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State Auto Financial Corp. (NASDAQ:STFC)

Q4 2010 Earnings Call

February 17, 2011 10:00 am ET

Executives

Steven E. English - Vice President and Chief Financial Officer

Robert P. Restrepo Jr. - President, Chairman and Chief Executive Officer

Matthew S. Mrozek - Vice President and Chief Actuarial Officer

Analysts

Larry Greenberg - Langen McAlenney

Caroline Steers - Macquarie

Matthew Rohrmann - Keefe, Bruyette & Woods

Larry Greenberg - Janney Capital Markets

Operator

Welcome and thank you all for holding. I’d like to inform parties that your lines have been placed on a listen-only mode until the question-and-answer portion of today’s conference call. (Operator Instructions) This call is also being recorded. If anyone has any objections, you may disconnect at this time.

And I’ll now turn the call over to your CFO, Steve English, you may begin, sir.

Steven E. English

Thank you, Holy. Good morning and welcome to our fourth quarter 2010 earnings conference call. Today, I’m joined by several members of STFC’s senior management team, our Chairman, President and CEO, Bob Restrepo; Chief Investment Officer, Jim Duemey; Chief Actuarial Officer, Matt Mrozek; and our Chief Accounting Officer and Treasurer, Cyndy Powell.

Today’s call will include prepared remarks by our CEO, Bob Restrepo, and me, after which we'll open the lines for questions.

Please note our comments today may include forward-looking statements, which by their nature involve a number of risk factors and uncertainties, which may affect future financial performance. Such risk factors may cause actual results to differ materially from those contained in our projections or forward-looking statements. These types of factors are discussed at the end of our press release, as well as in our annual and quarterly filings with the Securities and Exchange Commission to which I refer you.

A financial packet containing reconciliations of certain non-GAAP measures along with supplemental financial information was distributed to registered participants prior to this call and made available to all interested parties on our website, www.stateauto.com, under the Investors section as an attachment to the press release.

Now, I'll turn the call over to STFC’s Chairman, President and CEO, Bob Restrepo.

Robert P. Restrepo Jr.

Thank you, Steve, and good morning everyone. Fourth quarter results for State Auto Financial Corporation represented a solid improvement over both last quarter and the fourth quarter of 2009.

Our net income improved to $37.6 million, despite lower levels of investment income. Book value was relatively flat at $21.23, up slightly from the third quarter. The GAAP combined ratio of 97.6% was also a solid improvement both sequentially and relative to the fourth quarter of last year.

Continued improvements in personal insurance particularly homeowners and a lower expense ratio offset higher than average higher catastrophe losses as well as higher than normal large losses in the commercial liability line.

Year-to-date results for 2010 also demonstrated improvement. For the year, we reported net income of $24.5 million. Book value was relatively flat as earnings and improved investment values were offset our dividends and benefit plan revaluation. Our GAAP combined ratio of 104.6% and 96.7% excluding catastrophes.

We reported better results in personal insurance underwriting and our expense ratio, which was offset somewhat by higher levels of catastrophes and atypical large loss experience during the last six months in both in commercial automobile and general liability.

Personalized results were profitable for the quarter. Personal auto loss ratios were elevated somewhat, but a lot of this was seasonal and weather-related. For the year, loss ratios improved over two percentage points. Most significant though was the improvement that we saw in our homeowners loss ratio.

For the quarter, we saw a significant loss ratio improvement despite much higher levels of catastrophe experience resulting from several storms in October. Year-to-date, our ex-catastrophe and homeowners loss ratio improved as our profit improvement initiatives began to earn out and payoff.

Personal auto production continues to moderate. Price increases in the quarter were up 3.7%, but the real reason production is slowing continues to be the homeowners pricing and underwriting actions we’re taking.

Retention is stable, but new business is off by over 20%. The slide began last year during the fourth quarter when our homeowners pricing and underwriting actions began hitting the market.

For the next year or so, we expect our policy account production to be relatively flat, but premiums should grow in the low single digit area driven by price increases and a recovering economy. In homeowners, virtually all of our 9.6% growth comes from price.

We finished the year with a 10% price impact on our written premium growth. The earned impact of these pricing actions along with their insurance to value program, our wind and hail deductible rollout and our property claim changes are really paying off with substantial improvements in our ex-catastrophes loss ratio.

