Hanover Insurance Group Inc (THG) 2006 Q2 法說會逐字稿

Good day, ladies and gentleman, and welcome to the second quarter 2006 The Hanover Insurance Group earnings conference call. My name is [Sherelle], and I will be your coordinator for today. [OPERATOR INSTRUCTIONS]

I would now like to turn the presentation over to your host for today's call, Ms. Sujata Mutalik, Vice President of Investor Relations. Please proceed, ma'am.

Thank you, operator. Good morning and thank you for joining us on our second quarter conference call. Participating in today's call are Fred Eppinger, our President and Chief Executive Officer; Marita Zuraitis, President of Property and Casualty Companies; Mark McGivney, Chief Financial Officer of our Property and Casualty business; and Ed Parry, our Executive Vice President and Chief Financial Officer, who's calling in from a different location.

Before I turn the call over to Fred for the discussion of our results, let me note that our earnings press release and a current report on Form 8-K were issued last night. Our press release, statistical supplement and a complete slide presentation for today's call are available in the investor's section of our website at www.hanover.com. After the presentation, we will answer questions in the Q&A session. Our prepared remarks and responses to your questions today, other than statements of historical fact, may include forward-looking statements. There are certain factors that could cause results to differ materially from those anticipated by the press release, slide presentation and conference call. We caution you with respect to reliance on forward-looking statements, and, in this respect, refer you to the forward-looking statements section in our press release and slide two of the presentation deck.

Today's discussion will also reference certain non-GAAP financial measures, such as total segment income, segment results excluding the impact of catastrophes, and ex-cat loss ratios and accident year loss ratios, among others. A reconciliation of these non-GAAP financial measures to the closest GAAP measure on a historical basis can be found in the press release or the statistical supplement, which are posted on our website, as I mentioned earlier. With those comments, I will turn the call over to Fred.

Good morning, and welcome to our second quarter earnings conference call. I am pleased to announce another quarter of solid results. Segment income after tax was 52 million, compared to 53 million in the second quarter from a year ago. Because of very low cat losses in the second quarter of last year, we face a tough comparison to the prior year. Cat losses in the current quarter were 19 million, which is in line with our historical averages, whereas last year we only had 7 million of catastrophe losses in the second quarter. On a pre-cat basis, our property and casualty earnings improved by 9% from 97 million in the prior year quarter to 106 million in the current quarter. Continued strong loss performance drove this result. Ed will review our financial results in more detail and Marita will provide an update on the Property and Casualty operation shortly, but in my overview, I'd like to highlight our key accomplishments for the quarter.

And let me start by commenting on our growth. Nearly three years ago, we started our journey to create a special company that would deliver what we called the best of both, combining the products, technology and service capability of the best nationals with the local presence and responsiveness of the best regionals. It took significant investment and hard work to reposition the company, and we have made tremendous progress in a very short time.

As you know, we started our journey by aggressively attacking our margins through price and underwriting action. We have now a strong mix of business and very good accident year loss ratios. And more importantly, we now have the underwriting talent and analytical capabilities to maintain it.

In addition, unlike many of our regional competitors, we aggressively invested in new database products, innovative operating models and assembled a tremendous team to create a distinctive offering for winning independent agents that could allow us to hold margins and grow throughout the cycles, as top-quartile property and casualty companies have done. I believe what you are seeing in the last two quarters is evidence that these investments are really beginning to take hold. As we have always said, this is a journey and we must continue to improve every day. But we have clearly turned the corner from fixing our company to competing effectively with a distinctive offering for agents. If you look at our growth trends and strong accident year loss ratios, the momentum is very evident.

Our Commercial Lines segment recorded over a 13% growth in written premium for the quarter. This is ahead of our guidance and consistent with our objective of delivering growth that's above industry averages. We continue to see strong contributions from the investments we've made in our inland marine and bond businesses, which grew significantly. But, at the same time, our traditional drive lines also grew at about 9% country wide. Our highly automated operating model that is focused on rapid turnaround in our target market of 25,000 to $75,000 account size is beginning to take hold with our partner agents, where we see over 20% plus growth. And the number of these partner agents continues to grow.

As I look forward, I see continued momentum in the Commercial Lines. Our operating margin continues to mature and improve, the number partner agents continues to grow, our product enhancements, like our new commercial auto product launch in July, are being well received, and our specialty businesses continue to increase their penetration with our partner agents. This gives me confidence that we will sustain solid, profitable growth this year.

In Personal Lines, our written premium grew also 4% in the second quarter compared to the prior year quarter, driven by new business growth and our Connections Auto states. This represents a significant turnaround from where we were just a couple of quarters ago. The Personal Lines investment in service, operating model and product enhancements are also starting to take hold. New business production across our entire network is up 100%, now accounting for over $130 million in premium year to date. As we look forward in Personal Lines, we can also see continued momentum. This month, we launched Connections in New Jersey and are in the process of rolling it out in New Hampshire. We have five more states planned between now and December, and three more to quickly follow in the first quarter of next year.

We also expect to release a significant upgrade to our homeowner's product in September that enhances an agent's ease of use and our full Connections Home and umbrella in our market states - in all our target states, excuse me, will be up and out by the end of the first quarter. Given our production results in both segments, we remain comfortable with the premium growth guidance we gave you earlier this year of mid to high single-digit growth in both segments. Even though Personal Lines is not at that level, it is exactly where we expected it to be at six months and growth rates should ramp up as connections take hold in the additional states.

