Good morning, ladies and gentlemen, and welcome to Kemper's second quarter 2012 earnings conference call. My name is Karen, 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, Karen. Good morning, everyone, thank you for joining us. 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 Investors section of our website, kemper.com. We'd also like to mention that in our financial supplement this quarter, we added an additional page of disclosures related to our catastrophe frequency and loss and severity performance. You can find this information on page 11. This morning, you will hear from three of our business executives, starting with Don Southwell, Kemper's Chairman, President, and Chief Executive Officer, Jim Schulte, Kemper's Property and Casualty Group Executive, and finally, Dennis Vigneau, Kemper's Senior Vice President and Chief Financial Officer. We will make a few opening remarks to provide context around our second quarter results.
We will then open up the call for a question-and-answer session. Please note that our discussion today may contain forward-looking statements. Our actual results may differ materially from these statements. Please refer to our Form 10-K filed with the SEC on February 17th, 2012, as well as our second quarter 2012 Form 10-Q and earnings release for financial information on potential risks associated with relying on forward-looking statements. This morning's discussion also includes non-GAAP financial measures that we believe may be meaningful to investors. In our 10-Q supplement and earnings release, non-GAAP financial measures have been reconciled to GAAP where required in accordance with SEC rules. Now I will turn the call over to Don Southwell.
Thank you, Diana. As you heard in the introductions, I have asked Jim Schulte to join the call to provide details on our property and casualty business. I will confine my remarks to the following three topics. First, our recent decision about the direct business. Second, our life, health, and investment performance, third, our progress on capital. Starting with Kemper Direct. We recently announced that we are reviewing strategic options for the direct business and that we have ceased direct marketing activities. Over time, we had undertaken several significant actions to improve profitability in this segment. We were intentionally shrinking the business until loss ratios and acquisition fundamentals improved. We were not satisfied with the rate of progress. Given the reality that we were not getting an appropriate return on capital, we decided it was time to take more significant action. We have stopped direct marketing activities.
We are evaluating all of our options for Kemper Direct. Since our announcement, we have received a number of inquiries, which we are actively exploring. Turning now to our business performance. Overall, we're benefiting from the diversity of our portfolio of companies. The life and health businesses once again delivered steady top lines and good profits. This, along with our strong portfolio yield, has helped to offset losses in P&C. In the life and health segment, the top line held steady despite the discontinuation of sales of our dwelling and hospitalization products. We also delivered strong bottom-line performance and have taken price increases on life insurance to help offset the difficult interest rate environment.
Our Kemper Home Service Companies' flagship entity, United Insurance Company of America, was recognized as one of the top 50 performing life insurance companies by the Ward Group, a leading provider of benchmarking and best practice services for the insurance industry. This was the second consecutive year that our life business was recognized. On the supplemental health side, I'm pleased with our Reserve National team's performance as it continues its mix shift to products less affected by national healthcare reform. The investment portfolio delivered a solid performance as we navigate this low interest rate environment. While returns on our equity method investments were lower than last year's superior results, they were within our range of expectations. Despite the inherent volatility, we like the expected lifetime performance of these assets. As to capital, we are in a strong position.
We continue to be disciplined as we allocate capital across our four priorities, which include funding profitable organic growth, considering acquisitions that have a clear fit and make our existing businesses stronger, maintaining our competitive dividend, and repurchasing shares. On this fourth point, we've repurchased just over $50 million of stock year-to-date through July, which is good progress on our plan to repurchase up to $100 million in 2012. I want to be very clear about my views on the quarter. In life and health, investments, and capital management, we delivered solid results. On the P&C side, results were disappointing. Our priorities for P&C are the following. Improve margins before growth, increase homeowners' profitability, achieve overall rate adequacy, and continue to leverage our shared services to maximize operational effectiveness.
Now I'll turn the call over to Jim to provide color on the quarter's results and explain how his team is addressing these priorities.
Thank you, Don. Kemper's second quarter P&C results fell far short of expectations in two primary areas. First, although cat losses declined significantly over last year, losses in the quarter and year-to-date are well above historical averages. On a reported basis, the homeowners' combined ratio was 135 and 119 for the current quarter and year-to-date, respectively. Second, the P&C group's underlying combined ratio for private passenger auto deteriorated three percentage points over last year, resulting in an overall of 106% for the quarter. Severity is up in both liability lines and, to a lesser degree, in physical damage. As well, some business units are experienced higher claims frequency in physical damage coverages. I'll provide some perspectives on what we're doing to improve the profits across the group. I'll start with an overview of the entire P&C area.
