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Wall Street Breakfast

National Interstate Corporation (NASDAQ:NATL)

Q2 2007 Earnings Call

August 3, 2007 10.00 am ET

Executives

Alan Spachman - Chairman and CEO

David Michelson - COO

Julie McGraw - VP and CFO

Gary Monda - VP and CIO

Analysts

Elizabeth Malone - Keybanc Capital Markets

John Gwynn - Morgan Keegan

Presentation

Operator

Good morning ladies and gentleman, welcome to the National Interstate Corporation 2007 second quarter conference call. My name is Gendice and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session following the company's prepared statements. [Operator Instructions]. As a reminder, this call is being recorded for replay purposes.

Your hosts for today's call are Mr. Alan Spachman, Chairman and Chief Executive Officer; Mr. David Michelson, President and Chief Operating Officer; Ms. Julie McGraw, Vice President and Chief Financial Officer; and Mr. Gary Monda, Vice President and Chief Investment Officer.

Certain statements made during this call are not historical facts and may be considered forward-looking statements, and are based on estimates, assumptions and projections which management believes are reasonable, but by their nature subject to risks and uncertainties. The Private Securities Litigation Reform Act of 1995 provides a safe harbor for forward-looking statements. The factors which could cause actual results to differ materially from those suggested by forward-looking statements include, but are not limited to, those discussed or identified from time to time in National Interstate's filings with the Securities and Exchange Commission, including the annual report on Form 10-K and quarterly report on Form 10-Q. The Company does not promise to update such forward-looking statements to reflect actual results or changes in the assumptions or other factors that could affect these statements. I would now like to turn the call over to Mr. Michelson to begin the presentation.

David Michelson

Thank you for participating in our 2007 second quarter earnings conference call. Yesterday we reported another record quarter for earnings and continued solid top line growth. Specifically, our net income is up 31.7% for the quarter and 25.9% year-to-date. Our earnings per share are up 29.8% for the quarter, and 25.0% year-to-date. And gross premiums written increased 12.6% for the quarter and 11.3% year-to-date. Overall we are very pleased with the performance of our business. Net income was $11.9 million or $0.61 per share for the 2007 second quarter, and $22.3 million or $1.15 per share for the first six months of 2007.

This earnings increase reflects an increase in total revenues of over 20% and continued strong underwriting results with combined ratios in the low 80s. Our return on average shareholder's equity at June 30th, 2007 was 24.3%, again beating our target of 15% plus the rate of inflation. Our GAAP combined ratios continue to run favorable and consistent with prior periods. The GAAP combined ratio of 81.3% for the 2007 second quarter and 82.0% year-to-date are both within one percentage point of those experienced for the same period in 2006. Losses and loss adjustment expenses were slightly better than anticipated resulting in ratios of 58.8% and 58.9% for the 2007 second quarter and year-to-date respectively.

As has been our historic pattern, we again experienced favorable loss reserve development in both 2007 and 2006, which contributed to the better than expected loss results. It is always our intention to establish reserves as accurately as possible. However for the growing and changing book of insurance business, precision is a greater challenge and wielding conservatively in our pursuit of reserving perfection.

For the past five years, we reported favorable reserve development in the first half of each year. While the favorable development has contributed to our 2007 year-to-date earnings growth, it is not the whole story. Excluding the favorable development for both years, our 2007 year-to-date earnings are still up over 17%. We continue to experience some fluctuation in our quarterly underwriting expense ratios, primarily because of our diverse products that have varying expense components. These differences tend to balance out over longer periods of time, which can be seen this quarter. Our underwriting expense ratio for the 2007 second quarter of 22.5% was 1.7 points lower than the 2006 second quarter reflecting lower commission expense.

For the first six months of both 2007 and 2006, our underwriting expense ratio was 23.1%. Net investment income of $5.6 million for the 2007 second quarter and $10.7 million for the first six months was approximately 31% above the same periods last year. Our investment portfolio continues to increase reflecting the positive cash flow being generated from our operations and our growing ART business. We have generated $38 million in cash flow from operations during the first half of 2007. On average, our fixed income investments thus far in 2007 are generating yields at or above those investments that are already in the portfolio.

The effective duration on our fixed income portfolio was 2.8 years at the end of the second quarter. At the start of this year, to help diverse our holdings, we began investing in mortgage-backed securities, which are all guaranteed by federal agency collateral. We do not have any known exposure to the sub-prime lending market in our mortgage-backed portfolio. It has been widely communicated that the commercial insurance market remains soft.

In spite of this heightened competition, our gross premiums written of $81.9 million for the 2007 second quarter and $202.8 million for the first six months of 2007 were up 12.6% and 11.3% respectively. Equally satisfying to this double digit top line growth is the fact that all of our product components have shown increases compared to last year. The current market conditions primarily affect our traditional commercial products. Thus far we have maintained our pricing discipline, resulting in moderate growth in most of our traditional products and sustained profitability.

Overall, our rate levels have been relatively flat to slightly down while we continue to increase the number of group captive participants, the soft market conditions have also increased the challenge of adding new members to these programs. However, our captive program retention rate remains in excess of 96%. Once members experience the advantages of the group captive programs, they tend not to leave, regardless of the insurance cycle. In times when insurance pricing is highly competitive and often irrational, we turn our focus to new products, product extensions and product enhancements to grow our business. These efforts often involve relationships, education, systems development, and regulatory approval and as a result usually take months and sometimes years to realize their full potential.

Our growth in the 2007 second quarter was fueled by several new products that were started in the last half of 2006 and the first quarter of this year. There is never a shortage of new ideas at National Interstate and we always have something new in the pipeline. Several new ideas that are currently being introduced include an introduction of a taxi program in Hawaii, adding general liability and in the lowing coverages to one of our captive programs expansion of our commercial vehicle product into Texas and California, and for the first time in our history, we introduced a market incentive program for brokers designed to increase new submission flow in our core public transportation business.

This new broker incentive program was introduced in June to be effective for policies written beginning on August 1st. Thus far we have approximately $1.5 million of public transportation business that will be written as a result of this program. Our product diversification continues to benefit us by providing multiple growth opportunities and flexibility in those insurance cycles. In summary, we are pleased with the top and bottom line results for the first six months of 2007, and we are well positioned as we entered the last half of the year. Alan will share his thoughts before we take your questions.

Alan Spachman

Thanks, Dave. Solid quarterly and year-to-date financial results is getting to big business as usual at National Interstate. I continue to be encouraged by our ability to perform in even the most difficult market conditions and our quarterly manager's meeting, which was held earlier this week, every one of our product managers provided a mid-year product performance review. These reviews reinforced for me the clear advantages of our product management organization structure. Regardless of the current volume of the product, and what Bill Berkeley recently referred to as lunacy in the marketplace, we have people who are intensely focused on their unique product and highly motivated to profitably grow it.

All significant aspects of our business have met or exceeded our expectations during the first six months of this year. Our double-digit top line growth, our extremely strong earnings per share, and our better than expected return on average shareholder's equity provides a favorable outlook for the remainder of this year. Thank you again for your continued interest in National Interstate. Dave, Gary, Julie, and I will be happy to address any questions you may have.

Questions-and-Answers Session

Operator

[Operator Instructions]. The first question comes from the line of Beth Malone. Please proceed.

Elizabeth Malone - Keybanc Capital Markets

Thank you, and congratulations on the quarter. Could you just talk a bit more detail about what you are seeing in the market on the RV kind of business and it sounds like, listening to some of your competitors that they are looking for getting, you know growing their market share in a more competitive market, sounds like they're trying to get into some of the businesses that you all have had a good position in. And I'm just wondering is this what you could consider business as usual on this kind of environment or are you going to have to take some more dramatic actions, given the increased competition?

David Michelson

Good morning, Beth. This is Dave Michelson and what we are saying the RV marketplace; we are pleased with growth in that business component. One of the factors impacting our ability to grow is that RV shipments are way off, which obviously reduces our opportunities to grow new business. You know, we have strong competition out there, but we have for years. We have a strong distribution with specialty RV agents and we have also, you know, gone into some efforts to expand our distribution to help us in the future as well, but the growth that we are experiencing from our perspective is driven to a large degree by the reduction in shipments and we are also seeing there a lower average value per unit insured this year. That also, I think is due to the higher value new business unit sales being down. So our policy counts aren't off significantly. But our average premium per policy is also a little bit as well, which is also affecting it. We do have a relationship in place with the Family Motor Coach Association, which is a very large group of RV owners around the country and so we have got some marketing initiatives, you know, getting to penetrate that membership and grow our business as well.

Elizabeth Malone - Keybanc Capital Markets

Okay. The RV shipments being down. I assume that that's kind of an economic pressure in the general market for those typical buyers and does that indicate that you are somewhat economically sensitive in your business because I would think the trucking could also be sensitive to an economic factor.

David Michelson

We don't see the economic factor playing as much into the transportation businesses. One of our criteria, in terms of the types of transportation risks that we pursue are those that are already very financially sound. In fact significantly better than industry averages. So it might affect other underwriters that go after a broader spectrum of the business, but for the types of transportation risks that we are pursuing with the already very strong financials, we have not seen the economics affect our abilities to pursue those business components.

Elizabeth Malone - Keybanc Capital Markets

Okay.

Alan Spachman

Okay Beth. Maybe let me just weigh in. This is Alan, Beth. What we are seeing in our new business in RVs is a rise in the towable units, a little bit of a down turn in the motorized units and that may be a reflection of gas prices, it may be a reflection of the economy. These are not essential purchases in most regards. Much different than the trucking business, which is related to economic activity, as opposed to you know, things like fuel and the disposable income. So we are seeing policy count increases. It is just a different class of business that doesn't quite produce quite the same policy premiums that the high-end motorized units do.

Elizabeth Malone - Keybanc Capital Markets

Okay. And one other question on -- to your larger shareholder, American Financial. Is there any update into how -- you know, have you communicated with them. Is there any update into their interest in possibly changing their position, or anything?

Alan Spachman

Again, this is Alan, Beth. You know, we would refer any questions you have about American Financial to American Financial.

Elizabeth Malone - Keybanc Capital Markets

Okay. Thank you.

Operator

Your next question comes from the line of John Gwynn of Morgan Keegan.

John Gwynn - Morgan Keegan

Thanks. Dave, the public transportation initiative you mentioned earlier, is that a new book of business or is that just an ongoing program with higher commissions?

David Michelson

John, what we've announced was an incentive to pass new transportation brokers around the country who is open to all passenger transportation brokers and what we are attempting to do is increase our number of adapts on business they control. It is business they currently write, you know, with whatever insurance companies they have placed it with. So it is business they know. It is seasoned business and we are simply looking to give them an alternative in a marketplace that we think has. You know, a little turmoil in it right now and to give their clientèle an option to come with the largest regular passenger transportation business in the country that we think also provides a wonderful basket of services.

John Gwynn - Morgan Keegan

And this will turn up in your traditional transportation line?

David Michelson

Yes it will, John.

John Gwynn - Morgan Keegan

Okay. Julie, the reserve releases. Were those mostly 04 and 05 years?

Julie Mcgraw

For the first six months, John, it was really across all years. Primarily like 2002 through 2006.

John Gwynn - Morgan Keegan

Okay.

Julie Mcgraw

And they are just the normal course of reserve development. I wouldn't classify specifically releases, so to speak.

John Gwynn - Morgan Keegan

Okay. And Julie, also in this report you break out an expense item called the expense on amounts withheld. You had not broken out in the past, is that right?

Julie Mcgraw

Yes, I'm sorry. I had to pull up the selected financial statement. Yes we did.

John Gwynn - Morgan Keegan

Are you trying to tell me something there? It is included in your expense ratio, obviously, but..

Julie Mcgraw

No, John. In the past, it's been included in commissions and other underwriting expense and it relates to the interest on the funds held. And because it was a part of the captive business, the alternative transfer risk business, we thought since it was growing as our premium grows, we would just break it out separately on the summary of financial data.

John Gwynn - Morgan Keegan

Okay. Thanks. I just didn't know exactly where you were coming from on that. Alan, I know that your markets are highly competitive, but would you still consider or characterize Lancer as your most prominent, head on competition?

Alan Spachman

Well they certainly are in the passenger transportation business, John.

John Gwynn - Morgan Keegan

They don't do group captives, do they?

Alan Spachman

Not that we are aware of.

John Gwynn - Morgan Keegan

Okay. Their rating wouldn't support a group captive, would it?

David Michelson

You will have to ask them that, John.

Alan Spachman

I have a very -- I have an opinion on that, but I don't think it should be shared right now.

John Gwynn - Morgan Keegan

I understand. Okay, well thanks a lot.

Alan Spachman

Okay. Thank you John.

Operator

[Operator Instructions]. There are no more questions at this time. I would like to turn it back to management for closing remarks.

Alan Spachman

Thank you very much for your continued interest in our company. We had a great quarter. We are optimistic toward the balance of 2007. There are a lot of great things going on at National Interstate as Dave mentioned in his presentation, there is never a shortage of ideas-- new ideas in our company and some of the recent ideas are starting to pay dividends for us and for our shareholders and we see that as business as usual. Thank you again for your interest and your attention. We look forward to having this conversation with you in about 90 days. Goodbye.

Operator

Thank you for your participation in today's conference. This concludes our presentation and you may now disconnect. Have a wonderful day.

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