Donegal Group Inc (DGICB) 2010 Q2 法說會逐字稿

Good morning. My name is Shanika, and I will be your conference operator today. At this time, I would like to welcome everyone to the quarter two Donegal Group earnings conference call. (Operator Instructions). I would now like to turn the call over to your host, Jeff Miller, Chief Financial Officer. You may begin your conference.

Thank you. Good morning and welcome to the Donegal Group earnings release conference call for the second quarter ended June 30, 2010. I am Jeff Miller, Chief Financial Officer, and I will begin the conference call by discussing 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 an update on the business trends we are experiencing.

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 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.

We encountered a number of challenges that produced disappointing underwriting results in the second quarter of 2010. Increased claim activity from severe wind and hail weather events, including catastrophe events in the mid-Atlantic and Midwest region, and an unusually large number of fires throughout our operating regions led to an elevated loss ratio relative to our historical experience and targeted results.

Although the weather and fire losses are unfortunate realities, there were a number of positive developments during the quarter that I will talk about this morning, including a 9.4% increase in net premium writings as a result of both personal and commercial lines growth, much-improved prior-accident-year reserve development trends, profitability in our casualty line, and a sizable acquisition announcement last week.

Our net income for the second quarter of 2010 was $1.7 million or $0.07 per share of our Class A common stock compared to $4.4 million or $0.18 per share of our Class A common stock for the second quarter of 2009.

Our total revenues for the second quarter of 2010 increased 7.1% to $101.5 million, with net premiums earned increasing 6.2% to $93 million.

I mentioned that our net premiums written increased 9.4% over the second quarter of 2009. Organic writings increased 6.7%, attributable to a 3.5% increase in personal lines premiums and a 13.7% increase in commercial lines premiums. The remaining 2.7% overall net written premium growth was related to an increase in pooled premiums from Donegal Mutual's affiliation with Southern Mutual Insurance Company in the fourth quarter of 2009.

Our investment income for the quarter was $5 million, a decrease from the $5.3 million reported for the second quarter of 2009, as a result of the pressure on investment yields and the continuing lower interest rate environment. We reported $2 million in net realized investment gains during the quarter that resulted from the sales of bonds and equity securities where opportunities arose to lock in gains.

Our loss ratio for the second quarter of 2010 was 73.7% compared to the 70.7% loss ratio for the second quarter of 2009.

We incurred claims from severe weather events during both quarterly periods. We incurred approximately $10.3 million in weather-related losses in the second quarter of 2010 compared to $8 million in the second quarter of 2009.

From a catastrophe perspective, there was one hail event that impacted Pennsylvania and six wind and hail events that impacted our Midwest subsidiary that collectively add up to an impact of $3.8 million after reinsurance compared to $1.6 million in cat losses for the second quarter of 2009.

In both quarterly periods, we also incurred higher claims than our historical norms related to smaller pockets of storm activity that did not aggregate to a level that triggered reinsurance recoveries.

We've been reporting elevated numbers of fire losses over the past two years and several quarters, and we were disappointed to find in our analysis that there were $6.1 million of large fire losses incurred during the second quarter of 2010, which represented approximately $3 million more large fire losses than the year-earlier quarter, when we incurred a more normalized level of fire losses.

We were pleased to see marked improvement in our prior-accident-year loss reserve development trends, which began in the first quarter of 2010 and continued through the second quarter. We realized modest favorable development in the second quarter of 2010, and our development through six months is basically flat, comparing very favorably to the $6.7 million of unfavorable loss reserve development from prior accident years that we experienced in the first half of 2009.

We were also pleased to see underwriting profitability in casualty lines during the quarter, including commercial auto liability and workers' compensation. Our actuarial analysis of our current trends points to relatively favorable results outside of the impact of severe weather and the elevated number of large fires. And we continue to believe that we have a quality book of business in spite of the recent underwriting results that have not met our expectations.

Our expense ratio was 32.6% for the second quarter of 2010 compared to 31% reported for the second quarter of 2009, with both quarters' ratios reflecting lower underwriting base incentive costs due to the higher claim activity.

The increase in the second-quarter 2010 expense ratio primarily reflects increased acquisition costs related to the increased premium writing. Our combined ratio for the second quarter of 2010 was 106.4% compared to 101.8% for the second quarter of 2009.

Our book value per share increased to $15.19 as of June 30, 2010, compared to $15.12 at December 31, 2009, and $14.58 as of June 30, 2009.

Last week, our Board of Directors declared dividends of $0.115 per share of our Class A common stock and $0.1025 per share of our Class B common stock, payable on August 16 to stockholders of record as of the close of business on August 2.

