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Edited Transcript of PRA earnings conference call or presentation 4-May-18 2:00pm GMT

Q1 2018 ProAssurance Corp Earnings Call

Birmingham May 9, 2018 (Thomson StreetEvents) -- Edited Transcript of ProAssurance Corp earnings conference call or presentation Friday, May 4, 2018 at 2:00:00pm GMT

TEXT version of Transcript

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Corporate Participants

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* Edward Lewis Rand

ProAssurance Corporation - Executive VP, COO, CFO & CAO

* Frank B. O'Neil

ProAssurance Corporation - Senior VP of IR & Chief Communications Officer

* Howard Harley Friedman

ProAssurance Corporation - Chief Underwriting Officer, Chief Actuary & President of Healthcare Professional Liability Group

* Michael Leonard Boguski

ProAssurance Corporation - President of Eastern Insurance

* William Stancil Starnes

ProAssurance Corporation - Chairman, President & CEO

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Conference Call Participants

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* Amit Kumar

The Buckingham Research Group Incorporated - Analyst

* Arash Soleimani

Keefe, Bruyette, & Woods, Inc., Research Division - Assistant VP

* Jon Paul Newsome

Sandler O'Neill + Partners, L.P., Research Division - MD of Equity Research & Senior Insurance Analyst

* Mark Douglas Hughes

SunTrust Robinson Humphrey, Inc., Research Division - MD

* Matthew John Carletti

JMP Securities LLC, Research Division - MD and Senior Analyst

* Robert Edward Farnam

Boenning and Scattergood, Inc., Research Division - Senior Research Analyst of Property and Casualty Insurance

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Presentation

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Operator [1]

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Good morning, everyone. Welcome to the conference call to discuss ProAssurance's results for the first quarter of 2018. These results were reported in the news release issued on May 3, 2018, and in the company's quarterly report on Form 10-Q, which was also filed on May 3. These documents are intended to provide you with important information about the significant risks, uncertainties and other factors that are out of the company's control and could affect ProAssurance's business and alter expected results.

We also caution you that management expects to make statements on this call dealing with projections, estimates and expectations and explicitly identifies these as forward-looking statements within the meaning of the U.S. federal securities laws and subject to applicable safe harbor protections.

The content of this call is accurate only on May 3, 2018. And except as required by law or regulation, ProAssurance will not undertake and expressly disclaims any obligation to update or alter information disclosed as part of these forward-looking statements.

The management team of ProAssurance also expects to reference non-GAAP items during today's call. The company's recent news release provides a reconciliation of these non-GAAP numbers to their GAAP counterparts.

(Operator Instructions) Now as I turn the call over to Mr. Frank O'Neil, I would like to remind you that the call is being recorded, and there will be a time for questions after the conclusion of prepared remarks.

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Frank B. O'Neil, ProAssurance Corporation - Senior VP of IR & Chief Communications Officer [2]

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All right. Thank you, Drew. On our call today, we have Chairman and CEO, Stan Starnes; our Chief Operating Officer and Chief Financial Officer, Ned Rand; and Howard Friedman and Mike Boguski, the Presidents of our Healthcare Professional Liability and Workers' Compensation operations. Stan, will you start us off?

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William Stancil Starnes, ProAssurance Corporation - Chairman, President & CEO [3]

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Thank you, Frank. As I said in our news release, the trends that we discussed at length with you during our February year-end conference call are continuing into 2018, and that bolsters our optimism for the future. I do not believe anyone with any knowledge of healthcare professional liability can ignore the fact that the business climate is starting to change. And we stand to benefit over the long-term because of our superior financial strength, keen understanding of the market and our ability to meet the liability needs that our competitors cannot address.

In Workers' Compensation, Eastern's differentiated products and specialized underwriting are producing profitable results in a market that is as competitive as anyone can remember. I know that always is a source of concern for some investors, and we'll discuss our continuing confidence and the value Syndicate 1729 is creating for the organization.

We'll start with a brief overview of the consolidated financial results from Ned.

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Edward Lewis Rand, ProAssurance Corporation - Executive VP, COO, CFO & CAO [4]

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Thank you, Stan. We saw a 5% increase in gross premiums written in the quarter. Workers' Compensation led the way with an 8.5% increase, which highlights the success of our Great Falls renewal rights transaction in New England late last year. Premiums and Specialty P&C were up 2.7%. However, both segments were somewhat offset by a 2.8% decline in gross premiums written in our Lloyd's segment.

In addition to achieving strong retention, we continue to find opportunities to write properly-priced new business, despite the competitive market.

In the quarter, we wrote a total of 3 -- $30.4 million in new business, and much of that was written through broker submissions, underscoring the importance of the successful broker outreach we've undertaken.

Our coordinated sales and marketing strategy produced $8.8 million of business, an increase of $1.1 million year-over-year.

The consolidated current accident year net loss ratio was 81.5%, an increase of approximately 0.5 point over first quarter 2017 and reflective of our continued uncertainty about the long-term loss trends in healthcare professional liability, something Howard will have more details on in his comments.

Our net favorable loss development was $22.8 million, with favorable development from all 3 operating segments. More about that in our segment discussions.

Our expense ratio was down 0.6 points compared to first quarter 2017, primarily due to lower share-based compensation expenses in our Corporate segment, reflecting reduced incentive compensation levels.

With regard to our investment-related results, our net investment result was $23.7 million, down $1.3 million due to reduced earnings from our fixed income portfolio, primarily reflecting lower investment balances resulting from our capital management initiatives. We recorded net realized investment losses of $12.5 million due to mark-to-market adjustments.

Of note, as a result of the tax changes enacted at the end of 2017, we have divested about half of what was a $632 million annuity bond portfolio, given their reduced tax efficiency. We recorded a small gain on those sales, and the proceeds have been or will be invested in corporate bonds, taxable municipal bonds and some asset-backed securities.

Last quarter, we also mentioned our ongoing analysis of the base erosion and anti-abuse tax, or BEAT that could have imposed additional taxes on the premiums we cede to our segregated cell captive operation in the Cayman's. However, we expect the captive cell owners will elect to be taxed as U.S. taxpayers, which would exclude the premiums ceded to those cells from the scope of the BEAT. As a result, we believe any remaining in-scope premium will fall below the threshold for application of the tax as the BEAT is currently structured. We can elaborate more on this in future quarters. But we're not making any provisions for higher taxes due to the BEAT at this time.

