Erie Indemnity Co (ERIE) 2004 Q3 法說會逐字稿

Hello and welcome to this Erie Indemnity Company third-quarter 2004 earnings conference call. At the request of Erie Indemnity, this conference is being recorded for instant replay purposes. At this time, all participants are in a listen-only mode. Following the prepared remarks from management, we will open the call for questions and answers. Now I'd like to introduced your host for today's conference, Ms. Karen Krauss Phillips, Vice President and Manager of Corporate Communications and Investor Relations.

Thank you, Jake, and good morning. We appreciate all of you joining us today. On today's call, management will discuss our third quarter 2004 results. Joining me are Jeff Ludrof, President and CEO; Executive Vice President and Chief Financial Officer Philip Garcia and January Van Gorder, Senior Executive Vice President and General Counsel. Today's prepared remarks will be approximately 30 minutes. Following those remarks, we will open the call for questions. We ask that you please keep to one question and a follow-up.

We issued our earnings release and additional supplements yesterday afternoon. We also filed Form 10-Q with the SEC. On today's call, the management of Erie Indemnity Company will share important information about current and future initiatives being undertaken at the Company. As a result, certain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 may be incorporated into those comments. These forward-looking statements reflect the Company's current views about future events and are based on assumptions subject to known and unknown risks and uncertainties. These risks and uncertainties may cause results to differ materially from those anticipated as described in those statements.

Many of the factors that will determine future events or achievements are beyond our ability to control or predict. For information on important factors that may cause such differences, please see the Safe Harbor statements in our latest 10-Q filing with the SEC dated October 27, 2004 and in the related press release and 8-K.

In this call, we will discuss some non-GAAP measures. You can find a reconciliation of those measures to GAAP measures in the press release and in the supplements posted on our investor web site at erieinsurance.com. This call is being recorded and the recording is the property of the Erie Indemnity Company. It is not intended for reproduction or rebroadcast by any other party without the prior consent of Erie Indemnity Company. A replay will be available on our web site today at 12:30 PM Eastern time. Your participation on this call will constitute consent to the recording, publication, webcast (indiscernible) cast and the use of your name, voice and comments by Erie Indemnity. If you do not agree with these terms, please disconnect at this time. And now, Erie's President and CEO, Jeff Ludrof. Jeff?

Good morning and thank you for joining us today. I'm pleased to report that Erie Indemnity Company produced a solid performance during the third quarter of 2004 as underwriting profitability continued to improve and investment income bolstered our results. Following my remarks, Phil will provide details of our results.

But I can characterize the quarter this way. We remain focused on three primary aspects of the business -- underwriting profitability, competitive position and agent relationships. I will talk about all three, how they affected us this quarter and what you can expect from the company moving forward.

First, let's look at the high-level results. Net income was up by 4.1 percent to $58.6 million for the quarter ended September 30, 2004, as compared to $56.2 million a year earlier. Net income per share was 83 cents for the quarter, up from 79 cents for the third quarter of 2003. Direct written premium for the property and casualty group grew to $1 billion for the quarter, up 7.7 percent from the quarter ended September 30, 2003. This translated into management fee revenue for the Erie Indemnity Company of $246.4 million, up 6.3 percent from the comparable quarter a year earlier.

Since our first earnings call in February of 2003, we've talked about the need to improve underwriting profitability. If you have been with us for any of those calls, you know it has been a critical focus of the organization. We have employed several strategies to target the issue and those strategies are giving us the desired result.

For the third quarter, the Property and Casualty Group's reported statutory combined ratio was 88.6. This includes 3.6 points of catastrophe experience. When adjusted for the profit paid to the indemnity company, the statutory combined ratio was 83, which is a tremendous result for our organization. As a result of the Property and Casualty Group's underwriting performance, the property casualty subsidiaries of the Erie Indemnity company reported significant improvement in their GAAP combined ratio, finishing the quarter 94.5.

Being a regional company, we did not experience the impact of the season's hurricanes to the same degree many of our national competitors have. Since August, hurricanes Charlie, Frances, Ivan and Jeanne have brought record rains, floods, mudslides and tornadoes to communities stretching from Florida to Massachusetts. In the wake of Ivan alone, disaster areas were declared in 26 counties in Pennsylvania, eight in West Virginia, 15 in southeastern Ohio and 16 in the western half of North Carolina. According to the Insurance Information Institute, combined insured losses from these four storms will reach an estimated $23 billion.

