ProAssurance Corporation (PRA) Q2 2012 Earnings Report, Transcript and Summary

Good day everyone and welcome to the ProAssurance Second Quarter 2012 Earnings Call. Today’s conference is being recorded. For opening remarks and introductions, I will now turn the call over to Mr. Frank O'Neil. Please go ahead, sir.

Good morning, everyone. Thank you for being part of our call to discuss our second quarter 2012 results. Please bear with me while I handle some important legal statements. On Monday, August 6, 2012, we issued a news release reporting our results for quarter ended June 30, 2012. Subsequently, we filed an 8-K in our second quarter 2012 and Q with the SEC. These documents and our other SEC filings provide important information about our company and our industry as they discuss in detail many important factors that could affect the outcome of future events and thus cause actual results to differ materially from current projections or expectations. Please read and understand these cautions and be aware of the statements we make on this call dealing with projections, estimates, expectations are explicitly identified as forward-looking statements subject these and other risks. Expect as required by law or regulation, we will not undertake and expressly disclaim any obligation to update or alter information disclosed as part of these forward-looking statements. The content of this call is accurate only on Tuesday, August 7, 2012. We do not authorize nor review any transcripts you may obtain. So, please know that transcripts may contain factual or transcription errors that could materially alter the intent or meaning of our statements. And the final item. We’re going to reference non-GAAP items in our call today. Please refer to our recent filing on Form 10-Q and our recent news release for a reconciliation of these non-GAAP numbers to their GAAP counterparts. Participating in today's call are our Chairman and CEO, Stan Starnes, who has joined in remotely; Chief Financial Officer, Ned Rand; Howard Friedman, our Chief Underwriting Officer and Actuary; and Vic Adamo, our Vice Chairman. Stan, your opening thoughts please.

Thanks, Frank. The second quarter results are again solid. As we continue to prove the benefits of the disciplined approach to a business that demands both vigilant attention to current operational details and a long-term philosophy that rewards are consistent dedication to profitability and book value growth. That’s a proven combination that allows us to reward our shareholders and protect our policy holders. This was also a significant quarter in that we announced two transactions. The first, Medmarc, broadens our ability to ensure the wider scope of health care delivery while adding to our growing legal professional liability business. The second, Independent Nevada Physicians Insurance Exchange, or IND deepens our share in our traditional medical professional liability business. We have much to talk about so, let’s get started.

Okay, we will do that. Thanks, Stan. Let’s focus first on second quarter results and then we will update planned acquisitions. So, we'll go first to Ned.

Thank you, Frank. Gross premiums written were $102 million, a decline of $13 million over last year’s second quarter. Approximately $6 million of the decline is due to the effect of our two-year policies written last year and earned pro rata for 24 months, and we continue to see the impact of competitive market on our retention of business. Howard, will you characterize the state of the market right now?

Yes, the market is quite competitive right now. In some areas a bit more competitive than at the start of the year but still not at levels we have seen in previous soft markets. In fact, we see some slightly encouraging signs in some states. For example, we now know that one of the primary lower-priced competitors in the podiatric market is raising file rates by 20% in select states. Rates for lawyers’ professional liability are increasing across the industry. Taken as a whole, we continue to believe that the core physician and hospital markets will remain competitive given the favorable loss environment. Underwriting and pricing discipline has been a hallmark of ProAssurance in both hard and soft market. As you can tell from this quarter’s top line, we remain committed to writing only the business that supports our profitability targets and to walking away from business that does not meet our targets. I’ll also touch on reserve development. Net favorable loss reserve development was $60 million in the quarter, $10 million higher than last year’s second quarter and primarily from accident years 2004 through 2009. In the current loss environment, our favorable development is being driven by the continuation of loss severity levels that have proved to be different from our expectations. In this case the development is favorable because losses were lower than expected. While we are pleased with the current outcome, the statistics from the early 2000s remind us that loss costs can change rapidly and can result in industry-wide loss ratios well above 100%. We continue to exercise caution when considering today’s evolving loss environment as we set 2012 accident year losses. Ned?

