Good morning, ladies and gentlemen, and welcome to the Kemper's third quarter 2013 earnings conference call. My name is Stephanie, and I will be your coordinator today. At this time, all participants are in 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, and 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, and finally, 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 three 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 filed our Form 10-Q with the SEC and issued our press release and financial supplement. You can find these documents on the investor 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 15th, 2013, as well as our third quarter 2013 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 third quarter 2012, unless we state otherwise. Now, I will turn the call over to Don Southwell.
Thank you, Diana. Good morning, everyone, and thanks for your interest in Kemper. Today, I'll discuss our overall results for the quarter and cover specifics on our life and health group and on our investment performance. Denise will provide more color on the Property and Casualty Group's results, and Frank will review detail on our financial results, capital, and liquidity. I'll wrap up. Starting with our results. In total, we had another strong quarter, and we're happy with the progress in each of our segments. We generated $70 million of net income in the quarter, up from $56 million. On a net operating income basis, we earned $39 million compared to $25 million. These favorable results are in large part due to the actions we have taken to date, and we remain focused on implementing our plans.
Our Property and Casualty Group delivered another quarter of strong overall improvement. We remain on pace to meet all the commitments we outlined earlier to improve P&C fundamentals. Additionally, catastrophe levels were favorable. In total, we recorded about $10 million pre-tax of cat losses, about the same as last year. I remain pleased with our team's progress. Denise will cover our P&C performance and plans in more detail. On the life and health side, earnings were up almost 20%. In the Kemper Home Service companies, we saw improved underlying results and lower cat levels in the dwelling line sold by our career life agents. This was partially offset by higher expenses. Investment income was up to $8 million pre-tax, primarily from our equity method investments. Our Reserve National business continues its expansion with new products and markets. Expenses are up, but we are pleased with the market interest.
We still expect the total life and health groups earnings in the second half of 2013 to be at about the same level as the second half of 2012. Turning to investments. The portfolio delivered another quarter of solid results with our performance ahead of plan, primarily from higher returns on equity method investments and higher levels of investments. Although interest rates dipped back down after recent Federal Reserve messaging, interest rates are still ahead of the pace projected in the Federal Reserve base case scenario. A major milestone in the quarter was the sale of the Kemper building, home of our Chicago corporate offices, which resulted in a pre-tax gain of $44 million. We entered into a long-term lease agreement with the buyer for our office space and retained the naming rights and Kemper signage on the building. This is really just a financial transaction.
As we mentioned earlier, the sale is part of our capital strategy, which includes reducing our real estate portfolio. This was our largest single real estate holding, and the real estate portfolio now represents less than 3% of our total investment portfolio. Now I'll turn the call over to Denise to provide commentary on the quarter's P&C results and her team's actions to improve profitability.
Thank you, Don. The Property and Casualty Group's underlying results improved in the third quarter. We're focused on improving performance through aggressive actions such as rate increases, improved underwriting discipline, and product line management. We like the direction of the Property and Casualty results and also acknowledge more work remains to be done. Four key highlights for the quarter include, first, the Property and Casualty Group's combined ratio improved four points to 96.9% in the quarter. The underlying combined ratio also improved by nearly four points to 97.3%. Second, weather was less active, with catastrophe losses slightly below the prior year. Third, we continue to make progress with the actions to improve pricing, product management, and analytics capabilities, and we will continue to invest in these areas. Fourth, the direct runoff is going well, and once again, we exceeded our expectations.
Let's start our detailed review by looking at our largest business, Kemper Preferred, which provides home, auto, and valuables coverage to standard and preferred customer segments. Our story is similar to the results we saw in the second quarter. We continue to optimize our business mix to drive improved performance. Our Package Plus product, the premier offering for our target market, made up 60% of all new sales in the quarter. Moving on to specific product lines, the homeowners line continues to show improvement. Net written premium was about $2 million lower at $83 million, resulting from lower new business volume as a result of pricing and underwriting actions designed to improve the new business quality. Earned premium grew 2% due to a 9.5% increase in average earned premium, partially offset by lower volume.
