Donegal Group Inc (DGICA) 2007 Q3 法說會逐字稿

Good day, ladies and gentlemen and welcome to the third quarter 2007 Donegal Group Earnings Conference Call. My name is Shiquanaand I will be your coordinator for today. At this time, all participants are in a listen only mode. We will facilitate a question and answer session towards the end of this conference. [OPERATOR INSTRUCTIONS].

I would now like to turn the call over to your host for today's call, Mr. Jeff Miller, Chief Financial Officer. Please proceed, sir.

Thank you.

Good morning and welcome to the Donegal Group Earnings Release Conference Call for the third quarter ended September 30, 2007.

I am Jeff Miller, Senior Vice President and Chief Financial Officer, and I will begin the conference call by presenting financial highlights and analysis of the quarterly and year-to-date financial results. I will then turn the call over to Don Nikolaus, President and Chief Executive Officer, for his commentary on the quarterly results and an update on our business strategy.

Certain statements made in our Earnings Release and in this conference call are forward-looking in nature and involve a number of risks and uncertainties. Please refer to our earnings 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 submitted to the SEC. You can find a copy of our Form 10-K on the investor's portion of our website under the SEC filings link.

We are pleased to announce that Donegal Group achieved record quarterly earnings for the third quarter of 2007 which were driven by excellent underwriting results attributable to the absence of significant weather events, lowered claim frequency and a continuation of favorable prior accident year claim settlements during the quarter.

Our net income for the third quarter of 2007 was $11.2 million or $0.45 per share of Class A common stock on a diluted basis. An increase of 14.2% over the 9.8 million or $0.39 per share of Class A common stock on a diluted basis for the third quarter of 2006. Total revenues for the third quarter of 2007 were $85.4 million, an increase of 3.4% over the total revenues of $82.6 million in the third quarter of 2006. Net premiums earned for the third quarter increased 2.5% to $77.6 million, compared to $75.7 million for the prior year period. Our net premiums risen for the third quarter of 2007 were within a percentage point of those reported for the year earlier period with a slight shift in business mix as personal lines of writing increased by 3.8% an commercial lines writings were down 8.9% compared to the third quarter of 2006.

As a reminder when comparing third quarter of 2007 to the prior year quarter, we obtained additional growth of approximately 1.9 million in net written premiums in the third quarter of 2006, from an acceleration of the issuance of policies acquired from Shelby insurance company under an acquisition rights agreement that completed in that period.

Our investment income was $5.8 million for the third quarter of 2007, an increase of 7.9% over the $5.4 million reported for the third quarter of 2006. With the increase primarily due to higher levels of invested assets and improving yields generated from the reinvestment of maturity proceeds of lower yielding bonds that were purchased several years ago in a less favorable interest rate environment. We are continuing our investment strategy of shifting to taxes and municipal bond holdings which has somewhat slowed the growth of our pretax investment income but continues to benefit our net results by lessening our income tax expense.

Our third quarter 2007 loss ratio was 52.8%, just slightly above the record low loss ratio of 52.3% reported for the second quarter of 2007, and comparing favorably to the 56.2% loss ratio we reported for the third quarter of 2006. As I mentioned earlier, the absence of significant weather events and reductions in claim frequency in our regions during the quarter contributed to the low loss ratio.

Also, our prior accident year reserve development trends for the first nine months of 2007 continued to outpace the favorable trends we experienced during 2006. Primarily as a result of the settlement of open claims. Favorable reserve development in the third quarter 2007 was comparable to that of the third quarter of 2006 and approximated $2.8 million on a pretax basis.

Our expense ratio was 35% for the third quarter of 2007 compared to 32.6% reported for the third quarter of 2006. With the change attributable to increased underwriting based incentive compensation cost due to the favorable underwriting results, as well as additional costs related to the acquisition of new business premium writings, such as increases in advertising, underwriting reports and sales personnel cost. The excellent underwriting results produced a combined ratio for the third quarter of 2007 of 88.3% compared to 89.5% for the third quarter of 2006. Turning briefly to the year to date results, our net income for the nine months ended September 30, 2007 was $27.5 million compared to net income of $29.2 million in the first nine months of 2006.

