Good morning, ladies and gentlemen, and welcome to the Kemper's third quarter 2014 earnings conference call. My name is Danielle, and I will be your coordinator today. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. As a reminder, the conference is being recorded for replay purposes. I would now like to introduce your host for today's conference, Ms. Diana Hickert-Hill, Vice President, Investor Relations and Corporate Identity. Ms. Hickert-Hill, you may begin.
Thank you, operator. Good morning, everyone, thank you for joining us. This morning, you will hear from three of our business executives, starting with Don Southwell, Kemper's Chairman, President, and Chief Executive Officer, followed by Denise Lynch, Kemper's Property and Casualty Group Executive, Frank Sodaro, Kemper's Senior Vice President and Chief Financial Officer. We will make a few opening remarks to provide context around our third quarter results. We will then open up the call for a question-and-answer session. During this interactive portion of the call, our presenters will be joined by John Boschelli, Kemper's Vice President and Chief Investment Officer, and Ed Konar, Kemper's Life and Health Group Executive. After the markets closed yesterday, we issued our press release and financial supplement. In addition, we filed our Form 10-Q with the SEC, you can find these documents on the investors section of our website, kemper.com.
Please note that our discussion today may contain forward-looking statements. Our actual results may differ materially from these statements. For information on potential risks associated with relying on forward-looking statements, please refer to our Form 10-K filed with the SEC on February 14th, 2014, as well as our third quarter 2014 Form 10-Q and earnings release. This morning's discussion includes non-GAAP financial measures that we believe may be meaningful to investors. In our supplement and earnings release, we have defined and reconciled non-GAAP financial measures to GAAP where required in accordance with SEC rules. Finally, all comparative references will be to the third quarter of 2013 unless we state otherwise. Now, I will turn the call over to Don Southwell.
Thank you, Diana. Good morning, everyone, thanks for joining us on our call this morning. I'll provide a few opening comments, including an update on our life and health segment and our investment performance. Denise will update you on the property and casualty segment performance. Frank will cover financials, capital, and liquidity. I'll then close with a few remarks on our capital deployment before we go into the question-and-answer session. Let's start with the total view. At the end of the quarter, we announced a $35 million after-tax write-off of software for the property and casualty group. We included this non-cash charge in net operating income, but it's also instructed to consider our performance without the charge to better see trends, which included underlying improvement in many areas. In total, our net operating income decreased $37 million to $2 million.
Excluding the software write-off, net operating income from the quarter was almost flat with prior year, as improvement in the property and casualty underlying loss ratio nearly offset lower net investment income. Turning to our life and health segment, we had a good quarter, but not as good as last year. We reported $20 million in net income, down $3 million. Net investment income and lower premium revenue drove the decline. These were partially offset by lower benefit payments and insurance expenses. Premium revenue for the quarter was down 4%, although flat sequentially, primarily from a lower level of accident and health insurance premiums. Most of this premium decline is due to the non-renewal of a portion of Reserve National's hospitalization policies. These were required to be non-renewed in 2014 in accordance with the new national healthcare law.
Many of these hospitalization policyholders also owned other Reserve National supplemental policies, which they allowed to lapse when the mandatory hospitalization non-renewal occurred. Partially offsetting this decline was an increase in premium revenue from new supplemental products, which totaled about $2 million in the quarter. Life insurance premiums decreased 2% in the quarter, with a decrease in Kemper Home Service life premiums being partially offset by an increase in life premiums from Kemper Senior Solutions. Net investment income supporting the life & health segment decreased $7 million, with about $4 million coming from equity method investments, where we do expect some volatility, and the remainder coming from lower income from other equity interests and lower yields in this low-interest-rate environment. In total, insurance expenses declined in line with the decrease in earned premiums.
We continue our investment to grow the Kemper Senior Solutions and Kemper Benefits businesses, but some of this spend was offset by lower operating expenses at Kemper Home Service. Kemper Senior Solutions and Kemper Benefits generated $5 million in earned premium in the quarter. I'll remind you that these businesses are still in the early stages, so while market reception is favorable, expenses are still high relative to premiums, producing some drag on current earnings. I'll turn to our overall investment portfolio performance. We continue to see solid results given the challenging investment environment. Our total return was positive for both the quarter and year to date, coming in about 1.3% and 7.4%, respectively. This was driven by increased bond values from declining interest rates and equity appreciation. For the year, we have purchased $400 million of fixed maturities.
This included purchasing more than $280 million of investment-grade bonds with a pre-tax equivalent yield of 4.5% and more than $120 million of non-investment-grade bonds to replace most of the non-investment-grade redemptions to date. Our diversified fixed income portfolio remains 93% investment grade. I'll turn the call over to Denise to discuss our property and casualty segment results.
Thanks, Don. Property and Casualty insurance segment reported a net operating loss of $14 million, down from net operating income of $23 million. Excluding the software write-off, Property and Casualty net operating income was $22 million, with solid improvement in the underlying book of business. Overall, our underlying Loss and LAE ratio results continue to improve. In the quarter, underlying Loss and LAE ratio improved 3.5 points, with six of the last seven quarters showing quarter-over-quarter improvement. We feel good about the profitability momentum and look forward to continued progress. Overall catastrophe losses were below our expectations, but not as low as third quarter of 2013, which was an unusually light catastrophe quarter. While we remain focused on improving profitability, we are also addressing top-line challenges.
Overall net written premium was down 11%, primarily as a result of our deliberate actions to improve the overall quality and price adequacy of our book of business and to reduce catastrophe exposures. We are encouraged by agent engagement trends on new business and look forward to continued progress. As we implemented profit improvement strategies, we have also seen pressure on the retention front. While our premium retention is lower than expected, we feel good about the risk quality and improving price adequacy of the book of business. Turning to expenses, excluding the software write-off, our total expenses were down over $7 million as we are benefiting from lower acquisition costs as well as from lower expense levels following the organization realignment we implemented earlier this year. That said, we are seeing pressure on our expense ratio because of the lower premium level.
Earlier in the year, we indicated we are targeting a two to four point improvement in our underlying combined ratio in 2014. While we are achieving progress on the underlying Loss ratio, the expense ratio deteriorated with a decline in earned premium. We expect the pressure on the expense ratio to persist. Now I will provide some color on each of our lines of business. I'll start with auto. Private passenger auto experienced the biggest revenue pressure, with net written premium declining 13%, with roughly 20% of that decline related to the run-off of our direct-to-consumer business. New business levels are starting to improve, but written premium is down. Blended premium retention, which includes both standard preferred and non-standard books, was down 4% to 74.2%.
The Loss and LAE ratio improved one point, as a three-point improvement in the underlying Loss and LAE ratio was offset by higher catastrophes and a lower level of favorable reserve development. Average earned premium increased more than 3% and exceeded loss cost trends. Our low single-digit loss cost trends are mostly consistent with the industry. In the last year, bodily injury frequency has declined, while bodily injury severity has increased by low single digits, both consistent with the industry. Property damage and collision loss costs have escalated by mid-single digits, also consistent with industry trends. In commercial auto, net written premium increased 8%. The Loss and LAE ratio was 78%, with the underlying Loss and LAE ratio up a point to 82%. This remains an area of focus as we continue to shift the book to lower weight vehicles and lower limit policies.
In homeowners, net written premium was down 8% from both lower new sales volume and lower premium retention. Premium retention was down seven points to 84.7%. Home loss and LAE ratio improved 7.3 points to 58.9%. While catastrophe levels improved sequentially, they are still higher than what we saw in the third quarter of last year, which was a light catastrophe quarter. Homeowners' underlying loss and LAE ratio improved nine points to 49%, reflecting an increase of 11% in average earned premium and flat pure premium trends. We are pleased with the continued progress we are making on homeowners as a result of our focused profit improvement actions. Looking at the Property and Casualty segment in total, performance and outlook improved in the following key areas. Our underlying loss in LAE in auto and homeowners improved quarter-over-quarter in six of the last seven quarters.
Underwriting expenses were down $7 million year-over-year, we continue to have a sharp focus on expense management. New business writings improved each quarter of 2014, the direct-to-consumer run-off continued to proceed well. We remain focused on driving initiatives to improve profitability while gradually improving premium retention and new business. I will turn the call over to Frank.