The combined ratio of 96.9% for the quarter improved slightly, with a two-point improvement in the total Loss and Loss Adjustment Expense Ratio, offset by a one-point increase in the incurred expense ratio. The expense ratio was up about one point, primarily from increased agency and employee compensation expense related to the improved year-over-year financial performance. Our focus on improving the homeowners portfolio continues to build momentum. We are on pace for a 14% filed rate increase in 2013, up from our original 10% plan. This area remains our priority as we continue to implement the appropriate actions to improve and sustain the performance of the homeowners book of business. In the auto line, net written premium was $125 million, down 9% due to the intentional slowdown of new business and lower retention resulting from our profitability improvement actions. Earned premium was down 3%.
The underlying combined ratio increased about a point and a half to 103.9% from a slight deterioration in both the underwriting loss and expense ratios. We are not satisfied with the performance of the auto line and continue to take aggressive actions to improve its performance. While the average earned rate increase was 4%, this is the third quarter the pure premium has increased mid-single digits, largely driven by higher severity and bodily injury. We continue to work on price adequacy with improved price segmentation and filed rate increases, which will be about 9% for 2013. Now turning to Kemper Specialty. Kemper Specialty targets personal and commercial auto insurance consumers who have difficulty obtaining automobile insurance through the standard and preferred markets for a variety of reasons. Overall, the segment had a good quarter, with net income of $5 million, nearly double the third quarter 2012's results.
I'll start with comments on personal auto. Net written premium decreased 10% to $82 million, although up $1 million sequentially, as our rate increases pressured new business. Earned premium declined 9%. The combined ratio improved five points to 99% as a result of improved underlying loss and loss adjusting expense and lower catastrophe losses. Underlying results improved four points as rate increases and price segmentation advancements led to an average earned rate increase of more than 8.5%, outpacing a moderating pure premium trend. We remain ahead of our original filed rate plan and continue to expect to file almost nine points of rate increase in 2013, up from the 6.5% original plan. Briefly turning to Kemper Specialty's commercial auto results. Net written premium increased 3% to $13 million, led by new business. Earned premium increased 23%.
The combined ratio of 91.1% was up 13 points, largely from a nine-point increase in the underlying combined ratio of 105.2%. This was primarily driven by higher expenses and some deterioration of underlying Loss and Loss Adjustment Expense. We remain on pace to file 7% in rate increase in 2013. We also continue to tighten underwriting guidelines related to unprofitable, volatile classes of vehicles, and we are in the process of non-renewing a segment of these risks. Overall, I am pleased with our progress, and we remain focused on improving Kemper Specialty's underlying combined ratio in 2013. I'll update you on Kemper Direct. The runoff of the direct-to-consumer business continues to exceed our expectations. Net written premium at $28 million was down 23%, but about flat sequentially, with new business flowing and retention performing about as expected during the runoff period. Earned premium was $30 million, down 25%.
The combined ratio improved 28 points to 76.7% due to improved underlying results and lower expenses. The underlying Loss and Loss Adjustment Expense Ratio improved more than 18 percentage points. We recognized $5.7 million in favorable reserve development. In direct, the top line is consistent with our expectations, as is the underlying improvement. We have and will take rate actions in line with indications, as well as other underwriting actions to manage profitability through the runoff. We are on track to take 7% of rate in auto and 12% in home. This quarter marks the first complete year that Kemper Direct has been in runoff, and we have effectively eliminated or significantly reduced expenses, which has resulted in very favorable quarter-over-quarter comparisons for each of the four quarters in runoff.
To summarize the Property and Casualty Group, we are pleased with our progress in many areas and remain committed to following through on our plans to deliver a 3- to 5-point improvement in the underlying combined ratio in 2013. I'll turn the call over to Frank.
Thanks, Denise, and good morning, everyone. Today I'll cover Kemper's third quarter 2013 performance and parent company capital and liquidity. As Don mentioned, overall, we had another strong quarter with net income of $70.1 million or $1.23 per diluted share, up from $55.6 million or $0.95 per diluted share. This included a $28 million gain from the sale of the Kemper building, bringing total after-tax net realized gains for the quarter to $32 million, compared to $33 million in 2012. Our net operating income was $39 million for the quarter compared to $25 million last year. Total revenues were $636 million for the quarter, a $10 million decrease due to lower earned premiums offset by higher net investment income. The earned premium decline was in line with our expectations and mainly the result of profitability improvement actions we took in Kemper Direct and Kemper Specialty.
Consolidated net investment income across the portfolio was $82 million in the quarter, an increase of $12 million driven by higher equity method investment income and higher levels of investments. Equity method investments earned $8 million for the quarter compared to a loss of $1 million. Excluding equity method investments, yields were fairly flat as slightly lower yields on fixed maturities were offset by higher yields on equity securities. The third quarter annualized pre-tax equivalent book yield on average invested assets was 5.9%, up about 60 basis points, driven by the higher returns on equity method investments. Our average investment grade fixed maturity reinvestment rate increased about nine basis points in the quarter to just over 3.2%. I'll now discuss the financial results of each of our businesses, starting with P&C. Kemper Preferred reported net operating income of $11 million for the quarter, up from $8 million last year.
Overall, Preferred's combined ratio improved one point to 99.3% for the quarter due to improved underlying loss results, partially offset by higher expenses. The underlying loss ratio improvement of 1.6 points primarily was a result of higher average earned premiums for all lines outpacing loss cost trends. Insurance expenses increased primarily from higher employee and agent incentives related to the improved operating performance. Preferred's net written premiums were $223 million in the quarter, which was $15 million lower than last year. Net earned premiums were $221 million in the quarter, down from $223 million, as an 8.5% drop in policies in force was offset by higher premium rates, the higher premium rates Denise mentioned earlier. Overall, premium retention was 87.4%. Turning to Kemper Specialty. We reported net operating income of $5 million for the third quarter, up from $3 million last year.
The combined ratio in Kemper Specialty improved 3.6 points to 97.7%. The favorable impacts of our rate and underwriting actions resulted in a 2.6-point improvement in the underlying combined ratio. Specialty's net written premiums were $95 million in the quarter compared to $104 million last year, and net earned premiums were $98 million compared to $104 million last year. These results are in line with our expectations and are driven by the rate actions we implemented, which resulted in a decline of 17% in total segment policies in force. I'll turn to Kemper Direct. In the quarter, we reported net operating income of $7 million, up from $2 million last year, with a 76.7% combined ratio this year compared to a 104.5% ratio last year.
The underlying loss ratio improved 18.5 points to 65.4%, driven by lower severity and lower frequency in auto liability coverages and higher average earned premium rates. Kemper Direct's net earned premiums were $30 million for the quarter, down from $40 million, and in line with our expectations. Auto and home average earned premium rates increased in the quarter by 5% and 13% respectively, but were more than offset by lower volume. With the reduction in premiums and the runoff of reserves, we currently allocate just under $140 million in capital to Kemper Direct. Shifting to the life and health segment. Net operating income overall was $23 million in the quarter, an increase of $4 million. Earned premiums for the segment decreased slightly to $159 million, while net investment income increased $6 million after tax from higher returns on equity method investments and higher levels of investments.
The life business experienced higher expenses related to certain legal matters and startup costs related to Reserve National's new distribution initiatives, but these expenses were tempered by lower Kemper Home Service agent commissions. Finally, I'll discuss book value, capital, and parent company liquidity. Book value per share was $35.86 at the end of the quarter, down year-over-year and from year-end due to the impact of higher interest rates on our fixed maturities portfolio. Book value per share, excluding unrealized gains on fixed maturities, was $32.93, up 6% year-over-year and 8% from year-end. Statutory surplus levels in the insurance companies remain strong, and we expect to end the year with risk-based capital ratios of approximately 450% for the Life and Health Group and 340% for the Property and Casualty Group. During the quarter, we made a $55 million voluntary contribution to our pension plan, reducing pension insurance fees.
In the quarter, the life company sent $70 million of dividends to the holding company. In total, our insurance companies have about $110 million of ordinary dividend capacity remaining, of which we are targeting another $25 million of dividends from our life companies in the fourth quarter. Finally, from a liquidity perspective, the holding company ended the quarter with cash and investments of about $150 million and our $325 million revolving credit line remains undrawn. Now I'll turn the call back over to Don.
Thank you, Frank, and thanks, Denise. We continue to be in a strong capital position and our long-term capital deployment priorities remain unchanged. These include, first, funding profitable organic growth, second, strategic acquisitions, and third, returning capital to shareholders both through share repurchases and dividends. Given our efforts to improve profitability, we are not currently funding organic growth. While we've made great progress, we have much more work to do. We also want to see continued operational improvements before making an acquisition, although we do intend to keep powder dry for future opportunities. We have maintained our competitive dividend and continue to buy back shares opportunistically. In the third quarter, we repurchased $36 million of common stock, bringing our 2013 year-to-date total through the third quarter to two and a half million shares repurchased for about $85 million.
Earlier this year, we communicated our goal to achieve a double-digit ROE by the end of 2015 on a run rate basis, and we outlined a path that had four main elements. One, continued improvement in our P&C combined ratio. Two, full deployment of available capital. Three, increases in interest rates consistent with the Federal Reserve baseline scenario, which was published in November 2012. Four, normalized catastrophe losses. Our actions and results to date are consistent with our plans to achieve that goal. In closing, we had another good quarter. Our underlying performance continues to improve. Our actions are aligned to drive further progress, and we are optimistic about achieving our goals. With that, I'll turn the call back over to the operator, so we may take your questions. Operator?
Thank you. Ladies and gentlemen, to ask a question, please press star then one on your touch-tone telephone. If your question has been answered and you wish to remove yourself from the queue, you may press the pound key. Our first question comes from Brigitte Davison from Raymond James. Your line is open.
Good morning. Do you think you could talk a little bit more about Reserve National? I saw you mentioned the continued effort to expand distribution. I was just wondering if you could provide a little bit more detail, maybe where you are on the shift in product mix, maybe a little more detailed look at the agent count or any other color you think might be helpful.
Sure, Brigitte. I'm going to ask Ed Konar to address that. As Diana said earlier, he's with us today, and he can give you the best answer on that.
Thank you.
Good morning, Brigitte. Reserve National's been doing a number of things over the years, last couple of years anyhow, primarily moving away from their hospitalization products and moving into supplemental products that are less impacted by healthcare reform. They've been doing that primarily with their captive agency plan. More recently, in addition to that, they've been getting into some new distribution channels. Last year, about this time, they introduced what they call their Senior Solutions, which is life insurance and other supplemental products sold through independent agents. That channel is going quite well right now and is really exceeding expectations. They're also introducing two new distribution plays. One is a work site benefits play, and the other is a dental insurance play. Both of those are kind of in their infancy right now.
You guys considered selling this business once before. As it continues to turn around and shift into something a little bit different, is that an avenue you might consider again?
Brigitte, we consider this a core holding now.
Okay.
We do not have it on the market or intend to have it on the market.
Okay. Well, thank you.
Our next question comes from Paul Newsome with Sandler O'Neill. Your line is open.
Good morning. Thanks for the call. Perhaps you could talk a little bit about the competitive landscape for personal lines. We've heard a lot of comments on conference calls so far this season about lowering rates, as well as competition with respect to the new products and innovations in auto products. Are you seeing this in your own environment? Any thoughts on that change in the competitive landscape?
Denise, you want to take a crack at that?
Sure, I'd be glad to. Good morning, Paul. I think our market, because we serve such a variety of states and we have both standard preferred product and non-standard product, I'd say the market is variable both by product line and by market we serve. From a homeowners perspective, we continue to see firming market conditions, generally speaking, across the country with increasing rates and companies continuing to take appropriate underwriting actions to improve profitability. On the auto side, I would say we see the market conditions as variable depending on the state. We see, in general, rates rising across the country, but there certainly is also competition and capacity across the country for auto.
Great. Thank you.
Again, ladies and gentlemen, to ask a question, please press star then one on your touch-tone telephone. Our next question comes from Adam Klauber with William Blair. Your line is open.
Thanks. Good morning, everyone. A couple of different questions. Clearly, you're doing a really nice job turning around the underwriting margins in the different P&C units. When do you think we'll get better results in preferred auto? Specifically, is it more state specific? Are there still a couple of states that are just lagging? Is it just a matter of time before the higher rate? You're bringing in, obviously, higher rates more. Do we just need some more time towards the higher rates turn in? What will help that move in the right direction?
