Kemper's (KMPR) CEO Joe Lacher on Q4 2016 Results - Earnings Call Transcript

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Kemper Corporation (NYSE:KMPR) Q4 2016 Results Earnings Conference Call February 10, 2016 11:00 AM ET

Executives

Diana Hickert-Hill - VP, IR and Corporate Identity

Joe Lacher - President and CEO

Jim McKinney - SVP and CFO

Analysts

Paul Newsom - Sandler O'Neill

Amit Kumar - Macquarie Capital

Operator

Good morning, ladies and gentlemen, and welcome to Kemper's Fourth Quarter 2016 Earnings Conference Call. My name is Austin and I will be your coordinator today. At this time, all participants are in listen-only mode. Later we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, the conference is being recorded for replay purposes.

I would now like to introduce your host for today's conference, Ms. Diana Hickert-Hill, Kemper's Vice President, Investor Relations and Corporate Identity. Ms. Hickert-Hill, you may begin.

Diana Hickert-Hill

Thank you, operator. Good morning everyone, and thank you for joining us. This morning, you will hear from two of our business executives, starting with Joe Lacher, Kemper's President and Chief Executive Officer, followed by Jim McKinney, Kemper's Senior Vice President and Chief Financial Officer.

We will make a few opening remarks to provide context around our fourth quarter and full year results. We will then open up the call for a question-and-answer session. During the interactive portion of the call, our presenters will be joined by John Boschelli, Kemper's Senior Vice President and Chief Investment Officer; and Mark Green Kemper's Life & Health Division President.

After the markets closed yesterday, we issued our press release and financial supplement. You can find these documents on the Investors section of our website, kemper.com.

Please note that our discussion today may contain forward-looking statements. Our actual results may differ materially from these statements. For information on potential risks associated with relying on forward-looking statements, please refer to our Form 10-K and 10-Q reports filed with the SEC as well as our earnings release. We plan to file our 2016 Form 10-K with the SEC on or about February 13th.

This morning's discussion includes non-GAAP financial measures that we believe maybe meaningful to investors. In our earnings release and supplement, we defined and reconciled non-GAAP financial measures to GAAP, where required in accordance with SEC rules. And finally, all comparative references will be to the fourth quarter of 2015, unless we state otherwise.

Now, I will turn the call over to Joe.

Joe Lacher

Thanks Diana. Good morning everyone and thank you for joining today's call. First a quick thought. Chip Dufala is usually with us for these calls. He unfortunately got a bit of a -- case of the stomach food flu yesterday afternoon, so he's home and on the call with us. So, we wish him well and unfortunately you are going to have to listen to me do Chip's part of the commentary as we go through our introductory comments.

Just a side note the increased cost of PURELL for the floor will not be an impact on our expenses.

Before we walk through our results for the quarter and year, I want to step back and share a couple of quick thoughts. My sense is that you join these calls looking to evaluate our recent performance and to better project future performance.

While some quarters that's relatively straightforward task, this quarter's results will require a little more work from you and from us to help you accomplish those goals. It's important to remember that we're on a multi-year journey to rebuild our franchise. I'm encouraged by the progress to-date, but we've got more work to do.

We delivered strong improvement this quarter and we're pleased with our progress in our business transformation. That said, our underlying results are not quite as strong as the headline numbers may suggest and it would produce an accurate conclusion to take the fourth quarter numbers and just add on project improvements to model future earnings.

So, we're going to do a few things today. We're going to review this quarter's results. We're going to provide some insight into where these results are recurring and where and why you might make adjustments to estimate future performance. In addition we're going to update you on our progress on key initiatives.

With that, let's jump in. Net income for the quarter increased $27 million to $31 million and net operating income increased $24 million to $29 million. For the year, full year net income was $17 million compared $86 million last year and net operating income was $12 million compared to $70 million last year.

As I said before, we're pleased with the fourth quarter results. I want to make a few high-level observations that may be helpful as you think about future performance. Alliance United net income improved substantially. Last year we identified this business' results as a major problem and committed to a multipronged overhaul. We're succeeding on these initiatives and remain on track with our expectations.

That said the fourth quarter benefited from a couple of non-recurring items. First, we saw some favorable current year development related to reevaluation of the first through third quarter performance. This made the fourth quarter results look a little better than underlying.

Second, as most of you are aware, our P&C business has some seasonal variance and loss frequencies. Historically, the fourth quarter experiences an increased level of losses. In this period, AU experienced an abnormally low seasonality impact. This suggests underlying results were somewhat better than we would expect going forward. I'll go into some greater detail on both of these items in a few minutes.

