Erie Indemnity Co (ERIE) 2005 Q2 法說會逐字稿

Hello and welcome to the Erie Indemnity Company second-quarter 2005 earnings conference. 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 prepared remarks from management, we will open the call for questions and answers. Now, I would like to introduce your host for today's conference call, Karen Kraus Phillips, Vice President and Manager of Corporate Communications and Investor Relations.

Good morning, everyone. We appreciate all of you joining us today. On today's call, management will discuss our second-quarter 2005 results. Joining me are Jeff Ludrof, President and CEO; Executive Vice President and Chief Financial Officer, Phil Garcia; and Jan 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 would ask that you please keep to one question and a follow-up.

We issued our earnings release, as you know, with the additional supplements yesterday afternoon. If you need a copy of the press release or any of the exhibits, you can find these in the investor section of our website at Erie-Insurance.com. 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 their 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 and describe 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 statement and our latest 10-Q filing with the SEC, dated August 3, 2005 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 the supplement posted on our investor website at Erie-Insurance.com.

This call is being recorded, and the recording is the property of 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 website today after 12:30 Eastern time. Your participation on this call will constitute consent to the recording, publication, webcast, broadcast and 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.

Good morning, everyone. Thank you for joining us on today's call. Last quarter, I talked about transformation, about how your employees and agents worked together to bring about incredible change in our underwriting profitability results. As you have seen from our press release, the momentum continued during the second quarter of 2005. I will review a few financial highlights and offer some remarks on our progress and plans, Phil will offer a more detailed review of our financial results, and then we will get into the Q&A.

Net income for Erie Indemnity Company was $76.2 million for the second quarter 2005, compared to $57 million a year earlier. Net income per share was $1.10, up 36% from $0.81 per share during the second quarter of 2004. Our results included an accounting adjustment which Phil will review in just a few moments. Removing the effect of these adjustments still leads to a strong underlying operating result for the quarter.

The Property and Casualty Group produced a second-quarter reported statutory combined ratio of 87.9 and an adjusted statutory combined ratio of 82.7. The GAAP combined ratio for the Property/Casualty subsidiaries of the Erie Indemnity Company was 90.9% for the second quarter 2005.

We are also, as expected, beginning to see a modest turn in policies in force or PIF growth. While PIF growth overall declined on a year-over-year basis, we are seeing sequential increases in most commercial lines and homeowners. And, as you can see from the supplement included with the earnings release, private passenger auto is beginning to show signs of stabilizing.

Our retention ratio is stabilizing, as well. We finished the second quarter 2005 with a retention ratio of 88.3%. This was the same result recorded at March 31, 2005. The balance between underwriting discipline and quality growth is a priority focus for Erie in 2005. To that end, during the first quarter, we introduced a new segmented pricing model for Auto and Home using insurance scoring. The model allows us to be more refined in our risk segmentation, which helps ensure Erie's competitive position for the best business.

On last quarter's call, we said that industry experiences shows a short-term drop in written premium when companies have introduced insurance-scored pricing models. That bears out in our experience, as well. While it's still relatively early, we are seeing what we expected to see from the pricing model and continue to have confidence that it is working as designed. Our agents are starting to see more evidence of the model's effectiveness, especially those agents who are actively marketing and thus experiencing a balanced distribution of risk based on insurance scores.

We're watching our competitive position very closely, and are looking to continually improve the effectiveness of our pricing model. For example, we are introducing further pricing sophistication into the model. In July 2005, we announced a new safe driver discount of 8% in most states for new private passenger auto claims-free business. We have plans to add further rate interactions by January 1, 2006. These additional interactions will have the effect of continuing to make us more competitive for the best business.

But price is only one factor that contributes to Erie's ability to compete effectively in today's insurance marketplace. Leveraging our strong service brand to support our agents' sales efforts is a strategy that we're embracing, not by entering the realm of national advertising but through an integrated marketing communications approach that will preserve our low-cost business model while strengthening our ability to grow.

