Good day, ladies and gentlemen, welcome to the second quarter 2018 Employers Holdings Incorporated 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 follow at that time. If anyone should require operator assistance during the conference, you may press star then zero on your touchtone telephone. As a reminder, this conference is being recorded. I would now like to introduce your host for today's conference, Lenard Ormsby, General Counsel. Sir, you may begin.
Thank you, Imani. Good morning, welcome everyone to the second quarter 2018 earnings call for Employers. Today's call is being recorded and webcast from the investor relations section of our website, where a replay will be available following the call. With me today on the call are Doug Dirks, our Chief Executive Officer, Mike Paquette, our Chief Financial Officer, and Steve Festa, our Chief Operating Officer. Statements made during this conference call that are not based on historical fact are considered forward-looking statements. These statements are made in reliance on the safe harbor provision of the Private Securities Litigation Reform Act of 1995. Although we believe the expectations expressed in our forward-looking statements are reasonable, risks and uncertainties could cause actual results to be materially different from our expectations, including the risks set forth in our filings with the Securities and Exchange Commission.
All remarks made during the call are current at the time of the call and will not be updated to reflect subsequent developments. In our earnings press release and in our remarks or responses to questions, we may use non-GAAP financial metrics, including those that exclude the impact of the 1999 loss portfolio transfer, or LPT. Reconciliations of these non-GAAP metrics are included in our financial supplement as an attachment to our earnings press release, our investor presentation, and any other materials available in our investor section on our website. I will turn the call over to Doug.
Thank you, Lenard, thank you all for joining us on our call today. We had a strong second quarter, have performed well throughout the first half of 2018. Yesterday, we reported second quarter net income of $42.5 million, net income before the impact of the LPT of $35.6 million, adjusted net income of $31.2 million. Our second quarter adjusted net income increased 58%, or $0.34 per share from a year ago, our underwriting income more than doubled to $25.6 million. Our combined ratio before the impact of the LPT of 89.5% improved by 5.6 percentage points versus that of a year ago, our net investment income was up 12%. In the second quarter, we saw continuing solid new business growth, our top line continues to be challenged by declining rates on renewal business, stemming principally from falling loss costs.
We experienced an average premium renewal decrease of 3.8% during the second quarter, with an average premium renewal rate decline of 9.7%. For the same period one year ago, our average premium renewal rate declined by 2.6%. Our book value per share, including the deferred gain at June 30th, 2018, was $33.92, an increase of 1.8% from March 31st, 2018, including dividends, and our second quarter and year-to-date annualized adjusted return on equity each exceeded 11%. With that, I'll turn the call over to Mike for further discussion of our financial results.
Thank you, Doug. Net premiums written and earned for the second quarter each increased from a year ago, which Steve will address in his remarks. Our second quarter loss and LAE ratio before the impact of the LPT of 53.2% was 10.4 percentage points lower than a year ago. Nine percentage points of that improvement resulted from $16.5 million of favorable prior period loss reserve development relating primarily to accident years 2016 and 2017. The favorable development is the result of our key business initiatives, including accelerated claims settlements, geographic diversification, and the use of data analytics. Our second quarter commission expense ratio of 13.8% was 1.3 percentage points higher than a year ago.
Increases in profitability and growth-related agency incentives, as well as a higher percentage of business produced by our alternative distribution channels, which is subject to a higher commission rate, resulted in the higher commission ratio in the current period. Our second quarter underwriting and other operating expense ratio of 22.5% was 3.5 percentage points higher than a year ago. The increase was primarily the result of our aggressive development and implementation of new digital technologies and capabilities. Net investment income for the second quarter was $20.3 million, up 12% from a year ago. Our pre-tax book yield on the portfolio increased to 3.29% during the quarter versus 3.12% a year ago. Our effective tax rate for the second quarter was 17% versus 24% a year ago.
