Erie Indemnity Co (ERIE) 2007 Q2 法說會逐字稿

Hello and welcome to the Erie Indemnity Company second quarter 2007 earnings conference. At the request of Erie Indemnity, this conference is being recorded for replay purposes. At this time all participants are in a listen-only mode. (OPERATOR INSTRUCTIONS)

Now I would like to introduce your host for today's conference call, Mark Dombrowski, Supervisor Media and Public Relations. Please go ahead, sir.

Thank you and good morning. We appreciate all of you joining us today. Joining me are Jeff Ludrof, President and CEO; Executive Vice President and Chief Financial Officer, Phil Garcia; Tom Morgan, Executive Vice President of Insurance Operations; and Jim Tanous, Secretary and General Counsel.

Today's prepared remarks will be approximately 20 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 on our website at erieinsurance.com. We also filed form 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 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-Q filing with the SEC dated August 1, 2007, and in the related press release and 8-K.

In this call we will discuss some non-GAAP measures. You can find the reconciliation of these measures to GAAP measures in the press release and in 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.

Good morning everyone and thank you for joining us today. The news of Erie Indemnity Company's second quarter is positive, but it's tempered by the sudden death of our Board Chairman, Bill Hirt. Bill passed away on July 13th and he will be sadly missed. Bill created a strong foundation for Erie and his legacy will live on in perpetuity.

"We want to be a gem of a company" Bill would say about Erie. It is this phrase and the meaning behind it that led to our regional gem strategy, the strategy that guides our work today and into the future.

I sincerely appreciate the condolences that many have expressed regarding Bill's death. While we are saddened by the loss of Bill Hirt, he remains with us as a role model for being a humble and servant leader.

A great deal has transpired in the nearly three weeks since Bill's passing, involving his successor as Trustee of the H.L. Hirt Trust and its successor as Chairman of Erie Indemnity Board of Directors. Before we begin our discussion of the financial results I will take a few moments to recap what has evolved.

We previously issued a press release announcing that Elizabeth Vorsheck, Bill's daughter and a member of the Board of Directors, was unanimously elected to succeed Bill as Trustee. The process required three votes -- one from the remaining individual Trustee, Susan Hirt Hagen; one from the corporate Trustee, Sentinel Trust; and one from the Erie Indemnity Board of Directors.

In addition, this week the Board of Directors unanimously elected Tom Hagen to succeed Bill as Chairman of the Board. I support Tom Hagen and know that he is passionate about Erie's success.

Yesterday I also announced to our news release and to our employees and agents that I am stepping down as Erie's President and CEO and member of the Board of Directors. Part of being a leader, I believe, is to know when it's time to step aside.

When I accepted the mantle of President and CEO it was a very difficult time for our Company. Our then President and CEO was dying of ALS or Lou Gehrig's Disease, and our Company was in need of leadership.

We were also experiencing challenges in our underwriting results. In the past five years we have made significant progress that I am very proud to have been a part of. Our second quarter results are evident of that progress and evidence of our strong financial condition.

With new leadership in the role of Chairman, I believe it is a good time for me to step aside. With Bill Hirt's passing I took the opportunity to reevaluate my own path and know that this decision is the right one for me, for my family, and for the Company.

Former Erie Executive Vice President, John Brinling, has agreed to return to the Company and act as interim President and CEO upon my departure. John has indicated that he does not want to be considered for the position beyond an interim basis. I am confident that John will work toward making this transition as seamless as possible.

In the meantime, a search committee has been convened by the Board of Directors to identify my successor.

Our very solid financial condition will also contribute to a smooth transition. Our second quarter results were strong. We are excited by the growth we are starting to see.

With that in mind, I'll begin my comments about our second quarter results, followed by CFO, Phil Garcia, and, of course, we'll move quickly to your questions.

Our disciplined and steady management approach has shown positive results during the second quarter of 2007 with all indicators moving in the right direction. Net operating income per share increased 25.6% to $1.09 per share, compared to $0.87 in the second quarter of 2006. Every segment of the business contributed to this result.

Management fee revenue was up 2.1% from the same quarter last year due to an increase in direct written premiums of the Property and Casualty Group and a higher management fee rate. As the management company for the P&C Group, Erie Indemnity earns a percentage of the Group's direct written premium, not to exceed 25%. For 2007 the fee rate is set at 25%. In 2006, the rate was 24.75%.

With the pressure of the soft market, the Group's direct written premium has declined for several quarters. This quarter's result reverses that trend, even with the deliberate actions we're taking to ensure our competitiveness.

Average premium per policy dropped this quarter by 4.1% over a year ago, which is a reflection of our favorable loss experience. Rate reductions have helped spur new policy-in-force growth and retention. New policies in force were up 5.3% for the second quarter of 2007, with premiums from new business increasing by 13.5% over the second quarter of 2006.

Our all lines retention hit a six-quarter high, moving to 89.9%. At this pace, we expect our retention ratio to be into the '90s by yearend, returning Erie's historically high level. Phil will provide greater details about these results in just a few minutes.

Among the other factors influencing our policies-in-force growth are the 139 new agencies we brought onboard last year and the new agencies we recruited during the first quarter of 2007, which are beginning to produce business for us. And we've reported our 2007 goal is to recruit 200 new agencies by yearend. For the year to date we've appointed 135 new agencies and Erie now has nearly 1900 agencies representing the Company in markets where we do business.

I'd like to take a moment to thank our agency force for placing business with us and our policyholders for their continued support and trust in us. Erie has been built on referrals, and, according to our agents, referrals from loyal policyholders are still their primary source for leads.

As a Company we're doing more to build our brand awareness in order to leverage that positive word-of-mouth and support our agents' marketing effort, but in no way are we looking to jump into the intensely competitive and excessively expensive advertising war that national insurers are engaged in.

Erie's a relationship Company, committed to providing our customers superior personalized service at the lowest possible cost. Managing our cost of operations continues to be a top priority. After the first six months of 2007 we are maintaining our yearend projection of a 6% increase in operating expenses, excluding commissions, over 2006 levels. As we announced on the first quarter call, this is down from a 9% increase we projected in February, 2007.

We continue to invest in our IT infrastructure, delivering regular enhancements to our customers, agents, and employees, making it easier for all of them to do business with us.

For the second quarter, 2007, the Indemnity Company's underwriting operations segment produced a GAAP combined ratio of 84.8%, yielding an underwriting profit of $7.9 million. The underwriting results for the entire Property and Casualty Group in the second quarter of 2007 produced an adjusted statutory combined ratio of 77.7%, which included a very low CAT quarter and a positive reserve development.

At the onset of my discussion of our second quarter I made reference to our disciplined, steady approach to manage the Company, which is certainly reflected in our underwriting results. I'd like to commend our employees and agents for their continued diligence and commitment to Erie's underwriting philosophy and their collective effort to generate quality growth.

During the second quarter, we received word that A.M. Best Company affirmed the A+ Superior rating for the Property/Casualty affiliate of Erie Insurance Group. That keeps Erie Insurance Group in the highest category of Superior for financial strength. Only 9% of approximately 2,000 Property/Casualty insurers have earned this high rating. The rating outlooks are stable for our company.

A.M. Best noted that Erie's ratings reflect our strong risk-adjusted capitalization, improved operating performance, and favorable business profile. A.M. Best also noted our market presence is reflective of our reputation for excellent customer service, strong independent agency relationships, and extensive local market knowledge.

Best also acknowledged that Erie has positioned itself for continued earnings success through its disciplined approach in managing rate, while continuing to balance growth and underwriting profitability.

Phil, I'll turn it over to you to give further highlights of the quarter.

Thanks, Jeff. Good morning everybody. For the second quarter of 2007 net income increased to $70.5 million from $56.3 million at June 30, 2006. On a per-diluted-share basis, net income increased 29.2% to $1.11 in the second quarter of '07, compared to $0.86 last year.

Our net operating income, which excludes the effects of our net realized capital gains and income taxes on those gains, increased to $69 million, or $1.09 per share, or 25.6% from $56.7 million, or $0.87 per share for the same quarter in 2006.

The increase in net income for the second quarter of '07 was driven in large part by our improved underwriting operations, 43.5% increase in our Limited Partnership earnings compared to the second quarter of '06.

And positive direct written premium growth in the quarter and our continued expense control in our management operations allowed us to maintain our margins from management operations from the quarter of prior-year ago.

For a detailed look at our management operations, management fee revenue grew 2.1% in the second quarter of '07, compared to the second quarter of '06. It's the result of a .9% increase in our premiums of the Property/Casualty Group, as well as an increase in the management fee rate to 25%.

The increase in the direct written premium was a positive development during the soft market conditions we are experiencing where premium growth in the industry continued to slow and declining 1.3% in the first quarter according to A.M. Best.

The Property/Casualty Group implemented rate reductions over the last several years to improve our price competitiveness in the marketplace, which has decreased our average premium per policy. The declines in average premium-per-policy, however, were partially offset by improved new policy growth. Our total year-over-year policies in force increased by 1.8%, or 66,622 policies at June 30, 2007, compared to the growth of 13,195 policies in the second quarter of '06.

Our growth in policies in force was a result of our improved retention rate, our increased marketing efforts by our agents, and the expansion of our independent agency force for new appointments.

Our premiums generated from new business increased 13.5% to $112.4 million in the second quarter of '07 from $99 million in the second quarter of '06.

Our Private Passenger Auto new written premium increased 10.5% while our Commercial Lines new premium increased 24.1% in the second quarter of '07.

Total costs of management operations increased 3.2% in the second quarter. The commissions to our agents made up the majority of these costs. Our total commissions increased 2.7% in the second quarter as a result of the increase in direct written premiums of the Property/Casualty Group, increases in our accelerated commissions for new agents, our $50 Private Passenger Auto incentive, and increased accruals for agent bonus program.

Our non-commissions operating expenses increased 4.5% in the second quarter of '07. Our Personnel costs increased by 4.6%, which included the effects of decreases in full-time employment levels in 2007.

All other operating costs increased 9.8% for the three months ended June 30, 2007, mainly due to additional software license purchases and software maintenance agreement costs.

Turning to the Company's Insurance underwriting operations, as Jeff mentioned, we had another favorable underwriting quarter, generating a gain of $7.9 million in the second quarter of '07, compared to a gain of $300,000 in '06, second quarter.

The GAAP combined ratios were 84.8% and 99.4% for the quarters ended June 30, '07 and '06, respectively. The adjusted statutory combined ratios for the Property/Casualty Group for the second quarter of '07 was 77.7% compared to 92.3% for the second quarter of '06.

Development of prior-accident year loss reserves, excluding salvage and subrogation recoveries, continued to be favorable in the second quarter '07, improving the loss ratio 4.3 points, or $2.2 million. We had adverse development in the second quarter of 2006, which added .3 points to the combined ratio in that quarter.

The majority of this positive development in '07 resulted from continued favorable development of reserves on prior-accident quarters for Automobile Bodily Injury and Uninsured, Underinsured Motorists Liability coverages. Improvements in the accident quarter loss ratios in these lines were a result of improved severity trends, partly due to our implementation of the Specialty and Claims Unit.

We continue to benefit from very low catastrophe levels in 2007. The Company share of catastrophe losses, defined by our Property and Casualty Group, contributed 2.2 points or $1.1 million compared to 9.2 points, or $5 million, for the GAAP underwriting results in the second quarters of '07 and '06, respectively.

The Company's investment operations recorded income of $37.8 million in the second quarter of '07 compared to $29.5 million for this period in '06, an increase of 28.3%.

The earnings from real estate limited partnerships increased to $12.1 million in the second quarter of '07 from $4.5 million in the second quarter '06. Realized gains on sales of Commercial properties owned by our real estate limited partnerships were largely responsible for the increase.

Favorable market conditions resulted in a higher return on capital on our mezzanine debt and private equity limited partnership.

Our net investment income decreased 3.2% to $14.1 million in the second quarter of '07 compared to $14.6 million last year as a result of lower invested asset balances as a result of our share repurchase activities.

Our 2007 provision for income taxes was based on an annualized effective income tax rate of about 32.7% in the second quarter of '07. However, the second quarter of 2007 provision benefited from a $1 million settlement of an IRS examination for the years 2001 and 2002 and a $0.5 million reduction to interest expense as a result of the settlement of an uncertain Federal tax position.

The effective tax rate for the six months ended June 30, 2007 was also impacted by a change to the deferred income tax calculation related to anticipated salvage and subrogation and a recoverable recorded for the IRS audit for the years 2003 and 2004.

Finally, during the second quarter of '07 we repurchased 313,110 shares of our outstanding Class A common stock as part of our stock repurchase program. It was authorized in February of '06. The shares were purchased at a total cost of $16.7 million, or $53.26 per share. As of June 30, 2007, we had about $98 million remaining under the plan -- repurchase plan authorized through December 31, 2009.

Thank you for your attention. Now, let's open the lines for questions.

(OPERATOR INSTRUCTIONS) Adam Klauber from CCW (Cochran Caronia Waller).

Good morning everyone. Thank you. First of all, Jeff, congratulations. Wish you the best of luck. A couple of questions on the quarter. (Inaudible) that growth is turned around. I know you've been working on it for awhile.

Geographically is one area stronger than the other? Is the growth coming from Pennsylvania or outside Pennsylvania?

Adam, this is Tom Morgan. I'd say that most of our growth is coming from outside of Pennsylvania. We have probably our southeast region and, of course, our newer states contributing significantly to that. Our growth is relatively flat in Pennsylvania because of the rate decreases that we've taken in Pennsylvania.

Okay, Okay. And, from a competitive standpoint, at least in the Auto product, where would you say -- and, again, I'd break it down to two questions, inside Pennsylvania, outside Pennsylvania -- where are you compared to the big competitors -- State Farm, Allstate? Are you above your line or below? And obviously, outside it's going to vary per state, but if you have some sense that would be helpful.

Yes, it varies in each state, varies by competitor in each state. I'd say in general in Pennsylvania we're extremely competitive with State Farm. Allstate is a very difficult competitor at this point in time in Pennsylvania. So, and then, it varies around the other states.

But, in general, I would say that our competitive position has been improving, quarter to quarter, and so I'm comfortable with the progress that we're making.

Right, right. On the Commercial lines, we've seen a lot of -- or several outside surveys that talked about rates coming down month by month and getting worse and worse, and I realize all of that is probably more middle market and you tend to have smaller accounts, but on the Commercial side are you seeing, in your account size, which is a little smaller, are you seeing more rate pressure, say over the last three to six months than you had in comparison to 2006? Or, is it still pretty stable?

Well, I'd say that in general you're right. The extremely tough market in Commercial has really impacted the very large and middle market account. The smaller accounts, which tend to be our bread and butter, have seen strong competition and I would say that that competitive environment was pretty strong in 2006 and that continues in 2007.

And then, it just depends on the niche market that certain competitors seem to be strong in certain lines or certain classes of business in the different states and some places it looks extremely soft. In the small market and other areas we compete very well.

And you saw, Adam, that our new Commercial business for the quarter was up 24.1%.

Yes, I know you've had great growth in the market, but that's good to see. On a different topic, as far as your, I guess, real estate and mortgage-backed exposure, you talked about your exposure either or actually both at Indemnity and also the Exchange, to any exposure you may have to the sub-prime or even lower rated, say A and below in the MBS market.

Yes, you probably didn't get a chance to look, but on page 41 of the 'Q' under Item 3, we talk about both the Indemnity portfolio and the Exchange portfolio.

The Indemnity portfolio has approximately -- and I'll read it right from the 'Q' -- "--3.5% of our fixed income portfolio, which is about $900, is invested in structured products, which include mortgage-backed securities, collateralized debt, and loan obligations, asset-backed and credit-linked notes."

Our structured product portfolio has about an average rating of 8AA at Indemnity. At Exchange we approximately have about 8.7% of our fixed income portfolio in those same structured products, and again, have an average rating of about AA.

And none of the classes of securities that we own were downgraded or put on watch by S&P and Moodys a couple of weeks ago. So, we feel pretty good about our exposure to that marketplace.

Okay. Also, in your private or equity investments, can you remind me how much of that is real estate and have you seen any deterioration? Obviously, you had very strong incomes, so you had the best quarter, but any word about the real estate portion of that portfolio?

Well, it's Commercial real estate and we think the Commercial real estate markets are extremely strong. There is a little bit of residential, but it's mostly Commercial real estate. You can see that during the quarter we generated $20 million of earnings from limited partnerships, but $12 million of it came from our real estate portfolio.

We've been recording pretty strong gains on a few back-to-back orders in that portfolio. So we think that Commercial -- the Commercial market in which we have property are still strong. So, we think that portfolio is still well positioned.

Okay. And one last question. Expense growth has been obviously pretty good the last several quarters. Are there one or two factors that we should watch out for that could change that, the non-commission expense growth at Indemnity?

You saw what our growth was for the quarter and we didn't change the guidance, Adam, for a 6% growth number for the whole year. We plan on spending in the second half a little bit more heavily on IT, results of some acquisition expenses, underwriting acquisition expenses that we're going to be spending.

We're going to be getting some additional data from ChoicePoint to assist our agents in developing quote, so there is going to be some additional expenses there.

Okay. It sounds like you spent a bit more for growth.

Right.

Okay. Thanks very much.

Michael Phillips with Stifel Nicolaus.

Thanks everybody. A couple of questions, and I have two on the Personal lines side, Auto, and then one on Commercial.

On the Personal, can you talk about -- I guess it sounds like for (inaudible) Auto, the rate actions that you're currently taking now and how they compare to kind of what you've done at six to 12 months, obviously we see in the 'Q' the average premium and how that's changing, but kind of what you're doing today for Auto and how that would compare to what you did about six months ago.

(Inaudible). The more significant rate decreases were implemented six months to a year ago. I think that we see more fine tuning of rates going on both from ourselves and from our competitors. We see small decreases and small increases being filed in most of our states. State Farm may be the one exception to that. We've seen some larger decreases being filed by State Farm in a few states, but State Farm is trying to get to be more competitive even after those rate changes were extremely competitive against State Farm. I think that's where we're at.

It's in the growth you're seeing in Auto, the new business growth there. Can you describe mix of that, or is it more of the higher preferred business, more standard business, or how is that mix working?

Our Auto business is pretty much in the preferred market. We really don't rate non-standard Auto and so we're seeing good quality business come in. We continue to be an underwriting company and that's our focus and our pricing segmentation has allowed us to better price individual risks.

Okay. Then, over on the Commercial side, with the big 24% of growth in new business there, Commercial, are you looking at any different types of classes or of different types of risks today than maybe you were in six to 12 months ago?

No, I'd say that we are pretty much in the same market that we've been in. Our market continues to be mainstream America. The industry we call it the smaller accounts. We have the terminology of small and middle and I'd say that we go into -- we have a chart that shows we kind of go into halfway up the middle market accounts that the industry does. We are -- we have the capacity to handle larger value properties, et cetera, and we're being successful in doing what we do well.

Okay, great. I guess final question, do you put any kind of timeframe around looking for the permanent replacement for Jeff?

This is Jeff. There is a selection committee of the Board who will be focused on this and I expect that they will be approaching that in a very timely fashion. With that said, it's going to take time. I think we have a very strong interim solution here. And so, I would anticipate that more will be known as the weeks and months pass by, but I don't expect anything that will happen immediately. It will take some time, as it should.

Okay, great. Thanks. Congrats again.

(OPERATOR INSTRUCTIONS) James [Pan] from [PB&E Partners].

I wanted to thank Jeff for I guess your work over the years. You really need to stabilize you and the whole (inaudible) team (inaudible) the combined ratio to increase the investments and you've just done a very good job. I think you're going to be very much missed.

Question though, given what's happened with the change in management, Hagen and Bill Hirt, and I guess Hirt's daughter, can you be -- can you list some of the differences in philosophy behind how you think Hagen will run the Company versus how Bill ran the Company? Specifically, address the issues of financial discipline in terms of underwriting and share buyback and culture.

Well, let me start with culture and first of all, let me say that -- let me offer my own observation and not speak for Mr. Hagen.

I think approach that Mr. Hagen and Mr. Hirt have about underwriting is exactly the same. They both grew up in this Company, are committed to a strong underwriting discipline, equally as committed to active marketing and quality growth. That's always been the important ingredient, part of our Company, and I would say part of our culture.

At the same time, the culture itself, a people culture, where agents and employees really matter in delivering the results for this Company. I know that I can tell you without question that Tom Hagen is very passionate about that, of course, as was Bill Hirt, so there is a lot of similarities there.

Our Company continues to evolve in terms of its size, its financial condition, the changes in the marketplace, and I don't think it would be fair for me to speculate what will occur in the future relative to opportunities that exist out there in the marketplace, and therefore, changes that can't be anticipated today.

But I think there is more similarities in terms of their philosophy around the overall operations of our business.

A follow-up question. (Inaudible) Mr. Hirt has been on the Board for a period of time, but I seem to remember reading the (inaudible) two or three years ago and there always seemed to be the -- what do I want to say -- conflict between Mr. Hirt and Mr. Hagen in terms of who was going to (inaudible) around the Board and stuff like that and who was going to run the Company. I think that was my impression. Can you tell me if I was wrong or can you tell me what that was all about and how that's changed or what that was all about two or three years ago?

Well, James, I would only comment that yesterday is over. Today is here. Sadly, Mr. Hirt is no longer with us and that's a deep loss that we still mourn. I believe whatever disagreement existed in the past have been resolved. I see a spirit of cooperation occurring and I see that continuing in the future.

Thanks a lot.

And at this time, Gentlemen, there are no further questions in the queue.

Thanks everyone. And just a reminder that a recording of the call will be posted on our website, erieinsurance.com, after 12:30 PM Eastern time today. If you have any questions please call me, Mark Dombrowski, at (814) 870-2285. Thanks again and have a great day.

That does conclude today's presentation. We thank you for joining us. Have a wonderful day.