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Erie Indemnity Company (NASDAQ:ERIE)

Q2 2012 Results Earnings Call

August 03, 2012 10:00 AM ET

Executives

Karen Kraus Phillips – Vice President, IR

Terry Cavanaugh – President and CEO

Marcia Dall – Executive Vice President and CFO

Chip Dufala – Executive Vice President, Services

John Kearns – Executive Vice President, Sales and Marketing

Jim Tanous – Executive Vice President, Secretary and General Counsel

Analysts

Adam Klauber – William Blair

Operator

Good morning. And welcome to the Erie Indemnity Company Second Quarter 2012 Earnings Conference Call. I would like to introduce your host for today's call, Karen Kraus Phillips, Vice President of Investor Relations.

Karen Kraus Phillips

Thank you, Marie, and welcome everyone. We appreciate all of you joining us today. On today's call, management will discuss our second quarter 2012 results and other matters related to the company's second quarter operation.

Joining me today are Terry Cavanaugh, President and CEO; Marcia Dall, Executive Vice President and Chief Financial Officer; Chip Dufala, Executive Vice President, Services; John Kearns, Executive Vice President, Sales and Marketing; and Jim Tanous, Executive Vice President, Secretary and General Counsel.

Our earnings release and financial supplements were issued yesterday afternoon, and are currently available on our website erieinsurance.com. We will hear brief remarks from Terry and Marcia, and then open the call for Q&A.

Before we begin, let me remind everyone that today's discussion may contain forward-looking statements. These forward-looking statements reflect the company's current views about future events and are based on assumptions subject to known and unknown risks and uncertainties. These risks and uncertainties may cause results to differ materially from those anticipated as described in those statements. For information on important factors that may cause such differences, please see the Safe Harbor statements in our latest 10-Q filing with the SEC dated August 2, 2012, and in the related press release.

Also in this call, we may discuss non-GAAP measures. A reconciliation to the GAAP based results can be found in the 10-Q. This call is being recorded and the recording is the property of Erie Indemnity Company. It is not intended for reproduction or rebroadcast by any other party without the prior written consent of Erie Indemnity Company. A replay will be available on our website today after 12:30 p.m. Eastern Time.

Your participation on this call will constitute consent to the recording, publication, webcast, broadcast, and use of your name, voice and comments by Erie Indemnity. If you do not agree with these terms, please disconnect at this time.

With that, I will now turn the call over to Terry.

Terry Cavanaugh

Thank you, Karen, and good morning, everyone. Indemnity second quarter 2012 results were impacted by three primary factors, strong management fee revenue, higher operating expenses and lower investment income.

Combined, these led to an Indemnity net income per share diluted for the quarter of $0.80 compared to $0.94 last year. While we are pleased with our top line growth, we recognized that we need to address our operating expenses and gain greater management margin in order to produce operating leverage and create shareholder value over the long term.

Today, I will discuss our top line growth, our strategy related to investing in the operations for long-term success, and operating expense trends. Then, Marcia will discuss our financial results, including investment income in more detail.

Indemnity continues to seek solid top line growth, driven by an 8% increase in the Property and Casualty Group's direct written premium, reflecting an increase in both policies in force and average premium per policy. This increase reflects an ongoing strong retention and double-digit new business growth in both personal and commercial lines.

Our agents generated an increase of nearly 28% in new business premium in the quarter compared to a year ago, reflecting increases in new policies written and average premium per policy. While Indemnity is seeing positive top line growth, we are also experiencing pressure on our management margin as a result of higher operating expenses.

As I discussed last quarter, we are making investments in the business to ensure our strong value proposition remains relevant going forward for all of our stakeholders. We continue to make investments in our strategic priorities, new products and pricing sophistication, ease of doing business and service excellence.

On last quarter's call, I discussed two examples of the progress we made and the development of new products and pricing sophistication. First, on ERIE Rate Lock, our new personal auto product, and second, ERIE Secure Home, a new home insurance product we've introduced in several states. With the use of new pricing sophistication, both of these products allow us to get the right customers at the right price.

Regarding ease of doing business, we are investing in two coding systems, personal lines and commercial lines that impact our agents and their producers. The personal lines were introduced in our new web-enabled coding system for auto and are near completion on the second phase that enables home quote. It is intended to improve the agent experience and efficiency in coding and issuing new policies.

As we discussed last quarter, we are also making enhancements to our commercial lines platform to facilitate ease in quoting our products to targeted new accounts and then more effectively service our existing customers.

In conjunction with our focus on ease of doing business, we are working with our agents to increase our marketing presence through local campaigns focused on driving brand awareness and new business quotes. These critical investments by our agents and indemnity are helping to fuel our growth today and build positive momentum for the future.

Being above on service for our agents and customers is a key differentiator for Erie in the marketplace and maintaining our service reputation is an ongoing focus. I am proud to say that our work has been recognized.

Erie's service excellence was again acknowledged by our customers this quarter. We received the highest customer satisfaction rating among US national auto insurers for the Mid-Atlantic region by J.D. Power and Associates. This is particularly significant when you consider the number of catastrophes our customer experienced last year and the high volume of claims our agents and adjusters resolved.

From a service investment perspective, we are close to completing the implementation of our new billing platform. This new platform provides efficiencies in our billing operations automating manual processes and enhancing others. Given these investments and other factors that Marcia will discuss shortly, we're seeing operating expenses outpace our top line growth in the first half of 2012. We expect this to continue for the balance of the year.

We understand the importance of generating greater margin over the long term. We are working diligently to hold down expenses outside of strategic investment areas in both the near and longer term. We are reevaluating our expense trends and will be finalizing our 2013 business investment priorities during the second half of this year.

Before I turn the call over to Marcia, I would like to tell you about an organizational change related to our technology effort that will add significantly to our IT competency. This past Monday, I announced that Robert Ingram will be joining Erie Insurance as our new Chief Information Office reporting directly to me.

Bob is a seasoned executive and leader with the proven track record of IT success in the insurance industry. Bob joins us from the Hartford where he was most recently a Senior Vice President and CIO for commercial lines. Prior to Hartford, Bob held the CIO position in Safeco and Technology Leadership positions at USAA. As a member of our Executive Team, he will be a key player in helping build effective technology capabilities more efficiently.

With that, I will now turn the call over to Marcia to review the financials for the quarter.

Marcia Dall

Thank you, Terry, and good morning, everyone. Net income was $43 million, compared to $52 million in the second quarter of 2011. On a per share diluted basis, net income was $0.80 per share in the current quarter, compared to $0.94 per share in the prior year quarter.

As Terry indicated, higher operating costs and lower investment income in the second quarter 2012 offset our strong top line growth and were the primary reasons for the year-over-year decrease.

In our management operations, income before taxes was $59 million, compared to $64 million in the second quarter 2011. Management fee revenue was $308 million, up 8.3% year-over-year and consistent with the 8.2% increase in direct written premiums of the property and casualty group.

This result was driven by policy growth of 3.1% and a 3.7% increase in year-over-year average premium per policy. We are working to maintain our strong customer retention, while taking rate increases where appropriate, to more precisely price [of risk].

Renewal premiums increased 6% over the prior year, driven by a 3% increase in average premium per policy and a strong 90.7% retention ratio. As Terry discussed, our agents have generated significantly higher levels of new business premiums, in both personal and commercial lines, relative to the same period in 2011, through both new policy growth and higher average policy premium levels. New business premiums increased nearly 28%, compared to a year ago to revise 70% increase in new policies and an increase of 7% in average premium per policy.

Cost of management operations was $257 million or 12% higher than the prior year quarter. Our cost of management operations are made up as agent commission related expense and non-commission expenses. Agent commission related expenses represent approximately 65% of our cost structure, and are typically directly linked to our top line growth.

Agent commission related expenses increased 4.7% or $8 million in the second quarter 2012, compared to the second quarter of 2011. This is a result of the 8.2% increase in direct written premiums, and a $6 million adjustment related to prior periods, that partially offset commission related expenses. Excluding this adjustment, our commission expenses would have increased 8.3% for the quarter.

The adjustment represents the reimbursement by the North Carolina Reinsurance Facility, for commissions Indemnity previously paid to agents on the surcharges collected on behalf of the facility. These amounts were incorrectly retained by the exchange in prior periods. This adjustment has no impact on our agent's cash compensation.

Non-commission expense increased $19 million over the prior year quarter, driven by higher levels of acquisition related, information technology and personnel costs. Acquisition related costs increased $5 million due to high levels of the applications in policies, and increased agent related advertising and support cost.

Information technology costs increased $6 million, reflecting higher levels of software costs, professional fees and personnel related costs. All other personnel costs increased $8 million, as a result of higher healthcare retention cost, an increased in the estimate for annual incentive plan compensation related to growth and underwriting performance, and staffing levels primarily associated with policy acquisition and customer service functions. The second quarter 2012 gross margin for management operations was 18.6%, compared to 21.6% in the second quarter of 2011.

Now turning to the results of our investment operations. Indemnity recorded profit before taxes of $6 million, compared to profit before taxes of $70 million in the prior year quarter. Net investment income was $4 million for the second quarter of 2012 and 2011. Net realized losses on investments were $1 million, compared to gains of $6 million in the prior year quarter. There were no impairments in the second quarters of 2012 and 2011.

Our income from equity and limited partnership investments was $3 million in the second quarter 2012, compared to $7 million the previous year. The 2012 results reflect less favorable performance in private equity.

Now let's look at our results for the first six months of 2012. Indemnity's net income totaled $79 million, compared to $96 million for the same period last year. On a per share diluted basis, net income was $1.47 per share, compared to $1.72 per share for the prior year. Net income for the first six months of 2011, included $1 million or $0.02 per share diluted, related to the operations sold to the Exchange.

For our management operations, income before taxes was $105 million for the first half of 2012, compared to $112 million last year. The gross margin for management operations was 17.8% for six months of 2012, compared to 20.2% for the prior year period.

In investment operations, Indemnity recorded a profit before taxes of $14 million for the first half of 2012, compared to profit before taxes of $33 million for the same period in 2011.

