Good day, ladies and gentlemen, and welcome to the American Financial Group 2018 third quarter results. 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. If anyone should require operator assistance during the conference, you may press star then zero on your touch-tone telephone. As a reminder, this conference is being recorded. I would now like to introduce your host for today's conference, Diane Weidner, Assistant Vice President, Investor Relations. Ma'am, you may begin.
Good morning, welcome to American Financial Group's third quarter 2018 earnings results conference call. I'm joined this morning by Carl Lindner III and Craig Lindner, Co-CEOs of American Financial Group, and Jeff Consolino, AFG's CFO. Our press release, investor supplement, and webcast presentation are posted on AFG's website. These materials will be referenced during portions of today's call. Before I turn the discussion over to Carl, I would like to draw your attention to the notes on slide two of our webcast. Certain statements made during this call may be considered forward-looking statements as defined under the Private Securities Litigation Reform Act of 1995. These statements are not guarantees of future performance. Investors should consider the risks and uncertainties that could cause actual results and/or financial conditions to differ materially from these statements.
A detailed description of these risks and uncertainties can be found in AFG's filings with the Securities and Exchange Commission, which are also available on our website. We may include references to core net operating earnings, a non-GAAP financial measure, in our remarks or in responses to questions. A reconciliation of net earnings attributable to shareholders to core net operating earnings is included in our earnings release. Finally, if you are reading a transcript of this call, please note that it may not be authorized or reviewed for accuracy. Thus, it may contain factual or transcription errors that could materially alter the intent or meaning of our statement. Now I am pleased to turn the call over to Carl Lindner III to discuss our results.
Good morning. We released our 2018 third quarter results yesterday afternoon. If you'd turn to slide three of the webcast slides for an overview. Craig and I are very pleased to report a new third quarter record for AFG's core operating earnings of $2.19 per share, up 107% from last year's third quarter, which was impacted by significant cat losses. Our results include strong profitability in our property and casualty operations and excellent results in our annuity segment. Third quarter 2018 annualized core operating return on equity was 15.8%. Net earnings per diluted share were $2.26 and included $0.31 per share in realized gains on securities and a $0.24 adjustment to our A&E reserves. Craig and I thank God, our talented management team, and our great employees for helping to achieve these results.
Based on results through September 30th, we're increasing our 2018 core operating earnings guidance for AFG to be in the range of $8.35-$8.65 per share, up from our previous estimate of $8.10-$8.60 per share, and an increase of $0.15 per share at the midpoint. Our guidance does include a preliminary estimate of approximately $30 million for pre-tax losses associated with Hurricane Michael and the estimated impact of stock market declines in the fourth quarter to date on annuity segment earnings. Craig and I'll discuss our guidance for each segment of our business in more detail later in the call. I'd like to turn our focus to property and casualty operations. Earlier this month, we announced that we reached a definitive agreement to acquire ABA Insurance Services.
ABA Insurance Services is a market-leading provider of D&O and other complementary insurance solutions for banks, small businesses, and nonprofit organizations with a long track record of underwriting success and profitability. We expect the transaction to close later this year, we look forward to welcoming John Wells and his team as our 34th specialty property and casualty business. We're already a leading specialty writer of D&O with attractive niches in nonprofits, private companies, and small accounts. ABA Insurance Services adds another specialized niche within our Specialty Casualty group. If you'd please turn to slides four and five of the webcast, which include an overview of third quarter results. As you'll see on slide four, gross written premiums in our specialty property and casualty insurance operations were flat year-over-year, net written premiums grew by 2%.
A change in the timing of the renewal of two large transportation accounts from the third to fourth quarter impacted reported growth in the quarter. Excluding the timing of these policy renewals, overall specialty property and casualty gross and net written premiums grew by 2% and 5% respectively from the year ago quarter. Property and casualty operating earnings in the third quarter were significantly higher year-over-year. Higher property and casualty underwriting profit, principally due to lower catastrophe losses and higher property and casualty net investment income, primarily the result of higher earnings on limited partnerships and similar investments both contributed to the year-over-year improvement. The strong performance of these investments shouldn't necessarily be expected to repeat in future periods. Specialty property and casualty combined ratio of 95.7% included 3.7 points in favorable prior year reserve development. Catastrophe losses added 2.6 points.
Overall renewal pricing in our specialty property and casualty group was up 2% during the third quarter. That's the highest that we've seen in 17 quarters and above our overall loss ratio trend, which is about 1.5%. Loss cost trends remain stable, we're keeping our eye on inflation and interest rates. Excluding our workers' comp business, overall renewal pricing was up about 3% during the quarter. I'm pleased that we're seeing broader price movement in achieving renewal rate increases in the majority of our specialty property and casualty businesses. In our workers' comp businesses overall, we continue to see pricing pressure associated with strong industry profitability. Despite the rate decreases, we believe we're making appropriate returns in these businesses in the current policy year. I'd like to turn to slide five to review a few highlights from each of our specialty property and casualty groups.
