State Auto Financial Corporation (NASDAQ:STFC) Q4 2015 Earnings Conference Call February 18, 2016 11:00 AM ET
Tara Shull - Investor Relations and Finance Director
Michael LaRocco - President and Chief Executive Officer
Steven English - Senior Vice President and Chief Financial Officer
Kim Garland - Senior Vice President, Standard Lines
Jessica Buss - Senior Vice President, Specialty Lines
Arash Soleimani - Keefe, Bruyette & Woods, Inc.
Ronald Bobman - Capital Returns Management, LLC.
Paul Newsome - Sandler O’Neill + Partners, L.P.
Larry Greenberg - Janney Montgomery Scott LLC
Gary Ransom - Dowling and partners
Welcome and thank you for standing by. At this time, all parties are in a listen-only mode. After the speakers’ remarks, there will be a question-and-answer session. [Operator Instructions] Today’s call is being recorded. If you have any objections, please disconnect at this time.
I’d now like to turn the call over to State Auto Financial Corporation Investor Relations and Finance Director, Tara Shull.
Good morning and welcome to our Fourth Quarter 2015 Earnings Conference Call. Today I’m joined by our Chairman, President and CEO, Mike LaRocco; Senior Vice President and CFO, Steve English; Senior Vice President, Standard Lines, and Managing Director of State Auto Labs, Kim Garland; Senior Vice President, Director of Specialty Lines and Middle Markets, Jessica Clark; Chief Investment Officer, Scott Jones; and Chief Actuarial Officer, Matt Mrozek.
After our prepared remarks, we’ll open the lines for questions. 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 risks factors may cause actual results to differ materially from those contained in our projections are 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. A financial packet containing reconciliations of certain non-GAAP measures along with supplemental financial information is available on our website, 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, Mike LaRocco.
Thanks, Tara. Good morning, everyone. Our results for both the quarter and the year were poor. We did not make an underwriting profit and we failed to meet our growth objectives. Majority of our misses for both the quarter and the year were the result of our auto lines. In personal, commercial and every one of our programs, auto insurance results were awful. We began an intense review of the results after the second quarter. Last quarter, we reported to all of you many of our findings. Since that time with the addition of the new claims leader and more time, we have completed the review effort and have begun to take aggressive steps to correct the issues we found.
The auto loss issue cover many parts of the organization. It begins with our pricing and underwriting. We identified gaps in our models and underwriting rules that result in inadequate and incorrect pricing levels. Some of these issues also cause expenses to be higher than they should have been. Our new claims leadership also found the number of issues led to claims leakage or higher costs due to handling gaps.
Finally, we believe there is also what I call contract leakage. We feel some products need to be on different forms and some of our forms are broader than the market norms. Corrective action is being taken across all of these areas. Progress has already been made. Kim and Jess will cover all of this in greater details. We certainly have some positive results in 2015, E&S, the workers’ comp, and farm and ranch all continue to perform well against both profit and growth targets.
Our homeowners business was profitable for the year. And not because we had a light cat year, the non-cat loss ratio was outstanding. Again, I’ll let Steve and the business leaders address those results as well. I want to talk about my evaluation of the year, how I see 2015. And let me before I do that begin by saying the results were bad period.
However, I believe we accomplished a great deal in 2015, worked at a greater foundation for 2016 and beyond. In 2015, we appropriately addressed our expense ratio. At the State Auto Group level, we eliminated $10 million in unneeded expenses. We’ve realigned the organization to be flatter and more logical. As part of this, we had to make the hard decision to reduce our staff. We also made the quarter exit on profitable lines of business.
Finally, through a combination of retention, promotion, and recruitment, we built the new leadership team. This team has the skills to meet the emerging challenges in the P&C marketplace. It’s become a very – it’s become in a very different market and our leaders understand what’s needed to win. This organization alignment also led to the creation of the product management organization, but each product line held accountable to make an underwriting profit and growth.
We also restructured claims to better align with our product focus and better match skills with type of loss. All of this organizational change supported our companywide focus on one simple goal, profitable growth.
We developed the technology strategy that resulted in our decision to build a single platform architecture for all our products. This began with the build of the new policy quote and issuance platform for new business only. That effort is well underway and we’re on target for late third quarter launch in five states for auto, home, and umbrella. We’ll quickly add our remaining states and small business insurance. This platform will be efficient, effective, user-friendly, and a huge step forward for State Auto.
We know that for long-term survival, it is imperative that an insurance company have best-in-class technology. State Auto will achieve that objective. We have a core belief that the P&C industry will experience dramatic change in the coming years. We also believe the winners will be companies that have a culture that allows them to react, adapt, and take advantage of that change. We believe it is critical that we change our culture to give us a better opportunity to be one of the winners.
We’re in the process of a cultural change that will positively impact our ability to be nimble, responsive, creative, passionate, and driven. We eliminated traditional performance management and instituted a coaching environment. We created an atmosphere of candor and transparency, where every associate is encouraged to speak up and challenge the process.
It’s a culture where every associate is asked to think like an owner and most truly our owners, rules, processes, committees, guidelines, that only added bureaucracy had been eliminated, replaced by an open and collaborative approach to simply making a decision and moving forward. While it will take time for all of us to live this new culture, we’ll make it work and it will increase our ability to be an effective winning competitor.
I know our results report and we make no excuses, we own the results. I also know my belief that we had a strong year, because we made necessary changes to build a sustainable foundation does not overcome the results in the eyes of investors.
