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State Auto Financial Corporation (NASDAQ:STFC)

Q2 2012 Earnings Call

August 2, 2012 10:00 a.m. ET

Executives

Steve English - VP, CFO

Bob Restrepo - President, Chairman and CEO

Scott Jones - Chief Investment Officer

Matt Mrozek - Chief Actuarial Officer

Analysts

Larry Greenberg - Janney Capital Markets

Operator

Welcome and thank you for standing by. At this time, all participants are in a listen-only mode. (Operator Instructions). Today's conference is being recorded. If you have any objections, you may disconnect at this time.

I will now introduce your host for today's conference State Auto Financial Corporation’s Chief Financial Officer, Mr. Steve English. Sir, you may begin.

Steve English

Thank you, Christie and good morning everyone and welcome to our second quarter 2012 earnings conference call. Today, I'm joined by our Chairman, President and CEO Bob Restrepo; Chief Investment Officer, Scott Jones; and our Chief Actuarial Officer, Matt Mrozek.

Today's call will include prepared remarks by our CEO, Bob Restrepo and me, after which, we will open the lines for questions.

Please note our comments today may include forward-looking statements, which by their nature, involve a number of risk factors and uncertainties which may affect future financial performance. Such risk factors may cause actual results to differ materially from those contained in our projections or forward-looking statements. These types of factors are discussed at the end of our press release as well as in our annual and quarterly filings with the Securities and Exchange Commission to which I refer you.

A financial packet containing reconciliations of certain non-GAAP measures, along with supplemental financial information was distributed to registered participants prior to this call and made available to all interested parties on our website www.stateauto.com under the investors section as an attachment to the press release.

Now, I'll turn the call over to STFC's Chairman, President and CEO, Bob Restrepo.

Bob Restrepo

Thank you, Steve. Good morning everyone. Second-quarter results were similar to our first quarter but with improved non-catastrophe results and higher catastrophe losses. Our combined ratio of 110.4% was a significant improvement over last year but still produced a modest loss of $2.7 million or $0.07 a share.

State Auto Financial Corporation's book value at the end of the second quarter was $17.82 a share, which is a decrease of $0.13 from our restated book value at year-end. The current book value includes a reduction of $2.60 a share of the deferred tax asset valuation allowance which we established at the end of the second quarter last year.

The second quarter is traditionally difficult for State Auto because of spring storms. 2012 was no exception. For accounting for the homeowners quota-share treaty, our catastrophe loss ratio for the quarter would've been 21.4%, which is pretty close to our five-year average for the second-quarter. This year, though the homeowner quota-share treaty reduced our net catastrophe loss ratio to 13.2%, a significant improvement. We saw 13 catastrophes in the quarter but two of these accounted for over 80% of our catastrophe losses.

Catastrophe number 74 hit St. Louis, Louisville and the state of Tennessee in April. Late June catastrophe number 83, otherwise characterized as derecho, also produced significant losses for us in Ohio, West Virginia and Metro Washington DC. Neither of these catastrophes triggered a recovery from a catastrophe reinsurance treaty but our results did benefit from the homeowners quota-share treaty that we placed last year.

For the entire enterprise the treaty worked as expected. Since second-quarter results and catastrophes included a more normal mix of homeowner losses, the benefit in the second-quarter was more significant than what we experienced in the first quarter of this year. First-quarter featured a larger mix of commercial property and automobile losses due to hail.

This quarter the treaty reduced our underwriting loss by $24.4 million and improved our combined ratio by 6.8 points with a reduction to the loss ratio of 7.2 points and an increase in our expense ratio of 0.4 point. Year-to-date the treaty reduced our underwriting losses by $31.6 million, improving our combined ratio by 3.9 points with a 4.5 point improvement to the loss ratio and a 0.6 increase in our expense ratio.

While disappointed with a quarterly loss, we are encouraged by improvements in our ex-catastrophe loss ratio results in all three segments: personal insurance, business insurance and specialty insurance. We also reported an improvement in our expense ratio despite the impact associated with the homeowners quota share treaty. Improved commercial lines production and our continuing effort to manage expenses reduced our expense ratio in the quarter to 32.3%.

Before turning the call back to Steve, I will comment on our ex-catastrophe loss ratio result and production performance in each of the three segments. In personal auto, our personal auto results improved sequentially and relative to last year resulting from better non-catastrophe non-weather experience, largely driven by lower prior accident year large losses.

I mentioned last quarter we were beginning to see the benefit of liability claim actions we’ve taken over the last two years. We continue to experience increases in bodily injury severity in personal auto but we are managing these trends affectively with new casualty claim processes. Excluding catastrophes, our personal auto loss cost trends compared favorably to industry state results. In addition to improved claim performance, our personal auto line will benefit from increased prices and greater rate sophistication.

Our mid-single-digit price increases exceed current loss cost trends. Additionally we’re introducing our third generation of custom fit auto, a multivariate predictive model pricing tool. The third generation introduces 40% more price points than our previous model. Price increases and improved claim performance will continue to improve underwriting margins in our largest and historically most profitable line.

Personal auto premium production is performing better than we expected. Retention and new business are holding up despite our homeowners actions. Prospectively we expect retention will erode as the impact of agency termination begins to runoff business in our most unprofitable homeowner states. These include some of our largest states such as Ohio, Kentucky, Indiana and Tennessee.

Through the first six-months the total impact of agency terminations on our retention is approximately 1.5 points. The impact may be more significant in the second half of the year. For homeowners loss ratios improved on both the catastrophe and ex-catastrophe basis relative to last year because of significantly lower catastrophe and non-catastrophe weather-related losses.

Our non-cat non-weather results improved as we earned out significant ongoing price increases and benefit from implementing higher deductibles. The combination of significant price increases, higher deductibles and property claim improvements will continue to pay off and improve ex-catastrophe homeowner underwriting performance.

Homeowner prices were up substantially through six months. We are booking overall rate increases of 15% with higher rate increases in our most unprofitable states. We've increased our inflation guard factor by 3.3% and our insurance to value program is yielding an additional 3.5 points of price. All in, we are getting over 20 percentage point -- a 20% price increases and these prices are sticking. Like auto, homeowners production is fairly flat on a direct basis with price increases offsetting the plan policy loss we’re experiencing in most of our unprofitable states.

We are pleased with progress in our business insurance segment and are optimistic about continued improvements in profit and production. Loss ratios improved relative to last year on both the cat and ex-cat base. The weather was much calmer than last year. Large losses were flat, and we saw much better results in our middle market business. Only multi-peril property didn't perform well due to large losses and an above average frequency in severity of fire loss.

Commercial auto results improve sequentially due to lower catastrophes and fewer large losses. Bodily injury loss trends are elevated that are largely offset by better performance in the physical damage area. Similar to personal auto, pure premium trends are increasing for bodily injury. We are now getting price increases after several years of flat price and in the quarter price per exposure is up 1.2% and our monthly run rate continues to accelerate. We expect this line to benefit disproportionately as a result of insuring casualty claim handling processes.

And speaking to production, commercial auto retention is steady, policy count is up over 2% and our average new business premiums have increased. So a good growth in commercial auto and look forward to continuing solid performance in a traditionally strong line for State Auto.

Commercial multi-peril production increased driven by strong new business in our BOP Choice program. Price per exposure is about 2.4% for the quarter and we continue to get a very positive response from our agency plan to this new product. Commercial property results improved significantly because of better weather both catastrophe and non-catastrophe. In addition large loss activity in this line was unusually low in the quarter.

Liability results remain good because of underwriting discipline and the claim processes I discussed earlier. Liability production is strong driven by larger new business premiums, price increases of 3.3% and most importantly increases in the premium bases. Liability auto premiums increased substantially in the second quarter relative to the same quarter last year.

Before turning to the specialty segment, I’d like to say more about our significantly improved claim performance. We’ve reduced use of third-party appraisers and handled more liability trials with staff counsel. We have a very competitive cost structure, high levels of service and better managed payout. Our reengineered and reinvigorated claim performance will continue to pay dividends well into the future with improved loss and expense ratio performance.

Specialty results showed strong performance from our Rockhill affiliate and solid workers’ compensation results. We had some modest deterioration in RED in the quarter. As the market firms and standard underwriting appetite shrinks we are seeing more submissions to Rockhill. Our hit ratio remains the same but we’re getting price increases across the board except for certain liability ring of lines, which remained competitive.

Overall, our E&S segment has continued to generate significant growth and profitability and is exceeding our expectations. In workers’ compensation production is up significantly primarily in our RTW affiliate. Prices have increased in the double-digit range, particularly on larger account. We will also get more price on accounts under $25,000.

Loss ratios show excellent results coming from our RTW affiliate, good results in our legacy state auto business and improved results for our middle market accounts. We’ve re-underwritten the middle market book and are getting substantial price increases on business we want to keep. We expect this line will continue to improve for the rest of the year probably because of healthy price increases, and partly due to strong claims management.

In claims, RTW’s highly effective return to work program and our process for determining compensability at the front end of the workers’ compensation claim process are yielding big benefits and improved results. This process reduces both our indemnity payouts and the costs associated with workers’ compensation claim adjudication.

And with that, I will turn you over to Steve before we open up for your questions.

Steve English

Thank you, Bob. My comments today will touch upon investment, taxes and our recent reinsurance results. We continue to maintain a high-quality liquid investment portfolio with over 98% of our fixed maturities rated A or better with diversification among issuers, types of bonds and states of issue for our tax-exempt portfolio.

Our equity portfolio remains diversified across large-cap, small-cap international securities. This past quarter we saw value for fixed maturity securities dry as rates fell and of course equity security valuations fell over the quarter. The duration of the fixed income portfolio as of June 30, 2012 was 3.9. Net investment income for the quarter of $20.5 million compares to $25.2 million a year ago and $17.5 million for the first quarter of 2012. The year-over-year comparison reflects several factors, including lower overall levels of invested assets as a result of the reinsurance pooling change in homeowner quota share treaty.

In addition, new money yields remained at historic lows. Last year’s second quarter was a particularly strong for TIPS. TIPS of course reflect changes in the CPI index, and we recorded 1.7 million less in the second quarter this year compared to last year. On a sequential basis, however, TIPS income for the second quarter of 2012 was $2.9 million higher than the first quarter, driving the increase we reported.

During the second quarter of 2011, we established a valuation allowance against our net deferred tax assets. This year income taxes for the second quarter and year-to-date have been offset by the valuation allowance, and we have not provided for intra-period income taxes. We continue to believe we will not fall into the exception under AFC 740 and have determined that a zero effective tax rate is appropriate. Of course we will reevaluate this each reporting period throughout 2012.

To finish my comments this morning, as is our custom, I would like to give you a brief update on our recent reinsurance renewal. Effective July 1, 2012 we restructured and renewed our property per risk and casualty reinsurance programs. We moved up to June 1, the renewal date of our property catastrophe treaty. In general this year we took the opportunity to combine and reduce the number of treaties we have as well as adding additional reinsurance protection through increased limits and better terms and conditions.

For property cat, we now have one tower with 245 million limits with a 5% co-participation in excess of our traditional $55 million retention that covers all of our property business, both standard lines and specialties. For further protection we put in place separate coverage for Rockhill property exposures, which provides $40 million of limit in excess of $15 million of retention. These limits compared to previous limits of $160 million, excess of 55 million for property risks written by State Auto companies and $77.5 million, excess of $7.5 million for Rockhill.

The program is designed to provide coverage approximately equal to the combined all perils 100 year PML. The homeowner quota share treaty and a separate Rockhill surplus share treaty provide additional cat protection. We also combined our property per risk treaties in a similar manner buying one tower providing $17 million of limit in excess of $3 million retention with an annual aggregate deductible of $2 million, which is consistent with our expiring coverage. Just as in the property cat, we put in place on the Rockhill exposures a $2 million limits in excess of $1 million retention.

On the casualty side, we combined standard line and workers’ compensation exposures into a combined casualty structure. In addition, we purchased on top of that expanded casualty clash average and workers’ compensation catastrophe coverage up to $30 million. This allowed us to eliminate a separate umbrella quota share treaty that was in place.

Rockhill’s casualty exposures remain covered in a separate treaty with coverage of up to $11 million in a 13% co-participation. For standard lines risk, our retention remains $2 million and for workers’ compensation and Rockhill, the retentions remain at $1 million. From a pricing and ceded premium perspective, recent catastrophe experience and adding additional limit will cause an increase in ceded property reinsurance premium. This is offset by the creation of a combined casualty treaty, the elimination of the separate umbrella treaty and casualty reinsurance rates. All in, our ceded reinsurance premiums will not materially increase as a percentage of our gross written premiums.

And with that, we’d like to open the line for any questions that you may have.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question is from Stephen Levy from Prospector Partners.

Unidentified Analyst

Do you see the current environment as conducive to acquiring mutual companies? And if so, what are the factors contributing to that favourable backdrop? And if not, what’s prohibiting deals from happening?

Bob Restrepo

No, I think two things, number one, we’re not actively looking for opportunities over the next year or so. We are focused on implementing our strategy and improving our underwriting performance. Two, that isn't a bad time to be looking at mutual company opportunities. There have been several affiliations that have occurred over the last six to 12 months. Companies are under – particularly companies in the Midwest and the Southeast have had the same difficulties we have with the weather-related, catastrophe related property losses, which has eroded their surplus, put pressure on their financial strength ratings and in some cases have produced partnering.

And so my guess is assuming the weather is going to continue to be what it had been over the past couple of years and that there will be other opportunities going forward, particularly in the Midwest and Southeast for mutual company affiliations. Even if we were actively involved in the market, we track it and we wouldn't be looking for opportunities in the Midwest anyway, and that's where we see probably the biggest opportunities for mutual company affiliations. We've got ample amount of business in the Midwest.

Unidentified Analyst

And my second question has to do with the investment portfolio. You’ve extended the duration since the end of last year. Can you just share the thought process behind deciding to pick up yield versus lowering the duration to mitigate ultimate potential capital loss?

Steve English

Sure. While the duration has extended, it’s only been extended modestly. We typically have been trying to work the duration down to keep up about four, which didn't in all honesty, that is slightly in excess of our liability duration but not materially. What we have found though is going out and looking for yield, it really isn’t worth extending the duration significantly. Part of the reason our duration number bounces a bit because of the call days and payment terms of some of our municipal securities and as interest rate moves it can cause our duration calculation to move the accordingly.

Scott, I don’t know, do you have anything you'd like to add –

Scott Jones

No, that pretty much sums it up.

Unidentified Analyst

So you wouldn't foresee your duration changing much from where it sits today?

Steve English

No, like I said, we’re trying to keep it within the range that we’ve been at the last year or so. If you go back three years or prior you would have seen a significantly higher duration from our portfolio and that was primarily a function of the fact that we had a much higher levels of the longer dated in its posture.

Operator

Our next question is from Larry Greenberg.

Larry Greenberg - Janney Capital Markets

I think in the past, you had talked about getting the non-cat loss ratio for homeowners to the low 40s. Is that still the goal today or with the weather we've been do you have to have it even lower than that? Can you just talk about those issues?

Bob Restrepo

Yeah, Larry, our short-term goal is to get it into the low to mid 40s. Our longer-term goal is to get it lower than that. It did need to be in the high 30s given the kind of investment climate that we’re all operating in, it needs to be much better than that.

Larry Greenberg - Janney Capital Markets

And how far off do you think that kind of target is?

Bob Restrepo

We’re pricing now and will continue to price to achieve a ex-cat result better than the low to mid 40s. And as better in-depth, I think over the next two years that’s what we are targeting.

Larry Greenberg - Janney Capital Markets

And then your answer to the last question, you talked about presumption that weather is going to continue. When you look out given that factor and others, what is your goal for a return for a lot of shareholders and what kind of timeframe should they be thinking of right now?

Bob Restrepo

Yeah. Our goal has always been to have a double-digit return on equity and that goal hasn't changed. The biggest single, not the only but the biggest single obstacle we've encountered over the past couple of years in achieving that goal has been property insurance, specifically homeowners. And big part of our of strategy going back a couple years was to diversify through acquisitions and affiliations. But we haven’t been able to diversify fast enough. So what we're in the process of doing now is shrinking – shrinking that property business in areas that are the most cat exposed to accelerate diversification efforts. And the that's playing out as we speak.

We’ve taken, in addition to the pricing and underwriting and deductible and claim actions we've taken over the past three years. We have also taken those a couple of years agency actions in areas that we felt we were – had too much property business relative to our overall portfolio, we’ve accelerated those actions over the last 18 months. Some states, it takes two years for an agency termination to take effect and then of course it takes another year for that business to run off. So I think we are going to be in a much more diversified position from a property standpoint going into next year.

Larry Greenberg - Janney Capital Markets

So, what would be a reason with timeframe for expecting a double digit ROE, rack designing and whether it could have a big impact?

Bob Restrepo

Within the next two years.

Operator

Our next question comes from Brett Sherriff.

Unidentified Analyst

I was wondering if you could drill into the expense ratio decline a little bit further, give some of the components of the improvements there.

Steve English

Sure and actually there is really nothing all that significant to report. Part of that is the fact that we’ve just been managing our headcount better, being very aware of staff levels and some of the corporate initiatives that we've been embarking on that we talked about on prior calls. And then with some of the premium growth and you spread that out over a greater premium base for getting some benefit to a lesser extent within the RED business as that business runs away, it had a very high expense ratio. So we’re getting something there as well.

Unidentified Analyst

So you think this is a fair run rate going forward given those –

Steve English

I would say as far as the run rate goes, I don't like to look at one quarter as a trend. So I would say somewhere in the 33 range on cat basis, yes, plus or minus is not unreasonable expectation from a run rate perspective.

Unidentified Analyst

Just one numbers question, I was just wondering if you had the statutory surplus of the mutual –

Steve English

Well, the stat surplus on the public company subsidiaries is $600 million. If you would like the mutual, you’d have to contract Larry.

Operator

There are no further questions at this time.

Steve English

Okay. Well thank you Christie and we want to thank all of you for participating in our conference call and for your continued interest and support of State Auto Financial Corporation. We look forward to speaking with you again on our third-quarter earnings call, which is currently scheduled for November 6, 2012. Thank you and have a great day.

Operator

Thank you for participating on today’s conference. The conference has concluded. You may disconnect at this time.

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