Good day, ladies and gentlemen, and welcome to the AMERISAFE second quarter 2016 earnings conference call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session, and instructions will be given at that time. If anyone should require any operator assistance during the conference, please press star then zero on your touch-tone telephone. As a reminder, this conference call is being recorded. I would now like to introduce your host for today's conference, Mr. Vince Gagliano, Chief Risk Officer. Sir, you may begin.
Good morning. Welcome to the AMERISAFE 2016 second quarter investor call. If you have not received the earnings release, it is available on our website at www.amerisafe.com. This call is being recorded. A replay of today's call will be available. Details on how to access the replay are in the earnings release. During this call, we will be making forward-looking statements. These statements are based on current expectations and assumptions that are subject to various risks and uncertainties. Actual results could materially differ because of factors discussed in today's earnings release, in the comments made during this call, and in the Risk Factors section of our Form 10-K, Form 10-Q, and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statement. I will now turn the call over to Janelle Frost, AMERISAFE's President and CEO.
Thank you, Vincent, and good morning, everyone. Thank you for joining the call today as we discuss our second quarter results. Before discussing AMERISAFE's operations, let's talk about the industry as a whole. Companies are fighting to retain renewal accounts. In many cases, the underlying rates for those risks have declined, resulting in a decline in premium. To maintain or grow top line, companies are becoming increasingly competitive, a sign of a softening market. What's preventing a soft market? I believe we have not returned to the soft market or previous cycles because of low investment yields. Underwriting profit is necessary for companies to meet ROE goals. As I stated in our earnings release, AMERISAFE remains unwavering, both in our disciplined underwriting focus on our market niche and in producing consistent and superior results.
This quarter, we reported a combined ratio of 80.4%, an ROE of 13.7%, and earnings per share of $0.87. How did that discipline work this quarter? Gross premiums written declined 2.6%. This decline was a result of audit and related premium adjustments. More importantly, for policies we wrote in the quarter, premium grew 1.1%, and policy count grew 3.4%. Our policy count retention for the quarter was 93.5%, compared to 92.9% in the second quarter of 2015. The effective LCM for the quarter was 173, down from 181 in the second quarter of 2015. Our pricing concessions have been in response to the competitive market, but without losing sight of protecting the underwriting margin. Also, keep in mind, our pricing declines have been moderate and deliberate, coming off from all-time high of 186 in the second quarter of 2014.
As for the audit premium and related adjustments I mentioned, this was a drag to top line, and it was expected. Audit premium continued to remain positive, but not at the same levels as the previous year. This is driven by economic activity in the industries that we insure, and unless there's a significant change in the economy, I would expect this trend will continue in 2016. Relative to losses, the current accident year selection is 67.9%, a 1.9 percentage point improvement from accident year 2015. Coupled with favorable development from prior accident years, the quarter's loss ratio was 54.2%. The favorable development was largely a result of case development experienced in the quarter, primarily in accident years 2014, 2013, and 2009 and prior. Once again, I believe these favorable results are driven by our unique claims management process focused on maximum medical improvement, return to work, and expedient resolution.
Yet another example of our focus on discipline. I will now turn the call over to Neal Fuller, our CFO, to discuss the financials.
Thank you, Janelle, and good morning, everyone. For the second quarter of 2016, AMERISAFE reported net income of $16.6 million, or $0.87 per diluted share, compared with $14.3 million, or $0.75 per diluted share in the same quarter last year, an increase of 16.2%. Operating net income in the quarter was $16.3 million, or $0.85 per share, a 1.7% increase from the second quarter of 2015. Revenues in the quarter decreased by 2.4% to $97.6 million compared with the second quarter last year. Net premiums earned decreased 5.1% to $90.7 million when compared to the second quarter of 2015. This decrease was largely due to $3 million in lower payroll audits that Janelle mentioned previously, as well as an additional $0.9 million in lower assumed premium from mandatory state pooling arrangements.
Net investment income was $6.2 million in the second quarter of 2016, a decline of 10% when compared with last year's second quarter. The decrease was largely due to the decline in value of a hedge fund investment, which is marked to market through net income each quarter. Without the hedge fund, net investment income was down 2.6% compared to the second quarter of 2015. The tax-equivalent yield on our investment portfolio was 3.3% in the quarter, compared with 3.6% in the same quarter last year. There were no impairments or significant realized gains or losses during the quarter. The investment portfolio continues to be high quality, carrying an average double A-minus rating with an average duration of 3.04, with 52% in municipal securities, 32% in corporate bonds and the remainder in cash and other investments.
53% of our investment portfolio is classified as held to maturity, which is in a net unrealized gain position of $23.2 million at June 30th, 2016. These gains are not reflected in our book value per share, as these bonds are carried at amortized cost. With regard to operating expenses, our total underwriting and other expenses increased 2.2% in the quarter to $22.6 million, compared to $22.1 million in the second quarter of 2015. We saw an increase in bad debt expense, largely as a result of a change in estimate for a reduction we made last year in the second quarter, and a slight increase in compensation costs. By category, second quarter 2016 expenses included $6.3 million of salaries and benefits, $6.5 million of commissions, and $9.8 million of underwriting and other costs.
