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Baldwin & Lyons, Incorporated (NASDAQ:BWINB)

Q4 2007 Earnings Call

January 31, 2008 11:00 am ET

Executives

Leslie Loyet - Vice President, Financial Relations Board

Gary Miller - Chairman and Chief Executive Officer

Patrick Corydon - Senior Vice President and Chief Financial Officer

Joe DeVito - President and Chief Operating Officer

Analysts

Blayne Marder - Loeb Partners

John Gwynn - Morgan Keegan

Operator

Good day everyone and welcome to today’s Baldwin & Lyons Incorporated fourth quarter earnings conference call. Today’s call is being recorded. At this time for opening remarks and introductions I’d like to turn the call over to Ms. Leslie Loyet of the Financial Relations Board.

Leslie Loyet

Thank you all for joining us this morning for the Baldwin & Lyons fourth quarter and year end 2007 conference call. If you did not receive a copy of the press release you may access it online at the company’s website which is www.baldwinandlyons.com. I would like to remind everyone that we are hosting a live webcast for the call which can be accessed on the company’s website as well.

At this time, management would like me to inform you that certain statements during this conference call and in the press release, which are not historical, may be deemed forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995.

Although Baldwin & Lyons believe the expectations reflected in any forward-looking statements are based on reasonable assumptions, it can give no assurance that its expectations will be attained. Factors and risks that could cause actual results to differ materially from expectations are detailed in the press release and from time to time with the company’s filings with the SEC.

With that said, I’d like to introduce Gary Miller, Chairman and Chief Executive Officer of Baldwin & Lyons, and turn the call over to him.

Gary Miller

Thank you, Leslie. Welcome to those of you joining us this morning for the Baldwin & Lyons conference call reporting results for the fourth quarter and for the year 2007. We are happy you are with us and that you are interested in the company.

My name is Gary Miller, I’m the Chairman and CEO of the company. Joining with me in presenting the call this morning are Joe DeVito, President and Chief Operating Officer of the company, and Pat Corydon, CFO and Senior Vice President.

In this morning’s call I’ll begin with a short summary of how we did for the fourth quarter and for the year 2007. We’ll also examine what we might expect for the year 2008 and beyond. Pat Corydon will follow with a more detailed explanation of our financial performance and our current financial condition. Following Pat’s presentation, Joe, Pat and I will be happy to answer any questions that you might have

First let’s briefly examine the results for the year. The year 2007 was a record year for the company. The company’s highest ever pre-tax operating income of $39.5 million showed a 10% increase over the prior year. Pre-tax investment gains of $40 million far surpassed the prior year’s $17 million. We’ll comment more on that in just a bit.

All together record pre-tax income of $79.6 million most favorably compares to the $53 million of the prior year. Of course, taxes were also a record, but after-tax for the year 2007, Baldwin & Lyons reported a record net income of $55 million versus a prior record of $38 million in 2006.

For the fourth quarter, our pre-tax operating income slipped a bit and not was a record, but compared favorably with the earlier year. In the fourth quarter of 2007, the company made $5.7 million pre-tax from operating earnings versus $6.3 million in the fourth quarter of 2006.

However, investment gains were dramatic in the fourth quarter. The company had pre-tax investment gains of $24.4 million in the quarter, compared with $8.2 million in the prior year’s fourth quarter.

Net income, because of those large investment gains, increased more than $9 million for the quarter year-over-year to $20.4 million from $11.3 million in 2006. That’s an 81% increase. Obviously, another record was set with the net income number.

Now commenting on those most significant investment gains. As followers of the company know, the company is a relatively heavy investor in equity securities, primarily common stocks as compared to other similar property and casualty insurance companies. And that strategy has produced generally favorable investment results through the years and we have built up significant unrealized gains in our stock portfolios.

At the beginning of the fourth quarter of 2007, those unrealized gains totaled nearly $75 million before taxes, and as followers of the company also know, we have also made significant investments in limited partnerships through the years, mainly in hedge funds of one type or another.

Those investments also have, on the whole, done very well for us. At the beginning of the fourth quarter those limited partnerships had combined values of $74 million on funds invested of $37 million.

In the latter part of the year, the company elected to create a new investment vehicle in the form of a hedge limited partnership in which the company would own the majority interest. Associated with two individuals previously known to the investment committee, the company has created and funded a hedge fund named Maratan Partners that intends to follow proprietary investment techniques with the goal of out-performing the S&P 500 average while not greatly increasing margin cut risk.

