Earnings Call Transcript - KMPR Q2 2023

Operator, Operator

Good afternoon, ladies and gentlemen, and welcome to Kemper's Second Quarter 2023 Earnings Conference Call. My name is JP, and I will be your coordinator today. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. As a reminder, this conference call is being recorded for replay purposes. I would now like to introduce your host for today's conference call, Karen Guerra, Kemper's Vice President of Investor Relations. Ms. Guerra, you may begin.

Karen Guerra, Vice President of Investor Relations

Thank you, operator. Good afternoon, everyone, and welcome to Kemper's discussion of our second quarter 2023 results. This afternoon, you'll hear from Joe Lacher, Kemper's President and Chief Executive Officer and Chairman; Jim McKinney, Kemper's Executive Vice President and Chief Financial Officer; and Matt Hunton, Kemper's Executive Vice President and President of Kemper Auto. We'll make a few opening remarks to provide context around our second quarter results, followed by a Q&A session. During the interactive portion of our call, our presenters will be joined by John Boschelli, Kemper's Executive Vice President and Chief Investment Officer. After the markets closed today, we issued our earnings release and published our earnings presentation, financial supplement and Form 10-Q. You can find these documents on the Investors section of our website, kemper.com. Our discussion today may contain forward-looking statements within the meaning of the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements include, but are not limited to, the company's outlook and its future results of operations and financial conditions. Our actual future results and financial condition may differ materially from these statements. For information on additional risks that may impact these forward-looking statements, please refer to our 2020 Form 10-K as well as our second quarter earnings release. This afternoon's discussion also includes non-GAAP financial measures we believe are meaningful to investors. In our financial supplement, earnings presentation and earnings release, we defined and reconciled all the non-GAAP financial measures to GAAP where required in accordance with the SEC rules. You can find each of these documents on the Investor section of our website, kemper.com. All comparative references will be to the corresponding 2022 period unless otherwise stated. I will now turn the call over to Joe.

Joe Lacher, President and CEO

Thanks, Karen. Good afternoon, everyone, and thank you for joining us today. The industry continues to operate in what I believe is the most disrupted personal lines environment we've ever experienced. Recent competitors' earnings reports underscore this. While our financial results through the first half of 2023 fell short of our targets, we believe the actions we've taken and continue to take have positioned us to succeed in this difficult environment. Before talking about our results, I want to take a moment to explain a bit about this operating environment. Traditional historical patterns used by the industry to predict future behavior are producing patterns outside their historical norms. This variance is seen in broad aspects of consumer behavior, such as buying triggers, price elasticity, changes in driving patterns, propensities to file claims, seek medical treatments, and repair vehicles, as well as their willingness to litigate. These pattern changes are exacerbated by broad swings in competitors' actions. We believe this environment will continue for at least the next couple of years and has created a hard market that will likely persist for an extended period. Our specialty market expertise and our nimble, efficient operating model position us to navigate this environment effectively. We're continuing to evolve our capabilities, including investing in broad enhancements to business intelligence and accelerating the speed at which we digest and execute on insights. We have increased the forward-looking predictive analytics we use to operate our business, along with our execution margin of safety. Our ultimate priority is to achieve target returns and focus ourselves and our business to facilitate this, ultimately positioning ourselves to grow profitably and safely at the right time. Against this backdrop, let's discuss our results. Turning to our presentation, I hope you'll take away the following: first, we had strong sequential improvement in the underlying profitability of each of our businesses; second, the strategic initiatives we announced last November are on track to realize their anticipated benefits and produce meaningful value for our stakeholders; third, we reiterate our guidance, expecting to achieve an underwriting profit in the second half of 2023 and for 2024, we expect to generate a return on equity equal to or greater than 10%. Moving to Page 4, the consolidated results included strong underlying profitability improvement against the backdrop of elevated catastrophe losses and adverse prior year development, largely related to the second half of 2022. The six-point sequential improvement in Specialty P&C resulted from accelerating impacts of earned rate and non-rate actions exceeding loss trends, as well as the normalization of the episodic items we experienced last quarter. This improvement demonstrates that our actions are taking hold and producing the anticipated benefits. One final financial highlight I'd like to point out is our recent approval of approximately 30 points of rate by the California Department of Insurance for our Specialty P&C private passenger auto book. The collaborative effort between our teams and the CDI enabled this successful outcome. The rate change was effective August 4th. I'd like to now move to our strategic projects. As a reminder, last November, we announced a series of initiatives to unlock additional shareholder value. All these programs are on track to be completed on time and produce or exceed their financial targets and operational benefits. Key updates on these initiatives include receiving approval from the Illinois Department of Insurance for the formation of our reciprocal; Phase 2 of our Bermuda optimization effort is outperforming initial benefit projections; we completed the strategic review of our Preferred P&C segment, announcing our decision to exit that business. This action will enhance our return on capital and support profitable growth in our core businesses. Finally, we are achieving the expected expense savings with our cost structure initiatives. We are highly focused on maximizing shareholder value, beginning with returning the business to profitability. The solid progress we achieved this quarter is proof that the actions we've taken are generating the intended outcomes while advancing our long-term initiatives to enhance Kemper's strategic and financial profile. I'll now turn the call over to Jim to talk about more details.

Jim McKinney, CFO

Thank you, Joe. I'll begin on Page 5 with our consolidated financial results. We are pleased that each of our segments had strong underlying improvements that position us for profitability in the back half of the year. Several factors offset this progress, including goodwill impairment, catastrophes, and prior year development. For the quarter, we had a net loss of $1.52 per diluted share and an adjusted consolidated net operating loss of $0.26. The net loss included approximately $46 million of goodwill impairment charge connected to the strategic review of the Preferred P&C segment. The non-cash charge represents the full value of the goodwill associated with this business. The net loss and adjusted consolidated net operating loss included $39 million of current year catastrophe losses resulting from a very active catastrophe quarter for the industry and $26 million of adverse reserve development. Turning to Page 6, the adverse development was primarily driven by bodily injury and property damage activity that occurred during the second half of 2022, caused by pattern changes between the second and third quarters of 2022. These changes include extensions in claim reporting timelines and an increase in claims closing with payments. The first quarter of 2023 and accident quarters prior to the third quarter of 2022 generally aligned favorably with our prior loss selections. The short-tail nature of our business and the speed with which we collect and assess data provide us with high confidence in our reserving processes and their continued ability to react quickly to evolving conditions. Turning to Page 7, as Joe mentioned, we are reiterating our previous financial guidance. Despite the dynamic environment, we are committed to producing an underwriting profit in the second half of 2023 and achieving an ROE equal to or greater than 10% in 2024. Turning to Page 8, here we outlined Specialty Auto's path to underwriting profitability. Our second quarter underlying combined ratio guidance was 103% to 107%. We reported an underlying combined ratio of 102%, slightly below the low end of our range. In the third quarter, we expect further improvement and to generate an underlying combined ratio between 99% and 101%. Assumptions and risks are outlined on Pages 7 and 8. Pages 9 and 10 provide an update on our strategic initiatives. Each program is on track to be completed on time and produce or exceed its targeted financial and operational benefits. Starting with the reciprocal, the Illinois Department of Insurance approved the formation of Kemper Reciprocal. We expect to write business within the reciprocal in the third quarter and will provide additional program schedule details during our third quarter call. Our Bermuda Optimization initiative launched in 2022 is expected to unlock a greater amount of life dividends to the parent. We expect at least $200 million to be released before year end, up from $100 million as previously indicated. As Joe mentioned, we recently completed our review of the Preferred P&C segment. The business will be wound down, focusing on our people, policyholders, and working with our regulators to achieve the best possible outcome. The wind down of the business will enable the redeployment of more than $300 million in capital to our core segments, simplifying the business and enhancing capital deployment efficiency. As a result, starting in the third quarter, our segment reporting will only reflect our Specialty P&C and Life and Health businesses. Finally, our cost reduction initiatives are on track to produce their intended benefits consistent with our timing expectations. Since the program's inception, we have achieved approximately $117 million in run rate savings, roughly 80% of the intended run rate savings goal previously anticipated to be achieved by 2025. Once completed, we expect these initiatives to significantly enhance Kemper's financial profile, including improving cash flow generation and reducing volatility. Moving to Page 11, our insurance companies are appropriately capitalized and have significant sources of liquidity. At the end of the quarter, we had approximately $1 billion in availability. We continue to have the capital needed to navigate this environment while appropriately investing in advancing our core capabilities. As previously disclosed, we are committed to reducing debt outstanding by $150 million and bringing our debt-to-capital ratio back to our long-term target of 17% to 22%. Moving to Page 12, net investment income for the quarter was $106 million. Our pretax equivalent annualized book yield was 4.5%. Average investment-grade new money yields for the quarter ranged from 5% to 6%. I'll now turn the call over to Matt to discuss the Specialty P&C business.

Matt Hunton, Executive Vice President and President of Kemper Auto

Thank you, Jim, and good afternoon, everyone. Moving to Page 13 in our Specialty P&C business, we closed the second quarter with an underlying combined ratio improvement of 6 points. This was driven by the combination of increased earned rate, tightened underwriting actions, the normalization of episodic items, and expense efficiencies. We observed the loss trend continuing to moderate; frequency was flat year-over-year, and severity increased by 2% sequentially. Catastrophe losses in the quarter were elevated to 2 points or $17 million, which we experienced was above average and included a higher level of events from Florida flooding to Texas hailstorms. Including the recent California rate approvals Joe mentioned, the cumulative written rate since the second quarter of 2021 is expected to increase to 54 points next quarter. Of this rate, 17 points have earned in and that will increase to approximately 23 points by the end of the third quarter. We expect earned rates to accelerate as the California book renews in future quarters. We will continue to file for additional rate in all states as needed. Shifting to the commercial vehicle business, our underwriting and rate actions are continuing to positively impact loss performance. In the second quarter, the underlying combined ratio was 93.9%; the business is expected to deliver strong underwriting profits in the second half of 2023. The loss environment remains volatile, and we are being appropriately cautious in writing new business, continuing to suppress new business throughout the third quarter. In the fourth quarter, we plan to selectively write incremental new business to test new customer cohort buying and claim behavior. Particular items of interest include price elasticity, reporting patterns, and treatment and repair propensity, which will enhance our ability to optimally manage customer acquisition in this disruptive operating environment. We will conduct monthly and quarterly evaluations on the gradual expansion of new business based on our current view of underwriting profitability as well as insights from these tests. In summary, we expect a continued volatile operating environment for at least the next couple of years and believe our actions will provide continued improvement to underwriting performance, delivering on our profitability targets during the second half of 2023 and into 2024. Through this period, we will continue a 'test and learn' approach to safely and profitably manage new customer acquisition. I will now turn the call over to Joe to cover the Preferred and Life businesses.

Joe Lacher, President and CEO

Thanks, Matt. Moving to Page 14 and our Preferred P&C segments. This quarter, the benefits of profit restoration actions, including the continuation of lower frequency from non-rate actions, offset higher catastrophe losses of $21 million. Both auto and home and other had sequential improvement in their underlying combined ratios. Through the second quarter, our personal auto book had 10 points of rate earned that will increase to approximately 14 points in the third quarter. As previously discussed, our strategic review is complete, and going forward, the segment will be noncore. Turning to our Life and Health business on Page 15, I think we're all still getting used to reading and interpreting Life financial statements post LDTI adoption. To help provide clarity on items that impact distributable cash flow trends, my comments will focus on the drivers that impact this measure. These items have not been impacted by LDTI adoption. This quarter, we saw the lowest level of mortality frequency in the past 10 years, which is 12% below the 2018 and 2019 averages. Year-over-year, the average incurred gross death benefit decreased over 1%, issued premium increased by 0.5%, and life persistency aligns with pre-pandemic levels. The combination of these items positions the business for continued improved profitability and attractive distributable cash flow. Turning to Page 16, in summary, I'll leave you with this: the strong sequential results we generated this quarter demonstrate a meaningful step in the right direction. I continue to be confident about our ability to return the business to underwriting profitability in a difficult and dynamic operating environment. Highlights for the quarter include significant rate progress in the State of California, receiving approximately 30 points of specialty personal auto rate, strong progress in our strategic initiatives including our Bermuda Optimization effort, the establishment of the reciprocal exchange, the realization of over half of the desired benefits from restructuring and integration initiatives, and the completion of the strategic review of our Preferred P&C segment. In closing, I'd like to thank our entire Kemper team for their continued dedication to executing our strategic priorities to generate consistent long-term shareholder value. With that, operator, we may now take questions.