Last week, we also announced that we have entered into an agreement to purchase Michigan Insurance Company, which is a majority-owned stock subsidiary of West Bend Mutual Insurance Company. Michigan Insurance Company wrote over $100 million in direct premiums in 2009 exclusively in the state of Michigan and represents a significant growth opportunity for us.

Our press release described our intent to reinsure 50% of Michigan's business with outside reinsurers until we have more time to fully review and understand their book of business. And 25% of Michigan's business will be reinsured through a quota share agreement with Donegal Mutual and placed into its pooling agreement with Atlantic States, which is of course our subsidiary.

The end result is that 45% of the Michigan Insurance Company's premiums and underwriting results will be included in the Donegal Group financial results. The purchase price will be based on the book value as of closing, and we estimate the price to be in the $39 million range, which we will pay in cash.

We expect the acquisition to be immediately accretive based on the company's historical results, and we will be providing our technology and management assistance to improve the efficiency of Michigan's operations and their profitability over time. We are excited about the opportunity this acquisition represents, and we expect to close on the transaction during the fourth quarter.

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

Thank you, Jeff. Good morning, everyone, and thank you for joining our second-quarter conference call. Jeff has certainly given you a very good overview of the results for the quarter, and I would certainly like to comment on a number of issues.

The first would be the continuation into the second quarter of severe adverse weather and fires, which Jeff has indicated the cat results were approximately $10 million cat and adverse weather. And one of the logical questions would be, well, what is your Company doing to hopefully, going forward, mitigate these results?

Well, as one could understand, certainly in terms of weather events, we have no control over that. However, as seasoned underwriting people, we recognize that there are two components that we can do something about, and that is whether the pricing of homeowners' insurance adequately reflects the weather patterns that have been occurring over the last several years. And secondly, as we all know, real estate changes over time. So we have been very proactive over the last year-plus, and we are accelerating that in 2010.

We continue to aggressively make rate increase filings in all of the states in which we write homeowners in any volume, and we have not been timid about that. As an example, in the state of Iowa we recently filed and got approved a 9.5% increase; in Nebraska, 8.5%; in South Dakota, 12%. And in the mid-Atlantic states, they might range anywhere from 4.4% to 7%, in the Southeast as much as 8%. It is our intention in the fall to take another look and see what additional rate filings we might need to make.

We also have initiated, as of last October, a reinspection program. As many of you may be aware, when we write new business, many times we will physically inspect the property. And after so many years, it is good practice to go back and do a reinspection. So in all of our states where we have material amounts of homeowner premium, we have set up reinspection programs that will take place over a number of years. And we will do a significant number each year, into the thousands in each state, and it will determine whether the Coverage A amounts are correct, whether the condition of the property needs anything that needs to be improved.

And all of this is sound underwriting that we would traditionally use. But certainly, when you see weather losses and fires, you want to make sure that you are really on top of it.

Now, let's move on to some significant positive factors and results aside from the loss results, because candidly, we think the loss results and the earnings for the quarter are only a small part of the Donegal story.

We would want to point out again that our balance sheet strength continues to be very much an attribute of the Company. Our book value continues to grow. Jeff has reported it has grown to $15.19 per share.

We are particularly pleased about the growth that we have experienced, net premium growth of 9.4%, which is very good. And I will go on to explain a little bit about that and the reasons for it in a minute or two.

Commercial, we have been pleased to see that our commercial premiums are up over 10%, 13.7%. And one of our affiliations, Southern Mutual Insurance Company, is providing in the quarter $2.5 million of new premium to the Donegal Insurance Group.

With regard to the reasons for growth, certainly acquisitions are producing results. As you may remember, in 2008 we acquired Sheboygan Falls Mutual Insurance Company, which was demutualized and is now known as Sheboygan Falls Insurance Company. In 2009, we did an affiliation with Southern Mutual Insurance Company. And now, we are announcing an acquisition of Michigan Insurance Company.

Clearly, we are one of the regional companies that has been most active and most effective in our acquisition strategy. We have always tried to be selective. We look at numerous companies. We do due diligence on a number of companies. And we select and participate in those that we think will fit in to the longer-term business strategy and are consistent with the lines of business that we are currently in.

Other reasons for growth over the last number of quarters, we have talked about a number of initiatives -- focusing on excellent service, which we think is more important than many people might realize; our enhancement, continually, to our technology of WritePro and WriteBiz and rolling that technology into additional states; enhancements to our products and coverages, both in commercial and personal lines; expansion of commercial lines into additional states.

