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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Good afternoon ladies and gentlemen and welcome to Kemper's third quarter 2019 earnings conference call. My name is Chuck and I will be your coordinator today. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, the conference call is being recorded for replay purposes.
I would now like to introduce your host for today's call, Christine Patrick, Kemper's Vice President of Investor Relations. Ms. Patrick, you may begin.
Thank you Chuck. Good afternoon everyone and welcome to Kemper's discussion of our third quarter 2019 results. This afternoon, you will hear from Joe Lacher, Kemper's President and Chief Executive Officer, Jim McKinney, Kemper's Executive Vice President and Chief Financial Officer and Duane Sanders, Kemper's Executive Vice President and the Property & Casualty Division President.
We will make a few opening remarks to provide context around our third quarter results and then we will open up the call for a question-and-answer session. During the interactive portion of the call, our presenters will be joined by John Boschelli, Kemper's Executive Vice President and Chief Investment Officer and Mark Green, Kemper's Executive Vice President and Life & Health Division President.
After the markets closed this afternoon, we issued our earnings release and published our third quarter earnings presentation and financial supplement. In addition, we filed our Form 10-Q with the SEC. You can find these documents on the Investors section of our website at kemper.com.
Our discussion today may contain forward-looking statements. Our actual results may differ materially from these statements. For information on potential risks associated with relying on forward-looking statements, please refer to our 2018 Form 10-K, as well as our third quarter 2019 Form 10-Q and earnings release.
This afternoon's discussion also includes non-GAAP financial measures that we believe are meaningful to investors. One such measure that I would like to highlight again is as adjusted for acquisition. It is clearly important to understand our reported results, including the impact the Infinity acquisition has to Kemper overall. However, investors have also expressed an interest in understanding the underlying organic performance of the combined businesses. Since our as-reported financials don't include Infinity's historical information prior to the closing of the acquisition and our current results include the impact of purchase accounting, the underlying trends are not easily visible.
In an effort to provide insight into the underlying performance of the combined businesses, we also display our financials as adjusted for acquisition. This view removes the impact of purchase accounting and includes historical Infinity information for periods prior to the closing of acquisition to more easily provide a meaningful year-over-year comparison.
In our financial supplement, presentation and earnings release, we have defined and reconciled all non-GAAP financial measures to GAAP, where required, in accordance with SEC rules. You can find these documents on the Investors section of our website at kemper.com. Finally, all comparative references will be to the corresponding 2018 period, unless otherwise stated.
I will now turn the call over to Joe.
Thank you Christine. Good afternoon everyone and thanks for joining us on today's call. I am pleased to announce yet another strong quarter of financial and operational performance.
You can see this from looking page four. This quarter we made $129 million of net income and $136 million of net income, adjusting for the acquisition of Infinity which you will on the following slide. These numbers are up 40% and 3%, respectively. This translates on a per share basis to $1.91 and $2.01 respectively. Additionally, this resulted in a 37% increase in tangible book value per share and return on average equity, excluding unrealized gains of 13%.
Overall, Kemper generated industry-leading organic growth, we maintained very strong margins and we strengthened our balance sheet. Our strategy and business model continue to perform well. The opportunity for expansion within our specialty auto business remains strong which, coupled with Kemper's diversified business portfolio, should continue to drive industry-leading topline organic growth while producing strong profitability and creating significant long-term shareholder value.
The specialty P&C segment reported very strong results. We generated 10% topline growth with accelerating sequential quarter policy in force growth. We did this while maintaining an adjusted underlying combined ratio of 91%. We continued to outperform our competition. The strength of our model comes from a specialized and tailored focused on our target customers, a sustainable and expanding cost advantage and increasing product sophistication. These three advantages are interconnected. Our success amplifies these advantages and should enable future outperformance.
You can see evidence of this increasing strength in our ability to generate growth across a more diverse set of geographies. This quarter, we had double-digit profitable growth outside of California and its accelerating. Our combined company platform has created strong opportunities within the specialty auto market and we expect that dynamic to continue life.
