Old Republic International Corp (ORI) 2006 Q4 法說會逐字稿

Welcome to the Old Republic International fourth quarter 2006 earnings conference call. Today's call is being recorded. [OPERATOR INSTRUCTIONS] I would like to remind everyone this conference is being recorded and would now like to turn the conference over to Leslie Loyet of the Financial Relations Board.

Thank you, good afternoon, and thank you all for joining us for Old Republic's conference call to discuss fourth quarter and full year 2006 results. This morning we distributed a copy of the press release. Hopefully you have all had a chance to review the results. If there is anyone online who did not receive a copy you may access it at Old Republic's website at www.oldrepublic.com, or you may call [Liz Dolenball] at 312-640-6771 and she will send you a copy immediately. Before I turn the call over to Al Zucaro, Old Republic's Chairman and Chief Executive Officer, please be advised that this call may involve forward-looking statements as discussed on the ad sixth page of the press release. Risks associated with these statements can be found in the Company's latest SEC filings. With that, I'd like to turn the call over to Al for his opening remarks.

Thank you. Good afternoon to all. As always we'll add a few editorial comments to this morning's earnings release, and then, as was just indicated, we'll turn the microphone over to whoever is in interactive mode and allow for questions or any questions we may have left unanswered.

From a consolidated standpoint, both the fourth quarter and full year of '06, as you can see, produced top and bottom line results that were pretty much in line with what we indicated were our initial expectations at the beginning of the year. The main differences relate to, I guess, what you might call slightly -- a slight underperformance on the earned premium line of the general insurance business, and a much more accentuated downturn in the top line of our title segment. And as we pointed out throughout the year, the downdraft in which the title premiums and fees were caught during 2006 was not mitigated by a proportional drop in our expense structure.

Looking at general insurance first, our top line there, the trends in that top line, I should say, were consistently at the lower end of the 6 to 9% range we had hoped to achieve as we began work on 2006. We were up, what, almost 7% in our trucking -- in the trucking part of our business. We were up almost roughly 12% in what we categorize as financial indemnity coverages which for us includes fidelity and surety, errors and omissions, directors and officers liability as well as our consumer credit indemnity book of business. And we were about 7% up in the combined book of our home and automobile warranty lines.

The other coverages penciled out to anywhere between 0 to 4% growth, and as I recall saying during one of our quarterly chitchats last year, we're definitely climbing up a slippery slope when it comes to the top-line growth in general insurance. The persistency of the existing business remains very good, I would say, but we're increasingly faced with feeding frenzies, if you will, when it comes to bidding on new business. So at this juncture, we think that general insurance top-line trends for 2007 are likely to mosey along at a 2% to 3% upward clip from the 2006 premium base.

However, as those of you who follow us know, however, we should obviously get, and will get some zip from the emergence of the construction book of business we bought in late November of last year. That book should contribute about $200 million of earned premiums after reinsurance sessions for all of 2007, so that together with our expected organic growth of the 2 to 3% that I mentioned before, we could well produce 12 to 13% general insurance earned premium growth in 2007.

Looking at our cost of goods sold, in our case, of course, those are claim costs, and in 2006, they were about on the par with those of the preceding year at about 66% of earned premiums, as you see in the statistics. As you can see also in one of those statistical tables attached to the press release of this morning, the paid loss ratio for the year was a tad lower than the 2005 equivalent, so that means we added a little more to the loss reserve component last year, and as we reported in the past, the development of prior year reserves continued to be favorable, and, therefore, those prior year claim reserves did not have any adverse impact on the current underwriting profitability of the business.

We think we're doing a reasonably nice job of keeping production and general operating costs under control in our general insurance book of business. As you can see, the expense ratio last year remained within a range of 24 to 26%, and that range we think is very appropriate for the diversified mix of our particular business. So in combination, we reported a composite ratio of 90.7% for 2006. It's one of the best we've achieved in many, many years, and it brings to five consecutive years the number of years during which we've achieved underwriting profitability. And when we add the growing investment income contribution to the mix, we were able to deliver what we think is a very believable 14% plus increase in general insurance pretax income.

Turning to Mortgage Guaranty, profit margins there for the final quarter deteriorated to a much greater degree than had been the case for the first nine months of the year. As we noted in the press release, all of the margin compression came from the claim side of the underwriting equation. If we go back to 2005, when housing and mortgage lending markets went into negative territory, we'd see that quarterly paid loss ratios for our book of business did bounce around some, but they basically remained within a range of 30% to 37% of earned premiums.

