Hanover Insurance Group, Inc. Q1 FY2020 Earnings Call

Good day, and welcome to The Hanover Insurance Group’s First Quarter 2020 Earnings Conference Call. My name is Cole, and I will be your operator for today's call. Please note, this event is being recorded. I would now like to turn the conference over to Oksana Lukasheva. Please go ahead.

Thank you, operator. Good morning, and thank you for joining us for our quarterly conference call. We will begin today’s call with prepared remarks from John Roche, our President and Chief Executive Officer; and our Chief Financial Officer, Jeff Farber. Available to answer your questions after our prepared remarks are Rick Lavey, President of Agency Markets; and Bryan Salvatore, President of Specialty lines. Before I turn the call over to John, let me note that our earnings press release, financial supplement and a complete slide presentation for today's call are available in the Investors section of our website at www.hanover.com. After the presentation, we will answer questions in the Q&A session. Our prepared remarks and responses to your questions today, other than statements of historical fact, include Forward-Looking Statements regarding among other things. Our outlook for 2020 and the ongoing impact of the COVID-19 pandemic on company performance. There are certain factors that could cause actual results to differ materially from those anticipated. We caution you with respect to reliance on forward-looking statements, and in this respect, refer you to the forward-looking statements section of our press release, the presentation deck and our filings with the SEC which includes supplemental risk factors related to the COVID-19 pandemic and general economic condition. Today’s discussion will also reference certain non-GAAP financial measures such as operating income and accident year loss and combined ratios, excluding catastrophes, among others. A reconciliation of these non-GAAP financial measures to the closest GAAP measure on a historical basis can be found in the press release, the slide presentation or the financial supplement, which are posted on our website, as I mentioned earlier. With those comments, I will turn the call over to John.

Thank you, Oksana. Good morning, everyone, and thank you for joining our call. On behalf of the Hanover team, we hope you and your loved ones are safe and healthy during this public health crisis. Our Company achieved strong results in the quarter while navigating the challenges of the COVID-19 pandemic. We are positioned to manage this crisis and are committed to delivering on our promises to our stakeholders. I will start with comments about our business regarding COVID-19 and then provide an overview of our performance in the first quarter of 2020. Jeff will discuss our operating results by segment, review our investment portfolio, and share our financial outlook for 2020. After that, we will take your questions. Over the past two months, COVID-19 has dramatically changed how we live and work. Many people in the U.S. and over two billion worldwide are under some form of stay-at-home order, and we express our condolences to the families of over 200,000 people lost to this disease. Thankfully, thanks to the dedication of health professionals and first responders, along with scientists' collaboration and the private sector's response, I am confident our country will meet this challenge as we have in the past. If anything has become clear during this crisis, it is that our Company is resilient, adaptable, and compassionate. We are committed to working together to support our shareholders. Our business is fully operational, maintaining strong service levels, and we continue our proud tradition of being there for our customers and agents when they need us most. With the health and safety of our employees as our top priority, we quickly transitioned to a virtual work environment. Over 95% of our workforce has smoothly moved to remote work while providing high-quality service to our customers. The significant investments in technology and workflow we’ve made over the years, along with our continuity planning and shift to agile work practices, have positioned us well. I am incredibly proud of our 4,300 employees nationwide for their commitment and creativity. Additionally, I am proud of our response to support policyholders, agents, and local communities. Our extensive customer financial relief program includes a 15% premium return for personal auto for April and May and flexible bill payment options for those in need. We have also expanded personal auto and homeowners terms to cover delivery of essential goods, living expenses, and rental car costs related to repair delays. Our commitment includes $500,000 to local community funds for pandemic-related assistance and donations of medical supplies. From a financial perspective, our Company is strong, with a solid balance sheet, ample liquidity, and a quality investment portfolio. Our insurance portfolio, built on conservative underwriting practices, continues to yield broad-based profitability. We believe these elements will help us manage through COVID-19’s impact. We have conducted a detailed financial modeling process considering multiple economic scenarios and have earmarked approximately $13 million in reserves for direct COVID-19 related exposures. In the personal auto sector, we expect a short-term frequency benefit from stay-at-home orders, though this may be offset by premium returns and other exposure impacts. We do not foresee a significant impact on our homeowners business. With regard to commercial lines, the economic slowdown may lead to lower claims activity in the short term, but we are aware of potential increased risks if the slowdown continues. Regarding business interruption, most of our commercial multi-peril policies have an explicit virus exclusion. We have reviewed these exposures and believe that even in the most stressed scenarios, our overall operating performance should remain stable in 2020. Our net written premium growth in the first quarter was 3.5%, mainly driven by core commercial and specialty businesses. Personal lines growth was impacted by rate increases on retention but did not decline due to COVID-19, as most business renews before the crisis hit. In summary, our first quarter results met our expectations. With a strong financial position and sound underwriting practices, we are confident in navigating the current environment. We remain focused on the health and safety of our employees, meeting customer needs, and acting in the long-term interest of our shareholders. I will now turn the call over to Jeff.

