National Interstate Corporation Q2 2008 Earnings Call Transcript

National Interstate Corporation (NATL)

Q2 2008 Earnings Call

August 1, 2008 11:00 am ET

Executives

Julie A. McGraw - Vice President and Chief Financial Officer

David W. Michelson - President and Chief Executive Officer

Gary N. Monda - Vice President and Chief Investment Officer

Analysts

Elizabeth Malone - KeyBanc

John Gwynn - Morgan Keegan

Presentation

Operator

Good day ladies and gentlemen and welcome to the National Interstate Corporation 2008 Second Quarter Conference Call. My name is [Latisha] and I’ll be your coordinator for today. At this time all participants are in a listen-only mode, we’ll conduct a question-and-answer period following the company’s prepared statement. (Operator Instructions). As a reminder this call is being recorded for replay purposes.

Your hosts for today’s call are Mr. David Michelson, President and Chief Executive Officer; Ms. Julie McGraw, Vice President and Chief Financial Officer and Mr. Gary Monda, Vice President and Chief Investment Officer.

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

Julie A. McGraw - Vice President and Chief Financial Officer

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

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

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

David W. Michelson - President and Chief Executive Officer

Thank you Julie and thank you for joining our earnings conference call. Our results for the second quarter and first six months of 2008 have been mixed. Our growth and written premium was outstanding, during the 2008 second quarter our overall top line grew by 23.9% contributing to a 15.8% growth rate for the first half of the year. On the other hand our profits have not been at the level that we have achieved over the past several years.

National Interstate achieved an average GAAP combined ration of 81.7% over the past five years and experienced at least 25% investment growth in each of the those years. Well, we believe our results are still favorable to the P&C Industry as a whole, our GAAP combined ratios are higher both for the quarter and year-to-date and our investment growth is slowed.

The decline in the underwriting profits was primarily due to deterioration in the loss and loss adjustment expense ratio. Our 2008 second quarter loss and LAE ratio was 70.2% compared to 58.8% in the second quarter of 2007 and for the first six months a loss in LAE ratio is 7.1 point higher than last year. These loss in LAE ratios reflect increased claims severity primarily in the passenger transportation products as well as loss ratio deterioration from modestly declining premium rate levels over the past three years. These factors were offset by favorable development of prior year reserves of $500,000 for 2008 second quarter.

The commercial insurance markets started this off in 2005 and since then we have been able to limit our overall price decreases on renewing business to low single-digits. We have stated in the past that this lower pricing could begin to reward our extremely strong underwriting margins. We attribute a portion of the loss ratio increase in 2008 to the cumulative effect of this lower pricing.

The more significant impact on our 2008 second quarter and year-to-date loss in LAE ratios has come from large losses. Our businesses comprised of commercial policies with limits typically ranging from $1 million to $5 million. When we underwrite policies we anticipate that large losses will occur on these higher limit policies and we recognized that when they occur we could experience variations in our results.

While the number of larger claims in the first half of 2008 have not been out of line, the severity of these claims has been unusual. Thus far in 2008 the net incurred losses from our six largest claims have added approximately 5.8 points to our year-to-date loss in LAE ratio. Two of these losses have been reserved to policy limits. We are hesitant in characterizing these losses as unusual occurrences but the fact that they are primarily related to longer term customers occurred in our core passenger transportation business and don’t appear to have a pattern allows us to be cautiously optimistic.

The final aspect of our second quarter loss results was our favorable loss in LAE reserve development of $500,000 for the quarter reducing the unfavorable development for the first six months to just over $1 million. We remain confident in our reserving practices and the adequacy of a loss in LAE reserves. 2008 second quarter underwriting results were also adversely impacted by higher commission expense. We paid different commission rates on our various products and the quarterly commission expense can vary based on the product mix written during the quarter and whether we are offering any market incentive programs at the time. The underwriting expense ratio of 23.7% for the first six months of 2008 is on track with the 22.9% experienced for both the fiscal years ending December 31, 2007 and 2006.

The investment environment remains unstable during the second quarter, which contributed to slower growth in our net investment income and the impairment of several of our holdings reflected as a realized loss. During the quarter we added to tax-preferred municipal bonds, which affected our pre-tax investment income comparisons. On an after tax basis our net investment income was 2% higher for the 2008 second quarter and 9% higher for the first six months of the year. We felt the effect of lower yields as we invested our continued positive cash flow from operations. Our relatively short fixed income portfolio, effective duration of approximately 2.7 years will allow us to take advantage of rising yield that we are now seeing.

