Heritage Insurance Holdings Inc (HRTG) 2016 Q3 法說會逐字稿

Good morning and welcome to Heritage Insurance Holdings' third-quarter 2016 financial results conference call. My name is Denise and I will be the operator today.

(Operator Instructions)

Please note: this event is being recorded.

I would now like to turn the conference over to Melanie Skijus. Please go ahead.

Good morning. The third-quarter earnings release can be found in the investor 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 on 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, and Steve Martindale, Chief Financial Officer. Also on the call is Steve Rohde, financial consultant to the Company.

I will now turn the call over to Bruce.

Thank you, Melanie. I would like to welcome all of you to our third-quarter 2016 earnings call.

Before we begin a discussion of the quarterly results I would like to take a moment to reflect on the last few months and thank our employees for their unwavering dedication to our policyholders and the Company. After 11 years without a hurricane, Florida endured two hurricanes, Hermine and Matthew, in little over a month's time. Our claims and remediation service teams worked tirelessly to reach out and respond to policyholders impacts by the storms. I am proud of our team's response times and the execution we provided policyholders during and after both of these storms.

Our vertically integrated claims department has responded to roughly 3,000 claims in total, many of which were addressed within hours and days of the storms. We believe our unique approach to managing and resolving claims benefits our customers and helps to deter fraud from assignment of benefits schemes. Heritage has received 523 claims remain related to Hermine, and we have recorded $4 million in projected losses from these claims in the third quarter.

I wanted to get out early on Hurricane Matthew with an estimate on projected losses, as the media was inciting panic in the days leading up to the storm's landfall in the US and estimated industry projected losses were fluctuating hourly, given shifts in Matthew's projected path. I am happy to report that Heritage's losses for Matthew have materialized significantly less than we had previously estimated. As the storm track moved further east, projected losses diminished. We have had approximately 2,500 Matthew claims to date, and we anticipate approximately $30 million in incurred losses.

Aside from our hurricane activity, our core business operations have been good. We received a 9.9% rate increase on our Citizens policies that will be effective on December 15. The primary driver of the rate increase is an assignment of benefit and attorney-represented claims.

I will now turn to the third quarter 2016. Despite Hurricane Hermine, which resulted in loss and loss adjustment expenses of $4 million, we posted net income of $10.9 million and return on average equity of 11.7% of the third quarter. Other highlights from the third quarter are as follows: Gross premiums earned increased 28% year over year to $165 million. Policy count increased 36% year over year to 327,000 policies. Stockholders equity of $377 million increased 14% year over year. We repurchase 284,377 shares of common stock for a total of $4 million. Growth continued in voluntary personal lines, aided by expansion in North Carolina, with 4,899 policies in force at September 30, 2016. We began writing policies in South Carolina, with production showing steady growth month over month. Zephyr continues to perform well and the integration into Heritage has been seamless.

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

Thank you, Bruce. Good morning.

Gross premiums written for the third quarter were $147.2 million, down 1% compared to a year ago. Approximately 13% of the gross premiums for the quarter were written outside of Florida, with 11% coming from Hawaii and 2% from North Carolina. The decrease in premiums written can be attributed to an absence of Citizens assumption activity in the third quarter of 2016 verses $33 million in assumed premiums written in the third quarter of 2015. Voluntary business written by Zephyr in Hawaii and by Heritage in Florida and North Carolina offset most of the decrease in policies assumed from Citizens. New business in North Carolina continues to show strength, with $3.3 million in direct premiums written during the quarter.

Our total policy count at September 30, 2016, was approximately 327,000. The Heritage personal lines policy count was approximately 249,000. Heritage voluntary personal lines policies increased by 4,300 policies from last quarter, largely due to new business written in North Carolina. Zephyr policies in force stood at 74,000, bring us to a consolidated personal lines policy count of approximately 323,000. Our commercial lines policy count was approximately 4,000 at September 30, 2016.