Thanks, Howard. I want to mention a couple of other item. Net investment income is the primary component of our net investment results and those were down approximately 5% quarter over quarter. This is primarily reflective of the low interest rate environment that all insurance companies are dealing with right now. Also involved is the effect of the earnings or losses from unconsolidated subsidiaries, primarily the result of the amortization of tax credit limited partnerships which are important part of our investment strategy. The comparative effect of those tax credits is now becoming less noticeable, because the credits were in place by second quarter of 2011. And for those of you for whom this may be a new concept, these losses are expected and are more than offset by a reduction in our federal tax liability. We saw an uptick in underwriting, policy acquisition and operating expenses quarter-over-quarter primarily reflecting higher employee and benefit costs in the second quarter, driven by an increase in stock-based compensation and other incentive compensation. Also at work was a change in timing of recognition of policy acquisition expenses resulting from new FASB guidance. The bottom line was net income of $58 million or a $1.89 per diluted share, and operating income of $59 million or a $1.92 per diluted share. Return on equity, which we calculate by dividing annualized net income by the average of beginning and ending shareholders' equity was 10.4%, down a point from the second quarter of last year. Our focus on the bottom line is mirrored by our dedication to building book value. We are pleased to report that book value per share stands at $74.30. Tangible book value is $67.42 per share. That's our review of the second quarter, but I want to mention some capital management decisions that will affect the third quarter and beyond. We intend to repay $35 million in outstanding long-term debt, which consists of $23 million in trust preferred securities issued in 2004 to provide additional premium capacity and $12 million of surplus notes we assumed when we acquired (inaudible). The retainer [ph] will occur in August and we will be using funds from the authorization granted by our board for the repurchase of shares and retirement of debt. In July, we paid off a $17 million note and terminated an associated interest rate swap. Because we carried the note on our books at fair value and we retired it at par, we will recognize a book loss of $2.5 million in the third quarter. Our decision to repay the debt was driven by the economics of the transactions. The end result is that we will have no long-term debt by the end of August, which will eliminate related interest expense that was $2.7 million in 2011 and $1.3 million through June 30, 2012. When the payments are complete we expect to have $136 million remaining in the board's authorization to repurchase stock. Frank?

Thank, Ned. Howard, anything you can add about the loss in actuarial trends [ph]?

Sure, Frank. Frequency remains flat as it has been for some time. Severity continues to be below our prior expectation, currently estimated to be increasing at about 3% to 4% annually. Average renewal pricing in our physician book was up 2% quarter-over-quarter. Primarily at work here is the automatic step [ph] increase and the claims made policies that incepted in the Ascension Health Certitude program during the second quarter of last year. Absent those increases, renewal pricing essentially would have been unchanged. Premium retention in the second quarter was 88% in our physician book of business, down 2 points quarter-over-quarter consistent with our approach to the competitive nature of the market. Frank?

Thanks Howard. Now, let's swing over to Vic for an update on the status of Medmarc and IND.

Happy to give you an update, Frank. Both transactions are on track. Our legal counsel is reviewing the transactions as regulators in Vermont, where Medmarc is domiciled, and in Nevada, where Independent Nevada Positions Insurance Exchange is located. The regulators have been very responsive as we work with them to complete the required documentation and prepare the material that will lead to a vote of the policy holders of each company. We continue to believe that both transactions will close by January 1st of 2013. Until closing, we are limited to the extent that we can work on transition and integration, but as we said in our conference call in June, we do not expect significant issues in that regard. Medmarc will function as a distinct business unit given its distinct line of business. In the case of IND, they have a more robust operation in Nevada than ProAssurance. And we plan to move into the IND offices in Las Vegas and serve the doctors of Nevada from that location. Frank?

Thanks Vic. One general development I want to mention is the Missouri Supreme Court ruling on that state's tort reform laws. Last Tuesday, the Missouri High Court struck down the $350,000 limit on non-economic damages. Howard, could you walk through how that might affect the Missouri market?