I'm proud of these production results. Recall that just a year ago Personal Lines was actually shrinking by 10%. We assured you that we would turn the corner on growth in Personal Lines after the hard work on mix and margins was done and our new product was in place. And we have done exactly that. We also committed that we would continue to show momentum in Commercial Lines and you can see that we did that as well. At the same time, our primary focus is always about growing our profit. In both Personal Lines and Commercial Lines, we closely monitor mix and class of business, and we carefully manage growth at an agent level to ensure that we are writing business at attractive margins. The last two years of hard work getting to our current attractive accident loss ratios prove how serious we have been about margins.

So, in addition to top-line growth, I am also pleased with the other aspects of our performance this quarter. Our accident year margins continue to be strong and we continue to see stable reserve development, evidencing the strength of our balance sheet. And we are earning more than this cost of capital while we continue to invest in enhancing our capabilities and strategic positions. For example, our investments in claims are beginning to deliver results that give me confidence that we will sustain margin. Investments in our fraud units, medical management, auto claims and improvements to our overall operating model have delivered significant savings that should allow us to hold attractive margins while we invest in our business. And the quality of our property, worker's comp, auto and specialty mix is continuing to improve as we use our predictive model and agents give us preferred shelf space versus the weaker competitors.

To summarize, I feel very good about our performance and I believe we have turned the quarter strategically in our P&C business. Two and a half years ago, we started this journey to create a special company that focused on delivering a package of products, technology and service responsiveness to meet the needs of the best agents in the business. Obviously, we still have a lot of work to do in order to prove that we are a top-quartile company. However, we are in a very strong competitive position and exactly where we expected to be. Our results leave me confident that we're on the right path and I'm more convinced than ever that the best of both strategy, combining the products, technology and service capabilities of the best nationals with a local presence and responsiveness of the best regionals, is working and that we will be a very strong company in this very challenging market environment. With that, I will now turn over the call to Ed to review our financials.

Thank you, Fred. And good morning, everyone, and thanks again for joining our call. As usual, I'll be using a slide presentation during my remarks, which is available on the Internet. And I trust all of you have this available. Please turn to slide five for a review of our consolidated results for the quarter. Reported net income for the second quarter was $51 million or $0.99 per share, down from 72 million or $1.34 per share in the second quarter of 2005. 2005 second quarter income includes a federal income tax benefit of some $13 million or $0.23 per share, related primarily to our discontinued variable life and annuity business.

Income from continuing operations was 54 million or $1.04 per share for the second quarter of '06, down slightly from 57 million or $1.06 per share in the second quarter of last year.

Let's now look at slide 6 for a discussion of segment earnings. Segment income after taxes was 52 million for the quarter, as compared to 53 million a year ago. Our P&C segment generated 86 million in pretax segment income, down from $90 million in the prior-year quarter, while our Life companies posted a $1 million loss from continuing operations versus an $8 million loss last year. P&C segment results for the second quarter of last year benefited from unusually low cat losses. Cat losses for 7 million for the second quarter of last year compared to a more normal $20 million in the second quarter of this year. Excluding the impact of cat losses, P&C pretax segment income was $106 million in current quarter, up from 97 million a year ago. This $9 million improvement over last year was driven primarily by favorable loss performance in both Personal Lines and commercial lines, partially offset by increased expenses.

Let's now look at slide seven for a review of P&C results, starting with Personal Lines. The Personal Lines segment generated pretax earnings of 54 million in the current quarter versus 57 million in the prior year quarter. Cat losses were 9 million in the current quarter, up from 5 million a year ago. Excluding the impact of cat losses, pretax segment income was $63 million this year compared to $62 million in the second quarter of last year. As you can see, this $1 million increase was driven by favorable development of prior-year reserves, improvement in the underwriting results of involuntary pools, higher net investment income, all of which were partially offset by increased expenses.

Let me comment on each of these items, starting with development. Prior-year loss and LAE reserves developed favorably by $17 million in the current quarter, compared to $10 million a year ago, representing a $7 million increase quarter over quarter. This increase was driven by personal auto, primarily, and relates to a more recent accident years '03 and '04. Additionally, the current period benefited from an improvement in Massachusetts auto involuntary pool results and from an improvement in net investment income resulting from increased operating cash flows. Lastly, aggregate OUE and LAE expenses were $9 million higher in the second quarter compared with the second quarter of last year. This increase was due to the implementation of our new claims operating model, the impact of new accounting for stock-based compensation, and to a lesser degree, an increase in the proportion of overhead expenses for the segment.

Now let's look at Commercial Lines, which is on slide eight. The Commercial Lines segment generated pretax segment income of 30 million in the current quarter compared to 31 million a year ago. Cat losses were 11 million in this year's quarter, compared to 3 million a year ago. Excluding the impact of cat losses, pretax segment income was $41 million this year, up from $34 million the prior-year quarter. This $7 million increase was driven by growth in specialty lines, improved current accident year loss performance, favorable development of prior-year reserves, partially offset by increased expenses. Let me comment on each of these items specifically. Growth in our specialty lines and improved current accident year loss performance account for about $14 million in earnings improvement quarter over quarter. About half of this was driven by growth in the inland marina bond, which generally carry lower loss ratios than our traditional business. The other half of the improvement was due to more favorable performance current accident year performance driven primarily by commercial multi-peril, which was unusually low in the second quarter of this year and is expected to moderate by the full year.

Additionally in the quarter, prior-year loss reserves developed favorably by $9 million, up from $4 million in the prior-year quarter. Offsetting these items was an increase in expenses of approximately $12 million quarter over quarter. This increase was due to the continued shift in product mix and specialty lines, which carry a relatively higher expense ratio. The impact of new accounting for stock-based compensation, continued investments in technology, the implementation of our new claims operating model and, to a lesser degree, an increase in the proportion of overhead expenses absorbed by this segment.

