Executives
Stephen Sills – President and CEO
Jack Sennott – SVP and CFO
David Newman – SVP and Chief Underwriter
Analysts
Matthew Carletti – FPK
John Gwynn – Morgan Keegan
Alan Seymour – Columbia Managements
Zack Galler [ph] – Strategic Risk [ph]
Darwin Professional Underwriters, Inc. (DR) Q1 2008 Earnings Call Transcript April 28, 2008 4:00 PM ET
Operator
Good day and welcome to the first quarter 2008 Darwin Professional Underwriters earnings conference call. My name is Candice and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will conduct a question-and-answer session after the prepared remarks. (Operator instructions)
Before we begin, the company has asked me to read the following statement. To the extent any non-GAAP financial measures is discussed during this conference call, you may find a reconciliation of such measures to the most directly comparable financial measure calculated according to GAAP in the financial supplement made available today on the company’s Web site.
This conference call may contain projections, comments and other forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. Each forward-looking statement is based on Darwin’s plans and expectations as well as on current events and industry trends. Such statements are subject to risks and uncertainties as described in the company’s most recent 10-K and the actual outcomes or results may differ materially from those expressed or implied by any of these statements.
I will now turn the call over to Mr. Stephen Sills, President and Chief Executive Officer of Darwin Professional Underwriters. Sir, you may proceed.
Stephen Sills
Thank you operator and good afternoon everybody. Welcome to Darwin’s first quarter 2008 earnings conference call. As usual, I'm here with Jack Sennott, our Chief Financial Officer as well as several of the members of our senior management team. Each of them will be available for specific questions on their individual disciplines should they arise.
We released our first quarter financial results in our press release and I will start by providing some overview comments and then I will let Jack provide some details on our financial results.
This is our eighth quarter since we became a public company and we are very pleased with our company’s continued strong performance. The quarter’s net income of $14.9 million represents the best operating result in our history. This calculates to an annualized return on average equity of 22.7% and a growth in book value of 6.1% for the first quarter 2008.
Our loss emergence remains favorable and we are able to find and write new business opportunities to grow our book. We were also able to retain our best accounts in the face of continuing tough competition. Pricing pressure however is a major factor in all of our lines of business.
During the first quarter, renewal pricing decreased an average of 13% across all our lines. As I have said in previous conference calls, we think these extremely competitive market conditions will continue for the foreseeable future. However, while we are watching the pricing trend lines warily, we remain pleased with our overall profitability.
To very loosely paraphrase the concept behind a famous Kenny Roger song, we think Darwin’s profit levels particularly in the current environment bear out reliance on our underwriting team’s judgment as to what it takes to get a deal done and when it no longer makes sense to hold them and not compete on an account. As our results have shown to date, the judgment has been strong.
Of course, price is only one component in our toolkit along with our policy language and retentions. It is also our job as underwriters to see that we utilize all three components to generate profitable underwriting results. Again, our results to date demonstrate that we are getting this right. The confidence we have in the profitability of our business is best demonstrated by our favorable adjustments to prior accident year loss reserves this quarter. We have made favorable adjustments to our 2003 through 2007 accident years as they continue to develop at much better experience level than the originally established industry base loss ratios that we recorded when we first wrote the business.
Turning to premiums, our first quarter 2008 gross premiums written were $80 million, an increase of 7.8% over our first quarter 2007 writings. Additionally, our net premiums written for the first quarter were $58 million, an increase of 18.5% over the first quarter last year.
So, we’ve continued to execute our strategy of unearthing opportunities to grow the business. Those of you that have followed the insurance industry know that markets are always changing. As the current market softens further, our strategy remains unchanged. For those of you that have received our annual report, you will note that it’s wrapped in caution tape, a metaphor for our view of the business environment. We believe we can grow, but are cautious about it.
We will continue to distinguish ourselves by providing excellent service and by developing innovative products. We will also implement our strategy of, as we put it before, getting bigger by getting smaller from the average account size risk exposure perspective to better assure our profitability. The percentage of business that we classify as small approximates 47% of our in-force business as of March 31, 2008.
So we are pleased with our success in building the small business franchise we set out to do. Additionally, for 2008, if you look at our price changes by size of business, our pricing is down by only 8.1% in our small business compared to 13.6% and 19.1% for our medium and large-sized accounts respectively. As we have said many times before, this strategy is intended to buffer our profitability in a softening market.
Turning to our summary results, our 64.7% combined ratio for the quarter compares favorably to our first quarter of 2007 combined ratio of 92.8%. Our current quarter combined ratio has been impacted by reductions in our prior accident year loss results and related seeded [ph] premiums. These amounts favorably impacted the first quarter of 2008 by $7.5 million net of incentive compensation accruals, profit sharing and income taxes.