On the other hand, incurred losses, which, of course, reflect the combination of paid losses as well as increases in reserves we post for future claim payments, those costs, that combined incurred loss cost, moved up the ladder fairly consistently. Since delinquency ratios, which we show in press release statistics, remained relatively stable during that eight-quarter time frame that I'm talking about, the steady increase in reserves has been, therefore, largely a function of rising severity trends, together with some continued impact from frequency, or upward frequency numbers. So the picture that emerges with respect to our Mortgage Guaranty claim costs is that we think, and we believe that severity is the main culprit in the rising loss ratio trends in some quarters, whereas frequency has been the culprit in other quarters. And that as we sit here at the beginning of 2007, we think we're likely to experience their combined effects for a while longer. To a significant degree we think that the greater severity is a function of key factors such as larger insured loan balances, somewhat higher LTV loan values, and loans with deeper coverages.

Going back up the Mortgage Guaranty income statement, premiums from the traditional side of the business, they were down ever so slightly year-over-year, but, on the other hand, bulk business provided substantially all of the increase you see in the abbreviated income statement we include in the release. As has been the case for us for several years, bulk premiums written can show -- as many of you have seen, they can show some pretty significant swings quarter to quarter, and that's due to the combination of market dynamics as well as the opportunistic fashion that we think we utilize in approaching and reacting to those dynamics.

From an earned premium standpoint, the vast majority obtained from the bulk channel is coming from business we categorize as nonprime, rather than subprime business. We are not a big subprime underwriter of bulk channel business at Old Republic. At this stage of the game, we expect that traditional primary earned premiums will probably stay in a flattish, relatively low-growth mode, whereas the bulk side is likely to provide most of the upward momentum in the next 12 months or so.

And now looking at our last major segment of Title Insurance, the results there for the final quarter of the year were, I would say, significantly worse than we had expected. As we said in this morning's release, the biggest culprit in this turn of events was a top line which continued to move south at a faster pace, and that was particularly so throughout the year and continued through year end in the Western states, where most of our business is written through our own stores as opposed to being written through independent agency channels, as is the case for most of the remainder of the country.

I would say that the second biggest culprit stemmed from the operating expense side, where we have had very modest means of reducing those expenses. And I might add that the third major element was, as we indicated in the press release this morning, was relatively unique to the fourth quarter. And that, of course, relates to the increased reserves we posted for our share or our view of the exposure we face relative to industrywide class action litigation costs which we've regularly noted in our 10-Q and 10-K reports. As well as a provision we made to bring some premium rate classifications into line for certain classes of policies.

We think we've got our arms around these exposures and our estimates of what their dollar value is, so that we don't think we should incur any significant deterioration of these provisions going forward. But even if we eliminate these relatively special charges from 2006 results, the fact remains that the title part of our business went south at a lot faster and with a much greater thump in 2006 than we had expected. And as we look it at our crystal ball, we currently have no basis for suggesting that things are going to improve much before the tail end of 2007 at the earliest. And that, again, has been our view now for several quarters as we've reported to you throughout 2006.

So I think those are the additional thoughts and color, if you will, that we'd like to add to this latest news release relative to the three major segments results. From an overall standpoint, again, as you can see in the press release, the business produced very good consolidated cash flows last year from operations, of course, and we invested most of that money in income-producing debt as well as equity securities, in equities in particular we've favored higher yielding common equities, mostly with large and medium-cap companies. And together with the somewhat improved yield environment we have on the fixed maturity side, we were able to secure about, as you can see there, what, about a 10% increase in investment income for the year.

So on the basis of all that, and having just completed our budget for the coming year, as we look at 2007, we're fully expecting, I would say, that general insurance is going to continue to be our main engine of income sustainability at Old Republic. Underwriting-wise in that segment we think that the composite ratio is likely to show an upward tilt of, say, 200 to 300 basis points on top of last year's 90.3% level. So that would imply that we should be in a good position to deliver a 92 to 93, 93.5% combined ratio in 2007. To a significant degree, the rise in this ratio should again be offset by the greater -- by the benefits of the greater premium base we'll have of the 12 to 13% as I indicated before, when we include that new book of business that we bought late last year, and we also expect some continued growth in investment income.

Mortgage Guaranty, as I tried to say before, should show a modicum of bottom-line growth, and that should be the result of the combined beneficial effect of expense containment as well as some further investment income growth on the portfolio.

In Title Insurance, finally, as I just indicated, I think we're going to continue to be faced in that business with some pretty strong headwinds for much of the year, but nonetheless we should produce, I think, moderately better results for the year as a whole, if only because we don't expect to have a repeat of that $7 million additional provision we set up in the fourth quarter of '06. So I think that 2007 stands a good chance of doing -- of producing somewhat better results than we did for 2006. It's not going to be a barn burner, but it should be very good, steady progress for the overall makeup of our business. And with that final note, as was indicated before, we'll open it now to any questions some of you may have.

