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Navigators Group (NASDAQ:NAVG)

Q2 2014 Earnings Call

August 08, 2014 8:30 am ET

Executives

Stanley A. Galanski - Chief Executive Officer, President, Director, Member of Underwriting Advisory Committee and Chairman of Navigators Insurance Company

Ciro M. DeFalco - Chief Financial Officer, Senior Vice President and Member of Enterprise Risk Management Steering Committee

Analysts

Amit Kumar - Macquarie Research

J. Paul Newsome - Sandler O'Neill + Partners, L.P., Research Division

Adam Klauber - William Blair & Company L.L.C., Research Division

Operator

Good day, and welcome to the Navigators Group's Second Quarter 2014 The Navigators Group Incorporated Earnings Conference Call. Today's conference is being recorded.

We remind everyone that today's call includes forward-looking statements made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements concern future business conditions, expectations and the outlook for the company, based on currently available information that involves risks and uncertainties. The company's actual results could differ materially from those anticipated in the forward-looking statements. We refer you to the company's most recent Form 10-K and 10-Q for a description of the important factors that may affect the company's business. The forward-looking statements made on this call and any transcript of this call are only made as of this date, and the company undertakes no obligation to publicly update the forward-looking statements to reflect subsequent events or circumstances, except as required by law.

At this time, I would like to turn the conference over to Mr. Stan Galanski, President and Chief Executive Officer; and Mr. Ciro DeFalco, Senior Vice President and Chief Financial Officer. Please go ahead, sir.

Stanley A. Galanski

Thank you very much, and thanks for joining our call this morning. Yesterday afternoon, we reported net income of $16.9 million for the second quarter of 2014, up 21% from the second quarter of 2013, and $44.8 million for the first 6 months of 2014, up 61% from last year. We were pleased to report a combined ratio for the quarter of 95.3%, an improvement of 2.4 points over the second quarter of 2013.

Our profitable underwriting results were particularly noteworthy, given that the quarter included loss provisions for our total exposure to this Sewol ferry sinking, which occurred on April 16, off the coast of South Korea. While our participation on this loss pushed our Lloyd's Marine business to an underwriting loss for the quarter, I am delighted to report that the resiliency and the breadth of our global marine portfolio produced a combined ratio of 97.9% for the quarter, inclusive of the Sewol claim, and a 92.2% combined ratio for the 6-month period. We have every expectation that our Lloyd's Marine business will be profitable by year end.

Relatedly, as a result of $6.9 million of reinsurance reinstatement premiums, or RRPs, recorded in the quarter for the Sewol loss and several other marine liability claims, we reported an expense ratio of 34.6% for the second quarter. Adjusting for the impact of those RRPs, the quarterly expense ratio would have been 33.5%, 0.5 point improvement compared to second quarter of 2013 and spot on with our 2014 year-to-date expense ratio.

From a premium gross standpoint, gross written premium was up 5% for the quarter and net written premium increased 16.8%, as we continue to benefit from changes made to several of our ceded reinsurance treaties during the first quarter that allow us to retain more premium net for specifically selected casualty product lines, along with offshore energy and management liability risks.

Our profitable underwriting results, along with a 9.8% increase in net investment income, contributed to a 3.7% increase in the quarter in book value per share, which increased to $68.16, as of June 30. Our cash flow was $69.3 million for the quarter, an increase of 57% over second quarter 2013. All of this adds up to a solid underwriting and operating performance for the quarter.

Turning to our business units. Our Insurance Company marine team had a terrific quarter, generating $8 million of underwriting profit with combined ratio of 74.5% for the second quarter and 79.8% on a year-to-date basis. We experienced particularly strong underwriting results in the U.S. offices that are West of the Hudson River, particularly Seattle, San Francisco, Houston and Chicago. Insurance Company marine premium increased 11.7% on a gross basis for the quarter and 29.2% on a net basis. The renewal rate change for our U.S. Marine business was up 1.7%. And while the Sewol loss pushed the second quarter combined ratio for our Lloyd's Marine business to a 120.9%, the underwriting loss was limited to our marine liability product lines, with solid underwriting profit reported in our other marine -- major marine classes at Lloyd's, such as cargo and specie. The average renewal rate increases was about 1% for our Lloyd's Marine business during the quarter.

The U.S. Management Liability business of Navigators Pro performed exceptionally well during the quarter, as did our international management and professional liability portfolio.

