Donegal Group Inc (DGICA) 2011 Q1 法說會逐字稿

Good morning. At this time, I would like to welcome everyone to the Donegal Group Q1 2011 earnings.

All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. (Operator Instructions). Thank you.

Mr. Jeff Miller, Chief Financial Officer, you may begin.

Thank you. Good morning everyone. Welcome to the Donegal Group earnings release conference call for the first quarter ended March 31, 2011. I am Jeff Miller, Chief Financial Officer. I will begin the conference call by covering financial highlights and providing commentary on the quarterly results. Don Nikolaus, President and Chief Executive Officer, will then provide his comments on the quarter and update on market conditions and the integration of our December acquisition of Michigan Insurance Company, as well as his perspective on our current business initiatives and opportunities.

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 Investors portion of our website under the SEC filings link.

Our first-quarter net income represented a significant improvement over the results we experienced in the first quarters of 2010 and 2009. While we did not see record snowstorms such as those we experienced in 2010, a series of less severe weather -- winter weather events in the mid-Atlantic states produced a large number of property claims and contributed to a higher level of automobile accidents in our primary operating region during the quarter. We benefited from the Personal Lines premium rate increases we've talked about over the past year as they provided additional earned premiums and thereby contributed to improved underwriting experience relative to the first quarter of 2010.

Our earnings announcement discussed the effect of acquisition accounting on our first-quarter numbers. Although it is somewhat technical in nature, the purpose of providing that information is to show that the underlying fundamentals of our business improve to a greater extent than our recorded results might indicate on the surface.

Before I provide further details regarding our insurance operations for the quarter, let me first attempt to explain the acquisition accounting impact in less technical terms. When we acquired Michigan Insurance Company, which I'll refer to simply as Michigan, on December 1, 2010, GAAP accounting requirements dictated that we record the acquired assets and liabilities at their fair value. Certain of the fair value adjustments we made must be amortized in subsequent periods. Therefore, our 2011 results reflect a fair value accounting method for those specific items as opposed to the historical cost basis accounting method that we normally use to report our results. It is the differences between these two accounting methods that are highlighted in our release.

There are basically two significant items that impact our first-quarter numbers. First item resulted in a reduction of our earned premiums. Following GAAP requirements, we reduced the net unearned premiums we acquired by an amount that represented the market commission rate we could have received if we had transferred the net unearned premiums to a third-party reinsurer. In essence, we applied a fair value discount to the net unearned premiums we acquired in the amount of $3.8 million. We are now amortizing that discount as we earn the premiums. Because of a portion of Michigan's policies gave six-month terms, the effect of amortization was frontloaded into the month of December and into the first quarter. We amortized $0.5 million in December of 2010 and $1.8 million in the first quarter. The amortization in the first quarter reduced our quarterly net premium growth rate by 2% and added 1.8 points to our first-quarter GAAP combined ratio. The remaining $1.5 million of unearned premium discount will be amortized over the remainder of 2011. So, we expect a lesser impact the remaining quarters of the year.

The second item relates to additional expense we recorded with respect to net unearned ceding commission income. Following GAAP, we considered the deferred policy acquisition costs and unearning ceding commission income that Michigan carried on its balance sheet to have no fair value as of the acquisition date. We are now in effect re-building those items for premiums that Michigan writes subsequent to the acquisition. The effect was an increase to our GAAP underwriting expenses of about $700,000 in the first quarter. This additional expense increased our GAAP expense ratio by 0.7%. We will record the same kind of adjustments as Michigan writes premiums throughout 2011. However, the amount will vary based upon the amount of Michigan's premium writings in each period.

Summarizing the effect of the acquisition accounting on the first-quarter results, the $1.8 million reduction in premiums and additional $700,000 in expense combined for a reduction in pretax income up $2.5 million or $1.6 million after tax. That amount translates to $0.06 earnings per Class A take share for the quarter and 2.4 points on our combined ratio. Once the effects of these adjustments are behind us, our accounting for Michigan will follow our usual methods and our earnings will reflect the normal change in unearned premiums and deferred policy acquisition costs.

You'll notice that we emphasize statutory ratios in our earnings announcement. Because the GAAP acquisition accounting had no impact to our actual underwriting profitability as indicated by our statutory ratios, we considered those ratios to be more directly comparable to the prior-year ratios and to more readily demonstrate the improvement in our underwriting results.

