ProCentury Corporation (PROS) Q4 2007 Earnings Call February 21, 2008 10:00 AM ET
Edward Feighan - Chairman, President & Chief Executive Officer
Christopher Timm - Executive Vice President and President of Century
Erin West - Chief Financial Officer
David Lewis - Raymond James
Hello and welcome to the ProCentury Corporation Fourth Quarter and Year Ended 2007 Conference Call. (Operator Instructions) Now, I would like to turn the conference over to Jeffrey Racz.
Thank you. I’d like to welcome everyone to the fourth quarter 2007 earnings conference call for ProCentury Corporation. With me this morning are Edward Feighan, Chairman, President, and CEO of ProCentury; Erin West, CFO of ProCentury; and Chris Timm, Executive Vice President of ProCentury and the President of Century Surety Company. In a minute I will turn the call over to Edward. Erin will then discuss our financial results and Chris will provide an update on the company’s operations.
Before we begin, I would like to remind everyone that statements made on the course of the call that are not based on historical facts are forward-looking statements within the meanings of the Private Securities Litigation Reform Act of 1995. Actual results could differ materially from those stated or implied in the forward-looking statements as a result of factors that are detailed in yesterday’s press release and in our filings with the Securities and Exchange Commission. ProCentury makes no commitment to update any forward-looking statements based on new information, future events or otherwise.
Now, I would like to turn the call over to Edward Feighan, Chairman, President and CEO of ProCentury.
Edward Farrell Feighan
Thank you very much, Jeff, and thank you all of you on the call this morning for joining us as we review our fourth quarter of 2007 and our year-end results. I would like to start, if I can, by saying that last night in a joint press release with Meadowbrook Insurance Group we announced the execution of a definitive merger agreement. We will not be discussing the merger agreement in the course of this particular call, nor will we be responding to questions about the agreement in this call.
We have scheduled later this morning with Bob Cubbin, the CEO of Meadowbrook. He and I will be hosting a joint conference call to discuss the proposed merger and respond to any questions that you may have at that point. That call is scheduled for 11:30 this morning, Eastern Standard Time. And for anyone who would like to participate in the call, please jot the number down, it is 800-860-2442.
In addition, that call will be webcast and will be available to anyone who wants to listen to it on both our website at procentury.com and Meadowbrook’s site at meadowbrook.com. I will provide again this information at the end of the call and it is also available in last night’s announcement.
Well, throughout 2007, we’ve been able to tell the story of earnings growth quarter after quarter. We are pleased to report in this regard that the fourth quarter was absolutely no different. For the fourth quarter, our net income grew by 18% and for the year, net income increased by 18.7%. Net income per diluted share was $0.53 for the quarter and for the full year was $1.85.
Return on average equity, an incredibly significant measure for our operations, increased to 16.5% from the 15.9% in 2006, and this result gives us for a two-year timeframe placement actually above the range of our declared multi-year return on average equity goal of 13% to 15%.
Book value per share is currently now $12.05. That’s up 12.1% compared to December 31, 2006. So, we are very pleased with the results for the quarter and the year.
Premium growth has, if you’ve had an opportunity to review some of our financials, was quite a challenge in 2007 as it had been for many of our peers. For the fourth quarter of 2007, excluding a one-time accounting adjustment that we enacted in the fourth quarter of ‘06, premium declined by 32% compared to 2006. I need to ask you to focus on how we experienced that decline.
The 32% decline for the fourth quarter breaks down as follows. We had a 4% decline because we had discontinued an auto physical damage program at the beginning of the year. I believe that we’ve spoken about that on each of our ‘07 conference calls. And then we had a 14.9% decline due to a smaller amount of premium backlog that was booked in the fourth quarter of 2006, and so that added some distortion to real production numbers as we look at 2007.
And then finally, I think the most important data point to look at in this regard is we had a 13.1% decline in our core property and casualty business coming from our agents. So, we think that the most operationally meaningful representation of the premium decline is that 13.1% decline in our core business as measured by the change in our account current balances as presented to us from our agents force.
Again, excluding the accounting adjustment from 2006, 2007 production overall declined by 9.1% compared to 2006. And there were several factors contributing to the year-over-year decline that I am sure that you’ve heard spoken to in other conference calls.
First, we had increased competition due to some new players in the excess and surplus lines market. There was certainly a demonstrated renewed interest by the standard market in segments that we typically serve, and again, the decision that we had made earlier in the year to discontinue what we thought was an underperforming book of business that represented about $20 million in premium.
But in spite of the more challenging market conditions that we face, we’ve still been able to compete and to compete profitably, and we are proceeding with the guided optimism into 2008. We’re starting out the year with a very strong balance sheet, a solid capital position, and our pricing and underwriting discipline very much in place.
Our opportunity flow has been good and we’ve continued to exercise good judgment about what we will and will not accept. And finally, we are fortunate to continue to build on our new surety and environmental divisions that we announced in the last half of 2007, and we’ve recently enhanced our brokerage capabilities for contractor liability coverages.
Going into 2008 with the goals that we’ve set out to accomplish and our plans to get there, we’re very confident that we’ll be able to again meet our multi-year average return on equity target in the range of 13% to 15%.
And now I would like to turn the call over to our CFO, Erin West for some additional comments on our financial results.
Erin Elizabeth West
Thanks, Edward. For the quarter, net income increased by 18% to $7.2 million or $0.53 per diluted share. This compares to $6.1 million or $0.46 for the fourth quarter of 2006. Our operating earnings per share, which excludes realized investment losses, were $0.63 per diluted share, which included $0.10 realized losses net of tax.
For the year, net income increased by 18.7% to $24.8 million or $1.85 per share, which is up from $20.9 million or $1.58 per share in 2006. As Edward indicated, premium growth was a challenge in 2007. For the year, excluding the accounting adjustment from last year, 2007 production declined by 9.1% compared to 2006.
For the fourth quarter of ‘07, there were three main components of the decline: the discontinuance of the auto physical damage program in 2007, a smaller amount of premium backlog booked in ‘06 compared to ‘07, and an overall decline in our core property and casualty business.
Our combined ratio results illustrate our profitable performance in 2007. The fourth quarter combined ratio was 86%, consisting of a loss ratio of 51.1% and an expense ratio of 34.9%. This compares to a combined ratio of 93.8% with a 61.4% loss ratio and a 32.4% expense ratio in the fourth quarter of 2006.
At the end of 2007, our combined ratio was 91.7%, consisting of a loss ratio of 57.9%, and an expense ratio of 33.8%. This compares to a combined ratio of 94.5% in 2006, consisting of a loss ratio of 61.9 % and an expense ratio of 32.6%. Our expense ratio continued to run slightly higher due to an increase in our binding business compared to broker business, which has a higher acquisition cost.
I want to comment briefly on our favorable prior year development we had during the fourth quarter and also for the year. For the fourth quarter, we had $4.6 million in favorable reserve development, which is $3 million on an after-tax basis. This favorable development had a $0.22 impact on our diluted EPS for the fourth quarter.
During the fourth quarter of 2006, favorable prior year development had an impact of $0.07 per diluted share. For the year, we had $9.1 million in favorable reserve development, or $5.9 million on an after-tax basis. The favorable development had a $0.44 impact on our diluted EPS for 2007, compared to $0.05 in 2006.
Within our casualty line, the favorable development is due to better than anticipated results in accident years 2004, 2005, and 2006 for our claims-made contractor business. From a property perspective, the development comes primarily from accident years 2005 and 2006 with frequencies and severity experience better than what we initially anticipated.
In terms of our construction defect claim counts for the year, the actual claim counts were in line with our expectations and we haven’t changed our estimates for 2008 or 2009. The estimates are 503 and 368 expected claims in 2008 and 2009 respectively.
Our investment portfolio performed well in 2007 in spite of the uncertainty and volatility in the market. Our bonds continue to pay and the issuers continue to meet their obligations. For the fourth quarter of 2007, net investment income increased by 5.7% to $5.6 million compared to $5.3 million for the same period in 2006. For the year, net investment income increased by 14% or $22.1 million from $19.4 in 2006.
The pretax investment yields were the same for 2007 and 2006 at 5.1%, and our tax equivalent yield for 2007 declined slightly to 5.7% compared to 5.8% in 2006. For the fourth quarter, we recorded net realized investment losses of $1.4 million and for the year we recorded about $1.9 million or about $0.10 per share. For the fourth quarter of 2006, net realized gains were $117,000.
The duration on our fixed income portfolio is 4.6 years, which is up from 4.1 years at December 31, 2006. We continue to invest in high quality issues and our average credit quality remains at AA.
Now, I would like to turn the call over to Chris.
Christopher John Timm
Thank you, Erin. While it was certainly frustrating at times and more challenging markets in 2007 provided an opportunity to prove that our operating model works to produce profitable, predictable results for our shareholders. While the softening cycle made volume a challenge, it did not impact our ability to continue to produce business that meets our return on operational quality metrics to provide the returns that our investors deserve.
It has been said that the single most important metric over time of the quality of an insurance company operation is the increased intangible book value per share. We believe we are strongly positioned to continue our advance.
Operating in a market where reports of rate erosion for the year in the commercial casualty lines has been estimated to be 15% to 17%, our core casualty measured rate changes indicated a 5.1% overall through three quarters. Our fourth quarter pricing report is not yet complete, but we took no rate actions that would cause me to believe the full year results were outside that range, especially on a risk-adjusted basis.
The strength of our underwriting function has proven as our rate change when spilt between new and renewal business measures to be down 4.2% on new business and down 6% on renewal business. As you may be aware, companies that have indicated rate levels and movement to produce lower rates on new business when compared to renewal business have embedded an increase in reserving risk on their balance sheet, as well as putting future earnings at risk.
I am pleased to report that our operation model has been very successful at avoiding this risk to future earnings. We believe that we have the right operating model in place to succeed in any market cycle.
Our web-based quote, bind, and policy issuance platform, which we call Century Online, continues to be developed and by our surveys of our agents, we are the market leader. We have recently added garage liability to the portal and are now working on enhancing the other product offerings we already offer through Century Online, as well as adding our Marine division products.
Our data analysis capabilities continue to be best in class and allow us to make what we believe are the best decisions quickly on product development. We continue to improve and enhance our overall business processes to allow us to compete profitably in an increasingly competitive market.
Net income of $24.8 million for the year is record for ProCentury and, as Edward mentioned earlier, delivering a return on average equity of over 16% is an accomplishment in which we all take considerable pride. This was no small task and we appreciate our associates’ efforts.
In 2008, we expect that we will once again face a softening market. As commercial line’s standard carriers expand their risk appetite, growth will continue to be a challenge and a choice. Different risk classes in lines of business are migrating back to the standard market, effectively shrinking this surplus line segment. Our recent announcement that Edward mentioned in his opening remarks does give us more tools than ever before to meet our goals and objectives.
Since 2000, we have been focused primarily on business with short tail characteristics. More recently, we have been working to identify products and lines of business where we have the experience and the knowledge to selectively increase the tail characteristics of our casualty book without unnecessarily exposing ourselves to an unknown reserve risk. By selectively extending the tail characteristics of our book, we have the opportunity and the system in place to enhance net income for many years into the future.
We have reason to be optimistic going into 2008. Our agency franchise is strong and the quality of our agency partners is as high as it has ever been. We currently have 149 agents in 246 locations. During 2007, we added 22 agents with 33 locations.
A significant portion of the growth in our agency platform is due to a significant increase in marine agencies. We are pleased with the selected growth in our agency platform. We view this growth as a good indication that we’re earning the reputation that we seek to create among our agents, that is as a highly responsive, service-oriented underwriting carrier.
With that, I’ll turn the call back to Edward.
Edward Farrell Feighan
Thank you very much, Chris. And I just want to take this opportunity to thank my colleagues and associates here at ProCentury for the really impressive contributions that they’ve made to our 2007 successes. We delivered exceptional levels of profitability for the year, which resulted in a significant increase in book value per share. We’ve returned on average equity 16.5%, exceeding our range of expectations, and we’ve made good on our commitment to stay within the confines of disciplined underwriting.
I’d also like to thank our directors for their service to the company and our shareholders for their confidence in our team. We believe that we have accomplished a good deal since 2004 and we certainly have appreciated the support that all of them have given us.
Again, Bob Cubbin, the CEO of Meadowbrook, and I will host a call at 11:30 this morning. That number is 800-860-2442 and we will broadcast live as well as have it available over our websites.
That ends our prepared remarks and while we are not able to take calls or questions, I should say, on merger-related matters as we’ve made time for that 11:30, we are happy to respond to any questions or comments that you might have on our quarter and year-end results.
(Operator Instructions) Our first question comes from David Lewis - Raymond James.
David Lewis - Raymond James
I think you indicated that roughly your average rate reduction, both new and renewal, for the first nine months are down 5.1%. Your core book’s down 13.1% or something like that.
That is the fourth quarter, David. The book is down 9.7% for the year, or 9.1% or whatever.
David Lewis - Raymond James
So it’s 13.4% reduction in the quarter, then 9.1% for the year. I guess my question is do you feel like you’re losing any market share or gaining market share and is the difference between those numbers more reflective of just the contraction in the E&S market?
I actually think we’re strengthening our market share except in certain pockets. For instance, I believe that our competition is making headway on us on wind-driven property risks in Florida and the Gulf, because we still avoid that. And in a softening market, people are looking to grab premium on that.
But in our core book of business from everything we can tell, our average agents, when we talk to them are down 20% or more. And so I would assume that that means we are gaining market share, at least within our distribution system.
David Lewis - Raymond James
So, really it’s more of a contraction in the E&S market as well as competition.
Yes, that and competition. Sure. If you start out with a figure of 15% to 17% rate decrease, if people take those rate decreases, they got to write a lot more business to stay even in a very challenging market. And that’s why we are really focused on not just rates, but on the most predictable portion of our business.
We set out over a year ago to analyze our renewal business and the loss-free characteristics of it, and the frequencies on those accounts. And we have made a point to retain the most predictable portions of that business with our actuarial department figuring out the right credit structure that we needed on those accounts.
And so it’s very important for the ongoing health of the company and the returns to the shareholders for us to make sure that we retain that most predictable part of our book. However, if it’s a product where we might be charging $2,500 for and the standard market literally is under $1,000, usually under $700 for a better policy, it’s really business that we can’t even waste our time trying to retain.
David Lewis - Raymond James
Can you give us an idea of persistency levels in the fourth quarter and/or the year compared to the prior periods?
David Lewis - Raymond James
And any thought, just kind of the outlook of pricing as we got into 2008, do you think it would be pretty similar to what we saw in 2007, better, worse?
We are expecting, planning for and modeling down 5%. The marketplace itself is figuring 17% to 25%. So, at least from the people that I’m hearing, some of the credits and rate changes that they are putting into their book right now.
David Lewis - Raymond James
So, basically pricing is going to accelerate on the downside based on your…
In the overall broad market and it is down 5% for us.
Sir, at this time we do not have any questions.
And I want to thank all of our participants this morning, and hope that you all will have the opportunity to join us on our call at 11:30 and we thank you for your continuing interest in following our efforts here at ProCentury. As always, if you have any follow-up questions or concerns, please don’t hesitate to call either me directly, Chris Timm, or Erin West. Thank you all very much.