On the subject of taxes, the net realized investment losses I mentioned previously contributed to a significant increase in our income tax benefit, which was $3.4 million in the first quarter versus $1.2 million in Q1 2017.

In summary, net income for the quarter was $11.9 million or $0.22 per diluted share. Operating income for the quarter was $21.5 million or $0.40 per diluted share. At March 31, our book value was $29.28 per share, further reflecting the net realized losses in the period. And at the end of the quarter, we held approximately $103.2 million in unpledged cash and liquid investments outside our insurance subsidiaries. Frank?

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Frank B. O'Neil, ProAssurance Corporation - Senior VP of IR & Chief Communications Officer [5]

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Thanks, Ned. Let's dive now into our segment discussions with Howard Friedman in Specialty P&C. Howard?

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Howard Harley Friedman, ProAssurance Corporation - Chief Underwriting Officer, Chief Actuary & President of Healthcare Professional Liability Group [6]

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Thanks, Frank. I'll echo Stan's comments. The healthcare professional liability market does feel as if the tide that lifted all boats is starting to go out. Just in the last 3 weeks, we have seen 2 smaller competitors receive downgrades from A.M. Best, 1 after posting a combined ratio of 180 for 2017. Another significant competitor in the Northeast is now on negative watch.

Industry-wide, we continue to see a number of reports of large verdicts and while our paid loss data remains relatively stable, we are reflecting caution about this severity movement in our loss picks. The other concern for the future is that when severity increases, frequency often follows due to the publicity that large verdicts invariably generate. We've seen this before and the end result is typically a hardening of the market that benefits companies such as ProAssurance, when competitors with weaker balance sheets and potentially weaker reserves feel the pinch. While I recognize there could be some short-term pain, the long-term outlook is encouraging.

For our Specialty P&C segment, gross premiums written grew 2.7% in the first quarter. Within that $3.7 million increase was $1.9 million resulting from one of our insured facilities, bringing risks previously placed elsewhere into their ProAssurance contract. We believe that's another sign that we offer a product that larger entities prefer. We also wrote a $1 million policy for a multistate dental group. This was a broker-driven submission and bears out 2 points: first, our broker outreach continues to produce results; and second, that consolidation in health care continues. The idea that you could aggregate enough dentists to reach a premium level of $1 million would have been unheard of even 5 years ago.

Our premium retention in the physician line, which is the single largest line in the segment, was 91% for the quarter; that's a 1-point increase over Q1 2017. And pricing on renewing physician business, a key indicator of market strength, was up 1% quarter-over-quarter.

Renewal pricing in health-care facilities, where we see some of our largest policies, was 3% higher quarter-over-quarter. We view this as another indication that the healthcare professional liability market seems to be a little less price-competitive.

Our current accident year net loss ratio for the quarter was 90.4%, up 1.7 points over the first quarter last year, as we continue to be cautious in our view of upcoming litigation trends and as we reflect changes in our overall mix of business as it shifts towards larger policies and more complex risks.

Favorable reserve development continues to be strong, although lower than last year, something we had expected and tried to communicate. In the quarter, we recognized $20.6 million of favorable net loss reserve development in Specialty P&C.

Finally, our underwriting expense ratio increased 1.3 points compared to last year's first quarter, primarily due to acquisition costs associated with higher commission expenses on the larger policies we are writing, somewhat offset by an increase in net premiums earned as compared to 2017. Frank?

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Frank B. O'Neil, ProAssurance Corporation - Senior VP of IR & Chief Communications Officer [7]

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Thank you, Howard. Now we'll bring in Mike Boguski for comments about first quarter results on Workers' Compensation. Mike?

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Michael Leonard Boguski, ProAssurance Corporation - President of Eastern Insurance [8]

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Thank you, Frank. The Workers' Compensation segment operating results were $2.8 million for the 3 months ended March 31, 2018, consistent with the $2.9 million produced in the same period in the prior year.

Gross premiums written increased 8.5% to $91.3 million for the 3 months ended March 31, 2018, compared to $84.2 million for the same period in '17. This includes new business writings of $16.6 million during the quarter compared to $14 million in the first quarter of 2017.

Our 2018 new business results included $3.7 million related to the 2017 Great Falls renewal rights transaction, as Ned previously mentioned. We continue to be pleased with the integration and our geographic expansion into New England.

Order premium was $1.3 million in the first quarter of 2018, a slight increase compared to the $1.2 million in 2017.

Renewal pricing decreased 2.6% in the quarter, while premium retention was 86% compared to 89% for the same period in 2017. The renewal pricing and premium retention results reflect continued price competition in the Workers' Compensation marketplace.

We were successful in renewing 9 of the 10 available alternative market programs in the quarter. The program that did not renew was a result of a strategic decision by the program owner to access the captive.

Overall, alternative market program gross written premium increased 4.5% in 2018 compared to the same quarter in 2017, reflecting new business writings of $2.9 million and a premium retention of 91%.

The first quarter 2018 accident year loss ratio in our traditional business was 66.1%, consistent with the 66% booked for the same period in 2017. We continue to experience favorable trends in claim closing results, which have offset the impact of renewal pricing decreases.

We successfully closed 21.8% of 2017 and prior claims during the quarter, a strong result to start 2018 and consistent with recent trends. Favorable reserve development was $1.9 million in the quarter compared to $2.4 million in the first quarter of 2017, primarily related to alternative market business, but also includes approximately $400,000 in both periods related to the amortization of purchase accounting fair value adjustments for our traditional business.

The decrease in the 2018 expense ratio reflects the increase in net premiums earned and effective management of operating expenses.

The 2018 combined ratio of 92.6% includes 1.5 percentage points of intangible asset amortization and 1.2 percentage points of a corporate management fee.

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Frank B. O'Neil, ProAssurance Corporation - Senior VP of IR & Chief Communications Officer [9]

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Thanks, Mike. I'm going to ask Howard to bring his update on Lloyd's, but I also want to remind you that the results of our 58% participation in Syndicate 1729 are reported on a 1 quarter lag. Two other reminders: first, as we mentioned last quarter, we increased our participation in Syndicate 1729 to 62% as of January 1. Second, Syndicate 6131, the special purpose arrangement, or SPA, began writing on a quota share basis with Syndicate 1729 as of January 1. Due to the 1 quarter reporting lag, both changes will begin to be reflected in our operating results next quarter.

