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May 31, 2008

State Auto Financial Corporation Q1 2008 Earnings Call Transcript

Filed under: Conference Call Transcript — Tags: — admin @ 12:00 am

Executives

Terrence Bowshier – Vice President, Director of Investor Relations

Robert P. Restrepo Jr. – Chairman, President and Chief Executive Officer

Steven E. English – Vice President and Chief Financial Officer

Matt Mrozek – Corporate Actuary

Analysts

Joseph Demarino – Piper Jaffray

Meyer Shields – Stifel Nicolaus

Beth Malone – KeyBanc

Caroline Steers – Fox-Pitt Kelton

Melanie Ryerson – Langen McAlenney

Edin Imsirovic – KeyBanc Capital Markets

Matt Rohrmann – KBW

State Auto Financial Corporation (STFC) Q1 2008 Earnings Call April 24, 2008 10:00 AM ET

Operator

Welcome to the State Auto Financial first quarter earnings conference call. (Operator Instructions) Now I would like to turn the call over to Terry Bowshier, Director of Investor Relations of State Auto Financial Corporation.

Terrence Bowshier

Welcome to our first quarter 2008 earnings conference call. Today I’m joined by several members of STFC’s senior management team: our Chairman, President and CEO Bob Restrepo; Chief Operating Officer Mark Blackburn; Chief Financial Officer Steve English; Corporate Actuary Matt Mrozek and our Chief Accounting Officer and Treasurer, Cindy Powell.

Today’s call will include prepared remarks by our CEO Bob Restrepo after which we will open the lines for questions. Please note our comments today may include forward-looking statements which by their nature involve a number of risk factors and uncertainties which may affect future financial performance.

Such risk factors may cause actual results to differ materially from those contained in our projections or forward-looking statements. These types of factors are discussed at the end of our press release as well as in our annual and quarterly filings with the Securities and Exchange Commission to which I refer you.

The financial packet containing reconciliations of certain non-GAAP measures along with supplemental financial information was distributed to registered participants prior to this call and made available to all interested parties on our website, www.stateauto.com, under the Investors section as an attachment to the press release.

Now I’ll turn the call over to STFC’s Chairman, President and CEO, Bob Restrepo.

Robert P. Restrepo Jr.

Needless to say, we’re very disappointed in our first quarter results but we remain confident in the quality of our underwriting and our book of business. As you can see from our press release virtually all the bad news in the first quarter related to unusual if not unprecedented losses from bad weather and large commercial liability losses.

In addition, we put up a reserve to cover the estimated cost of settling some pending litigation related to our personal automobile business. Litigation and its ultimate settlements are not expected to materially impact our operations.

And finally, our non-standard automobile book had an unusually bad quarter after four years of consistent profitability. Since most of the negative notes has been the loss ratio, I’ll roll forward the major variances between the first quarter this year and the first quarter of last year.

Beginning with catastrophes, we had eight catastrophes identified by the Property Claims Services organization, or PCS. As you probably know, it was a tough quarter for the industry, with over $1 billion in losses reported, comparable to first-quarter losses for all of the last four years combined, and I’m afraid we got our fair share of them. When we made our announcement on February 14 about catastrophes to date, only three of the eight numbered catastrophes had been reported.

Although the subsequent finds were smaller in scale, the net result was an unusually bad string of storms in what’s usually a quiet quarter. This year we reported $35 million in losses, or 12.5 points on our loss ratio, compared to last year when we experienced $8.1 million in catastrophe losses, which accounted for 3.2 points in our loss ratio.

In addition to the eight numbered catastrophes, we had other bad weather, which affected many of our lines, with the biggest impact on homeowners and farm owners. Compared to last year, the net increase of weather-related losses in these lines was approximately $4 million, contributing to a net increase, an FDFC’s loss ratio of 1.4 percentage points.

