Kemper Corp (KMPR) 2015 Q4 法說會逐字稿

Good morning, ladies and gentlemen, and welcome to Kemper's fourth-quarter 2015 earnings conference call. My name is Abigail and I will be your coordinator for today. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. (Operator Instructions) As a reminder, this conference is being recorded for replay purposes.

I would now like introduce your host for today's conference, Ms. Diana Hickert-Hill, Vice President, Investor Relations and Corporate Identity. Ms. Hickert-Hill, you may begin.

Thank you, operator. Good morning, everyone, and thank you for joining us. This morning, you will hear from three of our business executives, starting with Joe Lacher, Kemper's President and Chief Executive Officer; followed by Denise Lynch, Kemper's Property and Casualty Group Executive; and Frank Sodaro, Kemper's Senior Vice President and Chief Financial Officer.

We will make a few opening remarks to provide context around our fourth-quarter results. We will then open up the call for a question-and-answer session. John Boschelli, Kemper's Senior Vice President and Chief Investment Officer, will join our presenters during the interactive portion of the call.

After the markets closed yesterday, we issued our press release and financial supplement. You can find these documents on the Investor section of our website, Kemper.com. Please note that our discussion today may contain forward-looking statements. Our actual results may differ materially from these statements. For information on potential risks associated with relying on forward-looking statements, please refer to our Form 10-K and 10-Q reports filed with the SEC, as well as our earnings release.

We plan to file our 2015 Form 10-K on or about February 12. This morning's discussion includes non-GAAP financial measures that we believe are meaningful to investors. In our supplement and earnings release, we defined and reconciled non-GAAP financial measures to GAAP where required and in accordance with SEC rules.

And finally, all comparative references will be to the fourth quarter of 2014 unless we state otherwise.

Now I will turn to call over to Joe.

Thank you, Diana. Good morning, everyone, and thank you for joining us today. Before I comment on our performance in the quarter and the year, I want to let you know how honored I am to be here leading Kemper.

I also want to acknowledge the hard work and many contributions of my predecessor, Don Southwell. He assembled the talented team and has been instrumental in helping me come up to speed quickly on the many aspects of our diverse business. Since joining Kemper just two months ago, I've been doing a deep dive on many fronts, and I'm learning a lot about our strengths, our opportunities, and our challenges.

Overall, I'd say we are not happy with our financial performance in the past couple of years, and it's going to take a couple of years for us to get it fixed. While we do have areas that are going well, clearly, we have issues we need to address, including some that drove results this quarter.

In the near-term, I'm focused on a critical few points that need my immediate attention while the team and I analyze our longer-term needs and plans. I commit to give you a strategic update this summer and so will withhold strategy comments for now while that assessment is still underway.

Given that context, I will now shift to discussing our fourth-quarter results and full-year performance. In short, it was a disappointing quarter overall and we will detail the drivers for you. Underneath those issues, we did have some positives as well and we will explore those too.

Nonstandard auto was our main problem area this quarter, especially the Alliance United business. This acquisition will not be accretive in its first full year. However, we do expect it will be in its second year. We think the issues in nonstandard auto overall, and Alliance United specifically, are fixable. We still feel good about the acquisition.

We're seeing positives from the changes we made to our preferred auto book, despite the headwinds and loss trends that the industry is experiencing. The fundamentals in our life and health segment are stable, and once again our investments portfolio performed well.

In total, Kemper's net operating income in the quarter was $5 million, down [$49.5 million -- $49 million] for the year, and was $70 million, down $27 million from last year. A significant driver was lower performance in the quarter from Alliance United. Other factors include increased catastrophe losses, higher underlying loss ratio in our PNC legacy lines, lower levels of favorable reserve development, and increase in life insurance expenses. Additionally, in the prior year, we received a large special dividend from one of our alternative investments.

Similar to other companies in the nonstandard auto industry, Alliance United's loss trends were pressured in the quarter. It was not a good time to be growing the line so quickly, given the uptick in frequency and severity. As you may surmise, this is a key area for my immediate focus. Denise will cover Alliance United in more detail when she discusses the P&C segment's performance shortly.

In total, Kemper's revenues were up $57 million in the quarter and ended the year at more than $2.3 billion, up $144 million, as the Alliance United acquisition contributed to the topline more than offsetting reductions in the legacy businesses.

Turning now to the life and health segment, the underlying results were stable. We earned $18 million in the quarter, down $16 million. You can see in our press release we had two main drivers for the decline. The largest driver was related to the fourth quarter of 2014 when we benefited from a $14 million after-tax special dividend from the recovery of one investment in our alternative investments portfolio.