So with that, I will ask Howard to tell us about Lloyd's.

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Howard Harley Friedman, ProAssurance Corporation - Chief Underwriting Officer, Chief Actuary & President of Healthcare Professional Liability Group [10]

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Thanks, Frank. Gross premiums written were down approximately $350,000 quarter-over-quarter to $12.4 million. Lloyd's is in a very competitive environment, and the Syndicate's attention to disciplined underwriting and proper pricing led to loss premium that was not fully offset with new business, although we did write $3.6 million of new business in the quarter.

Net premiums earned were $12.5 million, a 14.3% decline quarter-over-quarter, due to an increase in ceded premiums earned, as ceded premium increase results from revisions made last year to the Syndicate's reinsurance program to provide more protection and capacity. This created a relatively-higher proportion of ceded premium since reinsurance on the property catastrophe business, which is now more heavily reinsured, earns over a 12-month period, while reinsurance on many other classes of business earns over 24-months.

A decrease in net premiums earned was the primary factor driving a 2.7-point quarter-over-quarter increase in the net loss ratio. Also contributing was a decrease in net favorable prior year development as compared to last year, as well as fourth quarter losses resulting from the California wildfires.

It's important to note that the Syndicate, like the overall Lloyd's market, makes every effort to evaluate and establish accurate initial reserves for each loss event. However, the nature of the business with some coverage provided in the aggregate for events like windstorms or [various layers] on individual large risks, makes the initial estimates subject to change as additional information becomes available and underlying claims are resolved.

The Syndicate takes a conservative approach to establishing initial loss estimates, often increasing the overall loss expectation for the given underwriting year rather than absorbing initial loss reports in IBNR. All that's to say, that while we think the Syndicate's loss reserves are conservative and will develop favorably over time, there will be some lumpiness in this segment.

Underwriting and operating expenses were up approximately $1 million over the first quarter 2017. This was due mainly to increased staffing to address the anticipated growth in Syndicate 1729's operations and, to a lesser extent, new operational expenses connected to the start-up of the SPA, Syndicate 6131, which is focusing on contingency and specialty property business.

We believe the addition of a skill set of underwriters with proven track record of success in writing these short-tailed risks adds important diversification to the Lloyd's segment.

Our early indications for next quarter are that the results will unfortunately be comparable to this quarter, as the Syndicate continues to see attritional losses from the 2017 year of account at higher-than-expected levels.

We remain optimistic, though, that the 2018 underwriting year will reflect improved results given the pricing improvements that the Syndicate is seeing. Frank?

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Frank B. O'Neil, ProAssurance Corporation - Senior VP of IR & Chief Communications Officer [11]

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Thank you, Howard. Stan, I know you specifically wanted to address Lloyd's as you wrap things up.

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William Stancil Starnes, ProAssurance Corporation - Chairman, President & CEO [12]

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Thanks, Frank. It's clear from some of the meetings we've had with investors over the past few months that our investment in Syndicate 1729 and we do view it as an investment, is a cause for concern for some. I want to take a moment to again lay out our vision and assure you that it is our judgment that Lloyd's is an important part of the future we see unfolding for ProAssurance.

First, I assure you that we are cognizant of the fact that we have committed significant capital to the Syndicate. At the same time, I think our proven record of effective capital management should reassure you that we do not commit capital to Lloyd on a whim. Like any other start-up, the Syndicate will take some time to reach its full potential, and market conditions admittedly have made it harder than we expected or could have predicted. However, I want to emphasize our continued confidence in Duncan Dale and his team. But our vision is more than just participation in the ultimate underwriting profitability of the Syndicate. We know that having the ability to address international risk, especially in our life sciences division, will open up new opportunities that would be almost impossible, were it not for Lloyd's. And we are seeing opportunities open internationally for us through our contacts associated with the Syndicate. While these opportunities are small, we do believe that the world of litigation environment is trending closer to the American model for better or worse. And we are positioned to benefit when and where we are willing to commit our capital and expertise.

Finally, we are building real value at Lloyd's. The capital we have committed has tenancy rights and that alone has value. We also have a stake in the underwriting operations, the fee business of the Syndicate. And that has value now, and can have a mixed value as the book of business grows.

As I said, we understand that our Lloyd's Syndicate segment is not making any positive contribution to our bottom line at the moment. However, we are confident that Lloyd's will provide us opportunities to write profitable business outside our borders, just as we were confident that carefully adding strategic pieces to address the evolution of risk in the United States would ultimately boost our bottom line. And as for our domestic operating subsidiaries, I think you can feel the optimism in our remarks. The healthcare liability market shows signs of turning, as we have always known it would. And we are operating profitably in the niche we have created in Workers' Compensation.

And that cycle will turn when the national and package players see the results of their unsustainable pricing.

In short, we continue to run strong in a long and challenging race. I am extraordinarily optimistic. Thank you.

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Frank B. O'Neil, ProAssurance Corporation - Senior VP of IR & Chief Communications Officer [13]

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Thank you, Stan. Drew, we'll turn over the call for questions now.

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Questions and Answers

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Operator [1]

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(Operator Instructions) The first question comes from Paul Newsome of Sandler O'Neill.

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Jon Paul Newsome, Sandler O'Neill + Partners, L.P., Research Division - MD of Equity Research & Senior Insurance Analyst [2]

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I was hoping you could give us a little bit of a history lesson from your perspective on medical malpractice turns. And presumably, we're going to see more losses before we really see any big price increases because there always seems to be a lag between recognition of trend change. But could you tell us kind of what historically has happened in your opinion? If there is anything today that would make it different in terms of when -- when we would see sort of an inflection point between when the claims start showing up and then you see the resulting price increases? Just what historically has happened?