Steve, Jess, and Kim will go over in detail the report numbers. My only interest is to be certain of our investors have a full picture that this leadership team has not only attacked the poor performing businesses, but at a broader level has made the hard calls required to build a foundation upon, which State Auto doesn’t simply get better, but emerges as an industry leader.
Thanks, Mike. Today, STFC reported a combined ratio of 106.2 for the quarter and 101.5 for the year. This compares to a 113.3 combined ratio for the fourth quarter of 2014 and 105.5 for all of 2014.
A year ago, the reported results were impacted by Red reserve strengthening and then now expired homeowner quota share treaty. Schedules 1A and B disclosed the impact of those items on 2014 results to both the fourth quarter and full-year. In addition, the lifting of the deferred tax valuation allowance in the fourth quarter of 2014 impacted reported net and operating incomes.
As Mike noted, the quarter’s results were impacted by ongoing profitability issues and our automobile lines of business, as well as revised loss estimates for other and product liability, E&S casualty, and programs. We included development schedules in the investor packet to assist investors in evaluating 2015’s results as compared to 2014. The test of the results for 2015 continued a three-year run with cat loss ratios below 5%. There was no significant development of cat loss reserves from prior years.
On a reported basis, our non-cat loss ratio for the fourth quarter and all of 2015 improved over comparable 2014 periods. However, during 2014, we recorded significant adverse loss reserve development on RED and closed book of business of $71.3 million and $96.4 million in the fourth quarter and full-year respectively, adding 26.1 points and nine points to the reported non-cat loss ratios.
So you can see that in 2015 non-cat loss ratios results on a reported or calendar year basis actually deteriorated. As disclosed in the development schedule for the full-year 2015, non-cat losses included $10.7 million of adverse development adding 0.8 points to the reported non-cat loss ratio. For all of 2014, $50.3 million of adverse development was recorded, including RED, adding 4.7 points to the reported non-cat loss ratio.
Our accident year non-cat loss ratio results improved slightly in 2015 in total, but are not at acceptable or targeted levels. Personal auto, commercial auto, and E&S casualty reported adverse development of prior year losses in 2015, while all reported favorable development in 2014. Other and product liability reported less overall favorable development in 2015, and programs reported less overall adverse development in 2015. The 2013 and 2014 accident years drove the development of loss and allocated loss adjustment expense reserves.
Personal auto development was driven by bodily injury severity, which also impacted our 2015 accident year expectations as well. Bodily injury severity is also driving commercial auto results. Severity is contributing to less favorable development for other and product liability, program results are being impacted by progress with auto exposures, and E&S casualty experienced some larger umbrella losses.
Kim and Jessica will provide additional commentary in these lines of business, including pricing, underwriting, and claim steps being taken to address these trends. Homeowners other personal lines which includes our farm and ranch business, fire and allied property lines and other commercial are performing well. E&S property has had favorable experience, including the favorable runoff of prior year reserves.
Let’s talk for a moment about our assessment of RED programs. During 2015, the restaurant program outstanding claims are down to 620 from 898 a year ago. As a reminder, this program is subject to an adverse development cover place at the end of 2014. The trucking program open claim counts are down to 136 from 277 at the end of last year.
For the remaining RED programs, there are approximately 100 outstanding claims, RED reserves were $71.3 million at December 31, 2015, of which 57% relate to the restaurant program.
I’d like to take a moment to remind everyone that the adverse development cover is accounted for his retroactive reinsurance. The cover provides up to $40 million of coverage to the State Auto Group beyond the carried reserves as of the end of 2014.
Under the accounting rules, the 80C benefit is recorded concurrently with revised loss estimates to the extent funds were paid to the reinsurer at the time of contract inception. Any further benefits of the 80C after the full coverage limit are recognized over the estimated period of time to sell other claims. We’re not impacting the economics of the agreement its protection it provides, it is possible that loss reserve increases could be recognized in a period with the offsetting 80C benefit recognized in the latter period as the claims are actually paid.
During 2015, we did revise upward our estimate of ultimate losses for the restaurant program, but did not exceed the amount paid to the reinsurer. In the future, as claims continue to be adjusted, if estimates are revised upwards beyond the amount previously paid, we will disclose the impact to the financial statements, including the amount of 80C benefit that has been deferred for later recognition. We do not expect that to be significant though. Our ultimate loss estimates for the restaurant program are materially below the coverage limit of 80C.
During 2015, we did add 1.3 million to our ultimate estimates for RED programs not subject to the agency.
Before I turn the call over to Kim, I’ll comment briefly in a few other items. TIPS volatility continues to impact our net investment income results. Our exposure to TIPS has been about 30% since the end of last year.
With the recent drop in oil prices, we recognized $2.2 million in other and temporary impairments for the quarter related to our energy equity portfolio. Our total energy exposure for both equities and fixed maturities is less than 5% of our overall holdings. Rising interest rates resulted an increase to the discount rate used to revalue pension and postretirement benefits, adding $0.10 to our book value per share, which finished the year at $21.40.
Mike mentioned making some hard decisions around staff reductions. In the quarter, we recognized $8.9 million of charges related to a special retirement incentives and other staff reductions, with $6.8 million reflected in our acquisition and operating expenses and $2.1 million as unallocated loss adjustment expense. The expense ratio in the quarter remained consistent with our nine months 2015 expense ratio, as we reduced agent and associate incentive compensation due to lower profitability.
Finally, at the end of the year, STFC’s insurance subsidiaries have combined statutory surplus of $814 million, while group surplus stands at $1.2 billion.
Now, I’ll turn the call over to Kim Garland.