Our preferred auto line is experiencing the same adverse loss trends you've heard discussed across the industry. We were a bit late to recognize these trends and as a result, we had some unfavorable calendar year development this quarter. We see it now and we're responding appropriately. But that said we do expect at least a couple more quarters with this lines loss ratio will be pressured.

I'll now update you on a few key items from our September Strategy Session. We're making good progress on our expense reductions. We're committed to the targeted reductions we outlined. While we achieved our 2016 run rate goal, we know we'll need to invest a bit in 2017 to achieve our year end run rate target so we can expect some modest expense increases in the near-term before we achieve the anticipated reductions by the end of the year.

On the loss and LAE front, we stated that we're going to take out at least $85 million of P&C loss cost on a run rate by the year end 2018. We're on-track to achieve this, but I want to be clear that these reductions will come in a lumpy fashion. They will not be recognized in a straight line.

On investments we had another good quarter as we remain nimble in this challenging environment, while adhering to our investment principles. And we continue to make good progress strengthening our leadership team. We've added some key new members at the next level of our organization. It seems fully engaged becoming a more cohesive unit and is committed to driving the execution of our strategy.

This is a good time to shift to our Property & Casualty results. I mentioned how pleased -- excuse me, I want to mention how pleased we are that Naimish Patel joined our team recently to head up the Kemper Preferred business. Naimish brings a wealth of insurance experience. We look forward to his leadership as we focus our efforts on delivering tailored solutions to the important Preferred home and auto market.

In terms of our strategic initiatives, Naimish's arrival has allowed acceleration and separation of our Preferred and non-standard businesses, so that each can receive the focus it deserves. We continue working to build our capabilities for product and pricing sophistication, modernizing our platforms, and improving our claims effectiveness.

I will now walk through each of our major P&C lines of business, starting with non-standard auto. Since we purchase Alliance United in mid-2015, year-over-year comparisons blur the results and its performance in some cases was different from our legacy lines, so I'll walk through each individually.

In Alliance United, we took aggressive rate and other underwriting actions in 2016 and as a result, our average earned premiums grew, our underwriting margin improved. In addition, we filed for and received approval for another 6.9% rate increase on our gold product, which represents about half our book.

We expect to implement this increase in the first quarter of 2017 and expect to see continued improvement in our underwriting margin. We're in the process of designing and filing a new consolidated class plan for Alliance United. This will slow the pace of new filed rate increases until this plan is approved, which will be late 2017 at the earliest.

As we discussed during previous calls, we made an intense focus on increasing our claim staffing and reducing pending claims inventories. We continue to make progress in this area and the inventory declined in the quarter. We expected to take several more quarters to get to a normal level.

For the quarter, Alliance United reported net income of $2 million compared to a loss of $16 million. The quarterly underlying loss ratio improved 13 points to 87.6%, but both periods included the impacts of current year development from the first three quarters of the year.

Excluding this current year development, the underlying loss ratio improved four points in the quarter to 90.7%. The fourth quarter loss ratio was also down sequentially from the third quarter. This is unusual as Alliance United traditionally experiences its highest loss ratio in the fourth quarter of the year.

While we're pleased to see the underlying loss and LAE ratios improving, some abnormal seasonality appears to have accrued to our benefit in the quarter. Factoring in all of these items, I would view the fourth quarter normalized run rate to be several points higher than the 90.7% we experienced.

Our legacy non-standard auto business has been underperforming in recent years. Over the course of 2016, we aggressively applied corrective measures to this line through significant rate increases, focused underwriting actions, and agency management. We are now seeing positive results from these initiatives with year-over-year improvement in underlying profitability in each of the last four quarters.

The underlying loss ratio improved six points for the quarter to 74.6% and five points for the year to 75.9%. In addition to these profit improvements, net written premiums grew 3% in the quarter and 2% for the year.

We've achieved much of the needed profitability improvements. As we refocus and dedicate resources around our non-standard auto business, we will continue our profit improvement initiatives while expanding a long-term focus to policy growth.

I'll now turn to address our preferred lines and we'll start with preferred auto. We finished the quarter with a $6 million net operating loss compared to $1 million of net operating income last year, primarily from the impact of both prior year and current year reserve development.

Excluding current year development, our underlying loss ratio in the quarter was roughly flat. For the year, preferred auto reported a $4 million net operating loss, down $29 million, driven primarily by the impact of prior year development and a higher level of catastrophes.

The underlying loss ratio increased about 1.5 points to 72.6% as loss cost inflation outpaced our rate and underwriting actions.

On the topline, new business and policy retention both rose in the quarter and in the year. However, due to the smaller renewal base, net written premiums were flat in the quarter at $103 million and were down 2% to $426 million for the year.

Finally, on home owners, we earned $7 million in the quarter down slightly from last year. Accident quarter, catastrophe losses were light, but results were impacted by adverse development on the two hailstorms in North Texas that occurred in the first half of the year.