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Howard Harley Friedman, ProAssurance Corporation - Chief Underwriting Officer, Chief Actuary & President of Healthcare Professional Liability Group [3]

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Paul, it's Howard. Yes, for the history lesson, okay, even before my time, but mid-1970s, early to mid-1970s, significant increase in the frequency of medical malpractice, as it was called then litigation, coming after a long period of time where medical malpractice was an afterthought for most physicians, and sometimes, even covered on their personal lines policies. But there was an increased interest and that's what led to the departure of the commercial carriers, Aetna, Hartford and others, Employers of Wausau, that were offering that coverage in the late '60s and early '70s. With the increased frequency also came increased severity as well, and ultimately, that resulted in the formation of all of the -- what's known as the PIA or bedpan mutual-type companies, the physician and in some cases, hospital-owned carriers in the mid-to-late 1970s. Things settled down for a while, but if you recall, most of the business back then was written on an occurrence basis, and it was just a matter of time before the tail kind of caught up with things. And in the mid-1980s, beginning about 1984, so the losses really began to emerge on that business that had been written by these new companies. And those losses rippled through the industry and all the way through the reinsurance markets as well and the result of that, the latency of those clients and the increased cost and the adverse loss development, resulted in the reinsurance market for occurrence pretty much drying up and most of the business being converted to claims-made. Things kind of settled down because a lot of companies continued to write or -- continued to charge the occurrence price for their first year claims-made coverage and recovered for several years. And then as the 1990s progressed, there was tort reform, and there was tort reform in the mid-to-late '70s. There was another round of tort reform in the mid-to-late 1980s, which in both cases, settled things down for a while. And the marketplace became rather competitive in the mid-1990s, I think analogous to what we have seen over the past 10 years or so now. Some of the commercial carriers came back in, and I think some of the existing carriers got to be a little bit overconfident. And then we saw a big increase in severity in the late '90s, in retrospect '98, '99, but really didn't become evident until around early 2000. And again, a fair amount of adverse loss reserve development that was driven by severity at that point, really not by change in frequency, resulted in several insolvencies, resulted in St. Paul leaving the marketplace and also resulted in capital calls by a lot of the policyholder-owned mutuals and reciprocals and another round of tort reform. So again, that round of tort reform in the early 2000s really had a dramatic effect, it appears on frequency. We think it was the tort reform, lot of other things that may have caused it as well and nobody is really clear. And once again, things kind of got more competitive, frequency dropped dramatically, severity became more moderate and overall inflation in the economy was rather low, as you know, from probably 2005 up through -- up to the present time. So in terms of what's -- what is happening now, not completely clear yet, some of the severity now we think is being driven by the, I think I mentioned this last call, the aggregation of risk, physicians into hospitals, hospitals acquiring other hospitals and becoming larger. So essentially larger targets where physicians independently had $1 million policy limits, now as part of hospitals and employed physicians, really have the whole asset base of the institution behind them. So I think the expectations and the -- certainly on the part of plaintiff attorneys, are looking at larger potential awards and juries are seeing the institutions, in many cases, as being much larger and more capitalized. So that in itself, I think, is driving some of the severity that we see in the market. And again, wanted to point out that we're not really seeing this in our paid data, what we're being cautious about it because of what we're seeing in terms of the news, the verdicts that have come in other areas of the industry, and even in some of the cases that we're seeing and reserving now that have higher damages or higher potential damages. So not sure if that was the history lesson you wanted, but...

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Jon Paul Newsome, Sandler O'Neill + Partners, L.P., Research Division - MD of Equity Research & Senior Insurance Analyst [4]

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No, that's wonderful and very useful. If you're seeing the claims not necessarily in paid, but in sort of your outlook in general, does that mean that essentially there is a little bit more -- I don't want to use this term, there is a little bit more conservativeness in your IBNR and the [actuaries] you're setting today that you're -- because you're factoring in this severity, which you've not seen yet in paid, but you think is -- that looks like it's very much out there? Is that fair?

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William Stancil Starnes, ProAssurance Corporation - Chairman, President & CEO [5]

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I would say yes. I mean, it's certainly the intent in that by establishing higher -- what is essentially a higher initial loss ratio, estimate or higher initial loss pick on the same business, that -- assuming that there isn't a concern about, there is more conservatism there. If there is the change in actuality, then I think we're prepared in those reserves to deal with that. And that's always been our objective is to be prepared to deal with whatever comes our way in the reserves that we establish initially. And at this point in time, that means selecting a higher initial loss pick, which has obviously some short-term impact, but I think, positions ourselves more favorably for the future.

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Operator [6]

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The next question comes from Arash Soleimani of KBW.

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Arash Soleimani, Keefe, Bruyette, & Woods, Inc., Research Division - Assistant VP [7]

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So kind of a similar question. I noticed that, Howard said this time and you guys have also said in the past, you're not seeing it in your paids the severity uptick. But in the release, you also seem to imply that you are seeing trends of increasing severity and that continue to impact the results. So I guess, is it that you're not seeing it at all in your results? Or you're just -- you're seeing that in the market and you're trying to be cautious? I just want to make sure that you're really not seeing any impact in ProAssurance's book of business?

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Howard Harley Friedman, ProAssurance Corporation - Chief Underwriting Officer, Chief Actuary & President of Healthcare Professional Liability Group [8]

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Well, I think, what we're seeing, what we said even last quarter is that we are seeing instances certainly where our claims evaluation, the evaluation of cases that are being reported to us potentially have higher damages, and we're reserving for those on a case basis. So in that regard, you can say we're seeing something potentially. But we'd also say and, as we reiterated this time, that it's not coming through at this point on paid losses. In other words, cases are being resolved now, settlements and payment of verdicts that ultimately go to judgment and we end up paying have not changed more than the kind of severity trend that we've talked about before that's 3% or so. So it's a mixed signal. We're seeing it as the potential being there on open claims or newly-reported claims, but how that plays out, we don't know yet.

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Arash Soleimani, Keefe, Bruyette, & Woods, Inc., Research Division - Assistant VP [9]

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Okay. And I know in your 10-K, you guys say that you bake in a 2% to 3% severity trend in your pricing. So is that still the trend that you're baking in? Or do you see that moving up? And then I think you say like in terms of your reserving, you put an 8- to 10-point cushion above the pricing. So just wanted to see if those metrics have sort of changed at all given what you're seeing in the market?

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Howard Harley Friedman, ProAssurance Corporation - Chief Underwriting Officer, Chief Actuary & President of Healthcare Professional Liability Group [10]

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Yes. I'd say that the -- what we're building in -- it's -- well, first thing it varies by state and it varies by product. But overall, I think that 3% number, let's say, is still a good average -- weighted average estimate of what we're building in for severity trend right now. And the way that we reserve has not changed. In other words, we establish initial reserves at 8 points to 10 points over our expected pricing loss ratio. I'm not using the word cushion, I'm using the word -- the difference between where we establish our initial reserves versus our pricing. We price in order to be competitive, and we reserve more conservatively than that because of where severity might go.

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Arash Soleimani, Keefe, Bruyette, & Woods, Inc., Research Division - Assistant VP [11]

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Okay. And I was surprised with the 1% rate increase in physicians since it looked like it was down from the 2% in 3Q and 4Q of 2017. And I guess the comments you guys have been making it would seem to point to a increase or accelerating rates rather than the deceleration we saw this quarter. So just wanted to know if you had any comments on that?

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Howard Harley Friedman, ProAssurance Corporation - Chief Underwriting Officer, Chief Actuary & President of Healthcare Professional Liability Group [12]

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Well, again a few things. In any given quarter, it's the mix of the business that renews in that quarter in the states that might be more heavily concentrated. The business is not uniform from the perspective of even in the physician book across our book of business by state. There are some states that are much heavier January 1, some states that are more July and so forth. The 1%, I think, it's compared maybe to 1.4% last quarter, if I recall correctly, not significantly different from my perspective. And again, on the physician book of business, particularly the smaller and medium-sized physician business, we think that the rate adequacy is there. We're more concerned about it for the larger accounts and more concerned about it for the facilities where, as you saw, we got a higher average increase. So it really is mix-specific.

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Edward Lewis Rand, ProAssurance Corporation - Executive VP, COO, CFO & CAO [13]

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Yes. The other thing I'd point out, Arash, is that I don't want you to get out of sequence here. We're not talking about a sequential change from Q4 of '17 to Q1 of '18. We're comparing Q1 of '18 to Q1 of '17. So the same business doesn't renew in Q4 of '17 and Q1 of '18. We're comparing quarter-over-quarter. So don't try to draw any kind of rate trend thinking we're talking about a sequential number here.

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Arash Soleimani, Keefe, Bruyette, & Woods, Inc., Research Division - Assistant VP [14]

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Okay, that's helpful. And just -- I had a follow-up on the question I had before when we were talking about the severity trend, and Howard mentioned the 3%. So I guess, what's the -- based on what you're seeing, I guess, do you see the potential for 3% to become 5%? Or is this severity kind of crisis that is potentially occurring? Is it more of just like 1 point? I'm just -- I guess I'm trying to get a sense of how large the uptick in severity could be, like 3 to 5, 3 to 4, just let me...

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Howard Harley Friedman, ProAssurance Corporation - Chief Underwriting Officer, Chief Actuary & President of Healthcare Professional Liability Group [15]

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It's very difficult to say. And I'd love to know the answer myself, obviously, in terms of setting pricing. Right now, again, we're not seeing it directly. We're being conservative on in terms of what we're observing or hearing about in the marketplace, what we're hearing about in terms of reported jury verdicts and that type of thing. If you look back into the early 2000s, there were certainly times where we were using severity trend of 7%, 8%, 9% in our rate filings. I don't see that on the horizon right now. But that -- if you want a historical perspective, that certainly existed there for a number of years.

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Operator [16]

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The next question comes from Amit Kumar of Buckingham Research Group.

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Amit Kumar, The Buckingham Research Group Incorporated - Analyst [17]

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Just a few questions. The first question goes on the broader discussion on the market trend. And I think, Paul was asking about the cycle. Could you talk a bit about how should we think about capital allocation based on the environment? And how does -- how could that potentially impact the special dividend down the road? Because clearly, it seems the trends are turning, which is giving you probably new opportunities. So just refresh us because the special dividend has sort of stayed flat over the past few years?

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Edward Lewis Rand, ProAssurance Corporation - Executive VP, COO, CFO & CAO [18]

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Amit, it's Ned. So I think there is kind of 2 parts to that question, how do we think about capital allocation? Certainly we're keeping an eye on where the markets are headed and want to make sure that we have enough capital to support the business going forward. Funny thing about the -- one of the funny things -- the capital model the rating agency uses is largely driven by premium. You can charge 2x the amount for the same risk and the capital models would say you need twice the amount of capital for that same risk just based on what you're charging. So we're very observant about what's going on to make sure that we have capital to support that. I caution about taking the special dividends we've paid in the past and projecting them into the future, and I think we've said that repeatedly. We make an analysis of our capital needs and the capital we hold every quarter and try to be prudent stewards of that capital, and we will continue to do that.

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Amit Kumar, The Buckingham Research Group Incorporated - Analyst [19]

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The second question I had was on the broader market conditions in the hospital, I guess, business space. One player has exited or told people that they are exiting. What sort of opportunities does that create for ProAssurance?

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Howard Harley Friedman, ProAssurance Corporation - Chief Underwriting Officer, Chief Actuary & President of Healthcare Professional Liability Group [20]

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Yes. I think, it creates certainly some good -- potentially good opportunities. Any time if there is that type of action, smaller player, larger player or whatever, there is dislocation. There are some risks that are met -- would not have gotten on to the market for those upcoming renewal that will be now. There is also, I think, an increased awareness by the brokers and even by some of the larger accounts, the risk managers within hospitals and so forth, when they see that, when they hear about that, that there is a potential flight towards quality. There is a potential flight towards stable insurers, those that they think that they could go with and stay with for a number of years. And that's something that we really have demonstrated and stressed. So the idea of maybe just looking for the next year's premium and the lowest premium takes a little bit of a backseat towards going to a carrier that is going to be around that will be in the market to handle your claims down the road. And I'm not talking about insolvency necessarily. I'm just talking about a company that leaves the market, obviously has less interest in claims handling 3 years down the road because it's not a current customer. So I think all of that benefits us tremendously. And we hope to be able to take advantage of it, and hope that there are others that will, particularly from the commercial side, that make the same decisions about pulling back from the marketplace.

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Amit Kumar, The Buckingham Research Group Incorporated - Analyst [21]

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Got it. The final question is, if I were to sort of step back and your answers to Arash and Paul, you talked about market trends and you also talked about paids for ProAssurance. So clearly, you are being ahead of the curve and you are not witnessing those trends in your own book. Are you surprised by the stock reaction today? Do you think that the market is overreaching on the trend line and getting ahead of itself on the commentary?