Now let's take a brief look at production, which is on slide nine. Overall, net written premium was 598 million for the current quarter, up 7% from the second quarter of last year. Commercial Lines net written premium increased by about 13% over the second quarter of last year while Personal Lines increased about 4%. New business net written premium increased significantly for both Commercial Lines and Personal Lines, with a 44% increase in Commercial Lines to $81 million and a 120% increase in Personal Lines to $71 million. Marita, in a moment, will discuss production in more detail.

Let's now turn to the Life companies just very briefly. As I mentioned earlier, the Life companies reported a $1 million loss from continuing operations, which was due to lower than expected related expenses. In discontinued operations, we reported an after-tax loss of 3 million in the current quarter, which is in line with our expectations.

Before turning the call over to Marita, I'd like to update you on guidance we provided - we've been providing for the year. Our P&C results are generally tracking very well against the guidance we've provided. First, and I'm sure most importantly, total P&C earnings are consistent with our ROE targets and the guidance we've provided. We're delivering on the written premium growth expectations of mid to high single-digits, both lines. Total earned premium growth is on track for low to mid single-digit growth, with stronger earnings in Commercial Lines. Our current accident year margins are performing as expected. We expect that our net investment income for the second half of this year will be consistent with the second half of last year. Our full-year expected tax rate for our P&C business is 33%, while the expected rate for the entire company is 31%. We expect our expense ratios for the full year to remain generally consistent with our 2006 year to date results. With that, I'll now turn the call over to Marita.

Thanks, Ed. Good morning and thanks for joining our call. I want to start by reiterating how pleased I am with the performance. We're gaining the momentum we expected in both segments, and our loss performance remains strong and our overall returns are consistent with our objectives. Ed talked about our financials in detail, so I'll focus my remarks on growth, and I'm pleased to be in a position to have that discussion. As we have said from the start, we will grow by first investing in our capabilities. We don't intend to grow at the expense of margin. We have made meaningful investments in our products, in our underwriting insight, in teams of experienced field leadership. And this is enabling us to achieve our objectives.

Also, we have said from the very beginning that we will grow profitably, and this mandate hasn't changed. We continue to see growth momentum despite continuing to reduce catastrophe concentration in coastal areas. In Personal Lines, we had 3% growth for the first six months of 2006. And that compares to a 9% decline for the same period last year, and our current accident year results improved slightly. In Commercial Lines, we showed 11% growth to date, compared to 8% in 2005, and our accident year loss ratios, excluding cats, were 47%, which is significantly improved from prior year. We are growing in all segments of our business, just as we had planned. Remember, our objective is growth, not by winning business one policy at a time, but rather by building partnerships with agents and winning a significant position on their shelf. Our best of both value proposition, as Fred explained, that combines smart underwriting, products and the sophistication of the nationals with the responsiveness and the personal approach of the regionals, of knowing our agents and our competition better, and having an adult at the point of sale who makes decisions, is starting to take hold.

So let's look at our Commercial Lines growth, which was 13% in the quarter and year to date of 11%. Let me give you some more insight as to where it's coming from and why we feel good about it. First, we are growing in places and lines we had expected to. On a year-to-date basis, we reported robust growth in our inland marine and bond businesses, which grew 80% over the prior year. But our more traditional drive lines are also growing, with commercial multi-peril and commercial auto growing at a solid rate of 6% and 3%, respectively. As I said, our growth rates reflect an intended change in premium mix, with significant growth in traditionally higher-margin inland marine and bond businesses. At the same time, we're also improving our market share in our standard drive lines for both C&P and commercial auto.

One area where we remain cautious is worker's compensation. We are intentionally reducing business and higher risk rates and focusing our worker's compensation writings on smaller policies in lower risk rates. I know many in the industry are writing more worker's compensation and posting pretty attractive loss ratios for this accident year. However, this line has been tough over the last couple of years and it is a longer tail, as you all know. So we continue to approach it conservatively, writing accounts where we can combine it with our other business and where we are confident that we'll make money in the long term.

Let me turn on the growth in our inland marine and bond business. As you know, we've invested heavily both businesses over the past couple of years, and these investments are starting to pay off. Through June, we have over 85 million in premium and have generated 57 million in new business premium through the first six months. These are specialty businesses, where the success and the quality of the book is extremely dependent on the quality of the underwriting team. I believe we have assembled some of the best talent in the industry. These lines now represent 16.5% of our Commercial Lines book, providing us with better breadth and diversification of our earnings base.

The growth in our traditional lines is also in line with our strategy, as we are growing in first tier middle-market, which is our sweet spot. While our growth is driven by middle-market, momentum in the small commercial segment is also starting to pick up. Our strategy to leverage middle-market expertise with our partner agents to gain share in the small commercial segment is beginning to take hold. Although the market is tight, pricing is also hanging in there and I am also pleased with our margins. Through six months, our rate increases, including exposure growth, were at about 2%, with an uptick in the second quarter. Further, our accident year results in these lines also continue to remain solid, with a 47% loss ratio, excluding cats and development.

In terms of business quality, I am pleased with our mix of business. In all lines, we monitor our class mix, our policy size metrics very closely and these are tracking very well with our expectations. Finally, as expected, we are growing with partner agents, as Fred said, at a rate that is over twice the growth rate of our overall franchise.

Once again, I remain satisfied with the production. It is coming from the right places in the right lines and in the right market segments. Our strategy to create a total solution operating model in Commercial lines, tailored to our segment, which offers a broad risk appetite, problem solvers at the point of sale, together with unsurpassed service responsiveness, is resonating in the market.