For the quarter, we reported a result of 39.8%, which is the lowest we've had for several years and a 21-point improvement over the fourth quarter of 2009. For the year, we reported 6.4 percentage point improvement in our ex-catastrophes loss ratio and looking for continued improvement as we enter 2011.

All in all, we feel good about our personal insurance profit improvement. Production will moderate, but we expect it to recover as we complete the implementation of our homeowners remediation efforts.

Business insurance profitability improved sequentially as our loss ratio for auto, multi-peril and fire improves. These positive trends were offset somewhat by continued higher levels of general liability large losses and higher catastrophes loss experience relative to the fourth quarter of last year. Excluding the impact of RED, commercial production was lower by 5.2%.

Retention is steady, exposures seem to be stabilizing, but new business is off on all lines except for BOP, where our new BOP Choice program continues to perform well. We're not getting much help from price either. Pricing per exposures remains relatively flat and slightly negative for the year, down less than a point. All our growth in commercial lines continues to come from RED.

For the year, our new managing general underwriter in the program and alternative risk transfer market contributed over $83.2 million to our top line.

We continue to target an underwriting expense ratio in the low 30s. Our full year result of 33.8% is an improvement over our 2009 results despite additional expenses incurred as we build out RED. Primary contributors were commission changes, effective headcount control, and lower underwriting report expenses.

We're also making excellent progress in reducing the loss of adjustment expense ratio, which is embedded in our loss ratio, particularly in the property lines. A significant component of our profit improvement efforts in personal auto, homeowners, and business insurance is claims.

Over the past year, we've implemented new catastrophe teams, brought virtually all large property claim handling in-house and deployed over 70 property adjusters working from home. We've already begun to see dramatic improvements in both our loss adjustment expenses related to real property claim handling, as well as less leakage in claim than the repayments.

In the auto lines, first one, commercial automobile, still represent about 50% of our business. We've organized a new physical damage unit to better adjudicate property damage and physical damage losses. This two is paying off and less outside appraisal expense and better indemnity payout management.

Lastly, we now have staff counsel deployed in 11 offices around the country, which allows us to both reduce legal expense and better manage files for liability, bodily injury, and workers' compensation. Along with improvements we are making to our workers' compensation claim handling, our claims organization represents a substantial part of our profit improvement with more to come in the future.

Over the last few months, we also made several announcements regarding our enterprise risk and capital management. In November, we announced changes to our intercompany pooling arrangements for the State Auto Group. Beginning January 1 of this year, the pooling arrangement was amended to include operating results of the Rockhill Insurance Group, which we acquired back in February of 2009. We estimate that this change will add approximately $80 million of net written premium to the results of STFC in 2011.

Along with this change, we'll also revise our reporting segments and introduce a new specialty segment that will include line of business results for RED, Rockhill, and all of our workers' compensation and surety business. We think this change will both enhance transparency and better highlight our diversification progress.

Product and geographic diversification remains a key part of our business and operating strategies. The additional of Rockhill and RED, moves us further down the road of better balancing our personal lines business with more commercial and more casualty oriented business. We've made good progress and along with the pooling change, we decided to non-renew our catastrophe aggregate reinsurance treaty. This was done effective January 1.

On January 3, we announced a successful completion of our previously announced sale of State Auto National, a non-standard automobile insurance subsidiary to Hallmark Insurance Company. The closing was effective December 31, 2010. As we've discussed previously, this sale disposed a non-strategic business and allowed us to redeploy capital to our fast growing specialty business.

Steve English will discuss the financial ramifications of the pooling change, the new segment reporting, and the impact resulting from the sale of State Auto National on our financial results.

And with that, I'll turn you over to Steve.

Steven E. English

Thank you, Bob. As Bob mentioned, there have been a number of enterprise risks and capital management actions that will impact our results going forward.

Beyond the $80 million of additional net premium expected to be written by STFC in 2011, the pooling change will result in net cash and investments of $151 million transferred to STFC effective January 1, 2011. This represents loss and loss expenses payable and under premium reserves assumed by STFC of $158 million, offset by deferred policy acquisition costs of $7 million.

With the inclusion of the Rockhill Insurance Group to the pool, we will be revising our segment disclosures. First, the personal lines segment will be unaffected. A new specialty segment will include business produced by RED, Rockhill and the workers' compensation business produced by our independent agents and RTW combined.

As a result, the RED and workers’ compensation business currently reported as part of our business insurance segment will be reclassified to the specialty segment. In addition, a small $4 million surety book previously reported as other commercial will be moved to the specialty line and reported as Rockhill.

To help realign your models, we expected breakdown of the 2011 Rockhill Insurance Group, net written premium would be approximately $56 million Rockhill and $24 million of workers' compensation.

The 2010 RED net written premium of $83.2 million breaks down as $52 million commercial auto, $28.4 million commercial multi-peril, $2.5 million of other and product liability and $300,000 of fire and hail.

The sale of State Auto National impacted our fourth quarter results and will also have some impact on 2011. The sale resulted in a gain of $3.9 million, net of transaction costs and is included in net realized gains on investments in the fourth quarter results. As a reminder, we have retained the business that was on the books at December 31, 2010 through a loss portfolio transfer or reinsurance transaction. This means the runoff of that business will remain in the pool.

Additionally, we are sharing 100% of the business written in 2011 until such time as policies are issued through hallmark systems. A state-by-state transition plan is in place and being executed, and we anticipate STFC writing approximately $4 million to $5 million under this agreement as the transition is scheduled to be completed by midyear 2011.

Our book value per share was up slightly for the quarter despite earning $0.94 per share, the impact of investment valuations on benefit claims on accumulated other comprehensive income and dividend payments to shareholders offset our earnings.

Investment valuations for fixed maturities moved down as interest rates rose and the municipal bond market was under pressure. Equity valuations rose offsetting the bond somewhat. In total, investment valuations reduced our book value per share by $0.53. Annually, we re-measure our benefit plan obligation.

As a reminder, we re-measured the pension plan at the end of May 2010 as eligible employees made elections to remain in the plan or begin to participate in an enhanced 401K plan. Declines and interest rates at that time and changes and pension asset values resulted in an increase to the net pension liability in an after tax reduction of equity recorded through accumulated other comprehensive income of approximately $0.33 per share.

At December 31, 2010, we again have re-measured the benefit plan obligation. We utilize the Citigroup pension discount curve and match the duration of our liability since selecting a discount rate. At December 31, 2010, we selected a discount rate of 5.5%, compared to 6% used last year and 5.75% used in May. All told, accumulated other comprehensive income was reduced $0.20 per share in the quarter relating to our benefit plans driven principally by the annual re-measurements and the reduction in discount rates.

At December 31, 2010, the combined statutory surplus of STFC’s insurance subsidiaries now stands at $783 million. You may have noticed a new exhibit with our supplemental schedules. Given the current headlines being generated by state and local government budget issues, we provided some additional disclosure in regard to our municipal holdings.

You will note that we have reduced in 2010, our municipal holdings to 49% from 59% of the portfolio. While some of this reduction was due to sale decisions and maturities, we also had a large number of issues called during the year. While it's always disappointing to lose a higher yielding security due to a call by the issuer, the fact that issuers have in the funds to continue to call securities does provide some reassurance in regard to the financial condition of the issuers in our portfolio.

I’d like to point out that for this exhibit we removed any credit enhancements that might be present so that the ratings are based strictly on the underlying credit of the bonds. We also classify any escrow to maturity or pre-refunded bonds as AAA since they are fully funded to maturity with the trustee.

In regard to the sector composition of the municipal bond portfolio, almost half the portfolio consist of revenue bonds, sewer, water, electric. Over a little are only a little over 10% are state general obligation bonds and a slightly higher amount are pre-refunded or escrow to maturity. About 24% of the municipal bonds are general obligations of local governments.

Overall, we feel this broad range of sectors helps to diversify our portfolio, makes us less dependent on a particular sector. Our exposure by state exhibits shows the total fair value of the bonds issued by any entity within that particular state.

The total amount shown per state is not the total amount of state general obligation bonds. In most cases, the absolute dollar amounts are lower this year than they were at the end of 2009. Four of the states in our top 10 have a AAA rating, five have a AA rating and only one Illinois has an A rating.

