Erie Indemnity Co (ERIE) 2006 Q4 法說會逐字稿

Hello and welcome to the Erie Indemnity Company fourth-quarter and full-year 2006 earnings conference call. At the request of Erie Indemnity, this conference is being recorded for instant replay purposes. (OPERATOR INSTRUCTIONS).

Now at this time I would like to introduce your host for today's conference, Karen Kraus Phillips, Vice President and Manager of Corporate Communications and Investor Relations.

Thank you, Nola, and good morning, everyone. We appreciate all of you joining us today. On today's call management will discuss our fourth-quarter and full-year results for 2006. Joining me are Jeff Ludrof, President and CEO; Executive Vice President and Chief Financial Officer, Phil Garcia; Jan Van Gorder, acting Secretary and General Counsel; and Tom Morgan, Executive Vice President of Insurance Operations. Today's prepared remarks will be approximately 30 minutes. Following those remarks, we will open the call for questions.

We issued our earnings release and 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 Relations section of our website at erieinsurance.com. We also filed Form 10-K 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 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 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-K filing with the SEC dated February 26, 2006 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 erieinsurance.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 PM 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. Jeff?

Thank you, Karen, and good morning, everyone. Today I will touch on some of the primary drivers of our 2006 results and talk about where we are headed in 2007. Phil will give a few details on the financials for the quarter and the full year. We will then get to your questions.

In the fourth quarter, we saw a modest increase in policies in force and continued improvement in retention as we made steady incremental progress that will result in enhanced long-term value for our shareholders. In 2006 Erie's Property and Casualty group was facing the same issues most insurers are challenged with -- growing written premium in a soft market while maintaining underwriting discipline. We ended for the year with direct written premium down 3.9% compared to 2005 which put pressure on the management team revenue of Erie Indemnity. Yet, at the same time, we set our Regional Gem strategy in motion. We enhanced our competitive position while generating positive underwriting and investment results in Erie Indemnity and significantly improved the financial strength of the Erie insurance exchange. Our collective efforts in 2006 have positioned us well for positive changes in 2007 and beyond.

Here are a few highlights for 2006. First, we continued our focus on underwriting profitability. This balance led to underwriting profits for the Property and Casualty group and consequently Erie Indemnity. The P&C group ended the year with an adjusted statutory combined ratio of 89.4, which resulted in an underwriting gain of about $300 million. This contributed to the exchanges in policy holder surplus, which grew to a record level of $4.1 billion. The indemnity company closed 2006 with a GAAP combined ratio of 93.7, adding $13.4 million to the Company's bottom line.

Second, we improved our competitive position, bringing on new policyholders and retaining existing policyholders at an increasing rate. Policies in force started to build at the onset of the second quarter and grew steadily through the end of the year. In 2006 we added 39,000 policies, bringing our total policy count to 3.8 million. We expect this momentum to accelerate in 2007.

Third, we met or exceeded our cost management goals for 2006 in both the indemnity company and companywide, and we will continue to manage our expenses to maintain our low-cost position in the industry.

Fourth, we brought on an additional 139 new agencies in 2006 with plans to add another 200 in 2007. We also introduced online quoting to prospects in November of 2006 through our public website generating leads for our agents.

And finally, fifth recognizing the sound financial position of the exchange, in December the Board of Directors increased the management fee rate paid to the indemnity company from 24.75% to 25% and due to the strong capitalization of the indemnity company raised the quarterly dividend paid to shareholders of Class A non-voting common stock of $0.36 per share to $0.40 per share, enhancing total shareholder return. In February 2006 the board approved a continuation of our current share repurchase program, authorizing us to repurchase an additional $250 million of Class A common stock through December 2009. During 2006 we repurchased 4 million shares of Class A common stock, and in 2007 we will be opportunistic in buying back our stock.