Now, turning to Personal Lines. We recorded 4% growth in the quarter and 3% year to date. As expected, this growth was driven by personal auto and is supported by new business coming from our Connections Auto rollout states. We now have Connections Auto, our multivariate product in 11 states, as Fred has mentioned, having rolled it out in New Jersey in July and in the process of rolling it out in New Hampshire, which will make 12 states. New business growth remains robust in all of these states.

I remain satisfied with the quality of the Personal Lines new business. We carefully monitor our new business distribution, the flow and the hit ratios by agent and by risk tier. About two-thirds of our new business production continues to be generated by the superior risk tiers, which is consistent with our current mix. Our overall hit ratio is also where we'd like it to be, within the 25 to 30% range overall, with somewhat higher hit ratios and more attractive risk tiers. I remain comfortable that our Connections Auto book is performing appropriately. Connections has provided the competitive leverage we had expected it to. It is enabling us to diversify our footprint and exposure base while at the same time grow more robustly in our existing states.

Pricing continues to be adequate. We have detailed analytical processes in place to identify issues and to react quickly. Our strong team of state managers and actuaries watch production daily at very detailed levels to spot trends quickly and to respond to them. When introducing a sophisticated product such as ours, it is not unexpected to have to adjust rates in certain pricing cells. In our case, we have had to make remarkably few adjustments, and our analytics around new business quality is so thorough that we can identify issues and respond rapidly.

I am pleased with the results and the loss activity on new business is tracking consistent with our expectations. Our accident year results remain solid with a loss ratio of 55%, again excluding cats and development. This reflects over three points of improvement compared to our prior year. In both segments of our business, we're achieving the premium growth we expected just the way we had planned. I remain pleased with our progress and I'm optimistic that we will continue to deliver on our commitment. With that, I will turn the call over to Sujata.

Thanks Marita. Operator, we'll now take questions?

Thank you. [OPERATOR INSTRUCTIONS]

Your first question comes from the line of Ron Bobman from Capital Returns. Please proceed.

Wow, seldom first. Congrats on some real nice growth and underwriting margins. I was wondering, firstly, was there any changes in your gross or net KRW reserves in the quarter? Sorry if I missed it if you specified. And then I wondered if you could talk just about, not so much complications, but what it's like sort of trying to settle claims and the progress you're making with paids relative to incurreds in claims closed relative to original openings. Thanks.

Ron, I'm sorry. I didn't hear the first question.

Were there any changes to your gross or net KRW loss reserves?

Katrina or Rita?

Mark, are you there? Do you have that data in front of you? I do not believe that there were.

No, we did not adjust reserves for Katrina or Rita.

No, we did not change Katrina reserves at all. With respect to the second part of your question, we continue to make good progress. We've closed in the very high 90s percentage of our Personal Lines claims, probably in the low 80s around Commercial Lines. So that's - so we think we've made some good progress.

I will say that what we're starting to see, and I think others are seeing, just sort of given how slow it is for the area to come back, is that we're seeing some Personal Lines claims payments being delayed, some being reopened, paying a little bit more than original estimates. We are seeing that to some degree in Commercial Lines, particularly around business interruption, is the duration of the fundamentals of the area there are stretched out. So we feel good about how we're managing it, we feel good about how we are dealing with the insureds, and the statistics look pretty good. But I think it's fair to say there is a little upward bias in the numbers against our original projections.

But, obviously, as you said from the first part, not to the magnitude to make any changes as of yet.

We did not make any changes, no.

I got you. Any particular lessons learned as far as dealing with whether it'd be Personal Lines claims or the Commercial Lines claims that you'd share with us?

Really, nothing other than what I've just said.

Yes, I think one thing we would say about our operating model, Ron, is that we feel good - obviously, we're on top of it and we feel very good about where we are. We have increased the number of property adjusters in house in our staffing. We've done a very aggressive job this year of cross-training folks so that we have available more property adjusters in case we have another year. I feel good about the way we handled last year, but as you can imagine, one of the concerns I have is the outside adjusters. Because we've had two years in a row, a lot of the independent adjusters have made a lot of money and retired, and you have a lot of lower-quality people in that business, as you can imagine, because of the stress in the system. So what we've done is invested in our own capability in case we have, and we have also done a nice job creating preferred arrangements with firms that are outside adjusters that we know, that we track the quality on, that we had good feedback from our insureds this year on. So I feel like we are very much prepared in case we have another year this year.

Thanks. Hopefully not, for sure.

For sure.

Our next question comes from the line of Dan Farrell from FPK. Please proceed.

Good morning.

Good morning, Dan.

Can you talk a little bit about the pricing trends that you're seeing in both the Commercial and Personal Lines segments?

I - and I'll let Marita speak. We have actually, for our type of business, the small business, we have seen in commercial, actually, as Marita mentioned, a little improvement. Clearly, what you're seeing in kind of worker's comp and large comp in particular, a lot of folks are losing ground in some of the property lines, et cetera, and in Personal Lines. They're being more aggressive there. But we have seen stable pricing across the business for us.

Now, there are some really obviously aggressive things happening in cat zones, right? You've heard about all of that, what's happening in Harris County and in Texas and Long Island and places like that where many of the bigger companies are shifting volume dramatically. Almost, I would describe a lot of the rate environment as a wait and see. People see that the reinsurers are having to put more capital up, people are seeing that the RMS models are changing, and what we have seen is not a lot of aggressive behavior. Now there are pockets of regional companies, I would say second-tier regional companies in the Midwest, that are being aggressive. But I have not seen it in our kind of business in any kind of broad way. And, as you know, we don't write a lot of stuff over $250,000 where people have been talking about it. So we really haven't been effected by that. I don't know, Marita...

