Meadowbrook Insurance Group, Inc. Q2 2008 Earnings Call Transcript

Jul.29.08 | About: Meadowbrook Insurance (MIG)

Meadowbrook Insurance Group, Inc. (NYSE:MIG)

Q2 2008 Earnings Call Transcript

July 28, 2008 9:00 am ET

Executives

Karen Spaun – SVP and CFO

Bob Cubbin – President and CEO

Analysts

Beth Malone – KeyBanc

Nick Vandervest [ph] – Cigna Health

Robert Paun – Sidoti & Co.

Mark Dwelle – RBC

Tom Spiro – Spiro Capital Management

Walter Shankar – Scion Capital

Operator

Greetings, ladies and gentlemen and welcome to the Meadowbrook Insurance Group, Incorporated, second quarter 2008 conference call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. (Operator Instructions). As a reminder, this conference is being recorded.

It is now my pleasure to introduce your host, Ms. Karen Spaun, Chief Financial Officer for Meadowbrook Insurance Group Incorporated. Thank you, Ms. Spaun. You may now begin.

Karen Spaun

Thank you, and welcome to Meadowbrook's second quarter 2008 earnings conference call. I will lead off today's call with a review of our second quarter financial results. Bob Cubbin, our Chief Executive Officer will then follow with a review of our financial outlook and current market conditions. The call will be then completed with a question-and-answer session.

During this call, we may make certain statements related to future results and expectations. These statements constitute forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. We therefore must state actual results may differ materially from those projected and may involve risks and uncertainties that are outlined in our Form 10-K and 10-Q that are filed with the SEC.

Please note Meadowbrook undertakes no obligation to update or revise any forward-looking statements. If you have not received a copy of our earnings release, it is currently available on our website meadowbrook.com or you may give me a call and I will be happy to fax a copy to you.

Now, for our results. We are pleased with our growth in net operating income excluding amortization, increasing 50.3% to $10.1 million, compared to $6.7 million in 2007. Our results, for the second quarter reflected improvements in our expense ratio primarily related to the benefit call the elimination of the fronting fees paid prior to receiving our AM Best Upgrade and the benefit, from our ability to further leverage fixed costs.

Our results also benefited from an increase in net investment income due to positive operating cash flows and the net proceeds we received in our equity raise last year. In addition, we continue to see favorable development on prior year losses. Our results were impacted by a $1 million increase in amortization expense related to the acquisition of the USSU business in 2007 and 2008.

Our commitment to strong underwriting discipline and our controls over price adequacy resulted in an increase in underwriting profit to $7.3 million, compared to $1.8 million in 2007. And a 6.9 improvement in our combined ratio to 90.5% compared to 97.4% in 2007.

On a fee-for-service side pre-tax income excluding amortization was $1.7 million or a 7.4% margin in 2008, compared to $3.3 million or14.2% margin in 2007. A reduction in pre-tax income from total fee-for-service business was impacted by a $1.2 million reduction in intercompany commissions and fees, as we recognize a leveraging of fixed cost by reducing the management fees paid by the insurance company subsidiaries to the management company subsidiaries.

Excluding this reduction is fee-for-service pre-tax income excluding amortization would have been $2.9 million or a 12% margin. The reduction in the intercompany fees has the effect of reducing the unconsolidated GAAP expense ratio and the margin on the unconsolidated fee-for-service income. It does not impact consolidated income.

The remaining decrease in free-for-service pre-tax income excluding amortization reflects an increase in variable compensation and employee benefit.

Please refer to the earnings release for further details on a line by line analysis of our second quarter consolidated income statement.

With that, I will turn the call over to Bob Cubbin our Chief Executive Officer. Bob.

Bob Cubbin

Thanks Karen. We are very pleased by the overall results to the second quarter. Cash earnings were up over 50%, gross reserves continue to develop favorably and results were better than expected.

We continue to realize some of the benefits of our AM Best Upgrade by eliminating the fronting fees and have implemented new programs where production is ramping up and existing program continue to grow.

Despite the competitive market and select jurisdiction, we have remained committed to maintain appropriate level of underwriting profitability and continue to invest in the long term growth of our business. In the quarter, gross written premium was up 21% in comparison to 2007 and we remain confident on our ability to meet our full year pre-merger premium guidance of $385 to $395 million. This growth will come from new programs implemented in 2007 and 2008 as well as organic growth in existing program.