Looking forward in 2007, we are focusing on four key priorities that align with our Regional Gem strategy. Quality growth with plans to drive increases in policy applications while maintaining our underwriting profitability. Second, effective technology with initiatives to enhance ease of doing business for our agents, employees and customers. Third, personalized service with efforts underway to provide customized service options to our policyholders, prospects and agents. And fourth, cost management to hold the cost of our operations at the right level while continuing to work toward being a Regional Gem. We started 2007 by spending a week with more than 550 agents and their guests in Cancun, Mexico as part of our agent incentive contest that took place during 2005 and 2006. We took this opportunity to renew and strengthen our relationships as we also do to our collaboration with our many agent task forces. 2007 looks to be a productive year for accelerated unit growth and profitability. The market may remain soft for the balance of 2007, but we are positioned well to grow our policies in force and do so profitably with expectations of long-term positive results.

Now I will turn it over to Phil to address our financial results.

Thanks, Jeff, and thanks to all of you for joining our call today. First, I will provide you with some highlights on the fourth quarter and then some brief comments on the full-year results. We had a favorable fourth quarter with net income up 3.1% to $45.5 million compared to $44.2 million for the same period in '05. Our net income per diluted share increased 10.3% to $0.71 per share in the fourth quarter compared to $0.64 per share in the comparable quarter in 2005. Our net operating income per share increased 5.7% to $0.69 per diluted share from $0.65 per diluted share for the same period a year ago.

Now I will take a few moments to explain more of the details behind our fourth-quarter results, starting with the management operations segment. Our management fee revenue increased 1% to $214.1 million for the quarter from $213.8 million for the same quarter a year ago. Once again, management operations were affected by our slow premium growth as a result of our efforts to enhance our competitive position, as well as higher fourth-quarter operating expenses. The direct written premiums with the Property and Casualty group upon which the fee is calculated decreased 3.8% to $860.9 million in the fourth quarter of 2006 from $894.5 million in the fourth quarter of '05.

As you know, fourth quarter 2006 management fees were based on a rate of 24.75 compared to 23.75 in the fourth quarter of '05. In the fourth quarter 2006, our new premium written increased 2.7% to $85.7 million from $83.4 million in the fourth quarter of '05. The cost of our management operations increased 5.2% to $190.3 million in the fourth quarter of '06 from $181 million for the same period in '05. Our commission costs increased by 1.9% to $131.5 million in the fourth quarter of '06 from $129 million in the fourth quarter of '05. Our fourth-quarter 2006 cost of management operations excluding commissions increased 13% to $59.8 million in 2006 from $52.9 million in '05. Our personnel costs were the primary contributor to the increase with wages and salaries of 16.1% to $27 million for the fourth quarter of '06 compared to $23.2 million in the same period in '05. This was due to higher average pay rates, increased management bonus levels and additional information technology personnel costs allocated to the Company from the exchange with the decommissioning of the AIS project.

Moving on to our underwriting performance, the Company's insurance underwriting in the fourth quarter of 2006 broke even, producing a GAAP combined ratio of 100 compared to a gain of $2.1 million in the fourth quarter of '05 and a GAAP combined ratio 96.1. Generally the Company has its highest private passenger auto combined ratio in the fourth quarter of the year due to the onset of winter driving conditions in the mid-Atlantic region in which we operate.

Finally, some of our highlights from our investment operations, our net revenue from investment operations for the fourth quarter of '06 reflects income of $30.7 million compared to $23.6 million in income for the same period in '05. Our net investment income decreased 14% to $14.1 million for the quarter ended December 31, '06 from $16.4 million for the same period in '05 as a result of our lower investment asset balances due to our share repurchases during the year. Our limited partnership investments generated almost $12.7 million in earnings for the fourth quarter, about a 75% increase, driven primarily by our real estate partnership earnings. Our effective income tax rate in 2006 was impacted by favorable IRS audit adjustments during the quarter and an adjustment to lower the effective tax rate recorded through the first three quarters of 2006 to better reflect the actual effective income tax rate for the year. Our share repurchases in the fourth quarter were modest due to the strong price performance of our stock in the quarter.

Now I will take a few moments to go over the year, the full-year results. As we have noted in past calls, the insurance industry is a cyclical business, and we're feeling the effects of a softening market that was expected to continue through 2007 and beyond. As Jeff noted, this is impacting the direct written premium of the Property and Casualty group, which is the source of our management fee revenue. Obviously the softening market is favorable for consumers, lowering their premiums and making them less likely to shop for insurance, challenging the ability of insurers to grow policies in force.

For our full-year 2006, our net income was down 11.7% to $204 million from $231.1 million at the end of '05. Net income per diluted share decreased 6.3% to $3.13 per share from $3.34 per share at year-end '05. Our net operating income in 2006 per diluted share decreased 2.4% to $3.12 from $3.19 per share in 2005.

I will go through each segment beginning with the management operations. Our management fee revenue for the full-year 2006 increased .3% from a year earlier to $942.8 million. In 2006 our direct written premium was down 3.9% from 2005 to $3.8 billion. This was primarily driven by our rate adjustments to enhance our competitive position. We believe our pricing model allows us to remain competitive in this market environment for potential new policyholders and the retention of existing policyholders. The rate adjustments we implemented in 2006 were made possible by the improved underwriting performance of the Property and Casualty group.

The effective competitive rate actions effective in 2006 resulted in a net decrease in written premiums of $119.5 million. The effect of these pricing actions on Erie Indemnity Company was $30 million. We consider these actions necessary for growth, enhancing our competitive position in the marketplace and improving the retention rate with existing policyholders. Pricing actions approved, filed and contemplated for filing during 2007 will result in an estimated net decrease in direct written premiums of $83.8 million in 2007.

During 2006 our all lines average premium declined $51 per policy from a year ago, but our policies in force grew by nearly 39,000 policies in the past year. That is positive news in an environment where insurance industry analysts are predicting continued stagnant policy in force growth. The 12-month moving average policy retention rate accelerated slightly in the fourth quarter to 89.5% at December 31, 2006 from 89.2% at September 30, and the policy retention rate was 88.6% at December 31, 2005.

As we noted throughout 2006, we're making a concerted effort to control expenses, and our costs are in line with what we expected for the year. The cost of management operations increased by 4.5% in 2006. Commission costs rose 2.7% to $554 million in 2006 from $539.4 million for 2005, primarily due to agent bonuses. Our normal scheduled commissions decreased by 2.6% commensurate with the decrease in direct written premium. Agent bonuses in Erie Indemnity, which are primarily based on profitability, increased 33.3% or $23.7 million for the year to $94.8 million compared to $71.1 million in 2005. The cost of management operations excluding commissions increased 9.2% to $231.6 million in 2006 from $212.1 million in 2005, mainly as a result of increased personnel and underwriting costs.

While personnel costs for Erie Indemnity increased $11.7 million in 2006, we were successful in proactively managing our workforce in 2006 in response to our slower growth. On an enterprisewide basis, we decreased our workforce by about 200 full-time employees or about a 4.5% reduction, which enabled our PIF per employee to increase, and about 25% of these employees performed functions for Erie Indemnity Company. Our underwriting costs rose $3.1 million in 2006 due to modest growth in application activity and more audits of our worker's compensation policy.

For the year the Company's 5.5% share of the Property and Casualty group's underwriting gains totaled $13.4 million in '06 compared to $15 million in '05 using a reported GAAP combined ratio of 93.7 for 2006 compared to 93.1 in 2005. The reported statutory combined ratio for the Property and Casualty group was 93.5 for 2006 compared to 90.5 for 2005. And the 2006 adjustment statutory combined ratio for the Property and Casualty group was 89.4 compared to 85.7 for 2005.

We completed the year with a very good 89.4 adjusted combined ratio despite some modest reserve strengthening in our automobile and catastrophe injury reserve at year-end. The Company's share of our catastrophe losses for '06 totalled $8.5 million compared to $1.2 million in 2005. As we noted in our prior calls, 2005 was a very favorable Cat year for Erie, and our 2006 Cat losses were more typical of our historic experience.