You can see that for the municipal portfolio at the end of 2009, 90% was rated AA or better, and at the end of 2010, 91% was rated AA or better. When we consider that 2010 was a difficult year for state and local governments and that many entities were downgraded, we're proud of the fact that our AA or better ratio improved slightly.

Moving to investment returns, net investment income for the quarter and year-to-date are down consistent with prior quarter trends driven by the call activity previously mentioned in lower investment rates. The duration of STFC’s fixed income portfolio is 5.01 at December 31, 2010.

Addressing accident year development for 2010, in total STFC recorded $64.6 million of favorable prior year development or 5.1 loss ratio points. $3.3 million related to 2009 prior cat or 0.03 of a loss ratio point. This compares the $56.2 million or 4.8 points in 2009 with $10.9 million related to 2008 and prior cats or 0.09 of the loss ratio point.

Of the $61.3 million non-cat development, $12.7 related to loss adjustment expenses, $10.4 from homeowners, $9 from fire and allied, $6.8 from commercial auto liability, and $4.8 from commercial multi-peril with the balance spread across several other lines of business.

In general, the development was driven by better than expected severity in the 2009 accident year.

Finally, I would like to comment on our tax provisions for the year. During the fourth quarter, we trued up the provisions based upon actual results as compared to the estimated effective tax rates used throughout the year. As a reminder, we recorded $4.5 million of deferred tax expense in the first quarter of 2010 related to the federal healthcare legislation and its treatment of the Medicare Part D subsidy.

Absent that adjustment, our provision would have been on a year-to-date basis a tax benefit of $4.5 million as the first quarter adjustment exactly offsets this amount. While we finished the year with income before federal income taxes of $24.5 million, we experienced a tax loss principally due to the level of tax exempt interest and dividends received deductions from our net investment income.

Due to tax losses in 2008 and 2009, we are in a tax loss carry forward position and have recorded a deferred tax benefit of $4 million related to that tax loss carry forward. At December 31, 2010, we have recorded $86.3 million in net deferred tax assets, which we have concluded is more likely than not we will recover and therefore we have not provided for evaluation allowance.

In arriving at our judgment, we considered the weight of all available evidence, including past operating results, projected performance of the company, future taxable income and tax planning strategies among other factors. In the event, we determined that we most likely would not be able to realize all or part of our deferred tax assets in the future, we would be required to establish evaluation allowance with the charge to earnings and/or other comprehensive income at that time.

Of course, our judgment and assumptions are subject to change given the inherent uncertainty of predicting future performance or tax planning strategies, which is impacted by such things as severity and frequency of catastrophe losses, the price environment, investment market conditions, and planned loss and expenses control initiatives that might not be realized.

And with that, we would like to open up the line for any questions you may have.

Questions-and-Answers Session

Operator

Thank you. (Operator Instructions) And our first question does come from Larry Greenberg. Your line is open.

Larry Greenberg - Langen McAlenney

Hi, thank you, and good morning.

Robert P. Restrepo Jr.

Good morning.

Larry Greenberg - Langen McAlenney

Hey, Bob, can you give us some idea of how the additional Rockhill business performed in 2010 from an underwriting standpoint and should we assume kind of a similar yield on the proceeds to what your current embedded yield is?

Robert P. Restrepo Jr.

I’ll ask Steve English to respond to the second question, Larry, but regarding Rockhill and when I talk about Rockhill, I'm talking about strictly the excess and surplus business, not the workers' compensation business.

Larry Greenberg - Langen McAlenney

Right.

Robert P. Restrepo Jr.

It’s with RTW. Rockhill had a solid underwriting profits for the year, their premium was less than we expected because of the soft market, but a solid underwriting profit. They continue to have very disciplined underwriting and they also benefitted, they have a small wind program in the Southeast and obviously the absence of hurricanes helped them as well, but very pleased with their underwriting margins.

Steven E. English

Larry, this is Steve. On the assets moving over, I think I would assume somewhere around a 3.5% plus or minus yield.

Larry Greenberg - Langen McAlenney

Great, thanks. And then secondly, can you give us an idea of how much additional expense is coming from the build out of RED right now in the underwriting line?

Robert P. Restrepo Jr.

It affected our expense ratio and a lot of it has do with the technology that's associated with building a 50-state platform and plus the District of Columbia to support that program business and the alternative risk of the business. And when you kind of look at their expenses, just looking at my numbers here, it's about point two to point three on our expense ratio.