Third unusual but significant impact on our loss ratio was large commercial liability losses, particularly for commercial umbrella losses, all on prior accident year claims. These umbrella losses were reserved at full limit, and primarily resulted from commercial automobile losses. That its net impact was $3.9 million, accounting for another 1.4 percentage points in our loss ratio.

One development that we can’t consider a one-time event was deterioration in our non-standard automobile book written in our State Auto National Company. After 16 quarters of consistent profitability, the line turned south in the first quarter. Although a non-standard automobile only represents 10% of our total Private Passenger Automobile business, it’s been a consistent contributor to our overall profitability. In the first quarter, we saw an increase in both bodily injury severity and physical damage frequency, which produced unacceptable results.

As many of you know, things can change quickly in the non-standard auto world, with relatively low retention levels and six-month policies characteristic of that market. We’ve evaluated the quality of our business and don’t see significant changes in the complexion of the books, despite that we will accelerate our rate actions and evaluate agency planned performance to return this business to its recent profitability levels. Overall though, the net impact on our corporate results was not significant.

One could characterize our first quarter results as the product of a perfect storm, or at least a series of them. Our recent results have been characterized by volatility, both negative and positive. Last year was a good example, a mix of quarterly hits and misses, but ultimately a solid result. Looking forward we’ll continue to focus on maintaining our underwriting quality and our pricing discipline, while looking to diversify our presence both geographically and product-wise.

Notwithstanding the bad news on the loss side, production was up modestly and our expense ratio was flat despite the ongoing pricing pressures in the marketplace. Net-written premiums increased 9.7%, 8.4 percentage points of our premium increase resulted from bringing in Beacon, Patrons and our middle market business, which we call SAMI, into the underwriting pool.

In addition, we had reasonable organic growth resulting from the new product initiative and technology that we’ve implemented for our personal automobile and business owner or BOB product lines. Excluding the impact of Beacon, Patrons and SAMI, net-written premiums were up 1.3%.

Since the first of the year we’ve also been running off our personal lines book in Florida. Factoring out Florida, we actually increased our net-written premium results by approximately 2.6%. We remain optimistic that we can produce good underwriting profitability and steady organic premium growth by sticking to our strategy of developing and deploying new products, easier to use point-of-sale technology and multivariate modeling techniques.

We now have multivariate priced products for personal automobile, commercial property, commercial general liability and business owners. Over the next six to nine months we’ll expand support to commercial automobile and workers compensation. We also have an effort underway in personal insurance to build our comparable capabilities for homeowners. This will be the most important long-term fix to improving our non-catastrophe experience in the homeowner line.

We continue to make excellent progress in integrating Beacon and Patrons. We now have our full standard product line implemented in the state of Texas and expect to see production stabilize and begin to grow by the end of the year. Our focus with Patrons has been on integrating corporate and financial systems. We’ll look to introduce an upgraded product line and new systems beginning with Connecticut in the near future.

The success we’ve had in integrating Patrons and Beacon demonstrates that we have both the culture and the capability to identify profitable partners and quickly integrate new profit streams, which both enhance shareholder value and broaden our geographic footprint.

We’ll continue to aggressively look for profitable partnerships with other organizations and we remain optimistic that these kinds of acquisitions and affiliations will, over time, reduce the volatility inherent in our current business model and increase book value on a consistent basis year-over-year as we’ve done in the past.

With that Terry I’ll turn it back over to you for any questions we have.

Terrence Bowshier

Please open the lines for questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Joseph Demarino – Piper Jaffray.

Joseph Demarino – Piper Jaffray

What accident years primarily resulted in the increase in losses under the commercial umbrella?

Robert P. Restrepo Jr.

There were two. There were two losses that occurred in 2005 and two that occurred in 2006. And, again, as I mentioned all four related to commercial automobile claims.

Joseph Demarino – Piper Jaffray

And then you mentioned you’re seeing increased severity and frequency on those. Are you changing the way you’re reserving for future losses based on that? Do you think it’s more of a fluke type experience? Or if you could give a little more color there, that’d be great.