Second quarter cat losses were significant for the industry as a whole, we were not immune to that. While cat losses were less than last year's record levels, they're still above our expectations, we are continuing to take actions to improve profits. Overall, while we're not ready to call it a hard market, we continue to see signs of improving market environmental conditions in some states in both personal and commercial lines. Turning to direct, I want to reiterate that we have ceased direct marketing activities. We continue to take actions at the same time to improve underlying performance. I'll give you an overview of where we stand in Michigan, New York, and Florida. We have exited direct auto sales in Michigan and are in the process of non-renewing the book of business.
We are migrating the New York book to a new platform, we expect to achieve significant rate increases over the next two to three years. Finally, we decreased the Florida book 37% to $19 million in force over the last 12 months. On the remaining states, we continue to take actions in line with our indications. Overall, our current plans project the entire direct business to make a profit in 2013. I'll turn now to our largest P&C segment, Kemper Preferred. Like others in the industry, we experienced high level of cat losses in the second quarter. While the losses were below record levels from last year, they're still way above our expectations for the quarter. We're taking a number of steps to improve our results.
On home, we're taking significant rate action in most states, increasing deductibles, especially in states with tornado and hail exposure, improving the overall accuracy of our pricing. On auto, we've accelerated our current increases, are zeroing in on any problem business. The Preferred business has several ongoing initiatives aimed at increasing agency engagement and raising customer retention ratios, continuing to increase the mix of both new and renewal target market customers. As of the second quarter, the target market now represents over half of our in-force book. Over the near term, we're addressing the uptick in the underlying loss ratios to achieve pricing targets. In order to improve returns, we're taking many actions, including addressing distribution relationships, having subpar loss performance trends to develop improvement plans or take other corrective actions.
We're also continuing efforts to reduce the amount and mix of monoline auto business, particularly non-target market customers. The target market business tends to be more upscale business, which has better loss ratios and retention levels. Finally, we're reviewing performance metrics and capital allocation plans, particularly in homeowners. I'll note that some of the actions may result in fluctuations in customer retention ratios or in premium, but ultimately deliver higher profit margins and return for shareholders. We expect returns in the auto line to improve faster than in homeowners. Lastly, on Preferred, let me provide an update on the comprehensive rate actions we have in the pipeline to improve profit. On the homeowners book, we continue to file for double-digit rate increases. Many of the states have already approved them.
By the end of 2012, we now expect to achieve a countrywide average rate increase of 10%-11%, the majority of which we'll earn during 2013. This is 2.5 points above the original plan. We'll continue to take needed rate actions. If those actions don't give us adequate returns, we'll reduce our overall exposures where targeted returns cannot be achieved. On the auto book, we're targeting 7-8 points of filed rate on a countrywide basis by the end of 2012, the bulk of which we'll earn in next year. This is also 2 points above our original plan for the year. It's largely targeted at the severity trend we see in liability. While these actions will take some time to yield the full benefits, they are important steps for our long-term business model.
As we shift our business mix, we are seeing better underlying performance of target market policy. Stepping back, although we are pleased to see the positive results in the target market mix, new business, and policy retention metrics over the last few quarters, I want to reiterate Don's earlier comment. Our primary focus is to improve margins across the product lines and secondarily, to grow the business. Turning now to Kemper Specialty. Our non-standard segment also saw challenges in the quarter, particularly in the private passenger auto line. We saw the underlying combined ratio increase by over 5 points. Primary drivers include physical damage frequency and higher expenses. The business team is responding on multiple fronts to get ahead of those trends and restore profit, including the following. The 2012 countrywide rate action target has increased from 6%-10%. The timing of these rate actions have been accelerated.
Where possible, we are restricting new business growth and renewals in lower volume states and customer segments having higher frequency until adequate pricing is achieved or other corrective actions are in place to achieve targeted returns. In California, the business' largest state, we had our latest rate increase approved. A new personal auto class plan is slated to be filed later in the third quarter, with a targeted implementation date early in 2013. Finally, we have several ongoing agency engagement and customer segmentation initiatives. We're also taking underwriting and marketing actions to improve the results over the coming quarters. The commercial side, on the other hand, had another solid quarter and continues to grow premium. Turning now to Kemper Services Group. This group supports our P&C businesses for such areas as information technology, HR, claims, and legal.
The initiative allows us to take advantage of scale we have across the business. Accomplishments to date include the integration of most aspects of the claims process and IT effort, along with fully consolidated accounting, reserving, and HR functions. In sum, we're facing our challenges head on. We're taking decisive actions in Direct, and we are addressing our issues in Preferred and Specialty. We are committed to improving profit of these lines, and I feel good about the plans we have in place. With that, I'll turn it over to Dennis about the financials.
