Humana Inc (HUM) 2006 Q2 法說會逐字稿

Good day ladies and gentlemen and welcome to the KMG America Corporation second quarter 2006 earning conference call.

My name is Annika and I'll be your operator for today.

At this time all participants are in a listen-only mode. We will conduct a question and answer session towards the end of this conference.

[OPERATOR INSTRUCTIONS]

As a reminder ladies and gentlemen this conference is being recorded for replay purposes.

At this time I would now like to turn the call over to Mr. Kenneth Kuk, Chairman and Chief Executive Officer. Please precede, sir.

Good morning.

Welcome to KMG America's second quarter 2006 conference call. I have with me this morning Scott DeLong, our CFO. Jim Nelson, who is our General Counsel and Tom Sass, who is in charge of operations.

Before we begin I want to mention that certain statements made during this call relating to KMG America future operations, performance, growth, plans, and expectations of future developments are forward-looking statements under federal securities laws.

These statements are based on various assumptions and estimates that are subject to a number of risks and uncertainties. These risks are discussed in our second quarter Form 10-Q to be issued tomorrow and our Form 10-K for 2005.

In light of these risks, actual results may differ materially from those expressed in any forward-looking statements made during this call and should be considered carefully.

KMG America assumes no obligation to publicly update or revise any forward-looking statements.

This morning, KMG America released its second quarter earnings results of $0.05 per share. We are not happy with the results, which are below our internal forecast and lower than analysts' expectations.The shortfall is attributed to higher than expected claims in Kanawha's legacy blocks of business, which couldn't be offset by growth in margins in our new business.Fluctuating claims are fully expected in the insurance industry. But after several unusual items in the first quarter, it is disappointing to post another soft quarter. However, we continue to make good progress on the basics such as market acceptance, developing our brand, improving our products, and most importantly, producing sales. I have one last comment on claims and then Scott will discuss in more detail in a few minutes. There was no concentration of claims problems and there's no indication of a trend. Rather, it was a generally poor claims quarter in portions of the legacy businesses.

In our earnings release we announced a change in KMG America's full-year earnings guidance. Given our first 2 quarters earnings performance, we believe it is unrealistic to expect to achieve the full-year consensus estimate of $0.35 per share.

As previously indicated, we currently have 21 sales representatives and expect to remain at that approximate level until we can demonstrate adequate margins. Our belief is that we can best achieve acceptable margins with the existing group of high quality representatives. We feel we're making good progress with margins but clearly we're being challenged as a new participant to a greater extent than originally anticipated. As our existing block of business builds, this will diminish as an issue.

Sales for the second quarter for our new distribution brings year-to-date totals to about $25 million with continued but reducing concentration in stop loss. Annualizing 6 months would put us below our original full-year sales goal, but remember we have reduced our sales rep count and our overall expense level consistent with reduced sales levels.

Productivity per rep appears to be very acceptable. An easy way to think about productivity is that we have had the stop loss product available for 12 months, group life and disability in many states for about 8 or 9 months, and voluntary products for slightly over 1 year. Committed sales are those which are awarded but not yet have a policy issued. Actual issued sales from June of '05 through June of '06 plus committed sales total about $50 million. In other words, since June of '05 we have sold about $50 million in actual and committed sales. We started 2006 with 17 reps. Productivity of about $3 million per rep is consistent with expectations.

We have good traction with our stop loss product and we're doing well with voluntary products as well. Group sales are developing more slowly, but that should improve as we are now doing more integrated sales of all products on more cases. Additionally, we believe there is some firming of stop loss pricing and voluntary margins appear to be good. We are focusing intently on integrated group sales as we approach the January 1 renewal date. Further, we are maintaining pricing discipline, closing about 5 to 7% of available cases. We are attempting to find an appropriate balance between revenue and sales growth on one side and acceptable margins on the other.

Product development continues to progress. Our focus in 2006 has been to improve our voluntary offerings. We continue to add products such as voluntary whole life with riders that will be very attractive in the market. This not only broadens our product base, but also positions KMG America better to facilitate cross selling of our integrated product strategy.

Now I'll turn it over to Scott to talk about the financials.

Let me start by saying that these conference call comments will be filed with the SEC later today.

Operating income was $0.05 per fully diluted share or $0.03 below the analysts' consensus estimate of $0.08. As Ken mentioned, these results are also below our internal forecast, which was generally consistent with the analysts' consensus. The shortfall is due to adverse claims experience for the quarter in the acquired business segment due to 1 large claim. And to a lesser extent to increased severity compared to the first quarter on open long-term care claims. The impact from adverse claims is about $0.03 per share. Additionally, litigation expenses in the second quarter increased due to uneven legal activity from quarter to quarter. The $0.05 per share this quarter compares to $0.06 last quarter and $0.03 in the second quarter of last year, noting that stock option expense was not being charged against earnings last year.

Let me turn next to some detail about the results for the quarter. I'd like to start by separating the earnings contributed by the Kanawha legacy business from the operating losses from the new activity. The legacy business contributed $0.16 this quarter compared to $0.16 last quarter and $0.15 in last year's second quarter. The losses related to the new activity were $0.11 this quarter, $0.10 last quarter, and $0.12 last year. The shortfall from expectations would likely be allocated $0.02 to $0.03 to the legacy business and $0.01 to the new activity for the reasons I cited above.

Next, I'd like to provide additional color on the second quarter starting with the contribution of the larger employer activity targeted by our new sales channel. Sales for the quarter in the new channel were about $8 million of new annualized and issued premium, down from $16 million in the first quarter. This trend is consistent with normal seasonal patterns for group sales, which typically show light second and fourth quarter sales compared to the first and third quarters. This seasonality is not the case for voluntary benefit payroll deduct sales, which tend to build throughout the year. And these voluntary benefit sales were up in the second quarter, both in the new larger employer sales channel and in Kanawha's legacy specialty worksite channel, targeting smaller employers. To expand on this, voluntary benefit sales through the new channel reached $2.5 million and were up 40% over the first quarter, making up about 30% of overall sales in this channel for the quarter, consistent with our target product mix. And we continue to see more and more multi-product sales being closed, which indicates we are making progress on our integrative product strategy.

Product margins in the second quarter for this new activity were consistent with those in the first quarter with the overall benefit ratio dropping 160 basis points to 66.1% net after reinsurance, reflecting for the most part the increased percentage of voluntary products in the premium mix in Q2 where margins are better. As we've said before, margins in our stop loss and group business continue to be constrained because of both general market conditions currently and the fact that we do not yet have an established book of business, giving us a chance to incrementally improve margins at renewal. We just started to renew stop loss cases in the second quarter with this activity picking up throughout the second half of the year, peaking late in the year as we process the 1107 renewals.

The aggregate expense ratio was down this quarter to 49.7% from 50.6% last quarter and 54.8% in the second quarter last year, even though option expense was not included in the measure in 2005. While overall expenses including amortization were up slightly this quarter, premium growth from the new activity is growing faster and this should accelerate. This is a key measurement to follow, as it will make an important contribution to achieving our mid teens ROE target. We have said that this ratio should be in the low 30s as we approach scale.

Next I have a few comments on the performance of the Kanawha legacy business.

Premium income compared to last quarter was about flat after adjusting for a one-time return of premium last quarter following a mass cancellation of a policy form in Georgia. While we do expect the legacy worksite business to grow over time, much of the other legacy business is composed of closed blocks and slow decline, which will constrain overall premium growth there. The overall legacy benefit ratio increased 200 basis points in the second quarter to 82.2% from 80.2% in the first quarter. An improvement in the worksite segment was more than offset by higher benefit ratios in the senior and acquired business segments. A portion of the deterioration in the senior segment ratio resulted from a policy reserve pattern stemming from uneven policy anniversaries quarter to quarter. But a portion was also due to increased severity but not incidence in open long-term care claims, thus reversing the improvement we saw in the first quarter. The higher benefit ratio on the acquired business segment was largely the result of a single very large claim that, while heavily reinsured, had the added effect of temporarily accelerating VOBA amortization in this quarter, resulting in a combined impact on earnings of about $0.02 per share.

