National Interstate Corporation Q1 2008 Earnings Call Transcript

National Interstate Corporation (NATL)

Q1 2008 Earnings Call

May 2, 2008 11:00 am ET

Executives

David W. Michelson - President and Chief Executive Officer

Julie A. McGraw - Vice President and Chief Financial Officer

Gary N. Monda - Vice President and Chief Investment Officer

Analysts

Hugh Taylor - Taylor Investments

Eden [Neuraphics] - KeyBanc Capital Mkts.

Elizabeth Malone - KeyBanc Capital Mkts.

Presentation

Operator

Welcome to the National Interstate Corporation 2008 first quarter conference call. (Operator Instructions) Your hosts for today’s call are Mr. David Michelson, President and Chief Executive Officer; Miss Julie McGraw, Vice President and Chief Financial Officer; Mr. Gary Monda, Vice President and Chief Investment Officer.

I would now like to turn the call over to Miss McGraw to begin the presentation.

Julie McGraw

Certain statements made during this call are not historical fact and may be considered forward-looking statements and are based on estimates, assumptions, and projections which management believes are reasonable, but by their nature are subject to risks and uncertainties.

The Private Securities Litigation Reform Act of 1995 provides a Safe Harbor for forward-looking statements. The factors which could cause actual results to differ materially from those suggested by such forward-looking statements include, but are not limited to those discussed or identified from time to time in national interstate filings with the Securities and Exchange Commission, including the annual report on Form 10-K and quarterly reports on Form 10-Q.

The company does not promise to update such forward-looking statements to reflect actual results or changes in assumptions, or other factors that could affect these statements.

I’d now like to turn the call over to David Michelson.

David Michelson

During the 2008 first quarter our overall top-line grew by 10.2% and our alternative risk transfer component was up 15.7% compared to last year. We consider this a significant accomplishment considering the continuing soft insurance market.

Our earnings per share of $0.49 were down compared to last year, reflecting large loss activity, unfavorable loss reserve development from prior years and investment write-downs.

Our underwriting results for the 2008 first quarter remain strong, with a GAAP combined ratio of 84.3%, which was 2.9% points higher than the 81.4% reported last year. Large loss activity during the quarter, as well as unfavorable prior year loss and loss adjustment expense reserve development, contributed to the combined ratio increase.

We have noted on several occasions that our business is subject to quarterly loss fluctuations due to the timing and relative severity of large loss occurrences. Large losses are a fact of life in our business and are factored into our underwriting and pricing retainers; however, because premiums are earned proportionally over the term of a policy, the losses are recognized when they occur. The impact of large losses often does not coincide with the recognition of the revenue.

In the 2008 first quarter we had two larger passenger transportation losses that accounted for nearly 10% of our incurred losses for the period and reduced earnings by approximately $0.12 per share.

In addition, we experienced unfavorable loss reserve development of $1.6 million during the 2008 first quarter, which reduced earnings by approximately $0.05 per share. This is in direct contrast with the $1.6 million of favorable reserve development that is reflected in our 2007 first quarter results.

Our loss reserves have historically developed favorably compared to our original estimates. We believe the unfavorable reserve development for the 2008 first quarter is an aberration based on the last nine out of ten years in which incurred losses developed more favorably than our original estimates. Quarter- to-quarter loss reserve development is not nearly as predictable as year-to-year loss reserve development parents.

Like most other investors, we’re maneuvering through unstable and unprecedented investment market conditions. During the first quarter we experienced market value declines, primarily in our financial and real estate related holdings. During the quarter we wrote down two of our investments by $900,000 because we determined they were impaired. This write down was offset by net gains from sales and maturities resulting in net realized losses from investments of $600,000 for the quarter, which reduced earnings by $0.02 per share.

Our net investment income continues to grow, reflecting strong cash flows from operations as well as a higher tax equivalent yield of the portfolio. 2008 first quarter pre-tax net investment income increased 14.6% compared to the 2007 first quarter while after tax investment income was up 16.6%. Our tax accrual and yield of 5.53% increased 10 basis points during the quarter.

We continue to closely monitor our holdings and take advantage of current opportunities in the market. Based on the overall quality of our investments, we remain optimistic that relative to portfolio value we will not ultimately experience any material losses from sales.

The first quarter is important to us, as it relates to gross premiums written: over 1/3 of our premiums are written in the first quarter of the year, which is attributable to several large alternative risk transfer programs that renew during the quarter. We have historically experienced renewal rates in excess of 95% in our alternative risk transfer component.

In the first quarter of 2008, our renewal transfer ART continued with nearly 98% of the group captive members renewing.

We are obviously very pleased with these results and attribute this success to National Interstate pursuing only well managed transportation companies, developing customized programs, and providing the highest levels of customer service.

Our traditional insurance products continue to manage their way through a soft insurance cycle. In the 2008 first quarter the renewal rates for our commercial products averaged declines in the low single-digits. We consider this a positive outcome with such competitive conditions and as a result two out of three of our traditional components grew during the first quarter.

Transportation and specialty personal lines were up 3.8% and 2.6% respectively, while our Hawaii and Alaska component decreased 8.6% compared to the 2007 first quarter. We continue to make rational pricing decisions during this competitive insurance market.

Our efforts are clearly focused on the future. We continue to identify and develop new products as well as expand our existing products, for example, we continue to emphasize accident even recorders as an opportunity to improve our customers risk management as well as our loss costs.

We have relationships with several vendors and we are now providing accident event recorders to our insured’s at very favorable terms. Recently one of our large group cap to port wins mandated the use of accident recorders for all of its members. This is an example of our relationship with alternative risk transfer customers that goes beyond just providing insurance coverage.

We also have a stated objective to consider and evaluate acquisition opportunities. We are currently seeking to effectively use our excess capital and take advantage of our available credit and low debt-to-capital ration. We believe that our business processes and people are maturing to the point where we can enhance our organic growth with the acquisition.

Our primary consideration in evaluating such opportunities is assessing the cultural fit and synergies. We are proceeding with caution so we don’t adversely affect our culture or business model that has served us well to this point.

In summary, we continue to grow our business at double-digit rates and our margins compare favorably with the insurance industry. Large losses and reserve development adversely affected 2008 first quarter earnings, but our accident year losses and expenses are in line.

Our business fundamentals remain strong and we are confident that 2008 results will be consistent with the trends that we’ve established since becoming a public company in 2005. We expect to meet our return on equity objective in 2008, while providing our shareholders with a return on equity of at least 15% plus inflation.

Julie, Gary, and I will be happy to answer any questions that you might have.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Hugh Taylor - Taylor Investments.

Hugh Taylor - Taylor Investments

We’ve been shareholders since you went public and I have a number of questions I’d like to ask you. Can you talk about your reserve policy? I think I’m correct in saying in previous quarters you released reserves and now you’ve added to reserves. I’d like to get your philosophy on this, first of all.

David Michelson

We do not release reserves. It’s not been our practice. We don’t do any average reserving. We’ve held our adjustor’s to specific claims objectives and we don’t release reserves; so if you were to go back and look at the last ten years of our loss reserve development patterns, on an annual basis nine out of the last ten years we’ve had favorable loss reserve development.

What’s particularly noteworthy is that the range of difference between the initial reserves and when those years ultimately settle out is a range that doesn’t fluctuate much more than 10% and generally is less than 10% of the amount that was initially set. So there is not a lot of fluctuation, but when there is, it has generally been a favorable trend.

Hugh Taylor - Taylor Investments

The two large transportation losses you had, you said this morning the same thing you said in your press release: can you give us some color on that? Why are thy as large as they were, what type of client was it? I think the more transparency you provide the better understanding we’re going to have of your company.

David Michelson

We’re providing $5 million limits on passenger transportation companies, those are the limits that their required to carry. We are the largest writer of passenger transportation business in the country, so we know we’re going to have these losses from time to time. What we don’t know is what quarter of the year they’re going to fall in.

Hugh Taylor - Taylor Investments

How long tail are these types of losses?

David Michelson

There is a range and within a few years of the date of loss, we’re going to have a really good sense as to where the claim is heading. Obviously in the first week, in the first month, we’re still developing fact patterns. It depends upon how much cooperation we get in terms of getting at the information and of course it could be a couple years down the road before a suit is even filed.

Within a few years we’re going to ultimately know, but the more serious the injuries and the faster we know about them, the faster we’re going to put up the reserves to where we think the ultimate claim payments are going to be.

Hugh Taylor - Taylor Investments

So give me some color on these two losses please.

David Michelson

These two losses involve passenger transportation companies, they were both very serious in nature and neither one of these customers were new customers to National Interstate. One of the customers we have insured for over ten years, another customer we have insured for five years; so they are clearly clients that we knew, that we had underwritten and priced and retained year-after-year.

We use this expression periodically with our customers, because they feel bad as well, where we say, “bad things happen to good people”. In the case of the customer that’s been with us for ten years, that is clearly the case: a very fine operator, strong safety reputation, but they had a very serious loss that obviously was meaningful to our results.

I should also mention that as we’ve gotten larger and our surplus has gotten larger, we have ratcheted up or started to retain more of the loss on a per loss basis and so on a quarter-to-quarter basis when we have a large loss, it will add a little more lumpiness to our quarter-to-quarter numbers than it might have had five, six years ago when we weren’t retaining as much of the risk.

Hugh Taylor - Taylor Investments

What was that a bus rollover or a tanker truck blowing up?

David Michelson

They were two bus lines, yes. They were two passenger bus lines. Yes, they were bus lines.

Hugh Taylor - Taylor Investments

Your real estate loss or write down in the investment portfolio, what type of investment was that? Is this subprime that you gentlemen are investing in and lady?

Gary Monda

I’ll take a, no we did not have any significant direct exposure to subprime. Our exposure tends to be, first of all our portfolio is very high quality, roughly 76% of it is fixed income, and then we have some preferred exposure. One of the write-downs we had, for example, is National City Bank and it’s a preferred holding. We just looked at it, said all that’s going on with them, it was appropriate to write them down.

The issues we’re having relative to our portfolios, we believe is primarily industry and sector related, those industries and sectors are real estate and financial. The exposure we have is really household type names such as Freddy Mac, Fannie Mae, Merrill Lynch and then we do have a few hot spots and National City would be an example of one of those where we wrote it down during the quarter.

Less than 2% of our portfolio is really on our watch list, if you will, so we just don’t believe we have significant exposure relative to the portfolio.

Hugh Taylor - Taylor Investments

I would make one comment to you. That if we go into a rising interest rate environment you’re going to lose money net net on preferreds.

Gary Monda

Our third portfolio right now is down because of market conditions, our yield on them is higher than our average yield and frankly we’ve not really been active in the preferred market in the last probably nine months; so most of these are items that we’ve had for a little bit.

Operator

Your next question comes from Eden [neuraphics] of KeyBanc Capital Mkts.

Eden [Neuraphics] - KeyBanc Capital Mkts.

I just had a question on your ART business and the growth experience for this quarter. I was wondering if could provide us a little bit more color as to why your art business tends to be resistant to the pricing pressures that the general marketplace is experiencing.

David Michelson

First of all, in the traditional business that can be found in our transportation component, there obviously is a lot of market influence in that pricing. We start individually underwrite every risk obviously and we’ve been doing it pretty well for a number of years, but the pricing does fluctuate up and down, to a larger degree, as market conditions do.

The beauty of the alternative risk transfer business is that those customers’ prices are developed off of their historic loss experience, without much influence at all of market conditions. So, to that extent that they are well-managed companies already and the vast majority of who we write in our ART programs are, they already have a really good deal right out of the gate, because we’re pricing them off of their losses, not market conditions. So, that’s one aspect.

The second is, is that if it takes awhile for us to bring this to the forefront for them and some of them get it instantly and some of them get it after they attend the first couple of meetings, but they all ultimately do, and that is we enter into relationships with these customers. It’s not just a financial transaction where they’re paying us premium and we’re paying losses.

We have relationships with them. We work hard at developing those. We meet with them no less than twice per year; they have access to senior management; we provide them with specialized claim service, specialized customer service and they put a value on that. We outperform on the service side and the relationship side relative to what they’re used to from their relationships with prior insurance companies.

When you have therefore strong service levels and a great relationship and an already well-priced business, it has a tendency to be a little stickier, which is why we lose very few of them. We’re not going through the market cycles of losing 15% to 25% of our customers at every renewal, which is pretty standard for traditional commercialized insurance. That helps us maintain our top-line stability when you’re not losing your renewal opportunities.

Operator

Your last question comes from Beth Malone - KeyBanc Capital Mkts.

Elizabeth Malone - KeyBanc Capital Mkts.

One is on the Hawaii and Alaska business. Do you believe you have critical mass in those markets to make it worthwhile to have to suffer through these pricing trends in that market and exactly what is the strategy for being in that business given how successful your other markets are? Why wouldn’t you reallocate your assets to those other markets?

David Michelson

The Hawaii business, we’ve been doing business there prior to even opening an office in the fall of 1995, and we were doing bus business there prior to opening the office. Our entrée into Hawaii with an office allowed us to expand our product offering into trucks and into a general commercial business.

We recognize that it is not as high growth a business component as our other components, but why we like the Hawaii business is that the profitability has been consistently strong, so it’s still, in our view, allowing us to strive to hit our corporate objective of 15% ROE plus inflation, but we’re doing it with margins and we’re doing it relationships with customers.

We are a household name amongst the agency community and commercial lines risks in Hawaii. It’s a small community, but we recognize that it’s not high growth and that’s one of the reasons why we decided a couple years ago to carefully expand our presence utilizing some of our Hawaii staff with the similar risks in another under served geographic area, that being Alaska.

So, it’s allowed us to control expenses, to continue to pursue the same small risks that we’ve successfully written in Hawaii over the years that are very service oriented, where sometimes if you’re just the fastest company to respond, that’s going to get you the business.

Elizabeth Malone - KeyBanc Capital Mkts.

On the RV business, with gas prices as they are and all the pressures in the economy, where do you expect will be their loss trend in that and also the top line in that business over the next year?

David Michelson

It’s hard to project the future specifically, but obviously over the last couple years with gas prices being the way they’ve been, the number of new RV shipments has been down double-digit each of the last couple years. This clearly means that there are less new business customers available to us if there are less RVs being purchased; so we’re pretty pleased with the fact that we’re growing this product, given that the number of new business customer opportunities we have is lower.

One of the things that’s interesting about the RVs is that this is, generally speaking, discretionary miles. These people aren’t driving their RVs to their job; so what’ s happening, we see, is that as gas prices are up, many of the RVs utilization is down and of course if the wheels aren’t turning on the road, there’s not as many claims.

When the gas prices are up, it shrinks a little bit our new business growth opportunity, but it has somewhat of a favorable impact on our loss trends.

Elizabeth Malone - KeyBanc Capital Mkts.

Your initiative to write the small trucking delivery truck business, I think you started in Ohio, what have you seen so far in that market?

Operator

I would now like to turn the conference back over to Mr. David Michelson for closing remarks.

David Michelson

We saw some growth in Ohio, but Ohio was really intended to be our test market; to be close to our agents; to refine our computer systems; to refine the product and we really used Ohio as really a “work out the kinks state” so that we could expand into two of the bigger markets, which is California and Texas.

We are now starting to see increases in number of agents quoting, conversion rates, and number of bound applications. It’s not going to be a really big number in 2008 in terms of significantly moving our top line, but we’re seeing very favorable trends month-over-month and we’ll see what the remaining months of the year bring, but thus far the trends are moving in the right direction and we’re pleased.

In closing, I want to remind everyone that we continue to stay focused on our objectives and execute a business plan that we believe in and that has produced excellent results. We do not over react positively or negatively to quarterly fluctuations in our results. By maintaining this long-term perspective we have built a flagging business and we will continue to make National Interstate a solid investment choice. Thank you for participating in our conference call and for your interest in National interstate.

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