Our combined ratio for the first nine months of 2007 was 91.5% compared to 89.3% for the comparable period in 2006. Earnings per share for the first nine months of 2007 were $1.10 per share of Class A common stock on a diluted basis compared to $1.16 per share for the first nine months of 2006.

Our book value per share increased to $13.66 as a result of the favorable results and improved by market values during the quarter.

And we are pleased to announce that yesterday our Board of Directors declared dividends of $0.09 per share of our Class A common stock and $0.0775 per share of our Class B common stock, payable November 15th to stockholders of record as of the close of business on November 1st. At this point, I will turn the call over to our President Don Nikolaus for his comments on the quarterly results. Don?

Thank you, Jeff and good morning to everyone and thank you for joining our earnings conference call for the third quarter. And needless to say, we are quite pleased with the underwriting and overall net income levels that we have achieved for the third quarter. As Jeff has stated the historic earnings for the quarter and we certainly will continue to work hard to deliver these kind of very positive result.

The combined ratio of 88.3%, we believe is reflective of the commitment to underwriting discipline and adequacy in pricing and a continuation of the implementation of our overall strategy. Our return on average equity for the quarter of 13.3% is certainly well within the ranges that we would have hoped to obtain.

From the standpoint of the expansion of our distribution system in the third quarter, we're pleased to announce that we again had had a very successful quarter in terms of the appointment of new agents. We appointed 40 in the third quarter, which brings the year-to-date total to 157, which is actually above what we would have projected to have -- where we would have been at the end of the third quarter.

It's a number that we appointed in the third quarter is less than the first and second quarter, but I would remind everyone that we have always tried to get a leg up and appoint as many in the first and second quarter so you would have a period of time to get them oriented early into the mid-part of the year. However, it doesn't change the fact that we continue to work aggressively to appoint new agents and will do that in the balance of the year and certainly going into the year 2008.

I know that everyone is always interested in knowing what is going on in the competitive environment in the property and casualty industry. We would confirm that commercial rates continue to be quite competitive and there's no question about that. Personal lines also remains competitive but as we have indicated previously, we believe that it is somewhat more rational, at least from what our observations tell us.

We are pleased to tell you that in this quarter, we did actually make and were able to implement several rate increases in several of the states and in several of the product lines and personal lines. Two states we made filings and increased automobile rates and they're not two of our larger states, but two states in which we do automobile business. As part of our products, not all of our products in another state, we increased some homeowners and automobile rates and we are about to file in two other states homeowner increases that will average somewhere between 5% and 8.5%.

Now, having said that, that doesn't change the fact that it's a competitive environment but we are always looking for opportunities where we believe that it's appropriate, given the competitive environment or where loss ratios might indicate that we will take the appropriate rate action. I would like to also remind everyone of some of the strategies that we indicated at the second quarter earnings call that are part of our response strategy to the competitive environment.

Throughout the quarter, we continued to look for ways to enhance our automation. We are about live in 50% of our states with our change processing in WritePro and to remind you, that basically automating at the agent's desktop the endorsement of policies, which involves thousands of policy changes in a month's time. And we're looking to get all of our states automated in that regard and we're about 50% of the way there. And would expect before this year is out that we will have it live in the other jurisdictions. We continue to try to identify ways to promote quote activity in both our WritePro and WriteBiz automation systems because we recognize that there's a clear connection between the levels of quote activity and actual business to be achieved.

Also, we have been actively doing co-op and brand advertising to try to co-brand the agent as well as our self in our various regional markets and goes without saying that part of our strategy is to continue to have a disciplined underwriting approach and premium adequacy, because we believe each policy, whether it's personal or commercial, there's a right price for that policy and we're certainly trying to focus through our predictive modeling systems and other underwriting criteria to make sure that we're applying the accurate and correct premium for the appropriate risk and we're staying dedicated to our disciplined underwriting, which we think when we put all those things together, it's why we are able to deliver in this quarter an 88.3% combined ratio.

In the acquisition arena, we continue to see the opportunity for increased discussions about affiliation and acquisitions. And therefore, we think that bodes well for the future. We're not able to say to you on this conference call that we have any acquisition to announce because we don't, but we are actively engaged as we traditionally have been in that activity and it's certainly an important part of our strategy going forward.