As an example, Sheboygan Falls wrote very little commercial business. In the state of Wisconsin, we have rolled out all of our commercial products last fall. In states in the Midwest that Le Mars Insurance Company does business, we have expanded our positioning of commercial lines there. And certainly, the growth of the distribution system that we have announced over a period of time, how many new agencies that we appoint -- we believe that all of that has sort of kicked in over the last six months, and we are beginning to see the benefits of that in terms of what we believe will clearly be profitable topline growth.

With regard to other aspects of our operation, as far as the growth of the distribution system, for the second quarter -- in the second quarter, we appointed 42 new agencies throughout our distribution system.

Talking a little bit about the Michigan Insurance Company acquisition, I know that Jeff has given you a nice overview of that. A few highlights that I would want to focus on, and that is the sizable amount of premium that that provides as an opportunity for our Companies of about $106 million. They have a history of underwriting profitability, which is core for us.

They clearly have an experienced and capable management team, which we always look for in an acquisition. We will certainly supplement management and provide resources, but it's very essential that there be key people in that organization, and there are. They have an excellent knowledge of the Michigan market. We have done extensive due diligence, and we know that they have a very fine agency force.

And one of the positive aspects in addition to all of what I have just said is that the way it is going to be structured with the quota share reinsurance agreement, it gives the Donegal Group, over time, the opportunity for planned and guaranteed growth as we might determine. And the way that would work is that it will start out with an external reinsurance program called a quota share of 50% of the net premiums written.

As we determine it is appropriate, every year we can walk down that percentage of the external reinsurance and bring into our premium base whatever percentage we would deem appropriate for that particular year.

We like the structure of it. It's not only a company with scale, but how we can manage the bringing into the premium into our Companies we think is a unique position.

Talking a little bit about our overall acquisition strategy, we think it is unique among many of our competitors on a regional basis that are out attempting to do acquisitions. We think we have a unique approach to it. For one thing, we have a menu of approaches, whether it be with mutual companies or books of business or stock companies or the use of quota share reinsurance agreements.

We believe our acquisitions are people-focused and respect the legacy and relative independence of those entities, which many times an acquiree will want to know that they are not going to just implode and become totally integrated without some continuity of what they have helped to build. We think it is an approach that has been helpful to us.

So all in all, we would be saying that one of the strong points of our discussion this morning is that we continue to have a strong business model focusing on continuing to build profitable operations and expanding our footprint with profitable premiums.

At this point, I will turn it back to Jeff, and we will be happy to respond to questions.

Okay, thank you, Don. Shanika, if you would open the lines for questions, please?

(Operator Instructions). Matt Rohrmann, KBW.

Just a couple of questions. I guess first on the commercial lines growth, obviously very strong there. Don, what kind of pricing are you seeing in all those products? Obviously, a lot of the growth came from the initiatives that you mentioned. But has pricing firmed up at all or flattened out? Obviously, we've seen a lot of negative commentary there over the last couple of quarters.

Well, candidly, we don't see that it has necessarily firmed, but it has not deteriorated, in our opinion, any further. And where we have primarily gotten our growth is in additional states, the writings there, expanding some products. Also, our commercial operations have sort of been evolutionary over the last 20 years, where we gradually increase the scope of what we are willing to write. We, I think, use effectively reinsurance to enable us to do certain things.

So it has been from a combination of areas, but we don't see any great firmness in rates, and it may for a while be the new normal. But we also don't see it further deteriorating, at least at this point.

Okay, great. And then, obviously, we have seen sort of a flurry of M&A deals over the last month or so, and as you know, Donegal has been active over the last couple of years.

Has the expansion in the number of deals that we have seen recently, is that a lot of smaller companies that perhaps are capital-constrained kind of coming to grips with the fact that the market isn't going to turn around quite as fast as they thought?

I think it is companies -- for various reasons. They might be capital constrained. They may have technology issues; it is very expensive for modest-sized companies to develop the technology that is needed. It can be, depending upon the circumstances -- certainly not in Michigan, but we have seen other potential opportunities where rating-agency action would motivate companies to look for some strategic partner.

Okay, great. And then, Jeff, just one quick numbers question. You mentioned how much adverse development you had in the first half of '09. Could you just repeat that number?

I believe it was $6.7 million in the first half of 6009 (sic), and again, for the six months of 2010, it is virtually zero.

Okay. All right, great. Thank you very much, guys.

Dan Schlemmer, Macquarie.

Don, you actually just brought up that sometimes it is related to ratings, some of the transactions that get done. We did see that A.M. Best sort of commented on Michigan's rating. Can you talk a little bit about their -- A.M. Best I think just has a negative implication out, and your take on that, what that means, and what Donegal's -- how they are approaching that?