The second driver was from an increase of $5 million after-tax for legal fees in our life insurance line. On a full-year basis, we earned $72 million compared to $92 million last year. Excluding the impact of these two items, underlying earnings actually improved. Life and health revenues were $205 million in the quarter, down $18 million, with $16 million of the decline driven by lower net investment income.

On a full-year basis, revenues were $811 million, down $21 million from 2014. These declines were driven by the 2014 special dividend I just mentioned.

In the Kemper home service company's business, premium revenue was nearly flat at $116 million in the quarter, and expenses benefited from the field consolidation. In Reserve National, premiums remained stable despite the transition away from hospitalization products and toward life, home healthcare, critical illness, and accident expense insurance.

I'll turn now to investments. I'm pleased to report our investment portfolio performance remains an area of strength for us. Excluding last year's special dividend, our net investment income increased $8 million for the quarter and $15 million for the year. Our pretax equivalent yield is holding up well at 5.5% annualized for the quarter, slightly better than the full-year.

Our alternative investment portfolio, which primarily consists of LPs and LLCs, yielded 9% annualized for the quarter and 8% for the year. Total return was a positive 0.4% for the quarter and 2.2% for the year, primarily from net investment income offset by rising yields. We are very pleased with our alternative investment's performance, both for the quarter and year-to-date, in light of the equity and high-yield market volatility.

Now I'll turn the call over to Denise to discuss our Property and Casualty segment result.

Thank you, Joe. I'll start with the segment overview in total, and then go through the performance of each of our lines of business.

The Property and Casualty segment lost $5 million in the fourth quarter, down from income of $25 million a year ago. The primary drivers for the decline were elevated loss trends and adverse development in the Alliance United business, and to a lesser degree, higher frequency in the legacy nonstandard auto book. I'll discuss these in more detail shortly.

Additionally, we had a premium deficiency at Alliance United, resulting in a partial write-off of deferred policy acquisition costs. For the full-year, we earned $27 million, up from $25 million last year.

Our Property and Casualty revenues were $414 million in the quarter, up $97 million, driven by Alliance United. which more than offset a decline in our legacy lines. On a full-year basis, revenues were $1.5 billion, up from $1.3 billion in 2014, primarily from having the eight months of revenues this year from Alliance United.

Our policies in force increased sequentially, ending the year at $1.2 million, up from $823,000 last year, getting a lift from our acquisition. Net earned premiums were $392 million in the quarter, up $92 million. Excluding Alliance United, premium retention improved 2 percentage points, and new policies in force were up 15%; yet legacy earned premiums were $281 million, down $19 million.

For the full-year, segment net earned premiums were $1.4 billion, up $166 million versus 2014. The impact of Alliance United makes year-over-year comparisons difficult, as Alliance United runs at a higher underlying loss and LAE ratio, but a lower expense ratio than our legacy business. I'll provide more detail on profitability by line of business.

On expenses, we had a $9 million charge to write down a portion of Alliance United's deferred policy acquisition cost. The legacy P&C expense ratio was up about a half-point in the quarter.

Now I'll provide a fourth-quarter update on each of our lines of business. I will start with the nonstandard personal auto line. In the quarter, net premiums written were $186 million, an increase of $117 million. Net earned premiums were $188 million, an increase of $113 million. While Alliance United drove the majority of the increase, the legacy nonstandard auto net premium written were up 5%, and marked the fourth straight quarter of period-over-period increase.

The total loss in LAE ratio was 95.6%, with the underlying loss in LAE ratio at 92.7%. I will address the underlying performance at Alliance United separately from the legacy nonstandard book.

The Alliance United loss and LAE ratio of 105% includes an underlying loss in LAE ratio of 100.9% and 4.1 points from adverse preacquisition loss reserve development. Additionally, we saw significant current-year adverse development that increased the fourth-quarter underlying loss in LAE ratio by 6.7 percentage points. Obviously, this was a very disappointing performance.

The drivers of the underlying performance include -- one, broadly, the industry saw loss trends nearly double in California over the last year, to the midteens. Frequency and severity, and bodily injury and property damage liability were the drivers, as well as collision severity. Alliance United was subject to the same environmental factors that impacted the industry, such as increased miles driven, and more expensive repair costs.

Two, Alliance United's Claims Department was somewhat understaffed at acquisition. This staffing gap grew with the increased frequency trends, increased new business, and some disruption to hiring during the integration.

And three, we filed a class plan change and rate increase for a product representing about half of the business this year. This approval process is taking longer than typically expected.

In response to these developments, we have implemented a few very important operational actions. First, we continue to work with the Department of Insurance on this filing, and are accelerating the filing to increase rates on the remaining business.

