Employers Holdings Q3 2007 Earnings Call Transcript

Employers Holdings, Inc. (EIC)

Q3 2007 Earnings Call

November 14, 2007 1:30 pm ET

Executives

Vicki Ericson – VP

Douglas Dirks – CEO

Rick Yocke – CFO

Martin Welch – Pres. & COO

Analysts

William Wilt – Morgan Stanley & Co. Inc.

Daniel Schlemmer – Cochran Caronia Waller

Sam Hoffman – Foley & Lardner

Presentation

Operator

Good day ladies and gentlemen and welcome to the Employers Holdings, Inc. third quarter 2007 earnings conference call. (Operator Instructions) I will now like to turn the call over to Miss Vicki Ericson, Vice President of Investor Relations. Please proceed.

Vicki Ericson

Thank you and welcome everyone to the third quarter 2007 earnings call for Employers Holdings, Inc. After the close of market yesterday, we announced our third quarter 2007 earnings results and filed our form 10Q with the Securities and Exchange Commission. These materials are available on the company’s website at www.employers.com. Today’s call is being recorded and webcast from the Investor Relations section of our website where replay will be available following the call.

Representing the company on the call today are Doug Dirks, our Chief Executive Officer, Rick Yocke our Chief Financial Officer and Marty Welch, the President and Chief Operating Officer of our insurance subsidiaries.

Before I turn the call over to Doug for opening remarks, I would like to remind everyone that statements made during this conference call that are not based on historical facts, are considered forward-looking statements. These statements are made in reliance on the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. So we belief the expectations expressed in our forward-looking statements are reasonable, risks and uncertainties could cause actual results to be materially different from our expectations including the risks set forth in our filings with the Securities and Exchange Commission.

I’d also like to remind you that we use a non-GAAP metric that excludes the impact of the 1999 loss portfolio transfer or LPT. This metric is defined in our earnings press release available on our website. Now I will turn the call over to Doug.

Douglas Dirks

Thank you Vicki and welcome everyone. Our solid performance in the third quarter is evidenced by strong net income, in line with first and second quarter 2007 results. Positive impacts from favorable development on prior period losses, strong growth in policy count, continued evidence of prudent risk selection and a growing contribution from investment income. I would to preface my review of the third quarter results by noting that our year-over-year comparisons for this quarter are uniquely unfavorable largely because of timing adjustments to our loss and LAE estimates.

While we were a private mutual company, we recognized $81.7 million in favorable reserve development in the first nine months of 2006. With $68.9 million, or 84% recognized in the third quarter. In the first nine months of this year, and since our conversion and initial public offering, favorable prior period development of $43.4 million has been recognized with $15.6 million, $20.4 million and $7.4 million recognized in the first, second and third quarters respectively.

We continue to see benefits from previously enacted reforms in California, although at lower levels than we recognized last year. Our third quarter 2007 GAAP net income was $29.9 million, or $25.3 million before the LPT, compared to third quarter 2006 GAAP net income of $77 million or $72 million before the LPT. Looking at the nine months GAAP net income, through September 30, 2007 was $88.5 million, $74.8 million before the LPT, compared to GAAP net income for the first nine months of 2006 of $116.5 million, $101.9 million before the LPT.

Again the change was largely the result of greater favorable prior period development last year. We continue to operate profitably despite continuing, though moderating rate declines in our largest market, California. Despite this environment, California still presents us with attractive opportunities and remains a significant part of our growth plan. While California rates have declined in recent years, the October filing by the Workers’ Compensation Insurance Rating Bureau, were recommended an average 5.2% increase in advisory pure premium rates to be affective on policies incepting on or after January 1, 2008.

The recommended increase is based on the Bureau’s analysis of loss and loss adjustment expense data as of June 30, 2007 and takes into consideration additional expected lost costs resulting from the passage of Assembly Bill 338. This legislation was signed by Governor Schwarzenegger in October, and extends the period of time during which temporary disability payments may be awarded.

The current filing by the WCIRB is the first recommended increase since October 1, 2003 and suggests that rate decreases may be abating. However, the California Department of Insurance has not yet adopted and published its advisory pure premium rates for 2008. As we have stated in previous calls, in making any decision to change our filed rate, we analyze our current and anticipated California loss trends by class and determine what changes, if any, are necessary.

In our new markets we continue to focus on establishing relationships to support our recent expansion. While our geographic expansion is in the early stages, it is yielding positive results with increases in premiums written, policy count and the addition of our new strategic partner, Intego.

We also continue to focus on our existing markets including our recently announced exclusive relationship with the California Restaurant Association. I want to stress that as we evaluate new business opportunities in both new and existing markets, we adhere to our strict underwriting standards. And while this may affect how quickly we add premium, we believe it helps to ensure that incremental growth is profitable. Now Rick will cover our financial results. Rick.

Rick Yocke

Thank you Doug. Historically our premium has come primarily from California and Nevada, and California remains our largest state representing about 70% of total direct premiums written as of September 30 of this year. Our rates in California have declined 38.1% since January of 2006 leading to a 7.8% decline in net premiums earned quarter-over-quarter, and a 12.6% decline in the first nine months of 2007 compared to the same period in 2006.

I’d like to point out that in this declining rate environment, net earned premiums have increased in the third quarter relative to the second quarter of this year. That reflects strong retention as well as new policy growth that Marty will discuss later.

Our third quarter 2007 loss and loss adjustment expense ratio was 46.2% and 51.3% before the LPT. Third quarter losses in LAE were higher than last year due to the amount and timing of favorable prior accident year development, which Doug has already discussed, and a downward adjustment in the current accident year loss and loss adjustment expense estimate in the third quarter of 2006.

Additionally, in the third quarter of 2007 our loss and LAE estimates increased $1.6 million related to the commutation of an excess of loss agreement with GLOBAL Reinsurance Corporation of America. Our loss and loss adjustment expense ratio for the nine months ended September 30, 2007 was 42.4% and 47.6% before the LPT. For the nine months ended September 30, 2007 losses and LAE increased 16.3% over the same period in 2006 largely as a result of the favorable development last year.

Our commission expense ratio was 14% in the third quarter and 13.6% for the nine months ended September 30, 2007. There was a slight increase in the third quarter 2007 commission expenses due to a July, 2006 increase in the commission rates and an agency incentive commission plan adopted in 2007.

Our third quarter 2007 total underwriting expense ratio was 24.5% compared with 23.6% for the same period last year. Our nine months ended September 30, 2007 underwriting expense ratio was 25.8% compared to 19.7% for the same period in 2006. The nine month ratio reflects lower net premiums earned and an increase of $8.6 million primarily consisting of additional staffing and related operating expenses required for a public company, and higher technology and maintenance expenses.

Underwriting and other operating expense declined slightly compared to the first and second quarters of this year.

Income taxes in the third quarter and the first nine months in 2007, decreased compared to the corresponding periods in 2006 due to lower pre-tax income and lower effective tax rates. The effective tax rates declined because the ratio of tax exempt interest and dividends to pre-tax income increased as the result of the portfolio reallocation in the fourth quarter of 2006 and in the third quarter of this year, we reversed a $5.8 million liability for previously unrecognized tax benefits including interest.

The effective tax rates were 11.5% in the third quarter and 19.3% in the nine months ending September 30, 2007.

In the third quarter of 2007, our GAAP combined ratio was 84.7% and before the LPT, it was 89.9%. For the first nine months in 2007, our combined ratio was 81.9% and before the LPT it was 87.1%.

Net income from investments increased in the third quarter and the nine months ended September 30, 2007 compared to the same periods in 2006, principally due to an increase in invested assets, a portfolio reallocation in the fourth quarter of 2006 that increased our book yield, and interest income on net proceeds related to the IPO.

In the nine months ended September 30, 2007 we sold $55 million of fixed maturities for our stock repurchase program. And in October, we completed that program and have repurchased 3,911,272 shares of common stock for a total of approximately $75 million.

The fair value of our investment portfolio was $1.7 billion at September 30, 2007. Approximately 94% of our portfolio was comprised of fixed maturities of which 93% had an average rating of AA or better, and 51.3% of the portfolio was invested in tax exempt municipals. The duration of the portfolio was 5.72 with a book yield of 4.4% and a tax equivalent yield of 5.35%.

