Safeco Corp. Q4 2007 Earnings Call Transcript

Feb. 1.08 | About: Scudder New (SAF)

SAFECO Corporation (SAF) Q4 FY07 Earnings Call February 1, 2008 5:00 PM ET

Executives

Neal Fuller - IR

Paula Rosput Reynolds - President and CEO

Ross Kari - EVP and CFO

Mike Hughes - EVP-Insurance Operations

Tim Mikolajewski - Sr. VP and Head of Safeco Surety

Analysts

Dan Johnson - Citadel Investment

Alain Karaoglan - Banc Of America Securities

Jay Gelb - Lehman Brothers

Paul Newsome - Sandler O'Neill & Partners

Larry Greenberg - Langen McAlenney

Matthew Heimermann - J.P. Morgan

Joshua Shanker - Citigroup

Operator

My name is Gerald, and I will be your conference operator. At this time, I would like to welcome everyone to Safeco's Fourth Quarter Earnings Results Conference Call. All lines have been placed on mute to prevent any background noise.

After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions]. It is now my pleasure to introduce your host, Mr. Neal Fuller, Senior Vice President of Finance and Treasurer. Sir, you may begin your conference.

Neal Fuller - Investor Relations

Good afternoon, everyone. And welcome to Safeco's fourth-quarter 2007 earnings release conference call. Copies of our PowerPoint slides, financial supplement and news release, which we may refer to during the call, are available at safeco.com/ir.

This call is being broadcast live on the same website and will be available as an audio replay. We will also post a transcript by early next week. With us on the call this afternoon are Paula Reynolds, President and CEO; Ross Kari, our Chief Financial Officer; Mike Hughes, Executive Vice President of Insurance Operations; and Tim Mikolajewski, Senior Vice President and Head of Safeco Surety.

Other members of the senior management team are also in the room here for our Q&A session today. We'll start the call with a discussion of our results for the quarter and the year and then we'll open it up for your questions. We expect the call to last approximately one hour.

Please read the disclosures on slide 2 of the presentation regarding forward-looking statements we may make and non-GAAP measures we may refer to during the call today. These disclosures can also be found in today's 8-K filing, our press release and other filings with the SEC. We've had another quarter of very strong performance here at Safeco.

And with that, I'd like to turn the call over to Paula Reynolds. Paula?

Paula Rosput Reynolds - President and Chief Executive Officer

Thanks, good afternoon everybody. Thank you for joining us. As you can see from the materials, we did enjoy another strong quarter of profitability, and for the year we had earnings that were our second-best ever, second only to last year's record profitability.

Our net income for the quarter was $144.5 million or $1.56 per share. Our operating earnings for the quarter were $140.1 million or $1.51 per share. And our operating ROE was a noteworthy 16.2%. At our Investor Day in November, one attendee remarked to me afterwards something to the effect of, hurray. At last an insurance company management that's running the business like an investment business.

I took that remark to mean that he appreciated the fact that we are keeping our discipline in a soft market cycle, and we are prepared to contract the capital base as necessary to preserve best-in-class returns on equity.

So, for those of you listening today, I hope you will take three takeaways from the call. First, Safeco is a no-surprises company where we remain committed to the utmost in transparency and disclosure. You don't get a lot of spin. You don't get any spin with us.

Second, Safeco runs a portfolio of businesses, and while we try to have them all running on eight cylinders all of the time, we don't always get it right, but we are down in the details in every line, and we do deploy every tool at our disposal to generate improvements.

Third, the portfolio continues to produce meaningfully high equity returns with lower volatility than most companies in the financial services sector. So, let me hit on the highlights of the quarter. In SBI Regulator, can't even speak this afternoon. It actually happens we don't do this in the morning.

In SBI Regular, which is our automated platform small business line, we saw growth in net written premium and policies in force of almost 3%. We increased retention and we had positive price performance of 1% in the quarter. We posted these results despite market surveys, which indicated minus 5% pricing. This is a testimony to our careful selection of lines and our ease-of-use of the automated tool. Equally important, we have assiduously issued writing middle market risk for the recent MarketScout data showed pricing of negative 16%.

Second highlight would be our Surety line, where we've had another outstanding quarter with a combined ratio of 63%. We posted record profitability in premiums for the year and thus maintained our track record, now 26 years in duration, as the most consistently profitable surety carrier in the business. Safeco Surety remains focused on public works projects, where there is a significant backlog of projects not related to the residential real estate development cycle. Third highlight, our property line performed very well in the quarter with strong growth in profitability even after cat. Moreover, in our largest market California, our catastrophe management served us exceedingly well because today we're publishing revised and reduced reported losses for the wildfires to levels substantially below our market share.

Last highlight, our investment impairments have been quite modest, and the preponderance have not been triggered by changes in value associated with mortgage-related securities or related credit events. Our portfolio is weathering these stormy seas quite well. So overall, if I had to sum up 2007 in a few words, I would say that we have consciously calibrated the balance between growth to maintain our relevance and profitability to satisfy investors and that profitability of component. Specifically, we have generated consistently high ROE, we have delivered overall underwriting profitability, we've exercised careful stewardship of our invested assets, and we've actively managed capital for the benefit of our shareholders.

So let's talk about the cylinder that's not operating properly, and of course that is in auto. It's the one line that's not running at target. Frankly, it's the one where we had a quarter we wouldn't want to repeat. So we are going to spend a lot time on this call on auto because if you can listen past the headlines I think you might find that our depth of knowledge is quite relevant to understanding where the industry is right now. In other words, I think it's easy to be a pundit on auto but what will separate the winners in this game is the degree to which analytics are successfully embedded in a carriers execution on the business.

