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Meadowbrook Insurance Group Incorporated (NYSE:MIG)

Q2 2010 Earnings Call

August 3, 2010 09:00 am ET

Executives

Karen Spaun - Chief Financial Officer

Bob Cubbin - President and Chief Executive Officer

Analysts

Mark Dwelle - RBC Capital Markets

Brian Rohman - Robeco Investment

Sam Simon [ph] - Ulysses Management

Beth Malone - Wunderlich Securities

Operator

Greetings and welcome to the Meadowbrook Insurance Group Incorporated Quarter Two 2010 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. Thank you, Ms Spaun, you may now begin.

Karen Spaun

Thank you, and welcome to Meadowbrook Insurance Group’s second quarter 2010 earnings conference 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 the 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 risks 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 statements.

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 email a copy to you.

Before reviewing our results, I will take a moment to discuss some changes to be made to the presentation of expense line items on our income statement. In 2010, we completed an in-depth cost allocation study and made refinements to our process to track these costs on a functional basis. The purpose of the study was to align our internal expenses with those activities they support such as underwriting and related policy administration, claims administration or otherwise referred to us ULAE, or general, selling and administrative costs associated with the production and management of net commission and fee revenue, and general corporate expenses.

Upon completion of the study, we have the information to best define our inter-company fees and to treat these fees as an inter-company cost reimbursements for financial reporting purposes. This enabled us to align the consolidated results with the underlying nature or function of internal expenses. Previously, we used estimations based on an overall cost study that focused on inter-company fees in total and the reasonableness of the split between claims administration and policy acquisition costs.

These reclassifications were made to enable the user of the financial statement to calculate the GAAP combined ratio directly from the consolidated statement of income. As a result, the consolidated statement of income for the three months ended June 30, 2009, have been reclassified to conform to this revised presentation. These reclassifications do not change total expenses or consolidated net income as originally reported for the three months ended June 30, 2009. Please refer to our forms 8K filed on May 3, 2010 for further details.

For the three months ended June 30, 2010, these refinements resulted in 2.5 percentage point increase in expense ratio, a 1 percentage point decrease in the loss and LAE ratio and a decrease of $2.2 million in general, selling and administrative costs.

Now, with the results. We are pleased with the second quarter results as we continue to achieve profitable growth in a competitive environment. For the second quarter, gross written premium was up 21% and we generated net operating income of $12.6 million or $0.23 per share with solid underwriting profits continuing.

Net operating income increased by 5.8% to $12.6 million or $0.23 per share, compared to a $11.9 million or $0.21 per share for the second quarter of 2009.

Net income for the second quarter of 2010 increased by $1.3 million to $12.9 million, or $0.24 per share, compared to $11.6 million or $0.20 per share for the second quarter of 2009.

Revenues increased $36.6 million or 24.9% from $147 million in the second quarter of 2009 to $183.6 million in 2010. This increase reflects growth in net earned premiums from the business we implemented in the second half of 2009.

Our 2010 second quarter GAAP combined ratio was 96.2%, compared to 93.3% for the second quarter of 2009. Our 2010 second quarter expense ratio was 35.2%, compared to 33.9% for the same period in 2009. Our expense ratio increased 1.3 percentage points to 35.2% for the three months ended June 30, 2010 from 33.9% for the same period in 2009. This change reflects an increase in external costs primarily net commission expense related to new business added in the second half of 2009 where the agents performed and is paid for certain policy issuance functions.

The second quarter of 2010 loss and loss adjustment expense ratio was 61% compared to 59.4% in 2009. The accident year loss LAE ratio was 65.1% compared to 64.3% in 2009. The increase was driven primarily from higher than usual frequency in our commercial automobile liability, and physical damage lines of business. As previously mentioned Bob will be discussing the pricing environment during his prepared comments.

General, selling and administrative expenses decreased $2.3 million from $7.6 million in 2009 to $5.3 million in 2010. The decrease reflects our ability to leverage fixed cost.

During the second quarter of 2010, net investment income increased by $1.1 million to $13.5 million, compared to $12.4 million for the second quarter of 2009. The increase is primarily due to higher average invested assets and continued positive cash flows from operations.

The pre-tax book yield was 4.5% at June 30, 2010, compared to 4.6% at June 30, 2009. The effective duration of our fixed income portfolio is 4.8 years, which is consistent with prior year. The duration of our reserves is 3.1 years.

In 2009, we made a 28.5% minority investment in an insurance company related agency. For the second quarter of 2010, the after-tax equity earnings from that investment was $644,000 or $0.01 per share.

Book value per share at June 30, 2010, increased to $9.92, compared to $9.06 at December 31, 2009. Book value per share, excluding unrealized gains, increased $0.50 per share to $9.09 at June 30, 2010 from $8.59 at December 31, 2009.

At June 30, 2010, our combined statutory surplus was $359.1 million, compared to $351.8 million at December 31, 2009. At June 30, 2010, our trailing 12-month gross written premium to surplus ratio was 2.1 to 1 and net written premiums and surplus was 1.8 to 1. As a reference point, our targets for gross written premiums and surplus and net written premiums and surplus are 2.75 to 1 and 2.25 to 1 respectively.

Our capital position remains strong as we continue to generate profits and are able to fund dividend share repurchases and debt services from earnings. During the quarter, we repurchased 702,000 shares at an average cost of $8.38 per share. These repurchases increased book value per share by $0.02.

The tangible book value per share which excludes goodwill and other intangible assets increased by 13% to $6.97 per share compared to $6.17 per share at December 31, 2009. Please refer to our earnings release for further details on a line by line basis for the second quarter consolidated income statement.

With that I will turn the call over to Bob Cubbin, our President and Chief Executive Officer, Bob?

Bob Cubbin

Thanks Karen, and good morning everyone. Overall we are pleased with our results for the second quarter. We continue to exercise underwriting discipline in a competitive environment while writing profitable business at adequate price levels. Over the years we have built our business to create both geographic and product diversification. We believe this approach has enabled us to deliver strong performance through the current prolonged soft market and positions us to leverage our platform more fully, if and when the market shifts.

Growth during the Q2 was primarily the result of new initiatives that were launched in the second half of 2009. This additional premium is complimentary to our overall book of business and adds to our prospects for future growth.

While we continue to increase revenue, our primary focus remains disciplined underwriting and pricing adequacy. The majority of our new business has been comprised as a roll over of existing books of business that have a proven history of profitability and we were able to add price increases. As part of our pricing and reserving strategies, we recognize that poor ongoing economic condition and medical inflation do impact our underwriting profitability and have adjusted our expectations accordingly.

The reason we booked a higher current accident year loss ratio in the quarter on auto liability and auto physical damage was that we have seen an uptick in frequency of claims in the first quarter due to adverse weather and chose to continue to book at the higher more conservative level in the second quarter. We have added rate increases and taken other underwriting actions that we believe address these issues and will continue to monitor the situation.

While most of our programs and admitted business continue to grow the market for excess and surplus lines insurance remained competitive during the second quarter. However, we continue to maintain underwriting discipline and profitability even in this environment.

While rates are now stabilizing in the E&S market we intend to stay on course and write only business at profitable rates. Overall non-ENS rates increased modestly in the first half of 2010. Our workers comp rates were up by 4.2% largely due to our ability to take rate increases on roll-over business we acquired in '09. In California, our work comp rates are up 19%. Some other states continue to manage rate increase. Rates in lines other workers comp increased by over 1%. As I said, E&S rates were down slightly to stable.

We are on a strong capital position and were able repurchase approximately 700,000 shares during the second quarter. We have now year-to-date repurchased 2.2million shares. We will continue to officially manage our capital while positioning ourselves for future growth. We continue the look at acquisitions that will complement our business, but so far we have not found any that meet both our strategic and valuation objective.