I'd like to talk next about our new full-year 2006 earnings guidance. Over half of the reduction follows from the earnings shortfalls in the first 2 quarters, which, depending on your starting point could be $0.05 to $0.06. Last quarter we said a portion of that shortfall could be reversed back into earnings, which is still quite possible, but it may not come before the end of this year. The earnings shortfall this quarter, temporary in nature we believe, is not going to flow back into earnings later this year unless we have better than expected claims experience in the second half, which of course is possible but not something we will plan on. The balance of the lowered guidance results from the margin compression issue we have discussed all year. While we price each group and stop loss quote to achieve a positive margin after expected claims, commissions, and sales tax, it is currently less per dollar of premium than what we think normalized margins will be, particularly on stop loss. Reinsurance costs on stop loss further reduced the margin on these product sales, both in terms of percentage of premium and dollar amount. Our pricing discipline and market conditions have resulted in lower closed ratios and fewer sold cases so far this year, although all things considered, we feel our sales results have been good. Since there is a significant fixed cost associated with hiring new sales reps, we've slowed hiring activity until we demonstrate more conclusively the near-term margin opportunity. While the reduced target for new sales could modestly impact sales this year, there will also be an offset due to lower expenses. So while we have a good flow of sales in the pipeline, both committed and in process, the timing of sales could be a bit later in the year on average, which would mean a bit less earned premium growth this year. All these factors combine to produce a somewhat lowered expectation for new revenues and margin growth this year, and this accounts for the remainder of today's earnings guidance reduction.

In closing, let me call attention to the reserve transfers that are highlighted in the press release and accompanying Pro Forma tables.

It is very common following a material acquisition that a preliminary basis of purchase accounting adjustments will be used while the final actuarial analysis and detailed factor development is completed. Normally this work is completed within the first 12 months and the results are smoothly integrated in the reported financial results without creating any apparent discontinuities at the time the conversion to final factors is implemented. In our case, the complexity and scope of the work required 6 quarters to complete. And generally accepted accounting rules required that we book the entire one-time reserve difference into the current quarter with no adjustment to prior periods. And while there was no impact on total Company earnings in either 2005 or the first 6 months of 2006, the switch to the final reserve system did cause earnings as reported to be increased in the senior segment and to a lesser extent in the legacy worksite segment with the offsetting reduction in the acquired business segment. While we are unable to provide an exact calculation of the segment effects by calendar quarter, we have provided as supplemental Pro Forma disclosure in the press release tables what the approximate impact would have been. So as to provide a reasonable representation of what prior earnings by segment would have been to facilitate trend comparisons going forward. The primary impact is on policy reserves and benefit ratios, but we have also reallocated investment income by segment. We do not believe that these new reserve factors will have a material affect on total Company reported earnings over the next few years. And we have additional detailed analysis underway to confirm this. While the bulk of the final reserve work is now completed, there could be additional modest adjustments during the third quarter.

With that, I'll turn it back to Ken for the Q&A session.

We're ready to begin taking questions.

[OPERATOR INSTRUCTIONS]

Your first question comes from the line of David Lewis with SunTrust Robinson Humphrey. Please proceed.

Thank you and good morning.

Good morning.

Ken and Scott, can we talk a little bit more about kind of the margin pressures on the new activity? Is it that you think the brokers out there are taking somewhat advantage, as you're a new entrant?

Is it the fact that you're having to price it to the point to take the business away from the incumbent?

Just talk a little more detail. And why and when you think we might start to see more adequate margins.

This is Ken Kuk. There are several pieces to that question.

We have indicated that the stop loss market in total, the pricing is much softer than we would have hoped at this point. We have seen firming and we expect that to continue.

But I don't believe that we're seeing any significant amount of pressure from that product as a result of being a new entrant. Clearly there are some.

The next piece of the question are group sales.

I've indicated for a long time that selling a single group product alone is not very attractive from a return perspective.

Lapsed rates are higher when you only have 1 product and the profitability over time is diminished. In addition, those products, especially group life and disability, oftentimes have rate guarantees that go beyond 1 year, sometimes 2 and oftentimes 3.