Our total premiums in force at September 30, 2016, were $646 million, an increase of 19% from a year ago and an increase in 9% from the end of 2015. Commercial residential premiums in force were approximately $122 million. Gross premiums earned were $165 million for the third quarter of 2016 compared to $128 million for the third quarter of 2015. Our ceded premium ratio was 38.4% for the third quarter of 2016 compared to 35.8% for the third quarter of 2015. This is in line with the 37% to 39% guidance range we provided during last quarter's earnings call.

The increase in the ceded premium ratio is attributable to a shift in our mix of business to more commercial residential and wind-only policies, which have higher catastrophe reinsurance cost and a lower attritional loss ratio. Our loss ratio as measured against gross premiums earned was 32.7% for the third quarter of 2016, compared to 27.9% for the third quarter of 2015.

The increase can be attributed to weather claims associated with Hurricane Hermine of $4 million, coupled with reserve strengthening and adverse development totaling approximately $2 million related to litigated prior-year claims. Hermine added about 2.4 points to the gross loss ratio.

On our first-quarter earnings call, we provided guidance that our loss ratio, excluding hurricanes, would be in the 29% to 32% range for the remainder of 2016. Excluding Hermine, our loss ratio for the quarter of 30.3% was within our guidance.

IBNR represented approximately 58% of our total loss reserves at September 30 and the change in IBNR accounted for 2.1 points of the loss ratio for the quarter compared to 0.8 points for the third quarter of 2015. Our expense ratio as a percentage of gross premiums earned was 22.3% for the third quarter of 2016 compared to 20.1% for third 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 take outs, where there are no acquisition expenses associated with the premium.

We provided guidance on last quarter's earnings calls that had expense ratio ranging from 23.5% to 24% was reasonable going forward without the benefit of assumed earned premiums from Citizens. The benefit to our expense ratio from take outs was 0.7 of a point in the third quarter of 2016 compared to 2.8 points in 2015. Our combined ratio as a percentage of gross premiums earned was 93.4% for the third quarter of 2016 compared to 83.8% for the third quarter of 2015. Net income for the third quarter of 2016 was $10.9 million compared to $16.8 million for the third quarter of 2015.

On the balance sheet side, stockholders equity increased to $377 million, an increase of approximately $21 million December 31. During the quarter, the Company repurchased $4 million of its common stock for a year-to-date total of $20.6 million, resulting in approximately 1.4 million shares repurchased so far this year.

Statutory surplus in our two insurance company subsidiaries at September 30 was approximately $205 million and $72 million for Heritage and Zephyr, respectively. Our invested assets at September 30 were approximately $550 million, an increase of roughly $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. At September 30, our cash position was $131 million and our total assets were $1.1 billion.

Regarding Hurricane Matthew, we have received approximately 2,500 claims, and we have set initial reserves for virtually all of these claims. To date, we've closed over 75% of Matthew claims, paid loss and loss adjustment expenses of more than $6 million and incurred approximately $12 million on a reported basis. Based on our historical loss development factors, we could expect to report incurred losses from Hurricane Matthew of approximately $30 million in the fourth quarter of 2016.

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

(Operator Instructions)

Your first question will come from Arash Soleimani of KBW. Please go ahead.

Thanks, good morning. Just two questions. I think you had mentioned that $2 million of the adverse development was from AOB. There was about $3.2 million total of development. I was just wondering what the incremental amount over the $2 million is?

There's $2 million total. About $3.2 million is prior year, so there's some favorable development on the first couple quarters this year to net to $2 million. It's all AOB related.

Okay. So there was some favorable development on prior quarters this year that would have benefited the --

Right.

Okay. Then -- go ahead.

We are talking about really small amounts on a large reserve. The development is less than 1%.

Okay. The $3.2 million of adverse from prior years, not from this but from priors, was that all AOB related or was there anything else in there?

It's mostly AOB related. About half of it is actual results coming in a little higher than expected results. The other half is us actually increasing our loss development factors and strengthening reserves a little bit to make sure that we've got it handled going forward.

I think overall, the take away from my perspective is that really our loss development and adverse development from prior quarters has been pretty flat. When you look at the size of our reserves, the size of our policy count, et cetera, $1 million or $2 million movement overall is extremely small, as Steve mentioned, it's less than 1% development.