Our auto combined ratio was 102.9 for the quarter. The quarter had 2.2 points of prior year reserve development, primarily from favorable bodily injury reserves from accident years 2005 and prior. We also saw several current-year items, which affected the combined ratio in the fourth quarter. We had current year development of 1.3 points, which was an adjustment for prior quarters loss severity, as bodily injury severity remained high. We also had higher-than-expected expense ratio, which added about 1.5 points to the combined ratio and we saw the typical fourth-quarter seasonality, which we see in the winter weather, which added 3.5 points, including 2 points of IBNR. So, adjusting for these factors, we come down to an accident year combined ratio running rate of 99, which is 3 points above our target.

So what's going on with the other 3 points? First is premium. We did not earn enough premium into revenue in Q4, despite the rate increases we were granted. Part of that was timing, but part of it was mix. Consider that we have a preferred book, which on average has lower premium per policy associated with it. Also realize that Safeco True Pricing, our current generation auto product, which prices pointed business differentially, has had to be approved state-by-state. So, it was a complex calculation to predict when general rate changes would be approved, as well as when we would be allowed to collect additional premium on pointed business.

So, admittedly we just didn't get that prediction quite right. The remaining two points are general rate inadequacy from continued mid to high single-digit severity in BI and related coverages. So, as you listen to the rest of the call, and obviously Mike Hughes will elaborate further when he gets to his remarks, I think the test of whether we're on track to restore a 96 combined ratio has to be judged by how we answer the following questions.

One, can we get the rate changes for which we've applied in a timely manner? We know that we're ahead of a lot of our competitors in states because we recognized the trend earlier than many. But, you have to satisfy yourself that we're in fact going to get those rate changes we need to get profitability back in line.

The second question is, can we keep expenses we have cut from creeping back in? We've had a pretty good track record until Q4 of this year, and Ross will specifically address this question when he talks about our 2008 run rate saving.

Third, can we manage the claims and how severity affects our book of business? Mike will speak to that, as well, Eric Martinez, he is here, he's available to answer your questions.

And fourth, will our competitive position be damaged by taking price increases ahead of our competitors? We've always said we'll stand by our underwriting discipline, but we'll touch on some of the market dynamics we're seeing, including our limited exposure to the credit challenges of the marketplace.

So, with those opening remarks, let we turn it over to Ross for the financial results, and we'll come back to Mike Hughes for insurance ops, and then to Tim Mikolajewski to discuss Surety. Ross?

Ross Kari - Executive Vice President and Chief Financial Officer

Thank you, Paula. In light of the recent turmoil in the market, I'd like to start by taking you through our investment portfolio in some detail. I think you'll see that our conservative approach has served us very well. Then, I'll walk you through our capital management actions for the fourth quarter and finish with a review of progress in the area of expense management.

Slide number 5, provides a snapshot of our investment portfolio at year-end. The portfolio had a fair value at 12/31 of $9.2 billion, including 52% municipal bonds, 17% corporate bonds, 11% mortgage-backed securities and 15% equities.

Safeco's investment portfolio has no exposure to subprime mortgages, CDOs or CDO-squared, and no HELOCs or home equity lines of credit, and has no counter party credit risk exposure through credit default swaps. The quality of our portfolio remains solid, despite the roiling [ph] of the credit line.

The next two slides, numbers 6 and 7, provide further detail on our $4.9 billion of municipal bonds and our $1.0 billion of mortgage-backed securities. Our results, certainly reflect the benefits of working with a highly sophisticated advisor like BlackRock in these extremely volatile times.

You can see pretax investment income in the fourth quarter was $110 million, down 9% from fourth quarter 2006. You can see after-tax investment income was $90 million, down only 5% from fourth quarter 2006. Both figures reflect lower average balances in 2007, due to the $700 million special dividend paid to the parent, as well as the higher mix of tax-exempt municipal bonds. Municipal bonds made up 52% of the total portfolio at December 31st, up from 41% a year ago.

For the full year, P&C after-tax investment income was $371 million, and up 1% in 2007, despite lower average balances, as a result of the improved after-tax yield on the investment portfolio. Our average tax rate on P&C investment income was 18.4% in the fourth quarter, down from 21.7% a year ago.

Turning now to capital management, on slide 8 we've summarized the capital actions we took in 2007, including a large increase in common stock dividend and the repayment of our higher cost debt earlier in the year and share repurchases in the last nine months of the year. During the fourth quarter, we repurchased 6.5 million shares for $377 million, completing the previous $750 million share authorization. That brought our total for the year to 17 million shares or 16% of outstanding shares at the end of last year, which was all repurchased for $1 billion.

Our outstanding share count at December 31 was just under 90 million shares. You will recall that in 2006, we repurchased 1.2 billion of common shares. We also announced in December that our Board had approved another $500 million share repurchase program to be executed in 2008. Book value per share was $37.81 at quarter end compared with $38.32 at September 30. [inaudible] book value was $36.73, down 2% from $37.48 at September 30th, but up over 2% from a year ago.

We ended the year with a net written premium to surplus ratio of 1.9 times, which places us comfortably in our operating leverage target range of 1.7 times to 2.2 times. From a financial leverage perspective, we finished 2007 with a debt-to-total capital ratio of 17%. The current debt ratings would indicate a ceiling of 35% leverage, so we remain in a very comfortable position with a great deal of balance sheet flexibility.

Finally, I'd like to review with you our accomplishments for 2007 on the expense savings front. We told you that we had targeted expense savings of $50 million for 2007 and that a portion of that amount would be reinvested in the business, into our Open Seas unit, increased marketing spends, IT initiatives and other areas where we're investing to drive innovation and profitable growth for the future. We achieved those savings primarily through reductions in head count across the company offsetting in part by one time spending associated with strategic initiatives and IT and claims in advertising, much of which hit in the fourth quarter.

