Employers Holdings Inc (EIG) 2006 Q4 法說會逐字稿

Good day ladies and gentlemen and welcome to the 2006 full year and fourth quarter earnings call for Employers Holdings Inc.

[OPERATOR INSTRUCTIONS]

I would now like to turn the presentation over to your host for today's call, Miss Vicki Erickson, Director of Investor Relations. Please proceed ma'am.

Thank you, Annie, and welcome everyone to the 2006 year end and fourth quarter conference call for Employers Holdings, Inc. We appreciate your participation. After the close of market yesterday, Employers issued its 2006 full year and fourth quarter earnings results. Our 2006 Form 10-K will be filed with the Securities and Exchange Commission this evening at which time it will be available on the company's website at www.employers.com.

With us today on the call are Douglas Dirks, our Chief Executive Officer; Ric Yocke, our Chief Financial Officer; and Martin Welch, the President and Chief Operating Officer of our insurance subsidiaries. First, Doug will provide opening comments. Then Ric and Marty will discuss financial and operating results. Doug will close with a general update on the company and we will open the call for your questions.

Before we begin I would also like to remind you that during today's call we will make certain forward-looking statements that are intended to qualify under the Safe Harbor Provisions for such statements, established as part of the Private Securities Litigation Reform Act of 1995. All statements during the conference call other than statements of historical fact are considered forward-looking. Though we do believe the expectations expressed in our forward-looking statements are reasonable, we cannot assure you that they will be correct. Risks and uncertainties could cause actual results to be materially different from our expectations including the risks set forth in our filings with the Securities and Exchange Commission.

With that I will turn the call over to our Chief Executive Officer, Douglas Dirks.

Thank you, Vicki, and thank you to everyone for taking the time to join us today. 2006 marked a pivotal period in the 94-year history of this enterprise. Not only was it an outstanding year in terms of financial and operating performance but also because of historic changes in our organizational structure.

In 2006, we set in motion a major strategic initiative to enhance our corporate and operational flexibility through a demutualization and initial public offering of our common stock. Our stock started trading on the New York Stock Exchange on January 31, 2007. As part of the IPO we issued 30,762,500 shares at $17 per share. On March 9, 2007, a distribution was made to eligible members of 22,765,407 shares of common stock and $463 million in cash. A total of 53,527,907 shares are currently issued and outstanding.

As a newly public company we appreciate the confidence you have placed in us and we want you to know we are focused on building long-term shareholder value. Now our CFO, Ric Yocke will walk you through our financial results.

Thanks Doug. I'll start by providing a review of our 2006 calendar year results. I'd also like to mention how we look at these results. In measuring our financial performance, it's important to note that Employers uses a non-GAAP metric that excludes the impact of the 1999 loss portfolio transfer or LPT. We believe these measures as defined in our SEC filings are helpful to us in identifying trends in our performance because the items excluded have limited significance in our current and ongoing operations. As many of you on the call will know, the LPT was a nonrecurring transaction that resulted in a gain, which on a GAAP basis, is being amortized into earnings as claims are paid.

In terms of earnings, 2006 was a record year. Net income increased 24.7% to $171.6 million in 2006 from $137.6 million in 2005. Net income before the impact of the LPT increased a substantial 62.2% to $152.2 million in 2006 from $93.8 million in 2005.

Three major factors contributed to this increase. First, we had a favorable pre-tax prior year reserve development of $107.1 million in 2006 compared with $78.1 million in 2005. Total prior year reserve development in 2005 was $105 million after $26.9 million of favorable reserve development subject to the LPT.

Second, losses and LAE were lower by 38.7% to $129.8 million in 2006 from $211.7 million in 2005. This was primarily due to a 10.9 percentage point reduction in the estimate of current accident year losses to 65.2% of net earned premium for the year ended 2006 compared with 76.1% for the prior year. This adjustment was made after observation of several consecutive quarters of favorable loss development in California. These favorable loss reserve developments were due to the impact of past regulatory reforms designed to control loss costs in California. Before LPT related items, losses and LAE would have been $149.1 million in 2006 and $255.4 million in 2005.

Third, equity sales related to our investment portfolio reallocation in the fourth quarter of 2006 resulted in a pre-tax realized gain of $49.2 million.

For the full year, net premiums earned declined 10.3% to $393 million from $438.3 million primarily due to rate reductions in California. Rate reductions were partially offset by policy growth. Marty will discuss this trend when he reviews our operating results.

In the fourth quarter, we sold $169.2 million of equity securities in connection with the portfolio reallocation I just mentioned, reducing our equities to 6% of total investments. Realized gains on investments were $54.3 million, largely a result of the fourth quarter gain from this sale.

Our invested assets increased 7.5% to a record $1.72 billion at year-end due to increased cash flow from operations. The yield on invested assets grew to 5.29%. As a result of these two factors, net investment income increased 25.3% to $68.2 million at year-end. We maintain a conservative bond portfolio with an average duration of 5.89 and a AA+ credit rating by S&P.

In 2006, commission expense increased 3.2% to $48.4 million due, in part, to increased competition.

Underwriting and other operating expenses increased 25.6% from $69.9 million to $87.8 million. Over half of this increase was $10.0 million in nonrecurring costs related to the conversion of Employers to a public company. The remainder includes information technology maintenance and depreciation, professional fees, and costs for additional employees we hired to support increases in policy count and new public reporting requirements.

Our effective tax rate increased from 18.1% to 32.5% due to a greater level of tax-exempt income from the LPT in 2005 as compared to 2006, and the impact of non-deductible conversion expenses in 2006.

In summary, we saw our overall GAAP combined ratio decrease 7.3 percentage points to 67.7% from 75%. Before the impact of the LPT, our combined ratio was 72.6% in 2006 and 84.9% in 2005.

Our capital position was very strong at year-end. We had a conservative premium to surplus ratio of 0.6 to 1. Statutory surplus increased 20.7% to $640.5 million net of $33.9 million in additional minimum reserves related to California's Schedule P requirements. Shareholder's equity increased to $303.8 million. And equity including the LPT deferred gain increased 23% to $746.8 million.

I will now briefly discuss our results for the fourth quarter. We had net income of $55.1 million in 2006 compared to $74.5 million in 2005. Net income on a GAAP basis declined because fourth quarter prior year reserve releases were lower in 2006 than in 2005. That is, $25.4 million in 2006 and $51.5 million in 2005. Additionally, there was a favorable LPT adjustment of $26.9 million in the fourth quarter of 2005 while there was no such adjustment in the fourth quarter of 2006. In addition, most of the conversion costs were booked in the fourth quarter of 2006. These impacts were partially offset by the realized gain on equity sales that I've already discussed.

And fourth quarter net income before the impact of the LPT increased 8.8% to $50.3 million in 2006 from $46.3 million in 2005.

With that I'll turn the call over to Marty Welch, our Chief Operating Officer for a discussion of operation results.

Thank you, Ric. In 2006, our claims and underwriting operations continued to perform well contributing to the financial results Ric just reviewed. Claim trends continued to be favorable contributing to underwriting profits and positive cash flow. We have seen a decrease in average indemnity claim severity for the past two years and we have experienced an increase in net subrogation recoveries. Our dedicated fraud unit produced over $6 million in claims savings in 2006 and we continue to see improved penetration rates in our medical provider networks in both California and Nevada. We also improved our claim-closing ratio by 15% in 2006.

In California, ultimate losses continued to decline driven by overall decreases in frequency and severity and the benefit reforms that were enacted by the California legislature in 2003 and 2004. Those reforms targeted medical utilization, vocational rehabilitation, disability rating schedules and claim duration.

On the underwriting side, we increased the number of in-force policies to 29,742 in 2006 from 27,686 in 2005, a strong growth rate of 7.4% for the year. Our retention rate on policies was approximately 90%. This policy growth, while strong in real terms was insufficient to overcome the decline in premium we have experienced in California, principally due to declining rate levels. We expect to see a similar trend in 2007.

In Nevada, we experienced a modest decline of $6.4 million or 7.8% in direct written premium principally because of adherence to underwriting standards amid increasing competitive pressures. Overall, we expect to see similar written premium trends in 2007 where continuing consistent policy growth will partially offset but not totally overcome the decline in written premium.

We continued to geographically diversify our book of business. States other than California increased 4.2 points as a percent of our total premium, though California continues to be our largest market representing 73.5% of our 2006 direct premiums written. Of total direct premiums written, Nevada was 19.4%, Colorado increased to 3.4%, and we also saw increases in Utah, Idaho, and Montana. We began writing business in Texas and Arizona in 2006, though these two states represented less than 1% of our writings at December 31st. We see continued growth potential in these states going forward as well as opportunities in Illinois, Florida, and Oregon in 2007.

While ADP and Wellpoint continue to be our primary strategic partners, we will continue to expand our existing partnerships and seek new ones. We recently entered Texas and Illinois with ADP. We are selectively expanding into new states based on our analysis of premium rate adequacy, market dynamics, and political, economic, and regulatory climates. We plan to begin writing business in Oregon and Florida in the second quarter of 2007.

