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EMC Insurance Group Inc. (NASDAQ:EMCI)

Q1 2008 Earnings Call

April 24, 2008 11:00 am ET

Executives

Anita Novak - Director of IR

Bruce Kelley - President and CEO

Mark Reese - SVP and CFO

Steven Peck - SVP, Actuary

Rich Schulz - SVP/Claims

Analysts

Bob Farnam - Keefe, Bruyette & Woods

David Dusenbury - Dalton, Greiner, Hartman

Operator

Greetings and welcome to the EMC Insurance Group Incorporated first quarter 2008 earnings results call. (Operator Instructions)

It is now my pleasure to introduce to your host Miss Anita Novak, Director of Investor Relations. Thank you, Ms. Novak. You may begin.

Anita Novak

Thank you, Everis. Good morning, everyone, and welcome to EMC Insurance Group's 2008 first quarter earnings call.

The supplemental investor packet is available on the Investor Relations page of our website, which can be found at www.emcinsurance.com. The webcast for replay purposes is also available at this site until July 29, 2008. A transcript of the webcast will also be available for one year.

This presentation includes some forward-looking statements about our expectations for our future performance. Actual results could differ materially from those suggested by our comments today. Additional information about factors that could affect future results is addressed in our SEC filings, including forms S-1, 10-K, 10-Q and 8-K. Any information provided today should be read in conjunction with the 2008 first quarter earnings release with accompanying financial tables issued earlier today.

With us today are several members of EMC Insurance Group's executive management team. They are Mr. Bruce Kelley, President and Chief Executive Officer; Mr. Steven Peck, Senior Vice President, Actuary; Mr. Rich Schulz, the Senior Vice President, Claims; Mr. Ray Davis, Senior Vice President, Investments & Treasurer; and Mr. Mark Reese, Senior Vice President and Chief Financial Officer.

At this time, it is my pleasure to introduce EMC's Chief Executive Officer, Bruce Kelley.

Bruce Kelley

Thank you, Anita. I would like to talk just a little bit about market conditions this morning and what our expectations are for 2008.

The rate environment continues to be competitive we would not expect otherwise given the amount of capital within the industry. However, we believe there is some stability in the rate environment as well. For the most part, we are not seeing a free fall in pricing, which was prevalent during the last soft market and years ago. And we are requesting and getting slight increase in rates in some states and in some lines of business, though this is not the norm by any means.

Overall, we still consider most rates in most lines of business to be adequate. Our expectation is that this competitive environment will continue at least through 2008 due to the high level of capital within the industry and current economic conditions.

Slightly more than 37% of our commercial business includes our EMC Choice, target market and safety groups. This program business helps considerably in stabilizing our book of business especially during soft markets. Our retention levels remain in the 87% range, which exceeds industry standards and leads us to believe our rates are competitive.

We have other tools in our arsenal, which we did not have during the last soft cycle, and we believe they allow us to effectively compete within the marketplace.

We continue to acquire or create sophisticated systems to monitor our underwriting and pricing practices that allow us to analyze data at a summary level or to such a detailed level as to be able to view performance of individual underwriters or individual accounts. We believe these tools will provide ongoing stability in results by creating a more knowledgeable employee base and consistent risk selection and pricing.

We do not expect significant growth in premiums in 2008. Our underlying book of business in performing very well, and we are committed to maintaining the integrity of that book of business. Naturally, we would very much like to grow. But again, the underlying stability of a profitable book of business is paramount.

For that reason, we will continue to focus on rate adequacy rather than market share. We do expect some organic growth as a result of strategic planning within our existing 3,200 agents and through new business as we engage new agency partners.

Merger and acquisition activity is not on our radar screen at this moment, but we are always looking at possibilities. And given the current economic environment, we suspect there may be some opportunities in the future that may or may not fit into our current structure. We are always willing, however, to explore our options to increase our market presence through acquisitions.

As for our first quarter results, storms were a significant factor in our earnings performance. In fact, storm losses were more than double the amount experienced in any first quarter since we began reporting catastrophe and storm losses on a quarterly basis in 1996.

