Donegal Group Inc. (DGICB) Q2 2012 Earnings Report, Transcript and Summary

Good morning. My name is Tanisha, and I will be your conference operator today. At this time, I would like to welcome everyone to the Q2 2012 Earnings Conference Call. [Operator Instructions] Mr. Jeff Miller, you may begin your conference.

Thank you. Good morning, and welcome to the Donegal Group conference call for the second quarter ended June 30, 2012. I am Jeff Miller, Chief Financial Officer, and I will begin today's call with commentary on the quarterly financial results. Don Nikolaus, President and Chief Executive Officer, will then provide additional comments on the quarter and give a business update. Before I begin with my prepared remarks, please note that certain statements made in our news release and in this conference call are forward-looking in nature and involve a number of risks and uncertainties. Please refer to our news release for more information about forward-looking statements. Further information on risk factors that could cause actual results to differ materially from those projected in the forward-looking statements is available in the report on Form 10-K that we submit to the SEC. You can find a copy of our 2011 Form 10-K in the Investors section of our website under the SEC filings link. Further, reconciliation of non-GAAP information as required by SEC Regulation G was provided in our news release, which is also available in the Investors section of our website. Turning to the quarterly results, we are pleased with the significant improvement we saw in the second quarter, even though our -- the results did not meet all of our objectives. Net income of $2 million reflected a modest underwriting loss offset by investment income and realized gains. Operating income was $1 million for the quarter, compared to an operating loss of $4.5 million for the second quarter of 2011. Let me begin with the 3 primary drivers of the second quarter underwriting loss. First, we had above average weather losses in our operating regions of $11.3 million, including $3 million from the widely discussed derecho storms that swept across at least 13 states at the very end of June. These storms had damaging straight line winds that knocked down trees and caused widespread power outages, leading to thousands of policy holder losses for Midwest and Mid-Atlantic insurers. Our losses from the derecho storms were primarily related to homeowners claims from the states of Virginia and Ohio. Despite this catastrophe event, the impact of weather to our quarterly results was less severe than the tornado wind and hail storms that we experienced in the second quarter of 2011. However, the current quarter impact exceeded the average for the second quarters in the prior 4 years, 2007 to 2010. Second, we incurred nearly $7 million in large fire losses during the second quarter, much higher than the $2.4 million in the prior year quarter. Our claims management team always carefully analyzes these larger claims and again, this quarter they did not find any unusual trends or commonality among the losses, nor did they find that the losses related to any risk specific underwriting concerns. As we have said in the past, the level of fire losses we incurred tends to fluctuate from quarter-to-quarter and year-to-year. The $7 million which accounted for 5.9 points on the loss ratio for this quarter, was below the quarterly high of the past 2 years, but exceeded the average of approximately $5.5 million for the same 8 quarters. And third, we recorded development of $2.3 million compared to $1.5 million of favorable loss reserve development in the second quarter 2011. The change in development between quarters was primarily in the 2011 accident year and split evenly between our workers' compensations and personal auto liability lines of business. While the development remains modest in relation to our overall reserves, there are a few underlying factors to consider. A portion of the auto liability development occurred in one of our subsidiaries as a result of the settlement of large bodily injury claims that exceeded previously reserved amounts. The workers' compensation development and the remainder of the auto liability development primarily reflected conservative actuarial treatment on slightly accelerated payment patters for the 2011, an accident year. We will continue to monitor payment activity going forward, and we do not expect material further developments in these lines. From a loss trend standpoint, although we continue to see slight upticks in severity in workers' compensation and auto liability, similar to the past few years, we have noticed measurable decreases in frequency in those lines of business in 2012. For personal auto, we believe that reduced frequency of losses and the expected positive impact of rate increases will lead to improvement in that loss ratio as the year progresses. Our workers' compensation line of business continues to perform well overall, with the combined ratio at 89.8% for the quarter, in spite of the development. Despite the challenges presented by the weather in what we believe to be short-term increases in selected loss patterns, the ongoing implementation of our strategic plan produced another quarter of significant premium growth. Rate increases, commercial lines in new business initiatives and a reinsurance change by our Michigan subsidiary drove written premiums up 11.2%, and earned premiums up 12%. With written premium growth rates remaining high, we believe we have reason for optimism that our future underwriting profitability will return to our targeted levels as those premiums are earned over future quarters. As usual, Don will give more color on our new and renewal business activity and rate increases as part of his comments, but I'll briefly discuss the 3 major drivers of the premium growth. First, as we discussed last quarter, we reduced our Michigan Insurance subsidiaries external reinsurance percentage for 2012 to retain a larger portion of their writings. For the quarter, that reinsurance change added $2.6 million to our net written premium. Second, we continue to grow our commercial lines through new business writings, but an increasing portion our commercial lines growth reflects premium increases. Although they vary by product and geography, these premium increases range from low single digits to low double digits, and indicates to us that the overall rate environment is gradually improving. The premium growth contributed to the healthy combined ratio of 95.1% for commercial lines for the second quarter of 2012 and 92% for the first half of the year. And third, for personal lines, our growth, excluding the quarter share change in Michigan, came primarily from rate increases and reduced reinsurance reinstatement premiums compared to the prior year quarter. We have virtually no net exposure change in personal lines across our operating companies. As we have been saying for some time, we expect to continue to benefit from personal lines rate increases throughout the remainder of 2012. And we will continue to raise rates as needed to achieve our target of underwriting profitability for this business segment. Our expense ratio has remained fairly constant, as underwriting-based incentive costs did not increase materially during the quarter. We continue to manage cost and are working to achieve additional efficiencies throughout our organization. Turning to investments, we reported a decrease in investment income of $502,000 or 9.3% for the quarter, as a result of declining yields in our portfolio due to the continuing low interest rate environment. We repurchased 45,764 Class A shares at an average cost of $14.90 during the quarter, and our book value per share increased $15.36 on June 30, 2012, up from $15.01 at year-end. At this point, I'll turn the call over to Don for his comments on the quarter. Don?

Thank you, Jeff. Good morning, everyone, and thank you for joining our second quarter earnings call. Jeff has given you a nice overview of a summary of the second quarter, and what I'll do is, do a number of things including talking about business trends, rate increases, how we view the overall environment and some additional items. What I would like to start off with is to emphasize some of the factors that Jeff has referred to. And one of the things that we have sort of pondered as we have viewed the second quarter and year-to-date earnings is the fact that 2012, although nowhere near where we would like it to be and would plan for it to be, there is significantly a better tone to things and certainly, the trend in terms of overall losses, weather patterns, although not good, is much better than it would have been in 2011. Jeff has, of course, told you about the growth in net premiums written of 11.2% in the second quarter, and certainly about 12% in net earned premium. I'll talk a little bit about how that has been accomplished and why we believe that going forward, that has positive aspect associated with it. We also reported that the commercial combined ratio for the quarter was 95% approximately in the 6 months, it's 92% and later on, I'll be talking about what we are doing in commercial lines and we would want you to tie together that combined ratio which is quite favorable in commercial lines, and our strategic direction to increase commercial underwriting written premium as an overall percentage of our book of business. From an earnings standpoint, if you look at the 6-month period, we basically have earnings, although not where we want them to be, a little over $10 million versus $512,000 for the prior year. We have discussed weather and as you know, we don't want to turn earnings calls into weather reports, where the weather is the only factor that has to do with results. It certainly has been a major issue in much of 2010 and 2011, and we certainly cannot ignore it, but what we do need to do and we think that we are implementing strategies to do that, is to improve how we insulate ourselves to the extent possible, from the impact and effects of weather as they may occur going forward. In terms of our strategic plan as it relates to commercial lines, as we have indicated previously in our various acquisitions and you'd know, we have acquired a number of companies over the last 5 to 7 years, many of those companies have been focused in personal lines, and it gave us an opportunity in additional geographic areas to bring our commercial products in what we have to do, of course, is bring our various other companies or at least a number of our other companies to begin to do business in those geographic areas. And that has certainly been helpful as a portion, certainly not all, but as a portion of our growth and focus on growing commercial lines. In that regard, we have appointed 54 new agencies in the quarter year-to-date, it's 89. But I would say to you that our focus is more on developing the existing relationships with agencies and not nearly as much focus on appointing new agencies. We're interested in doing that, but our greater focus is to make sure that current appointments are working as effectively and that we are getting our share of premium within those agencies, because we think that's an important goal in terms of growing and improving our distribution system. From the standpoint of rate increases and exposure growth, in commercial lines, we experienced about 15.9% increase in commercial lines in the second quarter, and although I can't quote you exact statistics, our general overview would indicate that probably somewhere in the range of 35%-plus of that would represent premium and rate increases, and the rest would be new business coming to the company. One of the issues that always comes up in some of these calls is where are you with audit premiums? As you know, when workers' comp and general liability policies on the commercial side, that they're audited to determine payrolls, et cetera. And certainly, during the depths of the recession, there were return audits which for insurance companies, is never a good thing where you're handing back premium. In 2011, it began to go flat and in 2012, those audit premiums are up modestly. From the standpoint of rate increases, Jeff gave an overall statement about it. We have made significant numbers of rate increases in all personal lines, and we have taken rate action to increase commercial premiums in a very high percentage of our book of business. On the personal lines side, we continue to look at every state, every product line and personal line, and it's on an annual review and we are very much focused on making sure that we have premium adequacy and we have no hesitation to continue to raise premiums -- raise rates in order to achieve the rate adequacy. And our assessment is that this is an environment where many of our competitors are doing similar things, particularly in homeowners and to a degree in auto, and we are not bashful in terms of making sure that we're doing what is appropriate. From the standpoint of other underwriting actions, we have a number of initiatives that we began in late 2010 and have expanded it as we have gone along. We have done extensive reinspection of property risk, primarily homeowners, dwelling, fire and serving on the commercial side property. And the point of all of that is that we all know real estate doesn't get better with age, and we want to make sure that if we have risk that had potentially, because of time, have -- are not the same risk that we wrote previously, we need to take action relative to that, and we have done that in thousands and thousands of risks, well over 25,000 to 30,000 specific risks in that period of time. From the standpoint of underwriting, we are also, have been looking at and re-underwriting agencies that have had high loss ratios, and we are not hesitant about doing that. We want to do it in a constructive fashion, but that is certainly part of our initiatives. Also, on the renewal side on commercial, to emphasize it, we have a program that we internally audit to make sure that underwriters and technical assistants are making sure that we are getting the renewal premium and rate increases that are appropriate in commercial lines, and we are pleased to tell you that our retention percentages in both personal lines and auto are running quite well. In the personal lines, it would be high 80s, close to 88% to 89%, commercial is somewhere in the mid-80s, which we think historically, is quite good. From an overall environment, we believe that it's an environment in which you can get premium and rate increases that you can underwrite conservatively and you can take action with regard to specific risk that you deem appropriate. We believe it's the best underwriting environment that we have experienced in the last, probably the last 5 years. And we can do that and achieve growth at the same time, which is indicated by the numbers that I have made reference to. So trend is important and although the final results are not quite where we would like them to be, we know that the premiums that we are writing that we will begin to continue to earn more and more of that, and we believe from what we're seeing in the frequency trends of losses, that we're seeing nice improvements there. We would also want to point out that A.M. Best's most recent publication indicates that the Donegal Insurance Group, which includes all of our entities and affiliates, that we have moved up from the 104th largest property casualty insurance group in the United States to the 101 position, which growth is not everything but certainly, it is an important part of the equation. As we have said in prior calls, we believe, as an insurance group, that we are well-positioned. If you look at all the necessary aspects of that, whether it be balance sheet strength, a focused business strategy, technology that we try to make sure is second-to-none, and I would point out that we would expect sometime in the latter part of the third quarter beginning in the fourth quarter, to have available to our insured mobile applications, where they will be able to access policy information, pay a bill and make a claim through their iPhones or Blackberrys. We continue to ratchet up our use of data because data in our business has become extremely important, and we are working to continually expand our various predictive modeling in both personal lines and commercial. As you know, we have an investment in the bank called Union Community Bank, the public company owns about 48% of it. I'm pleased to report that for the 6-months period ending June 30, that their net profits after taxes were approximately $5 million, and that their Tier 1 capital, for those of you who understand banks, is 13.89%, which is quite strong. So at this point, I will turn it back to Jeff, and we'll be -- look forward to questions.

Okay. Thank you, Don. Tanisha, if you would open the line for questions, please?

[Operator Instructions] And we do have a question from the line of Brett Shirreffs.

I was wondering if we could dig into this development a little bit more. I think you said it was around 2.3 points overall, or $2.3 million. Was that the total magnitude of the average development or were there offsets in other business lines?

There would be some modest offsets in other business lines, although I believe the $2.3 million that I quoted is very close to the number that reflects the 2 lines that I mentioned, which would be workers' comp and personal auto. There was some additional modest development in commercial auto liability, which would've been offset by other lines. But primarily it's those 2 lines that I mentioned.

Okay. And actually, just on the commercial auto as well, that combined ratio ticked up quite a bit in the quarter. Anything happening there? Any trend you're seeing that's alarming?

I wouldn't say there's any alarming trends there, some pickup in severity is probably the main primary component of that commercial auto. And while we're talking about the development, maybe I can give just a little more information as to -- I kind of touched on the accelerated payment patterns that our actuaries noticed. What I meant by that, to give you more detail, is that, the paid losses in the workers' comp and personal auto liability and to some extent, the commercial auto liability lines, exceeded the expectations that the actuaries would've had, based upon the historical payment patterns. You go back a few years as they track those patterns, the current experience in the current quarter for the 2011 accident year would've exceeded the expected payments for that period of time. But they did not compensate us as they might have by reducing IBNR reserves at a faster rate than they would have historically done. So what they basically concluded is that it's too early to determine if what they saw was a relatively small but again, measurable shift in the payment patterns, whether that represented an acceleration of the timing of the payments or it actually was an increase in the amount we will ultimately pay to settle those losses. So they took a conservative stance, and that conservative position, they took basically accounts for much of the shift in that loss reserve during the current quarter.

And Brett, this is Don Nikolaus. To add to your commentary about commercial auto, I would point out that the combined ratio for commercial autos for the 6-month period is 93.7% on a statutory basis, and that -- no, excuse me, a 100.9%. And we don't believe that there is anything significant in that development in commercial auto that you're -- that combined ratio that you're saying. Also, when Jeff was giving you the additional explanation of how our actuaries approached the increase of paid losses, which, in most cases would be a positive, but our actuaries basically have said, "Hey it's only the second quarter, it may be very well be a positive, but we're going to approach it from a conservative standpoint." To think what it underscores is that yes, there is some modest adverse development in the quarter, but we would -- management would suggest that it reflects the conservative and strong approach that we would take to reserving.

Okay, that's great. It makes sense. And you mentioned $7 million of fire losses in the quarter. Would you have that number for Q2 '11 as well?

It was, I believe $2.3 million and that's if you look back through our transcripts, that's not what we said last year. Last year we would not have included the Michigan fires because we were reporting Michigan losses as a separate component. But it was $2.4 million. The number last year, they would be comparable to the $7 million this year, so a significant increase.

Okay. And in the release you mentioned adding some corporates to the investor portfolio. Is that a change in strategy going forward? Or what's Tony's outlook there if he's around?

Tony's in the room here. The, basically, the strategy is there, we're continuing to manage our exposure to the municipal bonds, and if we have a, as you know, a large concentration of our portfolio in municipal bonds and so, as we're looking for opportunities to put some money to work instead of earning basically nothing on our cash, corporate bonds was an area where we saw we could pick up some yields. That's just a modest increase there in the current quarter, but it's probably not going to increase that segment any further, it just was where we put the money in the current quarter.

Okay, great. And then just lastly for Don. Any outlook in the M&A environment? Or are you guys seeing any opportunities there?

Well I'm glad you mentioned that, because I usually say something in my comments about it. Brett, we continue, as always, to talk to investment banking people, talk to companies. We don't certainly currently have anything that's eminent, but we consider it to be sort of ongoing missionary work. You always want to be out and about, because these types of transactions don't happen in our business overnight and sometimes it's a matter of building acquaintance and some form of business relationship with the entities. So we continue to have interest and it's certainly part of our business strategy.

[Operator Instructions] And there are no further questions at this time.

Okay. Well, I guess to summarize, were it not for the severe weather event at the end of the quarter, and the unusual level of fire losses, we would've seen a much better picture for the quarter. We certainly appreciate everyone's participation today and hope to talk to you again in another 3 months.

Thank you, everybody.

This does conclude today's conference call. You may now disconnect.