Kemper's (KMPR) CEO Joe Lacher on Q4 2015 Results - Earnings Call Transcript

| About: Kemper Corporation (KMPR)

Kemper Corporation (NYSE:KMPR)

Q4 2015 Earnings Conference Call

February 5, 2016 11:00 ET

Executives

Diana Hickert-Hill - Vice President, Investor Relations

Joe Lacher - President and Chief Executive Officer

Denise Lynch - Property & Casualty Group Executive

Frank Sodaro - Senior Vice President and Chief Financial Officer

John Boschelli - Senior Vice President and Chief Investment Officer

Analysts

Christine Worley - JMP Securities

Paul Newsome - Sandler O'Neill

Ron Bobman - Capital Returns

Brian Rohman - Boston Markets

Adam Klauber - William Blair

Operator

Good morning, ladies and gentlemen and welcome to Kemper’s Fourth Quarter 2015 Earnings Conference Call. My name is Abigail and I will be your coordinator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes.

I would now like to introduce your host for today’s conference, Ms. Diana Hickert-Hill, Vice President, Investor Relations and Corporate Identity. Ms. Hickert-Hill, you may begin.

Diana Hickert-Hill

Thank you, operator. Good morning, everyone and thank you for joining us. This morning, you will hear from three of our business executives, starting with Joe Lacher, Kemper’s President and Chief Executive Officer, followed by Denise Lynch, Kemper’s Property & Casualty Group Executive and Frank Sodaro, Kemper’s Senior Vice President and Chief Financial Officer.

We will make a few opening remarks to provide context around our fourth quarter results. We will then open up the call for a question-and-answer session. John Boschelli, Kemper’s Senior Vice President and Chief Investment Officer will join our presenters during the interactive portion of the call.

After the markets closed yesterday, we issued our press release and financial supplement. You can find these documents on the Investors section of our website, kemper.com. Please note that our discussion today may contain forward-looking statements. Our actual results may differ materially from these statements. For information on potential risks associated with relying on forward-looking statements, please refer to our Form 10-K and 10-Q reports filed with the SEC as well as our earnings release. We plan to file our 2015 Form 10-K on or about February 12.

This morning’s discussion includes non-GAAP financial measures that we believe are meaningful to investors. In our supplement and earnings release, we defined and reconciled non-GAAP financial measures to GAAP, where required in accordance with SEC rules. And finally, all comparative references will be to the fourth quarter of 2014, unless we state otherwise.

Now, I will turn the call over to Joe.

Joe Lacher

Thank you, Diana. Good morning, everyone and thank you for joining us today. Before I comment on our performance in the quarter and the year, I want to let you know how honored I am to be here leading Kemper. I also want to acknowledge the hard work and many contributions of my predecessor, Don Southwell. He assembled a talented team and has been instrumental in helping me come up to speed quickly on the many aspects of our diverse business.

Since joining Kemper just two months ago, I have been doing a deep dive on many fronts and I am learning a lot about our strengths, our opportunities and our challenges. Overall, I would say we are not happy with our financial performance in the past couple of years and it’s going to take a couple of years for us to get it fixed. While we do have areas that are going well, clearly, we have issues we need to address, including some that drove results this quarter. In the near-term, I am focused on the critical few points that need my immediate attention, while the team and I analyze our longer term needs and plans. I commit to give you a strategic update this summer and so we withhold strategy comments for now while that assessment is still underway.

Given that context, I will now shift to discussing our fourth quarter results and full year performance. In short, it was a disappointing quarter overall and we will detail the drivers for you. Underneath those issues, we did have some positives as well and we will explore those too. Nonstandard auto was our main problem area this quarter, especially the Alliance United business. This acquisition will not be accretive in its first full year. However, we do expect it will be in its second year. We think the issues in nonstandard auto overall and Alliance United specifically are fixable. We still feel good about the acquisition. We are seeing positives from the changes we made to our preferred auto book despite the headwinds and loss trends that the industry is experiencing, the fundamentals in our Life and Health segment are stable and once again, our investments portfolio performed well.

In total, Kemper’s net operating income in the quarter was $5 million, down $49.5 million – $49 million for the year, with $70 million down $27 million from last year. A significant driver was lower performance in the quarter from Alliance United. Other factors include increased catastrophe losses, higher underlying loss ratio in our P&C legacy lines, lower levels of favorable reserve development and an increase in life insurance expenses. Additionally, in the prior year, we received a large special dividend from one of our alternative investments.

Similar to other companies in the nonstandard auto industry, Alliance United’s loss trends were pressured in the quarter. It was not a good time to be growing the line so quickly given the uptick in frequency and severity. As you may surmise, this is a key area for my immediate focus. Denise will cover Alliance United in more detail when she discusses the P&C segment’s performance shortly. In total, Kemper’s revenues were up $57 million in the quarter and ended the year at more than $2.3 billion, up $144 million as the Alliance United acquisition contributed to the top line more than offsetting reductions in the legacy businesses.

