Hanover Insurance Group Inc (THG) 2009 Q3 法說會逐字稿

Hello and welcome to The Hanover Insurance Group 2009 third quarter earnings conference call.

All participants will be in a listen-only mode for this event. (Operator Instructions). After today's presentation, there will be an opportunity to ask questions. (Operator Instructions). Please note this event is being recorded.

I would now like to turn the call over to Bob Myron, Senior Vice President of Finance. Please go ahead, sir.

Thank you, operator. Good morning. Thank you for joining us for our third quarter conference call. Participating in today's call are Fred Eppinger, our President and Chief Executive Officer; Marita Zuraitis, President of our Property and Casualty Companies; and Gene Bullis, our Executive Vice President and CFO.

Before I turn the call over to Fred for a discussion of our results, let me note that our earnings 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 fact include forward-looking statements. These include statements regarding expectations of segment earnings, pricing, [action] year results, premiums, expenses, development of loss and LEA reserves, returns on equity and other projections for 2009. 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 reliance on forward-looking statements and in this respect refer you to the forward-looking statement section in our press release, slide two of the presentation deck in the filings with the SEC.

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

With those comments, I will turn the call over to Fred.

Good morning, everyone. Thank you for joining us.

As usual I will take a few minutes to talk briefly about our results. I will review some of the initiatives we have under way and put our third quarter results and our competition position into context. Marita and Gene will provide additional insight into our performance and trends in our business. With respect to our earnings in the quarter, the fundamentals of our core business remain very strong. In addition all our strategic initiatives have good traction, which make us very positive about the current mix of our overall book of business, the growing partnership with winning agents and our expanding product offerings. Our business momentum and our financial strength position us very well for the continued disruption we see in the marketplace.

We also feel very good about the strength of our investment portfolio, our capital and liquidity position and the resulting flexibility it gives us with respect to the capital actions that we are taking to drive shareholder value. With respect to the results for the quarter as noted on slide four, we generated net income of approximately $50 million or $0.97 per share for the quarter, compared to a net loss of about $62 million or a $1.21 per share in the third quarter of last year. We generated segment income of approximately $45million or $0.89 per share compared to about $3 million or $0.07 per share quarter-over-quarter. Putting catastrophes aside, our combined ratio was approximately 2 points higher than the prior-year quarter, driven by higher than expenses accident year losses and higher expenses. On a loss side, earnings for the quarter were impacted by continuing weather related losses, the impact of the economy and the state of the insurance market. In particular, in Personal Lines the largest driver of our performance shortfall was above historical average losses for non-cat weather.

While this trend has put pressure on our short-term earnings, it has made significant rate increases much more achievable, particularly in many of our markets that are dominated by regional competitors. In Commercial Lines we had higher than expected losses in some lines that were driven by increased loss incidents as well as a more cautious approach towards setting our (inaudible) loss picks. We think this is a prudent approach given where we are in the market cycle as well as in the state of the economy and its potential impact on industry loss trends. We don't expect this to have a long-term impact on our results because of the improving quality and mix of the business and rating increases we are now achieving. On the expense side, earnings were impacted by ongoing investments we are making in product, distribution and infrastructure, principally in Commercial Lines as well as increased pension related expenses across our business.

From a top line perspective, we continue to be pleased with the growth trends and the progress we are making in our overall book of business. We are maintaining a disciplined underwriting approach both in terms of pricing and terms and conditions. Net written premium growth for Personal and Commercial Lines combined was 5.7% for the quarter and 3.2% year- to-date. The growth we are achieving is a result of the positive actions we are taking and the momentum we have established in many areas of our business. In Personal Lines we continue to thoughtfully improve our product offerings and at the same time improve our mix, writing an increasing amount of attractive account business. In fact, as of September 30, 2009 , over two-thirds of our business is now in accounts. We continue to manage our core states for margin, while growing in states targeted for growth. While overall our net written premium and Personal Lines was flat for the quarter, we grew 6.2% in the growth states. We have strengthened our field team in these states over the past 18 months and we are working hard to develop and build on partnerships with the best winning agent in these states in order to continue the positive momentum we have already established.

In Personal Lines, our overall rates were 4.4% above the prior year. And based on filed and improved rates, we expect this trend of pricing to increase in the fourth quarter and into 2010. We believe these increases will keep us ahead of loss cost inflation, also taking into account the ongoing trend of heightened weather related losses, all with a view toward increased profitability in future periods. In Commercial Lines we achieved 15% growth driven by our more specialized businesses such as niches, professional liability, marine and AIX, as well as our increased segmentation of our core Commercial offerings. We also continue to expand our specialty offerings with a long term view toward improving our overall mix and margin of our Commercial Lines business. Our outlook for all our strategic investments in speciality and niche areas is very bullish for the remainder of 2009 and 2010.

Separately, we continue to push ahead with our launch into the western part of the country. Leading with middle market niches and industry segments, along with a full breadth of our special offerings, all of which we feel align well with business opportunities in the region. Obviously, a significant portion of the agents we consider winning agents reside in this part of the country, as well as over 30% of the speciality niche businesses we target. Ultimately this expansion will improve our geographic diversification, leverage our product investments and build on our partnership strategy. We already have significant transparency to attract us new business opportunities with our selected partner agents and expect to see some meaningful impact on our 2010 results.

Though our westward expansion as well as generally across all our Commercial Lines platform, we are bringing on highly talented individuals as well as teams of people that we feel strongly will help us continue to drive growth in our Commercial Lines business. We have never been in a better position to acquire terrific talent in our business. While we are excited about the profitable growth and improvements in our mix of business we expect from the investments we are making, we are also keenly aware of the pressure these investments place on our expense ratio. However they represent a critical component of our long-term strategy and enable us to capitalize on the opportunities we see in the marketplace. While our expense ratio for the year will be at the high end of our previously issued guidance, we are pleased with the progress that is being made on all our strategic investments and confident that we are on track over the next five quarters to meet our investment hurdles and achieve the ROE improvement discussed during our Investor Day.