In January 2008, Baldwin has provided initial funding of $50 million to that partnership. To provide part of that funding for Maratan, Baldwin sold some equity positions managed by other outside managers during December in anticipation of its investment.

The year end balance sheet shows a larger than normal cash position in preparation for the 2008 investment in the new limited partnership hedge fund. The equities that were sold were generally sold for a price far in excess of cost, which produced a substantial investment gains in the fourth quarter. Maratan, our new limited partnership, is now up and running. We will keep you apprised of results in future conference calls.

While on the subject of investments, let’s look at the company’s investment income for the quarter and the year. Net investment income, that’s investment income after taxes, was up 6.8% for the year. Before tax, we were up only 0.2% showing the company’s shift through the year from taxable to non-taxable investments.

Our after tax yield increased 10.4% for the year and 1.2% for the quarter. With the development recently seen in interest rates at the national level, I doubt we will see further significant yield increases in our investments, unless we change our fixed-income portfolios duration, which is not planned.

Cash flow from operating activities remain positive for the quarter and the year. Pat will provide more details on that. As you know, we pay significant dividends to shareholders. That reduces funds available for company investment, although we presume our shareholders are investing those funded tax rates that are more favorable than the company’s.

Dividends paid in 2007 totaled $25.1 million or $1.65 per share, which, by the way, on today’s stock price represents a 6.6% cash yield.

Moving on to operations: in general, we are very happy with results. Happier with the year’s results than with the fourth quarter’s. We are pleased with the performance with our subsidiary and Protective Insurance Company. We have less enthusiasm for the results of Sagamore Insurance Company, only because of its decline in premium volume. Sagamore’s combined ratios and margins were satisfactory and would have been even better on higher volume.

But we’ll talk a little first about Sagamore. As most of you know, Sagamore writes non-standard auto insurance and small fleet trucking insurance, with a small fleet being defined as one to six power units. Actually, our average number of power units per policy is less than two.

In the past few years, we have seen several developments affecting non-standard auto insurers, including Sagamore. The age-old distinction between standard and non-standard insurance has been blurred, if not eliminated.

Utilizing credit scoring and other underwriting techniques, many of the standard companies are now writing risks that previously would have been classified non-standard. That invasion into the non-standard market has reduced risks available for the traditional non-standard agents and insurers.

In addition, auto insurers flush with good experienced results and generally chasing volume has caused rates to decline, putting pressure on both volume and margins. Sagamore has felt those pressures.

Despite heavy marketing and promotional efforts with increased advertising, new and increased promotions, various commission incentives, etcetera, Sagamore’s personal auto written premium declined 30% for the year, while earned premium declined 19%.

However, even with those volume decreases, I point out that the product operated at a 93.8% combined ratio for the year, when fee income is considered. Without fee income, the ratio was 101.7%.

Although it may be considered decent margins by many, those are higher ratios than we have previously enjoyed and reflect the lower rates available and the fixed expenditure pressure caused by lower volume. And while results are not bad, they are not so good that we are emboldened nor able to further reduce rates to chase volume.

So what’s in store for our auto product? First, we believe the market may be improving, meaning prices are probably no longer going down, and may in fact, be increasing. Many, including some of the biggest investor writers are reporting weaker operating results with both volumes and margins under pressure.

That normally means that rates should stabilize and eventually increase, and perhaps come back to levels we have maintained, allowing us to recapture some of the lost business. Next, we have had some success in our marketing and promotion announcements. With a revamped marketing department, we will build on those successes.

Finally, we too have broadened our horizons beyond being just another non-standard auto writer. Our new scorecard rating product has now been introduced in a few states. Utilizing many selection techniques with appropriate pricing, we should appeal to a broader market than before, and hopefully, volume will follow that appeal.

So, we are aggressively working to maintain and increase volume while not sacrificing our historically consistent profitability. It will not be easy, but if we do get some help from the market, good volume and better profits are doable.

To some extent, our small fleet products saw similar factors causing its volume decline. Sagamore’s small fleet operations has specialized in a short haul trucking. Much of the business is what we call aggregate haulers. Others call it dirt, sand and gravel haulers or dump trucks.