Robert P. Restrepo Jr.

Yes. We haven’t changed our reserving posture on either a either a case basis or on a fault basis. We consider this bad timing and then we’ll obviously monitor this as the year plays out, but it’s very inconsistent with our past patterns. And when we do our normal large loss analysis we didn’t see anything that was inconsistent with our underwriting practices which have been in place for a long time, so very unusual.

Joseph Demarino – Piper Jaffray

And then in relation to the five additional cats you mentioned since your prerelease on February 14. Can you provide us with what those were exactly? In the news I don’t recall hearing too much in particular.

Robert P. Restrepo Jr.

There were a series of, obviously five of them scattered throughout Missouri, Kentucky, Tennessee, and Alabama were states that were significantly impacted. They tend to be local unless you’re living in Texarkana, Texas, or Texarkana, Arkansas, which is where the last one hit. Then you’re not going to be rating it. It’s not something that makes the New York Times. But it definitely affected those local territories. But, as is true with any hail or wind and these were all wind events, pretty much, not as much hail. It was wind-related. They tend to be very local and very random.

Operator

Your next question comes from Meyer Shields – Stifel Nicolaus.

Meyer Shields – Stifel Nicolaus

The adverse developments, was that from what we would call “legacy State Auto,� or is it SAMI, Beacon or Patrons?

Robert P. Restrepo Jr.

It’s “legacy State Auto.â€� We did have one large loss in the SAMI line, but that wasn’t related to our umbrella losses that did, obviously, affect our other liability line.

Meyer Shields – Stifel Nicolaus

Can you talk about the relative performance of these different units that are now included in the pool?

Robert P. Restrepo Jr.

Let me talk about Patrons and Beacon, initially. Patrons and Beacon, as we, I think we have discussed in the past, tend to be very much personalized-oriented, over 70%. They tend to have slightly elevated expense ratios we haven’t fully integrated, but not significantly out of whack. And their loss ratios, last year, Beacon had an exceptionally good loss ratio, probably because the weather in Texas was relatively mild.

Patrons had a difficult quarter, unusual for them, with large fire losses that were not related to weather. Patrons tends not to have catastrophe-related claims, certainly not from a wind and hail standpoint, although being a northeastern company, organization, do have some exposure to hurricanes in the northeast.

But one of the reasons why we thought they were both very good partners was because, over time, definitely on a non-catastrophe basis, they have produced very, very good loss ratios. Their expenses tended to be elevated, so that they were very dependent on reinsurance because of their geographic concentration and they really didn’t have the size, scale or capability to make the investments in products and technology that we can make. So, that’s why we look for continued profitability, but also, once we get the organizations fully integrated, a lift to our organic growth as well.

In terms of SAMI, SAMI has been in existence for over 4 years. It has grown rapidly, so because of that rapid growth, it tends to get a disproportionate share of our IBNR reserves, which is appropriate for a rapidly growing business. But their case reserve levels have been very good since the beginning. We recruited, really, a super team of underwriting talent and we wouldn’t have brought them into the pool if we weren’t completely comfortable with the underwriting quality going forward.

Meyer Shields – Stifel Nicolaus

Is it the inclusion of Patrons and Beacons have led the associations to be flat even though last year there was some bonus accrual?

Robert P. Restrepo Jr.

Yes, it was absolutely a contributor as was SAMI. SAMI because of its personal or commercial orientation tends to carry a higher expense ratio and it’s somewhat elevated anyway cause if we tend to be in a build out mode. We’ve recently opened offices in Baltimore, Austin, Texas. We opened up an office about 18 months, two years ago in Phoenix, Arizona. We’ve obviously recruited staff and the expenses are somewhat ahead of the premium production and that’s contributed to the somewhat elevated expense ratio and each one of those three businesses relative to ‘legacy’ State Auto.