Our Property and Transportation Group reported breakeven underwriting results in the third quarter of 2018, compared to an underwriting profit of $6 million in the prior year period. Improved underwriting results in our ocean marine operations and a higher underwriting profit in National Interstate were offset by lower accident year profitability in several other businesses in this group. Overall results include 0.8 points of favorable prior year reserve development in the third quarter of 2018, compared to 1.5 points in the year ago period. Catastrophe losses for this group were $13 million in the third quarter of 2018, compared to $25 million in the comparable prior year period. Gross and net written premiums for the third quarter of 2018 were 11% and 10% lower, respectively, than the year ago 2017 period.
The decrease was largely the result of a change in the timing of the renewal of two large accounts in one of our transportation businesses from the third to the fourth quarter, as I noted earlier. As well as lower year-over-year premiums in our crop insurance business as we had expected. Gross and net written premium in the other businesses in this group for the third quarter grew by 6% and 4%, respectively, year-over-year. Overall renewal rates in this group increased 3% on average for the third quarter of 2018, with nearly all the business in this group achieving renewal rate increases. Today marks the closing of the 23-day harvest price discovery averaging period for corn and soybean contracts. Based on pricing as of yesterday, corn will finish down 7% and soybeans will finish down 15% from the spring discovery pricing.
National corn and soybean yields are expected to be at record levels. While we're generally comfortable with pricing, crop results are dependent on a state-by-state basis results, with certain states falling below expected profitability. Overall, we anticipate slightly above average crop profitability this year, following last year's very strong results. The Specialty Casualty group reported third quarter underwriting profit of $49 million compared to $2 million in the third quarter of 2017. The year-over-year improvement was primarily attributable to lower third quarter 2018 catastrophe losses within Neon, as well as higher underwriting profit in our executive liability business. The negative impact of catastrophe losses for this group were $12 million and $56 million, respectively, in the third quarters of 2018 and 2017. Gross and net written premiums increased 12% and 11%, respectively, for the third quarter of 2018 when compared to the same prior year period.
Growth within Neon was the primary driver of the higher premiums. To a lesser extent, our workers' compensation and excess and surplus lines businesses also reported higher year-over-year premiums. Renewal pricing for this group was up about 1% in the third quarter, and we continue to see pricing momentum in our social services, excess liability, and D&O businesses. Excluding our workers' comp businesses, renewal rates in this group were up approximately 2%. Our Specialty Financial Group reported an underwriting profit of $9 million in the third quarter, compared to an underwriting loss of $3 million in the third quarter last year. Lower year-over-year catastrophe losses in the lender-placed mortgage property book within our financial institutions business and higher underwriting profitability in our surety business were the primary drivers of this growth.
The negative impact of catastrophe losses for this group were $13 million and $31 million in the third quarters of 2018 and 2017, respectively. Gross and net written premiums increased by 8% and 2%, respectively, in the 2018 third quarter when compared to the same 2017 period, primarily as a result of higher premiums in our financial institutions business. Renewal pricing in this group increased by 6% for the quarter. If you'd please turn to slide six for a summary view of our 2018 outlook for Specialty Property and Casualty operations. Based on the results for the first nine months of the year, we now expect a 2018 combined ratio for the Specialty Property and Casualty Group overall between 93% and 94%. We've narrowed our range from our prior estimate of 92%-94%.
Specialty Property and Casualty Group's calendar year GAAP combined ratio has been between 92% and 94% each of the five preceding years. Our guidance for growth in net written premiums is now in the range of 5%-7%, also narrowed from the 4%-8% estimated previously. Looking at each segment, we now estimate a combined ratio in the range of 94%-96% in our Property and Transportation Group, up from the range of 91%-95% estimated previously. Net written premiums in this group were estimated to be down 1% to up 2% for the year, revised from our previous estimate of flat to up 4%. We now expect our Specialty Casualty Group to produce a combined ratio in the range of 93%-95%, narrowed a bit from the previous range of 92%-96%.
We revised our estimate for growth in net written premiums to be between 9% and 12%, up from our previous estimate of growth of 6%-10%. We revised our expectations for the combined ratio in Specialty Financial Group to be in the range of 89%-91%, up from the range of 86%-90% estimated previously. Our projection for growth in net written premiums is now in the range of 3%-6%, narrowed slightly from our previous estimate of 3%-7%. We continue to expect overall property and casualty renewal pricing this year to be up 1%-2%. Given the strong performance of certain investments, including limited partnerships and similar investments during this first nine months of the year, net investment income is now expected to grow between 15% and 18% year-over-year, a change from the 10%-13% growth estimated previously.