Our guidance range for net operating income is unchanged, and due to our strong performance in the first half of 2010 we continue to expect net operating earnings towards the high-end of the range between $50 million and $55 million or $0.90 to $1.00 per diluted share.

Thank you for your interest in Meadowbrook, and we will now open the call for question. Operator?

Question-and-Answer Session

Operator

Thank you. We will now be conducting the question-and-answer session. (Operator instructions).

Our first question is from the line of Mark Dwelle with RBC Capital Markets. Please proceed with your questions.

Mark Dwelle - RBC Capital Markets

First few questions. You mentioned on the pricing, I just want to make sure I heard you right. You said your rate increase in California comp was 19%?

Bob Cubbin

That’s correct.

Mark Dwelle - RBC Capital Markets

How do you do that? Nobody else on earth has come up with any kind of increase anywhere like that?

Bob Cubbin

We made two separate filings over the course of the last nine months and cumulatively on a written basis they will equate to 19%. So, we filed the result that we needed and got it.

Mark Dwelle - RBC Capital Markets

What proportion did that increase represent the growth in the quarter?

Bob Cubbin

On the earned basis, Mark, our net earned premium is up 28% year-over-year, but a lot of those rate increases in California is yet to be earned. So, it’s a relatively small amount.

Mark Dwelle - RBC Capital Markets

You talked about just in terms of getting rate overall. Of the overall new business growth in the quarter, what proportion would reflect rate and what proportion would reflect kind of new business growth, or I guess organic growth within the programs?

Bob Cubbin

Well, rate will part of be in the neighborhood of 2% maybe, 2% to 3% at the most and the rest would be organic growth.

Mark Dwelle - RBC Capital Markets

The growth is continuing to come both from the expanded geographies as well as deepening penetration within the products?

Bob Cubbin

That’s correct. There have been number of initiative, for example, on the environment side with Century as one of the synergies between the purchased companies. So we are seeing some growth there. The specialty products line has continued to be growth. So, we are enthusiastic about that. At the same time, I think the real growth from those initiatives will come when the competitive pricing environment will harden us a little bit.

Mark Dwelle - RBC Capital Markets

I might have missed this, Karen, you may have already covered it in terms of the increase in cost related to the past acquisition underwriting expenses. Was there anytime like unusual or one time in the quarter, or was just part of the process of the expense reallocation?

Karen Spaun

It’s really the reallocation of expenses.

Mark Dwelle - RBC Capital Markets

Okay.

Bob Cubbin

It’s pretty much represents that that’s the run rate going forward.

Operator

(Operator instructions).

Our next question is from the line of Brian Rohman with Robeco Investment. Please state your question.

Brian Rohman - Robeco Investment

All the excess capital and you mentioned acquisitions, what make sense from your standpoint so far as acquisitions are concerned? What sort of things you are interested in?

Bob Cubbin

Yeah, Brian, the same kind of things that we have historically been interested in, which is looking at geographic and product diversification that will give us something complementary. We do like fee business, and we are not reverse to also acquiring underwriting teams or companies with a balance sheet. So, all of those things that would be complementary to our business model would be appropriate.

The number one thing that we look for is that the management team that they fit with our culture and our approach to underwriting discipline. That’s really the number one thing that we look. The culture has to be complementary to how we look at the business.

Brian Rohman - Robeco Investment

Just looking backwards for a second, the ProAssurance acquisition, has everything pretty much worked out as you planned other than pricing in the E&S business world?

Bob Cubbin

Yeah, the ProCentury merger has delivered a lot of valuable things to the company: product diversification, underlying talent. It really has helped us through this prolonged soft market to leverage fixed cost as well. So, we are pretty pleased with the result of that merger. Obviously, if the E&S market would have firmed up a little bit sooner than it has that would have been certainly icing on the cake. We are very pleased with the team that we brought over from Century. The distribution system is solid and very supportive, good, long-term relationship which is really what we look for as well. So, I would say that we are very pleased with the results of that.