Second, we hired and onboarded a significant number of new claim professionals in 2015 and expect to add more over this year to address the claims staffing issue.

Third, we have taken actions to improve risk selection, price adequacy, and agency management. Collectively, these are now slowing new sales to more desired levels.

While Alliance United is not meeting our expectations, the long-term strategic value of this business remains compelling. We do expect the acquisition to be accretive in its second year. However, it will take a few years before this business will meet our profit objectives.

Now turning to our legacy nonstandard auto book. This business did not meet our target profitability last year. We, along with the industry, saw elevated loss trends over the course of 2015. Year-over-year profitability deteriorated every quarter and that trend continued in the fourth quarter.

We are in the process of rolling out a new product and rating plan that's currently being used on about 45% of our book. Over the course of 2015, we increased our filed rate levels to about 10 points. These efforts have yet to yield a significant impact on results.

In the quarter, we completed an overall review of our legacy nonstandard business and identified a number of initiatives to improve profitability. We are in the process of executing those initiatives, and we are going to reopen and expand the scope and urgency of that review to include every function and operating lever to drive improved financial performance in this business.

We are planning to file rate increases of nearly 7 points, with the majority in the first half of the year of our entire legacy book. Unfortunately, given the current results and the current industry loss trends, it will take some time before we achieve acceptable returns. In commercial auto, net premiums written were flat at $12 million in the quarter, and down 3% at $54 million for the year. Earned premiums were stable in the quarter and for 2015 at $14 million and $55 million, respectively.

For the quarter, the loss in LAE ratio deteriorated to 92%, driven by $1 million of adverse development and a 9.7% increase in the underlying loss in LAE ratio due to increased frequency and severity. We continue various agency management underwriting and rate actions.

Moving to preferred auto, net premium written were $102 million in the quarter, down $8 million, and were $435 million for the year, down $52 million from 2014. Net earned premiums were $109 million in the quarter, down $14 million and were $450 million for the year, down $76 million. New business written premiums grew by 8.5% as new policies in force increased for the sixth consecutive quarter to the highest level since the third quarter of 2013. Premium retention at 84% improved both year-over-year and sequentially.

The loss in LAE ratio was 75.7%, up 6.6 points primarily from lower levels of favorable prior year development. The underlying loss in LAE ratio increased to 76.2% for the quarter. When you look at quarterly results, there are periodic changes that occur from prior periods within the year. When we remove the current year development, we are seeing a modest improvement in the quarterly underlying loss and LAE ratio.

Over the past several years, we've executed a number of profit improvement actions, which have been resulting in steady improvement and profitability. The underlying loss in LAE ratio was 70.9% for the year and improved about 1 point. We still have a ways to go but continue to make progress.

Now turning to the homeowners line. Net premiums written in the quarter were $64 million, down $3 million and totaled $276 million in the year, down 7%. Net earned premiums were $70 million in the quarter, a $6 million decrease. For the full year. net earned premiums totaled $286 million, an 8% decrease from last year. New business production grew 9% from last year. Premium retention improved 4 points to 84% and was up sequentially for the fourth straight quarter.

Catastrophes in the homeowners line finished at 18% of earned premiums in the quarter, up 13 points from last year and above our expectations. The quarter has been relatively mild until the last week of the year, when tornadoes struck in north Texas.

The loss in LAE ratio was 61.6%, as the underlying loss in LAE ratio increased 4.9 points to 46.4%, primarily from increased severity from large fire losses. Average earned premium decreased slightly as mix changes offset 4% filed rate increases.

So looking at the Property and Casualty segment in total, it was obviously a disappointing quarter. While the Alliance United acquisition failed to meet expectations, the long-term strategic value of the business remains compelling. However, it will take a few years before this business will meet our profit objective.

Our legacy nonstandard auto business continues to underperform against a backdrop of deteriorating industry loss trends. And so we are going to take a fresh look with an increased sense of urgency to significantly change the trajectory of this business. Efforts to stabilize preferred auto and home premiums show continued progress, and we expect this progress to continue.

Now I will turn the call over to Frank.

Thanks, Denise, and good morning, everyone. Today I'll cover Kemper's consolidated performance, capital and parent company liquidity. For the fourth quarter, net income and net operating income were both $5 million or $0.09 per share compared to net income last year of $65 million, or $1.24 per share and net operating income last year of $54 million, or $1.02. For the year, our net income was $86 million, or $1.65 per share compared to [$115 million], or $2.12.

Net operating income was $70 million, or $1.35 compared to $97 million, or $1.79 per share last year. For the full year results for 2015, both net income and net operating income included a software write-off of $7 million after-tax, or $0.14 per share. Similarly, the prior year's results included a software write-off of $35 million after-tax, or $0.66 per share.

