Earnings Call Transcript - RLI Q2 2021

Operator, Operator

Good morning ladies and gentlemen, welcome to RLI Corp's Second Quarter Earnings Teleconference. As a reminder, we will open the conference up for questions and answers after the presentation. Before we get started, let me remind everyone that through the course of the teleconference, RLI management may make comments that reflect their intentions, beliefs, and expectations for the future. As always, these forward-looking statements are subject to certain factors and uncertainties, which could cause actual results to differ materially. Please refer to the risk factors described in the company's various SEC filings, including the annual report on Form 10-K as supplemented in the Form 10-Q for the quarterly period ended June 30, 2021, which should be reviewed carefully. The company has filed a Form 8-K with the Securities and Exchange Commission, that contains the press release announcing second quarter results. RLI management may make reference during the call to operating earnings and earnings per share for operations which are non-GAAP measures of financial results. RLI's operating earnings and earnings per share from operations consist of net earnings after the elimination of after-tax realized gains or losses and after-tax unrealized gains or losses on equity securities. RLI's management believes these measures are useful in gauging core operating performance across reporting periods but may not be comparable to other companies' definitions of operating earnings. The Form 8-K contains a reconciliation between operating earnings and net earnings. The Form 8-K and press release are available at the company's website at www.rlicorp.com. I will now turn the conference over to RLI's Vice President, Chief Investment Officer, and Treasurer, Mr. Aaron Diefenthaler. Please go ahead, sir.

Aaron Diefenthaler, Vice President, Chief Investment Officer and Treasurer

Thank you, Travis. Good morning, everyone and welcome to RLI’s second quarter earnings call for 2021. Joining us today are Jon Michael, Chairman and CEO, Craig Kliethermes, President and Chief Operating Officer and Todd Bryant, Chief Financial Officer. Pretty standard structure for today's call with Todd running down the financial results for the quarter ended June 30. Craig will add some commentary on current market conditions and our product portfolio. We will then open the call to questions and Jon will close with some final thoughts. Todd?

Todd Bryant, Chief Financial Officer

Thanks, Aaron. Good morning, everyone. Yesterday, we reported second quarter operating earnings of $1.09 per share results reflect positive current year underwriting profit supplemented by favorable benefits from prior year's loss reserves. All in, we experienced 25% top line growth and posted an 84.8 combined ratio. Additionally, our core business was complemented by a strong quarter from Maui Jim and Prime. While investment income was down modestly in the quarter, year-to-date, operating cash flow of 165 million has supported growth in R&S invested asset base. Realized gains for the quarter elevated as we rebalanced our equity position, leaving a modest 4 million change in unrealized gains on equity securities. As you know, large movements in equity prices and comparable periods can have a significant impact on net earnings, which you can see in both the quarterly and year-to-date comparisons to 2020. Aggregate underwriting and investment results push book value per share to $27.46 up 11% from year-end, inclusive of dividends. We're able to talk more about market conditions in a minute, but from a high level, all three segments experienced growth. Property led the way, up 33% as rates and market disruption continued to support growth. Casualty gross writings improved 24% with all major product lines contributing. For surety, premium was up 11% as our contract and transactional business grew nicely in the quarter. From an underwriting income perspective, the quarter's combined ratio was 84.8 compared to 88.4 a year ago. Our loss ratio declined 4.1 points to 44.4. Storm losses booked in the quarter totaled 8 million with 7 million impacting the property segment and 1 million in the casualty segment. On an overall basis prior years reserves continued to develop favorably enhancing both the casualty and property loss ratios. Surety, however, experienced adverse loss development in the quarter as we further strengthened incurred but not reported reserves on the 2020 accident year for the energy portion of our commercial surety business. Lastly, on the loss front, our current accident year loss ratio for casualty continued to improve. On an underlying basis, if you exclude prior year's reserve benefits and catastrophes, our casualty loss ratio was down 7 points. COVID-related impacts in 2020 account for about 4 points of that decline. Excluding that however, the loss ratio was still down 3 points. Improving mix and modest reductions in loss booking ratios similar to what we discussed in the last few calls have driven the positive results. With respect to COVID specific reserves, amounts are largely unchanged from year-end. Moving to expenses, our quarterly expense ratio increased by 0.5 to 40.4. Similar to last quarter, the increase is driven largely by amounts accrued for performance-related incentive plans. The combination of significantly higher operating earnings and improved combined ratio and growth in book value drove these metrics higher. Apart from elevated incentive amounts and continued technology-related investments, other operating expenses were relatively flat. On the asset side of the balance sheet, our investment portfolio had the major components pulling in the same direction, with positive results from equities and fixed income. Higher bond returns have come alongside lower reinvestment rates, as Treasury yields have declined from the highs we saw earlier in the year. Despite the return of lower yields, strong operating cash flow is accruing to the benefit of total invested assets. A growing portfolio helped to flatten the curve of investment income, which was down just over 1% in the quarter. Total return was 2.8% for the quarter and we continue to put money to work in nearly all environments to stay fully invested. Apart from the capital markets exposure, invest the earnings were significant compared to 2020. Maui Jim and Prime contributed 10.6 million and 3.6 million respectively, both benefiting from robust markets in an improving macroeconomic environment. All in all, a very good quarter and a strong first half of the year. And with that, I'll turn the call over to Craig.

