Donegal Group Inc. — Q2 2018 Form 10-Q
Business context and reporting period. This unaudited quarterly report covers the three and six months ended June 30, 2018. Donegal writes personal and commercial property and casualty insurance through independent agents and owns 48.2% of Donegal Financial Services Corporation (DFSC). The insurance operations are closely integrated with Donegal Mutual, including an underwriting pool in which Atlantic States assumes 80% and Donegal Mutual 20% of pooled results.
Financial performance
- Second quarter: Net premiums earned rose 6.1% to $185.7 million; total revenue rose 6.7% to $195.8 million. Net loss was $0.8 million, or $0.03 per Class A and Class B share, compared with a $2.3 million loss in Q2 2017.
- First half: Net premiums earned increased 6.8% to $367.5 million and total revenue increased to $385.1 million from $362.6 million. The company recorded a net loss of $19.0 million, or $0.68 per Class A share and $0.63 per Class B share, versus net income of $2.8 million in the first half of 2017.
- Underwriting: The combined ratio was 105.6% for Q2, versus 106.4% a year earlier; for the first half it deteriorated to 112.4% from 103.9%. A ratio above 100% indicates underwriting losses. First-half GAAP underwriting loss was $45.4 million, compared with $13.4 million in 2017.
- Investment and other income: Net investment income increased to $6.3 million in Q2 and $12.7 million in the first half. Realized investment gains were $1.5 million and $0.6 million, respectively, down from $1.1 million and $3.6 million in comparable 2017 periods. DFSC equity earnings rose to $0.8 million for Q2 and $1.4 million for the first half.
- Cash flow and liquidity: Operating cash flow was $36.1 million for the first half, down from $44.4 million. Cash ended the period at $53.7 million, up from $37.8 million at year-end 2017. Investments totaled $1.01 billion.
- Capital and debt: Total assets were $1.81 billion and stockholders’ equity was $419.7 million at June 30, compared with $1.74 billion and $448.7 million at year-end. Borrowings under lines of credit were $60 million in total: $25 million from M&T and $35 million in FHLB advances. The company also had $5 million of subordinated debentures.
Material changes and management commentary
- First-half net premiums written increased 4.2% to $391.2 million. Commercial lines grew 6.2%, supported by rate increases and new accounts; personal lines grew 2.5%, with rate increases partly offset by underwriting measures and policy attrition.
- Management attributed the first-half underwriting deterioration primarily to higher loss costs, especially in automobile lines. The first-half loss ratio increased to 79.6% from 70.4%; Q2’s loss ratio was 73.1% in both years.
- Prior-year reserve development was unfavorable by $26.2 million in the first half of 2018, including $18.8 million for commercial automobile and $7.4 million for personal automobile. Management cited worsening litigation trends and delays in receiving claim-severity information. Q2 alone had approximately $0.5 million of favorable development.
- The company recorded a $1.9 million restructuring charge for consolidating Peninsula branch operations into its home office, effective July 2, 2018. Management expects annualized expense savings of approximately $3.7 million.
- Donegal and Donegal Mutual agreed to sell DFSC and its bank subsidiary for approximately $85 million in cash and Northwest Bancshares stock. Before closing, DFSC is expected to pay an approximately $30 million dividend; Donegal Group expects to receive about $14.5 million of that dividend plus consideration valued at $38.9 million to $43.0 million. Closing was anticipated in Q1 2019, subject to regulatory approvals and other conditions.
- Management recorded a first-half income tax benefit of $10.9 million, based on an estimated carryback of the 2018 taxable loss to prior tax years. The filing cautions that interim results are not necessarily indicative of full-year results and provides no specific earnings guidance.
Risks, contingencies, and unusual items
- Loss-reserve estimates are inherently uncertain. Management estimated that a 1% change in net loss reserves would affect pretax results by approximately $4.4 million. Further adverse development could materially affect earnings and financial condition.
- The company reported $747.6 million of gross unpaid losses and loss expenses, including $307.8 million of reinsurance recoverable. It held 523 debt securities in unrealized-loss positions, which management considered temporary; no investment impairment losses were recognized in the first half.
- The M&T credit agreement requires covenant compliance. The company did not meet the minimum interest coverage ratio requirement, but M&T waived it at June 30, 2018. The M&T facility was renewed in July 2018 and expires in July 2021.
- Effective March 1, 2018, umbrella-liability reinsurance changes increased maximum loss retention from $250,000 to $1.0 million. Catastrophe reinsurance generally covers losses above stated retentions and aggregate deductibles, up to $170 million per occurrence.
- Other stated risks include severe weather, reserve adequacy, legal and judicial developments, reinsurance availability and cost, interest rates, competition, and regulation. The filing reported no material change to previously disclosed risk factors, no legal proceedings, and effective disclosure controls.
Important facts for investors to verify
- Whether automobile claim severity, litigation trends, and reporting delays lead to further reserve strengthening.
- Whether underwriting actions and pricing improve combined ratios, particularly in commercial and personal automobile.
- Whether the DFSC sale closes on the expected terms and timing, and how proceeds will be used.
- Whether the M&T covenant waiver or future covenant compliance creates additional financing constraints.
- How equity-market valuation changes under the accounting rule adopted in 2018 affect reported investment gains, earnings, and equity.