So we've more to do, we've worked in 2007 to eliminate redundant season or processes and to outsource functions where we can take advantage of intense capabilities at lower operating cost. As a result you see on slide nine, significant improvement of two points in our combined LAE, and expense ratios for the fourth quarter and over two points for the full year. On slide number 10, which illustrates productivity measures, we have been tracking with you for the past year, shows a slowdown in the trend of the improvement but significant improvement nevertheless when you compare the fourth-quarter metrics with the metrics of a year earlier.

So PIF per FTE was 593, a 6% improvement over the fourth quarter of 2006, and operating expense per PIF was $231 in the fourth quarter of 2007 or 9% better than the year-ago period. We expect both metrics to continue to improve over time, though the trends may show some volatility on a quarter-to-quarter basis. In 2008, we expect to take out an additional $25 million to $50 million in expense. Some of these savings will benefit the bottom line directly and we may choose to reinvest another portion in various strategic initiatives.

Some of the expense savings actions that we're considering could result in restructuring charges as well. We expect our savings to be driven by a number projects, including for example, further outsourcing and back-shop functions to lower-costs markets, and continued review of in-house operations, create efficiencies using Lean and Six Sigma methodologies. We will update you on our progress on upcoming calls.

Now I'll turn it over to Mike and Tim Mikolajewski to discuss our insurance segment and Surety results.

Mike Hughes - Executive Vice President-Insurance Operations

Thank you, Ross. Reviewing our P&C operations in the fourth quarter, we delivered a solid quarter with an overall combined ratio of 93.6%, which includes 3.3 points of capacity losses of $46 million. Favorable prior-year development in the fourth quarter was 3.8 points or $53 million. While total net written premium was flat, we continue to grow in our very profitable business segments, personal property, small commercial and surety, and we continue to have momentum in those areas.

As you see on slide number 11, in auto, we posted a combined ratio of a 102.9, as Paula reviewed. We remain committed to getting back to the 96 combined ratio by year-end, and in fact we have made a great deal of progress towards bringing the auto back towards our long-term target. As Paula mentioned, we are running [inaudible] year combined ratio of 99%, which is 3 points higher than our long-term target of 96. The 3 point difference reflects the fact that our loss costs has continues to rise higher than we expected, particularly in bodily injury severity. We've studied our loss... our auto loss cost trends, especially bodily injury, and we know that it's not isolated to certain states. In fact BI, bodily injury is running high in most of our states. We've reviewed our auto book and our business mix is strong. Our models are very solid, and we have identified as previously mentioned, one sale relating to MVR violations that has not kept up with loss cost trends. We are fixing that with rate increases in the rollout of Safeco True Pricing for auto, our next-generation of multivariate underwriting model. Safeco True Pricing underwrites all policyholders, new and renewal.

On slide number 12, we've summarized specific steps we're taking in 2007, and are taking also in 2008. In the fourth quarter, we obtained rate increases in 17 states for an average annualized increase of 8%. During 2007, we increased auto premium rates in 34 of our 44 states, for an average increase of plus 4%, most of which will be earned into premium in 2008. And we're filing for another 6% in rate in 18 states in the first quarter of 2008. In the fourth quarter, we launched Safeco True Pricing for automobile in eight additional states. Tessy [ph] I understand that I wasn't coming in very well. Let me start that final paragraph.

In the fourth quarter, we launched auto Safeco True Pricing in eight additional states, bringing the total to 23 states at year-end, which is more than half of the 44 states in which we operate. With the additional rollout in the first half of 2008, we expect 80% to 85% of our auto premium will be up on Safeco True Pricing by July 1. We continue to review underperforming independent producers. We've canceled the appointments of 300 unprofitable agents, and we're in the process of re-underwriting the books of another 350 agents. On the claims front, we're working on several initiatives to improve the efficiency and effectiveness of our claims organization, including additional training for adjusters focused on best practices, as well as leveraging a higher utilization of our vendor networks and providing more technology support for the speed of handling claims. So, for example in 2008, we are putting our 2000 adjusters through a week of intense training on best practices and we've already completed the program for all 600 of our auto bodily injury adjusters.

In 2007, we increased the percentage of estimates written by our partner Body Shop to 34% from 11% in 2006, which allowed us to reduce the number of Safeco staff. Additionally, we have plans in the fourth quarter to implement new technology that will enhance our claims capture, adjuster dispatch and predictive modeling of losses. Taken together, these actions, rate increases, re-carrying of our insured risk, agent reviews and enhancements in our claim processes are expected to restore our auto segment to underwriting profitability. We're working to hit our target run rate combined ratio of 96 before year-end, and we are continuing to apprise you of our progress towards that goal throughout the year.

As for market conditions in auto, we're seeing an increasing number of carriers filing for rate increases. We track closely 12 major competitors' rate actions, and in the fourth quarter we saw an increasing percentage of filings that were increases versus decreases compared to earlier in the year. In the fourth quarter, almost 60% of the filings were for increases, reaching a high of 75% in December.

Slide number 13, gives you a view of the pricing environment for auto, property, and small commercial. Now turning to slide number 14, we had another excellent quarter in personal lines property, with the combined ratio coming in at 90%, or 76% excluding catastrophes. Net written premiums grew 5%, and our policy count grew over 8%. We continue to have a competitive advantage in property through our multivariate predictive model. And we continue to demonstrate our core competency and competitive advantage in catastrophe exposure risk management with the fourth-quarter wildfires in California. In November, Safeco was one of the first to publish an estimate for losses when we announced $35 million of loss. By quarter end, we had reduced that estimate to $27 million, or less than half the loss that would be indicated by our homeowners' market share in California.

The schedule on slide number 15, which we borrowed from Morgan Stanley, shows how our competitors stacked up against us in this cat event. This is no fluke. We've consistently incurred less than our market share of the loss in major cat events. We also had a strong quarter in commercial with a combined ratio of 90, including 92 for SBI Regular. SBI Regular had 2.6 points of catastrophes. Growth in both policy count and net written premium was about 3%. Again, small commercial is a market where automated underwriting model differentiates Safeco, in terms of underwriting accuracy and speed and ease-of-use for agents, giving us a competitive advantage.

Going forward, we continue to see opportunities for modest growth in property in small commercial, at our underwriting profitability targets, and we expect to be able to bring back the auto combined ratio to our target, a run rate of 96, before the end of the year.

Now Tim will review our Surety segment.

Tim Mikolajewski - Senior Vice President and Head of Safeco Surety

For 2007, Surety posted a record year with a pretax underwriting profit of $148 million. As you see on slide number 16, we have been delivering excellent combined ratios and beating the surety industry average for decades even when the economy has gone into recession, causing problems for our less disciplined competitors. As you look at this graph, I should note that our business has grown much more diversified over time and we are better positioned now to weather an economic downturn than we were 10 or 20 years ago.

We finished a great year with another great quarter. Our combined ratio was 62.8% in the fourth quarter versus 58.9% a year ago. And year-over-year growth in fourth quarter net written premium was 14%. Also, our growth in the fourth quarter and for the full year for that matter came from our existing customers, primarily in the public funded municipal work sector.

As many of you know, Safeco Surety's business breaks down into two areas. Our contract product, where we write performance bonds for contractors, makes up about 75% of our total written premium. The other 25% of our business is commercial surety where we write a variety of compliance type obligations and low-risk financial guarantee bonds, primarily for Fortune 1000 companies or large private companies in diverse industries.

Slicing our book a bit differently, about 75% of our accounts have been with Safeco for over three years, many for much longer than that. That's significant because the highest risk for surety claims from our experience has been in the first three years of the surety relationship. Overall, surety market conditions continue to be stable although we are starting to see some pricing pressure, mostly in commercial surety. We've seen some new entrants using pricing or more flexible underwriting terms and conditions to try to gain market share in the commercial surety sector. Funding for 85% of our contract surety projects comes from the public sector. Our customers are building the nation's highways, bridges, schools and hospitals, construction that is funded by states and the federal government.

So as we think about the potential for an economic downturn or tightening in the credit markets, the fact that liquidity is not going to be as readily available as it has been in the past, we don't expect that to have a significant impact on the profitability of our contract business in the near term.

For the next 12 to 18 months, we still see a pent-up demand for infrastructure projects. We expect some contractors that are previously focused on residential projects to shift over to the public works sector where building continues to be strong. Where they have been typically say five bidders on a project, you might see 10 to 12 bidders. Some of these newer entrants may be less experienced and also financially weaker especially if they've been buffeted by a downturn in residential construction. And, if they are inexperienced or financially weak, they are not likely to be Safeco Surety clients. So, we might not get as much of this business.

As you can see by our track record, we will walk away from business if we are not confident about its profitability. As a result, we're expecting our top line growth in Surety to moderate somewhat in 2008 and looking forward into 2009.

With that, I'll pass it back to Paula.

Paula Rosput Reynolds - President and Chief Executive Officer

One obvious question that's on investors' minds is how will your company fare in a potential recession? Besides the conservative approach we take in managing the balance sheet, being good stewards of your capital, we believe that the business at Safeco is better positioned than many of our competitors to weather a downturn in the economy. In our homeowners’ line, credit and mortgage accounts have been used in our rating models since 1999 and we were one of the first carriers to do so. If adequate rate and segmentation on our new and in-force book and our customer base heavily tilted towards the preferred market, which will be less subject to dislocations and less moral hazards than that of many of our competitors. 70% of our book is rated with an Insurance Bureau Score IBS greater than 700, which is of course the top one-third of the IBS range.

Only 1% of our book contains an IBS score below 300, which is the lower third of the range. We have not uncovered any connection in our book to subprime exposure and of course we continue to monitor for losses and trends, our losses and trends for any correlation to what's going on in the broader economy.

In small commercial, we also have a preferred book of business from a credit… commercial credit standpoint. We do have a small business focus with 95% of our book being less than $10 million in premium side. This segment is more stable on pricing as we've often mentioned and has the best opportunity to react in a changing environment. Small companies with a small workforce may not be as susceptible to a rise in unemployment or is likely to get it over extended due to poor financial discipline.

We have a very limited exposure to homebuilders because we have shied away from writing anything other than orders [ph] contractors for many years now.

To sort of wrap it up before we open it up for your questions. One, we capped 2007 with fourth quarter of strong results. Two, we continue to work to improve profitability in auto and drive autos’ combined ratio back to our long-term target of 96%. And three, the return on equity in the fourth quarter and the full year remained in the high-teens, driven by excellent underwriting and personal and properties, small commercial and surety, solid investment performance and combined with our very accurate capital management.

With that, we'd like to open it up to your questions.

Question and Answer

Operator

Operator: Thank you. Today's question-and-answer session will be conducted electronically. [Operator Instructions]. Your first question comes from Dan Johnson of Citadel Investment.

Dan Johnson - Citadel Investment

Great. Thank you very much. Let's start a little bit with the auto business and talk a little bit about the loss inflation environment that seems to be where, where the source of the combined ratio increased. Can you start off by walking us through some of the frequency and severity statistics as you have them for the fourth quarter and how that has changed maybe over some of the more recent quarters?

Mike Hughes - Executive Vice President-Insurance Operations

Yes hi Dan, Mike Hughes. Thanks for the questions. In the fourth quarter on automobile, our total lost cost was about 5% that will slightly negative frequency and five to six points of severity. And as we've talked before to you, when we look deep into the severity in '08, it does go into the bodily injuries severity that standing out and that was in the high single-digit numbers from a severity perspective. What's changed from prior quarter is that the lost cost have been running about 5%, which really was not our expectation at the beginning of the year and that the BI severity remains high in that high single-digit number. Our frequency is slightly negative across our books and I also mentioned, which... how we're looking to calibrate and look at our book is our property damage frequency continues to be negative. So the number one issue for us is BI severity.

Dan Johnson - Citadel Investment

All right. So that… I mean those numbers don’t sound that different than before and we'd previously hope to get to sort of 96 by middle of the year. It is the issue that we think that the loss inflation environment will stay higher, longer whether it's going to take longer to get revenue for policy up to a point to bring the combined ratio back down.

Mike Hughes - Executive Vice President-Insurance Operations

Really, the BI severity has definitely stayed a little higher than our expectation and as we calibrated in the fourth quarter where we thought we were running an action year between 97, 97.5, you have heard us mention that it is 99 and we do believe, given the significant rate increases that we have taken and the work that we are doing in claims and the work that we are doing with our producers and Safeco True Pricing that we can be at a running rate of 96 in the second half of '08. We are pushing back a little bit whether it's a third or fourth quarter, but you will see and you can see in one of our chart, we took significant price in the fourth quarter, eight points of price, we have got 17 filings in the first quarter, which we think will generate at least six points of price and we have had success bringing in Safeco True Pricing now in over half our states and we should have over 80% or 85% of our business in Safeco pricing before the end of the first half of the year. So we are still pushing that 96.

Dan Johnson - Citadel Investment

Great. And then on the reserve release front in aggregate, relative to the first three quarters of the year, we ran a good sort of $0.20 in earnings above, but it came from a bunch of different places. Can you sort of kick through the more notable reserve releases and just give us a little color on that? Thank you.

Mike Hughes - Executive Vice President-Insurance Operations

We took $14 million down in automobile and that was ‘05 bodily injury and prior, which you've seen from us and other carriers. In the commercial side, in SBI Regular, we took down about $12.5 million, it was a combination of workers’ compensation and general liability. On the general liability, it was really a lack of emergence from '03 and prior. On the workers’ compensation, it was '05, '06 years and really lower severity than we expected and then in our safe book, we took down about $3.5 million and on safe, it was primarily general liability '03 and prior lack of development. I think on our Surety side, we took $16 million and really that was a lack of any emergence of claims from 06.

Dan Johnson - Citadel Investment

And then this is a simple math question is the AOCI actually declined in the quarter when we had a pretty good decline in interest rates. I'm sure I'm missing something but why didn't the AOCI actually go up in the quarter?

Ross Kari - Executive Vice President and Chief Financial Officer

Well, we had a pretty good decline in benchmark rates, however the credit spreads for many of the types of investments that we have and that everybody is holding pretty much offset the decline in the benchmark rates to where you're not seen a big OCI adjustment on the fixed income side. The decline in OCI on the equity side, I think you know what's happened in the equity markets.

Dan Johnson - Citadel Investment

That’s what it was, because it even amused me, I mean everything had price appreciation in the fourth quarter in bonds, but I totally forgot about your equity portfolio. Thanks very much.

Ross Kari - Executive Vice President and Chief Financial Officer

Okay.

Operator

Your next question comes from Alain Karaoglan.

Alain Karaoglan - Banc Of America Securities

Good evening. Two questions, one a quick one for Ross in terms of the expense saving of $25 million to $50 million, are you expecting to let that go through to the bottom line or are you going to be reinvesting it in the business? And the second question is on personal auto, are you questioning or should you question your tiering [ph] models? Are they doing what they're supposed to do given the results that we've had or how are you thinking about that?

Ross Kari - Executive Vice President and Chief Financial Officer

$25 million to $50 million and some of it will go through to the bottom line. We have a few big projects that... we're working on that could take some reinvestment. But I would say and we are committed that fair amount of that would flow through the bottom line.

Mike Hughes - Executive Vice President-Insurance Operations

And on the auto tiering [ph], we have... we are bringing in a new pricing model called Safeco True Pricing which we started to bring in, in July which prices both our new and renewal business. And previously that there was... we have identified one set of our business in our other model, our SNAP model that wasn't performing well within a specific variable. That was in handling the right price for MBRs where there was some frequency of hits on MBR violations and where there were some frequency of loss for a particular insured. And with our new model, this will automatically priced it appropriately and get the right tier. So back to the whole auto picture, it is a combination of addressing the bodily injury through rate increases, it is a combination of making a change to returning with our Safeco True Pricing and then continuing to do the basic blocking and tackling with our producers.

Alain Karaoglan - Banc Of America Securities

Thank you very much.

Operator

Your next question comes from Jay Gelb of Lehman Brothers.

Jay Gelb - Lehman Brothers

Thank you. First I had a question on the capacity for the share buybacks. I was hoping if you could touch based on what you talked about the Investor Day where you could lever up more and then use the proceeds to buy back stock. Then also I know you didn't buy back any stock in January. I was hoping if you could speak about that and then I have a follow-up.