Thanks, Denise. Good morning, everyone. Today, I'll cover Kemper's overall Q3 2014 performance, capital, and parent company liquidity. We reported net income of $5 million, or $0.09 per share, compared to $70 million, or $1.23 per share last year. Our net operating income was $2 million, or $0.04 per share for the quarter, compared to $39 million, or $0.69 per share last year. Both net income and net operating income included the previously announced software write-off of $35 million after tax, or $0.67 per share. Total revenues were $540 million for the quarter, a decrease of $96 million, resulting from a $45 million decline in earned premiums, $41 million lower net realized gains, and $10 million lower net investment income.
$39 million of the decline in earned premium was from Property and Casualty, of which $7 million was from the continued runoff of our direct-to-consumer business, $6 million was from lower life and health earned premiums. The net investment income decrease of $10 million was driven by lower income on our equity securities, fixed maturities, and equity method investments. The Q3 annualized pre-tax equivalent book yield on average invested assets was 5.1%, down about 80 basis points from last year. I'll discuss the financial results of each of our businesses. The Property and Casualty insurance segment reported a net operating loss of $14 million for the quarter compared to net operating income of $23 million last year. The current quarter results included the $35 million software write-off.
Excluding this impairment, the Property and Casualty segment's combined ratio improved 0.8 points to 96.1% for the quarter, driven by improved underlying Loss and LAE results, partially offset by higher calendar quarter catastrophes and higher expenses as a percentage of earned premiums. The underlying Loss and LAE ratio improved 3.5 percentage points to 66.8%, primarily from higher average earned premium rates in personal auto and homeowners. Catastrophe losses and LAE were $14 million in the third quarter compared to $10 million last year. Insurance expenses, excluding the write-off, dropped $7 million, but the expense ratio increased 1.4 percentage points to 28.1% in the third quarter, driven by the lower premium base. Shifting to the Life and Health insurance segment. Net operating income was $20 million for the quarter compared to $23 million last year. In the third quarter, net investment income decreased $7 million compared to last year.
Insurance expenses decreased $4 million as lower home service agent commissions and lower legal expenses were partially offset by higher startup costs related to our Reserve National growth initiatives. I will now cover book value, capital, and parent company liquidity. Book value per share was $39.96 at the end of the quarter, up more than 8% from year-end, largely from the impact of lower market yields on our fixed maturity portfolio. Book value per share excluding unrealized gains on fixed maturities was $35.31, up 2% from year-end, due primarily to the impact of net income. Statutory surplus levels in our insurance companies remain strong, and we estimate that we will end the year with risk-based capital ratios of approximately 430% for our Life and Health group and 330% for our Property and Casualty group. Overall, we estimate that we ended the quarter with more than $250 million of excess capital.
The software write-off did not impact our calculations of excess capital or statutory surplus because the asset was not admitted for statutory accounting. During the quarter, the Life and Health group paid a dividend of $54 million to the holding company and we're planning for our insurance subsidiaries to pay additional ordinary dividends of at least $25 million during the fourth quarter. Turning to liquidity. At the end of the quarter, the parent company held cash and investments of about $300 million and our $225 million revolver remained undrawn. I will now turn the call back over to Don.
Thanks, Frank. As you just heard, we are at a strong capital position. Our long-term capital deployment's priorities remain unchanged. First, funding profitable organic growth, second, strategic acquisitions, and third, returning capital to shareholders, both through share repurchases and dividends. We make our near-term decisions within this framework as we evaluate options. Beginning with our first priority, we are selectively funding organic growth in certain areas, yet in total, premium revenues are declining in 2014, as we shared with you earlier. As a result, organic growth will not use capital this year. As for our second priority, we routinely evaluate opportunities for strategic acquisitions and are keeping some powder dry. Turning to our third priority, returning capital to shareholders. We repurchased more than 800,000 shares in the third quarter. In addition, we maintained our competitive dividend.
In total, we returned $43 million to shareholders in the quarter and $146 million year to date. When we look at our progress overall, we are pleased in some areas and remain committed to continuing our turnaround in others. We're optimistic about our prospects. With that, I'll turn the call back over to the operator so we may take your questions. Operator?
