Hanover Insurance Group Inc (THG) 2007 Q2 法說會逐字稿

Good morning, ladies and gentlemen. and welcome to the second quarter 2007 The Hanover Insurance Group Incorporated earnings conference call. My name is Shanek, and I will be your coordinator for today. At this time all participants are in listen-only mode. We will be facilitating a question-and-answer session towards the end of this conference. (OPERATOR INSTRUCTIONS) As a reminder this conference is being recorded for replay purposes.

I would now like it turn the presentation over to your host for today's call, Sujata Mutalik, Vice President of investor relations. Please proceed.

Thank you, operator. Good morning and thank you for joining us for our second quarter conference call. Participating in today's call are Frederick Eppinger our President and Chief Executive Officer, Ed Parry our Executive Vice President and Chief Financial Officer, Marita Zuraitis, President of Property and Casualty Company. Before I turn the call over to Fred for a 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 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 facts, may include forward-looking statements. There are certain factors that could cause actual results to differ materially from those anticipated by this press release, slide presentation and conference call. We caution you with respect to the lines on the forward-looking material and in this respect refer to you the forward-looking statements section in our press release and slide 2 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, (inaudible) ratios, and accident year loss ratio, 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 statistical supplement, which are posted on our website, as I mentioned earlier.

With those comments I will turn the call over to

Good morning, and thanks for joining the second quarter earnings conference call. We continue to make good progress towards another strong year. Our second quarter after tax segment earnings of $59 million compares to $52 million in the second quarter '06, up 14.5% for the quarter. Driving this improvement are the results of the property and casualty business, which generated $98 million in pre-tax earnings compared to $86 million from the prior year, supported by improve earnings in both commercial and personal lines. Along with the earnings improvement we also reported an overall 4% written premium growth for the quarter and a solid combined ratio of 94.2%. Clearly we have lot of positive momentum in our business, and we have challenges we must remain focused on, so let me review briefly the positive trends that are reflected in our results and the challenges facing us as we look for the outlook for the year.

Let me start by commenting on our healthy level of favorable reserve development relating to prior accident years, which was a significant driver of earnings improvement for the second quarter. We believe that our reserves remain strong and this favorable development is indicative of the strength of our balance sheet and the improvements we have made in the quality of our book over the past few years. And as Ed will comment on later, we now expect the favorable development of prior-year reserves will be more in line with what we reported in 2006. Additionally, we continue to maintain discipline if our current accident year loss picks. Our second quarter reflects a compression in our current accident year margins. As we mentioned before we expected our current accident year margins, particularly in personal auto, to experience some strain due to the market conditions in our growth.

In the current quarter, accident year margins were further impacted by large property losses in both homeowners and C&P. I don't view these large losses as an ongoing trend and I am comfortable we are aggressively taking pricing action as we see the need. Therefore I am confident we will deliver on our overall earnings targets. Additionally we continue to gain traction on our expense commitment. Both our underwriting and loss adjustment expense ratio improved in the quarter and I remain confident we can deliver 1.5 of expense efficiency I committed to achieving in 2007.

Turning to growth in our net written premium, we reported an overall growth of just under 4% for the quarter. While market conditions are certainly a factor in tempering our growth, reported growth is also negatively impacted by some anomalies, which we will discuss. When we look at our core growth there is still a very strong positive momentum that gives me confidence that we will achieve our growth commitments for the year in both personal and commercial lines. And Marita will, as usual, discuss our growth in some more detail, so let me just briefly highlight some of our accomplishments in each of the segments.

Our Commercial Lines segment recorded just under 5% growth in net written premium for the quarter. These growth figures are more adversely impacted in the second quarter by certain actions in Louisiana both this year and last, which Marita will discuss in more detail. Excluding Louisiana, which is causing this aberration, our net written premium growth is 7.8%, which is still very healthy for the current market and exactly where we expected it to be. There's no question that the market continues to be competitive, particularly in the more traditional drive lines, but I continue to believe that there is a real market opportunity for us to grow by working with our agent partners, leveraging our operating model and specialty capability to say continue to profitably gain market share. Our strategy is working, and I continue to see good momentum with our partner agents as we create a distinctive combination of broad product capabilities, advanced technology and responsive service.

Our specialty business continues to show solid growth at 27% and our partnership agent also shows significant growth, demonstrating our ability to be more resilient to market conditions by giving us broader options for profitable growth. Additionally we continue to enhance our value proposition for our partner agents with broader product offerings and improved service capabilities, giving them yet another reason to do business with us. We recently announced the acquisition of Professionals Direct, a specialized provider of lawyers' professional liability. This investment further expands our specialty capabilities, enabling our agent partners to meet more of their clients needs and grow their businesses. We expect to close this transaction late in this quarter or early in the fourth quarter.

Further, we launched a significant upgrade to our small commercial platforms, which should give us some added competitive advantage in the market to help us sustain our overall growth objectives for the year of mid to high-single growth. Our accident year margins reflect some compression in the current quarter and Marita will discuss that in some detail, however we continue to remain prudent, balancing our growth objectives with discipline around profitability and we will take all the actions required in short tail line to achieve our overall earnings targets.

So let me now turn to Personal Lines. Personal Lines net written premium growth for the quarter was just under 3%. Once again, second quarter was adversary impacted by a drop in our participation in the Mass CAR pool, which Marita will discuss. Adjusting for this our growth was just around 4%, which is more in line with our expected growth for the year, and our overall expectation for the year of mid single-digit growth remains unchanged. The personalized market is a challenging environment. Obviously there's shopping in the market and pricing is under some pressure, particularly in markets with difficult economies.

Additionally, we also took some purposeful action to improve the profile of our new business while we were -- that we were writing and we also adjusted our pricing with some of the new states we entered last year. We expect the combination of the macro trends and our purposeful actions to result in some lower growth for the next quarter, pushing back up by year end. However we still expect to meet our guidance in Personal Lines for the full year, which is mid single-digit growth. I remain very encouraged by a momentum in Personal Lines business. Premium growth outside our big four states was encouraging, 21%, and our new Connections Home product was launched in 14 states starting in April and gives us some lift in production, both in the third and fourth quarters. Also, our efforts in profiling books of business and converting agents to partners should gain traction and further help us achieve our growth objectives for the year. As I review our progress I remain convinced that our agent targeting and total account approach is working and we're building momentum and market share on the shelf space of winning agents. At all times we endeavor to carefully manage our growth at an agent level to ensure attractive margins.

To summarize I feel very good about our performance and I believe we have strategically positioned the Company in the best possible way to become a top player in this market. We remain on track to meet our commitments to you for 2007. We are singularly focused on creating a top quartile company and so we are working on all the critical levers to deliver top quartile returns. We expect to make our growth targets for the year, we also expect to make our expense ratio commitments for the year, and we now expect our current accident year loss ratios to come three points higher than 2006, given some weather and larger losses in the first six months of year. And at the same time the favorable development of our prior year's reserves is expected to come in higher and we believe similar to 2006 levels. I am convinced that our best of both strategy combined the products, technology and people quality at the best nationals, with a local presence and responsiveness of the best regionals makes us a distinctive carrier for our partner agents and should enable us to take advantage of the market opportunities, as weak companies struggle through this kind of market conditions. It will continue to take focus and hard work to remain successful, and by doing so over time we should create significant value for our agents and shareholders throughout the cycle.

Before I turn the call over to Ed I want to take a moment to thank Ed for his long service and all his contributions, as this will be his last conference call with us, and I wish him the best in the future. As you may be aware from the press release last week John Leahy will assume the roll of Executive Vice President and CFO effective September 1, and I look forward to introducing him to you. So with that, let me turn the call over to Ed for the review of our financials.

Thank you, Fred, and good morning everyone and I also thank you for joining our call. As usual I'll be using a slide presentation during my remarks, and I trust all of you have this available. It's available on our website. Please turn to slide 5 for a review of the consolidated results for the quarter. For the quarter we reported net income of $60 million or $1.14 per share, up from $51 million or $0.99 per share in the second quarter of last year. Income from continuing operations was $60 million for the second quarter or $1.14 per share, compared to $54 million or $1.04 per share in the second quarter of last year.

Let's turn to slide 6 for a discussion of our segment earnings, which drove the results. Property and Casualty pre-tax segment income was $98 million in the second quarter of '07, up from $86 million in the second quarter of last year. The pre-tax impact of Cats was $15 million in the current quarter compared to $20 million a year ago. Excluding catastrophes, P&C pre-tax segment income was $113 million in the current quarter, up from $106 million in the prior-year quarter, representing an increase of $7 million. Underlying this increase were higher losses, which were more than offset by a number of other factors. Losses were higher in the quarter due to higher current (inaudible) losses, which were partially offset by higher prior year favorable reserve development. Also contributing to improved earnings were lower loss adjustment expenses, higher investment income, and more favorable results from involuntary pools. Our Life companies posted earnings of $1 million from continuing operations compared to a loss of $1 million in the prior-year quarter. For the first six months of this year the Life segment earnings were break even. As you know we expect them to remain at break even for the full year.

Now let's look at slide 7 for a review of the P&C results, starting with a discussion of Personal Lines. Personal Lines pre-tax segment income was $56 million in the quarter, up from $54 million a year ago. The pre-tax net impact of catastrophes was $9 million in the current quarter and $7 million in the prior-year quarter. If you exclude catastrophes, Personal Lines pre-tax segment income was $65 million this year compared to $61 million a year ago, an increase of $4 million. Underlying this increase were higher losses that were more than offset by several other factors. Losses were higher in the quarter due to higher current accident year losses, which were partially offset by higher favorable development of prior-year loss and loss adjustment reserves. Current accident year losses were higher in this year's quarter by about four points. This increase was driven in part by the expected growth-related increase in personal auto. Additionally, current accident year losses in homeowners were adversely impacted in this quarter by large property losses.