Steven E. English

I’d also add on the expense ratio. For our contingent bonus for the agents we accrued this quarter on a comparable like an annual run rate so we didn’t adjust that downward just based on one quarter’s results. And then also we had some higher expense in this quarter relative to stock option expense because we changed the timing of the grants of those options from the second quarter to the first quarter.

Meyer Shields – Stifel Nicolaus

Can you just talk about what you’re seeing competitors do with rate levels in personal lines?

Robert P. Restrepo Jr.

What we’re seeing of is what we saw last year was the mix of flat pricing or increased pricing and based on what I’ve read, based on what I’ve seen in the marketplace and based on what I can infer from accident year trends, we’re expecting personal automobile prices to go up in the low single-digit range.

Operator

Your next question comes from Beth Malone – KeyBanc.

Beth Malone – KeyBanc

Given the market conditions, do you anticipate, and you’ve been pretty aggressive about making acquisitions in the last few years, how do you see the acquisition environment right now for more books of business?

Robert P. Restrepo Jr.

What we think it’s still warm if not hot. Obviously there’s still more buyers, Beth, than there are sellers out there but with the continued competition particularly in commercial lines, but even in personal lines which is where we’ve made two acquisitions with personal lines oriented companies.

The inability of a lot of the smaller companies that we’re targeting to really make the investments in technology for both personal and commercial lines for these various pricing techniques and the inability to really have a full suite of point of sale systems in place to make it easy for the agents to do business with them is really impairing them. It also affects their financial strength ratings over time because they really don’t have the traction to produce the underwriting profits over time that AM Best and the other rating agencies are looking for.

We expect continued competition, not just from a price standpoint but also from a capabilities standpoint, that will make quite a few companies really seriously consider whether they can succeed on their own, both on the stock side as well as on the mutual company side. What we’ve learned, particularly with Patrons, is certainly the culture around a mutual company and how you approach a mutual company affiliation. It’s very different from a stockowner, whether it be a public or private entity.

The process is slower for a whole bunch of reasons, and there isn’t necessarily the same level of urgency or immediacy. But as we’ve experienced with Patrons, sooner or later there are, we think, quite a few mutual insurance companies out there that will wake up and smell the coffee and view us as a very good partner.

Operator

Your next question comes from Caroline Steers – Fox-Pitt Kelton.

Caroline Steers – Fox-Pitt Kelton

Could you please comment on loss cost trends and where you see these trends going in the near future?

Robert P. Restrepo Jr.

Let me start with personal automobile and I’ll ask Matt Mrozek, our corporate actuary, to add some color. For personal automobile, definitely over the last couple quarters we’ve seen a modest uptick in our pure premium trends. We are affected by some seasonal trends, so we saw an uptick in frequency this past quarter. It remains to be seen whether that frequency will tick back down.

But in our case we have seen modest upticks in severity, which have produced pure premium trends in the low single digits. We tend to lag what I’m reading among our competitors, but we don’t think we’re completely insulated from those pure premium trends, which is why we’re planning single to mid-digit price increases for our personal automobile book going forward to make sure that our rates are consistent with the more recent loss trends we’re seeing.

Homeowners, our issue is weather, catastrophes and non-catastrophes, when we look at our frequency and severity trends on a non-cat, non-weather basis they seem to be pretty consistent what we’ve seen in the past. We’re mindful that the economic downturn in some of our states may produce fraudulent claims.

We haven’t seen that. We haven’t seen that from a claim perspective. We haven’t really seen it in our frequency or severity trends to date. And obviously a lot of those trends would affect our farm owner business, which is the major line in our other personal insurance line.

Looking to commercial lines, this quarter we really haven’t seen anything untoward from a commercial automobile standpoint. We’ve obviously had an uptick in severity related to just a couple of large losses and large umbrella losses in the other liability line. Our workers’ compensation trends because of the size tend to be a little erratic. But pretty comfortable with the frequency and severity trends and workers’ compensation and actually had a pretty decent quarter in that line.