Our expense ratio for the second quarter was 24.9%, compared with 23.1% in the second quarter last year. The majority of the change in expense ratio was due to the decline in net earned premium mentioned earlier, and with the remainder due to the increase in expenses mentioned above. Our tax rate increased to 32.4% in the quarter, up from 28.8% in the second quarter last year. The increase reflects the larger amount of taxable income compared with tax-exempt during the quarter as a result of the increased amount of favorable prior year development. Return on equity for the second quarter of 2016 was 13.7%, compared to 12.3% for the second quarter of 2015. Operating ROE for the second quarter was 13.6%.
On July 26, 2016, the company's board of directors declared a regular quarterly cash dividend of $0.18 per share, payable on September 23rd, 2016 to shareholders of record as of September 9th, 2016. Just a couple of other items to discuss. Book value per share increased 8.8% from year-end to $25.83 at June 30th, 2016. Our statutory surplus rose to $409.4 million at June 30th, 2016, up $38 million from year-end. Finally, AMERISAFE will file our Form 10-Q for the second quarter this afternoon after the market close. That concludes my remarks, and we would now like to open the call up to analysts and investors for our question and answer session. Operator?
Thank you. Ladies and gentlemen, if you would like to ask a question at this time, please press the star and then the number 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. Our first question comes from the line of Matt Carletti with JMP Securities. Your line is now open. If your phone is on mute, please unmute it. Our next question comes from the line of Mark Hughes with SunTrust. Your line is now open.
Thank you very much. Janelle, your point about audit premium trends, do you expect those to continue at kind of roughly the current pace?
We do. We think audit premium will remain positive, but not nearly as robust as it was last year. It will be a drag to top line for at least, I assume, the rest of 2016.
You got, I guess, an easy comparison in the third quarter.
I will.
The hedge fund investment, could you refresh me what drives that and any early read on what the trend has been in three Q?
This is Neal. We have a hedge fund investment at the parent company, it has a large portion of it invested in life insurance stocks. With the Brexit vote coming right at the end of the quarter, those stocks tanked pretty significantly, that drove down the value of the hedge fund investment, which is mark-to-market. Since that time, we believe that those stocks have risen somewhat and recovered some of their value. We think that overall it's still down from where it was at the year-end. We continue to look at that investment and think about that's what's causing the volatility in the net investment income.
The bad debt issue, you highlighted a change, a change in the way you calculate bad debt in the second quarter of last year. Did I hear that properly? If so, are you going to be lapping that? Will we see bad debt recede in the third quarter?
You are hearing that properly. We made an adjustment to our allowance based upon our historical experience last year, second quarter, we took bad debt down by about $1.1 million. The significant increase you see here is just a year-over-year comparison, we don't expect to see that significant increase from a comparative standpoint in future quarters.
Oh, so it was a positive, or you reduced your bad debt expense in this quarter last year, so you had a tough comp. Is that right?
That is correct.
The policyholder dividends, seem like they're a little higher this quarter. What should we expect there?
We would expect them to run at about the rate they've run so far this year, probably about 1% to 1.3%. We have seen an increase in the amount of policyholder dividends as a result of activities that we have in certain states where we compete on the basis of policyholder dividends. We expect them to be around 1% to 1.3% going forward.
Generally, the operating expense ratio, I think, last quarter you had suggested about 25%. Is that still a good number on a go-forward basis?
Yes. We think the run rate will be somewhere between 24% and 25%.
Okay. 24%, 25%. How about the tax rate? Tax rate was a little higher this quarter. What should we use for the rest of this year?
That's a good question. The tax rate is largely driven by the amount of favorable development that we see each quarter. I would look just to the historical record to try to estimate the tax rate.
Right. Maybe this quarter is a little higher than history, and so we might look back at history and use that as our guide. Is that what you're saying?
Yes.
I.e., a little bit lower, perhaps? I know you don't want to say that.
It's going to fluctuate based upon the earnings of the company and the amount of underwriting profit. That's largely what drives it.
I know you've had some initiatives to try to grow the top line. At the same time, competition, I think as you described, has been increasing. How do I think about the competition? When I look at these broader pricing surveys, they have casualty pricing flat, maybe they're down slightly. Gallagher said as much on their call just a little bit ago. You describe pricing being under pressure, your LCM is down a bit, down year-over-year. How do I square that situation?
Yeah, that's a really good question. I guess the question everybody's looking as to where it's going to head in the next few quarters. There is definitely an increasingly competitive market. We're not seeing, and I think I said this on last quarter's call, we're not seeing the irrational behavior we've seen in prior soft markets. We are starting to see some multi-line carriers that have typically, or in the last few years, quarters, have pulled away from workers' comp because it wasn't profitable, deciding that, yes, we will quote some workers' comp. From an AMERISAFE standpoint, you mentioned our sales initiatives. We are starting to, I think, see traction there. I've talked in the past about our green, yellow, red. We are seeing more greens, so we're doing a better job of bringing in the things we want to see.
