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Executives

Steve Walsh - Director, Investor Relations

Bruce Kelley - President and Chief Executive Officer

Mark Reese - Senior Vice President and Chief Financial Officer

Ron Hallenbeck - Vice President

Kelvin Sederburg - Vice President and Appointed Actuary

Scott Jean - Vice President and Chief Actuary

Brad Fredericks - Assistant Vice President

Lisa Simonetta - Senior Vice President, Claims

Analysts

Paul Newsome - Sandler O'Neill

Neil Cybart - KBW

EMC Insurance Group Inc. (EMCI) Q4 2013 Earnings Conference Call February 20, 2014 12:00 PM ET

Operator

Greetings, and welcome to the EMC Insurance Group Fourth Quarter 2013 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.

I would now like to turn the conference over to your host, Steve Walsh, Director of Investor Relations. Thank you. Please begin.

Steve Walsh - Director, Investor Relations

Thank you, Roya. Good morning everyone and welcome to EMC Insurance Group’s 2013 fourth quarter earnings call. A copy of the press release is available on the Investor Relations page of our website, which can be found at www.emcins.com/ir. The webcast is also available on this site for replay purposes until May 20, 2014. 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 could 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 2013 fourth quarter earnings release with accompanying financial tables issued earlier today.

In addition, certain non-GAAP terms may be used during today’s discussions. Please refer to the company’s press release and/or SEC filings for a description and reconciliation of these terms.

Mr. Bruce Kelley, President and Chief Executive Officer and Mr. Mark Reese, Senior Vice President and Chief Financial Officer have prepared remarks this morning and other executive officers are available to answer questions.

At this time, it’s my pleasure to introduce the company’s President and CEO, Bruce Kelley.

Bruce Kelley - President and Chief Executive Officer

Thank you, Steve and welcome to those joining us this morning. Earlier today, we reported our operating income of $0.95 per share and net income of $1.20 per share for the fourth quarter of 2013 compared to operating income of $0.99 per share and net income of $1.01 per share in 2012. Operating income of $2.88 per share for the year exceeded the high end of our income guidance as operating results for the fourth quarter were better than expected.

Recent pricing trends continued to the fourth quarter as premium rate level increases in our commercial and personal lines of business remained in the upper single-digits. At EMC, we focus on building and maintaining strong stable partnerships with our independent agents. Through these partnerships and the tireless effort of our branch offices, we have been able to consistently increase property and casualty insurance rate levels that have surpassed both the industry average and our increase in loss costs over the past three years. We remain optimistic that we will continue to achieve rate level increases in the property and casualty insurance segment during 2014 although at a somewhat lower level. Reinsurance premium rate levels are expected to fall in 2014, especially for catastrophe excess of loss business. However, this business only accounts for approximately 20% of the reinsurance segment’s total book of business. Despite the decline in reinsurance rate levels, premium income for the reinsurance segment is expected to grow in 2014, but at a more modest level than 2013.

Premium income growth for the quarter was strong, up 9.5% in the property and casualty insurance segment and 38.7% in the reinsurance segment. In the property and casualty insurance segment, the vast majority of the growth was associated with rate increases on renewal business in our commercial lines as well as some growth in insured exposures. Premium rate levels increased at all branch locations and across all major lines of business. Renewal rates across both our commercial and personal lines of business increased approximately 7.4% during the year. However, premium income from our personal lines of business was down slightly due to an intentional reduction in policy count to lessen exposure concentrations. Commercial lines policy count was up 2.1%, while personal lines policy count was down 11%.

We are also seeing a lot of good opportunities for new business with strong growth in the Northwest, Southwest and Southeast parts of the United States and we expect to increase penetration in these areas going forward. This growth outside the company’s core Midwest market helps diversify the company’s book of business geographically while staying consistent with the existing book of businesses mixed by industry and line of business. The 38.7% increase in the reinsurance segment’s premiums earned is unusually large due to the significant decline that occurred in the year end 2012 earned, but not reported premiums on several pro rata accounts.

