EMC Insurance Group's (EMCI) CEO Bruce Kelley on Q2 2016 Results - Earnings Call Transcript

| About: EMC Insurance (EMCI)

EMC Insurance Group Inc. (NASDAQ:EMCI)

Q2 2016 Earnings Conference Call

August 9, 2016 12:00 ET

Executives

Steve Walsh - Director, IR

Bruce Kelley - President & CEO

Kevin Hovick - EVP & COO

Scott Jean - EVP, Finance & Analytics

Mark Reese - SVP & CFO

Analysts

Paul Newsome - Sandler O'Neill

Operator

Good afternoon, and welcome to EMC Insurance Group's 2016 Second Quarter Results Conference Call. [Operator Instructions]. I would now like to turn this conference over to Steve Walsh, Director of Investor Relations. Please go ahead.

Steve Walsh

Thank you, Nicole. Good afternoon, everyone and welcome to EMC Insurance Group's 2016 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 archived webcast will be available for approximately 90 days following the earnings call. The transcript of the webcast will be available for one year.

This presentation includes some forward-looking statements about our expectations for future performance. Actual results could differ materially from those suggested by our comments today. Additional information about factors that could affect future 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 2016 second quarter earnings release with accompanying financial tables issued earlier today. Certain non-GAAP terms may be used during today's discussion. Please refer to the company's press release and SEC filings for a description and reconciliation of these terms.

Speaking today will be Bruce Kelley, President and Chief Executive Officer; Scott Jean, Executive Vice President for Finance and Analytics; Kevin Hovick, Executive Vice President and Chief Operating Officer; and Mark Reese, Senior Vice President and Chief Financial Officer. They will be available to answer questions following the prepared remarks.

At this time, my pleasure to introduce the company's President and CEO, Bruce Kelley.

Bruce Kelley

Thank you Steve and welcome to those joining us today. Earlier today we reported net income of $0.29 per share and operating income of $0.24 per share compared to net income of $0.42 per share and operating income of $0.32 per share in the second quarter of 2015.

Net income was impacted by deterioration in our underwriting results in both segments and by decline in realized investment gains partially offset by an increase in investment income. Underwriting results in the property and casualty insurance segment were impacted by the cost of the new inter-company reinsurance program as well as increase in large losses which are losses greater than $500,000 for EMC Insurance Company's pool excluding catastrophe in the storm losses. Underwriting profit in the reinsurance segment declined primarily due to a significant increase in catastrophe and storm losses stemming from the Alberta wildfire especially when compared to the relatively low level of catastrophe and storm losses reported in the second quarter of 2015.

The GAAP combined ratio for the quarter was 103.4% up from 101.1% in the prior year quarter. Book value rose to $26.81 per share representing an increase of 1.9% for the second quarter and 6.1% for the first half of the year. Driven primarily by an increase in unrealized gains on the investment portfolio and net income. Book value excluding accumulated other comprehensive income increased to $23.08 per share from $22.45 per share at year end.

Premiums earned increased 1.3% for the second quarter. in the property and casualty insurance segment, premiums earned increased 0.5% after the session of $3.2 million of premium to employer's mutual for the cost of the new aggregate catastrophe excess of loss reinsurance program. Excluding this cost premiums earned would have increased 3.3%. The majority of this increase is attributed to growth in insured exposures, small rate level increases in commercial lines renew business and an increase in both commercial and personal line new business.

Very little has changed in the marketplace since the first quarter. Renewal rate level increases remain in the low single digits as there is heightened competition for quality accounts with good loss experience and our retention levels remain strong at 86.6%. In the reinsurance segment premiums earned increased 4% while premiums written declined 3%. Now this disparity reflects changes made to the structure of the excess of the loss reinsurance program with the Employers Mutual for calendar year 2016.

In 2016 the reinsurance segment is paying a premium to employer's mutual for the excess of loss reinsurance protection and is also purchasing industry loss warranties ILWs from external parties to provide increased protection in peak exposure territories. In 2015 the reinsurance segment paid a larger premium to Employers Mutual 8% of total assumed reinsurance premiums. Because it included the cost of ILWs purchased by Employers Mutual for its benefits.

During the second quarter the reinsurance segment purchased $4.5 million of ILWs which was recorded to see the premiums written and generated the decline in premiums written reported for the quarter. However, only $915,000 of seeded premiums earned were recognized on the ILWs during the quarter which contributed to the increase in premiums earned reported for the quarter. Now, before I conclude my remarks I would like to take this opportunity to thank Ron Hallenbeck who has served as president of EMC Reinsurance Company for nearly 22 years and will be retiring on August 19 after over 42 years with EMC.

When Ron took over as president of EMC-RE in 1944, it was a much different company than it is today. Its business was concentrated in domestic property lines as a way to help diversify the predominantly casualty booking a business in our property and casualty insurance segment. EMC-RE was rated B+ by A.M. Best Company with premiums earned of only $37 million and approximately $25 million in statutory surplus.

Now the reinsurance industry was still recovering from hurricane Andrew which at the time was the costliest US Atlantic hurricane in the history. It decimated the reinsurance industry and forced many reinsurance companies to close their doors. Today EMC-RE has sought more casualty and some international opportunities providing better diversification.

During his tenure, Ron was able to stabilize and grow the business into an A rated company that boasts of a statutory surplus of over $190 million and has reported an average combined ratio of approximately 94% over the last 10 years. Thank you Ron Hallenbeck. Vicki Freese, Assistant Reinsurance Manager will assume the position of EMC Reinsurance Company upon Ron's retirement.

Vicki has worked in the reinsurance department for nearly 30 years and has significant reinsurance underwriting expertise on domestic and international reinsurance programs and on all lines of business. Vicki is well known to our brokers and seeding companies with which she enjoys long standing relationships. While Ron's leadership and expertise will be missed, I am certain this will be a seamless transition and we will continue EMCs tradition of superior customer service and support.

Finally, A.M. Best Company affirmed the financial strength ratings of A-Excellent with stable outlook with pool members of EMC insurance companies and EMC reinsurance companies. A.M. Best noted the ratings reflect our excellent level of risk adjusted capital and favorable core underwriting results as well as the benefits we will continue to derive from actions taken in recent years to improve pricing and risk selection.

A.M. Best also noted that the enhancements we have made to our predictive modelling tools and sophisticated monitoring system when leverage regional network and supported by long standing agency relationships have enabled us to more effectively through the market cycles. The enhancements to our systems that A.M. Best refers to are a product of art culture continuous improvement, one of our beliefs. Advancements in technology have enabled us to make significant improvements across the company. We must embrace innovative technology to achieve a competitive advantage.

So with that I will turn the call over to Scott Jean, Executive Vice President for Finance and Analytics, to talk about the recent announcement of our innovation lab. Scott?

Scott Jean

Thank you, Bruce. And good afternoon everyone. The innovation lab is a network of people working together to find new and creative insurance related solutions that set our agents apart while creating value for policy holders. The goal is to find solutions that meet the customers' needs and that are technologically feasible and economically viable. The lab has many projects in the works that meet this criteria. It acts like a new startup company that partners with independent agencies to build and implement new solutions while remaining nimble and responding to change quickly as data and feedback are received.

A recent successful art company Innovation Labs is our rewards program that utilizes our telematics app that we discussed in the first quarter earnings conference call. This program hopefully provides substantial value to policy holders by allowing fleet to improve not only safety but fuel economy, uptime in driver retention, representing the potential for a significant cost savings of all fielders. Agents will be able to brand the app and make it available to all of their clients. Due to the technological advances we have data available to us that didn't exist a few years ago.

Understanding this data can give us additional insight into our business and promote future growth and profitability. I was told to provide additional updates regarding new solutions and developments in the innovation lab that will help us to continue fleet improvement products and services we offer to our agents and our policy holders. Over the past couple of years, we have spoken about our efforts to improve the performance of our commercial auto line of business including the work performed by our commercial auto task force. Unfortunately, the commercial auto line of business remains challenging and we have not been able to gain the traction needed to improve profitability. Lower gas prices have led to an increase in miles driven which resulted in increase in lost frequency. When coupled with an increase in lost severity, these macro and industry trends have offset the benefits we gained from these actions.

In this projection forecast continued deterioration in the commercial auto line of business. With the combined ratio of forecast of approximately 109% in 2017. We are forecasting similar deterioration in our book of business if no additional steps are taken to improve profitability. The commercial auto lines of business represents approximately 25% of our commercial business. So it is imperative that we improve results and return commercial auto to underwriting profitability within the next 3 years. This will represent meaningful improvement to our operating results. The commercial auto task force started us in the right direction but more intensive work is required to turn this line around to the mule-year accelerate profitability project was developed and made this a priority for the entire company.

With that I will turn the call over to Kevin Hovick, Executive Vice President and Chief Operating Officer, to discuss additional details regarding this project.

Kevin Hovick

Thank you, Scott. And good afternoon everyone. Scott mentioned the goal of this project is to return this line of business to profitability within the next 3 years. The project includes 8 teams that will complement local branch efforts, each focusing on different opportunities to further improve areas such as pricing, claims handling and underwriting. This project will also introduce better tools to help agents struggling with commercial audible profitability, such as our telematics solutions.

There are so many opportunities for improvement within this line of business, were simple changes can have a meaningful impact on results. For example; we are currently developing software that will automatically identify and summarize pertinent information contained in driver motor vehicle reports. So that our underwriters can work more efficiently. We are also reviewing our composite rating guidelines to ensure that we are getting the appropriate premium for the exposures we are ensuring. The compilation of improvements like these that management believes will lead this line of business back to profitability.

We will continue to provide updates in future quarters as we monitor and evaluate the success of this project. We also like to provide an update on the progress of our personal line initiative. As a reminder the effective January 1, of this year a newly created personal lines operations assumed responsibility and accountability for growth and profitability of this business in the 22 state we actively write personal lines business. The current implementation of our new personal auto and homeowners products are on track with our initial expectations. We have implemented both products in seven states. And plan to implement them in four additional states during the remaining month of August. We expect to complete the implementation of the new products in the majority if not all of the remaining 11 states before the end of the year.

Initial reception from our agents has been very positive. As we transition to our new products we expect personal and business to continue to decline through the second half of 2016. Reducing the impact is underperforming business is having on our underwriting results. Our new business premium trend has been negative for many years, but we recently sought become slightly positive as our new products began to enter the marketplace.

We will continue to monitor the competitiveness of our products in each of the states. And gather data necessary to make future enhancements to ensure we are writing quality business.

At this point I'll turn the call over to Mark Reese, Senior Vice President and Chief Financial Officer.

Mark Reese

Thank you, Kevin, and good afternoon everyone. The company's loss and settlement expense ratio remained relatively flat at 70.2% in the second quarter compared to 70.6% in the prior year quarter. Although there were variations between segments. Our loss and settlement expense ratio for the property casualty insurance segment decreased to 72.9% from 74.4% in the second quarter of 2015. This improvement is attributed to an increase in the amount of favorable development experience and prior years' reserves, which was partially offset by an increase in large losses.

Two commercial fire losses during the second quarter are primarily responsible for the increase in large losses. And contributed to the 92% loss and settlement expense ratio reported for commercial property line of business. Approximately $1.6 million of catastrophe and storm losses will recover from employer's mutual, under the new reinsurance program. Taking this recovery and the premiums paid to employers mutual into consideration, the new reinsurance program added 0.6 percentage points to loss and settlement expense ratio in the second quarter. Catastrophe and storm losses accounted for 14.8 percentage points of the segment loss in settlement expense ratio down slightly from the 15.3 percentage points during the second quarter of 2015. But still higher than expected.

The loss and settlement expense ratio in the reinsurance segment increased to 61.6% for the second quarter of 2016 compared to 57.9% in 2015. This increase is primarily attributed to a higher level catastrophe and storm losses and reported large losses which we defined loss is greater than $1,000 as well as lower amount of favorable development and prior years reserves. The decline in the total cost of the revised excess the loss reinsurance program with employer's mutual, produce an approximate 1.3 percentage point decrease in the loss and settlement expense ratio for the second quarter 2016.

The portion of the loss and settlement expense ratio attributable to catastrophe and storm losses increase significantly in 2016 Totaling 16.6 percentage points, compared to an unusually low 4.3 percentage points reported for the second quarter 2015. Losses associated with the Alberta Wildfire represented approximately 10.1 percentage point of the increase. The acquisition expense ratio increased to 33.2% for the second quarter 2016 compared to 30.5% in 2015. Higher policyholder dividend expense associated with EMVI dividend groups in the property and casualty insurance segment is largely responsible for this increase. In addition, the cost of the intercompany reinsurance programs added 0.9 percentage points to the ratio for the second quarter of 2016.

Net investment income increased 6.5% in the second quarter due to an increase in dividend income and an increase in interest income, resulting from a higher average invested balance it fixed maturity securities. The yield I knew fixed maturity investments remains below the average book yield of the fixed maturity portfolio. And will therefore likely continue to limit future growth in net investment income. Effective duration of the fixed maturity portfolio excluding interest only securities declined slightly to 4.3 to 4.6 at year end. Total return and the equity portfolio is 2.5% which was equal to the total return of the S&P 500 for the second quarter. Like many in the industry catastrophe and storm losses were higher than anticipated during the second quarter. As a result we are lowering our 2016 operating income guidance to arrange a $1.55 per share to $1.75 per share from the previous range at $1.70 per share to $1.90 per share.

The revised guidance is based on a projected GAAP combined ratio of 99.4% for the year. And investment income growth in the low to mid-single digits. The projected GAAP combined ratio as a load of 10.2 percentage points for catastrophe and storm losses up from the previous expectation of 9.1 percentage point. No shares were repurchased during the quarter under the company's stock repurchase program. Approximately $14.6 million remains under this program.

Before I open it all up for questions I would like to comment on our transition to a new reserving methodology in the property and casualty insurance segment. Many of you have heard us discuss our reserving methodology on previous earnings conference calls or at industry conferences. As our current methodology is different than most public insurance companies. We recently approved the adoption of the new reserve in methodology for the determination of book -- of direct book reserves referred to as the accident your ultimate estimate approach in order to better conform to industry practices and provide increased transparency of the drivers of our performance.

The new methodology is well understood by practitioners and industry constituents. So our reserving methodology will no longer be a barrier to understanding the impact that reserve development as on our financial results. The transition to the new methodology in the third quarter is not expected to have a material impact an operating results. However, there will be some movement of direct book reserves between loss reserves and settlement expense reserves and likely some movement of direct book reserves between lines of business and accident years.

So with that we are now ready to open a call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Paul Newsome of Sandler O'Neill. Please go ahead.

Paul Newsome

Good morning, thanks for the call. I wanted to ask about a little bit more on the new reserving methodology, specifically are we -- will it change the overall size of what's reported as favorable reserves development on a quarterly or annually basis? Just a little bit more details about magnitudes, maybe and in terms of -- I realize it's not a bottom line issue, but in terms of how it's specifically reported.

Steve Walsh

Sure, Paul. This is Steve. I think Mark Reese is going to take the first shot at that one.

Mark Reese

Good morning, Paul. Yes, I can't really tell you definitively whether we're going to see a change in the amount of favorable reserve development reported. I would expect that we will see a small decline. The big advantage is going to be the fact that we will be able to identify the exact drivers of that development, where under our current methodology, oftentimes it gets muddled in our -- the processes that we use to develop the reserves and then allocate them to years [ph]. So under the new methodology, when we change assumptions, that will the driver of the development and therefore we'll be able to really focus in on what the drivers are.

Paul Newsome

Great, thank you.

Operator

Our next question comes from Anthony Tow [ph] at KBW. Please go ahead.

Unidentified Analyst

Good afternoon. Thank you for taking my questions. It looks like the acquisition ratio increased by 270 bps year-over-year. What drove that and should we expect a higher run rate moving forward?

Steve Walsh

Sure, Anthony. Mark's going to take that one again.

Mark Reese

Yes, good morning. Yes, there's really two drivers for the increase in the acquisitions expense ratio. The first was we had a rather large increase in the accrual that we have to set up for policy holder dividends on our Safety Dividend groups. Several of those programs had very good results end of last year and into the first part of this year. And that drove the -- a large increase in the accrual. The second item was the fact that the inter-company reinsurance program that we have with our property and casualty insurance segment, we had a large amount of heated premiums associated with that, so that had about a 0.9 percentage point increase in the ratio that we reported.