Ross Kari - Executive Vice President and Chief Financial Officer

The capacity to lever up is still that what it was at the investor day. And we have target for financial leverage to keep it in the 25% to 30% range. So you can calculate how much we could issue either a straight debt or even hyper debt that would keep us under the 30% threshold to come up with that number. But the number is about the same. In terms of January, we are not operating under any kind of 10b5-1 program right now or ASR program, and January is clearly a blackout period for us. So that under no circumstances when we have been buying in the open market in January because of a blackout. The capacity is still the same right now in terms of levering up to use the proceeds to buy back stock. We got to look at debt markets right now and what's the risk-adjusted cost of borrowing right now. It would been nice to see credits spreads start to come back in over the next several months, ultimately have reduced the cost of doing that, so part of it is a timing issue.

Jay Gelb - Lehman Brothers

Okay. And then my follow-up is on Surety. In sort of the last recessionary period, Safeco along with the rest of the industry saw the [inaudible] in Surety go pretty dramatically and I was hoping you could give us some insight into what do you think will prevent it from happening this time. So even if Safeco's results are better, should we expect a marked amount of deterioration in the Surety combined ratio or do you think something is different about your book this time that helps you to prevent that?

Tim Mikolajewski - Senior Vice President and Head of Safeco Surety

Sure, Jay. This Tim Mikolajewski. I think if you look at the last recessionary period, which is around 2000, 2001 and you did see our combined ratio jump up pretty significantly at that point. And really that was largely related to our Enron exposure. So if you back the Enron exposure out of there we had combined ratios more in the 85, 86 range than versus the 97. So during that recessionary period our book of business performed pretty well even as the industry had some issues with companies like K-Mart and WorldCom and different companies like that that they went out of business. So, our commercial book is pretty diversified from the standpoint of a number of different industries and just historically it has performed incredibly well even through the up cycles as well as the down cycles. On the contract surety side, construction contractors have made significant margins and build their balance sheets very, very strongly over the last four years given the robustness in the construction industry. So, most of them have built balance sheet so that they can withstand a pretty good downturn in the construction economy and not to be in a situation, where they are going to be defaulted on projects. So we feel pretty good about 2008. We will kind of play it out to see how the economy changes and look at 2009 and see whether we have any concerns at that point. But right now we think that it would respond pretty well to a bit of a downturn in the marketplace due to the credit quality of the business that we handle.

Jay Gelb - Lehman Brothers

With the percentage of your book in the... dedicated to the public works business be a factor as well?

Tim Mikolajewski - Senior Vice President and Head of Safeco Surety

Very much so, because as we mentioned 85% of bonds we write in the construction sector are funded by public money, state federal government, cities, counties and with the demand for infrastructure in the United States we are still hearing some pretty positive things coming out of the large departments of transportation around the country as far as projects that are going to be out in the marketplace.

Jay Gelb - Lehman Brothers

Thanks for the answers.

Tim Mikolajewski - Senior Vice President and Head of Safeco Surety

Yeah.

Operator

Your next question comes from Paul Newsome with Sandler O'Neill.

Paul Newsome - Sandler O'Neill & Partners

Thank you and good afternoon. I just wanted to see if my math is right... thinking about sort of the usage of cash over the next year. It looks like you took about $1 billion out of statutory surplus over the course of last year and that funded your buyback to date, not going to where I hope you expect to either earn about $500 million in the future. It looks like your surplus is pretty much kind where it should be at about two to one premiums and surplus. If that's correct, that it kind of follows that most of which you're going to earn over the course of the year will be used for the buyback and I guess leverage up perhaps a little bit to fund the dividend. Is that a fair conclusion?

Ross Kari - Executive Vice President and Chief Financial Officer

Yes. That's a fair interpretation of the math. The buyback program is completely set up as a discretionary program right now. It's not on autopilot, so we have the ability to execute it opportunistically. But, I think your math is right.

Paul Newsome - Sandler O'Neill & Partners

Okay. So, the idea is that essentially the capital levels will stay about where they are, maybe a little bit leveraged but... a little bit more leveraged by the end of the year?

Ross Kari - Executive Vice President and Chief Financial Officer

Now we always do have the potential to put on financial leverage, because our financial leverage ratios is so low and those proceeds as well to buyback stock.

Paul Newsome - Sandler O'Neill & Partners

And maybe I could just beat on the auto thing, just a little bit more. But… and I am having trouble, pardon me, I'm have a horrible cold, I'm having trouble with the math a little bit, with your rate increases. I mean it looks you're at an average 4% rate increase over the course of the year, but 5% underlying inflation that we should expect at least a couple of more quarters of deterioration before things turn around. Are you jacking up rate so quickly right now, that over the course of the year, you will be able to implement them enough to actually turn that overall premium rate increase above what the underlying inflation is?

Mike Hughes - Executive Vice President-Insurance Operations

Yes. Hi, Paul, Mike, how are you? A couple of things. We have accelerated the rate increase. You can see, in the fourth quarter, we accelerated it 8 points. In the first quarter, we are at 17 filings for six more points. In the second quarter, I didn't talk about, but we have another 18 filing for six to seven points. So, that's one piece of it. So, you've got two combinations of earned premium from the rate in '07, and then the rate that's going to be earned in '08. Secondly, then you have what we talked about with our carrying and our Safeco True Pricing coming in that will address some of the... that one unprofitable sell that I talked about, and where we've already got it in 40% of our book which it will start to make an impact, it will be in 80% of our book by the end of the first half of a year. The third piece is, the work we've done with unprofitable producers, we closed out 300 agents and we're re-underwriting another 350 agents. Re-underwriting means we go back, we look at the data and actually we re-tier them in most cases, we re-tier them upwards. And then, fourth piece is Eric Martinez and his team is working hard on taking a solid claims organization and even finding more ways to offset some of the BI litigation. And some of the things we've done there is, I mentioned we just went through some intensive training with all our auto bodily injury adjusters and that is really to make sure they're using best practices, inhaling some of the BI inflation we're seeing. Secondly, Eric also added a little bit on the SAF side, so that our most experienced unit managers have a smaller level span of control in working with all our adjusters. And looking back at some other things that we have been working on overall for auto, from a claims perspective, including our direct shops which we've enhanced how much utilization we use there from 11% to 34%. So, you take a combination of all those things and we're still pushing for that 96