Prior-year loss and loss adjustment reserves developed favorably by $22 million in the current year quarter as compared to $17 million a year ago, representing an increase of $5 million. This increase was driven by improved severity trends in personal auto and in our liability lines, primarily related to the most recent prior accident year. As I said, the current quarter's earnings benefited from several factors. First, loss adjustment expenses were $5 million lower in the current quarter, primarily due to lower technology expenses and lower expenses associated with the use of independent adjusters. Next, net investment income was higher due to an increase in operating cash flow. Lastly, we saw more favorable results from the involuntary reinsurance pool in Massachusetts.

Now let's look at Commercial Lines results on slide 8. Commercial Lines pre-tax segment income was $39 million in the quarter compared to $30 million a year ago. The pre-tax net impact of Cats was $5 million for this year and $12 million for last year. Exclude Cats, Commercial Lines pre-tax segment income was $44 million in the current quarter compared to $42 million in the prior-year quarter, an increase of $2 million. Underlying this increase were higher losses, which were more than offset by lower loss adjustment expenses. Current accident year losses were higher in this year's second quarter by about five points and were driven by the CMP, or commercial multiple [peril] lines. CMP losses are comparatively high this year due to higher large property losses this year and unusually low losses in the second quarter of a year ago. The favorable development of prior-year reserves was $13 million in the second quarter of '07 compared to $9 million a year ago. Reserves developed favorably across most lines in the quarter, with the largest increase seen in C&P. Lastly, loss adjustment expenses were $4 million lower in the current quarter compared to a year ago, resulting primarily from lower legal expenses and lower legal services reserve provisions.

Now briefly on production, which is on slide 9. Overall, net written premium was $620 million for the quarter, up 4% from a year ago. Commercial Lines net written premium was up 5%, Personal Lines was up 3%, and Marita will discuss this in more detail in a moment. Lastly, before I discuss or reiterate the guidance that Fred already provided, I'd like to comment on our exposure to the subprime sector. For us this is a very straightforward discussion. We are not an investor in subprime mortgages, either directly or indirectly through mortgage-backed securities. Additionally we are not an investor in CDOs and we're also not an investor in the credit derivative market, where you're currently seeing a reasonable amount of volatility. As you know we have a reasonably conservative portfolio and are primarily a fixed income advisor -- investor.

Now a moment on guidance. We expect mid digit-single growth in Personal Lines and mid to high single-digit growth in Commercial Lines. We expect catastrophes to be at 3.5 to four points. We expect an increase in the overall current accident year loss ratio of about three points, which is up from our previous guidance of two points. A 1.5 point decrease in the aggregate OUE and LAE ratios, net investment income $10 million higher than a year, an effective tax rate of 33% to 34% for the P&C business, and P&C earnings consistent with a levered 12% P&C ROE. As Fred said we now expect favorable developments for the full year of '07 to approximate the 2006 level. Finally, for our Life segment, we expect pre-tax segment earnings from continuing operations to be at breakeven and expect to generate $20 million to $25 million of dividendable surplus over each of the next two to three years.

And with those comments I'll now turn the call over to Marita.

Thanks, Ed. Good morning, everybody, and thanks for joining our call. I'm also pleased with our second quarter results. Our Property and Casualty business reported top-line growth of 3.6% and a combined ratio of 94.2% for the second quarter. Once again, these results are consistent with our objective of growing. while delivering solid returns and very consistent with our performance in previous quarters. As usual my comments will focus primarily on our profitable growth and my view of our prospects, so let's start in Commercial Lines.

In Commercial Lines we reported growth of 4.8% for the quarter, and as Fred pointed out, this figure is adversely impacted by about three points because of certain actions that we took in Louisiana, both last year and this year, that are affecting this comparison. Let me explain this. As you may recall, the regulatory environment in Louisiana was uncertain following Hurricane Katrina. The Louisiana insurance commissioner enacted an emergency ruling, spending the authority of insurance companies to cancel or nonrenew certain personal and commercial property policies. During this period we initially renewed many of our policies on a short-term basis. Subsequently, in April we converted all much these short-term policies to annual policies and recorded the incremental months of premium in the second quarter, so the premium in the second quarter of 2006 was unusually high.

As you know, the Louisiana ruling was enacted to create a stable environment in the aftermath of a major catastrophe, allowing the economy to settle and giving insurers enough time to make the appropriate renewal decisions. It was successful in doing this and now we have greater clarity around these issues. Consequently, our Louisiana premium will decline this year because of a combination of our own catastrophe management actions, using dynamic portfolio optimization models, and because many of the policies coming up for renewal were for businesses that were never rebuilt. While our full-year growth will reflect the effect of our exposure management actions in Louisiana, which were accounted for in our projections, the second quarter results are impacted more significantly. For this reason we believe that it makes sense to look at our growth numbers, excluding Louisiana, just for the second quarter.

