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EMC Insurance Group Inc. (NASDAQ:EMCI)

Q2 2014 Earnings Conference Call

August 7, 2014 11:00 ET

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

Mick Lovell - Vice President, Business Development

Analysts

Paul Newsome - Sandler O’Neill & Partners

Neil Cybart - KBW

John Deysher - Pinnacle

Operator

Good morning and welcome to EMC Insurance Group’s 2014 Second Quarter 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. As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Steve Walsh, Director of Investor Relations. Thank you, sir. You may begin.

Steve Walsh - Director, Investor Relations

Thank you, David. Good morning, everyone and welcome to EMC Insurance Group’s 2014 second 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 November 7, 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 the 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 2014 second 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 all. Earlier today, we reported an operating loss of $0.04 per share and net income of $0.08 per share for the second quarter compared to operating income of $0.47 per share and net income of $0.48 per share last year. In an announcement on July 21, we estimated our operating loss will be approximately $0.02 per share, but subsequently had a small revision in the financial statements that reduced operating results by an additional $0.02 per share.

The first half of the year has been challenging due to losses stemming from severe winter weather and unusually cold temperatures in January and February and higher than anticipated catastrophe and storm losses during the second quarter. The frequency of convective storms, which includes tornadoes and hail and wind storms, was down for the first six months of the year compared to recent averages. However, the second quarter storms impacted the areas in the Midwest, where we have sizable exposures, but improved premium rate adequacy achieved over the past several years reduced the impact of these storms otherwise would have had on our results.

The reinsurance segment has generated strong operating results over the past several years, but it has the potential to produce somewhat volatile operating results in a given period. The reinsurance segment’s relatively high amount of losses and settlement expenses in the second quarter, especially when compared to the exceptionally low amount reported in the second quarter of 2013, was responsible for much of the increase in the GAAP combined ratio from 102.2% in 2013 to 109.6% in 2014.

Based on actual results for the first six months of the year and projections for the remainder of the year, we revised our 2014 operating income guidance on July 21 from the previous range of $2.65 to $2.90 per share to a range of $2 to $2.25 per share. The revised guidance is based on a projected GAAP combined ratio of 101% for the year and a mid-single digit increase in investment income. The projected GAAP combined ratio has a load of 11.2 percentage points for the catastrophe and storm losses.

Net written premium growth for the quarter remained in the mid single-digits in the property and casualty insurance segment, growing 6.8%. Net written premiums in commercial lines of business were up 9.4%, while personal lines of business were down 10.4%. In the reinsurance segment, net written premiums were down 13.9% due to an extension of the renewal date of two large facility contracts from May 1 to July 1 and rate level declines on catastrophe excess of loss business. We anticipate that we will continue to implement rate level increases in the property and casualty insurance segment during the remainder of the year, although at a somewhat lower level than those implemented during 2013. Rates on line for excess of loss reinsurance business declined approximately 7% to 8% during the January 1 renewal season, but those declines were partially offset by a slight increase in retentions and an increase in limits purchased. Premium income was up 5.3% for the quarter.

In the property and casualty insurance segment, premiums earned increased 5.8%, with the vast majority of the growth attributable to rate level increases on renewal business, growth in insured exposures and an increase in retained policies. Premium rate levels increased at all branch locations and across all major lines of business. Renewal rates across our commercial lines of business increased approximately 5.1% and personal lines of business increased approximately 3.1% during the first six months of 2014. However, net written premiums from our personal lines of business continue to decline due to an intentional reduction in policy count to lessen exposure concentrations. Commercial lines policy count was up 2.5%, while personal lines policy count was down 10.6%. New business in the Northwest, Southwest and Southeast parts of the United States grew and generally should continue to grow at a slightly faster clip than other regions. This growth helps diversify the company’s book of business geographically, while staying consistent with the industry and line of business mix of the existing book of business.

In the reinsurance segment, premiums earned increased 3.6%, reflecting growth in specialty casualty and marine business. Premium growth was limited by the previously noted extension of a renewal date of two large facility contracts from May 1 to July 1 and rate level declines on catastrophe excess of loss business. Retention levels based on policy count remained strong and above industry averages, with commercial lines of business at 86.7%, personal lines of business at 83.8% and an overall retention level of 85.4%, which approximates the retention level at the end of 2013. We are pleased that we were able to continue to obtain rate level increases while maintaining our consistent high retention level. 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 stock increased 5.4% to $36.05 per share from $34.21 per share at year end 2013. Excluding accumulated other comprehensive income from the calculation book value increased 1.3% to $30.18 per share from $29.78 per share at year end 2013.

Now, 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. The loss and settlement expense ratio increased to 79% in the second quarter from 70% in the prior year. As Bruce discussed earlier on the call, the increase in this ratio is primarily attributed to the reinsurance segment. In the property and casualty insurance segment, the loss and settlement expense ratio was consistent with the prior year quarter. However, this ratio was higher than we projected due to a higher than anticipated amount of catastrophe and storm losses.

Second quarter catastrophe and storm losses accounted for 20.9 percentage points of the combined ratio, which is above the company’s most recent 10-year average of 18 percentage points and well above the 16.8 percentage points experienced in the second quarter of 2013. There were no catastrophe and storm loss events in the reinsurance segment during the quarter that exceeded the $4 million retention level contained in the excess of loss agreement.

We experienced favorable development on prior years’ reserves of $6.6 million in the second quarter compared to $2.1 million in the prior year quarter. The majority of the increase in favorable development occurred in the property and casualty insurance segment and is primarily attributed to an increase in favorable development on open claims and a decline in IBNR emergence. 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 and 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. Large losses, which we define as losses greater than $500,000 for EMC Insurance Companies pool, excluding catastrophe and storm losses increased to $9.9 million or $0.48 per share after tax in the second quarter of 2014 from $6.5 million or $0.33 per share after tax in the second quarter of 2013.

As previously reported, two office buildings owned by EMC Insurance Group’s parent company, Employers Mutual Casualty Company, were damaged by a fire that occurred on March 29, at an adjacent building that was in the process of being renovated. Employers Mutual was self-insured for the first $5.0 million of loss to its campus. This loss is subject to the EMC Insurance Companies’ inter-company pooling agreement, so approximately $1.5 million associated with this event was included in large losses for the quarter. The remaining increase in large losses resulted from an increase in other fire related losses and from an increase in commercial auto losses.

We have seen, as have other commercial insurance carriers an increase in large losses in the commercial auto line of business over the past few years. We are carefully analyzing our commercial auto accounts and taking steps to identify and mitigate the causes of these losses. Commercial auto losses with significant exposures are being reviewed early in their life cycle by litigation specialists in order to establish adequate reserves in a timely manner. In addition, as commercial auto policies renew, we continue to evaluate the underlying exposures to determine if we are getting an adequate price for the risks we are insuring.

Large losses for the first six months of 2014 increased to $14.1 million or $0.68 per share after tax, from $9.5 million or $0.47 per share after tax in 2013. Claims frequency and severity were both higher than expected through the first six months of the year due to losses stemming from the severe winter weather during the first quarter and convective storms during the second quarter. Renewal rate increases continue to exceed our estimated loss cost trend.

Results for the second quarter of 2014 reflect a significant reduction in the amount of net periodic pension and post-retirement benefit costs allocated to the company. Net periodic pension benefit costs declined to $196,000 in the second quarter 2014 from $725,000 in the same period in 2013. This decline reflects an increase in the expected return on plan assets due to an increase in plan assets and a decline in the amount of net actuarial loss amortized into expense.

Net periodic post-retirement benefit costs changed significantly as a result of the plan amendment that was announced in the fourth quarter of 2013. The company recognized net periodic post-retirement benefit income of $771,000 in the second quarter of 2014, compared to net periodic post-retirement benefit expense of $728,000 in the same period in 2013. The plan amendment created a large prior service credit that is being amortized into expense over 10 years. In addition, the service costs and interest cost components of the revised plan’s net periodic benefit costs are significantly lower than those of the prior plan.

Turning to our investment results, net investment income was relatively flat for the second quarter, increasing 0.3%, but was up 6.7% for the first 6 months of the year. These increases reflect a higher average invested balance in fixed maturity securities and an increase in dividend income; however, approximately $442,000 or 2.1 percentage points of the increase for the first six months of 2014 resulted from the early payoff of a commercial mortgage backed security during the first quarter of 2014 that was purchased at a significant discount to par value. This accelerated accretion of the discount to par value and therefore increased investment income.

The investment income amounts reported for the second quarter and first six months of 2013 include $201,000 of funds received from a litigation settlement on one security. Excluding this amount from the calculations, the increases in investment income would have been 2.2% and 7.7% respectively. The average coupon rate on our fixed maturity portfolio, excluding interest only securities declined slightly to 3.9% at June 30from 4% at year end 2013. The effective duration of the fixed maturity portfolio, excluding interest only securities, decreased to 5.0 from 5.7 at year end 2013. Duration contracted as interest rates declined during the first quarter. Total return on the equity portfolio was 4.9% for the quarter and 8% year-to-date, compared to 5.2% and 7.1% for the S&P 500.

During the first quarter of 2014, we invested in a limited partnership that is designed to help protect the company from a sudden and significant decline in the value of its equity portfolio. The carrying value of this limited partnership declined $533,000 and $772,000 after tax during the second quarter and first six months of 2014. These declines are reported as realized investment losses and reduced the amount of net realized investment gains reported for those periods. No shares have been repurchased under the company’s $15 million stock repurchase program that was put in place in November of 2011.

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

Question-and-Answer Session

Operator

Thank you. At this time we will be conducting a question-and-answer session. (Operator Instructions) Our first question is from Paul Newsome with Sandler O’Neill & Partners. Please proceed with your question.

Paul Newsome - Sandler O’Neill & Partners

Good morning everyone. Thank you for the call. I wanted to ask a bit about the large business fire losses that we are seeing in the quarter and seem to be seeing from across the industry for a while now, at what point do we kind of think this is not a sort of one-off quarterly issue and it’s just a part of the general claims inflation trend?

Scott Jean

Good morning Paul, this is Scott Jean. I don’t know that we have necessarily seen an increase in fire losses prior to this year. This year we did see an increase especially in the first quarter which I attribute a lot to the cold winter weather and the fact that a lot of homes were using heating elements that weren’t typically used as much as in the past. Second quarter we did see an increase again in fire losses particularly in homeowners. I don’t have an explanation as to why that occurred, but I am not ready to say there is a trend there. Actually in 2014 we have seen an increase, but I don’t know that we have seen it too far beyond the current year.

Bruce Kelley

Well, Paul, I think it’s consistent with what other companies are experiencing and so I don’t think that we are out of line.

Paul Newsome - Sandler O’Neill & Partners

No, I am not asking that question, I am asking whether or not we think this is a – at what point do we think it’s an industry trend and not an EMCI trend, because you are right, everyone – virtually every other company has seen an uptick in the fire losses?

Scott Jean

I guess the reality is the industry may be seeing some increases and if they are, we as an industry, need to respond and increase our rates as appropriate and do what we can to mitigate losses going forward, but I am not sure who necessarily makes that call for the industry other than each company responding based upon their own experience to adapt to what they are seeing on their own book of business.

Paul Newsome - Sandler O’Neill & Partners

Great. And I would like to revisit the trend of cat losses, particularly in the second quarter, and how you are currently viewing them?

Scott Jean

This is Scott Jean again. We did see an increase in a second quarter loss of cat losses compared to previous quarters, especially within the second quarter. As far as kind of a long-term trend, we have seen increases during the second quarter, but we have also seen a decrease in the third and fourth quarter in the most recent years. As far as the number of actual storms that are occurring, they have been declining in recent years, but they have just been hitting in areas that we have exposure. I guess, I am not sure what other questions you had beyond that.

Paul Newsome - Sandler O’Neill & Partners

Well, there is a debate within the industry travelers would be a good example that suggests that the claims trend for catastrophe losses is positive. So, it’s an upward sloping line and therefore there should be incremental cat loads put into pricing prospectively. There are other companies that disagree with that view. I would like to see what your view on it is?

Scott Jean

One thing that I look at, I don’t just look at, for example, a 10-year average when we are selecting our cat loads for our pricing and for our projection that we provide in our guidance. And looking at other types of things, we are looking in exposures, what has changed in exposures, what is changing as far as the percentage of cat losses, the percentage of those exposures and we are looking at trends. So, if we do see an increase going on, we take that into consideration in our pricing and in our forward-looking projections. So, looking back historically, you do see many periods in history, especially back in 1970 to 1974 where there is a significant increase, for example, in severe tornadoes, F3, F4, F5 tornadoes. And after that period, the number of tornadoes dropped off significantly. We are seeing a period of more active storms in the recent history. Is that a long-term trend? I am not ready to say that, but we do need to respond to what’s happening with our insurance losses. And in fact, we have seen an increase in recent years. We have to respond with our pricing and how we are managing our exposure to catastrophes.

Bruce Kelley

Paul, I think when you look at our company, you can see that we have taken these exposure reductions and also over the years besides the exposure reductions, we haven’t really tapped into our reinsurance treaties very significantly. So, irrespective of what’s going on in the weather, we are continuing to look at our book of business and make underwriting judgments, so that we can reduce and spread our risk.

Paul Newsome - Sandler O’Neill & Partners

Good, thank you very much.

Operator

Our next question is from Neil Cybart from KBW. Please proceed with your question.

Neil Cybart - KBW

Good morning. My first question has to do with rates. Specifically, can you break it out further such as maybe by property, casualty, maybe by geographical footprint or even maybe types of business, such as what are you seeing in commercial/auto versus worker’s comp? I am just trying to get a better handle as to how you are faring with the broader industry rate pressure that’s out there?

Mick Lovell

Neil, this is Mick Lovell. I am happy to answer that question for you. As we have mentioned, we do have solid rate increases across all lines of business, so each of our lines, commercial auto, property, liability, comp or bop, all those lines of business will experience rate increase and have so far in 2014. Likewise, all of our branch offices have also seen rate increase for their branch office in 2014 across the board. Now, if you drill down further and you look at a line of business within a branch, there is going to be some anomalies there, but we don’t have any branch offices that are dropping rate in the line of business at any great pace. So, we do have pretty widespread geographic rate change going on. We have good cross line of business rate change going on as well.

Now, from a size of account standpoint, that’s probably what’s driving the rate pressure more than anything else. Our larger accounts and as we see larger accounts come in, those seem to be the dominant force in driving that rate pressure. We are not going to be able to achieve as much rate on those larger accounts generally as we could on say a middle market or a smaller account. As we go through the rest of this year, I would anticipate we see that dropping down into those middle market or smaller accounts a little more so than it is now and becoming even stronger on those larger accounts. But do know that unlike some carriers we do choose to take rate increase at the account level. We don’t make broad brush strokes to say we are going to get 5%, 10% or 15% on every account. We take into consideration the account characteristics and allow our underwriters to scrutinize those accounts and get more rate where they should and be more competitive where they feel they can.

Neil Cybart - KBW

And are you also getting rate increases in property? I am thinking maybe like in the Midwest, some of this exposure to storms. I mean, even in that area, are you able to get rate increases at this time?

Mick Lovell

Yes, we are. Actually, our property rate increase for mid-year is about 6.4% compared to the overall of just over 5%. So, we are seeing a little bit stronger property rate increase than we are in some other lines. When you look at our business owners, which is generally a property-based type policy, that rate increase is 7.1%. So, we are seeing stronger rate increase in some of that property. As we look at the way our branches have been able to price some of our larger property intensive group programs, like our schools and municipalities, especially in the Midwest, states like Kansas, Iowa and Nebraska, we are seeing stronger rate increases on the property side of that business than we are traditionally through the remainder of the book. So, yes, we are identifying that and we are getting better rate increase than what we show even on overall in those territories, in those lines.

Neil Cybart - KBW

Okay, thank you. My next question maybe I guess is for Scott, what percent of the large losses is due to the commercial auto? And if possible, is there anyway to get additional detail as to maybe industry type or just more background as to the commercial/auto large losses?

Scott Jean

This is Scott. I don’t know that I have a specific number for you as far as the percentage of large losses that are coming from commercial auto, but I can tell you it is a fairly good percentage of what we have been seeing. And it hasn’t necessarily been real large claims, but we have seen an increase in the severity of smaller claims that have pushed it into closer to that $500,000 level. Kelvin, do you have something you want to add?

Kelvin Sederburg

Yes. I don’t have quite an apples-to-apples comparison. I have got some information looking at losses that are over for current accident year losses that are over $100,000. The commercial auto liability segment is producing around 15% to 20% of those losses and that’s just in a current accident year. And of course, this particular year, with over $100,000, that’s throwing in commercial property where we have had a number of large losses coming from catastrophes and such like so. That might not be the best apples-to-apples comparison I have but that is definitely up from the previous year by about several million dollars.