Paula Rosput Reynolds - President and Chief Executive Officer

But I think Paul to your point, I don't think that we see, we're going to deteriorate further. In another words, we've taken all these actions. We didn't get any traction on them really in Q4 or what traction you would've expected we got was unfortunately more than offset by the bump up in the expenses in Q4. But, we’ve got all these things really starting to operate and we think that even though we don't have a lot of hope on severity, turning in the opposite direction on us, we don't think that we are going to fall deeper into the hole in Q1. We think it will go the opposite way.

Paul Newsome - Sandler O'Neill & Partners

No. I am just trying to get my arms around the fact that, in terms of... you tended to have a lag effect between when the… you can implement rate increases and actually get them through so.

Paula Rosput Reynolds - President and Chief Executive Officer

Exactly. And I think that that's what I tried to say in my opening remarks. We thought we'd actually earn in more in Q4 than we did. We were slow to go. And I think that that has sort of calibrated our expectations. And I think as well, we missed the mix issue and how the mix issue was also driving through how much rate we would take. But the fact is, is we are first in line in these states and a lot of this stuff is still pending, so that gives us a certain helpfulness. The second thing is I think we are very much on top of our game actuarially now on the importance of predicting these mix shift and how that is going to affect our ability to actually realize earn-in revenue. And third, we spent... we just trained 600 BI adjusters on their best practices to remind and they got to be in the game with us every day, because every day counts. We've gone to a whole daily reporting on all of our claims to try to put way more visibility into it than we've ever had before. So honestly, we watched January day-by-day and that is part of what gives us some confidence that we are not seeing anything that would make us believe that our plan to begin to get traction in the other direction can't be achieved even in Q1.

Paul Newsome - Sandler O'Neill & Partners

I'll keep fingers crossed for the first quarter results. Thank you.

Paula Rosput Reynolds - President and Chief Executive Officer

Yes. We are living in the same world here. But I think having been taken... buying the woodshed in the insurance industry over the last year in auto, I mean, I don't think we put ourselves out here on thinking that we could get this thing moving back the other way unless we felt some confidence that all these actions together would begin to make a difference.

Operator

And your next question comes from Larry Greenberg of Langen McAlenney.

Larry Greenberg - Langen McAlenney

Now, I feel really guilty because I'm going to continue to beat this dead horse. But, not everybody is convinced that the auto marketplace is accommodating of rate increases and you guys are out there pushing price. I am just curious with PIF coming down, how do you convince yourself that there isn't some adverse selection going on?

Mike Hughes - Executive Vice President-Insurance Operations

Hey Larry, Mike, thanks. First off you know our book has really been moving towards preferred. And that's where we've been really focused. So, on the adverse selection, we can look at our statistics, our movement has gone from 81% preferred this year to 84%. And if you really go back to last two years, the book has moved 6, 7 points preferred. So then how do we know we got the preferred tiered rate, as we look at the individual variables in our entire book. And you know our credit, and we specifically look at some key variables including insurance bureau scores or credit. And our credit is very high on our book of business, 85% of our book of business has credited I would call average or higher. So we feel pretty good that that is not taking place. And if you look at our renewal retention, you will see actually throughout the year we were actually able to increase our renewal retention by almost a point and part of our New Safeco True Pricing is to protect that. It provides additional discount for cross sell, provides discounts for tenure. So one other point, we are watching that very closely, but I'll mention that the market as a whole, we watch what our competitors are doing every day and we have started to see an uptick in pricing starting to take place, not as much as we are taking but we have seen it. I think I mentioned before, in the second quarter this year we look at our top 12 competitors and we saw that about 30% of the market was taking rate, 70% going down. In the third quarter that went to 50-50 and in the fourth quarter we have seen it move up to 60%, 65% of our competitors starting to take-rate and it was certainly pronounced in December. So we are trying to manage all that.

Paula Rosput Reynolds - President and Chief Executive Officer

Larry, maybe I will make one other observation to look at. Any time you are taking rate you've got an elasticity of demand you are trying to fight and so we have been trying to be very careful to try to keep the rate increases in the cells where we have been concentrating on retention in a place that doesn't begin to trigger customer switching. So somebody is going to get rate increase for some pointed business that we are okay because we are trying to ward off adverse selection, but we've really tried to be very, very down in the weeds as to which cell in the segmented tool are actually going to take the largest rate increase. But we haven't just sort of pushed thing, hey we are going to push 6% through here and everybody is going to get it. That is absolutely not the way we are doing it.

Larry Greenberg - Langen McAlenney

Is there any geographic variance as to what you are seeing amongst your competitors? Are there any places that you are finding rate as being pushed more aggressively than others?

Paul Newsome - Sandler O'Neill & Partners

Across the board now.

Mike Hughes - Executive Vice President-Insurance Operations

Yes. That's a difficult one to respond to Larry. I can't say anything fixed out, other than in general I think some of our key competitors are seeing the BI inflation move up and I think some of them even on their analyst calls have talked about in general getting rate increases across the country. Where we see the BI inflation, it has been in many states.

Neal Fuller - Investor Relations

Larry, this is Neal Fuller and I had looked at the rate filings as well and across the board there is no pattern necessarily, and there are some surprising months. Some of our major competitors taking double-digit rates in states that are very large for them. And so I think that that's what we have seen and as Mike mentioned 75% of the filings that we saw in the month of December were increases versus decreases.

