Hanover Insurance Group Inc (THG) 2008 Q2 法說會逐字稿

Good day, ladies and gentlemen, and welcome to the quarter two 2008 Hanover Insurance Group earnings conference call. My name is Michelle. 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 today's conference. (OPERATOR INSTRUCTIONS) As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the presentation over to your host for today's conference, Ms. Sujata Mutalik. Please proceed.

Thank you, operator. Good morning and thanks for joining our call for the second quarter earnings conference call. Participating in today's call are Fred Eppinger, our President and Chief Executive Officer, Eugene Bullis, our Executive Vice President and CFO and Marita Zuraitis, President of Property & Casualty Company. Before I turn the call over to Fred for a discuss 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, the 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 a questions in a 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 facts that could cause actual 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 statement section in our press release and slide two of our presentation deck. Today's discussion will also reference some non-GAAP financial records such as segment income after taxes, total segment income and segment results excluding the impact of catastrophes, ex-cap loss ratios and accident and 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 of 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, everyone. And thank you for joining the call today. I am very pleased with the second quarter results. After tax segment earnings were $55.5 million or $1.07 per share. Combined ratio was 95.5% and annualized P&C levered operating return on equity was 13%. EBIT and premium growth exceeded 3% for the quarter and was in line with our expectations given the competitive market conditions. Additionally, as you know, we announced yesterday we have entered into a definitive agreement to sell our remaining run-off life business to Goldman Sachs -- a Goldman Sachs entity, resulting in a modest GAAP loss as expected, while generating about $220 million of incremental liquidity for us at the holding company. This provides additional financial flexibility for us and allows us for more efficient capital management. Gene and Marita will review the specifics of this quarter's results in their remarks.

My comments will focus on how we are faring relative to our expectations so far this year and, taking into consideration the market challenges, why we believe we can continue to compete successfully and outperform the industry and many of our peers. We withstood the highly active cat quarter well. Our cat losses of $38 million, while very high for this quarter, was at the low end of our expected range given the overall $6 billion reported loss sustained by the industry and our market share and the affected geographies. I think everyone knows that Michigan was one of the places hard hit. As you know, cat management has been one of our priorities for the past five years and we have taken many steps to diversify and manage our cat exposure. We continue to proactively manage our cat concentration using model data to set underwriting guidelines for out field and to monitor the quality of our growth. We've also restructured our reinsurance programs to make them more effective. Overall, we have made meaningful progress, which we believe should lead to lower earnings volatility and give us a meaningful advantage over the regional companies that are overly concentrated.

Additionally, our ex-cat underwriting performance has improved significantly and is a reflection of the high quality of our underwriting teams. We have demonstrated our ability to make the right decisions, balancing our growth objectives with the importance of maintaining margin. Our ex-cat accident year loss ratios have improved through the first half of the year and we expect to maintain an improvement for the full year. Additionally, we continue to sustain favorable development of prior year reserves. Both our ex-cat accident year loss performance and our track record of consistent development speak to our underwriting strength and our conservative approach to pricing. We will be relying on these skills even more as we successfully compete in today's challenging economic environment.

Our financial position remains strong and gives us greater flexibility in the market. Companies are being challenged not only by the soft P&C cycle but with the added pressures arising from the disruption in the financial markets. We remain very pleased with our investment portfolio. We have highly diversified, predominantly fixed income portfolio, one that has no exposure to subprime mortgage risks. Furthermore, we are pleased to be one of the few companies to receive financial strength rating and debt rating upgrades from both Moody's and S&P this year. Moody's upgraded us in January, as you know, and S&P upgraded us in June. This third-party market validation of our financial position stands out. While the pace of our success is being challenged by today's market conditions, our performance under these conditions further validates the soundness of our strategy. More than ever product distinctiveness, strength of agent partnerships and the effective operating model that efficiently deploys professionals and rapidly responds to unique opportunities will be the differentiating factor for our Company.

Clearly, there is a coming disruption in the marketplace that will create tremendous opportunity for strong companies. But in today's market, going head-to-head for generic middle market or large business or competing on price with thousands of agents with an undifferentiated auto product, will put a significant strain on returns. We are positioned to compete in a more effective and distinctive way. You've heard me say this before. We have not had the luxury of this journey during a hard market, so our Company has been built to withstand tough competitive pressures. We have worked diligently to develop a product offering that is complete and offers distinctiveness to our mid-sized partner agents and, at the same time, we have substantially improved our operating model and agent facing technology, enabling us to compete on ease of service and ease of doing business. Leveraging these tools, we continue to form new and deep and existing partnerships with agents in a very thoughtful manner. You are seeing the difference in our growth with a 3.3% net premium growth in the second quarter. This growth came primarily from our commercial specialty lines and was supported by strong renewal retention in both personal lines and core commercial. In addition, we see strong growth with partner agents that are consolidating their own market.

Personal lines growth was just under a percent for the quarter, which lines up well with our expectations for the quarter and is consistent with our overall expectations of flat growth for the year. As we discussed last quarter, we have four states in our portfolio that would be challenging from a growth perspective. Michigan with its weak economy and shrinking personal lines market presents a significant challenge. Additionally, our coastal exposure management actions in Florida and Louisiana have and will continue to have an impact on our growth rate this year, but they will also help us with our long-term margin. Finally, in Massachusetts we are transitioning so a new competitive market, as you know, in which we have filed an average 8% rate decrease. However, we fully expect to offset this rate pressure with increasing pith counts by the end of the year on the strength of our value proposition. I am convinced we are the best company for winning independent agents in Massachusetts and our sophisticated product approach and limited distribution strategy will help the best agents win. Outside of these four states, we continue to see the validation of our strategy leading to positive growth momentum. This growth is driven by an improvement in renewal retention and a new business production that has remained stable with -- and with partner agents contributing significantly to the flow of our new business. All in all, we expect our personal lines growth will likely be flat to marginally up for the year. And we expect to deliver on our overall growth guidance of mid single-digit growth in the aggregate by leveraging strong commercial lines business segment growth and continued growth from targeted personal lines states.