As you recall, we did not renew the excess of loss agreement with the exchange in 2006 and decided not to renew that reinsurance agreement in 2007. There would not have been any recoveries in 2006 had that reinsurance arrangement been in place.

Finally, I will review our investment operations which performed exceedingly well in 2006. For the year ended December 31, 2006, net revenue from investment operations decreased by 12.8% to $103.6 million from $118.9 million for the same period, again because we had lower invested asset balances during the period from share repurchases. Net investment income was down 9.2% to $55.9 million for the year ended December 31 from $61.6 million at the close of the year ended 2005.

In 2005 we also generated income from our net realized gains from our portfolio of $15.6 million as opposed to only $1.3 million in net realized gains in 2006. Our limited partnership investments generated almost $42 million in earnings for the year, an improvement over a very strong year in that investment category in 2005.

As part of our capital management plan, our share repurchase program was active during 2006 with 4 million shares of Erie Indemnity Class A common repurchased for a total of $217.4 million or an average price of $54.20 per share. Over the last three years, we have repurchased over 7 million shares of our Class A common stock at a cost of $370 million. Approximately $130 million in outstanding purchase authority remains under the current program which expires December 31, 2009.

And finally, I would be remiss if I did not comment on the financial performance of the Erie Insurance Exchange during the year. The underwriting and investment results in 2006 for the Exchange were outstanding and generated statutory surplus growth in excess of $700 million. At December 31, 2006, the exchange's statutory capital stood at a very strong $4.1 billion.

Now I will turn the call back over to Jeff.

Thank you, Phil. Before we open the call for your questions, I would like to address the bylaw changes approved by our Board of Directors in December. In essence, the changes clarify and streamline our majority Class B shareholders' authority. The board unanimously approved the changes that went into effect immediately. We had our February board meeting last week, and the nominating committee discussed their list of candidates for election to the board. At the meeting the board voted to set the size of the board at 14 directors and presented all current directors as nominees except John Graham who will be retiring at the end of this term. To fill Mr. Graham's seat, the board nominated Elizabeth Vorsheck, daughter of Board Chairman F. William Hirt. A press release announcing the slate was issued yesterday afternoon. The proxy and annual report will be mailed to shareholders the week of March 19.

I also want to invite you to join us here in the home office in Erie, Pennsylvania for our annual shareholders meeting on Tuesday, April 17 at 9:30 AM Eastern time. And now if we could have our first question please.

(OPERATOR INSTRUCTIONS). Michael Phillips, Stifel Nicolaus.

A couple of questions. One, we talked about this quite a bit last quarter; I was just wondered if you could update us on thoughts of the noncommission expenses in '07 and how you expect that to look?

Sure. We can talk a little bit about that. We have provided some guidance on that in our 10-K just so you know. We believe that our noncommission expenses -- let's start with personnel expenses first, which are the lion's share of the noncommission expenses. We believe that those will increase about 5%. Overall we believe noncommissioned expenses will increase about 9%. That is what we are targeting in our financial plan. That is disclosed in our 10-K.

Now the reason the majority of the expenses, the personnel expenses are only going up 5 and the total noncommission are going up 9 is we plan to make a fairly significant investment in -- continued investment in moving our IT systems forward. And so we are going to be spending about $14 million to $15 million in our plans for 2007 in addition to what we spent last year on IT. So again, a 9% target driven by a higher level of spend for IT in 2007.

Thank you. Can you update me on any changes in your appetite for looking at nonstandard or higher risk auto risk? Your appetite there?

Mike, our view is that the previously referred to nonstandard has become quite blurry over the years with the advent of sophisticated pricing. What we have been evaluating at Erie is ways that we can potentially expand while maintaining underwriting profitability our appetite for risk across a continuum of pricing. And so we have efforts under way to evaluate the underwriting standards that we use and the pricing points that would enable us to have prices that would bring profitability for risks that may have some blemishes on them.