We again experienced market value declines during the second quarter primarily in our preferred stock portfolio. As a result in the 2008 second quarter we recognized other than temporary impairment write downs of $1.6 million related to preferred stock holdings in three financial institutions as well as Fannie Mae and Freddie Mac. For the year we have written down investments of $2.5 million representing less than 1% of our cash in invested assets. We remain confident in the overall quality of our investment portfolio.

For the first six months of 2008 we have grown our top line nearly 16% and our 23.9% growth rate in gross premiums written for the second quarter was the highest since the fourth quarter of 2006. We continued to identify opportunities in the market and since the beginning of 2007 we have introduced 11 new products.

Most of our growth continues to come from the alternative risk transfer component which grew 46.6% in the 2008 second quarter and 25.2% for the first six months of the year. During the 2008 second quarter we added two new ART programs both related to trucking. One of the new programs created exclusively for beverage distributors is particularly exciting because it is in a new sector of the market that is new to us and has growth potential.

We now have eight specialty group captains serving customers in the trucking industry. We also continue to experience very strong renewal rates in our existing captive programs, which contributed to our sustained growth in the alternative risk transfer component. We have also experience growth in two other components, transportation which is up 11.2% for the 2008 second quarter and 7.7% for the first six months and specialty personal lines which is up 8.2% for the quarter and 5.5% year-to-date. Pricing in the transportation products remains very competitive despite the soft market conditions we continued to maintain modest premium decreases on renewing policies and attract new transportation customers.

Specialty personal lines primary product, recreation vehicle and its related companion auto product are feeling the effect of the struggling economy and high fuel costs. We have seen a shift to smaller lower premium units. Overall, this component grew because our commercial vehicle product is gaining momentum in the three states that it is currently being sold. Our Hawaii and Alaska component continues to lag last year from the top line perspective, this is mature profitable component and the fact that it is down this year is a representation of our disciplined underwriting approach in all markets.

We have clearly struggled so far this year from a profitability perspective. We have continually stated that lumpiness in our quarterly results from low severity is a possibility. However, when time would prolong the soft insurance markets and unprecedented turmoil in the investment environment our quarterly earnings will be affected.

We continue to maintain the business model and the underwriting and claims practices that have got us to this point and identify ways to improve the business. Examples include our continued emphasis on accident even recorders and driver education programs with our customers, which we believe will have a longer term favorable impact on our claims results.

We are also maintaining our aggressive marketing efforts without loosing sight of responsible pricing. This disciplined approach has resulted in the ongoing development and introduction of new products and high customer retention in our existing programs. We have a quality book of business and our business fundamentals remain strong. Julie, Gary and I will now be happy to answer any questions that you may have.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Elizabeth Malone, KeyBanc. Please proceed.

Elizabeth Malone

Good morning.

David Michelson

Good morning, Beth.

Elizabeth Malone

I have a couple of just clarifying questions here on the quarter. On the new programs that you all enlisted can you give us an idea what kind of premium does that reference that or what’s the size?

David Michelson

The two new products that were added in the second quarter, the two new trucking products, contributed at least, on an initial basis approximately $12 million of our second quarter that just a premium on day one.

Elizabeth Malone

And whether it works, as you get the premiums the first day but we shouldn’t assume that there is -- is there a $12 million contribution for every quarter going forward or?

David W. Michelson

No, no that would be the approximate annual premium on day one, the kick off date of the program and as you know, these group captains have a common anniversary date and but throughout the year the program is still being marketed and new customers can be added.

Elizabeth Malone

Right. And on the losses that weren’t currently unusual severity you experienced, can you give a little bit that was in the transportation whether you [chat] about this and how much did that severity get reflected in the second quarter and loss ratio and in the expenses?

David W. Michelson

The majority of the larger loss activity was in the passenger transportation products, they were with customers that for the most part were multi year customers with us, so they were customers that we know very well and they were involved in over the road motor vehicle accident. It was in the [chattel] earlier predominantly.

Elizabeth Malone

Okay. And what was the impact in second quarter loss ratio from the incident?

David W. Michelson

We had impact in the second quarter of approximately six loss ratio points from the severity that we have identified in the release.

Elizabeth Malone

Okay. And then, as far as so -- even though this is the second quarter you have seen a spiking severity like this, your analysis of the losses doesn’t indicate if it is any kind of pattern its not -- didn’t have anything do with more buses on the road because people are driving less because gas cost so much, so there is more demand on these buses and they are (inaudible) or something like that?

David W. Michelson

Our severity would not be attributable to an increased utilization due to economy conditions, we have a similar number of larger claims period-to-period but just so happens that the six claims we have talked about this average severity on those six is one in higher than average severities that we have seen before.

Elizabeth Malone

Is that the inflation?