Our life and health business returned to a more normal level of earnings and delivered modest growth. The stable cash flows and diversification benefits it provides to Kemper continue to enhance shareholder value. Our preferred P&C business turnaround continues. Despite all the positive changes we are introducing, given the modest size of this business, we continue to expect a higher level of ongoing quarterly volatility in both underlying and catastrophe results.
From a financial strength standpoint, we currently maintain roughly $830 million of available and committed contingent liquidity. This liquidity, coupled with our current debt to capital ratio of 16.7% provides us with significant financial flexibility. We also took action this quarter to further fortify our balance sheet through the contribution of roughly $55 million to our pension bringing the liability within a fully funded range.
And with that, I will hand the call over to Jim to discuss the consolidated quarterly financial results in more detail.
Thank you Joe and good afternoon to everyone on the call.
Let's turn to page five to discuss the third quarter financial results. This quarter was another solid quarter for Kemper with top quartile results leading to strong growth in earned premium, adjusted consolidating net operating income per share and net income per share. Earned premiums grew 7.8% to $1.1 billion. Excluding the impact of purchase accounting, net income per share was flat and adjusted consolidated net operating income per share declined 8%, which when normalized for one-time discrete items, would have increased 22%. We will discuss this point in more detail on the next page. These numbers drive ultimate shareholder value creation reflected in this quarter's 21% growth in tangible net book value per share excluding net unrealized gains on fixed maturities and a 20% return on tangible equity.
Turning to page six. I would like to remind you that the third quarter of 2018 was positively impacted by a partial satisfaction of an arbitration judgment and the benefit from tax reform. Excluding those items and a few discrete items in 2019, adjusted consolidated net operating income grew by a robust 22%.
Moving to page seven. Here we isolate the key sources of volatility in our earnings. Adjusting for these sources of volatility, our underlying operating performance continues to increase substantially over the previous year. The combined company operating platform is helping to drive strong shareholder value creation. This is largely a result of market share gains and strong profitability related to our Kemper auto platform. In addition, we are pleased with the increase in life sales and the long-term stability of the cash flows this provides our operating model.
I will now turn the call over to Duane to discuss the results of our P&C segments.
Thank you Jim and good afternoon everyone. Let's start with the specialty P&C insurance segment results on page 8. Our topline continued to see strong growth. Earned premiums increased to $783 million for the quarter, up 10% over the third quarter of 2018. Policies in force increased 7%, demonstrating Kemper's leading competitive position within the specialty auto market. Our third quarter year-to-date as adjusted underlying combined ratio was 92%, a one point improvement over the six months ended June 30.
As Joe mentioned earlier, we are outperforming the competition. We believe, this is driven by the three strengths of our model. First, our specialty market focus targets a combination of nonstandard and Hispanic customers and customers in challenging geographies. Our deep understanding of their needs and the nuances that drive success in these markets provide a competitive advantage. We are also low-cost provider focused on achieving expense efficiencies and effectively manage loss costs which are our products' ultimate cost of goods sold. This is combined with leading product sophistication which allows us to more accurately price within our specialty markets. We are fully realizing the benefits of our franchise as these distinct advantages mutually strengthen each other and deliver a systematic, sustainable competitive advantage and enable us to continue to drive industry-leading results.
On page 9, you can see the results of our preferred P&C insurance segment. Earned premiums were $191 million for the quarter, growing 4% over the third quarter of 2018, primarily reflecting the impact of rate actions taken over the past year. The underlying combined ratio for the quarter was 95%, up slightly from the third quarter of 2018.
Turning to catastrophes. Many of our competitors reported elevated losses this quarter. Our experience, however, was relatively benign, reporting $12 million in losses, compared to $18 million in the third quarter of 2018. This quarter is another example of what we have noted in the past. Based on the size and distribution of our book, combining overall industry losses and market share is not a good predictor of our catastrophe results. This quarter also included a benefit from the negotiated sale of our subrogation rights from 2017 and 2018 California wildfires which was recognized as $15 million in favorable prior year catastrophe development. While underwriting results in this segment remain below our profitability goals, we expect improved actions in claims pricing and underwriting will move us towards our desired results.