Our expense ratio is tracking at a lower level due to the reduction in the intercompany fees paid by our insurance subsidiaries to the management company, as we are able to leverage their cost and share those savings with the insurance company.

We are maintaining their focus on sustainable profitable results with reduced exposure to the volatility usually associated with market underwriting cycle. Our focus on small average premium accounts with specific differentiated risk characteristics or an affiliation with an association or specialized agent allows us to provide customized and responsive service.

We protect ourselves against severity with the purchase of excess-of-loss through insurance and by geographic diversification.

While our first quarter’s annualized return on beginning equity was 10.9% due to capital raise in 2007 and the increase in amortization expense, we remained committed to our long term goal of 14% to 15%. This goal will be accomplished by increasing our underwriting leverage through select revenue enhancement opportunities.

We will also be able to increase our investment leverage through cash from operation and the limiting of the duration of our reserves and growth of invested asset. We will be able to increase free-for service income through new opportunities and GAAP earnings will grow as amortization of intangible can grow. We will also see an increased ROE through the reduction of expenses by continuing to lever fixed cost over a larger revenue base.

In addition, we will manage our capital structure as balance in debt to total capital maintaining the appropriate level of premium to surplus and use shareholder dividends and shareholder repurchases to optimize our capital structure while maintaining the strength in our balance sheet.

Our business model focuses on balancing stable purchase to profit with a conservative investment strategy maintaining a solid fee-for-service business and limiting underwriting volatility through targeting specialty programs in smaller accounts with both geographic and a product diversification.

The merger with ProCentury should help to accelerate our progress wherever we go. The merger investment integration with ProCentury is going well and we will close on July 31st. The merger is expected to withstand and compliment our specialty line capabilities with ProCentury’s insurance professionals and product expertise in the surplus lines market.

The combination of our two companies create the more diversified platform and gives both companies the size and product depth to compete at a level that couldn’t be achieved as separate entities. Upon completion of the merger the combined entities will for the most part continue to operate the respected insurance subsidiaries as they were operating prior to the merger, only better.

We have been working with the ProCentury team on new business initiatives and are excited by the opportunities of creating a larger marketing platform through our combined distribution network. We have also been concentrating on the integration of our operations.

We have already begun the process of bringing ProCentury’s products to our distribution system, particularly in markets where they have been historically under represented. This business combination also gives us the ability to better and more effectively manage through the market cycle.

As I said, we are confident that our full year in 2008 guidance can be achieved. We expect to be able to show demand full evidence of the potential growth from the merger in the near term as the opportunities emerge and are implemented.

We will be providing information on the former results as a combined companies by mid August but presently we are not in a position to comment on a specific to the ProCentury second quarter results.

We thank you for your continued interest in Meadowbrook. At this time, we will open the call to questions. Operator.

Question-and-Answer Session

Operator

Thank you. Ladies and gentlemen, we will now be conducting a question-and-answer session. (Operator Instructions). Our first question is coming from Beth Malone of KeyBanc.

Beth Malone – KeyBanc

Thank you. Good morning and congratulations on the quarter. Just a couple of clarifications or developments on -- could you just explain a little bit more on the investment portfolio. Do you have a lot of securities that were considered very low risk just months age were now under concerned? Any exposure to just Freddie or Fannie preferred or bonds in the portfolio?

Bob Cubbin

First on the Freddie Mac, we don’t have any Fannie Mae or Freddie Mac bonds in our portfolio. And as you know Beth we maintained a very conservative high investment grade portfolio other than temporary impairments that we put on the quarter 158,000 or so, really was dictated by EIPS 9920. We saw the intense and ability to hold their bonds to maturity and we believe that it is still good money. So our investment portfolio has not deteriorated over the last few quarters and we do not expect to see it deteriorate in the future either.

Beth Malone – KeyBanc

Okay and then on the reserved development, where did that come from? Was that on the workers division line or --

Bob Cubbin

Well, actually it came from a lot of different areas that workers comp definitely continued to be favorable line of business for us but our professional liability claims made are authorized liability, our general liability, all performed very, very well.

Beth Malone – KeyBanc

Okay and then in terms for the pricing environment. Obviously, the market in general is discussing some pretty double digit decreases in a lot of sectors and could you just describe a little bit how -- given your situation how you’ve been able to avoid a lot of that pricing pressure that we are seeing in general?

Bob Cubbin

First I think a lot of the things that you heard about tend to be a little bit maybe exaggerated in some cases but when we look at the small account that we focus a lot of our attention on -- that has historically been much more volatile. You don’t see big price increases during the hard market you don’t see big price decreases in the stock market. It just tends to be a little more even to you as all of the radar screens of a lot of companies. So you jus don’t get a whole lot of people who can efficiently enter that market and find underwriter and produce that business. So it does also give us higher retention ratio than the traditional market as well.

The other thing is that, during this—on affiliation specialty agent who controls the business or an association of some sort has a little bit more adhesion to the group concept. So people tend not to buy on prices they don’t leave on price - - that just a little more inspiration from some of that up in down.

Now there are select jurisdictions obviously where we are in impacted by price decreases. Some of our fee-for-service business has been impacted by that the agency division for example more competitive. Some of our fee-for-service business in the New England areas was impacted by lower workers compensation prices but it’s really isolated institute and select jurisdiction where that has been the case.

So by diversifying ourselves geographically and staying now to some of the more competitive areas of business and in fact it’s really what – and dealing this partners and associations that kind of have a little bit more control in a little bit more loyalty to it really kind of adds up to being able to avoid some of that predatory pricing

Beth Malone – KeyBanc

Okay and the last question on the share repurchase program, you announced that was expanded recently. When would you be able buy back stock and how much excess capital do you have at the holding company for that purpose?

Bob Cubbin

The share we purchased the board authorized in extension is $3 million shares over the next 24 months as when we determine that there are market opportunities to purchase the shares at economically reasonable prices, we will repurchase them. We do have cash available at the holding company but we’re really kind of waiting until after the closing of the ProCentury merger in order to revisit exactly how and when we will start that project, they are going to be done in market transaction but we do have certain limitations in the market based upon- just to our clients.

So early in August, we will be in a position to start repurchasing some shares and we will monitor our cash position and make sure that we are not ready to follow- of anything to do with our priority, our premium to surplus and also paid financing. So we will monitor that in over a period of time we’ll be buying back as sure as our balance sheet will allow.

Beth Malone - KeyBanc

Okay. Thank you.

Bob Cubbin

Thank you, Beth.

Operator

Our next question coming from Nick Vandervest (ph) of Cigna Health.

Nick Vandervest – Cigna Health

Good morning, Bob, Karen. Congratulations on a great quarter here.

Karen Spaun

Thanks.

Nick Vandervest – Cigna Health

I just had a question in the press release you referred to that some of the USSU policies had been converted and obviously that lowered the intercompany fee. I’m curious, can you walk through exactly how that lowered expense ratio?

Karen Spaun

Hey Nick, this is Karen. Actually there are two items the USSU fees did not lower the intercompany fees, that was a separate item. The USSU – converting the USSU business to our paper what that did is – last year we had about a million dollars of fee revenue that was unconsolidated net commissions on fees. This year that so said fees were not unconsolidated commission and fees but were eliminated in consolidation.

Nick Vandervest – Cigna Health

I see.

Karen Spaun

Okay and the intercompany fees was a separate issue as we have been able to leverage our fixed cost. We reduced this fixed portion of those management fees between the insurance company and the management company.

Nick Vandervest – Cigna Health

I see. So those are unrelated issues?

Karen Spaun

Correct.

Nick Vandervest – Cigna Health

Okay. What I’m really pin down here is the expense ratio was significantly lower with what we are expecting and congratulations on achieving that but it is solely –Is this the low expense ratio totally due to the elimination of the fronting fees and that further leveraging of fixed cost?

Karen Spaun

Correct and elimination of the fronting fees is about point and a half and that is an on going I mean that’s our current run rate and so are the fees and the fees were also probably about point and a half.

Nick Vandervest – Cigna Health

Okay. One other question, the two big surprises, first of all being the expense ratio during the quarter which we’ve just discussed and also the top line growth and that where do you guys see that going from here? I mean it really were kind of blow out as far as what we were expecting and you expect this to be a run rate or --

Bob Cubbin

Nick, it’s Bob. What we said in the last quarter was that it put sometime for us to start realizing the benefit of the upgrade to A minus by AM Best because our business does take time to run club. So this is really an untarget with what we anticipated going forward. So, that’s why last quarter and this quarter we reiterated our expectation that we would be able to hit the $385 million to $395 million in GWK for this year so yes it’s a lot higher than it was in the first quarter but we do believe that this is really where we expected to see growth start to ramp up on the initiative in 2007 and early 2008.

Nick Vandervest – Cigna Health

I see. Do you have any concerns that, we’re seeing a lot of companies obviously and you discuss right but you see working a lot of companies, backing off in this environment and here we have you guys doing double digit growth, do you have any concerns about destroying that growth and establish offering margin?

Bob Cubbin

Not really because as I said in answer of that question, our approached to the business is different. We’re not really competing head on to bring that business in with anybody. Either program that has been identified and targeted by us, we just were not able to write them because of the AM Best situation and we’re not really growing per market share. If we didn’t grow in a quarter we would be okay with that.

We’re very much focused on maintaining our underwriting discipline and we have not written a lot of business that we otherwise could have because of that underwriting discipline. We’re very committed to getting the right prices and more importantly, creating the long term relationship that will allow us to hold on to that business and continue to grow without any incurring expenses. So, it’s very, very important that we maintain our underwriting discipline in the process. I mean we don’t loss business, it’s not as hard to grow your up-line. If we’re loosing a lot of business, you might have to add 40% in order to make up for the 20% you lost. So, holding on and retaining your business really help us to growth in a long term.

Nick Vandervest – Cigna Health

Okay. Thank you very much, that’s very helpful.

Bob Cubbin

Thanks Nick.

Operator

Thank you. Our next question is coming from Robert Paun of Sidoti & Co.

Robert Paun – Sidoti & Co

Good morning.

Bob Cubbin

Hey, Robert.

Robert Paun – Sidoti & Co

Bob, you spoke about the ROE goal of 14% to 16%. Do you have timeframe to achieve that?

Bob Cubbin

Yes, and it’s one of those processes that you go through. The merger -- the capital raise of last year obviously set us back a little bit in terms of adding new equity and then having to take time with the AM Best Upgrade and then the ProCentury merger so we still expect to get there by 2010. So I think the ProCentury merger should help to slower rate the process of getting to that number. Obviously, if the market work should dramatically softened in 2009 that may impact us but we really don’t expect to see that happen. So, we’re still on track with hitting there by 2010.

Robert Paun – Sidoti & Co

Okay, one other question. Given the current economic slow down, have you seen any change in the frequency of claims? I guess specifically in the Workers’ Comp line?

Bob Cubbin

Yes, I think there’s a little disconnect between the economic condition and Workers’ Compensation. The Work Comp market has changed dramatically over the last ten years even the last five years as there is more automation and other improvement in the manufacturing process that it just reduced the number of injuries. Loss control and manage care, it help to take people back to work more correctly but actually the opposite has been true with our experience in the last couple of years where frequency is actually down.

The other thing is that you have to look at geographic differences in the economy. We know a lot of Workers’ Compensation business in Michigan for example, which is our home state where unemployment is higher than it is nationally but if you look at unemployment statistic across the country they’re really not as bad compared to historic level. So, we really have seen a decreased in frequency and really don’t expect to see that dramatically change over the near term.

Robert Paun – Sidoti & Co

Okay, thanks. That’s all I have.

Bob Cubbin

Thank you.

Operator

Thank you. Our next question is coming from Mark Dwelle of RBC.

Mark Dwelle – RBC

Hey, good morning.

Bob Cubbin

Mark.

Mark Dwelle – RBC

Couple questions, just kind of building on a couple of other prior thoughts related to the revenue growth. Are you seeing any greater opportunities in any particular class of business general liability as compared to Work Comp or anything or it’s been mid-staying pretty well the same there?

Bob Cubbin

Well, Mark as you’ve seen from us in the past, you can’t always predict exactly where your growth is going to come from. We have initiative across the board. We trying to grow all of our lines of business and our fee for service business but in particular, we have seen more general liability programs, not all of which met our underwriting criteria. But we’re going to continue to see an opportunity “in Workers’ Comp” and in other classes of business.

It’s not something that we kind of intentionally go out to, grow one over the other. We really have to be opportunistic and determined where that coming from. Of late, we have seen a few new very well underwritten Workers’ Comp programs but we brought those on. If we see the same thing in the general liability side quarter package, we will likewise go as well but really is opportunistic-driven as supposed to any kind of concerted effort to grow one side of the business or the other.

Mark Dwelle – RBC

Just a question, okay thanks for that, in terms of -- you had the USSU now for a full year. How is that compared in terms of how it’s come up relative to your initial expectation? Is it a little bit better, a little bit worst, about the same?

Bob Cubbin

It’s a little bit better than we expected. We have moved some of the business through our own paper which was one of the benefits of bringing that on, plus you know the business has done well. It’s a market where there are only a handful of competitors who also had exhibited a tremendous amount of discipline in the pricing of their product. Again, there are some isolated instances where we had to either walk away or not be going to lower our prices to keep certain piece of the business but overall, the business is growing very, very well and we’re pleased with the management team and their integration into our operation.

Mark Dwelle – RBC

Okay. With respect to their reserve releases in the quarter, Karen maybe you could share what years those related to? What accident years?

Bob Cubbin

Mark, yes, in general what we’ve seen is pretty much all the accident years had preformed very, very well but obviously as you get more information on the over years and frequency as come down versus our expectation, generally those are going to be in 2005 and prior accident years. The 2007 probably pretty much in line with our expectation. The 2006 has preformed pretty well as well but we’re not going to take down reserves on the greener years until we have adequate statistical evidence to support that though it’s pretty much the older years at this time that we have seen favorable development on.

Mark Dwelle – RBC

Okay and my last question, with respect to the merger, you have implied in your opening comments that you’d have some further information available on pro forma and so forth sometime around mid August. In the meantime, is it fair to assume that there will not be a lot of amortizable goodwill related to this field?

Karen Spaun

Mike, that’s a correct assumption. There will be some amortizable goodwill but until you have the closing balance sheet you cannot calculate that.

Mark Dwelle – RBC

Okay.

Bob Cubbin

And that will be included in our pro forma discussions in the future.

Mark Dwelle – RBC

Okay. That’s --

Bob Cubbin

We’ll include some estimates on that Mark, once we have a firm handle on that.

Mark Dwelle – RBC

Okay. All right. I think that’s all questions. Thanks.

Bob Cubbin

Thanks Mark.

Operator

Thank you. Our next question is coming from Tom Spiro of Spiro Capital Management.

Tom Spiro – Spiro Capital Management

Good morning.

Bob Cubbin

Hi, Tom. How are you?

Tom Spiro – Spiro Capital Management

I’m fine. I’m fine and congratulations on such a strong quarter.

Bob Cubbin

Thank you.

Karen Spaun

Thank you.

First, I may have missed this but what was the company’s pricing experience in the quarter we are generally speaking, our prices are stable, down a little bit to down from 3%? Where were they?

Bob Cubbin

Yes, we were down a little bit, Tom, and mostly again, it’s really related to the Workers’ Compensation in Nevada, Florida and Massachusetts. Our expectations for the year are that we will overall on a composite base this fee down from around 3% or 3.5 % and that can fluctuate quarter to quarter in small increments but nothing dramatic. Now, there are isolated jurisdictions where pricing may be lower than that but if it does get significantly lower than that, then we’re not going to be putting in that market.

Tom Spiro - Spiro Capital Management

And what’s the experience and or thinking with respect to your loss cost inflation?

Bob Cubbin

Loss cost inflation continues to rise. Again, you’ve got some jurisdictional differences there. It’s not really kind of a national trend but certainly the cost of medical care and prescription drugs is up and that would be the primary driver of cost inflation on the loss side. So, it definitely is continuing to go up. In some places, it could be 7%, 8%. Some places at 3%. So, it’s the state that verified (inaudible) business as well. So, we will continue to see that going up as inflation on the medical side increases.

Tom Spiro - Spiro Capital Management

And next, lots of the financial turmoil out there obvious to all of us. Bob or Karen, are our relationships with the reinsurance sound? The reinsurance themselves looking healthy?

Bob Cubbin

Yes, actually we take great pains to make sure that we deal with very stable, steady, long-term partners on the reinsurance side and we’ve been blessed with very, very good relationship with very solid strong companies with good balance sheets. So, we continue to see adequate levels of pricing on the reinsurance side with very good partners.

Tom Spiro - Spiro Capital Management

And same question with respect to our risk-sharing partners, do they have the resources to really share the risks?

Bob Cubbin

Absolutely and the way we structure our risk-sharing relationship is by collateralizing all the obligation of our partners and we make sure that they maintain kind of an overcollateralized position in order to protect themselves against any reserved development or any change in circumstances. So, we’ve had not had any problems with our risk-sharing partners and they remain very strong and able to live up to the obligations.

Tom Spiro - Spiro Capital Management

Thanks. Last question, I had the impression, Bob and Karen from a number of your presentations over the last two, three years that the Meadowbrook model relied on the income basically from three sources, underwriting income, investment income, fees and service income and then in the soft market, we would look to the fee and service income and the investment income to drive us forward. And yet here in the second quarter of what is soundly regarded as a soft market, it really is the underwriting income that drove us forward and I’m kind of curious whether perhaps my understanding was incorrect or the model shifted a little bit or how do you account for that?

Bob Cubbin

Well, you don’t plan on having fantastic underwriting results in a softer market but sometimes, it happens and I think that the discipline that we’ve shown over the years in underwriting business that we can maintain and that we can get adequate pricing on is really what’s driving that but as we also have experienced, the underwriting results have been favorably impacted by our upgrade to upgrade to A minus. So, that has given us opportunities to write even better business and to also reduce our expenses.

So, as we been able to positively grow that up with leverage or fixed cost, that drives the expense ratio down and as we’ve been able to add profitable business that help us lever our balance sheet better, so your underwriting profits should go up. Investment income and fee businesses are steady stable, very predictable courses of profit and that remains a very key component of our balanced business model.

Tom Spiro - Spiro Capital Management

Thanks so much.

Bob Cubbin

Thanks, Tom.

Operator

(Operator instructions) Our next question is coming from Walter Shankar with Scion Capital.

Walter Shankar – Scion Capital

Thanks, good morning. You will own ProCentury before they report, since they haven’t reported and you can own them tomorrow, I mean by Thursday, will there be any reporting or discussion of how they’re doing? Will we wait for your next quarterly update or --

Bob Cubbin

Walter, what our intent is they don’t file a 10-Q or a quarterly report but by mid-August, it’s our intent to communicate to the market on a pro forma basis that combines company’s results. So, directly or indirectly, we will be commenting on and giving information on their performance on a year-to-date basis in mid-August.

Walter Shankar- Scion Capital

Okay. Secondly, coming back to the buyback, now that you know all the costs for the acquisition, the number of shares and the composition, can you give us some sense as to what room if any, I guess calendars before, they will be to do a buyback relative to the covenant on the acquisition debt?

Bob Cubbin

Yes, the relationship with the bank and the pro forma that we originally presented to them were based on our expectations of what the weighted average share price is going to be for our stock and so we need to sit down with them and go through the current state of affairs and to work with them to establish what those cautions would be.

They will be sitting down with the bank over the next week or so to say that and to get their buy end as to how much of that we would like to do and we have to balance everything as we go forward.

So our finance committee and our board will be studying exactly how much we should be buying and at what prices. Obviously depending on what the market reaction is, over the next month, we’ll also determine how many shares we will be able to buy back. So, there are a number of factors that we have to look at but I believe that over the course of the next six months or so, we will have adequate access to cash to reacquire as many shares as we see economically viable to do.

Walter Shankar- Scion Capital

Stating the obvious which probably would be mirrored by most people on the call, buying in your own stock at under second times earnings and then the discount to book appears to be a pretty attractive alternative. You know that I know that. I just wanted to hear you say we all agree.

Bob Cubbin

We definitely agree.

Walter Shankar- Scion Capital

Thanks a lot.

Operator

Thank you. There are no further questions. I would like to hand the call back over to management for closing comments.

Bob Cubbin

Okay, we appreciate everybody participating and if you have additional questions later, Karen and I will be available. Thank you very much.

Operator

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

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