Thank you. [OPERATOR INSTRUCTIONS] Our first question today is from Mark Finkelstein from Cochran Caronia Waller.

A couple of quick questions here. Can you just elaborate on the increase in the severity trends on the MI business? I'm firstly curious if you happen to know the average claim cost expectations at the third quarter versus the fourth quarter, alternatively, how much your expectation for claims to increase were on a percentage basis.

On claim costs, let's see if I can quickly go through some statistics I have here, or I should have. We are buried in statistics around here. I just can't put my hands on it, and shame on me for not being prepared for that type of question, but I can say that the severity has bounced around over the last eight quarters. I would say that the rise has been fairly steady. But, on the other hand, as I said before, the other element in the rise in claim costs has been due to frequency trends and the assumptions we make as to where they're likely going to end, and in some quarters, frequency has had more of an impact than severity. So I think it's, again, it's a combination of the two, but unfortunately, Mark, I am not able to give you the quantification that you're looking at.

Okay. One more question on that. Just to understand your expectations for '07, I know there's obviously higher claims this year, particularly in the three Midwest states that have been referenced, but is it your expectation -- like how much deterioration in the loss ratio are you thinking for '07, or do you kind of see it with this severity increase, staying relatively flat with where we are at now?

Well, our own budgeted numbers show some upward tilt to that loss ratio. But, good lord, we have been unable to predict with any degree of accuracy in the past. But given a choice, there's no question that we would tilt towards an upward trend rather than a downward trend, at least for the first three quarters of this year. Again, to a large degree, all of this is a reflection of what happens in the mortgage lending and housing markets. Mortgage lending in particular. And the extent to which the quality, the credit quality that we've underwritten as an industry over the past several years continues to bite to us some degree.

Okay. And then just moving on to the general insurance business, I guess you've kind of gotten past the one win renewals on the construction books. I'm just curious if there were any trends that differed from your expectations in terms of how that business is renewing?

No, it's coming in pretty much as we expected. We don't have in that particular book, the new book I take is it what you're talking about?

Exactly.

We don't have that much in the month of January and February, but it starts picking up after that.

Okay.

But at least what we had has come through pretty flawlessly.

Okay. Then just finally on general insurance, do you -- was fourth quarter earned premium levels affected in any way by an arbitrarily high level of retro adjustments, given kind of the favorability?

No, there was not an impact this quarter.

Okay. That's what I have. Thank you.

Okay, take care.

Our next question will come from Bill Laemmel from Divine Capital Markets.

Bill Laemmel, how are you, sir?

Pretty good. Well, listen, I think it was a heck of a quarter seeing as how the housing business and especially the title business has deteriorated, and especially with the high fixed costs in the title business. But, anyway, we've had all this wonderful weather Al, and you're charging around the West with all these trucks, and I just wonder if there's any -- if the mild weather has helped you out there.

So far we don't have any indication that there's any significant change in either frequency or severity, other than what we have been experiencing pretty steadily throughout 2006. There has been some greater severity as well as additional claims, and that's led us to post a somewhat higher loss ratio, and -- but having said that, we don't expect that 2007 is going to show anything remarkably different from that.

Okay. Thank you very much.

Yes, sir.

And we'll take our next question from Greg Peters from Raymond James.

Good afternoon. I had a number of questions. First, in the context of the guidance you provided for the combined ratio for general insurance, I'm somewhat surprised that you're only anticipating a modest erosion, I think 200 to 300 basis points was your suggestion, because it would appear, based on all of the information we're getting from outside, or other sources, that pricing across the board, with the exception of property cat, seems to be deteriorating on the order of, say, 10 or 15%. So I'm just curious what parts of your book are experiencing less than 10% price erosion, because I would have anticipated there might have been a little bit more margin erosion, I suppose, based on what I have been reading.

Yes. Well, again, no two books of business are the same, as you know, Greg, and we're fortunate in having a book of business that's reasonably well diversified, both in terms of the regions as well as the types of coverages that we write. You take things like the home warranty business, or the automobile warranty business which in combination are pretty significant book for us, about 150 million, or thereabouts, that doesn't have much price deterioration, nor appreciation, I might say, attached to it. You take our E&O, D&O book of business, we've had some slippage there but again nothing that major that's going to affect that loss ratio significantly.

With respect to our big books in the trucking area, I just, in answer to Mark's question, or, rather, Bill Laemmel's question, we just don't see any acceleration of claim frequency or severity beyond what we have already experienced. And the same with the construction book of business, which we -- which is about a $250 million book of business before that acquisition, and now gets just about doubled after that acquisition of the book. And we think that those books can clock in at 95, 97%, combined ratio.

As a matter of fact, as I speak, as I answer your question, I recall a question from you either last quarter or the prior quarter as to -- given the fact that we were indicating that at worst we were experiencing a 2 to 3% slippage in overall rates, as you may recall, you asked, well, when can we expect some deterioration of the combined ratio? And as I recall answering, I said, well, probably by mid-year of 2007. And given that, putting that in context, and the fact that we still have very good persistency on our business across the board, and the fact that our main issue, or main problem, has to do, as I indicated, with our inability to write very much new business, which obviously is the one that's always most subject to rate deterioration, if you assume that you have good persistency on your business, then the combination of all those factors leads us to the assumption we are making of likely not experiencing more than a 200 to 300-basis-point deterioration. That's a long-winded answer, but it's the best I can do.

Understood. Well, I think you said 2%, 2 or 3% organic growth on your book, then the bonus coming from the acquisition.

Exactly.

I've got to believe, if that comes to pass, when we get to the end of this year, that's going to be a result that's going to be noteworthy in that it's going to stand out. I have to believe that a lot of the market is probably going to experience some top-line erosion.

Well, again, the lion's share of our top-line growth is going to be, as you just pointed out, from this new book, which is being put on top of no book last year.

Indeed.

So that alone is going to make that top line good, and that book, as far as we can see, and that's the reason we bought it, feels pretty good to us, and we think it's going to clock in at a very reasonable and adequate underwriting margin.

Okay. One other general insurance question, then I'll move on to the MI. You commented in your press release, or in your comments, I think, you noted the IB&R, the prior period reserve leases were favorable again for Old Republic for 2006. I'm wondering if you have a number behind that.

It's usually ranged for us between 2, 3%, 4%. I don't have that number in front of me but that's where it is.

When the K comes out and we look at it, we're not going to see anything materially different from '05 to '06?

Exactly. It's going to follow the same pattern and trend that you are looking at when you look at 2005 and prior in the 2006 10-K.

Perfect. Thanks. Then onto the MI. You, in response to one of the other questions, I think mentioned, or talked about an expectation of possible loss ratio, continuing deterioration, at least for the first couple of quarters of -- or first three quarters of this year, and I'm wondering how we should be looking at this, because if you look at the quarterly trend, I mean, should we think about this sequential? Because we use the 53.6% in the fourth quarter, or should we use the year '06 results? I'm just trying to gauge what you're saying, because if I use the 53.6% in the fourth quarter, which I think is the highest loss ratio you've -- at least I have on my model for you guys since 1992 --

You're correct, yes.

I'm just trying to get some added perspective there, Al, please.

Well, I guess if I were sitting in your shoes, I will address the question from the standpoint of sitting in your shoes on the outside.

That would be great.

And I would attenuate any significant down quarter and attenuate any significant up quarter and try to, as I say, level out the trend in the loss ratio, and if you do that, I think you will see that it leads to a somewhat upper -- it leads to a definite upward tilt. And depending on how you model it, it's going to take you to a 42 to 47% ratio potentially.

Is it -- is there any --

The reason I say that, and the reason I equivocate, is because we ourselves continue to be surprised quarter to quarter. It's hard to think of that business in terms of its having repeatability in terms of the patterns and the effects of both frequency and severity assumptions on the loss ratio that you end up each quarter. It's a very dynamic and somewhat fluid situation that we look at when we are reserving. So given that, you can understand why we're reluctant to point you in a more accurate direction.

Would that be -- you gave some fairly specific guidance with respect to earned premium targets for '07 for general insurance. You were less specific with MI.

Right.

In terms of just the consolidated earned premium, should I infer from the -- just your last answer that you're -- based on all of these uncertainties, that you're just unwilling to go there?

Yes, I think I said in my brief comments, Greg, that we thought that the earned premiums from the traditional channel -- and I believe I used the word, would mosey along, something to that effect.

Yes.

Which means probably a little bit of growth, 1 or 2%, which I think is what we have been experiencing for the last several years, year-over-year basis, and that most of our growth, given the maturing aspects of our bulk business for the last -- that we have written in the last two or three years, and given the fact that we are not to any significant degree, in the subprime area of bulk business, that most of our growth, though limited, will come from bulk business as opposed to traditional. Now, I know that doesn't give you the kind of answer --

Well, I like the mosey for the primary, so do you have a -- I understand.

A little better than mosey.