Excluding Louisiana, net written premium growth was 8%. Once again Louisiana will cause downward pressure growth for the full year, but not to the extent that we saw in the second quarter, which is why we have confidence that we can deliver our high to mid single-digit growth commitment for the year. As in previous quarters, most of our growth came from the specialty lines that we have aggressively developed over the past couple of years. We reported strong growth in our inland marine and bond businesses, which grew 27% for the quarter. In the second quarter of 2007 we had $50 million in direct premium in these businesses compared to $39 million in premium over the same period last year. These lines now represent 20% of our Commercial Lines book, giving us better breadth and diversification of our earnings base and enabling us to compete in the current market while maintaining underwriting discipline. There's no question the market has become significantly more competitive, and our traditional drive lines showed lower growth than our specialty business. Retention for the quarter, excluding Louisiana, also improved 1.4% compared to the first quarter of this year and is now at 82.2%.

As the market continues to become more challenging, it is even more important to remain consistent and disciplined in our underwriting and we believe that we continue to balance the trade off between quality and pricing. You saw some compression in our accident year margins this quarter and as Ed pointed out, this is due primarily to two factors; some large loss activity and an unfavorable comparison, driven by unusually low losses in the second quarter of last year. Aside from these factors we are maintaining our margins in Commercial Lines. The Michigan economy continues to cause some pressure, but we continue to refine our underwriting to maintain profitability. We are constantly balancing pricing and underwriting discipline to maintain attractive margins, which is why the recent issue you see with large loss activity is not expected to be a long-term issue. At the same time we continue to focus our strategy to grow profitably through strong partnerships with winning agents and by providing agents a distinctive value proposition, by offering them superior service, ease-of-use technology and a broad suite of insurance products.

To that end we have some exciting new developments that are aimed at increasing our profitable growth momentum. The recent acquisition of Professionals Direct, although small in size, is exiting news for our agents. This acquisition gives us a leveragable product extension, allowing us to provide our agents immediate access to professional liability coverage for lawyers, and also enabling us to extend this capacity in the the future to other groups that are similar in nature. Additionally, we have entered into a partnership with AIG that will give us the ability to offer BOP miscellaneous professional liability coverage starting in August of this year, which will be 100% reinsured to AIG. Designed as an endorsement to our business owners policy, this product will cover consultants' offices, notaries, real estate and travel agents, thus further rounding out our Commercial Lines product offerings. These additional coverages with the ease-of-use delivery model will provide significant account rounding opportunities for our agents.

We have also recently launched our small commercial platform as planned, which we believe should provide us with some added leverage for profitable growth in the latter part of the year. This platform enables account view capabilities with up-front eligibility checks, automatic prefills for all lines of business on a single quote. This system has been in use for only a short period, so it's too early to share any results. However, agency feedback has been very positive, and we're optimistic that this new enhanced platform will increase new business production and ensure ongoing margin in following quarters. To conclude on Commercial Lines I would like to reiterate that we're very pleased with 5% reported growth. We have a lot of momentum in our business and initiatives under way that should provide some additional growth opportunities.

Now let's look at Personal Lines. In Personal Lines we recorded net written premium growth of 2% -- 2.8%, sorry, for the quarter and 4.9% year to date. In Personal Lines, as well, our quarterly growth rate was impacted by a change in our participation rate in the Mass CAR pool, the impact of which was to lower our second quarter growth rate of about a point. Excluding the effect of Mass CAR the second quarter net written premium growth would have been 3.6% compared to the prior-year quarter. I remain encouraged with our growth, particularly in light of the challenging market conditions, and I'm optimistic that we can appropriately drive the growth rate up during the latter part of the year. So let me explain the factors impacting production in the current quarter and also discuss the actions that we have under way that should provide a lift in the fourth quarter.

First, as Fred pointed out, second quarter growth reflects the impact of a 12% mandated rate decrease in Massachusetts personal auto. Of course this was not a surprise and was baked into our expectation for the year. In addition to the Massachusetts effect, our production was impacted by some corrective actions we started taking late last year outside of Massachusetts. As you will recall, last year we completed the rollout of our Connections Auto product in all of our key states. We implemented an aggressive rollout plan and the results in our states were very encouraging. Given the aggressive rollout, it's not uncommon to need some adjustments upon review of the new business that was written. You saw compression in our accident year margin this year. Some of it is related to large loss activity in the homeowners line, as well as the rollout of our Connections Auto product and the amount of new business associated with it.

Seeing indications of this trend, at the end of the last year we took actions that would alter the flow of new business being brought to us by some agents. These corrective measures were aimed to improve our new business mix, such as increasing the proportion of multi-car policies, driving whole account business consistent with our strategy, and increasing average premium size of a policy. We are starting to see the above improvements in our mix of new business. Additionally, we also took some pricing action, which is again not uncommon under the circumstances. While these actions will yield positive results, improving margins over time through better pricing and improved mix, we are at an inflection point now and you are seeing the impact of these corrective actions on growth and also on margin. At the same time some of our positive levers designed to grow more profitable segments haven't fully picked up yet. These positive levers include increased efforts in profiling books of business and converting agents to partners. I am already starting to see momentum on this front.