Okay. I guess the thing I was trying to back into, so if I take your gross loss ratio and I back out $4 million of losses for Hermine, I back out the $3.2 million of adverse, I get a core gross of loss ratio of 28.4%, which is better than 3Q 2015's core gross loss ratio by about 140 basis points. I'm also trying to determine what's driving that 140-basis point year-over-year improvement, especially given that AOB this year is probably more of an issue than it was last year at this time?

Yes, that is right. Really, the better loss ratio this year is due to our mix of business, which includes more commercial residential and more wind-only business, which has a much lower attritional loss ratio.

I'd also add that our loss ratios in North Carolina have been very good. We've added quite a bit of policy count there in premium and as mentioned previously, I think we are on track for a $9 million to $10 million year in North Carolina and that book of business so far has performed incredibly well.

That's great to hear. Then going -- building onto that comment on new business. Can you talk about what the new business volumes were both in homeowners and commercial residential and how that compared to last year?

I can talk about -- the volume is up this year compared to last year.

Hang on. We're pulling all of underwriting reports.

I can tell you our in force business is up even quarter over quarter on the voluntary side.

We look at our option and say in commercial residential, for example, you really look at dollars that you -- in terms of your write. You can't really look at a PEF count. I would think that the third quarter of this year in commercial residential was less than the third quarter of last year and that really just reflects our view of risk. Some of the pricing that we've seen in the market from some of the other players, we want to make sure we are approaching that business at the right combined ratio. Definitely on, I would say, personal line side, obviously our policy count is pretty flat there year over year, which is in line with our expectations.

This is Steve Rohde. Our sales for the third quarter of 2016 on the voluntary personal line side was consistent with last year. The difference is that we have more business being written in North Carolina and less in the Tri-County, so we've shifted the mix of business away from the AOB-prone area of Tri-County and moved into North Carolina. The rest of the state is pretty flat from year over year.

That's -- to add to Steve's point there, a big reason why you see voluntary production fairly flat as he mentioned, an increase in North Carolina. There are wholesale areas in the Tri-County on a personal lines basis that we think are, this point in time, uninsurable.

Therefore we have really curved that voluntary production down there quite significantly for, I would say, the last six months. Until we see a fix on the legislative level to the assignment of benefit abuses taking place down there, we are really not interested in doubling down on the Tri-County at this point in time.

Basically, if we need to understand the Q reason why gross premiums written were down modestly over year, that primarily stems from your caution in Tri-County?

That's right.

That makes sense. Along the same lines, what was retention in each of your sub-segments including organic business, Zephyr, and take out business?

Zephyr is averaging probably around a 93% retention ratio. You guys have the number for Florida?

Florida voluntary is running just under 80% and then Florida takeout is running just above 80%. (Technical difficulty) residential for the quarter was lower because some de-risking that we did in the Tri-County. It was running closer to 70%.

77%, you said?

70% on commercial residential.

Okay. When you say de-risking, you just mean policies that you yourself choose to either non renew or --

Correct. We kind of looked at it and said listen, the pricing on these policies should be higher. Our belief is different from some of our competitors. I'm not really interested in expanding the top line and sacrificing profit. I don't think that makes sense.

We're operating in Florida. We all know the perils in Florida, especially with the cat risk. I believe you have to have a certain underwriting margin in order to operate here and to justify the risk that you take on a hurricane retention basis. We're not interested in adding top line and running a 99% or 100% combined ratio. That doesn't fit our business model.

We're going to make sure that we price the business to maintain a healthy and justified profit margin and if we're not able to get that margin, then we will let somebody else take that risk and make little to no profit on it. That's just not business we're interested in pursuing.

Okay, great. That makes a lot of sense. I think you mentioned already, but how many Matthew claims did you have? From the total claims, how many have you closed?

Right now we have about 2,500 Matthew claims. About, I'd say, I think the last report was 76% of the claims have been closed. We've adjusted almost all of those claims. Right now, if you want to look at our incurred and reserves, I'd say about $13 million or so, roughly, that's an approximate number, in terms of where we are in losses. Obviously we've come out and said losses could get as high as $30 million, but we're going to use Management's best estimate in the fourth quarter once we see what the actual paids are and see how many claims continue to come in.

Right now claims are not really coming in at a big volume. They're kind of tailing off. There's a chance that might do significantly better than the $30 million reserve. I'd like to highlight that, because right now, based on what we're seeing, that's very probable. I think $30 million is good outside number for what ultimate losses could look like.

Okay. You said you had $13 million in case reserves now?

$13 in incurred on a reported basis. We've paid -- today it's about $7 million and then about $6 million in case reserves open, for a reported incurred of $13 million.

Okay. How much more do you have in IBNR, then?

We have not set the IBNR for it yet. The difference between the $30 million and the $13 million would be what we're thinking IBNR could be.

Okay. My last question, I just wanted to know, we talked about this on the last earnings call for 2Q, just an update on rate increases? I think last time you also mentioned that in addition to potential rate increase there was an alternative you were working on with the OIR. I was just wanted to get an update on those items.

Obviously, our big policy count segment is the Citizens HO-3 policy form. That's a big component of our overall Florida policies in force. We did receive a 9.9% overall rate increase. In the Tri-County, that's about 15% rate increase there.

One of the alternatives that we are looking at with OIR is capping water claims at $10,000. That is particularly true on older homes, say 40 years and over. We were able to get that approved.

That is, I think, a real benefit. Policyholders still have a lot of coverage there, but on older home 40 years and up, just like many other of the Florida carriers, there's a $10,000 cap per occurrence for water. We have pretty high percentage of our overall takeout portfolio in terms of HO-3s that are over 40 years old. That number I believe is north of 50%, I would say.

This is going to have a meaningful impact on the loss ratio. That helps us to curb additional rate increases on innocent policyholders that would otherwise get a rate increase because of assignment of benefit fraud that is taking place in that area. This is a win-win for the consumer; it is a win-win for the Company.

It helps to control our loss ratios. We are very thankful for the OIR for all their help in working with us on a good solution to help to address the assignment of benefit issues.

You said -- I heard a 9.9% and a 15%. Can you clarify, what were those numbers again?

The overall rate increase is 9.9% and in the Tri-County the rate increase is capped at a maximum of 15%. Putting much most of the policies down there will generate roughly a 15% rate increase.

Okay. The 9.9%, that is the overall. Is that across your entire personal residential portfolio, the 9.9% average, or (multiple speakers)?

The Citizens HO-3 policy form.

Okay. What percentage of your business is that?

That's about 75% of the takeout book is Citizens HO-3 policy form.

Okay. This $10,000 cap, is that basically language that gets applied at renewal or is that kind of effective as the certainty for all the policies?

It's available at -- it gets put on automatically at renewal. The other thing that we are able to do, is we are able to offer our policyholders a $10,000 cap on their water claim in exchange for roughly a 25% decrease on their AOP premium.

We think that is extremely important so we can go to houses that are under 40 years old. We can approach the consumer and let them know that we can actually reduce their premium and in exchange they take a $10,000 cap on their water coverage.

That is an effort that we have ongoing now where we are reaching out to agents and consumers to try to save them some money on their premium and cap the dollar amount of the claims. Since the vast majority of our policyholders are fairly honest people, and do the right thing, we do think that the response rate there will be pretty significant.

You said this cap was on homes that are under or over 40 years old?

It is an automatic $10,000 cap on homes 40 years and older. There's an optional cap of $10,000 for homes 39 years and under.

This new language, is this specifically for the Tri-County or for the whole --

No. It's for all policyholders across the state.

Are you seeing any impact positives from the new Citizens language that you'd implemented?

It's too early to tell yet. I mean, the language certainly does help to cap the emergency restoration component of the claim until we have a chance to go in and adjust it. We were unique in that we were able to get language included that stated that there was, on reasonable delays, in terms of letting us in to adjust the claim, that the cap continues indefinitely.

That language definitely helps our claims department address some of the abuses we've seen in the past where the contractor will go in, they'll report the claim, they'll will be in there doing demo and remediation and they refuse to let us in to inspect their house. That is an unreasonable delay and we're going to apply the caps. That's fair. It's in our policy language. It's in our endorsement language. That will definitely help us to curb some of the abuses that are taking place.

It's too early to tell exactly what the impact of that will be because in my opinion, the language should go a lot further. Despite the language, there's nothing to stop the lawyers from coming in and filing suit. I think it will have some impact, but it is too early to tell really what the extent of that impact will be, but it is definitely a useful tool.

Sorry, what was the effective date of the 9.9% increase and the $10,000 cap?

12/15.

Okay, great. Thank you very much for all those answers.

Thank you, Arash.

The next question will be from Mark Hughes of SunTrust. Please go ahead.

Thank you. Good morning. Could you give me some general thoughts when we think about the gross premiums written in the fourth quarter with Zephyr coming on line, your takeout activity, the potential year-over-year change when we think about your new business production?

How should we think about the gross premiums written in the fourth quarter? You were essentially steady in the third quarter. How is the either fourth quarter shaping up or what are some of those dynamics we should consider?

Just on a general basis, and I'll let the Steves chime in. Definitely on the take out side, we are not doing take outs right now from Citizens. We've telegraphed that for quite some time now. Until we see assignment of benefit reform, we are not going to be assuming policies from Citizens.

In fact, we had approval, for example, to take some wind-only policies, about 2,000 of them, in October. We ran the numbers on that portfolio. It didn't make sense. We didn't select one policy.

I believe that anybody that's assuming policies right now, particularly from the Tri-County, which is where a lot of the policies are at Citizens, I think that they're just going to lose money on every one of them. Until we see bigger rate increases at Citizens and/or assignment of benefit reform, meaningful reform, I would not advocate assuming policies out of the Tri-County in Citizens and that's where a lot of the policies are.

We've been focused on our voluntary side of it. That's why we diversified and bought Zephyr insurance. Obviously that has worked out well year over year. We've seen an increase in gross premiums of about 28% year over year. We've seen a 36% increase in policy count year over year. It has worked out well for us.

We are continuing to expand our voluntary production outside of Florida. The voluntary premium that we are writing in Florida is directed away from the Tri-County in areas of the state where we are profitable. That is going to be the overall thesis going forward. I would think kind of fourth-quarter numbers, we'd see it be barely flat, would be my guess.

Okay, thank you for that. In North Carolina, you said on track for $9 million or $10 million this year. Will South Carolina ramp up at the same pace? I know you've got a partnership in North Carolina that helps. Is there anything in South Carolina?

Mark, we do not have a strategic partner in South Carolina. I would expect that production growth there would be much more modest. I think right now in terms of South Carolina, we don't really have a lot of premium there compared to North Carolina.

About $200,000 was written in the quarter in South Carolina. North Carolina, obviously the strategic partnership with National General has been instrumental to our market penetration there. We are incredibly appreciative of the partnership that we have developed over the last two years with National General.

We are looking at expanding that partnership in other states. It has been very symbiotic for both companies. We do think that there are additional opportunities in the future to grow with National General and augment their need for a good homeowners carrier in some other states. That's a process that we are undertaking right now.

The G&A in the quarter was a little lower than we'd looked for, little lower than in was in the first six months. Was that anything unusual there, or is that kind of 8%, 9%, is that sustainable?

That is about where we are at now. Just having reached some scales of economy here. We are able to stay flat on the expenses.

The tax rate, as we think about that going forward, what is a good number?

38.5%

With the rate hike for Citizens, are you anticipating that you might see some loss of policies there? Your retention might drop, or nowhere else to go?

In my opinion, it's hard to say, Mark, but I would not expect a meaningful movement in terms of the policy count down there. The reason for that -- especially if you look at it on a premium basis. If you had a little higher attrition there because you're getting a higher rate increase, they kind of balance one another out. I firmly believe that you have to price for the risk and we are doing that. We are pricing for the risk. It is either going to be a profitable book of business, or we will not write it.

IF there is attrition in that book of business, because there's a roughly 15% overall rate increase in the Tri-County, then there is attrition. Somebody else can pick it up at a lower price and lose money on it. That would be great for them and that's something that we are just not willing to do. IF there's a little bit of attrition there, we are okay with that.

It's about bottom-line profit. It's about making money and pricing for the risk. That is something that we have had as the core DNA of our business mentality since day one.

That's okay with us. If we have fewer policies there, it will actually -- if we are not getting the right rate, you could actually have fewer policies and make more money than you would having more policies and not getting enough rate. That is really the focus that we have.

Then a final question. Capital management, are you seeing M&A opportunities out there? If not, what is your view on the share buybacks at this point?

Yes, there are definitely M&A opportunities out there. I'm also looking at this, Mark, and saying, our share price right now is 10% below our book value. We are not losing money around here, we are making money. We're accreting to book value every quarter.

The shares right now, from our standpoint, they are the cheapest they've ever been. I don't know if that's just a reaction to two hurricanes and what that does to our book value, but we are not seeing an erosion in book value. At 0.9 times book, that is an incredibly attractive point from our standpoint to increase the share repurchase program.

Thank you.

The next question will be from James Naklicki of Citi. Please go ahead.

Thanks, guys. My first question relates to the rate increase here. If you look at the Citizens HO-3 business, what sort of core loss trend has that business been producing this year, particularly if you strip out the cats for the year? What has been a core loss trend there?

The loss ratio has been about 38%.

Okay, but how about the loss trend that would be comparable to the 9.9% rate increase you are going to get?

Looking at year over year, right now were running, like Steve said, a 38% loss ratio for our personal lines homeowners business in Florida. If you go back to the second quarter of 2015 before we started seeing the increase in AOB, that was running a 34% type at loss ratio.

Then prior, in 2014, we were running in the 28% loss ratio. We've gone from a 28% loss ratio in 2014 to now a 38% loss ratio in 2016. That really started changing in that second quarter of 2015 when the AOB became an issue. Again, we didn't realize that in second quarter of 2015 is really when we got the development in the fourth quarter and the first quarter of 2016.

If you look at it, probably 10 points or so in terms of the increase in loss ratio over a two-year period. If you average it out, maybe it's a 5-point per-year average and we are getting a 15-point rate increase there.

We are just looking at this and saying, we've got to be ahead of the curve. Until the legislature in South Florida decides to get their act together and do something to curb the abuse, rates are going to go up on their constituency.

I see that some of these guys had a little trouble on their reelection last night. I know that the rising insurance premiums were a part of it. Maybe they shouldn't have locked AOB last year. They would probably still be in office.

We are really looking at some substantive changes out of the legislature to address this. I can tell you from speaking off the record to several of the leaders in both the House and the Senate they are very, very much in support of comprehensive AOB reform this session.

I'm glad to see that and we are cautiously optimistic that we may actually see a fix this session. It's Tallahassee politics, and until you get up there in the thick of things, you never know what's going to happen.

Got you. Thanks for that. When you think of your pricing strategy, you are targeting some combined ratio. Should we be assuming that there could be as much as a 10-point improvement in the combined ratio next year to something in the low 80%s? Is that realistic, or do you think there is still be issues and it will improve, but not by that much?

We've ran combined ratios in the past in the upper 70%s, low 80%s, because of the economic benefits of Citizens depopulations. The way that works with the zero ceding commission and no expense ratio an no reinsurance cost, et cetera, it does move that number down and on a normalized basis you're probably upper 80%s, low 90%s

Our target is an 85% combined ratio when you look at all our products. This year we are closer to 90% because of the AOB issues, as well as a little bit of hurricane issues as well. With this rate increase, we would expect us to get back down to the, assuming no hurricanes in 2017, of about 86% to 87% combined ratio.

Okay, thank you very much.

You're welcome.

Ladies and gentlemen, that will conclude our question-and-answer session. I would like to hand the conference back over to Bruce Lucas for his closing remarks.

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

Thank you. Ladies and gentlemen, the conference has now concluded. Thank you for attending today's presentation. You may now disconnect your lines.