We experienced only one major loss, but numerous claims associated with the storms in the Southeastern United States during February. We estimate that these unusual winter tornados added 4 points to our first quarter loss ratio. These storms were not confined to one branch territory, but rather affected several of our branches throughout the Southeastern United States.

Net investment income was relatively flat during the first quarter, which was somewhat unusual for us. This was caused by a significant amount of call activity on our United States Government Agency securities. Due to the low interest rate environment, we invested the proceeds from these called securities in short-term investments until more suitable long-term investments could be identified.

The immediate effect was a small decline in our investment income for the quarter, but once all the proceeds are reinvested, we should once again see growth in our investment income.

With that, I will ask for comments from Mark Reese, Senior Vice President and Chief Financial Officer. We would be happy to answer any questions after his presentation.

Mark Reese

Thank you, Bruce.

Operating income for the first quarter was $10.1 million, which is down from $13.9 million reported in the first quarter of 2007. Net income for the first quarter was $8.2 million compared to $14.7 million for the same period in 2007. The declines in operating income and net income reflect an increase in catastrophe and storm losses, a decrease in the amount of favorable development experienced on prior year's reserves and a moderate but steady decline in our overall premium rate levels.

In addition, net income was negatively impacted by $2.9 million of other than temporary investment impairment losses that were recognized on 13 securities in the company's equity portfolio. These impairment losses were recognized, because the company's equity manager indicated that these securities, which were in an unrealized loss position, would likely be sold before they recovered to their cost basis. As a result, the intent to hold these securities to recovery did not exist.

Net written premiums increased 1.3% to $91.1 million in the first quarter. This increase in attributed to a 12.9% increase in the reinsurance segment, as the property and casualty insurance segment experienced a 1% decline in commercial lines and a 1.5% decline in personal lines.

New business premium was down 12% in commercial line and up 13.2% in personal lines, with much of that coming in selected territories with greater profit potential.

As Bruce mentioned, catastrophe and storm losses were unusually high in the first quarter, totaling $0.27 per share compared to $0.12 in 2007. The notable storm losses consisted of approximately 150 claims. Of those claims, only one is considered to be a large claim. All these claims represent storms that occurred throughout the quarter, the majority of them occurred in the Southeast United States during February.

Investment income was relatively at $11.9 million for the quarter as compared to one year ago. The company experienced a high level of call activity on its Government Agency securities during the first quarter as a result of the declining interest rate environment. The proceeds from these called securities were invested in short-term securities until attractive long-term opportunities could be identified.

As of March 31st, approximately 55% of the $211 million in proceeds received from the called securities had been reinvested in the long-term securities, including $40 million in municipal bonds, yielding 5% to 5.4%; $18 million in 10-year corporate bonds, yielding 6% to 7.25%; and $7.5 million in commercial mortgage-backed securities, yielding 6.7%.

The total rate of return on our equity portfolio for the first quarter of 2008 was negative 10.25%, which compares to negative 9.44% for the S&P 500. The current annualized yield on our bond portfolio is 4.884%, and the effective duration is 4.76 years, which is up from 3.75 years at the end of 2007.

Based on first quarter results and our expectations for the remainder of 2008, management is reaffirming the 2008 operating income guidance of $2.10 per share to $2.35 per share.

On March 10, 2008, the company's Board of Directors authorized a $15 million stock repurchase program. This program became effective immediately and does not have an expiration date. The timing in terms of the purchases will be determined by management based on market conditions and will be conducted in accordance with the applicable rules of the SEC. Common stock purchase under this program will be retired.

As of April 18th, 121,899 shares of common stock had been repurchased at a cost of approximately $3.4 million. Employers Mutual has about $4.5 million remaining in its own $15 million stock purchase program. This program will remain dormant while the company's repurchase program is active.

At this time, I would like to open the phones for questions.

Question-and-Answer Session

Operator

(Operator Instruction)

Our first question today comes from the line of Bob Farnam with Keefe, Bruyette & Woods. Please proceed with your question.

Bob Farnam - Keefe, Bruyette & Woods

Hi there. Good morning. I have a few questions. One is on the growth in the reinsurance segments. You said there were several new contracts. Can you just give more detail as to what was in those and maybe if we should be expecting continued growth in that segment?

Bruce Kelley

The reinsurance segment has two segments of it, the Mutual Reinsurance Bureau and the Home Office Assumed Reinsurance Department. The Mutual Reinsurance Bureau's business was relatively flat. However, we were able to pick up some new accounts in our Home Office Assumed Reinsurance Department.

And those accounts, we have been working on for many years to secure, and we are pleased that they came our way. I wouldn't say that they are harbinger of future accounts, but we are hopeful that we will get future accounts from both the Mutual Reinsurance Bureau and the Home Office Assumed Reinsurance Department.

Bob Farnam - Keefe, Bruyette & Woods

Okay. Second question is going into the combined ratio, taking out the development in the quarter, taking out the catastrophe losses, looks like it was about 107.6 normalized. I know in past, we have said that that includes some degree of conservatism and you expect those to develop downwards just going forward. Can you give us an idea of what we should be expecting for the ultimate accident year '08 numbers from here?

Bruce Kelley

Let me turn it over to Steve Peck, and he can give you his analysis of the ultimate number.

Steven Peck

I can give you a projection, Bob, on a consolidated basis. The projection at yearend was in the neighborhood of 101.5 for accident year 2008. That would probably differ some for the Group, and the 101.5 has not been updated since we've put together early in the first quarter.

Bruce Kelley

And that's the number that we are using when we're estimating our earnings. So, that's how we get to our earnings range that we project to you.

Bob Farnam - Keefe, Bruyette & Woods

Okay. So the 101.5 includes some measure of catastrophe losses. Is that correct?

Steven Peck

What needs to be recognized there, Bob, and I think we pointed that out on previous calls is that because of our intent to reserve relatively conservatively, we would expect that the latest accident year would tend to develop downward.

For example, if you look back at 2007 accident year, by my calculations, and this will be on a statutory basis, grew very close to 112% for accident year 2007 at the end of March. By the end of the year, it came down to neighborhood of 107.5%. By the end of March this year, that's down to about 106%. I don't have much giving you a figure here, but I strongly suspect that 106 will continue to fall from there.

If you look back at 2006, and I don't have Group figures here, but on a consolidated basis, the combined ratio drops about 8 points after the end of 2006. If you look back at 2005, I don't have the numbers, but you see a similar pattern. We do have a recent track record of declines in the combined from compared to the earlier evaluations.

Bruce Kelley

And at this point, Bob, I'd remind you that the majority of these changes in reverses are the results of closing the claims and taking down our reverses. So, ever since 2004 when we got our reverses up to a higher level of adequacy, they've been performing as Steve has just presented.

Bob Farnam - Keefe, Bruyette & Woods

Okay. Is the degree of conservatism going into those picks come down over time or you'd expect that '08 is pretty much on a similar basis what we've seen happening for '07 and '06?

Bruce Kelley

Just one point. We aren't making lost ticks. We're just showing you what the aggregates of our claims, examiners, analysis or claims are. Steve?

Steven Peck

Yes, Bob, I could tell you as of yearend on a consolidated basis in the full range of estimates, the carried reserve fell about 5 points to somewhere in the neighborhood of the 85th percent of our full range. We don't really make a point estimate. But if you were to pick a midpoint of our selected range, the carry reserve did fall a bit at the end of 2007 compared to 2006 about a point from roughly 5% down to 4%.

Bob Farnam - Keefe, Bruyette & Woods

Okay.

Steven Peck

I am sorry. Go ahead.

Bob Farnam - Keefe, Bruyette & Woods

Just going to another topic, the rate decline, it sounds like it's at least 5.5% for the year is what you are looking for. Can you give us an idea of what you are seeing in terms of frequency and severity trends? In other words, putting them all together, what type of deterioration might be seen?

