Hanover Insurance Group Inc (THG) 2012 Q2 法說會逐字稿

Welcome to the Hanover Insurance Group's second-quarter earnings conference call. My name is Larissa, and I will be your operator for today's call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session. Please note that this conference is being recorded. I will now turn the call over to Oksana Lukasheva. Please go ahead.

Thank you, Larissa. Good morning and thank you for joining us for our second-quarter conference call. We will begin today's call with prepared remarks from Fred Eppinger, our President and Chief Executive Officer, and David Greenfield our Executive Vice President and CFO. Also in the room and available to answer your questions after our prepared remarks are Marita Zuraitis, President Property and Casualty Company; Andrew Robinson, President of Specialty Lines; Bob Stuchbery, President of International Operations and Chief Executive Officer of Chaucer.

Before I turn the call over to Fred, 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 such as our guidance, total segment income, and income per share for 2012 and commentary on 2013 and '14.

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 statements action in our press release, Slide 2 of the presentation deck, and our filings with the SEC.

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

Thank you, Oksana, and good morning, everyone, and thank you for joining our call today. The results released late yesterday were in line with the early information we provided two weeks ago. Net income per share for the quarter was $0.46 and operating EPS was $0.22 which translates to an annualized operating ROE of 5% through the first six months of the year. Our book value per share, which is now $58.81, increased 8% over the last 12 months and 2% during the quarter.

Though our earnings for the quarter were disappointing due to some specific challenges we faced, we continue to see favorable trends in our businesses and progress on our strategic priorities that positions us well for continued earnings improvement. Weather once again affected our domestic results. Our catastrophe losses in the US were $71 million or 9 points of the combined ratio. Additionally, in response to some emerging loss trends in auto lines, we increased our loss estimates most notably for 2011.

We also increased loss estimated on our Contract Surety book. However, despite these challenges, we produced a profitable quarter given our diversified and improved portfolio. Importantly, we made progress on our key strategic priorities. We continue to improve the quality of our business mix for targeted pricing and underwriting activity and increase share of the higher-margin business in the mix. We further strengthened our position and alignment with winning agents while maintaining a disciplined focus on pricing. We have also gained expense leverage through operating model efficient.

Finally, July 1 marked one full year since we completed the acquisition of Chaucer. Over the past year Chaucer has delivered strong, pre-tax segment earnings of $88 million. Before I go into these areas in more detail and offer some thoughts on the market, the trends we are seeing in our business, and the impact they should have on our 2012 and longer-term outlook, I would like to have David review our second-quarter results and provide you a better context.

Thank you, Fred, and good morning everyone. Net income for the second quarter was $20.8 million or $0.46 per diluted share, compared to a net loss of $32.2 million or $0.71 per diluted share in the prior-year quarter. Our segment income this quarter with $10 million or $0.22 per diluted share, a substantial improvement over the loss of $38.4 million or $0.85 per diluted share in the prior-year quarter.

The difference between net income and segment income is due to our realized gain from CMI, a small Worker's Compensation third-party administrator business we sold. This business was not a strategic part of our core operations, and the sale allowed us to free up a modest amount of capital. This transaction resulted an after-tax gain of $11 million or $0.24 per share, which is included in discontinued operations.

Catastrophe losses this quarter was $74 million compared to $157 million in the second quarter last year. While losses in the quarter were much lower than the record high cats we experience a year ago, they still represented nine points of the domestic combined ratio which is about three to four points higher than the longer-term expectations for this business. The quarter was also impacted by unfavorable prior-year reserve development.

Overall for the Company, we recorded net unfavorable prior-year development of $17.2 million or 1.6 points of the combined ratio. Compared to net favorable development of $15.3 million or two points in the second quarter of last year. The unfavorable development was primarily attributable to a $13 million increase to the contract portion of our surety book which is included in our other commercial lines business as well as $8.3 million related to auto lines.

As you know, we significantly refocused and re-underwrote our Surety business beginning in 2009. Given the financial crisis and subsequent weaker economic conditions, certain issues in our book became apparent. As a result of our actions, premiums in the Contract Surety book was reduced from a high of $80 million in '08, '09 to only about $40 million this year.

Over the last two years we have dramatically tightened our risk and financial metrics, upgraded our credit rating criteria, as well as brought in a new leadership team. As we mentioned in earlier calls, our Contract Surety book is currently divided into accounts we intend to support which presents the majority of the book, and accounts that were put in runoff, which includes accounts already in claims or are otherwise closely monitored so that any potential loss can be managed for the best outcome.

During the quarter, we completed a comprehensive account by account review and applied further stress testing for persisting economic pressures on our book. As a result, we identified some issues, primarily in the runoff portion of the Contract Surety portfolio, which led us to record increased prior year losses of $13 million this quarter.

By way of background, we have been in this business for a very long time. Our Contract Surety book focuses on general construction with an average bond value of less than $2 million. The average duration of a project is less than two years, although projects frequently begin subsequent to the date the bond is written so there is an extended exposure period that runs from the date the bond is written to the date the project is fully completed.

To try to put this in perspective as to how this business impacts our financials, our overall Surety book of business performance over the past 2.5 years has averaged a combined ratio of 138%. Nonetheless, the attractive core of our Contract Surety business continues to perform well, and we continue to realize good performance in the commercial portion of the surety book.

Finally, as it relates to our recent quarter loss experience, we have seen improvement in the underlying loss patterns. While we are still seeing claim activity, the average size of losses has moderated as the average project completion ratio improved compared to only a year ago.

All in, we are confident we have taken all the appropriate actions to improve the financial performance of this business. And, while we anticipate a moderation of loss activity from the runoff portion of the Surety business, we have incorporated in our financial outlook a higher expectation of losses for the second half of the year than we originally planned. At the same time, we believe we will continue to see positive earnings contributions from commercial Surety and the go-forward Contract Surety books. And we believe this issue will have little to no impact on our 2013 earnings.

Besides the Contract Surety impact, we recorded unfavorable loss reserve development of $5.1 million and $3.2 million in our commercial and personal auto lines, respectively. The increase in net ultimate loss estimates was primarily in the 2011 accident year driven by higher severity trend in liability lines which began to materialize in the first quarter this year, including the impact of a small number of large losses in commercial auto.

That covers the more significant loss developments this quarter. We had some pluses and minuses in other areas. In Homeowners, we recorded unfavorable development of $3.5 million that related to late reported hail claims on non-cat storm losses in the latter half of 2011. And we continue to see favorable development in the multi-peril line and workers' compensation line in the US as well as at Chaucer overall.

While unfavorable development recorded this quarter is clearly a focus for us, it represents less than 0.5% of our total net carried reserves, and we believe we have reacted relatively quickly through regular underwriting and pricing actions which have been underway and will continue.

Moving on to a discussion of our underwriting year results -- accident year underwriting results, excluding catastrophe losses -- in commercial lines, the accident year combined ratio was 98% for the current quarter compared to 97.9% last year. Underlying the stable margins, our expense ratio continued to improve. The improvement comes from fixed cost leverage driven by earned premium growth, a more normal pace of business investments, as well as the improving efficiencies in our operating model.

The quarter's expense ratio 36.4% was impacted by the timing of certain performance-based expenses. The six-month 2012 expense ratio of approximately 38% is more in line with our expectation for the full year.

The reported commercial lines current accident year loss ratio indicates deterioration in auto and other commercial lines. But, on a fully developed 2011 basis, results are more consistent as we are seeing relatively stable loss trends as favorable frequency trends are offset by emerging severity trends. In Personal lines, the accident year combined ratio excluding catastrophe losses was 91% in the current quarter compared to 91.8% in the second quarter of 2011.

The improvement is attributable to more favorable non-catastrophe weather losses in the current quarter notably in our homeowners line. In auto, through six months the accident your loss ratio was flat. Like the industry we watch this line closely and analyze the liability as we continue to react with appropriate rate actions.

Chaucer delivered its highest quarterly profit since the acquisition closed a year ago, generating $30 million of segment income before taxes. Chaucer's combined ratio of 91.9% included a low level of catastrophe losses of $3 million and favorable reserve development of $5 million primarily within the 2010 and 2011 accident years.

Chaucer's expense ratio with 37.2% this quarter, which is in line with our long-term expectations for this business. We continue to be pleased with Chaucer's business portfolio, disciplined underwriting practices, as well as the more favorable market trends evident in its business segment.

Moving on to a discussion of our investment results, net investment income was $68.5 million for the quarter, up about 12% compared to the $61 million earned in the prior-year quarter. The Chaucer invested assets acquired last year are the main driver of the increase offset by lower yields on re-invested assets. For the second quarter our overall earned yield on the fixed maturity portfolio was 4.3%. The Hanover's fixed maturities yielded 5.1% compared to 5.3% in the prior-year quarter, and Chaucer investments yielded 2.3%.

As you can see, on a sequential basis, we continue to generate a strong level of net investment income. Our yields are relatively unchanged as we continue to find favorable investment grade opportunities in the fixed income space. At June 30, 2012 we held $7.7 billion in cash and invested assets with fixed income securities representing 85% of the total. Roughly 94% of our fixed income securities are investment grade, and the average duration in the portfolio is four years.

Our balance sheet remains strong. We ended the quarter with $2.6 billion in shareholder equity. Our book value per share at June 30, 2012 reached an all-time high at $58.81, up 8% from the $54.44 at June 30, 2011 and 2% from $57.65 at March 31. Our capital management approach balances rating agency and regulatory capital requirements with plans for reinvestment in our business and opportunistic capital uses.

And we will continue to be diligent balancing all of our capital requirements and opportunities going forward. During the quarter we repurchased 259,000 shares of common stock for $10 million in open market transactions. We have $125 million remaining in our share repurchase program, which we can deploy opportunistically based on market conditions.

We have good financial flexibility with a debt-to-capital ratio of 26% and total capital in excess of rating agency requirements for our ratings. Our holding company cash and investments were $185 million at June 30, representing two times our external interest in dividend requirements, and we also maintain a $200 million credit facility that provides additional flexibility.

As a confirmation of our overall financial strength and the health of our Company, all rating agencies affirmed our current ratings in this year's review cycle which for us typically runs April through June. In their reports, they noted improvement in our market position and business diversification, lowered integration risks associated with Chaucer, and strong enterprise risk management culture and processes.

Overall, despite the environment and some of the specific challenges we have discussed, we are pleased with the underlying trends in our business and our financial position. With that, I will turn the call back to Fred.

Thank you, David. As I mentioned earlier and David just reiterated, we feel very good about the fundamentals of our business, our position in the market, and our prospects in the future. When we evaluate the progress on our strategic priorities, we are pleased with the headway we have made, particularly given the on-going pressures in the economy and the current marketplace.

At this critical time for the industry, we remain fully committed to underwrite the best business. This means a heightened focus on pricing actions, continued exposure management practices, effective measures in the run-off portion of our Surety book, and continued efforts on realizing the value of operating model efficiencies. Through these lenses, I'd like to review the business initiatives we continue to implement this quarter as well as discuss the market environment in each business segment beginning with commercial lines.

We achieved growth of 9% in core commercial on the second quarter 2012 primarily driven by pricing, continuing strong retention levels and increased new business with our partner agents. Overall, price increases in the core businesses were just over 6%, demonstrating the continued success we are having in driving rate improvement. Our price increases in the middle market were 7% in the second quarter of 2011.

In commercial auto, where we experienced an increase in severity, our pricing increase 5% compared to 1% a year ago, and we are planning and expect to receive higher rate increases through the end of the year. We approach price increases in a thoughtful targeted manner so as to minimize disruption and improve the overall quality of our book. We believe our results this quarter demonstrate that this strategy is working. Retention continues to be strong, and we are confident our distribution strategy will enable us to achieve additional rate increases in the coming quarters.

We continue to increase new business production and further strengthen our position with winning agents who understand and are aligned with our focus on the importance of writing profitable business. New business is coming from our targeted industry classes with lower property component, and we believe the quality of this business has never been better. The growth momentum in all of our business provides us the flexibility to be more aggressive in our profit improvement initiatives.

Our exposure management actions are on course. And, while we curtail some growth primarily in the CMP lines in certain states, we believe this is the right trade-off to make considering recent weather patterns and trends. As a result of the price earning through our book, mix changes, and given our current view of loss trends, we continue to be confident in improving results going forward.

In our Specialty lines we grew 20% this quarter driven by [x], healthcare, management liability, and specialty industrial segments. Rate increases across specialty businesses averaged over 8%. And, importantly, as our newer businesses mature, and, as we gain efficiency in our core commercial segment, our expense ratio continues to move down from its high watermark of 43.5% in the first quarter 2010 when we were making our most substantial investment in commercial lines. And our normalized expense ratio run rate has decreased by over a full point from last year.

In line with our aspirations to be a top quartile insurer, we had to go through a period of very significant investments to build our competitive advantage in commercial lines. We have always been attentive to our expense base, and we remained focused on our goal and continue to execute on our promises as we build a strong and profitable insurance franchise.

In personal lines, our focus on improving profitability translates into continued rate increases and managing pockets of exposure concentration in certain areas. In terms of pricing, the momentum we saw in the first quarter improved during the second quarter as our applied rate increased to 5% in auto and 9% in homeowners compared to 4% and 7% respectively. And we expect continued pricing opportunities going forward.

It is important to note that the steps that we are taking are not limited to rate. We are working on a number of levers as we target improved underwriting margins. They include underwriting actions particularly changing underwriting standards with respect to actual cash value groups, win deductibles as well as risk selection and location. We continue to actively mitigate property exposure in the second quarter as we did in the first. While these efforts are ongoing, they affected growth during the second quarter more than in recent quarters and were reflected in the premium decline of 1%.

During the quarter we executed a renewal rights transaction with another party affecting approximately $30 million in annual net written premium and eliminating roughly 80 legacy agents in New York, New Jersey, and Connecticut. This transaction included 100% coinsurance agreement running from May until this agreement is expected to be fully executed, a period of approximately 18 months. As we discussed at investor day, we believe reducing micro-concentration in some geographic areas enables us to improve long-term margin in our business and provide additional profitable capacity for our partner agents.

Adjusting for this transaction, we would have reported a net written premium growth of 4% in personal lines. This growth rate is more in line with the premium increases expected for the rest of the year. We will continue our pricing and underwriting efforts to achieve further margin improvement. We believe that we will be successful given our strong relationships with our agents and the unique value proposition we bring to our customers.

Finally, we could not be more pleased with the way Chaucer has performed in the year since we completed our acquisition, and we are very excited about the opportunities that lie ahead. With Chaucer, we now have a more diversified balanced company with greater scale, higher earnings resiliency, broader product capabilities, and greater earnings power. The financial benefits of Chaucer have exceeded our initial expectations. As part of the Hanover for four quarters, Chaucer has proven to be accretive to our organization.

This said, we are only beginning to unlock the strategic value and distribution synergies that Chaucer brings to our Company. While we intend to proceed methodically, we expect these synergies should further help build long-term shareholder value by improving the distinctiveness of our Company for our best and largest agents and brokers and enhancing our long-term returns and book value.

In the meantime, the market environment (inaudible) continues to improve. Rates and terms and conditions strengthen a majority of the property lines and especially in those areas affected by last year's cats. Additionally, as the market responds to recent losses in energy and marine sectors, we are seeing pricing in these accounts improved as well. This said, in UK Motor, rates have moderated on the back of substantial increases over the last two years.

The current underlying loss trends in Chaucer's business continue to be favorable. The quarter benefited from low frequency and severity of large losses, and this was complemented by benign non-catastrophe activity. Top line growth also continues to track our expectations. We are confident Chaucer will continue to add to our earnings power and strengthen our market position with the best distributors going forward.

Based on the trends we just discussed and incorporating the first six months of operating results, we currently expect our segment earnings for the full year 2012 to be in the range of $2.70 to $2.90 per share. The major drivers for the change from our original outlook are the following. We now expect catastrophe losses for the year to be six points of the combined ratio reflecting the first six months of actuals as well as a higher provision for July catastrophes in the US, which puts our third-quarter catastrophe loss ratio expectation at around 7% of earned premium.

Our updated outlook also incorporates a more conservative view of our auto margin, no material impact from prior-year reserve development favorable or unfavorable, and a more conservative view on our Contract Surety book. Overall, despite the challenges this quarter, we are excited about the capabilities we've built into Hanover, the progress we have made, and the momentum we have in the marketplace.

We have a very strong and balanced book of business, but, as we've mentioned in the past, because of the recent weather patterns and economic trends, we believe it is important to remain focused on our underwriting, pricing and mix management to ensure we can continue to improve our financial position. Given our strong position with agents and brokers, our improved mix and maturing businesses, as well as the addition we have made to our team including Chaucer, we are strongly positioned to fully capitalize on the changing market and achieve our financial goals.

We are in a good position to significantly improve our financial position in 2013 and reach our financial goals in 2014. Thank you.

We are now ready for questions.

(Operator Instructions)

Dan Farrell, Sterne, Agee

A couple of questions, first on your new back guidance -- the back half of (inaudible) how do we think about that for maybe next year. Is that -- should we put that as the run rate because of you are engaged in ongoing catastrophe management. And then, I'm also surprised you bumped third-quarter more. I realize we are in hurricane season but you've also done a lot to address (inaudible) because some of the events that have taken place thus far?

Dan, I am sorry, it was very hard to hear you, if you can talk a little bit louder.

I think we got some of it, Dan, and maybe you can come back around. Let me start with the second point on the cats. We bumped the cats in the outlook because of obviously what happened in the second quarter, but also, you will recall there was a lot of activity around the end of June and into early July. So we already have an indication of some activity in July. Now I realize it is early in the quarter, but we are taking a view that we think the quarter will be a little bit higher than our original expectations as a result of what we have already seen for the first month of the quarter. It always prudent if -- you can do the math that we gave you, but it is saving $10 million to $12 million more in the second quarter because of what we saw, and it was that significant storm, the last few days of June and then it was the first three or so days of July that drove It.

The other question you had was about our cat picks. As you know, last year a couple of things, we felt that it was very important, we said it at investor day, to assume that some of the weather patterns that we are seeing are real. So we took our non-cat estimates up 3 point this year. That's why some of the rate activity kind of transitioning through this year.

We also took our cat percentages up. We haven't yet determined exactly what our cat percentage will be next year. But, as you know, we have thinned out a lot of business. At the investor day, I talked about $200 million worth of business because it is not just -- it's not really hurricanes. It's this notion of having some micro-concentrations with all of these kiddie cats that we are experiencing that are quite different. And so we have taken a lot of action to reduce, we had mentioned, about $200 million worth of business, which we are about two-thirds of the way down finished. And so I am not necessarily sure we will take up our cat estimates next year at all or if that much. Because, again, we believe that our mix -- all our strategy towards a more balanced geography and a more balanced property casualty I think offsets -- offsets kind of the trends in the industry. So, again, I think we are likely to be close to where we are today at the end of next year, but we haven't really fully assessed that.

That is helpful. And then just on the Surety line, you said you pushed the provision for higher losses through the rest of this year. And that through prior year development or higher accident year loss rate, it's unclear to me if some of the contracts you obviously started in 2008 -- it seems like some construction, not as much in the reserve development, but obviously you've taken some higher ticks as well. And then 57.1% accident year loss ratio ex pat in commercial line is that a run rate, or should we think that is having a little extra to sort of catch up for the previous quarter?

Let me try to cover that first point, Dan. When you look at Surety it's a little bit different than the more traditional insurance lines in terms of current year versus prior year determination, because as you point out, the projects span multiple years. The premium is written in a particular year and then the point at which a project fails is sometimes debatable in the process. Obviously the day we get the notice or the day we determine is one thing, but the actual date in which we might choose to determine a loss could be different.

So, I don't want to bog you down in all the details of that, if you will. I do think we will see some prior year development and potentially some also current accident years. We talked about in the outlook. I couldn't predict for you at this point without knowing explicitly what projects fail or what projects we're seeing losses come through whether it's going to show up in prior year of current year. So, it's one of the reasons why made the comment about just looking -- trying to look at the ratios in this business more on longer-term basis than on a period-to-period or quarter-to-quarter basis or year-over-year basis.

And in terms of the run rate, I don't have that in front of me, I think in terms of the other commercial line run rate where we are now is similar to where we will be in the second half of the year, maybe within 1 point or 2. I don't expect to be much different from a comparative standpoint. And I think if you compare it year over year, we were higher last year in the third-quarter in the other commercial lines. So, we think that will also sort of work its way out as we go into the second half of this year.

Just one additional follow up. You talked about all this (inaudible) that you are working through some of it this year. but you don't think there much if any tax impact in 2013. Could you talk broadly about what gives you that confidence that you know -- (multiple speakers)

Yes. Dan, that's a good point. This book, again, if we were in this business, if Hanover was in the business 100 years, Surety. There was a small portion of this book that we inherited that was small contractors and had certain characteristics. That portion of the book grew a little bit, but that is the book we really attacked in '09. It has very specific credit characteristics. If you look at the losses we have experienced, that is where the vast majority of all the losses are coming from. And that is basically going away.

So that book of business and those projects are finishing. And so you can look at the kind of result in all the different ways look at losses and experience in those particular projects. That business is pretty much done. So by the end of the year, that's a loss going away. So that is why we look going forward, and the business we have actually kept in our core business is running very, very well. The credit characteristics are outstanding. It's got more mixed toward a more sophisticated contractor. It is more commercial surety, it's more flow commercial surety. And so the core of our book, both contract and commercial, that remains is quite attractive. And the rest of the business and the projects are essentially getting finished, and that is why it is pretty clear what is going to happen by the end of this year.

Cliff Gallant, KBW

When I look at the guidance now and if I sort of back of the envelope math. I figure 3 or 4 points of the bad weather in the second quarter and in the third quarter were to be pulled out, that would indicate that your underlying or normalized earnings powers was in the $4 range. That means an average ROE -- I think it's a little less than 7%. Is that the way we should be thinking about the profitability potential of the Company today? Is that the right math?

I think if you look at the components, the three components we talked about, the weather, you can do the12 and see what that is -- that change. And the other is probably a point in Auto that comes from these trends where we think it is conservative and appropriate, given what other people are seeing in the industry to take a different outlook -- a little bit more conservative outlook, particularly on the severity side of the Auto business going forward. And then to a much lesser extent, some -- the Surety adjustments. The upside obviously, the reason why we think there is going to be so much upside in '13 is our price almost across the board is above our loss cost pretty significantly now. So even in commercial auto and in personal auto where we're making adjustments, our current rate level is better than our loss cost trends. So what you're going to see is increasing earning power in the business in '13. That's why we're so confident. And then, obviously, the drag to your point, as Surety ends, there is an upside to that. So that is why I think between -- through '13, the improvement of mix, the pricing earning its way in. We also will have additional leverage on the expense side. We think that earnings power increases in '13, and, as I said, I think by '14 we are in our target range.

Okay. All right. Thank you.

Meyer Shields, Stifel Nicolaus.

A couple of quick ones and then maybe a bigger picture question -- with the real rights transactions, should the offset to written premium growth, is that pretty evenly spread over the next three quarters?

No. Actually a lot of it affected us this quarter because of the way the transaction came through. We do -- we expect we will be back on a growth pattern to the comments that Fred made when we get into the next two quarters. And really, overall, the amounts involved here are not that significant that I think it would affect your spreading, if you will.

Okay. So the fact that it was actually negative growth you are saying is an anomaly.

Yes. A lot of it has more or less through now.

That is very helpful. What were the PMI results reported that until now, anything commercial?

Yes. It is pretty spot on a performance basis, so I won't go through the actual number. But it really will have a very tiny effect on our -- really almost no effect on our earnings going forward.

It was a pure servicing business so there was no underwriting aspect to it.

Right. I understand that. And the bigger picture -- you talked about how rate increases are exceeding current terms. And I think that is consistent with what we are hearing across the board. What leading indicators do you look at to see where a trend will be when these rate increases are being earned.

The indicators for trend, you are saying?

Right. In other words --

Go ahead.

-- trends get worse now and then ultimately keep up with or even exceed the earned premium increases stemming from higher rate levels.

I guess we look hard at the trends and what the timing of the trends are, and, as I said, we haven't seen anything in the trends. If you look at frequently, because our mix of business is getting better in most of our businesses, we are seeing a continued decrease in frequency. And, as we said, in a couple of the auto lines, we are seeing severity pick up a little bit. But the loss cost trends in total have not changed that much for us across the board so far. So we don't see that changing right now, and we see the pricing trends maintaining and going up a little bit in our businesses.

Okay great. Thank you very much.

Matt Carletti, JMP securities.

Fred, I just had a question -- wanted to talk about UK Motor for a second. In recent conversations I have noted some people are a little more concerned about the line. I would not say alarmed in any way, but it comes up in conversation and you mentioned the rate environment easing a bit. Is that your only concern right now, or are you seeing underlying car trends deteriorating as well? And kind of as an add-on to that, is that a line that longer term is core to Hanover, or might at some point you look for options if it were to deteriorate?

I'm going to let Bob answer the question, and I can follow up Bob if there's anything.

First move on to the rate expectations we've got. Obviously you have had a situation where there needed to be some quite severe adjustments over the last couple of years which we managed to get through and the market did as well. So we have seen a moderation of those rates increases in 2012 as we brought that group back on track. The book is, (inaudible) the corporate failure we have got has remained pretty static, we are very selective about what we do right. We have a very low market share in the UK. so some of the industry dynamics with -- being talked about, probably aren't as apparent to us and quite significant to us. And so (inaudible) from our point of view, we are comfortable with the rating numbers we are seeing at demand performance of that book. I really don't know indications, because everything other than we expected taken from market conditions.

If you recall from our earlier conversation, to Bob's point, I don't want to describe it as a nonstandard, but we have a very interesting mix of program business and some specialty auto business. And it is not that big, and we got good rate increases over the last -- very significant rate increases the last couple of years. And we've had very stable earnings right now. So I think we're -- we feel like we're in a pretty good place right now, and we don't see a big change in our ability to earn the margins we expect this year.

That's fair.

Okay. That's helpful. And then just kind of a follow-up on the ROE and kind of acts that your improvement discussion, refresh my memory, is it a 12% ROE, or 11% to 13% is the target. So going on the math that was gone over before, you pointed to normalizing things, I think you might call rough numbers, if you were to normalize this year, let's say, so a 7% ROE. So I guess you feel confident that, given the rate increases you're seeing and the loss cost environment you're seeing, that, over two years, '13 and '14, there's 500 basis points of ROE improvements to be had?

Yes. again, one of the things that is unique about us, you guys know this, in '09 when we got rate increases, we had made the Company better. But my view was that our portfolio wasn't distinctive enough and wasn't diversified enough to have sustainable ROE's in the range that we believe we needed to do to be one of the better companies. And so, a lot of our investment from '09 forward was to change the portfolio, whether it was the contract acquisition of renewal rights deal, the investments we made in some of the specialty lines, our portfolio now is dramatically different. It has a nice geographic spread. it's 50/50 casualty property. It is much more distinctive in its mix as far as industry solutions. And so when we look at, it's not -- we are little bit different than others. We get really three things that are helping us.

One is, what I would call, the traditional pricing that people are getting, that we are getting as well, that is really quite helpful. And I would add to that pricing is that we are doing really good work on portfolio improvement, particularly around property. So we have gotten off of, as I said, we focused on about $200 million worth of business that were property centric in places we did not think we could get excess returns or adequate returns. So we have gotten rid of those, and we've gotten rid of a lot of this micro-concentration. About two-thirds of this is behind us. We have been pretty creative with renewal rights and other ways, but we -- some transition costs to that, obviously, but the combination of just core pricing in that has been very helpful.

The second point, though, is the maturity of our businesses. So what we have now is probably $1 billion worth of business that either because of its geography or because it's a relatively new business, where we built the operating model in specialty or we invested in it. That those businesses are maturing, so not only do I have an operating leverage point, we have a loss ratio point. Because there is no question we minimized new business penalty when we did that, and we did renewal rights and all these other creative reasons to avoid new business penalty. But, obviously when you're business matures and you get the kind of rate increases we are getting, 8.5%, 9% in Specialty and rate increases and margin improvement and mix improvement across the board in some of these new businesses. All of those maturing businesses have huge leverages for us. And, if you add the operating expense leverage, it is very material and you are seeing it, right? It's over 5 points since our peak when we started investing.

And the final point that I would tell you, is that our retentions -- given the market dynamics, and because we focus on smaller average policy size. And because of the disruption and the percentage of our business with partner agents, what we are seeing is we're getting better retention and better stability in a lot of the high margin pockets, which, again, helps the overall performance of the business. So when you look at our leverage, yes, you get the pricing, but we have a lot more other levers because of where we are and what we have done that gives us a lot of confidence and how we are getting it. At investor day I talked about the big components, right, the rate, the mix, and the maturing of these new businesses, and if you look at the portfolio, we have so much more higher-margin and more stable business. Now, I had another one, after today's conversation, we obviously are also putting behind some of the last legacy issues of the -- that we had. And one of them is this Surety business that was not as good as it should have been, and we have probably made a mistake on getting rid of the business quicker. But that is going to be behind us, too, and that is why we are pretty -- we are confident in increasing earnings power of the Company.

We've got to prove. We have to keep delivering it, but if you look at our underlying mix and the moment we have with agents, it is tremendous right now. We are getting best looks at best business, and we are allowed to take the mix changes, because of our partnership position with the agents that we have. So it feels pretty good, but it's little bit different than the traditional guys that are saying my mix is exactly the same, and I am just getting rate. We have other levers because of the investments we have made that we control, if you will. So that is why I feel quite good about.

That is very helpful and the last question is a numbers question following on the rate increases which have clearly have been very nice. Can you give any sort of guidance on where you at least think your loss cost inflation numbers are now so we can kind of get an idea what -- or if you think yours are any different than say kind of the numbers that are thrown around in the industry whether on personal lines or commercial lines or otherwise?

We don't normally talk about the numbers, per se, Matt, but I would say we are not dissimilar to the industry is, we're definitely a few points below where we're getting on rate. So we are very comfortable about the trend, if you will, that Fred was talking about in terms of pricing above our loss cost trend. I would say the other point to be made here is we still have very strong retentions which also gives us the opportunity to drive more rate. So we are not worried at all about the loss cost point at this moment, in this juncture. And, again, I won't go into the actual numbers there, but we're not dissimilar to what we're seeing in trends -- (multiple speakers)

And again, one of the things about us is that we have -- of you look at our -- we have the lowest percentage of middle-market workers' comp in the top 20 companies, too. So that is the one line where the lost cost, has continued to be a pretty significant trends, and we just don't experience it. We are mostly a small Comp writer, and we have a small percentage of Comp? So most of ours -- it is more contained. Because even the severity thing that we are talking about in commercial auto is a very contained thing. It is pretty obviously to see, and we can address it quickly with rates. We haven't -- we don't lot of the long tail -- we don't have public company D&L which I think is another place where people look at that, and say they are a little bit harder. Ours are much more short-tailed, more manageable much more clear and with a gap to us, it is pretty stable.

To your point on commercial auto Fred, when you think about the second quarter of last year we were only getting 1 point of auto price, in a very profitable book. In this quarter getting 5 points of price on that auto book as you mentioned in your script, and only a slight increase in the severity trend plus with what the industry is seeing, it bodes well to what we will be able to build into price in the auto line going forward. So I think that is a very good example of that.

Thank you for the answers and best of luck.

Ray Iardella, Macquarie

A couple of quick questions, I guess first, maybe, David, on the stress test that you outline on the [Sureity] reserves, just curious can you give us a high level where the parameters you are assuming and the worst case scenario? Is it a drastic downturn in the economy, just give us some thought if possible?

I'm going to ask Andrew Robinson who leads our specialty business to comment on that.

Ray, obviously we went through 2008 a pretty severe downturn in the economy. And the construction economy was largely maintained by big infrastructure projects which really isn't where most of our contact books is. So what we are able to do very directly is back cast against a prolonged period that looks like 2008. So what we were able to do, when Fred talked about a go forward book, or David talked about it, what we are able to do is get to the segment of the market that we feel has credit quality well in excess of where the market is today that we would feel comfortable and allowing us certainly some comfort if there was a further downturn in the construction economy. I would say that also what we are thinking very seriously about is where our business is placed.

For example, looking at the upper Midwest is very different than looking at Texas or even down in parts of the Gulf where there is a good deal of land reformation work. And so some of that is very geographic centric about how we look at our portfolio. And so it was those combination of things. And, through the course of the process, I would not say we were surprised by what we concluded and what accounts we are going to support and what accounts we are not. We are just more comfortable that what we have is a view that does look at this sort of stress test of the economy that looks like sort of a period of 2008 prolonged into the future.

That is helpful and I guess my question was more focused on the accounts where you guys have reserves right now. Is there any stress testing you're doing around that? And kind of put some parameters around the worst-case scenario? What are the reserves currently held on that discontinued book and give us an idea of worst-case scenario in your mind as it stands right now.

I think that is exactly what we did and what you saw us do. And so that is why we put the money up. We -- the vast majority of that was about this which says what could happen, what is the worst outlook? And, to David's point, most of it we adjusted in the reserves. But we also are saying on a go forward, we did some adjustment in our outlook to really capture in a pretty bad scenario because we thought it was the right thing to do to be conservative and just really do this and put it behind us. And that's what you're seeing is that kind of assessment and the impact of it on this quarter.

And, Ray, I would add one other item, which is whenever we see a claim situation or a prospective claim situation, we are looking at the principal across all bonded exposure and non-bonded exposure. So if you think about -- our point of view is really looking at the entire financial characteristics of the principal so that we can understand how activities as it relates to some contract that we have or multiple contracts that we have might be affected with some non-bonded exposure, etc. So, for us, we are pretty comprehensive in understanding how some of these things relate and what really could be the ultimate loss associated with a single claim you're getting.

That is helpful and I appreciate the color, so just putting it all sort of big picture, I guess, the majority of the change was IB&R as opposed to any specific cases reserves. Is that the right way to think about it?

No, they're both. Because they are runoff business, we can specifically identify it to the account, it would put it into the case. So we literally did every single account left in our book and did this and assessed it. And again, to Andrew's point, this is a business we were in for a very long time. It was geographically centric to where we used to be big. It had characteristics -- it was mostly small contractors. And, as you know, when the credit crisis came, they were the most affected by this. And so we believe we have a good handle on it. And, as I said, with this stress test on our go forward book, I want to echo how good we feel about our go forward book. Because, even with all of these stress tests and assessments, our go forward in all of these performed very, very well. And so we feel very good about where we are right now in the go forward.

That is helpful. And then maybe moving on sort of ex-Surety in maybe some of the auto line, was there any movement in the loss picks for the current year?

Again, in our outlook, we have tried to adjust looking at the past and looking at our book -- what I was saying about our outlook, a big portion of our outlook change is just taking a more conservative point of view on the current accident year pick in auto, particularly personal auto, we are not as big in commercial auto, and we don't write heavy trucks or anything. So most of our activity is really personal auto. And I would tell you also, that we are not just looking at our book, we are also listening to the industry dialogue about what the industry is seeing and what is unfolding in the industry. Which makes us want to take the conservative point of view on this, because we are not the only person talking about what is happening with severity in the auto book. So we thought it was appropriate for us on a go forward basis to affect our picks. And again, most of this is '11 and forward. Really that's what it is, and that's how we addressed it.

But, besides those points, I think, Ray, there is very little movement in our other picks for the year.

Okay, so second quarter no movement really up or down year-to-date?

Over -- I'm sorry you have to expand on that.

During the second quarter did you adjust any of your loss picks for the current accident year?

Just in the lines we have talked about we have, but across the other lines, very -- we might have tweaked some things but really marginally.

Not materially

And then lastly, and then I'll re-queue. Sorry to take up so much time. Buybacks? What is your thought on that going forward? I know there was marginally some buybacks in the second quarter, but just any color would be helpful.

And I made some references in my remarks, but we saw the opportunity to deploy some capital in buybacks. There was a lot of volatility in the market. We saw there was some good value in putting some money to work here, and we did do some buybacks. And, as I said in my remarks, we're open to potentially doing some more. But, I would tell you, it would be very modest amounts through the rest of the year. So, we have a lot of authorization left. No way are we going to be spending that entire authorization. And I think as we see where our share price is today, and as we look at the volatility in the marketplace, we are going to opportunistically look at putting some money against more buybacks.

Okay. Thanks you for all the answers.

Ray, we don't have anyone else on the line, so we will take your last question. You mentioned you'll re-queue.

No. That was all I had.

Thank you, everyone, for your participation today, and we are looking forward to talk to you next quarter.

Thank you.

Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect