Earnings Call Transcript - DGICA Q2 2020

Operator, Operator

Ladies and gentlemen, thank you for standing by, and welcome to the Donegal Group Inc. Second Quarter 2020 Earnings Conference Call. At this time, all participants have been placed in a listen-only mode, and the floor will be open for your questions following the presentation. I would now turn the call over to Jeff Miller, Chief Financial Officer to begin.

Jeffrey Miller, Chief Financial Officer

Thank you very much. Good morning, everyone. Welcome to the Donegal Group conference call for the second quarter ended June 30, 2020. Yesterday afternoon, we issued a news release outlining our quarterly results. For a copy of that release, please visit the Investor Relations section of our website at donegalgroup.com. In today’s call, Kevin Burke, President and Chief Executive Officer, will provide an update on our business strategy and discuss recent developments. I'll follow Kevin’s comments with highlights of our quarterly financial results. At the conclusion of our prepared comments, we will open the line for any questions you might have. Before we get started, please be aware that our commentary today includes forward-looking statements that involve a number of risks and uncertainties. We described forward-looking statements in our news release. And we provided further information about risk factors that could cause actual results to differ materially from those we project in the forward-looking statements in the report on Form 10-K that we submitted to the SEC. You can access our Form 10-K through the Investors section of our website. Also we use certain non-GAAP financial measures to analyze our business results, and we refer you to the reconciliation of non-GAAP information also included in the news release we issued yesterday. With that, I’ll turn it over to Kevin.

Kevin Burke, President and Chief Executive Officer

Thanks, Jeff, and welcome, everyone. Overall, we are pleased with our second quarter results, and we remain cautiously optimistic as we monitor the uncertain long-term impacts created by the COVID-19 pandemic. Our employees and independent agents as well as our customers have proven to be adaptive and resilient in responding to the challenges related to COVID-19 and the related economic disruption. Conditions and government responses have varied widely across our regions with restrictive mandates that may vary even from county to county within a given state. We’ve continued to focus our efforts on serving our agents and customers while paying close attention to all the regulatory activity, to ensure compliance with all the state and local requirements that apply to us. In late March, we moved aggressively to equip our employees with the technology and tools they needed to conduct our business remotely. While the vast majority of our employees continue to work from home, we are beginning to bring small numbers of employees back into our offices. And when our agents and customers are comfortable doing so, our marketing staff and agents are beginning to resume limited in-person meetings. I want to emphasize that we are taking the health and well-being of our employees, agents and customers very seriously. And as such, we’re being extremely vigilant when it comes to making sure interactions are conducted with appropriate precautions. All the states in which we conduct business began to ease restrictions and reopen their economies during the second quarter. But a number of states have taken a step back following reports of virus resurgence. Since it appears that we may be dealing with starts and stops for the foreseeable future, we are pleased that our online agency portals allow our agents to easily generate new business and provide support to our customers as needed. As a reminder, our business is roughly 60% commercial lines, primarily including multi-peril, automobile and workers compensation products. While we write our fair share of larger accounts, we specifically target small to medium sized businesses like contractors and mainstream business owners that serve critical roles in their local communities. Many of these small businesses received critical, well-deserved financial assistance through government programs that help to bridge the gap until they could fully or partially reopen for business. As a result, we experienced relative stability within our commercial lines premiums. The level of new business submissions from our agents remains very strong, even as our overall premium retention rate increased during the quarter. We quickly responded to any requests for reductions in commercial premiums because of material decreases in exposure related to the pandemic. Midterm endorsements reduced premiums in excess of $1 million during the second quarter, and we expect that we will continue to see declines in exposure-based premiums as we complete premium audits at the end of the policy terms during which shelter-in-place orders were in effect. Moving to personal lines, we saw a substantial decline in personal auto claims activity in the month of April and May, which led to significant improvement in our second quarter loss ratio. Auto claims in the month of June began to return closer to our historical experience as driving activity began to increase. We view the early months of the second quarter as a short-term aberration that will not likely reoccur. We will continue to monitor our personal auto results over the course of the remainder of the year and file rate adjustments we believe are appropriate in light of our loss experience. I am pleased to report we continue to make progress on the development of our new auto and homeowner products and we are on track for deployment for the first group of states in July of 2021. In a minute, I’ll turn the call over to Jeff for his comments on the results for the second quarter. But I want to highlight our net income of $22.7 million or $0.79 per diluted Class A share for the quarter. We had much improved underwriting performance in our insurance operations, with a second quarter combined ratio of 92.3% compared to 102% in the second quarter of last year. Included in our net income figure was $5.1 million or $0.18 per diluted class A share of after-tax net investment gains, as the market value of our equity security holdings rebounded during the quarter. The net income, coupled with the increase in the value of our available-for-sale bond portfolio, drove a 7% increase in book value to $16.77 at June 30, 2020 compared with $15.67 at December 31, 2019. We also continued to maintain our dividend payments and policies throughout recent months as one of Donegal’s core objectives is to achieve solid results and returns and also reward our stockholders over time. We declared a regular quarterly cash dividend of $0.15 per share of our Class A common stock and $0.1325 per share of our Class B common stock. The dividends are payable on August 17, 2020 to stockholders of record as of the close of business on August 3, 2020. With that, I’ll turn the call over to Jeff for more details about our second quarter operating results.

Jeffrey Miller, Chief Financial Officer

Thanks, Kevin. As usual, I’ll highlight a few of the operational and financial metrics for the second quarter. Overall, net premiums written decreased 2.1% to $193.7 million and net premiums earned declined 2.3% to $184.4 million for the second quarter of 2020. Included in the net premiums earned figure is the impact of personal auto premium refunds in Michigan that totaled approximately $840,000. Net premiums written for commercial lines increased 4% while net premiums written in personal lines declined by 8.7% during the quarter. Commercial premiums accounted for approximately 55.6% of our net premiums written during the second quarter of 2020 compared to 52.3% for the second quarter of 2019 and 61% during the first quarter of 2020 as a large number of commercial accounts renewed at January 1st. We were pleased that our underwriting activity remained steady during the second quarter, in light of the challenges our agents and customers faced as they dealt with significant uncertainty as the coronavirus spread and government shutdowns went into effect. Net premiums written in our commercial auto business grew by 10.5% in the second quarter with premium rate increases accounting for 8.3% of the total growth. Commercial multi-peril increased by 6.7% with virtually no rate adjustment. Conversely, worker's compensation net premiums written declined 8% with rate decreases responsible for 5.5% of the decline and the remainder attributable to the widespread disruption of business activity due to coronavirus-driven restrictions. In addition to a continuation of steady premium growth, we are also pleased that our commercial lines business segment continued to perform well, delivering a statutory combined ratio of 93.5% for the second quarter of 2020, which was comparable to the 92.9% combined ratio for the prior year’s second quarter. The reduction in personal lines net premiums written continues to be a function of lower new business growth, partially offset by rate increases that averaged 4.1% for the quarter. The decline was again due to our emphasis on pricing discipline, which resulted in a natural attrition in premiums that exceeded new business writings, primarily as a result of lower claim frequency in personal auto related to reduced driving activity during the period. We experienced greatly improved underwriting performance as evidenced by the 88.1% statutory combined ratio in our personal lines segment for the second quarter of 2020 compared to 108.5% for the prior second quarter. Moving to the loss factors that impacted our underwriting results. We reported a 57.1% loss ratio for the second quarter of 2020 which compared favorably to the 69.7% loss ratio for the second quarter of 2019. We mentioned the reduced auto claim frequency which was one of the primary drivers of the improvement. Weather-related losses of $18.7 million or 10.1 percentage points of the loss ratio for the second quarter of 2020 were higher than $17 million or 9 percentage points of the loss ratio for the second quarter of 2019. The weather-related loss activity for the second quarter was above our previous five-year average of $15.1 million or 8.7 percentage points of the loss ratio for second quarter weather-related losses. Large fire losses, which we define as individual fire losses in excess of $50,000 for the second quarter of 2020, were $7.4 million or 4 percentage points of the loss ratio. That amount was modestly higher than the large fire losses of $6.2 million or 3.3 percentage points of the loss ratio for the second quarter of 2019. We had favorable reserve development for losses incurred in prior accident years of $6.6 million, reducing the second quarter of 2020 loss ratio by 3.6 percentage points. The development was primarily in our personal auto and worker’s compensation lines of business, although we had modest favorable development across our other major lines of business as well. We continued to increase overall reserve strength with actuarially determined reserve increases continuing to exceed the rate of exposure growth during the second quarter. The expense ratio was 34.3% for the second quarter of 2020 compared with 31.3% for the second quarter of 2019. We attribute the increase to several factors, including an addition of $1.6 million to our reserve for potential premium receivable write-offs as a result of the COVID-19 economic disruption, an increase in technology systems-related expenses, commercial lines growth incentives for our agents, and higher underwriting-based incentive costs for the second quarter of 2020. Overall, our combined ratio was 92.3% for the second quarter, comparing favorably to the 102% combined ratio for the prior year quarter. Net investment income of $7.2 million was down $118,000 for the second quarter of 2020, a 1.6% decrease relative to the prior year quarter, primarily due to a decrease in the average investment yield. As a reminder, we increased our short-term funds in the first quarter of 2020 by borrowing $50 million from the Federal Home Loan Bank to bolster our liquid assets. We are continuing to maintain a higher than usual level of short-term investments, and the very low investment rates on those funds further contributed to the decline in the average yield on our portfolio compared to the prior year quarter. Net investment gains of $6.5 million for the second quarter of 2020 compared favorably to the $1.6 million for the prior second quarter. The net investment gains in 2020 were due primarily to improvements in the value of equity securities we held at June 30th, 2020 as the equity markets rebounded from the COVID-19 concern-driven fall off at the end of the first quarter. In conclusion, net income excluding net investment gains was $17.6 million or $0.61 per diluted Class A share for the second quarter of 2020 compared to $3.6 million or $0.13 per Class A share for the second quarter of 2019. With that, I'll turn it back to Kevin for closing comments.