And we are being very careful not to do single group sales with a longer-term commitment.

I would expect that because every transaction we do is a take over, we are under additional pressure when compared to existing participants.

Voluntary products, and you see David that the level of sales activity is increasing very nicely in voluntary; we think we're getting full margins.

Okay. And how many or can you give us; let's talk about maybe the July 1 renewals.

One can you give us what the July 1 renewal commitments are? And 2, what percentage of those group sales are being incorporated with voluntary benefit sale?

I do not have the number for July 1 available. I can say that total issued premium, annualized new premium, committed sales where there is not yet a policy issued but there will be, plus one small package of that we committed to, total approximately $40 million.

So if we had $25 million of actual issued premiums through June 30, there's $15 million more in total new premium that's coming on shortly or already has come on.

So at $40 million of total, we feel quite confident that full-year we will get to our revised internal projections based upon sales organization of about 20 or 22 reps.

And what is that new production level expected for the full-year of '06?

Well we said continuously that we expect $3 to $3.4 million per rep. And we started the year with 17. And we are at 21 right now.

Now you'll recall that we have a 3 to 6-month start-up period, lag period for new reps. So the people we hired this year, we would expect substantially less than full $3.5 million of production from them.

So we can take maybe 18 or 19 reps times the $3 million and get pretty close?

That's pretty reasonable.

Okay, just lastly, maybe an update on the ING lawsuit and the increased expenses in the period, will that persist in the third quarter?

The second quarter included a fair amount of discovery depositions plus the appeal was heard. We are waiting for the results of the appeal. It would be my expectation that we will get the results of the appeal sometime before the first of September, so within the next couple of weeks.

There hasn't been a lot of activity thus far in the third quarter. But the discovery process will accelerate, I would guess towards the end of the third quarter into the fourth quarter.

Right. Thanks very much.

Your next question comes from the line of Craig Siegenthaler with Credit Suisse. Please proceed.

Good morning.

Just as a follow-up to that last question, can you quantify how much of that expense increase was one-time in nature just so we can get a modeling perspective for the next several quarters?

It was probably a penny to a penny and a half, cent to a cent and a half.

And that's the additional kind of one-time event?

Yes, I wouldn't refer to it as one-time, but it was the extraordinary number that occurred in the second quarter. I'm not saying that we couldn't have another quarter that looked just like it at some point in the future.

This is Scott DeLong. I guess in one sense you can say every dollar we spend is one-time because its just costs of a one case that eventually will be behind us.

What it's possible that the process could continue for some time. And the expenses that get booked to each quarter ebb and flow with direct correlation to the activity that's taking place in the courtroom and deposition quarters and so on.

Okay. The second question I had, I actually have a few more.

What's the status on the long-term care re-writes that you've been doing? I think you had a few pass last quarter. What's kind of the status there?

This is Scott DeLong.

Right after the, within a week of when we had the last conference call we got a confirmation from the state of Florida that our filed rate increase had been approved. And it was essentially everything that we asked for. It was somewhere between 10 and 11% as I recall.

Those approved rate increases become effective on the next policy anniversary. There's a little bit of time to incorporate those rates into the billing systems.

And I think, if I'm not mistaken, we said that that rate increase would go in effect for anniversaries on and after September 1.

We have other probably less material filings that are still in process. We have not received responses from the various regulators on those.

Those come at any time. Sometimes they're approved, as they were in Florida. Sometimes they come back with more questions.

So it can be a protracted process.

And is Florida about 50% of your block?

Florida is about 30% of our block.

Okay.

So I mean we're satisfied with the way things have progressed. That successful filing in Florida was very satisfying.

Okay. Good, good.

My final question, I'm just going to kind of break it apart cause it's all related.

Can you break out your sales results specifically by disability, group, life, and stop loss?

And also just inform me what percentage of premiums were ceded to reinsurance reach for those products.

And the final thing is, how is this state approval process? because you normally give us kind of it was approved 40 out of 48 target states for each of these products too. That would be very helpful.

This is Scott DeLong.

Let me start with the first part of your question.

Okay.

If you look on the last page of the press release, I think there is a distribution of sales by product type. I mean we break it out by life, stop loss, disability income, and other A&H for the group products.

And then there's some break ...

Okay, got it.

So I think that takes care of it.

As far as the status of the approvals, I'll ask either Ken or Tom to address that question.

This is Tom Sass. And let's see on the premium breakdown on the new business that we've written stop loss is about $18.2 million through June 30.

The disability, the voluntary business, the life insurance is about $1.3 million. The balance is voluntary. And the disability component of the voluntary is about $2.4.

Can you talk about how much is ceded?

The ceded. The ceded amount, we've got a reinsurance levels on the stop loss of it's been $300,000. It was $200,000 prior to June 1 or June 30.

Can you relative number? Like if you, like $800,000 out of a million of premiums assuming like 80% of something like that.

It's about 33%.

For stop loss?

Yes, for stop loss.

Okay.

And it's now dropped significantly into the low 20s with the change in the reinsurance level in June.

Okay, so third quarter drops from the low 20s?

That's correct.

And what about for life and disability?

On the group disability side it's a quota share arrangement. We retain 15% of that risk.

On the life insurance it's $200,000 retention on the life. And right now it's a very small percent of the block of business because it's really, it's not a straight percent of premiums. It's how many lives you have covered under your groups that exceed that $200,000.

So it's a pretty small percentage at this point.

So in total that would be low single digit percentages.

Okay. So if I look at the aggregate business mix here, could I estimate maybe in the low 20s as a percentage you retain out of this business? Or what would be if I look at the whole block?

In the third quarter it would be quite a bit under 20% in total.

Okay.

And Craig, this is Scott. On the voluntary benefits, we retain virtually all of that.

So make that distinction between the core group products where there is reinsurance, particularly on disability income and stop loss, and very, very little reinsurance on the voluntary benefits.

Okay. And actually the one question you guys didn't answer yet that I asked was on the state approval process for the products. You used to give us an update on that. I was just wondering where you guys stood with all the products?

Right. On the eccess risk now we're up to 45 states being approved. And I think we have a total of 47 possible. So we're very close there.

We've got one state we're still working on. We actually withdrew the Hawaii just because of some of the issues with the state and what they're requiring.

The disability income, we're approved in 37 states right now. And that's moving along, continues to move along.

The group term life, we're approved in 44 states.

Okay. And the one I missed is group life. You said you were at 40 now? You've got one more?

In the group life we're in 44 states.

44 out of 47 I guess is your target there?

That's right.

Okay. Great. Thank you very much for all the help.

Thank you.

The next question comes from the line of Mike Grasher with Piper Jaffray. Please proceed.

Good morning, gentlemen.

Scott or Ken, could you walk us through again I guess how you arrive at the per share impact of the acquired books claims this quarter?

Mike, this is Scott DeLong. I'm not quite following your question. Could you repeat that?

Well, if I'm not mistaken I think you were implying that the adverse claims in the quarter from the acquired book, I think you said $0.03 or $0.04?

Oh, okay.

How exactly you arrived at that.

All right. Well, there's 3 components to the charge to earnings or the impact to earnings.

The first is just the net after reinsurance ceded costs of the claim. Which was about $300,000.

Then there, you may recall from last quarter there was an issue with one of our reinsurance treaties where over time there had been underpaid reinsurance premium. Most of that impact is what we feel is reimbursable under the indemnification provisions of our stock purchase agreement.

But any impact after the acquisition of Kanawha would be on KMG America's nickel.

That underpaid reinsurance premium that needs to be paid now is $78,000.

And then I mentioned in my opening remarks that that one large claim caused a temporary acceleration of the amortization of the VOBA asset, the value of business-acquired asset. And that is because that amortization is linked to insurance in force.

And insurance in force dropped significantly as a result of this one claim.

Now as I said, that should be a one-quarter effect.

So you add those up and tax affect it and you'll get a little over $0.02.

We also said the open claims on long-term care, while we have about the same number of open claims this quarter as we had last quarter, and therefore the incidence of claims hasn't changed, the severity of claims has changed. We have a higher percentage of open claims this quarter that are nursing home related as opposed to home healthcare related, which was a higher proportion than last quarter.

And that cost us about $100,000.

So you put all of those together and depending on how you round your $0.02 or $0.03.

Okay, that's helpful.

And then could you give us an update in terms of the investment portfolio? What the new money yields you're receiving?

Well with the continued treasury in the 5% range and we typically get around 100 basis points more on corporate for example split. We're even for the 6% range on new money rates right now on our investment portfolio.

That was 6%?

Yes, above 6%.

Okay, thanks, and then one final question just going back to sort of the benefit ratio and claims there, within the other segment, the worksite in the senior market. I guess would you consider this quarter results out of both of those segments to be exceptional from the standpoint that you've got a 78% benefit ratio within the senior market. And the worksite continues to improve at 69%.

I mean we've seen improvements year-over-year as well as sequentially. Are these numbers sustainable or I mean as much as we had the adverse on the acquired book or it seems like we're seeing more positive development on the other books.

Well I'd have to say the benefit ratio on the long-term care block was up this quarter versus last quarter. And as it was explained in the press release, some of that was due to the open claim phenomena I just discussed.

Some of that is due to just the pattern of how the policy reserves change from quarter to quarter. And I noted in the press release that we have a bit of an anomaly in terms of how the uneven pattern of policy anniversaries throughout the year affects that progression of policy reserves.

We had the same affect in the second quarter last year. Now that goes away, but I, in the third quarter.

We don't know how the claims experience is going to be with long-term care. When you have a claim it tends to be for a very large amount because they can run over a number of years, depending on what the benefit is.

So we've noted all along that the long-term care block has volatility in it. The, we wouldn't normally expect the kind of volatility from one claim in the acquired block that we saw in this quarter. But there's volatility as well.

So I think in general we're satisfied with the progression of earnings and claims experience in the legacy block as a whole. But it is volatile from quarter to quarter.

Thank you.

[OPERATOR INSTRUCTIONS]

Your next question is a follow-up question from the line of David Lewis with SunTrust Robinson Humphrey. Please proceed.

Thank you. Ken, you indicated that some of your stop loss business is just now coming up for renewal and it's obviously the first set of policies that are being renewed on an annual basis.

Can you give us any idea of what kind of rate increase you're getting year over year?

I would ask Tom to comment on that.

Yes. This is Tom Sass.

We've had the July renewals come up. That was our biggest block. And again, remember that we're a new block of business that's growing.

We had good retention. In July there were 2 of 7 or 8 groups that did terminate. And those were anticipated, probably 2 of the poorer performing groups.

On the balance we've gotten, and there's some plan changes that go in. We adjust deductibles. But kind of on a, if you look at them in a same and similar basis we're probably getting somewhere between 16 and 18% increase.

Okay. And Ken is there any strategy that potentially starts to increase the individual reps to sell voluntary benefits in the small case market? Is it something you've considered?

Yes, David. In fact we're doing it. We have a strategy of growing that business. We had considerable organization change there last year and some turmoil, to be honest, as we changed the reporting relationship, especially worksite to our new KMG America sales management team.

But we are aggressively pursuing growth in that channel. And we're very optimistic we're going to get it.

We recently spent a fair amount of time with a lot of their top producers. There's good energy and enthusiasm. And that market continues to be pretty strong with good margins.

So clearly a piece of our strategy is to grow specialty worksite more aggressively.

Okay. And I think that's all I had. Thank you.

At this time there are no questions in the queue. I would now like to turn the call over to Ken Kuk for closing remarks.

I repeat while we are unsatisfied with the quarterly earnings results, we continue to make good progress on softer issues like market acceptance and brand awareness and more importantly on earnings growth, sales growth, and efficiency measurements.

The progress is slower than we expected but its still good progress.

We haven't changed our opinion about the long-term potential of KMG America. And our entire organization remains very upbeat and optimistic about the future.

Thank you for joining us this morning.

Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Thank you and have a good day.