That is an overview of our insurance operations and I will turn the call back over to Doug.

Thanks Marty. Now I'd like to discuss our two largest markets, California and Nevada. California continues to be a profitable market for us. While rates have decreased, we continue to see loss cost improvements in California resulting from observed decreases in frequency and severity. We believe that favorable impacts related to the reforms in California will continue in the near term. We expect that we will further reduce our rates in California in 2007 as a result of cost savings arising from previously enacted reforms as well as increasing competition. In this increasingly competitive market, we will stay committed to producing an underwriting profit by carefully selecting risks within our clear underwriting standards. All of these forces will, however, continue to drive down premium written in 2007.

No changes were made to previously enacted worker's compensation reforms by the California legislature in 2007. This year, the area of the reforms that seems to be getting the most attention is permanent disability. It's too early at this point however to speculate on potential outcomes or impacts from any changes to the manner in which permanent disability awards are determined.

In Nevada, rates have declined 11.4% since 2003 but average rate levels will increase in 2007 as a result of the decision of the Nevada Insurance Commissioner to increase rates 3.4%.

Now I'd like to make a few comments about our capital management plans. Our board of directors has approved a $0.06 per share dividend, which will commence in the second quarter of this year. Also, if approved by our board of directors, we expect to initiate a share repurchase program of up to $75 million in 2007 and $50 million in 2008.

In closing, I'd like to summarize our very strong year. We have achieved historically high levels of net income and statutory surplus. We had impressive accident year results and favorable prior year development. We experienced strong retention levels and saw continuing strong growth in policy count. Our investment income increased. We are proud of what we have accomplished and we are committed to delivering long-term value to our customers and our shareholders. Thank you for joining us for our first investor call covering our financial and operating results. That concludes our formal comments. Now we'll be happy to take your questions.

[OPERATOR INSTRUCTIONS] And your first question comes from the line of Amit Kumar with Fox-Pitt Kelton. Please proceed sir.

Hey guys. I guess, starting with the premiums I'm just wondering just based on the commentary, is it fair to assume that '07 premiums would be down compared to '06?

Let me begin by addressing what the WCIRB announced in California a couple of days ago and they'll be making a filing this morning. There's going to be a recommendation filed with the California Insurance Commissioner that's recommending an 11.3% decrease in pure premium rates in California beginning July 1, 2007. As we look at that decrease (company corrected after call) it will have an impact on the top line. Although we've indicated that we believe we will have strong policy count growth, these rate decreases are not going to be overcome purely by growth in policy counts. So we believe it does have an impact on the top line.

The other thing I think we need to look at in terms of the impact in California -- the other thing it's telling us is that reforms from 2003 and 2004 are still having a positive impact on the market. And we're continuing to see favorable development across the market in terms of frequency and severity.

Okay. In terms of the new states, do you think you're on track or has that slipped a bit in terms of entering Florida and Illinois? Maybe you can update us as to, if the licenses have been received or if you're still in that process.

Yes, I'll take that one, Amit. This is Marty. As you know our business plan is to grow our business by serving more customers and diversifying the book, and organic growth in the new states is one aspect of that. In Illinois, we just began writing business in Illinois in 2007. And we expect to begin writing business in Florida and Oregon beginning in the second quarter of 2007. We had hoped to be writing business in Florida sooner than the second quarter but we did experience some delays in obtaining some regulatory approvals from that state. But we've now obtained all of those necessary approvals and are in the process of readying our systems to begin accepting applications.

Okay. And in terms of -- and this is the final question, I guess when you look forward, clearly the top line is under a lot of pressure. I think you've alluded to competition and that has resulted in higher commissions. I guess when you look towards '08, what are your top processes in terms of capital management including, I don't know, possibly M&A?

I'll address that question. In terms of what we expect looking that far out, one of the key benefits of our transactions of demutualization and conversion to a public company is our access to capital management tools that we didn't have as a mutual company. I addressed a couple of those in my comments. One of those is dividends and the other one is share repurchases. Also, in terms of being able to manage our capital and achieve greater amounts of leverage, that can be achieved a couple of ways. One can be through organic growth, which our business plan clearly contemplates. And the other would be through opportunistic acquisition opportunities. And they are opportunistic and so at this point I wouldn't have any other comment on that.

Okay. Fair enough. Thanks so much. I'll re-queue if I have any additional questions. Thanks.

Thank you.

Your next question comes from the line of Matt Carletti with Cochran Caronia Waller. Please proceed sir.

Good afternoon. A couple of numbers questions to start off. One is do you have the after tax number for the realized gain in the quarter?

Thanks for your question on that. If you'll give me a second, the after tax was $32.0 million.

Great. Okay. And then, other numbers question, just how should we think about the tax rate going forward? Would kind of a low 20s run rate be a good assumption in our modeling?

Again, good question. I believe that would be an appropriate forward look. This year we had a surge, as we discussed earlier, in taxable income. We'll normalize going forward with our tax-exempt portfolio becoming a more normalized low 20s rate.

Okay. Those are the numbers questions. A little bit bigger picture, one is in terms of -- I guess we've been through kind of most of the first quarter here in '07. What are you thinking in terms accident year loss picks? We saw '06 kind of come in around 65 or so ex-LPT, ex-favorable development, just kind of the accident year pick. How should we think directionally about that as we go into '07?

Well, since we've not even closed the first quarter of 2007 yet, we're not prepared to make any comments on what our expectations are there.

Okay. Last question, the recent events at the state fund, could you comment a little just on if you see any opportunity in that? Do you think it's a little bit of them maybe getting back to their mandate of being insurer of last resort and maybe not - a fund that might not be acting as much like a private market company any more, maybe giving up some more market share? And is that an opportunity for you?

Well, let me comment on what we're aware of. Because what we know we know from the same public sources that everyone else sees. The state compensation fund has terminated its Chief Executive Officer. The Insurance Commissioner has ordered a full audit of the fund. For us, we can't predict or speculate on what the outcome of the audit might be. And therefore it's difficult for us to speculate as to what the impact any of this will have on the marketplace. Our business strategy for California is well defined and it's not going to change as a result of potential civil or criminal investigations that could occur with officers or directors, former directors of the fund. So at this point we don't see it impacting our strategy but again to the extent that market conditions change, we'll be able to respond and react accordingly.

Great. Thanks very much. Continued best of luck.

Thank you.

Thanks Matt.

Your next question comes from the line of William Wilt with Morgan Stanley. Please proceed sir.

Hi. Good afternoon and congratulations on getting to this point.

Thank you, Bill.

A couple questions if I may, Marty mentioned the policy count growth, about 7.4%. I was hoping first to just confirm that that is -- whether that's California only or for whole company. And then beyond that, just any color you could add on the history of policy count growth over the last year or two or what -- how 7.4% compares to what it has been recently.

I'll take that, Bill. This is Marty. That is for the entire company, the 7.4%. That's total policies at the end of 2006 in force compared to the end of 2005. The 2005 number was also up from 2004 in a similar range.

Okay. Thanks for that. Another question, Doug, I guess you mentioned operation leverage and spoke to that dividends, share repurchases, as part of capital management. What's the current thinking on the prospects for adding financial leverage?

Well, as we've indicated from our comments, our return on equity is influenced heavily by previous events, one being an inability to manage capital as a mutual and the other one being strong profitability in the book of business. As we've seen it through 12/31/06 our premium to surplus leverage has dropped 0.6 to 1. And that is below what we see in the industry. We would expect to continue to improve that leverage through organic growth, through the capital management tools I discussed. And again if there are opportunities to add business other than organically we'll certainly look at them. But we are challenged because of the strong profitability that the book of business is produced in recent years.

Does -- I guess just trying to interpret that -- does that mean financial leverage is not necessarily on the radar screen, or I guess I'm trying to parse what you described.

Well, again, we're writing at 0.6 to 1 so we're not suffering because of a lack of capital to support our business strategy.

Oh, understood. I guess what I was -- the implication was would you consider adding financial leverage? I don't know if it would require regulatory approval but down-streaming the proceeds from financial leverage or essentially using financial leverage to embark on an accelerated share repurchase I guess would the effective way of a levered recap.

This is Ric, Bill. Are you specifically asking whether we're looking at debt?

Correct, yes.

We don't have any proactive plans on debt at this point.

That's fine. I'll sneak in one other if I may, a bigger picture question. I guess with reference to, for instance, ADP and the process by which you would grow in other state, in other states in which you're -- I guess you've mentioned Texas, Illinois and Florida. What strategies are you undertaking currently, for instance, in Florida recognizing that the valve is just now beginning to be turned on or will be in the second quarter of '07? What processes, procedures do you have underway to win business through the ADP channel in Florida or in other states where you've begun a relationship with them?

Well, I'll certainly answer that one. We continue to have a strong relationship with ADP. We ended 2006 as their largest partner in the state of California. And they are very enthusiastic still about us expanding with them into other states. They have strong sales forces in both Florida and Illinois. And we anticipate leveraging their market penetration in those two states as we continue to grow. As you said, we're just kind of getting ready to turn the engine on in Florida. So we're not heading down that road at a great clip at this point. But we do anticipate that that opportunity will accelerate as we head toward 2008.

Thanks for that. Best of luck.

Thank you.

Thanks Bill.

[OPERATOR INSTRUCTIONS] And your next question comes from the line of David Merkle with Hovde Capital. Please proceed sir.

Hello. Can you hear me?

Yes.

Okay. I have three big picture questions. You've got a lot of capital to deploy. And I'm just wondering what you see as your sustainable competitive advantages over your competitors that will enable you to deploy it profitably over the next say three to five years?

We have a very focused approach to the business we write and our underwriting appetite. And we think that's very important in what we do. So, in terms of competitive advantages and sustainable growth over the long term, we really look at our ability to focus on small employers and convert submittals into policies. And we've been very successful at that in the past. I would also point to our strong strategic relationships that have supported the business well in the past and we believe will continue to offer growth vehicles for us in the future.

Okay. Do you think it's easier to grow now by acquisition or organically? Which is cheaper or better?

It would depend on the opportunity. I think if it were an acquisition there would be no way to answer specifically which would be better without knowing the terms of what an acquisition might look like. So it really varies and it depends on the opportunity.

Okay. I guess my last question is, what do you see is as the most important change in the competitive environment at present in the markets you serve? And it might vary by state, so you could walk me through that.

Well, certainly we would agree with you that it varies by state because these are individual state marketplaces. And even within individual states the market conditions can vary from region to region. Why don't I let Marty address what he's seeing in the marketplace in terms of competition?

Yes. I think in California, David, it's basically just a function of the results have been good for the capital that has been playing in that state the last few years. And as the rate filing decreases that are recommended by the bureau and the commissioner continue, carriers are just competing and retain the market share that they have. In some of the other states, it's just a function of the rate levels that are there today and the extent to which carriers are trying to increase that market share. I don't know that we think the competition is extremely severe in any of the states we're operating in today. But it is certainly competitive.

Thanks ever so much.

Thank you.

And your next question comes from the line of Gary Ransom with Fox-Pitt Kelton. Please go proceed sir.

Yes, good afternoon. I wanted to ask about loss trends. And you talked on several occasions about the trends being favorable, but I assume that that also varies considerably from state to state. And I wanted to particularly ask about what you're seeing as the trends in the newer states that you're entering, whether it's Florida or Texas or Illinois? And whether, as we add in trends from those other states, does that change what the overall company's loss trends look like?

When you look at the impact the other states have on our overall financial results, they're relatively minimal given the size of the California and Nevada book of business. We do closely monitor all the rate filings that occur in those states and make judgments as to whether or not we think the market conditions are improving or declining. In Nevada, I indicated that we've seen a rate increase for the first time in many years effective March 1st of this year. And that speaks for almost 20% of our book of business. In California, we continue to see that favorable development. As to the other states, again we monitor it. It ultimately has some impact on our book of business. But for the most part, California and Nevada determine the overall profitability.

Yes and I guess I was just trying to think about it over the long term. Maybe another way to ask the question is are there any states that you're entering where you see the severity increases or the trends in total are going up at a faster clip than -- considerably than what you might see elsewhere? I mean, say a 5 to 10% increase in total loss cost trends. Is that occurring in any of the states?

Well, part of our analysis, Gary, before we enter a state really is to, just to look at that profitability potential, the rate adequacy, which would certainly include a view of the loss trends both from a medical and indemnity frequency and severity standpoint. So, all the data that we are looking at is national data. It's everybody's data. We don't have any of our own there. We do know that in Florida and in Texas, for example, there was some meaningful reform there in the last few years, which has had a positive impact on the loss costs. But that's really about all we can speak to from a broad standpoint of measurement.

If you use it as another measurement, what's happened with rate levels in those states. If you look back over the last several years, two of the states that we're doing business in, Illinois and Montana have seen increasing rate levels. And assuming that those rate projections of the various bureaus are correct, that would indicate increasing pure premium determinations.

And in all the other states that you are dealing with it is going down?

We have seen -- I'm just looking at, I'm going back to 2006. There have been rate level increases in Montana and Illinois, not in any of the other states that we're operating in.

Okay. All right. Thank you very much.

Thank you all very much. I'd like to thank the operator and all of you for attending our call today. We appreciate it very much. Thank you.

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