Kevin Burke, President and Chief Executive Officer

Thanks, Jeff. I want to, again, thank everyone at Donegal for their resilience and perseverance as we continue to navigate uncharted waters. It’s been a challenging time for all of us and the commitment of our agents and employees has been phenomenal. Despite the headwinds from coronavirus-driven economic disruption, our solid operational results for the second quarter reflected improving underwriting profitability, operational efficiency, and our ability to successfully compete in the marketplace. Our focus on operational excellence is gradually translating into improved financial performance and book value growth. In closing, our goal remains to successfully execute on strategies designed to generate consistent favorable returns for our stockholders over the long term. With that, we’ll ask the operator to open the lines for any questions that you may have. Thank you.

Operator, Operator

Thank you. Our first question comes from the line of Sean Reitenbach of KBW.

Sean Reitenbach, Analyst

Hi. So my first question is what are you guys seeing with worker’s compensation claim frequencies in the quarter and what do you expect that forward? Is it going to sustain the current rate decreases going forward?

Jeffrey Miller, Chief Financial Officer

Good morning, Sean. Thanks for that question. This is Jeff. We did see a significant decline in frequency in the early months of the quarter, April particularly. Then the second half of May and into June we saw a fairly steep increase in the frequency that came back very close to our normal claim reporting levels. In some of the regions, we didn’t see as much of a drop-off as we did in others, but there was a short-term decline in the frequency. One of the things that impacted the overall loss ratio for worker’s comp is that we did see a lesser amount of favorable prior year reserve development compared to the second quarter of 2019. So that somewhat skewed the loss ratio if you compare quarter over quarter. As it relates to the rate decreases that you mentioned, we continue to see some modest declines in the overall rate impact in worker’s comp. It’s been fairly steady over the last four or five quarters. This quarter was 5.5%, which is relatively close to what it would have been toward the end of 2019. We believe we will continue to see some modest declines in the overall rate impact to our book of business. I know some have been suggesting that we might be nearing a bottom. We have not necessarily seen that. We do expect those declines to somewhat moderate, but we’re continuing to see very good experience in worker’s comp and so we kind of expect that the rate bureaus and NCCI will continue to show us some lower rates going forward.

Sean Reitenbach, Analyst

Thank you for that. And then also on auto claim frequency, I think you guys talked about it. Reverting back, do you expect that to be kind of sporadic coming back or a steady climb from here, and do you have any read on kind of future frequency in terms of changing consumer habits and what the impact of that might be?

Kevin Burke, President and Chief Executive Officer

Sean, this is Kevin. Yes, in June we did start to see a return back to some level of normalcy on the auto and private passenger auto in particular. The activity is clearly picking up and despite, again, some starts and stops in different regions, we're seeing that there is a lot more activity on the road. If you go back and reflect on two months ago, just even within the State of Pennsylvania, you go back two months ago, and you think about what the traffic was like or lack thereof, and today there is a very noticeable increase. So we did start to see the frequency of claims increase in June. As we look forward over the next two quarters, it’s very, very difficult to forecast what may happen. However, our view is that we’re going to continue to see an uptick in getting back to normal driving habits, because we’re not anticipating necessarily that you’re going to see a shutdown like we dealt with in April and May. I think that if anything, by the end of the year, we may get back to that breakeven point in terms of loss ratio. So that’s what we’re anticipating. But again, we’re going to be keenly watching it quarter after quarter. And so, we’ll see what the remainder of the year looks like.

Sean Reitenbach, Analyst

Thank you.

Operator, Operator

Your next question comes from the line of Bob Farnam of Boenning and Scattergood.

Bob Farnam, Analyst

Good morning. I have a question about the reserve developments. Can you provide the dollar amounts of the developments you've observed? Additionally, I'd like to discuss the personal auto segment because I know it has been challenging. I was surprised to see a notable amount of favorable development there, so I'm curious about what factors contributed to that.

Jeffrey Miller, Chief Financial Officer

Certainly, Bob. This is Jeff. I'll begin with the auto segment and then move on to the other lines. In personal auto, we experienced favorable development this quarter of approximately $3.4 million, which was a pleasant surprise for us. As you are aware, this line posed challenges a few years back. I believe part of the reason for the improvement is the strengthening of reserves we implemented in 2018, where we took a conservative approach. We're noticing modest favorable development across several older accident years from 2015 to 2019, with similar favorable trends in liability claims for each year. This suggests that our estimations were accurate, at least for now, as we reflect on our previous conservatism. Regarding physical damage claims, there has also been favorable development in this aspect of the personal auto portfolio, contributing about half of the current quarter's development. The physical damage claims are a short-tail line, allowing us to quickly assess the expected outcomes. Over recent years, we've been increasing our incurred but not reported (IBNR) reserves to ensure we adequately prepare for weather-related impacts that might transition from late accident years to the next. Most of this pertains to the 2019 accident year, and we find our reserves in the physical damage area to be somewhat redundant. For other business lines, we noted about $1.3 million in favorable development for worker’s compensation during this quarter, which is significantly lower than the unusually high $6.5 million we saw in the second quarter of 2019. It’s not surprising to see some moderation in worker’s comp development given the rate declines over the past two years. We're glad to observe that this line continues to perform well and shows modest redundancy in reserves. The remaining development is fairly evenly distributed across other lines. We saw some positive development in commercial multiperil (CMP) and homeowners, while commercial auto remained roughly flat. We are just relieved not to see any adverse development in that line since we have been focusing on strengthening our reserves. I hope this provides the insights you were looking for.

Bob Farnam, Analyst

Yes, I'm curious about the auto segment. Regarding the higher expense ratio, you've mentioned a couple of factors impacting that increase. Could you provide more detail on how much the agents' incentives have contributed to that number? Also, is the reserve for credit losses something that will continue, or is it more of a one-time charge?

Jeffrey Miller, Chief Financial Officer

Sure. It’s Jeff again. That was an excellent question. The receivable reserve, specifically the premium receivable reserves, had a $1.6 million impact in the current quarter. We don’t necessarily anticipate that will increase. We allocated about $400,000 in the first quarter, so we currently have a $2 million reserve for potential uncollectible premiums. Our cash receipts have been robust. We had paused cancellations for a 60-day period from the end of March to the end of May. Once we lifted that suspension, we managed to bring all those past-due balances current and spread them across any remaining installments for our customers, providing them extra time to pay those premiums. This has led to no cancellation activity so far, and it appears we are successfully collecting those premiums. However, we will see what the rest of the year holds. We are aware that some regions are experiencing economic challenges, and we are noticing some restrictions that may lead to additional business closures. Therefore, we hope that the $2 million reserve is conservative, but only time will tell. Regarding incentives, the commercial lines incentives for growth were around $800,000 in the second quarter. We believe this is partly due to the strong new business growth we booked in the second quarter and partly due to the incentives offered to our agents. The major factor affecting the expense ratio was the incentive-based compensation linked to improved loss ratios, agency compensation profit sharing, and employee incentives. The accruals were higher than they have typically been. Additionally, technology system-related expenses had about a $700,000 quarter-over-quarter impact, specifically associated with our technology initiative known as project Nautilus. We expect this trend to continue throughout the year.

Bob Farnam, Analyst

Right. And I assume that the loss ratio-based incentives that’s probably more of a one-time thing, based on the auto experience during the quarter, probably returning back to normal. So you’re not going to see that huge benefit on the loss ratio going forward?

Jeffrey Miller, Chief Financial Officer

That is correct. So the expense ratio is directly inverse to the loss ratio in that respect.

Bob Farnam, Analyst

Right. And one more question. Kevin, you said that you’re probably expecting further premium pressure due to audits and whatnot going forward. Can you give us any color as to maybe what you’ve seen thus far in terms of audits?

Kevin Burke, President and Chief Executive Officer

We have not completed many of the audits yet. In the first six months, we limited access to the accounts, which has made it challenging to forecast the potential premium adjustment. So far, there has been a premium adjustment of about $1 million. However, we are observing that the accounts are paying their premiums, and most businesses remain operational, even if partially reopened. Our interactions with agents indicate that despite economic difficulties, most accounts continue to be in business. These are encouraging signs. The extent of potential premium reductions is still uncertain, and I prefer not to make a forecast at this time.

Bob Farnam, Analyst

All right. I thought I'd give it a try and see what you thought, but...

Kevin Burke, President and Chief Executive Officer

I appreciate the effort. You’re not the only one that’s asked that question.

Operator, Operator

Your next question comes from the line of Jamie Inglis of Philo Smith.

Jamie Inglis, Analyst

Hi, good morning guys.

Kevin Burke, President and Chief Executive Officer

Good morning, Jamie.

Jamie Inglis, Analyst

Can you discuss the homeowners line? The combined ratio improved by about 4 points, and you mentioned that weather-related losses might account for 1 point of that. What other factors influenced this improvement?

Jeffrey Miller, Chief Financial Officer

Sure Jamie. This is Jeff. A couple of metrics here I can give you to help understand. So the core loss ratio in homeowners in second quarter of 2019 was around 27.3%. That actually declined to 24.9% in the second quarter of 2020. The weather impact was about 5 points higher in 2020. The fire loss impact was about 2 points lower, and the remainder was kind of a shift in the development impact. So we had an adverse development impact in the second quarter of 2019 of just around 5 points. We had favorable development of about 3 points in the second quarter of 2020. So a number of moving parts there that contributed to the decline quarter-over-quarter.

Kevin Burke, President and Chief Executive Officer

You know we have reduced some of our exposure as well in terms of some of the homeowner’s numbers of policies in the past year.

Jeffrey Miller, Chief Financial Officer

Right, that’s correct.

Jamie Inglis, Analyst

Okay, good. I’d like to discuss commercial auto, which showed a significant improvement for the reasons you mentioned. I’m curious if you have an idea of how the loss ratio might have been affected if the miles driven had remained the same. You've made substantial efforts to improve the underlying book of business. Do you have any insight on whether those improvements are still beneficial, or if they are no longer having an impact? Any additional thoughts on that would be appreciated.

Kevin Burke, President and Chief Executive Officer

The continued action that we’re taking on, it has absolutely helped. I also ask Jeff to comment on this as well. It would be very, very difficult to forecast the impact that the pandemic has had on the loss ratio for commercial auto. Clearly less miles driven, less activity has had some role. To pinpoint that is going to be very difficult. What we’ve continued to do is be fairly aggressive on taking rate. The average rate for the second quarter was 8.3% in commercial auto and we’ve also taken several steps to limit just the exposure of having the number of vehicles that we’re currently writing. That does vary by geography. We have certain regions that we have continued to struggle with in terms of getting our commercial auto profitable. As you can imagine, we’re being more aggressive in that area, not just on rate, but also from an underwriting standpoint in limiting exposure going forward. Other regions have performed adequately, and so we continue to take rate, but we’re not being as aggressive in terms of limiting exposure from that standpoint. We hope that over the next continued quarters that this will continue to work itself through the book of business and we’ll continue to see a drop in loss ratios.