The reduction in the effective tax rate was largely the result of the Tax Cuts and Jobs Act, partially offset by a higher proportion of fully taxable income during the current quarter. As of June 30, 2018, our fixed maturities had a duration of 4.4 and an average credit quality of double A minus, and equity securities represented 8% of the total investment portfolio. Now I will turn the call over to Steve.
Thank you, Mike, and good morning. Net written premiums for the quarter of $185 million were up $2 million or 1% from the second quarter of 2017. The primary driver of this increase was new business growth, which increased more than $10 million over the comparable period in 2017. The new business premium growth rate of 25.7% quarter-over-quarter was the result of increases of submissions, quotes, and bound policies. We saw double-digit new business growth in both our core as well as our alternative distribution channels. This growth has occurred with both new partnerships as well as long-term existing partnerships. With respect to renewals for the quarter, we continue to see high policy unit retention rates. In fact, for the year, our unit retention rates are up over the comparable period in 2017.
This improved retention result was offset by an overall premium renewal rate decrease of 9.7% for the second quarter versus the rate level in effect on those policies a year earlier. This is driven by the soft market cycle with declining loss costs in virtually all of the states we do business in, as well as a very competitive environment. It should be noted, however, that we continue to see strong payroll pickup during the final audit process, a reflection of the strong economy, and the fact that our policyholders are hiring additional staff, as well as increasing the number of hours worked from existing staff. This increase in payroll has been exceptionally strong over the past four quarters. During the quarter, we entered the states of West Virginia and New Hampshire. We now write business in 42 states as well as the District of Columbia.
We plan on entering the remaining four states that are not monopolistic states during the remainder of 2018, which will complete our national footprint initiative. This will allow us to tap into revenue opportunities that we previously would not have had an opportunity to capitalize on. Mike mentioned earlier our investment in developing and implementing new technologies and capabilities. I want to speak to a couple of examples that have already begun and the expected impact they will have. We have started an initiative that is focused on eliminating unnecessary touchpoints for our customers during the policy life cycle. Much of this will be focused on both the automation of necessary processes, as well as the elimination of touchpoints that don't add value. We know this will improve our customer's experience and will also drive greater internal efficiencies.
We are working on other initiatives tied to improving our customer's digital experience. Some of these initiatives have recently been launched. There are others that will be released in future quarters. We expect the investments we are making in this area will have a positive impact on future revenue opportunities. Now I will turn the call back to Doug.
Thanks, Steve. As we progress into the second half of 2018, our overall accident year results continue to be in line with expectations. New premium growth remains strong, although the steady headwind continues to be declining average premium renewal rates compounded by competitive pressures. Offsetting some of the impact of declining rates are higher than expected payrolls on renewal business and stronger than expected new business growth. We continue to make good progress as we aggressively develop and implement a variety of strategic technology and analytic capabilities, which lead to improving underwriting and claims results and sustainable operating efficiencies. Though many of these initiatives are multi-year in nature, our implementation plans allow us to roll out new capabilities centered on customer and agent experience as they are developed, consequently allowing us to realize financial and operational benefits sooner. With that, operator, we'll now turn the call over for questions.
Thank you. Ladies and gentlemen, if you have a question at this time, please press the star then the one key on your touchtone 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 Mark Hughes with SunTrust. Your line is now open.
Thank you. Good morning.
Good morning.
Mike, could you talk about what accident years these favorable developments, the reserves have come from? Yeah, I'll leave it there. What accident years were affected by this?
Thanks, Mark. What I had mentioned in my comments is it came from 2016 and 2017 predominantly, the majority of which was 2016.
Okay. The loss cost trends have gotten more favorable. You talked about the 9.7% rate decline. Are loss costs declining at the same pace as you see it?
Yes. Mark, this is Steve. That's exactly the way we see it, I don't frankly expect that trend to turn any time in the near future. In fact, as you may know, New York has proposed an overall loss cost decrease of 11.7% for October filing, and we're seeing similar decreases in other states that we do business forecasted for the future. Clearly, our renewal rate is lower because of the declining loss cost, and to some degree, just the very competitive market that we're in today.
Do you think losses are going down faster than that 9.7%?
In some states, I would say that's probably true. I wouldn't make that as a blanket statement across the country as a whole.
The audit premium, I think in some quarters, you've made some comments about the impact on the quarter. How did it affect this quarter? It sounds like it's still positive, but how was it year-over-year?
On a year-over-year basis, year to date, our audit pickup, the actual audit pickup is up 9.1%.
Was that stronger or weaker, or higher or lower in the second quarter?
I don't have that information right in front of me, Mark.
Okay. Very good. Thank you.
Thank you. Our next question comes from Matthew Carletti with JMP Securities. Your line is now open.
Thanks. Good morning.
Good morning.
Actually, I just want to follow up on both questions Mark had, just a little more detail. Maybe start with the favorable development in the quarter. Mike, I caught your comment that most of it was 2016, a little bit 2017. Can you give us a little more detail on where it was coming from? Was it mostly case reserves that have been put up and resulted better? Was it more kind of IBNR and just as it aged, the claims that then come in? Just curious kind of what buckets it's coming out of.
It's largely case reserves, and we've talked about reserve salvage, we've talked about accelerated claims settlement, and as I mentioned, that's what we're seeing, and we're comfortable in reducing our reserving position for those periods as a result.
Okay.
Another component there, Matt, is California Medical continues to develop favorably over expectations. It is balanced. Obviously, the book is tilted towards California, and we're seeing good experience there, but this is more of a national phenomenon, that results are better than expected generally across the board.
Okay. That kind of led into my next question, which is more just on the loss cost side. It sounds like you're pretty happy with what you're seeing. Can you break it out for us, kind of what you're seeing, what's more frequency, kind of what frequency's doing versus what you're seeing in severity? I'm guessing medical is kind of the biggest driver there.
Yeah. The big driver for the decrease in loss cost, Matt, is frequency. The market's seeing that. We're seeing a decrease in frequency as a percentage of payroll as well. That's the big driver for it. Medical inflation has been pretty moderate. That could change in the future, but it's been pretty moderate at this point. The severity is not really the big driver for the decrease in loss costs. It's really the frequency decline that continues to happen in the states that we do business in, not only for us, but the industry as a whole.
Got you. Are there environmental factors that when you look at frequency, the big declines, I think it's been kind of the big debate in the industry is, how long will it continue? I mean, do you, in your book at least, see, can identify some drivers that you think are longer-term trends and that you expect it to continue for the foreseeable future?
Yeah, I think at least in the near term, Matt, I don't see any reason why this frequency decline will turn the other way. There are companies today that we know that are working on automation that will even mitigate some of that risk even more effectively in the future than it does today. I think where there could be a turn is if the economy starts to suffer. The industry saw an uptick in claims, and in particular, in certain states, in the last recession, and that was a result of high unemployment and people making claims that they didn't make while they were employed. I think that's the area where we could see an uptick if the economy turns. Right now, in the short term, I don't see anything that would turn that trend the other direction.
Okay, great. Appreciate the answers. Congrats on a very nice start to the year.
Thanks. Thanks, Matt.
Thank you. Our next question comes from Amit Kumar with Buckingham Research. Your line is now open.
Hey, thanks, and good morning. Just a few, I guess, follow-up questions. Number 1, in the prepared remarks you talked about new employees and hiring picking up. If I recall correctly, in the past, generally when you see new employees come in, they're untrained and there is an uptick in loss cost trends. Can you just talk about what you may or may not be seeing as it relates to these new employees coming into the system?
Yeah, I'll address that one, Amit. I think our book of business is different enough from the industry book as a whole that we're probably less susceptible to that outcome. We do write lower hazard business.
It does generate less severe losses. I guess I would contrast it with a book of business that's heavily tilted towards the construction trades, where not only are you bringing people that might have less experience, but there's a higher likelihood of having a severe injury. I think if in fact what you say is correct, and I'm not disputing it, I'm not certain the data's as clear anymore as it used to be. I do think we're less susceptible to that risk.
Got it. That's a fair point. The second question I had is, maybe you or . There was a comment regarding other initiatives and additional customer initiatives are in the pipeline. Could you just briefly expand on what these other initiatives were which you were referring to?
I'll do it very generally, Amit.
Yes, sir.
We are very actively analyzing and developing plans that utilize different types of technologies and different types of analytical capabilities. It's across the business. It's not purely an underwriting initiative or a claims initiative. We're looking at our agency plant management. We're looking at virtually anything that could benefit from a different technology approach or a different analytical capability approach. It truly will be across the business. Some of it involves core system replacements or upgrades, and some of it is purely new capabilities that we're building that I think will be unique to us given our position in the market.
Got it. That's helpful. The final question I had was regarding competition. Could you expand, is this sort of new competition, the usual competition, or legacy carriers who might have pulled back and who are now looking at the loss trends and are coming back? Maybe just give a bit more color on that. Thank you.
Sure, Amit. This is Steve. First of all, the first thing that comes to mind in response to that question is we are definitely seeing a renewed emphasis from competitors that may be in the market at some point, will be out of the market at a later date. They're more aggressive now than they have been in the past. That's obviously because of the profitability of the workers' compensation product. I wouldn't say that we're seeing any brand-new competitors come into play. I would say that some of our existing competitors are becoming quite a bit more aggressive in terms of both pricing and then also the commissions that they're willing to pay to procure new business.
Got it. That's helpful. That's all I have. Thanks for the answers.
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 Robert Farnam of Boenning & Scattergood. Your line is now open.
Hey there, and good morning.
Good morning.
A question, probably continuing on the competition theme. Do you suspect you'll see any more accounts because of the downgraded AmTrust, being that it's such a large workers' comp writer?
I don't know that I can answer specifically relative to them. I would say generally, whenever there's any type of disruption in the marketplace, it creates new opportunities to at least see business, not necessarily win it, but at least see it. We are seeing an uptick in our submissions. I don't know that I would attribute it specifically to the downgrade of AmTrust, but they are a large comp writer. To the extent that they've created any disruption in the marketplace, I would expect we would see an increased business flow as a result of that.
Okay. All right. When you're talking about the heightened competition, do you see that both in the core business as well as the alternative?
Yes, we do.
Okay. I guess the growth in the new states, probably largely going to be coming from the alternative book rather than the core book. I would think that these states are probably not large in their own right. If you're going to see some growth, it's probably going to be from the alternative book?
That's where it starts. When we enter a new state because of the longstanding relationships we have with some of those partners and their national presence, that's where the revenue stream starts. As we develop more time in those states, we start to see the core business start to accelerate as well. Over a period of time I can't tell you exactly what that mix would be, but I do know that historically, it starts off strong with alternative, and then as we appoint new agents in those new states, the core starts to make a positive move as well.
Is the whole alternative, that may be one of the benefits that you have from it, is you get kind of a quick peek into what the market's like before you can actually get in there with a core book?
Exactly. The other benefit we get too, Bob, is that those long-term partnerships that we have, they have a very good handle on our underwriting appetite. So, they know the type of risk that we're willing to write, as opposed to appointing a new agent. When we appoint a new agent, there's an educational process that needs to take place. We don't have to do that with the alternative partners.
Right. Okay, good. Thanks for that. Last question I have is, given the changes in the tax environment and the changes in interest rates, I know you've kind of lowered your muni portfolio. Just want to know what other changes you're thinking of doing in the investment portfolio at this point.