For the year net income was $3 million, down $18 million, primarily due to those two hailstorms, partially offset by higher favorable prior year reserve development in 2016.

From a topline standpoint in 2016, similar preferred auto, net written premiums on our home owner's book were down from a smaller renewal base, but both new business and policy retention were up for the year. We will continue to push forward on our initiatives to improve the business performance of all lines of business in Property & Casualty.

Now, I'll talk -- briefly talk about our Life & Health business. We earned $23 million in the quarter, up $5 million benefiting from lower legal expenses. For the year, we earned $30 million, down from $72 million from a year ago with the decline mainly driven by the $51 million after-tax charge we took in the third quarter of 2016 as we implemented new voluntary outreach efforts using databases such as the Social Security Death Master File to reduce legal expenses helped offset this charge.

We're encouraged to see the earned premiums stabilize and we'll continue our efforts on this front. Overall, we continue to focus on operational efficiency and getting the most out of our distribution channels across this division.

Overall, again, I'll say, remember we're on a multi-year journey to rebuild our franchise. I'm encouraged by the progress to-date and we have more work to do.

With that I'll turn the call over to Jim to wrap-up our comments on the quarter.

Jim McKinney

Thanks Joe. Starting with investments, we had another good quarter in terms of net investment income in the pretax equivalent annualized book yield achieved. Net investment income of $80 million was essentially flat for the quarter as the larger investment base was mostly offset by lower rate.

During the quarter, alternative investment income was $11 million for the quarter. This was slightly above our quarter end run rate expectations. For the year, net investment income was down $4 million, as $9 million of lower investment income on alternative investments was partly offset by $5 million of higher investment income on the rest of the portfolio as we benefited from a larger asset base.

In total, the investment portfolio generated a pretax equivalent annualized book yield of 5.4% for the fourth quarter of 2016 and 5.1% for the year. It's important to note that despite the rise in interest rates, overall investment yields remain compressed. Maturing yields generally are above new money rates creating a slight headwind in the upcoming quarters.

Total return for the quarter was negative as the impact of higher yields on our fixed maturities more than offset net investment income. For the year, total return was positive, driven by net investment income.

Moving the corporate and other, results improve $7 million in the quarter and $14 million for the year. The quarter is driven by lower pension expense and higher net investment income and the year is driven by lower pension expense.

Turning to liquidity, the parent company continues to maintain ample liquidity. The company held cash and investments of approximately $300 million. In addition the company's $225 million revolver remained undrawn and available at year end.

From a capital perspective, we ended the year with more than $200 million of excess capital. The statutory surplus levels in our insurance companies remains strong. We estimate that we ended the year with risk-based capital ratios of approximately 395% for our Life & Health Group and 325% for our Legacy, Property & Casualty Group.

Looking to debt, our 6% $360 million senior notes mature May 15th. We're planning to refinance $250 million or more prior to maturity. The balance will be repaid using the company's cash reserves.

To reduce our interest rate risk in the fourth quarter, we entered into a $250 million 10-year treasury interest rate hedge. The year-end fair value of this financial instrument was $1.6 million. This fair value change is included in cumulated other comprehensive income.

Last, book value per share excluding unrealized gains on fixed maturities was $35. This was an increase of $0.73 from the third quarter. On a year-over-year basis, book value per share excluding unrealized gains on fixed maturities was essentially flat.

With that, we're pleased to turn the call over to the operator to take your questions. Operator?

Question-and-Answer Session

Operator

We will now begin the question-and-answer session. [Operator Instructions]

And our first question comes from Paul Newsom with Sandler O'Neill. Please go ahead.

Paul Newsom

Good morning. I was wondering if you could talk a little bit about the form of the problem in the preferred business because -- well, everyone seems to have a problem, it seems to be a little bit different between companies whether it's primarily a frequency issue or also and/or also a severity issue.

Joe Lacher

Great question Paul and thank you. What we've got is a little bit of both. It's -- the primary issue here was we were late in spotting the trend. I would tell you that the biggest chunk of it is probably for us in the frequency side of the house, which is part of the reason that we missed it.

We had a reasonable significant -- reasonably significant shift in frequency inside of our book of business. We were consciously moving away from some parts of the higher frequency piece the book that we're underperforming. And that mixed change just as you'd logically expected, some less high-frequency stuff and more low frequency stuff that causes the overall books to look like the frequencies tempering.

That tempering masked some of the increased frequency that we were -- we're seeing overall. So, that's the big driver of it. We saw some severity earlier in the year and we were responding to that. Our issue now is because of the frequency miss. That make sense?

Paul Newsom

Yes, that makes perfect sense. So, and I assume it's essentially a rate fix at the end?

