Heritage Insurance Holdings Inc (HRTG) 2016 Q2 法說會逐字稿

Good morning and welcome to Heritage Insurance Holdings second-quarter 2016 financial results conference call. My name is Andrew and I will be the operator today. (Operator Instructions). Please note this event is being recorded. (Operator Instructions). I would now like to turn the conference over to Melanie Skijus. Please go ahead.

Good morning. The second-quarter earnings release can be found in the Investors section of heritagePCI.com. The earnings call will be archived and available for replay.

Today's call may contain forward-looking statements. These statements, which we undertake no obligation to update, represent our current judgment and are subject to risks, assumptions and uncertainties.

For a description of the risks that could cause our results to differ materially from those described in the forward-looking statements, please refer to our annual report on Form 10-K and other filings made with the SEC from time to time.

With us on the call today are Bruce Lucas, Chairman and CEO; Steve Martindale, Chief Financial Officer; and Steve Rohde, former CFO and current financial consultant to the Company. I will now to the call over to Bruce.

Thank you, Melanie. I would like to welcome all of you to our second-quarter 2016 earnings call. Before we begin a discussion of the quarterly results, I would like to take a moment to thank all of our employees for their dedication and commitment to our Company.

We are growing the Company while maintaining the highest levels of service in response to our policyholders and these achievements are made possible by the concerted effort of all of our employees.

I am happy to report we saw a significant rebound in the second quarter as losses were lower and weather was more mild relative to the first quarter. Net income increased 147% compared to the first quarter and return on equity was 20.2% for the quarter.

Our voluntary production in Florida and Hawaii has been stable and our production in North Carolina continues to expand. Importantly, production in our new states led by North Carolina, currently account for roughly half of all new business written.

In North Carolina our average insurance score is above 800. This insurance score is significantly better than the state average and reflects the attractive risk profile of the policies we are writing. Our North Carolina initiative is an important step in our diversified business plan and we recently launched operations in South Carolina, which is our fourth state in which we write business.

In addition, we have licenses in Georgia, Mississippi and Alabama, we are working on several new state applications and we plan to continue our growth outside of Florida.

With respect to our acquisition of Zephyr Insurance, the transition to date has been seamless and we continue to be impressed by the management team in Hawaii. Tropical Storm Darby was a relatively benign storm and Zephyr did not incur any losses. As a reminder, Zephyr does not have any exposure to named storms unless there is a hurricane watch or warning in place at the time of the loss.

I would like to provide a few highlights from the second quarter of 2016. Gross premiums written increased 31% year over year to $177 million. Gross premiums earned increased 29% year over year to $164 million. Policy count increased 49% year over year to 331,000 policies.

Net income was $18.4 million, a 147% increase compared to the first quarter of 2016. We repurchased 527,989 shares of common stock for a total of $6.9 million in the second quarter.

Business in North Carolina continued to ramp up with over 2,300 policies and roughly $2.8 million in premium written through June 30. During the quarter we placed our 2016-2017 reinsurance program and have roughly $3 billion in catastrophe reinsurance protection. This level of reinsurance reflects the Company's conservative approach to risk management and our focus on protecting both our policyholders and stockholders against the peril of a hurricane.

We continue to look at the best avenues for shareholder returns. We don't believe our current share price is reflective of the Company's value, ROE and business prospects as evidenced by the substantial purchases made by our officers and directors, including myself, during the second quarter.

We believe in the future of the Company, we are heavily invested in that future and we will balance return of capital through share repurchases and dividends with opportunities we see on the horizon for growth and strategic expansion.

We will also continue to evaluate attractive M&A and opportunities to form key partnerships which we believe will strengthen our Company for years to come.

I will now turn the call over to Steve Martindale, our CFO, to provide more detail on our financials.

Thank you, Bruce, and good morning. Gross premiums written for the second quarter were $177.3 million, an increase of 31% year over year. Approximately 10% of the gross written premiums for the quarter were outside of Florida with 8% from Hawaii and 2% in North Carolina.

Related to our assumed business, takeout activity from Citizens was minimal for the quarter with less than 2,000 policies assumed. The written premium associated with these assumptions was more than offset by late opt out activity from prior quarters.