Operator, Operator

Your first question comes from Greg Peters from Raymond James. You may now ask your question.

Greg Peters, Analyst

Okay. Good afternoon, everyone. I have a couple of questions.

Joe Lacher, President and CEO

Greg, I'm not sure - unfortunately, we can't hear you.

Operator, Operator

It seems like Greg's line got removed from the podium.

Joe Lacher, President and CEO

So why don't we go ahead and move to the next question, and we'll get Greg back in queue when he is back.

Operator, Operator

Okay, thank you. Your next question comes from the line of Paul Newsome from Piper Sandler. Your line is now open.

Paul Newsome, Analyst

Hello. Thanks for the call. So, I was hoping you could talk a little bit more about the impact of non-rate actions in the quarter on the underlying business, whether we've seen the full impact there? It's just going to be sort of impact of rates prospectively or if there are some other things happening under the hood that would be helpful?

Joe Lacher, President and CEO

Sure, Paul. And maybe I'll start, and we'll tag team this a little. I'm going to give you a broad comment, and then you guys can talk a little bit specifically. We're going to continue to have a set of non-rate actions that are going on, and they're going to have different potential impacts. For example, we significantly slowed down new business last quarter and will likely have that slowdown largely in the third quarter. That provides a non-rate action that gives an immediate benefit to calendar year losses. When we think about a cohort or its experience, it tends to have higher losses in its first year and lower losses in subsequent years. So if you slow the new business down during that period, it gives you a little juice. Eventually, we're going to be writing more new business and that will expand. Matt was careful in his comments and so was I that we are likely to do gradual expansion in the fourth quarter, but very much with a test-and-learn orientation to look at the patterns going on in the environment. That may provide nominal pressure, but we're going to focus first on underwriting profitability and making sure that it's not a significant driver there and that we're using it to learn what patterns are going on. That will likely cause us to add underwriting tools to our toolbox or use them differently given the volatile nature of the current environment. So I'm going to expect we're going to continue to find different non-rate actions to manage things going forward. I think what you're asking is how to model what you're looking for. And what I might guide you to is, you might want to take an earned rate measure for improvement for some time until we target or get close to target profitability. And then you should work off our guidance from there. The measures should focus you on our guidance and the timing that comes from that. As we hit those targets, we don't anticipate dropping to a 75 combined ratio. We anticipate that once we've clearly, solidly, and comfortably gotten there with our expanded margin of safety, we'll move towards growing. Again, I'm not signaling a growing in the third or fourth quarter, but we'll move in that direction, so it will start offsetting some of that.

Paul Newsome, Analyst

Makes sense.

Jim McKinney, CFO

Yes, Paul, this is Jim. The only thing I would add to what Joe said is, I think you might see incremental benefit coming in, in the third quarter from underwriting actions. But most of what you're going to see at this stage is going to be incremental earned rate that will flow into the book. And that will again align with Joe's comments, that will begin to offset and take the place of some of the underwriting actions that have been put in place to help us get to this position as we move forward.

Joe Lacher, President and CEO

We started, Paul, giving you guys some rate and non-rate direction a year or so ago, partly to try to help get to a number. We acknowledged at the time that as the rate came in, we might unwind some of those non-rate actions. I think I’m going back to what I said a moment ago, all those cross items are in our guidance, and we're trying to give you the answer rather than ask you to sort of work the components underneath because it would be almost impossible for you to work the individual components. We're just trying to provide the answer at this point. It's probably less important to break those apart going forward, and we're going to have more trouble helping to dissect them because they will move in multiple directions.

Paul Newsome, Analyst

But still helpful to understand what could be happening so we will see it. I wanted to ask a little more about the Life operation and the capital optimization. So a couple of $100 million potentially removed from the Life U.S., concerning to the parent. Maybe you can talk about where that total Life capital ends up and both in size and distribution?

Jim McKinney, CFO

Yes, happy to kind of walk through it, Paul. Good question. Big picture-wise, yes, there is capital in the Bermuda entity. When you think about it across both, you're talking about $280 million that would be sitting there today. Overall, one of the things I think you need to consider is we're resetting or there is a component that is resetting some of our reserves that will release reserves and equity currently held within those entities, so that will increase. You might not see a meaningful change in the actual capital level inside the Life companies. We've made some initial filings and placements with the Department of Illinois and others that have been in place for many years regarding our mortality trends. We said we would come back and update those as we had strong mortality tables and experience. We've done that coupled with our Bermuda initiative which is essentially freeing up equity from a statutory perspective that will then be able to come up. So you won’t see a meaningful change in the overall capital dollars involved; there will just be a difference in the reserve level if those reserves are reset to represent more of a true mortality curve and the benefits from our experience perspective.

Greg Peters, Analyst

Good afternoon. Hopefully, you can hear me now?

Joe Lacher, President and CEO

Welcome back.

Greg Peters, Analyst

That's good. So I wanted to start my question off with, Joe, in your comments you talked about this being an unprecedented time for the personal lines business. And you mentioned buying triggers, embedded in that as retention. I'm just curious with all the rate that's being thrown at the consumer, and it's not just your company, it's other companies as well, but particularly considering your position in the Specialty business, which has lower limits, I’m curious about how the consumer is responding to this since it seems like you could be pushing the envelope of what consumers can afford. So just your perspective on that.

Joe Lacher, President and CEO

Yes, sure. Let's tag team. I know Matt has a couple of thoughts, and I’ll add some in a second.

Matt Hunton, Executive Vice President and President of Kemper Auto

Hi, Greg. So, what we’re seeing from a consumer perspective is that persistency or take rates, retention rates are at or higher than what we would have observed historically. This is against what we would have modeled in normal times. The function of this is less of a demand dynamic and more of a supply dynamic. So as we're seeing competitors in the market slow down their appetite, specifically in markets like California and Florida and now we're starting to see it arise in Texas, we're seeing that the take rate on pretty high average premium dislocations is actually holding strong. We'll see as the markets start to get more rate adequate and consumers move through sort of elasticity maturation if those persistency rates will continue to hold. But for now, we're actually seeing retention rates sticking. When we consider the outlook of our business and how we are managing through that, it's a highly sensitive variable for us in terms of our projections.

Jim McKinney, CFO

Part of what we're considering, Greg, as we go through this is an example that might pertain to a generalization, but a rule of thumb could have been that if someone receives more than a 10% rate increase, they're likely to shop, and this would typically impact your retention or persistency. In a normal environment, there is broad availability and some place to go. In a more restricted environment, where competitors are tightening underwriting and raising rates, there might not be a more competitive option. Therefore, even a substantial rate change of 20 or 30 points might be accepted. In a low unemployment environment, people might need to keep their vehicles to work, which increases the importance of maintaining insurance. So that triggers their commitment. Part of what we've highlighted is that in a normal model, hypothetically if we took a 25-point rate increase, we would expect a certain retention drop; we actually observed retention rates increase. One question that arises is whether this will result in a change in buying decisions a year from now, or whether consumers will adapt to the new rate, effectively resetting their expectations. With our test-and-learn from gradual expansion, we are trying to measure those behavior changes. Presently, in this strong employment, low unemployment environment, we're observing behaviors that make sense, but they diverge from historical patterns. We're very vigilant about watching these dynamics and are increasing our business intelligence and predictive analytics to better understand these changes moving forward.

Greg Peters, Analyst

Yes, it does provide some color. It's surprising that retention is going up as your rates are increasing. I wanted to pivot and, in relation to those comments and to other points from your prepared remarks, on Slide 13, I appreciate that one chart showing cumulative PPA rate activity since the second quarter of '21. I was intrigued that this chart showed filed rates reaching 54.8% in the second quarter and only going to 56% in the third quarter. Yet, I noticed you just secured a 30% rate approval effective in the third quarter. So, I would have expected the filed rate to increase more relative to where it was in the second quarter. Does that question make sense?

Joe Lacher, President and CEO

It - the filed rate shouldn't be over-analyzed too heavily; it's mainly about the delayed approval. You're expecting it to go up further, and let me ensure I understand your perspective.