While once a type of business shunned by many insurers, we found that when properly selected, it was excellent business. Now others have also discovered this. And, while aggregate truckers were previously rejected by some of the bigger commercial auto writers, that business is now welcomed and written, sometimes at too low of a rate in our opinion.

With more companies writing, some at these regressive rates, we find it harder for us to add new business and to retain that which we had. Again, we are marketing more aggressively; we sharpen our pencil with rates, while keeping an eye on profitability; we looked to other opportunities in trucking types we previously did not emphasize, but the end result has been less volume, although still profitable.

In fact, from one year to the next, 2006 to 2007, our already profitable loss ratios for small fleet trucking improved by a full 10 points. In a small way, limited to a niche product, what I’ve described is the picture of a soft market, and so we expect here.

Others can attempt to rewrite specialty biz, but whether they can handle their writings as well as a specialist, will ultimately be seen. In fact, just recently, one of our competitors admitted their reserves were wrong, big time, and all of the earnings reported in the past couple of years were really not there.

Looking at Protective Insurance Company results, we can report that Protective’s volume increased in the year 2007, fueled by its independent contractor and reinsurance assumed products, gross premiums written increased by 16.8%, and net premiums earned increased by 11.9% for Protective year-over-year.

We still had some volume challenges in our package fleet excess products, caused by revenue decreases of our insureds − since many of our policies were written at a rate that is a percentage of our insureds’ revenue − and also insurance rate decreases and some loss of business early in the year.

In the second half of 2007, no packaged excess business was lost and some new accounts were added. At a combined ratio of 92% for the quarter and 89% for the year, which were better than the prior year’s results in this line, were most satisfactory and allow continuation and reinforcement of an aggressive marketing approach.

As I said, in this line, we also saw much better loss ratios, 15 points better. That does give us some room to compete.

Volume in our independent contractor product continued to increase in the fourth quarter, as it has in all of 2007. Expansion of products to existing customers, and the addition of new customers combined for a volume increase of over 40% for the year.

Due to some, we believe, unusual claims severity in the fourth quarter, our combined ratios for this product reach 102%. Such volatility might be expected with results fluctuating from quarter to quarter, where we write and retain fairly high limits of coverage. Those higher limits allow severity claims to impact results in any quarter.

However, it is felt the 90% combined ratio reported for the year 2007, a longer measure avoiding the peaks and valleys of the shorter measurements, is more reflective of the performance of this line of business. Yet, we’ll keep close watch on the products results.

Further expansion should be expected in 2008 with same customer sales increasing, and with the addition of new customers as our expanded ic2 program, which we have previously discussed in other conference calls, continues to gain market acceptance.

Results in our reinsurance assumed line of business for the quarter were marginally profitable, with a combined ratio of 96.6%. The yearly results were much better with a combined ratio of 80.6%, although, that fell short of last year’s excellent 53.8%.

While there is substantially increased volume, up 90% over last year, earnings were down by $1.4 million because of the higher loss ratios incurred this year. A quick analysis will reveal that the Paladin venture we have previously discussed was a cause for both the higher combined ratio in 2007, and a decrease in earnings in the reinsurance assumed line.

The Paladin venture operated at a 112% combined ratio for both the quarter and for the year, on yearly premium volume of $12.8 million. The non-Paladin reinsurance assumed business produced nearly identical results in 2007, as we saw last year, with a combined ratio on that portion of the business in the low 50s.

We are not pleased with the Paladin results. When we introduced the venture we knew and advised you Paladin writes a different type of reinsurance than that which we had previously written, and that which makes up the remainder of our current writings.

The Paladin business has more of a working layer cover, providing reinsurance to generally small insurers that write business in local or small geographic areas. Because of that concentration, regional or localized storms will cause losses for those small insurers that, taken together, exceed their retention and evade the layers of reinsurance we write for them.

In 2007, there were too many such storms; smaller storms that probably never made the national news occurring in geographic areas where we provided reinsurance protection. So, while there were no major hurricanes or earthquakes that made the reinsurance of larger catastrophes unprofitable, there were for us, numerous smaller localized storms that made our Paladin book unprofitable.

The question, of course, is whether the storms and the damage the caused are unusual and not to be expected on a frequent basis. Looking into others’ experience prior to our agreement with Paladin, we believed such frequency of storms would be unusual making our Paladin results at 2007 appear to be an unusual year.