At the onset of the third quarter, we introduced a number of new marketing communication tools to our agents, including a comprehensive branding campaign. The creative concept positions Erie, together with our agents, as delivering on our true blue promise of service. Coupled with the campaign, we launched our first co-op marketing program that provides reimbursement to agents for using campaign and other approved marketing materials -- for example, our new agent sign program to market Erie in conjunction with their agencies.

At the same time, we introduced an online lead-generation program, allowing agents to obtain insurance-scored leads for new Auto and Home business. The program has been enthusiastically embraced by our agency force. Agents access all of the creative materials and marketing programs through our new Web-based marketing management system we call At Blue (ph). Agents like what they see in these new programs, and they are responding. Our plan is to further develop these offerings based on agents' feedback as we move forward in 2005 and 2006.

To add even more interest and motivate policy sales, we launched an agency incentive contest on June 20th that runs through June 30, 2006. The contest involves sales in all Erie lines of business -- Commercial, Personal and Life -- and we are off to a great start. Momentum is beginning to build, but we have to manage that momentum effectively to ensure a balance between growth and underwriting discipline. Our aim is profitable growth. We believe we're on track toward achieving this goal.

We are looking toward the future and investing in areas of critical importance -- investments and underwriting, pricing, technology and marketing. Effective expense management is also a central part of our business model. These investments, however, I believe, will leverage us for future growth.

Phil will now give you the details of our second-quarter financial results.

Thanks, Jeff, and good morning, everyone. As Jeff noted, our financial performance was positive during the second quarter. Consolidated net income for the second quarter of 2005 increased 33.7% to $76.2 million or $1.10 per diluted share, compared to $57 million or $0.81 per share diluted during the same period in 2004.

Operating income was $1.01 per share diluted in the second quarter 2005, an increase of 29.5% from the $0.78 per share diluted in the second quarter 2004. Operating income is a non-GAAP measure which we reconcile to net income in the investor supplement included with the earnings press release.

Primary drivers of these results were continued improvements in underwriting profitability and increased revenue from Investment Operations. During the second quarter 2005, we also recorded an adjustment to the valuation of our limited partnership investments of $14.2 million that impacted net income by $0.13 per share diluted. I'll get into more details on this adjustment when I discuss the Investment Operations segment results.

As you know, we segment the Company's operations into three main components -- the Management Operations, the Underwriting Operations and the Investment Operations -- and I am going to begin my discussion of the financial results with the Management Operations segment. Our management fee revenue decreased 0.7% for the quarter ended June 30, 2005, compared to the second quarter of 2004. Management fee revenue is based on management fee rate, which is established by the Board of Directors, also by the growth in direct written premiums of the Property/Casualty Group and by changes to the allowance for management fees returned on canceled policies. The higher management fee rate in 2005 of 23.75% versus 23.5% for the first and second quarters of 2004 resulted in 2.7 million more in management fee revenue for the quarter ended June 30, 2005. This was offset by lower direct written premiums of the Property/Casualty Group, which decreased 1.1% in the second quarter of 2005 to $1.1 billion. Management fee revenues were increased by $1.1 million and $2.8 million in the second quarters of 2005 and 2004, respectively, due to decreases in the estimated allowance for management fees returned on mid-term policy cancellations.

The management fees are returned in the exchange when policies are canceled mid-term and unearned premiums are refunded to policyholders. The 2005 allowance adjustment reflects a leveling-off of cancellations, evidenced by the policy retention ratios of 88.3% at both June 30, 2005 and March 31, 2005, and 88.4% at December 31, 2004.

Our premium service charges grew 2% during the quarter to $5.4 million from $5.3 million in the second quarter of 2004. As a result, total revenue from Management Operations was flat at $259.7 million for the quarter, a decrease of 0.6% from $261.3 million for the second quarter of 2004.

