Erie Indemnity Co (ERIE) 2007 Q3 法說會逐字稿

Good day everyone and welcome to the Erie Indemnity Company Third Quarter 2007 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, Karen Kraus Phillips, Vice President and Manager of Corporate Communications and Investor Relations.

Thank you, Laura, and good morning everybody. We appreciate all of you joining us today. Before we get into the particulars of the call, I want all of you to know that after this quarter, we are no longer going to print and distribute the quarterly shareholder report. The report is redundant information that can easily be found in the quarterly earnings releases and 10-Qs. If you have any questions about this, please give me a call.

Joining me for today's call are John Brinling, Interim President and CEO; Executive Vice President and Chief Financial Officer, Phil Garcia; Tom Morgan, Executive Vice President, Insurance Operations; and Jim Tanous, Executive Vice President, 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 Web site at erieinsurance.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 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 control to predict -- for projection. 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 31, 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 those measures to GAAP measures in the press release and in the supplement posted on our investor Web site 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 Web site this afternoon at 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, John Brinling. John?

Good morning and thank you for listening in. Last year at this time, I was looking forward to my upcoming retirement after a very rewarding 38-year career with Erie. Beginning in January of this year, I assumed the role of retired Executive Vice President. Approximately 90 days ago, that budding career as a retiree was interrupted by a phone call from Erie's newly elected Chairman of the Board, Tom Hagen. I accepted his and the Board's invitation to return to the Erie as Interim President and Chief Executive Officer while search is undertaken for a permanent appointment to the post. That search has begun but, for sometime, I will remain in this position with the full authority and responsibility for keeping our Company moving forward.

My intent has been to focus the attention and energy of our organization on fewer high-priority initiatives, particularly those that build and reinforce the infrastructure of our organization, which is necessary for our long-term success. This morning, I will talk about the goals we have established for the Erie Insurance Group and what we are doing to achieve them. The progress towards these goals directly impacts the performance of the Erie Indemnity Company. Phil Garcia will then give highlights of the third quarter financials and then we will open the call for your questions.

You have heard us talk about our Regional Gem strategy. To support that strategy and provide greater clarity, we developed a vision statement. Our vision is to be the best regional insurance company, delivering the highest levels of service and protection through independent agents at a cost that competes with any competitor's business model. What's not in the vision is as important as what is. The vision clearly states our intent to remain a regional, not a national carrier. It says we are an insurance company, not a financial services organization. It reflects a commitment to our independent agent distribution system, not the multiple distribution channels or going direct. And it also speaks to our low-cost business model, a model capable of competing with the direct writers. To support this vision, we have identified a number of 2012 targets we are working to achieve.

I want to direct your attention to the slide on your monitor. It shows the targets we have established. The first is quality growth. Note that our target is industry sensitive. We don't want to force growth when growth comes at a very high cost in the marketplace. That will be counter productive to the organization and for you, our shareholders. The second, underwriting profitability calls for Property and Casualty Group to have a reported combined ratio of 101.5% and an adjusted combined ratio of 96%. This assumes a 25% management fee, with a gross margin on the management fee of 22%. The third target is superior protection. Our policyholder surplus must remain strong to secure the promise we make to our policyholders and support future growth. Fourth, improved productivity will allow us to contain cost and become more competitive. The fifth is control operating expenses. By doing this, we can keep the cost of our products low, remain competitive in the marketplace and ensure appropriate profit margins to the Indemnity Company. And sixth, being above all in service continues to distinguish the Erie from its competitors and one measure of our success in this area is our ability to retain our policyholders.

All of these goals are attainable. We have reached or surpassed these levels in the past. We believe they are not only achievable but, even more important, sustainable. In 2007, we are making contributions towards each of these targets. Let me share a few examples. In the area of quality growth, during the third quarter, we appointed 47 new agencies, bringing our total for the year to 176 at September 30, 2007. We are likely to surpass our goal of 200 new agency appointments by year's end. You recall that in July 2006, we launched an 18-month incentive to give our agents $50 for each new qualifying private passenger auto application. The incentive was to run through December 2007. Given the soft market conditions we are continuing to face, we decided to extend the incentive for six months through June 2008. We announced this to our agents yesterday.

As additional motivation, on October 1, we launched an [all lines] travel incentive contest for our agents. This year loan qualification period runs through the end of September 2008. In underwriting profitability and superior protection, the adjusted combined ratio of the Property and Casualty Group is at a record level of 82.3%. Erie Indemnity Company's net income benefited from a GAAP combined ratio for the property/casualty subsidiaries of 88%, yielding a $6.2 million underwriting result. The Exchange's Policyholder surplus grew to $4.8 billion by the end of the third quarter 2007, which is another record high. We continue to see improvement in our productivity measure. Policies in force per employee, which has improved by a little more than 5% since the end of 2006.

We continue to put focus around our cost of operations for the Erie Indemnity Company. When you exclude the impact of the $8 million in charges we took during the quarter, we held the increase of our non-commission expenses to 6.5% for the third quarter 2007. This puts us on a course to meet our year-end projection of 6% increase over the 2006 levels, excluding these charges. And our all lines retention rate for the Property and Casualty Group reached 90% at September 2007. That's the highest it's been in more 15 quarters.

Our attention and energies are focused on getting things done and on completing priority initiatives to enhance our capabilities and to develop the infrastructure we need for long-term success. Towards that end, we have laid out our plans for 2008 and beyond, which includes geographic expansion. In October, we announced plans to begin writing in our twelfth state, Minnesota, by the fourth quarter of 2009. Our priorities are balanced to ensure we are providing the protection and service our policyholders deserve while continuing to enhance shareholder value. Our capital management strategy reflects that balance. We look to keep our surplus strong, to safeguard our policyholders' protection and bolster the Company's competitive position. At the same time, we will continue to manage the capital of Erie Indemnity for above-average return to our shareholders.

As part of our capital management strategy, in September, we announced $100 million reauthorization of our share repurchase plan through December 31, 2008.

Phil, I will turn it over to you to discuss our third quarter financial results.

Thanks, John. Staying with the topic of share repurchase in the third quarter of '07 in conjunction with our stock repurchase plan, we repurchased 1.6 million shares of our outstanding Class A common stock. Shares were repurchased at a total cost of $89 million or about $53.30 per share. As John noted, in September 2007, our Board approved a continuation of that stock repurchase program for an additional $100 million through the end of '08. We have about $109 million in repurchase authority remaining under the plan. Our Board also authorized a separate purchase of 1.9 million shares at a cost of $99 million or $52.04 per share from the Estate of Bill Hirt, and the Bill Hirt 2004 Revocable Trust. And as you know, Bill Hirt, our former Chairman, passed away in July.

Overall, we had a positive third quarter in 2007, as net income increased to $53.5 million from $52.8 million at September 30, '06. On a per diluted share basis, net income increased 5.8% to $0.87 in the third quarter of '07 compared to $0.82 last year. Our net operating income, which excludes the effects of our net realized capital gain and income taxes on those gains, totaled $51.3 million or $0.84 per share compared to $53.4 million or $0.83 per share for the same quarter in '06. And as we reported, these results were affected by charges totaling $8 million or $0.09 per share for any additional compensation that may be due to our former CEO, Jeff Ludrof, and a judgment and a lawsuit arising from our termination of an agency.

Our management fee revenue grew 0.3% in the third quarter of 2007 compared to the third quarter of 2006. A slight increase in management fee revenue was due to the management fee rate being set at its maximum level of 25% in '07 compared to 24.75% last year, plus a slight increase in our direct written premiums in the quarter. Overall cost to management operations increased 6%, including net increase in commission costs of 0.3%. Our non-commission operating costs increased 20.8% in the third quarter of 2007, driven primarily by personnel costs, which included the charge of $3.7 million. Our all other operating costs increased 52.6% for the three months ended September 30, '07, driven by the charge for the judgment and the lawsuit of $4.3 million. Excluding the charges, our non-commission operating expenses, as John said, rose 6.5% for the quarter.

Given the charges during the quarter, gross margins decreased to 16% in the third quarter of '07 from 20.5% in the third quarter of '06. Excluding these charges, the gross margin for the third quarter would have been 19.2%. As we have noted in recent calls, Property and Casualty Group implemented rate reductions over the past three years to be more price competitive. We estimate that those pricing actions approved, filed and contemplating for filing reduced the direct written premiums of the Property and Casualty Group by about $86 million during 2007, of which approximately $72 million occurred in the first nine months of 2007. As a result, our year-over-year all lines average premium per policy declined to $978 at September 30, '07 from $1011 at September 30, 2006. Our estimate at this time of pricing actions approved, filed or contemplated is an increase of about $3 million during 2008.

Improved new policy growth and retention are helping to offset the decreases in the average premium per policy. Our year-over-year policies in force grew 2.1% or by about 80,000 policies. This increase puts our total policies in force count at nearly 3.9 million at September 30, 2007. This compares favorably to our year-over-year growth of 23,000 policies through the third quarter of 2006. Our overall policy retention ratio improved to 90% at September 30, '07 from 89.2% at September 30, 2006.

Our new policy growth has been positively impacted by the expansion of our independent agency force through new appointments. Premiums generated from new business increased 9.3% to $105.9 million in the third quarter of '07 from $96.8 million in the third quarter of '06. Our new business policies in force increased 6.4% to 460,685 at September 30, 2007 from 432,881 at September 30, 2006.

Turning to the Company's insurance underwriting operations, we had another excellent underwriting quarter, generating a gain of $6.2 million in the third quarter of '07 compared to a gain of $5.7 million in the third quarter of '06. The GAAP combined ratio of the insurance underwriting operations improved to 88% in the third quarter of '07 from 89.2% for the quarter ended September 30, 2006, driven by favorable development of prior accident year loss and loss adjustment expense reserves and continued low catastrophe losses. The adjusted statutory combined ratio for our Property and Casualty Group for the third quarter of '07 was 82.3% compared to 83.7% for the third quarter of '06.

Our development of prior accident year loss reserves for the Property and Casualty Group, less our salvage and subrogation recoveries, continued to be favorable in the third quarter of '07, improving the loss ratio 7.8 points or $4.0 million compared to an improvement of 3.8 points in the third quarter of '06. Most of the positive development is coming from improving loss trends for our automobile, bodily injury and uninsured -- underinsured motorist bodily injury coverages. Catastrophe losses contributed 3.4 points to the GAAP combined ratio in the third quarter of '07 compared to only 1.6 points in the third quarter of '06.

Our investment operations continued to deliver strong results, with income of $30.5 million in the third quarter of '07 compared to $22.9 million for the same period in '06, an increase of 33.5%. Our net investment income was $12.2 million in the third quarter of '07, which is comparable to what we produced last year in the third quarter. Growth rate was flat because of our lower invested asset balances as a result of our share repurchase activity.

Our income from earnings from limited partnerships increased to $14.2 million in the quarter. Our private equity and mezzanine debts limited partnerships generated $8.5 million and $6.7 million for the quarters ended September 30, '07 and '06 respectively. Our real estate limited partnerships generated earnings of $5.7 million and $4.2 million in the third quarters of 2007 and 2006 respectively.

Thank you for your attention. Now, we will open up the line for your questions.

Thank you. (OPERATOR INSTRUCTIONS) We will turn first to Michael Phillips with Stifel Nicolaus.

Thanks. Good morning to everybody.

Good morning, Michael Phillips.

Good morning, Michael.

Hey guys. Couple of questions. Phil, I think the first is probably for you on the reserve development for auto BI, is that mostly '06, '05, or where is that coming from?

It is -- yes, the most accident years is where we have the most reserve, so that is where -- the most recent accident years were the most effective. And again, it is prior to '07.

Right, okay.

And it's improving severity trends we have talked in the past about, especially BI units we have put in place around the country, and we are seeing improved severity in auto BI, and auto UM and UIM, and that's where most of the prior development is coming from.

Okay. If I could turn to -- I don't know how you guys think about agency book rollovers or is that something you guys try to pursue at all or how active you are in that? Could you talk about that and if you active in that all, and if you are, how are things changing in that in the past few months with all the softening market?

Mike, that's something -- this is John Brinling.

Hi, John.

That is something that we do, but on a very limited basis. We have done that occasionally, but it's not something we really focus on.

Okay. I think some of the numbers you guys have talked about in the past, this could be going back a while, was x% of your agents produce x amount of your business for you. I think, it was like 80/80 and maybe it's down to 70/70 now or something. Does -- did that ring a bell and what do those stats look like now?

Do you have those?

I think that -- this is Tom Morgan.

Okay.

What we have talked about before is that typically our -- in our agencies, we have about 70% to 80% of the book of business in their agency, and I think that's the statistic you have talked about before. At one time, we probably said 80%, I think as other companies such as Progressive have expanded their appetite, et cetera, that it would be more appropriate to be somewhere in the 70% to 75% range. Probably 70% of our agents have 75% of their book of business (inaudible). And so, I think that's the statistic you are quoting.

Yes, that is. Okay. And two more for you, can -- with the handoff on LA side to Perot Systems there, what kind of implications that had so far, because it seems pretty early, any disturbances, anything, slower issuance or anything like that that you can talk about that's happened earlier that you are not too happy about or any positive there too?

Well, the handoff to TAG/Perot, Mike, has been a disappointment for us. We still feel that the long-term prospects for it are very good. But, quite frankly, there was more business in the Q that when -- in the pipeline, when we handed over to them. And so, that kind of puts them behind immediately. They weren't as ready in some areas to service the business as we and they thought. So, it has not gone well. We have worked very hard, both they and we, consider it an extremely high priority to resolve those issues, and we have focused a lot of resources on getting it right. I met with the TAG/Perot people this morning and they've reassured me that they have put it at the very, very top of their priority to get resolved. But, it is not going as well as we would like right now.

Okay, thanks. And if I could turn to specific lines that I am curious about, commercial auto and your comp, kind of what you are seeing specifically in those two lines in terms of just overall competition and kind of what you think is going to be happening in the next 12 months there, for commercial auto and comp?

Yes, commercial auto -- this is Tom again. For commercial auto, I would say that most companies that I see continue to have that as a very profitable line of business and we remain extremely competitive in that line of business. But, because of the profitability, you would expect it -- in the future, you would see some squeezing of that competitive position. Work comp, we have seen our results improve over time and has allowed us to become more competitive. We have installed a new rating tier using the various companies of the Erie Insurance Group that have allowed for more competitive rates for the very best risks.

Okay, thanks guys. I appreciate it.

Thanks, Michael.

Thank you.

Thanks, Michael.

(OPERATOR INSTRUCTIONS) We will go to Blake Phillips with Fox-Pitt Kelton.

Hey, good morning.

Good morning, Blake.

I guess I will start off with the estimated, I guess, reductions for '08 since that $3 million increase on premiums, does that you are estimating a net rate increase for next year?

Right. At this time, we are estimating that basically our rating actions are going to be neutral, right, for the year. That's subject to change. This -- we always do this in the third quarter Q; we kind of give you the next year's view of the world from our perspective at this point in time. Now, if the marketplace heats up, we will update you every Q with that, with what our expectations are, what are filings are going to look like. But right now, as we said here, last year in the third quarter, we said -- I believe we said we would see about a 2% drop in rates; right about $80 million -- $80 million, $90 million. So now, we are saying -- our crystal ball says that our anticipated rating actions are going to be basically neutral for 2008.

Okay. I am guessing this is pretty heavily personal auto weighted and based on maybe Progressive and Allstate saying they are going to be as aggressive in rates next year given they are not hitting their targets, could you just give some more rationale behind it?

Well, Allstate, I believe that they were going to take 4% in something like 28 different markets in auto. But, we think we are very competitive now in all of our markets and our underwriting results are good. So, if the marketplace -- this allows us to stay here at this price point; we think we are well positioned. So, I guess that's what we are saying right today in this number.

Okay. And then I guess just real quick, is there some reason for the seasonality in the life business in the third quarter? Seems like it is lower pretty consistently at least for the last three years.

When you talk about seasonal, you mean the net income number we reporting for Erie Family Life?

Yes.

Well, there is a lot of charges in there in connection with this whole TAG/Perot conversion. So, there is a pretty heavy expense load in the third quarter.

Okay.

Yes. Their business is not as seasonable as ours, but they have the same kind of spring and fall dinner meeting bubble that we have in terms of written business and the seasonality of it.

Okay, thanks.

Thanks, Blake.

Thanks, Blake.

And we will go now to [James Pan with CP&E Partners].

Thanks. Thanks for the buyback and the good underwriting results. I just had a couple of quick questions on your investment portfolio. I noticed in the Q that it said 5% of your fixed assets were in structured finance products.

Right.

-- that were still highly rated for the S&P. Just a couple of questions on that. Is that the same ratio as what have in Exchange or does the Exchange have more [other] ratio?

Well, we have -- in Indemnity, we have about $37 million in structured products and obviously, we reported that; I think the number is 5%. At the Erie Insurance Exchange, we have about $650 million of a portfolio. I think it is about 8% -- 7% or 8% that is structured products.

Now, given that that a AAA rating doesn't quite -- or AA rating or highly rated doesn't quite mean as what it once did.

Right.

Can you give us some color on what the bid-ask spread has been on that $650 million or the $690 million that you have totally in [the total investments]? In other words, how far has the bid-ask spread since the credit crunches hit last summer?

Well, we haven't had any of our portfolio be downgraded other than we had four securities -- at the Exchange I am talking about now, okay, James?

Okay.

So, in the second quarter, on these four structured product securities, we wrote them down $10.5 million in the second quarter and in the third quarter, we wrote them down $1.7 million. So you can see that the erosion on those four, which were a problem, was greater in the second quarter than in the third, a 5 to 1 margin.

Right. That's -- what I am conferring is that you think that that period hit the trough of the credit crunch in terms of your investment portfolio, is that correct?

Well, we are crossing our fingers that these structured products -- the bids seem to be holding in there on our portfolio at the Exchange because the Exchange portfolio is a lot bigger. Really, it is insignificant at Indemnity, $37 million.

Right. How are you pricing the -- are you pricing that on the bid side or on the $650 million?

On the $650 million?

Yes, in the Exchange.

Well, we have a team that just goes through them and tries to get the best prices they can and we talk about it, and then we mark them down, and we talk about whether they should be impaired or not.

Is there a liquid market for them?

Some, there is not.

How much doesn't have a liquid market?

That I don't know off the top of my head.

Okay, thanks a lot.

Sure.

Thanks, James.

And at this time, we have no further questions. Mr. Brinling, I will go ahead and turn the conference back to you for any additional or closing remarks.

Two weeks ago, we concluded the fall session of our annual dinner meeting tour. You have heard about these dinner meetings before on the call. These annual events mark the culmination of our branch production contests and give us an opportunity to celebrate the success with agents and employees. We split the contest periods, nine branches hold contests in the spring and nine in the fall. The contest ran during the third quarter, August and September, and we saw good results as evident from the new policy production rate. The real value of these dinners is the opportunity to talk face to face with our agents and hear what they are experiencing in their day to day operations. I can tell you that the overall tenor was positive. Agents and employees shared enthusiasm about Erie's direction and our competitive position in the marketplace despite the continuation of the soft market. I believe, even with the recent changes in leadership, our agent relationship is strong.

I again want to thank you for your participation today and look forward to talking with you again on our fourth quarter call scheduled for February 28, 2008.

Thank you, John. I want to remind you that today's call will be archived on our Web site, erieinsurance.com, by 12.30 this afternoon. And again, this quarter will be the last distribution of our quarterly shareholder report. Thank you for your time and if you have any questions, please don't hesitate to call me at 814-870-4665. Thanks so much.

With that, we will conclude today's conference. Thank you everyone for joining us.