The estimated impact of these catastrophes on Erie's Property and Casualty Group was about $36 million, adding 3.6 points to the third quarter 2004 reported statutory combined ratio. The Erie Indemnity Company's 5.5 percent share of those losses is about $2 million, adding 3.7 points to the third quarter GAAP combined ratio and a reduction in net income of 2 cents per share.

While devastating, catastrophes like these spotlight Erie's above-all in service commitment. Employees from offices throughout the Company provided support to our response in the affected areas. Likewise, Erie agents did a tremendous job providing first contact with policyholders who suffered a loss, taking claim reports, surveying damaged properties, answering questions and providing advice and comfort.

One policyholder, a former agent with a prominent competitor, shared her impression of Erie's claim response with our Raleigh branch manager. She said, and I quote, "This is phenomenal. I've never seen anything like it. You're going to get more business because of this. The entire neighborhood is talking".

Well, that is an outstanding endorsement and we know that kind of service is invaluable in attracting policyholders and in attracting additional prospects to our business.

As we have talked about our initiatives to improve underwriting profitability, we have also talked about the expected impact these initiatives would have on our retention ratio and new written premium production; in particular, our pricing strategies and our agents' efforts to re-underwrite their book of business. We have reached a point where our loss experience indicates less additional premium is required to offset our lost cost. As we discussed on the second quarter call, we've been able to adjust our rate projections based on the positive improvement in our experience.

Last quarter, we projected the rate change impact on written premium in calendar year 2004 to be $302 million, based on rates approved, filed and projected at that time. At the end of this quarter, we are adjusting that slightly to $300 million. In some cases, we have moderated our pricing actions to affect Erie's competitive position in the marketplace. To further enhance our position, we also introduced insurance scoring this past August, solely for underwriting purposes. And during the second quarter of 2005, we will integrate insurance scoring with other underwriting characteristics into a refined price segmentation plan for both private passenger auto and homeowners insurance. This will enable to company to better match the price with the associated risk and give our agents more latitude for placing business with Erie.

In addition to enhancing our competitive position through pricing strategies and other marketing efforts, including incentive-driven sales and promotion programs, we have also expanded our distribution network. As of the beginning of October, we appointed 22 new agencies and plan to end the year with 30 new appointments in 2004. And, we plan on increasing agency appointments in 2005.

I've talked about this before on our calls, Erie's rigorous agent recruitment process and the importance we place on our service culture. The typical profile of an Erie agent is a person who is involved in their community -- very service oriented, compassionate and outgoing. These are people who care about their policyholders. These are people who want to do business with the Company, a company they believe and a company they can trust. They are loyal and expect loyalty in return. The relationship we share with our Erie agents has very deep roots. Some of our agents are second- and third-generation Erie agents. They know this company and we know them and preserving our relationship is critical to our mutual success.

Just last week, we concluded our fall annual dinner meeting. At these meetings, we celebrate our relationship and have the opportunity to acknowledge the great work our agents and employees do to serve our policyholders. I also take the time to address the group and share the good news and new challenges we are facing as a company.

One of those challenges is the prolonged development and deployment of Erie Connection, our new agents interface system. First, let me say that our current agency interface systems are competent systems that work effectively to meet our agents' and Erie's needs. In fact, we're in the process of updating our DS Pro agent interface to be fully Windows XP compliant. This will allow agents to upgrade their own equipment and continue to use DS Pro while waiting for the full deployment of Erie Connection. At present, nearly 50 agencies and 1000 employees are operating the Erie Connections system as a pilot group to aid us in the design and testing. We are about ready to release a new version of the system to the pilot group, a version that we believe will improve functionality and address bugs in the current release.

We are also looking at ways that we can improve the user interface; that is, the look and feel of Erie Connection. Customizing the system for Erie has been a much larger effort than we anticipated when we started this project. The team responsible for the development of the system is working very hard to ensure that agents and employees have the best system possible to support their work.

Before I turn the call over to Phil, I would like to address some recent news that his hit our industry -- the New York Attorney General's civil suit brought against insurance broker Marsh & McLennan and the ongoing investigation. The news coverage on this matter has painted the industry with a very broad brush, so let me dispel a few potential misconceptions.

First, Erie Indemnity Company is not an insurance broker. We operate as a managing attorney-in-fact for one client, the Erie Insurance Group of Property and Casualty Insurers. Secondly, Erie does not place or accept business through insurance brokers. We sell our products solely through our independent insurance agents, who are appointed by us. And third, both Erie and its independent agency force are committed to the highest legal, ethical and professional standards in the conduct of our business. Erie's corporate code of conduct, which is the viewable on the investor relations section of our public web site and our corporate culture, both promote fair dealing. Among the actions that Erie does not tolerate are fraud, conflicts of interest, collusion, kickbacks, dishonesty, theft and other illegal or unauthorized actions.

Profitability-based contingent commissions are part of our agents' compensation program. Frankly, contingent commission arrangements as used by Erie are very common within the industry. The contingent commissions or bonuses Erie pays to its agents are based primarily on underwriting profitability, which enables the Company to have lower loss cost and offer lower prices to our customers. Agents place business with Erie because of our competitive coverages, our competitive prices, our financial strength and our outstanding service. They place business with Erie because they are confident in placing the trust of the customers in our care.

Now, I will turn the call over to Phil.

Thanks, Jeff, and good morning, everyone. As Jeff stated, we continue to see consistent improvement in underwriting profitability. This positions us well as we move into 2005. For the third quarter of 2004, net income increased by 4.1 percent to $58.6 million, or 83 cents per share compared to $56.2 million, or 79 cents per share for the third quarter 2003. Net income, excluding the effects of net realized capital gains and income taxes on those gains, rose 5.4 percent for the quarter to $58 million, or 83 cents per share, up from $55 million, or 78 cents per share for the same quarter in 2003.

As I review the management operations, you can refer to the exhibit entitled Consolidated Statement of Operations Segment Basis, which was included in the supplemental data issued with the press release. First, I would like to discuss the performance in our management operations segment.

As you may recall last quarter, we announced an increase in the management fee rate to 24 percent from 23.5 percent. The rate increase was in effect throughout the quarter, the same as the management fee rate of 24 percent in the third quarter of 2003. Management fee revenue grew by 6.3 percent to $246.4 million for the third quarter 2004, compared to $231.7 million in the third quarter of 2003. Management fees represent 75 percent and 75.1 percent of the Company's total revenue for the third quarter of 2004 and 2003, respectively. Direct written premium of the Property Casualty Group in the third quarter of 2004 grew by 7.7 percent, totaling $1 billion compared to $971 million a year earlier.

Earlier, Jeff addressed the slowdown in new written premiums and policies in force. This is an expected result of our efforts to improve underwriting profitability; specifically, our efforts to control exposure growth, loss severity and improved risk selection. As agents complete the list underwriting cycle and we introduce more refined segmentation in our pricing model as well as other marketing initiatives, we believe their sales efforts will be more productive.

Year-over-year policies in force growth was 1.8 percent, a slower rate than the 3.2 percent at the end of June 2004, again, as our efforts to control exposure growth and improve risk selection have slowed our growth. For the first nine months of 2004, direct written premiums of the Property Casualty Group increased 9.8 percent to $3.1 billion, compared to $2.8 billion for the same period last year. The year-over-year increase in average premium per policy was 8.2 percent to $1042 from $964 for the 12 months ended September 30, 2004. The year-over-year policy retention ratio declined to 88.7 percent at September 30, 2004 from 90.6 percent at September 30, 2003. Again, the lower retention rate is an expected result of our effort to manage our exposure growth.

Another consequence of our focus on underwriting profitability is the continued decline in new policy premium. For the quarter, new written premium decreased by 17.4 percent overall from the high levels of new policy premium written in the third quarter of 2003. Personal lines new written premium decreased by 14.7 percent, while commercial lines new written premium decreased by 23.4 percent for the three months ended September 30, 2004 versus the same period last year.