Greg Peters, Analyst

Yes, I would expect the 54.8% to increase to 70% or 65% or something with the additional California approval.

Joe Lacher, President and CEO

The 54.8% included the California filed rate; it hadn’t been approved yet. This is filed, not approved.

Greg Peters, Analyst

Got it, okay.

Jim McKinney, CFO

In the third quarter, it will become part of the written rate. Keep in mind the entire book won't have it, but everything written in the quarter will include it. That's why it moves up, and we'll renew them over the policy term.

Greg Peters, Analyst

Got it, that makes sense. And then on Slide 6, in discussing your adverse reserve development, you mentioned elongated development patterns in the second half of '22, with more claims closing with payments. How do you see those trends in the first half of '23 compared to what you observed in the second half of '22? Will we be looking at another situation in six months where there's another reset because of adverse changes in these patterns in your book of business?

Jim McKinney, CFO

Great question. A couple of points on that. First, what we observed across our book has become much more transparent at this point. There was a jump up in terms of ultimate losses incurred between Q2 and Q3, which has continued moving forward from last year. If you consider the trajectory, we consistently had been between 0.5 and 2 points for three quarters, and now we see an increase occurring in Q3. We've incorporated that pattern change into our current picks. I don't think this pattern will repeat. When evaluating our Q1 results, those developed favorably from an entry-year basis by about $6 million, which is modest. Based on our observations, we feel very good about our loss picks. Of course, we experienced a trend change that was unusual both for the industry and our book. We have conducted thorough analysis and segmentation and believe we have adequately addressed any emerging trends. While we cannot guarantee against future changes, we remain diligently observant.

Joe Lacher, President and CEO

If I can add a bit, Greg, Jim has been clear that we observed this pattern change between the second and third quarters and that new pattern is integrated into our current picks. In response to your second question regarding the possibility of another pattern change, we cannot predict that because, by definition, a pattern change is unpredictable. However, we maintain heightened sensitivity and vigilance in watching these dynamics.

Greg Peters, Analyst

Okay. The final question I have, regarding your guidance for the third quarter and ROE guidance for next year. Considering all the volatility, I wonder if it’s worthwhile to provide those guidance figures. We understand that is your goal, but it seems there’s a risk; other companies are projecting numbers and then missing them in this volatile near-term environment. With respect to your ROE targets, do these include or exclude the Preferred business? From an accounting perspective, will this be categorized under discontinued operations, and will it impact the income statement?

Jim McKinney, CFO

The guidance does not include the redeployment of capital from the Preferred Personal Insurance business, which will be a positive as it comes through as a tailwind. This guidance is based on our expected results, focusing on where we believe the business will converge. Any enhancement from capital redeployment will be slight; it will provide a tailwind over a two, three, or four-year period. We expect to report on our core business moving forward, with non-core items likely to include anything related to the Preferred Personal Insurance business. This classification will likely be determined during our review in the third quarter, while our core businesses will focus on the Kemper Auto and Life businesses.

Greg Peters, Analyst

It is.

Joe Lacher, President and CEO

Greg, we fully understand your concern regarding guidance and are trying to accomplish a few objectives. First, you referenced Slide 13, illustrating the connection between written and filed rate, which Jim distinctly highlighted. The connection between earned rate and written rate suggests it is filed, approved, and now actively being written. Previously, filing without approval may have involved elements of optimism, but that is no longer the case.

Greg Peters, Analyst

Got it. One last clean-up question because I can't help myself: litigation was mentioned, especially regarding increased attorney representation; is that concern state-specific or is it across your entire footprint?

Jim McKinney, CFO

Hi, Greg. No, great question. It’s across the entirety of our footprint. We’re observing different behavior there. Some may label it social inflation, while others may term it attorney abuse; I’ll let you decide the designation, but we're definitely noticing an uptick. This appears to be a pattern within the industry, and we’re doing everything possible to create the best outcomes for our customers.

Greg Peters, Analyst

Thank you for the answers.

Operator, Operator

There are no further questions at this time. I will now hand over the call to Joe Lacher; please continue.

Joe Lacher, President and CEO

Thank you, operator. And thank you, everybody, for joining our call today. We appreciate your time and attention and look forward to speaking to you again with our third quarter results.

Operator, Operator

Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect.