Good day, ladies and gentlemen, and welcome to the AMERISAFE third quarter earnings conference call. At this time, all participants are on listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. If anyone should require assistance during the conference, please press star then zero on your touchtone telephone. As a reminder, this conference call is being recorded. I would now like to turn the conference over to your host, Ms. Janelle Frost. You may begin.
Good morning. Welcome to the AMERISAFE third quarter 2012 investor call. If you have not received the earnings release, it is available on our website at amerisafe.com. This call is being recorded. A replay of today's call will be available, and 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 and comments made during this call and the Risk Factors section of our Form 10-K, Forms 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 Allen Bradley, AMERISAFE's Chairman and CEO.
Thanks, Janelle. Good morning, ladies and gentlemen. Thank you for joining our third quarter 2012 earnings call. As usual, I'll make a few remarks and then turn the call over to Jeff and Janelle for more details. First of all, I'd like to take this opportunity to express our condolences to the families of those who lost their lives as a result of Hurricane Sandy. We also wish to express our concern and empathy for all who have suffered mightily as a result of this storm. The news stories and related photographs and videos of the impacted areas demonstrate the dramatic destruction caused to the property and to the communities by the storm. We believe that the resilient and determined residents of the Northeast and Mid-Atlantic states will recover and will thrive once more. Those residents will be in our thoughts and prayers as they strive to return to normalcy.
The third quarter was a solid quarter for AMERISAFE. At the same time, the workers' compensation market exhibited continued signs of stress and disruption. We have observed carriers implementing underwriting programs apparently intended to improve underwriting results, thereby demonstrating their reduced appetite for this line of business. Other writers have exited the market totally. As a result, the number of carriers engaging in aggressive competition has contracted noticeably. While we are not in a full-blown hard market, availability of coverage considerations are growing, and pricing considerations are diminishing. No place is the change more noticeable than in the high hazard workers' compensation risk. Additionally, residual market volumes are rising materially. According to the NCCI, the most recent quarter year-over-year increase in the residual market premium was a remarkable 89%.
This increase is a clear indication that the voluntary workers' compensation market is becoming less flexible in terms of risk selection as well as pricing. Loss cost trends are rising but only modestly. The NCCI's latest round of loss cost or rate changes included 20 states with loss cost and rate increases and only nine states with loss cost or rate decreases. Carriers, however, appear to be focused on increasing rates beyond those required by approved increases in loss cost and rates. Other constituencies have begun to notice these rising costs as well, prompting legislative initiatives to address changes in various state workers' compensation programs. We view all of these changes as an opportunity for AMERISAFE. These opportunities, however, are not without risk, and we recognize it is incumbent upon the management team at AMERISAFE to act accordingly.
I'll turn it over to Jeff for more details on our quarter.
Thank you, Alan, and good morning, everyone. I'll make a few comments about our operational performance and trends before turning things over to Janelle to present a summary of our financials. From an operating standpoint, we had a good third quarter, generating a combined ratio of 98.5 versus combined ratios of 103.8 in the second quarter and 102.3 in last year's third quarter. Our third quarter was highlighted by a 17.6% year-over-year increase in gross premiums written, our seventh straight quarter of double-digit year-over-year increases. As has been the case throughout 2012, the third quarter increase was due to two factors. First, we showed a 16.6% year-over-year increase in premium from policies written during the quarter, which we refer to as deck sheet premium.
Our third quarter deck sheet premium increase was the highest quarterly increase in our public company history, and it occurred during a period of continuing increases in our pricing. Clear confirmation that the overall work comp market is hardening. The second factor in the increase in our growth premiums written was a 22.9% increase in payroll audits and related premium adjustments. Regarding payroll audits specifically, we experienced an 18.8% increase over the year-ago quarter, and we are frankly surprised that audits have continued to be a top-line tailwind for us. We wouldn't have expected this trend, now eight quarters long, to be as prolonged as it has been. These year-over-year quarterly increases in audits will eventually come to an end, but for now, we're happy to benefit from them.
In terms of pricing, our effective loss cost multiplier for voluntary work comp written in the third quarter was 1.66 or 166% of the approved loss costs in the states that use this mechanism for pricing. This pricing represents a year-over-year increase of almost 11% and is the highest level we have seen since we began calculating this metric. Our increased pricing has also contributed to an increase of over 20% in our average renewal premium, which has, in turn, led to a substantial increase in our third-quarter premium retention, from 86.8% in Q3 2011 to a very robust 102% in Q3 2012. In terms of policy retention, we experienced a small year-over-year decrease in the 2012 third quarter to 91.2% from 92.7% in the third quarter of 2011.
Regarding losses, we are seeing some positive signs for accident year 2012, including decreasing claim frequency, both payroll and premium based, decreased reported indemnity claims, and increased closure rates. 2012 is still very green, so we have maintained our net current accident year loss and LAE ratio at 76.5%. We are especially pleased to see our frequency measures decreasing and even more pleased that the decrease is attributed not only to increasing rates, but to increasing exposures and decreasing reported claims as well. Relative to prior years, we experienced stabilizing development in the third quarter relative to prior accident years, resulting in a lowering of our overall ultimate loss in LAE estimate for these prior years by $1.6 million in the aggregate. In her comments, Janelle will provide further color around our loss ratio and its components.
In terms of severe loss experience, we have not seen the proliferation of large claims in 2012 that we have experienced in prior years. Our largest loss year-to-date totals only $1.98 million. We are pleased with this result, but as Alan and I have said repeatedly, we are in a lumpy and unpredictable business providing coverage to very dangerous occupations, and one never knows when a catastrophic loss might occur. For now, though, we can say that 2012 has had a good three quarters of severe loss experience. As I mentioned earlier, our claims closure rate was up again in the third quarter. All three quarters of 2012 have now had increased closure rates. Finally, our paid to incurred ratio decreased for the second straight quarter in 2012, which we view as an indicator of possible case reserve strengthening.
Overall, I can say that I'm very pleased with our third-quarter operating results. With that, I'll turn the discussion over to Janelle for details regarding our financial performance.
Thank you, Jeff. For the third quarter of 2012, AMERISAFE reported net income of $7.1 million, or $0.38 per share, compared to $4.9 million or $0.26 per share in the third quarter of 2011. Gross premiums written rose 17.6% from the year-ago quarter, attributable to $10.2 million of growth in policies written in the quarter and over $3 million in positive audit and related adjustments. Net premiums earned increased 12.4% from the year-ago quarter. Our net investment income totaled $6.8 million in the third quarter of 2012, an increase of 4.7% from the third quarter of 2011. The tax equivalent yield on our investment portfolio was 4.5% for both the third quarter of 2011 and 2012. In total, revenue for the third quarter of 2012 was $80.4 million, up 12% from the year-ago period.
Our current accident year loss ratio for the quarter was 76.5%, compared to 78.2% a year ago. Our incurred loss and loss adjustment expenses totaled $53.9 million for the quarter, which included $1.6 million of favorable prior year development. This compares to loss and loss adjustment expenses of $49.3 million in last year's third quarter, which included $1.1 million of favorable prior year development. In total, our net loss ratio for the third quarter of 2012 was 74.4%, compared to 76.5% for the third quarter of 2011. Total underwriting and other expenses increased 0.9% to $16.5 million, compared to $16.4 million in the third quarter of 2011. The 2012 third-quarter expense components included $5 million of salaries and benefits, $5.4 million of commissions, and $6.1 million of underwriting and other costs. The expense ratio decreased to 22.8% from 25.4% in the same quarter a year ago.
In total, our combined ratio was 98.5% for the third quarter versus 102.3% for the same period in 2011. Return on average equity for the third quarter of 2012 was 7.7%, compared to 5.7% for the third quarter of 2011. Book value per share at September 30th, 2012 was $20.46, an increase of 8.6% from the same period in 2011. Our statutory surplus was $313.5 million at quarter end. Finally, we had strong cash flow from operations of $59.1 million for the first nine months of 2012, compared to $29.8 million in the same period in 2011. We keep cash as a holding company for our share repurchase program, retiring debt, or future acquisitions. To that end, our board extended our share repurchase program through December 31st, 2013. That concludes my prepared remarks on the financials. I now turn to the discussion back to Alan.
Thanks again, Janelle. As I said earlier, AMERISAFE had a solid third quarter. That depiction of the quarter is one couched in relative terms, not in absolute ones. While producing a combined ratio of 98.5% for the quarter or a 99.4% for the year to date may be admirable considering the overall condition of the workers' compensation industry, it is not acceptable to this management team. Our objective is to produce superior returns for our shareholders, we have much work to do to reach this goal. I am convinced that the steps taken thus far have advanced AMERISAFE well down the path toward achieving our goal. On a personal note, I hold options to purchase 439,000 shares of AMERISAFE. Those options were granted in 2005 in connection with the initial public offering of the company, they will expire in November 2015.
I recently entered into a 10b5-1 plan that will permit the exercise of up to 100,000 of those option shares over the next year. I would expect to sell a sufficient number of shares to cover the exercise price of the options and to pay the related tax liability. I presently intend to hold the remaining shares indefinitely. With that, we'll open the call for questions.
Thank you. Ladies and gentlemen, if you have a question at this time, please press *1 on your touchtone telephone. If your question has been answered and you wish to remove yourself from the queue, please press the # key. Again, if you have a question, please press star then 1. Our first question comes from Matthew Carletti of JMP Securities. Your line is open.
Hey, good morning.
Morning, Matt. Hey, Matt.
I just wanted to follow up on, both Alan and Jeff's commentary on pricing and loss trends. It sounds like pricing is continuing to go the right way and that's been going on for a while, and it's nice to see that frequency's down, severities are behaving themselves, the closure rates are up. All that smells to me like accident year loss ratio improvement at some point. Can you walk me through your thoughts there, both in terms of am I thinking about that right? When you might assess that and do you look to adjust 2012 at some point before the end of the year? Do you view that as more of setting a new bar for 2013 when you enter it? Thanks.
Okay. Well, thank you for your question, Matt. First of all, we are seeing an improved picture on pricing as we go forward. As Jeff mentioned, we had a 1.66 or 166% of the loss cost in the third quarter. Just for point of reference, that's an 11% increase over the 1.50 that we had in the third quarter of 2011. In addition to that, volumes are up. We have launched a number of underwriting initiatives. Those underwriting initiatives have dealt with a lot of things of which obviously we don't want to discuss for competitive reasons, but one of which is raising our minimum premium policy to allow us to operate much more efficiently, and to be able to process the flow of applications, which by the way, is up 23% for new business applications. Those are the positive side.
The other side is that we were very disappointed in the second quarter when we had to take a small amount of prior year adverse development as it relates to accident years 2010 and 2011. We're taking a very prudent approach to 2012 accident year, and it appears to be justified at this point that it's prudent. Although, shall we say, there's no pressure on us to raise that loss ratio at this particular point in time. We want to get through the whole year and see what the whole year looks like before we make an adjustment to any current accident year pick, and we want to be very prudent because it's easy to take it down, it's hard to put it back up. That would be the approach that we would look to see on it.
I wouldn't want to promise you, yeah, we're going to look at that, or we'll be able to do that in the fourth quarter. We don't know that, but we do intend to do what we can to avoid these prior year adverse developments that we experienced in the second quarter. Jeff?
Yeah, Matt, great question by the way. I guess I'll add a couple things. First of all, you're exactly right, frequency is looking good. Severities are stable. One of the things I guess I didn't mention was the mix of claims is improving as well. We seem to be trending toward more medical only as a percentage of our whole claims inventory, which bodes well for severity, certainly. From my more granular perspective than Alan's, we still have a lot of headwinds out there when it just comes to adjusting a lot of the claims that we find ourselves trying to deal with. Pain management, return to work issues are still strong. It's still tough to work with the Centers for Medicare & Medicaid Services in terms of settling Medicare eligible claims.
A new kind of phenomenon is the use of more modern medical procedures like modern prostheses and spinal cord stimulators and that kind of thing, as a result of modern medical improvements. As well as an almost epidemic increase in use of opioids and prescribing of opioids by our medical establishment in our covered areas. That currently, and probably even more so than Alan, makes me nervous about taking down an accident year before we really see how it plays out given all of these down in the trenches headwinds.
No, thanks. That's very helpful.
I want you to be sure and note on this call that Jeff said he was more conservative than I was.
I'll be sure to write that down. Just one more question, just kind of transitioning to the topic of leverage and capital. The operating leverage has slowly been improving as kind of rates have risen and the market's turned. I think you're a long way from the kind of 1.4x, 1.5x that I think you've talked about as being optimal or what you'd like to hit at a peak of a market. Is this sort of the ramp where as rates get better and then obviously you like that business more, you'll write more of it and you kind of plan to ramp into that leverage as you reach the peak of a market? Kind of as you do that, do you think that you have ample capital, more than enough capital, and how do you think about capital management in that regard?
I guess leave it there.
Right. Okay. We clearly have ample capital, maybe more than enough capital as one looks at it now. I will tell you that we are seeing many opportunities to grow our business. We have lots of opportunities to take advantage of the disruption in the marketplace. The thought behind my comment that there are opportunities but the comments are not without risk, is that we want to make sure we choose those opportunities appropriately and not just act irrationally and impulsively. We're doing that. I'm fully convinced we're doing that. One other thing that's critically important to remember, by the way, as you see in the expense ratio this time, and I think you will see going forward, we have the right amount of human resources, of people, of infrastructure to support much larger writings without a corresponding increase in fixed cost.
We've got those things, we've got the capital. Is it a perfect match at this point? I think that the way to think of it is to ramp up. I don't think this market is in a full-blown hard market. The filed rates and loss cost are probably the best they have with the available information, but I think you're going to see a several year trend of those continuing to ramp up. We do not want to grow aggressively at a time where we have concerns about the adequacy of the loss cost, okay? We're told from time to time, oh, you need to reduce your rates at this point in time. Our analysis shows that our approach to rates is appropriate, and we intend to stay the course on that. Lower that effective LCM to 158 and you won't believe the dollars that'll flow in.
All right. Well, thank you very much for the answers and continued best of luck.
Okay, thanks.
Thank you, Matt.
If you have a question at this time, please press star then one. Our next question comes from Mark Hughes of SunTrust. Your line is open.
Thank you. Good morning.
Good morning, Mark. How are you?
I'm good. You might have touched on this, I'm sorry, I jumped on a little bit late, but the construction industry, what is your read on the underlying level of activity, and then how do you think about the opportunities there relative to other end markets?
Mark, this is Jeff. Our results have been improving in construction from an experience standpoint. That's the one governing class group where we're growing the most, or at least we grew the most in the third quarter and year to date. There's plenty of room for construction seems to be on the uptick. We're going to take advantage of that as long as we can get the price we want.
Right.
That is our fastest growing governing class code right now.
We're seeing an expansion of exposures in there too, Mark. It's not just rate. We're seeing greater work activity in the construction area. Roofing has been, isn't that right, Jeff? Roofing has been one that has grown pretty remarkably. You get a rate and you get more exposures, more units. I think also we've seen some growth in services as well, another form of our business, as well as the trucking.
Right.
Mark, I don't know if you were alluding to anything related to the recent tragic events in the Northeast, but as you probably know, we do provide coverage in Pennsylvania, Maryland, Delaware, Virginia. In some of those surrounding areas that may have not been impacted as much, we do not provide, we are not even filed in New Jersey and Connecticut, and we have no rates and forms in New York. To see a big uptick from, let's say, some of our construction insureds or roofing insureds move into those areas to try to help in the rebuilding, that wouldn't have a huge impact on our business.
Right.
I didn't know if that was going to apply to your question or not.
I was curious, but I was also interested in the underlying momentum, which seems like it's been building by-
Very healthy
many accounts. Renewal rights deals, do you see many of those? Has there been an increase in that activity? Is that something you're seeing?
A number of those, and that's an increase from before where we were seeing suggestions of acquiring the corpus of companies. As companies reduce their interest in workers' comp, they usually have a book of business they want to perhaps offload. We are pursuing them. I can tell you that it's one of those things that's difficult. We would like to see the renewal rights things, transactions come our way, but we're not going to get away from the severity-driven business. We're not going to get away from businesses in areas where we can service them. Geographic expansion, while possible, is not a primary strategy, it is more of a secondary strategy, and increasing market penetration in the states where we currently do business is the primary strategy. We have seen a number of those, some we haven't been successful with.
You can read into that we did make efforts. We still are seeing submissions even from those that we were not successful with, where agents, there are not a lot of folks that write high hazard business, and there's even fewer of them as we go forward.
Right. You're waiting.
Going to get from that.
You're waiting for your competitor's corpus to become the corp and just take the business that way.
Your words, not mine. Your words.
Happy Halloween.
Yeah. The spirit of the holiday. Those are my only questions. Do you guys have a bet on next Tuesday by any chance, Alan and Jeff?
We bet it's going to be close. I can't tell you, and we've been asked, of course, from time to time, what is the aftermath of it? What impact does that have for the workers' comp industry? I think that's a subject to great debate and great disagreement, like it seems like everything else is surrounding this election.
Yeah. Okay, great. Thank you very much.
Thanks, Mark.
You're welcome.
Our final question comes from Randy Binner at FBR. Your line is open.
Hey, thanks.
Good morning, Randy.
Good morning, Alan. How are you?
Good.
Good.
Good. I guess it's just the growth potential seems good kind of via your commentary around the market and construction. Perhaps some new renewal right flow. I guess what I'd ask is, if I think back to when you were writing more in a hard market, obviously your premium to surplus leverage was quite a bit higher.
Right.
I guess my question is, you're a high hazard workers' comp company. I wouldn't see any reason in my mind why, if the opportunity came along, you couldn't go up to 1.25 or even 1.5. You're a little below 1 now. Is that still true, or would that cause a hiccup at AM Best? Would they pause, or could you just go right to there from here quickly if you needed to on the current capital base?
Good question, I appreciate it because it is a very relevant question. Yes, we could go to 1.25, 1.3, 1.4, perhaps even 1.5. We would like to do that. I'll tell you right now, we would like to move to that level of operational leverage. The problem with leverage is that it works both ways. It's pretty thin when you're at 99.4% combined ratio year-to-date. We would look to expand our leverage, and we are expanding our leverage, but we would not want to get that far out on the limb unless we were sure that we were profitable. Because if you write at a multiple of 1.5 to 1 and you end up having a 1.10, that leverage works the same way, but in the opposite direction.
We do think that's where we're headed in terms of profitability, and we would intend to expand our writings as that profitability improves.
Okay. That's helpful. I guess my two follows would be, I think you kind of covered this with Carletti's question, it seems like at this point that 2009 to 2011 accident year loss ratios that you have up, given that you added a little bit last quarter, you had the commentary around frequency and severity. Are you to the point now where that's becoming much, much less likely to affect your current calendar year profitability? Is that how we should simplistically walk away from this call that 2009 to 2011's less and less in play?
Well, I think it's always the older a year is, the more reliable the numbers are. 2009 is far more reliable than a 2010. 2010 is more reliable than 2011, and 2011 more than 2012. I would tell you as you walk away here today, that if you want to take the idea that we're cautiously, very cautiously optimistic about 2012, that's a fair assumption. We also know that people can do incredibly dangerous things and have incredibly bad outcomes in the business we're in. With our reinsurance structure, we can feel the impact of that rather quickly. It is progressing in a positive fashion. With respect to the prior years, they were very stable during the third quarter, and our results reflect that.
I'm sorry, did you not mention accident year 2011 in all that intentionally, or did I just miss it?
No, definitely. I'm sorry, did I skip it?
No, I didn't know if the inference was that one's probably still probably the most dangerous, right?
It is. Because of its age, it is the one that would have the greatest volatility other than-
Yeah. Okay
obviously the current action year, which isn't even finished yet. Let me make it specific, 2011 was stable during the third quarter.
Yeah. Understood.
Certainly well within what we would've expected to see.
The last question I have, just as far as looking at new opportunities, given the rate increases and then the past underwriting experience of people in the state of California, I don't think that you've been that interested in California historically. Maybe I'm putting words in your mouth, but it seems like you've watched it warily. Is California getting to the point where you could do something there?
We do look at California and keep a reasonably close eye on it. We do think the situation out there is improving. Although, quite frankly, Randy, I'm a little bit perplexed about the latest events. The legislature passed what appears to be some reform in California. There was a pending rate increase for 12% or thereabouts, and so the regulators chose to not approve that. Now, I know in California you can charge whatever rate you want and that carriers are pretty much ignoring whatever the filed position is, but that gives me a little bit of pause in that, think of it this way from our perspective. Cut the rate now, and we'll give you the reforms in the future. That's not exactly the sort of environment we find very enticing to move into.
All right. Understood. That's helpful. All right. Well, that's all I have. Thanks so much. Good quarter.
Thanks, Randy.
Yep.
Thanks, Randy.
Yeah.
Thank you. I'm showing no further questions in the queue at this time. I'll hand the call back to Mr. Bradley for closing remarks.
Thank you again, ladies and gentlemen, for joining us this morning. I want to add another point in that you may have seen our press release yesterday afternoon announcing that our board of directors has selected Jared Morris to act as lead director. The decision to create the position of lead director was based upon our review of recommended structures, governance structures for companies that have an executive serving as both chairman and chief executive officer. Of course, that's what AMERISAFE does. For seven years, Jared has served with distinction on our board of directors and has been a longtime chairman of our nominating and corporate governance committee. He will be an outstanding lead director for this company, and I congratulate him on his selection to serve in that capacity.
On another personal note right at the end here, you know that from past calls that my father's birthday is in November. He is, as always, present in the room. On Monday he'll be 93, so happy birthday, Dad. With that, thank you very much.
Thank you. Ladies and gentlemen, this concludes the conference for today. You may all disconnect and have a wonderful day.