Brian Rohman - Robeco Investment

I am sorry, I missed it earlier. Did you make a comment E&S pricing?

Bob Cubbin - President & Chief Executive Officer

I did. yeah, its pretty much stabilized at this point. Last year, at this time, I think we were down about 4%. This year it’s under 0.5%. So, that certainly is indicative of at least a stabilizing environment which is good. So, we are hanging on to the business now that’s out there and you know, first you get stabilized before you can see any firming. Obviously, the economic conditions in general may help dictate how long this soft market continues.

Brian Rohman - Robeco Investment

Workers comp, you mentioned California 19% price increase. I have heard some other price increases. Is this correct that yours is probably at the higher end? What percentage is California of your total book of business? California Workers Comp of your total book of business?

Bob Cubbin - President & Chief Executive Officer

It’s probably around 20%. So around $150 million maybe.

Operator

Our next question is from the line of Sam Simon [ph] with Ulysses Management. Please proceed with your question

Sam Simon - Ulysses Management

Hi, thanks for taking the question. Just couple of questions here. On the increase in net commission expense for the agents that’s doing more work for you, is this going to be an ongoing higher expense structure there? Is this structurally less profitable business on the expense side?

Bob Cubbin

What we look at when we write business is the combined ratio. So, the expense ratio is obviously just one component of it. The business is very profitable and has a very good track record. So, from an overall combined ratio standpoint this is very profitable good business. We also believe that the outsourcing of that function is not necessarily a negative thing. It helps us not to have to add internal fixed costs. So, having that as a variable cost is a benefit in certain environments.

Sam Simon - Ulysses Management

Do you underwrite the agent? How do you control their risk management?

Bob Cubbin

Yes, we have underwriting guidelines that we agree to upfront and we get real time information as to what they are underwriting. We also audit on a regular basis. So, on at least on a monthly basis, we have a review of certain files just keep testing it. It’s not that we don’t trust people but you need to verify that they are complying with your underwriting standard.

Sam Simon - Ulysses Management

So the tick up we saw here in expenses over time we should get back in increased profits overall?

Bob Cubbin

Yeah, that’s correct and we do think that as we move forward we can also continue to leverage our internal fixed costs with the current platform. So, we have got, we have got the capacity within our company to add additional business without adding additional expense.

Sam Simon - Ulysses Management

Great. On the commercial auto side it sounded like the frequency uptick was really Q1. Did that continue into Q2, or is it too soon to know from the claims pattern?

Bob Cubbin

Yeah, on the auto physical damage side there was slightly higher frequency in the second quarter as well, but we do believe we have addressed those issues in both the way that we have reserved on a year-to-date basis for that. Also the underwriting actions and rate adjustments that we have made, we believe, we have addressed that issue. So, it is really in the process to conclude that there’s a pattern and certainly out of line with what we had seen in prior accident years. Instead of waiting to see if that is indeed the pattern we have booked it as a higher more conservative level and if it is not an ongoing continuing pattern then we would adjust our estimates as additional evidence emerges.

Sam Simon - Ulysses Management

What percentage of the overall book of business did this commercial auto affect?

Bob Cubbin

It’s relatively small amount; it’s not a huge dollar figure. I don’t have the exact numbers in front of me, but it’s a small percentage of our overall book.

Sam Simon - Ulysses Management

Okay, but to move the needle then on the loss side it must have been a pretty noticeable uptick?

Bob Cubbin

Not really. I think the only reason that its even noted is that there wasn’t anything else that was showing any deterioration. So, even small amounts of deterioration show up when your overall book is very stable. So, we just wanted to point that out as being really the one thing out of line with our expectations in the quarter.

Sam Simon - Ulysses Management

Last question, the prior years continue to develop favorably. Is there anything to think about there as we go forward? Is it that some have talked about potentially favorable development across the industry coming to an end over the next couple of quarters? Is there anything you can say about the prior year book?

Bob Cubbin

Well, we have continued to see overall favorable development from our older accident years. Really what I would say about that is that as we have priced the most frequent policy years, we have been using those higher expected accident year loss ratios in our pricing. So, we do believe that we have been adequately pricing our products over the last few years and if favorable development does continue, then the more current accident years may show that same pattern. At this point, we continue to monitor for that and watch it. If those patterns emerging continue then we’ll see additional changes in our estimate. Right now, we aren’t saying that there is more favorable development. If we got that, we would have booked it in this quarter.

Operator

Our next question is from the line of Beth Malone with Wunderlich Securities. Please proceed with your question.

Beth Malone - Wunderlich Securities

Congratulations on the quarter. On the share repurchase program, you were more aggressive in the first quarter than in the second, but I assume that it had something to do with the price of the stock. Going forward, what’s the policy for share repurchase? Do you have an eye -- do you have a set less than book value kind of metric or what is it that makes -- determines how aggressive this share repurchase would be?

Bob Cubbin

There’s a number of things that we have to consider in managing our capital and the share repurchase is just one of them, opportunities to deploy the capital within the business is another. So, we monitor our share repurchases on a daily and weekly basis. If the pricing is something that we think will be advantageous to shareholder value then we’ll buyback shares. We certainly would prefer to buyback shares below book value. On the other hand, we would prefer to have our shares trading at above book value. So, you know, it’s really just all in the balance and all in the mix of our capital management, Beth.

Beth Malone - Wunderlich Securities

On the case of acquisitions, I know that you acquired some decent size programs here recently, certainly that was part of the reason for the change in expense that you experienced, but what the outlook for that? Do you see lots of opportunities to continue to get these larger kind of lumpy, premium programs on to Meadowbrook and has the market condition changed either in your favor or not in your favor in terms of attracting this kind of business?

Bob Cubbin

Well, the pipeline for new business is always something that we’re working on. When we’re creating long-term relationship many times it takes many, many years. As we described before, some of our new business initiatives in 2009, were really the culmination of three or four years of discussion. So, there is always the possibility of moving over large, as you as refer to it as lumpy programs, but in general, we’re trying to establish relationships with people who control business that have the same kind of underwriting discipline and culture that we have. So, smaller programs are also attractive to us, have always been attractive to us and then allowing our partners and us to grow that business organically that’s certainly a strategy that we successfully utilized before.

On the acquisition front, in general, I do think that valuations are starting to be, I think for the most part, more of a recognition of the current environment, the prior multiples on business acquisition were much higher. So, I think that’s 52-week highs are becoming more on the lower end that we may see an increased activity in the M&A area. We’re active in that area, Beth. We’re just disciplined about who we choose to bring on as a partner.

Beth Malone - Wunderlich Securities

Does that also suggest that over time the mix of business is going to trend towards larger programs?

Bob Cubbin

No, I don’t think so. Again it’s very difficult to predict that because you don’t know what, you know will culminate in something in the next 18 to 24 months. For the most part, we believe that keeping a diversified book of business and keeping a balance between larger and smaller and medium sized programs makes a lot of sense, it just creates a lot more predictability. We really feel like we’re in a good position to be selective in who we do business with as opposed to just looking at the size or the geography or the class of business.

Beth Malone - Wunderlich Securities

Did you all look at the PMA Capital deal?

Bob Cubbin

We watched the public information that was being disseminated.

Beth Malone - Wunderlich Securities

Okay, so something like that wouldn’t be something that you would be interested in?

Bob Cubbin

We really have a hard time talking about hypotheticals. We really look at specific things and make a judgment call as to whether or not it would be complimentary or not to our business.

Operator

Thank you. There are not further question at this time. I would like now like to turn the floor back over to management for closing comments.

Bob Cubbin

Okay, well, we very much appreciate your interest and the strong questions that were asked. We appreciate that. If you have any further questions please don’t hesitate to contact us. Thank you very much and we’ll talk to you soon.

Operator

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

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Source: Meadowbrook Insurance Group Incorporated Q2 2010 Earnings Call Transcript

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