Our total policy count at June 30, 2016 was approximately 331,000. The total Heritage personal lines policy count was approximately 253,000. Heritage voluntary personal lines policies increased by 4,550 during the quarter, largely due to our expansion into North Carolina.

The Zephyr acquisition added approximately 74,300 personal lines policies, bringing us to a consolidated personal lines policy count of approximately 327,500. In addition, our commercial lines policy count was approximately 3,600 at June 30, 2016.

Our total premiums in force at June 30, 2016 were $660 million, an increase of approximately 29% from one year ago and an increase of almost 12% from the end of 2015. Commercial residential premiums in force were approximately $125 million. Gross premiums earned were $164 million for the second quarter of 2016 compared to $127 million for the second quarter of 2015.

Our ceded premium ratio was 33.5% for the second quarter of 2016 compared to 25.4% for second quarter of 2015. The increase in ceded premium ratio is largely attributable to the significant reduction in premiums assumed during the fourth quarter of 2015, and the first quarter of 2016 of $72 million compared to $215 million of assumed during the fourth quarter of 2014 and the first quarter of 2015.

On June 1 we renewed our catastrophe reinsurance program. We have purchased approximately $3 billion of reinsurance coverage compared to approximately $2.2 billion of coverage in 2015. This year's program provides for $1.9 billion of first event protection in Florida and $1.1 billion first event coverage in Hawaii.

The increase in coverage was necessary in light of our significant growth, including commercial, residential and wind only business in Florida and the acquisition of Zephyr. The total cost of the 2016 program was $240 million compared to $177 million for the 2015 program.

The cost of the annual reinsurance program is amortized over the 12 months beginning June 1. Accordingly, the ceded premiums, or reinsurance costs, are significantly higher for the month of June versus the first two months of the second quarter and the first quarter of 2016.

We expect the ceded premium ratio to be in the 37% to 39% range for the rest of the year depending on takeout activity in the fourth quarter. Comparatively, the ceded premium ratio on the 2015 and 2016 reinsurance program was approximately 35%.

Our loss ratio as measured against gross premiums earned was 29.8% for the second quarter of 2016 compared to 26.7% for the second quarter of 2015. As we reported on our first-quarter earnings call, our loss ratio for the first quarter of 2016 was 44.1%. The first-quarter loss ratio was impacted by severe weather activity and over $14 million of adverse development on prior year reserves, particularly 2015.

We indicated that it would be reasonable to expect our gross loss ratio to be in the 29% to 32% range for the remainder of the year considering the elevated loss ratio we had been experiencing in personal lines, primarily driven by the increase in water claims associated with the assignment of benefits issue, offset somewhat by the increase in commercial residential business which has a much lower loss ratio than the wind only business of Zephyr.

It appears that the reserve strengthening we did at March 31 was in line with what was needed, at least as measured at June 30. During the quarter we had approximately $200,000 of favorable prior year development.

Quarter one losses had unfavorable development of approximately $800,000 despite the strengthening of the loss development factors last quarter. The weather-related claims activity that occurred during the second quarter was in line with expectations. Water-related claims activity, particularly in the tri-county, improved when compared to the first quarter, but remained elevated when compared to a year ago.

IBNR represented approximately 60% of our total loss reserves at June 30 and the change in IBNR accounted for 3.2 points of the loss ratio for the quarter compared to 4.1 points for the second quarter of 2015.

Our expense ratio as a percentage of gross premiums earned was 22.4% for the second quarter of 2016 compared to 19% for the second quarter of 2015. The year-over-year increase in our expense ratio is primarily related to the larger benefit realized a year ago from assumed earned premiums from Citizens takeouts where there are no acquisition expenses associated with the premium.

The benefit to the second quarter of 2015 was 3.3 points compared to 1.9 points in the second quarter of 2016. Our combined ratio as a percentage of gross premiums earned was 85.7% for the second quarter of 2016 compared to 71.1% for the second quarter of 2015.

The larger takeouts from the first quarter of 2015 and the fourth quarter of 2014 resulting in the lower ceded premium and expense ratios in 2015 was the primary reason for the significant difference in the combined ratios. The elevated personal lines loss ratio in the second quarter of 2016 also contributed to the higher combined ratio.

With the new reinsurance program, and assuming no hurricanes this year, we believe that a combined ratio in the range of 90% to 92% is a reasonable expectation for the third and fourth quarters.

Net income for the second quarter of 2016 was $18.4 million compared to $25.4 million for the second quarter of 2015. Zephyr contributed approximately $3.2 million to our consolidated net income in the second quarter of 2016.

On the balance sheet side, stockholders equity increased to $372 million, an increase of approximately $16 million from December 31.

During the quarter the Company repurchased $7 million of its common stock for a year to date total of $16.6 million resulting in approximately 1.1 million shares repurchased so far this year. Statutory surplus in our two insurance subsidiaries at June 30 were approximately $209 million and $75 million for Heritage and Zephyr respectively.

Our invested assets at June 30 were $550 million, an increase of approximately $150 million from December 31 with about half of the increase attributable to the inclusion of Zephyr's invested assets into our consolidated balance sheet.

Our cash position at June 30 was $143 million. Most of the cash was in our two insurance subsidiaries where we were holding larger balances for reinsurance deposits that were due in July. Our total assets were $1.1 billion at June 30.

With that Bruce and I are now available to take your questions.

(Operator Instructions). Mark Hughes, SunTrust.

Do you think the assignment of benefit issue has stabilized here? You had mentioned that the water-related losses in the tri-county were better in 2Q. Was that a weather issue or do you think the AOB has kind of hit its plateau for now?

Well, it is impossible to predict the future. So, I will caveat it that way. But we have seen a reduction in water loss claims. The water loss claims are not weather-related, those are mainly burst pipes. And we have also seen a leveling off of litigation from attorneys that represent in particular assignment of benefit contractors.

So, quarter over quarter we have not seen an escalation in the number of lawsuits filed. That appears to be plateauing. I think others in the industry have seen that as well. And in terms of the water loss ratio, we are doing a little bit better quarter over quarter and there is a lot a premium in tri-county, so a 2% improvement is pretty significant.

Right. Can you give us sort of a lay of land in terms of takeouts now? And maybe I will put it in the broader context, when we think about the growth trajectory for Heritage, given the voluntary production, given the takeout opportunities, what should Heritage be doing at the top line over the next year or two?

Yes. So, in terms of takeout activity, we think takeouts are going to be minimal for the remainder of this year. We like the quality of the book that we have right now, we are credit scoring our voluntary policies. That has been very effective in terms of underwriting new risk.

We are focused on expanding our footprint outside of Florida, that is the main driver of our growth. We are also going to look at some M&A opportunities as well. But we have been saying for a while that Citizens is slowing down. And I think that is probably the prudent way to go.

Given that the vast majority of the policies right now are in the tri-county area, we do not have an increased appetite in the tri-county for personal lines. We would rather go in and take that TIV that is available there and write it in commercial lines. We think that is a much better play.

Our loss ratios there are very modest at around 5%. And although reinsurance costs are much higher, we simply do not have assignment of benefit problems in that book of business and that is a huge diversifier and hedge that we have in place.

I think you wanted to know kind of our thoughts on what it would look like next year. We are not really in the position to give forward guidance a year out on where our voluntary growth is going to be simply because we are ramping up in new states and we have some new initiatives that are in process and it is just too early to predict what that will be.

But I do think for now we are essentially a flat Company in terms of top-line growth, but we are getting better risk profiles, improving loss issues and getting more reinsurance synergy. So, the bottom line should benefit from our business plan.

Thank you. And then -- I think that covered it. From an expense ratio standpoint, not as much benefit from the take outs. Should you get any leverage there or are we in kind of a similar -- kind of steady holding pattern on the expense ratio?

Yes, I made the big driver on why expense ratio was up a little bit, and it wasn't up a ton, it was maybe 10% or so, is simply a reflection of the fact that in 2014 we had a huge commercial residential takeout and a very big personal line takeout. And so, that took the expense ratios year over year say second-quarter 2015 and dropped them down.

As we said, going back to the time of our IPO road show, the commercial residential opportunity in terms of Citizens was essentially a one-time opportunity. We got pretty much 95% of the good policies there. So it was a one-time pop at the end of 2014 and beginning of 2015.

That is why you saw the expense ratio a little bit lower a year ago. I think that in terms of G&A we are probably going to be fairly flat from where we are now. I think that is a good gauge.

And flat on an absolute basis or ratio wise?

This is Steve Rohde. I would say that going forward if you take out the benefit of the takeouts that our expense ratio is running in the 23.5% to 24% range is what we should be considering.

Great, thank you.

Arash Soleimani, KBW.

Can you just quickly talk about in terms of AOB have you adopted Citizens' policy language or (inaudible) the new policy language?

That is a good question, Arash. We did submit some revisions to the Citizens policy language that have been approved by the OIR. So that adoption of that endorsement is in place now and so we just have to put it on the book of business.

But we felt like there was some language that really needed to be tightened up there. And we worked with OIR for a long time on that language to find a good solution to some potential issues that we saw. And I am happy to report that that approval was secured this week.

Okay, great. And is that language similar to what we saw at Citizens where I think they said it is something in the neighborhood of 3,000 for emergency repairs and then more major repairs must be inspected by the insurers? Is it along those lines or did you guys do something a little bit different?

The language is essentially identical to the Citizens policy endorsement. So all the caps on coverage, etc., are identical. Our big thing was we believe the policyholder should have an obligation to allow us to inspect the property post loss.

And what the lawyers do, they advise their client to report the claim and then they never want to let the insurance carrier in to even adjust the loss. That is their MO. They want a situation where the claim is reported, they demo, they rebuild, they send us a bill, we never even get a chance to look at it.

That violates the terms and conditions of our policy and it results in denied coverage. You have to give us an opportunity to look at it, and this is an issue that Citizens has been talking about as well.

So, we strengthened language around policyholder obligations or duties in terms of letting us into the property to actually adjust the loss. And I think that is just a favorable step that will help to curb some of the abuses that we are seeing from [signment] of benefit contractors and the trial bar.

So, basically if repairs are made and you are not there to adjust them first, you can be pretty confident that you are not going to be on the hook in that scenario?

Well, the language as written provides that if they unreasonably withhold access to the property that the caps are in place. And we think that is fair. We have had multiple examples, I can give hundreds of them, where we actually -- we always send an adjuster out to the loss no matter what. And we have no problem knocking on the door and saying; let us in to take a look.

And it is shocking when you see the home owner home and a contractor in there doing repairs and the home owner says, we are not going to let Heritage in because advice of counsel is not to let the insurance carrier in to adjust the loss. That is shocking.

So we are taking a little hard line against that because we think that is wrong, it violates the policy terms and conditions. And if they have a loss we have to be able to adjust it before we pay out. Otherwise we have no idea if there was even a loss that occurred.

And we look at it too from the consumer side, Arash. What happens to the poor consumer when they sign away all their rights, they don't know what is going on, they are told what to do and it results in a denied claim.

They then owe tens of thousands of dollars potentially to an AOB contractor who had no right to do what they did and they don't even have coverage in place, that consumer is the one that actually pays the price.

And we are trying to do what we can to protect the consumer as well. These are our policyholders and we hate to see them being taken advantage by unscrupulous contractors and trial attorneys.

Right, right. Thanks for that thorough answer. And the next question, I think there was an article in one of the Florida papers just on one of the recent rate increases I think you were filing for. I just wanted to see, maybe it was the 14.9% increase, if I remember correctly.

Is that something that you I guess are refiling? Or is that delayed at this point? I just wanted to know how to think about that in terms of the rate environment for your book over the next few quarters?

Sure, and that is a great question. First, I would like to thank the Florida Office of Insurance Regulation for working with us on that filing. We did have a filing in place at 14.9%. And then we have given the OIR numerous proposals, variations of that filing that are designed to curb AOB abuses and reduce rate increases on policyholders.

So, we have given them several things to consider, a lot of things to work through. We are trying to be innovative and find a cure for the disease instead of simply treating it by rate increases on innocent policyholders who had nothing to do with the fraud. That is our goal here.

We want to keep our rates as low as possible, but there is no doubt that there is a small percentage of policyholders who are engaged in this fraud and they are driving up rates for everyone.

So we have some proposals pending with the Office of Insurance Regulation that we believe will go a long way to curbing the source of the fraud and stop it from happening and in exchange we can give some rate cuts to our policyholders.

They have been great in looking at every proposed solution. We are all working hand in hand to try to find a fix to the problem. So, it is too early to comment, but, yes, we are working with OIR pretty much every week and we will have a resolution soon I am sure. But until then I really don't want to comment publicly about private conversations that we are having with our regulators.

Okay, that is fair. I guess just a question I have on the loss ratio side. With I guess -- is it fair for us to think of those going forward the same way I guess you have guided to in the past if the rate changes don't happen?

Well, I guess I look at it, Arash, and say there will be a rate change of some magnitude here on the book of business. I am not going to say what that will look like. I can tell you though we have not had one person at the OIR tell us that we are not entitled to a pretty significant rate increase. The conversation has never taken place.

So rather than raising rate though, if we can find a solution that actually stops the fraud from happening, and all that does is punish the fraudulent and protect the innocent. And in exchange for that curb of abuse we could have a much lower or potentially no rate increase, that is the best solution because the innocent are being protected.

And I have every faith in Commissioner Altmaier and the OIR that they are going to decide in favor of innocent consumers and work with us to fix this problem.

Okay thanks for that. And last question. Where are you setting initial loss picks now versus a year ago?

I think we are in the same place we were a year ago, we reserve to the mid -- roughly the midpoint of the actuarial range.

Yes, this is Steve Rohde again. For the first quarter of 2016, the first half of 2016 our -- for personal lines we said a 39% ultimate loss ratio compared to a year ago we would have been at 34% for the first half of 2015. So it has gone because of the assignment of benefits issue largely, again, from the assignment of benefits issue [by 5 points] from where we were before.

But we are reserving based on the development factors that we see in our loss triangles. We use an independent auditor that sets our reserves. And so our methodology really isn't any different. It is just we had an increase in first quarter because we didn't like the uptick in litigated claims.

Now I am glad that that has slowed, it is not as elevated as it was say fourth quarter and first quarter. But when we saw that increase in litigated claim activity we had a duty to increase reserves. And we took our lumps in the first quarter much like I think some other people in the market have done this quarter.

Right, okay. Thanks for all of the answers and congrats on this quarter.

Matt Carletti, JMP.

Bruce, I just had a question on your new reinsurance program and I appreciate a lot of the quantitative color that you provided. We have heard a lot of -- on a lot of the earnings calls a lot of the reinsurers talk about how in Florida they have taken an approach to kind of inflate themselves from AOB of trying to be more selective in who they support.

And so, I was curious if you can give us any color on was there any change in kind of the -- or major change in kind of your panel of reinsurers, whether for the better or for the worse?

Yes, we did have a big change in our panel and that was for the better. We had a panel of reinsurers on Zephyr's program that were essentially nonexistent on Heritage's reinsurance program.

So having some of the combined layers where we had multi-zonal coverage including our cat bonds, it allowed us to significantly diversify our reinsurance panel, that was extremely synergistic for us, it was very beneficial for us.

We were able to reduce concentrations with some of our old reinsurers and kind of diversify that -- the spread of coverage around much, much better. So, we actually had a really positive change year-over-year from this year's treaty to last year's treaty.

I would like to add that we have 20 new reinsurers on the program this year and it is about 38% of the capacity. So, we diversified significantly.

Great, great. And then just one numbers question. I apologize, I think you mentioned this, I just didn't catch it. What were the assumed premiums in the quarter from takeouts?

They are essentially zero. I mean, we assumed about 2,000 policies but late opt outs offset that. So it was netting to essentially nothing.

Okay, great. Thanks very much.

Yes, and to kind of further on that point, when we are in the first half of the year what we are really focused on is managing the reinsurance treaty and our projected PML. So, we are very careful as to what we are adding. We don't want to get over concentrated in the tri-county and that is the number one focus that we have right now.

And if we are going to take risk there we -- luckily by design we have a great hedge in place with commercial residential. And that is really where we are going to pick up TIV in the tri-county, we think that is a much better growth driver because you simply don't have the AOB problems in that line of business that you have in personal lines.

Right, right. All right, great. Thanks for the color and congrats on a quarter where things seem to be headed in a little bit better direction.

Mike Zaremski, BAM Funds.

A couple questions, first regarding the catastrophe load. In the past you have said to model the catastrophe load by taking the full retention and roughly dividing it by three because that is the probability of a large cat on any given year.

Can you update us on that math given the evolving footprint and the new reinsurance program? And I guess related to that, can you clarify if your loss and combined ratio guidance from the prepared remarks includes that cat load?

Yes. So, I mean our retention on a first event in Florida is $40 million. So, I guess that would be the top-line number that you take divided by 3, so roughly $13 million or so a year in pretax. And our numbers do not include cat loads that we report. We simply don't know when a catastrophe will happen. But I understand that analysts and a lot of investors impute some type of cat load in their forward projections.

Okay, got it. That is helpful. I think some analysts [aren't] including much of a cat load. And my next question is on the buyback authorization. Now you guys used I think $7 million of the $60 million this past quarter. Can you elaborate on how you guys think about buyback versus I guess -- I know it is wind season right now, versus growth and your excess capital position and what not?

Sure. So in terms of kind of balancing it, we always look at what is going to drive ROE higher. Is it a buyback, it is a dividend that you give to shareholders, is it playing in our own reinsurance tower with our retention?

We balance all of that and then we look at things like M&A opportunities that are in the market and what does that do to the ROE needle. And then we make a decision based on what generates the highest return. That's always been our focus.

So in this past quarter we looked at it and said we were obviously better served in participating in our reinsurance tower especially on a first event basis down low because it is the highest rate online. And over time, yes, you may have a cat year where that level gets eroded. But the numbers don't lie. And over time that is the single highest ROE that you can deploy between the two.

With respect to share buybacks, we look at it and there are times when we have traded below book value, which Mike, as an original IPO investor, to us we think that is ludicrous.

We are looking at this market and we generally think about it in terms of for P&Cs, if you are a book for you P&C you are basically assuming that there is no ROE at all in the Company. Well, that certainly isn't the case.

And when you trade at below book value you are assuming that the entity is losing money on a year-over-year basis, that is definitely not the case.

And so, we looked at where our share price is trading and we had no problem buying back stock at numbers that were essentially at book value, sometimes a little bit above it, sometimes a little bit below it and I echo those sentiments.

And in the quarter officers and directors bought about $785,000 of stock and I bought almost $450,000 worth of shares personally. So, I think our individual mentality mimics that of the corporate mentality. There are opportunities to repurchase stock with excess cash; at these valuations we are going to do it.

We had to keep some money aside because we are getting for our reinsurance retention in Osprey because we are getting a much higher ROE there. But now that that is placed and we have excess capital at the holding Company it is something that we are certainly going to take a hard look at again.

And what is the excess capital level at the holding Company? If you can say.

Yes, between $5 million and $10 million immediately.

Yes. And then every month we have accretive earnings that come into the MGA.

Okay, got it. And lastly, did you guys mention the -- any reserve movements this quarter during the prepared remarks? I may have missed that.

I don't believe so.

No, we just -- we had a couple million dollars of additional IBNR added and it remained at 60% of our total loss reserves, IBNR did.

Okay, so a couple million dollars of negative development, is that (multiple speakers)?

No, the development was $600,000 overall. But we increased IBNR by $4.2 million during the quarter.

And that was because of just increased loss reserves.

Yes.

Okay, thank you for the insights.

As there are no further questions this concludes our question-and-answer session. I would like to turn the conference over to Bruce Lucas for any closing remarks.

I would like to thank everyone for joining our second-quarter earnings call.

The conference has ended. You may disconnect your lines.