Thanks, Jim, and good morning, everyone. As you've heard, the second quarter results were below our expectations in two areas. Catastrophe losses in the homeowners book were well above historical averages, and elevated underlying combined ratios were experienced in the P&C group. I'll get into details by business on both of these topics, as well as other performance drivers in just a few minutes. First, let's walk through Kemper's consolidated revenues and earnings. Reported revenues for Kemper were $609 million in the second quarter, flat with last quarter, and 6% lower than the prior year. Earned premiums were $529 million in the quarter, down slightly from last year, largely from actions taken in Direct. Consolidated net investment income for the company was $75 million this quarter and included $1 million from equity method investments.
Last year's net investment income was $83 million and included $11 million from equity method investments, an exceptionally strong quarter. As a reminder, this asset class inherently has a less predictable earnings pattern, but they also have historically delivered lifetime returns well above other asset classes and provide important diversification benefits for the overall portfolio. Aside from the $10 million change year-over-year I mentioned, net investment income grew $2 million or 3% due to higher average invested assets. The pre-tax equivalent annualized book yield on the portfolio was 5.6% for the period, down 50 basis points from last year. Finally, net realized gains in the quarter were $4 million pre-tax, lower by $14 million over last year.
On a consolidated net operating basis, Kemper's second quarter net loss was just under $1 million, or $0.01 per share, compared to a net loss of $20 million or $0.33 per share reported in the second quarter of 2011. This year-over-year improvement of $19 million was comprised of the following three items. First, $31 million or $0.51 per share from lower CATs, partially offset by lower after-tax earnings from equity method investments of $6 million or $0.11 per share, and $5 million or $0.08 per share unfavorable impact from the increase in the underlying personal auto loss ratio across the P&C group. Shifting to the details of each of the operating units' performance, I'll start with Kemper Preferred, where the net operating loss for the period was $10.3 million, an improvement of $23 million over the second quarter of 2011.
This improvement was primarily from $30 million lower weather-related losses, which was partially offset by $4 million higher frequency and severity of non-CAT fire losses, $2 million of higher severity in auto liability, and $2 million lower net investment income. On the revenue front, net written premiums increased about 4% to $233 million, and earned premiums grew 2% compared to the prior year. Overall premium retention in the first half was 88%, up two points compared to last year. Shifting to Kemper Specialty, the net operating loss in the period was $2.8 million, compared to a net operating gain of $5.3 million a year ago. This result was comprised of an $11 million decline in personal auto, partially offset by $2.8 million higher earnings in commercial auto. Let me add some further color here, beginning with the drivers of the $11 million variance for non-standard personal auto.
First, the business had a $5 million shift in development, $4 million unfavorable in the current period from higher BI severity, mostly in the 2010 and 2011 accident years, compared to $1 million favorable development in the second quarter of last year. Secondly, $3 million mostly due to higher claims frequency and physical damage, resulting in an increase in the underlying loss ratio of four points. Lastly, $2 million of lower investment income, coupled with $2 million of higher expenses, the majority of which was related to technology enhancements. Shifting to the commercial book, that performed well during the quarter, earning $4.8 million after tax, an increase of $2.8 million over last year. The main driver here was $2.3 million higher favorable prior year development across all accident years related to the mix shift in this product line.
Kemper Specialty net written premiums were $99 million in the quarter, reflecting lower volume on the personal auto side and higher volume in commercial auto. Earned premiums were $107 million in the second quarter, lower by approximately $7 million compared to 2011. Policies in force were roughly 306,000 at the end of June, down 10% over the same period last year. Let's shift to Direct. The team continues to execute its plans to improve overall profitability, and for the second quarter, the business reported a net operating loss of $2.9 million, an improvement over last year of $1.9 million. The drivers of that variance included $2 million improvement from actions taken to reduce premium volume, $2 million improvement from lower CAT losses, and higher favorable development.
These favorable items were partially offset by $1 million lower income on equity method investments and $1 million unfavorable impact of increasing severity and liability lines. Let's shift to life and health. Net operating income increased over 8% to $19.5 million from lower catastrophe losses of $3 million, which was partially offset by $1.5 million of lower net investment income. Overall, earned premiums remain relatively stable at $161 million. The teams in life and health continue to respond proactively to the challenging environment with price increases on new business, expanded supplemental product offerings, and by maintaining a disciplined approach to expense management. I'll wrap up on book value and capital. Book value per share increased in the quarter to $36.42, up from $35.69 at the end of the first quarter.