At this point, I would turn it back to Jeff. We would usually welcome the opportunity to be responding to questions.

Okay. Thank you, Don.

Shiquana, if you would open the line for questions, please?

Yes, sir. (OPERATOR INSTRUCTIONS). Your first question comes from the line of Mike Grasher with Jaffray. Please proceed.

Hi. It's Mike Grasher with Piper Jaffray.

Jeff, a couple of questions. You made a comment about the tax rate perhaps going lower. How much lower do you expect it to be during 2008?

Well, as I said, we continue to invest in tax exempt municipal bonds. I believe the third quarter the effective tax rate was like 28.6%. It was lower on a year to date basis because of the lower pretax income in the first quarter. But I think we would expect that effective tax rate to level and possibly go down a few more percentage -- tenths of a percent in 2008 as we continue to invest in the tax exempt bonds. Assuming the same level of pretax income.

Your thinking is 10 to 20, maybe 30 basis points lower from where we are today.

I think that would be a reasonable number.

Okay. And then do you have a statutory capital number?

Yes, I do. It is $327.9 million.

Okay. And then Don, a couple of questions. Could you provide any outlook for us with regard to premiums? Obviously, the WritePro could have a major impact. Can you give us some sense or what or where you think premiums might be headed for 2008, given the WritePro, as well as the offsetting softer environment?

Very candidly, Mike, that's a very difficult question to answer because I'm sure all other companies are scratching their head about that, as well as we would be. I don't know that we can say to you that we think that premiums for our company are going to be up by a certain percentage or whether they're going to be flat. I can only say to you that we are working aggressively to try to counter the competitive environment and I don't mean that we're out slashing prices inappropriately. We're trying to become far more proactive in the marketplace, whether it be appointing new agencies or increasing the contacts with our existing agencies and doing some of the other things that I've indicated. My hope and expectation would be that our companies would see some reasonable, maybe low single digit increases in premiums going forward. That would certainly be what we would be looking to achieve as a minimum.

Okay. And could you remind us again in -- when you're appointing new agents, what is sort of the -- I guess how quickly are they up and running in terms of actual production for you?

It's generally in all reality, I know we would like to thing it's faster than that, but in all reality, by the time that you get them appointed and get all the papers filed with the state insurance department and get them oriented as to your products, it probably takes a good six months before you begin to really see any kind of activity out of them. And that's -- there will be some that will in the first month will be banging out policies. There will be others that won't do anything until four, five, six months after you get it started. But I would say we shouldn't expect a lot to happen until the latter part of six months.

Okay. And then just to follow up on that, do you have a sense of what normal or average production might be for a new agent during the first year and how that changes over a period of two or three years?

I can tell you what our expectation is of an agent and I guess I would caution you about going and doing multiplication of what I'm going to tell you. But what we expect of an agent is after the first full year, okay, of an appointment, we would expect that they would have generated $100,000 of premiums and by the end of the third year that they would have generated $300,000 of premium. And of course you get a bell curve out of that. You get a certain percentage that don't achieve that. You get a bunch that do and you get a few that are above that. That gives you the criteria that we try to manage against when we appoint new agencies.

Okay. And then final question on that issue is how long thinking about the bell curve, those that are short, how long do you allow them to get up to your expectations?

Well, there's another component of this, because we are so focused on profitability, we will temper our decision with regard to a new agency if they have been submitting a quality book of business. And if the loss ratio is good. So as an example, you can have someone who starts to write a tremendous amount of new business and you see that their loss ratio is starting to get a temperature and then you can see someone else who is not writing a lot of new business but they're writing business but it's an excellent book of business and the loss ratio is good, well, our philosophy would be that we would be very patient with the agent that is more gradual in their book but is quite profitable.

So we look at a couple of criteria and needless to say, if you have someone who does nothing or very little and there's nothing to distinguish them as being a future strong possibility as an agent, then after a year, year and-a-half, we will probably suggest that it's not a good relationship and we might both better be off -- both might be better off if we didn't continue the relationship. We try to have as little of that as possible but in all business relationships, those things occur.

Certainly. Well, thank you for your comments.

You're welcome.

Your next question comes from the line of Michael Phillips with Stifel Nicolaus. Please proceed. Please proceed.

Thanks. Good morning, everybody.

Good morning, Mike.

Couple of questions. Jeff, I think Jeff said when he gave the premium split it was 3.8 up in personal and down 8, 9 in commercial. Is that correct?

That is correct on a written basis.

Okay. Help us. If I'm correct with my historical stuff here. Looks like that's a pretty big drop off of commercial for the first time in a little bit. Can you help us besides just is it just increase in competition or anything else that's going on there that you can point to and when you maybe can think about that at least turn it around a little bit or are we at the bottom here?

Well, I can give a few comments on that. Then I'll ask Don an what he thinks on the business side.

On a financial side, being the director written premiums for commercial were down about 6.4% and because the earned premiums will be lagging that, of course the earned premiums are down about 2% and because the reinsurance is based upon the earned premiums, that is a larger number. You didn't get the corresponding savings on the reinsurance on a written basis that you did on the direct side. So that's what's driving the net to be a lower number than we have seen in some time. But as far as what's driving it, our commercial policy counts are actually increased. So what we're seeing is that we're writing a larger number of smaller accounts and some of the larger accounts because that's where the most intense competition is, we are losing some of those premiums and that's what's driving the decrease.

I probably would like to add a little flavor to this. Needless to say, we don't like the fact that commercial premiums through the quarter were down by that percentage.

However, I'm not sure that we're prepared to read too much into it, in that not all the months of the quarter would have reflected some kind of a downward trend. So some were flatter and I think one of the months was somewhat more down than others. So I don't know that we're seeing this as -- that this is further deterioration that we should necessarily anticipate.

And there was one of our subsidiaries that is in somewhat of a specialty, I don't know whether we use the word too much specialty, they basically write some garage business, which is pretty in most people's world, in ours it's a specialty from what we generally do. That line of business was seemed to be more competitive in the quarter. But as Jeff indicated, our actual policy count of new business in commercial is I think as he quoted was actually up. So we're cautiously optimistic that we're not going to see those kind of declines in the next quarter.

Okay. Great. That was very helpful.

Don, I guess now if we could turn to personal lines, your comments, some of your comments on personal lines sort of reminded me a little bit of comments we heard yesterday from Allstate and that is I think what you said today was at least for you guys it's probably the first time I've heard you guys say in some of our smaller states we're taking some rate increases. I haven't heard you say that in a while. Allstate said something similar to that yesterday. First part of the year was predominantly rate increases do you see anything like that at all? Your comments of what you're doing sort of echo that a little bit. I want to see what you think about the competitive landscape in that regard.

We also follow what some of our other competitive are saying. I don't know that we can reflect exactly the same thing that they're saying. We find it still to be quite competitive but we have in this quarter felt that it would be appropriate in several of those states that we should go for some modest increases. And so to that extent, there's probably some similarity between what you heard on the conference call and what you hear today.

But they probably sounded a little bit more positive about the environment, although it sounded to me as if our personal line growth was up better than what you were hearing from them. So we have said for several quarters, we didn't think the personal line rates had become irrational, that we thought that the competition was still rational and we'll certainly stick with that, with the ability to get certain rate increases, particularly in homeowners.

Okay. Perfect. And just only one last kind of a nitpicking numbers kind of a question, I guess for Jeff. The service fee income or service charge income seemed to pick up a bit this quarter. Anything unusual there or just kind of random noise?

I don't know that there's anything I can point to specifically that's driving that increase. We have continued to charge installment fees for policy holders that pay on installment. There's late fees in there. Policy counts again are up.

So even though the premiums haven't increased as dramatically with the policy counts being up, that means there's more payments coming in and more service charges being collected.

We're happy about that. More fee income.

That's right. Okay. Thanks, guys. Appreciate it.

Your next question comes from the line of Scott [Laurel]. Please proceed.

Hey, Jeff. Donegal has $31 million in debt, interest rate 9% and it's callable next year. Do you plan on paying that off?

We're certainly talking about it, Mike as you've been -- or Scott. As you've indicated, that is a high interest rate and certainly if we don't need that capital and can pay it off, it's certainly something we're looking at as part of our overall capital management. As you mentioned, there is a portion of it that's callable in May of next year. It's 15 million of the 30 million is callable in May and another 10 million in October. So those are things that are on the radar. We're looking at them very closely.

We would have the option of refinancing them if we had a use for capital or need for capital. And the current interest rate environment is more favorable than it would have been as far as the spread over LIBOR is better than it was when we participated in this trust preferred deal four or five years ago. So it is certainly something we're looking at and we'll make that decision sometime early next year.

All right. Also, in March you have a repurchase program. How many shares this quarter did you repurchase and at what price?

We weren't real active this quarter in repurchasing shares. We had 32,000 shares we purchased during the quarter. We're pulling out the average price here.

That was it?

That was it. $15.20 was the average price on those.

And the second quarter you repurchased 140,000?

It was 127. There's 165 total since March.

All that tells me, Don, you say you're actively engaged in talking on an acquisition. If you listen to your first quarter call, your second quarter call and you're actively engaged, you definitely have an acquisition coming down the pike and I would hope it's not close to the vest. Hope it's in the $100 million range. Can you comment on that, please?

Well, Scott, I think if you go back and read any of the transcripts of these prior conference calls, we generally in the last three quarters have said very similar things, because it would be truthful and accurate in each of those quarters. The fact that we haven't repurchased much of our stock has absolutely zero connection with any potential acquisition that we might anticipate and I can say to you that the numbers that you're quoting about the size of an acquisition, that number is probably unrealistic at this point in time.

You really think? I mean, you can't handle $100 million? Easy.

The purpose of these calls is to answer questions. I'm happy to do that. What we're capable of doing and what is reasonable in the market and what is available and what we should consider at a point in time are two totally different things.

Well, I think you have enough of capital to do something medium to larger as you have done in the past. And please note, this is the first time you have said actively engaged in an acquisition.

I did not say that this morning. I said we're actively engaged in discussions with companies about potential affiliations. It's no different than we have said for multiple quarters. You should not read any more into those words than hopefully anybody has ever read into those words.

We talk to people all the time. And we hope that at some point a discussion materializes into something more. But there's never any assurance of that. And it depends on a lot of circumstances including whether it's an appropriate acquisition, whether the price is right, whether the market is correct where they may be located. So we're trying to be as -- disclose as much as is appropriate but we certainly never want to mislead anybody in terms of what might happen or what might not happen.

Your next question comes from the line of Darnell [Zies] with Lord Abbett. Please proceed.

Hey, guys. Just a couple quick questions. Could you just touch on the increase in investment income again? What exactly caused that?

Sure, be glad to Darnell.

We have put more money to work, so the average invested assets are continuing to increase. And over the last year as we have put money to work and as maturities of investments that we purchased several years ago when the yields were much lower, we're finding that the replacement securities that we're putting the money into, the yields are much better. So that's starting to show up in the investment income. As we put that money to work in more favorable yielding securities.

And also, the short term interest rates have been pretty good over the last year, so that's also contributing to the increase in investment income.

Just one other question on the expense ratio. Just seemed a little high, understanding that you had pretty good underwriting results and bonuses. Is there anything you can do to possibly lower that or anything that can be done to possibly bring that down?

As we said before, the largest component of that is incentive costs, incentive underwriting based incentives for our agents is what we call contingent commissions. That's not to be confused with contingent commissions that are paid to brokers. It's profit sharing commissions that we pay to our agents.

The plan that we have in place currently is very competitive with our other -- with our peers and we do pay out a fairly significant percentage if an agent does well and has a low loss ratio, we're happy to share that profit with them and we think that that's a large part of the reason for our success from an underwriting standpoint is that the agents are partnered with us and so we are comfortable with the amount of incentive compensation that we're paying.

The third quarter, because we have nine months now of good underwriting results, and if you looked at our combined ratio through six months, it wasn't as good as it was through nine months. So there's still somewhat of a cash-up in the third quarter until we get to the end of the year, that should level off.

Let me add something to the expense ratio issue. One of the topics that I remember covering at the second quarter earnings call is -- and we have talked about it in general certainly internally.