In addition to efforts to manage exposure growth and improve risk selection, our pricing strategies have significantly contributed to our underwriting profitability results. The rate increases we've taken have more than offset the impact on premium volume of the declines in new unit growth. As Jeff mentioned, due to improving experience and to ensure our competitive position, we have modified our rate change projections for all of 2004 from $302 million in additional written premium at the end of the second quarter to $300 million today. For 2005, we estimate premium increases of about $77 million, or about a 2 percent increase in written premium. Combined with increases in exposure value, we expect increases in the average premium per policy of about 3 to 4 percent in 2005. Market conditions may of course effect these 2005 estimates. The change in average premium could also be affected by the transition of our book of business to our new segmented pricing model, which will be rolled out in the second quarter of 2005.

One final point on management fees. Each quarter we record an estimated allowance for management fees returned to the Erie Insurance Exchange for midterm policy cancellations. Third quarter 2004 and 2003 revenues were reduced by $4.6 million and $1.3 million, respectively, due to changes in this allowance, which was partially offset by an adjustment for returned commissions. The higher estimated allowance was the result of higher policy cancellation experience in the most recent quarter.

Service agreement revenue decrease for the third quarter of 2004 to $5.4 million dollars from $6.7 million during the third quarter of 2003. Included in service agreement revenue is the service fee income received from the Erie Insurance Exchange as compensation for the management and administration of voluntary assumed reinsurance from nonaffiliated insurers. These fees decreased substantially during the third quarter of 2004 due to our winding down of the assumed reinsurance business. For that reason, assumed reinsurance premiums written by the Exchange were negligible in the third quarter of 2004, as compared to $27.7 million in the third quarter of 2003.

Also included in the service agreement revenue are service charges the Company collects from policy holders for providing extended payment plans on policies. The service charge revenue for the third quarter of 2004 was $5.3 million, compared to revenue of $5 million for the same quarter a year earlier, up 6.7 percent. The cost of management operations increased by 10.7 percent for the third quarter of 2004 to $188 million, from $169.8 million for the same period in 2003. Commissions paid to our independent agency force account for the majority of these costs. Commission costs totaled $140.2 million for the third quarter of 2004, a 12 percent increase over the $125.2 million recorded for the third quarter of 2003. Commission costs were effective during the third quarter of 2004 by a charge of $13.8 million for the agency contingency bonus versus $6.4 million in the third quarter 2003 due to the significant improvement in underwriting profitability.

For the current year, our estimate for the annual agency contingency award results in an expense increase of approximately $20 million over 2003. The bonus is based on the 36-month underwriting profitability of the direct business written within the Property & Casualty Group. Scheduled commissions increased to $120.8 million for the quarter, driven primarily by the 7.7 percent increase in direct written premium that I referenced earlier. For 2005, our scheduled commissions will grow more slowly than the increase in direct written premium. This is due to commission reductions in some commercial lines, which we previously announced. As we indicated last quarter, this commission reduction will result in an increase in 2005 net income per share of approximately 19 cents.

Other operating expenses, excluding commissions, increased by 7.1 percent to $47.8 million for the quarter, compared to $44.6 million a year earlier. Personnel costs, including salary and wages and employee benefits and payroll taxes, which encompass the largest component of other operating expenses, increased 14.7 percent to $29.4 million for the third quarter of 2004, compared to $25.6 million for the same period in 2003. Contributing to the increase in salaries was a 4.3 percent increase in staffing levels, as well as normal pay rate increases. Total employee benefit costs increased 12.4 percent in the third quarter of 2004, compared to the third quarter of 2003.

In the third quarter of 2004, pension plan costs increased to $2.3 million from $1.8 million in the third quarter of 2003 due to the change in the discount rate assumption. We expect pension plan costs to be about $800,000 higher per quarter in 2004 than in 2003. The gross margin for management operations was 25.3 percent for the third quarter.

Next, I will review the results of our insurance underwriting operations. Before I do that, I would like to refer you to the new supplement we provided regarding our underwriting results. We've provided detailed statutory results of the Property & Casualty Group's underwriting pool, along with a reconciliation of those results with the GAAP insurance underwriting results of the Erie Indemnity Company. We believe this information will be very useful to investors in gaining a better understanding of our underwriting results. We have also provided quarterly adjusted statutory combined ratio data by line of business. As Karen mentioned, the supplement is also available on the investor relations section of our website.