Turning to commercial lines, we grew 7% for the quarter which is in line with our expectations. This growth reflects the impact of our specialty business growth from our investments in individual professionals, our small acquisitions of Verlan and Professional Direct, as well as an increased growth from our partner agents as they leverage our capabilities for their own growth. Growth in our specialties was 14% in the quarter and we expect it to accelerate through the year. Renewal retention in our core business also remains strong for the quarter despite highly competitive pricing pressures. Of course we're affected by the market conditions, particularly in the middle market commercial segment where pricing and competitiveness continues to be intense. At the same time, we continue to maintain a positive outlook for commercial lines growth on the strength of our specialty portfolio and from excellent positioning of our small commercial platform. We have made significant upgrades to our small commercial model and platform during '07 and with many of those enhancements which included more pricing and ease of doing business, the performance in our small commercial business has started to gain traction and we expect to gain further momentum as the adoption of this enhanced model continues to increase with our existing and new partners.

Overall, I am pleased with our progress. We are tracking well against our expectations of margin and growth. We are seeing good traction against our strategy despite the market. The somewhat slower pace of growth, along with the greater focus on specialty, is putting a little bit of pressure on the pace of improvement and our expense ratio. While we continue to gain operating efficiencies, we also believe that it is in our best long-term interest to continue to make opportunistic investments in our business platform, thereby positioning us well to take advantage of the disruptions that we are beginning to see. Because of the solid loss performance I see sustaining this year, I believe we can make some incremental investments and capitalize on some of the opportunities while generating solid returns with a combined ratio in the mid-90s. It remains our objective to get another 1 to 2 points out of our core expense ratio, however it will take a little longer to emerge because of the investment we plan on taking in the next two quarters -- or making in the next two quarters. Before I turn the call to Gene, I want to comment on the FAFLIC transaction. I am very pleased with the outcome of the deal. It improves our capital structure. It eliminates a significant element of complexity and confusion in understanding our business. And we were able to obtain this outcome with the right economics and an excellent outcome for our life policyholders. I am glad that we have the additional liquidity provided by this transaction, which we'll put to work to increase shareholder value either by strengthening our P&C franchise through strategic acquisitions, by returning excess capital to shareholders in the form of additional share buybacks or some combination of the both. With that, I will now turn the call over to Gene for a financial review of the business.

Thank you, Fred. Good morning, everyone. As usual, a slide presentation of the accompanies my remarks and I trust all of you have this available. Please turn to slide five for review of our recent announcement on FAFLIC. As you know, yesterday we announced the sale of our remaining run-off life business, First All America or FAFLIC to Commonwealth Annuity, a Goldman Sachs company. We've been working towards this for sometime and we are very pleased with the outcome. Commonwealth Annuity is a company that has worked well -- we have worked well with before. As some of you may recall, in 2005, we sold our variable annuity business to Commonwealth Annuity. This transaction is expected to close in the fourth quarter of 2008 and is subject to regulatory approvals that are customary for such deals. The businesses included in the FAFLIC sale are the closed block of traditional life insurance policies, group retirement business and guaranteed investment contract businesses. Hanover will continue to retain FAFLIC's accident and health assumed pool business through a reinsurance agreement. The accident and health business has been in run-off since 1999 and its projected total net GAAP insurance liabilities of about $130 million represents about 10% of the total insurance liabilities of FAFLIC.

As we announced in our press release, we expect total net proceeds from the sale including preclosed dividends to approximate $220 million after certain transaction costs and intercompany account settlements. The connection with the closing of this transaction, The Hanover is seeking approval from the Massachusetts Department of Insurance for a pre-close dividend consisting of various assets valued at approximately $160 million. The Company expects to sell the majority of the dividend and assets such as the home office building, certain tax attributes and other assets that were held at FAFLIC to its wholly owned subsidiary, Hanover Insurance. Both the proceeds and this dividend are expected to increase liquidity at the holding company by approximately $220 million. The transaction is also expected to result in a projected net after-tax loss of approximately $66 million. The rating agencies have responded very favorably to this transaction and our financial strength ratings and ratings outlook were affirmed by Best, S&P and Moody's in their public comments issued yesterday. Specifically, they viewed favorably the increased liquidity resulting from the monetization of the capital in the run-off business which could otherwise only be released through occasional dividends and they also recognized that the sale was expected to have only a modest impact on Hanover Insurance's capital adequacy and profitability. We were very pleased with this response.

Pursuant to FAS 144, accounting for the impairment of disposal of long lived assets, we have now classified the for sale FAFLIC entity as discontinued operations and have reflected the $66 million estimate GAAP loss in our second quarter financials. Turn to slide six for review of our second quarter financial results. We reported an after-tax net loss of $10.2 million or $0.20 per share in the second quarter of 2008 compared to net income of $59.8 million or $1.14 per share in the prior-year quarter. The current quarter's net income reflects the estimated loss on the sale of FAFLIC of approximately $66 million or $1.27 per share. Additionally, net income for the current quarter also included a gain of $11.1 million or $0.21 per share, resulting from the sale of our premium finance business AMBRO that closed in June of 2008, as well as net realized investment losses of $7.6 million or $0.15 cents per share, primarily from increased impairments. This increase in investment impairments in the current quarter was attributable to credit market conditions and was not directly associated with financial institution issuers.