When you have a soft market, as we have been in, it is also a time to be building your organization to be taking -- to be able to take advantage of circumstances as they might change over time, as the market at some point might turn to a harder market. So we have been investing a lot of money in technology, a lot of money in having the right people, expanding our franchise, basically our distribution system, because we think that we're building a much stronger entity for the future. And one of the easiest ways to drive down the expense ratio is of course to have increased writings. And those will occur over time.

And we would be confident that as they do, that because of all of the investment we have been making and we think appropriate investment in our future, that the expense ratio will come down appropriately as part of the implementation of that strategy.

Okay. Well, that's it. Nice results guys and best of luck.

Your next question comes from the line of Meyer Shields with Stifel Nicolaus.

Thanks, good morning.

Good morning.

I apologize for the double teaming. I'm out of the office today. When you have newly appointed agents, are there any initially higher commission levels associated with them? I'm thinking of things analogous to Erie's bonus program.

Well, in the high percentage of our agency appointments, there is not a higher commission structure, unless, as part of appointing that agent, if we have been able to negotiate a book transfer.

If we've been able to negotiate a book transfer from some other company that has been selected by that agent, sometimes there is additional commission associated with that because it's very expensive for an agent to take the labor and time to transfer business from one book to another and they incur additional salary cost as a result of that. So many times in conjunction with a book transfer that we might provide additional incentive, but as across the board, there are not higher commissions paid to new agents.

Now, having -- talking about incentive compensation for agents, for new business we have for all agents, including new agents, Meyer, we have new business commissions that are targeted for certain levels of production and so forth.

Okay. That's helpful. Were there any book rolls of size in the quarter?

We are always working on book rolls. I don't know that I can statistically quote you the exact number but it would not be uncommon for us to out our distribution system to be working on 10, 20 book rolls in our various -- because it's part of the new business strategy, so -- and they might be small books, they might be larger books. But that's been something we've done for years.

Okay. That's helpful. One last question, if I can. Within homeowners, I guess we've been hearing some talk about companies raising rates. Are these rates keeping pace with the level of loss cost inflation or they just getting to a normal level of underwriting profit but below what we would have seen in 2004 through '06?

Well, I think that they're probably keeping pace with loss costs, because keep in mind, that most homeowner losses involve some type of physical repair. And therefore, as construction cost, material cost, labor costs have gone up, that's reflected in your homeowner loss cost and therefore, your rates sometimes have to respond to those factors.

Okay. Thanks so much.

You have a follow-up question from the line of Mike Grasher with Piper Jaffray.

Just wanted to follow up from the acquisitions earlier, the questions around acquisitions. Don, could you remind us what your desired level or optimal level of risk to capital would be?

In terms of the size of an entity? Size of an acquisition?

That was going to be my follow-up question, was what size would be ideal for acquisition. Just in general, operating on a risk to statutory capital basis, are you comfortable at 1, 5, 1, 2, where would you like to be?

We would be comfortable at somewhere between 1, 4 and 1, 5. We certainly wouldn't want to be going much over 1, 5 or 1, 6 because rating agencies begin to take a look at you there. But certainly we have -- we have certainly more than adequate capital to grow aggressively, whether organically or by acquisition.

In terms of the size of acquisition, it would certainly be ideal to be able to do a 50 million or a $75 million in terms of premium or $100 million acquisition for that matter. But that's not always necessarily the size of entity that might be available or the size of entity that may be want to have those conversations. It's not that we wouldn't be looking to identify those size of opportunities. But many times the opportunities are anywhere between 10 and $30 million in premium and we're not going to pass those up. But at the same time, we're not going to certainly say that we'll only play in the larger type of opportunities.

We think that sometimes size is not necessarily as important as whether there are follow-on opportunities with an acquisition, maybe it gets you into a geographic area where you want to start to do business and you want a beachhead, a place to start. There can be a very strategic reason for an acquisition and therefore the size of it relative to your plan for growing your franchise, size might at some point be a secondary matter.

That's helpful. Appreciate the color around that.

[OPERATOR INSTRUCTIONS]. At this time, there are no further questions. I would like now to turn the call back over to Mr. Jeff Miller for closing remarks.

Thank you and we certainly want to thank everyone for their participation today and for listening to the conference call. And we wish you a good day. Thank you very much.

Yes, thank you everybody. We appreciate your interest.

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect and have a good day.