Income from Management Operations decreased 10.2% during the second quarter of 2005, compared to the second quarter of 2004. This was due primarily to the flat revenue growth from Management Operations that I just mentioned and an increase in noncommission expenses, which are included in the cost of Management Operations. Overall, the cost of Management Operations increased 2.8% to $198.1 million during the quarter from $192.7 million in the second quarter of 2004.

Now, I would like to spend a little time reviewing the second-quarter sales results for the Property/Casualty Group, which is a driver for the management fee growth for the Company. As you know, our emphasis on underwriting discipline during 2004 has resulted in a decline in policy sales and reduced policy retention ratios for the Property and Casualty Group in 2005, as we anticipated.

In 2005, we're taking a more balanced approach to managing quality growth while continuing to maintain underwriting profitability. In a climate of relatively stable pricing in our markets and declining sales growth in the industry, as Jeff mentioned, the Company implemented several marketing initiatives to support agent sales growth efforts for the remainder of 2005 and into 2006.

During the second quarter of 2005, the Property and Casualty Group recognized policy growth in homeowners and other personal lines and continued growth in most commercial lines of business. Personal auto policy growth is now showing signs of stabilizing. For the Property and Casualty Group, the average premium per policy in 2005 has increased, as a result of rate increases initially effected in 2004 which were offset by the anticipated decline in new policies in force, resulting in lower overall total direct written premiums.

Total new business written premium declined 10.7% to $101.2 million in the second quarter of '05 from 113.4 million in the second quarter of '04. Personal lines new business written premium declined 14.6% to $67.9 million from $79.5 million for the second quarters of '05 and '04, respectively.

Commercial lines new business premiums decreased 1.8% to $33.1 million in the second quarter of '05 from $33.8 million in the second quarter of '04. The private passenger auto new business premium written decreased to $40.4 million from $50.2 million for the second quarters of '05 and '04, respectively.

While total policies in force have declined on a year-over-year basis, down 0.5%, policies in force increased by nearly 10,000 policies for the quarter, a positive sign. In 2004 and 2003, substantial rate increases were filed by the Property and Casualty Group for certain lines of business in various states to offset growing loss costs. The Property and Casualty Group writes one-year policies; therefore, rate increases take 24 months to be reflected fully in earned premiums. It takes 12 months to implement a rate increase to all policyholders and another 12 months to earn the increased premiums in full. Because of the timespan for full recognition of premium rate increases, certain rate increases approved in 2004 are now being earned in 2005.

The improvement in underwriting experience affords the Property/Casualty Group the ability to implement some targeted rate actions to be more price competitive for potential new policyholders and improve retention of existing policyholders overall. For instance, as Jeff just mentioned, we announced a new safe driver discount of 8% in most states for new claims-free auto business effective July, 2005. We estimate that the impact of pricing actions approved, filed and anticipated through June 30, 2005 will result in a net decrease in direct written premiums of $10.1 million in 2005. And in 2006, we anticipate implementing additional rate interactions in Auto and Home.

The implementation of insurance scoring and segmented pricing has provided us with the sophistication to price policies with varying degrees of risk. This results in more competitive rates being offered to customers with the most favorable loss characteristics. To enhance future growth, the Company also plans to continue its agent appointment efforts in 2005. Through the second quarter of 2005, 24 new agencies have been appointed in existing territories, with a goal of 75 agency appointments in 2005. And, as Jeff discussed, we have numerous marketing programs and incentives we have introduced in the second half of 2005.

Now, I would like to move on to a discussion of the cost Management Operations for the second quarter '05. The cost of Management Operations increased 2.8% for the second quarter of '05 to $198.1 million from $192.7 million during the second quarter of '04, primarily due to increases in personnel and underwriting costs. Commissions to independent agents, which are the largest component of the cost of Management Operations, were impacted by a 1.1% decrease in the direct written premiums of the Property and Casualty Group in the second quarter of '05 and the reduction in certain commercial commission rates. Commercial commission rate reductions became effective on premiums collected after December 31, 2004, and resulted in a $5.5 million reduction in scheduled rate commissions in the second quarter '05. Second-quarter '05 commission expense was also impacted by a $7.2 million increase over the prior year and the estimated payout of bonus awards to agents, recognizing quality growth and favorable loss experience.