Sure, Frank. It means that losses are likely to increase with the removal of the cap. We will be watching that and also looking for signs that frequency may rise in that state now that it may become more attractive to file lawsuits. We have not historically factored the caps into our Missouri rate-making and reserving but have been guided by actual loss data. However, the Missouri market has been dominated by a number of smaller companies formed under a state law that allows Missouri-domiciled insures to get started with a relatively small amount of capital. Most of these companies have operated primarily on the post-tort reform era and have grown rapidly by selling lower-priced assessable policies, which allow those insurance companies to force current or formal policyholders to pay addition premiums should the companies' reserves prove inadequate. So, the ruling could have a significant effect on the smaller insurers and their policyholders and could create some market opportunity for a larger company such as ProAssurance. Certainly, this will have an unsettling effect on health care providers and patients in Missouri who have benefited from the stable medical legal requirement since 2005. Frank.

Thanks, Howard. Stan, your background might give you some additional insight. Will you comment on the effect this will have on health care and the effect it could have on other state courts considering tort reforms right now?

Frank, it will be unsettling to everyone and every institution delivering health care in Missouri because it removes the certainly and predictability of fair treatment in the court rooms of Missouri, and that’s unfortunate. It's too early to know the effects, but I assure you we will be extra vigilant in Missouri. As for the effect on other state courts, my experience tells me that it will be determined on a state-by-state basis. The general argument used by the plaintiffs is well known and understood and has been rejected in some states and accepted in others, but it's certainly unfortunate because of what it could mean for the future of health care costs and availability in Missouri. Switching topics, although we covered the importance of our two announced transactions in a call on June 27, I want to reemphasize how important both will be to us. Medmarc offers us a singular opportunity in the medical technology and life sciences realm of health care which we think will continue to be significant as multi-faceted health care systems grow in importance and complexity in the next decade. We have to be able to serve that market to offer a complete health care liability solution, and we are excited to have an innovator such as Medmarc become part of ProAssurance. While we know the traditional physician market has been shrinking, it is clear that there will always be a need for a medical liability insurance company that is dedicated to serving the needs of those physicians who choose not to join larger groups or become hospital employees. The addition of IND will make us the market leader in Nevada and set the stage for us to respond to some growing opportunities there as health care evolves. Gaining a larger share of that market and expanding to get a solid base of operations in the West is a major step forward for us. Finally, I want to highlight the fact that ProAssurance was named to the prestigious Ward's 50 for the sixth year in a row. This is significant recognition of the overall financial and insurance performance that sets ProAssurance apart from our competitors. I wish to salute the senior management team at ProAssurance for their vision and dedication, and I'm especially proud of the enthusiasm and commitment of our employees, who are the backbone of our success. My thanks and congratulations to each one. Frank, all in all it's an exciting time for ProAssurance and we look forward for the future.

Thank you, Stan. Amy, I think that concludes our prepared remarks. We'll open it up for questions.

[Operator Instructions] And we’ll take our first question from Mark Hughes with SunTrust.

Could you remind me how much Missouri is of your total premium and if you had more favorable development there? I know you are not pricing for -- assuming the caps, but have losses come in better than expected and so you have benefited from them?

Yes. Hey Mark, Missouri is not a -- even a top five state for us. We don’t have the exact figure here, but yes, $10 million to $15 million probably in premium. Howard?

Yes, in terms of the loss environment, it’s hard to say. I think the cap has been applied by some judges in some cases over the time that it has been in effect. So, there has been benefit on those cases that have gone to trial, resulted in a jury verdict that included non-economic damages and where those damages were limited and the case was resolved and not appealed. So, there has been some benefit and therefore that would be factored into the loss experience. There are other cases were the cap was not applied or certainly settlements where it was not specifically considered. So, it’s not entirely clear the beneficial effect that it’s had or the effect that now that it is gone. But we do think that it will have the effect of increasing client frequency over a period of time just because cases that have historically involved strictly or mostly non-economic damages, that might not have been as attractive will now be more attractive to bring to a trial.

Missouri is the state that we talked about the companies that have come into being under that law called the 383 company, and those companies really have come to dominate the Missouri market. Those are the companies you mentioned during your prepared remarks.

But it’s still a relatively small part of the book, it sounds like, in any case.

Howard, was your language perhaps more upbeat in the press release on the reserve picture?

I think what we are trying to explain in the news earnings release is that, and what we’ve been saying over the past several quarters or years, that the severity has been less than expected and that as time goes on and it gets factored more and more into the data that we are able to make judgments and our decisions about loss reserves with that in mind. The expectation that we all had that the lower frequency would result in higher average claim severity has proven to be true to some extent but not to the extent that we thought, so we are just trying to be a little bit more explicit in some of our comments about that.

And last question, the higher operating expenses this quarter, would you expect that those could be sustained at this level or do some of those expenses drop off or drop down going forward?

Yes, Mark, that kind of makes it hard because there are a lot of moving parts on expenses. A part of what -- on the employee costs, a part of what was driving it was stock-based compensations expenses and as our stock prices increased the value of the stock-based compensation has gone up and that runs through the P&L. And so that is kind of a going-forward item, and unfortunately I don’t have in front of me a breakdown of the pieces. The other impact to incentive comp for the quarter was more of a one-off adjustment. So, I would not expect it to continue. The other component is the new DAC guidance that was put out by FASB and it will take a year, a full year before that kind of gets settle down out, but the effect that it’s having right now is it’s increasing operating expenses. We saw this in the first quarter as well. Once we get through a full year of the adoption of that, we’ll see those costs kind of normalize. It doesn’t impact the actual expenses, it’s just the timing of the recognition of the expenses.

We will take our next question from Matt Rohrmann, KBW.

Howard, I know, going back four, five years, talking to you about those 383 companies that you mentioned. Is the ruling based on how aggressive they have been pricing and we have kind of view them as, and these are my words, more of a nuisance in that market over time with the aggressive pricing. Is this ruling a killer for those type of companies, given how aggressive they have been?

I think the – this is Howard. I think certainly the issue is going to be how they reserve and to what extent those cases that they have open in particular and how those cases are reserved. And that’s hard for us to tell. We do think that it will have a -- it should certainly have an effect the company that is entirely in a market and where that market has experienced a change. If you look back 10 years ago, something similar happened in Oregon and it had a pretty significant effect on the company that was the dominant rider in that market. So, if you collectively look at these companies being Missouri only and with the elimination of the cap we would expect some significant reserve increases, but I don’t know ultimately what effect it will have on these companies. Again, as I mentioned in my comments at least some of the companies are assessable, meaning that the policyholders can be required to pay additional premiums for prior use of coverage.

And then just a quick question that I believe that European debt exposure for you guys is pretty much minimal, but I just wanted to verify that with you.

Yes, it is. I've got some detail here, just one second and I'll pull it up. Yes, if you take a look at our Q, we have got some information in there, but at June 30 we have debt securities totaling $127 million that were kind of with European exposure. $37.2 million of that is industrial and utilities in Europe, $44.2 million is energy and about $46 million is financial.

[Operator Instructions] We will take our next question from Ray Iardella, Macquarie.

Couple, maybe starting out with Howard, is if I could, maybe could you talk about the decline in the current accident year loss ratio, was that more mix driven or is there something else going on or did you guys re-estimated the loss tick-down for the current accident year?

I guess let me start by saying, no, we didn’t re-estimate it down, and when you see the Q there is a fair amount of disclosure in the Q about that. There is a number of things going on in the quarter. We had little bit of a change in sale premium. We also had a change or a benefit from the re-estimation of seeded premium from some old reinsurance years that resulted in a higher net earned premium than we would have otherwise had, it was little under $3 million of additional net premium. So, that had the effect of pulling the loss ratio down a little bit. And like I said, there is a table with some disclosure that will help guide you through that process and the comparison to the prior quarter. Year-to-date, I think it is fair to say that we are booking basically the same net loss ratio that we have done and that is roughly in the 84% range. So, it is a lot of noise but no change in approach.

Okay. Fair enough and then maybe for Ned. Just on the operating cash flow, it looked like a little bit low in the quarter, I mean, anything going on there? I'm sure there is a lot of moving pieces, but I know paid losses might have picked up a little bit, can you take about that?

Yes, so it is exactly that. And it’s -- a lot of just has to do with timing. We did see a pickup in paid losses in the quarter, in particular, paid a couple of large losses that were settled, so older cases where they were ultimately resolved during the quarter. We do expect significant reinsurance recoveries on those losses because if they do hit the excess layers, they go to our reinsurers. So we would expect some recovery to come forward in the next couple of quarters on them, but a lot of it is timing related.

Okay, that’s helpful. And then maybe last sort of strategy question for Stan or Vic. Just thinking about the Medmarc transaction. Certainly, a little bit of a new business line for you guys, but certainly kind of close to where you guys have been operating in the health care space. I mean, should we look for other acquisitions or from ProAssurance in these sort of tertiary or lines that are similar to this, or are you guys going to be more focused on the core physician book going forward?

Well, we’re not going to change our commitment to insuring physicians in private practice. That remains steady. But in order to keep that commitment to those physicians, we think we have to offer products throughout the spectrum of health care. The health care system in the United States is changing dramatically over the next number of years. And in order to be a significant participant in our niche in that system, we think you’re going to have to offer products across the spectrum of the system. That was what was compelling to us about Medmarc. As you see physicians moving into larger and larger organizations, you’re going to have to be an enterprise that has the geographic scope and the financial reach to provide products for the entirety of the organizations. And so, that's sort of our strategic index, if you will, is what will enable us to participate fully in the health care system in the United States, which will evolve in the coming years. And as acquisitions come along that enable us to do that in an efficient and an effective manner, a manner which benefits the policy holders, a manner which benefits the shareholders, then we’ll look carefully at every one of those. My view of the world is that every company in the United States that offers professional liability to physicians is at a fork in the road. And they either are going to have to shrink as their universe of traditional policy holders shrink or they’re going to have to expand to accommodate the world that’s coming. And we think that will offer us opportunities.

I appreciate that answer. I mean, so is there any other products that you guys think are attractive right now that aren’t in your product suite? And thanks again for all the answers.

You are more than welcome. We are in the process of reviewing that now. And I am not going to telegraph our exact strategy other than to say that we think it is going to be important for an organization like ours to offer a total package of insurance products to the health care system that is evolving in United States.

Ray, before we move on just let me follow-up the table that might be helpful for you on the accident year loss picks, is at the top page 55 of the 10-Q.

We'll take our next question from Matt Carletti, JMP Securities.

Just had a quick question on capital. Clearly I think more than plenty by any sort of leverage ratio that we might look at. With the recent performance of the stock, buybacks are at least less financially attractive. How should we think about your capital? Is there potential for an increased regular dividend, would you consider a special dividend at some point, or on the flipside, do you think you have enough growth opportunities to put the bulk of that to work and you’d rather hold on to it?

Ned?

Yes. Hey, Matt, it’s Ned. I guess it is easiest to say, it’s just we kind of have all options on the table, and kind of like Stan said, we're not actually going to telegraph what our intensions are but we do have all options on the table. We recognize that the excess capital that we hold is a drain on our ROE and that can be impactful to the book value multiple that we trade at. Our desire certainly is to take that excess capital and put it to work in the insurance space and we are continually looking for opportunities to do just that. But we are leaving all options on the table.

Our next question comes from Mark Hughes, SunTrust.

Yes, Howard, the 3% to 4% increase in severity, was that a little lower than you had talked about before or is that still [ph] use in language of about 4%? Am I over-reading that or is that something of a change?

I think we changed that last quarter. I think in 2011, we were talking about 4 to 5. Though, I think you could say this year again with the additional data I am looking at it, the current estimate is 3 to 4. We will find out if that is right a few years from now.

[Operator Instructions] We will take our next question from Ray Iardella, Macquarie.

Thanks for taking a follow-up. Just quick numbers question maybe for Ned. In fourth quarter assuming that the deals close, anything in terms of additional expenses we should be looking for, any kind of time you can give us numbers-wise?

Ray, probably not at this point. We hope to have these deals closed either by 12/31 or 1/1 and so some of those expenses may go into 2013. We will have -- we have been incurring expenses all along, legal expenses and the like. Where we will have expenses are around fairness opinions and such fees with investment bankers and things like that, that will be larger. And I think what has been paid on both sides of the transactions is kind of market norm.

Thank you. At this time there are no further questions. [Operator Instructions] And gentlemen, at this time there are no further questions in the queue.

Thank you very much, Amy. Thank you everyone for participating in the call, we look forward to speaking with you again in the November.

Thank you. That does conclude today’s presentation. Thank you for your participation.