Our submission count's down. We'd just like to see more of that.
Right. Your voluntary premium was up this quarter slightly. That was the first time in the last three quarters. Do you think you just kind of hold in this range, kind of hold your own, rather than grow?
You know what? That's probably true. Let me rephrase that. We will protect the underwriting margin. We're trying to be as responsive as we can to the market. Only at what we're willing to accept.
Right. As you see it now, are there any new initiatives? You say you're getting more traction, but submissions are still a little bit sluggish, you might say. When you put all that together, does the extra traction get you a little more forward progress, or is that just helping you hold steady?
It really depends on what the competitive market's going to do. I think we're doing a good job of holding steady. I mentioned that we grew policy count, and I talked about a couple of quarters ago on the call that going into this softening market, or if we reach a soft market, policy count is where I was focused because if I can maintain those policies I know I want to keep in our renewal retention rates, which was up this quarter, I feel like we're positioning the company correctly.
Any notable change in the large losses? I think they were actually lower than normal earlier in the year.
Yeah.
That help?
At the end of when we reported first quarter, at the time that we ended the quarter, we didn't have any large losses. I think on the call I alluded to, we had one come in subsequent to the quarter, but before the call. Right now, when we say large losses, that's excess of $1 million. We're at a count of five. Just to put that in some perspective, accident years 2014 and 2015 are at 12. That's not an unusual amount for us. There's nothing in those losses that would cause us to want to change our loss pick for the year.
Understood. Thank you.
Thank you.
Thank you, Mark.
Our next question comes from the line of Matt Carletti with JMP Securities. Your line is now open.
Hey. Good morning. Sorry about that before, my line went dead.
I thought you were using language, Matt.
Right as I clicked over, the line just went silent. Anyway, Mark covered most of my questions. I guess the one I have left is on accident year loss ratio. As we sit here and past several quarters, it sure seems like prior period development is obviously starting to come through pretty strongly from some semi-recent years. It's kind of always been an insurance where when bad things happen in prior years, it has implications for current accident year loss ratios. I guess the question's the opposite of that. If the prior years kind of keep coming through better than expected, is it right of us to think that there's probably ongoing positive implications for the current accident year loss pick going forward?
I believe you know AMERISAFE, and you know AMERISAFE well. We're in a lumpy business. We are conservative about what we do. There's nothing in the underlying data six months in that would cause us to believe our loss ratio needs to change at this point. The frequency's about where we thought it was, severity is about where we thought it was. To your point about the favorable development, that's case by case. That's just how it happens for us. We've had good things happen, but bad things can happen as well.
Right. No, that's a very fair answer. Thanks very much, and congrats on another nice quarter.
Thanks, Matt.
Thanks, Matt.
As a reminder, ladies and gentlemen, if you would like to ask a question, that's star then one. Our next question comes from the line of Randy Binner with FBR & Co. Your line is now open.
Hi, guys. Good morning. This is actually Alex Combs on for Randy Binner.
Yeah.
Good morning. I was wondering if you could touch on the breakout of accident years for the $12.4 million of favorable development.
Sure. Accident year 2014 was $3.8 million. 2013 was $4.2 million. 2012 was $1.7 million. 2011 was $0.1 million. Then 2011 and prior was $2.6 million.
Okay, great. It seems like a big portion of that release comes from the 2012 and 2013 accident years, when we had a mini hard market there.
I'm going to write that.
What's that?
I'm going to write that one down, a mini hard market. I like it.
When we look at your Schedule P kind of as developed workers' comp loss ratios, we think this could kind of get to the 2006-2007 range, which is down to about 50%. I guess, is this consistent with the way that you're looking at 2012 and 2013 data? This would imply a considerable amount of reserve redundancy going forward.
Right. We've been pretty vocal about the fact that the favorable development that we received, and particularly those years that you're talking about, 2012 and 2013, have come from case development. I've said all along, I think that those years from a case reserving standpoint probably were a shift in the paradigm, if you will, because that was coming off of accident year 2010, where we got it wrong, the industry got it wrong. I think we all took a look and said, "Are we being realistic about how we're setting these case reserves?" In particular, return to work. Coming out of the Great Recession, return to work's a large part of what we do, and there weren't jobs to go to, so we factored that into our case reserving, and now I think the company's reaping the benefits of that.
Okay.
That would've been a change from 2011, actually 2012 and forward, which would include 2014, 2015, and 2016.
All right, great. Thanks. That's all I have.
Thank you.
I am showing no further questions at this time. I would now like to turn the call back over to Ms. Janelle Frost for any closing remarks.
Thank you. I began my comments calling this an increasingly competitive time in the market. There are numerous macro factors which influence the direction the market goes from here. Regardless, AMERISAFE is well-positioned for the upcoming twists and turns. Our focus on underwriting discipline, claims management, and expense frugality will continue to support our commitment to our stakeholders. Thank you.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may now disconnect. Everyone, have a great day.