A new promotional incentive program was initiated in June '05 to encourage new policy growth from our independent agency force. The program will run over a 12-month period from June '05 through June '06, and the total cost to the Company is estimated at approximately $2.5 million, which will be incurred proportionally in '05 and '06.

The cost of Management Operations excluding commission costs increased 14.1% for the three months ended June 30, 2005, to $53.1 million from $46.6 million recorded in the second quarter of '04. Personnel-related costs are the second largest component in the cost of Management Operations. The Company's personnel costs totaled $31.8 million for the second quarter of '05 compared to $27 million for the same period in '04, an increase of 17.8%.

Contributing to this increase was a 15.8% increase in salaries and wages due to several factors, including a 4.6% increase in staffing levels, primarily from IT personnel that are no longer deployed to the Erie Connection project. These IT employees are now working on projects benefiting the Erie Indemnity Company, and therefore their salaries are not subject to the IT cost-sharing agreement. Other factors contributing to the rise in salaries and wages were an increase in base pay rates and expenses associated with external IT contract labor. Costs incurred related to this external IT contract labor increased $0.4 million to $0.9 million in the second quarter of '05.

Total employee benefit costs increased 31.7% to $5.6 million in the second quarter of '05, compared to 4.2 million in the second quarter of '04. This was primarily due to a reduction in the liability for the Company's workers' Compensation benefit costs of $0.9 million in the second quarter of '04. Without the 2004 workers' Compensation adjustment, employee benefit costs would have increased 8.6% in the second quarter '05.

The Company also incurred additional underwriting expenses of $1.8 million in the second quarter of '05 related to the introduction of insurance scoring for new and renewal Auto and Home policies. The Company did not incur any costs for insurance scores in the second quarter of '04.

The Company's Insurance Underwriting Operations segment produced an underwriting gain of $4.9 million in the second quarter '05 versus a $4.9 million underwriting loss in the second quarter of '04. The Company's insurance subsidiaries' share of the Property and Casualty Group's direct business generated underwriting income of $6.3 million and $2.3 million on a statutory basis in the second quarters of '05 and '04, respectively. The improvement in the Property and Casualty Group's underwriting results is due to several factors -- the initiatives implemented to focus on underwriting profitability, low catastrophe losses during the second quarter and favorable development of prior accident year losses.

The direct business of the Property and Casualty Group generated underwriting income of $114.6 million in the second quarter of '05, compared to $42.7 million in the second quarter of '04. And for the six months ended June 30, 2005, the Property/Casualty Group's direct underwriting income was $261.3 million versus $43.9 million for the same period in '04. The Property and Casualty Group's reported statutory combined ratio was 87.9% and 93.2% for the second quarters of '05 and '04, respectively. The adjusted statutory combined ratio of the Property and Casualty Group was 82.7% and 87.3% for the second quarter '05 and '04, respectively.

The seasonal increase in claims volume for the second quarter of '05 contributed 4.3 points to the Property and Casualty Group's adjusted statutory combined ratio, which was somewhat offset by 3.1 points of positive development of prior-year reserves. Also affecting the Property and Casualty Group's adjusted statutory combined ratio was 1.4 points of salvage and subrogation recoveries on prior-year claims.

During the second quarters of '05 and '04, the Company's share of catastrophe losses as defined by the Property and Casualty Group amounted to 0.2 million and 1.2 million, respectively, and contributed 0.4 points and 2.3 points to the GAAP combined ratio, respectively.

Now, I would like to discuss the results of our Investment Operations. Revenue from Investment Operations increased to $47.3 million in the second quarter '05 from 21.6 million in the second quarter '04. Revenue from Investment Operations increased in the second quarter '05, primarily as a result of two factors -- one, a $14.2 million correction to record a market value adjustment to the equity and earnings of the limited partnership investments; and, two, increased realized capital gains. Our net investment income, which includes interest, dividends and other current income, rose 2.1% to $15.9 million in the second quarter 2005 from $15.6 million in the second quarter 2004.