Turning to segment income after taxes, which now represents the results of our ongoing P&C operations and excluded realized gains and losses from investments. Earnings were at $55 million or $1.07 per share for the second quarter. This compares to $56.7 million or $1.09 per share for the second quarter of last year. Turning to slide seven. Our property and casualty business generated $94 million in pre-tax income, down from $96 million in the prior year quarter. Pre-tax catastrophe losses were $38 million in the current quarter or $23 million higher than the prior year period. The interest expense on our long-term debt remains unchanged at $10 million and our GAAP effective tax rate remains steady at 34.5%. Now let's turn to slide eight for a review of our segment results starting with discussion of personal lines. Pre-tax earnings from our personal lines business were $39 million in the current quarter compared to $55 million in the prior-year quarter. Catastrophe losses were $24 million in the second quarter of 2008 compared to $9 million in the second quarter of 2007. Excluding catastrophes, segment income was $63 million in the current quarter compared to $64 million in the prior-year quarter. Excluding catastrophes, current accident year loss margins improved by about $3 million in the quarter. And the ex-cat current accident year loss ratio was 57.4%, down 1 point from the prior-year quarter, driven by improved homeowner severity.

Large losses in our homeowner's line were at normal levels in the current quarter compared to a high incidence of large losses in the prior-year quarter. Partially offsetting this improvement in severity was the high incidence of non-cat weather related losses, predominantly in homeowner's again. We quantify the impact of these non-cat weather related losses to be about 1 point on our overall accident year ratio in the current quarter. We noticed good improvement in personal auto frequency, not unlike what we're hearing from others. There is certainly some valid speculation about improved auto frequency being driven by high gas prices and lower mileage driven. This could well be true, it's too early to tell. We are tracking these trends. We are not reflecting it in our pricing or our reserving yet. Prior-year loss in LAE reserve development was favorable by $21 million in the second quarter of 2008, down $2 million compared to the same quarter of 2007. Prior-year reserves continue to develop favorably across all lines. The favorable development in prior-year reserves is predominantly in our auto line and relates to our more recent accident years.

Finally, expenses were about $2 million higher in the current quarter, primarily due to higher loss adjustment expenses resulting from a larger number of cat and non-cat weather related losses. Turning to commercial lines on slide nine, pre-tax earnings from our commercial lines business were $53 million in the current quarter, compared to $39 million in the second quarter of 2007. Catastrophes were $13 million in the current quarter, compared to $5 million in the second quarter of 2007. Excluding catastrophe, segment income was $66 million in the current quarter or $22 million higher than the prior-year quarter. This increase in commercial lines earnings is primarily due to improved ex-cat accident year loss margins. Our ex-catastrophe accident year loss ratio improved across all lines and was 43.9% in the current quarter compared to 50.1% in the prior period's quarter. This improvement is attributable to lower loss severity and growth in specialty lines, as the lower specialty loss ratio continues to favorably impact our ex-cat accident year loss performance arising from the correlated mix shift. In addition, losses in last year's second quarter were unusually high, due to high incidence and large losses in our C&P line.

The favorable development of prior-year reserves was $16 million in the second quarter of 2008, compared to $13 million in the prior-year quarter. Reserves developed favorably across all lines with the improvement coming principally from our commercial multiple peril and worker's comp lines and related primarily to more recent accident years. Debt investment income was up $4 million in the current quarter, primarily due to the transfer of employee benefit related assets and liabilities from FAFLIC to Hanover Insurance at the beginning of the year. These earnings improvements were partially offset by higher expenses. Underwriting and loss adjustment expenses were higher, resulting from the continued investment in specialty lines which include the integration of our recent specialty acquisitions, which carry a higher expense ratio relative to our existing book which is the flip side of the mix shift benefit on the loss ratio. Turning to slide ten for a recap of our key underwriting ratios. Our combined ratio was solid at 95.5%, up one point from the prior period despite significantly higher cats. Six points on the combined ratio in the current quarter compared to two points last year. Offsetting this is a solid three-point improvement in our ex-cat accident year loss ratio, which is at 52% for the quarter. Favorable development of prior-year loss reserves remain consistent and contributed over six points of benefit to the combined ratio of both periods.

Our culture of strong underwriting discipline is evident in this these ratios. Our expense ratio is short of our guidance driven by several factors, including increased specialty growth, the disadvantage for moderately lower or premium growth and our ongoing investments in the operating platforms that are all targeted to improve our long-term position. While we remain committed to our objective of reducing the expense ratio in our core business by two points over the next 24 months, our objective is to deliver combined ratios to balance the maximization of short-term returns with investments that improve our long-term prospects. As Fred indicated, we'll most likely fall short of our goal to improve our expense ratio by one point this year for both LAE and OUE combined. We expect to come in flat to our full-year ratio of 43.9% in 2007. However, we will continue to position ourselves for expense ratio improvements as our business model productivity and growth strategies take hold. Overall, net written premium was $641 million for the current quarter, up 3.3% from the second quarter of last year. So overall growth is in line with expectations and is supported by growth in commercial lines of 7% primarily from our specialty business and an uptick in our personal lines growth to 1%, arising primarily from improved retention. Marita will discuss production in more detail in her remarks.

Turning to a review of our investment portfolio, the quality of our investments portfolio remains solid. The Company holds $6 billion in cash and investment assets at June 30th, 2008, which includes $1.3 billion of FAFLIC assets that are classified as held for sale. Six maturities represent 91% of our investment portfolio with a carrying value of $5.6 billion. 94% of our fixed maturity portfolio is rated investment grade. We continue to have no exposure to investments in subprime mortgages or subprime mortgage backed securities and little or no exposure to the secondary credit risk presented by financial guarantors. Residential mortgage backed securities constituted about $1.1 billion of our invested assets, with less than 15% held in non-agency securities. Commercial mortgage backed securities constitute $468 million of our invested assets Approximately 92% of our CMBS holdings were from pre-2005 vintages with 5% from 2007, 3% from 2006 and no 2005 vintage. Our entire CMBS portfolio has a weighted average loan-to-value ratio of 67.1%. As of June 30th, 2008, we held $808 million of municipal bonds in our portfolio with an overall rating of AA minus. Financial guarantor insurance enhanced municipal bonds represent $356 million or 44% of this portfolio. The overall credit rating of our insured municipal bond portfolio, giving no affect to the insurance enhancement, was A minus.