As noted in our 2012 fourth quarter earnings release, excluding the change in earned but not reported premiums the increase in fourth quarter premiums earned is primarily attributed to growth in the offshore energy and liability proportional accounts, moderate rate level increases and the addition of some new business. Net written premiums decreased 16.2% in the fourth quarter. In the property and casualty insurance segment net written premiums in commercial lines of business were up 10.5%, while personal lines of business were down 8.9%. In the reinsurance segment net written premiums were up 42.5%.

Retention levels based on policy count remained strong and above industry averages with commercial lines of business at 86.3%, personal lines of business at 83.5% and an overall retention level of 85%. Retention levels are down slightly from the prior year in both commercial and personal lines of business, but personal lines is showing a slightly larger decline due to our intentional reduction in policy count.

As we stated before the relatively consistent overall retention level demonstrates continued support for ongoing premium rate level increases in our renewal book of business and indicates that we are not pricing ourselves out of the market as we work towards increase margins. Retention levels in the mid to upper-80% range are well within our comfort level and expectations due to the large amount of commercial lines group business contained in our core book of business. This business tends to consistently renew because of marketing strategies designed to reward favorable loss experience.

Book value of the company’s stocks increased 10.2% during the fourth quarter to $34.21 per share, an increase of 10.1% from year end 2012. Just over four percentage points in the quarter and year-to-date increases are attributed to previously announced changes in Employers Mutual Casualty Company’s retiree healthcare plan. In addition to the significant decline of the plan’s projected benefit obligation that was recognized in company’s year end financial statements, the company will benefit from a substantial decline in the plan’s net periodic benefit costs beginning in 2014. In fact, we expect to recognize approximately $3.1 million of income in 2014 compared to $3 million of expense in 2013. Excluding accumulated other comprehensive income from the calculation, book value increased 3.3% during the quarter to $29.78 per share and increased 8.8% from year end 2012.

Now before I turn the discussion over the Mark Reese, our Chief Financial Officer, I want to revisit the Deep Customer Connections agent survey conducted during 2013 by a third party vendor on our behalf. The results of this survey confirmed our reputation for prompt and fair claim service. It also revealed the need to provide better communication and improved technology. Our agents want to be able to quickly obtain the status of a claim including contact and payment detail. As a result of the effort and the collaborative effort of many departments, we now have an improved claims increased service within agent access that provides our agents with the most important information at their finger tips.

With new claims increased service – excuse me the new claims increased service has received nothing but positive feedback from our agents. With agents being able to quickly obtain the status of a claim without having to place a phone call to their EMC claims adjuster, this will benefit or agents and cause our staff to focus on the items most important to an agency success. We currently have additional issues underway which should allow us to capitalize on these opportunities and continue to improve the ease of placing business with EMC.

In addition, I am proud to note that EMC Insurance Companies is listed for the second consecutive year as one of the 40 best companies for leaders by Chief Executive Magazine. EMC ranks 26th in 2014 jumping from 35th in 2013 and is listed among other notable companies such as IBM, General Electric and 3M. The annual ranking is based on worldwide survey of organizations conducted by the magazine. We are very proud to rank 26 on the list and focus on creating a culture that emphasizes leadership development, nurtures talent and establishes teams at all levels of our organization.

The latest example of our emphasis on developing leaders from within follows the previously announced retirement of Lisa Stange, Vice President, Chief Investment Officer and Treasurer in March. As Brad Fredericks, Assistant Vice President, Investments will be assuming Lisa’s responsibilities upon her departure. Although she couldn’t be on the call this morning, I want to take this opportunity to thank Lisa for her outstanding leadership of our investment department during the past five tumultuous years and wish her well. Brad has over 15 years of experience in portfolio management and securities analysis. And he has been with EMC since 2010. We look forward to continued investing success with Brad in his new role of leading the investment department.

With that, I will turn the discussion over to Mark Reese, our Chief Financial Officer.

Mark Reese - Senior Vice President and Chief Financial Officer

Thank you, Bruce and good morning everyone. I would like to begin this morning by having a brief discussion about the reserving methodology utilized by the property and casualty insurance segment and more specifically about the composition of the development amounts that are produced under this methodology at each year end. Under the reserving methodology utilized by the property and casualty insurance segment, IBNR loss reserves, bulk case loss reserves and settlement expense reserves are established in total and the total is then allocated to the various accident years.