I'll now turn the discussion over to Craig to review the results in our Annuity segment and AFG's investment performance. Thank you.
Thank you, Carl. I'll start with a review of our annuity results for the third quarter, beginning on slide seven. Statutory annuity premiums were $1.38 billion in the third quarter of 2018, an increase of 57% from the prior year period. Sales of traditional fixed and indexed annuities in 2018 by AFG and the industry continue to be significantly higher than sales in 2017. We're pleased with our premium growth, and we continue to earn our targeted returns despite a competitive market. While we've seen third quarter sales growth in all of our channels, production in the retail and broker-dealer markets continues to be particularly strong due to the launch of several new products and our efforts to expand our penetration of these markets. Rising interest rates, as well as the favorable impact of tax reform, allowed us to selectively raise credited rates on new business this year.
Looking back in 2017, the annuity industry faced uncertainty related to the proposed Department of Labor rule, which was later vacated in 2018. Furthermore, interest rates fell in 2017, and in response, AFG implemented several decreases in credited rates in 2017 to maintain appropriate returns on new sales. The rate decreases resulted in a negative impact on premiums in the second half of 2017. Turning to earnings results, pretax annuity earnings were $117 million in the third quarter of 2018, compared to $102 million in the third quarter of 2017, an increase of 15%. The components of fair value accounting are shown on this slide. Under GAAP rules, a portion of the reserves for fixed-indexed annuities is considered to be an embedded derivative and is recorded at fair value based on the estimated present value of certain expected future cash flows.
Assumptions used in calculating this fair value include projected interest rates, option costs, surrenders, withdrawals, and mortality. Variances from these assumptions, as well as changes in the stock market, will generally result in a change in fair value. Some of these adjustments are not economic in nature for the current reporting period, but rather impact the timing of reported results. The impact of fair value accounting for fixed-indexed annuities includes an ongoing expense for annuity interest accreted on the FIA embedded derivative reserve. The amount of interest accreted in any period is generally based on the size of the embedded derivative and current interest rates. We expect both the size of the embedded derivative and interest rates to rise, resulting in continued increases in interest on the embedded derivative liability. In the third quarter of 2018, the stock market increased 7%.
This increase exceeded our expectation of a 1% increase and resulted in a significant favorable impact of $12 million for the quarter. For an analysis of fair value accounting, see our quarterly investor supplement, which is posted on AFG's website. Annuity earnings before fair value accounting for fixed-indexed annuities were $119 million in the third quarter of 2018, up 12% from the prior year period. Turning to Slide eight, you'll see that AFG's quarterly average annuity investments and reserves grew by approximately 10% year-over-year. In addition, as shown in AFG's quarterly investor supplement, AFG's annuity segment results were again favorably impacted by exceptionally high returns on certain investments required to be marked to market, including very strong earnings from limited partnerships and similar investments. These high returns should not necessarily be expected to repeat in future periods.
The benefit of these items was partially offset by the runoff of higher-yielding investments. Please turn to Slide 9 for a summary of the 2018 outlook for the annuity segment. Due to significantly stronger than expected earnings in the third quarter of 2018, we're increasing our guidance for annuity earnings before the impact of fair value accounting for FIAs and unlocking. We now estimate that these earnings will be in the range of $440 million-$450 million compared to our previous guidance of $430 million-$450 million. As a result of the decrease of 9% in the S&P 500 since September 30, 2018, we now estimate that pre-tax annuity earnings, including fair value accounting and the second quarter unlocking charge, will be in the range of $385 million-$425 million, which is lower than our most recent guidance, but equal to our original 2018 guidance.
As you'll see on Slide 10, this guidance indicates fourth quarter earnings of between $44 million and $84 million. This range is significantly lower than recent quarterly results for two primary reasons. Primarily, interest rates and stock market can have significant positive or negative impacts on the annuity segment's results. Due to increases in stock market and interest rates in the first nine months of 2018, the impact of fair value accounting has generally been positive, resulting in a total of $14 million of earnings in the first nine months of 2018. As of yesterday morning, the S&P 500 had decreased by 9% in the fourth quarter. This decrease, assuming no recovery in stock markets before year-end, will have a negative impact on AFG's earnings. This negative impact is included in our updated guidance.
