Donegal Group Inc. — Q3 2018 Form 10-Q
Reporting period: Quarter and nine months ended September 30, 2018. Donegal is a property-and-casualty insurer operating through independent agents, with personal and commercial lines; it also holds a 48.2% interest in Donegal Financial Services Corporation (DFSC).
Financial performance
| Metric | Q3 2018 | Q3 2017 | Nine months 2018 | Nine months 2017 |
|---|---|---|---|---|
| Total revenue | $199.9 million | $185.7 million | $585.0 million | $548.3 million |
| Net premiums earned | $187.7 million | $177.3 million | $555.1 million | $521.5 million |
| Net income (loss) | $1.2 million | $7.1 million | ($17.8 million) | $9.9 million |
| Class A diluted EPS | $0.04 | $0.26 | ($0.64) | $0.36 |
| Combined ratio | 105.2% | 99.6% | 109.9% | 102.4% |
- Premium growth was offset by sharply higher claims. Net premiums written increased 1.1% in Q3 and 3.2% year to date. Commercial lines supported growth; personal lines written premiums declined 3.0% in Q3, reflecting underwriting actions and attrition.
- Net losses and loss expenses were $140.7 million in Q3, up from $114.4 million, and $433.1 million year to date, up from $356.8 million. Year-to-date GAAP underwriting loss was $55.2 million versus $12.7 million in 2017.
- Investment income rose to $6.6 million in Q3 and $19.3 million year to date. Realized investment gains were $3.5 million and $4.1 million, respectively. DFSC equity earnings increased to $0.7 million in Q3 and $2.2 million year to date.
- Q3 underwriting expense ratio improved to 29.6% from 34.3%; the year-to-date ratio improved to 31.3% from 33.3%. Savings and lower underwriting-based incentives contributed; the nine-month comparison includes a $1.9 million Peninsula restructuring charge.
- Operating cash flow was $59.9 million for the first nine months, compared with $62.7 million. Cash was $55.3 million at September 30, up from $37.8 million at year-end.
- Total assets were $1.824 billion and stockholders’ equity was $415.5 million, compared with $1.738 billion and $448.7 million at December 31, 2017. Accumulated other comprehensive loss widened to $18.9 million from $2.7 million, principally reflecting investment-value changes.
Debt, liquidity and capital
At September 30, the company reported $60 million of borrowings under lines of credit: $25 million under its M&T revolving facility and $35 million of Atlantic States advances from the Federal Home Loan Bank of Pittsburgh. The M&T facility is $60 million, expires in July 2021, and had $35 million of remaining availability; its outstanding rate was 4.51%. The FHLB advances bore 2.32%. The company also had $5 million of 5% subordinated debentures. Cash and short-term investments were approximately $60.4 million.
Management reported compliance with credit-agreement requirements other than the minimum interest-coverage ratio, which M&T waived at September 30 and December 31. Insurance-subsidiary dividends available for distribution without prior regulatory approval in 2018 totaled approximately $31 million; subsidiaries paid $6 million to Donegal in the first nine months. A quarterly dividend was declared after quarter-end: $0.1425 per Class A share and $0.125 per Class B share, payable November 15, 2018.
Material changes, outlook and risks
- Reserve strengthening: Insurers recorded $28.9 million of adverse prior-year reserve development in the first nine months, versus $5.0 million in 2017. New information on automobile claim severity and reporting trends led to $13.0 million of additions for prior-year personal auto and $19.1 million for prior-year commercial auto, partly offset by development in other lines. Management cited worsening litigation trends and delayed reporting of claim severity. The 2018 net development was 7.5% of December 31, 2017 net carried reserves. Management noted that each 1% change in net reserves would affect pretax results by approximately $4.6 million.
- Peninsula consolidation: Branch operations were consolidated into the home office effective July 2. The company recorded a $1.9 million second-quarter employee-termination charge, paid about $0.8 million in Q3, and had roughly $1.1 million accrued at September 30. Management expects annualized savings of approximately $3.7 million. A branch real-estate sale was expected to generate $1.2 million net proceeds in Q4; a $1.0 million impairment was recorded in Q3.
- DFSC transaction: Donegal and Donegal Mutual agreed to sell DFSC to Northwest Bancshares. Donegal expects a pre-closing dividend of approximately $14.5 million and transaction consideration valued at $38.9–$43.0 million. Subject to approvals and closing conditions, management anticipated closing in Q1 2019.
- Investment accounting: A new standard effective January 1, 2018 moved equity-security fair-value changes into earnings. The company transferred $4.9 million of net unrealized gains from accumulated other comprehensive income to retained earnings upon adoption. Q3 and year-to-date gains therefore include fair-value movements, not solely realized sale proceeds.
- No formal earnings or premium-growth guidance was provided. Management cautioned that nine-month results are not necessarily indicative of full-year results. Principal risks include reserve-estimation uncertainty, automobile severity and litigation trends, weather and catastrophe losses, reinsurance availability and cost, interest rates, investment-market and credit risk, regulation, and competition. The filing reported no material change to the risk factors in the 2017 Form 10-K and no material litigation.
Important facts for investors to verify
- Whether automobile claim severity, delayed reporting and litigation trends lead to further reserve increases, and how much of the $28.9 million adverse development is concentrated in specific accident years and subsidiaries.
- Whether underlying underwriting performance improves: the 2018 combined ratios exceeded 100% for both Q3 and the first nine months, despite premium growth and lower expense ratios.
- Completion, timing and final value of the DFSC sale, including regulatory approvals, the pre-closing dividend and the mix of cash and Northwest shares.
- Actual Peninsula consolidation savings and completion proceeds from the real-estate sale.
- The impact of investment fair-value volatility on reported earnings and equity, alongside the company’s liquidity and borrowing costs; also confirm the continued waiver status of the interest-coverage covenant.