Regarding our share repurchases, during the second quarter, the company repurchased our 360,000 shares of our outstanding Class A common stock, at a total cost of $25 million. For the year through July 19, 2012, shares repurchased under the program, totaled almost 650,000 at a total cost of $48 million. As of July 19, 2012, we had approximately $90 million remaining in our repurchase program.

Terry Cavanaugh

Thank you, Marcia. In addition of the J.D. Power and Associates award I mentioned earlier, we learned in mid-July that for the fifth year in a row, Erie was named in the Ward's 50 list of top performing property and casualty companies, out of the 3.000 companies nationwide.

The Ward Group recognizes businesses for their operational excellence through financial strength and a superior performance over a five year period. This is the 22nd year for the Ward's 50 lists and the 15th year Erie has been named.

These recognitions are important and gratifying, and it is the dedication and experience of our employees and agents that stand behind these honors. I know many of them listen-in on this call. They are engaged not just in creating, but celebrating Erie's success and I want to thank them for all they do to make it impossible.

As I said earlier, throughout 2012, we continue to make investments in new products and pricing sophistication. Agents doing business for our agents and customers, as well as service enhancements. At the same time, we are actively managing expenses outside these areas and closely evaluating expense trends on our strategic investments for 2013. Our goal is to continue to grow the business and position for future success, producing long term value for our shareholders and meaningful products and services for agents and customers.

Operator, you may now open the call for questions.

Question-and-Answer Session

Operator

(Operator Instructions) We have a question from Adam Klauber from William Blair. Your line is open.

Adam Klauber – William Blair

Thanks. Good morning, everyone.

Terry Cavanaugh

Good morning, Adam.

Marcia Dall

Good morning, Adam.

Adam Klauber – William Blair

A couple different questions. Number one, you've clearly been growing nicely both on a [tiff] basis -- [tiff] basis excuse me and also getting higher premiums. Particularly in the commercial area where in the last couple quarters, your average premium change is going from 3% to 5%, do you think it's going to stabilize around 5% or do you think there is potential for that to go high over the next six, 12 months?

Terry Cavanaugh

Yes. That's a difficult thing to look at. I think that's made up obviously of price as well as exposure. Our premium per policy is relatively small compared to may be other companies you might be looking at, and so the movement there is easier – might be easier for us to accomplish than some other companies.

We read the same economic data you do, and I guess I am a little concerned about what we're seeing, but I think again we work very hard to make sure that we have the best customers and the agents are doing a good job of finding successful businesses that are finding success, whether it'd be on mainstream or on the manufacturing area.

Adam Klauber – William Blair

Okay. On the auto business, again, looking at competitive data we are seeing increased loss cost, particularly severity move up but also frequency is beginning to pick up. So, are you seeing that at the exchange and also because of that do you think any more weight there also?

Terry Cavanaugh

We've got a pretty strong book of automobile business. We have been very focused on making sure that we've got the right price for the exposure. We believe that the industry is looking that also. We had a little uptake in our loss ratio on an accident year basis, but we are comfortable that we are pricing that to the exposure. And I think again based upon our mix and the marketplace that we are in, we are in good shape.

Adam Klauber – William Blair

Okay. And then as far as the expense growth, it looks like your non-commission expenses grew from $73 million in the second quarter of 2011 to $92 million, roughly $20 million. Could you give us sort of a in buckets, not exact, what's the breakdown of that, where is that coming from, just give us some idea?

Terry Cavanaugh

Yes. I mean, again, we've got it related in a number of different buckets. I think we talked about there is a technology spend there, roughly $6 million. We have some other personal expenses that talk about. We have benefits health issue that we are dealing with that is increasing. We have a pension exposure. We have then just other acquisition costs that we have by virtue of the fact that we are growing the business. We have acquisition costs that are growing in terms of MBR costs and other underwriting survey tools that we utilize, and so it's a number of different areas. I don't know Marcia if you want to give any more color round that.

Marcia Dall

Yes. So seldom the way to think about it is the volume in agent related advertising support is roughly $5 million of that increase, the technology as Terry mentioned is about $6 minion, and that's both in personal, software and professional piece.

And then the third bucket being around $8 million is the personal, excluding IT. What that is when series of healthcare issues and tension issues so interesting, we are seeing healthcare costs increase, which is very common across the various companies.

Obviously our pension costs increased year-over-year and that's what we're seeing fall through here as well as the increase in our estimated incentive comp based and our strong growth performance. And the fact that our combined ratio for the P&C Group is materially improved over last year because last year we had a lot of cat and this year have less and then just higher staffing level.

Adam Klauber - William Blair

Okay. That's helpful. Thank you very much

Karen Kraus Phillips

It appears that we don't have any further questions, so I just want to thank you all for joining us and remind you that a recording of the call will be posted on our website, erieinsurance.com after 12:30 p.m. Eastern Time today. And if you do have any questions, please call me 814-870-4665. And thanks everyone and make it a great day.

Terry Cavanaugh

Thank you very much.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program and you may now disconnect at this time.

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