Our investment portfolio includes less than 3/100 of 1% of sub prime mortgage debt or derivative securities. Our total exposure in the financial sector is approximately $98 million or 5.7% of our total portfolio of $1.7 billion.

In summary, in the third quarter the Company continued to be financially strong as reflected in our AM Best rating of A minus with a positive outlook; our conservative investment portfolio with solid returns, our sound and conservative reserving practices and our long term attention to capital management. With that, I’ll turn the call over to Marty.

Martin Welch

Thank you Rick. To update you on our operations I will begin by talking our direct written premiums and our continuing strong growth in policy count. Starting with policy count, we continue to grow our business at a very healthy rate. We have increased in-force policies by 12.7% since September 30, 2006. Our California in-force policy count increased 17.4& year-over-year at September 30, while in Nevada we experienced a 7.2% decline in policies over the past 12 months.

This Nevada result is expected as we encounter continuing competitive pressures, maintain adherence to our underwriting guidelines and manage our book of business within targeted risk profiles. We continue to emphasize growth in our new states, evidenced by total policy count growth of 33% in states other than California and Nevada since September 30, 2006.

As Rick indicated earlier, written premium continues to be impacted by falling California rates though we are experiencing improvement in that premium trend. On a state by state basis, for the nine months ended September 30, 2007 California represented about 70% of the total direct premium and Nevada was about 19%. Our newest states, Arizona, Oregon, Florida, Illinois and Texas, grew about $3.5 million to 1.3% of total direct premiums written. Illinois is gaining traction as we appoint additional independent agents in that state, and Florida continues to be a two-pronged market approach utilizing ADP and independent agent producers.

Our relationship with ADP continues to be strong though they have made some structural and leadership changes within their sales and insurance operations in recent months. We believe these changes will actually produce additional opportunities going forward due to the renewed emphasis being placed on our joint sales efforts.

We continue to execute our strategy including growth in our new states and the pursuit of additional strategic partners. We were very pleased to recently announce our new strategic partnership with Intego Insurance Services LLC. Intego is a distributor of web based property and casualty insurance products. Beginning in December, this new partnership will enable us to offer our Workers’ Compensation product, combined with small business payroll processing services through the use of Intego’s online payroll product.

This partnership will initially focus on Illinois, Florida and Texas. While Intego will afford us meaningful growth opportunity as we expand, our initial expectations for 2008 are a few hundred policies.

Additionally, this month we announced our relationship with the California Restaurant Association as a Workers’ Compensation provider of choice for their members. CRA is the largest trade association in the United States and while their relationship does not guarantee additional business, the CRA is the voice for more than 88,000 eating and drinking establishments in California, of which 22,000 are CRA members today.

Restaurants represent the single largest class of business that we write, well over 3,000 of our policy holders and we do expect this relationship to further strengthen our retention of restaurant business as well as produce more new restaurant policy holders in the future.

Overall, our insurance operations continue to successfully execute our strategy of growing profitably in both new and existing markets. With those comments, I will turn the call back over to Doug.

Douglas Dirks

Thanks Marty. In closing as always, we remain committed to underwriting disciplined, profitability and the focus on specific markets within our targeted classes of business that we believe provide greater opportunities for profitable returns. Thank you for joining us for our third quarter earnings call covering our financial and operating results. That concludes our formal remarks and operator if you would please, open the line to questions.

Question-and-Answer Session

Operator

You have a question from the line of William Wilt – Morgan Stanley

William Wilt – Morgan Stanley

Good afternoon, looking at the WCIRB data, I think you alluded to this Doug in your prepared remarks, looked like there was a bit of an inflection point in the frequency and severity of losses, frequency being less negatives then it had been and severity ticking up. Is that consistent with what you’re observing?

Douglas Dirks

Bill it’s a little early right now to predict and inflection point based on that one observation, although I would have to say it doesn’t surprise us that we’re now four years into reform and you would expect at some point that all of the reform benefit will emerge. So again we’re not surprised by it, but I would really be looking to see that next data point to confirm that that was in fact the inflection point.

William Wilt – Morgan Stanley

Sure, thanks for that. Two others if I may. The accident year loss ratio at 59.7% if I did the math correctly is several points lower than it has been at preceding few quarters, I don’t know if you could comment on whether that’s a new view on the appropriate accrual going forward, whether there was some noise in the quarter, something unusual, any observations would be great.

Rick Yocke

We did make an adjustment of our current accident year provision rate in the third quarter so it’s not background noise as we looked at the emerging data for 2007; we lowered our provision rates slightly.

William Wilt – Morgan Stanley

Okay, that’s helpful and then the third if I could, I’m forgetting the name of the court case, but there was a case recently, settled between or adjudicated between the state comp insurance fund, WellPoint I think, one of the big health insurers in a hospital. I guess the thrust of it was that the Workers’ Comp carrier had been getting discounts, so the heart of the dispute was that the Workers’ Comp carrier seemed to be getting discounts for hospital services, physician services, etc. that arguably that they shouldn’t have been, irrelative to the, related to the PPO. Is that anything that you can comment on, I mean, are your claims subject to PPO discounts, do you have direct relationships with or agreements with hospitals and other medical providers to garner discounts?

Douglas Dirks

You know Bill, I am familiar with the case, I believe if it’s the one I’m recalling correctly it was settled in a way that it doesn’t represent any precedent in terms of how companies might interact with individual providers. So from that stand point, I don’t know that it has legal meaning to us. It is something that we’ll monitor; at least as we understand it today, don’t believe it presents a problem for us.

William Wilt – Morgan Stanley

Is there any way, and then I’ll turn it over to others, is there any way to quantify or add color to the extent to which employers benefits from volume discounts or PPO discounts in the relative to paying say full freight for hospital and physician services, you know, across the totality of your claims?

Douglas Dirks

Not that I have in front of me at the moment, you know, we could probably develop some type of estimate as to what that might represent, but to tell you the truth, right now I just couldn’t even give you an estimate of what that is.

William Wilt – Morgan Stanley

Okay, thanks very much.

Operator

Your next question comes from the line of Matt Carletti – Cochran Caronia Waller

Daniel Schlemmer – Cochran Caronia Waller

Hi, actually it’s Dan Schlemmer, I’m using Matt’s line, going back to, you had the question about the accident year loss ratio, I just want to make sure it’s clear. You haven’t changed your policy of where you book relative to the projections, is that right, I think 8% is your normal margin there and you haven’t changed that?

Rick Yocke

No we have not changed our position relative to our actuarial consultants at all.

Daniel Schlemmer – Cochran Caronia Waller

And the change in the accident year loss ratio then is purely experience based, I mean is that a fair way to say it?

Rick Yocke

Ask your question again please?

Daniel Schlemmer – Cochran Caronia Waller

Is it fair to say your change in your accident year loss ratio was purely based on a change you saw in the experience?

Rick Yocke

That’s correct.

Daniel Schlemmer – Cochran Caronia Waller

Okay. On the commutation, can you sort of clarify I guess in general, when you see a commutation usually there’s actually a benefit that comes out of it, not an adverse amount, can you sort of give us the background on the transaction?

Rick Yocke

Well I’ll summarize it. We have a situation where the reinsurers trying to wind up their affairs had approached us with a proposal to commute the agreement. As we look at it on a present value basis, we believe that it was a good business decision to commute the agreement, however when you look at it on a GAAP book basis, we do not discount our reserves. Consequently since many of, the large part of the liability remained unpaid, you end up with what appears to be a, well it is a write-down, but it disguises the economics of the actual arrangement.

Daniel Schlemmer – Cochran Caronia Waller

Okay, do you know, I hate to put you on the spot too much, but do you know what the impact would have been if you did take the benefit of that discounting?

Rick Yocke

As I said, we viewed the arrangement to be a good business deal. We would have viewed this to be a profitable arrangement between ourselves and the reinsurer.

Daniel Schlemmer – Cochran Caronia Waller

Understood, thank you. Last question, just the two relationships you went through in the comments, Intego and the California Restaurant Association, do you have a dollar amount expectation of any kind that you can share with us just overall how much you’re thinking that can add over the next year?

Martin Welch

We’re far too early in these relationships to be putting up premium expectations. We certainly are pleased with both of those relationships and think that they will inure a benefit to us in the future as we go forward but at this point, I wouldn’t want to throw a dollar out there for what it would mean to 2008.

Daniel Schlemmer – Cochran Caronia Waller

Alright thank you.

Operator

Your next question comes from the line of Sam Hoffman – Foley & Lardner

Sam Hoffman – Foley & Lardner

Hi, can you comment on the expected level of price competition in the general pricing environment going into 2008 irrespective of the bureau’s recommendations, how much price competition are you expecting?

Douglas Dirks

I’m not sure how we quantify that in terms of are we expecting reductions in our rates overall based on competitive pressures or are you looking for what we think the market will go down in general?

Sam Hoffman – Foley & Lardner

I guess I’m looking for what you think will happen in the market and then what will happen with your renewal book?

Martin Welch

The California market has become more competitive obviously over the last few years. It’s not sustained competition from the same competitors consistently. It varies by region within the state; it varies by particular classes of business. So I think overall we would expect to see the market continue to be competitive as carriers look for the best risks in the market. What we’ve been focusing on is increasing the amount of submittals that we get to our marketing and sales efforts so that we have an opportunity to see more good business and be able to compete that way. Drive the top line and the bottom line results by seeing more of the types of accounts we would like to write.

Sam Hoffman – Foley & Lardner

So what do you think the overall pricing change will be in the market next year, best guess and what do you think is going to happen to your overall pricing as a result of the initiatives you just talked about?

Martin Welch

I don’t know what the overall market pricing will be in California. I wish I knew. It would make our setting of strategy a little bit easier. Again I think the market continues to be competitive. I don’t think we’re seeing underlying results in California that are going to drive competitors out of the market place. I still think from our stand point, it’s an attractive market. I would expect it presents similar opportunities to others. What impact the commissioner’s ruling if any will have on rate levels remains to be seen. But at this point, and I’ll go back to Bill’s first question, it’s beginning to appear that we may have seen the inflection point in the market, but again it’s a little too early to be predicting that.

Sam Hoffman – Foley & Lardner

Just two other detailed questions, your commission ratio increased from 12.4% to 14%, year-over-year, is that something that we should expect, continued increase going forward or were there one-time items in the quarter?

Rick Yocke

Well I think what that’s primarily a reflection of is, one year ago we increased our commission rate to 12.5% primarily in California. And that has worked its way through the entire book of business now as we got to the third quarter of 2007. At this point in time, we are, we have not other decisions that we have made or will make regarding our commission rates as we go into 2008.

Sam Hoffman – Foley & Lardner

Okay, and final question is what is your investment yield and what’s your new money yield?

Rick Yocke

Our tax equivalent yield is 5.35%.

Sam Hoffman – Foley & Lardner

And it’s the same on new money.

Rick Yocke

Approximately.

Sam Hoffman – Foley & Lardner

Okay thank you.

Operator

We have a follow up question for the line of William Wilt – Morgan Stanley.

William Wilt – Morgan Stanley

Thank you for taking the follow up. Two, one numbers one first. Revisiting the 59.7% loss ratio in the third quarter, is it possible to parse that between the catch-up from the first half of the year that presumably is benefiting the third quarter and then the underlying third quarter run rate accrual?

Rick Yocke

The total adjustment through nine months resulting from the change in provision rate was approximately $6 million.

William Wilt – Morgan Stanley

Okay, I’ll work it out from there, thanks. And the more general question, on Assembly Bill 338, I guess the Workers’ Comp Bureau weighed in that it would increase rates 3% or you can tell me it’s some small positive increment as I recall, is it your sense that that Bill will be essentially cost-neutral or only increase costs slightly? And I guess I’ve observed, and you can react to this however you see fit, that increasing or extending the temporary disability benefits in the face of potentially slowing economy could, has some attendant risks and I didn’t know if you wanted to react to that observation or not.

Douglas Dirks

The Bureau did amend its rate filing and added an additional 1% as a result of 338, and 338 extends the period of time that an individual can collect temporary disability from 104 weeks over two years, to 104 over four years. I think the way you present it, there is a possibility that that increased period of time could lead to greater utilization of that benefit. But I think the Bureau’s number probably has incorporated that. We would tend to agree with them, that if it has an impact, it will likely be minimal.

William Wilt – Morgan Stanley

Great, thank you.

Operator

There are no further questions at this time.

Douglas Dirks

Thank you everyone for joining us today and we look forward to speaking with you again to cover our 2007 year end results. Thank you.

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