As you know, the Erie Indemnity Company's Property & Casualty Insurance subsidiaries retained 5.5 percent of the underwriting results of the Property & Casualty Group. As I give the combined ratio and results of the Property & Casualty Group, I will discuss our reported statutory combined ratios. These ratios do not exclude the profit component of the management fee paid to Erie Indemnity Company and are therefore not an apples-to-apples comparison with the industry. The profit component accounts for about 5.6 points of the reported statutory combined ratio for the third quarter of 2004.

As we said previously, the reported statutory combined ratio for the Property & Casualty Group was 88.6 percent for the third quarter of 2004, down from 93.2 percent in the second quarter of 2004 and 100.2 percent in the first quarter of 2004. When adjusted for the profit component of the management fee, the reported statutory combined ratio drops to 83 percent for the quarter. For the first nine months of 2004, the reported statutory combined ratio was 93.9.

Our catastrophe experienced during the third quarter of 2004 added 3.6 points to the reported statutory combined ratio, primarily due to the effects of Hurricane Ivan, as Jeff mentioned earlier, and was largely offset by 3.2 points of positive development of prior years' reserves.

We continued to experience positive development on losses of prior accident years. Through the first nine months of 2004, this resulted in a positive reserve development of approximately $120 million, which are reflected in the Property & Casualty Group's results. As I indicated last quarter, we believe we are beginning to see the results of our efforts to further develop our claims staff and develop more specialized claim settlement and review practices; for example, specialized teams to adjust workers compensation, bodily injury and uninsured and underinsured motorist claims.

For the quarter, the Property & Casualty Group's personal lines had an adjusted statutory combined ratio of 82.7 percent. The group's commercial lines adjusted statutory combined ratio for the quarter was 84.1 percent. Augmenting that further, in our group's personal lines, private passenger automobile, our largest line of business, recorded an adjusted statutory combined ratio of 85.3. Direct homeowners business produced an adjusted statutory combined ratio of 74.4 percent. This is, again, a dramatic improvement from 2003 results and is due to improvements in frequency, average premium per exposure and reduced catastrophe losses.

As I said, we see the same indications in our commercial line combined ratios, which had been attested statutory combined ratio of 84.1. The adjusted statutory combined ratio for workers compensation remains relatively flat from last quarter at 101.2 for the third quarter of 2004.

Erie Indemnity Company's reported GAAP combined ratio for the third quarter was 94.5, compared to a GAAP combined ratio of 110.2 (ph) during the same period of 2002.

The underwriting results for the Property & Casualty operations of the Erie Indemnity Company were affected by a reversal of recoveries under the excess of loss reinsurance agreement with the Erie Insurance Exchange. The reversal of recoveries is attributable to the positive loss development experienced on prior accent years, especially the 2003 accident year. This reversal resulted in a charge of $1.2 million.

In total, Erie Indemnity Company recorded underwriting gains on a net basis of 2.9 million in the third quarter of 2004, compared to losses of 4.9 million for the third quarter of 2003.

Investment operations recorded income of $21.2 million during the third quarter, compared to $19.8 million for the same period in 2003, an increase of 6.9 percent. There were no impairment charges during the third quarters of 2004 or 2003. Net investment income increased by 2.2 percent to $14.8 million for the third quarter of 2004, from $14.5 million for the third quarter of 2003.

The Company also recorded equity and earnings from limited partnerships in the third quarter of 2004 of $3.8 million, compared to $1.3 million in the third quarter of 2003. During the third quarter, we continued our share repurchase activity, repurchasing 338,656 shares at a cost of $16.1 million, or an average cost per share of $47.65. For the first nine months of 2004, the Company has repurchased a total of 956,730 of its outstanding Class A stock at a total cost of $44.6 million, or an average share price of $46.50. As you may recall, the plan allows the Company to repurchase up to $250 million of its outstanding Class A common stock through December 31, 2006.

Last quarter, Jeff made some comments about the ensuing soft markets and the effects of that will have on the industry as a whole and on Erie. He talked about Erie's commitment to our long-term fundamental strategy, talked about discipline, underwriting discipline and pricing discipline. As our results indicated, we're taking deliberate steps to ensure our competitive position into 2005 and beyond. By concentrating on underwriting profitability improvement and bringing down our combined ratio in the manner in which we have, we're fundamentally strong with a desirable policy owner base and are well positioned to build on that solid foundation. We're addressing critical elements of our long-term business model, reunderwriting to ensure superior policy owner population and refining our price segmentation model to augment our competitive position. We're actively addressing the challenges we're facing with Erie Connection, our new agent interfaces and believe we're making process progress.