Well, there are two press releases by A.M. Best, one with regard to our acquisition of Michigan and one with regard to Michigan. You may be aware, and the others on the line may be aware, that whenever acquisitions are announced, A.M. Best will always issue some type of a press release. And they have very strict rules that either they will say it is with either negative or positive implications. And in this case, they said with negative implications. But then they go on to explain that it doesn't mean that it is going to be a decline in rating. It is simply that that is the designation they give it.

We would be very optimistic that it will continue to retain its A rating and that we also, as the acquirer, although it will not be any type of a financial guarantee or anything of that nature, the fact that we are providing management and resources is an element that A.M. Best takes into consideration. It's no different than, in our judgment, than West Bend was in a similar relationship, and they are an A-rated company, and also A.M. Best, as a separate rating, gave it to Michigan.

We cannot speak for A.M. Best, but we would be optimistic that Michigan will continue to retain the A rating that they currently have post the acquisition by us.

And then staying on the Michigan and West Bend, can you talk a little bit about just sort of the Company's mix of business? Does it look a lot like Donegal in terms of lines of business, target, target size, etc.?

It does. It is probably similar to us in terms of the commercial is a bit higher, in terms of the mix. Personal lines is 52%; commercial lines is 48%. So they are actually a little more slanted in commercial lines than we are, but we would be happy to be at 50-50. So it is a good balance.

They are in the same classes of business. Generally, when we did our due diligence, we did not see any material differences in the type of classes that they would write in commercial as compared to us.

They're also writing small to medium-sized accounts, as us, and of course, their personal lines are the same kinds of personal lines that we write. That is, of course, one of the things we look for, is that we want an acquisition to fairly well look like what we look like. Certainly, there can be some variations, but we don't want it to be dramatically different.

Okay. And then I guess two questions, sort of related. I guess the first, just want to confirm -- my understanding is Donegal currently has no Michigan exposure. And then the company being acquired is completely Michigan. If you can just confirm that that is right or correct me.

And then secondly, what does that do to your thinking in terms of catastrophe reinsurance or how you look at that?

Well, that's a good question. First, the answer is that Donegal currently has no exposure or no business in the state of Michigan, and Michigan Insurance Company currently only does business in the state of Michigan.

And let me add a little bit there. For some time, we have been working on a Midwest strategy in acquiring companies. And if you look at a map, you will see that we are in Wisconsin, South Dakota, Iowa and Nebraska. We are not currently in Michigan and Minnesota and Illinois, all states that we want to enter. And this provides a good opportunity to enter into that state.

From a standpoint of reinsurance, we are conservative buyers of reinsurance, which means that we are rather risk-averse, and that when we place the cat covers for Michigan, we will make sure that there is very good reinsurance coverage and that the retentions are not excessive.

Michigan has a better cat history than some of the other Midwestern states, and Michigan Insurance Company has not had any significant adverse cat events that are outside of the norm. But we will manage that very closely, as we try to do in all of our jurisdictions.

And then last question, and just, just on the premium side -- so what I'm hearing is, I think you're saying of the $106 million on a go-forward basis, half of it you are going to cede externally. Half goes to -- it's going to stay with Michigan -- I'm sorry, a quarter stay with Michigan, and a quarter is going to be ceded from Michigan up to Donegal. If I heard that right, I guess I'm not sure I understand the distinction on the portion kept within Michigan versus the portion ceded to Donegal postacquisition. I'm not sure why that would matter. Am I thinking about that wrong?

Dan, let me provide a little bit of additional explanation over there. The 25% that is ceded to Donegal Mutual will be placed into the pooling agreement, which means that Atlantic States will get 80% of business and Donegal Mutual will retain 20% of it. So the 80% or 20%, basically $20 million of the $100 million, if we are using round numbers, will go into Atlantic States. $25 million will be retained by Michigan. So when you add those two together, basically, $45 million or 45% of the Michigan premiums will be in the Donegal Group consolidated results.

Yes, that's the part that I was missing. Thanks for the clarification. I appreciate it.

(Operator Instructions). There are no further -- I'm sorry, you have a follow-up from Dan Schlemmer.

Yes, good. I was hoping I would get to get back in, but I wanted to make sure I wasn't monopolizing your time.

I guess if you could maybe talk a little bit about the loss ratio, And I guess I am looking at the $10 million. If you back out the $10 million that you were talking about in your press release, you come out to I think about a 63% loss ratio.

Is that maybe the right number to be thinking about in terms of your casualty book plus your property book with a more normalized cat load? Or I guess I'm trying to think in terms of a run rate with a normalized cat load. How would you look at that?