I think the one thing that we saw that was a bit of an aberration is we did see an uptick in non-weather, non-catastrophe-related. We’re not sure if all non-weather but we definitely saw an uptick in our property severity in the multi-peril line. So commercial lines the trends seem to be pretty consistent with what we’ve had from a paid claims standpoint as well as from an incurred standpoint the one outlier would be in this quarter an uptick in commercial property severity.

Caroline Steers – Fox-Pitt Kelton

Also you had mentioned that BI severity and PD frequency was up in non-standard auto. Do you happen to have the amount that those were up?

Robert P. Restrepo Jr.

No, no we don’t. I’m sorry.

Caroline Steers – Fox-Pitt Kelton

Where do you see most of your growth coming from, going forward? Are you still looking to mostly personal lines when you potentially make an acquisition or both?

Robert P. Restrepo Jr.

We’re looking for both. The best opportunities have been personal lines, but that’s not our primary focus. We’ve looked at several opportunities. We’ve probably looked at more commercially-oriented opportunities over the last year than we’ve looked at personal lines opportunities, both standard and access to surplus opportunities. But either the mix of business wasn’t right. It wasn’t a good cultural fit. The price wasn’t right. Whatever it happened to be, it just wasn’t a good match.

So we continue to look at both opportunities. It’s just that we’ve been only successful so far with Patrons and Beacon, which tend to be personalized-oriented. But we’re very much interested in commercially oriented opportunities, both from a standard and “non-standardâ€� basis, specialty in ENS.

Our focus continues to be smaller companies, so we’re not looking for big transformational M&A or affiliation opportunities. We continue to remain focused on organizations in the $50 to $250 million premium range.

Operator

Your next question comes from Melanie Ryerson – Langen McAlenney.

Melanie Ryerson – Langen McAlenney

Taxes in the quarter, it seemed to us that you didn’t fully tax effect the underwriting losses, and we were just hoping you could walk us through that.

Steven E. English

In interim financial reporting, you take a look at an expected overall effective rate for the year. So that rate is based on that. Now, given our volatility due to weather and other factors, the way we set that rate is, we took a look at the last three years’ results in the second, third and fourth quarters, and set that rate based on that past history. So we will, of course, reevaluate that in June, when we have the full six-month numbers at that time.

Operator

Your next question comes from Edin Imsirovic – KeyBanc Capital Markets.

Edin Imsirovic – KeyBanc Capital Markets

What were the total reserve developments in the first quarter?

Robert Restrepo

Can you be a little more specific? Are you talking about the total on an incurred, as well as IBNR?

Edin Imsirovic – KeyBanc Capital Markets

Right.

Matt Mrozek

We typically don’t comment on the prior year reserve development on an acting year basis, outside of catastrophes. And for catastrophes, we did have $1.8 million of favorable reserve development on prior accident years. And that contributed with the current quarter total of $35 million of catastrophe loss.

Operator

Your next question comes from Matt Rohrmann – KBW.

Matt Rohrmann – KBW

What was the cost of the share purchase in the quarter?

Steven E. English

In the quarter it was $20.7 million.

Matt Rohrmann – KBW

Bob, any localized 2Q weather that comes to mind? Weather, as you spoke to some of the losses you’d only hear of if you lived in Arkansas or something like that, anything for the second quarter.

Robert P. Restrepo Jr.

We had a storm, another storm in Arkansas, in the Fort Smith area where we’ve got a concentration of very good agents. That’s been the only significant event so far. It was not big enough to pre-disclose, but it wasn’t a small thunderstorm either.

Operator

And there are no further questions at this time.

Terrence Bowshier

We want to thank all of you for participating 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 second quarter earnings call, which is currently scheduled for July 24, 2008. Thank you.

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