During the year end allocation process, a portion of the total book reserves maybe reallocated from the current accident year to prior accident years or from prior accident years to the current accident year to achieve the actuarial department’s desired reserve levels by accident year. When reserves are moved to or from prior accident years, the change is reported as development on prior year’s reserves. However, this type of development is mechanical in nature. It does not have an impact on earnings, because the total amount of carried reserves did not change. Therefore, we identify, quantify and disclose this mechanical development so that users of the company’s financial statements can better understand how development on prior year’s reserves impacts the company’s results of operations.

So, when you look at the reported development amounts for the fourth quarter, we had $5.2 million of favorable development in 2013 compared to $258,000 of adverse development in 2012. However, included in these amounts are $6.5 million of favorable development in 2013 and $4.6 million of adverse development in 2012 that resulted solely from a reallocation of bulk reserves between the current and prior accident years in the property and casualty insurance segment, which had no impact on earnings. When the reported development amounts are adjusted to exclude these mechanical development amounts, the resulting implied amounts of development that had an impact on earnings are approximately $1.4 million of adverse development in the fourth quarter of 2013 compared to approximately $4.3 million of favorable development in fourth quarter of 2012.

So, it is important to understand the difference between the reported development amounts and the implied amounts of development that have an impact on earnings, because you get a completely different answer when calculating normalized earnings. I also want to stress that this reallocation of reserves between the current and prior accident years only occurs at year end. Therefore, the development amounts reported for the first three quarters of the year are not impacted. The information presented at the bottom of the consolidated statements of income contained in the press release, have been expanded to show how the implied amounts of development that have an impact on earnings are calculated.

The change in fourth quarter implied development is primarily attributed to the property and casualty insurance segment, which experienced adverse development of $3.2 million in the fourth quarter of 2013 compared to favorable development of $1.4 million in 2012. For the year ended December 31, 2013, the implied amount of favorable development declined to approximately $6.3 million from $30.3 million in 2012. Both the property and casualty insurance segment and the reinsurance segment experienced large declines in favorable development for the year. The decline in the property and casualty insurance segment is primarily attributed to unfavorable outcome on a few large prior year claims, but also reflect a slight decline in the amount of both case loss reserves carried at year end 2012. The decline in the reinsurance segment was generally expected. As expected loss ratios used in the development methodologies applied to the contract year 2012 were somewhat lower than previous contract years due to an extensive actuarial study performed during 2012.

Development amounts can vary significantly from quarter-to-quarter and year-to-year depending on a number of factors, including the number of claims settled in the settlement terms and should therefore not be considered a reliable factor in assessing the adequacy of the company’s carried reserves. The most recent actuarial analysis of the company’s carried reserves indicates that carried reserves remain within the top quartile of the range of reasonable reserves, but at a slightly lower level within the quartile relative to the 2012 evaluation.

The primary catastrophe and storm loss event impacting the property and casualty insurance segment during the fourth quarter was a nearly mile-wide tornado in Wayne, Nebraska. Fourth quarter 2013 catastrophe and storm losses accounted for 5 percentage points of the combined ratio, which is higher than the company’s most recent 10-year average of 3 percentage points, but below the 6.9 percentage points experienced in the fourth quarter of 2012. There were no catastrophe and storm loss events in the reinsurance segment during the year that exceeded the $4 million retention level contained in the excess of loss agreement.

Effective January 1, 2014, Employers Mutual Casualty Company renewed the reinsurance agreements that provide protection to the full and each of its participants, including protection against losses arising from catastrophic events, the favorable pricing terms along with expanded coverage. The notable changes include increasing the top limit of the property catastrophe program by $5 million and removing the 5% co-participation on a program. In addition, a portion of certain layers of the property catastrophe program were expanded to 120-hour coverage for wind perils up from 96-hour coverage, which remains the coverage time period on the balance of the catastrophe program. Even with these additional limits and expanded coverage terms, we still expect ceding less premium under the 2014 property catastrophe reinsurance program than in 2013.

Large losses, which we define as losses greater than $500,000 for the EMC Insurance Companies pool, excluding catastrophe and storm losses, increased significantly to $7 million or $0.34 per share after-tax in the fourth quarter of 2013 from $4.1 million or $0.21 per share after-tax in 2012, primarily due to several large fire losses. For the year, large losses were relatively flat increasing a modest 4.7% from 2012. Excluding the impact of catastrophe and storm losses, large losses and related development, claims frequency increased 0.6% and claims severity increased 2.9%. Rate level increases continued to exceed the increase in loss cost.

Turning to our investment results, net investment income increased 1.1% in the fourth quarter, but declined 2.5% for the year. The decline in net investment income for the year is primarily due to the low interest rate environment that has persisted for the past several years, but was mitigated by considerable growth in the fixed maturity portfolio, strong dividend earnings on the equity portfolio and a slight increase in interest rates. The average coupon rate on our fixed maturity portfolio, excluding interest-only securities, declined slightly to 4.03% at year end 2013 from 4.23% at year end 2012.

The effective duration of the fixed maturity portfolio, excluding interest-only securities, increased to 5.65 from 4.20 at the end of 2012, but remained relatively consistent with duration at the end of the third quarter. Duration extended as interest rates rose during the second quarter. Total return on the equity portfolio was 10% for the quarter and 31% for the year compared to 10.5% and 32.4% respectively for the S&P 500. During the fourth quarter we took advantage of the outsized equity returns achieved during the year by selling some stock. In addition, we are taking steps to address our long-term equity risks by reducing downsize exposure. No shares are going to be repurchased under the company’s $15 million stock repurchase program that was put in place in November of 2011.

Looking ahead our preliminary estimates for losses associated with the severe winter weather and unusually low temperatures that blanketed a wide geographic area for much of January is approximately $3.5 million to $4 million. With two months still remaining in the quarter it is likely that our first loss ratio will be higher than in the recent years. However, we see no reason to change our overall loss assumption for the year at this time.

Management is projecting that 2014 operating income will be within a range of $3 to $3.25 per share. This guidance is based on projected GAAP combined ratio of 96.8% for the year and investment income consistent with their amounts reported in 2013. Projected GAAP combined ratio has a load of 10 points for catastrophe and storm losses.

At this time we are ready to open the call for questions.

Question-and-Answer Session

Operator

Thank you. We will now be conducting the question-and-answer session. (Operator Instructions) Thank you. Our first question comes from the line of Paul Newsome with Sandler O'Neill. Please proceed with your questions.

Paul Newsome - Sandler O'Neill

Good morning and thanks for the call. I was wondering you could focus a little bit on the reinsurance operation and the growth that we have seen there, which has been pretty substantial. Could you – I know some of that line comes from things like offshore energy where we heard sort of mixed things about the competitive environment, maybe if you talk about what exactly happened there with that growth as well as why you feel confident in that business?

Ron Hallenbeck

This is Ron Hallenbeck. We are fairly confident that the company that we work with is doing a good job on that area. We do not have specific information as far as the competitive situation, but we are monitoring it. I guess we have been pleased with the results so far.

Kelvin Sederburg

And this is Kelvin Sederburg. I would also like to reemphasize what was mentioned in the narrative and I believe is in the release about if you are comparing quarter-to-quarter the fourth quarter earned premium for the reinsurance segment was high, looks high because fourth quarter of 2012 or the change looks large, because fourth quarter 2012 the way EBNR was being handled and the booking of EBNR had a little bit of a timing aspect there. So the comparison of quarter-to-quarter is a little bit misleading on the earned premium side.

Paul Newsome - Sandler O'Neill

Thanks.

Operator

Thank you. (Operator Instructions) Thank you. Our next question comes from the line of Neil Cybart with KBW. Please proceed with your question.

Neil Cybart - KBW

Thank you. Good afternoon everyone. You mentioned you saw commercial rate increases in the high-single digits and then and that’s roughly unchanged from the first nine months of 2013 what loss cost trends are you seeing?

Scott Jean

Hi Neil, this is Scott Jean, Chief Actuary. Loss cost trended in pretty much in line with the expectations. The observed loss cost trend for the year was about 3.5%, but that includes increases in severity due to inflation, which also impacts our premium income due to exposure changes. So after adjusting for this, our loss ratio trend was approximately 1.5 points, which is obviously well below the level of rate increases we obtained.

Neil Cybart - KBW

Okay, thank you. I guess that leads into my second question, your P&C accident year loss ratio looks somewhat elevated in the fourth quarter. Does that look like large losses had an impact, but even if I exclude the large losses I still see a sizeable year-over-year increase? So, if rates are exceeding loss costs, can you maybe give me a little bit detail on why the accident year loss ratio remains so elevated?

Scott Jean

Neil, this is Scott Jean again. I can address that. The difference is that you are seeing especially looking at the fourth quarter accident year numbers can best be understood in light of the comments that Mark made earlier this morning regarding our reserving methodologies. During the fourth quarter of 2013, we shifted bulk reserves from previous years to the current accident year, but this move didn’t have any impact on earnings. Last year, the opposite happened, so a comparison between the fourth quarter of ‘13 and the fourth quarter of 2012 looks much more extreme than the actual experience reflects. So, after adjusting for these shifts the two accident year quarters are comparable. And excluding these shifts, we actually saw improvement in our year end accident year loss ratio, which was very much in line with our expectations for the accident year.

Neil Cybart - KBW

Okay. Your guidance includes 96.8 combined ratio you had very strong reinsurance results in 2013, what is your guidance improving in terms of reinsurance expectations?

Mark Reese

And Neil, it’s Mark Reese. I will take that question. 2013 was obviously a very strong year for our reinsurance operations. We would like to see that continue into 2014, but realistically that’s not likely to happen. So, our guidance anticipates the combined ratio in the mid 90s for the reinsurance operation for 2014.

Neil Cybart - KBW

Okay, thank you. So your investment portfolio duration 5.65 years, what is your view on the risk of inflation? I mean is there any concern with kind of running with elevated duration?

Brad Fredericks

Hi Neil, this is Brad Fredericks. I would say that our duration did extend a little bit during the year, but as far as inflation concerns that could be a longer term issue. So, with the yield curve as steep as it is right now, you are being more than concentrated by extending duration slightly to take advantage of that.

Neil Cybart - KBW

Do you have any plans on extending it even further?

Brad Fredericks

No. I would say we are about where we want to be in duration, give or take quarter of a point maybe.

Neil Cybart - KBW

Okay, thank you. My last question, I am not sure if I missed this, I think Mark you mentioned something about first quarter loss ratio, was that related to the winter weather, I don’t think I heard your full comments?

Mark Reese

Yes. We are just commenting that through January we are expecting about $3.5 million to $4 million of losses associated with the severe winter weather, but we have not adjusted our expectation or guidance to take that into consideration, it’s only one month. We have a long way to go. So we don’t feel it’s necessary to adjust our expected loss ratio for the year.

Neil Cybart - KBW

And have you seen those trends continuing with the busy weather in February?

Mark Reese

I haven’t seen any specific reports through February, so I can’t respond to that.

Lisa Simonetta

At this point, this is Lisa Simonetta from the Claims department. At this point in time, we have the numbers till the end of January and that’s reflected in Mark’s comments.

Neil Cybart - KBW

Okay, that’s it for me. Thanks.

Mark Reese

Thank you, Neil.

Operator

Thank you. We have no further questions at this time. I’d like to turn the floor back over to management for closing comments.

Steve Walsh - Director, Investor Relations

Thank you, ladies and gentlemen. This concludes today’s conference call. I’d like to remind you that a webcast for this call will be available on the company’s Investor Relations page of the company’s website at www.emcins.com/ir until May 20, 2014 and a transcript of this conference call will be available for one year, which can also be accessed from our Investor Relations page. We appreciate your interest in EMC Insurance Group and have a great day.

Operator

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

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