I will now turn the call back to Jim.
Thank you Duane. Our life and health division's results are on page 10 of the presentation. Our continued focus on improving distribution capabilities resulted in earned premium growth of 2%. This quarter, the operating profit for the business returned to more typical levels with a benefit expense ratio within a normal range of volatility. During the quarter, we released $15 million in reserves related to ongoing outreach efforts in our life insurance policy payment claims process.
Turning to investments on page 11. Our portfolio remains diversified and highly rated as demonstrated on the bottom left of the page. Looking at the chart on the upper left, you could see the investment performance over the past five quarters. This quarter, we produced $92 million in net investment income, largely in line with our performance in the third quarter of 2018. The liquidity that our operating model creates from the life insurance business permits us to match fund P&C liability. The net result is a decrease in short-term portfolio yield, volatility and its corresponding impact on net investment income. The pretax equivalent annualized book yield of 4.4%, down from 5.2% in the third quarter 2018, is due to a shift in asset mix in connection with the addition of the Infinity portfolio. Also, we increased our investments in corporate owned life insurance. This contributed $3 million to the other income line, compared with $1 million over the prior year. This allocation enhances investment returns with attractive risk characteristics is an example of how we continue to evaluate all options to maximize shareholder value.
On page 12, we highlight our strong capital and liquidity position. In the third quarter, operating cash flows increased $22 million to $367 million, compared to the third quarter of last year. Our increased scale and disciplined operational and financial management continue to enable these results.
Turning our attention to the chart in the upper right of page 12, you can see that our insurance groups are well capitalized. In the upper left hand corner, we present parent company liquidity. At quarter end, we had substantial financial flexibility with $169 million in cash and investments and $660 million in borrowings available from our revolver and our subsidiaries. Our debt to capital ratio was 16.7%, somewhat below our normal range. The combination of all of these items provides substantial flexibility to support continued growth and shareholder value creation.
With that, I will turn the call back to Joe for closing comments.
Thank you Jim. I would like to take a moment to note the other press release we issued today. When I arrived at Kemper four years ago, we needed to fix a number of things in the organization and needed the talent to get moving on those fixes quickly. Mark Green was one of the first people, we brought on board and he took on two core responsibilities, leading the life and health division and a broad business development role. We now reached a point in our evolution where each area will benefit from focused leadership.
As such, I had asked Mark to assume a new position with responsibility for business development and reinsurance. This role leverages Mark's strong entrepreneurial background and many of the skills he has developed over his career. He will continue to lead the life and health division while we search for a leader in that role. I greatly appreciate Mark's efforts over the past three years and I look forward to continued success.
In conclusion, this quarter demonstrated the continuation of our focus to build Kemper's overall value. Our profile of specialized businesses continues to produce revenue growth, solid earnings and attractive shareholder returns. Thanks to the ongoing efforts of our committed team, this quarter's results confirm that our strategy and business model continue to perform well. We are expanding Kemper's reach and our ability to serve specialty markets with easy-to-use, affordable and appropriate insurance and financial solutions.
Now we will turn the call back to the operator to take your questions.
[Operator Instructions]. And our first question will come from Greg Peters with Raymond James. Please go ahead.
Good afternoon team. I had a couple of questions. First of all, just stepping back from the big picture perspective, I think it would be appropriate for your management team to weigh in on some of the frequency and severity trends that we have heard others comment on, both in California and outside of California. And Joe, maybe you can dovetail that with your comments and clarification around your growth outside of California in specialty P&C?
Sure, Greg. I will take a shot at it. And then we will see if anybody else wants to add on top of it. And I will do them almost in reverse order. Our growth outside of California has been a strategic focus of ours. It's not that we don't like California. We do like it. We continue to perform well there. It's an important state for us and we continue to grow inside of California. We saw a distinct opportunity to take the strength of our franchise and grow outside of California and have been doing that.
We described that prior to the Infinity transaction, after the Infinity transaction. It's been a focus of the organization. One of the things we expected might take a little bit of time after the transaction to fully realize some of the internal synergies we needed to get, not expense synergies, but capability synergies and we are seeing those bear fruit and come to fruition and are excited about that growth opportunity again outside of California. It's got nothing to do with not liking the state.
Relative to -- I am sorry. Go ahead.
It's the outside of California. I am sorry to interrupt you, Joe. That was rude.
No. Go ahead Greg. I was shifting comments. So go ahead.
Yes. I just wanted to clarify, is that within existing geographies or there are new geographies involved?
It's largely existing geographies with the definition that they were existing at either Kemper or Infinity prior to the transaction. But in some cases, they were relatively newer states. We have got significant growth in Florida and Texas. We have also got very significant growth in Georgia, to lesser degrees Louisiana, Arizona, some other spots around that. So we are seeing that it's not just one state. All of those states had activity begun prior to our transaction with Infinity. Some were more sizeable than others and as such the smaller ones are having much bigger growth rates. But it's more than one and I think that answers your question.
Yes. It does. Why don't you guys do a little bit more frequency and severity, I think though?
Frequency and severity, in general we are seeing similar trends to what people are describing, other folks have described on frequency. We are seeing modest upticks on severity, a little more in California, a little more in BI. We are not particularly seeing anything that I would describe as crazy outsized. We are seeing a lot of folks talk about social inflation and you know that's interesting, a lot of folks jumping on the bandwagon. We are just not seeing it run through our numbers to the point where we would have looked to coin a phrase and blame it on something. It's just a little normal uptick that's running there. We believe that perhaps if other folks are seeing it, maybe why we are not. Our specialized focus might have a customer group that's a little less exposed to it. We have got a lower limits profile. There may be any number of reasons that have us seeing something a little different but it wouldn't be something we would have poked at to highlight.
Got it. Just another follow-on in the specialty. The improvement was violent and substantial. I think somewhere in your comments, one of you mentioned the possibility for volatility going forward and also maybe you can dovetail that in with comments around where you are on cost savings? I think you had said 80% of your cost savings have been achieved, et cetera.
Okay. So help me understand, Greg. So either we have got a little background noise or I got lost in your question. So the volatility we were describing was relative to our preferred business. It's smaller. What were you asking about specialty?
There was a violent improvement in the results. And so I guess ultimately what I am looking for is the sustainability of these results going forward.
So which results are you specifically pointing? Are you looking at the underlying combined ratio on specialty?
Yes, That's exactly where I am focused.
Hi Greg. We highlighted this last quarter and we will highlight it again this quarter. I think the way to read the numbers is to look at the year-to-date numbers for the loss picks in the other elements. You have got a little bit of intra-year development, favorable intra-year development that's rolling through the quarter this quarter. It doesn't overly change what our loss picks is for the entire year. You are seeing, if you go to page 36 and 37 of the supplement or 37 and 38, relatively in line with year-over-year results and relatively in line with the first quarter picks. So not a whole lot of volatility. It's just how that intra-year rolls through.
And really, to put a really fine point on it, Greg, in the second quarter, we thought we were seeing a little bit of a temperature for the year, you have got a little bit of intra-year development from the first quarter and we were wrong and so you get the positive version of that in the third quarter. So the year-to-date number is really the right way to look at that. And if you think of those together, what you would see is a fairly consistent view on profitability throughout the year.
Right. [Indiscernible] so page 37 and 38, you had --
You are breaking up a little bit, Greg. Can you restate that?
I am sorry. I think the pages 37 and 38, [indiscernible] questions. Thanks.
37 and 38 will show you, if that was your question.
Yes. Thank you.
Yes. Greg, they are just to highlight your as adjusted numbers for the nine months are 92.5% and 91.7% for the quarter. If you look at that relative to prior year of 92.6%, relatively flat when you are thinking about the specialty auto business. If you include CD in the results on a year-over-year basis, we have improved roughly one point in terms of the total combined ratio.
Thank you.
And our next question will come from Paul Newsome of Sandler O'Neill. Please go ahead.
Great. Congratulations on the quarter. I was hoping you would just give a little bit more color on the competitive environment for both the nonstandard auto business as well as preferred? And maybe if there is a contrast between the two?
So you were a little faint, Paul. I think what you said was looking for color or commentary on the competitive environment on separately nonstandard and preferred and a recognition they were likely different competitive environments. I am just confirming that.
Yes. Sorry about that.
No problem. Duane, you want to take a shot?
Yes. Got it. Thanks Joe. So I would say, on the specialty side, albeit first between the two, I would say they are very different because your players in both those spaces are primarily different players. But on the on the specialty side, it is a dynamic that changes across from state to state. And you will see, we will take Florida for example, you will see some competitors that have not had good results are taking significant rate increases, others that have done well, introducing new products. So there is a lot of variation across that but, outside of maybe just a few, no real large swings. I would say it's nuanced and it's marginal up and down.
And then of course, inside the preferred space, you have got a lot of sophisticated players there. And again based on limit distribution and the things that Joe mentioned, where some of that social trend kind of activities taking place, you might see a little bit more than what we are finding and where the specialty products have the lower limit distribution and may not be seeing as much of that adverse impact.
Great. And just a quick, did you fully book all of the subrogation rights returns from the wildfire? Or there a piece that may come later?
No. That's the full net impact results that we are expecting receive, Paul.
Great. Thank you, Congrats on the quarter.
Paul, just to touch just one second on and to add a little bit to Duane. We transitioned, one thing that I think to highlight in terms of that competitive environment and as Duane said relatively stable from what we have seen in the past and the other I think what's important to point out is that our relative competitive strength as a company had increased during that period of time, both because of the scale that we have, our loss cost management capability, our product sophistication and just our overall cost discipline. And the net result of that is, I think you are seeing us continue to be an increasing force inside this space. And I think it's important to look at it on that relative basis versus just purely what the competitive environment is on its own.
Great. Thank you.
Our next question will come from Seth Rosenberg of UBS. Please go ahead.
Hi. Great. Thanks guys. A couple of questions for you. So maybe this dovetails with what Greg was asking in specialty on the frequency and severity. But looking at the results you had in commercial auto this quarter, they are very strong. You are not seeing any of the same trends that others are talking about in regards to attorney involvement and higher severity there. Maybe you can remind us what's in that book?
Yes. I would say, yes, I think the descriptor that we gave and as Joe kind of explained that, that is consistent. Our profile there too is very similar to what we write on the specialty side. So I think, again, we are not immune to it, but certainly the activity is more prominent where you have got bigger limits and where we don't have fleet business. It's a one, it's a two car. It is an artisan, contractor with a pickup truck. So we are finding ourselves in a pretty good spot right now. Again, I am not telling you we are immune to it, but from everything we are seeing today, that's not showing up.
We manage the books, Seth, as much more like a personal lines book of business, given that they are one, two, sometimes three vehicles and we run it and operate it that way where some of the broader industry might look at commercial vehicle and they are thinking about it as a big commercial auto policy, where they are either fleets or there is bigger books and they are trying to do individual account underwriting and it's just a different way of selecting the risks, pricing its limits profile and produces a different result. We are highly confident that we can continue to achieve these results because of the way we are managing the business and selecting the policies and the customers and to somebody degree, it's a different market than the goo that you see when you just look at a stat line of commercial vehicle.
Got it. Makes sense. And then it looks like it's small in terms of discount, but just thinking about the sale of the classic auto book, how should we think about that moving forward? Does that any material impact on to the loss ratio versus expense ratio mix?
Minimally at all. I mean it's a $16 million book. We ceased to write new business actually November 1. Renewals will start to transition out March 1. And again, it's a very minor percentage to the book overall.
Got it. And just one --
Yes. If I can follow-on, you are asking a great question. And I think Duane highlighted it highlighted well. To answer your specific question and sort of its impact on the numbers, the bigger issue is, how do we think about things strategically. We looked at that business and we said we are pretty good at it, we are making a reasonable margin, but when we looked at it, we said it's not better with us than it would be somewhere else. Moving that business to Hagerty probably did a better job for customers. They are doing a better job with it overall. And our ability to create a specialty there, we weren't going to generate long term outsized growth and shareholder value creation. So it was more of a hobby for us than a strategic focus. So it was time to let it thrive with somebody else. The bigger item there is less what it does to our numbers and more how we think about the strategy.
Got it. And it makes sense. And then just one last one, if I can. So I thought you made a good point, but given that the makeup of the book, it's not really effective to look at state geographies and think about cat losses. So just any early indications on how you guys are think about the fourth quarter wildfires in California?
Yes. This is Duane. Yes, I would say, they are within expectations. We are not seeing anything outsized there in terms of either count or size in terms of the individual losses. So nothing really to report.
Okay. Thanks.
[Operator Instructions]. And our next question will come from Christopher Campbell of KBW. Please go ahead.
Hi. Good afternoon gentlemen.
How are you doing, Chris?
Okay. Doing good and yourselves?
Wonderful.
All right. So a quick question for you guys on the specialty P&C expense ratio. It looks like that's normalized and you guys aren't seeing as much of the DPAC gap stuff in there year-over-year. Now it looks more normal where I would expect it. So is like 17% to 18% like a good way we should be thinking about that going forward?
Yes. I think that's a reasonable expectation. And to your point, we highlighted both at the time of acquisition and then in subsequent quarters that there was a really quick run off of kind of the VOBA amortization just due to the overall policy life of the book of business as a whole. I think you will see that both again in pages 37 and 38. I think the expense ratios that you are referencing kind of that 17% to 18% is a reasonable range to kind of think about what a normal kind of expense load for us to incur.
Yes. I think page 20 as well in the supplemental will give you some insight on that too.
Okay. Great. I am sorry. Go ahead.
No. That was it.
Okay. Great. And then I mean should we expand, I mean, as you are growing that? Like what would be like the potential upside for scale-driven economies on that number? Or is that pretty lean where you are at right now?
Chris. I would highly it fairly lean obviously. There will be additional dollars that we get. But in terms of on a ratio basis, it's is impacting thinking about you know an additional point or half point, if you just kind of thinking about a book of business that's over $3 billion, that would be a $30 million-plus number to kind of move that point. I think you should think about at more as kind of the incremental dollars that will add. So if there is five, 10 overtime, we will accrue those things. But in terms of that having a half point impact on the ratio, I am not forecasting that. I think you should really think about that in that 17% to 18% type range.
Said differently, Chris, at this point we think that's very reasonable range and we have got attractive margins. If we were to find more expense savings and synergies, we would likely be deploying that into growing the business rather than expanding the margin because we believe that growing the business at those attractive margins grows earnings per share and grows book value per share and creates more shareholder value than it would be to be pushing the margin down.
And when we do that, that ratio may move around a little bit based on how we are dealing with pricing, but we are at a point where we believe shareholder value creation is best served by expanding our growth in these margins. So I would encourage you not to be trying to model that expense ratio going down because it's just not how we are thinking about driving the business. It may, as we work mix is a different things, but the primary goal is the growth piece of these margins.
Okay. Got it. That makes sense. I am sorry. Okay. Well and then dovetailing on the growth, right? So the earned premiums are up. Probably they are up $70 million in that segment. But then the non-cat loss ratios or like the current accident year loss ratios are down 20 bips. Now I would have expected there to be kind of a new business penalty. So I guess, like, what's the dynamic happening there where you were able to grow premiums by like 10%? And then you are getting lower on accident year margins?
I think, Chris, you are hitting right on the fact that we have got an attractive business model. And Duane sort of went through those points, the specialized focus being good at the target customers, being good at target geographies, bringing on the benefits of scale into our product sophistication, the sizable expense advantage we have now and its increasing our ability to do a better job on loss cost management. Everyone of those items works together to allow us to be a stronger organization and that allows us to generate stronger growth and do that at attractive margins. So all of those things play together and once you have the advantages, it allows you to accelerate.
Okay. Got it. And then if I am just thinking about like your target market? I mean are there areas where you are starting to get saturated? Or is there just that much like greenfield ahead of you? I guess I don't really have like a good way of like thinking about the nonstandard market in some of your geographies and like what your market share is versus what potential could be.
I think probably we are at a point, Chris, when we sit and look at it, we can ride this force for a long time. We are very thoughtfully growing outside of California where you might have looked and said, boy, that's where we might have the most concentration. We are leveraging our strengths to grow outside of those geographies and continuing to be successful there. I think you know we are probably a long way from being tapped out on growth at our size. Give us your $25 billion or $30 billion and I will start worrying about it.
Okay. Perfect. And then just one last numbers question on the preferred P&C auto piece. The underlying combined ratio was up 250 bips year-over-year. I guess any color on what's driving that?
Yes. This is Duane. And I think there you are seeing a little bit of pressure on the new business side. As you would recall, we have introduced a new platform and new product. We actually rolled in our last product in May of this year. So we are now in everywhere we are going to be in. And of course now that it's in, we have got to go back and we are going to dial it in. So we have got a little bit of new business penalty that's in there and the gang is working hard in terms of understanding what those drivers are and making those corrections. It really is a perfect example, Chris, of the two questions in combination where that preferred business we are still working on enhancing our capabilities there and we don't have the same strength and competitive advantages that we do in specialty and the new business penalty you would expect to see you are seeing there and it will work its way in. We have got a longer average customer life. So we have got a longer period of time for that to work its way through. So we can get comfortable that may be a value-added transaction over the long term. But you are seeing the real strength of the specialty franchise, when you compare the two.
Great. Thanks for all the answers. Best of luck in the fourth quarter.
Thank you.
Our next question will come from Matthew Carletti of JMP Securities. Please go ahead.
Hi. Thanks. Good afternoon. Just a quick one, a follow-up I think on Chris's last question there. Joe or Duane, kind of pulling preferred together, can you give us an idea of, kind of the old proverbial baseball analogy, what inning are we in? Or how should we think about how much progress has been made? How much more path there is ahead till we get to a point that you feel you have those competitive advantages and the business's run rate?
Yes. Good question. I think in terms of the efforts and the progress, I would say we have made some huge strides, albeit in terms of getting it to where we wanted, I would hide say we are probably in the middle innings, the fourth, fifth inning of the game with more work to do. I think anytime you launch a new product and Joe mentioned, on an annual policy basis, you have got to get market feedback and you have got to get results. And so we are still truing those up. But with what we have done in terms of the build, the segmentation and all the effort that went in to get it into the marketplace, we now have more insight in terms of what we need to do and that's what we are spending our time.
When we dealt with the issues dealing early on, Matt, the first thing the business needed was a different policy administration system and you have been following the organization long enough to recall that the company had a written off its first version at a more sophisticated policy administration system. Fortunately, we recovered most of that from our arbitration award. But we didn't recover the time.
We put in Guidewire's policy ministration system. That enables us to be much more nimble and much more effective. That had to be done before we could start deploying some of these capabilities. So that's in. We have taken the first shot in a new and updated product and having the new business penalties we would normally expect running through or having the disruption that occurs when you normally convert programs from one rating system and one rating program to a new system and a new program.
So that's running through right now. We expect that to take probably another 12 months to get through the system. And we will continue to improve our capabilities inside of that space. We are going to get hopefully some tailwind help from the claims side because we use parts of our claim department between specialty auto and preferred. We clearly have a focus on some parts of this that are specialty and some that are uniquely preferred.
But there are some pieces like the physical damage adjustments, when you are dealing with the metal on vehicles that very much works back and forth between the two groups. Some of that scale advantage that we are getting and strengthen the specialty side will have a halo effect and eventually work its way into preferred. And as Duane said, it just moves a little bit slower with 12 month policies.
Okay. Great. Very helpful. Thanks for the color. Congrats on the quarter and best of luck going forward.
Thanks a lot.
This concludes our question-and-answer session. I would like to turn the conference back over to Joe Lacher for any closing remarks.
Thank you operator and thanks everyone for your time today and your interest in Kemper. We look forward to speaking with you again next quarter. Thanks.
The conference has now concluded. Thank you for attending today's presentation. You may now disconnect.