Thank you, Jack. Good morning, everyone. For the first quarter, we reported a net loss of $40 million, or $1.4 per basic share, compared with net income of $122.4 million, or $2.97 per fully diluted share in the prior year first quarter. After-tax operating income was $86.8 million, or $2.23 per diluted share compared with $80.7 million, or $1.96 per diluted share in the prior year quarter. The difference between net loss and operating income in the first quarter of 2020 primarily reflects the decrease in the fair value of equity securities and, to a lesser extent, fixed income impairments. These impairments are part of the adjustments made to reduce the unrealized appreciation of investments recorded in stockholders’ equity. Our combined ratio was 95.2% compared with 95.8% in the same quarter last year. Lower expenses and fewer catastrophes contributed to the improvement in the combined ratio. While the current accident year loss ratio was slightly higher, by 0.4 points, catastrophe losses totaled $37.9 million in the first quarter of 2020, or 3.3% of earned premium, which was below our expectations for the quarter. Relatively calm weather in January and February gave way to a more active March, with a notable impact from tornadoes that hit Tennessee, accounting for a large portion of the catastrophe losses we incurred in the quarter. Regarding prior year reserves development, we were slightly favorable for the quarter. Minor changes in some older legacy voluntary pool businesses were more than offset by net favorable developments in our ongoing P&C business. We experienced favorability in workers' compensation and certain specialty lines, which continue to perform better than expectations. However, we observed unfavorable development in commercial and personal auto due to increased activity in prior accident years related to bodily injury. Nonetheless, we feel comfortable with our current accident year 2018 and 2019 auto picks. Reflecting our disciplined approach to financial management, expenses came in better than expected for the quarter, thanks to lower discretionary spending and the timing of certain accruals. When examining our underwriting results by line, the personal lines combined ratio, excluding catastrophes, was 87% for the first quarter, down from 91.6% in the same period last year, primarily due to the improvement in current accident year losses. The personal auto loss ratio of 67% improved by 3.6 points from the first quarter of 2019, mainly due to more favorable winter weather during the quarter, as well as the decline in physical damage and comprehensive auto property frequency starting in the latter half of March due to various stay-in-place orders. Although we are anticipating a significant decrease in frequency in the second quarter, we expect the positive results to be lessened by potentially higher severity associated with increased repair costs and the $30 million premium refund we announced earlier this month. Setting those usual and temporary impacts aside, the underlying trends in personal auto are performing in line with our expectations. The homeowners loss ratio of 48.4% was stable compared to last year. We have seen favorability from mild ex-cat winter weather similar to auto, though partially offset by an uptick in fire losses. Personal lines net written premiums rose 2.1% in the quarter, highlighting our focus on profitability in a competitive market. We aim to find a successful balance between rate and retention, alongside expanding our whole account offerings with many of the industry's top agents. Our continued discipline and enhanced account proposition will position us well in the forthcoming months as the competitive landscape responds to normal loss trends and ongoing severity pressures. Moving on to commercial lines, our combined ratio excluding catastrophes was 94.7%, up from 92.6% in the first quarter last year. The increase was mainly due to a higher current accident year loss ratio, partially mitigated by favorable development and reduced expenses. Excluding catastrophes, the commercial lines current accident year loss ratio increased 2.4 points to 61.2%, driven by two primary factors: one unusually large fire loss and COVID-related reserve actions. The fire loss took place in the CMP line and triggered our property per risk annual aggregate deductible for the full sum of $10 million, which significantly contributed to the increase in the CMP loss ratio during the quarter. We determined an economic benefit existed in maintaining this annual aggregate deductible, however it tends to be particularly painful in the quarter that a large loss manifests. Our commercial lines loss picks also include an increase in a reserve provision primarily to cover potential COVID-19 related losses, specifically within those sub-limited policies where we offered limited coverage for virus-related exposures. As Jack mentioned, we conducted thorough reviews of policies and contract language in our commercial lines business. We identified a total of 538 commercial multiple payroll policies in core commercial and mono line property policies in our healthcare business within specialty that have BI endorsements and, by our intention, do not include an explicit virus exclusion. Many of these policies may incur potential losses, as they might be shut down for cleaning rather than outright closure since many of them operate as essential businesses. Each of these policies has a total of $25,000 sub-limits for this coverage. To put the number of policies in context, we hold nearly 400,000 commercial policies as a whole. Based on these facts, we allocated $13 million in reserves, including reserve additions in the first quarter. The majority of our COVID exposures, and by extension of these reserves, is related to those 538 identified policies. Given the population and the low sub-limits, we anticipate that the losses will remain quite manageable. The commercial auto current accident year loss ratio, excluding catastrophes, improved by 3.3 points to 66.5%. We are experiencing the benefits of prior rate increases and targeted underwriting actions that we discussed in previous calls. Compared to personal lines auto, we did not observe the same level of frequency declines in March, which likely reflects the increased delivery activity in certain industry sectors and geographical areas. Shifting to worker's compensation, the ex-CAT accident year loss ratio increased by 3.7 points from the year-ago quarter to 63.4%. This increase aligns with our prudent loss selections amidst an industry-wide decrease in rates, as well as the timing of a loss selection adjustment in the first quarter of last year. We are very confident in our overall book of business; however, we remain cautious in the current pricing environment. In other commercial lines, the current accident year loss ratio, excluding catastrophes, improved by 2.3 points to 55.3%, reflecting a favorable comparison to significant property losses a year prior. The loss ratio in this line is elevated relative to our plan and includes a portion of the increased reserve provision covering potential COVID-19 losses that I previously mentioned. Commercial lines net written premiums grew by 4.5% in the first quarter. Our team is committed to expanding businesses, industries, and geographies that align with our profitability targets, while continuing to pursue granular underwriting and pricing actions in areas such as non-specialized programs. We witnessed strong growth in our core commercial businesses led by CMP and worker's compensation, as we moved forward with increased pricing in auto lines. The robust underlying growth momentum through March was somewhat offset by a planned reduction of approximately 6% in our programs portfolio. Moving on to our investment performance, our net investment income for the quarter was $69.6 million. The majority of our net investment income remains resilient against the current market environment. Our portfolio has a duration of 4.2 years, meaning just under an eighth of it is anticipated to roll over each year. Short-term interest rates have a manageable effect, and we are navigating the downturn in interest rates and the recent widening of corporate credit spreads responsibly. It's worth noting that our investment income in the first quarter included approximately $7 million from partnership income, which reflected both income and market appreciation through the end of 2019. We report these partnerships on a one-quarter lag following the occurrence of earnings. Our partnership mix skews towards credit and mezzanine funds, which have historically exhibited lower volatility compared to broader equity markets, but still demonstrate some correlation to the S&P index. Based on valuations as of March 31st, it is possible for us to report a loss on these partnerships in the second quarter. We trust our fund managers and believe this asset class, which offers strong long-term returns, is suited for investors who can handle the associated volatility. We maintain confidence in the structure of our investment portfolio. It is high quality, well laddered, and effectively diversified across industries and asset classes. Fixed income and cash make up 85% of our total $8 billion portfolio, with a weighted average quality of A plus, and 96% investment grade. At the conclusion of the first quarter, equity securities accounted for approximately 6% of our total investment portfolio. Moreover, over the past three years, we have cut our exposure to BBB issuers from 6% of fixed income to 4%, and our exposure to below-investment-grade issuers from 6% to 