Total revenues were $617 million for the quarter, an increase of $57 million or 10% as roughly $110 million of earned premiums from the Alliance United acquisition were partially offset by lower earned premiums from our legacy P&C. On a full year basis, our total revenues increased 7% to more than $2.3 billion, driven by lower -- driven by over $270 million of earned premiums from Alliance United, offset by lower earned premiums from our legacy P&C business.

Earned premiums in the life and health segment decreased about $20 million, primarily from lower life insurance premiums, which included an $8 million deferred premium adjustment in the first quarter of 2015. Net investment income decreased $14 million for the quarter and $7 million for the year due to the $22 million special dividend we received in 2014. Excluding this special dividend, both the quarter and year increased from higher returns on our equity method investments while the year was also driven by higher yields on fixed maturities.

The investment portfolio in total generated a pretax equivalent annualized book yield of 5.5% for the fourth quarter of 2015 and 5.3% for the year compared to 6.5% and 5.5% for the quarter and year 2014. The Property and Casualty segment reported net operating loss of $5 million for the quarter compared to net income of $25 million last year. This decline was due to Alliance United's results, which included adverse development and the resulting EPAC write-off as well as poor results from our legacy P&C book.

For the year, the Property and Casualty segment reported net operating income of $27 million compared to $25 million in 2014. Given Alliance United's fourth quarter, results did not meet our expectations and were a drag on the full year. Net operating income for the life and health segment was $18 million for the quarter compared to $34 million last year and $72 million for the year compared to $92 million last year.

Last year, the life and health segment's net operating income benefited $14 million from the special dividend it received in the fourth quarter. Excluding that dividend, net operating income decreased for the current quarter and year by $2 million and $6 million, respectively, due to higher legal expense and a deferred premium adjustment booked in the first quarter of 2015 offset by higher investment income.

Net operating loss from corporate and other increased $3 million and $9 million for the quarter and year, respectively, primarily from higher pension costs driven by assumption changes at the end of 2014 and lower net investment income. Looking ahead to 2016 pension expense, we increased our discount rate by about 40 basis points and adopted the most recently published mortality tables at the end of 2015.

Additionally, we are reducing our expected long-term returns on pension investments and adopting the full yield curve approach for estimating interest and service cost. As a result of these assumption changes, we expect our pension expense to decrease about $11 million after-tax for 2016. To put that in perspective, pension expense increased by about that same amount in 2015 compared to 2014, largely due to the adverse effects of assumption changes.

I will now cover book value, capital, and parent company liquidity. Book value per share was $38.82 at the end of the year, down 3% from last year, largely from the impact of higher market yields on our fixed maturity portfolio and dividends paid, partially offset by net operating income. Book value per share, excluding unrealized gains on fixed maturities, was $35.13, up 2% from the prior year, primarily from net operating income, partially offset by dividends.

Statutory surplus levels in our insurance companies remain strong and we estimate that we ended the year with the risk-based capital ratios of approximately 390% for our life and health group and 325% for our legacy Property and Casualty group. We estimate that our insurance companies will have a maximum ordinary dividend capacity in excess of $170 million in 2016.

During 2015, we repurchased more than 1.2 million shares of common stock for a total cost of $44 million or $35.57 per share. In total, we returned $93 million of capital to shareholders. We estimate that we ended the year with more than $225 million of excess capital, and from a liquidity perspective, the parent company held cash and investments of about $340 million while our $225 million revolver remained undrawn.

I will now turn the call back over to Joe.

Thanks, Frank. Capital allocation is a key part of the overall business assessment process that I've been conducting. As I look at the sources and uses of capital, I'm mindful to address both our short-term needs and long-term return objectives.

We work for our shareholders who expect and deserve production of attractive returns. The good news is that our current capital position is strong. Historically, we've described our strategic capital allocation priorities as funding growth for new business that delivers appropriate returns, acquisitions that are accretive to our business, and returning capital to shareholders through dividends and share repurchases.

We will share with you more about our capital allocation priorities doing during our strategic update in the summer. And my commitment to you is that we will be prudent stewards of your capital.

Now I will turn to call over to the operator to take questions. Operator?

(Operator Instructions) Christine Worley, JMP Securities.

A couple of questions on United Alliance and the nonstandard book legacy. Can you sort of give us an idea over the past year how much of the growth in those separate pieces has come from rate? And then how much has been just growth of -- expansion?

Sure. Christine, I'll take that question. The majority of the growth at Alliance United this year has come from new policy growth, although there is some additional rate flowing into the book from primarily mix shift changes that we are experiencing in that book. But the majority of that growth is in fact coming from policy enforced growth.