Larry Greenberg - Langen McAlenney

Okay. Thank you.

Operator

(Operator Instructions). Caroline Steers, your line is open.

Caroline Steers - Macquarie

Hi, everyone. Just a couple of quick questions. The first one is just on auto BI frequency, it looks like that was a little bit higher in the quarter. And I'm just wondering, I'm sure that some of that is related to cat, but I was wondering what’s driving that and what state you sort of seeing the highest trends?

Robert P. Restrepo Jr.

The trends, I'll ask Matt Mrozek, our Corporate Actuarial to respond, but some of that, Caroline, is seasonal and we tend to have a lot of deer hits here in the midwest, particularly in October that in the fourth quarter, kind of effects there, frequency and severity of bodily injury. But Matt, any other observation?

Matthew S. Mrozek

In addition to those figures, which are on a calendar year basis of closed claims, we also look at and consider when we manage the book, the accident year figures and the accident year figures are bit more stable and BI frequency is lower on accident year basis and BI premium would be more in the range on 2% to 3% versus mid-teens based on the calendar year exhibit.

Caroline Steers - Macquarie

Okay, thanks. And then just wanted to know if you had any updates on any cat so far in the quarter? Are you seeing any increased claims activity, just the trends you're seeing so far?

Robert P. Restrepo Jr.

Nothing material and a lot of the activity that we've seen it’s weather-related is obviously in the Northeast. We've got a nice presence now in Connecticut, but it’s not significant enough for us to have anything material. And so far we're halfway through the quarter, it's pretty consistent with our average first quarter experience and the last year's first quarter in 2010 was an average first quarter for us, so the trend so far very much consistent with averages and with last year's first quarter.

Caroline Steers - Macquarie

Okay, great.

Robert P. Restrepo Jr.

But we also had a lot of snow.

Caroline Steers - Macquarie

Okay, great. Thanks.

Operator

Matt Rohrmann, your line is open.

Matthew Rohrmann - Keefe, Bruyette & Woods

Hay, Bob, Steve, how are you?

Robert P. Restrepo Jr.

Hi, Matt.

Matthew Rohrmann - Keefe, Bruyette & Woods

Just two quick questions. One, Steve, I guess with some of the tax changes and the losses, is a mid 20s number reasonable in 2011?

Steven E. English

I think what I would do, Matt, is use about a 20% effective rate on your investment income assumption and then use 35% on the balance.

Matthew Rohrmann - Keefe, Bruyette & Woods

Okay. And then just on the reporting changes, are we going to be able to get a look at that in the K or anything like before reporting next quarter?

Robert P. Restrepo Jr.

No, that will be first publicly available with the first quarter Q.

Matthew Rohrmann - Keefe, Bruyette & Woods

Okay.

Robert P. Restrepo Jr.

The K will remain with the existing disclosures.

Matthew Rohrmann - Keefe, Bruyette & Woods

Okay. All right, thanks, guys.

Robert P. Restrepo Jr.

Thank you.

Operator

Larry Greenberg, your line your line is open.

Larry Greenberg - Janney Capital Markets

Thanks. As we try to get some sense of the underlying trends in underwriting throughout the year, I know you don't give us deserved development on a quarterly basis, but I mean can you give us any color on that? I mean, was there more in latter half of the year? Did the fourth quarter get a disproportionate benefit from that?

Robert P. Restrepo Jr.

Again, I will ask Matt to respond, but as it with prior years, it's both fairly consistent because of our reserving practices and generally short-tailed business. It's pretty consistent on both an annual and on a quarterly basis, Matt?

Matthew S. Mrozek

And given the short-tailed nature, a lot of the reserves emergent haven’t fairly soon the year, but 2010 versus 2009 would be very consistent throughout the year and how that emerged.

Larry Greenberg - Janney Capital Markets

Great. Thank you.

Operator

And I am showing no further questions at this time.

Steven E. English

Okay, well, thank you, Holy. We want to thank all of you for participating in our conference call and for your continued interest and support to State Auto Financial Corporation. We look forward to speaking with you again on our first quarter earnings call, which is currently scheduled for May 3, 2011. Thank you and have a nice day.

Operator

Thank you. This does conclude the conference. You may disconnect at this time.

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