The majority of this negative impact is non-economic in nature and is expected to reverse over time. Much of the remaining impact is economic, but would reverse over time if the stock market recovers. To a lesser extent, as can be seen in our investor supplement, income from the annuity segment's equity in investees , primarily limited partnerships that are required to be marked to market, were $25 million in the third quarter of 2018 and $77 million in the first nine months of 2018, reflecting year-to-date returns of approximately 15%. We are not forecasting such high returns to continue in the fourth quarter of 2018. These earnings expectations do not reflect any potential earnings impact from our annual fourth quarter review or unlocking of major actuarial assumptions in our fixed annuity business.
We continue to emphasize earning the appropriate returns on new sales regardless of the competitive environment. Based on our strong sales year to date, we now expect that our 2018 full year annuity premiums will be up 17%-20% from the $4.3 billion reported in 2017. This is an increase from our previous estimate of growth of between 10% and 15%. The resolution of the Department of Labor fiduciary rule has provided lift for the retail market, and a current demand for shorter surrender charge period products fits well with our product strategy. Our guidance reflects the introduction of new products and opportunities to grow our business in the registered investment advisor and broker-dealer markets. Our recently launched Landmark 5 product targeted for these markets has been particularly successful due to its short duration and simple design.
Please note that fluctuations in the returns on investments, large changes in interest rates and/or the stock market, and higher or lower FIA option costs as compared to our expectations could lead to significant positive or negative impacts on the annuity segment's results. Additional information on the annuity segment's earnings, premiums, investments, and reserves can be found in AFG's quarterly investor supplement posted on our website. Please turn to Slide 11 for a few highlights regarding our $48 billion investment portfolio. AFG reported third quarter 2018 net realized gains on securities of $27 million after tax and after deferred acquisition costs. This compares the net realized losses on securities of $8 million in the third quarter of 2017. As of September 30, 2018, unrealized gains on fixed maturities were $93 million after tax and after DAC.
As you'll see on Slide 12, our portfolio continues to be high quality with 90% of our fixed maturity portfolio rated investment grade and 98% with an NAIC designation of 1 or 2, its highest 2 categories. We've provided additional detailed information on the various segments of our investment portfolio in the quarterly investor supplement on our website. I will now turn the discussion over to Jeff, who will wrap up our comments with an overview of our consolidated third quarter 2018 results and share a few comments about capital and liquidity.
Thank you, Craig. Slide 13 summarizes AFG's core operating earnings results on a consolidated basis. The $2.19 of core EPS is based on core net operating earnings in the quarter of $198 million. The year-over-year increase in core earnings in the 2018 third quarter was primarily the result of strong operating earnings in our insurance businesses. Property and casualty pre-tax operating earnings were 66% higher year-over-year. Specialty P&C underwriting profit was $46 million higher in the 2018 third quarter, primarily due to lower catastrophe losses. P&C net investment income grew $14 million or 15% year-over-year, primarily the result of unusually high returns on certain investments, including limited partnerships and similar investments. 2018 P&C other expenses were $6 million, which was roughly in line with the 2017 third quarter. Pre-tax earnings for our annuity segment increased 15% year-over-year. Interest and other corporate expenses decreased by $2 million.
Parent company interest expense decreased by $6 million year-over-year as a result of our 2017 debt refinancings. Starting in Q1 this year, this line item includes income and expenses related to AFG's previously reported runoff lines of business. Slide 14 provides a reconciliation of core net operating earnings to net earnings. Recall, AFG adopted ASU 2016-01, effective January 1st, 2018, which requires holding gains or losses on equity securities to be recognized in net earnings. The impact to our income statement will vary each quarter, depending on the performance of the securities held in our equity portfolio. In the third quarter of 2018, AFG recognized $27 million or $0.31 per share in net after-tax realized gains. Realized gains increased net earnings in the quarter. Net earnings were reduced by an A&E reserve adjustment of $21 million or $0.24 per share.
According to data provided by S&P Global Market Intelligence, industry three-year survival ratios for asbestos and environmental reserves were 6.7 times paid losses as of year-end 2017. In contrast, the three-year survival ratio for AFG's P&C insurance businesses now stands at 15 times paid losses. As indicated on slide 15, AFG's adjusted book value per share was $57.22 as of September 30th, 2018. Annualized growth in book value per share plus dividends was a very strong 15.6% for the first nine months of 2018. We returned $31 million to our shareholders with the payment of our regular quarterly dividend during the third quarter. Recall on August 21st, we announced an increase in our regular annual dividend by 14%, from $1.40 to $1.60 per share on an annual basis. AFG has increased its dividend in each of the last 13 years. This increased dividend was paid on October 25th.