Unidentified Analyst

Great, thanks. That was helpful. And lastly, are you receiving -- are you still receiving higher than pure rate increases and how should we think about your core combined ratio changes going forward in that context?

Steve Walsh

Anthony, we're going to switch gears and Scott James is going to take that one.

Scott James

Good afternoon. It's based on what we're seeing. We do believe that our rate increases are exceeding what the industry is saying, although it's been much smaller this year than we have seen past years. One thing we talk about sometimes is, well, the lost cost spend relative to our rate increases that we're achieving. Looking at our long-term lost cost spread, we -- it does very closely approximate the rate increases we've been getting, but that is a little bit higher. So one might expect deterioration in our loss ratio over the next two years if in fact rate levels start to decrease. That is one of the primary reasons we're so focused on improving commercial auto profitability if we can achieve our goals there, that'll help mitigate some of that downward pressure on rates. We also, with our innovation lab, they're very focused on agent differentiation, which means two things. Differentiating ourselves within agencies and also differentiating our agents that write business on our behalf.

Now with that in mind, we believe that we can take less rate decrease than what other companies will be looking to take because of that differentiation we provide. So in regards to your question on what to expect long term, we are taking a lot of steps to help mitigate the impact that rate level decreases will have on that future loss ratio.

Unidentified Analyst

Great, thanks for the answer. I'll return back to the queue.

Operator

[Operator Instructions] Our next question comes from Paul Newsome of Sandler O'Neill. Please go ahead.

Paul Newsome

I was hoping you could give us a little thoughts on what makes your -- currently your commercial auto business different than your peers. And we broadly are looking at commercial auto writers like a Progressive; it's very profitable in the business but then there's also folks that are even less profitable than yours; AIG or National Interstate. So obviously you're in between, but could you just talk about exactly what that commercial auto business does and how it compares to its peers?

Joe Walsh

Yes, thanks, Paul, for the question again. Kevin Hovick's going to start out with that.

Kevin Hovick

Hi Paul. This is Kevin here. You know, we don't write commercial automobile on a very -- most of the commercial automobile we write is with a package. We write with the property, the casualty, and the workers compensation that we kind of underwrite the total of the insured. We kind of oversee their operations, see what they are doing, and get a better feel for the management. That's what we are finding is really key to, basically the commercial automobile towards the management's attitude towards improving the results. I sit in on quite a few of the reserve committees. Meetings where we set reserves on the individual policies, I see what's happening with our commercial automobile results, almost all of it has to do with the driver error and lot of it is stuff that if we work closely with a lot of the Analytics, the predictive modeling and with our loss control, we can continue to work with our policy holders to better identify methods that we can improve the drivers capabilities and prevent the accidents. So again, we write mainly in packages. We don't write commercial automobile by itself and that gives us a better window into the insurance operation because management of their fleet at the policyholder level is going to be the key to success of that business.

Bruce Kelley

And Scott Jean can add a little bit to that as well.

Scott Jean

Yes. Couple of things that I will add to that. We do not write a lot of long-haul trucking but you have someone on the books that front row reading on the industry that's really driving a lot of that deterioration for that carriers is long-haul trucking so our mix of business is slightly different than what we see in the industry. I do believe that one of the primary drivers of the increase in frequency within the industry is increased mileage and a lot of carriers not recognizing that we are taking steps to identify and recognize that increase in mileage.

The more people are driving, the more likely they can have an accident. So, we are taking steps to try and identify that. But with that commercial auto project we have currently going, we are looking at a lot of different areas to really dig in so currently I would say our book of business is probably better than the industry because of the lack of long-haul trucking. But I believe within the tools we are creating in our project, we are going to see and have a lot of better data available to us to make more informed decisions moving forward and there is room for improvement and we do believe that as a result of the efforts we are making now, we are going to see some significant improvements over the next few years and we're actually taking steps right now.

Long-term, we have a goals but what can you do right now to improve profitability in the short term and that is our focus also.

Paul Newsome

Fantastic. Thank you.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Steve Walsh for any closing remarks.

Steve Walsh

I would like to thank all of you for joining us today. We appreciate your interest in EMC Insurance Group and look forward to speaking with you again on our third quarter earnings conference call. Have a great day.

Operator

The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.

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