't able to handle the claims like we are. I will turn it over to Kevin Hovick, who is in charge of business development.

Kevin Hovick

Thanks, Bruce. Just quickly to answer that, we have had our underwriting managers in for a meeting here earlier this week. There doesn't seem to be any significant moment out there as far as what the competition is doing. There have been lot of regional company operating under the national kind of a footprint. We compete against lot of the regional companies and even some of the national companies, like they all are very mutual that has a lot of regional type of approaches. What we are seeing right now is that a lot of companies out there are kind of -- fundamentally, some of the things we do, we have the Target Markets, Safety Groups, Mystical [ph] business, governmental entity.

We see a lot of companies trying to come in and take that business away from us, I believe, can pretty much -- (inaudible) is a premiere writer of some of that business and were able to send off some of the competition. Again, most of our competition seems to be with the regional type writer. There are a few companies that were mentioned in our meetings on the east coast and the Midwest. In the west coast, we do tend to go up against some of the national writers, some of the larger stock companies.

Bob Barnum – Keefe, Bruyette & Woods

Would the larger competitors or the regional competitors going in after your target markets, are they basically trying to compete on price or they are offering different things for the agents or what not?

Kevin Hovick

Well, we are confident that to compete, I think, we are against some of the programs that we put together, because we developed some with our risk improvement loss control over the years, again our branch and claims service. We’re getting reports that from our branches some companies are coming in and saying, “We will cut EPC’s premium by such a percent. Just give us a chance to take a look at it.” We see some of that, but once they take a look at it and put it in front of maybe either a school board or a city council and they try to compare coverages to coverages and what they have, we are able to retain it to a certain degree. We are having to be competitive. There is no doubt about that. We have to offer some programs as far as some dividend programs. But I think, as Bruce has mentioned in his comments, we do have some walkaway prices and we just can’t – we are only going to go so far, but we’ve been able to use our sales approaches and maintain the business that we’ve established.

Bill Murray

Bob, this is Bill. As Kevin has mentioned, we’ve seen a fair amount of competition. The interesting thing I think going forward will be how companies will respond to basically the lack of a significant hurricane season this year. Of course, we typically don’t write huge volumes of business in those coastal areas. So for us what we need to be is very alert to pricing opportunities in the Midwest where we’ve had some significant storms in each of the last couple of year. And that’s what we would intend to do, stay on top of the pricing and that’s where our 16 branches are structured, gives us a real opportunity to do that because of the local prices.

Bob Barnum – Keefe, Bruyette & Woods

Okay. And it sounds like you have been getting rate increases in personal lines. Can you just give us an overall rate change in personal lines versus commercial lines for the quarter?

Mark Reese

So far, year to date, we’ve been able to get in and out, 2.7% increase on personal lines premium, that’s as far as what has been filed with the insurance department. Commercial lines, we are looking at about 0.1% to fairly flat.

Bob Barnum – Keefe, Bruyette & Woods

0.1%?

Mark Reese

Yes.

Bob Barnum – Keefe, Bruyette & Woods

All right. I know last quarter, you talked about some of the larger non-cat losses, some of them where fire related. Anything specific going on in this quarter with the large losses in terms of types [ph] of claims?

Bruce Kelley

I’ll turn it over to Rich Schulz, the Head of the Claims Department to talk about our third quarter losses due September 30.

Rich Schulz

Nothing really has changed. The large losses remain are commercial fire losses. The overall numbers are similar. We’ve just had a couple of them that were particularly large.

Bob Barnum – Keefe, Bruyette & Woods

Okay. And last question from me would be guidance. What is the catastrophe low [ph] that you are including in the guidance numbers now?

Bruce Kelley

I’ll turn it over to Scott Jean who gave that number.

Scott Jean

The fourth quarter cat loss is 5.7% versus 3.5% on the property casualty side, a little bit – and higher on the EMC resize.

Bob Barnum – Keefe, Bruyette & Woods

Okay, very good. Thanks, guys.

Bruce Kelley

Thanks, Bob. I appreciate it.

Operator

(Operator instructions) Thank you. There are no further questions at this time. I would like to hand the floor back over to management for any closing comments.

Anita Novak

Thank you Becky, and thank you ladies and gentlemen. This now concludes this conference call. I would like to remind you that a playback of this call will be available on the company’s Investor Relations page of the company's Web site at www.emcins.com/ir until November 6, 2009. And a transcript of this conference call will be available until October 23, 2010, which can also be accessed from our Investor Relations page later today. We appreciate your interest in EMC Insurance Group and all of us wish you an enjoyable day.

Operator

This concludes today’s teleconference. You may disconnect your lines at this time. Thank you all for your participation.

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