Joe Lacher

Largely it will be a rate fix. What I tell you is this is a case where again trying to figure out how to think about this on a marching forward basis. There was some unfavorable inter-year development in this preferred line. So, the current quarter because it was inter-year or current year development, isn't quite as bad on a real run rate basis as it looks, but there's an issue there and that issue will percolate its way into the next two quarters and may actually go up a hair from that adjusted basis before it goes down.

So, this may be a reasonable number to think about when you project forward because it -- because we relates, it take is a little while to get the rate moving and have an earn-in. so, it will be a quarter or two.

Paul Newsom

Okay. That makes sense. Thank you.

Joe Lacher

Okay. Thanks Paul.

Operator

[Operator Instructions]

Our next question is from Amit Kumar with Macquarie. Please go ahead.

Amit Kumar

Thanks and good morning. Just a few questions. First of all, just going back to the discussion on the loss cost trends, was that on the BI side are on the PD side?

Joe Lacher

Great question. Thank you. It was pressure in collision [ph] and BI. The mixed changes are really what muted in the BI side of the house. So, both were running through there. The part where we missed is probably driving the biggest issue on this is BI.

Amit Kumar

Got it. That's helpful. And I guess related to that is -- and I know you've previously discussed this regarding the pricing. How should we think about, I guess, the level of price increases you need from here versus the lost cause? And what sort of impact it will have on your book going forward in terms of topline?

Joe Lacher

Yes, this one is going to be a complicated one Amit for us to be able to talk about and for us to help you model going forward because a couple of things are happening. We clearly are at least several points away from target profitability in a number of the P&C lines.

We've identified a series of improvements for you that we're driving on expenses and P&C loss cost and LAE. We expect the economic equivalent of that $60 million to $65 million of pretax expense and the $85 million of pretax loss together a $90 million after-tax benefit. We expect that to accrue to the bottom-line and anything else we're doing will adjust around making ourselves appropriately competitive in the marketplace.

So, from a practical perspective, we're going to increase rates to get us to where we think we ought to be in the right -- at the right time. At the same time, we're doing those things, so we're going to be operating all the levers. While we're not trying to give you earnings guidance, we're trying to tell you that the net effect of what we're doing on rate and underwriting and the loss and LAE and the expense should put us in the zone of being near that target profitability and that's the net of all those items you should expect to see.

Amit Kumar

Got it.

Joe Lacher

That's not exactly what you asked, but I think it's what you were looking for.

Amit Kumar

Yes, directionally it helps. Just related to that would be can you remind us how much of your book is six months versus 12 months?

Joe Lacher

That varies by line. Our AU book has a variety of policy terms that that three quarters of the a two-thirds to three quarters, we might have to back to you on this precisely, but I think two-thirds to three quarters of it is six months or less in AU.

Our split in our legacy non-standard is -- our legacy non-standard ex-California is 90% six-month. We've got a little longer duration in our California non-standard. The bulk of our preferred is 12 months.

Amit Kumar

Got it.

Joe Lacher

And then the home owners is obviously all 12-month.

Amit Kumar

Thank you.

Joe Lacher

I love to have a crisper answer for you. What we've got is a quilt of a series of businesses here that operated differently and each one of them was working a little differently in the market.

Amit Kumar

That's -- maybe a suggestion might be to add some commentary in the 10-K. That would be very helpful if that makes it easier for you. The final question I have is on the capital situation. I know that previously you've talked about pulling back on repurchase since you want to fix this issue first and you mentioned a $200 million number. I'm curious has any thought process changed on capital management? Or is that on the backburner?

Joe Lacher

No, thanks. Great question. Right now my focus in terms of our capital management strategies are aligned with kind of resetting the debt story associated with our upcoming maturity. And I'm focused centrally on ensuring that people understand the story, understand the risk aligned with the business.

Once we get to that event, we'll continue to look for opportunistic ways to deploy capital in the most efficient way for our shareholders. And when we get to that point and we understand what the opportunities are, then we'll have further thoughts on it.

Amit Kumar

Got it. I'll stop here. Thanks for the answers and good luck for the future.

Operator

This concludes our question-and-answer session. I would like to turn the conference back over to Joe Lacher for any closing remarks.

Joe Lacher

Thank you, operator. I'm pleased that we're starting to get some traction on several fronts in our quest to deliver profitability improvement. Our Life & Health segment delivered solid performance. We're encouraged to see some positive trends from our ongoing actions in Alliance United. We're seeing tangible progress in our legacy non-standard auto line and we're taking some clearly needed actions within the preferred lines.

We're focused on taking the right steps we need to deliver the improvement we outlined in our strategic update last fall. We appreciate your time today and your interest in Kemper and we look forward to future updates. Thanks a lot.

Operator

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.

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