Thanks, Steve, and good morning, everyone. The most important thing to cover is our private passenger auto results. Why are the results? What they are in the fourth quarter? And what are we doing to improve our auto profitability?
Last quarter as part of our auto discussion, I told you that we had uncovered both pricing and claims issues. Since then covering the claims issues, our claims department has reorganized in the separate personal claims and commercial claims units. This reorganized claims department undertook an effort to review case reserves on every open auto liability claim. This resulted in both an overall strengthening of auto liability case reserves and changed our overall view of our accident year 2014 would eventually emerge.
But even without the adverse loss reserve development, our auto business would not be achieving our target combined ratio of 96. To improve our auto profitability, we have or on the process of taking the following actions. In the first four months of the year, we are viewing the auto rates in all of our states and filing rate changes.
As of today in our 28 states, we have completed 23 reviews, 13 filings, seven implementations. These reviews and filings include increasing higher BI, increase limit factors, reducing some discounts that were either too aggressive or undeserved, and implementing a revised actuarial analysis methodology that we believe is better suited to states, where we are smaller and our data has lower credibility.
Establishing an appropriate reserve levels, taking the overall rate increases and cleaning up some pricing segmentation issues are necessary, but not sufficient conditions were being profitable in personal auto. Profitable auto insurance companies also minimized their "leakage”. Our definition of leakage includes underwriting claims contract and expenses.
We have already identified approximately 5 points of leakage in our auto business. This includes auto underwriting. For example, today we allow agents to override information that has pulled from the current carrier database. In claims, we have been using too many third-party vendors and our governance of those vendors was not strong enough. By bringing more claims activities in-house, reducing the number of third-parties where we use them, and stronger governance should release – reduce leakage from this item.
Contract, we identified areas of improvements to modernize our forums. Expenses report ordering, we are moving the ordering of some reports from the close stage to the issue stage of the new business process. This should reduce report ordering expenses. Also, we are implementing tighter controls to minimize the duplicate ordering of reports.
Our team is addressing these leakage areas as rapidly as possible. Some of the fixes are immediate like eliminating the overriding – overwriting of the current carrier information and some will take time to modernizing of our auto contract. The reality of insurance is that many of the fixes take sometime to impact financial results. Rates have to earn in, and our situation is a bit more challenging as about half of our policies are annual policies instead of six-month auto policies.
Our leakage issues cannot be fixed immediately, i.e., it takes time to rewrite and implement or revise auto contract. Of course, we do get some immediate benefits from expense and underwriting fixes. The reality is that, we’ll take a couple of quarters before these fixes start to impact our financial results in some more time before the improvement is sufficient to allow us to achieve our 96 combined ratio. But we do have a clear path to profitability. While the immediate focus is appropriately on our auto profitability issues, the longer-term question is can stay auto become profitable and growing across all of our product lines. It’s important to discuss the progress that we are making on this longer-term question.
For auto and homeowners, quotes in new business are up. Quotes are up 8.5% across auto and homeowners 4Q 2015 versus 4Q 2014. New business is up about 10% across auto and home 4Q 2015 versus 4Q 2014. This is the first increase in these metrics since 2009. It’s an early sign that our efforts around reinvigorating our new business production are starting to take hold.
New policy system and new business quoting and issuing capability, we remain on schedule to launch the first five states for auto, home, and personal umbrella in Q3 2016. Our development is far enough along, that is clear the difference between our current quote and issue system and our new one will be night and day. The most important metric that we will be monitoring is what we call our efficiency ratio.
The percentage of time that a competitive quote is turned into a new business policy. We expect our efficiency ratio will improve dramatically with this new system. And redesigning our pricing segmentation models for both auto and homeowners, in each product line, we’ve identified new variables that we believe will add significant predictiveness to our pricing models and will be rolling out a telematics option with our new auto product, which we believe will be meaningful.
Farm and ranch, our product management approach drives fanatical focus on each individual product line with a goal of each product line growing as fast as possible, while hitting their combined ratio target. In 4Q 2015, we implemented a new quoting system for farm and ranch. New businesses doubled since the implementation of the system and an easier quoting system will allow us to expand our farm and ranch points of distribution.
Our farm and ranch product line is currently profitable and growing. Today, it’s a $50 million product line that we believe has only scratched the surface of its potential. In our product management approach, it shows us that this product line gets the attention it needs to achieve its full potential. We are very excited about our farm and ranch business.
Our current performance in personal auto is unacceptable. Last quarter we identified the reasons for poor auto performance, this quarter we started to implement the actions to turnaround our personal auto business. There’s still a lot of work to do and the impact of these actions will take some time to show up in our financial results. But we’re confident that these are the right steps to bring this product line back to health.
Now, I’ll turn you over to Jessica to discuss the business and specialty insurance segment results.
Thanks, Kim. Since taking over commercial lines in August, my team has been focused on identifying the pricing, underwriting, and product changes required to return as a profitability with most of our attention on our commercial auto and box business.
In addition to profitability improvements, we are also working on growth initiatives across all commercial lines, with priority given to our profitable lines, commercial package and worker’s compensation. Our business insurance loss ratio for the fourth quarter and 2015 are very disappointing, but not surprising.
The opportunities for improvement we identified beginning in August surrounding underwriting pricing and claims will take time to earn out and only then will they positively impact results. I’m optimistic regarding our outlook and our pathway back to profitability despite the poor results in the fourth quarter and 2015 overall. I’m confident the actions we’ve identified and are in the process of being implemented will drive improved underwriting results in 2016.
Let’s start by looking at the root causes and fixes for deteriorating BOP and commercial auto results. One of the major contributing factors to the worsening of these two product was the intentional strategic shift to larger accounts beginning in 2011, as part of an effort to reduce our expense ratio and a focus on increasing casualty exposures relative to property to diversify.
While we believe in the premise of that strategy, we were not well-positioned at that time to profitably execute in terms of the product, underwriting expertise, technology or pricing segmentation. This is evident in the results of our larger BOP and commercial auto fleets associated with those policies.
While the entire industry has struggled in commercial auto due to increased frequency and severity, our results are worse driven by the larger fleets caused by inadequate rates in underwriting, as well as insufficient use of predictive models. We see this in both the loss ratio of larger accounts and accounts that the renewal model identifies as worse risks. The five-year loss ratio on accounts greater than $10,000 is approximately 12 points higher than accounts less than $10,000, and 24 points higher on the risks the model would predict to have higher frequency and/or severity.
In addition to these issues, we have identified leakage in claims and within our underwriting process, including consistency with respect to driver evaluation, risk assessment, and vehicle class.
To address these issues, we’ve identified opportunities for improving controls within Bizet [ph] our online agency quoting system. And in December, we implemented a new renewal pricing tool that makes use of our predictive model and includes additional rating variables, which will allow us to better match rate to risk.
The newly created renewal pricing tool alone is projected to add 7% to 10% of additional rate. We also implemented desktop underwriting procedures and training focused on upfront underwriting of MVRs, tier utilization, driver records, and vehicle classification. Our new business model with associated pricing tool was deployed to our field teams last week, which will give underwriters price guidance based on risk characteristics.
Finally, we’re making changes to our Bizetquoting system, which will remove the ability of our agents to Tier, classify, or price larger accounts, thereby placing those responsibilities with the State Auto underwriter. Placing risks in the appropriate Tier based on eligibility can add up to 15 to 25 points of rate depending upon the state.
As I mentioned last quarter, we are also evaluating account sizes and classes, as well as underwriting and pricing model to improve our BOP products profitability results. Over the past five years, our BOP book similar to commercial auto has shifted from smaller BOP under $10,000 to larger BOP over $10,000 that were more casualty focused in classes such as auto service, restaurants, and grocery and convenience stores, all of which are better suited on a package policy.
Today, 30% of our portfolio consist of policies over 10,000 versus 22% in 2012. The biggest concern is that, our BOP policy is over 50,000, have a five-year loss ratio of 77.5% versus policies less than 10,000, which have a five-year loss ratio of 60.8%. The liability part of these larger BOP were on a five-year loss ratio of 14 points over property due to increased severity.
These more complex types of exposures require more experience underwriting and pricing, which was not in place when these products were launched. To address these issues, we are taking for actions. First, we are requiring all BOP over 50,000 to be moved to a package policy and therefore better underwritten.
Second, we will turn up automated quoting capabilities for agents to eliminate underwriting leakage and promote proper classification tier and pricing.
Third, we’ve eliminated pricing tiers, which offer lower rates.
And fourth, we have created a new commercial lines appetite statement and underwriter training that will ensure we’re getting risk that we can write successfully and align our agents with our commercial lines capabilities.
We are seeing much better results in our small commercial auto and BOP book, and we are confident we can continue to write this profitably. The implementation of Guidewire for small commercial at the end of 2016 will provide us with an efficient system, a solid product, and an ease of doing business offering to our agents, coupled with other growth initiatives focused on small commercials. This will allow us to turn business trends positive, while reducing our expense ratio over time.
In addition to underwriting changes, we’ve also made some changes to our claims practice to minimize claims leakage. First, we’ve reduced the number of third-party vendors we utilized in the claims process in order to leverage pricing. Second, we’ve outsourced segregation activities to improve recoveries. And third, we’ve significantly expanded our fraud detection reporting capabilities.
Addressing these various forms of claims leakage will also decrease loss and loss adjustment expenses driving improved underwriting profitability. Our package policy excluding runoff of our large account solutions business performed well in the fourth quarter as – and was in line with our year-to-date expectations. Targeted rate increases and better pricing segmentation has positioned us to be adequately priced and competitive on targeted segments of this business. This is one of the lines we’ve started focusing on for growth given its stable profitable position.
In the fourth quarter, we saw reversal of new business trends and CPP new business actually increased by 9.7% in policies and forth and 29% of written premium over fourth quarter 2014.
On last quarter’s call I mentioned that we’re realigning our field operations to drive accountability and better match underwriting talent to agency needs. We’ve completed that reorganization and are now positioned to provide excellent agency service.
The combination of these underwriting pricing and reorganization initiatives will help us return to underwriting excellence and help us grow profitably in this segment. As a result of the realignment, we are now also reported worker’s compensation within the business insurance segment, which we believe appropriately reflects how the business is written and managed. This change will not affect our disciplined niche approach.
The worker’s compensation unit results were again very solid for the quarter and year-to-date. As the market softens, we are still growing, although, we are starting to see rate increases slow in most states. Our workers compensation strategy remains the same grow profitably, while remaining disciplined, as the market shows further signs of softening.
Moving onto specialty. The overall results of the ongoing specialty insurance segment continued to be good, but the quarter and year-to-date did not perform, as well as expected, driven by large casualty loss development and deterioration in two specific programs within our program unit. The specialty segments non-cat loss ratio for the quarter was 66.5% and 59.7% year-to-date.
We’ve been successful in navigating a challenging market and leveraging our niche market positions and underwriting excellence to maintain underwriting profit. The E&S property market continues to be soft due to excess capacity in capital entering that space. The story is consistent with prior quarters at minimal storm activity, aggregated business models, collateral market, and reduced reinsurance costs combined to make growth very difficult in this market.
Rates were down on average of 8% to 10%. We continue to look for creative ways to leverage our strong relationship to identify new business opportunities, including seeking out aggregated books of business with partners who have proven track records of being profitable. We’ll continue to stay disciplined and focus on profitable renewals and rate all the business we can at the right rates having only those risks that we believe are accretive to our portfolio. The non-cat loss ratio in this unit continues to be outstanding, driven by low current accident year activity and favorable development of prior accident years.
In our E&S casualty unit, we continue to look for opportunities to grow both organically and through acquisition of underwriting teams. Year-to-date, rates increased 2.2% for this unit. Our strong broker relationships have protected us from adverse market impact and allowed us to continue to grow although at a slower pace. We’ve also continued our practice of adding underwriters in strategic geographic locations to grow our business profitably, which has resulted in organic growth of 10.1% for the year. We did see sizable increases in the 2015 quarterly and year-to-date non-cat loss ratios, which were 62.6% and 64.4%, respectively.
As mentioned, the increases were driven by a change in the mix of business and adverse development on prior accident years in our healthcare and umbrella products. We continue to be very pleased with the makeup and quality of this book, we did, however, make the decision to exit healthcare in early 2016. The decision was based on a combination of profitability fundamentals, license scale, and the competitive nature of this space, all of which hampered our efforts to grow profitably.
The programs unit continues to add programs to help diversify our overall portfolio of niche within niche programs. We continue to get more than 10,000 new program submissions for review each month. We implemented two new programs during the fourth quarter, which we estimate to have 2016 premium of approximately $12 million.
We also terminated one program due to profitability concerns, driven by frequency and severity. Our performance in the program space is disappointing. However, the results were adversely affected by terminated programs and commercial auto experience that mirrors our internal commercial auto results.
Our three most disappointing programs were driven primarily by commercial auto. One of those has been terminated and the other two are undergoing aggressive rehabilitation programs. Terminated programs contributed 7 points to the loss ratio. We’re disappointed in some of our auto programs, where we have not seen the performance improvement we expected, given the large rate increases we previously implemented.
We’re making underwriting changes, adopting a more sophisticated analysis, including introduction of telematics where possible to improve results. We’re very focused on our largest program. Our analytics team is working with the program manager to conduct univariate and multivariate analysis, including additional data on the auto liability coverage line to identify characteristics driving the loss. This analysis will be completed by March 31, 2016.
Finally, we’ve reached an agreement with this program on a commission reduction which will go into effect March 1, 2016. Rate increases for the program unit in 2015 were 4.5% year-to-date. The non-cat loss ratio for the quarter was 107.1% and 80.7% for the year, including 16.7% was for prior-year development.
Now, I’ll turn the call over to Mike for closing comments.
Thanks, Jess. It’s been a challenging and exciting nine-and-a-half months. I hope over the last two quarters, we have demonstrated that we are a leadership team that will be transparent and candid. As a matter of fact, I hope today that came through loud and clear. Our results are poor and that is unacceptable. I also hope though that we properly communicated our confidence and optimism. Confidence that we’ve identified the causes and then we also have the plan to fix those issues and the ability to execute that plan.
With that, I’ll turn it over and open it up for questions.
[Operator Instructions] Your first question comes from the line of Arash Soleimani from KBW. Your line is open.
Thanks, and good morning. So I think you said on one of the new quoting systems you’re rolling out, that alone will allow for rates that are 7% to 10% higher. I’m – I just wanted to kind of get your thoughts, how much rate do you think you actually need to get auto within your targets?
Good afternoon. This is Jessica. And I think you’re referring to my comments which were focused on commercial auto and the renewal pricing tool that we put into place at the end of fourth quarter. That is just an indication based upon that tool on larger accounts how much rate we would actually achieve it. We just ran it just by the fact that using the model and associated with proper rate for the risk. So that’s the seven to 10 points.
But you’re exactly right. We will need a combination of additional rate, but most other than that just underwriting changes in claims changes, plus the other benefit that we’ll see, as I mentioned as we have many accounts that are not properly placed and the tier is based on eligibility, based on drivers and MVRs and vehicles, again that said add an additional 15 to 25 points.
We have some leakage in our claims areas with lack of expertise in commercial claims areas. So it is going to be the combination of all of those things that are going to be required to bring us back to profitability. We will need additional rate and we are making additional rate filings to address those needs. This is simply the impact of just the one tool that we’re implementing. But, again, it’s not going to be just the right solution, we’re going to have to and we are addressing issues in underwriting and claims as well.
Thanks. And obviously given, the rate actions that you don’t need to take. I know, you said one of your objective is profitability, but also growth. But with the rate actions that will have to come through, I mean, how should we think of the growth trajectory, I guess, in the near to medium-term? Is it fair to think of it as – go ahead sorry.
Sorry, Arash, this is Mike. It’s the right question. I think the thing that’s interesting and I hope you heard consistently across the comments from all four of us is that, a lot of this is pricing issues across the spectrum of risks. And some of those risks obviously need more rates thus we’re having the loss ratio problem. But there’s also some places where we can be significantly more competitive, because we’re on the other end of that spectrum, where we’ve been charging too much rate.
So we have, obviously, we don’t project our plans, or don’t share those plans and a lot of detail. But we expect this year that we’re going to begin to turn the corner from a – we’ve been decreasing our customers and our premium for sometime now. We believe that 2016 will result in a churn of that and we’ll start either seeing the amount of lost customers decreased rather significantly and in some of our lines of business we will have growth.
So I think it’s – when you look at it at the high level, which is what you will have to do when you look at the rate need, the conclusion immediately is that with that type of rate mean they won’t be able to grow, but there are number of segments where we believe we have a lot of confidence. We believe homeowners is an example of that. But even in our auto lines of business, there are targeted segments that that and some states that we believe we have real opportunity in.
Thanks. That’s helpful. And lastly, what type of adoption do you expect to get on the – or a level of adoption on the telematics offering just since you had mentioned that you expect it to be meaningful?
Yes. I think we’re going to have – that the meaningful probably has two pieces right? I think adoption when you do those things is always, it’s not a slam dunk I think if we get between 15% and 30% of our business – new business selecting that option, I think that would be sort of a good first step on the box.
I think the second, the two other parts that I think are meaningful is inside some of our sort of more agents who work with sort of regional carriers, I think it could be a real differentiator for us. So I think that that would make us more meaningful in the auto. And it’s no sort of news to anybody that sort of the impact on knowing the best drivers and the worst drivers and what you can do from either giving discounts and getting more competitive on the people who deserve it or sort of avoiding folks that you need to avoid can really drive things. But I do think adoption right out of the box, it’s going to be a ramp up for us.
Yes. Now as I mentioned it in the program space that our largest program is working with us in conjunction with what Kim is doing on the personal line side for telematics. And we would based on the requirement of us doing business with the program and the types of tow trucks and companies we work with expect when we get there a little bit high of an adoption, because it will be a requirement and seems to have a higher adoption rate in the commercial line space.
Anyways what that percentage is, to be fair, I don’t know exactly, but I would expect something close to the 50% or higher just based on a requirements.
All right. Thank you very much for the answers.
Your next question comes from the line of Ron Bobman from Capital Returns. Your line is open.
For the transparency and the frankness and to some extent sort of bearing us with the details on your analysis, so it was worthwhile. I had a question, Mike, I think in your prepared remarks you commented that you’ve completed your review. Were you commenting on just personal auto, were you commenting on personal and commercial auto, all lines could you recover that statement please?
Absolutely, I was referring to all lines and you are never done. So maybe I didn’t choose the right word and saying that we completed it. But because good companies and companies like the one we are building, which is focused on as much as possible understanding the data and the analytics and the results. So I’m thrown that out there, it’s just a little clarifier. But my comment to specifically your question was across both auto in commercial and personal and even in our program business. I think, we had a little bit more of a head start in the personal line side.
I’m sorry, go ahead.
I’m sorry, we did it across all of our lines of business. So the very specific answer is it wasn’t just personal, personal commercial and programs. We had a little bit of a head start in personal insurance. So this quarter we’ve got – we caught up a little bit on commercial, but it was meant to cover all of those.
Thanks. Someone else in the team commented about all open claims being reviewed for, in essence, case reserve adequacy. I think that comment related just a personal auto. But basically, I sort of wanted to ask that sort of similar question now that I asked before sort of where all commercial auto claims reviewed for adequacy and adjusted as same fit at Q4 and the same goes for the program line?
Yes, just to be clear when we talked about the claims looking at the auto files, both personal and commercial. From a program standpoint, it’s a little different situation, because with our program business depending on which program it is and specifically to the two auto programs the work that’s being done there is not complete yet in terms of all of the claims. But we’ve been focusing there on rate adequacy and some of the process in terms of risk approvals there. But the claims review to your question was both personal auto and commercial auto.
Okay, thanks. So as it relates to the largest program, which your colleague sort of described about sort of ongoing work some of it’s going to be completed by the end of March this calendar year. I mean candidly, my question is sort of how much uncertainty are we faced with respect to reserves backing that book of business?
So let me start and then, if Matt wants to see – wants anything on the reserve side. We’ve had a relationship with MTU for quite a long time, a very good relationship with them. And we are collecting substantial additional data points that we’re going to be able to use similar to our standard commercial lines auto side and better price segmentation and risk selection. They have actually been collecting the data, but we are putting it in more of our warehouse multivariate model which hasn’t been used in rating previously. So I’m very optimistic that that is going to have a very good effect on our loss ratio.
That being said, we have put time parameters to reevaluation and making sure that we’re starting to see that improvement. The other thing that we’ve done just sort of give us a little bit of a cushion and I mentioned in my comment, as we’ve gotten them to agreed to a reduction in commission starting March 1, which is not insignificant and that will give us some relief until we’re able to actually get the loss ratio back where we want to.
In terms of reserves, I’ll make the comment that we have obviously been strengthening those reserves over the last couple of quarters. On that book, however, I would say ask there [ph] so much our own commercial auto book. So there would be nothing unique just because it’s a program, I don’t believe that would make us or make it more volatile than just standard lines commercial in general.
Just two additional comments from me. It’s – one is that just to make it clear how focused we are. And Jess and I are actually going down and meeting face-to-face with the program administrators, because I want us to both have eyes on them and discuss these issues.
The second thing is what Jess said it is an auto program. It’s a wheels program. And it’s kind of a perverse way to think about it, but most of our problems happen to be on all auto-related risks. And I guess if you’re looking for silver lining, I happened to be an optimist that’s going to be troubling at times. But the optimistic view of that, of course, is that these are lines of business that are – have a more direct relationship between the actions you take and those things getting fixed. The tails tend to be a little shorter and then a lot of other lines. And our program business, as Jess mentioned, is an auto program.