Parent cash at the end of the third quarter was $250 million. We maintain sufficient capital in our insurance businesses to meet our commitments to the ratings agencies. Our excess capital stood at approximately $865 million at September 30th, 2018. Remember, we plan to hold approximately $200 million to $300 million as dry powder to maintain flexibility for opportunities as they may arise. Our management team reviews all opportunities for the deployment of capital on a regular basis. Wrapping up on page 16, we show a single-page presentation of our updated 2018 core earnings guidance, the midpoint of which has moved up by $0.15 per share. Our guidance assumes an effective tax rate of approximately 19% on core pre-tax operating earnings. AFG's expected 2018 core operating results exclude non-core items such as realized gains and losses, and other significant items that may not be indicative of ongoing operations.
Thank you. We'd like to open the lines for any questions.
Thank you. Ladies and gentlemen, if you have a question at this time, please press the star, then the one key on your touch-tone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. To prevent any background noise, we ask that you please place your line on mute once your question has been stated. Our first question comes from Greg Peters with Raymond James. Your line is now open.
Good afternoon, and thank you for the call. I wanted to just focus on, as far as the Property and Casualty operations are concerned, I was looking at your supplement, and on pages eight, nine, and 10, you provide details on each segment. There was one line item on each of those pages that caught my attention, and that would've been the combined ratio line, excluding catastrophes and prior year development. I noted that in all three lines or all three segments, the combined ratio, excluding catastrophe and prior year reserve development, was not only up on a quarter-over-quarter basis, but also on a nine-month-over-nine-month basis. I was wondering if you could help reconcile the moving parts in each of the segments which are causing this upward trend.
Greg, this is Jeff Consolino. First, thank you for studying our investor supplement. We're pleased when people make use of the information that we provide them with. In past quarters when we talked about trends here, we've always started by saying you've got to look at each of the sub-segments individually. I think that each one has a different dynamic at play. Overall, though, just a reminder that we're aware of these trends, and we certainly look at these trends when we provide our guidance for the year. Whatever you're seeing here on those pages has been fully reflected in our expectations for our earnings results in 2018. If you'll indulge me for a second, let me just go through each of the pages. I'm going to focus on the quarter rather than year-to-date, if you don't mind.
For Property and Transportation, it is correct, we've moved up on that ratio. If you split it between the movement and the underlying loss ratio and the expense ratio, it's 1.2 points higher for the current accident year loss and LAE ratio, excluding cat losses. We talked on our last quarter call about some elevated loss activity in our aviation group and our equine group within this. That, plus some of our international business account for that 1.2-point rise. On the expense ratio, that is 1.3 points higher. Our two biggest business units in Property and Transportation are crop and National Interstate. As Carl talked earlier about crop being slightly smaller year-over-year in terms of premium, and crop also has the lowest expense ratio in the group.
A lower balance of crop business will necessarily elevate the expense ratio a little bit as the other lines of business in P&T take a bigger share. In addition to that, National Interstate, which is better than one-quarter of our earned premium in this segment, had an increase in its expense ratio for what I would term to be internal accounting purposes. We've had them under our ownership for two full years and brought them into our expense allocation architecture. That rose by allocating some of our corporate expenses down into National Interstate and artificially inflated the expense ratio in this segment. For Specialty Casualty, this is a big chunk of our overall business. It's about half of our written premium. Here, our current accident year loss in LAE ratio, excluding cats, actually declined by 1.7 points.
The reason for that is that we've had an improvement in the loss ratio for Neon, excluding cats. Neon is a relatively large unit here. That's being driven by better performance in Neon's underwriting. On the expense side, that rose by four points. I talked about Neon being a relatively big share. Neon's gone from being about one tenth of the earned premium in the segment to about one seventh, and operating at Lloyd's carries a higher expense ratio. That increased the expense ratio in this sub-segment, with Neon being a bigger piece. Another piece of that is Summit, which is another large business unit for us here. They represent nearly a quarter of the earned premium base.
Summit pays policyholder dividends, which we include in expenses, and since Summit's operating results and loss ratio have been very good, the policyholder dividend ratio has risen, which contributed to a rise in the expense ratio. In addition, Summit receives fees for managing some third-party mutual entities. Those entities have declined in size as Summit has grown, and the offsetting expense benefit of managing those has relatively decreased in the quarter. Those are the most significant items I would point to for the expense ratio change there. I can go more quickly on Specialty Financial, which is the last of the three sub-segments. What you're seeing there is driven by our financial institutions business and the lender-placed mortgage property business. We've said in past quarters that you look at the combined ratio with the expense ratio and the loss ratio moving in opposite, countervailing directions.
We had an improvement in the loss and LAE ratio, excluding cats for the current accident year, of a point and a half. All else equal, that would raise the expense ratio because of profit commission components. One last factor that really contributes to the eight-point increase, and this will carry across more broadly, spread across our whole business. With very high cats in 2017, we had a reduction in that commission expense that was effectively clawed back in the third quarter of 2017. That was meaningful, but not present in the third quarter of this year. If you go back for this sub-segment, in the last 10 quarters, the expense ratio has only been under 50% for one quarter, which was a year ago. This really is a return to a more normal expense ratio for the sub-segment rather than indicative of an ongoing elevation or difference.