Statutory solvency and surplus levels in the insurance companies remain strong. Risk-based capital ratios were 480% in life and 290% for the property and casualty business. On a combined basis, the insurance operating units have a max ordinary dividend capacity of roughly $175 million for 2012. Currently, we anticipate that between $70 million and $90 million will be paid as dividends to the holding company during the second half of the year, with all of that slated to come from the life business. In terms of liquidity, the holding company ended the quarter with cash and investments of $163 million and a $325 million revolving line of credit remains undrawn. I'll now turn the call back over to Don.
Thank you, Dennis and Jim. As you just heard, we did have a challenging quarter, yet we have solid plans in place to address key issues. At this time, I'd like to turn the call back over to the operator so that Jim, Dennis, and I may take your questions. Operator?
Thank you, sir. Ladies and gentlemen, if you have a question at this time, please press star followed by the number one key on your touchtone telephone. If your question has been answered or if you would like to remove yourself from the queue, you may press the pound key. Again, if you do have a question, please press star and then one at this time. One moment for our first question. Our first question comes from the line of Paul Newsome from Sandler O'Neill. Sir, your line is open.
Good morning. Actually, I have two topics, but let's start with the claims trend issue. I think when we last discussed, it seemed to be more of a PIP issue, and fairly focused in a fairly small number of states for obvious reasons. This sounds much more broad-based across all of your businesses and across all of your states. Is that true, and can you offer any theories as to why it may be happening?
Paul, I'm going to ask Jim Schulte to take the first crack at that.
Yes. Thank you. It is definitely true that we were seeing significant issues on PIP, especially in the states of Florida and Michigan and New York on a direct basis. Late last year, we began to recognize other trends beginning to develop, especially on BI and liability lines in general, and to some degree, on physical damage. Those trends accelerated as the year progressed, and we are taking great action to address that.
Is the issue that you just missed that acceleration?
I would say we saw it, and it came faster than we expected.
Okay. I'd like to switch very quickly to the life side of the business. Obviously, on a year-over-year basis, the life business did fine, but sort of quarter-by-quarter, I think of life insurance business, not like the P&C business, as being sort of a more of a continuous business. The earnings were a lot less than sort of the quarterly run rate we've seen in the past. Perhaps you could talk to that. Is this a sort of a $90 million business which is what we should think of from the quarter, or is it more of a $100 million plus business?
Paul, there are definitely some things going on in the life business that over the long haul will provide challenge. The most obvious is low interest rates. Our portfolio yield is holding up quite well, and yet it still is down, I think, 50 basis points from the same quarter last year. With roughly $3 billion of assets, that has an impact. Interest rates in the future, if they stay low, that'll continue to have some impact on this business. Short of giving guidance, I would just say that we've been taking actions that help to offset these low interest rates. Certainly, we've been trying to keep the top line steady and controlling our expenses. In addition to that, we recently took a price increase on our basic life insurance products to recognize the fact that interest rates aren't what they used to be.
Terrific. I'll re-queue. Thank you.
Thank you. Our next question comes from the line of Adam Klauber from William Blair.
Thanks. Good morning. To follow up on Paul's question, what is in the preferred auto book, what's the rate that severity is running now versus, say, six months ago? What type of rate increases are you putting in now in that preferred auto book just across the board compared to six months ago?
Jim, do you want to take that one, too?
Sure. I'd be happy to. At the end of the year, we had taken approximately two to three points of rate on both home and automobile. Right now, our plans on home call for about a 10%-11% rate increase across the country during 2012.
On auto, we're going to run at about 7%-8%.
The 7%-8%, what does that compare to six months ago? Is that in that 2%-3% range?
That would be correct.
Okay. How about what's been the jump in severities compared to six months ago, severity trend?
It's up approximately 2% on the liability line.
Okay. In homeowners, as you've begun to put in some of the higher rate increases, how have retentions been running?
Retention has remained pretty strong on homeowners. We really target the package business, which combines auto and home together, and retention has stayed up pretty well on home.
Okay. That's good to hear. In the non-standard specialty book, what type of rate increases are you putting in that book of business for the higher PD?
We are taking approximately 8%-9% year-over-year. We intend to have that by year-end. That would be up significantly from last year.
Okay, great. As far as the direct business, you mentioned you've already received several inquiries. Are you running a process? Do you have a banker going out to people, or is it more just people calling in interested, or parties calling in interested in the division?
Adam, we did note that we had several inquiries. Let me just expand a little bit on this topic. As Jim indicated, we expect to be profitable in 2013 with a cessation of marketing spend and with the actions taken in some of the problem states and with a significant seasoned book. Our internal options include profitability. Any external option will have to be better than our internal option. We are trying to do this on a relatively fast but careful and cautious basis, a thoughtful basis, rather. We're not going to have a standard auction where we spend a long time trying to round up people. The likely suspects have come to us and will be identified quickly, and we should reach a conclusion for what's best for shareholders in the not-too-distant future.
Great. How much capital support that business?
Dennis, you want to take that one?
Sure. We've got roughly $175 million supporting that business line.
Okay. Well, thank you very much.
Thank you. Our next question comes from the line of Steven Schwartz from Raymond James & Associates.
Hey, good morning, everybody. Just to follow up on the last question. Don, you're renewing, right, on the direct marketing side of the business, it's just that there's no new sales?
We are.
Outside of the three states.
Outside of the three states, we are stopping marketing spend. We're fulfilling sales. Some sales continue to come to us through the websites or on affinity cases that are in place. We are fulfilling sales. We haven't discontinued new sales. We've discontinued marketing spend.
Okay. I guess what I don't understand maybe is, all right, if I'm a client of Kemper Direct and I want to renew six months from now, can I?
Yeah.
Or not? Yes. Okay, good. All right, just making sure. If I can, on the life side, I've been well aware for a long time that there's seasonality on the loss ratio. Although it didn't seem to show up in this quarter. What I am wondering about is on the expense side. Is there seasonality on the expense side? Because the expense ratio is much higher than the first quarter. I've actually seen that that's kind of been a pattern for the last couple of years.
Dennis, do you want to help out with that?
Yeah, I'd say there's not really any identifiable seasonality to that business. There are fluctuations quarter to quarter, but nothing that I'd point to that would drive any sort of meaningful expense fluctuation.
Okay. One more, if I may, on life, and then I'll go back to auto. There's a lot of talk about ACA coming in in 2014, and the potential to maybe arbitrage the costs, arbitrage the penalties, arbitrage the fact that it's guaranteed issue with accident and health and other types of policies. I'm kind of wondering if Reserve National is looking at that.
Dennis?
When you step back at a high level, here's how we're thinking about Reserve National. They've been, as you know and we've talked about previously, since late 2009, they've been repositioning their business, their product suite, as well as repositioning the distribution force away from those products that have been most affected by national healthcare reform and towards a much broader array of supplemental product offerings that should be far less likely to have any negative impacts as that comes into full implementation, which quite frankly, is still, in many ways, just uncertain at this point. They've been thinking about the issue that you raised, but forging ahead and just really doing all the necessary blocking and tackling on the distribution and product side to continue to move the business forward so that whatever may develop, they're as well-positioned as they can be for those changes.
I'll just add that we have discontinued sales of our hospitalization products, which are subject to the medical loss ratio requirements, and the field force is making the transition very nicely.
Okay. Finally for Jim, with the price increases that you're talking about, I think it was Don who said he thought maybe, not ready to call a hard market, but things are changing. Looking at this, are you going to be in line when you're done competitively, do you think, Jim?
Yes.
Okay. All right. Thank you guys very much.
Thank you. Our next question is a follow-up from the line of Paul Newsome from Sandler O'Neill.
I just wanted to kind of make sure on this thought. The aggregate price increases for the auto and home business, the personal lines, is that enough at this point to get you to the level of profitability that you think you should have? Or are we sort of implying more than one round of price increases above the underlying claim cost? I'm thinking simple math, you're sort of 110 combined. All-in price increases are probably eight or nine, and you've got an underlying loss cost trend of maybe three or maybe four. That takes you from a 110 to something that's still probably not break even. Am I just doing too simple on the math, or do we need more price increases?
I'll answer it in two ways. One on homeowners. I believe homeowners will take a series of rate increases over the coming years to bring that line back to profit. You know, homeowners is heavily driven by weather, and weather can change overnight, and that picture could clear up very quickly. Auto actions there will show up much quicker. Even there, it will take a series of rate increases to bring us back in line.
I would just add, Paul, that 110 is probably not the right starting point for your simple approach because it does include some abnormally high weather.
Yeah. From your lips to God's ears. I hope that's right. The weather's been bad. Thank you.
I'm with you.
Thank you. I see no additional questions in the queue at this time.
Thank you, operator. This is Diana. If anybody has any follow-up calls, you can contact me directly.
Ladies and gentlemen, thank you for your participation in today's conference. This does conclude the program. You may now disconnect. Everyone, have a good day.