Just two quick numbers questions if I could. Phil, do you have the dollar amount of the IRS audit in the quarter?

The adjustment was in the -- I don't want to quote it because I cannot remember it specifically -- but we had some IRS adjustments, audit adjustments that obviously were favorable because we drove our effective tax rate down to the 26 and change for the quarter.

And then what we were also doing was we were slightly over accruing during the first three quarters at a higher effective tax rate than we should have been. So we made the adjustment in the fourth quarter to get the total year effective tax rate down. So you have the effect of both of those in the quarter. We disclosed what we think our effective tax rate should be about 32 and change, 32, 32.2, 32.3. That is what you want to use going forward. But you have the effect of both those adjustments in the fourth quarter. I don't want to quote one or the other, but both of the effects are in there.

And then finally, on the investment operations side, what is the sale of the real estate mean I guess going forward for future income in that division?

Well, it is really earnings driven from our real estate limited partnership portfolio. It is both a portfolio of income producing real estate, as well as opportunistic sales of buildings, opportunistic partnerships. So there is an earnings stream associated with obviously the income producing real estate investments, but it was a terrific year for office real estate, the office market that we had investments in those limited partnerships. And so we did quite a few sales, realized gains from sales of those opportunistic assets.

I'm not going to make a prediction going forward. Last year we had terrific earnings from our limited partnership investments. This year they were even better. So I cannot predict what the office markets and the multi-family real estate markets will do in the coming year.

(OPERATOR INSTRUCTIONS). Charles Gates, Credit Suisse.

One question. Could you elaborate on the competitive environment in personal auto insurance that you see, how that has evolved, and if you can, could you compare and contrast that with what might have existed in the past?

Yes, very good question. The competitive environment I would characterize as being very rational, which really contrasts to what passed offed markets have involved. Due to the advent of sophisticated pricing amongst various carriers, we believe and like to see this rational pricing versus chasing market share which leads to greater fluctuations in profitability levels. So I think there's a more stable market, a very competitive market. I believe the soft pricing is going to exist undoubtedly throughout 2007 and into 2008. There is a lot of indicators that would lead me to making that statement. We see lost costs remaining flat, and ours are well within our pricing expectations as undoubtedly they are with many others competing in the private passenger auto marketplace. So it is rational. It is very competitive but very different from past soft markets as I said where I think carriers were chasing without rational pricing.

What is the principal form you believe that competition is currently taking?

I think that in the private passenger auto market clearly pricing sophistication is driving the marketplace. I think that companies distinguish and separate themselves out there by having the appropriate tools and then offering in the case of Erie a complete value proposition that includes talented local accessible agents backed by effective and talented Erie employees. So I believe we have them both, but I think companies are clearly moving in the direction of distinguishing themselves with pricing sophistication.

(OPERATOR INSTRUCTIONS). It appears there are no further questions at this time. Mr. Ludrof, I would like to turn the conference back over to you for any additional or closing remarks.

Yes, I would just like to make a few remarks. Thank you, everyone, for joining us. As you can see, we made steady progress in 2006 in every dimension of our business, but in 2007 we are picking up the pace. We've added some key talent to our leadership team in 2006 who have hit the ground running, and in 2007 just this month we brought on a new Senior Vice President to head up our Commercial Business. His name is John Kearns, and John was formally with St. Paul Travelers. We have a full house, the team is primed and moving forward, quality growth, effective technology, personalized service and cost management. Those are our goals and we are laser-focused on achieving those goals in our personal lines, commercial lines and life and annuity businesses. The changes we're making to enhance growth and curtail costs give us a distinct advantage right now and even more so as the market turns.

I thank you again for joining us, and I look forward to seeing you in person on April 17.

Just a reminder, everyone, that a recording of the call will be posted on our website, erieinsurance.com, after 12:30 PM Eastern time today, and if you have any questions at all, give me a call at 814-870-4665.

Thanks, again, and make it a great day.

Once again, ladies and gentlemen, that does conclude today's conference. We have do appreciate your participation.