Again, thank you for studying the supplement and asking the question. I hope that wasn't too much detail, but that's how we'd analyze those three pages you referred to.
Well, that's excellent color, and it's almost like you were prepared for the question, Jeff. I'll stop on that point. Two other topics to discuss. Your investment income guidance and results clearly are tracking ahead of expectations, I'm curious if you have a view on how, call it sustained levels of market volatility might affect this line as we think about 2019.
Hi, Greg, this is Craig. What I would say is the returns on market to market assets have been exceptionally strong year to date through the first nine months, we don't expect that to continue. We would project a more normal rate of something in the neighborhood of 10% or so on a go-forward basis. It can be somewhat lumpy as you know. Our expectation on the lifetime returns would be higher than that. It'd probably be, I don't know, what, 12%-15% or some number like that. In the first year or two, when you make investments in private equity or some of the assets that are market to market, you don't have earnings. It weighs the overall returns down a bit.
From a reported earnings standpoint or investment income standpoint, I would think something more in line with a 10% type number would be a good number to use for projections.
Thank you for that color. Craig, I don't want to steal your thunder, but I did have a question for you in two parts. First of all, can you talk about the competitive environment in the retail side of your business? It looks like you're continuing to do a lot better this year than last year. Secondly, on your guidance, the pre-tax annuity guidance, this is slide nine of your conference call presentation. The range that you updated has been expanded. You lowered it, but you also increased the size of the range, I'm just curious about the mechanics behind that.
Sure. First of all, on the competitive environment, it is a competitive environment. Generally, always is a competitive environment. Having said that, the industry premiums are growing at a very strong rate. As you know, we just raised the guidance for higher premiums to overall premiums up 17%-20%. We think that the industry will probably be a little bit stronger than that. For a number of reasons, and when I say industry sales, I'm talking specifically about traditional fixed-indexed annuities. For a number of reasons, including the elimination of the noise over the Department of Labor fiduciary rule, higher interest rates, volatility of the stock market, just a number of things are really driving the industry premiums to very healthy picture there, even though it is a competitive environment.
On the reason for the wide range at this point in the year, it just boils down to the volatility of the stock market, Greg. The earnings are very sensitive to movements in the stock market. This may help you understand the real underlying fundamentals of the annuity business and what we're projecting in the quarter. We put out a midpoint of guidance yesterday. We got to finalize that number in the middle of the day. Since then, we've had a nice recovery in the stock market. We put out a midpoint of the guidance of $64 million. At that moment in time, the impact of the 9% stock market decline was a little over $32 million. If you normalize the projection that we put out, it takes you up to the mid-90s.
In a normal environment, we view a normal run rate for annuity earnings as being $95 million-$100 million. Certainly, that can change with big swings in interest rates or the stock market. That gives you an idea of the sensitivity or the impact of the really major decline in the stock market since September 30. I'll also tell you that before this conference call, I ran numbers based upon the current level of interest rates and the current level of the stock market. Right before I came into the conference call, it took our best guess from a $64 million midpoint to a high 70s midpoint. That gives you some idea of the sensitivity. This is just a one-day difference, just because of the sensitivity of interest rates and stock market.
That's an interesting answer. Just as a follow-up, I think you said the 9% decline cost $32 million. Is it fair to say that we can think going forward that in any given quarter, if the market moves for every 1% up or down, we can pick up $3.5 million of incremental earnings or lose $3.5 million of incremental earnings just on your existing block?
There are a lot of items that go into, especially fair value accounting. Let me give you a couple of rules of thumb, and they are just that. They're rules of thumb. In a rising stock market, every 1% change has an impact of a half a million to $1 million on both pre-fair value and fair value earnings. At a decreasing stock market environment, each 1% decline has an impact of $1 million to $2 million on both pre-fair value and fair value accounting earnings. Total of $2 million to $4 million. It isn't linear, but that is the impact from a decreasing stock market. Obviously pretty sensitive.
Exactly. Thank you for those benchmarks, and thank you for all the answers.
You bet.
Hey, Greg, this is Jeff. I just wanted to pile on for one moment here. You rightly noted that the range of guidance had expanded for the reasons that Craig then explained. You just go forward one page in that slide deck to slide 10, which is a new slide for us, I think that this is a helpful tool to see really the range of earnings that Craig has presented before fair value accounting is quite tight, reflecting our ability to see with great clarity how the business is going before these non-economic and possibly ephemeral effects of fair value accounting.