Paula Rosput Reynolds - President and Chief Executive Officer

So I think to Mike's earlier point you sort of... when you think, you BI, you say, oh, my goodness it must be the usual cuts back and it is not. It is out there everywhere. And Erik has done a fair bit of analysis of underlying root causes even within BI and there is sort of a theory going, you probably heard it on other calls, but it’s sort of the… kind of I would call the Jell-O theory or balloon theory, but it is this whole thing of managed care and states getting after the medical cost for their employees. I mean these are all squeezing down the cost of healthcare to those recipients. And so in a place where you have the obligation to take care of the claimant you get the brunch of some of that medical cost increase so as everybody in the society has gotten better about managing medical care, it squeezes out on the other side and I think that's why... its one of our theories about why you're seeing it so much of this right now.

Paul Newsome - Sandler O'Neill & Partners

Great. Thanks very much.

Operator

Your next question comes from Matthew Heimermann of JPMorgan.

Matthew Heimermann - J.P. Morgan

Hi, good afternoon everyone. I had I think three quick numbers questions. First was the stat you included in your press release on the 4% increase in 34 or 44 states. Can you... what's the weighted average of that 4.2 across the entire 48 states versus just the 34 where you increase rates?

Ross Kari - Executive Vice President and Chief Financial Officer

I believe the 4% is really for our entire book. We are… Neal is looking back at a stat here, but we'll get back to you on that.

Matthew Heimermann - J.P. Morgan

Okay. That's fine. I just was curious, just how relative share of those states premiums we sort of increased. The other thing was, I was wondering is, is there any, within your rate filings, is there any distinction between what you're doing with rates for new versus renewal business?

Ross Kari - Executive Vice President and Chief Financial Officer

Actually, I go back to Paula, first of, I want to make a point that where we are getting the rate we're trying to get it new and renewal on the right segment that need the appropriate either BI increases or the appropriate where we’ve had some renewal clients for MBRs or prior losses. Second, our Safeco True Pricing carrying is very unique that we are bringing out and that its unique in that where most of our competitors only use it for new business, we're using it for both new and renewal business. And we really believe down the road that is going to give us some significant competitive advantage.

Matthew Heimermann - J.P. Morgan

Okay. And then the last question, that's helpful. The last question I had was on the just retentions, I would expect... from your standpoint I would assume that if you're pushing price and you are out ahead of the curve, there's probably going to be short-term some type of retention hedge you get, what would kind of be the normal retention move you'd expect with this type of rate, because your rate seem to be significantly, the [inaudible] seem to be significantly higher?

Mike Hughes - Executive Vice President-Insurance Operations

We do have some elasticity curve, but I don't want to go into all the specifics. But I will tell you so far where we went for eight points of the increase in the fourth quarter and we went for about three or four in the third quarter. Our retention held firm, it held flat and our elasticity curve giving you one priority data point here really says when we go for over 5 or 6 point, that's where we start to see a change, but it's been holding tight right now as we look at next year, we are factoring in that we know we're accelerating six points of increase that will be spread over the right cells, in the right particular states. We think we'll have some low negative single digit growth in automobile and that's if the marketplace really stand still.

Matthew Heimermann - J.P. Morgan

Okay. That's helpful, and I'll just follow up later for the answer to the first question. Thanks.

Neal Fuller - Investor Relations

We've got time for one more question operator.

Operator

Yes sir. Your final question will come from Jo Shanker, of Citi.

Joshua Shanker - Citigroup

Good evening everyone. You know I'm not a big fan of the share repurchase, but I just want to find out. If you look forward and you don't get the rate increases you're hoping for, would you still proceed with the share repurchase in the same intent as you've done so in the past?

Ross Kari - Executive Vice President and Chief Financial Officer

We play that by year as we go forward. I can't say exactly how we would react. So, but I still firmly a fan of managing our capital to the appropriate level for the level of the underlying business. So, and we're going to focus on maintaining our capital ratios and leverage ratios in appropriate manner. So...

Joshua Shanker - Citigroup

Okay.

Neal Fuller - Investor Relations

This is Neil Fuller, I think we've got plenty of balance sheet flexibility as well as the obviously the operating leverage. And we don't foresee any difficulty getting these rate increases given the fact that they're actuarially justified. And the fact that, again 75% of the increases we saw in December were for increases from our competitors. So, we feel... we feel that similar requests will be made at the State Regulators in across the country.

Paula Rosput Reynolds - President and Chief Executive Officer

So Josh, let me wrap up on this. Your views have not gone unappreciated here. Now, we are trying to be very thoughtful about the issue of what really grows long-term value and let me also say that, besides all of Neil and Ross' remarks about the fact that we do have balance sheet capacity here to try to manage the capital structure appropriately, we are not entirely dependent on rate increases to float our boat this year. One of the goals that we set and the sort of four goals we set for ourselves for the year is that we have to do some things to get rid of the drag on our business. And for Mike, uses my way of example that we're re-underwriting, manually re-underwriting the 300 producer's books. There is many, many activities that we have in place this year to make sure that we don't leave a bunch of money on the table or operate in a way that’s probably this year every nickel counts and we are chasing after all of it.

Joshua Shanker - Citigroup

Well, best of luck to you in a challenging environment. I wish you the best.

Paula Rosput Reynolds - President and Chief Executive Officer

Thank you.

Neal Fuller - Investor Relations

Thank you. That concludes our conference call today. Thank you for your participation. If you have questions, follow up, I am available and Karin Van Vleet at 206-473-5020. Thank you.

Operator

Ladies and gentlemen, this concludes today's Safeco's fourth quarter earnings results conference. You may now all disconnect.

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