A little better than mosey? Fair enough. I suppose the one final area worth covering, at least in this go-around of my questions, would be the title business, and given your experience with the overhead relating to the direct channel versus the agency channel, and the fact that every time we hit this point in the cycle with title insurance the direct always causes you problems, do you think it's time to just turn off the direct business altogether and just move completely to an agency model there?

No, because, first of all, you don't have a choice. If you want to operate on a national scale in title insurance, you don't have a choice but to be a direct writer in the Western states. Why? Because that's the way the business is written there. Just like you don't have as much of an opportunity to be a direct writer on the Eastern states because a lot of that business is written through attorney agents, abstractors, and what have you. Okay? There's very much of a -- very many differences in the regionality of that business as to production sources. That's point number one. If you want to be national, which means you've got to be in the biggest state in the country, then you are stuck with direct.

Now, as you know, we have, however, tried to grow our title business in other than the Western states for the last 10, 12 years, and we very -- have succeeded in doing that, and as you know from looking at our statistics today, we get some 67, 68% of our business through agency channels in total. So that's working for us. But we have to accept the fact that in the direct markets like the West Coast, in the downturn you're just going to have to manage one of two ways. And that is either to take the marrow out of the bones, and the bones, in our case, of course, are the talent that we have out there, or whether you keep that talent pretty much in place so that you can benefit from their experience and their relationships when the market turns around.

And as a final point, I mean, from our standpoint, being in the title business as we are, we must look at that business in terms of its average performance over cycles. And that's a business which in good times produces a better than 20% return, post-tax return on equity, and in bad times looks pretty shabby, as it does right now. But on average it's been a good business, and we expect it to be -- to continue to be a book business.

Then finally, we think it fits with the rest of our business, whether it's general insurance or Mortgage Guaranty, in terms of giving us diversification and balance. And admittedly there's a price to be paid for that and now we're paying that price. But it's not something that's going to go on forever. Housing is here to stay. It's still the foundation of the American dream, as they say, and it's a good business long-term. That's my dissertation in answer to your question, Greg.

A long way of Old Republic. Thanks so much for your answers, Al.

[OPERATOR INSTRUCTIONS] And we do have a question from Stephen Mead from Anchor Capital Advisors.

Can you hear me?

Sure. How are you, Stephen?

I'm fine. Just from a cash flow standpoint, as you look at, say, the mortgage business, Mortgage Guaranty business, and the Title Insurance business, and you look at sort of 2006 versus 2005, then 2007, in terms of impact just on cash flow, can you help me just sort of get a sense of what the trends have been and what the outlook would be for, say, 2007 as far as on a cash basis?

Right. Okay. The best way I can answer for you is one, look at the statistics that are attached to the press release where we show paid loss ratios for each of the three segments, and you will see that those typically are lower than the incurred loss ratio which means, therefore, that there's less outflow on the claims side than is indicated, okay.

Secondly, what I might point out to, and we don't have it in the press release, and I don't remember them offhand, but I will say this to you. That, one, when you look at our general insurance business, its cash flow absent the beneficial effect of the cash flow we obtained by virtue of that book of business we bought in late November, early December last year, that cash flow was up from 2005. And again, it was up in reflection of the somewhat lower paid loss ratio that you see in those statistics.

Number two, when you look at Mortgage Guaranty, again, those paid loss statistics are pretty stable, and I can tell you that the cash flow in Mortgage Guaranty, as a result of that steady to downward pattern of paid losses, together with what I think has been very good cost containment by the Mortgage Guaranty operation, that that cash flow was up again in 2006, relative to 2005. And finally, the title business, now there, because, again, it's a top-line driven business there, cash flow suffered significantly. But again, title insurance is not the main driver of our consolidated cash flow. Don't hold me to this, but my recollection is that cash flow in Title Insurance last year was still positive at around 20, $22 million out of the total cash flow that we posted there of $1.04 billion as I remember in the press release. So the fact that Title Insurance is not going to -- is going to perform, we think, somewhat better than 2006, particularly as the year progresses, to us means that our consolidated cash flow, including the accretive feature of the new book of business in general insurance, should be pretty strong in 2007. Now, that's a long-winded answer to your question.

That's helpful. Thanks.

Okay.

[OPERATOR INSTRUCTIONS] And it appears there are no further questions today, Mr. Zucaro. I'll turn the conference back over to you.

Okay. Well, judging from the dearth of questions, I guess we'll pat ourselves on the back and think that we did a pretty good job in the press release and in these comments and answers to the questions to have addressed whatever thoughts were out there. So as always, we appreciate your taking the time to visit with us and keep up with our ongoing story of long-term success at Old Republic. With those words, I bid you a good afternoon.

And that does conclude our conference call today. Thank you all for your participation.