I'll take that, Bob. We have just created a new portfolio. It's going to be fairly modest, we are starting to invest in new bank loans. That'll have a nice little pickup in yield on a fraction of the portfolio. Absent the slight decrease in munis and the new bank loan portfolio, we're pretty content with where we stand.
Okay. Very good. Thanks.
Thank you. We do have a follow-up question from Mark Hughes with SunTrust. Your line is now open.
Thank you. On the commission expenses up a little bit, I guess the alternative distribution influence that. Do you anticipate that that will continue in the coming quarters?
Mark, I don't know. There are two drivers for the increase that you're referencing. One is the base commission rates for the alternative distribution channel is higher, although we've grown in both the core and alternative, it's grown at a faster pace this year and in this quarter on the alternative. That's impacting it. The other thing that's impacting it is we have an agency incentive agreement with a certain number of our agents that are linked to, first, profitability and then growth. We've seen an uptick in the year-over-year in the number of agents that are qualifying for that incentive payment. From our standpoint, it's hard to forecast what the second half of the year will look like. Those are the two drivers, though, that will determine whether those trends continue.
When they qualify for that incentive payment, is that a sort of an immediate payout, or would that be accrued over the subsequent four quarters or something like that?
Yeah. It's accrued over the year, and it's paid out in the beginning of next year.
Okay. Is that more profitability rather than volume, or is it both?
Well, they will qualify for a payment if they meet profit goals, and then they earn an additional amount if they meet growth goals.
Yeah. Then, Mike, your latest thoughts on the impact of the investments this year. I think you've given maybe a specific expense ratio impact. You care to update that? Any change?
It's a tough question to answer at halftime. We have a sense of what we're going to spend in aggregate, but we have a lesser level of precision as to exactly when that's going to emerge. Right now, we're very satisfied with the spend in aggregate. It may or may not translate into exactly 4% for, an increase of 4% on the expense ratio for this year. We'll have more information as the year continues.
Okay. The investment income, I think you touched on this, but nothing unusual in this quarter. Is it $20.3 million? Is that a reasonable run rate, when we think about the Q3?
Yes, I don't see any reason why it wouldn't be consistent from here on in the short term.
Yeah. Okay. Very good. Thank you.
Thank you. Our next question comes from Cliff Gallant with Philadelphia Financial. Your line is now open.
Thank you. Good quarter. Actually, Mark asked my question, but as a follow-up, I'll ask about capital management. Was there any update in terms of buyback and your capital here?
Cliff, it's Mike. We always look at share repurchases, and I think I've said before that our constraints are holding company liquidity, other initiatives, and right now we have two big initiatives. One we've been talking about this entire call, which is our IT and customer experience initiatives, and we've even quoted how much that's going to be. That's a drain on corporate liquidity. The other is we do have a pending acquisition, which we hope to conclude shortly. How much statutory capital and surplus is going to come across in that deal as a requirement for us is unknown. We're being pretty conservative with our holding company liquidity, and as such, we have not been big share repurchasers of recent, but we always look at it.
Okay. Actually, I'll ask another follow-up on in terms of Southern California and how the book is looking there. Is there any update in that area?
Southern California? Southern California, from a revenue standpoint, our new business is growing. There's a lot of competitive pressure now. The Southern California market is more profitable today than it has been in the past, and that's really a result of the reforms from a few years ago. That's lending itself to heightened competition there. We see at renewal time, Southern California and California in general is one of the reasons why you see the renewal rate decline that we're seeing. The loss costs have dropped. Over the past five years, loss costs in California have dropped more than 35%, and I don't expect that trend to change in the short term. It's a more profitable environment than it has been because of the reform. From a new business standpoint, we're growing in Southern California.
Wow. Okay. Thank you very much.
You're welcome.
Thank you. This concludes today's Q&A session. I would now like to turn the call back over to Doug Dirks for closing remarks.
Thank you, everyone, for joining us today. We appreciate your interest and participation. We look forward to speaking to you again on our third quarter results. Thank you all very much. Have a great day.
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.