I would agree with Fred. It's held. I would describe it as a flattish market. Our strategy to do business with partner agents and to write more business with less certainly helps us by keeping less of the business in the marketplace, writing business with agents who control their accounts and shifting shelf space as opposed to playing the individual account game has certainly helped us there. But it is a flattish kind of market and we're keeping a very close and watchful eye over it.

I tell you, the other thing that I would tell you that helps us dramatically is that particularly in places like the Midwest, people talk about how people are going to go from the coast to the Midwest. What really happens is the national players have a very hard time getting at the mid-size agents where we play. They can get at the large guys. So what you're seeing is attractive lines in certain geographies, for large business with large agents, is quite competitive. The issue is that if you get down in the place where we play, in our size category of mid-size agents, you're really competing against regional companies that don't have the sophistication and the product offerings. So we have been a little bit shielded by pricing. We would also tell you that when the market's hard in this kind of business, they do not move up as much, either. So it is the nature of the business we deal with.

Okay. That is helpful. And then, with regard to reserve development, in the past I think you've said that reserve development would be less of a positive impact to '06 versus what is was in '05. Given what was seen in the first half of the year, does that view still hold with you guys?

I think it is fair to say at this stage of the game, through this year, we are seeing more than we expected as we began the year. So we still expect to seek it to a lesser degree than a year ago, but maybe not as much as we originally thought.

All right, great. Thank you.

Your next question comes from the line of Jay Gelb from Lehman Brothers. Please proceed.

Good morning. I wanted to touch base on the expenses. The expense ratio this year so far is running around 34% and I'm just trying to get a sense of, based on the investments you made in particular this quarter on the claims process and other technology, is there any potential for that to improve in the second half versus the first half?

Let me actually talk about that. That's a great question, Jay. At the end of the first quarter, mid first quarter, the transparency to our earnings for this year became clear that they were going to be better than I expected and we had planned for. And our mix, I felt very, very good about kind of the stability of those earnings. Clearly, what I've done is accelerate some investments, which will continue through this year. And let me tell you what I did and why I decided to do it.

What I've seen is this whole market change that we expected where the shake out is occurring, I'm starting to see the differentiation occur. And so what I have done, I've accelerated four things. One is we accelerated our investment in our specialty businesses. We're going to invest another 2 million or so in [churning] marine and particularly in the fidelity area. There's some teams available, some talent available We're getting good penetration with our partner agents. The margins were held. I've seen the partner agents come on board. We decided to make that incremental investment.

The other thing we did is we added two waves of connections. When we started the year, we weren't going to do the final wave of this year and I have added one in the first quarter. So that expense will also continue through this year. As you know, it costs some money to enter a state like that.

The third thing that I did is I accelerated our home development pretty significantly. What we're seeing right now is a real opportunity in some of the umbrella business for us, and this whole total account approach we're using in Personal Lines, is so different from the national guys who are trying to commoditize the business and think about it as one product and appointing all of these agents. So a lot of our agents are quite attracted to rounding out accounts as a way to sustain and retain their business. So we have accelerated our Connections home owners to be done by the end of the first quarter of next year. And, again, I thought that investment was prudent. The other upgrade that we have in home was in the plan originally.

And, of course, we mentioned the claims operating model. The claims - what we have done because of our investment in our claims operating model is given us a lot more transparency to our loss management and I also believe we won't have the scaling issues. Because if you recall in our strategic offsetting, we talked a little bit about the operating model, making sure that like on a notice of loss, we can scale and do it well. And if you think about our Connections Auto, instead of writing a third of the business for a third of the market, we now right 80 or 85. So the needs we have around fraud management and rapid response to auto claims went up. So I feel great about that and I did accelerate it a little bit so that more of it would be done this year.

So as you know, I tend to manage our business based on top-quartile ROE.. So I think about if I can see transparency in the ROEs and I see a market opportunity that can pay back relatively quickly, I've done that. So it's a long way of saying that I see this year, as we've said at our planning session - this is kind of the high water mark for [yield]. And I see it staying high this year, but I feel very good about looking forward and having it really start going down over the next couple of years. And I also feel that it's not a vulnerability right now, given where we're investing and the kind of pay backs we're seeing from these opportunities. But, again, for 18 months, I have been talking about being three points too high. I feel that when we're done these investments, it is important for us to get that three points out because while - look at us compared to say, regional companies. Our loss ratio and LAE is much lower. I don't think we can sustain more than our expense ratio being this three points. I'd like to get those three points down because I'd like to have excess margins vis-a-vis our competitors. And I...

That makes sense, Fred. Do you think you can get a full point out of the expense ratio in 2007 versus '06?

I think we can get something significant. We haven't finished our planning, but I do think it's not insignificant. And we give our guidance - when we think about our strategic plan next year, we'll talk about it. But it's not insignificant because, again, if you just think about three categories that we track. One is sharing fixed costs. Obviously, that's just math, right? We have things like regional presidents and I've over invested that to be able to handle the growth. So there are some fixed costs, if you will, in our system, overhead in field leadership, that will be a third of the savings.

A third of the savings is throughput. One of the things we invested in is imaging, front end, et cetera. And we manage throughput pretty aggressively. And so I'm starting to see that throughput increase. So our premium per personnel, if you will, will improve as that automation occurs. And then the third part is a lot of one-time things. It costs us to roll out a connection state. You've got to hire a sales force, you've got the technology aspects, you've got the marketing, you've got the regulatory expense. So that was a burst this year, an incredible burst. Part of the reason I'm trying to accelerate home is that once we get Connections Home done, that's a lot a one-time costs that you're not going to sustain. Yes, there is some depreciation on the IT, but that was a lot of one-time promotional and development costs that kind of goes away.

