Earnings Call Transcript - UFCS Q4 2020

Operator, Operator

Good morning. My name is Chuck, and I'll be your conference operator today. At this time, I would like to welcome everyone to the UFG Insurance Fourth Quarter and Year-End 2020 Financial Results Conference Call. All participants will be in a listen-only mode. Please note this event is being recorded. I will now turn the call over to Randy Patten, Assistant Vice President and Controller. Please go ahead, sir.

Randy Patten, Assistant Vice President and Controller

Good morning, everyone, and thank you for joining this call. Earlier today, we issued a news release on our results. To find a copy of this document, please visit our website at ufginsurance.com. Press releases and slides are located under the Investor Relations tab. Our speakers today are Chief Executive Officer, Randy Ramlo; Mike Wilkins, Chief Operating Officer; and Dawn Jaffray, Chief Financial Officer. Please note that our presentation today may include forward-looking statements as defined in the Private Securities Litigation Reform Act of 1995. The company cautions investors that any forward-looking statements include risks and uncertainties that are not a guarantee of future performance. These forward-looking statements are based on management's current expectations. The actual results may differ materially due to a variety of factors, which are described in our press release and SEC filings. Please also note that in our discussion today we may use some non-GAAP financial measures. Reconciliations of these measures to the most comparable GAAP measures are also available in our press release and SEC filings. At this time, I'm pleased to present Mr. Randy Ramlo, CEO of UFG Insurance.

Randy Ramlo, CEO

Thanks, Randy. Good morning everyone, and welcome to our fourth quarter and year-end 2020 conference call. As we mentioned in our press release, on February 11, 2021, our fourth quarter results were negatively impacted by social inflation, resulting in an increase in severity of current accident year losses and in prior accident year reserve strengthening. Social inflation continues to impact the entire industry. Unfortunately, our two largest states, Texas and California, are amongst the highest trending social inflation states, meaning the impact to UFG is magnified. In recognition of social inflation trends during 2020, and particularly in the fourth quarter, new commercial auto and general liability claims were reserved with more pessimism. Additionally, progress has been made to shorten the claims cycle, with reserves being established earlier in the process than in past years, with new analytic insights driving these outcomes. Also, during the fourth quarter, we reviewed the reserve adequacy of our open prior year/accident year case reserves in consideration of our more pessimistic view. The full-year of 2020 results were also negatively impacted by a historical level of catastrophe losses. Catastrophe losses added 13.5 points to the combined ratio in 2020, which is the highest in the last five years and significantly higher than our five-year historical average of 5.6 points prior to 2020. During the year, we experienced catastrophe losses of $231 million before reinsurance, $142 million net of reinsurance. The majority of these losses came from three significant events that occurred in some of our largest geographically exposed areas. Two of these events impacted Cedar Rapids, Iowa, the location of our corporate headquarters. These events were the August Midwest derecho with peak winds of 145 mph, and a hailstorm in April, impacting the Greater Cedar Rapids, Iowa area. The third event was Hurricane Laura, which impacted another heavily exposed area for UFG in Southern Louisiana, the location of our 2019 agent of the year. Though we are very disappointed with our results in 2020, we remain optimistic about our future. Throughout 2020, we focused on building the foundation of our new strategic plan to improve profitability. Our strategic plan, which we call, 'One UFG boldly forward,' contains a number of initiatives aimed at long-term profitability, portfolio diversification, sustainable growth, and continuous innovation. As a result of our efforts, we are able to point to some early underlying improvements, including our fifth consecutive quarter with a decrease in the frequency of commercial auto losses and commercial auto exposure units. We also saw improvement in our core loss ratio, despite reserves being established earlier in the claims cycle and with more pessimism. Our core loss ratio improved 0.6 and 0.4 percentage points, respectively, in the fourth quarter and full-year 2020 compared to the same periods in 2019. Mike and Dawn will go into more depth in a few minutes discussing additional positive outcomes from our strategic plan in 2020. Although the level and speed of improvement this year was unacceptable, we firmly believe that we are on the right path forward and will remain focused on improving profitability as part of our strategic plan. In regard to the ongoing pandemic, as a reminder, nearly all the policies we have issued contain contract language that specifically excludes business interruption coverage losses attributable to viruses such as the COVID-19 pandemic. At this time, we expect the effect of COVID-19 on claims currently under our coverages to be manageable. However, the pandemic continues to evolve, and we cannot predict how future legislation, regulation, or court actions will impact us. Before turning the call over to Mike, I want to mention that UFG reached an important milestone on January 2, 2021, our 75th anniversary. Though much has changed in our 75-year existence, we remain committed to our humble roots and founding belief that the insurance business is a people business. It was our Founder, Scott McIntyre, Sr., who instilled in the company the principle of doing business the right way and treating people the right way, a legacy that I'm proud to say is carried out daily by UFG employees across the country. I will now turn the call over to Mike Wilkins.