Craig Kliethermes, President and Chief Operating Officer

Thank you, Todd, and Aaron, and good morning, everyone. A very good quarter as Todd mentioned, with 25% top line growth and an outstanding 85 combined ratio. We were very pleased with our results and our position in the marketplace. We're seeing widespread growth across almost every product in our portfolio as a result of an improving economy, higher retention rates on renewal business, increased submission flow on new business, and rising rate levels. Although the frequency of claims slowed during the pandemic, they have begun climbing back to previous levels and we remain watchful of the long-term impact of social inflation. We also continued to keep an eye on the cost inflation associated with rising building material and labor costs. This could prove challenging as we enter the hurricane season, which will likely increase the cost of rebuilding but also lengthen related business interruption claims. We think there is more opportunity to get rate, as the industry is still underperforming overall. The industry must more broadly recognize the rising risk levels associated with inflation, the uncertain impact of the pandemic, the possibility of a rising number of severe weather catastrophes, and more unique exposures like the recent building collapse. We anticipate that these factors will drive and sustain current rate levels and momentum. We have the benefit of underwriting discipline and private diversification. This permits us to navigate all market conditions, pushing for rate adequacy where needed, shrinking our position if necessary to maintain underwriting margins, or growing shareholder value. Now for some more detail by segment. In casualty, we grew top-line 24% and reported an 83 combined ratio as we've benefited from significant favorable reserve development. Rates overall are at or above loss costs as we achieved 6% for the quarter and 7% year-to-date. Rates are still up significantly in excess liability products and select auto markets where we compete. Rates remain relatively flat in primary liabilities, small package business and even in several auto niches where competition remains fierce. We achieved growth and underwriting profit across all major products in our casualty portfolio. We have benefited from a quicker recovery in the public auto space as buses are coming back online faster, and we're also realizing goodwill earned with our customers and our producers last year when we reduced premium in recognition of exposure changes during the pandemic. Casualty growth excluding our transportation unit was still up 18% for the quarter and 12% year-to-date. In property, we achieved top-line growth of 33% while reporting an 84 combined ratio. All of our major products in this segment grew top line and reported underwriting profits. The pace of rate changes is flattening; it's still positive across the board. Overall, rates were up in property 8% for the quarter and 9% year-to-date, with catastrophe insurance continuing to lead the way at plus 17% for the quarter and plus 21% year-to-date. PMLs for wind are up about 15% for the year but are still well contained at the 250-year level with reinsurance protection. I don't want to move on from this segment without commenting on the recent collapse of the Champlain tower in Surfside, Florida, which was a very tragic event. Our thoughts continue to be with the families of all those impacted. We do write contractors, architects, and engineers and properties in the area but we do not target multi-unit high-rises or condo associations in any of our businesses. Although our loss exposures appear minimal at this time, we will continue to do our part by tightening our underwriting guidelines and as a result, improve the risk management posture of contractors and those responsible for building maintenance in our chosen market. In surety, we reported 11% top line growth and a 96 combined ratio. We were able to achieve an underwriting profit in this segment despite an elevated risk environment related to the number of bankruptcy filings in the energy sector of our commercial surety business. We maintain significant reinsurance protection against large losses. We also have strong partners who value our underwriting discipline and have mutually benefited from our relationship for over two decades. Our underwriting team remains disciplined and continues to underwrite core profit in the space. We have further tightened our restrictive standards targeting the highest credit quality principles, insisted on more structured protection and collateral, raised rate levels and lowered tolerances for any delayed commissioning work by the principal. Our commercial contract and miscellaneous surety markets are growing and remain profitable year-to-date with an 87 combined ratio. Overall, an excellent quarter and a very nice first half of the year. Our disciplined underwriting diversified portfolio of niche products and talented team have delivered once again. They enable us to provide a consistent underwriting appetite to our customers and producers and strong stable returns to our shareholders. I want to thank all of our associate owners for all of their hard work over the last quarter and throughout the last year. We recently welcomed them back to our offices this week and look forward to continuing to foster the close community, strong culture, and collaborative learning that makes the RLI difference work even better. Now I'll turn it back to the moderator to open the call for questions.

Operator, Operator

Thank you. The question-and-answer session will begin now. Our first question comes from an unidentified analyst.

Unidentified Analyst, Analyst

Just looking at the reserves and surety, we saw a flip to unfavorable development this quarter. I think you mentioned it was some incurred but not reported reserves and some energy policies. But was just wondering if you could provide a little more color into the change in the quarter.

Todd Bryant, Chief Financial Officer

We discussed the 2020 accident year, particularly in relation to the energy sector. We increased both direct and ceded reserves as our actuaries evaluated the situation. This may indicate a higher level of risk, and there is an increased likelihood of bankruptcy. In line with our usual practices, we took appropriate measures in response. If you recall, the last significant adverse development in the surety segment occurred in the fourth quarter of 2018. Such occurrences are infrequent, but they have happened before.

Unidentified Analyst, Analyst

Okay, great. Thanks. And then just kind of looking, Maui Jim results are pretty strong in the quarter relative to past results even prior to COVID. So just curious if there's anything that stood out to you all there, maybe some pent-up demand or some new sales initiatives or possibly something else that drove that kind of growth in the quarter.

Jon Michael, Chairman and CEO

The demand for Maui Jim has rebounded nicely. Their sales were fairly comparable to the 2019 levels. During the pandemic, the management team at Maui Jim managed their way through that very nicely. They reduced operating expenses during that time and a lot of those operating expenses have not come back. And so, saw margin improvement and I think we're seeing some of that come through. We fully expect some of those expenses to come back to like travel and the like and marketing. For example, those things come to mind. But we're really pleased with what they've been able to do managing their way through that. I don't know about pent-up demand, maybe. But I think it's just the back to the level they were at in 2019.

Operator, Operator

Our next question comes from Jeff Schmitt, William Blair.

Jeff Schmitt, Analyst

I believe you mentioned casualty rates averaged 6%. And I guess they were 8% last quarter, maybe 10% last year. Not surprising to see some deceleration. I mean, they've been compounding now for a couple of years. But, CPI inflation moving up, social inflation still in the background. Maybe that moves up as courts reopen more. You mentioned maybe that provides some support for rates at current levels? Or could that potentially put some upward pressure on rates? Are you seeing that at all?

Craig Kliethermes, President and Chief Operating Officer

The factors you mentioned tend to accumulate each year. My comments were focused on how the industry has effectively managed to keep pace, particularly in our specific areas, with loss cost inflation. However, we anticipate a further loss cost deflation of around 5% or 6% next year. Therefore, we need to keep adjusting rates to stay ahead of that or, at the very least, maintain our current margins. That’s our outlook.

Jeff Schmitt, Analyst

How much inflation are you seeing for medical costs instead of just CPI inflation?

Craig Kliethermes, President and Chief Operating Officer

I don't know that we actually have it broken down at that level. I mean, I think we've talked in the past in casualty using loss cost trends of let's say, 4% to 5%, that's net of any exposure trend. So we would do that, as you know, need that kind of rate increase; otherwise, your current rates and your loss ratios are going to have to start going up.

Jeff Schmitt, Analyst

Right, right. And then, I think you've mentioned in the past, a lot of your book is in construction. Could you discuss what type of rate and exposure growth you're seeing that book as the economy picks back up?

Craig Kliethermes, President and Chief Operating Officer

Yes, sure. I mean, we are seeing growth in contractors or their jobs, certainly has picked up. It really didn't slow down as much as you might think, during the pandemic. I mean, many of them were still working, there were some select places that were ordered not to work anymore. And then, these guys were picking up a lot of that backlog right now. So, we still feel like the demand is strong. There's still a lot of competition, though. We would say in the type of contractors we write, we typically write like middle market and smaller artists and contractors. That's still a pretty competitive space. So, it's not like that's very difficult to achieve a double-digit rate increase in that market because there's just more competition there.

Operator, Operator

Our next question comes from Meyer Shields, KBW.

Meyer Shields, Analyst

I guess this is for Craig. Can you give us a sense in terms of how widespread the sort of under-maintenance of large buildings is in Florida? I mean, different things I just don't know how it looks on the inside?

Craig Kliethermes, President and Chief Operating Officer

That's a good question. I mentioned that we don't underwrite many high-rise buildings. However, we do require inspections as part of our underwriting process. We also consider the funds that these buildings have allocated for capital improvements. If a building doesn’t have funds set aside, it could face a situation where repairs are needed, but there's no one willing to cover the costs. This is similar to dynamics in clubs where necessary contributions are often avoided. Generally, we primarily underwrite two or three-story buildings, so I don’t have much specific insight on larger buildings, which may not be particularly helpful.

Meyer Shields, Analyst

Okay. No, that's I mean, we're looking forward, that's helpful. Within transportation, I'm trying to figure out on the underwriting side, whether the fact that people had been driving these vehicles for a year or so was that impacting claim frequency.

Craig Kliethermes, President and Chief Operating Officer

In our segment, realized transportation primarily consists of three components. Public auto has seen a decline in frequency, and the exposure base has also significantly decreased. At one point, we returned nearly 80% of our premium, possibly around 60%. Consequently, there was minimal driving activity. When considering the exposure base, it seems the frequency may not have fallen as much as thought. In the trucking sector, particularly long-haul trucking, operations continued without significant interruption, with drivers still delivering goods. There may have been a slight reduction in activity due to fewer vehicles on the road. However, many were driving faster, which may have caused an overall decline in frequency due to congestion. We primarily insure vehicles that travel directly from one location to another, with the exception of emergency vehicles like ambulances, which are typically used more frequently. Many contractors are traveling between jobs or from their bases to job sites. Thus, the decline in frequency is likely more evident in auto than overall transportation. We do not underwrite much personal auto insurance, but we have seen a rebound. While it hasn't fully returned to previous frequency levels relative to the exposure base, I expect it to continue improving based on current trends.

Meyer Shields, Analyst

Okay, perfect. And then one last question. I guess for Todd, when we look at reinsurance recoverables, it was a pretty big jump on a sequential basis. Was that the surety issue we're talking about? Or is it something else driving that as well?