Well, as we've said, we're disappointed with our results in auto. Certainly, having said that, what I'll say is that we are working very hard on that auto book of business to turn that around. We filed a pretty good amount of rate, or will have filed a pretty good amount of rate this year.
Yeah.
About 9%, that's on top of just under 8% last year. Our average earned premium continues to climb each quarter. We're seeing that start to earn in. We've also been very thoughtful about where we write new business and how much new business we write, and about our general pricing segmentation and the sophistication of our pricing product. I think what I would say is that we continue to work hard in each state to ensure that we are working hard on our pricing and risk selection, and we will work to continue to improve all of that as we work to improve the overall performance of this line of business.
Are there a couple states that are dragging down the average?
No. We've looked at that, and what I'd say is that really what we're seeing are the loss trend affecting pretty much across the country. There's not a standout state or two that's driving the performance in the Preferred business.
Okay. Just following up on that, what is loss trend running in, if you look at PD versus BI within the Preferred book?
Yeah. In the Preferred book, really the driver of our loss trend has been consistently from the three quarters of this year. It's been largely driven by BI severity. It's in the mid-single digits. In the earlier part of the year, we did have some severity and frequency on our collision book, really it's been the BI severity each quarter.
Is that holding at the current level? The BI severity.
It's been fairly consistent when we look on a quarter-over-quarter in terms of where it is.
Okay. What's your retention in the preferred auto now versus, say, six months ago or a year ago?
Well, certainly the retention is less than where it had been. We're down maybe a couple points in our auto line in preferred. That's actually about what we expected given the pricing actions and other underwriting actions that we're taking.
Okay. Moving to the specialty again. You've had a very nice turnaround in underwriting margins there. What's the competitive environment specifically in non-standard? I know a year ago you had some larger players who were really, I think, backing off somewhat. Is that still the case, or are you seeing more competition creep in that market again?
No, we still believe that that market is hardening. We still see rate coming into that marketplace, and hardening is probably too strong, but we still see that market firming.
Okay. At some point, do you think you'll start growing that business again now that it's getting profitable, or do you think you're still in margin improvement mode for the foreseeable six, nine months or so?
I think I'm hesitant to make general statements.
Sure.
We manage our book of business really much more discreetly than that by state. Really even more carefully than that. So there are markets that we are already growing. Our private passenger book, our commercial vehicle book. Then there are other markets where we continue to work on our pricing, and we will grow when we believe that we are in a position to be able to do that.
Okay. Thank you. One, I guess, last question. When we think about capital deployment, you've been doing a nice job of buying back stock. I know if there are opportunities, you'd be interested in those opportunities, if M&A does not pop up, is share buyback still the preferred means of utilizing excess capital?
Adam, that's probably a fair characterization. We certainly believe our dividend is competitive, and that's another way to get capital to shareholders. We weigh exactly what you said. What's our excess capital position, keeping enough powder dry for future acquisitions? We keep an eye on the stock price. I think in prior calls, people made fun of me for saying at two times book, we probably wouldn't be buying back. That's just a way of saying we are somewhat price sensitive as well. We've bought back an awful lot of stock at very attractive prices this year. We look at the EPS impact, the ROE impact, the amount of excess capital, and then we make our decisions day by day. We're very happy with what we've been able to do this year. Frank, did you want to add anything to that?
I don't think there's anything I can add, Don. I just agree with it all, and I think this upcoming quarter, we'll keep the same path we've taken as far as looking at all those options. As you said, price sensitive is in the equation.
Okay. Thanks a lot.
Thank you. Again, ladies and gentlemen, to ask a question, please press star then one on your touchtone telephone. I'm currently showing no further questions. I will turn the call back over to management for closing remarks.
Thank you, operator. I do have just a few closing remarks. We're making tangible progress to improve profitability in each of our businesses, and I am pleased with our progress to date. While we know we have more to do, it was another good quarter. We continue to focus on the targets that we outlined earlier in the year. We remain committed not only to fulfilling our promises to our customers, but also to delivering shareholder returns that we all need and want. Thank you for your time this morning, and we will update you on progress on our next call.
Thank you, ladies and gentlemen. That does conclude today's conference. You may all disconnect.