Mike Wilkins, CFO

Thanks, Randy, and good morning, everyone. In my portion of the call, I will discuss the progress of our strategic plan, focusing on the positive outcomes of the past year, while addressing our 2020 results and our plans for improvement. First, as mentioned throughout 2020, our focus has been on reducing the size of our commercial auto portfolio by non-renewing underperforming accounts and reducing the number of exposure units. During 2020, we successfully decreased our commercial auto book, which now makes up 28.7% of our portfolio compared to 31.2% at the end of 2019. Looking at only new premiums, on slide six in our slide deck, commercial auto accounts for 24% of the new premiums added in 2020 versus 32% in 2019. Our goal is to have commercial auto represent closer to 24% of our portfolio mix, which we are achieving. Part of the strategy in balancing our book of business is also to improve our risk selection. In 2020, we established a centralized approach to underwriting, establishing consistency across our geographic regions using a broad brush in selecting risks in our strategic plan to balance our book of business. In 2021, we intend to be more targeted on where and what we write based on state and geographic region, especially focusing on the states that have the highest trends of social inflation, Texas, California, and Florida. With the sale of our personal lines renewal rates nationwide effective September 1, 2020, we believe we have reduced our exposure to the type of catastrophe events we experienced in 2020, especially near our headquarters. We remain disciplined regarding our pricing strategy, specifically on our commercial auto, property, and umbrella books of business. The commercial auto average renewal rate increase remained in the double digits at 10.5% in the fourth quarter of 2020. The commercial auto average 12-month rate increases have been in the low-double digits since the beginning of the year. We continue to get the most rate in our bottom 30% of our retained commercial auto book. As a reminder, we are non-renewing a large percentage of our underperforming commercialized business in the bottom 30% of our book. Commercial property improved in the fourth quarter, with the average renewal rate increases now at 7.4%, up from 5.8% at the third quarter. As we stated last quarter, we believe there is an opportunity with our commercial property book to be more aggressive with rate increases and reduce undesirable exposures as we see signs of the market hardening. From a claims perspective, our strategic plan focuses on shortening the claim cycle time, reducing legal expenses, and the impact of litigation. As Randy mentioned, the impact from social inflation for UFG is more significant than other carriers given the concentration of our book of business in Texas and California. Part of our strategy to address this is improving our legal and claims process. In the fourth quarter, we started to see the impact from the strategy of shortening claim cycles and setting case reserves earlier in the claims process with more pessimism. Additionally, we recognize that increased specialization by our claims adjusters will allow us to deploy enhanced expertise on our most complex and severe claims. In the fourth quarter, as a precursor to specialization, we deployed a team of experts to review reserves on open claims leading to prior accident year reserve strengthening. We also deployed analytics models for claim severity in the fourth quarter. This model assists our adjustors by identifying early and regular indicators of the severity of the loss. We expect to release a case reserving model for commercial auto by the third quarter of 2021 in continued support of our reserving accuracy. Additionally, we are pursuing opportunities for early but equitable settlements, reducing the tenure of our open claims. I will wrap up my portion of the call today discussing some of our growth strategies. Our strategic plan is to grow and expand our profitable lines. Our most profitable lines in 2020 and the lines we believe present us with the greatest opportunities are surety and E&S. Both our surety and E&S lines exceeded the profitability and written premium goals in 2020. Our plans are to continue to grow these lines in 2021. For E&S, this includes state and product expansion, and for surety, this includes additional surety producers in the northeast U.S. Another historically profitable line that we intend to grow is assumed reinsurance. Growth in this line will allow diversification of our current portfolio mix. We have several new assumed reinsurance programs in place in 2021 that will diversify our overall book of business. Lastly, in mid-2021, we are excited to begin the initial rollout of a new online quoting experience for our agents, allowing us to increase our straight-through processing of policies and grow our profitable BOP line of business in the future. With that, I'll turn over the discussion to Dawn Jaffray.

Dawn Jaffray, CFO

Thanks, Mike, and good morning, everyone. In the fourth quarter, we reported a consolidated net loss of $8.9 million compared to a net loss of $23.2 million in the same period of 2019. For the full year of 2020, we reported a consolidated net loss of $112.7 million compared with net income of $14.8 million for the full year of 2019. As Randy and Mike mentioned, the quarterly results were impacted by the severity of losses from what we believe to be the influence of social inflation and prior accident year reserve development. During the fourth quarter, we recognized unfavorable prior accident year reserve development of $12.4 million, primarily driven by our commercial liability and auto liability lines of business. For the full year of 2020, we had favorable development of $17.7 million compared to favorable development of $5.3 million for the full year of 2019. As a reminder, we've had continued favorable prior accident year reserve development every year since 2009. Catastrophes were significant and impactful on results during 2020 with results of $142 million compared to $64.4 million for the full-year of 2019. Also contributing to the fourth quarter net loss was the continued impact from the severity of losses. Moving on to investments, we reported an improvement in the fourth quarter for both realized investment gains and net investment income. This is primarily due to an increase in the fair value of our investment portfolio recovering a portion of these realized losses and a decline in investment income from the first three quarters of 2020. In the fourth quarter of 2020, the fair value of our investments in equities—which I refer to as phantom gains—increased by $32 million pre-tax compared to a $4.4 million increase in the fourth quarter of 2019. Net investment income increased by $0.9 million in the fourth quarter compared to the fourth quarter of 2019, primarily due to an increase in the fair value of our limited liability partnerships or our bank funds. Our bond portfolio also increased in 2020 with an after-tax unrealized gain of $36 million during the year. Despite these improvements in the fourth quarter, we reported net realized investment losses of $32.4 million and a decline in net investment income of 34% for the full year of 2020 compared to the full year of 2019. We have reduced some of the volatility in the investment portfolio with the sale of equities we undertook this year. As for our operating metrics for the quarter, we reported a combined ratio of 123.1% compared to 117.9% in the same period of 2019. For the full year, we reported a combined ratio of 115.9% compared to 109% for the full year of 2019. We did see a decrease in the expense ratio in the fourth quarter of 2020 to 30.8% from 32.2% reported in the fourth quarter of 2019. The decrease is primarily the result of a decrease in commissions. For the full year of 2020, the expense ratio was 33.5% as compared to 32.6% for the full year of 2019. The increase of less than one point was primarily due to our continued investment in technology initiatives. We have several expense initiatives as part of our strategic plan, including a change in our agent commission structure, the establishment of a vendor management office, and a shift in the design of our pension and retiree medical benefits plans. In the second half of 2020, we began to see some impact from changes to our commission structure. These changes include an adjusted agency commission schedule aligning with the profitability of our lines of business and an adjusted agency profit-sharing plan emphasizing profit over volume. These changes will have a greater impact in 2021. We also established a centralized vendor management office in 2020 to better track and manage our vendor contracts. We believe this approach will provide opportunities for further negotiation of contracts and ultimately additional cost savings going forward. For the pension plan, we made the decision at the end of 2020 to transition from a traditional defined benefit pension plan to a cash balance pension plan, which significantly reduced our long-term liability and our volatility in the potential benefit obligation. This had a positive impact on equity in 2020 and will have a positive effect on our expense ratio beginning in 2021. In addition, we just announced the difficult but necessary decision to change our retiree medical plan to a voluntary plan funded exclusively by participants commencing at the start of 2023. We are currently working through the financial reporting and accounting implications of this decision. Our expectations are that this decision to end employer-provided funding for the retiree medical plan will have a short-term benefit to the expense ratio in '21 and '22, with the greatest proportion of the impact to 2021. Longer-term, we expect this action will provide some additional saving to the ongoing escalating cost of benefit expenses for UFG. For reference, the retirees' medical plan liability at December 31, 2020, was about $32 million. This existing obligation will be recaptured along with released prior credits into the income statement over the next two years. Although dependent on premium levels, with these expense management actions, our expectation is that our expense ratio will be lower in 2021, with a conservative estimate for the ratio to decrease by approximately two points for our 2021 performance year. We will provide a more definitive number during our first quarter 2021 conference call, following the completion of the required accounting and actuarial valuation of this change in the retiree medical plan. Moving on, I will end my portion of the call by discussing capital matters. As of December 31, 2020, I am pleased to report that we continue to maintain a strong balance sheet to support our business and our One UFG strategic plan initiative. At the end of 2020, we made the decision to leverage our balance sheet by adding $50 million of long-term debt, with the addition of two surplus notes from a privately negotiated transaction. The new instruments result in a small impact on our capital structure, with UFG now holding 6% in terms of a debt-to-equity ratio. This decision to add additional debt capital will support the profitable growth initiatives Mike discussed as part of our One UFG strategic plan. Also during the fourth quarter, we declared and paid a $0.15 per share cash dividend to shareholders of record, as of December 4, 2020, marking our 211th consecutive quarter of consistently paying dividends, dating back to March of 1968. Lastly, during the quarter, we did not repurchase any UFCS shares. We made the decision, in mid-March, to suspend share repurchases. We remain authorized by our Board of Directors to purchase an additional 1.8 million shares of common stock under our share repurchase program, which will expire at the end of August 2022. And with the closing of our prepared remarks, I will now open the line for questions.