What drives the wide range, this outline item on slide 10, impact of fair value accounting, which you can see not only the range for that, then also the assumption with respect to the change in the S&P 500, which in this case is down 5 to down 12. This is an addition to our slide deck to help you get more of a grip around the phenomenon you identified of the wide range.
I appreciate that slide and actually noted that for the fourth quarter, based on what's going on with impact to fair value and just the market, that the year-over-year guidance looks to be down. I guess I can't help myself, just as we're talking about how the changes in market affect
your earnings for the life block. Maybe you could finish up with just how the change in market conditions might affect the sales as well. I promise that's my last question.
Sure. Greg, this is Craig again. What I would say is market volatility is very good for sales. Whenever we see a lot of volatility in the stock market or in particular declines in the stock market, we see more people wanting to reduce risk, and that's very good for the sales of fixed annuities and indexed annuities where, in any given year, you can't lose money.
Okay. Thank you for your answers.
Thank you. Our next question comes from Paul Newsome with Sandler O'Neill. Your line is now open.
Good morning. Just a few here. Small ones, I think. First, I want to ask the timing of the two transportation deals. Should we assume that premium shows up in the fourth quarter, there's sort of an extra benefit there from a revenue perspective?
Paul, this is Jeff. Yes, those shifted to the fourth quarter, as a consequence, our premium guidance incorporates them coming through in the fourth quarter. Obviously, for full year 2018, it washes out Q3 versus Q4, you would see the impact when you look at Q4's reported results this year versus last year once we report fourth quarter earnings.
Okay. Should we expect any update of kind of where your capital position and what you would be interested in doing from a capital management before the year-end, or should we wait? Would it be normal for you to wait till you report the fourth quarter earnings in, I guess, February?
This is Carl. Yeah, I think you can expect an update on capital management between now and year-end. In the past year or really in the past conference calls, we've mentioned that as we see what's on our plate, and we get into finalizing our business plans for next year, we'll review the potential for a special dividend.
Great.
Sometime over the next 30-60 days or so.
Could you give us a little bit of an update on what's going on with Neon? There've been some press reports that there might be some changes there.
I will let Jeff talk about that since he was in London here just recently.
I am not sure exactly, Paul, what press reports you are referring to, but obviously we would not want to comment on any kind of market rumors surrounding Neon's status. We would say, though, that if you follow the trade press closely, which I am sure you do, that the environmental voice is changing. The Performance Management Directorate is taking a very harsh lens and training it on all of the syndicates with a goal towards improving the overall Lloyd's combined ratio. As a result, many industry observers say there has never been more challenge and more pushback on business plans in the market than there is today. That will affect 2019, but that is an ongoing situation that affects Neon, that similarly affects all of the syndicates in the market.
From us, from a big picture perspective in the last couple quarters, Carl's commented that Neon's made improvement, but still not at the level we would like it to be at. We did rebrand and fundamentally change the business starting in 2016 under the leadership of a new management team, and have cleaned up the balance sheet by taking out the legacy liabilities through a reinsurance to close transaction and redone the business plan. Each and every year since then, inclusive of 2016, we have really hit all the benchmarks we have wanted to hit. This new level of scrutiny from Lloyd's, I think, does call into question whether that kind of growth strategy is really going to be feasible in the new environment. Time will tell whether this is a point-in-time thing or a change in Lloyd's overall philosophy.
Fantastic. Thank you, and I will let some other folks ask questions. Appreciate it very much.
Thank you. Ladies and gentlemen, if you have a question at this time, please press star and one on your touch tone telephone. Our next question comes from Larry Greenberg with Janney Montgomery Scott. Your line is now open.
Good afternoon, at least where I am. Thank you. A couple of questions. I'm just wondering first whether you would share what your range of expectations is for partnership income in the annuity segment for the fourth quarter.
Yeah. It would be a more normalized number. Time will tell. We don't get the marks for a while, but it would be a more normalized number, something in the neighborhood of 10%.
Okay. You would expect a positive partnership return, even given what the stock market has done.
We would. As I said, we aren't going to get marks here for some period of time. Typically get them, the ones that we'll book in the fourth quarter. It's based upon marks at the end of the third quarter, those are just trickling-
Right
in right now. We don't have a real good handle on what a precise number might look like, we certainly would expect it to be positive.
Okay, thanks. Then, on slide 10, Jeff, I think you were talking about it. I'm a little bit curious. Your implied guidance has a range for the S&P of down 5%-12%, the commensurate fair value accounting is -$12 million-$42 million. Given that you have $10 million-$12 million built in of interest on the embedded derivative, I would've thought that the negative mark could be a little bit worse. I'm wondering, is that just interest rates offsetting the negative impact of the S&P?
Larry, thank you for being a student of fair value accounting. On that same slide 10-
My head is spinning. I'm trying.
On that same slide 10, at the bottom of the slide, we have also our expectation for the change in the average 5-year and 15-year corporate A2 rates. That's the rate at which the embedded derivative is discounted to present value. As rates rise, that is a benefit. Flipping to the supplement on page 13, you picked off the interest on the embedded derivative. You picked off the change in markets. There's another line item for impact of changes in interest rates, higher or lower than expected. With rising rates expected in the quarter, that would be an offset to the interest component and the change in markets component.
Okay, thanks. Just the last one. For this kind of built-in headwind for the impact of the embedded derivative, is there an offset in terms of pricing on the business or crediting rates that you build into the model?
Yeah. Larry, we are absolutely including that in the pricing analysis and determining what kind of credited rates we can pay.
Great. Thank you.
Thank you. Our next question comes from DeForest Hinman with Walthausen & Co. Your line is now open.
Hi. Thanks for taking my questions. Just to focus a little bit more on the Property and Transportation business, you cited three areas, aviation, equine, and international. Can you walk us through any type of issues there? Is it a continuation of a trend, one-time item? Anything we're doing to kind of address those, I don't know if I want to use the word unsatisfactory, but not that great results there on the underwriting side?
Yeah. This is Carl. I can give a little bit of color. The aviation market, that's a relatively small business for us. One we just started a couple of years ago. As others have been seeing some severity and volatility, and not enough pricing to go along with the business, we've seen some of the same thing. I guess the good news, bad news is there have been a number of competitors that have left the market, which provides opportunities, and our pricing actually, we're beginning to see double-digit increases in pricing there in the quarter. Right or wrong or otherwise, we're going to see just how firm this part of the cycle in that business becomes. Both pricing and terms are changing. We're tightening our underwriting guidelines and we're attempting to improve that business.
In the equine mortality, you can get quarters and years where total losses and horse mortality can be a little bit lumpy in that. We'll continue to make the adjustments we need to make in that business. In our international, there are some startup costs that go along with starting a business in Singapore a number of years ago, and some early mistakes on a few accounts or types of business that we wrote that we pretty much worked through at this point. That would be the color around those three businesses. We're optimistic that we've been making the changes in those businesses to see a bright 2019 or a much brighter 2019.
The comfort level with the fourth quarter cat losses as they relate to the hurricanes, is that based on feet on the ground numbers coming in, or is that more an estimate based on some previous results or third-party services?
This is Jeff. This is not based on modeled output. Sometimes people disclose numbers that just take their portfolio and run it through a commercial model and report that. This is based on reporting back to us from our business units as to what they expect their gross exposures will be. It reflects the application of our catastrophe reinsurance program. We have a lot of confidence around the number, in part because we are a consistent buyer of catastrophe reinsurance. We've indicated in past investor meetings and calls that we've got two towers or pillars of catastrophe reinsurance, one that covers our U.S. Property and Casualty Group and one that covers Neon.
Each one has a $15 million per event net retention, a large gross loss that would affect both pillars would result in $15 million to each in a net retention or a sum of 30. It's pretty hard to drive that number up since we buy a large amount of recurrence protection vertically. The number of 30 for Hurricane Michael that Carl talked about earlier would reflect a full retention loss for each of those two pillars, and that would pretty much cap us out.
Okay. That's very helpful. That's it for me. Thank you.
Thank you. We do have a follow-up question from Paul Newsome with Sandler O'Neill. Your line is now open.
I thought maybe just you could weigh in on the workers' compensation frequency trends issues that seem to be hitting other insurers, and doesn't sound like you're having some of the same issues, but maybe you could give us some of your thoughts based upon your own experience.
Happy to. We're not really seeing the same elevated frequency trends as maybe some others are. Republic actually remains negative in our California business. We really consider Summit relatively flat, though one thing we're watching closely is a year-to-date frequency through the third quarter's up 0.5% year-over-year for lost time claims in all of our Summit states combined. Again, we consider that trend relatively flat, but it's a little bit of a departure from the negative frequency, actually, that Summit's had over the past couple of years. We think that maybe that little tick up is partially attributable to a higher percent of lesser experienced workers out there in this economy. Again, except for you or others asking the question, we wouldn't consider that trend in Summit. We consider that a relatively flat trend in that.
Thank you for all the help. Appreciate it.
Thank you. This concludes today's Q&A session. I would now like to turn the call back over to Diane Widner for closing remarks.
Thank you all for joining us this morning, and we look forward to talking to you again when we share our results for the fourth quarter.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may all disconnect. Everyone have a great day.