Thank you. Ladies and gentlemen, if you have a question at this time, please press star then one on your touch-tone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. Our first question comes from Charles Dargan from Raymond James. Your line is now open. Please go ahead.
Thank you and good morning.
Good morning.
Morning. I had a couple questions. First of all, I was curious about what your latest thoughts are on telematics.
Denise, you want to grab that one?
Sure. I'd be glad to grab that. Good morning. We've been looking into telematics and the various applications of telematics, both from a rate perspective and a customer experience perspective. What I'd say is we continue to look at that, and continue to examine exactly when and how we want to apply telematics in our business model.
Say that again? Yeah. I also had, I guess, a couple more. I was really interested also in any thoughts you guys might have on the pricing cycle in homeowners. Are we near the top or is there some room left?
I'll take that one as well. Our point of view from our book of business is that we'll continue to evaluate how our book is performing relative to expectations. We'll continue to look at what indications tell us about the book of business and loss trends, then we'll continue to take an appropriate amount of rate or other underwriting actions to achieve the outcome that we want. Looking more broadly in the marketplace, we do continue to see, I'd say, disciplined underwriting and disciplined rate-taking in the homeowners' marketplace.
You guys haven't made up your mind or have any thoughts on where exactly the industry is as far as the market as a whole?
Homeowners, it's a volatile marketplace, particularly when I think about catastrophes. This year maybe for the industry is turning out perhaps to be a lighter year, and last year was a lighter year, but there's still volatility, and it can affect carriers in very different ways. I guess I think about it and I think that carriers are in different places. So, I guess I believe that there is still some need to continue to address profitability and to get appropriate returns over the long term and not just in a single year. I'd say that there's still some need for rate in the industry, and we'll continue to see that.
If I can sneak in one last one. Related to the Reserve National, how much of the non-Obamacare policies have you guys sold in the fourth quarter of last year? If you have that number.
I'm sorry, could you repeat the question?
The non-Obamacare hospitalization policies for Reserve Nationals sold in the fourth quarter of last year?
Yeah, we don't sell any policies that are part of the Obamacare exchanges. All of the policies that we sell are various kinds of supplemental products that are not subject to those rules. Does that answer your question?
Thank you. Our next question comes from Paul Newsome from Sandler O'Neill. Your line is now open. Please go ahead.
I'd like to maybe talk a little bit more about the old goal of reaching a 10% ROE in light of the shrinkage in the size of the business on both the property casualty and life side of the business. Are we getting to a point, given the decline in the business, where the scale is such that both sides of the business really can't give us a double-digit ROE? If that's the case, is the next thing for us to follow rebuilding that scale?
Well, Paul, scale is certainly an issue. More scale makes things easier. I would say that given the top-line trends that we've seen, we've got some temporary expense ratio pressures, that we're not materially in a different place as far as our ability to achieve. It does push out our timeline. We've constantly talked about also looking for opportunities to grow through acquisition. We see the same thing you see, that it's easier with more scale. We'd like to have more scale, we want to do it in a smart way. We'll look for smart ways to build our scale.
I guess one of the things I'm struggling with, I don't know if you can respond as detailed as I would like, is that I'm having trouble coming up with how to come up with more than an ROE that's in the mid-single digits in general. Especially given it looks like your portfolio yield may be falling given where interest rates are at. The life side, you've got the A&H business that's going away in part because of the Obamacare. Obviously the P&C side has shrunk a lot this year as well. I'm having trouble, given where your capital position is, the desire to hold all excess capital, I'm having trouble coming up with those pieces.
Is there any way you could kind of walk us through how those pieces, not necessarily next year, but over the next couple of years, could move in a way that would give you a higher ROE?
Yeah. There's four elements we've talked about that are necessary to get us to a double-digit ROE. One of those is just simply that CATs are normal. In any given year, you're going to have some volatility due to CATs. Normal CATs is one element of that. Continued improvement in the P&C profit margins. We've talked about getting our combined ratio down in the 95 range, and that's an important element. A third important element is increasing interest rates because we believe that they will happen. Timing is difficult, but particularly given our life business interest rates staying where they are not conducive. We've planned on interest rates to move pretty much as the Federal Reserve base case scenario projects, and that is a slower projection. Excuse me. A slower growth this year than they projected last year.