Operator, Operator

We will now begin the question-and-answer session. And the first question will come from Paul Newsome with Piper Sandler. Please go ahead.

Paul Newsome, Analyst

Good morning. Thanks for the call. Hope everyone is well. I was hoping you could give us a little bit more details on what you call social inflation. Is it very much specific to commercial auto, and is there any sort of additional details to the kinds of lawsuit severity that you are seeing that would give us a sense of what might be going on?

Randy Ramlo, CEO

So, I'll start with this one, and then Corey can add some insights from the claims perspective. We've noted that a couple of states frequently mentioned in the media as challenging are Texas and California, which happen to be our two largest markets, presenting us with a significant issue. Commercial auto insurance has become a major target, similar to how workers' compensation was at one point, but the scheduled limits on compensation have reduced its appeal. However, commercial auto, especially those covered by an umbrella policy, has been a notable focus of litigation. It's not solely about jury or judgment awards, but we are observing two specific trends in claims: traumatic brain injuries and post-traumatic stress syndrome. It’s surprising how often we see these conditions even in low-impact claims. Our analytics tools identify characteristics of claims that indicate a high likelihood of litigation and unfavorable outcomes, both of which are concerning. This could be influenced by physicians being more inclined to diagnose these conditions, which can lead to larger settlements. It often results in juries and judges overlooking negligence, alongside the likelihood of these injuries occurring. For UFG, the auto sector is a major focus, particularly with umbrella policies. Unfortunately, we have a high percentage of our portfolio in auto insurance, significantly more than many of our competitors. As Mike mentioned, we're actively working to align this better, while also dealing with challenges in difficult states, which has been detrimental for UFG. Corey may want to provide additional specifics regarding claims.