Sales of our common equity securities in the second quarter of 2005 drove the $6.2 million increase in net realized gains on investments. There were impairment charges of $1 million included in the net realized gains or losses on investments in the second quarter of '05, primarily related to equity investments in the consumer products industry. There were no impairment charges on fixed maturities in the second quarter of '05.

The adjustment of $14.2 million to equity of earnings of limited partnerships corrects our accounting for the Company's share of unrealized appreciation in the limited partnerships, which was previously recorded in the Company's shareholders' equity. Included in the adjustment is $9.4 million or $0.09 per share diluted related to net unrealized gains for 2004 and prior years.

Going forward, the equity and earnings of limited partnerships will reflect the Company's share of the current partnership income, including realized and unrealized gains or losses. In the first quarter 2005, the adjustment was $1.9 million or $0.02 per share diluted. And in the second quarter '05, the adjustment was $2.9 million or roughly $0.02 per share diluted.

Our private equity and mezzanine debt limited partnerships generated earnings of $12.9 million and $0.1 million for the three months ended June 30, 2005 and 2004, respectively. Our real estate limited partnerships reflected earnings of $7.7 million and $1.4 million in the second quarters of '05 and '04, respectively.

During the second quarter of '05, we also continued our capital management activities, with the Company repurchasing 223,930 shares of its outstanding Class A common stock in conjunction with its stock repurchase plan that was authorized in December of '03. The shares were purchased at a total cost of $11.6 million or at an average per-share price of $51.64. The plan allows the Company to repurchase up to 250 million of its outstanding Class A common stock through December 31, 2006.

Thank you, and now, I will turn the call back over to Karen.

Thanks, Phil. That concludes our prepared remarks. Nate, if you could now open the call for questions from our phone audience?

(OPERATOR INSTRUCTIONS). Patrick O'Brien, Alex. Brown Investments.

The costs of the Management Operations -- could you explain the dynamics there? You said that some of the personnel costs, I think, had been laid off to the exchange and are now on the Company's books. What is that going to look like going forward? Is there more of that to come, or does it flatline from here?

What we talked about just now and in the release was that some of the Erie Connection team, which we have been talking about -- we have been quantifying that in prior Q's. And some of the team which was working on the Erie Connection project and being accounted for under our technology cost-sharing agreement, whereby the costs are spread mostly amongst the exchange but some to Erie Indemnity Company, those employees are coming off that program and coming back and working on projects at Erie Indemnity Company -- in particular, projects around our pricing segmentation capabilities and some capabilities in our commercial lines, some Web-based capabilities in our commercial lines. So those employees will increase our personnel cost run rate, and they will be back in the Indemnity Company's cost structure going forward. But those are important initiatives. As we've talked about, our segmented tiered pricing initiatives are extremely important to our competitiveness. And so they are going to be working on those projects. We're going to have a higher run rate of personnel expenses.

Do I just annualize the second quarter, or is there more to come on?

Yes, I would take the trend in the second quarter and assume that that's going to continue in the third and fourth quarter. We will give you more guidance on that as the quarters go on.

Meyer Shields, Legg Mason.

I may have missed this, and if I have I apologize. But I'm trying to reconcile the reduced commissions for some commercial lines with the agency incentive program. Those seem to be working at cross purposes.

Well, we made the change in commercial commissions last year, because we felt we needed to make that change in our commercial lines. We plowed some of those commercial savings from those commissioned cuts into our bonus program for our agents, so you saw that our commercial commissions for the quarter were down 5.5 million, but our bonus accrual was up $7.2 million.

So what we are saying is on our flat commissions for commercial, we're going to pay our agents less, but if they produce a profitable book of business for the Company we are willing to pay them more, which was part of our profitability initiatives for the Company. We felt it was important to restructure our profitability bonuses to reward truly profitable agencies. So remember that there is that dynamic going on.

Now, the other part of your question refers to our new incentive contest, our incentive contest for the second half of this year and the first half of next year, which is intended to incent the agents to sell auto, home, life and small commercial. So it's all of our products. So we don't think it's at cross purposes.

Okay, that makes sense. A second question, if I will. Do you have any sense of what the loss cost inflation rate is like, really, across the major lines of business?

Yes. We continue to have positive frequency trends like those that are being experienced in the industry as a whole. We continue to have positive frequency trends in almost all of our lines of business. Our severity trends are modest in our personal lines, a little higher in our commercial lines. And so, we feel pretty good about where we are in our pure premium trends right now.

(OPERATOR INSTRUCTIONS). Beth Malone, Advest.

Congratulations on the quarter. Could you just talk a little bit about -- I know all of this has been the result of an initiative by the Company to improve and tighten up your underwriting standards down to your agents. And I know, when it was first introduced, there was a lot of unsettled communications between the agents in trying to get familiar with what the direction Erie was trying to take. How would you characterize how the agents have responded to the situation now? Is everybody pretty placated, or is it now understood that this is part of market standard? Or are there still a lot of challenges, missed opportunities of business you should be getting but aren't because you still haven't gotten everybody on board?

Well, Beth, I think any time you introduce a significant amount of change -- and that's certainly what we have gone through, together with our agents -- you're going to have that kind of confusion, and you're going to have a lot of different opinions as to what is right. What we have experienced together, though, is a transformation, I think, of experience for our agents and for our company, recognizing that a re-commitment to the fundamentals of the business -- underwriting, re-underwriting -- are a core to a long-term strategy of success.

Our agents have now seen the benefit of that. We have talked about the changes that we made to our founders award program, and our agents saw a doubling of the founders award program, our bonus program, as a result of both the changes to the program itself as well as their commitment to the return of underwriting and re-underwriting discipline.

Agents now, having experienced that, I believe, see the benefit. I believe they are even further engaged and further enthused to stay engaged, and understanding that we need to both maintain this underwriting discipline while actively working on growing profitable business. So, like any cloud, there is always a silver lining. I think the silver lining for us has been that we have engaged, we have everybody's attention. Admittedly, we disturbed a good number of their thinkings, but collectively we have come together. And clearly, we're making a lot of positive progress. So I'm encouraged by the engagement of our agents, very encouraged by their involvement in digging into these underwriting and re-underwriting disciplines. And it's obviously reflected in the financial results. I think, if we take that same type of activity and expand, as we are with these marketing initiatives, we're going to see that balance that we seek of underwriting disciplines and quality growth.

And what is the outlook for -- I guess acquisitions are not a big factor in your growth strategy, but continued expansion -- is it going to accelerate now that you have gotten things kind of settled down in your core business?

Well, we want to continue to expand in our current markets. As you know, we obtained our license in Minnesota. We still have not set any plans to expand into the state of Minnesota. But these marketing initiatives that we mentioned are an opportunity for us to grow profitably in our existing markets, once again working with a group of focused agents. We see a lot of opportunity for us to expand our market share.

That concludes the question-and-answer portion of our call. I will now turn the call over to Mr. Ludrof for some final remarks.

Well, thank you for your discussion this morning. As we move into the second half of 2005, I believe our foundation is very strong. As I've said, our agents are engaged, and we are certainly gaining momentum. We will continue to make targeted investments in our competitive position, in technology and in marketing, investments that will yield positive returns in the future. And we will do all of those with a keen eye on underwriting discipline, effectively managing growth to ensure underwriting profitability.

I thank you for your time. We look forward to sharing our third-quarter results with you early in November.

Thanks again, everyone. That concludes today's call. Again, a recording of the call will be posted on our website, Erie-Insurance.com, after 12:30 PM Eastern time today. If you have any questions at all, please call me at 814-870-4665. Thanks again and have a great day.