Additionally, we introduced our Connections Home product in ten states in April -- I mean with April effective dates. This new product, which primarily enhances the ease of doing business for our agents, was well received and should help us meet our growth objectives by enabling the agent to round out an account. We are already seeing an uptick in the hit rate on quotes for our homeowners policies with our new umbrella endorsement capabilities. There's no doubt that we are affected by the difficult market conditions and declining prices and a worsening homeowners market. Additionally, Michigan continues to be a challenging environment. The economy in Michigan is putting strong pressure on the insurance market, and we will have to work harder to maintain our market share in this core state. However, we know the marketplace, and we will deploy the necessary tools to remain a dominant writer with strong margins. Although it is very difficult to predict what the market and prices will do through the end of the year, we believe for the reasons that I've described so far that our third quarter growth will be similar to this past quarter's, whereas growth will gradually pick up at the end of the fourth quarter as some of our strategic initiatives take hold. And on an overall basis we still believe we will hit our mid single-digit growth guidance that we gave at the beginning of the year to the extent that the growth remains prudent.

And with they'll turn the call over to Sujata.

Operator, we'll now open up the call for questions.

(OPERATOR INSTRUCTIONS) Our first question comes if the line of Heather Hunt with Citigroup. Please proceed.

Thank you and good morning. I just wondered if you could talk about your winning agents. I know you said you're getting more gross from your winning agents than you have in the past. Can you identify how much of your premiums are coming from them versus the regular agents and how quickly your winning agents are growing?

I think, Heather, it's a matter of time to shift to winning agents. Right now we are seeing the majority of our growth coming from winning agents. Our growth from our winning agents is out pacing our overall agency plant probability by about twofold, as we shift to more partner agents, by giving them more attention, our best underwriters, and certainly our best product offering, as well.

So I think if you look at it, Heather, today we talked about the top 200 and then is cascading from there, but we had mentioned in the past, over the last twelve months we've grown about 20% with our -- what we call the winning agents, the core agents. But the vast majority of our growth now is coming from folks where we're one, two or three, a good 60%, 70% of it. So it is -- feels very good about how we're moving towards our partner agents and our volume and our growth.

And are you growing -- how quickly are you growing your pool of winning agents, as well?

We are -- it's a little bit different answer in Personal and Commercial, so in Personal Lines obviously we're in a lot of new states. So what you're seeing there, we ta -- we use the word conversion a lot because in many of these new states we have 100 or so new appointments over the last couple of years, and over time what we're doing is penetrating them and identifying them as partners, so those convert over time, Where in Commercial we probably haven't tweaked the list that much over the last couple years, maybe 100 or so across the whole network. And so what you're seeing us do is we have something -- we have different tiers of emerging partners, based on how much progress we're making with them. And so we're getting, I would say, a couple hundred that are converting, if you will in our nomenclature, from just regular agent to say really what we call emerging partner agents in the last couple of quarters, so there's really quite good momentum in that.

Yes, I think Fred's absolutely right. In Commercial Lines we had most of our future defensible partners appointed. We have profiled all those partners, and we are in the process of building business plans that talk about long-term maximum value, multiple-year plans that get us there. I think Fred's right, in Personal Lines we still, in new geographies, have some partners yet to be identified, but also have a strong list of current partners that through good business planning will maximize the results with these agencies.

Okay, great. Thanks. Are you seeing any incremental gain from smaller players that you've targeted as being weak and maybe going --

That's a good question, Heather. Right now one of the interesting things -- you've seen it the last three quarters, right? -- a pretty consistent shrinkage of small players, particularly Personal Lines and small Commercial, and what we're seeing is agents are getting nervous about their capabilities. And so for us that's why we talk about this in the fourth quarter. We have a lot of commitments now that are just emerging from people as they think about partnering with us that's starting to emerge in the third and fourth, because there was a little bit of a wait and see. In the last couple of quarters what you're seeing is there's a real beginning of a shrinkage and I guess a retrenchment, if you will, of these small folks that don't have capacity and capabilities in [multi-area] products, so we're actually seeing that quite a bit.

What's interesting is you're seeing it first in the places like Michigan, where the economy's a little tough and a lot of regional companies are just having real problems, which again gives you a little bit of an indication that we do believe that this momentum and the shakeout will occur, as it always does in this kind of soft market. We're in that place now where the folks that don't have good tiered products, the folks that don't have enough number one or two agent positions where they can get price increases, really start sliding to the side and you're seeing it. Again I would say that you're going to see it across the market in the next couple of quarters for sure.

Okay, great. Thanks. I will let somebody else ask some questions. Thanks very much.

Thank you.

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

Thanks and good morning.

Hey, Jay.

I just wanted to confirm a couple points on the guidance. First, on the premium growth, is that inclusive of everything or are you backing anything out in 2Q?

No, no, Inclusive of everything.

Okay. And then on the reserve releases when you say it's going to be consistent with 2006, are you talking on a dollar amount basis or combined ratio point?

Dollar amount.

Based on what you already put through in the first half, I guess that would imply a slowdown in terms of the pace of releases. Is there anything that you're seeing now that would lead you to that conclusion?

Yes, that's right. So you would see a slowdown in the pace and we've been talking about a slowdown in the pace, although we certainly didn't see as much as we would have thought in the first quarter and the second quarter. As we've said, the reason for that is that the reserving actuaries is -- they've been doing their picks over each of the last several years as they've seen at that time some of the then prior accident years reserve develop favorably, they tend to reflect that in lower picks in the more recent accident years or the current accident years. So over time -- and we've seen this phenomenon in our Company and others during hard market periods, where as a result of that you see less development over time, and that's what we're expecting. We haven't seen it yet but we continue to expect it.

I see, okay. And then the next issue is, first, could you comment on the pending changes in Mass auto, whether you find that to be perhaps more of an opportunity going forward? And then second, if you could update us on your conversations with A.M. Best and the positive outlook and what that could mean for capital management? Thanks.

Let me comment on Mass because we obviously are thrilled about it. We worked hard with the regulators in the state to make our state more like others, and I think this is a big step in that direction. It'll take some time to evolve, but in essence the more we're able to use data and information to segment and target accounts, the more we have a significant advantage. We are much better than many of the regional companies here in Massachusetts. We obviously have earned a lot of money. We know how to underwrite in Massachusetts, we've proven that over the last three years. And the ability to actually target and use some of the other things we've built in the other states get us pretty excited about being able to continue to grow profitably.

We also think that it [supports] that risk these single state companies that essentially played the game and didn't win anywhere else. They didn't have any of the technology or the data-type products, they didn't have any consumer facing things that you need in other states. A lot of these big players there don't have any of that. So, we've already seen a lot of agents come to us and say, wow, you guys seem to do this well, let's talk about how we work together. So we see that as a very positive thing for us, and over time I would like to see it to be -- attract other -- a larger company that would stabilize the market a little bit rather than continue to shrink the number of companies, and I'm not afraid of that. I'm actually pretty encouraged by what I see. So that's a very good positive.

On the outlook there's really no new news there. We have had good conversations. We now have in all three rating agencies positive outlooks, and if they go by their internal track, where they -- over the next twelve months, we feel very confident that we keep performing, there could be some good news on all that front. And as you know, we've outperformed the first half of the year from our expectations as far as earnings, which allow us to have additional capital on our balance sheet, and we continue to out perform our expectations that we've given them. So I'm encouraging by being in a very good position as we look toward the rest of the this year going forward. But we really don't have any additional information that -- and the more normal timing of like Best would be at the end of the year when they look at our numbers. I don't know, Ed, if there's any other comments --

Yes, I think that's right, Fred. There is no new news per se at the moment.

But again, when we meet with them every quarter with our results, we -- you know what our guidance was at the beginning of the year. We've outperformed that in the first half of the year. We have more cash, more capital on our balance sheet, so all of those trends are good, obviously when you're having the conversations with them that we're doing everything we said. The expense issue that we've always talked about, we're right on track to do exactly what we said we would do. So very good conversations and I feel great about it. I think it's -- again by the way, when that happens that's another uptick for us with our agents, which I expect to see next year.

How would you prioritize the potential excess capital situation, growth opportunities versus maybe buying back your stock at 1.1 times book?

Yes. I think that as we've said, as we get to the end of this storm seas -- the storm season unfolds and we look at our capital situation, we will have to the conversation with the rating agencies to determine what to to do. If I felt that there was some growth opportunities that could exceed cost of capital, obviously I'd be excited about those, whether it's specialty companies or other things that could enhance our ability to grow and out earn our cost of capital. But obviously, we would also consider -- whether it's share buybacks or dividend increases, et cetera, that are appropriate, given the fact. As we've said, we have not gotten any indication that we need additional capital on our balance sheet for any of these rating actions, so -- and obviously, if we have a good year, the math would say that we have more capital at the end of year than the beginning of the year, so obviously all of those options will be considered seriously as we look at the end of the year like we did last year. And again, Ed, is there something else we should --

Yes. No, the only other opt -- I think that that's right. The only other observation I'll make now, Jay, and I've made this before is that if you look at -- if you look at our statistics and you particularly look at operating leverage, we're more levered -- slightly more levered than other companies that are similarly rated. So you're seeing a lot of companies that are doing substantial share repurchases in an environment where they're not growing their top line and they're struggling, quite frankly, with their earnings, but they're in a position where they've got a one-to-one premium surplus ratio or better. Our business profile is different. We're growing the top line. We're investing in the business and its reflected in the expense ratio -- in the expense levels, which is improving in the ratio as we get growth. But this is a growth story, and we begin at a point where on operating leverage basis we're more levered than the average. So I just -- all of that, together with everything that Fred's mentioned, comes into the mix when you think about what the right actions for this Company around share repurchase.

And I would -- one other thing I would mention, our strong premise here is -- what we've tried to build here is boring earnings growth, and what you're going to see is a lot of volatility in weaker companies and more companies whose mix, where it's not as solid. And in my view, you're going to see some especially good company valuations. Because of the cycle, companies with good capabilities, their valuations are going to change dramatically. We've already seen that. obviously. The market's a little odd right now, trying to figure out who's going to sustain value and who's not. And so for us, as we can continue to perform and demonstrate we can continue to perform, I think it could create lots of different opportunities for us. Again, I go back to the premise that this is about creating sustained shareholder values, so you decide which way to go based on what's available to you, and we will absolutely do that at the end of this year.