David W. Michelson

No, it just so happens that these claims that we had again with longstanding customers just happen to be very severe claims, when we were watching the CNN last year and we were reading and watching severe claims that were occurring, last year we didn’t get our share. They seem to be going more in different directions and not towards us. The first six months of this year unfortunately some of those claims have come our way.

Elizabeth Malone

Okay. So, does this change the pricing or do you recapture these severity from these customers that have had the higher losses, you adjust their premiums to reflect that so that you would recapture some of those loss in the next 12 months?

David W. Michelson

Well yeah, our approach to underwriting and pricing, the large transportation business is to look at that particular customers trailing years of history and use that as the basis for developing their next year’s pricing. So, you should -- if there is large loss activity with the particular customer, their pricing going forward would change.

Elizabeth Malone

Okay, thanks. And then, on the investment portfolio, is there anything that you will be doing differently to try and improve the returns or this is mostly driven by overall interest rates experienced so its just a fact of lower interest rates is driving a lower return on the investment portfolio.

David W. Michelson

I would say, its what you just said, although we have -- we stay relatively short in some of our investments, in the short term return last year really up until the beginning this year, we are good, now we are finding we have put that money into lower interest bearing investments. Although, we have seen, as everybody seen bit of an optic in the last month or so, because we are constantly reinvesting that money we would anticipate some of that to be coming back. And no, we are not doing anything significantly different in our strategy.

Elizabeth Malone

Okay, thanks.

Operator

Our next question comes from the line of John Gwynn from Morgan Keegan. Please proceed.

John Gwynn

Thanks. Dave, the four large claims that you have in the second quarter is that a combination of both ART and traditional business?

David W. Michelson

Yeah, looking at the four large claims in the second quarter and really this six large claims year-to-date it’s a combination of traditional passenger transportation business and there are a couple of those large losses that are with ART customers as well.

John Gwynn

Okay. And Dave, I take up from your comments that you’re still totally comfortable with your underwriting and risk selection do you have the same comfort level with your reinsurance programs that you have in place?

David W. Michelson

We do, I mean, we have strong relationships with selected key re-insurers and one of the things that we really provided ourselves on over the years is we want to develop partnerships with re-insurers just like we want to develop partnerships with our captive customers. And so, our re-insurers are on multiple programs of ours. So, when we reinsure that happens to be participating on our passenger transportation treaty might also be on our truck transportation treaty, might also be on our treaty for wide Alaska business and could even potentially beyond our personal lines treaty. And the idea that in any given year one aspect of our business could have lumpiness and then other aspects of our business could have very smooth sailing but in the aggregate the re-insurer looks at their total results with us so that they don’t overreact and under react.

John Gwynn

Right. And then, as I understand your retentions range from $1 million to $5 million obviously the higher retentions on the accounts that you have more experience with, is there any thought of maybe bringing that $5 million in?

David W. Michelson

We have ranch to deduct our retention over the years, I mean going back to the very beginning in the company where we took very -- a low moderate risk and as we gain confidence in the customer base and just the underwriting and claims practices we were building and on the growth of our shareholders equity to support our writings, we have taken on more net retention. So, we evaluate that every year, I mean, quite honestly if the reinsure its market place has a desire to insure excess layer of risk and a cost is less than our view of it, we would look at the re-insurers if they want more that they possibly get more in years where our valuation of the excess layer appears to be possibly a little lower or even in lot lower then we are at that might be a year where we take a little more risk. But, on all of our programs while we are participating the policy limits we do have re-insurers involved on the excess layer with this as well. But, the level of participation does flow each year but that working layer that we take has increased over time.

John Gwynn

Just one last comment, you all obviously have a little bit of favorable development in the quarter $500,000, which is less than a point on the loss ratio but that compares with almost $3 million favorable development in the second, which was 4.7 points, I think I got that right, right Gary?

Gary N. Monda

Yeah, its right, John.

John Gwynn

Gary, thanks. That’s all I have thanks a lot.

David W. Michelson

Thank you, John.

Operator

(Operator Instructions). At this time there are no questions, I would like to turn the call back over to David Michelson.

David W. Michelson

In closing I want to be clear that we continued to maintain a long term perspective on this business during our 19 history we have experienced several setbacks and come back stronger as a result. National Interstate is an objective driven company and from a shareholder view point achieving a return on shareholders equity of 15% plus inflation is our main objective. We remain focused on this objective and are confident in our ability to achieve it. Thank you for participating in our conference call and for your interest in National Interstate.

Operator

Thank you for your participation in today’s conference this concludes the presentation, you may now disconnect.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: [e-mail]. Thank you.