However, what happened before is of no comfort when our money is first on the line and lost. We have examined all of Paladin’s writings and, while refining our approach a bit, our conclusion is that the book of business is sound and that we have expectations for better results in 2008, if normal, as we believe normal, expected weather prevails.

Obviously, we will continue to monitor and reappraise this business as we do all lines. All products combined, Protective operated at 98.9% for the fourth quarter and an excellent 88.2% for the year 2007. So in summary, for underwriting operations, a quarter with results less than those to which we have grown accustomed, but a very good year of which we are most proud.

We will have a not-so-good quarter every now and then. We hope only every now and then, and we also hope we can continue with the very good years. Our prospects are good. Our trucking business seems strong, with the independent contractor product leading the way. As before mentioned, we expect continued expansion with this line.

Our packaged excess business is doing better, with good results and improving volume prospects. Reinsurance assumed will have fairly flat volume this year as were writing to a level of catastrophe loss with which we are comfortable, and that is not expected to change in 2008.

Paladin aside, we will do well with a lack of big catastrophes and less well if any happen. Paladin, we’ve already discussed. We hope for a fewer weather events and better results.

Sagamore continues to be a challenge. We do believe that a continued increase in the cost of items that make up insurance claims − medical bills, wages, repair costs, etcetera − will must ultimately be reflected in rates. We, and others, will not continue to compress margins.

That, along with increased marketing activity, product development and all of our other efforts should turn around the volume decline from both our auto and small fleet trucking products. So, tempered optimism are the words for Sagamore for 2008.

Concluding my remarks, the company made $4.5 million on operating income for the quarter. Investment gains added to $15.9 million due to the significant amount of conversion to realize from unrealized investment gains, combined with the declining equity market, our unrealized gains decreased by $19 million before tax.

With dividends of $0.35 per share paid during the quarter, the book value of a share of stock increased by $0.19 per share this quarter, ending the year at $24.98.

With dividends of $1.65 paid during the year, and a yearly increase in book value of $1.38, the total shareholder annual return on the book value of a share of stock for 2007 was 12.8%.

And as usual, regarding the subject of dividends, the company’s Board of Directors will meet next week. The subject of dividends and the amount thereof will be discussed, with consideration of the company’s earnings, return on investments and its capital needs.

And now, I’ll turn the meeting over to Pat Corydon. At the conclusion of the meeting, Pat, Joe or I will be happy to answer any questions you might have.

Patrick Corydon

Thanks, Gary. On the consolidated basis, premium written for the quarter was up 16% from last year. As was the case in earlier quarters this year, this growth was concentrated in the trucking independent contractor business, which experienced premium written growth of over 54% and in reinsurance assumed, which nearly doubled.

As Gary mentioned, premium declines in personal automobile and small fleet trucking products, partially offset these increases.

For the year, premium written was 3% higher, with the components of the change being largely the same. Independent contractor premium was up 42% and reinsurance assumed business more than doubled this year, while the Sagamore products experienced declines of slightly over 30%.

Net premium earned improved 8% quarter-to-quarter and 5% for the entire year in line with direct premium written and reinsurance changes.

Premium ceded to reinsurers averaged 23% of direct premium written for the quarter compared to 14% for the fourth quarter of 2006, reflecting changes in reinsurance treaties effective in June of 2007, including changes to the reinsurance structure of our independent contractor program to address the larger worker’s compensation component of this business. For the year, the average ceded rate was 18.7% compared to 13.5% last year.

Underwriting operations for the quarter produced a consolidated combined ratio of 106%, 1.6% higher than the fourth quarter of 2006, as increases in the consolidated expense ratio exceeded a 2.5 point decline in the loss ratio.

Combined with the favorable results achieved during the first 9 months, the annual 2007 consolidated combined ratio of 91.1% is almost 2 points better than the 92.9% reported last year. The consolidated loss ratio this quarter was 69.1% compared to 71.6% last year.

The fourth quarter continued the favorable trend towards lower frequency and severity of losses in both large fleet and small fleet trucking than we had experienced in earlier quarters, although this quarter produced a smaller favorable development on prior period losses in fleet trucking.

Reinsurance assumed, however, experienced a significant increase in loss ratio from the very favorable results achieved in the fourth quarter of 2006, as catastrophes related to both U.S. and non-U.S. risks were reported this quarter.

For the year, better large and small fleet trucking experience resulted in a consolidated loss ratio of 60.2%, a significant improvement over 2006’s results, despite much larger reinsurance assumed losses in 2007.

Excluding activity related to retrospective policies and reinsurance assumed, developments of prior year losses produced a redundancy this quarter of about $800,000. This brings the year-to-date non-retro-, non-assumed redundancy to approximately $16 million or 8% of beginning reserves.

This savings pattern is more favorable than some prior years primarily because of the company’s higher net retention since 2001. As Protective retains more of the net loss the potential for net development, both positive and negative, is increased.

Offsetting the more favorable losses incurred this quarter, was a four point increase in the consolidated expense ratio. Similar to the third quarter, this increase resulted almost entirely from increases in non-affiliated commissions on independent contractor business as well as higher commissions on the doubling of the company’s reinsurance assumed premium.

The overall non-affiliate commission rate, net of ceding commissions from reinsurers, increased from 7.3% in the 2006 fourth quarter to 10.7% this quarter, with all other expenses increasing by less than half a point.

For the full year, the consolidated expense ratio was up slightly over four points. Non-affiliated commission increases contributed 3.6 points of this change while a large, nonrecurring credit recorded in the first quarter of 2006, related to recovery of previously written-off reinsurance, served to lower the 2006 expense ratio by almost half a point. Otherwise, the expense ratio was essentially flat year-to-year.

The ratio of consolidated operating expenses to operating revenue increased from 25.3% to 27.9% for the quarter and from 24.2% to 27.7% for the year for the same reasons.

As we noted in our last conference call, our pre-tax investment income has been impacted by three factors this year. Most significantly, the redeployment of the majority of the company’s fixed income portfolio in the municipal bonds has served to reduce pre-tax investment income while enhancing after-tax yields.

At year-end, 60% of our fixed income portfolio is composed of municipal bonds, up from 48% a year earlier. As a result, pre-tax yields for the year were up 4.2%, while after-tax yields are up over 10%.

The second factor, which became more significant in the fourth quarter, is the decline in short-term interest rates. During the third quarter, we reported that for the first time in four years we experienced a small decline quarter-over-quarter in available, short-term investment yields.

This decline widened in the fourth quarter, with average short-term yields dropping almost 11% from last year and 9% from last quarter. Also, for the first time since 2004, bonds purchased this quarter produced a slightly lower after-tax yield than those maturing or sold during the quarter.

The third factor affecting investment income is a lack of increase in average invested funds resulting primarily from the payment of $63 million in regular and extra cash dividends to shareholders over the past 8 quarters, as well as redeployment of investment funds into limited partnerships which produced realized gains but not investment income.

All factors considered, pre-tax investment income declined 5.6% with after tax income down only 0.3% for the quarter. For the year, pre-tax investment income was up slightly with after-tax income increasing by almost 7%. There were no significant changes to the average duration of our bond portfolio this quarter which remains at approximately two years while the expected average maturity is about 3.7 years.

As Gary noted earlier, investment operations produced $24.4 million in pre-tax gains this quarter, three times the gains reported in the prior year period. The increase came from two sources.

First, in anticipation of re-deploying funds into the new Maratan investment vehicle in 2008, we sold equity securities with approximately $25 million in market value during the quarter, generating $13.5 million in realized gains.

And second, the company’s limited partnerships again performed extremely well during the quarter, generating investment gains of $10 million. The majority of the limited partnership gain came from our investment in the Indian markets.

Overall, limited partnerships increased in value by 13% this quarter and have appreciated 40% during 2007. I would point out that two-thirds of the appreciation reported for the year in limited partnerships is estimated to be composed of unrealized positions.

Holding gains on the company’s investment portfolio decreased $12 million after-tax this quarter, reflecting the gains realized on equity security sales during the quarter and general market conditions. For the year, unrealized gains declined $10 million after tax, principally reflecting $11 million in after tax gains realized from direct trading activity.

Cash flow from operations was $6 million this quarter compared to $2.5 million in last year’s fourth quarter, with the improvement related to collections of reinsurance recoverable on paid claims.

For the year, 2007’s operating cash flow of $27.6 million compares to $17.2 million reported in 2006. Adjusted for reinsurance recoverable transactions, 2007’s operating cash flow is almost $5 million better than the prior year.

Reinsurance recoverable on unpaid losses declined from $160 million at December 31, 2006 to $134 million at 2007 year-end, reflecting the settlement of a number of larger claims this year as well as Protective’s generally higher net retention under reinsurance treaties during the past several years. Reinsurance recoverable on paid losses totals only $1.1 million at year-end and is all current.

Shareholder’s equity increased $3.2 million this quarter after the payment of $5.3 million in cash dividends to shareholders. For the year, shareholder’s equity has increased $23.1 million after payment of $25.1 million in dividends, an improvement of 13.5% in total.

We have posted a full set of quarterly financial statements, including product level revenue and combined ratio data, on our website at baldwinandlyons.com. Click on our Investor Relations page and select presentations from the drop down menu. From this page, select the latest financial supplement, which can be downloaded using Adobe Acrobat or printed for your use.

Also, the additional financial tables included in the Investor Relations section of our website have been updated to include current quarter information. This concludes our formal presentation. At this time, we’ll be happy to answer any questions listeners may have.

Question-and-Answer Session

Operator

We’ll take our first question from Blayne Marder - Loeb Partners.

Blayne Marder - Loeb Partners

Let’s talk about your investment book. One, tell us a little bit about Maratan Partners, what exactly is the strategy there? And did you say $50 million you ceded them with?

Patrick Corydon

That’s correct, $50 million. And their strategy is to use a combination of − and I can’t go into this too deeply because it is a proprietary strategy on their part − but it’s using a combination of equity and debt and to leverage it in a way to provide for enhanced returns relative to the S&P 500, while not going out any further on the risk horizon in doing so.

Blayne Marder - Loeb Partners

Are you talking about capital structure, arbitrage, that type of trading?

Patrick Corydon

No, it’s a little simpler than that, actually.

Blayne Marder - Loeb Partners

Really?

Patrick Corydon

It really involves the trading of a very small number of different instruments that in combination are expected to enhance yields but as I said, we’ve been asked not to get into too much detail on it.

Blayne Marder - Loeb Partners

Fair enough, can you disclose the principals of the fund?

Patrick Corydon

Not at this time, I don’t believe so.

Blayne Marder - Loeb Partners

And then in your investment book in general, especially regarding tax exempt securities, how many of those or dollar amounts are insured by the monoline insurers?

Patrick Corydon

Blaine, I don’t have that information.

Blayne Marder - Loeb Partners

Is the majority of your book insured by the monoline insurers?

Patrick Corydon

Yes, I believe it is. All of our entire book of bonds is investment grade stuff and towards the high end of that range. We don’t try to enhance our yields by taking much risk at all in our bond portfolio.

Blayne Marder - Loeb Partners

Just remind me, is your bond portfolio available for sale or held to maturity?

Patrick Corydon

It’s typically held to maturity just simply because it’s so short. Our investment manager will make trades from time to time, but it’s not the main focus. As I said, our average duration is somewhere around two years and most of our maturities on the municipals we buy, a lot of them have pre-funded dates that are only three and four years out.

Blayne Marder - Loeb Partners

But what I’m talking about, Pat, is from a GAAP perspective, you’re not marking these to market or marking them to model, you’re simply saying we expect to realize all the cash flows and we’re going to leave them at cost on our balance sheet.

Patrick Corydon

No. They’re all marked to market.

Blayne Marder - Loeb Partners

So what have you seen as far as pricing? The prices of your munis as these monolines come under pressure?

Patrick Corydon

Actually the market value of our entire bond portfolio, which, as I said, is about 60% comprised of municipal bonds. That market value increased by $1.1 million in the fourth quarter and has increased by about $2.5 million during the year, which again, I think reflects the quality of what we’re buying. So we’ve had positive impact.

Blayne Marder - Loeb Partners

You’re one of the few. So the independent contractor business, the loss rate in Q4 ticked up. Is this seasonal? Because again, we saw this last year in the fourth quarter or is it just periodic increase in loss severity?

Gary Miller

No, it’s not seasonal, as such. As I said, it’s more a function of severity of claims and that’s pretty much the luck of the draw, if you will as to, you know you’re going to pick up some severe ones and the timing, probably it’s coincidental that it occurred in the fourth quarter of both years.

Blayne Marder - Loeb Partners

And can you maybe discuss your thoughts, Gary, about the opportunity and challenges around your largest customer? They face this union backlash and state backlash about the independent contractor status of their employees. Is it an opportunity? Is it a challenge? How are you thinking about the business with that customer?

Gary Miller

Without going into any great detail, I would say that we’re equipped to handle the insurance needs of the customer and what are now classified as independent contractors, regardless of the ultimate finding on their status. As you may know they’ve shifted in California to a more of a small fleet concept and we’re providing insurance for those operations just as we do for sole contractors.

Blayne Marder - Loeb Partners

So your business in California hasn’t changed dramatically in terms of premium or profitability versus your other states?

Gary Miller

No.

Blayne Marder - Loeb Partners

That’s interesting. Okay, and then the Paladin relationship. It’s somewhat disappointing this year. Does it make you look differently or slow your enthusiasm, if you will, for similar arrangements as far as expanding your business?

Gary Miller

I don’t think so as far as similar arrangements. Obviously, it’s disappointing any time you lose money with any arrangement or on any product. And you closely examine it and you look in the mirror and you basically say, “Did I do the right thing?” And, I think we’ve concluded that certainly it still looks like it’s a sound business approach that had some bad results.

And we have to remind ourselves from time to time that’s why people buy insurance is because they have losses. And so, occasionally, that hits us with bad operating results. We’ll keep track certainly of Paladin, but no, if other opportunities present themselves, we’ll evaluate those one by one and apply the same criteria as to whether we think we’ll make money in those opportunities or whether we can’t.

Blayne Marder - Loeb Partners

Okay. Thanks, Gary. Is Joe on the call?

Joe DeVito

I’m here, Blaine. How are you?

Blayne Marder - Loeb Partners

Good, thanks. As I look at your core ROE, excluding unrealized gains/losses, it was about flat. The way I calculated was just a tad under 9% for ‘07 versus ‘06. What are you doing to expand that? In terms of what books of business? What additional writings?

Because your balance sheet is growing. So the ROE, you’re not generating enough insurance business to really move the needle there. Can you just give us your thoughts?

Joe DeVito

You and I have talked about this before too. I think that ultimately what our goal is to promise impressive, long-term, financial rewards, and so that’s the view that we take. We certainly want to only do what’s rational, and be cognizant of the short-term but be aware that our view is always a longer-term view.

We’ve looked at the product lines, and basically, it’s really growth through diversification of product lines. I think this year is a perfect example of how the breadth of our offerings allows us, perhaps, to be more opportunistic than others, especially for a company of our size.

Where we have declines in the Sagamore volume, we get the excess picking back up, we get big increases in the independent contractor. Where we have disappointing results in the Paladin, the rest of the reinsurance assumed looks good.

So, the idea to grow the ROE would be to continue to utilize our core competency in the products that we offer, but also look to add new products. We’ve looked at public transportation; we look at expanding our brokerage services.

We’ve already done that this year in terms of selling services to current customers and prospects where we’re not just leasing capital but providing risk consulting services, claims services, loss prevention services.

We’re in the process of forming an excess and surplus lines company; protective specialty insurance company where we’ll write some non-wheeled business, maybe some program business; leverage some of the brokerage relationships that we’ve established in the independent contractor markets.

So, the overall strategy is to continue to add to our product lines, be as opportunistic in expansion as market conditions will allow, and continue to emphasize our execution. Particularly in our claims handling, I think we execute better than most and that’s the long-term strategy to increase the ROE.

Blayne Marder - Loeb Partners

And finally, one additional question and that’s on Sagamore. Gary, with your opening comments, I thought “he’s going to put this business in runoff,” but then towards the end you sounded more optimistic that you’d see some volume rebound in 2008.

What I’m hearing from other insurers is that pricing is going up, yes, but loss costs are ahead of that and we could expect a decline in 2008. What are your thoughts on the Sagamore business?

Gary Miller

Well, I let Joe address that, Blaine.

Joe DeVito

Essentially, Blaine, again, if you think about what I said about the breadth of our offerings, the pool is deep or shallow to some extent depending upon market conditions. We think, quite frankly, that market conditions are probably better now for the Sagamore products than they’ve been in the last several quarters.

If you remember, what we’ve done, as Gary mentioned, that loss ratio has crept up a bit and we’ve allowed it to do so more than we would perhaps in the past because we didn’t want to see that volume decline at a greater rate than it already is, and in addition, the expense ratio goes up because you can only, at best, become as lean as you possibly can. You’ve got some fixed costs there.