Steven Peck

That is a little bit difficult to say. But on the frequency side on an all lines basis, we were pretty flat compared to the first quarter of 2007, up about 0.8%, but the upper Midwest, as you know, had a fairly tough winter. We saw a lot of freezing claims, a lot more freezing claims in 2008 first quarter than we did in 2007, saw more collision claims, though I am not sure of what that 0.8% means right now. On a perspective basis, I don't think it's necessarily a good predictor that frequency is going to increase this year.

On severity, on a reported basis, the average size of newly reported claims during the first quarter of 2008 compared to first quarter of 2007, our severity was actually down about a point. And that's excluding storms. And I should also mention the frequency was excluding storm.

Bruce Kelley

We also have Rich Schulz here, the Senior Vice President for Claims. Rich, do you have any commentary on frequency or severity.

Rich Schulz

I'd just say that in 2007, we saw an increase in work comp claims, and it was weather related. And in fact in the earnings call of that quarter, we were asked why the increase in frequency. We've got a very similar first quarter this year. We saw a lot of increase in smaller work comp claims and slip-and-falls.

Bob Farnam - Keefe, Bruyette & Woods

Okay. I'll re-queue if I have any other questions. Thank you for that.

Operator

(Operator Instructions)

Our next question comes from the lines of David Dusenbury with Dalton, Greiner, Hartman. Please proceed with your question.

David Dusenbury - Dalton, Greiner, Hartman

Hi. Just a question on the reserve development. You were clear to say in the press release and on the call that these are really closed claims. Was there a higher experience of settlements this quarter versus others?

Rich Schulz

No. the closure rate was almost identical to 2007.

David Dusenbury - Dalton, Greiner, Hartman

Okay. Thank you.

Operator

(Operator Instructions)

Our next question comes from the line of Bob Farnam with Keefe, Bruyette & Woods. Please proceed with your question.

Bob Farnam - Keefe, Bruyette & Woods

Had a one more question. In terms of exposure in the Midwest and the tornado and hail losses, has there been an uptick in terms of losses related to non-cash weather claims in general, not specifically for the quarter, but do you see that happening?

Bruce Kelley

I would comment, and then I am sure Rich Schulz may have a comment also. Certainly, as I mentioned, we saw an uptick in the homeowners' line freezing claims. Those are freezing claims, a lot of them that were not quoted as storm claims. And then, of course, the collision claims also were not quoted as storms on that particular area. Rich alluded to the first quarter 2007, if you want to expand on that, go ahead.

Rich Schulz

Yes, once again, in 2007, we saw an uptick in frequency and the work comp claims. And when we went back and analyzed it, we were able to see that it was basically slip-and-falls weather-related Kansas and Iowa. We took a look at some of what we were seeing this year in the first quarter.

Once again, we had an increase in actual claim count of about 3% in work comp and a good portion of that was once again weather-related slip-and-falls in the Midwest.

So, we're not seeing a major trend. We're seeing weather-related. We had a bad winter in 2007 in a couple of our states where we write a lot of business. And this year, once again, we had a heavy winter with a lot of ice and snow.

Bob Farnam - Keefe, Bruyette & Woods

Okay. And is it safe to assume or not that your exposure in these areas has increased year-over-year?

Rich Schulz

Well, in terms of policy count, our policy count is up. But from the claims perspective, I'm not seeing any substantial difference in the exposure. With the types of business we are seeing, the slip-and-falls occurs and is in this type of business, in some of our elementary and secondary schools, and we haven't been seeing big gains in the policy count in those areas.

Bob Farnam - Keefe, Bruyette & Woods

Okay. All right, that's it. Thanks.

Bruce Kelley

Thank you, Bob.

Operator

(Operator Instructions)

Thank you, but there no further questions at this time. I'd like to turn the floor back to management.

Anita Novak - Director of Investor Relations

Thank you, ladies and gentlemen. This now concludes this conference call. I would like to remind you that a playback of this call will be available on the company's website at www.emcinsurance.com until May 13th, and a transcript of this conference call will be available until April 2009, which can be accessed from our website as well later today.

We appreciate your interest in EMC Insurance Group. And all of us wish you an enjoyable day.

Operator

Ladies and gentlemen, this concludes today's teleconference, and you may disconnect your lines at this time. Thank you for your participation.

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