Craig Kliethermes, President and Chief Operating Officer

Yes, Meyer, that's certainly a large part of it. I mean, I think we are seeing growth. So you're going to get some seeded incurred but not reported reserves, if you will, just from a normal growth and reserve standpoint. But definitely, the surety side had a big part of that.

Operator, Operator

Our next question comes from Mark Dwelle, RBC Capital Markets.

Mark Dwelle, Analyst

They answered several of my questions, but I have a couple more. Craig, you mentioned that renewal retention rates are higher. Could you clarify that a bit? I just want to confirm that you're talking about the percentage of existing policies that renew with you, to ensure I'm on the same page as you.

Craig Kliethermes, President and Chief Operating Officer

That's correct. Our retention rates are up, on average a couple of points compared to the past year-to-date and for the quarter. I attribute this to the service level we provide to our customers and producers, especially during the pandemic. We effectively reached out to those who were still willing to engage on-site. Our underwriters maintain strong relationships with the producers, and we continued to connect even during challenging times. This has yielded positive results, as many businesses were not actively seeking new options, making it harder for producers to shop around due to the limitations of building relationships from a distance. I anticipate that retention rates across the industry should generally improve because of this. However, as travel resumes and relationships can be strengthened further, the situation may change. Overall, we have benefited from improved retention across nearly all our products.

Mark Dwelle, Analyst

That's definitely helpful. Are you seeing any signs of more aggressive behaviors, beyond what you normally see, was fairly robust in any given day?

Craig Kliethermes, President and Chief Operating Officer

I mean, it depends on the space. But overall, I would say, it's probably about the same. There's always markets that are entering and exiting depending on their loss experience a lot of times, at least in our niches. I mean, we find new entrance and depending on the product line, it takes a while to learn your lesson, some places it takes longer than others, then you come in with broader forms with same rates or lower rates and broader forms or the same form and you end up over time losing money in a casualty line. But it does take time for that to manifest and happen. So we constantly see new markets that I think that they're smarter than everybody else that come in and a lot of times they get burned. Sometimes they make it and they're a long-term competitor; a lot of them will exit too. So I don't think that we've seen any more or less necessarily a cry; I was going to comment across our entire portfolio. I think in surety in general, people probably have become a little more reserved, I guess; it used to be I mean, the feeding frenzy there for a while as far as how many new markets we had. And I think one point in time we had about 25 markets made up a big part of the market share and that's probably doubled over the last five years and then more recently, I think people being a little more cautious there because of the potential economic downturn from the pandemic that was reason.

Mark Dwelle, Analyst

That's helpful color, appreciate that. One last question and this is just my own depth of knowledge. Do you have any particular exposure to sort of cyber liability, cyber terrorism, some of the things that we've been seeing in the news lately? Is that a common coverage that you could be exposed to?

Craig Kliethermes, President and Chief Operating Officer

Yes, Mark. I've mentioned cyber in a previous call, and we have some exposure to it. Our largest risk was in our management liability business, but we've significantly reduced that because of concerns over managing the aggregation of risks. It’s challenging to determine our overall exposure and protect our balance sheet from large-scale events.

Operator, Operator

Our next question comes from Jamie Inglis, Philo Smith.

Jamie Inglis, Analyst

Nice quarter. I have got two questions. First, maybe in the casualty area. In the environment we're in right now, we're courts are opening. Do you see any changes? I mean, it seems to me kind of stories must have been thinking of things to do for last year. And is it too early to tell whether there's going to be any change? Have you seen anything sort of paid to incurred change or when or how might that happen?

Craig Kliethermes, President and Chief Operating Officer

Yes, Jamie, this is Craig. I mean, obviously, we're a relatively small player in a lot of the niches or will not be a big player, but we're in very small niches. So it's sometimes it's difficult to just look at the data and determine. I don't think we've seen anything that we would point out significantly. Certainly, we would agree that the court system was closed for the most part, but realized only probably less than 2% of our claims ever go to court to be decided; we decide those outside court, hopefully don't even have to have an attorney involved for most of them. But we don't litigate a lot of claims. So we haven't seen a significant amount. There were opportunities to settle claims during that time because people didn't have the leverage to that they were going to take it to court, or they wanted money before they didn’t want to wait long enough to take it out. So they're willing to take the cash up front to get a fair settlement as opposed to try to roll the dice with a jury or whatever. So we saw some of that. I mean, I don't think we've seen any material changes. I mean, certainly we believe that social inflation, which was prevalent before the pandemic, before the courts were closed. I think that's still alive and well, I don't know if anything happened during the last year, year and a half that would have tamed that. I think what's happened over that 18 months probably only made it worse in the long term. But I think that's yet to be determined. That's why I think we take a more cautious view, a more long-term view to inflationary trends, loss cost trends and don't want to react like we didn't react a lot last year to the fact that frequency was down because we're expecting to come back up. Just because severity may have flattened a little bit over the pandemic, I don't think we thought that the trends were now zero.

Jamie Inglis, Analyst

Great. To begin with the property area, you have had excellent online research over time. This may be an unfair question, but I'm trying to understand your perspective. It seems that in our current world, frequency and severity could change, and there are uncertainties surrounding these factors due to beliefs about climate change. Could you provide a brief overview of your thought process regarding setting reserves? Do you foresee any changes in the future based on the current environment?

Todd Bryant, Chief Financial Officer

Jamie, this is Todd. Let's discuss this from an underwriting perspective. These are shorter-term policies that renew every year, so you can make decisions annually about what you want to underwrite. This will affect overall risk assessments, and you'll quickly know if you incur a loss and what the impact will be. Recently, inflation and rising costs have also played a role. We utilize models in our development processes. While Craig addressed the probabilistic loss modeling, we are also considering factors beyond just modeling, such as concentration risk. You need to evaluate all these aspects to make informed decisions. Additionally, expect to see some changes related to climate in our modeling efforts; you can approach this with either a long-term or short-term outlook. All these factors influence and guide your decision-making.

Jon Michael, Chairman and CEO

And sort of our reserving process goes, that's all looking backward. So it really has no impact on reserving. The impact on reserving in property would be an increased cost of materials and labor and construction. I think our claims people factor that in when they come up with their estimate for capacity, particularly in this environment right now with the rising cost of building materials and labor. So when we come up with an estimate, if we have a hurricane, which I assume we will this year, next quarter. Take that bet. Same, I would like to bet it. It's probably going to cost more to fix the building and replace stuff.

Operator, Operator

Our next question comes from Meyer Shields, KBW.

Meyer Shields, Analyst

I just have one quick follow-up, if you could walk us through the change in the 30 segments expense ratio on a year-over-year basis?

Todd Bryant, Chief Financial Officer

Yes, this is Todd. The influence is partly due to overall corporate expenses. If you look at that, we'll discuss it more during the Q&A session. You might expect the combined ratio losses to lead to a decrease, but there are overall corporate expenses affecting everyone, particularly in terms of retirement. So, the increase is more influenced by that rather than any other factors.

Meyer Shields, Analyst

Okay. And that seems to have outweighed whatever offset would be from the reserve charge.

Operator, Operator

There are no further questions. I will now turn the conference back to Mr. Jonathan Michael.

Jon Michael, Chairman and CEO

Thank you all for joining us. We did have a good quarter, very satisfying. Just below 85 combined, gross premiums are up 25% during the quarter, I just like to thank all of our associates for continuing to help our customers through the pandemic and beyond. And we look forward to talking to you next quarter. Thank you.

Operator, Operator

Ladies and gentlemen, if you wish to access the replay for this call, you may do so by dialing 1-888-203-1112 with an ID number of 6282591. This concludes our conference for today. Thank you all for participating. Have a nice day. All parties may now disconnect.