And can you quantify what the rate increases you have achieved on that book have been?

The average written premium is up mid-single digits on an exposure basis.

Okay. And then same question for the legacy book. I mean, are you getting any growth there outside of rates?

In the legacy business, our legacy nonstandard business, our policies in force are actually down, so we are not adding policies to our portfolio at this time. And what we are seeing is rate coming through from our actions in the book.

Okay. I mean, from an actuarial perspective how -- I mean, I know you filed the 7% -- how much additional rate do you think you need to sort of get in line with what you are seeing from a loss cost perspective?

There's a ways to go on this book of business, as I said. This is going to take a few years to get this book. You are talking about Alliance United turned around. And we will take the rate that we need on our portfolio as we work with the Department of Insurance on the product that we've got filed right now. We will continue to take the additional rate on the rest of the book.

And then we'll continue to take other underwriting agency management risk selection issues to be able to improve our price adequacy and our overall risk selection in the book. But it will take a period of time to get it to our target returns.

And Christine, this is Joe. I'll just add on top of that, I mean, obviously we're dealing with California, which is a more challenging environment to get rate. So we'll have to -- we won't rely solely on the rate lever to respond to this. As Denise was saying, we will be more aggressive with all of the tools at our disposal.

Okay. And what's your average policy length on the Alliance United book?

The vast, vast majority is well under 12 months.

Okay. Well under, so more in the three to six month range, then. Is that fair to say?

Yes. Under six months.

Okay. Under six months, great. And then just sort of one last question. I mean how should we think about sort of the moving pieces from a combined ratio standpoint? I mean, if we look at the addition of people on the claim side, how quickly do you expect the losses to come down due to that sort of offsetting what additional expense then you may have there?

So let me see -- let me answer -- let me see if I can answer the question around Alliance United and the combined ratio there. What we are seeing is a significant deterioration in industry loss trends, and those same deterioration and industry loss trends affected Alliance United. We saw that come through in our prior-year development and in our current-year development.

We are addressing that with rate and underwriting and other actions, but it is going to take a period of time to restore that book of business to our profit objective. The key issue on this book of business really is the loss trend, recognizing the loss trend and then acting upon it.

With respect to the claims, we are already working on the claims to address that staffing issue. We've added several claims professionals throughout the year and we will continue to do so to address the staffing needs that we have.

If your question, Christine, was narrow -- Denise is trying to answer the full impact on the combined ratio -- if it's really a narrow question on, are we going to drive up the LAE by adding claims adjusters before they have an ability to impact loss cost?

Christine Worley

Right.

On that one, in particular, trade, we are very confident that adding the adjusters will more than pay for itself in loss cost management.

Okay. Great. Thank you very much for the answers.

Paul Newsome, Sandler O'Neill.

Good morning and thank you for the call. The -- I have a broad question and then a couple of narrow ones. Broadly, we are referencing a lot of trying to get profitability up to our targets but we have a bit of a change in management. What are those targets now?

Paul, I'm going to differ giving you a real specific answer on that one. What I want to do is to spend a little more time digging into all of our businesses and really get a sense of where we want to take all of them, broadly.

It's a fairly easy statement when you look at our nonstandard businesses, our legacy, and Alliance United to say that they are not close to a reasonable target. We need to provide very reasonable returns for our shareholders on a consistent going-forward basis and do it by delivering consistent and replicable competitive advantages in the marketplace. And particularly in these two businesses where we are not delivering that right now.

So, at a minimum, we've got to be in the double-digit ROE range. But we will give you a more specific answer by the summer as we dig more into these businesses.

That's fair. Specific question -- the $5 million in after-tax legal fees on the life side, is that related to the lawsuit with the Illinois Treasury? And should we expect that those be, at least in the near-term, a recurring type costs?

The $5 million is related to our unclaimed property litigation and issues on a number of fronts. We will continue to pursue our legal options in that arena, hopefully until we have an appropriate conclusion. I don't anticipate you will see charges of that size on a regular basis but it would be somewhat surprising to me if this ends quickly.

Our hope is, is that this is an adequate view of what should be -- which should cover the issues we know that are out there over a reasonable period of time, but things may change on that. So the crisp answer is, you shouldn't expect this kind of number every quarter.

Okay. Thank you. Back to the Property & Casualty business, when you filed the rate plan -- could you talk about the timing of when you filed the class plan for United Alliance? And then sort of what's the -- how long it took? And then if there's any way to think about how quickly it can go through? I realize it's California and that's a hard question to ask, but any more details -- but sort of when it was originally filed and kind of how long it lasted, would be great.