Comparatively, the first quarter of 2007 was favorably impacted by $0.6 million for favorable development of prior accident year results net of comparable offsetting incentive compensation accruals, profit sharing and income taxes. This quarter's results were again reflective of our establishing of initial loss ratios based upon industry wide expectations and then reflecting over the passage of appropriate time Darwin’s own experience.
As our business continues to grow, as we gain more actuarial credibility in our data and as we close claims in a given accident year, we are able to increase the waiting of our experience in our recorded loss ratios. This quarter continues the trend of our accident years developing more favorably than the industries results for the same period.
Before I turn the call over to Jack, I wanted to provide a quick update on the evolving sub prime credit exposure facing the industry. I will let Jack provide you with some of the more details on our investment portfolio which we continue to see as largely unaffected by the sub prime issues.
From the insurance companies' perspective, we believe that the underwriting decisions we have made regarding these classes of business have positioned us well. As mentioned last call, we have avoided real estate classes since the inception of the company and have written only a small amount of financial institution business. Consequently, we continue to see insignificant exposure in our book of business at this time due to sub-prime exposures. We have a handful of claims that have arisen out of the sub prime crisis.
Currently, five policies are subject to claims where the exposure is primarily classified as a sub-prime exposure. Two of the policies are from the same financial institution clients, a sub-prime lender where we have $10 million D&O limits excess of $60 million underlying and a $10 million fiduciary limit excess of $25 million underlying. The remaining matters involve a $2 million primary miscellaneous E&O policy, a $1 million lawyer’s professional policy, and a $10 million part of $50 million excess of $350 million A side only D&O policy.
In addition, we have two other policies which are the subject of claims where a sub prime issue is more peripheral to the claims. These two involve $100,000 limit on a lawyer’s professional policy and $20 million excess of a $145 million A side only D&O policy.
We remain comfortable with our reserve positions on these claims and continue to see our book of business as largely unaffected by sub prime exposures particularly relative to our peers.
Additionally, given our underwriting decisions to date, we believe that we are very well positioned to take advantage of hardening market conditions in the financial area if we see an opportunity.
With that as background, I will turn the call over to Jack to provide you with some more detail on our results. When Jack’s finished, I’ll make some concluding remarks and then we will take questions. Jack?
Jack Sennott
Thanks Stephen. As Stephen mentioned, our first quarter net income was $14.9 million, which represents a 184.7% increase over the $5.2 million we earned in the first quarter of last year. This net income generated earnings per diluted share of $0.87 for the quarter compared to $0.31 per share for the first quarter of 2007.
Our combined ratio was 64.7% for the quarter compared to a 92.8% combined ratio for Q1 ’07. Additionally, investment income was up 15.8% to $6.1 million for the quarter compared to $5.2 million for the same period last year.
Stephen mentioned that our gross premiums written were $80 million for the current quarter compared to $74.3 million for the comparable quarter last year, an increase of $5.7 million or 7.8%. The $80 million of gross premiums written in the quarter breaks down as follows. Approximately $42.2 million was attributable to E&O business, $27.8 million was attributable to the Medical Malpractice business, and $9.1 million was attributable to the D&O business, and $900,000 was attributable to our general liability business.
Our growth was driven by our medical business which was up 23% for the quarter. Comparatively, our D&O business was up 3% and our errors and omissions line was down 1.4%. Our growth in the medical business came primarily from the writing of new Medical Malpractice liability policies, namely those in our hospital professional liability and miscellaneous medical facility classes of business, as well as the addition of business written in the senior living class of the business.
Our E&O business was down slightly in the quarter due primarily to competitive pricing pressures on many of our larger managed care E&O renewals which are heavily concentrated in the first quarter.
Turning to losses, we have made a favorable adjustment to prior loss reserves and the corresponding reinsurance balances totaling $15.4 million. This adjustment requires that we record offsetting additional incentive compensation and profit sharing commission expenses of approximately $3.9 million. Based upon contractual agreements with certain key employees and program administrators, taken together these adjustments positively impacted the income statement by $11.5 million pretax or $7.5 million net of tax, which equates to $0.44 per share. These favorable adjustments affect the 2003 through 2007 accident years and we have included our current carried gross and net loss ratios for each of our accident years in our financial supplements which we posted this morning on our company’s Web site.