But, we’re thinking now we did not really participate much in the way of rate decreases. As Gary’s mentioned, in his address and in prior conference calls, what we’ve done is increase marketing, we’ve restructured the marketing department, we’ve established relationships with agents.

So we’re not so sure, as others start to go up, that we need to go up quite as much. We’ve got a little bit of severity tick up in BI liability, but in a lot of our other products we’re in pretty good shape.

In addition, the new scorecard rating is going to allow for a wider expansion of offerings to a customer base than heretofore existed. We’ve increased the limits that we’ll write. We can offer more now to what is called the mid-standard market as opposed to non-standard.

We did not have credit as a part of our scorecard rating prior to this. And what we found is while it doesn’t impact our core business as much, we could, we were getting – to some extent – some adverse selection in that credit is the 800,000 pound gorilla out there now, even more important than driving record to some extent, with some companies.

So while we before this, would write good drivers with maybe mediocre credit, because credit is such a big scoring factor now, we were left with bad drivers with bad credit. Scorecard changes that whole mix.

So, it’ll still be a tough go, but we think that we’ve got an opportunity to at least slow the rate of decline, and maybe we’ll be 5%-10% over. But in the long run, the more granular rating is going to allow us an opportunity to write more business, and that will be a good thing for us.

Operator

Your next question comes from John Gwynn - Morgan Keegan.

John Gwynn - Morgan Keegan

Pat, the prior period development numbers that you supplied, 800 for the quarter and 16 for the year, was it contained adjustments for several factors? Could you give me what the adjustments were again?

Patrick Corydon

If you recall, it’s now finished, but through August of this year, a big portion of the independent contractor program that we had was on a retrospective form. So, as savings were recorded in the settlement of claims, the majority of that money went back in terms of premium refunds to the insured.

So, we have always taken that out and looked at that as a separate component of the savings since it didn’t all fall to our bottom line. The other adjustment is reinsurance assumed. And that’s a situation where, as you I’m sure are aware, the majority of the reserves on our books of reinsurance assumed, are provided to us by the ceding insurers.

And therefore, we look at them and we may bolster them from time to time, but essentially they’re others’ reserves. So, the savings and/or deficiency that might flow through in that book is something that we look at separately from our own internally-generated loss reserve developments.

John Gwynn - Morgan Keegan

And, Gary, in the past few years you’ve significantly raised your retentions on the packaged excess product. Would 2008 be a year where we’ll see any further change there, either up or down? I guess not down given your obvious pleasure with margins.

Gary Miller

John, it’s hard to say. We’ll be beginning our renewal of reinsurance treaties here in the next couple months and it’ll be a market-based decision, if you will. We don’t go into it with any preconceived notions, we basically look at what’s available and what’s offered and make the best deal that we see at the time.

John Gwynn - Morgan Keegan

And also, Gary, the P&L on your assumed reinsurance book, I believe at one point you said it was 18 to 20, is that still the case?

Gary Miller

No, it’s higher than that, John, now. Although we have, in certain instances, bought some retrocessional protection that might keep it down somewhat, but you know, probably it’s closer to 25 to 30 at this point, John.

John Gwynn - Morgan Keegan

Is that an apples-to-apples comparison with what you’ve said in prior years, given the different nature of the Paladin business?

Gary Miller

Paladin affects it to some degree, although Paladin is not a writer in the heavy storm areas like Florida and writes very little in the way of earthquake, and really where Paladin adds to our total accumulation, which we do by the retrocessional protection for, primarily is for a Northeast hurricane or Northeast storm.

Otherwise, it’s pretty much the same as it’s been in prior years with maybe we’re a little bit more aggressive, having booked some products we probably are willing to assume a little bit more P&L, John.

John Gwynn - Morgan Keegan

So that I don’t have to rely on the transcript, how do you spell Maratan?

Gary Miller

It’s Maratan.

Operator

At this time there are no further questions in the queue. Mr. Miller, I’d like to turn the conference back to you, for any additional or closing comments.

Gary Miller

Thank you very much for joining us and we will meet with you again in three months. Thank you.

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Source: Baldwin & Lyons, Incorporated Q4 2007 Earnings Call Transcript
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