Jeffrey Miller, Chief Financial Officer

Yes, this is Jeff. Just to add to that, I think one other consideration is that we have been raising rates now for almost three years. So on average over the past two years, our quarterly rate increases have been just under 9%. This is the third year that we’re reporting rate increases in excess of 8%. There is a compounding of those rate increases over the last several years, and despite that, we’ve continued to struggle to get that line of business profitable. We do believe that the significant additional rate will eventually compensate for the loss ratio. As Kevin said, it’s really unfortunate that we had the pandemic effect because it’s difficult to determine the experienced improvement from what would have happened without it. We’re continuing to work at that line of business and we do expect improvement. We know that the decline in claims frequency on the commercial auto was much less impactful than it was in personal lines, but there was some impact there.

Jamie Inglis, Analyst

Okay, great. Thanks a lot.

Kevin Burke, President and Chief Executive Officer

Thank you.

Operator, Operator

Your next question comes from Douglas Eden of ECM.

Douglas Eden, Analyst

Good morning, Kevin and Jeff.

Kevin Burke, President and Chief Executive Officer

Good morning, Doug.

Douglas Eden, Analyst

Yes, congratulations on another strong quarter, and it hasn’t gone unrecognized at all that you’ve now reported six straight quarters of stable reserves and favorable loss development. So well done by you all and the team. I do have two questions. First, is Mountain States still on track to come into the public company domain? I think we talked before about January or sometime in the first quarter of 2021. And number two, any sense I know it’s a bit early perhaps, but on reinsurance pricing. I know you guys go well out in advance talking to the brokers with regard to COVID and so forth, and any sense on what reinsurance pricing is going to be for you all at the next renewal?

Kevin Burke, President and Chief Executive Officer

Kevin here. Thank you for the positive remarks on our results. Regarding Mountain States, it is progressing as planned. We anticipate bringing them into the pool around January. The outcomes have been improving each quarter, and Jeff and I are monitoring it monthly to ensure our business reflects the underwriting changes we implemented a few years back. We are also experiencing strong growth in several targeted states, including Utah. Everything is currently on track, and we are optimistic about potentially integrating them. I’ll let Jeff address the reinsurance question.

Jeffrey Miller, Chief Financial Officer

It is a bit early to provide a detailed update. We’ve just begun discussions with our intermediaries regarding the reinsurance renewal and are in the process of compiling data to present to the reinsurance market in the coming month or two. Early signals suggest that discussions around reinsurance rates firming are taking place, with outcomes likely influenced by the individual loss experience of various carriers. We anticipate some pressure on our reinsurance rates as we approach 2021. On the property risk side, we have seen some loss activity, but not particularly on the casualty or CAT side. Therefore, we do not expect any significant rate increases, although there may be some pressure on the casualty program due to concerns around social inflation from reinsurers. Additionally, the impact of COVID losses could exert pressure on reinsurance rates, even though we haven't experienced any direct COVID losses ourselves. There will likely be significant focus on exclusionary terms for pandemic-related losses, which does not alarm us since all our policies include those exclusions. We expect reinsurers to seek similar exclusions in their contracts as well.

Douglas Eden, Analyst

That’s helpful. Thanks to you both. Another great quarter.

Jeffrey Miller, Chief Financial Officer

Thanks, Doug.

Kevin Burke, President and Chief Executive Officer

Thanks, Doug.

Operator, Operator

At this time, there are no further questions. I will now return the call to Jeff Miller for any additional comments.

Jeffrey Miller, Chief Financial Officer

We appreciate everyone’s participation today. Thank you for joining the call and we look forward to speaking to you again after reporting our third quarter financial results. Have a great day.

Kevin Burke, President and Chief Executive Officer

Thank you.

Operator, Operator

Thank you for participating in today’s conference call. You may now disconnect.