State Auto Financial's CEO Discusses Q3 2012 Results - Earnings Call Transcript

| About: State Auto (STFC)

State Auto Financial Corporation (NASDAQ:STFC)

Q3 2012 Earnings Call

November 06, 2012, 10:00 am ET

Executives

Steve English - CFO

Bob Restrepo - President, Chairman & CEO

Scott Jones - VP & CIO

Analysts

Paul Newsome - Sandler O'Neill

Brett Sherriffs - KBW

Ron Bobman - Capital Returns

Larry Greenberg - Langen McAlenney

Operator

Good morning and welcome to the third quarter State Auto Financial Corporation Analyst Call. At this time, all lines are in a listen-only mode until the question-and-answer session. (Operator Instructions). Today's call is being recorded. If you have any objections, you may disconnect at this time.

And now I will introduce your host for today's conference, STFC Chief Financial Officer, Steve English.

Steve English

Thank you, Evan. Good morning everyone and welcome to our third quarter 2012 earnings conference call. Today, I am 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 President, Chairman and CEO, Bob Restrepo.

Bob Restrepo

Thank you, Steve and good morning everyone. At this point third quarter results we think mask underlying improvements in our business and a brightening outlook. In the quarter, ex-catastrophe loss ratio has improved in our personal insurance, business insurance and Rockhill businesses. Catastrophes were mild relative to our five year trend.

But this good news was offset by first, the need to increase reserves for two terminated programs in managing general underwriting unit RED. Secondly, the impact to our combined ratio resulting from the homeowners quota-share reinsurance treaty in the quarter. And third, lower investment income.

Our third quarter combined ratio of 110.2% included a loss reserve adjustment of $19.5 million for the two terminated RED programs which added 7.5 points to our reported combined ratio. The underwriting loss was increased by another $13.1 million or 5.8 percentage points because of the quota-share treaty impact. The net impact of these two factors increased our combined ratio by 14.5 percentage points.

I don’t like but for any more than you do, but for these two significant factors and our combined ratio would have been 95.7%. Year-to-date, our combined ratio is a 110%. The net impact of the RED reserve adjustment through three quarters was 2.5 percentage points and the homeowner’s quota-share reinsurance treaty reduced our combined ratio by seven-tenths of a point. Our reported combined ratio ex-RED and without the homeowner’s quota-share treaty would have been an honored 6.2%, through three quarters, putting us on-track for a significantly improved year-end results.

In the third quarter, our net loss of $5.5 million or $0.14 per diluted share was a significant improvement over last year’s third quarter loss of $58.7 million, or $1.46 per diluted share. State Auto Financial Corporation’s book value at the end of the third quarter was $18.30 a share, an increase of $0.48 from the second quarter and $0.35 increase from our restated book value at year-end.

Our current book value also includes a reduction of $2.45 a share for the deferred tax assets valuation allowance that we established at the end of the second quarter of last year. Trailing four quarters return on equity result of 13.6% was impacted by some non-recurring items recognized in the fourth quarter of last year; Steve English will explain these following my comments.

Before I discuss the generally positive trends in our core personal business and specialty insurance segments, I would like to give you some background on RED. When we acquired Rockhill in 2009, RED was a relatively new organization which had an agreement with Rockhill to build out a profitable book of business in the alternative risk transfer and program management market. For Rockhill, it was an opportunity to diversify and achieve greater scale.

Following State Auto’s purchase of Rockhill we saw similar opportunity and a strategy to diversify into more casualty business and achieve greater scale in commercial lines. We began writing business through RED in late 2009. Unfortunately, implementing the strategy proved to be difficult; our initial hope was to focus on alternative risk transfer, but the market did not present or it presented few acceptable opportunities.

In the program management area, we experienced some operational issues in providing technology to support RED’s business model which also inflated our short-term expense ratio. Additionally, it became clear that balancing what we considered to be desirable program business that align without risk management strategy differed from RED’s production focus.

While 2010 results were reasonably good, 2011 results began to deteriorate and we experienced multiple technology issues. We quickly reduced new business writings and began repricing and re-underwriting the largest two programs. With continuing poor results, we began terminating programs, replacing the management team and downsizing the business. Even though we’ve had a complete operational overall, we’re not exiting the program business; we’ve already integrated the remaining portion of RED’s business into Rockhill’s specialty programs organization.

We have an excellent team of Rockhill executives in place. We have an operating model that is much less risky. We have a complete control now and oversight of all pricing, underwriting and claim processes. While this initiative makes sense to what strategically executing the plan and a very negative impact on what otherwise would have been a decent quarter and a significantly improved year. We faced up to the bad news quickly and put it behind us, so we can focus on improving our core business results.

And let’s now turn to those core business results and discuss each of three segments. In personal lines, the Personal Auto loss ratio improved relative to the third quarter of last year because of lower catastrophe experience. Ex-catastrophe, results were relatively flat from last year on both the quarterly and year-to-date basis. We continue to experience higher bodily injury severity. This is partly because of new claim practices which established initial case reserves as closed to open as possible, but we’re also seeing thing higher liability severity trends as has been widely reported throughout the industry.

To offset these loss trends we’ve increased rates 4.3% this year and our plan calls for somewhat higher pricing levels in 2013. As these price initiatives earn out, we expect improving margins on our largest and traditionally most profitable lines. Personal line production after accounting for the pooling change was slightly negative resulting from agency terminations in unprofitable catastrophe prone states and the residual impact of our aggressive homeowners underwriting and pricing actions.

Speaking of homeowners we saw significant improvement in our loss ratio with or without catastrophes and with or without the homeowners’ quota-share reinsurance treaty. We targeted an ex-catastrophe loss ratio of 45% this year and are increasingly confident that we will achieve it. This year while increased prices and homeowners by 15% and plan a comparable price increase in 2013 along with mandatory deductibles, agency management actions and insurance-to-value programs, we are well underway to fixing this historically unprofitable line.

In the business insurance segment, loss ratios results were much improved on both catastrophe and non-catastrophe basis. Loss ratio results benefited from significantly lower catastrophe losses, better weather, fewer large losses and more consistent case reserving practices. Third quarter price per exposure increased 4.4% from the same steady run rate increases.

We expect the price increase in the 5% to 6% range by year end. Business insurance production overall is rising from price increases, modest improvements in the economy and increase in the business premiums. Commercial automobile loss ratios improved both in the quarter and year-to-date. Commercial auto price per exposure is up 3.4% in the quarter and we expect to achieve a mid-single digit run rate by year end.

Reduction increased after adjusting for the polling change driven by more new business, improved retention and increased prices. Commercial multi-peril loss ratio results also improved in both the non-cat and cat basis. Price per exposure is up over 5% for the quarter and we saw increased price, new business production and improved retention driven by our BOP Choice line.

Commercial property results were significantly better. We had fewer large losses and significantly better catastrophe experience. Trends in this line are similar to commercial auto and commercial multi-peril. We are seeing price per exposure up 5.2%, better retention and more new business.

General liability loss ratios were inflated a bit in the quarter, but significantly improved on the year-to-date basis. Price is increasing but in the low single digit range. As with the other commercial lines, production benefited from price increases, better retention and increased business flow. In 2013, we will complete the implementation of the new pricing and underwriting capability that we call business insurance evolution. This will increase our pricing precision, underwriting discipline and productivity particularly for policies under $5000 which represent over 80% of our inforce business.

Specialty insurance results still exceptionally strong performance in our Rockhill subsidiary and RTW our model line workers’ compensation business. Both segments continue to produce underwriting profit and healthy growth. Overall results were hurt by RED and by prior acts and (inaudible) development in a small book of workers’ compensation business written in our middle market unit.

As for RED, we terminated substantially all the business and have re-underwritten the small amount business that we expect to retain. Except for middle market, workers’ compensation is performing quite well. We remain cautious about the outlook though and careful about what kind of business we write and where we write it. Production in the specialty segment will be flat as growth in Rockhill and RTW is offset by the RED runoff.

With that, I'll turn it over to Steve before we open it up for your questions.

Steve English

Thanks, Bob. Today I will give an update on the homeowner quarter share treaty and make a brief comments on investment income, reinsurance other than the homeowner quota-share treaty, and our reported trailing 12 month ROE.