We’ve recorded our 2008 accident year at a direct loss ratio of 62.5%. Darwin’s total expense ratio was 26.3% for the quarter ended March 31, 2008 and 29.1% for the same quarter last year. Overall, our expense ratio decreased during the current quarter compared to the quarter ended in 2007 due to improvements in both the general and administrative expense and commission expense ratios.
Our general and administrative expenses decreased to 13.9% for the first quarter of 2008 compared to 16.1% for the first quarter last year. This improvement was driven by our ability to spread our admin costs, including the additional compensational added expenses which were recorded in connection with favorable reserve leases over a larger premium base.
Our commissions incurred as a percentage of net premiums earned decreased to 12.4% for the first quarter of 2008 compared to 13% for the first quarter last year. The improvement in the commission expense ratio is due to an increase in the ceding commissions received from reinsurers in connection with the restructuring of our reinsurance agreements in April 2007, as well as the reduction in ceding premiums of $3.7 million recorded in the first quarter. These improvements were partially offset by higher direct commission rates paid to brokers.
At March 31, 2008, we continue to maintain an extremely strong balance sheet. We had $887 million in total assets, $612.6 million in cash and invested assets, and $269.3 million in stockholders equity. Our book value per share as of March 31, 2008 is $15.84, an increase of 6.1% for the first three months of 2008. If you exclude mark-to-market adjustments on our investment portfolio, our book value per share is $15.58.
Our cash flow is strong as well with first quarter cash flow of $49.9 million compared to $39.7 million for the first quarter of 2007. It continues to be strong as paid losses remain low with payments of $5.2 million this quarter.
Turning to investments, our portfolio duration is 4.11 year at March 31, 2008, which is up from our year end ’07 average duration of 3.9 years. We have increased the percentage of our portfolio invested in municipal securities which represents approximately 45.2% of the total portfolio as of March 31, 2008 versus 39.4% at year end ’07. These securities which generally have five to ten year durations have been subject to quiet a lot of volatility given the issues with the monoline insurers.
In many cases, we believe the market overreacted to news impacting the municipal bond market and consequently these securities were attractively priced at points during the quarter, provided us with an opportunity for better tax equivalent yields. Even in the face of an overall declining yield on securities caused by a steepening of the yield curve as well as reductions in interest rates designed to improve liquidities and financial markets.
Accordingly, our taxable equivalent yield on investments held is 5.16% as of March 31, 2008. As we have stated in the past, our strategy in purchasing municipal securities has always been to view the security assuming no insurance guarantee exists and that the creditworthiness of the security is dependent on the strength of the underlying issuer.
As you will see in the table we provided in our financial supplement, the average credit quality of the underlying issuer for these municipal securities is AA and these securities are currently trading at a net unrealized gain. We believe that these securities remain attractive investments and we see no issues with their ability to pay.
Overall, we continue to have a strong investment grade average credit rating in our portfolio and currently have 15.6% of our portfolio in cash, short-term investments and fixed maturity securities with maturities of less than one year.
As for an update on our sub prime mortgage exposure, our total investment to sub-prime mortgage or asset backed securities at March 31, 2008 is $0.5 million. We currently hold two securities that would be classified as sub prime and both are currently rated AAA and neither are under credit watch by Moody’s, S&P or Fitch.
In addition, these holdings are expected to pay down really within the next two months and are current with all their payments. We believe that our collateral position on both of these securities is strong and consequently we have very little exposure to sub prime defaults in our portfolio.
In addition to the sub prime mortgages, we also hold $7.2 million of Alt A or low documentation loan securities. These are also all rated AAA and have an average life of approximately 1.5 years with strong collateral and little exposure to defaults in this portion of our portfolio.
The remainder of our $146 million of mortgage and asset backed securities in our portfolio is rated a very high quality AAA with the exception of two corporate mortgage backs, which are rated BBB which had a market value of just under $0.5 million at quarter end.
This mortgage backed portfolio was secured by a minimum of 20% or greater collateral and in many cases is backed by government agencies. In addition, all of these securities are priced nicely, so we believe that we have current information on all of them, and we see no permanent impairment issues on our portfolio at this time.
In summary, we believe we have a strong, stable, fixed income portfolio that protects our capital base and strengthens our balance sheet and with that, let me turn it back to Stephen.
Stephen Sills
Thank you Jack. As I mentioned before, we are pleased with our results for the quarter and we remain confident about our prospects. We still like the business and believe we can grow it. More importantly, we believe we will continue to be able to write profitable business. Darwin’s capital base remains very strong and grows stronger as we continue to grow our book value. Notwithstanding the fact that our results continue to reflect the need to grow into our capital base, our annualized return on average equity of 22.7% is significantly up from our 13.7% return in ’07.