Turning now to the Life and Health segment, the underlying results were stable. We earned $18 million in the quarter, down $16 million. You can see in our press release, we had two main drivers for the decline. The largest driver was related to the fourth quarter of 2014 when we benefited from a $14 million after-tax special dividend from the recovery of one investment in our alternative investments portfolio. The second driver was from an increase of $5 million after-tax for legal fees in our life insurance line. On a full year basis, we earned $72 million compared to $92 million last year. Excluding the impact of these two items, underlying earnings actually improved.

Life and Health revenues were $205 million in the quarter, down $18 million with $16 million of the decline driven by lower net investment income. On a full year basis, revenues were $811 million, down $21 million from 2014. These declines were driven by the 2014 special dividend I just mentioned. In the Kemper Home Service Companies business, premium revenue was nearly flat at $116 million in the quarter and expenses benefited from the field consolidation. In Reserve National, premiums remained stable despite the transition away from hospitalization products and toward life, home healthcare, critical illness and accident expense insurance.

I will turn now to investments. I am pleased to report our investment portfolio performance remains an area of strength for us. Excluding last year’s special dividend, our net investment income increased $8 million for the quarter and $15 million for the year. Our pre-tax equivalent yield is holding up well at 5.5% annualized for the quarter, slightly better than the full year. Our alternative investment portfolio, which primarily consists of LPs and LLCs, yielded 9% annualized for the quarter and 8% for the year. Total return was a positive 0.4% for the quarter and 2.2% for the year, primarily from net investment income offset by rising yields. We are very pleased with our alternative investments performance both for the quarter and year-to-date in light of the equity and high-yield market volatility.

Now I will turn the call over to Denise to discuss our Property & Casualty segment results.

Denise Lynch

Thank you, Joe. I will start with the segment overview in total and then go through the performance of each of our lines of business. The Property & Casualty segment lost $5 million in the fourth quarter down from income of $$25 million a year ago. The primary drivers for the decline were elevated loss trends and adverse development in the Alliance United business and to a lesser degree higher frequency in the legacy nonstandard auto book. I will discuss these in more detail shortly. Additionally we had a premium deficiency at Alliance United resulting in a partial write-off of deferred policy acquisition cost. For the full year, we earned $27 million, up from $25 million last year.

Our Property & Casualty revenues were $414 million in the quarter, up $97 million, driven by Alliance United, which more than offset a decline in our legacy lines. On a full year basis, revenues were $1.5 billion, up from $1.3 billion in 2014, primarily from having the 8 months of revenues this year from Alliance United. Our policies in force increased sequentially ending the year at $1.2 million, up from $823,000 last year, getting a lift from our acquisition. Net earned premiums were $392 million in the quarter, up $92 million. Excluding Alliance United, premium retention improved two percentage points and new policies in force were up 15%, yet legacy earned premiums were $281 million, down $19 million. For the full year segment that earned premiums were $1.4 billion, up $166 million versus 2014. The impact of Alliance United makes the year-over-year comparisons difficult as Alliance United runs at a higher underlying loss and LAE ratio, but a lower expense ratio than our legacy business. I will provide more detail on profitability by line of business. On expenses, we had a $9 million charge to write-down a portion of Alliance United’s deferred policy acquisition costs. The legacy P&C expense ratio was up about 0.5 point in the quarter.

Now I will provide a fourth quarter update on each of our lines of business. I will start with the nonstandard personal auto line. In the quarter, net premiums were $186 million, an increase of $117 million. Net earned premiums were $188 million, an increase of $113 million. While Alliance United drove the majority of the increase, the legacy nonstandard auto net premium written – net premium written were up 5% and marked the fourth straight quarter of period-over-period increase. The total loss and LAE ratio was 95.6%, with the underlying loss and LAE ratio at 92.7%. I will address the underlying performance at Alliance United separately from the legacy nonstandard book.

The Alliance United loss and LAE ratio of 105% includes an underlying loss and LAE ratio of 100.9%, and 4.1 points from adverse pre-acquisition loss reserve development. Additionally, we saw significant current year adverse development that increased the fourth quarter underlying loss and LAE ratio by 6.7 percentage points. Obviously, this was a very disappointing performance. The drivers of the underlying performance include; one, broadly the industry saw loss trends nearly double in California over the last year for the mid-teens. Frequency and severity and bodily injury and property damage liability were the drivers as well as collision severity. Alliance United was subject to the same environmental factors that impacted the industry such as increased miles driven and more expensive repair costs. Two, Alliance United’s claims department was somewhat understaffed at acquisition. The staffing gap grew with the increased frequency trends, increased new business and some disruption to hiring during the integration. And three, we filed the class plan change and rate increase for our products representing about half of the business mid-year. This approval process is taking longer than typically expected.