Neil Cybart - KBW

Okay, thank you. I know you don’t give guidance by segment, but the reinsurance operations, has been quite volatile, I believe Bruce mentioned that in the prepared remarks. We now have at least somewhat of a run-rate in 2014, which is quite a bit weaker versus 2013. Looking at our overall guidance though, it would seem to suggest there may be some improvement in the second half of the year in reinsurance. Is that a fair assumption to make? I mean, should we be thinking that there could be some positive moderation in reinsurance in the back half of 2014?

Ron Hallenbeck

This is Ron Hallenbeck. Well, the third quarter is always a very concerning quarter for reinsurance in fact it’s our hurricane activity quarter, that and part of the fourth quarter. I think you have to keep in mind that reinsurance rates have decreased in the cat line, but our cat business is - represents only about 20% of our total book of business. Our main focus for reinsurance is the smaller regional company, working layer business that’s more experience rated. We do have potential to be volatile from quarter-to-quarter, but over the long-term we feel that we are producing appropriate profit line.

Kelvin Sederburg

And Mr. Cybart, this is Kelvin Sederburg, everything Ron said is absolutely right. There is also some reason for a little bit more optimism in the earned premium as we were fairly conservative on bookings some earned, but not reported premium at quarter end due to the unknown – a few contracts that were in negotiations that were extended and that we also knew have – actually has an earning pattern where we earned it uniformly over the year. We actually know there is some of – a little bit more of the risk attached at a different point in time, later in the year or actually the beginning of next year. So due to that uncertainly the EBNR book for those particular contracts was conservative. We didn’t know if we would be retaining them or not. They have been retained and so there is some optimism that earned premium is going to be a little bit stronger here in the third and fourth quarter.

Scott Jean

This is Scott, I will add one additional thing. The assumed book was affected a little more than they typically are by Midwest convective storms and that had an impact on the results. We don’t anticipate that’s going to be an issue necessarily going forward remaining two quarters, so I am expecting the loss ratio and the combined ratio for the assumed EMC re-portion to come down a little bit during the third and fourth quarter assuming that there are no major hurricanes, which is the primary exposure that they face during the second half of the year.

Neil Cybart - KBW

That was actually going to be my next question, so there were some, if I word this correctly, non-cat property losses in the reinsurance, when I am looking at the pure loss ratio, so if I am excluding the cat losses, you would say there probably was some elevated frequency in property losses?

Ron Hallenbeck

Yes, it was definitely higher than the prior quarter, the 2013 quarter.

Neil Cybart - KBW

Okay. Thank you for all the answers.

Ron Hallenbeck

Thanks for your questions.

Operator

Our next question is from Don – John Deysher from Pinnacle. Please proceed with your question.

John Deysher - Pinnacle

Good morning, I was just curious on the share repurchase plan, it’s been almost three years since that was implemented, I don’t believe you have bought any shares and I was just wondering if you could frame that for us in terms of what the trigger might be to repurchase shares maybe you can add some color there as to what might get you off the fence in terms of actually pulling the trigger there?

Bruce Kelley

John this is Bruce Kelley. We take a very measured approach to this in that we look at the total environment of the book value of our stock and where the industry is, we did repurchase a number of shares in the low-20s. And now since our book value has come up, we are closer to book value we are not as eager to repurchase shares. The program will still stand and so there may be some opportunities if there is a shot for us to repurchase shares, but we want to continue to repurchase shares over time.

John Deysher - Pinnacle

Okay. When you bought it in the low-20s, what percentage of book was that?

Bruce Kelley

I believe it was around 80% of book value or less.

John Deysher - Pinnacle

Okay. Because right now it’s trading at about 83% of book value, so if you bought at 80% previously, is it fair to assume that if the shares came down somewhat to around 80% or somewhere in that range that you might be active on the share repurchase front?

Bruce Kelley

We might be, yes. Mark?

Mark Reese

It was probably actually closer to 70% of book value, it might even have been 65% when we made those purchases under our previous program.

John Deysher - Pinnacle

So 65% to 70% might be a more reasonable measure?

Mark Reese

Correct.

John Deysher - Pinnacle

Very good. Thank you.

Operator

(Operator Instructions) Gentlemen, there are no more questions at this time.

Steve Walsh - Director, Investor Relations

Thank you. Ladies and gentlemen, this concludes today’s conference call. I would like to remind you that a webcast of this call will be available on the company’s Investor Relations page on the company’s website at www.emcins.com/ir until November 7, 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.

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