Our property results this past quarter were outstanding relative to last year and our historical third quarter trends. As a result, you can see from schedule two our investor packet, we ceded under net underwriting gain to our homeowner quota-share partners.

On a year-to-date basis, the quota-share results have improved our combined ratio by seven-tenths of a point, as mentioned by Bob. We monitor each month our compliance with the terms of our treaty and I have no concerns that we will not meet our obligations in regards to pricing targets and exposure management.

Consistent with prior quarters, our overall levels of investment income is lower as a result of the cooling change in the homeowner quota-share agreement. Beyond that though, our investment in Treasury Inflation Protected Securities or TIPS can create some income statement volatility as amounts we record as investment income are impacted by changes in CPI.

For the quarter, our TIPS income was lower by $2 million compared to a year ago, and lower by 4.7 million on a year-to-date basis, compared to a year ago. Total return however on the TIPS portfolio through September is 6.4%.

As Bob mentioned in his comments, we are seeing positive movements in our business insurance premium due to price and increase in exposures. However, our net written premiums for business insurance, specifically the other liability [one] is being impacted by reinsurance change we mentioned last quarter.

Effective, beginning July 1, 2012, we're no longer ceding umbrella premium under a former quota-share treaty, and instead those risks are now subject to our casualty excess of loss treaty. Business insurance segment net written premiums included $7.2 million of unearned premiums transferred as a result of terminating the umbrella quota share reinsurance arrangement.

For the three and nine months ended September 30, 2011; 3.4 million and 10.4 million of written premiums respectively were ceded under the terminated umbrella treaty. For the three and nine months ended September 30, 2012 the termination of this umbrella treaty accounted for 14.6 points and 4.7 points respectively of the net written premium growth compared to the three and nine months ended September 30, 2011 pro forma net written premiums.

We reported a trailing ROE of 13.6% which I would like to comment upon. The fourth quarter of 2011 included an unusual tax benefit caused by the core key accounting exception we discussed last year and was driven by an allocation between the income statement and other comprehensive income.

As you may recall, we were required to book tax expense against other comprehensive income and then offset it with tax benefit in the income statement. In addition, the fourth quarter included a 14.9 million post retirement benefit curtailment gain as a result of our decision to no longer offer retiree health benefits for certain retirees. These two non-recurring items are impacting our reported ROE.

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

Question-and-Answer Session

Operator

(Operator Instructions) our first question comes from Paul Newsome with Sandler O'Neill. Your line is open.

Paul Newsome - Sandler O'Neill

Could you walk through some cash given capacity, what you have with the holding company and what can be dividend out from the subs to give us a sense of how the dividend can be paid and how much liquidity have experienced probably?

Steve English

Sure, the parent company at September has roughly, Scott.

Scott Jones

Like I think $26 million.

Steve English

$26 million in cash and securities on hand. The dividend capacity of course is based upon the state rates surplus of the insurance subsidiaries that capacity presently on an annual basis is roughly $60 million. So when you think about the parent company's ability to fund its operations, it collect fee income from the its OEM subsidiary which is [stake hold] financial services is our internal investment management company, it collects roughly $7 million or $8 million a year and free cash flow presently and then the combination of that along with dividend and capacity which is roughly $60 million a year, as well as it does collect a certain amount of funds, Paul from employees stock purchase plan and things of that nature.

Paul Newsome - Sandler O'Neill

Terrific, and then I have to ask, the Hurricane Sandy what kind of exposures should we be thinking about, if any?

Bob Restrepo

It’s early on Paul, its Bob Restrepo. Obviously from an industry standpoint there's a lot of moving pieces, there's questions about how Hurricane and wind deductibles can be applied, there's questions about flood coverage versus wind coverage and storm coverage and there is also questions about the commercial exposure particularly if it involves private flood. That's from an industry perspective. From our perspective, we do no business, that's incidental business, we have some specialty accounts but we've seen very little claim activity in New York and New Jersey where a lot of the modeling firms indicate that maybe 70% of the losses will be. So we expect incidental claims in those two states.

Looking along the coast line, Virginia and Maryland are decent states for us but we've traditionally been well inland 50 miles or more inland. In Connecticut, it’s the fast growing state for us but we have the low presence in Fairfield County which at least anecdotally we've heard as where significant loss activity.

Surprising or not surprising actually the biggest area of storm activity we've had is in Northeastern Ohio. And the Cleveland area and then over towards Youngstown and Mentor, the storm exited through Western Pennsylvania that created a lot of flooding activity as well as some wind damage in Northeastern Ohio and that's where we've had the bulk of our claims.

We really haven’t enforced [parse] through them enough to find out how many of the claims are flooding related, how many of those claims fall within the deductible but we don't expect nearly the same kind of exposure that some other northeastern carriers expect to see.

Operator

Our next question comes from Brett Sherriffs with KBW. Your line is open.

Brett Sherriffs - KBW

You mentioned some development in workers’ comp, I was just wondering if you could discuss that a little bit more and that's separate from the $19.5 million I am assuming?

Bob Restrepo

Yeah, it is and it’s not a significant amount but overall obviously, industry results in workers’ compensation are poor. We actually in our legacy state auto which is focused on small business and our RTW business have very good combined ratios. We are producing underwriting profits. Over the past couple of years, we've written as an accommodation workers’ compensation business as part of middle market accounts and we've defined middle market accounts as generally accounts that exceed a $100,000 in premium. We had about 30 accounts that we identify as performing very poorly. We terminated those and that's what has contributed to the prior accident year development but again it hurt our overall workers’ compensation line but when you look at the entire enterprise was overall didn't have a material impact.

Brett Sherriffs - KBW

Okay. Can you break out the dollar value?

Steve English

Brett, at the end of the year we will give a full report on development by line of business. We typically do that in the next analyst call.

Brett Sherriffs - KBW

Okay, and then, just lastly, looks like there were some negative cats in homeowners. Could you breakout, current quarter versus prior quarter favorable for that?

Steve English

Why don’t I’ll just give you some commentary on as to why that is and then again we typically cover that year end but it's interesting in this first year with the quarter share because any favorable development that we're experiencing on property, cats reserves are in a homeowner line from 2011 and prior are not shared with the quota share treaty. That's a 2012 perspective treaty. So what you are seeing going on in the numbers are couple things.

One, we did report or did record some favorable development from 2011 prior and then secondarily, the large Derecho storm that hit at the end of June, we actually revised slightly downward our expectation of the homeowner losses from that storm as well.

Now that favorable development because it's on a 2012 storm is subject to the quota share treaty. So you end up with somewhat odd looking results because of that revaluation of the second quarter storm and the fact that prior year development is not shared with quota share treaty.

Operator

(Operator Instructions) And our next question comes from Ron Bobman with Capital Returns. Your line is open.

Ron Bobman - Capital Returns

I was wondering how many claims you received so far from Sandy?

Steve English

We can tell you a number but quite frankly it’s a meaningless number, but so far it’s been under 2,000.

Ron Bobman - Capital Returns

And how about the mix of what homeowners, commercial and auto?

Bob Restrepo

The vast majority are homeowners, well over 80% of them are homeowners and obviously, with flooding exposure you would expect to see a lot of automobile comprehensive losses but we just haven’t seen much of that at all. It’s virtually all property related and virtually all of those are homeowners related and as we get into this what we have experienced from prior cats particularly this year because we have been increasing the mandatory wind deductibles, a lot of these claims that we would have traditionally paid are now falling within the increased homeowner deductible.

So what we have seen in Derecho was a good example. We have seen a higher percentage of our claims not covered because of the higher deductibles that’s too soon to tell how that will play out with Sandy, but again what we don’t expect it to have an impact on our results that some other folks will experience.

Ron Bobman - Capital Returns

And Bob the deductible, obviously there has been a lot of public press with the State Commission or the State Governors compelling or requesting the personal alliance companies the big ones particular to not cause the windstorm or hurricane elevate deductibles to be at play here because this storm hit shore as just a wind storm and not a hurricane. I am sorry, is that different from the point you were just making?

Bob Restrepo

Well, it is different, because they are different types of deductible. The deductible obviously, we don’t have hurricane deductibles in Ohio and that's where we’ve had our biggest single volume of losses, but we do have wind deductibles, so we are not influenced by whether it’s a [name] storm or not.

Ron Bobman - Capital Returns

Okay, okay.

Bob Restrepo

If its wind related, it’s subject to the deductible. Our experience on the East Coast, so a lot of these states are sighting Connecticut last year and Irene where Governor Malloy influenced that I use that term, influenced the industry to outweigh the deductibles and some deductibles were just strictly at the name storm hit and our deductible really provided for a 36 hour period that if it was a name storm within 36 hours and it hit land the deductible applied, but that causes a lot of consternation and confusion within our independent agents, when they companies with different types of deductibles structures.

So we made a business decision to weigh that particularly when the largest competitors in the state decided to weigh, we are among the last company standing, so what we decided to made a business adjustment to weigh that our biggest concern was establishing a precedent and that concern is legitimate, but that's with the other states are reciting right now, you did for Connecticut why don’t you do it for us.

Ron Bobman - Capital Returns

Okay, and then would you…

Bob Restrepo

Industry let me put it that way.

Ron Bobman - Capital Returns

So Bob what did you say?

Bob Restrepo

It doesn't bode well for the industry.

Ron Bobman - Capital Returns

All right and would you (inaudible) a guess I think that’s sort of [T plus seven or T plus eight], would you (inaudible) a guess as to whether you’ve received 90%, 70%, 50% of the ultimate claim count from the storm?

Bob Restrepo

It’s very early on. I can't say the numbers are tailing off, but one of the things we learned from the Derecho is that these claims can be reported for six weeks after the event and they tend to be less significant. We tend to get the most significant claims earlier on and I can tell you that we haven't had any large losses and these kinds of losses in excess of $100,000. We have had no large losses reported to-date. And that gives us some feeling of comfort looking to the future but it’s very, very early on for us to estimate what the total claim value will be as well as the total number of claims that are actually covered.

Steve English

Ron, this is Steve English. Our policy typically has been that at whatever point in time we are in a position to make an assessment of a storm estimate and if it rises to a certain level of materiality and we typically will put out a press release in that regard but its just, at this stage the reporting is early, the coverage decisions are premature and we just don't have an estimate yet.

Ron Bobman - Capital Returns

In the past whether it would be Derecho or Irene, at this point in time would you have been three quarters through the receipt flow of claims?

Bob Restrepo

No, I would guess maybe 25% to 30%.

Ron Bobman - Capital Returns

I'm sorry.

Bob Restrepo

25% to 30%.

Ron Bobman - Capital Returns

Wouldn’t it been submitted to you at T plus eight in prior events.

Bob Restrepo

Yes, maybe only a third of the claims would (inaudible).

Ron Bobman - Capital Returns

Okay, I am not sure I understood exactly what you are saying.

Steve English

First week that these things, they will take 45 days to three months to really get, 45 days to get a reasonable handle, three months to get an absolute handle.

Operator

Our next question comes from Larry Greenberg with Langen McAlenney.

Larry Greenberg - Langen McAlenney

Just wondering, if you could discuss pricing trends relative to expected loss cost trends for both commercial and personal automobile.

Steve English

Yes, we are behind or we roughly equal. But we need additional price increases in both personal and commercial auto to get ahead of the lost curve particularly from a bodily injury standpoint. So we are basically pricing to keep up with current lost trends but we need to get ahead of the lost trend to improve our margin.

Larry Greenberg - Langen McAlenney

And do you have plans to do that.

Steve English

Yes. Yeah we've actually exceeded our planned target for this year as the number I cited roughly 4.5% and we plan to have a higher price increase next year for both personal and commercial automobile.

Larry Greenberg - Langen McAlenney

So is it fair to see you've been pushing price and loss cost just keep moving up in line with what you are pushing on price.

Steve English

The bodily injury in particular TIPS is an issue, but bodily injury has definitely continuing to increase at a level beyond what we originally expected in our price assumptions.

Operator

At this time, we're showing no other questions in queue.

Bob Restrepo

Okay, thank you Evan and we want to thanks all of you for participating in our conference call and for your continued interest in support of State Auto Financial Corporation. We look forward to speaking with you again on our fourth quarter earnings call, which is currently scheduled for February 19, 2013. Thank you and everyone have a good day.

Operator

This concludes today’s conference. You may disconnect at this time.

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