Finally, let me turn to slide 15, which is a new disclosure on agency securities. We hold $1.2 billion in agency securities of which $1.1 billion represents ownership in Fannie Mae or Freddy Mac issued or sponsored securities. Our position consists of $951 million of mortgage backed securities and $174 million of non-subordinated senior debt. We have no investments in that preferred stock or equity. Moving to slide 20, on this slide, we have some key metrics that outline the strength of our balance sheet. You see a slight contraction in the book value at June 30th, 2008, which is due to the estimated nonrecurring loss on the sale of FAFLIC of approximately $66 million or $1.27 a share. Excluding AOCI, shareholder's equity and book value per share were up, even with the FAFLIC loss. Our debt to total capital was up slightly, resulting from the write-down of FAFLIC but it remains solid and reflects our exceptionally strong capital position. Liquidity at the holding company will improve significantly after the FAFLIC holding and completion of our related transactions. Holding company cash and cash equivalents were $262 million at June 30th and is expected to increase by $220 million as a result of the FAFLIC transactions.

This additional liquidity will not be available until some time in the fourth quarter. By that time, the hurricane season will also be behind us and we will be in a much better position to evaluate our alternatives and will have more to say about capital management at that time. In the meantime, we have continued our stock buyback program and have repurchased 1.4 million shares so far for approximately $60 million and have $40 million available under our current authorization. Before I turn the call over to Marita, let me recap our outlook for their. We maintain our guidance on net written premium growth. We expect mid single-digit growth in commercial lines and we expect to grow in personal lines to be relatively flat for overall net written premium growth of mid single digits. We now expect our aggregate underwriting loss adjustment expense ratio to be flat with 2007's ratio. However, we still expect to achieve modest growth and operating earnings per share, assuming normal cats for the remainder of the year. In summary, even with difficult market conditions, we believe our business platform will be capable of delivering above industry average results. With that, I will turn it over to Marita for a for a review of our property casualty business.

Thanks, Gene. Good morning, everybody. And thanks for joining our call. We had another solid quarter as you can see from last night's release. And I'm particularly pleased with the strength of our earnings, despite a high level of catastrophe losses in the quarter. Catastrophes contributed over six points to our combined ratio yet our overall combined ratio is 95.5% reflecting strong underwriting. Our ex-cat ratio accident year loss ratio was under 52% for the quarter or three points better than the prior year quarter and favorable development of prior-year reserves continue to remain solid. I'm proud of our discipline underwriting teams, who have maintained a solid book of business under challenging conditions while delivering growth consistent with our expectations. This high quality underwriting provided us the flexibility to absorb unseasonably high catastrophe losses while still exceeding our targeted return on equity.

Let me provide a little more color on the $38 million of catastrophe losses sustained in the quarter. As you know, this was a sizable event for the industry with over $6 billion in reported losses in many state as cross the country. In most of these states we have meaningful presence. However, about a third of the catastrophe losses in the quarter were from the storm that impacted Michigan, where as you know we have the fourth largest market share. Our overall losses and losses from individual storms that impacted the quarter were either proportionate or lower than our market share would indicate. Catastrophes are part of our business, which is why we have spent the last five years managing this risk and diversifying our exposures to minimize earnings volatility and preserving our capital. I'm pleased with how we have fared through this highly active cat quarter and it gives me confidence that our efforts focused on reducing concentration, the non-renewal of our Florida home business, managing concentrations of business in our core states like Michigan and New York, strengthening our underwriting guidelines through proactive use of model data and the close monitoring of the increased exposures in our new growth states like Georgia, Virginia, and Illinois are being effective.

While we actively manage exposure to improve our risk profile, we are equally committed to honoring our obligation in the event of a loss and being thoughtful about the needs of the affected parties. Our claims teams were highly responsive during this active cat quarter and our efforts were recognized by our agents and their customers. There's always a randomness where catastrophes hit, which is why careful exposure management is not enough and has to be combined with the right reinsurance structure. Our second quarter performance, along with the changes we've made with our catastrophe reinsurance treaty, give me added confidence with our ability to reduce earnings volatility and preserve capital through this hurricane season which has been predicted to be an active one. At this point, I'd like to update you on the latest change we've made to our cat treaty. Effective July 1st, we bought an additional $200 million in limit for our northeast exposure. This is in excess to the $700 million limit we purchased at the normal 01/01 renewal date. This layer has a 45% Hanover co-participation and increases our coverage tower to $900 million for the northeast. With this added layer, our reinsurance limit will cover us for a 1 and 250-year event. We were able to purchase this top cover at a competitive price of $3.5 million and we feel good about this additional balance sheet strength.

Let me now turn to a discussion of each of our business segments, providing some insight on underwriting profitability and growth in the quarter. Our personal line segment recorded net written premium growth of about 1% and a combined ratio of 98.4%, which includes almost seven points of catastrophe losses in the quarter. Despite this, our accident year loss ratio improved by one point relative to the second quarter of 2007. Favorable development if prior-year reserves was solid at $21 million and comparable to the prior-year quarter. Loss trends showed modest improvement, driven by improvements in both severity and frequency despite the higher incidence of non-cat weather losses. We continue to be take pricing action in most of our states and earned pricing remains stable at about 1.5% in the quarter. This figure includes Massachusetts with its average 8% rate decrease. Excluding Massachusetts, earned pricing would have been 2.8% in the quarter.

Now turning to growth. Personal line growth of about 1% is in line with our expectations given the current market conditions. And I'm also pleased that this growth reflects a substantial lift from improvements in retention. Or business mix has shifted to a more desirable, high quality multi-car, multi-line business, which aligns with our account focus strategy. These accounts are typically less price sensitive and therefore have higher retentions. And while high quality new business continues to be hard to get, we have maintained our new business production year-over-year thanks to the increased support of our partner agents. Last year we disaggregated our overall growth into two parts. We talked about the challenges we face in the four states of Michigan, Massachusetts, Louisiana and Florida, and our outlook for these states. Offsetting the challenges that these four states have, we talked about the increasing growth momentum we observed in the remaining states. At the end of the second quarter, we are tracking to expectations for both of these groups.