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William Stancil Starnes, ProAssurance Corporation - Chairman, President & CEO [22]

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Amit, I don't believe there's anybody in this room that can tell you what the stock market means or what it's doing on any given day. I would simply emphasize to you that we, as always, are very focused on the long term. We are very focused on the long-term profitability for the organization. We are very focused on long-term welfare of our shareholders, and lots of different things motivate investors to take lots of different moves, and we understand that. But we need to remain focused on the things that will serve us well. We're in long tail lines of business. They don't change a whole lot quarter to quarter without some major form of disruption. So we have to be careful, not to be influenced by things that will be of little help to us today and no help to us tomorrow. That's why we regard the long term. Additionally, I think investors are understandably influenced by the perception of the analyst and there's just a wide divergence in the estimates the analysts give of our earnings. And that's why divergence is understandable because of the uncertainties that exist with respect to our lines of business. To give estimates of earnings, you have to make projections as to what the favorable loss development or the adverse loss development is going to be, and we don't have any idea of what that's going to be next quarter until we see the actual results. We are a very result-driven organization. So that wide diversity of expectations probably triggers some of the volatility in our shares. That's not a criticism of you guys. I think you got an almost impossible job and you do it well. But I think it does account for a little bit of the volatility you're seeing. But the message I would give to you and all of our investors is we remain very focused on the fundamentals of our business. We remain very focused on providing long-term value returns to our shareholders. We remain committed to the notion that if we don't have a good use for the capital, we'll return it to the shareholders as we have done in enormous amounts over the last number of years and nothing has changed about that. And so that's part of the reason I remain very, very optimistic about the future as I know that we are focused on the long term and the things that will make us strong for the next number of years.

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Operator [23]

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The next question comes from Mark Hughes of SunTrust.

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Mark Douglas Hughes, SunTrust Robinson Humphrey, Inc., Research Division - MD [24]

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I'll switch to Workers' Comp. Just sort of curious, Mike, I know you have been pursuing a higher-severity strategy. Can you talk about any progress there?

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Michael Leonard Boguski, ProAssurance Corporation - President of Eastern Insurance [25]

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Yes, Mark. We're off to a really good start with our Eastern Specialty Risk unit. In the first quarter last year, we wrote $5 million in premium with an attractive loss ratio. The first quarter of 2018, we wrote $1.8 million in that unit with favorable loss ratios as well. We have not seen claims severity in the unit, and it's contributing to our operating earnings. So we're off to a good start.

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Mark Douglas Hughes, SunTrust Robinson Humphrey, Inc., Research Division - MD [26]

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The corporate expenses in the quarter, am I right in thinking those were a little bit below trend? Anything unusual there? How should we think about that going forward?

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Edward Lewis Rand, ProAssurance Corporation - Executive VP, COO, CFO & CAO [27]

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Mark, this is Ned. As we said in our comments, this really is driven by compensation expense, in particular, the compensation -- the long-term compensation expense, which is driven in part by the results of the organization. And that was down both in kind of the impact of earnings on that as just well as the quantity of awards that have been granted over the last several years.

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Mark Douglas Hughes, SunTrust Robinson Humphrey, Inc., Research Division - MD [28]

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And then the tax rate that was applicable this quarter, what were the puts and takes there when we look at the operating earnings, what was the applicable tax rate?

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Edward Lewis Rand, ProAssurance Corporation - Executive VP, COO, CFO & CAO [29]

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Yes. So I think when you look at operating earnings, the tax rate is around a negative 2.4% or 2% or somewhere in that range. And really you've got a couple of factors. You've got the impact of the municipal bonds that we do hold, which lower us from the 21% rate. Likewise, dividends that will bring us down. But most meaningful, it's the low-income housing tax credits and historic tax credits that we carry. And we get into a negative effective tax rate because we have the ability to carry kind of the excess credits that we've got back 1 year. So we can carry a portion of those credits back to a prior year, which brings us to a negative effective rate in the quarter.

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Operator [30]

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(Operator Instructions) The next question comes from Matt Carletti of JMP securities.

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Matthew John Carletti, JMP Securities LLC, Research Division - MD and Senior Analyst [31]

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Just going to -- just follow-on on the tax question, I guess. Ned, given some of the changes you've talked about in the investment portfolio and kind of over time, the runoff of the tax credits. What's a good kind of run rate to assume as we look forward for income taxes? I assume it's not negative 2% into perpetuity?

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Edward Lewis Rand, ProAssurance Corporation - Executive VP, COO, CFO & CAO [32]

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Not in perpetuity. That negative 2% is based on kind of our view of the tax rate for the year, outside of -- for operating earnings. A lot of variables at play there, so that certainly can change. But as we sit today, kind of a very low single digit or very low single-digit negative tax rate is what we would anticipate. Now like I said, a lot of things that can cause that to change, but that is kind of for the 2018 year what we currently would expect. And then the tax credit again -- I'm sorry, the tax credits -- so we made the tax credit investments in 2009 time range -- time frame. And so we're beginning to see those begin to tail off. So we've got around $21 million or so of tax credits for this year and that number that would be available for next year will reduce and reduce going forward for the next several years.

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Matthew John Carletti, JMP Securities LLC, Research Division - MD and Senior Analyst [33]

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Okay, great. Thank you. And then 2 other questions.

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William Stancil Starnes, ProAssurance Corporation - Chairman, President & CEO [34]

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Matt, let me point out, there is some -- there is a couple of slides in our latest investor deck that provide some level of detail on how those will run off.

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Matthew John Carletti, JMP Securities LLC, Research Division - MD and Senior Analyst [35]

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Okay, great. Next question, if I could just revisit the history lesson real quick, with kind of a follow-on. Kind of the last major cycle, which I think Howard you pointed to, is kind of feeling the most like this one, kind of the late '90s and early 2000s. Once we started seeing severity rise, some downgrades, some competitors leaving the market, kind of where we are today, how long was it before pricing kind of really saw a change? And when it did happen, how sharply did it happen?

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Howard Harley Friedman, ProAssurance Corporation - Chief Underwriting Officer, Chief Actuary & President of Healthcare Professional Liability Group [36]

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So I think the -- we started to see severity at least in terms of being recognized and acted upon in early to mid-2000, at least by some of the companies including ourselves. Pricing began to change at that point for some companies like us, and others really it took over the course of the next 18 months or so. But one thing that I'll point out, though, is that there were some intervening forces there that really accelerated things. One was the departure of St. Paul, which was the largest carrier at the time in the medical professional liability market, announcing at the end of 2001 that there were leaving entirely. And then, 2 or 3 pretty significant failures that began in 1998, '99 and continued up through about 2002, that in combination with St. Paul, diminished the overall market capacity probably by a quarter or so in premium volume. And that, in itself, drove pricing, just supply-demand kind of thing. And so I think, the pricing changes that result, in the absence of anything as dramatic as that in terms of the market availability, I think the pricing changes will take a little while to -- assuming that this severity is accurate and real, when everything else [meets] the severity increase, I think it's going to take a while. The other thing that's different right now is that there are many competitors in the market that have very large capital bases relative to their premium. And while that -- while there was adequate capital, maybe more than adequate capital in the late '90s, it probably wasn't to the same extent that it is right now in terms of the overall industry premium to surplus ratio, just as a rule of thumb kind of thing. I think that will also have a little bit of a dampening effect until some of the loss activity becomes very apparent, and the competitors decide to not use their capital to support it, but actually need to use changes in pricing to respond to it.

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Matthew John Carletti, JMP Securities LLC, Research Division - MD and Senior Analyst [37]

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Okay. And then last question, just thinking about kind of the industry and barriers to entry, as pricing does, let's say, improve over the next however long it takes, couple 2, 3 years. If you think of one end of the spectrum being say property cat reinsurance where alternative capital is readily available and you can kind of get up and running very quickly. How would you characterize the medical liability business today in terms of, if somebody that's been out of the market for a very long time wanted to get back in or a newcomer wanted to get in, in terms of whether it's infrastructure relationships, claims, so be it, how hard is that?

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William Stancil Starnes, ProAssurance Corporation - Chairman, President & CEO [38]

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It's Stan, Matt. I think, it's difficult because this remains a retail business. And by that, I mean, it's a state-by-state business. If you are in this business in 50 states, you are in 50 different businesses. It takes claims people on the ground. It takes a local knowledge that cannot be acquired overnight. From a financial standpoint, I mean, I guess you could be in this business as easily as you could the cat business, but it's the operations that are local and it'll require infrastructure around the country in the areas in which you're operating. There have been some efforts over the last number of years to write it over the Internet or to write the business from one location and they just haven't fared that well. And I think one reason they hadn't fared that well is because at its base, this remains a very local business. And as Howard indicated earlier, and looking at these local businesses, you also have to differentiate between the individual physician business and the larger risk, the hospitals, integrated clinical networks, those sorts of things. And I think the pricing for those will probably behave very differently. You saw the difference in the price increases in this quarter over first quarter last year, and there was a difference in individual physicians and the larger risk. The thing about the larger risk is that there are relatively fewer competitors for those risks. There are not as many companies that have geography in the balance sheet to compete for those risks. And those are the risks that people are beginning to shy away from in terms of staying out or getting out of the market. And if the severity thing proves to be accurate, that's another factor you have to take into account. Remember severity ripples through every open claim you have. So if you've got claims that arose in 2012 and we all do, they were priced with one thing in mind. If severity is what it is in 2017, that's how those claims will have to be resolved. So severity is the big, big kicker. Frequency, we think we can manage because we write essentially a claims-made book of business and don't have much occurrence business of any type. So we think we're well positioned there. But remember, the reason we get so conservative about severity is because it does have an outsized impact in the sense that it goes through every open claim that you have. And what looks to be adequate capital today could be inadequate capital tomorrow simply because of severity. So as you look at the competitive landscape, you have to keep all of those things in mind. Unfortunately, they don't lend themselves to predictions as to when something will happen. And we're not in the business of making those predictions. We have to run the business based on the data we see at the time and the conclusions we draw from that data. I hope that makes some sense to you.

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Operator [39]

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The next question comes from Bob Farnam of Boenning and Scattergood.

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Robert Edward Farnam, Boenning and Scattergood, Inc., Research Division - Senior Research Analyst of Property and Casualty Insurance [40]

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I think just expanding on Matt's question there. The severity questions could be coming from litigation, I would imagine, that's probably the driver. So you really can't tell whether things are going to be changing in terms of litigation environment in the near term. Is that?

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William Stancil Starnes, ProAssurance Corporation - Chairman, President & CEO [41]

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Yes. Remember that one of the things that makes the MPL business different than most other insurance business is that virtually every one of our claims is a lawsuit. And you're right, that's where -- that's the driver of severity. You read in the paper about these big verdicts. Big verdicts produce -- the verdicts happen in relatively small number of cases because -- I mean, while we've been on this call, automobile carriers have had more claims than we'll have in a year. But the small number of cases that produce these big verdicts, it ripples through every open claim you've got, and when the plaintiffs' bar reads about the large verdicts, their settlement demands go up to accommodate that. And that's where you really see the impact of severity is in the rising settlement demands and what happens in that regard in terms of your claims handling. So it's not like the CPI where you can look it up from quarter to quarter. It's something that you have to deal with on a regular basis based on what you're seeing at the time, and I'm fond of saying that we're in a business where we drive down the road with the windshield blacked out and the only view we have is through the rearview mirror. So that's what we have to do in terms of analyzing severity.

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Robert Edward Farnam, Boenning and Scattergood, Inc., Research Division - Senior Research Analyst of Property and Casualty Insurance [42]

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All right. And so I guess, this whole conversation about the historical element is -- yes, back in history, you had crises that -- the premium leaving the market and the rates going up a lot. But you really can't -- just because the severity looks like it's tweaking up now doesn't necessarily mean that anything is coming right around the corner, you could still be in this kind of whole pattern for a while before things really hit the fan, I would imagine.

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William Stancil Starnes, ProAssurance Corporation - Chairman, President & CEO [43]

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It certainly is a possibility. I mean, I don't discount any possibility. I don't discount the possibility of a slow upward trend. I don't discount the possibility of something happen more rapidly than that. We try very hard to make rational, judicious decisions based on what's in the best long-term interest of the organization. I can tell you this from my experience during all of that history Howard talked about is, we all almost always get it wrong in terms of timing.

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Robert Edward Farnam, Boenning and Scattergood, Inc., Research Division - Senior Research Analyst of Property and Casualty Insurance [44]

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Right. Okay. And one, off that topic, so with the Lloyd's operation, I imagine there is still frustration out there just because the -- as you've been years now in that business, it doesn't seem to be improving all that much. I guess, you want to point to the potential of other international opportunities? Is that -- are you looking pretty much in professional liability or you're looking to get into other lines? Maybe just give us an example of what these international opportunities might be for you to build some business there?

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Edward Lewis Rand, ProAssurance Corporation - Executive VP, COO, CFO & CAO [45]

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Rob, this is Ned. I think where we see the opportunities are both in the healthcare professional liability line and our life sciences products liability line. As Stan mentioned in the prepared remarks, we're seeing a lot of the world of litigation environment that is trending towards a U.S. style litigation environment. And as a consequence of that in the healthcare professional liability area, you're seeing increases in severity and frequency of claims in a lot of countries. On the life science side, a lot of development of product and a lot of clinical trial work happens outside the United States, and there are certainly opportunities out there. The focus on the Syndicate over the last number of years has been to build out the infrastructure and to get it up and running, to get it profitable. The challenge has been on -- the level of business that we've written has not been enough for the infrastructure we're building. We know that it'll come over time, but it's not happening as quickly as we'd like because we're being very cautious in how we do underwrite that business. But there will be -- there will come a time where we can really leverage that for these other opportunities. That's where we expect them to come from.

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Robert Edward Farnam, Boenning and Scattergood, Inc., Research Division - Senior Research Analyst of Property and Casualty Insurance [46]

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Right. And all the international opportunities will flow through the Syndicate?

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Edward Lewis Rand, ProAssurance Corporation - Executive VP, COO, CFO & CAO [47]

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Not necessarily. I think a lot of the sourcing may come through Syndicate and then -- it may be business that the Syndicate chooses to write, it may be business that we choose to write more directly through a reinsurance arrangement with one of our U.S. domestic carriers.

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Operator [48]

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And we have a follow-up from Arash Soleimani of KBW.

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Arash Soleimani, Keefe, Bruyette, & Woods, Inc., Research Division - Assistant VP [49]

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How much of the specialty business is on an E&S basis?

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William Stancil Starnes, ProAssurance Corporation - Chairman, President & CEO [50]

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Let's see. I'd say probably and, this is off the top right now, I'd say probably in the 10%, maybe 10% to 15% range overall. We write E&S business for physicians, facilities, allied health. We also write E&S business in our product liability area. And that's why I'm a little bit -- I'm giving you a bit of an estimate right now because just trying to put this together in my head as we go.

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Unidentified Company Representative, [51]

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And Arash, let me clarify this, did I hear you ask how much of the specialty, like ProAssurance specialty?

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Arash Soleimani, Keefe, Bruyette, & Woods, Inc., Research Division - Assistant VP [52]

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Yes, Specialty P&C segment.

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Unidentified Company Representative, [53]

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Oh, okay.

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Arash Soleimani, Keefe, Bruyette, & Woods, Inc., Research Division - Assistant VP [54]

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And the reason I was asking is because in the earnings release, I think you had said that part of the loss ratio impact came from higher loss expectations for E&S. So I guess I just wanted to see why you were mentioning E&S specifically because it looks like the kind of severity trends you guys are mentioning seem like they would be, I guess, more -- outside E&S. It seems like it would also apply to the standard market. So I was just curious why you pointed out E&S in the release.

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Edward Lewis Rand, ProAssurance Corporation - Executive VP, COO, CFO & CAO [55]

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Yes, that's more -- that's one of the places we see a lot of the larger risks because it requires more creativity and more...

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Howard Harley Friedman, ProAssurance Corporation - Chief Underwriting Officer, Chief Actuary & President of Healthcare Professional Liability Group [56]

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Flexibility to write the business.

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Arash Soleimani, Keefe, Bruyette, & Woods, Inc., Research Division - Assistant VP [57]

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Okay, that's fair. And then just a quick follow-up on Lloyd's. I think, the expense ratio you said there came from investments associated with anticipated growth in 1729, and then also with the establishment of 6131. So in terms of the 1729 piece, I guess, what were the investments exactly there? Because I thought from a headcount perspective, that was probably kind of starting to reach the level it was sort of going to level out at?

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Edward Lewis Rand, ProAssurance Corporation - Executive VP, COO, CFO & CAO [58]

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Yes. Arash, that's a great question. So you may recall that Lloyd's right now, we use the services of a turnkey service provider called Asta that handles a lot of the back-office operations. So historically, they have done accounting, they have done systems, they have done HR, they have done actuarial. A lot of that is a back-office work, has been handled by Asta. The plans for the Syndicate are ultimately to migrate away from Asta and have all those services in-house. And so we are slowly decreasing our dependency on Asta and using less and less Asta resource by bringing additional resources into the organization. So as an example, we brought in late last year an actuary to handle reserving and some of the solvency modeling and things like that, that we've relied on Asta for. There is a handover period where you end up kind of doubling up on cost, as you bring somebody in, get them up to speed, get all of the work in processes migrated to those individuals. At the same time, you got Asta providing the services and you double up for a little while. So we're going to see that off and on for the next several quarters as we continue to build out the infrastructure of the organization and bring work internal that is currently being provided by Asta. But as that's being done, we'll have some duplication of expenses.

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Arash Soleimani, Keefe, Bruyette, & Woods, Inc., Research Division - Assistant VP [59]

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Right. So basically, it sounds like you're saying 2018 will be a year of overlap, but then 2019 should be kind of like a clean year.

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William Stancil Starnes, ProAssurance Corporation - Chairman, President & CEO [60]

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Yes, it will depend on when we kind of -- term they use at Lloyds is "turn the key". It will be dependent upon when we make that final transition away entirely from Asta and kind of stand out Dale Underwriting Partners as a truly stand-alone managing agency. It may not be by the end of 2018, I guess, is what I'm saying. So we could see this continue into 2019.

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Operator [61]

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This concludes our question-and-answer session. I would like to turn the conference back over to Frank O'Neil for any closing remarks.

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Frank B. O'Neil, ProAssurance Corporation - Senior VP of IR & Chief Communications Officer [62]

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Thanks, everyone. May the force be with you. And we will talk to you in August.

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Operator [63]

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The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.