Okay, Paul. For Alliance United, we filed a new class plan with a rate increase in the summer of this year. And we have been working back and forth with the Department to get that filing approved. And we are still working with the Department to get that filing approved. We expect to, very soon after, file another rate increase on the remaining product in the Alliance United portfolio.

Great. Thank you very much.

Ron Bobman, Capital Returns Management.

I had a couple of questions I guess largely focused on Alliance United. What -- could you describe -- and I assume sort of following, Joe, your arrival -- what sort of claims review has been done on both case and IB&R levels, whether you engaged any outside providers or whether you relied upon solely in-house staff? For starters, could you describe that?

Sure. Sure. What we've done -- and I'll comment again as you requested largely during my tenure -- we've dug into the case reserves, and how those are put up, how the process is managed. We've done that ourselves. We've had our outside auditors doing it and we've had at least one, maybe two third-party groups, depending on how you think of the review, going through and taking detailed reviews for us on those case reserves and claim practices -- their claim practices, AU's claim practices compared to ours and compared to the industry.

So we've taken a broad and deep review of all of those elements. And all of those are informing both the numbers that we booked this quarter and the actions that we are currently executing.

Do you consider -- and I understand you can get more information and through the continued passage of time -- but do you consider sort of the headquarters review of this work that you've done, complete? Or is there still broader additional case files to be looked like, broader production areas to look at? In essence sort of is your claims audit, your reserve audit on this acquired enterprise and the book they are producing for you today, that you inherited -- is it complete? Or is it fair to say that there's really some more work to be done?

Ron, while there's always the potential for something else to be found, I would say this is a largely complete review. We've been very deep and thorough. This is a book that turns over; has a relatively short tenure. We've been looking at the data since we've been owners for more than eight months -- we've been deep inside of those items.

There were a number of issues that made it somewhat challenging to read when we first acquired it. Alliance United -- as companies do from time to time, had undergone a claim process where they were closing some claim files near the back end of last year and the early part of this year in a different way than they had in the past. That causes data to be a little more challenging to read. I think it was challenging for the folks that were booking their numbers.

It was certainly a challenge for us reviewing that information in the first 90 days that we had the book. We have cleared all of the clutter out of that and understand how that impacts the numbers, and have a clear view on it. Again our outside auditors and the outside expert we had look at it, have all been through it, understand it. And when you get a dozen actuaries, you will get 15 opinions.

But even with them as a group, they are largely honed in on a consistent view of this, and believe we've got a thorough view and a thorough understanding, and have taken the appropriate action based on that.

Thanks. The -- I assume that all claims are handled in-house. They don't and Kemper doesn't rely upon third parties?

We do periodically use independent adjusters or appraisers and TPAs for parts of the items. We don't have the scale that we want in all spots, so it's largely in a case where we don't have the geographic presence or the geographic spread. It's not a case where we are wholesale taking a state or taking a whole section of a state. It's more covering the edges.

And we typically drive that only on the simplest claims. Anything that's got what you might describe as hair on it, regardless of where it is, we pulled those in. And the group has a much tighter, narrower authority. You can almost think of it as a minor use of supplemental staffing rather than a broad outsourcing.

Okay. In the same area -- and I know nonstandard retention levels are much, much lower than standard lines and -- but I'm curious about sort of -- what I'd like to understand is -- so rate isn't where you want it to be, where it needs to be, and it sounds like it's materially lower and it's going to take a couple of renewals, and firstly an approval by the state to get rate on this book where it needs to be.

What -- so are retention levels higher than they might otherwise be desirable? Are we continuing to write business that effectively is underpriced at a deficient margin or is that not the case?

Ron, are you asking about Alliance United or --?

Yes. Alliance United, sorry.

Alliance United's retention persistency is actually pretty consistent over time. And so with -- really with the policies being six months and under policies, we have the opportunity to get the rate into the book for new business as we write it, and then the renewals as we renew them. So we have that opportunity. And yes, as soon as we get that rate filing approved.

And then my last question -- thanks for your patience, because I know it's been a few. You said that expect Alliance United to be accretive calendar 2016. I assume that's I assume that's sort of on a total income basis -- the investment income off of the cash flow and underwriting -- added to underwriting income. But can you give us a statement on what you think the combined is actually going to be four 2016 calendar 2016, or you hope it to be?

Well, let me adjust first a little bit on your question. What we said -- and I'm not trying to parse words but to make sure we understand it -- what we said is it was not going to be accretive in its first full year of ownership, which is not a calendar year of ownership. it's from acquisition.

Okay. Great.

And that we believed it would be accretive in the second year, so that's a little bit of a time spread there. We don't typically do forward-looking views of combined ratios so I'm going to defer from giving you that much detail.

We do recognize for this book that they are largely six-month policies that we do have a number of levers that we can pull that we have not been pulling as hard as they can be pulled, and we will actively engage in those. And the analysis -- the other part of your question on how we are defining accretive, we are looking at it on an independent basis to say what did it add to the organization being here?

So that takes into account all of the different components of that. Investment income, the fact that as we did that analysis if we hadn't bought the business, we wouldn't have made the [$70-ish million dollar] payment. We would have had those dollars in-house so is a view of with and without.

Okay. Thanks for the help. I appreciate your complete answers.

(Operator Instructions) Brian Roman, Boston Markets.

Thanks for taking my questions. A bunch of questions -- you talked about doing comprehensive claims review for Alliance United. Are you doing that for the other Property-Casualty lines?

We have expanded that review for all of our nonstandard where it's the principal issue. It does run across and use similar claim resources so we are looking and exploring that. We haven't made a call on whether we would do it in our preferred area. What I tell you is a lot of what we are learning out of those two nonstandard reviews will lift and update where appropriate and use it across.

I'm sorry -- two nonstandard reviews?

Alliance United and then our legacy nonstandard business.

Got it. Okay.

There's some element, Brian, that those needed to be fully insightful to look at them differently, because we would start with what was Alliance United doing before the acquisition? What were we doing as we integrated it? And then, what was our legacy nonstandard business doing?

Got it.

So you could think of it as one with three parts, you could think of it as a couple -- I'm trying to be fulsome in the answer.

And I'm interested in this Alliance United as well as the other nonstandard businesses. I mean, you bought Alliance United, you closed on April 30 of last year. So between April 30 and basically the beginning of the first quarter -- or pardon me, fourth-quarter -- of fiscal 2015, October 1 -- you saw a need for rate increase. You saw a need for comprehensive review.

Is there something that changed precipitously during that -- what's that, about a six-month period? Or is it just things have been mounting for a while?

There were a handful of issues, Brian, that sort of hit simultaneously. The lost trend in the nonstandard business in general have been relatively benign across the industry for a number of years. It has spiked during that time period you described and California has spiked more significantly.

That spike probably started just before the business was acquired, so you get that as an environmental factor. Alliance United has had a long history of significant growth, and it would have been our expectation that that would have generally continued. So it did going into the wrong time to be growing with that lost trend.

Given their growth, they have been, for some period of time, somewhat behind on claim staffing, and were -- an acquisition that was known to us earlier and they were sort of constantly running to hire folks to staff as they could to keep up with their growth. We probably got a little delayed in that claims staffing on integration, and so we are behind on that staffing level, so have been aggressively working to catch that up, which is not ideal from a timing perspective as well.

They had made those claim actions where they were -- altered their behavior on some claim closing items near the end of last year and the early part of this year, which made the data that we look at to determine lost trends and determine where we are, harder to read. It was hard for us to read, it was hard for our outside expert to read. It was hard for our outside auditor to read. Everybody had the same challenge, it wasn't a brain cramp on our side of having a problem reading it.

All of those things were simultaneous. And then the normal ordinary course rate process that they would've gone through, they were probably a little delayed from what they normally would have been. My guess is with a relatively small set of staffing, their side was distracted and was a little bit behind on that because they were dealing with an acquisition. So we diligently moved on that after closing and got it filed. And it's gotten hung up in the Department longer than any of us would've expected.

So there's a lot of things that happened simultaneously. We wouldn't describe those as excuses but as an explanation. All of them happening at the same time with that industry rising lost trends made it hard to see the pace that this was deteriorating. And that's what I think is driving the issues and where we are now.

Whoever you bought Alliance United from, is there any sort of earnout?

There is. There's a couple of indemnification provisions. Frank, do you want to help describe what the numbers are on that, to get them off.

Yes. From a holdback perspective, there was a $12.5 million holdback that was a general indemnification bucket and then a $5 million holdback that was related to some legal matters.

And have those been paid or are they still being held back?

They are still being held back at this point.

And what's the trigger that says that -- I guess --

The first part of it -- Brian, I think I know where you're going with the question. The first part of it -- the $12.5 million will not be paid out based on where the results have been. And I'm fairly certain that the $5 million for legal expense accrual, there will be some piece of that or all of that which will not be paid out as well.

And what will that do? Lower your cost basis? How does that work? Or is that just a cost that you will not incur in the future?

Well the amount that we paid or we published that we paid for this was the $71 million in that range. That included this holdback, so effectively that amount would be reduced by whatever ultimately comes back to us.

And as stockholders, how do we get that back? That will be through what, some sort of reversal or -- of the purchase price or --?

Are you asking how it runs through the financial statements? Or the economics?