The U.S. D&O business produced an underwriting profit of $4.7 million in the second quarter. This resulted from continued favorable loss emergence patterns for the quarter. I've reported to you previously that we have successfully repositioned through the portfolio to one that is heavily consisted of excess business, today more than 90% of the portfolio is excess business, with an average attachment point above $50 million. While repositioning that portfolio over last 2 years we've also reduced the inventory of primary public company D&O claims for the 2006 through 2012 underwriting years by more than 50%. Despite a challenging pricing environment for Excess D&O, gross written premium was up 2% for the quarter and net written premium increased 22.8%. Our U.S. D&O team has worked diligently to return the portfolio to profit, and this quarter is an important milestone for them.

International operations of Navigators Pro produced a combined ratio of 63.1% for the second quarter with profitable underwriting results in both the D&O and Professional Liability lines. International D&O gross written premium increased 22% on a gross basis and 55.5% on a net basis for the second quarter. Renewal rates were down an average of 4.6% for the quarter in a competitive climate that was fueled by benign loss activity.

International Errors and Omissions gross and net written premium grew 55.5% for the quarter, with renewal rates down an average of 5.7% for international E&O, largely from rate decreases on 2 large renewals.

Our London team has done a particularly good job of capturing attractive new Side A excess D&O opportunities on international risk and also select non-US listed IPOs.

Our Insurance Company Property Casualty business had another very solid quarter, with gross written premium up 10.8% and net written premium up 31.9%, with a combined ratio of 98.9%.

Navigators Specialty, our U.S. excess and surplus lines underwriting unit continued to drive the premium growth.

Specialty Primary Casualty premiums grew 25.2% on a gross basis and 30.8% on a net basis. Specialty Excess Casualty gross written premiums increased 6.5% for the quarter, gross, but 60.2% on a net basis. We continue to capitalize on what we believe to be attractive opportunities in the construction liability niche, particularly for project policies and construction wrap-ups. And we continued to achieve positive renewal rate change in specialties, with Excess Casualty renewal rates up an average of 2.5% for the quarter and primary rates up around 1%.

The third component of Navigators Specialty is Professional Liability, which is a portfolio that we have been reunderwriting over the past 18 months.

U.S. Professional Liability business had a slight underwriting loss for the quarter, and premium volumes down about 30% as a result of our decision to exit the small law firm professional liability market and the termination of a relationship with another program manager who specialized in real estate professionals. The U.S. Professional Liability business remains soft, with rates down an average of 1% to 2%, depending on the particular niche.

The second operating unit within the Insurance Company Property Casualty segment is Navigators Commercial, which consists of environmental casualty, excess casualty, and life science business, produced on an open-brokerage basis, primarily through U.S. retailers. That unit produced profitable underwriting results with, combined ratio of 97.2% for the quarter. Gross written premium for commercial product lines increased 22%, and net written premium increased 46%.

Our Environmental Casualty team benefited from an increasing capacity from a $15 million to $25 million, which helped to track a number of new accounts as a result of the higher limit, while their contractor's pollution liability business continued to experience strong growth.

The Life Science team had strong renewal retention, achieved about 2 points of renewal price increase and benefited from an exposure growth in a growing market segment.

Also within the Property Casualty segment is NavTech, our first-party energy and power generation underwriting unit, which underwrites business both for the insurance companies and at Lloyd's.

Insurance Company NavTech business produced a slight underwriting loss for the quarter as a result of higher-than-normal attritional loss activity, while Lloyd's NavTech business produced a profitable combined ratio of 95.9% for the quarter. On a global basis, NavTech's gross written premium was down 10.6% for the quarter for several good reasons. First is the abundance of capacity for both offshore and onshore energy business, which puts pressure not only on the pricing but on our ability to get the line size that we want on attractive business. Secondly, offshore energy renewal rates were down an average of 7.1% for the second quarter for the insurance company and about 3% at Lloyd's. And third, we continue to emphasize underwriting discipline, including a limited appetite for Gulf of Mexico windstorm exposures under the current trading conditions, and a reluctance to include coverage for first party renewal of wreck in energy package policies. However, despite this, on a net basis, global NavTech premiums were up 7.4% for the quarter.

Finally, within the Property Casualty segment is Navigators Re, which underwrites specialty treaty reinsurance business. Navigators Re produced a combined ratio of 95.4% for the quarter, with gross and net written premiums up 12.2%. Within that unit, our Latin American treaty reinsurance business continued to perform very well, with combined ratio of 59.6% for the quarter.