The last point I would make is that we did spend a lot on predictive modeling in the last 18 months and I am glad I did. So those are kind of one time, too. The set up, well, we did them like others. People have set up predictive modeling to re-underwrite their books. The real expense for us is, yes, there's some there, but the real expense is putting on the front end so you can use it in an offensive way to target better classes. And that costs a little bit of money because you have got to incorporate it into your front end. So those - all those transparency, all that transparency we have, I think, in those three categories, tells me that you could see a significant reduction in 2007. But I'm not - again, our planning is not finished yet and I'm trying to see how this is all going to roll out. But I - obviously, in my view, you want to do it aggressively because you want to get rid of that vulnerability that could exist in case the market turned more difficult next year.

Okay, thanks for that answer. And then I just want to follow up on...

Hey Jay. I'm sorry to interrupt you. This is Ed Parry. Let me just give you a little bit more on that. And I want to be a little bit direct on one of the questions you asked. You asked - I think part of your question was what is going happen in the second half of this year? And what we've said is we expect the aggregated expense ratios in the second half of the year to be what they were in the first half of the year.

And what I would add to Fred's remarks is, well, that is right. There are some, to some degree, one-time investments. It's very clear and it's been very clear over the last couple of years, that this business is underinvested in, right?. This is a P&C company that was shrinking and that really hadn't seen much in the way of investments technology or otherwise for a period of seven, eight or nine years. I for one know that because I have been at the company that long, longer than that.

So what we're seeing in our case is a ramp up in expenses over the last three years in an effort to generate very profitable growth on the top line. So what that means to me is while I think we'll see a little bit on the expense side around some of these one times, I also think we're going to continue to need to invest in the business. What's really going to drive an improving expense ratio is growth. And what we're now seeing is we're starting to see growth for us that is multiples of what the industry is seeing. So I guess what I caution you to do, as you think about your view of the company for '07, and your thinking about expense ratios, I'd think a lot more about what you think growth is going to do to those ratios than what you think the traditional expense management. Because again, the business has been under invested in, and we're going to continue to invest in the business in the right ways in order to drive this growth, which at this point, is three, four, five times industry average.

Okay. That's helpful. Thank you. And then just two other quick ones. I believe you said net investment income should be, I think, consistent in the second half of '06 versus the first half? I just don't...

Second half of '06 should look like the second half of '05.

Oh, I see. But why wouldn't it be higher? I mean, you're already running at 56, 57 on a run rate in the first half. Why wouldn't it be at least consistent with that in the second half?

Cash flows are little bit improved. New money rates, though, for us are down, right? Because we invested long a number of years ago when rates were higher, so for us, the maturities portend for a low new money rate. So we've got a lower new money rate, a little bit better operating cash flow, and we think the confluence of those will generate what I just said, which is a net investment income in the second half of the year looking like the second half of last year.

Right. But you've been a little conservative on the investment income outlook previously, right?

Yes. So that's how we think about it. I will leave it to make those judgments.

Jay, the only thing I'd add to what Ed said is, remember, we did have a couple of hundred million at the holding company before we did the buyback earlier in the year, which obviously has an effect as we move through, given that we've completed the buyback.

Okay. And then finally, can you just update us where you are with the rating agencies and how that sets you up, hopefully, for initiating a more aggressive buyback in 2007?

Again, on the buyback, and this question was asked in the first quarter, as well. The dialogue with the rating agencies continues to be very positive. We're still sort of in the ratings season with Moody's. We're - in terms of buybacks or any other capital management activities, we really wait until we get to the end of the year to see where we are in capital. For us, part of it is what goes on in the Life company and what our expected can be from the Life company. And it isn't really until we get to the end of the year and look at the capital on all of our businesses, touch base with the agencies, talk to the regulators, particularly in Massachusetts around Life company dividends, before we can have a point of view on that.

Okay. Okay. Thanks very much.

Thanks Jay.

Your next question comes from the line of Larry Greenberg from Langen McAlenney. Please proceed.

Thank you. Ed, I was a little confused on your discussion on the tax rate. Were you reporting where you were at mid-year or were you offering new guidance for the balance of the year with PC at 33 and the total at 31?

Yes, I was offering new guidance for the full year effective rate. So we expect the full year effective rate for P&C only to be about 33% and full-year effective rate for the entire company to be about 31%.

And is that just driven by better assumed underwriting? Or is there something else in there? And can you give us what your effective tax rate is on investment income?

Yes, on the first question, and I'm going to ask Mark to respond to the second one in a moment. But what is driving the higher effective rates is higher earnings. There's nothing in there that's particularly unusual. Plus, we primarily - we've essentially worked through the net operating losses that were available to the P&C business that were generated some years ago. So less operating losses and more earnings.

Larry, on your second question, we'll have to get back to you. I just can't do the 35% on taxables, something a lot less than that on munis. So we'll get a specific response back to you on the tax rate on [NIO].

Okay. Great. And then, secondly, just qualitatively, are you seeing any impact in the marketplace yet from the new cat models, and I'm talking more in terms of geographically concentrated companies having to pull back and seeing business available from that?

Yes. There is no question. I mean, what you're seeing is some of the regional companies in particular in segments. You've seen the big announcements of the big companies, but in many, many places now, these micro markets, you're seeing regional companies have to pull back in micro markets on very good business with significant agents. And I think as the renewal season goes on, you're going to see even more of it.