4%. Consequently, we are confident that our portfolio can withstand any downward ratings migration arising from the economic ramifications of the coronavirus outbreak. We have also significantly reduced our exposure to specific fixed income industry classes that are inherently more volatile. The energy sector now constitutes only 2.9% of our overall fixed income portfolio, down from 5.3% three years ago, and is 92% investment grade. More than half of our energy exposure lies within the midstream sub-sector, where most operations are backed by fixed fee contracts, making them more resilient in times of economic uncertainty. Our exposure to industries more sensitive to the economic effects of COVID-19, including airlines, hospitality, and retail, collectively makes up less than 3% of our portfolio. Our commercial mortgage-backed securities are 95% AAA rated and well-diversified by property type, area, and vintage year. Our CMBS holdings also benefit from over 30% credit enhancement, and we have a considerably lower proportion of retail industry exposure in our CMBS holdings compared to the public conduit universe, with very strong loan-to-value metrics. Despite the robustness of our investment portfolio, it was not immune to the extraordinary volatility experienced in the first quarter, leading to an overall decline in book value per share of 5.1%, even after considering solid operating income. We are long-term capital allocators and are confident in our capacity to manage current financial market risk and volatility effectively. In fact, based on market values as of last Friday, we have recovered a substantial portion of the decline in book value, which underlines the strength and quality of our portfolio. Before opening the line for questions, let me share some thoughts on our outlook for 2020. As Jack mentioned, we undertook an extensive financial modeling exercise incorporating broad cross-functional participation throughout the company. We further stressed numerous assumptions across our entire business portfolio, including prolonged stay-in-place orders, possible related premium cancellations and endorsements, and pressure from increased risks associated with vacant properties, legal activity, and recession-related losses such as surety-related risks. We feel optimistic about the output from this exercise, which provides helpful parameters for our updated outlook for 2020. Accordingly, we are reaffirming our original ex-CAT combined ratio guidance of 91% to 92%. Due to significant uncertainty regarding the duration of the slowdown and the extent of premium decline, we cannot provide guidance on premium growth at this time. Beyond the premium return measures we announced earlier this month, we are closely monitoring endorsement, new business, and cancellation activity, which will depend on the severity and pace of the economic recession and ultimate recovery that is difficult to forecast. Regardless of premium levels and the ensuing reduction in loss frequency, we are confident in our financial discipline and ability to adjust our expenses throughout the year while balancing short-term needs with our long-term strategic focus. In terms of underwriting performance, we still expect catastrophe losses to be 4.6% for the full year. Please note that due to our geographic footprint and seasonal effects, we are setting our second quarter catastrophe assumptions at 5.6%. Regarding net investment income, excluding the partnership component, we are still optimistic about our income expectations across various asset classes, accommodating potential losses from partnerships in the second quarter and presuming a gradual improvement in market conditions over time. Our overall NII outlook now stands at around $255 million for 2020, with some variability on either side. We believe the second quarter will yield lower net investment income compared to the quarterly run rate for 2020, given the potential for marks on investment partnerships. It’s important to remember that our investment partnerships make up less than $300 million of our total $8 billion investment portfolio. In summary, we feel optimistic about our anticipated 2020 results and have faith in our capacity to navigate the economic effects on premiums in future years. We have demonstrated our ability to perform even in challenging circumstances, and we will continue to do so. Our company remains robust. Over the years, we have diversified our portfolio by state and sector, while fortifying our earnings stream in each business. We possess a solid balance sheet, strong liquidity, and a high-quality investment portfolio. We believe these components will enable us to manage any market challenges effectively and come out as a stronger performer within the industry. With that, we will now open the line for questions.

Thank you. We will now begin the question and answer session. Our first question today comes from Matt Carletti with JMP. Please go ahead.

Thanks. Good morning. Just a few questions. Maybe I will start with Jack and Jeff. Is there any insight you can give us into what you have seen in April so far? And I appreciate your comments that we have no idea of how long this goes or the shape of the downside and upside. But in terms of even just qualitatively new business production retention, endorsements, cancellations, just any color you could provide on what you've seen so far in April, as we have progressed further into the stay-at-home impacts would be helpful.

Yes, Matt this is John, thanks for the question. I will tell you that it is still very early. We are pleasantly surprised that many of our agents have transitioned very well to the remote environment. I think as an industry, I'm frankly impressed at how well the business of property and casualty insurance is performing, and we are responding to our customers' needs effectively. Early indications suggest there is some new business submission activity that may decline. It’s early to say anything specific, but we expect that ranges substantially by industry class and to some degree geography. What we're encouraged about is that our efforts to use our analytical approach with agents and doing more active pipelining will assist us during this period, where we have identified accounts we wish to work on with agents instead of solely reacting to a flow that may indeed decrease. We anticipate that retentions will rise. Early signs indicate that this might indeed happen, but the wild card will be how many cancellations or mid-term adjustments and exposures we see in the future and how those will impact our top-line trajectory. In early assessments, we are glad to observe a level of stability as we get started.

And Matt on the claims side, we are clearly seeing a significant reduction in claims across numerous areas, with the trend being quite meaningful.

Okay. Maybe this ties into your guidance pieces. My main question revolves around, you suspended the top-line guidance, which completely makes sense to me, I think that is pretty common. But you affirmed the expense ratio guidance, while some peers have indicated they expect upward pressure on the expense ratio, not downward. Can you discuss that disparity where, with the vaguer outlook on net written premiums, you can still reaffirm your anticipated expense ratio improvement? Is that, Jeff, related to what you mentioned in your comments about how you can make decisions on where to pull back or that you have more flexibility in your optional spend compared to others?

Yes. If you split the combined ratio into its two components, we reaffirmed a 10 basis point improvement for the expense ratio. We are able to balance slightly between the long-term and short-term while focusing on expenses to achieve this in the projected expense scenarios for 2020 that we foresee. From a loss ratio perspective, we are confident that claims activity will offset the contraction we are likely witnessing, or are seeing in net premiums.

Alright. And lastly, if I can just ask for an update on your views regarding capital management. We saw that the ASR closed out in Q1. There were additional open market purchases; I forget who commented, but you mentioned you paused activity in mid-March. How should we view your perspective on capital management going forward? I mean, you mentioned a near-term expectation of downward pressure or at least reduced top line, and obviously a stock trading at lower valuations than previously. How should we take that into account?

So Matt, yes, as you mentioned, we completed the ASR, and we did about $40 million in additional buybacks, then paused in mid-March. Our current view on buybacks is to adopt a wait-and-see strategy. We have not decided whether to re-engage or if we are done for the year. That will depend on how the situation progresses and our perspective at that time. At this moment, we have ample capital and are satisfied with our operations; however, we believe it is prudent to monitor the situation. It may seem obvious, but just to clarify, we don’t foresee any changes to our regular dividend payout. Any consideration of special dividends will likely follow the same approach as our buybacks.

And our next question comes from Paul Newsome with Piper Sandler. Please go ahead.

Good morning. I have just two questions. One is broad, and one is quite specific. So, maybe start with the broader aspect. Throughout previous major events, we have witnessed shifts in underwriting behaviors. I’m curious if you see any areas where you believe underwriting practices will fundamentally change, either for yourselves or others in the industry.

Yes, Paul, this is John. Thanks for that question. Jeff mentioned some of the financial scenario work we've conducted, which reviewed our existing portfolio and pondered the potential implications based on various challenging factors. Concurrently, Rick and Bryan have been diligently considering our adjustments in the approach to business and the rising need for rapid adaptations in the way our customers operate. We conducted analyses assessing potential effects on sectors of our business that might require further aversion. Historically, we have made meaningful reductions in our penetration of the restaurant and hospitality sectors based on observed liability trends from previous years. Scaling back in major metropolitan areas as part of that effort will likely prove beneficial. Looking ahead, we foresee that the service economy will thrive, but this will likely occur in a much-altered landscape, and we are actively engaging in scenario modeling to prepare for that future.

Just adding a brief comment: we feel our core book provides resilience through this downturn. To echo what Jack shared, specific sectors, such as restaurants and hospitality, represent only about 7% of our overall portfolio, which is a minimal percentage. Our efforts to retract from major metropolitan areas have driven down our exposure by approximately 20% over four years, and these areas are more greatly impacted by COVID-19. Another point I would note is that we currently assess not only operational viability but also the financial stability of entities as key components in our underwriting.

Thank you. I had some questions regarding the commercial auto environment. Could you provide more details about what triggered the reserve development there? We had hoped that this year would be a turning point in general. Can you shed light on what is occurring?

Regarding prior year development, overall, we experienced favorability, which included positive trends in personal lines and other commercial lines. However, we did witness unfavorable developments in the auto sector, mainly offset by triumphs in workers' compensation. We feel confident in our reserves overall. This quarter saw some unique factors in the auto sector, particularly in commercial auto concerning bodily injury, and we deemed it necessary to adjust accordingly. Despite this, we still have confidence in our selections for 2018, 2019, and 2020.

Are those changes tied to specific case issues or reflect broader trend changes?

The majority relate to specific case issues, particularly unique instances. We are not immune to the overall trends in litigation that people have observed in recent years, yet most of this involves individual cases.

Great. Congratulations on the quarter, everyone!

Thank you, Paul.

And our next question comes from Meyer Shields with KBW. Please go ahead.

Great, thanks. I have a question for Jeff. Can you discuss new money rates and whether there has been any shift in your investment allocation strategy for new money at this time?

No, we haven't materially changed our portfolio mix. New money rates have decreased, as rates have dropped and spreads have widened slightly. Given a 4.2-year duration, it generally takes about eight years for our portfolio to roll off. Due to the timing of cash flows, we typically don't engage in significant new investing in the first four months of the year; it usually picks up later in the year. New money yields have decreased, but we have factored those levels into our guidance for the year. However, we are not pursuing or reshaping the portfolio for higher yield.

Thank you. Can you provide insight into the expenses that you've cut back on in the first quarter, and how that will affect operations through the remainder of 2020?

We did not make any specific cuts in the first quarter. While expenses were down year-over-year, they were not down as much compared to our guidance. The slight decrease in expense ratio reflects timing regarding new hires and certain accrual adjustments. As we look to the rest of the year, some expenses, like travel and entertainment and conferences, will naturally decrease. We also have flexibility to manage other expenses to meet the decline in premiums to address our expense ratio appropriately.

Lastly, it appears my rough calculations for the fourth quarter indicate that commercial lines rates may have moderated a little. Can you discuss that?

This is Jack. To clarify, you are inquiring about the pricing trajectory in our commercial lines?

Yes.

Yes. As articulated in the script, the rate trajectory within commercial lines is continuing to rise. We are witnessing sequential improvement. What we reported in the fourth quarter exhibited particularly high pricing results due to a significant influence from the exposure side. We tried to clarify in our fourth quarter call that the pricing highlighted was somewhat inflated due to changes in exposure bases during that quarter. I would say there’s a similar occurrence in the first quarter, where the exposure element is slightly lower than what we typically observe, not influenced by the economy, rather impacted by the usual flux of exposure bases. So when viewing the core 4.6% rate that runs through the book, that represents an actual enhancement over previous metrics. We are also recognizing incremental improvements in our specialty portfolio.

Great. Thank you very much.

Thank you, Meyer.

And this concludes our question and answer session. I would like to turn the conference back over to Oksana Lukasheva for any closing remarks.

Thanks, everybody, for your participation today. We look forward to speaking with you next quarter. Stay healthy.

Be well.

The conference is now concluded. Thank you for attending today’s presentation. You may now disconnect your lines and have a great day.