So one of the reasons that we’re more confident about the future is that one, we understand auto really well and may not look it in our results. But two, the tails on those are ones that we can manage.
Okay, I’m sorry. Thanks for your patience and your answers. And one more question, I think in the prepared press release, there’s sort of a quote from you Mike about, we have all the readership people in place ready to tackle these problems basically and move the organization and improve results something to that effect. And I just want to make sure about the next level of execution sort of operating management, your colleague mentioned sort of deficiencies in commercial auto claims expertise, I think was an element to the challenges in the past. At the lower level of management, do you have the staff and the expertise to execute this plan?
Yes, I believe so. We’ll never – we’re always going to challenge ourselves and that truly means ourselves and all of our leadership, and all of our associates in this new cultural building to generate skills like being more nimble and responsive and creative and all that. But I believe the changes that when I talk – I did talk specifically about the senior leadership team, which I’m very proud of, I believe in with 100% confidence. And I think what they have done though is, they’ve done the same thing.
So I didn’t say that in my quote. But what we’ve done is, as those folks have come on Board, they’ve gone through their organizations and chosen their leadership positions as well. So I have a great deal of confidence at the next level down as well.
Thanks, again. Best of luck.
Thank you so much.
Your next question comes from the line of Paul Newsome from Sandler O’Neill. Your line is open.
Good morning. And I want to reiterate as well that the candor is refreshing my confidence that things are improving goes up when I hear that sort of candor, I think, that let alone. So I just want to ask a specific question on the product pricing by product. And you mentioned in there that each product is now now going to be required to make an underwriting profit. How much of a change is that from the past, where you largely underwriting on a sort of account basis or an agent basis prior to this and just, I guess, from there obviously looking to see how profound that issue is?
Yes. It’s a little bit difficult for me to answer. Obviously, I’ve asked a lot of questions about our approach. I’m not suggesting that the folks prior had done things like subsidized products or knowingly wrote products that are loss. I think there was a broader view to roll things up at a personal lines level or commercial lines level, and look at it at a higher level. I think the focus was more at that rolled off level and managed a little bit more at that level. Again, I want to be careful here that I wasn’t here so it’s unfair for me. I’m not being critical, I’m just giving you my observation.
So I think it’s a significant move not as much as a departure from there, but the level of focus we are bringing to saying auto insurance needs to hit a 96. The homeowners needs a hit a 92. Jess in her specialty lines business, this is how she has been running it. She had an E&S leader of causality and a property in a program leaders and workers’ comp leader.
So from a specialty standpoint, it’s not as much a departure, but she is bringing that same type of kind of many apple focus that says each line of business have to stand on her own. And in the middle market space when you’re writing account business, it’s very easy for an underwriter to say, the total accounts $7000, so I know the model says to write the auto at a 1,000, but let’s write it at a 800 or 600, because I can roll it all together.
That is a fools game and it never plays out over time. And while you have to be thoughtful about that and you have to explain a little bit more, but that on the middle market space is an example. But even in the, like I say in the personal lines we didn’t really focus on a kind of a byline management of that and that that change, I believe, it will be significant, again, this is, we have a lot of proven to duty all. But Kim?
I think the biggest organizational change you’re seeing from us is historically product managers manage the state and then manage the auto and homeowners. And everybody now has an exclusive responsibility for managing a single product. So there’s nobody who has responsibility for both auto and homeowners, I guess, except for me. But everything is sort of byproduct line. And when you use sort of organize your thinking, your management information, all of that, at least, our belief is, if there are issues, they sort of float more float to the surface or you find them more quickly and then you can react to them.
Yes. And the last thing I will add, as I think the other thing that we gained here is that product management used to be just about what’s the right rate. So how much rate do we need to fix the problem and now product management is about taking all the inputs, how can we be better underwriters? What can we do in claims? What can we do in products? And it’s all aligned under the product manager whereas before it all reported into different people and that that unity approach to the product was not something we focused on.
Great. Thank you.
Your next question comes from the line of Larry Greenberg of Janney. Your line is open.
Hi, and good morning. So looking at the personal auto line, there’s obviously been a pretty large degree of variability in the X cat loss ratio on a quarterly basis throughout the year. And clearly, it looks like most of the reserve strengthening that took place for the year, took place in the fourth quarter. If we looked at the full-year ex-cat loss ratio and adjusted for the adverse reserve development, I mean, does that give us a decent representation about where the profitability of the line is right now?
So, walk me through again the two adjustments you wanted to make? One was for reserve development and the other is look at it for the whole year?
No, I mean, just – so the year came in, I think, 69.7, the ex-cat loss ratio. And it looks like there were 3.2 points of overall adverse development. So if I adjust it for those three points get it to 66.5 or so ex-cat loss ratio. So I’m asking is that a kind of a reasonable starting place thinking about that line for the year?
Yes, I have to like double check the math and make sure. But I think the answer is, yes, right? I think that’s fair. The thing that we – what we are thinking about it as, but there’s nothing in here that says, hey, we think we’re adequate and more in good shape if you take, you adjust for all those moving pieces.
And really the three big pieces or levers that we’re going to try and pull. One is sort of the operations we think we’re spending money or paying out money, we shouldn’t be paying out if we tighten those up. I think that closes some of the gap. We talked about some pricing segmentation changes especially on the sort of bodily injury higher limits business.
So every – I talked about all the filings and reviews that we’re doing. Everyone of those has an increase in the higher limits factors. We’ll close some of the gap there. And then even on top of that we have the inadequate base rates that we have to sort of address. So I think if you make your adjustments, you’re probably on the right ballpark of the gap and those are the three levers we’re going to pull to close that gap, if that’s where you were looking for.
Great, thanks. And then, Jessica, I probably missed this in your prepared remarks. But it looks like the other products and liability line in commercial had a pretty large uptick in the loss ratio in the quarter. And it appears that reserve development wasn’t the issue there, or at least there wasn’t the issue for the full-year, I’m not sure exactly what the fourth quarter number was, but what’s going on in that line?
Okay. So two things. One is – that account is impacted by runoff book on large account solutions.
So that’s the one thing that we were seeing. And low prior year development also would be the two part of the two largest factors.
So there was more favorable development in earlier quarters compared to the fourth quarter?
Okay. Was there reserve strengthening in the large account segment of that business?
Yes. There was.
Okay, thanks. I guess maybe a final question. So you did have some unusual items in the expense ratio. Is it possible to give us an idea of how you would characterize the underlying expense ratio moving forward?
Yes, Larry, this is Steve. So as I mentioned in the – in my prepared remarks in the fourth quarter, we had the charge go through and the – but in conjunction with that we revised downward our agent and employee associate incentive compensation. I would say – I would think about the expense ratio for 2016 as being slightly higher than what you see in the 2015 number.
The reason for that is, we still are experiencing – are still recording some profit commission from the quota share treaty that’s running through those numbers. So I can tell you for the year that was about $4.2 million good guy going through there. And that’s being driven by the fact that the homeowners book from those action appears to continue to split out some favorable development given the property nature of that, that’s going to dry up. So, it will be a tick higher for that reason only, but for that adjustment in that range should be a pretty good proxy for 2016.
Okay. Thank you.
[Operator Instructions] Your next question comes from the line of Gary Ransom from Dowling and Partners. Your line is open.
Hi. I wanted to ask about the agent reaction to all the changes that has been going on at the company. It sounded like you alluded to some better productions or some of them are, at least, buying in. I just wondered if you could give us a little more color on the array and reaction you’re seeing from the agents, of course?
Hey, Gary, this is Mike. It’s interesting. I think on balance, it’s really favorable, and I’ll give you both sides of that in a minute. I think on the concern side is, anytime there’s change and we’ve reduced staff, so maybe an underwriter that they like is no longer there or maybe their salesperson that’s calling on them is no longer there or maybe he was an executive who they had a personal relationship.
So I think change creates certainly some stress and there has been that type of feedback in terms of concerns. The reason I’m very confident that on balance it’s more favorable is a lot of the things we have done have been about eliminating unnecessary kind of bureaucratic stuff that they had to put up with.
So forms they had to fill out or processes they had to complete or maybe an approval process involve two or three people when only needed to be involve one person. So I think those types of changes and we’ve made a bunch of them, most of which by the way were generated ideas from our associates is one leadership ideas is our team of people step to speak up and saying, while in a heck we’re doing this and we just stopped doing it quite frankly. So I think the agents have reacted favorably to that.
The second thing is that we are being as candid and transparent with them as we’re being with you all, and they have reacted very favorably. They really appreciate good news or bad news. They can take it, they just want to know what the hell is going on, and they want us to be clear about that, and I think that clarity has been positive.
And then the third piece is just the emphasizing to them that we want to profitably grow. It’s been a tough four to five years for our agents. We’ve been decreasing our volumes a lot of that by design we had to, and but we had rate increases, we got out of some cat prone areas. We terminated some agencies. So they’ve gone through this extended period of having the kind of pare back with State Auto.
We’re now coming out with a message of look, there’s still going to be rate changes. There’s still going to be some corrections in there. But we not only want to be profitable, we want to grow, and we want to be a player in the property and casualty marketplace. And I think you take that along with the other things we’ve done and on balance the feedback has been favorable.
If you think about growth over the longer-term, do you think that’s coming from better penetration of your existing agents, or is there some potential for agents growth as well?
Both. I think that there’s so much growth opportunity. It’s – I don’t even know where to begin. I mean, we’re right now we’re a very small player and I love our size, because we have the opportunity to being more nimble and responsive and so on and so forth to be a real player in this marketplace. If we can take on those characteristics that I talked about in my opening comments.
But if you look where we are at, I think that there’s a huge amount of opportunity with the agents that we have today. We have very few that have a significant amount of dollars with us, there’s upside there. There’s geographic upside. There are a bunch of states, where quite frankly all of our states where we could grow in, so there’s geographic opportunity.
We’ve already appointed, I think, 22 new agents through less than eight weeks of this year, which is a big move forward. We’re not going to be a massive agents appointee. But there are opportunities in some geographic areas where we don’t have agent penetration. So there’s that opportunity. So, it’s very exciting to me, if I can just kind of great to get this question, because I can take a breath from all the lousy results. But I get very excited about our longer-term opportunities.
I would look at sort of – we put new technology in farm and ranch and production really jumped up with that. And I would look at that as maybe you can – nearing the coal mine. I mean, we’ve lived with this cycle a lot. You give people sort of better, easier, front-end tools, they give you more stuff. And that’s sort of one of the reasons we’re excited, the same agency plan just sort of gave us a lot more stuff. And so we believe there’s more to get once they get better tools later in the year.
Well, thank you for all that color.
And there are no further questions at this time.
Thank you, Ron. Thanks for your questions. We want to thank you for all your participation 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 first quarter earnings call, which is currently scheduled for Thursday April 28, 2016. Thank you, and have a good day.
Thank you. That concludes today’s fourth quarter 2015 earnings conference call. Thank you for participating. You may disconnect at this time.
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