Let me tell you one of the things that I see. A couple of the regional companies in particular have taken on more risk. And the way they managed it is they obviously took on more. That effects their cost of risk. And as they work that through, yes, it is cheaper or makes them hold their rate on reinsurance. But their absolute cost of risk by taking on that additional loss potential should work it through rate. So we're seeing geographic action - and again, they tend to be micro. Now we all know that on Cape Cod, Massachusetts, for instance, all of the regional companies have actually had to pull off, or most of them. You've seen it, though, on the coast of Maine. You've seen it in Connecticut. You've seen it in places you don't quite expect it because, again, the reinsurers in these concentrated, small companies are talking to them about their concentration. What is fascinating about it is I think you're going to see it in the Midwest. I think these tornado seasons hit a couple of the regional companies with bigger numbers than people expected and, remember, even though their - in general, their risk profile is different, they have highly concentrated books.

And so what is happening, I think, is as people are kind of working through what they're mix needs to be - now one of the things I caution people is one of the things that I see happening, because most of these regional companies are losing the auto war. There really is no companies that I know of that are under $300 million in auto premiums that are not shrinking. So what they're doing to react to this problem they have of concentration and property and losing the auto war is you're going to see them go into more aggressive positions on comp, I think, or large accounts to cover their overhead. So what we're seeing is agents can see these kinds of actions. They get nervous, and so the biggest benefit for us is that agents are starting to really be thoughtful about how many winning companies they want on their shelf space. And it's one of our big advantages. Because if you're going to replace some volume for regional companies, you don't necessarily want to give it to a national company. You want to give it to another regional company so you have a stronger company. But you have a mix on your shelf space. So we absolutely are seeing it.

Now, the issue for us is there are some places that I just - obviously, you'll see it and we have no interest in it. So there are places - obviously, Florida is the classic. But there are places in Harris County in Texas and in Long Island that we walk away from it too, because it still hasn't adjusted rate wise because there's enough naive companies still to take on the business at the wrong rate level. But I think there's a tremendous - you're going to slow see the shakeout. You asked something about the model. The RMS models, obviously, are very recently in everybody's hands. The question is what the rating agencies are going to do what with those.

Obviously, the extreme RMS model changes the 250 and the 100 year storms dramatically for most players. And the question is, how are the rating agencies going to think about that? My guess is they're not going to be as dramatic as people think, that you're going to see some more gradual changes in the way the rating agencies think. I think we've already seen a little bit of their thinking this year and I feel it is going to be manageable for bigger companies like us. But I do think your single-state companies, there are a lot of single-state companies that are going to have a real problem because of their concentrations.

The only thing I would add to Fred's response, and we've talked about this before, whether something we need to manage as a company and we take it very seriously, and we have a strong, individual account underwriting drill. We have a strong geographic concentration drill, and then we step back and look at the balance sheet and say, how much is too much? One of the benefits of our operating model is having adults at the point of sale and having the strength that we have in the marketplace as opposed to trying to centralize this, is really key. Because we can look at individual risks and geographic concentrations at much higher degree than many companies of our size. So we feel very confident in our underwriting talent in that regard.

Again, from macroeconomics, what I would tell you we've been talking about since the beginning that the industry is going to consolidate over time and it already has, frankly, if you see the winners grow at dramatically different rates than the losers. But this drives the macroeconomics of our business. We are a business that has a spread risk, so scale matters. So it has to put a disadvantage to small, subscale companies that cannot invest and spread their risk. By definition, it is going to catch up with them. And to me, all these models just accelerate the need for this to occur.

We all know, though, that it's state regulated, so states will do some crazy things to protect their small companies, with kind of cat funds and stuff like that. But I do believe that it will drive the consolidation.

Thanks. That's very helpful.

Your next question comes from the line Ken Zuckerberg from Carlan Advisors. Please proceed.

Yes, good morning. A question for Fred and then one for Marita. Fred, and maybe Ed, how will the continued mix shift into specialty impact your reinsurance program and capital needs, if at all?

Yes. One of the things that I would say is when we talk specialty, is a matter of degrees. Most of our inland marine and bond growth is coming from what I would call flow, inland marine and flow bond. We have a middle-market appetite in both of those business. So this is traditional in the marine business. It's contractor's equipment. It's furriers, it's jewelers, it's builder's risk. We're not doing high-level specialty inland marine business to which we would need separate covers. We have appropriate covers for what it is. And I do not see any big need for special reinsurance arrangements because of the nature of our specialty business.

Yes, I would say in general, both the specialty points. But, in general, if you look what our growth is, our growth helps our P&Ls. The whole notion of our strategy, of mixing Personal Lines with our target states, is to broaden our mix. So, actually, our mix and flow helps us dramatically to spread our risk. And what you're seeing is a more diversified portfolio. This was a property-centric company when we started this journey. It was shrinking in auto and growing in home. We are a very different mix, both personal and commercial now. And the spread continues to get better. And so our only - the concentrations that we have that are significant are in places that are more prone to what we call kitty cats, like freezes and stuff, like Michigan. So in my view, as I look out, I like our reinsurance portfolio and profile as we go forward. We'll become more and more, over time, an attractive place for reinsurers to invest.

I would also say on the bond side, we have a list of some strong partners on the reinsurance side that we have been doing business with for years and have enjoyed a strong relationship with them.

So it really offers diversification without that added costs of having to purchase specialty covers...

Absolutely. It is more of the same and it's a spread as opposed to getting more broad-

And remember, one of the things - if you come back to our strategy, we're all about mid-size agents and flow, as Marita said. To me, it's rounding out and locking in these agents with this flow business. It's highly automated, so it's hard for the big guys to dip in and dip down by a commercial [share], right? We do a lot of stuff that's small face value. We do not do large contractors. We're really about flow. But it is also a business that's not so big that the big guys want to be all over. So it's a nice business, it's big for us. It's going to be bigger. But it's not something that attracts a lot of easy capital. And that's why I love it. And just the same with our niches. We are very much into things like moving and storage, which everybody has a little bit of it. But it's about underwriting skill, a lot about insight locally, but it's not the national accounts, big account things that attracts big capital.