All right, thanks for the answers.

Thanks, Jay.

Our next question comes from the line of Dan Farrell with Fox Kelton. Please proceed.

Hey, Dan.

Hey, good morning. I apologize if I missed this in your comments, but can you just give a little more detail on the larger losses that you saw in homeowners and commercial, the nature of those losses and how much of a point impact it was on the loss ratio, and also why you think they're a short-term phenomenon?

Yes, just impact and just talking about this generally, from a Commercial Lines standpoint, the statistic is probably the lumpiest statistic that you have month to month. We do not expect that to continue. It was an unusually high month. There's no trend in the losses when you look at the them loss by loss. And in addition to that, as we stated, we had a very unfavorable comparison to a very good quarter the year before, so there's nothing in the Commercial Lines property large losses to let us think that that's going to continue, and really nothing trend wise. From a homeowners perspective, some of it has to do with where the market is going in homeowners. Again, not a clear trend, not a big concern, something that we'll watch as it relates to homeowners and pricing, but really nothing that is concerning us at this time from a large loss perspective. Quarter to quarter, month to month, property large losses, especially ex Cat, do tend to be pretty lumpy and bounce around a little bit. We spent a lot of time and energy dissecting it, and there's really not a lot in it that concerns us from a trend perspective.

And, Dan, what we do -- obviously these things you always look for patterns, right, whether it's geography or type of risk or a profile of the insurer, and there really was nothing, and value of the house. There really wasn't anything, and again, you have this occasionally and we had some of it, so I -- it's something we actually tear apart and so there was really nothing that we saw that made us pause and say this is a trend that we're going to see.

Would you say it was a point of negative impact, a half point on the loss ratio? Was there any general sense you can give us?

Well, year over year in Commercial Lines we saw a five-point increase in the current accident year. I would say that's probably a -- of large loss we've seen in C&P it's probably a couple of points of that.Moer of it had to do with the unfavorable comparison. On Personal Line where we saw -- what was it, a four-point increase?

Right.

-- in the current accident year. I'd say about half of that was large losses and half of that strain, given growth in Connections.

Okay. And then just broadly on the accident year loss trends, when you initially said you were -- you expected accident year loss ticks to go higher a couple of points this year, you said one of the drivers was a lot of new business that you were putting on the books, and I think first quarter call you mentioned that you hadn't actually seen paid trends backing that up, that the paid trends hadn't been changing. Are you seeing changes in that now or is it just your expectation that at some point the real losses will tick up?

No, we're starting to see it now, which is what's -- which is in part what's driving us to what we're now seeing is a three-point increase year over year on the current accident year.

Like we stated in our comments, we have taken some of the actions expecting this, but we are starting to see some of the that come into the second quarter. A lot of these actions are already put in place to begin to counter that.

And again, it's more Personal Lines than Commercial Lines.

And, Dan, you've seen what we do over the last two, three years. We have -- obviously we try to price for it, we try to be conservative in the way we think about it, because we're trying to grow our business and trying to be thoughtful about the price point and how we think about our accident years, given that. And I feel good about how we're managing it and how we're thinking about it.

Okay. Thank you, guys. That was helpful.

Thanks.

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

Good morning and thank you.

Hey, Larry.

Fred, I think in the past you've talked about earning your cost of capital -- which I think you put about 12 -- through thick and thin, and without really wanting you to get into guidance, I guess just generally, given what you're seeing in the marketplace right now, do you have concerns about being able to do that, given market conditions and trends, over the foreseeable future, recognizing that you've committed to 12 or so for this year?

Yes, yes. No, it's a great question. It's obviously the reason we talk so much about not just winning one risk at a time and new-new, and how we talk about getting balanced with partner agents and being able to get out of the new business market and doing it through renewals and how we think about -- help an agent think about their books and weaker players and moving business over intact. And as you look at our business mix, one of the things that you know we did is I got us out of most of our large businesses right away, in the the first year I was here, because of the price sensitivity. We changed our mix away from business that is tended to have a lot of ENS swing and the type of exposures they were.

Our whole strategy is geared to take advantage of this kind of market. Those companies -- those regional companies that have been a little trash collector that have taken on the bad or the worst risk to keep hanging in there and grow and be worthwhile to the agents, those guys are coming under pressure. And what we believe is that if we do what we're doing with rounding out accounts in Personal Lines and on Commercial Lines, leveraging some specialty capabilities and our operating model's rapid response and book thinning capabilities, that we can earn that cost of capital.

Now, if we can't, we're going to do something different, but what you've seen historically from us with much less product and what's much less capability is an ability with a pretty high expense ratio to out price and get enough premium price with partners to make these investments and get to the improvement we're in. So I still believe right now that we are in a very good place because this is the kind of market where people start to create the disruption. I would tell you that most of the stuff is small face-value stuff, so it didn't go up as much and it doesn't go down as much, okay? So, yes, it might change two to three points here and there, but I'll tell you, it doesn't swing as much and when you look at what's happening in Personal Lines in everybody's results, what's interesting to me is everybody's talking about trying get rate, right?