I will close my comments by thanking our employees here at Darwin for all they do. We just celebrated our fifth birthday as a company and it’s been a great pleasure building this business with them.
And with that, we are happy to take any questions you may have.
Question-and-Answer Session
Operator
Thank you sir. (Operator instructions) Our first question will come from the line of Matthew Carletti at FPK. Sir, you may proceed.
Matthew Carletti – FPK
Hey, good afternoon.
Stephen Sills
Hi, Matt.
Matthew Carletti – FPK
Hi. Couple of questions, Jack, first one just on pricing. I got the overall numbers for the book, but can you give a little more color by-line of business.
Stephen Sills
Sure, they were very tight this quarter. Medical was at down 12.9%, E&O also down 12.9%, D&O down 13.8% and overall was 13 down.
Matthew Carletti – FPK
I was there pretty close and similarly by line related question, the reserve released in the quarter, was that any particular concentration in a line of business or is that pretty spread as well.
Stephen Sills
Yeah, well remember it was across all the years. We have not given that information out by-line but we remain pleased with the performance of all of our lines of business and they were all impacted in this reserve release.
Matthew Carletti – FPK
Okay and then last question is capital question in terms of you got a kind of slowing top line growth just given the market and throwing off very nice returns. What’s your view of capital as we go forward in terms of if you do get to the point where you don’t think you will be able to deploy it all, say in the writing business.
Stephen Sills
When we don’t think we will be able to deploy it all, we will look to other alternatives, but right now we stay focused on deploying it and growing the business profitably. We are pretty pleased with the return on equity that we are able to generate this quarter and as we continue to grow the business and grow the capital base we think that we are on the right track.
Matthew Carletti – FPK
Great, thanks a lot.
Operator
Our next question will come from the line of John Gwynn of Morgan Keegan. Please proceed.
John Gwynn – Morgan Keegan
Thanks. Jack, the reinsurance ceding commission change you mentioned is in your release. Is this a – this is a negative expense item line.
Stephen Sills
That’s right
John Gwynn – Morgan Keegan
And in terms of in commissions and brokerage right?
Stephen Sills
That’s right
John Gwynn – Morgan Keegan
Is this is a major change.
Stephen Sills
No, we were able to increase them slightly. With last year at April of ’07 we are able to get some improvement in them and as you recall John, this is what we call a risk attaching reinsurance policies, so it’s all policies written from April 1 2007 to April 1 2008. So, that last years ceding commission improvement has worked its way into the financial statement over this past year. We – just as we announce in the press release, renewed our reinsurance terms again, we are able to get another slight improvement there and that will work its way in over the next year as well.
John Gwynn – Morgan Keegan
Okay and no, my other questions have been answered, thanks a lot.
Stephen Sills
Okay
Operator
(Operator instructions) Our next question will come from the line of Alan Seymour of Columbia Managements, please proceed.
Alan Seymour – Columbia Managements
Yes, wonderful quarter guys
Stephen Sills
Thank you.
Alan Seymour – Columbia Managements
My question has to do with the – your effort into the (inaudible) business. I understand that there is some legal issues going on in terms hazards waste exposure from most of the roads. How do you guys look at that as an exposure for you, as an exclusion, is it something you are monitoring in terms of the watching status or how do you look at that?
Stephen Sills
The – first of all the amount of business that we are writing in that area is been actually a little disappointing so far, so we really don’t have that much of it, but in terms of – David do you wanted – just the exposures of…
Alan Seymour – Columbia Managements
Yes, I mean generally.
Stephen Sills
David Newman, our Chief underwriting officer.
David Newman
Yeah, generally, the short line railways really aren’t doing a lot of the hazardous materials anyway. The policy coverage only covers sudden and accidental and if it’s got major exposure, we tend to not to get involved in it.
Alan Seymour – Columbia Managements
Okay, great, thanks.
Operator
(Operator instructions) Our next question will come from the line of Zack Galler [ph] of Strategic Risk [ph]. Please proceed.
Zack Galler – Strategic Risk
Hi, good afternoon. The $5 million increase in goodwill and intangibles, could you touch on, please?
Stephen Sills
Yes, driven by the acquisition of our subsidiary AMS that we announced back at the end of the year – that transaction closed in January.
Zack Galler – Strategic Risk
Thank you very much.
Stephen Sills
You’re welcome.
Operator
(Operator instructions) I will turn the call back to management for any closing remarks.
Stephen Sills
Thank you everyone and we will speak to you next quarter. Thank you.
Operator
Thank you for your participation. You may now disconnect. Have a great day.
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