Good morning. My name is Keisha, and I will be your conference operator today. At this time, I would like to welcome everyone to the Donegal Group Inc., Q4 2012 Earnings Conference Call. [Operator Instructions] Thank you. Mr. Miller, you may begin your conference.

Thank you. Good morning, and welcome to the Donegal Group conference call for the fourth quarter ended December 31, 2012. I am Jeff Miller, Chief Financial Officer, and I will begin today's call with commentary on the quarterly and full year financial results. Don Nikolaus, President and Chief Executive Officer, will then provide additional comments on the quarter and our current business trends and outlook for 2013. You should be aware 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. We plan to file our 2012 Form 10-K within the next few weeks. 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 fourth quarter results, we are very pleased to be reporting significant improvement, which continued the trend to the first 3 quarters of 2012. Net income increased to $6.2 million from a net loss of in last year's fourth quarter, and the operating income swung by almost $10 million from a loss of $4.3 million last year to operating income of $5.1 million. The substantial improvement primarily reflected improved underwriting results. In particular, our commercial lines of business performed very well with the statutory combined ratio of 88.5% for the fourth quarter. Our…

Thank you, Jeff, and good morning to everyone. Thank you for joining our fourth quarter earnings conference call. Jeff has given you a extensive overview of the results for the quarter. And not to repeat many of what he has indicated, but we're certainly pleased that our operating earnings, net income, earnings per share, are all significantly better than they would have been in the fourth quarter of 2011 and we believe are continuing somewhat of a trend in the improvement of our overall results. The combined ratio on a statutory basis for the year came in at 99.81%, which we think is significant and an important accomplishment that would've been part of what we have been working hard to achieve. On the commercial side, with the combined ratio being 88.5% for the quarter and 91.2% for the entire year, reflect the importance of our strategy to increase commercial writings as an overall percentage of our book of business. In the quarter, we had an increase of 15.5% in our commercial writings, with 1.8% for personal line. I'd like now to turn to Hurricane Sandy. Jeff has told you the effect of Sandy, which, relative to many of our competitors, would be relatively modest, with the $3.1 million after reinsurance plus the reinstatement. And what I would like to do is give you a little bit of background. We believe it reflects, over an extended period of time, the results of some, we think, well-managed cat exposures. Because as you know, we do not write in coastal areas and fortunately, we did not have any business in New York that was anywhere close to the most severe impact of the storm. We do not do business in Virginia -- or rather, in New Jersey. And in Virginia and Maryland, we,…

Thank you, Don. Keisha, if you could open the line for questions, please.

[Operator Instructions] And our first question comes from Richard Todaro with Kennedy Capital.

With the price increases that you're seeing and as the premiums flow through next year, do you guys have any idea of the range of combined ratio you'd be looking for next year that you're targeting?

Well, we certainly -- in our business plan each year, we have combined ratio targets. Premium increases, certainly, are a big component of whether or not we've reached those targets. We have historically had a combined ratio target in the mid-90s. I think, for 2013, our target is 95% to 97% as an overall entity. But certainly, that is very dependent upon whether -- and the other factors that are outside of our control.

And I completely understand that there's a number of things that are out of your control. But based on the way the price increases are rolling through, all things being held equal from this year to next year, if the losses were the same. Would you think you'd be able to achieve that target?

We believe that target is achievable, yes. With the projected premium growth, absolutely.

And can you talk about the adverse development? And you'd mentioned that it was from like 2011 workman's comp year. And I know that workman's comp is not a big portion of your business, but some of the other guys in the space have had some pretty big issues there. So I just want to make sure, as you're looking at your adverse development, is there anything we need to be fearful of or any trends that are developing that you're behind the curve on or how do we think about it?