That's really helpful, Fred. And a specific question for Marita. I'm definitely not flirting, but it's great to hear your voice again.

You can flirt. It's okay.

Okay, there we go. I mean, it's insurance. We've got to make it a little more interesting. Marita, you've been involved with a couple of different turnarounds, operational and otherwise, in past jobs. And, I guess, just in your mind, could you offer how this one is different? It certainly seems like we are seeing the signs earlier in terms of - the good signs of diversification and business coming your way. But if you could offer your perspective, I think that would be very helpful.

Yes. I think it is all about the vision and strategy is right. I think Fred's vision and the vision of this company to build something different for winning agents was needed in the marketplace. I think people understand the vision and the mission. It is a very different place in that everybody is aligned with that. I think we have got the right people. I think there are good underwriting basics here and we have built on those. We're not afraid to make the investments that we need. I think we invested ahead of the growth, and it is a good, strong company with a good, strong underwriting drill. And I am very optimistic about our future. But I think it all comes from having the right vision, making the right strategic priority investments, and following through. And hard work, and it's just a really good group.

And I would say we have one big benefit and I think we should be very clear about it. Some of the things that Marita was involved in and, frankly, what I was involved in in 20 years at McKinsey, had real balance sheet issues because of long tail problems. I'll tell you, it is so much better to take an expense risk than have a loss risk.

Do you mean all the boring book of business...

It is so wonderful. We do not have asbestos or environmental or California comp or Florida comp. What this is is an under-invested, expense-driven turnaround based on great products and delivery of service to mid-sized agents. That is a lot - it's hard because it's a lot of nickels and dimes. But we don't wake up every morning worrying about 1974 biting at us, which I think some of the other turnarounds - and I do not think people understand that about us. That's what makes the risk here so much less, is we operationally pull this off.

And, again, having seen a lot of these really well-intentioned turnarounds get bit by asbestos or environmental or California comp. We don't have any of that. So, to me, that's the other advantage we should be very explicit about and why I'm so bullish and why I feel transparent. I mean, one of the things people say, well how can you manage with expenses? Well, we have short tail lines. It is a very transparent world we live in. We can adjust in a monthly basis versus being - a lot of these smaller companies live off of liability and they cover their expenses on long-tail liability stuff. We don't do that. We have mostly short-tail lines that are very transparent. So just to be fair - you don't necessarily agree with everything, but we have a very structural advantage.

You're absolutely right. But when you combine that with what I'm convinced is the best team in the business, you've got a good, strong shot.

Thanks very much.

You're welcome.

Your final question comes from the line of Patrick Meegan from Hotchkis and Wiley. Please proceed.

Hello, everyone. Thanks for taking my questions. Just a quick follow up from Jay Gelb's question on the buyback. Why wouldn't you initiate or what the impediments to initiating a buyback after you get on the other side of hurricane season this year?

After we get on the other side of hurricane season, we're sort of approaching year end and we are seeing our year-end numbers come in. And then, as you know, I think, there is a process, particularly around the Life company. And the Life company dividend has a lot to do with how we think about share repurchases and our total capital position. It's a process that then ensues around having a conversation with them. What we've learned in the past is they are really hesitant to make any commitments until year-end numbers come in. They don't necessarily have to be final, but you sort of have to have crossed 12/31, you have to have 10 or 11 months of numbers in and you have to feel pretty good about what can happen in that last month of the year. So that's an element, an important element, of how we think about repurchases, because it is an important element of bringing up excess capital, when we think about the capita for the whole company.

Again, Pat, just like last year, the way it is very straightforward. Just what you said, once hurricane season is behind us, and it's our best model is clear, we will do just what we did this year. We won't wait for [Best] to do their review. We'll reach out to them. We'll talk to them about capital requirements, and what their model means to us. At the same token, just like we did this year, we'll go early to the state, try to get some transparency on the dividends because of the Life performance and the transactions. If we have the same kind of clarity as we did this year, we'll do what is right. If we believe there's excess capital, we will take an action and if we don't, we won't.

So you're absolutely right. At that point of the year, we'll have a lot more transparency and I think this year, we demonstrated that we do it all of the time. We think about it. We talk to everybody that's appropriate and we make a decision. But we do - those two things - those are three pretty critical things. The hurricane season, what is best and what those are guys going to think about what these RMS models and which one are they going to use and how are they going to think about our capital adequacy? And the third thing, we do believe that we need to see a little bit of transparency from the Life transaction and those dividends that we fully expect out of the Life company near year-end. So I think it's - again, I think that's the fair way to think about it.

Did you guys - just a quick follow-up. Did you guys or can you guys take dividends out of the P&C in '05? I'm sorry, in '06?

Can we in '06?

Yes.

Yes. I mean, our lead P&C company, Hanover, is a New Hampshire-based company, which is a 10% of surplus for ordinary dividends.

And so you've got dividend capacity there but you're waiting to see what the new RMS models come out with before you make a decision about can we or will we-

Right. And again - go ahead, Ed.

As Fred said it well, we're waiting to get a picture on all three of those things. But clearly, it's a statutory matter, New Hampshire's a 10% of surplus state.

Okay. All right. Thank you guys very much.

Thanks, Patrick

Thank you, operator. Thank you all for joining the call.

You're very welcome. And, ladies and gentlemen, thank you for your attendance in today's presentation. This concludes today's conference. You may now disconnect. Have a most pleasant day.