Yes. A little of both but most of the financial statement. Because this doesn't happen very often.

So the holdback is effectively already booked as a receivable. I mean, that's what happened as the development and these other things that have led to filling up that bucket. So from a financial statement perspective, it's essentially booked.

As we booked some of the equitable charges, we booked an offset from the income statement for a receivable, so it was -- as it was being used, it was a buffer to the results.

Okay. Is Alliance United a standalone company from an A.M. Best standpoint?

It is. It's a standalone company. We did not bring it into our pool. It's a nonstandard company and writes on a more leveraged basis than the rest of our pool so we have it separate.

And do you think it will need a capital injection at this point? Or is that -- obviously that is to be determined but is it something you could see them needing at some point?

Yes, Brian. We do anticipate with the fourth quarter results that it will need a capital contribution. We are waiting on finalizing stat because that's really what will drive it.

Okay. Joe, just I want to get back to something you said earlier -- you don't project returns, do projections. But you talked about expecting double-digit returns, returns on equity. When you review or go over your strategic plan with investors, as you said this summer, are you going to try and provide some sort of pathway to some higher level of return on equity?

I'm trying to see if I'm understanding your question and making sure I'm answering it correctly. We have to, from a reasonable perspective, to deal with investors, tell you what we think our strategy is and what kind of reasonable returns that we are going to get. And it will not be a pie in the sky hope strategy. We'll have a point of view about how we are going to operate and how we are going to get there.

Okay. And right now you have plenty of capital, right?

Correct. That is one of the things we feel particularly good about.

All right. Those are my questions for now. Thank you very much.

Adam Klauber, William Blair.

A lot of discussion on Alliance and nonstandard. But I also notice that the loss ratio in the preferred also jumped up a lot during the quarter. I guess a couple of questions there. One is that, is that a bit of an accident in your catch-up? Because it moved from [68 to 76], so a big jump. And two, could you talk about the trends that necessitated a higher loss ratio on the preferred side?

Sure, Adam. So with the preferred auto, there really are a couple of things going on here in the preferred auto in the first -- the fourth quarter. First of all, we have seasonality in our loss cost in the preferred business and we have that in the fourth quarter. It's always our hottest and in fact continues to be our hottest in 2015. So that is really just a seasonality in our book of business.

I think the second thing going on here has to do with prior development. So if we strip away the prior development from current year and prior year, what we actually find is that the underlying performance of this book of business continued to improve in the fourth quarter. So we actually are continuing to make progress in the underlying when you strip away those pieces of information.

Okay. So as we think about that book, are you still I guess pushing for more rate next year? And at what point do you think that will start showing unit or PIF growth?

Yes. So while we like the progress we've been making now for many quarters, it's still not positioned to get us to where we need to be. So we have more work to do to improve this portfolio and it does mean increasing rates in the next year. We're looking at mid-single digit rate increases next year across our portfolio. So that and continued efforts around improved segmentation and underwriting actions to drive continued progress on that line.

Okay. Okay. Thank you. And then one question on the equity method investments. With markets stressed. can we expect the lower income out of that portfolio?

We have a background noise on our end. Can you just repeat that one more time, Adam? I'm sorry.

Oh, sure. Yes. On the equity method investments, with having some stress and overall financial markets, does that suggest a tougher outlook for that portfolio?

This is John speaking. From the equity method, most of those assets or most of those investments are debt related, so the underlying investments are in debt related instruments. So I kind of always go back to general economic trends. So if we have a recession, those will probably be hurt. But if it continues to move along, like they are right now, we hope it continues to perform like it has.

Okay. Thanks a lot.

And we have time for one final question. And our question comes from the line of Ron Bobman with Capital Returns. Your line is open.

My questions were asked by others. Thanks.

Thank you. And I'm showing no further questions. I'd like to turn the call back to management for closing remarks.

Thank you, operator. And thank you for all of you for joining the call today and your interest and questions. I'd like to leave you with just a couple of final thoughts.

We do know this was a disappointing quarter and we've had some tough financial results for the last couple of years, but I don't believe that these results define our franchise or our potential. We have a strong brand. We've got a strong balance sheet with a strong capital position, and a talented and committed team.

We are fully engaged and I'm committed to you to let you know that we are going to work tirelessly to address our near-term issues and to deliver a focused strategy -- one that delivers attractive financial returns to our shareholders, serves our customers and agents well. I appreciate your patience as we evaluate every aspect of our business to refine our plans. Our team is energized as we move to keep -- to help Kemper realize our full potential. And I look forward to updating you in future calls.

Thank you for your time this morning and for your interest.

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may all disconnect. Everyone, have a great day.