Sure, I'd be glad to respond. That's an excellent question. And I think, probably, I'll talk about development and then ask Don just to give an overview of the types of workers' comp business we're writing because that's an important component of the answer to that question. Looking at the full year, overall loss reserve development, we had like $7.6 million, which was about 3% of our prior year loss reserves. And that's for all lines. And I did mention that that's primarily related to workers' comp and auto liability and it's higher than expected severity, generally in the 2011 year. I will say we think the 2011 year was somewhat of an aberration. If you look at our other accident years, we had favorable development in virtually all of them. And we noted in -- as we looked to the 2012 accident year, that the number of reported workers' comp claims declined in 2012 versus 2011, and that was in spite of fairly significant premium and exposure growth during the year. As we're growing in commercial lines, workers' comp is definitely a part of that because we're an account writer and the workers' comp premiums tend to be a large component of the overall account. So we did see some fairly significant growth in the line. I would say our actuaries responded to the 2011 development somewhat by increasing their expectations for the 2012 accident year, the workers' comp loss reserves. It's a line that we're continuing to monitor very carefully to make sure that we're fully understanding the trends. But at a 98% combined ratio for the year, you know, we think that's quite favorable. And again, the development, adding 3 points to that ratio is not real significant, and we don't see anything there that would cause us undue alarm.

And let me just add a few commentary. We think that in our reserves, whether it's the workers' comp or private passenger automobile as reported, our conservative, needless to say, Jeff has given a good explanation of the analysis. But with regard to workers' comp classes, we historically have been a main street writer of commercial business. We do not write any heavy industrial exposures, we write a certain modest amount of light industrial exposures. We are certainly cautious about the classes of workers' comp that we write. But certainly, you are going to have losses. As Jeff has indicated, that we were favorably impressed with the reduction of the number of losses. And particularly, not only workers' comp, but also bodily injury losses in 2012 were somewhere in the neighborhood of 7% less than they were in 2011. So yes, we have some very modest adverse development, but we believe that it reflects quality conservative, reserving base, both at the case reserve level and also at the IBNR level.

And on the -- and I'm still relatively new to insurance and you guys may have covered this and I just missed it, but it looked like your combined ratio and personal auto was higher year-over-year. I didn't know how much of that, if any, came from the Sandy and what you're thinking about in that area?

That's a very good observation, and we've looked into that. You're correct. The combined ratio was higher in the fourth quarter than in 2011 fourth quarter and higher than our year-to-date numbers as of September 30, 2012. There were a combination of factors that impacted that, although I would say that no one factor was a significant amount. But when you add everything together, it did result in an elevated combined ratio. The fourth quarter is historically a higher loss quarter for personal auto, and that could be related to weather events, it could be related to a holiday travel. There was some Sandy impact because physical damage claims, particularly flooding, is a covered peril for auto. It's not for property, but for auto, as flooding would occur, that would be a covered peril. So we did have some Sandy claims that impacted it. I mentioned in my prepared remarks that medical loss trends, I think, that's an industry-wide phenomena that's impacting that particular line of business. We also -- our actuarial analysis is quite in-depth at the end of the year more so than at the quarter end. So there could be some truing up of actuarial assumptions based upon trends that we saw during the year. But we did not see an increase in very large losses or -- and as we said, there was lower numbers of reported bodily injury claims. So it is an area we're for focusing on. It's an area where you'll see rate increases continuing into 2013 to make sure that we're ahead of the loss trends. But we think a lot of the fourth quarter impact was more timing than any other changes in the trends that we're seeing.

Are you guys able to increase price and still retain customers, or is the market, with GEICO and the rest of these guys so competitive, that you won't be able to achieve price or how do you think about that?

Well, we think clearly that we can achieve price because a lot of our major competitors, national companies that are in the independent agency system as well as the direct writers, are all taking rates and we don't think that taking rate is a big problem. We may not -- the premiums, overall, may not grow as aggressively if we did not increase the premiums of the rates. But we don't see a problem in terms of retaining a very high percentage of personal lines because we have very good retention rates and don't anticipate that, given this environment, that they would deteriorate.

In your workman's comp line or workers' comp line, you had a pretty substantial growth year-over-year. Is that mainly price or was there some acquisition in that?

Well, it represents an overall growth in the effort to grow commercial line. And as Jeff said earlier, we are account writers and although we will, on occasion, write monoline workers' comp. So the growth in commercial workers' comp really reflects an overall growth of all of the other lines of business. Many times, workers' comp can be a larger part of an account. But it really is part of the fact that we are growing accounts, and that it's a part of an overall strategy.

And I guess, the last question would be on acquisitions and your available capital versus actually you guys selling the business. It looks like you guys have -- I don't know, are you guys around or a little around 1:1 ratio on equity premiums? Or can you do more acquisitions? I know you're debt-to-equity is 18%. And so how much capital do you have to do them, what's the market like to do that? And then also on the flip side, I know that you had the -- and you still may have the activist shareholder that saw some of the companies that are owned, like yours, going out at 2 times book, this kind of pushing you in that direction. And so I'm kind of curious how you think of this from a board standpoint as far as adding shareholder value?

Well, as you had indicated that you have recently become involved in property casualty insurance from an analyst standpoint, historically, and you may not be aware, that historically, we have done a fair number of acquisitions over the last 10 to 15 years. We think that we have developed a real skill in doing it and we have a menu of opportunities to do it because if you are certainly familiar, we have a affiliation with Donegal Mutual Insurance Company, who is our largest controlling shareholder, and we can do mutual-to-mutual acquisitions. We can then demutualize them, we can do surplus notes, we can do quota shares, we can do acquisition of stock entities, such as Michigan. And we continue to have an appetite to do acquisitions. We're, on an ongoing basis, having conversations with various companies. And generally, they're companies of modest size anywhere in premium from $15 million to $100 million in premium. And we believe that those opportunities will avail themselves going forward. I think, as we would all recognize, the M&A market has not been particularly strong over the last 18 months to 2 years, but we would think that going forward, there will be more opportunity. And we believe, as you have identified, we have a relatively low debt-to-equity ratio. And we think with all of the menu of approaches that we can do acquisitions, we have certainly good opportunities to do that and to do it in a comfortable way.

And as far as the -- I mean, clearly, if there's been acquisitions, and I know that was probably 1.5 years ago or 2, that the other mutual got bought out at 2 times book, as far as -- I mean, if that's $30 here, if somebody could pull that out of your company. That seems like it would take a lot of work from internal to build that sort of shareholder value. So and clearly, you guys are doing a good job. So I'm just curious what you're thinking on that.

Well, we believe that we have an excellent business strategy. It is time tested. We think, as I said earlier, that a regional company, well capitalized, well managed with a good business plan, has lots of opportunities. And our mutual company that has a controlling interest in Donegal Group has expressed, in various settings, including the 2012 proxy statement, that it is very supportive of the continuing relationship between Donegal Group and Donegal Mutual, and continuing to be committed to the independence of the entire Donegal Insurance Group. And we believe that shareholder value, you can look at it as a flash in the pan at a particular moment or you can look at it as being a process over time, where success is measured as appropriately as it should be. So we think that there is great possibilities for the continuing growth and independence of our insurance group.

Our next question comes from Brett Shirreffs with KBW.

I wanted to ask about the expense ratio. It was a little bit lower than the prior quarter, and it was the lowest it has been so far in 2012. Is that 29.2% a good run rate ratio based on the growth you've had or where do you kind of see that going in 2013?

I would say, certainly from a statutory expense ratio, we're trying to drive that down into the 28%, 29% range. On a GAAP basis, it would probably be closer to the 30% to 31% range, with the difference being, for statutory purposes, we'd subtract out these service charges and we use the net written premiums as the base as opposed to the GAAP ratio, which uses net premiums earned as a base. So as the growth that we experienced in 2012, in our net premiums written, as that translates to increased earned premiums, we would expect to see some improvement in the expense ratio. However, if our profitability continues to improve, we would expect to pay additional profit-sharing commissions to our agents, as well as incentives to our employees. So that would have an offsetting impact.

So I think where we're currently reporting in that -- I assume you're talking about the GAAP combined ratio, which was 29.3% for the fourth quarter, that's probably a little bit low because of the impact of Sandy reducing some of the expected projected incentive payments that we would have otherwise been paying out. So the 30% to 31% range is probably a good run rate.

As a follow-up to that, Brett, we, of course, continue to find ways to be as efficient as possible. And also, as your premium is growing, we're leveraging our expense base. So our hope would be, that as it has been that the expense ratios, on a quarter to yearly basis, trend downwards, but we'll have to see how the first quarter and second quarter go to be able to give you more clarity as to how it might be effective in 2013.

Okay. And does that include headcount reductions or were those kind of efficiencies?

No. It's not based upon headcount. A matter of fact, we have been hiring strategically, where we need underwriters and claims people. What we're talking about is through technology and other means, being able to handle the increased writings of business without some significant increase in the expense base.

Brett, an example of that would be the Michigan acquisition. When we acquired them, they had some fairly significant IT costs. We migrated all of those systems into our Donegal Systems, and now we're running that system off. So as those systems are no longer being used, we'll be saving significant dollars. Some of that started to occur in the latter part of 2012, and you will continue to see those savings in 2013.

Okay, great. And maybe just staying on Michigan for a second. I thought you reduced the quota-share again. How do you kind of come up with the 10% reduction number versus assuming more of that business based on your leverage ratios?

I think that -- and Jeff can certainly add to this, it certainly involves a significant financial analysis that our financial people, under Jeff's direction, does. And also, because we are relatively conservative in our approach financially and from an underwriting standpoint, we would be inclined to take it somewhat gradually. If you look back, we reduced it by 10% in the prior year. We simply want to make sure that we're not assuming too great of an increase of premium in any one particular year, recognizing that also that we're growing organically. So we're simply monitoring that our growth of premium does not necessarily escalate too quickly in any particular year. So it's a careful analysis to try to balance growth with, basically, being cautious to make sure that we don't adversely affect other metrics in the process.

I would just add. As it relates specifically to Michigan, we're very pleased with that acquisition and with the -- we were very pleased as we went through the first 2 full years that, really, were no surprises. We are very confident in the company, but we are in a process of finalizing the transition to our systems and into some of our Donegal processes and internal controls. So all of that factors into the decisions and provides a comfort level for increasing the amount of business that they are retaining. And certainly, a part of the equation is making sure that the leverage ratios are appropriate and Michigan does have sufficient surplus to retain an additional 10% of the business.

Okay. And then on the investment side. Jeff, you noted some expense allocation adjustments in the quarter. I was wondering if you could quantify that and maybe what your outlook on investment income is going forward. Would you expect a similar mid-single-digit decline in 2013?

We're projecting a modest decrease in investment income for 2013 as a result of the continuing low investment yields. We expect approximately $65 million of cash flow from our portfolio that's currently yielding an average of 4%. And right now, our reinvestment rates are averaging around 2.5%. So the hit to investment income, just based upon that cash flow, would be about $1 million in the year about a 15 basis point reduction in our overall portfolio yield. Now, of course, we're hoping that we can offset much of that decrease with the new money investments. But along with our peers, we're fighting an uphill battle to maintain investment income in the current rate environment. As for expenses, every fourth quarter, we analyze some of the expenses that are allocated between various functions, whether they be loss adjusting, underwriting and investments. And there was a small amount of increase in those expenses. I don't have the number at my fingertips, but my recollection is somewhere around $0.5 million with the impact to the investment income.

The bottom line, Brett, we would anticipate a very modest percentage decline in investment income. I think for 2012, it was something like 3%, somewhere in that range. And we don't think that it would be any greater than that in 2013. As you know, we don't have control over what's happening in interest rates. But based upon what we currently see, it shouldn't be any more significant than that.

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

Okay. Well, we appreciate everyone's participation and very good questions and wish everyone a good day.

Thank you, everybody, for your participation.

And this does conclude today's conference call. Thanks for your participation. You may now disconnect.