In Michigan, where we see no signs of economic relief, we continue to focus on maintaining profit margins. The weak economy and shrinking personal lines market has resulted in lower Michigan policy counts. However we are managing this state well and that reduction is not getting any worse. Personal line policy counts have been down about 1% for the past five quarters and this trend continued in the second quarter. Net written premium was down 1% in the quarter, better than the 4% decrease we reported in the first quarter of 2008 and is as we had expected. Net written premium in our homeowner's line grew, despite lower policy counts due to inflationary rate adjustments we have been able to take on the books. The net written premium decline in personal auto also moderated during the second quarter, benefiting in part from the rate action taken on our auto book earlier in the year and we have more planned for the subsequent quarters. As I said, our focus in Michigan remains on the bottom line, maintaining margins while maximizing our opportunities for growth. We have stepped up our agency management actions and we are working closely with our partner agents to gain market share. We continue to believe that, barring any further deterioration in the economy, we can maintain and over time improve our performance.

Turning next to Massachusetts. Net written premium was up about 10% in the second quarter. This was better than we had expected. As you may recall, managed competition came into effect starting April 1st, 2008 and at that time, our average 8% filed rate decrease came into play together with a more sophisticated multi-variant auto product. The results were good. Our product fared well in the market and we gained business in this new competitive environment. Our personal auto policy counts in Massachusetts were up 7% relative to the prior-year quarter and our net written premium was up 12%. Of course, these are early indications and we know we benefited from the increased flow of new business as the advent of managed competition resulted in more shopping by consumers. We recognize that this increased flow will not likely be sustained at these levels. However, the performance of our new auto policy in the second quarter as well as the lift we got in homeowners policy counts this quarter gives me confidence that we will compete effectively in this new environment and that our total account value proposition works with our agents in the state, which in turn will enable us to grow our market share over time. Despite this positive outlook, 2008 will remain a transition year for us and we do not expect Massachusetts to meaningfully contribute to the overall premium growth in the year.

Finally, turning to Florida and Louisiana, where we have taken exposure management actions that have significantly improved our risk profile. We are tracking according to plan. The non-renewal of our Florida home policies is progressing as planned and our exposure actions in Louisiana are also on track. Our expectation is for a 16% reduction in premiums by year end in these two states combined. Growth trends in the remaining states are increasingly positive with a growth rate of 4% in the second quarter, coming predominantly from increased retention resulting from our improved mix of business. As you may recall, we have taken significant corrective actions during the latter part of last year to improve profitability of our connections auto book. We can now see the mix improvement that these actions were specifically designed to address, the proportion of our new business with multi-car policies and whole account business has increased and is already translating into better retention and improved margins. In summary, I'm very pleased with the personal lines results in the quarter and I'm confident that we will continue to deliver solid margins in the segment while maintaining net written premiums at last year's levels, despite the challenges we face relative to our state mix and the market in general.

Turning next to commercial lines, we had another solid quarter with segment earnings of $52.7 million and a combined ratio of 91.7%, which includes five points of catastrophe losses. Reserves related to prior accident years continue to develop favorably across all lines, reflective of our disciplined underwriting. Our current ex-cat accident year losses also improved six points to 44% in the quarter. This improvement is attributable to lower severity trends resulting primarily from a normal level of large losses in the current quarter compared to an unusually high number of large losses that were detailed in the prior-year quarter. Additionally, growth in our specialty lines which typically carry a lower loss ratio continues to favorably impact our accident year loss performance. Net written premium growth of 7% in the quarter and in line with our expectations. This growth came primarily from specialty business which grew over 20%. As expected, the integration of PDI and Verlan provided a good lift in the quarter. The assimilation of these two acquisitions is going well. We were pleased with our partner agents response to the new capabilities introduced with these acquisitions and we've already started to leverage the Hanover agency distribution to cross-sell these new specialty products.

Our other specialty grew 14% driven primarily by our bond business were the availability of high business opportunity still remains good. Our underwriting discipline remains strong in this area and our conservative appetite intact. Our traditional business also continued to show positive momentum in the quarter with some growth in exposures and improved retentions. Pricing is increasingly competitive, particularly in middle to large market segments and new business is getting more and more difficult to find at reasonable price. However, we are continuing to compete effectively in the small market segment on the strength of our new small commercial platform and I continue to hold a positive outlook for growth in this segment as our small commercial model continues to gain traction with our partner agents. To sum up the growth story in commercial lines, I continue to remain confident that we will meet the mid single-digit growth objective we laid out at investor day and I also feel good about making our overall commitment to mid single-digit growth. Even more importantly, while we expect to make our growth goals, we expect to do so by maintaining or improving our accident year margins as we did in the first half of the year. I think our results have demonstrated our commitment to underwriting discipline, putting margins and prudent risk management before growth and gaining market share in a manner that is true to our strategy. And with that I'll turn the call back to Sujata.

Thank you, Marita. Operator, we'll now take questions.

(OPERATOR INSTRUCTIONS) Your first question comes from the line of Jay Gelb of Lehman Brothers. Please proceed.

Thanks. Good morning.

Good morning, Jay.

Fred, I think you've spoken over time about the potential for return on equity enhancement after the sale of the life insurance is complete and you're able to deploy those proceeds. What's your thoughts in terms of how much enhancement might be anticipated as a result of when that transaction is fully completed and the proceeds deployed.