You've seen the winning companies and the stable companies all understand that frequencies kind of turning on them and it's getting to be moderate but it's not shrinking any more, and so what you're going to see is people start taking pricing action, and it's inevitable that the guys that are weaker with three-tier products can't do that effectively. It's the guys that have a broader product that have more accurate pricing that can get one or two points now. These other guys that are hanging on are going to keep shrinking. Again, it's inevitable.

So my view is what -- the things we said we were going to see we are seeing. If I see it going crazy, we obviously will change our perspective, but see, I'm not -- the people that are overstating these swings are the folks that tend to have large accounts, a lot of ENS business. In the core lines what you're seeing is -- is it pressure, sure, Is it competitive, yes. But the trend towards better players and agents trying to move stuff to better players is there, and I'm more convinced today than I've ever been that we are in a very good spot. And I tell you, this whole specialty -- so many people, the specialty teams and stuff, are talking to us about joining our Company and getting -- being part of our Company because they can see what we're doing as being unique, kind of like Chub, combining specialty with flow business, stabilize your profit flow.

So again, it's a journey. Every day we work at this. We obviously still have some expenses to get out of our system. We still -- we just the first quarter introduced the homeowners product, Connections Home. We just introduced the new Personal Lines small commercial products. So we're still a little bit of work in progress, but I see a lot of transparency to continued earnings, and -- but again, I think it's a great question because for us I'm want here to grow the business at low returns. And as you know, our long-term compensation executive is three-year average 12% return through the cycle on performance shares, and it's because we believe in that. We believe that's required to be able to justify continued growth. So, while it's difficult, I'm very optimistic about where we are. I can -- and as I said, I look at people's results and it's so clear we're in a much better position in so many ways than these small regional companies that are having to take actions right now because their mix isn't very good and they didn't -- they weren't conservative enough about how they did pricing and set it up and they're running into the wall, and I don't see us there at all.

Thanks very much on that. Also, just with this AIG relationship and the structure of the contract, I understand 100% reinsured, so it's really more to round out product offerings to your agents, but are there profit contingencies in there? Can you make money on this thing?

Yes.

Oh, yes.

There's definitely fee income associated with this, but the key play for us -- gravitating towards more options for fee income is definitely something that we think about and will do more of. But the real play is, as you mentioned, being being able to round out the accounts, being able to have one more reason why agents want to convert books of BOP business to us because we offer a product and a capability that somebody else doesn't, and the ability to put a few hooks in our new small commercial platform, as we roll it out. So we constantly look for ways to find those capabilities for agents that might not exist in some of the other companies' BOP portfolio.

And there'll be a number of these classes that nobody else this. We worked on this for a year with them. 'It is not exclusive, but we're way ahead of anybody doing anything. We're the first one they've done it with, a lot of these no one else has that. And again, if you think about today's market, say you have a $5,000 BOP and a notary, you can throw a couple hundred dollars on it. All of a sudden you're selling something nobody has, it's not as price sensitive, and the young producer has something to sell. It also allows an agent, as they look at book of business, to hold their renewals, right, with stuff they currently have by talking to these agents, not about shopping again but enhancing their coverages a little bit in this kind of market. And so it's the perfect thing to increase retention, increase revenue, and allow us to get agents to move things in our direction. And again, for me those kind of things are different than a regional company that can barely automate their BOP. So I feel pretty good about stuff like that that enhances our value proposition enough to increase retention and increase growth a little better.

Thanks very much.

Thanks.

Our next question comes from the line of Cliff Gallant with KBW. Please proceed.

Good morning.

Good morning, Cliff.

Most of my questions did get answered. Maybe you can talk a little more about the expense ratio improvements and how much more room you think you have there?

Yes, Cliff, we've -- I've talked a lot about saying -- I think that on the OUE side we were three points. If you look at our overall expenses there was -- I really believe that we had invested 3% incrementally as a company -- actually in total -- and I committed this year to get 1.5 out. I think next year our goal is to get another one out, because again, we put all of this stuff in to improve throughput. We've done it to automate and create more variable costs like we did in IT. I think we showed you just today the -- literally the structure of our economics and technology and how we got a big improvement there, so I believe that we're going to get another one next year, and another one after that. We're going to continue to work that lever, because obviously we've always planned on doing it.

The big -- the last big remaining investment that's kind of unusual has been this claims investment that we're in the middle of this new operating model that's being implemented this year. And so I feel that we're going to get -- deliver on our commitment this year and we;ll have more room next year. And -- see again, why I feel and -- we'll get our margins and I look at what we're trying to do, I think it gives me some clarity in our ability to -- say on the expense side to continue to improve as we move forward. But there is more room, as we've said to you guys before. We clearly knew we invested, we know where we invest it, and we're being thoughtful about getting it some this year, some next year and the year after.

Thank you. I want to say good luck to Ed and nice job keeping the Company out of the subprime mess. (LAUGHTER)

Thanks a lot, Chris.

This will now conclude the Q&A portion. I would now like to turn the call back over to Sujata Mutalik.

Thank you, everyone, and thank you again for joining our call. And of course, if you have any questions, feel free it call us. See you again next quarter.