In response to these developments, we have implemented a few very important operational actions. First, we continue to work with the Department of Insurance on this filing and are accelerating the filing to increase rates on the remaining business. Second, we hired and onboard a significant a number of new claim professionals in 2015 and expect to add more over this year to address the claim staffing issue. Third, we have taken actions to improve risk selection, price adequacy and agency management. Collectively, these are now slowing new sales to more desired levels. While Alliance United is not meeting our expectations, the long-term strategic value of this business remains compelling. We do expect the acquisition to be accretive in its second year. However, it will take a few years before this business will meet our profit objectives.

Now, turning to our legacy nonstandard auto book, this business did not meet our target profitability last year. We, along with the industry, saw elevated loss trends over the course of 2015. Year-over-year profitability deteriorated every quarter and that trend continued in the fourth quarter. We are in the process of rolling out a new product and rating plan. It’s currently being used on about 45% of our book. Over the course of 2015, we increased our filed rate levels to about 10 points. These efforts have yet to yield a significant impact on results.

In the quarter, we completed an overall review of our legacy nonstandard business and identified a number of initiatives to improve profitability. We are in the process of executing those initiatives and we are going to reopen and expand the scope and urgency of that review to include every function and operating lever to drive improved financial performance in this business. We are planning to file rate increases of nearly 7 points with the majority in the first half of the year of our entire legacy book. Unfortunately, given the current results and the current industry loss trends, it will take some time before we achieve acceptable returns.

In commercial auto, net premiums written were flat at $12 million in the quarter and down 3% at $54 million for the year. Earned premiums were stable in the quarter and for 2015 at $14 million and $55 million respectively. For the quarter, the loss and LAE ratio deteriorated to 92% driven by $1 million of adverse development and a 9.7% increase in the underlying loss and LAE ratio due to increased frequency and severity. We continue various agency management underwriting and rate actions.

Moving to preferred auto, net premiums written were $102 million in the quarter, down $8 million and were $435 million for the year, down $52 million from 2014. Net earned premiums were $109 million in the quarter, down $14 million and were $450 million for the year, down $76 million. New business written premiums grew by 8.5% as new policies in force increased for the sixth consecutive quarter to the highest level since the third quarter of 2013. Premium retention at 84% improved both year-over-year and sequentially. The loss in LAE ratio was 75.7%, up 6.6 points primarily from lower levels of favorable prior year development. The underlying loss and LAE ratio increased to 76.2% for the quarter.

When you look at quarterly results, there are periodic changes that occurred from prior periods within the year. When we remove the current year development, we are seeing a modest improvement in the quarterly underlying loss and LAE ratio. Over the past several years, we have executed a number of profit improvement actions, which have been resulting in steady improvement in profitability. The underlying loss in LAE ratio was 70.9% for the year and improved about 1 point. We still have a ways to go to continue to make progress.

Now, turning to the homeowners’ line, net premiums written in the quarter were $64 million, down $3 million and totaled $276 million in the year, down 7%. Net earned premiums were $70 million in the quarter, a $6 million decrease. For the full year, net earned premiums totaled $286 million, an 8% decrease from last year. New business production grew 9% from last year. Premium retention improved 4 points to 84% and was up sequentially for the fourth straight quarter.

Catastrophes in the homeowners’ line finished at 18% of earned premiums in the quarter, up 13 points from last year and above our expectations. The quarter had been relatively mild until the last week of the year when tornado struck in North Texas. The loss in LAE ratio was 61.6% as the underlying loss in LAE ratio increased 4.9 points to 46.4%, primarily from increased severity from large fire losses. Average earned premium decreased slightly as mix changes offset 4% filed rate increases.

So, looking at the Property & Casualty segment in total, it was obviously a disappointing quarter. While the Alliance United acquisition failed to meet expectations, the long-term strategic value of the business remains compelling. However, it will take a few years before this business will meet our profit objectives. Our legacy nonstandard auto business continues to under-perform against the backdrop of deteriorating industry loss trends. And so we are going to take a fresh look with an increased sense of urgency to significantly change the trajectory of this business. Efforts to stabilize preferred auto and home premiums show continued progress and we expect this progress to continue.

Now, I will turn the call over to Frank.

Frank Sodaro

Thanks Denise and good morning everyone. Today, I will cover Kemper’s consolidated performance, capital and parent company liquidity. For the fourth quarter, net income and net operating income were both $5 million or $0.09 per share compared to net income last year of $65 million or $1.24 per share and net operating income last year of $54 million or $1.02. For the year, our net income was $86 million or $1.65 per share compared to $115 million or $2.12. Net operating income was $70 million or $1.35 compared to $97 million or $1.79 per share last year. For the full year results for 2015, both net income and net operating income included a software write-off of $7 million after tax or $0.14 per share. Similarly, the prior year’s results included a software write-off of $35 million after tax or $0.66 per share.

Total revenues were $617 million for the quarter, an increase of $57 million or 10%, as roughly $110 million of earned premiums from the Alliance United acquisition were partially offset by lower earned premiums from our legacy P&C. On a full year basis, our total revenues increased 7% to more than $2.3 billion, driven by lower – driven by over $270 million of earned premiums from Alliance United, offset by lower earned premiums from our legacy P&C business. Earned premiums in the Life & Health segment decreased about $20 million, primarily from lower life insurance premiums which included an $8 million deferred premium adjustment in the first quarter of 2015.

Net investment income decreased $14 million for the quarter and $7 million for the year due to $22 million special dividend we received in 2014. Excluding the special dividend, both the quarter and year increased from higher returns on our equity method investments, while the year was also driven by higher yields on fixed maturities. The investment portfolio in total generated a pretax equivalent annualized book yield of 5.5% for the fourth quarter of 2015 and 5.3% for the year compared to 6.5% and 5.5% for the quarter and year in 2014.

The Property & Casualty segment reported net operating loss of $5 million for the quarter compared to net income of $25 million last year. This decline was due to Alliance United’s results, which included adverse development and the resulting DPAC write-off as well as poor results from our legacy P&C book. For the year, the Property & Casualty segment reported net operating income of $27 million compared to $25 million in 2014. Given Alliance United’s fourth quarter, results did not meet our expectations and were a drag on the full year. Net operating income for the Life & Health segment was $18 million for the quarter compared to $34 million last year and $72 million for the year compared to $92 million last year. Last year, the Life & Health segment’s net operating income benefited $14 million from the special dividend it received in the fourth quarter. Excluding that dividend, net operating income decreased for the current quarter and year by $2 million and $6 million, respectively due to higher legal expense and a deferred premium adjustment booked in the first quarter of 2015, offset by higher investment income.

Net operating loss from corporate and other increased $3 million and $9 million for the quarter and year, respectively. Primarily from higher pension costs driven by assumption changes at the end of 2014 and lower net investment income. Looking ahead to 2016 pension expense, we increased our discount rate by about 40 basis points and adopted the most recently published mortality tables at the end of 2015. Additionally, we are reducing our expected long-term returns on pension investments and adopting the field – the full yield curve approach for estimating interest and service cost. As a result of these assumption changes, we expect our pension expense to decrease about $11 million after-tax for 2016. To put that in perspective, pension expense increased by about that same amount in 2015 compared to 2014 largely due to the adverse effects of assumption changes.

I will now cover book value, capital and parent company liquidity. Book value per share was $38.82 at the end of the year, down 3% from last year largely from the impact of higher market yields on our fixed maturity portfolio and dividends paid partially offset by net operating income. Book value per share excluding unrealized gains on fixed maturities was $35.13, up 2% from the prior year primarily from net operating income partially offset by dividends.

Statutory surplus levels in our insurance companies remain strong and we estimate that we ended the year with the risk-based capital ratios of approximately 390% for our Life & Health group and 325% for our legacy Property & Casualty group. We estimate that our insurance companies will have a maximum ordinary dividend capacity in excess of $170 million in 2016. During 2015, we repurchased more than 1.2 million shares of common stock for a total cost of $44 million or $35.57 per share. In total, we returned $93 million of capital to shareholders. We estimate that we ended the year with more than $225 million of excess capital. And from a liquidity perspective, the parent company held cash and investments of about $340 million, while our $225 million revolver remained undrawn.

I will now turn the call back over to Joe.

Joe Lacher

Thanks, Frank. Capital allocation is a key part of the overall business assessment process that I have been conducting. As I look at the sources and uses of capital, I am mindful to address both our short-term needs and long-term return objectives. We work for our shareholders to expect and deserve production of attractive returns. The good news is that our current capital position is strong. Historically, we have described our strategic capital allocation priorities as funding growth for new business that delivers appropriate returns, acquisitions that are accretive to our business and returning capital to shareholders through dividends and share repurchases. We will share with you more about our capital allocation priorities during our strategic update in the summer and my commitment to you is that we will be prudent stewards of your capital.

Now, I will turn the call over to the operator to take questions. Operator?

Question-and-Answer Session

Operator

Thank you. [Operator Instructions] Our first question comes from the line of Christine Worley with JMP Securities. Your line is open.

Christine Worley

Thank you very much. Couple of questions on United Alliance and the nonstandard book legacy, can you sort of give us an idea over the past year how much of the growth in those separate pieces has come from rate and then how much has been just growth of expansion?

Denise Lynch

Sure, Christine. I will take that question. The majority of the growth at Alliance United this year has come from a new policy growth. Although there is some additional rate flowing into the book from primarily mix shift changes that we are experiencing in that book, but the majority of that growth is in fact coming from policy in force growth.

Christine Worley

Can you quantify what the rate increases you have achieved on that book have been?

Denise Lynch

The average written premium is up mid single-digits on an exposure basis.

Christine Worley

Okay. And then same question for the legacy book, I mean, are you getting any growth there outside of rate?

Denise Lynch

In the legacy business, our legacy nonstandard business, our policies in force are actually down. So, we are not adding policies to our portfolio at this time. And what we are seeing is rate coming through from our actions in the book.

Christine Worley

Okay. And I mean from an actuarial perspective, how – I mean, I know you have filed the 7%, how much additional rate do you think you need to sort of get in line with what you are seeing from a loss cost perspective?

Denise Lynch

There is ways to go on this book of business. As I said, this is going to take a few years to get this book. You are talking about Alliance United turned around. And we will take the rate that we need on our portfolio as we work with the Department of Insurance on the product that we have got filed right now. We will continue to take the additional rate on the rest of the book. And then we will continue to take other underwriting agency management risk selection issues to be able to improve our price adequacy and our overall risk selection and above. But it will take a period of time to get it to our target turns.

Joe Lacher

And Christine this is Joe, I will just add on top of that. I mean obviously we are dealing with California, which is a more challenging environment to get rate. So we will have to – we won’t rely solely on the rate lever to respond and as Denise was saying, we will be more aggressive with all of the tools at our disposal.

Christine Worley

Okay. And what’s your average policy length on the United Alliance book?

Denise Lynch

The vast, vast majority is well under 12 months.

Christine Worley

Okay, well under some more in that three to six months range then, is that fair to say?

Denise Lynch

Yes, under six months.

Christine Worley

Okay, under six months, great. And then just sort of one last question, I mean how should we think about sort of the moving pieces from a combined ratio standpoint, I mean if we look at the addition of people on the claims side, how quickly do you expect the losses to come down due to that sort of offsetting what additional expense spend you may have there?

Denise Lynch

So let me see – let me see if I can answer the question around Alliance United and the combined ratio there. What we are seeing is a significant deterioration in industry loss trends and those same deterioration in industry loss trends affected Alliance United. We saw that come through in our prior year development and in our current year development. We are addressing that with rate and underwriting and other actions, but it is going to take a period of time to restore that book of business to our profit objectives. The key issue on this book of business, really is the loss trend, recognizing the loss trend and then acting upon it. With respect to the claims, we are already working on the claims to address that staffing issue. We have added several claim professionals throughout the year and we will continue to do so to address the staffing need that we have.

Joe Lacher

If your question, Christine was narrow – Denise is trying to answer the full impact on the combined ratio. If it’s really a narrow question on, are we going to drive up LAE by adding claims adjusters before they have an ability to impact loss costs, on that one in particular trade, we are very confident that adding the adjusters will more than pay for itself in loss cost management.

Christine Worley

Okay, great. Thank you very much for the answers.

Operator

Thank you. Our next question comes from the line of Paul Newsome with Sandler O'Neill. Your line is open.

Paul Newsome

Good morning and thank you for the call. I have a broad question and then a couple of narrow ones. Broadly, we are referencing a lot of trying to get profitability up to our targets, but we have a bit of a change in management, what are those targets now?

Joe Lacher

Paul, I am going to defer giving you a real specific answer on that one. What I want to do is to spend a little more time digging into all of our businesses and really get a sense of where we want to take all of them broadly. It’s a fairly easy statement when you look at our nonstandard businesses, our legacy and Alliance United to say that they are not close to a reasonable target. We need to provide very reasonable returns for our shareholders on a consistent going forward basis and do it by delivering consistent and replicable competitive advantages in the marketplace. And particularly in these two businesses we are not delivering that right now. So at a minimum, we have got to be in the double-digit ROE range. But we will give you a more specific answer by the summer as we dig more into these businesses.

Paul Newsome

That’s fair. Specific question, the $5 million in after tax legal fees on the life side, is that related to the lawsuit with the Illinois Treasury and should we end – should we expect that those be at least in the near-term recurring type costs?

Joe Lacher

The $5 million is related to our unclaimed property litigation and issues on a number of fronts. We will continue to pursue our legal options in that arena, hopefully until we have an appropriate conclusion. I don’t anticipate you will see charges of that size on a regular basis, but it would be somewhat surprising to me if this ends quickly. Our hope is that this is an adequate view of what should be – which would cover the issues we know that are out there over a reasonable period of time, but things may change on that. So, the crisp answer is you shouldn’t expect this kind of number every quarter.

Paul Newsome

Okay, thank you. Back to the Property & Casualty business, when you filed the rate plan, could you talk about the timing of when you filed the class plan for United Alliance and then sort of what’s the – how long it took and then if there is any way to think about how quickly you can go through, but I realize it’s California and that’s a hard question to ask, but anymore details about sort of when it was originally filed and kind of how long it lasted and moving great?

Denise Lynch

Okay, Paul. For Alliance United, we filed a new class plan with a rate increase in the summer of this year and we have been working back and forth with the department to get that filing approved and we are still working with the department to get that filing approved. We expect to, very soon after, file another rate increase on the remaining product in the Alliance United portfolio.

Paul Newsome

Great, thank you very much.

Operator

Thank you. Our next question comes from the line of Ron Bobman with Capital Returns. Your line is open.

Ron Bobman

Hi, good morning. I have a couple of questions. I guess you already focused on Alliance United. What – could you describe the, I assume, sort of following, Joe, your arrival. What sort of claims review has been done on both case and IB&R levels whether you engaged any outside providers or whether you relied upon solely in-house staff? For starters, could you describe that?

Joe Lacher

Sure, sure. What we have done in – I will comment again, as you requested largely during my tenure. We have dug into case reserves, how those were put up, how the process is managed. We have done that ourselves. We had our outside auditors doing it and we had at least one, maybe two third-party groups depending on how you think of the review, going through and take the detailed reviews for us on those case reserves and claim practices, their claim practices – AU’s claim practices compared to ours, compared to the industry. So, we have taken a broad and deep review of all of those elements. And all of those are informing both the numbers that we have booked this quarter and the actions that we are currently executing.

Ron Bobman

Do you consider – I understand you can’t get more information and to the continued passenger time. But do you consider sort of the headquarters review this work that you have done is still complete or is there still broader, additional case files to be looked at, broader production areas to look at? In essence, sort is your claims audit, your reserve audit on this acquired enterprise and the book they are producing for you today and that you inherited. Is it complete or is it fair to say that there is really some more work to be done?

Joe Lacher

Ron, while there is always the potential for something else to be found. I would say this is a largely complete review. We have been very deep and thorough. This is a book that turns over at a relatively short tenure. We have been looking at the data since we have been owners for more than 8 months. We have been deep inside of those items. There were a number of issues that made it somewhat challenging to read when we first acquired it. Alliance United, as companies do from time to time, had undergone a claim process where they were closing some claim files near the back end of last year and the early part of this year in a different way than they had in the past. That causes data to be a little more challenging to read, I think it was challenging for the folks that were booking their numbers. It was certainly a challenge for us reviewing that information in the first 90 days that we had the book. We have cleared all of the clutter out of that and understand how that impacts the numbers and have a clear view on it. Again, our outside auditors and the outside expert, we had to look at it have all been through it, understand it. And when you get a dozen actuaries, you get 15 opinions. But even with them as a group, they are largely honed down a consistent view of this and believe we have got a thorough view and a thorough understanding and have taken the appropriate action based on that.

Ron Bobman

Thanks. I assume that all claims are handled in-house, if they don’t and Kemper doesn’t rely upon third parties?

Denise Lynch

We do periodically use independent adjusters or appraisers and TPAs are parts of the item. We don’t have to scale that we want in all spots. So, it’s largely in a case where we don’t have the geographic presence or the geographic spread. It’s not a case where we are wholesale, taking a state or taking a whole section of the state. It’s more covering the edges. And we typically drive that only on the simplest claims. Anything that’s got, which you might describe a hair on it, regardless of where it is, we pull those in. And the group has a much tighter, narrower authority. You can almost think of it as a minor use of supplemental staffing rather than a broad outsourcing.

Ron Bobman

Okay. In the same area and I know nonstandard retention levels are much, much lower than standard lines and – but I am curious about sort of – what I would like to understand is, so rate isn’t where you wanted to be where it needs to be. It sounds like it’s materially lower and it’s going to take a couple of renewals and firstly an approval by the state to get rate on this book where it needs to be. What – so are retention levels higher than they might otherwise be desirable, I mean you sort of – are we continuing to write business that effectively is under-priced to get efficient margin or is that not the case?

Denise Lynch

Ron, are you asking about Alliance United or...?

Ron Bobman

Yes, Alliance United. Sorry.

Denise Lynch

Alliance United’s retention persistency is actually pretty consistent over time. And so with, really with the policies being six months and under policies, we have the opportunity to get the rate into the book for new business as we write it and then the renewals as we renew them. So we have that opportunity and yes, as soon as we get that rate filing approved.

Ron Bobman

And then my last question, thanks for your patience, because I know it’s been a few. You said that you expect Alliance United to be accretive calendar ‘16. I assume that’s sort of on a total income basis, the investment income off of the cash flow and underwriting income, but can you give us a statement on what you think the combined is actually going to be for calendar ‘16 where you hope it to be?

Joe Lacher

Well, let me adjust first a little bit on your question. What we said and I am not trying to parse words, but make sure we understand it. What we said is it was not going to be accretive in its first full year of ownership, which is not a calendar year of ownership, so right from acquisition. And we believe it would be accretive in the second year. So that’s a little bit of a time spread there. We don’t typically do forward-looking views of combined ratios, so I am going to defer for giving you that much detail. We do recognize for this book that they are largely six-month policies that we do have a number of levers that we can pull, that we have not been pulling as hard as they can be pulled and we will actively engage in those. And the analysis to the other part of your question on how we are defining accretive, we are looking at it on an independent basis to say what did it add to the organization by being here. So that takes into account all of the different components of that, investment income, the fact that we as we do that analysis, if we hadn’t bought the business, we wouldn’t have made the $70 million ish payment, we would have those dollars in-house. So it’s a view of with and without.

Ron Bobman

Okay. Thanks for the help. I appreciate your complete answers.

Operator

Thank you. [Operator Instructions] Our next question comes from the line of Brian Rohman with Boston Markets. Your line is open.

Brian Rohman

Good morning. Thanks for taking the question. A bunch of questions, you talked about doing comprehensive claims review for Alliance United, are you doing that for the other Property & Casualty lines?

Joe Lacher

We have expanded that review for all of our nonstandard where it’s the principal issue. It does run across new similar claim resources. So, we are looking and exploring that. We haven’t made a call on whether we do it on our preferred area. What I tell you is a lot of what we are learning out of those two nonstandard reviews will lift and update where appropriate and use it across.

Brian Rohman

I am sorry, two nonstandard reviews?

Joe Lacher

Alliance United and then our legacy nonstandard business.

Brian Rohman

Got it. Okay. So...

Joe Lacher

There is some element, Brian, that those needed to be fully insightful to look at them differently, because we start with what was Alliance United doing before the acquisition, what were we doing as we integrated it and then what was our legacy nonstandard business doing. So you could think of it is one with three parts, you could think of it as a couple. I am trying to be fulsome in the answer.

Brian Rohman

And I am interested – Alliance United as well as the other nonstandard businesses. I mean, you bought Alliance United you closed on April 30 of last year. So between April 30 and basically the beginning of first quarter – pardon, fourth quarter of fiscal ‘15, October 1, you saw a need for rate increase, you saw a need for comprehensive review. Is there something that changed precipitously during that, what’s that about, a 6-month period or is it just things that have been mounting for a while?

Joe Lacher

There were a handful of issues, Brian that sort of hit simultaneously. The loss trend in the nonstandard business in general had been relatively benign across the industry for a number of years. It has spiked during the time period you described and California has spiked more significantly. That spike probably started just before the business was acquired. So, you get that as an environmental factor. Alliance United has had a long history of significant growth and it would have been our expectation that, that would have generally continued. So, it did going into the wrong time to be growing with that loss trend. Given their growth, they have been, for some period of time, somewhat behind on claim staffing. And we are at acquisition that was known to us earlier and they were sort of constantly running to hire folks as fast as they could to keep up with their growth. We probably got a little delayed in that claims staffing on integration. And so we are behind on that staffing level, so have been aggressively working to catch that up, which is not ideal from a timing perspective as well.

They had made those claim actions where they were altered their behavior on some claim closing items near the end of last year and the early part of this year, which made the data that we look at to determine loss trends and determine where we are harder to read. It was hard for us to read. It was hard for our outside expert to read. It was hard for our outside auditor to read. Everybody had the same challenge. It wasn’t a brain cramp on our side of having a problem reading it. All of those things were simultaneous. And then the normal ordinary course rate process that they would have gone through, they probably were a little delayed from what they normally would have been. My guess is with a relatively small set of staffing, their side was distracted and we are a little behind on that because they were dealing with an acquisition. So, we diligently moved on that after closing, got it filed and it’s gotten hung up in the department longer than any of us would have expected. So, there is a lot of things that happened simultaneously. We wouldn’t describe those as excuses, but it’s an explanation. All of them happening at the same time with that industry rising loss trend made it hard to see the pace that this was deteriorating and that’s what’s I think driving the issues and where we are now.

Brian Rohman

Whoever you bought Alliance United from, is there any sort of earn-out?

Joe Lacher

There is. There is a couple of indemnification provision guidance, frankly, want to help describe what the numbers are in that, because I will get them off.

Frank Sodaro

Yes. From a holdback perspective, there was a $12.5 million holdback, there was a general indemnification bucket and then a $5 million holdback that was related to some legal matters.

Brian Rohman

And have those been paid or are they still being held back?

Frank Sodaro

They are still being held back at this point.

Brian Rohman

And what’s the trigger that says that – I guess, firstly...

Joe Lacher

The first part of it Brian, I think I know where you are going with the question. The first part of it, the $12.5 million will not be paid out based on where the results have been. And I am fairly certain that the $5 million for legal expense accrual, there will be some piece of that or all of that which will not be paid out as well.

Brian Rohman

And what will that do, lower your cost basis, how does that work or is that just a cost that you will not incur in the future?

Joe Lacher

Well, the amount that we paid or we publish that we paid for this was the $71 million in that range. That included this holdback. So effectively, that amount would be reduced by whatever ultimately comes back to us.

Brian Rohman

And the stockholders, how do we get that back, that will be through what, some sort of reversal or of the purchase price?

Joe Lacher

Are you asking how it runs through the financial statements or the economics?

Brian Rohman

Yes. A little of both, but both the financial statements as this doesn’t happen but this doesn’t happen very often?

Frank Sodaro

So the holdback is effectively already booked as a receivable. I mean, that’s what’s happened as the development and these other things that have led to filling up that bucket. So from a financial statement perspective, it’s essentially booked.

Joe Lacher

As we book some of the incremental charges, we booked and offset from the income statement for a receivable. So it was – as it was being used, it was a buffer to the results.

Brian Rohman

Okay. Is Alliance United a standalone company from a A.M. Best standpoint?

Joe Lacher

It is. It’s a standalone company. We did not bring it into our pool. It’s a nonstandard company and writes on a more leverage business than the rest of our pool, so we have it separate.

Brian Rohman

And do you think it will need a capital injection at this point or is that – obviously, that is to be determined, but is it something you can see them needing at some point?

Joe Lacher

Yes. Brian, we do anticipate with the fourth quarter results that it will need a capital contribution. We are waiting on finalizing stat, because that’s really what will drive it.

Brian Rohman

Okay. Joe just I want to get back something you said earlier, you don’t project returns – do projections, but you talked about expecting double-digit returns on equity, when you review or go over your strategic plan with investors as you said this summer, are you going to try and provide some sort of pathway to some higher level of return on equity?

Joe Lacher

I am trying to see if I am understanding your question and making sure I am answering it correctly. We will – we have to from a reasonable perspective, to deal with investors, tell you what we think our strategy is and what kind of reasonable returns we are going to get. And it will not be a pie-in-the-sky hope strategy. We will have a point of view about how we are going to operate and how we are going to get there.

Brian Rohman

Okay. And right now, you have plenty of capital, right?

Joe Lacher

Correct. That is one of the things we feel particularly good about.

Brian Rohman

Alright. Those are my questions for now. Thank you very much.

Operator

Thank you. Our next question comes from the line of Adam Klauber with William Blair. Your line is open.

Adam Klauber

Good morning everyone. Thanks. A lot of discussion on Alliance and nonstandard, but I also noticed that the loss ratio and the preferred book also jumped a lot during the quarter, I guess a couple of questions there. One is that, is that a bit of an accident year catch-up, because it moved from 68 to 76, so a big jump. And two, could you talk about the trends that necessitated higher loss ratio on the preferred side?

Denise Lynch

Sure, Adam. So with the preferred auto, there really are a couple of things going on here in the preferred auto in the fourth quarter. First of all, we have seasonality in our loss cost and the preferred book of business and we have that in the fourth quarter. It’s always our hottest and in fact continues to be our hottest in 2015. So that is really just a seasonality in our book of business. I think the second thing going on here it has to do with prior development. So if we strip away the prior development from current year and prior year, what we actually find is that the underlying performance of this book of business continued to improve in the fourth quarter. So we actually are continuing to make progress in the underlying when you strip away those pieces of information.

Adam Klauber

Okay. So as we think about that book of business, are you still, I guess pushing for more rate next year and at what point do you think that will start showing unit or PIF growth?

Denise Lynch

Yes. So while we like the progress we have been making now for around – for many quarters, it’s still not sufficient to get us to where we need to be. So we have more work to do to improve this portfolio. And it does mean increasing rates in the next year. We are looking at mid single-digit rate increases next year across our portfolio. So that and continued efforts around improved segmentation and underwriting actions to drive continued progress on that line.

Adam Klauber

Okay. Thank you. And then one question on the equity method investments, with market stress, can we expect lower income out of the portfolio?

Joe Lacher

We had a background noise on our line, can you just repeat that one more time Adam. I am sorry.

Adam Klauber

Sure. Yes. On the equity method investments with having some stress in overall financial markets, does that suggest a tougher outlook for that portfolio?

John Boschelli

This is John speaking. From the equity method, most of those assets or most of those investments are debt related. So the underlying investments are in debt related instruments. So I can’t always go back to general economic trends. So if we have a recession, those will probably be hurt, but if it can you just move along like we are right now, we hope it continues to perform like it has.

Adam Klauber

Okay, thanks a lot.

Operator

Thank you. And we have time for one final question. And our question comes from the line of Ron Bobman with Capital Returns. Your line is open.

Ron Bobman

My questions were asked by others. Thanks.

Operator

Thank you. And I am showing no further questions. I would like to turn the call back to management for closing remarks.

Joe Lacher

Thank you, operator. And thank you for all of you for joining the call today and your interesting questions. I would like to leave you with just a couple of final thoughts. We do know this was a disappointing quarter and we have had some tough financial results for the last couple of years. But I don’t believe that these results define our franchise or our potential. We have a strong brand. We have got a strong balance sheet with a strong capital position and a talented and committed team. We are fully engaged and committed to you to let you know that we are going to work tirelessly to address our near-term issues and to deliver a focused strategy, one that delivers attractive financial returns to our shareholders, serves our customers and agents well. I appreciate your patience as we evaluate every aspect of our business to refine our plans. Our team is energized as we move to keep – to help Kemper realize our full potential. And I look forward to updating you in future calls. Thank you for your time this morning and for your interest.

Operator

Ladies and gentlemen, thank you for participating in today’s conference. This does conclude the program. You may all disconnect. Everyone have a great day.

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