During the quarter, we recorded a slight deterioration in our crop reinsurance treaty results for the 2013 underwriting year, bringing back year to about a breakeven results, albeit better than the industry average result, but certainly below our expectations for profit.

Our Accident and Health reinsurance business produced profitable underwriting results for the quarter.

In summary, it was a very solid quarter. Underwriting profit more than doubled compared to the second quarter of 2013, and for the first 6 months, it more than tripled compared to the same period in the prior year. This reflects a successful diversification strategy that has led to a very balanced specialty portfolio, the successful repositioning of our U.S. D&O portfolio, and our strong global franchise in ocean marine insurance. We are benefiting from the decision taken earlier this year to selectively reduce the amount of reinsurance purchase for certain product lines, which is allowing us to achieve double-digit net written premium growth. We continue to focus on ongoing expense management. And adjusting for the RRP's impact due to the large marine liability loss for the quarter, our operating cost for the quarter were consistent with our plans.

And with that, I'll turn this over to our CFO, Ciro DeFalco.

Ciro M. DeFalco

Thanks, Stan. Good morning, everyone. Thanks for joining us.

Our second quarter net income of $16.9 million or $1.17 per share reported yesterday after the market close includes: net operating earnings of $15 million or $1.04 per share; after-tax foreign exchange transaction losses of $1 million or a negative $0.07 per share; and net realized gains after tax of $2.9 million or $0.20 per share, with 0 OTTI.

First quarter's combined ratio of 95.3 includes a reported loss and LAE ratio of 60.7 and an all-in expense ratio of 34.6, comprised of net commission expenses of 13.9% and other operating expenses of 20.7%.

The second quarter included $6.6 million in total reinsurance reinstatement premiums, or RRPs, with $3.9 million related to the sinking of the Sewol ferry in South Korean waters. These RRPs negatively impacted the combined ratio by 2.8 percentage points or $0.30 per share. The quarterly consolidated results include: $11 million of underwriting profit, with $13.2 million of profit coming from the U.S. insurance companies; and a $2.2 million loss from our Lloyd's operations, driven by the Sewol loss.

Net investment income of $15.6 million increased $1.4 million, or 9.8%, compared to the same period last year. As part of for diversification strategy, the equity portfolio includes a $40 million allocation to preferred stocks at June 30, with a book yield of 6.2% and a tax equivalent yield of 8.2%.

Net realized gains of $4.5 million pretax or $2.9 million after tax, referenced previously, with a result of normal, active portfolio management. And we did not have any OTTI losses in the quarter.

Our overall portfolio's unrealized gain position increased $20.4 million or $13.4 million, after tax. In the quarter, as interest rates decreased during the second quarter and spreads tightened, up-ing our corporate construction products in the fixed income portfolio.

The investment portfolio value as of June 30, 2014, increased by $111 million to $2.7 billion, with a book yield of 2.52%, which is down 23 basis points from 2.75% in the first quarter, which included 27 basis points from the Vodafone special dividend reported in 1Q '14, and was also up 11 basis points from 2.41% for the same period last year.

The total return on the trailing 12-month basis was 2.81%, up 93 basis points from 1.88% in the first quarter and up 58 basis points from 2.23% for the same period last year.

Our investment portfolio has maintained its AA average credit quality rating with a duration of 3.8 years, which compares to 4 years for the same period last year.

GAAP shareholders' equity at June 30 was $972 million, up from $902 million at December 31, 2013, and $874 million at June 30, 2013.

Book value per share increased by $2.44 or 3.7% in the quarter to $68.16, primarily driven by solid operating results and an increase in unrealized gains across our investment portfolio. It should be noted that book value per share has increased 7.7% in the first 6 months of this year. Our annualized ROE was 9.9% and our operating ROE was 8%.

And finally, net cash flow from operations was a positive $69.3 million for the quarter, and is $78.1 million for the year.

And that concludes my report. We'll turn the call open for questions. Thank you.

Question-and-Answer Session

Operator

[Operator Instructions] We'll take our first question from Amit Kumar of Macquarie.

Amit Kumar - Macquarie Research

So thanks for the -- a little bit on the Lloyd's marine losses. Just wondering. There has been a few more event in Q2 to-date, and how should we think about those losses going forward?

Stanley A. Galanski

In my mind, attritional, there's nothing on our radar screen. Absolutely.

Amit Kumar - Macquarie Research

Okay, great. So on the reserve development, can you guys sort of broadly speak about which accident years the development is related to?

Stanley A. Galanski

Yes, the -- you're talking about the release of, let's say, the $20 million. Hold on one second. I'll give you those numbers. Yes, actually, we'll be happy to. The $20.5 million, which is broken up between $13.9 million for the U.S. Insurance Company's and $6.7 million for the Lloyd's operations are underwriting years 2011 and prior. And most of that [indiscernible] to 2010. But Amit, it's also important to note that our current year strengthening was $12.8 million. So part of our robust reserve process review is a balancing of those -- both of those drivers, not just the prior year but the current year.

Amit Kumar - Macquarie Research

Okay. So basically, currently, competitive market conditions that we've been hearing about, how do you -- should we think about, like, the pricing and the margins in both, like, the Insurance and the Lloyd's business for the rest of the year?

Stanley A. Galanski

Well, let me see if I can give you a little color on it. I think that the specialty underwriters really vary significantly by product line. And I mentioned earlier, I think, that the most competitive business, as we see in terms of price pressure and difficulty in getting the amount of business that we want on a particular risk, would be in the energy space. There is so much capacity out there today. And even with an increase in construction activity and more E&P going on in the world, it's just tough to: a, get as much business you want on the best risk, and we tend to be, I think, a little more highly selective in terms of risk selection and pricing in terms, so that puts a little pressure on the top line. I think, similarly in the international D&O and E&O business, it's been a very good business for the industry. There has not been a significant amount of loss activity, other than in well-known classes like U.K. Solicitors and Italian [indiscernible] -- obvious problem [indiscernible] type classes. So I think, we would expect to see pricing erosion there. But having said that, look at the business and say, well, where does that take it relative to what we believe the technical pricing of the portfolio is in the technical pricing of individual risk. So you may have a minus 3 or a minus 5, or whatever that number is on a risk or on a portfolio, but where do you think your portfolio was priced? And so when all that's said and done, where do we see the most concern about the ability to attract pricing is consistent with profitable underwriting results. I would put the U.S. professional liability market right at the top of that, hence you see our premiums are down 30% there. It just seems like it's a commodity business and there is just not enough rate going into it to keep up with, what we believe, the losses are associated with it.

Operator

Our next question comes from Paul Newsome of Sandler O'Neill.

J. Paul Newsome - Sandler O'Neill + Partners, L.P., Research Division

I actually like to ask a broad question. Obviously, one of the themes that we've heard this quarter is that the reinsurance market is in pretty much a free fall. And your business is more heavily reinsurance-dependent than a lot of the other companies I follow. How does this, the current reinsurance market, in your view, impact what you're doing? And maybe, perspectively, some thoughts on what that might -- how that might work out for your own business?

Stanley A. Galanski

Okay, great. Well, I guess, a couple of observations on that. First of all, I think that reinsurance has, for 40 years, been a core part of our business strategy, and that our fundamental strategy is to write complex risks that, by their nature, have severity exposures and not a high degree of frequency of loss. And we use reinsurance to protect our balance sheet. We couldn't do that for 40 years, without good trading relationships with high-quality business partners. So, I think, when we look at the universe, our trading partners don't fundamentally change that much. There may be trade change in an individual insurer when we change the structure, say, our casualty programs as we did in the first quarter of this year, but the kind of panel that supports them has been remarkably consistent. And I think that reflects the fact -- there has been a good trading relationship for them as well. We don't do that just on the financial strength. We evaluate the quality of the management team, because we always want to be in a situation where we can pick up the phone, if there ever were a dispute, and know we can resolve it in an honest, integrity, gentlemanly fashion. So that, I'd say, really means that our programs have not changed fundamentally in terms of who we trade with. A lot of the alternative capacity that we've read about, that is just flooding the industry, has not really impacted what we do. I think that's a strength of the company, because, I think, your ability to collect and your ability to have effective long-term trading relationships is really important when you do what we do. But secondly, I think, as reinsurers have seen the pressure on their ability to grow their business, it has contributed to a willingness to structure programs differently than they might have 2 or 3 years ago. And when we -- did our debt deal was to raise enough capital to, obviously, expand, as we're planning to do in Europe, but to eat more of our own cooking selectively on businesses where we thought we could increase our retention. Some of these things involve structures that might not have been achievable 2 or 3 years ago. So I think the competitive pressure the reinsurers have felt has contributed to that on our behalf. And again, I don't think that, that means we're torching our reinsurers. It just means it had more flexibility that allow us to structure things in ways -- and I think we have done a pretty good a job of capitalizing on that. But fundamentally, they are our business partners, and we want them to do well. Having said that, as a seller of reinsurance, we have for a long time have been in the marine treaty market, obviously, at Lloyd's, but we have our other navigators product lines. They are very specialty niche-oriented lines. And the Latin American business, honestly, has held up a little bit better than what we thought. But from a pricing standpoint, I think that's a testimony to selling to the right customers. People who buy reinsurance, because they need to buy, not because they are arbitrage margins. And then in other specialty classes, like A&H, it's, I think, been very effective trading relationship still. And again, it's such a niche portfolio. It's less of a treaty business than an insurance business that manifests itself as reinsurance.