I think you can do the math, but as we look at the holding company, it's a combination of really two things, Jay. One is obviously, there was, if you think about it, there was a dead capital -- amount of dead capital that sat out there, if you think about the ROE based on the GAAP number of almost $300 million dollars. Obviously our GAAP level of capital changes because of, one, the losses, but also all of a sudden that becomes liquid and goes to the holding company. So if you think about the math of that drag, of that 300, obviously that is deployed towards businesses that are in 12% plus ROE or is given back to shareholders, the math just is one-for-one, with every dollar that I can make that happen. The other thing, the complexity I think that will unfold over time, is obviously our capital structure and the way our debt is structured, et cetera, was kind of a legacy of where we were and our ratings status, et cetera, and the risks of having this dead business on your books. So as we get more clarity at the end of the year, with the rating agencies, particularly Best, about where we are now with our rating on the P&C side and the liquidity needed, my view is we'll become more regular. When you look at our capital ratios and combining your holding company with your P&C. That's yet to unfold as we talk to the rating agencies, but obviously we had this odd situation which we had quote unquote contagion risk from this life book that has been decreased over time because we got out of the volatile stuff. But now we are basically out of all those risks, right? We don't have any of that, so we're much purer P&C business and so my view is that it's both the use of the immediate capital but then thinking about the capital structure to become a more normal P&C company. I'm pretty encouraged by both aspects of that, right?

So if we think there are opportunities to do what we've done with little acquisitions or investments in people that can return 12%, you are essentially taking a 0% return and making it 12%. If we can also -- if we can't do that, we can also give it back, right, like we did at the last life transaction where I gave $200 million plus back after the last time we liquidated the life transaction. So we're going to also consider that, because if there isn't opportunities to use the capital, we'll make a judgment on how much we think we should hold. And you could see further discussion and announcement when we know more about the cat season and our Best conversations. But again in the past, what we did is we gave back a bunch and then we utilized some. It's, again, this is to me, you can see us becoming more normal, right? I mean, one of the issues we had was not just that the capital was in a life business and wasn't earning returns. We had to get regulatory approval to get access to it. So it wasn't accessible. It was zero returns and trapped. And now it'll be at our discretion, based on what's appropriate to maximize the shareholder value of the Company and to make sure that our ratings are sustained and improved. So I think it's a much straightforward thing. And again, you can do the math and we can give you more specifics as the close comes, but it's pretty straightforward.

Right. All right. Thanks for that answer. And then, in terms of how the overall company-wide GAAP book value impact is, my sense is that the proceeds from the sale of the life company were at least higher than we were expecting.

Yes.

It looks like with that GAAP capital going out and getting the cash back in, if my math is right, it doesn't look like there's going to be much dilution at all to book value at the end of the day. Is that right?

Exactly. I mean, if you think about what most people had estimates out there, right? They had somewhere around $3 million detriment to GAAP. That was kind of -- if you look at most of you guys and how you looked at it, and as it turned out it's not. It's about a buck and a quarter, right? I'm very pleased with the outcome, right? I mean, I couldn't have been happier with it. Plus it's with a great counter-party, right, so Goldman's a very stable company. So both our -- I think the regulators are going to be very pleased, and in our early conversations they are, with the quality of the company that it's going to. Plus we've already done a transaction with them, so the little hidden things that you sometimes get in these kind of transactions we believe will be minimal, because we've already gone through a more complex transaction with the same entity. So I just believe on all fronts, the certainty of it is great. The outcome for shareholders and for the regulators is great, and the financial implications, at least when I look at you guys estimated and frankly what I thought, it's a very good outcome.

RIght. And then on the broader issue, with just one day post announcement, now that Hanover is a pure play property casualty company and we're seeing some other regional pure play property casualty companies getting taken out at two times book or higher, is that something that is more on your radar screen?

It's interesting. Again, I believe our job is to maximize the value -- the shareholder value of this institution and do it by making sure the franchise is as valuable as it possibly can because the capabilities and strength of it. And I believe that we have set ourselves up. And again, I believe very strongly that '09 is going to have a very challenging accident year results for a lot of our competitors. I also believe you're going to see a ton of transactions hit the streets. I see a lot of big guys are going to be selling divisions and parts of their P&C businesses and you're going to see a flood of that in the next 12 or 18 months as do you in most cycles. So I don't know how that's going to play out, but what I do know is that we've positioned the company with an unbelievably strong balance sheet with great capabilities and the ability to create a heck of a lot of value in a disruptive market. The rest of it I can't control, right? I can tell you we're a hell of a lot stronger company than we were three years ago, two years ago, six months ago and I think that for partner agents we're a very attractive option for them. So I look at it and I see we have more shareholder value creation opportunities today than we've ever had. If you could imagine how many calls I get now from very good teams that are scared and the disruption that's being created by these transactions and the fallout of these transactions create a lot of different ways to create value for our shareholders and we're open to all of them. That's our job, to make sure that we're thoughtful and we're open to all of them. But I can tell you that things are unfolding just as we expected them three years into a soft market.

Thanks very much.

Yes.

Your next question comes from the line of Dan Farrell of Fox-Pitt Kelton. Please proceed.

Good morning.

Good morning, Dan.

I think obviously you said given that you've got so much capital now, the holding company over -- you're going to be a little over $450 million, you're going to look towards repurchase and doing deals. Can you talk about your view of the environment for those sort of smallish transactions that you did like these PDI and Verlan, which clearly you have done well I think so far and just maybe talk about what you can do going forward.

Exactly. I mean, obviously we're not the kind of player that's going to go out and pay two times book for something. People with expectations of 4% ROE don't even register with me. So when I look at the environment, what I believe is that the pricing for these acquisitions is going to come down dramatically over the next 12 to 18 months. There's going to be a flood of them. The results, and particularly in the specialty businesses, are coming home to roost here. If you look at some of the specialty returns underneath people's date, you're seeing the accident years, particularly in some the liability lines decay pretty rapidly. And I was at the S&P conference and I agree with what Bill Berkeley said when we were doing the presentation together. '09 looks to be a troubling year for some of these weaker players. And so when I look at this, I believe that the ability to pick up teams that have distinctive kind of brand recognition and capability are going to be there and they're going to there where we can make the economics make sense. And now if they're not, we won't do it. But I look at every day, we have opportunities from private companies or equity-based companies that are a little subscale but they have a good position in one thing or another, that are under the radar screen, that other people are not going to be that interested in, because of their size and ability to move the needle that really make a difference to us given our strategy. So I think on one front, there's a lot of opportunity.