In 2005, we will be looking for even more ways to increase the ease by which our customers, agents and policyholders do business with us. Our employees and agents are engaged and motivated and we are achieving positive momentum. And as Jeff said, we will continue to take a deliberate, disciplined and balanced approach to underwriting profitability and quality growth. Thanks for your attention. Now I'm going to turn the call back over to Karen.

Thank you, Phil. That concludes our prepared remarks. Jake, if you can now open the call for questions for our phone audience.

(Operator Instructions). Adam Klauber, Cochran, Caronia & Co.

As you really had foretold, growth, particularly pith (ph) growth has come down as you have restructured the underwriting practices. At what point can we look for that to stabilize? I want to say that pith growth. When can pith growth stabilize and began turning north?

Adam, we expect that to happen in the fourth quarter. We expect our retention ratio to bottom in the fourth quarter. In 2005, obviously, we're going to have a better comparison year in 2005, comparing against 2004, as opposed to 2004 against 2003. So we expect positive unit growth in 2005.

A follow-up question. You have raised the management fee from 23.5 to 24 percent. Could you give us some of the factors you look at in 2005 that will determine whether we'll go higher from 24 back up to the 25 percent level?

As you know, the fee was 23.5 for the first six months. The Board raised the fee for the third quarter from 23.5 to 24. We will review that like we always do in December of every year with our Board. And again, what we look at is balancing the interest of Erie Insurance Exchange with those of Erie Indemnity Company. We look at the surplus levels and the exchange, we look at the underwriting profitability of the exchange and measures around our performance there. And then, we look at Erie Indemnity Company and our desire to keep a consistent stream of earnings growth, operating earnings growth at Erie indemnity Company, within our target range of 10 to 15 percent. So we look at all those factors, we put them before our Board and they balance the interest of these entities in setting the fee.

Thank you, Phil.

Thank you, Adam.

(Operator Instructions). Meyer Fields, Legg Mason.

The underwriting results are really, really strong. And I should also say that we appreciate the supplement; that's very helpful.

We've struggled through the conversations around how you get from our core results to the Erie Indemnity Company results. And so we put together this exhibit, which I think does a good job of getting from the pool down to Erie Indemnity Company's results.

It certainly does. I had one quick question, though, with respect to that. What is the net impact on the Erie Indemnity combined ratio from prior period development? You mentioned the 1.2 million in the reversal of recoveries. I'm wondering if there was any favorable development offsetting that?

Yes, there was. Like we said, there was 3.2 points of positive development in the pool, which is about $32 million in the pool. So if you take 5.5 percent of $32 million, you get 1.6 million, 1.7 million. So you can see that on that reconciliation that we just spoke about. At the bottom of it, we have the combined ratio components and we break out the number of points of positive reserve development, number of points catastrophe losses. It's on there at the bottom.

And the full 5.5 percent flows through that?

Yes. We would get -- Erie Indemnity would get 5.5 percent of the $32 million in positive reestimates on our reserves. And then of course, we told you that we had the reversal of recoveries under the reinsurance agreement, which you can also see on that exhibit, of $1.2 million. So tend to net, those tended to net each other during the quarter.

Okay. Has the improved underwriting changed your expectations from when you're going to expand into new states?

No, it hasn't. We have continued to focus the organization on improving the underwriting profitability. And we see expansion into Minnesota specifically as something that, as you know, has been on the table for a number of years now. But because we have devoted so much time to underwriting profitability, we wanted to control our exposure growth. So we will certainly look at many ways to grow our company in units and premiums, expansion being just one of those.

Last question. You mentioned that in a second quarter of 2005, you expect to introduce a segmented rate plan. Is that in all states?

Yes it is. In all states where we are allowed to.

Thank you very much.

(Operator Instructions). There seems to be no further questions. I will turn it back to Ms. Karen Krauss Phillips for closing remarks.

Thank you everyone for being on the call today. Obviously, that concludes the call. Again, a recording of the call will be posted on our website, eirinsurance.com, after 12:30 PM Eastern time today. If you any questions at all, please feel free to call me at 814-870-4665. Thank you all again and have a great day.