In terms of our core Commercial Lines pricing, we continue to have pricing increases on our small, Commercial and middle market businesses in the the low single digits. Moving onto our balance sheet and capital. We consider prudent management of our investment portfolio and our capital to be core tenants of our operating strategy. In particular, capital management is an important lever to increase shareholder returns. With capital markets continuing to normalize and our capital position continuing to strengthen, we made several important capital management decisions during the quarter. First, we successfully completed the process of restructuring a portion of our debt through drawing a $125 million 20-year loan from the Federal Home Loan Bank of Boston at a cost of 5.5%. This served to lower our overall cost of capital and decrease our interest expense on a post tax basis by approximately $2 million per year.

Second, we continue to buyback stock during the quarter in October at prices below our book value, which is immediately accretive to book value and earnings per share. Third, we increased our existing share buyback authorization by $100 million and expect to continue to opportunistically utilize the program. And lastly, we increased our annual dividend by 67%, to $0.75 a share and announced our intention to move to a quarterly dividend in 2010. All of these items represent tangible steps to increase shareholder returns and the buybacks and increased dividends demonstrate confidence we have in our Company's overall financial condition and our ability to generate strong, profitable growth going forward.

As shown on slide four, our book value per share increased by 10% in the quarter and 30% for the year-to-date, driven by increases in the value of our investment portfolio, as well as our operating earnings. At $48.06 per share, our book value per share is now the highest it has been in any point in the Company's history. In summary, we produced solid results in a very difficult economic and market environment. And while we anticipate some negative trends to persist through the end of the year and into 2010, we are very optimistic about our Company's ability to manage through it and create significant shareholder value.

Although the insurance cycle has not fully turned, I am pleased with our ability to achieve price increases in both Personal and Commercial Lines and I am very pleased with the quality and the mix of our new business coming from our new product investments. Our ex-cat combined ratio of 93.7% is very solid compared to many of our regional competitors but does not meet our expectations. However, given mix improvements, our pricing actions, increased expense leverage, we are confident that we will see meaningful improvement in 2010. Without question, the past year has been characterized by more change and challenge than I have seen at any time in our business. But with disruption comes real opportunity. I am very pleased with the way our Company has performed over the course of the year and I am more confident than ever that we are positioned to capitalize in the opportunities that will unfold over the next several quarters.

With that I will turn the call over to, Marita, for a review of our

Thanks, Fred. Good morning, everyone. Thanks for joining us today.

Fred gave you a broad overview of our operations and I will review our business specific trends, starting with the discussion of our overall P&C results on slide seven. Our third quarter produced $74 million of pre-tax segment income compared to $14 million in the prior-year quarter. Segment earnings were up from last year, primarily driven by lower catastrophe activity. Excluding cats, the combined ration in the current quarter was $93.7, compared to 92% in the prior-year quarter. This moderate margin compression is reflective of a number of factors, including increases in expenses driven by investments in our operating model and our product breadth and higher losses in some business lines driven by weather and economic conditions. Net written premiums were $689 million in the quarter, this represents a 5.7% increase over the third quarter of 2008. Our more specialized businesses such as niches, professional lines, marine and AIX, as well as increased segmentation of our core Commercial offerings fueled our year-over-year premium growth.

I would like to discuss the drivers underlying these results in more detail starting with Personal Lines. Turning to slide eight. Our Personal Lines segment reported pre-tax earnings of $27 million in the current quarter, compared to $18 million in the prior-year quarter. Earnings in the current quarter were impacted by lower cat losses, higher underwriting expenses and higher ex-cat accident year losses in our homeowners line which was primarily weather related. At our second quarter earnings call, we shared with you plans to accelerate some technology, product and ease of doing business investments in our Personal Lines in our third quarter and fourth quarters of 2009. We can now see these expenses running through our numbers in the current quarter.

These initiatives gathered under the umbrella of Think Hanover campaign leveraged and emphasized our total account product suite, allowing us to support our growth initiatives in our newer states and to more effectively preserve margin and market share in the core states. We expect these higher expenses to continue in the fourth quarter, but starting in 2010 our cash spending on these projects will decrease significantly. As we've discussed in the past, expenses in the current quarter were also impacted by increased pension costs compared to the prior year. And finally, the year-over-year expense comparison also was affected by a reduction of variable compensation expenses made in the third quarter of 2008 which was related to the first three quarters of 2008. The variable compensation reduction was a consequence of decreased profitability in 2008 due to heavy cat losses in the third quarter. Higher ex-cat accident year losses and Personal Lines were driven by ongoing higher than usual weather related losses in our homeowners line.

While weather had a more limited affect on profitability in this quarter compared to the first and second quarters of this year, the fact that the trend is continuing makes it an ongoing area of focus and a main driver of continuing rate increases in our homeowners line. Overall, the combination of increased rate to address these weather related losses, along with our prudent risk appetite and underwriting practices makes us comfortable with the expected profitability of this business. Our business mix also continues to improve, driven by successful initiatives implemented last year to write more account business, to move away from higher risk drivers and to carefully manage our coastal property exposures.

Turning to slide nine to discuss our Personal Lines growth for the quarter. Net written premiums decreased two-tenths of a point compared to the prior-year quarter. Our growth strategies in Personal Lines as well as our top line results remain similar to prior-year quarter trends. We are striving to preserve our market share and margin in Michigan, Massachusetts, New York and New Jersey, while increasing exposure in states targeted for growth. Written premiums decreased 2% in our Big Four states combined in the quarter. With respect to states targeted for growth, however, net written premium increased 6% and PIF grew 5% with impressive momentum in states like Ohio, Illinois and Wisconsin. Overall, we continue to grow Personal Lines business that's associated with a lower risk profile and higher retention. We attribute our retention improvement in Personal Lines to successful, past mixed management actions in homeowners and in Connections Auto and our focus on writing more multi-car and multi-account business that's consistent with our strategy. As I just mentioned, the investments that we are making in our Think Hanover program are intended to make writing account business more convenient and beneficial to our agent.

As Fred mentioned, 66% of the new business we write in Personal Lines is now coming from full accounts, which means we underwrite the customer's home, auto and other lines. The portion of our account business has grown 4% since the end of 2008 and 9% since the end of 2007. As a result of this whole account strategy, our PIF counts in homeowners business grew 5% in the quarter, primarily coming from our newer growth states like Ohio and Wisconsin. In Personal Lines overall we continue to see sequential and year-over-year improvement in the growth of policy accounts which comes from states targeted for growth. We expect to sustain this upward momentum going forward as we anticipate better retention of this business due to our improved profile. At the same time we remain disciplined in our approach to pricing, pushing enough rate to get ahead of loss cost inflation as well as pricing our homeowners line to address the higher weather.

Our auto rates increased 4% in the quarter, while homeowners rates were up 5% and we have larger increases in both auto and home in the pipeline. As we look into the future we have visibility into growth and profitability improvements in Personal Lines which are supported by investments in product and ease of doing business enhancements as well as our commitment to the independent agency channel which we know is very important to our partners.

Now moving onto Commercial Lines on slide 10. Pre-tax segment incomes for the quarter was $39 million compared to a $7 million loss in the third quarter of 2008. Catastrophes were $9 million in the current quarter compared to $59 million in the third quarter of last year. On an ex-cat basis the current quarter combined ration was a 94%, or 2.5 points higher than the prior-year quarter. Our Commercial Lines underwriting expenses were higher in the current quarter compared to the prior-year quarter, reflective of continued investments in product, distribution and infrastructure in new and existing lines of business and geographies which are critical to our future success. In contrast with across the board technology and basic infrastructure investments in the beginning of our journey six years ago, we are now making more targeted and discreet investments in specific areas of business which we believe have the best growth and profitability potential. This investment strategy has been very effective. Over the last two years we have actively investigated in several of our specialty Commercial Lines, products and platforms which are now driving significant growth.

Our total specialty growth even excluding AIX was 15% in the current quarter. We are also seeing growth from our investments in selected industry segments is Commercial middle market. Lastly, we expect that costs we occur ahead of premium in our westward expansion initiative will be beneficial to our top and bottom line in future periods. Clearly these investments have put additional pressure on our expense ratio, however we consider these investments to be critically important to position us well for profitable growth in the future. We are willing to take this expense risk in order to take advantage of the market opportunities in front of us. They not only make sense on a stand alone basis but they also allow us to grow our share with partner agents across multiple lines of business as we become more meaningful to each of them.

As in Personal Lines, higher pension costs and a reduction of variable compensation expenses in the third quarter of 2008, negatively impacted the year-over-year expense comparison. Our ex-cat accident year losses were lower overall in the current quarter when compared to the prior-year quarter. This is due to better results in CMP large losses when compared to unusually high incidents of large losses in this line in the prior-year quarter. Partially offsetting the lower CMP large losses in the third quarter this year was a moderate severity increase in some of the other Commercial businesses. Our bond portfolio which is principally contract and Commercial Surety historically has had very limited level of losses. Given the state of the economy and level of activity we are now seeing, we have adopted a more conservative approach to establishing loss picks, reflective of a higher incidence of losses which is quite typical in this recessionary economic environment. This more cautious approach to loss picks also drove us to increase current accident year loss expectations for our workers compensation line and Commercial auto lines which were driven by a combination of negative audit premiums and as well as higher severity assumptions.

Now turning to growth on slide 11. Our 15% net written premium increase in Commercial Lines for the quarter reflected the impact of our AIX acquisition, as well as growth in our niche, professional liability, marine and segmented middle market products. We are positioning our current Commercial Lines growth strategy to minimize the impact of the recession and at the same time we continue to emphasize specialization and deeper industry segmentation which allows us to get an edge in pricing thus maintaining and improving margins. So far we have been relatively successful in this regard and I would like to discuss our thought process related to each of our Commercial Lines businesses starting with our core lines. In our flow, small and middle market businesses we try to explicitly avoid recession-sensitive industry classes like contractors and building owners which are prone to retail and office vacancies. We have minimized those classes in our new business writings to a negligible level. We also continue to tighten underwriting on all flow businesses and to hold firm on pricing.

We reduced new business flow - - which reduced our new business flow which decreased 8% in the third quarter of 2009 compared to the prior-year quarter. At the same time our retention rate on renewal business is holding relatively well. Rate increases flattened a bit on a sequential quarter basis, however our rates were still up 2.5% in small Commercial and 1% in middle market in the quarter. We did experience exposure decreases in the quarter clearly driven by the economy. To mitigate this we continued to segment our middle market businesses by the packaging of coverages and terms for specific segments. We believe this will allow us to continue to grow our segmented middle market business and more importantly will help us preserve margins. Our segmented new business grew 6% including such segments as hospitality and assisted living. Our middle market niches continue to grow at a significant pace despite the slowdown in the economy and the difficult market conditions.

Recently we've concentrated our product development efforts in more recessionary-resistant business classes like education, human and professional services. Some of our best people and most experienced underwriters have been tasked to service these products. As a result, all of our niche offerings combined produce net written premium growth of 35% on a year-to-date basis. Our inland marine line grew 20% during the quarter and stands at 8% year-to-date. Our marine book is a highly diversified and profitable book of business and we are very pleased with the growth. We are also extremely pleased with the substantial traction that AIX has achieved in the first half of the year validating the synergies gained by combining our businesses. Hanover's retail distribution and our A rating contributed to AIX's top line in the quarter. Our Hanover professionals unit which grew 49% in the quarter continues to give us high quality business from a limited number of committed agents with lawyers professional liability capability.

We have recently added an employment practices liability insurance program to the Hanover professional portfolio to address the unique risks of small and mid-size businesses and organizations and allows us to be more distinctive to our agents local markets. This program offers protection for employers wrongful acts, including coverage for discrimination, constructive discharge, termination, failure to hire, negligent supervision and temporary workers. With respect to our outlook on the market, the overall state of the economy and the pricing climate in the insurance industry makes us cautious about near-term pricing. However, we are confident that with our partner agent support and continued product innovation and industry segmentation, we will be able to continue to grow profitability across our Commercial Lines businesses.

So in conclusion while continuing whether a slow recovery in pricing and the recession put some pressure on third quarter results, we remain satisfied with our strong fundamentals and above industry average top line growth. We expect the improvements that we are making in our mix and product offering to be fully reflected in our bottom line results in future periods as we continue to implement our strategy.

With that I will turn the call over to Gene.

Thank you, Marita. Good morning, everyone.

As you just heard our third quarter operating income was $45 million after tax, or $0.89 a share. Both weather and the difficult economy played a role in our results for the quarter. Based on our year-to-date results and a more cautious outlook for the remainder of the year, we are adjusting our full-year 2009 pre-tax segment earnings outlook to a range of $280 to $290 million. Pre-tax segment earnings excluding interest on corporate debt and real life investment gains and losses. This revised outlook is based on an assumption of a modestly higher ex-catastrophe current accident year loss ratio when compared to the full year of 2008, reflective of higher weather in the first three quarters of the current year, as well as a stronger than expected negative impact on the economy on our accident year picks. All other assumptions remain unchanged.

Combined Personal Lines and Commercial Lines we expect to achieve mid single-digit net written premium growth with some full-year catastrophes of 4.2% of net earned premium. We continue to expect lower prior year development as compared to actual amounts in 2008. We expect our full-year total expense ratio to be on the higher end of our current guidance of 1 to 1.5 point increase driven by higher pension costs and other investments in our business. And we expect an effective tax rate of 33%.

I would like to touch on a couple of other items not covered yet on this call on our income statement for the third quarter before I move on to discussing our balance sheet. Net income this quarter was higher than operating income by about $4 million driven by a Federal income tax benefit of non-segment income. This benefit was related to a release of a deferred tax valuation allowance associated with real life investment losses recorded earlier in 2009. In the third quarter of 2009 , operating results reported in the other P&C segment were $7.5 million and included the affect of favorable reserve development of $10.5 million from run off voluntary pools business. The reserve development relates to pools that are in run off with excess in casualty reinsurance association, or Akra, being the largest. Every four years the association has a third party actuarial firm perform an actuarial study on pool reserves. The $6.4 million favorable adjustment of our Akra reserves was based on the results of this periodic study which was completed in the third quarter.

Additionally, during the quarter we lowered our estimates on a large pool claim by $3.1 million. This higher favorable development in our other P&C insurance segment was approximately offset by higher pension expenses and lower net investment income in the segment due to a lower level of holding Company investment assets. Now I would like to move on to a discussion of our balance sheets starting with a quick overview of the Company's investment portfolio. I am now on slide 13.

At the end of September, we held $5.3 billion in cash and invested assets including assets in our discontinued accident and health business. Cash and fixed maturities with a carrying value of $5.2 billion represent 97% of our portfolio, nearly all or roughly 93% of our fixed income securities are investment grade. Composition of our portfolio remains largely unchanged from the prior quarter. The average duration of the portfolio is 4.1 years. Net investment income from continuing operations in the third quarter was $62.1 million compared to $65.5 million in the prior-year quarter. This decrease is primarily due to our utilization of fixed maturities to fund the 2009 repurchase of our corporate debt at the end of the second quarter of 2009. While this lower level of invested assets produced lower than invested income, it also lowered our pre-tax interest expense by $3.7 million in the third quarter of 2009. The decrease in that investment income this quarter also reflects lower net new money yields. The earned yield on our fixed income portfolio has remained relatively flat at 556 throughout the nine months in 2009 compared to 560 for the same period last year. New money yields were 492 in the third quarter of 2009 and 466 for the nine months.

I would like to draw your attention to our CMBS information on slide 15. In the third quarter we added $63 million of CMBS to our portfolio through targeted act of purchases. The market value of CMBS portfolio at the end of September was $338 million which still represents only 7% of our overall fixed income holdings. Approximately 20% of our CMBS is fully to fees and approximately 77% of the Company's CMBS holdings are pre-2005 vintages with 8% now coming from 2007 and 7% from 2006 and 8% from 2005. Although we have added some asset risks from more recent vintages, we feel very good about these selections as they are very well protected, predominately first cash flow AAA paper. We have very strong CMBS expertise which we have clearly demonstrated through this market cycle. Notably as of the end of September our CMBS portfolio is in a net unrealized gain position.

Moving on to a discussion of our unrealized position for the quarter on slide 16, a total market value of our investment portfolio, excluding cash, increased to $5 billion at the end of the third quarter. This quarter we saw a significant improvement in our net unrealized position which moved from $72 million pre-tax loss at the end of the second quarter of 2009 to $118 million pre-tax gain at September 30. Improving credit spreads combined with relatively stable treasury rates helped boost market values within the portfolio.

Turning to page 17 for a discussion of our recent capital management actions. Our strong capital position and normalization of capital markets allowed us to undertake several notable capital actions in the third quarter. At the end of the quarter we successfully completed the process of restructuring a portion of our debt through drawing a $125 million 20-year loan the Federal Home Loan Bank of Boston at a cost of 5.5%. This served to lower our overall cost of capital and decreased our interest expense on an after-tax basis by approximately $2 million a year. As of September 30, 2009 , we are carrying $434 million of debt, which is made up of $122 senior debt, $166 of subordinated [ventures], $125 million of Federal Home Loan Bank loans and $21 million of miscellaneous debt inherited from recently acquired subsidiaries. Our debt-to-total capital ratio is now at 15%, giving no equity credit to the subordinated securities and including the full Federal Home Loan bank loan as [jet] in the financial leverage calculations.

During the third quarter of 2009 we repurchased approximately 725,000 common shares for $29 million. At the end of the quarter we had $104 million of capacity remaining under our recently expanded $200 million stock repurchase program. During October we've also repurchased approximately 239,000 common shares for $10.2 million through a 10b5 1 program, leaving $94 million remaining under our current share repurchase authorization. Finally, we recently declared an annual dividend of $0.75 a share, which represents an increase of $0.30, or 67% from the dividend paid last year. As Fred mentioned, capital management is an important overall of our operating strategy and we will use this level over time along with earnings growth to achieve our targeted returns.

On slide 18, we've displayed changes in our book value which improved by 10% in the third quarter of 2009 and 30% on a year-to-date basis. The improvement was primarily driven by increases in the fair value of our investment portfolio of $159 million after-tax for the quarter, or $3.18 a share as well as earnings. On slide 19 we have some key metrics that highlight the strength of our balance sheet. Our GAAP equity grew to 8.4% in the quarter to $2.4 billion. The growth was higher on a per share basis reflecting the $29 million of share repurchases. Our insurance company statutory capital stood at $1.7 billion at September 30 and 1.5 to 1 our premium-to-surplus ratio remains more than acceptable for our current ratings and mix of business.

From the liability side of the balance sheet our loss and LAE reserves remain strong. We believe our loss picks are appropriately conservative given the economy and we also continue to have a margin of about 5% between carried reserves and our actuarial indications. Holding company cash and investment securities were $311 million at September 30. In summary, our goal is to use our capital as effectively as possible to strengthen our organization, take advantage of growth opportunities and insure that we are positioned to win in the long term.

With this I will turn the call back

Thank you, Gene. Operate, that concludes our prepared remarks. Could you please open the line to questions.

Thank you. We will now begin the question-and-answer session. (Operator Instructions).

Our first question comes from Jay Gelb of Barclays Capital.

Thanks, good morning.

Good morning, Jay.

In terms of the guidance outlook for 2009 being taken down just a bit, what implications are there for that for 2010, especially looking in terms of the expense ratio, as well as capital management with stock trading low in the book value.

Yes, I actually feel like for 2010 the conversation we had at Investor Day still holds. Obviously the Company has three levers, Jay, that are pretty clear for our improvement of our returns. We have the capital lever, the expense lever and the mix and margin lever. There is no question that the economy and kind of the uncertainty around this non-cat weather has made us be a little bit more conserve in the fourth quarter, but if you look at the rate we are achieving and frankly what has already been approved, we feel very, very good about the increasing margin in Personal Lines. - - as some uncertainty around how the weather unfolds, but we've assumed that the significant above average weather continues. And so, I feel like while there are short-term issues there, I feel like the vast majority of that we have transparency to overcome. So, I look at our accident years and I say we will see improvement next year. I feel good about the mix in Commercial and what we are achieving. Obviously the economy and the return premium in places like comp put a little pressure on that but we are achieving rate increase and our mix is improving a lot. So I feel pretty good about 2010 about how that will unfold.

On a capital side, obviously, as I said, one of the things that I am watching is the particular opportunities that present itself to us, both organically and inorganic. We are seeing some interesting opportunities present themselves to us in the marketplace, partly because of our upgrade, partly because of this West Coast expansion. We obviously have started doing some capital actions that give capital back as I couldn't have transparency to the excess, if you will. We will continue to move in that direction if it is appropriate. If there are opportunities to increase shareholder value, I will do it. But we are obviously not shy about moving in the direction of giving capital back to shareholders if we feel that it is excess. Again I think we've signaled we've shown what we are doing. And as these opportunities either come about or don't, we will react appropriately. That is why I feel confident, then, the run rate by the end of next year, I think I have some transparency to significant improvement in our return.

The final lever is this expense thing. And - - as I look at the IRR of every single thing we have investigated, I am really not disappointed in anything. Do I wish that pricing in Commercial was a little bit robust faster? Sure. The IRRs on everything I can get my hands on as far as early results, I feel very, very good about. So I see a real leverage of expense opportunity next year. It probably won't unfold in the first quarter, but as this stuff comes in, as I watch the West Coast expansion, you will see improvement on our expense ratio. So if I take together all those three levers, I am still focused on and relatively confident that by the end of next year we will do as we said at the Investor Day. - - is there a little drag in the fourth quarter, maybe in the first quarter, sure. But again if you look at these rate increases, we are still a significantly a Personal Lines Company.

And if you think about where we are in our state, we are in some big states where it is dominated by regional companies. We outperform them by multiple points. What this weather gives us is an opportunity to take - - continue to take our price increases as we do, but up them a little bit. Just think about our competitors having to take a 12% or 14% rate because they were behind. That creates massive disruption for them. So not only will we get away with this 5%, 6%, 7%, 8% rate increases that we are going to earn our way through. My view is we have a chance to actually grow because of the disruption of what they are having to do to catch up creates some real opportunity for us. So I actually think that helps us - - throughout next year. So I feel good about all of them. So, I would say yes, we are being conserve about the fourth quarter. As we give new guidance, we will probably do it at the next quarter call for next year. We will try to talk about how the sequence through the year, but I feel still, that what we've said in Investor Day is very doable as the year unfolds.

What does that translate into a return on equity for 2010's trend?

Well we haven't guided that average for the year. But what I said is, I would like to see us get to that target run rate by 6 quarters, which is actually the fourth quarter of next year and I believe we can get there. But we will. As I said we haven't given all the guidance on the average numbers and all that for the year, which we will at the next earnings call.

Is that consistent with the Investor Day, the 12%.

Yes, absolutely. Because I talked about this - - getting to the 12% in a six-quarter period, because the big thing, right, is I've go about a 1.5 of excess expense that we are putting into the model here to take advantage. And I have a lot of excess capital, right. And I still have excess capital even after the actions I have taken because I am looking for, is there going to be opportunities unfold for us. In those cases, those are going to get better through the year. Right. On the capitol I am going to make a decision as soon as we - - it's transparent that it's excess, right. If we can't use it to increase shareholder value, we will give it back. And on the expense side, that will go down. In essence these investments are coming through for us. Again, if they are not, I will ratchet back what we are spending. So it was 12%, kind of six-quarter run rate is what we talked about.

Right. And could you just finally, can you quantify the excess capital at this point?

Yes. Again we have done a little bit, but if you look at - - if we look out next year, it is in that 300 to 400 range still. I mean, we have done a lot of interesting, good things. But, we are also earning in the money, so I would say it is still in that range as we look, - - to the full-year next year.

That is very helpful. Thank you.

Thank you.

Our next question comes from Dan Farrell of FPK.

Good morning.

Good morning, Dan.

Fred, can you just comment on what you are seeing currently in the environment for MNA activity.

Yes. It is fascinating. I would tell people this is the quietist storm I have ever seen, but it is a storm. What do I mean by that? Clearly, the spreads on investment bases have come back as a sigh of relief that is visible. But underneath all of this what we see is continued turmoil, particularly for the small companies. I mean, again, what we are seeing in particularly the geographies we compete in, a lot of these regional companies are getting killed. There's a lot of 115's, 120's out there and they are under a lot of stress. So we see both organic opportunities because of that as they have to shrink and hunker down. But I would also say that for some of these small, capitalized specialty companies, there are more and more meaningful conversation about should they get out because of the capital they have to carry and the uncertainty with the economy.

I mean, it is the first time in 50 years. We can talk about the capital thing that's coming back and all that. But the reality is it's the first time in 50 years that the cycle has coincided with an economic downturn. Those two things puts tremendous pressure on folks that are heavy into some of the specialty areas that are most affected by the economy. So our view is you're going to see it. Is there still some higher than should be expectations about pricing for some of these? Sure. But what we see is lots of meaningful conversation going on out there with some of these smaller - - especially companies - - and frankly, in some of the other companies that are subscale in some lines thinking about capital preservation and protection. So I would say we are getting into that stage of the market, that if you are going to see renewal rights, you will start seeing them in the next 12 to 18 months as people re-jigger their portfolio.

And again, I don't think it's - - in our business everything happens slower than people expect, but it's going to happen. You can see the strains out there. You can see some of the opportunities that are presenting. Our philosophy is that I don't need them. I don't need any transactions to do what we are trying to do. But we are constantly having conversations because there are wonderful teams out there that are contemplating their future, and I still think there is some real opportunity. The other interesting thing that is happening, and it is the thing, it's this tale of two cities, that I am sure you guys see even better than I do as you talk to companies. Is this - - all this additional capacity or new capacity, if you will, coming from Bermuda and overseas to the big brokers for large accounts has created a blood bath in some of these segments at the high end. That's going to put continued earning pressure on some of these guys.

Luckily those folks don't have the distribution, the retail distribution and the operating model to get the small faced value stuff. But that puts pressure on the people we compete with, that live up there. That live in the wholesale market, the program equivalent companies that compete against AIX that almost go through wholesalers in large accounts which helps us, because we are protected by that and their overall economics will be challenged by that. So I remain bullish on what you are going to see. I don't think it will be easy. I don't think you're going to have the big transactions, per se, but I think you're going to see the continued consolidation of smaller companies and the share shift in the retail channel with small companies.

That is helpful. Thank you.

Thank you.

Our next question is from Cliff Gallant or Keefe, Bruyette & Woods.

Good morning.

Good morning, Cliff.

Just wanted to talk a little bit more about the expense lever.

Sure.

For the expense ratio to go down you really needed to leverage existing platforms. I was wondering if there is anything you could do more proactively. Are you considering any reductions in anything?

No, I mean, Cliff, it's both. I talked about - - you've heard me talk about this a lot. It is a third, a third, a third for us almost.

Yes.

It is - - if you look at - - Marita mentioned one of our big capital investments in discretionary expenditures this year, which was Think Hanover. We believe that there is a wide open opportunity as some of our Personal Lines preparers went direct and some of the other guys were commoditizing by appointing all of the agents to go to fewer agents with the account offering in (inaudible). We put a significant amount of effort in this over the last 15 months. Spending on a above run rate and - - IT product investments in Personal Lines. The way it works, about half of that is expense and half of it is capitalized. Well you will see us this year take our discretionary investment in technology will go down. So that is very proactive. And if you remember two years ago we put a lot of work in variablizing our IT costs. We can take our IT costs down very quickly and it is very variable, mostly with partners., outside partners. We have that ability to do it. So we proactively can move there.

Second, a big part of our expense this year was our pension ratchet up because of the way the timing of the capitol market collapsed in the fourth quarter/first quarter. Some of that comes back for us as well. So you will see that as a more quicker expense lever, as well. So, yes, it is growth, but there is this discretionary spend stuff that you will see us manage. The other thing I would tell you is that we don't - - because it gets in the wash, our through put efficiency has gone up every quarter we have had this journey. So we have worked hard on variablizing a lot of different costs like data entry and stuff. So some of this is very proactive. Again, that's why I - - we'll get some of it next year. As we give guidance next year, we will be a little clearer about it. But it is not hard to imagine us getting more leverage on our expense base. Now the one warning I would give you is that I will also be very open about whether we see opportunities. Because what I am seeing is lots of action. Not a lot of decisions yet on transactions and things, but we will always be very transparent. If I see something that creates a significant IRR in the future, in the shareholder return, we obviously will jump on it.

But this West Coast expansion, our upgrade and the disruption we are seeing with some of the major players we compete with has created a transparency and a comfort level in my ability to see an IRR very clearly and get commitments before we started. If we didn't see this disruption, would I have waited probably six more months because of the ramp down of Personal Lines? Absolutely. But I saw the opportunity and doubled down doing a little bit doing both at the same time. We believe the expense leverage is absolutely there, we will take some proactive action to get at it. But I will also be very transparent particularly over the next two quarters if I see anything elsewhere where I feel that there is a real opportunity to take a lower risk opportunity to capitalize on it, which we believe is an expense risk versus a loss risk, but, again, we will be completely open to that.

All right, thank you.

Thank you.

Our next question comes from Michael Phillips of Stifel Nicolaus.

Thanks. Good morning.

Good morning, Michael.

Calling upon Fred, that we are still largely a personalized company. A couple of questions on that segment. Fred, you mentioned in the opening comments, 6.2% increase in your growth state and Marita said that the core four were down 2. What was the number for the non-core four? Is that what you mean by the growth states? Is that everything else?

Yes.

That is basically everything.

Okay, great. I am trying to get the dollar amount of this discretionary IT spending in Personal Lines that impact in the third quarter.

Well, in total, the discretionary, if you looked at what we have done over the last five or six years, the run rate of a company - - I believe a normal run rate for us is going to be in the $45 million discretionary run rate level. This year - - and again, I can't give you the exact numbers of expense versus amortization, that number got into the low 60's. Right. So because we accelerated a budget development. And so it is real money, to take it back down to that normal run rate. Now, again, some of that is capitalized. Some of that is expense. It typically runs 50/50. But it is why I guided to this additional investments. What I saw was an ability to take some teams, and I really did believe to accelerate some of our niches, Personal Lines, we increased our segmentation, we brought in a technology team, we are building this technology product that's being launched in January.

All of that also has filing that you have to do and adjust in our technology because of the filing of all those products. That is why the discretionary went up. In addition there was personnel attached to that. But that is why I guided up. Because In the first quarter I saw this opportunity and I started accelerating that stuff so I could hit the ground in the third and fourth quarter. That's what - - we've said from the beginning the momentum would come in the third or fourth quarter because a lot of this stuff was coming into fruition, the Think Hanover, the specialty businesses were being filed and all the states being approved. We were getting kind of - - hitting a little bit more on all cylinders on some of the earlier niches that the distribution was receiving these products. Then in January, we are able to hit the West Coast expansion in most of those states with our full compliment of specialty and niches.

All of that required an acceleration of discretionary spend to the tune of, again, just the IT portion, you are talking a $20 million acceleration. And again so, it is very deliberate. There is nothing - - none of this is ad hoc. None of this is backing into a problem. And what's ironic, guys, people talk about expense ratio, but because everybody else we compete against is shrinking at 6% or 8%, there expense ratio is getting pretty (expletive) close to ours. And what I'm proud about is that most of ours is completely discretionary towards these IRR's that I am comfortable with and will be able to be managed. Again, I am - - would I rather not have to do it? Sure. I would rather have all these products done. But it feels relatively good for us as we look into next year. Again, there is none of these that we are not seeing the kind of mix and product lift that we wanted. And the agents reception has been has been excellent. There's a couple of states like New York and California that have dragged on approval, that always kick in ahead a little bit. But what we expect to get it, get it passed - - but other than that, the reception has been excellent.

And specifically in Personal Lines because we packaged the product enhancements with the the ease of doing business enhancements in the Think Hanover campaign, that the buzz and the attraction and the impact that we are getting is much more substantial than if we had stretched it out. So clearly the acceleration of these IT investments and product investments in the third and fourth quarter bode well for the traction that we will get in Personal Line in the 2010. Which is why we talked about our cash spend in that area being less than 2010 because it really was an acceleration and a packaging of all those things together so we could have market impact with the Think Hanover offering.

Okay. Can I sneak one more in before we - -

Sure.

With Personal Lines you say 4% to 5% auto and home rate increases and that's probably going to get even better. I can see the confidence for next year improving next year there. On the specialty side, I can also see it there. How confident are you that you can do that, maintain or improve the current action year margins on the core Commercial Lines?

That's a great question.

And in the core Commercial as we mentioned in the script, that is exactly why you saw new business at a lower level in the third quarter than had been prior. You see price holding, 2.5 in small and 1 in middle market is not significant but it's certainly better than the averages that we are seeing out there in the industry. We are very careful about what we take in. We are very careful on how we price it. I would say we are holding our own, but I completely agree with you. I think it is an excellent question. We have intense focus on that segment. That is a segment that the growth will be what the growth is. We underwrite it prudently, we price it appropriately and if it sticks, it sticks and if it doesn't, we are okay with that because we are seeing growth in (inaudible-two people speaking at once).

One of the things to remember about us, the non-segment and middle market we have - - most of our business is quite small, right? The vast majority. So while 2.5 in some of the lines aren't complete, inflation - - it is pretty (expletive) close. And what we are doing is re-underwriting. So we actually feel pretty good. But it is the challenge, that to me is the heart of what we need to focus on for our momentum. It's the making sure that all our middle market is segmented and achieving the right rate and our mix continues to improve. But again, one of the benefits we have, is most of our business is small. We got out of most all of our large accounts, and frankly, like model line comp, we don't have it. So for the most part, our issue is kind of the small - - what Marita likes to call shmiddle, which is the low end of middle market, the unsegmented portion of that and making sure that our underwriters are absolutely gets (inaudible) rates. Again, we have gotten rate. Most of our competitors will talk about middle market not being positive. We have been positive in middle market now for a full quarter. And we have been positive obviously since April on most of our business. So, I feel good, but it is the right question. It is the place we need to zero in and make sure that we are managing our business properly.

Okay, guys. Thanks a lot. I appreciate it.

Yes.

Thank you. Our next question comes from Sam Hoffman of Lincoln Square Capital.

Good morning, Sam.

Good morning. I just have two questions. On other Commercial Lines, your loss ratio which had been in the 35% to 40% range pretty consistently since 2006 and even into the beginning of this year is now kind of in the mid 40's. I think last quarter you had described kind of an increase in severity of the cause and of the increase in the loss pick. And now I think it is kind of the permanent increase, at least for the time being. So, I guess my question is, can you give a bit more color as to what specifically is causing it? Is it just the Surety business? Or are there other classes of business that you are being more conservative on. Also, are there other lines that are giving you concern where you potentially might need to increase the accident year pick in the future?

Sure. Good questions. The other obviously makes good money for us. So let me just - - The other has changed the nature of what's in other has changed dramatically since the dates you described. We didn't own AIX before. Obviously, also in there is a lot of the other specialty lines. And bonds is obviously in there, too. So, what we have done, again, when you look at what we have looked at, it is particularly around the Surety business. It is not a big amount. But we did take the accident year up because of where we are in the cycle. We still are doing great, we are making money, it's fine. But I just feel that given where we are in the cycle, and given the activity we are seeing in contractors in general in the industry, that it was appropriate for us to do it. It obviously, at the same time, we are thinking about pricing going forward. I feel very good about what pricing we are achieving in those Lines.

On AIX, we did have some severity, but it was on programs. If you recall what I said before the last call, and I feel very good about this - - when we bought AIX, there was some programs, because of their ratings, not programs we would have written. So we have discontinued all those programs. But there was some severity that came out of those programs as we ran them off. So that we feel good that that is gone. So I don't think that was a permanent thing. It was just one of those things where they as a lower-rated company did a little bit of stuff that was a little more volatile that we wanted to drive off. So, again, you are absolutely right. We did take it up. We are being conserve there. I feel like the earnings of that business has been outstanding for us and will be fine. But we did take it up.

Are there other lines that you think might require an increase in the loss pick going forward?

Obviously this year in our numbers, and Marita talked about it in our script, with the return premium in comp, there is an impact. Now what is interesting about us is that we don't have much comp in total. We don't have a lot of monoline comp and we don't have a lot of large stock. So the smaller comp is performing very well for us. But we did have a movement in that line which is almost directly attributable to the increase in return premium. Again, it is a peanut in total, but it is the other place we looked. The auto, while over time, that has come down a little bit, it is still very attractive to us, our Commercial auto and we see it actually stabilized.

So the question for us is not the huge fear about our Commercial results. I tell you, our Commercial results is really a - - it is two issues. One is earning in the additional expense we have in Commercial, which changes our combined ratio dramatically. And then the other issue is just making sure as we go forward in our flow businesses, as was asked earlier, that we are achieving the kind of rate and pricing and mix that we are comfortable with so that we don't have a slow decrease in margin. Again, I don't see that happening yet. And so I feel very good about what is coming in. And as Marita said, we will slow the growth there. Because we have plenty of growth in stuff where we believe we have adequate margins, so there is no real need to push it. So I feel we are in pretty good shape.

And when does the AIX business that is not the quality that you are looking to have - -

Pretty much gone. I would say this quarter - - because again, the nice thing about them, they have a contract. The way those programs work, they can just stop. Right? There is no remnant. It just goes away. We would have closed on December of last year, I guess. So there might be a little bit in the first quarter, but a vast majority of that stuff is all behind us. So I feel very, very good by the way about - - I tell you, the AIX stuff, our rating increased, them coming on board, using a retail distribution, the quality and what I call age of that business, most of the business we are picking up with AIX is stuff that was with the people we were getting it from for years, if not decades. So it is stuff that is stable, transparent and good margins. So I am pretty excited about it.

Okay. My other question is for 2008 and 2009 , you have experienced pretty consistent higher non cat and cat losses in homeowners and Commercial Lines than you would have capitalized. Because of that you would - - accepted. What in your statistical analysis makes you believe that this is actually good business? Meaning, in the states that you are located in, at the pricing you are going to be getting, is this in fact good business. Or has it been under priced given the higher cats that are expected currently in the marketplace and given the companies have really been competing aggressively in moving their business to the Midwest from places like Florida, California and so

Yes. It's a great question. So, again, when we look at it, you have got to remember, the entire industry destroys economic value, right? So on average, it is not just homeowners. The entire industry doesn't earn cost of capital through the cycle. So homeowners is not a unique thing about our industry. So when you look at some of those analysis that say homeowners is under-priced. We outperform in our core states against regional companies in a lot of cases 5 to 10 point. So there is no question that homeowners has under performed through the cycle. And there also isn't any question that the Midwest, parts of the Midwest, has chronically had some problems, probably in the last three, four, five years that have been exaggerated as people have gone to those markets. So both of those things are true.

Now if you look at our business, through the cycles have been great. So, yes, for seven quarters we have had above average non-cat weather. And I wish I was smart enough to know if it was permanent, but I am not. But what I am smart enough to know is to assume that it is. And take rate that essentially gets us to cost of capital assuming it is permanent. Our data would tell us this is a relatively cyclical thing. Over the last couple of decades, the last two years have been the worst two years as far as non-cat weather and it is spiking. It is somewhat cyclical. But that is just better for us if it goes back to normal, so we have assumed a higher. The question you asked is the right one.

We believe very, very strongly this account focus, mirror fluent focus that we have, that our full account and our homeowners on a stand alone basis in the account will earn cost of capital through the cycle. We believe that. We believe we can achieve excess returns in that business and in the accounts through the cycle. Now, again, I would tell you that you are absolutely right about this non-cat weather. It has been - - there's 26 states in the last two years that have had their single worst storm ever and it's all occurred in the last couple of years, which is a remarkable thing, right? So, again, I do think that it is important for us to stay on top of rate. It's important to make sure that we are not doing monoline home. You have seen us get out of Florida home. You have seen us get out of Rhode Island home. You have seen us decrease our exposures in the Southeast dramatically where we thought there was chronic problems with pricing. But I think where we are, we are very confident that we have set it up to get our targeted returns through the cycle. Okay?

Okay. Thank you.

Thank you.

This does conclude the question-and-answer section. Gentlemen, do you have any closing remarks today?

We don't other than to thank everyone for their participation on the call and we will look forward to speaking with you again in a quarter's time. Thanks very much.

Thank you for joining us today. At this time, the conference has ended. You may now disconnect your line.