The second point I would make is that I really do believe -- I've said it time and time again -- the more likely situation is that there will be transactions among the big guys. There are people right now talking about selling big pieces of our their business. You know the obvious ones, but there's more than the obvious ones. That disruption, when those things change hands, create unbelievable opportunity for us. If you look at where we built our marine business, it was essentially because of the St. Paul Traveler's merger. We were able to take a lot of those teams and capitalize on that disruption. That opportunity is going to be rampant in the next 18 months if we're thoughtful. So I look at that as also an opportunity. Now, do I think in, like in a place like personal lines where scales matters and diversity of geography, there will also be opportunities, yes, but that's more of my view of an expense play. You have to look at it as a short-term economic benefit, because that really is about enhancing your claims and pricing capability by geography. Those will also be available. My issue with those, however, is you have to be very careful with those prices. Because I think what you are going to see is those personal lines books will be at renewal rights deals within 18 months because the guys that are selling, for the most part, there's going to be some big guys that sell for strategic reasons, but a lot of those are going to be because they are sub-scale and they are going to get adverse selection.

So again, I look at the world -- if you look at the last three cycles, three to four years into the cycle is when the separation, the have and have-nots happens. The big guys that are thoughtful capitalize on it. The key will be saying no to certain transactions and capitalizing on others. I don't need them. Let me be clear. I don't feel that I need any big transaction. I think I can create tons of shareholder value more than any regional company in this country over the next couple years without them. But I will be continuing to take advantage of taking teams and if there is an acquisition and a brand that makes sense, we'll look at it. I've turned down 20 of them in the last 12 months. So this isn't something that I think I need or that I have -- the money's burning a hole in my pocket or any of that. If it isn't out there, we'll give it back.

The other thing I would tell you is that I feel very positive about our conversations with Best. We've got to earn it. We've got to make sure that we continue to demonstrate. But if we get Best to move in a positive way at the end of the year and the beginning of next, we're the only financial service company in the country that's gotten the three big rating agencies to give us an upgrade in this period of turmoil. That creates more momentum than people realize. Agents watch that. And if you look at us, we're going counter to all the trends and I feel good about that, because what it says is that our partnership strategy, our ability to get unfair advantage with some of these consolidating agents is big. Let me make one final point. In our calls, we talk about the consolidation of the carriers. The other big trend that's obvious, right, is the -- it's accelerating consolidation of the agents. Our whole strategy is built on the premise that that was going to happen. So if all indications are showing that that's going to accelerate and if capital becomes a little bit more available, it's going to happen really rapidly.

So by picking the winning agents and building a strategy that kind of helps them increase their earnings as they consolidate, creates an enormous opportunity for us. You're going to see us establish, for instance, a new organization for brokers that are multi-state and multi-organization to serve their needs in a specific way, because what we're seeing is tremendous opportunities from the fallout of that as well. So again, just a lot of stuff's happening right now. I feel good about where we are. We will be thoughtful. We will be prudent and -- but I do think that the opportunities are there. Again, a big difference between us and somebody that's ten times our size, something little moves the needle very significantly to us that's easier to integrate and not as complex because we're not that big. So a lot of things that other people would consider grounding errors can create great shareholder value for us. So it's not a bad place to be in, given the frothiness of the large transaction.

That was a very helpful answer. Thank you.

Your next question comes from the line of Rohan Pai of Banc of America Securities. Please proceed.

Good morning.

Good morning.

I just wanted to -- the questions I have were on the specialty lines. Did you -- and maybe I missed it, but did you give the contribution of Verlan and PDI in this quarter for the premiums risen?

We did not specifically break it out. The lift would be relatively small when you add it to everything. We had about 20% growth across specialty, 14% in the core. It would be included in that. The interesting thing about PDI and Verland, to Fred's earlier comments, is the reason these type of acquisitions give us some early lift and we have a lot of confidence in the future lift, is because all of our agents have this business. It fits very clearly in our appetite in our real house. It's what we do. And with agents having these capabilities, with us knowing what partner agents have it, we can see the future lift. But early on, they're relatively small and they wouldn't really begin to show up in the numbers yet. But we are starting to see that lift with a limited number of agents we brought these capabilities to so far. And there's a lot more to come.

I guess the sequential margin improvement that you see in the specialty lines, it seems that the combined ratio ex-cat and reserves has gone down to below 80%, so I guess that's not coming from these new lines? It's on your core inland marina surety?

Most of that would be coming, just by sheer numbers, from bond and in the marine.

Finally, just on the bond book, if you could tell if there's any benefit your getting from maybe the dislocation from Liberty Mutual Surety -- I mean, I meant Safeco. And also, what you're seeing on the credit side maybe not on your own book but just generally across the market, if you're seeing any deterioration there.

What I would say to that overall is we intentionally gave you all a very clear breakdown of our surety business at investor day and those numbers percentage-wise really haven't changed. But you're exactly right. This disruption has allowed to us take advantage of individual account opportunities with partner agents in the surety segment without compromising our underwriting or changing our appetite. If you're willing to keep your underwriting powder dry, if you will, there's a lot of opportunity out there that are very good underwriting team can take advantage of. But clearly, some of it would come from that as well as others. And we think there's even more opportunity as we continue to take a disciplined approach to growth while we're hanging tight with a very strong underwriting drill around that.

Okay. One more thing. On the credit environment overall, not on your own book, I realize you are being much more conservative and narrow focused, but just the surety market overall, are you seeing any deterioration in trends?

We wouldn't. Again, we have tightened up our underwriting criteria. We have a very small percentage of larger contract surety type things. And because of our appetite and where we play, we can either avoid or underwrite the types of things that you're talking about. So, no we don't see -- we obviously know the trends are there, but we don't see any change in our trends.

Great. Thank you.

You're welcome.

Your next question comes from the line of Michael Phillips of Stifel Nicolaus. Please proceed.

Good morning, everybody.

Good morning.

Question around personal lines if I could for a minute.

Sure.

Everything I guess I'm going to say is -- I hear what you're saying on those four states that you mentioned at the beginning Michigan, Florida, Louisiana and Mass. But how much of a drag of those four states is a homeowners drag versus an auto drag? Seems like it's mostly a homeowner's drag, except for Mass obviously.

Yes. I mean, we can break that all out for you specifically, but I would say in general that's probably not the case, that it's all a homeowner's drag. I mean, obviously when you look at Michigan and the size of that state, it really does drive our numbers and the economy is having impact in both homeowners and auto and the overall personal lines market in that state is shrinking. We're able to mitigate some of that by aligning ourselves with the right agents and working hard on managing getting as much price increase as we can with improvements in the product and working with those agents to maintain as flat of a position as we can. But the personal lines market in that economy is just shrinking. So I would say it's just as much auto as it is homeowners in that state. Obviously in Florida and Louisiana it is homeowners. We sold our homeowners business in Florida. We're taking very tough action in Louisiana as we -- as the population moves north. But that is obviously being driven on the homeowners side. So it really gets down to an individual state dissection of the numbers, which we tried to give you transparency on.

I want to make a comment on personal lines. Because I think there's a real change in the marketplace that we are kind of excited about and it's a two-fold change. One is that there is a pricing -- obviously everybody's talking about pricing, right? But what's interesting about it is I would argue that part of the reason why the big guys in particular are being so aggressive at pricing in auto right now is that they expanded too many agents. And so many of them have appointed so many agents and then they try to go head-to-head with each other and they're getting adverse selection and a deterioration in their auto that they've had to really take aggressive pricing. And what's interesting to us is that that pricing umbrella is good, but what's also good about it for us -- because we go to our agent with this notion of a limited distribution, it has made all of our agents more interested in giving us an unfair advantage over the national guys because they are commoditizing the business, because they are giving every aggregator access to their products.

So one of the things we haven't built into our thinking yet, is this level of conversations we're starting to have with so many agents about giving us more of an unfair advantage because, one, we go at it on an account basis versus a line of business auto basis and, two, they're really nervous about the commoditization these big guys are doing by giving aggregators. And one of the biggest was Safeco before they sold. They had expanded their agents dramatically. You heard them talk about how many agents. And that kind of thing scares agents in this kind of shopping market. So we're actually -- we look at both the price increases we think that'll come through in the second half of the year and the ability to get some share shift from partner agents as they want to go with people that have a more constrained distribution as a real potential here. I think you're going to see a turn in the auto market in the next 12 months as people struggle with this market of how you grow and how you compete with the likes of a Geico. Our whole view with not going head-to-head on auto, but doing it on an account basis, do it on a limited agency basis, go after and help them shift share within their shelf space, to me is going to get real nice traction in the next 12 months if people get really scared about all of the pricing action that is driven by the big guys, because of the adverse selection they're getting by going to aggregators. So again, it's not showing completely in the numbers for us, but you're starting to see that decay and you're starting to see the conversation happen in a more dramatic way. So in general, I'm probably more optimistic about personal lines for the next 12 months than I've been in quite a long time, because I was assuming that the market would last longer, soft like commercial. I think it's going to actually be shorter because of the pricing actions and the more targeted actions by some of the bigger players.

Great. Thanks. The comments I guess on the price and action of the competitors in personal line for the auto is a good segue to my follow-up question. We're seeing that turn I think already for some of the big guys.

Absolutely right.

Recently in the past x-number of months. Pretty recent. I think that's in contrast to what -- at least what I understood from you the past, pretty consistent, modest rate increases when you could for the past couple years.

Again, our philosophy's a little different, right? Because our game is about account rounding and retention. Our view is you stay ahead of inflation in every state, every quarter, every month. And so we don't do price discounts, we don't do reductions, we don't compete on price. A lot of these guys took 14, 10, 12% reductions in the last couple of years. What you've seen us do constantly is get it over inflation. Now, are they giving us an umbrella because of this disruption? You bet. But when they were taking decreases, we were steady. And if you looked at our homeowners, we were taking very steady increases. So what's happening now is because they're having to take 14% in Tennessee, we're able to shift to underneath them but you won't see us go for 14. You'll see us go for 5. Because what we will do is build our national margin but enhance the retention of our agents. We will not -- we don't have to do the knee jerk reaction that they do in some of these states because of their adverse selection. And what I'm hoping is that you'll see our 2 or whatever it is now, 2.5 creep up. And again, so I'm pretty bullish.

The other thing you're seeing in the rate increases, you've got to understand, we don't have a Florida book. If you look at their books, we don't have Texas personal lines, we don't have California personal lines and we don't have Florida personal lines. That's where the high premium per policy is. And what you're seeing in those states, particularly Texas and Florida, they're getting behind. And so we don't have a lot of those to make big numbers come out. We're a very midwestern, northeastern company. But it is an interesting time because they're having to dramatically adjust, where I'm very comfortable that we'll improve our accident years given the prices we've already filed and we're in the process of filing in the states we're in. It's a little different philosophy.

But Fred's right. The solid 2.8% we got in the quarter outside of Massachusetts, I feel good when you combine that to retention trends holding and improving. It tells you that you can continue to take that approach that he outlined quarter after quarter.

Yes. We believe we'll see accident year improvements. And I don't think -- so many of the other folks aren't talking about that yet.

Thanks. I think that's it. I think that's a big point. Real quick, was that 2.8 Marita, was that just auto excluding Mass or was that everything?

It's everything.

That's everything, okay.

We'd have to go back and check. But I think it is everything.

Thanks very much.

Thank you.

And that does conclude the question-and-answer session. I'll now turn it back to Sujata for closing remarks.

Thank you, everyone, and thanks for joining our call again. And we'll be here to answer any follow-up questions.

Ladies and gentlemen, that does conclude the presentation for today. You may now disconnect. Have a great day.