Operator

[Operator Instructions] And we'll take our next question from Adam Klauber of William Blair.

Adam Klauber - William Blair & Company L.L.C., Research Division

A couple of questions. In the E&S nonprofessional lines, how is the flow from the standard market? Are you still seeing a positive flow? Today, has that positive flow ebbed in the last 6 to 12 months?

Stanley A. Galanski

I would say, yes, it has. And what is really, I think, going on: wholesale brokers seem to be as busy as they ever were, and certainly, we've got plenty of business to look at. But, I think, increasingly, moving into the part of the market where standard lines carriers are looking to grow their topline and are doing the inevitable things they do, as the market softens, which is broadening their risk appetite. And making decisions on complex risks that maybe they wouldn't have looked at in a harder market, and we would question whether they have the expertise to really understand what they are getting involved with. So it does contribute to a higher level of competition. But I think what has helped offset for that for us is 2 factors. Number one, the general growth in construction activity, which is a big part of what we do, not all of what we do, but certainly drives a lot of the E&S business. And secondly, people having to take corrective actions onto selective portions of their portfolio that therefore get pushed back into the market. And sometimes that makes sense for us and sometimes it doesn't, because there are times when a 50 or 75-point rate increase still won't make a particular risk or a particular [indiscernible]. So for us, even though -- given about the tightness in the New York construction market, as a primary insurer, we just don't think it makes sense. You've got to be excess of $4 million or $5 million to do anything in New York contracting in our mind. So -- it very much varies by segment -- but, yes, I'd say the standard line carriers definitely are finding the allure of premium associated with the E&S business, which inevitably happens in the cycle. And we can manage through that.

Adam Klauber - William Blair & Company L.L.C., Research Division

Okay, okay. And you mentioned construction. Could you give us -- is the geographic growth there more oriented towards one area like Southeast, Northeast, or is it pretty well spread?

Stanley A. Galanski

It's spread. But we've always been strong on the West Coast, and through the Rocky Mountain states and areas like that. And we've never really had a significant Southeast. Florida is just not our thing.

Adam Klauber - William Blair & Company L.L.C., Research Division

Okay. That's helpful. On the Professional Liability, how are the older years performing?

Stanley A. Galanski

They are okay, actually. It's the mid-years. Professional Liability for us, and we're talking about Errors and Omissions, is not really a long-tail business. I mean, in theory it is. But it's a claims made product and those losses tend to develop reasonably quickly. So for us, where you'd really see emergence patterns in years that we actively watch -- or the more recent years, and I would say that's probably like 2009-2010 on forward. And for us, it's really about the restructuring of the portfolio more than anything else. Our view was that the small law firm business was just too much of a commodity. We weren't bringing real value to the thing. And we tend to do better on things that are complexity-worthy. Individual risk decisions matter, not whether it's okay. For four lawyers and you run it through a machine and a price pops out, that just has never really worked out well for us.

Adam Klauber - William Blair & Company L.L.C., Research Division

Okay. And then I'm sorry if you said it before, but how is your Stock Plus [ph] business going?

Stanley A. Galanski

It's going fine. Yes, it's okay. That's essentially in the health insurance, the health reinsurance, yes.

Adam Klauber - William Blair & Company L.L.C., Research Division

What type of growth did you see year-over-year in that?

Stanley A. Galanski

You know what, that business has been kind of relatively flat for us, but the most important thing is whether we're making any money on it. So we're happy with the underwriting results, but it's not been a growth business in 2014.

Operator

[Operator Instructions] And it appears we have no more questions, I would like to turn it back to Mr. Stan Galanski.

Stanley A. Galanski

Okay. Well, thank you, operator. Thank you for taking the time for the call today and for your continued interest in Navigators. Have a great day.

Ciro M. DeFalco

Thank you, all.

Operator

And that does conclude today's call. We thank you for your participation.

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