Let's leave the technical accounting topic and move on to insurance operations. As the release shows, we achieved a 20.7% increase in net written premiums with about two-thirds of the growth coming from Michigan and one-third from organic growth within our other states of operation. Our Commercial premiums, exclusive of Michigan, grew by 12.8%, representing an increase in the number of Commercial accounts we wrote across all of our regions. Our Personal Lines premiums, again exclusive of Michigan, grew by 4.8% with the majority of that growth from pricing increases.

Our retention rates showed modest improvement in both Personal and Commercial Lines for the rolling 12 months ended March 31, 2011 compared to a year earlier, and so we saw a number of favorable trends in our organic growth during the quarter.

Our statutory loss ratio for the first quarter of 2011 was 69.4% compared to 74.5% for the first quarter of 2010. To provide some additional details on our losses, we incurred weather-related claims that totaled approximately $7.5 million in the first quarter of 2011 compared to $9 million in the first quarter of 2010, when two major snowstorms in the mid-Atlantic resulted in record numbers of claims.

As I mentioned at the outset, for the first quarter of 2011, we did not incur a significant number of claims from a single catastrophe event, but multiple smaller storms generated property losses and contributed to an increased number of auto accidents.

We incurred a significantly reduced number of fire losses during the first quarter of 2011 compared to the year-earlier quarter, which was a continuation of a favorable trend we noted in the fourth quarter of 2010. The impact of large fire losses, which we define as greater than $50,000 in damages, decreased to $4 million in the current-year quarter from $8 million in the first quarter of last year.

The final point I'd like to cover regarding insurance operations is reserve development. We tend not to focus heavily on prior accident year loss reserve development trends in the first quarter of the year. But we are pleased that our prior-year reserve development for the first quarter of 2011 was modestly favorable compared to slightly adverse for the first quarter of 2010. The impact of the favorable development on our quarterly results was not material, basically less than a 1% reduction in our combined ratio.

Turning to the balance sheet, our book value per share increased to $14.96 as of March 31, 2011, compared to $14.86 at year-end. As noted in the release, we continued to intentionally lower the percentage of our total investments that were invested in municipal bonds from 61.7% at year-end to 58.2% at March 31. We shifted funds in the US government bonds and high-quality mortgage-backed securities and our average portfolio yield held steady during the quarter. We did not repurchase any shares during the quarter due to trading restrictions related to the pending merger of Union National Financial Corporation with and into Donegal Financial Services Corporation, which we have discussed in past calls.

Before I turn the call over to Don, let me just mention briefly that the first quarter of 2011 will be remembered for several significant events affecting the insurance industry at large, especially the tragic earthquakes in Japan and New Zealand. As a regional US insurance group, we were not directly impacted by those large events. However, we purchase reinsurance from global reinsurance companies and there are early indications that the worldwide events are beginning to impact reinsurance rates. Because our reinsurance program renewed on January 1, we do not anticipate any indirect effects of the earthquakes on our current reinsurance costs. Should these macro events contribute to higher reinsurance costs for the industry at large and lead to a hardening of premium rates within the primary insurance markets, we are certainly well-positioned to benefit from an improved rate environment.

At this point, I will turn the call over to our President, Don Nikolaus, for his comments and perspective.

Thank you Jeff. Good morning to everyone.

Needless to say, we are pleased that we are able to report significant improvements in our earnings as compared to the first quarter of 2010. Although they are certainly not at the level that we would wish going forward, we think the trend is an important ingredient and certainly something that we are going to be talking about a little bit more during this call.

Jeff, I think, has done an excellent job of trying to explain the purchase accounting anomalies that would be impacting and have impacted the first quarter of 2011. Hopefully, all of you have a reasonably good understanding of it. It seems rather straightforward that those amounts are not the effect of operations, that they are required under accounting rules, and we certainly are and want to be in full compliance with that. But as an example, the unearned premium reserve, although we had to fair value it, basically discount it, we certainly have no intention of selling our unearned premium reserves relating to Michigan, expect to collect it in full, but it is an accounting adjustment that needed to be made as part of that. Therefore, it is part of the reason we have tried to focus on some of the other metrics that clearly explain that this is a much better quarter than the same quarter in 2010.

Some of the trends, and Jeff has highlighted them, for instance the change, the increase in net premiums written, a very hefty 20.7%, which certainly reflects the Michigan Insurance acquisition, but we would not want it to be missed that our results in that 20.7% do include an increase in net premiums written organically of 7.6%, which is a combination of rate increases in Personal Lines, as well as achieving growth in Commercial. The 99% combined ratio, which is below the magic 100%, we were very pleased to see that and certainly we will be working very hard to move that combined ratio down further going into the year.

In Commercial, we have worked diligently, as we have talked in prior earnings conference calls about rolling our Commercial products out into additional states, as well as into subsidiaries that we have acquired that were not previously very active in Commercial writings. Our organic growth of 12.8% certainly reflects that activity.

We were also pleased to see that we had some positive reserve development, certainly given that a year ago there was a modest negative development, so we believe that also to be another favorable trend. From the combined ratio standpoint, Commercial Lines, we had a combined ratio of 94.3%. That's consistent within the general range of what we have experienced in the past, and it's also one of the reasons we would be looking to moderately increase our writings of Commercial Lines because we think, although it's the softest part of the insurance market, the spot and the type of business that we write continues to be quite profitable.

In the quarter, we began the integration of Michigan Insurance Company into the Donegal Insurance Group. As you all know, it's one thing to do acquisitions; it's another to effectively and cost effectively to integrate companies that you acquire into your operation. Although from a sales and underwriting standpoint, they have relative autonomy, there are lots of areas where we are integrating them, all of the accounting, financial, investment, actuarial. We are also now in the process of beginning to aggressively plan to roll them on to our Information Services systems.

We are also pleased to announce, although it's not reflected in the first quarter, that early second quarter we have started to do business in the state of Indiana. We have rolled into that state all of our Personal Lines products and we'll have our Commercial products available there in the month of May. So far, we have appointed approximately 20 agencies to represent us in that state, and we look to significantly ramp that up over time.

Company-wide, we appointed approximately 52 new agencies. As you know from prior conference calls, particularly in the areas, geographic areas, where we have made acquisitions, we have been active in growing our distribution system.

One of the things that I would also point out is that, in our business, it is important as -- where you write business, not only what you write. As an example, several years ago, we exited the writing of homeowners business in the state of North Carolina. Certainly, given the most recent storms in that state that we feel that was an appropriate -- we felt then and we feel so today that it's an example of where the process of underwriting includes many elements, including where you will write particular products.

In the early part of 2010 and throughout 2010 into 2011, we implemented a proactive plan to improve underwriting profitability. We continue to work on that. Multiple rate increases, we are again looking at Personal Lines rate increases in some states in addition to the ones that we have already undertaken. We continue to expand our underwriting actions, particularly in Homeowners and Property Risk, to reinspect significant numbers of property, which is part of a prudent legacy approach to the writing of property.

We also continue to focus on consolidation of administrative functions in the home office of the Company in an effort to reduce expenses. We believe that, over time, that can be beneficial in terms of our expense ratio.

We also in the latter part of 2010 put into effect fee income increases such as installment payments and late fee increases, which is not necessarily gigantic in terms of the numbers but it is all very helpful in terms of underlying profitability. Our acquisitions currently, other than the pending closing of Union National acquisition, we don't have any other acquisitions pending, but we continue to reach out and to talk to other companies which would be how we would have approached it in the past.

At this point, I will turn it back to Jeff, and we will open it up for questions.

Thank you Don. If you'd open the line for questions, please?

(Operator Instructions). Matt Rohrmann.

Good morning. A couple of bigger picture questions and then, Jeff, I'm sure you're excited to know I have a number of numbers questions. Obviously, you guys had some weather impact in the quarter, but there were a number of regional players that fared far worse. Could you talk more on sort of what you touched on earlier in terms of really knowing what markets to write in and what particular areas did you avoid that perhaps others didn't?

In all fairness, as we all know, catastrophe results can clearly reflect where you are writing business. Needless to say, in 2010, a number of the weather events hit areas that we have strong levels of insurance in, such as Pennsylvania and parts of the Midwest. We do not write any property risk of any significance, as an example, in New England or New York, and some of our competitor companies do. So sometimes it's a matter of where you are, where you particularly have your book of business. What I was returning to is there are some geographic areas that if, as management, if you look at and see that either doesn't have a very good judicial, legislative, or regulatory climate, or whether there is a propensity for storms, as an example. We have recently given notice to the State of Oklahoma that we will no longer be writing any property business in that state. It's a state where it's very difficult, fine state, good people, but there is just an ongoing series of catastrophe events, and we are not sure that you can effectively write around that. So we have just recently sent that notice within the last month.

As I made reference to in North Carolina, we had significant concerns about their beach plan. We felt that was a reason not to any longer do business there. So we are always looking at where we can begin to do business and are there lines of business in some areas where you either want to deemphasize or whether you want to say sayonara to.

Great. Then obviously you guys have a number of initiatives going on the topline side. I was curious. Were there any particular standouts, either regions or lines, on the Commercial side that drove the organic piece of the growth?

I would say, on the Commercial side organically, it was all lines. There was no particular emphasis on any particular line. As you know, we are account sellers, so that when fire -- organic growth is up by 12.8%, it would generally reflect most of the Commercial lines, Commercial auto package, BOP, and certainly a certain amount of Workers Comp that goes along with that.

I'm assuming you would still sort of define the Commercial Lines marketplace as fairly competitive.

I would, although I would have to say that, as we have said in some other prior calls, that we don't see the pricing getting any more aggressive than it has, but it certainly isn't necessarily significantly improving either. Our success in growth I think has been in expanding some product lines and also expanding into some of the additional states.

Great. Then Jeff, a couple of quick numbers questions. I know you mentioned you have some impact from the ceding commission amortization coming forward. Is that going to be amortized as straight line through the last three quarters of the year?

It will be based upon the pattern in which the premiums are earned, so more than likely we will see a larger impact in the second quarter and not much impact at all in the fourth quarter. So it will continue (multiple speakers)

Then what kind of offsets will there be? As you write the business, there could be other commissions or anything like that?

There really aren't any other offsets. It's a matter of getting the accounting to a normalized basis, so it's kind of just rolling into the numbers over the course of 2011, and then going forward, it will be normalized.

Obviously, with the moves on the investment side and then obviously whatever the results end up being on the underwriting side, is a tax rate of 20% fairly accurate for what you expect throughout the year in aggregate, or is 15% more accurate? It seems like it's been lower than in respect the last couple of quarters.

I think we used around 15% in the first quarter as our projected effective rate. That's based upon the level of tax-exempt interest income that we are projecting. If earnings end up being a little stronger than what they have been in the last couple of quarters, then hopefully that will return to the 20% which was more of a normalized rate.

Then obviously you utilized last quarter and then this quarter your revolving credit line. How long do you expect to use that for?

At this point, probably too early to say. It will based upon future operations and profitability. We have no requirements to pay it down other than just to pay the interest, which is quite reasonable at this point. But I would say over time we plan to pay that debt down so that we can reload the gun for future acquisitions.

Great. Then last question -- could you just run over -- did you say there was $4 million in fire losses in the quarter?

Yes. The fire losses for the quarter were around $4 million, which is a fairly -- well, that compares to last year which was $8 million, but $4 million is a very significant improvement over what we have seen over the course of 2010. So for a quarterly period, that's a very favorable number.

Great, thanks very much guys.

(Operator Instructions).

Will pause a minute to see if there are any other follow-up questions. While we are waiting, maybe Don had alluded to the fact there were some second-quarter claim results in North Carolina. We are aware that Donegal policyholders in a number of our operating regions have been impacted by tornadoes and severe storms that tore across the country in early April. Our claim staff is hard at work helping those policyholders recover from the storms and evaluating the extent of insured damages. We don't write in, like Don said, in North Carolina or some of the other areas that were hard hit, but at this point, we are tracking a number of the storms for potential recoveries under our Intercompany Reinsurance agreements. But it's too early to be able to give any details other than to say that Intercompany retention amounts are relatively low, so the financial impact will be limited. I wanted to just give that update concerning the second-quarter storms.

Seeing no other questions in the queue, I think we are probably ready to wrap up. Appreciate everyone's participation this morning.

Ladies and gentlemen, thank you for your participation. This does conclude today's conference. You may now disconnect.