The way we looked at that is the weather -- we would say an average level of weather losses in a quarter would be somewhere around $5 million. But we had about 5.6% in our loss ratio that was abnormal weather, so 5.6 points. And then in the fires, we typically would view a level of maybe $3.5 million of fires to be typical in a quarter, and we had $6.1 million. That translates to 2.8 points.

So between the fires and the abnormal weather, we have about 8.4. So if you pulled the 8.4 off of the 7.3, that would give you a more normalized run rate for the loss ratio. I couldn't do that math in my head, but the 8.4% is what I would say is abnormal losses in our loss ratio.

Great, thank you. And then on the growth -- and I know you talked about it before; I think you said 13% growth in the commercial lines -- is there anything -- 13% excluding the Southern Mutual, if I have my numbers right. Is there anything in particular that you are seeing, particular states' lines or classes of business, or is it really just across the board seeing higher success rates?

It is across the board. Of course, workers' compensation, we are working off of a lower base. The workers' compensation was down significantly in 2009. So that would show the greatest improvement. So we are seeing about an 18% increase in workers' comp, about 10.5% in commercial auto, 14% in the commercial multiperil. So it is spread across all of the commercial lines, and as you know, we are account writers. So generally, we are writing an entire account as we -- when we grow in commercial lines.

As to states and where that is coming from, it is a mix. We have seen improved growth rates in commercial lines in the mid-Atlantic region, as well as, as Don mentioned, in some of these other regions where we've acquired companies that did not historically write commercial lines. So we are seeing nice commercial lines growth in the Midwest, in Wisconsin, and also in our Peninsula subsidiary that writes the commercial garage liabilities, we have seen some nice increases over there.

So it is spread across a number of our regions and subsidiaries and across lines of business. So we are pleased to see that it is not concentrated in any one location or line of business.

Going back to the Michigan Insurance Company, do you have -- so there is $106 million of premium that's coming under the umbrella, I guess. And you're talking about taking maybe $45 million write-off.

Is there a long-term expectation? Do you think one year out you are going to have pulled in more of the $106 million, or is that more of a five-year plan? Any lowering the external reinsurance and pulling more of it internal? Do you have a timeline in mind?

We don't have any defined plan, but what we would anticipate is that we would probably do so much a year. So as an example -- I'm not saying this is what we will do, but as an example, for 2011 or 2012, we might take it down to a 40% external.

So we would walk it down as we would look at a number of things, including loss experience, overall growth other places, leverage ratios -- a combination of metrics. But that would be the plan, to walk down the external reinsurance gradually over a period of a modest number of years. But sitting here five years from now, might we still have some of it in external quota share? That's possible. It's also possible we wouldn't.

Just to add to that, from a leverage ratio standpoint, we certainly have the capital available to take on that additional premium. So we certainly are in the driver's seat as to the timing of that and have the capital available as we are comfortable and believe that the book of business represents business that we want to bring into our revenue stream.

Great, thanks. Last question, I promise. Just real quick -- Union National, is there an update on the timing of that? Is that going to happen during the quarter -- obviously, you never know for sure until you get final approval, but where your expectations are right now?

We would expect that it is probably more a fourth-quarter event, Dan. We don't think it's going to happen by September 30. The shareholders' meeting for Union National will probably be sometime in September.

And we would also remind those on the call that our banking operation is a small part of our overall financial services industry. Currently, it represent about a 1.5% of our invested assets in terms of our investment in the banking side. When we complete the acquisition, it will represent probably about 4%. So it is a very small piece.

It also, if you came to Central Pennsylvania and you came into Lancaster and York County, where we have a nice presence in terms of Donegal Insurance Group, the combination of the bank involvement, as well as the insurance involvement, there is a cross-pollination potential, because it is a great area for our franchise.

So we think that it is an asset to be doing this. Also, it enhances our investment that we already have had for the last 10 years in banking in Lancaster County. So it is very modest in terms of our overall scope, but we think that it will be successful and is part of the overall strategy.

Great, thanks. Exciting times, so thanks for sharing all of that.

Matt Rohrmann, KBW.

Gentlemen, sorry, just one more question. Don, I guess last quarter you had mentioned the rollout of WriteFarm. I just wanted to see if that was on track and you were still expecting around $4 million or $5 million annually from that plan.

It is still on track. Matter of fact, there were meetings this week in terms of the rollout plan. There was a lot of technology that had to be developed. The expectation is that it will be on the street on October 1, and I can assure you that it will be.

Okay, great. Thank you, Don.

Thank you, everybody.

At this time, there are no further questions.

Well, we thank everyone for their participation and wish everyone a good day.

Thank you for participating in today's conference call. You may now disconnect.