Corey Ruehle, Claims Manager

Hi, Paul. This is Corey Ruehle. If you look at our social inflation on an overall basis, it's running right in line with what the industry is seeing as well. If you break out commercial auto for California and Texas, it's about double that year-over-year over the last five years. We are seeing some positive results though. Our new suit counts, starting in January of 2019 until now, have been dropping steadily, but if you look at those new suits, California and Texas run almost half of the total for overall new suits. Our closing cycle time on those suits has continued to be very steady. And so, what we've created is a nice gap between the number of new suits coming in and the number of closed suits that we're still maintaining. Our payment cycle time has also improved over the last few years, which to me is a good leading indicator that we're actually getting out ahead of these claims. We've also been tracking for new commercial auto BI claims that come in a given quarter, what level of reserving that we're establishing on those claims, and I can tell you that we've almost doubled where we were at traditionally starting in the third quarter of 2019 and all of 2020. So, we're making really good progress there. As Randy had mentioned, we also instituted the severity model in the fourth quarter of last year, and that severity model has allowed us to be able to triage these claims to the rate adjustors right off the bat, so that we're getting out ahead of these claims and seeing improved settlements. If you look at social inflation on claims that are open longer than two years versus those claims that we're able to close in less than a year, the gap is continuing to widen there too. So the longer a claim is open, especially if it is in litigation, we're seeing quite a bit more inflation there.

Paul Newsome, Analyst

So, my second question in regards to the math of the fundraising of the $50 million in surplus notes debt, could you kind of put together the pieces of why $50 million would be needed to fund growth when it looks like the book is actually going to shrink at least on a revenue basis because of your underwriting initiatives?

Randy Ramlo, CEO

So, maybe we'll let Dawn tell you a little bit about it. She was most heavily involved in the surplus note. So, I'll let her kind of give a little background.

Dawn Jaffray, CFO

Sure, I'll make a couple of comments here, Paul, and then I'll ask Mike to weigh in as well. Clearly, our growth opportunities looking forward made sense for us to add some additional, what's treated for insurance purposes, as capital, as you know, in the form of a surplus note. Yet on a GAAP basis, it's treated as a debt. And we thought it was an opportunistic time to add a very small amount that was to support our various 'One UFG' plan initiatives.

Mike Wilkins, CFO

And, Paul, this is Mike… You were accurate, that we expect to see premiums shrink going forward. However, we do have some areas that we plan to try to grow fairly aggressively. Areas that have been extremely profitable for us in the past, we think represent good opportunities going into the future. The main areas there would be our surety operation, excess surplus lines, and assumed reinsurance. We've set out fairly aggressive growth goals in those areas and felt this was a good move to make sure we have that adequately supported.

Paul Newsome, Analyst

Is there a need to allocate cash appropriately for that specific segment at close? Or if the business is contracting, why is there a requirement for more surplus capital? Perhaps we can discuss this further later and I'm interested in understanding how management has been approaching this.

Dawn Jaffray, CFO

Thanks, Paul. I think that the main point is just continuing our historical approach to retaining a strong balance sheet and being prepared for the future. As you're aware, this is a very small amount relative to our overall capital structure. And we've had no debt-type instruments and the uniqueness of this opportunity being a surplus note was also a part of the draw for us.

Paul Newsome, Analyst

Great, okay, thank you. I'll let some other people ask questions if they have more. I appreciate the call.

Randy Ramlo, CEO

Thanks, Paul.

Operator, Operator

The next question will come from Marla Backer with Sidoti. Please go ahead.

Marla Backer, Analyst

Thank you. So, I have a couple of questions in part a follow-up to what the discussion just talked around. First, during 2020 we obviously saw a lot of delays if not outright closures in the courts. Do you think there's any impacts of that in terms of what you're seeing that makes you more pessimistic now in the social inflation?

Randy Ramlo, CEO

So again, I'll make a quick comment and then ask Corey if he has any thoughts. Early on in the pandemic, we observed some willingness to settle claims, but I'm not sure that has continued. Most predictions suggest that this isn’t just a short-term trend; it seems to be an ongoing issue. Another factor is income inequality, which significantly influences states with the largest income gaps, often resulting in substantial judgments. We haven’t encountered many problems in that regard; rather, we are seeing a percentage added to what a typical judgment would have been four or five years ago. Some courts seem poised to start reopening, but I'm uncertain if the pandemic has had a significant overall effect on social inflation. It appears to be more about shifting societal attitudes. Corey, do you have any comments?

Corey Ruehle, Claims Manager

Hi, Marla. When we examine some leading indicators that contribute to social inflation, we noticed positive signs even before the pandemic began. I mentioned our new suits being dropped, and despite the pandemic, the year-over-year decline has remained consistent. Thus, there wasn't a significant drop when the pandemic started. It will be interesting to see how the reopening of courts affects this, particularly in terms of how people may approach matters. Regardless, we are committed to a fair yet aggressive strategy for settling claims as promptly as possible.

Marla Backer, Analyst

Okay. And then in terms of higher reserving and earlier reserving, does that mean that we should expect to see that trend continue at least until we sort of anniversary this slight shift in your strategy vis-à-vis reserve?

Corey Ruehle, Claims Manager

We're going to continue to review claims on a regular basis. One thing about social inflation is, it is a moving target and that claims are changing on a daily basis. And so, it's important for us to continue to do a constant review, and there could be some continued developments into 2021, but there'll be more to come there.

Marla Backer, Analyst

Okay. And then…

Randy Ramlo, CEO

Hi, Marla, this is Randy. Go ahead. Okay, this is Randy again. One kind of further comment I would make is usually when you hear of reserve strengthening, you'll look that the reserve was maybe put up incorrectly, and I think what we're more seeing is just that the game has kind of changed. The reserves we may have put up a year or two ago were kind of adequate for the times, but as we have kind of seen things settle and develop as we mentioned, we've just become a bit more pessimistic on what it's going to cost to settle some of these claims.

Marla Backer, Analyst

Thank you. Okay, my last question, I'm actually switching topics now, you talked before in your prepared remarks about introducing an online platform for your agents sometime in mid-2021. Can you expand a little bit on the platform, and also talk about the potential perhaps at some point down the road to expand its functionality a bit to possibly offer some direct-to-consumer offerings? Thank you.

Randy Ramlo, CEO

So, Marla, this is Randy. We probably will respectfully not touch the going direct-to-consumer question right now, because we could make some enemies with that, but I think I'll let Mike tell you a little bit about our platform; he has a good handle on what are some of the offerings.

Mike Wilkins, CFO

Hi, Marla, this is Mike. So, yes, a little bit more information about the initiative. We’re going to release that as a pilot in April, so not that far away, but expect a broader release to seven states mid-year. It's a product that is aimed at the small business segments. So, they're often referred to as the BOP segment in insurance, Business Owners Policies. We'll expand to additional states about every three or four months after that initial mid-year release. The user interface is very intuitive. It's been built to be very flexible. We market 100% through independent agents. And the tool was built in collaboration with our agents to support them issuing that business now. What is common in the business owners segment is a lot of that business is handled in our service centers. So, we have a service center that provides a lot of servicing for the agents. And we've also designed the system to make servicing that business easy and also allow the insurers to do some of the self-servicing of that business as we go forward. So, it's very flexible. It will allow us a lot of opportunities to change the way we do business with the insurers and with the agents over time. And we're pretty excited about it.

Marla Backer, Analyst

Okay, thank you.

Operator, Operator

This concludes our question-and-answer session. I’d like to turn the conference back over to Randy Patten for any closing remarks. Please go ahead, sir.

Randy Patten, Assistant Vice President and Controller

This now concludes our conference call. Thank you for joining us and have a great day.

Operator, Operator

Ladies and gentlemen, this concludes today's program. Thank you for joining us and have a great day. You may disconnect your lines.