National Interstate's (NATL) CEO David Michelson on Q2 2014 Results - Earnings Call Transcript

Jul.29.14 | About: National Interstate (NATL)

National Interstate Corporation (NASDAQ:NATL)

Q2 2014 Earnings Conference Call

July 29, 2014 10:00 ET

Executives

David Michelson - President and Chief Executive Officer

Julie McGraw - Vice President and Chief Financial Officer

Gary Monda - Vice president and Chief Investment Officer

Analysts

Vincent D’Agostino - KBW

Operator

Good day, ladies and gentlemen. Welcome to the National Interstate Corporation 2014 Second Quarter Conference Call. My name is Candice, and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer period following the company’s prepared statements. (Operator Instructions) As a reminder, this call is being recorded for replay purposes.

Your hosts for today’s call are Mr. David Michelson, President and Chief Executive Officer; Ms. Julie McGraw, Vice President and Chief Financial Officer; and Mr. Gary Monda, Vice president and Chief Investment Officer.

I would now like to turn the call over to Ms. McGraw to begin the presentation.

Julie McGraw - Vice President and Chief Financial Officer

Thank you, Candice. Certain statements made during this call maybe forward-looking. The factors that could cause actual results to differ materially from those forward-looking statements are listed in our earnings release and SEC filings, including the Annual Report on Form 10-K and quarterly reports on Form 10-Q.

Certain financial measures that we use on this call such as net earnings from operations are expressed on a non-GAAP basis. Our GAAP results and reconciliations of non-GAAP to GAAP measures can be found in our earnings release available on our Investor Relations website at invest.natl.com. Any projections previously released by us speak only as of the date on which they were made and may vary from actual results. We assume no obligation to publicly update such projections.

I’d now like to turn the call over to Mr. Michelson.

David Michelson - President and Chief Executive Officer

Thank you, Julie. Good morning and welcome to our second quarter conference call. Yesterday, we reported our 2014 second quarter results, which reflected a net loss per share of $0.54 for the quarter and $0.14 for the first six months. The net loss was driven by $28.1 million of average prior year claims development, including $20 million of reserve strengthening during the second quarter. For the first six months of 2014, we have experienced $29.9 million of adverse prior year claims development representing approximately $1 per share.

Industry trends have indicated the commercial auto policies written during the prolonged soft market conditions were at rates below those required to keep pace with changing economic and societal influences related to claim settlements. These influences, such as limited access to medical information due to HIPAA regulations, increased litigation costs, lower spending on safety and increased fraud trends have resulted in adverse industry results of prior year claim reserves in the commercial auto liability line, which is our largest line of business.

As we noted in our 2014 first quarter conference call, based on SNL’s compilation of 2013 statutory financial results, of the approximately two dozen mainland companies that we view as key competitors in our various transportation markets, only four of them posted combined ratios below 100% in 2013 with the remainder of them, including several of our most respected competitors with combined ratios above 100. Unfortunately, we have not been immune to the difficulties that are reflected in the industry results for commercial auto. We have experienced unfavorable prior year claims development for seven consecutive quarters, though such development appeared to have lessened in the first quarter of 2014 as compared to the previous three quarters. During the second quarter of 2014, actual incurred claims development of $8.1 million was higher than expected and led us to undertake a comprehensive review of our reserves for losses and loss adjustment expenses, including a review by a leading independent global actuarial firm.

We used this additional actuarial data, as well as various data inputs and other factors, including but not limited to claims processing procedures, our historic loss experience and that of the industry, loss development factors as well as actuarial analysis provided by Great American to establish management’s best estimate for loss reserves as of June 30, 2014. The comprehensive review of these various factors and data points contributed to our decision to further strengthen our loss reserves by $20 million in the second quarter. The reserves strengthening primarily related to accident years 2011, 2012 and 2013 beginning with the 2010 accident year combined ratios have been elevated compared to that we experienced in 2009 and prior, primarily due to losses in the commercial auto line of business. Although we continue to believe our current pricing and risk selection have improved dramatically over the past two years, we felt it was prudent also strengthen our 2013 accident year reserves.

Excluding prior year development, our 2014 second quarter combined ratio would have improved 20.2 points to 96.3% and our year-to-date combined ratio would have been l1 points better or 96.1%. We view this as an indication that our current accident year is moving towards underwriting results that are more in line with our expectations. We remain focused on improving our risk selection and have been pricing our business in recognition of the lost cost inflation that has emerged primarily in the commercial auto liability line.

In regard to improving the quality of our book of business in 2013 we exited several unprofitable businesses including the commercial vehicle product that was included in our personal lines component and we priced away or chose not to renew approximately $65 million of business. In the first half of 2014, applying the same disciplines as we did in 2013, we had an additional $20 million of non-renewed business. We share this as an indication that we are remaining disciplined in our risk selection, but also to show that the decrease in this amount is an indication that overall our book of in-force business is of higher quality.

As we have repeatedly stated for the past two years improving the pricing for the insurance we write to properly compensate with the deterioration during the prolonged soft insurance market and to reflect lost cost inflation that has escalated since 2010 has been our top priority. In the first half of 2014, we have averaged approximately 7% rate increases on renewed business including approximately 9% in the 2014 second quarter. For some of our products the rates are up double digits and we are applying the same pricing criteria to our new business opportunities.

The improved pricing as well as recently introduced new products are also favorably impacting our top line. Gross premiums written for the second quarter and for the first six months of 2014 are up 8% which is in line with the average rate increase we are obtaining. Our alternative risk transfer component increased 13% for the first six months compared to last year as a result of the addition of new customers as well as from rate and exposure increases on renewal business.

Our transportation component grew 8% for the first six months primarily attributable to rate increases for existing customers as well as new business from recently introduced products that are taking hold. In 2012 the company addressed a market need by offering expanded limits to trucking insurance and in 2013 introduced waste operations and traditional heavy haul insurance products all of which have contributed to the growth.

Other aspects of our business including investments and underwriting expenses are performing well and as expected. Net investment income of $8.8 million for the 2014 second quarter was 11% ahead of the 2013 second quarter and net investment income of $17.5 million for the 2014 first six months was 10% ahead of the same period last year. The increase in net investment income is attributable to a modest increase in average cash and invested assets as well as new fixed income purchases that yields higher than were available prior to mid-2013.

Our underwriting expense ratio of 20.5% for the 2014 second quarter and first six months was improved compared to the same periods of 2013 and historic run rates primarily due to expenses growing at a slower rate than earned premium. The commercial auto insurance market has definitely been a difficult space to be in for the past several years. Pricing has been competitive and the claims environment remains somewhat unpredictable. While our results have not been up to our own high standards, we do take some comfort in the fact that even after recording the adverse claims development our underwriting results for all of our recent accident years except for 2011 with a combined ratio of 103 had been profitable and although still early the 2014 accident year is showing improvement.

At this time, Julie, Gary, and I will address your questions.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) And our first question comes from the line of Vincent D’Agostino from KBW. Your line is now open.

Vincent D’Agostino - KBW

Hi, good morning, everyone.

David Michelson

Good morning, Vincent.

Vincent D’Agostino - KBW

Just few questions. I will start with an industry one and then head to the obvious. Our transportation research team here has been telling us about a driver shortage in the transportation industry for a few years now. And actually a couple of weeks ago there was an article in the Wall Street Journal about how trucking companies really can’t find enough qualified drivers to put behind the wheel. And so what I am curious is, is from your vantage point, if the implication here is that if less experienced drivers are being hired and then pair that with an aging driver force, I am wondering if that’s having any contribution to the higher loss cost trends for commercial auto insurers like yourself?

David Michelson

Well, I would say from an industry perspective, clearly with the driver shortage across the entire industry that would have to naturally bleed into some drivers making to cut that previously wouldn’t make the cut. I would tell you from a trucking standpoint in particular and as you know from our discussions about our alternative risk transfer products, it is our objective from a risk selection standpoint to try to select top quartile business in whatever segment we are in. And with top quartile business means stronger revenue per mile, operating profits, those companies having the ability to pay the appropriate wages to attract the drivers they want to attract into their workforce, possibly unlike the second and third and fourth quartile.

I am not going to suggest for a moment that any insurance company can say all of their insureds are perfect at the driver they select, but it’s clearly something we are watching. I mean, we underwrite management when we underwrite our transportation business. That includes obviously assessing their financials and their financial strength, the driver pool, the driver turnover, the average age et cetera. So, we are continually looking at that. And we have beefed up our whole risk management platform to be a consultative approach that our consultants are going in and talking about their CSA scores and trends and drivers and avoidable accidence. And just an overall safety theme to try to combat what are challenging conditions in the marketplace. We are trying to work collaboratively with our customers to combat some of those forces.

Vincent D’Agostino - KBW

Okay, thanks for the color there. It’s actually really helpful. And then I guess just shifting gears to the reserve side of things, what I am curious about is when you engaged with the actual consultant, getting the number right on past reserves is obviously pretty important. But I am kind of curious about as well is if there was any review of National Interstate’s – and therefore I would assume also Great American’s reserving processes in an attempt to identify any areas of improvement that might prevent a recurrence of this going forward? And then secondly, should we be thinking about this being, let’s call it, a deck clearing charge that sets up enough margin of safety to the point, where we really shouldn’t see any adverse reserve development coming through in the next few quarters?

David Michelson

Yes, relative to the independent actuarial review in addition to reviewing our amount of reserves that we are holding, there was also a review of our claims, but we have been doing that ongoing review for a number of consecutive quarters as well that’s already led to a number of positive changes in our claims organization relative to recognizing the slowdown of information coming into our claims departments, do what plaintiff attorneys are doing, beefing up staff, hiring in additional claims management, claims managers being in the files side-by-side with the adjusters from the ground up. So, a lot of things we have been doing in the claims department over the last number of quarters, but yes, the actuarial firm did look at our claims processes. And we are obviously exposed to other independent sets of eyes and feedback, whether it’s reinsurers that come in and audit us as well. And the comments that we’ve received from reinsurers are generally positive as well. I’m not going to suggest we’re perfect. It’s an ongoing work in progress, but we put a lot of effort into being as proactive as possible relative to claims reserving.

Relative to your other question, we don’t ever want to talk about this subject again and we know what subject that is, and that’s obviously the adverse loss development. That being said, actuarial science is not perfect. It’s not precise. Any actuary is going to do an analysis and come out with a range. And you put three actuaries in a room and you’re going to get three different ranges. Generally speaking with the right data inputs, the ranges are going to be pretty close. But you’re still going to get three different answers from three different actuaries. It’s management responsibility to use all of these data inputs as well as internal analysis and make informed decisions with the best available data to us at that point in time.

And data develops, and we’re going to have new data in three months just because of we’re going to – the data is going to be three months older. So, it’s ongoing, but we don’t want to talk about this again, but not us or anyone can ever make that promise. But again we use all kinds of data inputs a well as internal analysis to come up with representative financials as of June 30, as best we can and making informed decisions with best available data.

Vincent D’Agostino - KBW

Thank you. And then just one last one and I’ll hop back in the queue. Just looking at the step-up in the pace of rate increases this quarter, I just wanted to check and see if that was the result of the comparative environment granting you some leeway with competitors pulling out a little bit or whether this is essentially you’re pushing for more rate and then purposefully pricing yourself out of some of the renewals and new business and I guess that would speak to the $20 million in business shed, year-to-date. So I just wanted to touch base on that.

David Michelson

In every one of our niches, we could give you examples of competitors that have tightened up underwriting a little bit and/or exited. And in those same niches competitors that have come into the marketplace. So, it’s a moving target within the industry, I mean, we had between 2004, 2011, 28 consecutive quarters in this industry of commercial auto rate level decrease, 28 straight quarters out in the industry, that’s a big hole for the industry to climb out of it – it’s showing up, the industry results. In the commercial auto ROE according to timing in 2005 was 15.4%. The commercial auto ROE in 2012 was 3.2% that’s which 28 straight quarters of industry competition and rate decrease does. We personally are being relentless on individual account underwriting, not broad brush across the board, individual account underwriting precision, quoting the right rate, whatever that is. One account could be a double-digit increase and other account could be a 6% increase. We could have accounts that are getting flat rates, but it’s individual account underwriting and we’re fearless that if we don’t get the right rate we’re going to walk, even if we like the account, even if they are multiyear insured. You do have accounts naturally in any book that do deteriorate over time and that business is sure, that gets shed and that was a part of the $65 million along with the CV and program business that we made decisions to get out of. But we’re going to get the right rate on new business coming on to the books whether it’s new products or legacy products and we’re going to charge the right rate on renewal business and whatever we keep we keep and we’ll be obviously want to keep business and we want to grow that’s the fun part of the business but we only want to grow for growing profitably and trending that accident year combined ratio towards what we know is what our expectations are as well as the expectations of shareholders.

Vincent D’Agostino - KBW

Thanks for that. I wish you guys a lot of luck. It’s been a tough slog. So talk to you soon.

David Michelson

Thank you, Vincent. Appreciate your support.

Operator

Thank you. (Operator Instructions) And I’m showing no further questions at this time. I would like to turn the call back over to Mr. David Michelson for any further remarks.

David Michelson - President and Chief Executive Officer

Obviously, our recent results have been below our expectations and the reserve strengthening in the 2014 quarter was particularly painful. However, we are maneuvering through some very challenging insurance markets and societal influences regarding claim settlements. We remain confident in the actions we have taken since 2013 and are positive regarding our current and future business. Thank you for participating on today’s call.

Operator

Ladies and gentlemen, thank you for your participation in today’s conference. This does conclude the program and you may all disconnect. Have a great day everyone.

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