Earnings Call Transcript - UFCS Q2 2020

Operator, Operator

Good morning. My name is Grant, and I'll be your conference operator today. At this time, I would like to welcome everyone to the UFG Insurance Second Quarter 2020 Financial Results Conference Call. Please note this event is being recorded. I will now turn the call over to Randy Patten, Assistant Vice President and Controller.

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 and 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 Second Quarter 2020 Conference Call. First, to our employees, agents, policyholders, and shareholders, we hope everyone is safe and healthy during this ongoing pandemic. I continue to be amazed by the extraordinary work being completed by our employees during this time, delivering our outstanding service to agents and policyholders without interruption while working remotely. These efforts are truly remarkable, considering the higher-than-normal catastrophe losses we experienced in the second quarter of this year. As we mentioned last call, we had a preexisting business continuity pandemic plan already in place prior to this year. Thanks to our past experience in personally dealing with catastrophes, including the floods of 2008 and 2016 at our corporate headquarters, we were well prepared and had the technological infrastructure in place for a seamless transition to work from home. This plan was activated in mid-March and continues to be followed on a daily basis. While our essential services employees have remained in our offices as necessary, the majority of our employees continue to work remotely. We have had ongoing discussions on a return-to-office plan for our employees, but no definitive dates have been set yet. Of course, the safety, health, and well-being of our employees will be the top priority of our return to the office plan when it is finalized. Also, as we mentioned during the first quarter call and as a reminder, nearly all of the policies we have issued contain contract language which 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 impact of the COVID-19 pandemic continues to evolve, and we cannot predict how future legislation, regulation or court actions will impact us. Although we are still in the midst of the pandemic, and it is early in the litigation process, a bit of good industry news emerged from two recent court decisions, one in New York and one in Michigan. In these decisions, the courts upheld the physical damage requirement with business interruption coverage. This is a promising sign that contract law will be upheld in the courts. Through the first half of 2020, the COVID-19 pandemic did not have as much of an impact on our core insurance operations as we expected. A large portion of our book of business is with contractors, who have not been impacted as significantly as many other types of businesses. The 1% decrease in net premiums earned in the first half of 2020 as compared to the first half of 2019 is primarily due to our focus on improving profitability through non-renewal of underperforming accounts in our commercial auto line of business. There was some impact to net premiums earned related to the current economic environment, but it was less significant than the impact from our commercial auto profitability initiatives in the first half of 2020. We anticipate some additional pressure on premiums in the second half of the year as we expect some decrease in new business submission and net endorsement premiums. On some business, we have reduced payrolls, sales and other exposure units. In addition, we anticipate premium growth will taper off in the latter part of 2020 due to a combination of underwriting and business factors. We estimate an overall reduction in net premiums earned in the range of 6% to 8% in the second half of 2020. Overall, we believe uncertainty remains surrounding the overall economic impact of COVID-19 pandemic. Although there was a moderate recovery in the financial markets this quarter, the impact on the economy as a whole may not be felt for some time. Unemployment continues to remain at historically high levels, and a number of businesses are not operating at full capacity or have closed their doors. These factors may contribute to future pressure on premiums and the demand for our products, which could impact our financial condition and results of operations. Before turning the call over to Mike to discuss our operational results, I'll briefly comment on our quarterly results. The themes this quarter were historically high quarterly catastrophe losses, improving core insurance profitability and, as I just discussed, manageable impact from the COVID-19 pandemic through June 30, 2020. As we previously announced on July 29, 2020, the largest impact on our financial results during the second quarter of 2020 was catastrophe losses. In the second quarter of 2020, we reported $50.6 million of catastrophe losses or 19.2 percentage points of the combined ratio, compared to $22 million or 8 percentage points in the second quarter of 2019. Our historical average for catastrophe losses in the second quarter is 12.2 percentage points. The second quarter of 2020 marks the highest quarterly impact on the combined ratio since the second quarter of 2011, when we experienced losses from a tornado in Joplin, Missouri. This one-out-of-every-10-years quarter included 20 catastrophic events primarily in the Midwest and Southern United States. The majority of losses came from seven of the 20 events, with the largest being a hailstorm near our home office in Cedar Rapids, Iowa. Included in our catastrophe losses this quarter is also $4 million in losses from the riots and civil unrest in Minneapolis, Minnesota, where we incurred two large fire losses. As for our operational results, I'm pleased with the progress in improving the profitability of our book through our underwriting actions and use of analytical tools. Despite the challenges we faced with the COVID-19 pandemic, in the second quarter of 2020, we reported a 10.2 improvement in our commercial auto loss ratio. We also had an 11.9-point improvement in general liability and a 9-point improvement in our workers' compensation lines of business. Improvements in these lines of business contributed to a 5.8-point improvement in our core loss ratio, which excludes caps in our prior accident year reserve development. Mike will now discuss the improvement in more detail.

Mike Wilkins, COO

Thanks, Randy, and good morning, everyone. As Randy mentioned, we continue to make progress with improving the profitability of our commercial auto book of business in 2020. In the second quarter of 2020, we again saw a decline in the frequency of commercial auto claims. Since June of 2019, commercial auto frequency is down 8%. Additionally, our 12-month moving average of insured commercial auto units has declined 14% since June of 2019. Slides 7 and 8 in the slide deck on our website present these declines. Although the COVID-19 pandemic may have contributed to some of this decline, it is important to note that the decline in both frequency and number of insured units began well before the pandemic and is primarily the result of our deliberate strategic actions. Also, another important point is that frequency of claims continued to decline in the second quarter, even when miles driven increased during the months of May and June of 2020. The reduction in commercial auto claims frequency and number of commercial auto exposure units, along with favorable prior accident year development, resulted in an improvement of 10.2 points in our commercial auto loss ratio during the second quarter of 2020 as compared to the second quarter of 2019. Year-to-date, the improvement in our commercial auto loss ratio was 10 points. We also experienced an 11.9-point improvement in our other liability line of business and a 9-point improvement in workers' compensation during the second quarter of 2020. We are very pleased with these results. As we take steps to return our commercial auto line of business to profitability, we acknowledge that we stand to lose entire accounts since we have traditionally been a package writer. For the third consecutive quarter, we experienced a decrease in both policy and premium retention as we focus on non-renewing underperforming commercial auto accounts and continue to seek rate increases. The average renewal pricing change for commercial lines increased 6.6% in the second quarter of 2020 compared to a 7.6% increase in the first quarter of 2020. The renewal pricing increases were driven by commercial auto and commercial property rate increases. During the second quarter of 2020, the commercial auto effective rate change increased by 12.4% compared to an 11.6% increase in the first quarter of 2020. Also during the second quarter of 2020, the commercial property effective rate change increased 7.3% compared to a 5.9% increase in the first quarter of 2020. Personal lines renewal price increases remained in the mid-single digits. I will wrap up my portion of today's call by discussing a couple additional strategic decisions we made during the second quarter to improve profitability. First, in May, we entered into a personal lines renewal rights agreement with Nationwide Mutual Insurance Company. This agreement was completed as part of our long-term strategic planning, allowing us to concentrate our efforts on growth and profitability of our core commercial lines business, including commercial insurance, excess and surplus lines insurance and surety bonds. Our commercial lines represent 94% of our business mix. UFG's entry into this agreement was purely strategic and was not initiated as a result of market conditions from the COVID-19 pandemic. This agreement provides our independent agents the opportunity to transfer their personal lines policies to Nationwide Mutual Insurance Company beginning in the third quarter of 2020 subject to the receipt of applicable regulatory approvals. As part of this agreement, Nationwide will offer contracts to almost all of our personal lines agents across the country with the exception of agents in Louisiana. A decision related to our personal lines business in Louisiana will be made at a later date. Also during the second quarter, we named Jeremy Ball as our Chief Underwriting Officer. In this new role, Jeremy will lead the Corporate Underwriting Department and focus on the implementation of our underwriting strategic initiatives. Jeremy's first priority will be to drive the implementation of the UFG way of underwriting, promoting consistency across the enterprise, portfolio steering, quality assurance, and staff development. Finally, we continue to make progress with the development of our analytical models. We anticipate that our BOP analytics model will be in production for use in the third quarter of this year, and our workers' compensation model will be in production in the fourth quarter. With that, I'll turn over the discussion to Dawn Jaffray.

Dawn Jaffray, CFO

Thanks, Mike. And good morning, everyone. In the second quarter of 2020, we reported consolidated net income of $6 million compared to a net loss of $4.2 million in the same period for 2019. Year-to-date, we reported a consolidated net loss of $66.6 million compared with net income of $40.3 million in the same period of 2019. The increase in the fair value of our investments in equity securities, or what I like to refer to as unrealized gains of $29.8 million, along with an improvement in the profitability of our core commercial auto and liability business, contributed positively to the net income reported in the second quarter of 2020. These positives were offset by the historically high quarterly level of catastrophe losses, some realized investment losses and a decrease in premiums earned from our continued efforts to improve the profitability of our commercial auto business through non-renewing underperforming accounts. Operationally, we reported an adjusted operating loss of $6.5 million or $0.26 per share in the second quarter 2020 compared with an adjusted operating loss of $14.9 million or $0.59 per share in the same period of 2019. Also, a one-time pretax benefit of $5.7 million in our second quarter of 2020 was attributable to the renewal rights agreement from our personal lines business with Nationwide. Year-to-date, we reported an adjusted operating loss of $5.2 million or $0.21 per share compared with an adjusted operating income of $8.5 million or $0.33 per share in the same period of 2019. Net investment income decreased 10% in the second quarter of 2020, primarily the result of a decrease in invested assets. Year-to-date, net investment income declined 51%, primarily due to the change in the value of our limited liability partnerships, or what we refer to as our bank fund. A couple of additional items to note with our investment portfolio: Our equity portfolio remains in an unrealized gain position of $144 million as of June 30, 2020. And we recognized an after-tax unrealized gain of $32 million in our bond portfolio during the first 6 months of 2020. In addition, we recognized pretax realized investment losses of $14 million on a GAAP basis. These realized losses were primarily from the sale of equity securities. We had a gain as measured against our actual cost basis for these securities. We saw an opportunity to reduce future volatility in our equity portfolio from certain holdings and use offsetting tax losses. Moving on to operating metrics, the combined ratio in the second quarter of 2020 was 111.4%, improving slightly compared to 111.7% in the second quarter of 2019. Year-to-date, the combined ratio was 108.2% compared to 103.9% in the same period in 2019. Our core loss ratio, which removes the impact of catastrophe losses and prior accident year reserve development, improved by 28 points in the quarter, primarily due to improved profitability in our commercial auto, other liability and workers' compensation lines of business, as Mike has mentioned. We recognize prior accident year favorable reserve development of $10 million and $23.8 million in the second quarter and year-to-date 2020 respectively, compared to unfavorable prior accident year reserve development of $9.4 million and $4.7 million in the second quarter and year-to-date 2019. The prior year favorable reserve development in 2020 was primarily from our commercial property and workers' compensation line of business. Our total reserve position remains within actuarial estimates. The expense ratio increased 1.5 points in the second quarter and 2.1 points year-to-date in 2020 as compared to the same periods in 2019. The increase in the expense ratio during the second quarter as compared to prior year second quarter was primarily due to our continued investment in technology, including our multiyear Oasis project, which is an upgrade to our underwriting technology platform. Year-to-date, the aforementioned increase in technology costs, along with the acceleration of the amortization of our deferred acquisition costs in our commercial auto line of business, added to the increase in the expense ratio, the latter of which added about a point to the expense ratio. I will now end my portion of the call discussing capital matters and cash flow. As of June 30, 2020, our year-to-date cash flow remains positive. Our capital position, including having no debt in our structure, remains strong. As of June 30, 2020, we had $146 million in cash and equivalents compared to $121 million at December 31, 2019. We continue to look for opportunistic investments to drive investment income as maturities arrive. As many in the industry have done, we have implemented payment leniency programs for some of our policyholders as a result of the COVID-19 pandemic. As of June 30, 2020, we did not see a significant impact to premium cash inflows or an increase in our allowance for bad debt accounts as a result of these programs. Our canceled, lapsed and non-renewed accounts, of which the majority of non-renewed accounts were UFG initiative driven, represented an increase of only 5% year-over-year. However, uncertainty remains with the pandemic. The impact of writing down of deferred cancellations, both state-mandated and UFG-provided leniency; and the corresponding collectibility of any premiums or requirement to return premiums in future periods is yet to be determined. And future impacts on the financial markets, the investment portfolio and demand for our products could impact our results. At this time, we have no intention to draw funds from our credit agreements. But it is available in the event a need arises. We maintained our current level of cash dividends during the second quarter. During the quarter, we declared and paid a $0.33 per-share cash dividend to shareholders of record as of June 5, 2020. Of note, this marks our 209th consecutive quarter of consistently paying dividends. And lastly, during the quarter, we did not repurchase any UFCS shares. We made the decision in mid-March to suspend share repurchases in the interim. As a reminder, we had repurchased just over 70,000 shares for $2.7 million on a year-to-date basis. 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 this month unless it is extended by the Board. And with the closing of our prepared remarks, I will now open the line for questions.

Operator, Operator

Operator Instructions. Marla Backer, with Sidoti.

Marla Backer, Analyst

So just a couple of questions to clarify some of the items. What we've been hearing from other insurers and reading about is that the frequency of auto collisions declined during this pandemic, but the severity climbed in many markets. So that doesn't seem to be what you're saying. Is that the way to read that?

Randy Ramlo, CEO

This is Randy. We've actually experienced the exact same thing. I think we mentioned that we're pretty heavily in the construction area, so that line of business kind of continued through most of the pandemic. But our frequencies were down pretty considerably. But we didn't have any break in the severity of losses. So it seems like the people that were out driving around on empty roads must have been driving faster. But we have experienced kind of the exact same thing.

Marla Backer, Analyst

And on the Nationwide agreement, can you just provide a little bit more color there? So why was the agreement structured to exclude that one state? Was it specific to Nationwide because they don't write policies there? Or what was the reason for the way it was structured to exclude Louisiana, I think you said?

Randy Ramlo, CEO

Yes, that's exactly it. I think Nationwide writes in 49 states. And Louisiana is the one that they don't. So we'll get that figured out going forward. We're having pretty good success. The non-renewals kind of start, starting 10/1. We've got commitments from high 80% of agents to go with a Nationwide deal. So not much more to comment, other than we think it's going pretty well. We have to get approval from all the states. And we've had good progress there, but we're not completely done with that process yet. So Mike, do you have anything to add?

Mike Wilkins, COO

No, I think you hit all the high points there, Randy. I think we have three states remaining that we don't have approval from yet. I think two of those are pretty close. So yes, good progress. We are no longer writing new business in the personal lines segment, so we are seeing the production already starting to decline even in the second quarter a little bit.

Marla Backer, Analyst

That's great news about the business interruption clauses being tested and supported in those two states you mentioned. Is there anything else we should consider regarding potential testing of the policies due to COVID? Are there any implications from the riots that have occurred in many markets? Or is there anything else we should be mindful of that might come up related to COVID in the near future?

Randy Ramlo, CEO

This is Randy. I'm not an expert, but I think the main concern moving forward is the possibility of more shutdowns, which might lead to additional business closures and bankruptcies, resulting in a contraction of the insurance industry. The future is uncertain. Riots and civil unrest are covered perils, so if the riots persist, which have calmed down somewhat, they are included. However, I don't see that as a significant aspect of the industry overall. On the legislative and regulatory front, things have been relatively stable. There's a major question regarding how workers' compensation will adapt, especially with some negative feedback in California. We don't operate in that market and don't handle medical malpractice or similar areas. For us, this isn't likely to be a major issue, but we monitor specific states and legal cases closely, as situations can change. I'd be dishonest if I claimed to have all the answers.

Operator, Operator

Our next question will come from Paul Newsome of Piper Sandler.

Paul Newsome, Analyst

I wanted to ask a little bit more about the premium reduction comments that you made for the second half. I think recall, if you said it correctly that you're looking at a decline of 6% to 8%. And does that include the runoff of the personal lines business in there as well? Or is it just the commercial lines that we're talking about?

Mike Wilkins, COO

Hi, Paul, this is Mike. I'll try to take that one. Yes, that does include the personal lines runoff in that calculation as we tried to make an estimate for the second half. A couple of other things that we think will probably impact the second half written premium are our specialty division, which has experienced strong growth in the first half. We believe that growth will continue in the second half, but we don't expect the percentage increase to be as significant for various reasons. Because of that, we anticipate a smaller contribution from that unit. Additionally, we have a program with Arrowhead writing some earthquake business in California that has reached its capacity. Thus, in the second half, we expect to see some growth from rate increases in that segment, but we are not expecting the same level of contribution from it in the second half as we saw in the first half. Combined, these factors make us a bit more pessimistic about the top line in the second half.

Paul Newsome, Analyst

And then, relatedly, could you talk about sort of the outlook for the expense ratio? I assume that, or would expect, that we'd see some pressure there because of the declining premium. But obviously, there's some offsets here while you're shutting down your personal lines business. Could you help me with that?

Dawn Jaffray, CFO

Sure. Hi, Paul, this is Dawn. You're correct that the decline in premium will definitely impact our numbers. Additionally, we still face some challenges with our inability to defer on the commercial auto due to the loss ratio not meeting the requirements of the formulaic calculation we need to perform. I think in the third quarter, it will be interesting to observe the effects of payments that were deferred for cancellation, which we haven't been able to cancel because of state mandates. Currently, those payments get deferred and are billed out over the remaining term. We're also continuing to invest in technology, similar to what many companies are doing. Realistically, we may see a figure between 33.5 and possibly 34, depending on the circumstances surrounding the decline in premiums.

Paul Newsome, Analyst

Is it fair to say that both of these issues, the premium and the expensing, are likely topics we will discuss in the first half of next year? I imagine that personal lines will take that long to run off. Additionally, considering beyond the first half, perhaps looking into the second half?

Dawn Jaffray, CFO

I think it will depend. As you know, and as Mike and Randy have both indicated, Paul, we've also taken on a considerable amount of deliberate non-renewals. So clearly, we are looking at every element of our expenses. The commissions and salaries are the two biggest components of our expense ratio. So we have to pay attention to both of those. We have looked at a few changes in our commission plans that will start to take effect. But I think it's a little early to say completely what will happen. But with a smaller premium base, I would expect there to continue to be pressure next year, in the first half of next year. But we're going to look for ways to offset that.

Paul Newsome, Analyst

Was there much resources dedicated just to the personal lines business at United Fire?

Randy Ramlo, CEO

This is Randy, Paul. It made up about 6% of our writings. And we probably benchmarked a bit high on expenses. So that's kind of about that same area. I think there are how many employees? Under 20, I think?

Mike Wilkins, COO

Yes.

Randy Ramlo, CEO

It's not a major factor, but it was likely something that contributed to our overall costs. One of the reasons we partnered with Nationwide is that we faced challenges competing as a small player in personal lines, and the outlook for smaller carriers like us seems somewhat bleak. Therefore, I don't anticipate it will significantly impact long-term expenses, but it may pose some short-term challenges.

Paul Newsome, Analyst

That makes sense. Many people are noticing the same trend. I was also curious if you could discuss the reasons behind the decline in invested assets. You mentioned that perspective earlier. Looking at the balance sheet, it seems there haven't been significant changes in total invested assets. Are you currently in a cash flow-negative position, and is that contributing to the decrease in invested assets? Or is there another factor at play? I'll let you address that.

Bob Cataldo, Analyst

Hi, Paul, this is Bob Cataldo. Thanks for the question. No, we have not initiated any effort to reduce or eliminate cash in the portfolio. What you're observing is simply a natural decline as the business has contracted slightly. It makes sense that the assets would follow that trend. We did reduce a bit on the equity side, as Dawn mentioned earlier, but that was opportunistic and more of a rebalancing exercise rather than a shift in our investment philosophy or policy.

Operator, Operator

Operator Instructions. This will conclude our question-and-answer session. I would like to turn the conference back over to Randy Patten for any closing remarks.

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

The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.