Increasing interest rates is certainly part of what will be required. Most importantly, it's full deployment of capital. We would like some of that deployment to come in terms of growth and not entirely in terms of returning to shareholders. Is that helpful, Paul?
Absolutely. Thank you very much.
Yeah.
Thank you. Our next question comes from Matthew Carletti from JMP Securities. Your line is now open. Please go ahead.
Hi, it's actually Christine Worley standing in for Matt. Just had a couple of questions on your exposure management. Looking at the top line. Given previous guidance, we would've thought that the pressures that we're seeing there would've started to ease by now. Can you sort of give us an update on where we are with that? Are we starting to turn a corner, or should we expect these double-digit top-line declines to continue for at least the next couple of quarters?
I think for us in property and casualty, we're starting to see some trends improve on new business. I think I've shared that we're focusing very much on the agent experience and our sales rep deployment, making it easier to do business with. We're seeing that translate into improved new business, certainly on a sequential basis. We like that. The pressure really has been on the retention, and that really reflects a lot of the hard work we've been doing in our pricing and improving our price segmentation as well as our catastrophe management work. That's where we've seen the biggest impact, certainly to the book of business. It's the right thing for us to do. We like the outcome on the underlying loss improvement. We like the outcome in reducing some of the catastrophe exposures.
Those are the right things to do, but we do expect some pressure there.
Okay, it sounds like continued pressure on the retention side, but some improvement on the new business side.
Right.
Okay, perfect. Yeah, you touched on it in your previous answer, but the accident year loss ratio improvement that we've seen throughout the year, is that reflective of the exposure management actions that you've taken, or is it more sort of looking at where the book is running for the year and trying to true up where you think it'll eventually fall out or where it should fall out?
We really have been working for a good period of time of improving our underlying accident year improvement. It's been more deliberate than catastrophe management, exposure management. It's included risk selection and price adequacy, and really all through our operations. We've actually been at this for a good period of time, when I look at our underlying results, I really attribute it to a lot of that hard work between underwriting and exposure management and price adequacy. Naturally, there's always a loss trend that goes into that. That's environmental in nature that may influence. When I think about our progress, our progress absolutely reflects the hard work of improving profitability.
Okay, perfect. Thank you very much.
Our next question comes from Adam Klauber from William Blair. Your line is now open. Please go ahead.
Thanks. Morning, everyone. Couple questions. Could we go over cash available for dividends and buybacks? Frank, I think you said maybe you have $300 million at the holding company. How much cushion do you usually keep in?
You're correct. We have about $300 million of cash and short-term investments at holding company. We target somewhere between $40 million and $60 million for cushion.
Okay. I think you mentioned the dividends. I missed it. What's your statutory dividends this year?
We took $54 million up from the life group this quarter. We took $100 million up from P&C earlier in the year. We have remaining capacity at the life group of $25 million and at P&C group of about $38 million.
Okay. aside from profitability getting better or worse, is there any reason we should think next year your dividend capacity should be any better or worse than this year from the subs?
There should not be a material change to the dividend capacity from the subs.
Okay. That's helpful. On the technology write-off, you wrote off the software. I guess, what direction are you taking now with your technology efforts?
Okay. I think I'll take that one, Adam. It's important to us to continue to build platforms that serve across our property and casualty business. We do intend to continue that pursuit, and we're in the process then of evaluating alternatives to continue that process.
Okay. It sounds like we'll hear more about that later. Is that a good way of thinking about it?
Sure. The only thing I would add is that we've got some systems initiatives that are ongoing, that will allow us to improve things in the short term as well, and we will continue those.
Okay. Then finally, again, a lot of discussion on the improvement in underwriting, and that's a great sign. I think nine months, I calculated the improvement in the underlying accident year for P&C was well over 200 basis points if you exclude CATs and development. I'm trying to phrase this correctly. How material is getting rid of the direct business to that improvement?
That's an interesting question. I think the direct business was important in the sense that it was a big expense item for us, and we weren't approaching our profitability targets with the speed that we wanted to. That certainly has been a part of it. Aside from the direct, the ongoing business has demonstrated really a substantial amount of improvement across all of our lines, with the exception of commercial vehicle, which is the one that we're still working on. Our direct business was the right decision and has contributed to our improvement, but it's really been across lines with the exception of commercial vehicle.
Okay, thanks. Sorry if you mentioned this before, what type or what level of rate increases are you putting in to the commercial vehicle line now?
It's, I think about 5%-6% on our commercial vehicle book of business.
Okay. Thanks a lot.
Thank you. Again, if you do have a question, please press star then one on your touch-tone telephone. Our next question comes from Jason Bussell from Millennium. Your line is now open. Please go ahead.
Hi. Good morning. I'm sorry if I missed this earlier. I think in the release, the book yield on the investment portfolio was 5.1%.
John, is that the exact number?
Yeah. That's for the quarter, yes.
What is the new money rate?
That's a loaded question, kind of. We are investing across the platform of different types of investments. What we put to work for the quarter in the investment-grade area was about a 450 pre-tax equivalent yield.
450 pre-tax. I think to expand on Adam's question, the holdco cash. I know that you have a debt maturity coming up next year. Is the intention to use some of that to retire, I guess I'm trying to understand what debt to capital level the company expects to be running at, and if you currently expect to retire that maturity.
The way we're looking at it right now is we're preparing to retire that maturing. When we issued our hybrid, we committed to bring our debt to capital ratio down in line with where it had been historically. What we really are doing now is monitoring our options with the long-term intent to bring that ratio down more in line with where it has been. We have a 2017 maturity also out there. We're looking at our options, and we're monitoring it.
Down to where it's been, you mean in the low twenties?
That's where it's been historically. Correct.
Okay. Thank you. Then one follow-up for Denise. I know that you talked about retention falling. Were you referring to just home or auto, too?
I was referring to both lines.
What is the retention now versus a year ago outside of direct in personal auto?
We don't break that out because we report now by segment.
Oh.
The direct business continues to decline at about the same rate that it had been. We report today on an online basis.
Okay. I'm wondering, given the fact that you're facing challenges with retention, presumably some of the business you'd like to keep, what's the operate in the auto business? Is it a rate issue? I guess I'm trying to understand why the non-direct, the personal auto retention is facing challenges, because it's not as cat exposed for you, obviously.
Yeah. That's true. We've been addressing the underlying performance of the auto book of business. We were dissatisfied with where it was performing and set out to improve that line several quarters ago as well. It's really talking about improving the underlying book of business there in the auto, and as a result of that, we, for several quarters now, have been addressing that profitability with rate and underwriting risk selection actions primarily. It's from that work that we're experiencing the pressure on retention.
Were there any regions in auto that you wanted to address with rate and underwriting actions, or was it more on the non-standard side or on the preferred side?
It's state specific. We look at it, product line specific as we do our indications and evaluate the book of business and then make choices about applying rates. It is by state and by line. Therefore, it will vary depending on what we see the trends being and where we see the line by state performing relative to our expectations. It's variable.
Okay. It sounded like from your comments regarding new business, that the agent experience is improving, that you sound like you've got a good handle on these issues, and they'll probably turn around.
Yeah. The new business we are seeing a sequential basis improvement in our new business. Again, we've been addressing that as well. We expect that to continue to make progress.
Thank you. That's all my questions. I appreciate it.
Thank you. I'm not showing any further questions at this time. I would now like to turn the call back to Don Southwell for any further remarks.
Thank you, operator. Excuse me. Before we wrap up, I do have just a few comments on our results in the quarter in really four areas. In Property and Casualty, we continue to improve our underlying performance, but the software write-off and the top line did pressure overall results. Our life and health segment profits were good, but slightly lower due to reduced investment income and the expenses associated with funding our strategic growth initiatives. Our investment portfolio continued to deliver in a tough reinvestment environment. Finally, our capital and liquidity positions remain strong, which afford us great flexibility. We continue to focus to deliver to the shareholder returns that we all seek. We do appreciate your time. Look forward to updating you next quarter.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude today's program. You may all disconnect.