Good day, ladies and gentlemen, and welcome to the Q2 2017 Employers Holdings 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, please press star then zero on your touch-tone telephone. As a reminder, this conference call is being recorded. I would now like to turn the call over to Ms. Vicki Mills. Ma'am, you may begin.
Thank you, Ashley. Good morning and welcome everyone to the second quarter 2017 earnings call for Employers. Yesterday, we announced our earnings results. Today we expect to file our Form 10-Q with the Securities and Exchange Commission. These materials may be accessed on the company's website at employers.com and are accessible through the Investors link. 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, Steve Festa, our Chief Operating Officer, and our Chief Financial Officer, Mike Paquette. Statements made during this conference call that are not based on historical facts are considered forward-looking statements. These statements are made in reliance on the safe harbor provisions 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 new financial supplement as an attachment to our earnings press release, our investor presentation, and any other materials available in the investor section on our website. Now I'll turn the call over to Doug.
Thank you, Vicki, and thank you all for joining us on the call today. As in the first quarter, we again produced strong financial and operating results in the second quarter of this year. Excluding impacts of the LPT agreement, our current quarter net income increased 13% or $0.08 per diluted share. Our underwriting income increased 19%, as our combined ratio improved 3.7 percentage points. We reported operating income of $0.60 per diluted share, an increase of 30%, with an annualized operating return on adjusted equity of 8.1%. Our book value per share was $32.95, a six-month increase of 4.2%. In the current quarter, final audit premium remained strong, reflecting increases in payrolls, number of employees, and hours worked for our insureds. We again delivered strong new business growth in the quarter by actively seeking and finding new opportunities that meet our underwriting requirements.
These strong results reflect the successful execution of our business strategies and our consistent and deliberate portfolio strategy, despite the soft market trends that have remained largely unchanged. As in recent periods, our markets remained highly competitive, while in general, rates linked to improving loss costs continued to decline. In light of these market conditions, our retention in the second quarter remained high and payroll exposure increased. Overall, renewal premium declined slightly in the quarter, driven by one territory in our Southern California market. Our average renewal rate for the first six months of the year decreased a modest 1.8%. As a monoline workers' compensation writer, we believe we are in the unique position of intimately knowing and quickly reacting to changes in our markets, and we have demonstrated this capability over the years.
We consider this a competitive advantage that we intend to maintain and strengthen as we actively engage in technology, data, and analytic initiatives. We often get questions on the current political and economic environment and potential policy changes and the impact they could have on employers and on workers' compensation broadly. While there is uncertainty about what may or may not transpire along these lines, we are well-positioned to benefit from additional economic growth, tax reform, and positive changes in interest rates. With that, I'll turn the call over to Mike for further discussion of our financial results.
Thank you, Doug. We delivered solid financial results in the current quarter in line with our expectations. Net premiums written and earned for the second quarter each decreased 3% period-over-period, which Steve will address in his remarks. Our second quarter combined ratio before the impact of the LPT of 95.1% than the 98.8% reported a year ago, due to an absence of large losses in the current period. Our second quarter commission and underwriting and other operating expense ratios remain consistent with those of a year ago. Net investment income for the second quarter decreased slightly from a year ago due to non-recurring expenses associated with an investment accounting provider change. At quarter end, our fixed maturity portfolio had an average pre-tax book yield of 3.2% and a tax equivalent book yield of 3.7%.
The lower net realized gains on investments for the second quarter was related to greater sales of equity securities a year ago as part of a routine rebalancing of our equity investment portfolio. During the second quarter of 2017, we redeemed a $12 million surplus note payable with a resulting $2.1 million gain. Our effective tax rate of 23.9% in the quarter was higher than that of a year ago, primarily due to favorable LPT adjustments made during the second quarter of last year. As of June 30th, 2017, the market value of our investment portfolio was $2.6 billion, an increase of 4.5% from a year ago. At the end of the second quarter, our fixed maturities had a duration of 4.1 and an average credit quality of double A minus, and our equity securities represented 7.6% of the total investment portfolio.
Now I will turn the call over to Steve.
Thank you, Mike, and good morning. Net premiums written for the quarter of $183 million were down $5.7 million, or 3%, from the second quarter of 2016. This decrease was primarily a result of a decline in final audit premium year-over-year. Despite this decrease, it is important to note that we continue to see strong payroll pickup at final audit relative to the inception of the policy, with this quarter exhibiting almost double-digit increases, which was driven by additional hiring of employees, increasing wage rates, as well as additional hours worked by existing employees. With the exception of the second quarter of last year, this percentage increase in payroll pickup is the largest we have seen in more than three years. From a new business production standpoint, we grew our new business revenue period-over-period by 3.9%.
This occurred despite a declining rate environment in the majority of the states in which we operate. This is also an improvement over the new business growth we saw in the first quarter of this year. This growth has occurred not only in the new states that we have recently entered, but we have seen growth in many of the states where we have had a long-term presence across a variety of geographic territories. A substantial contributor to this growth has been from our alternative distribution channels, both long-term as well as more recent partnerships. In previous calls, we have discussed the strong retention rates on our smaller premium policies. Those trends continued in the second quarter. We also have previously discussed additional pressure from a competitive standpoint on larger middle-market policies.
Our renewal premium for the quarter was down slightly from the prior year's second quarter due to a decrease in one of our territories in California. Absent this decline in one territory, our renewal premium would have increased period-over-period due to strong renewal production in the rest of California as well as the rest of the country. Now I will turn the call back to Doug.
Thanks, Steve. While our investment income is impacted by continuing low yields, our underwriting profitability is at record levels. Our strong earnings and positive cash flow have allowed us to continue to invest in our business while returning capital to shareholders, most recently through increases in our dividend. We are maintaining the strength of our balance sheet and creating increased value for our shareholders, as evidenced by our continued growth in both book value per share and operating return. 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 number 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. Our first question comes from Mark Hughes of SunTrust. Your line is open.
Thank you. Good morning. The last quarter, I think your anticipation was that you would probably see positive growth in subsequent quarters. It sounds like this quarter was largely audit premium that held you back. Do you think as we consider the second half of the year, that you probably see positive gross written premium trends?
Mark, this is Steve. I'll take that question. I think we've said this before, it's difficult to predict premium with certainty. However, what we would expect is written premium, absent audit premium, to be in a relatively tight range, slightly up in some markets, essentially flat or slightly down overall throughout the year, given current conditions. I would expect it to be within a range of slightly up or flat, or even slightly down in the second half of the year.
Which region had the renewal issue, and was that something you did, or was it a competitor that targeted some of your accounts?
The territory that we're referring to is Los Angeles County. The renewal impact that we saw was, as I said earlier, not on our small business. The retention rates on that were very high. On the middle market accounts, there's a lot more pressure from a competitive standpoint, even this year relative to comparisons of last year, especially in Los Angeles. What we've said before and held through this quarter is that if we don't feel like we can maintain the profit gains that we've occurred over the last couple of years, then we're willing to let some of that business go. We saw that happen in the second quarter. We're not going to chase top-line growth at the expense of the bottom-line improvements we've had.
Is that because rates are finally adequate in L.A. County?
Yes. I would say that if you review the results from WCIRB and other entities, California's a much more profitable state than it historically has been. That's adding to heightened competition as well.
The down 1.8, am I correct in thinking that that's similar to Q1? Is there any change so far as you sit here today in Q3?
It's market's flat.
Okay. Flat as in flat at down 1.8 or
Yes
flat as in zero?
Yes.
Yep, okay. Steady. The non-recurring expense for the advisor changes, sounds like that was taken out of net investment income. Is that right? What was the amount of that?
There's two things, Mark. We changed our investment accounting provider. Two things occurred. One, we had to run parallel with our existing provider. That increased our investment expenses by about $100,000, which you won't see into the future. The other is that the prepayment speed assumptions and call assumptions are slightly different between the providers. That gave us a one-time $300,000 increase in our premium amortization. We'll get that back over time. The combination of the 300 and the 100 got you about a $400,000 decrease, of which 300,000 is temporary.
Understood. Doug, any thoughts on inflation? There had been this. I think both the NCCI and the WCIRB kind of pointed to an uptick in medical inflation in 2016. I think if I've heard you correctly, you say you haven't seen that in your book. You're not sure about their methodology. Where do you see that today?
I think you have to be careful in how you're defining medical inflation, because it can include not only pure inflation as an increase in unit cost, but it can also be impacted by or defined to include increases in utilization. Certainly on the medical side, from time to time, we've seen that. We don't feel that our book is being pressured. Particularly our reserve book is being pressured by unexpected inflation. Certainly, we're seeing on a broader national economic scale an attempt to actually encourage a bit of inflation in the economy. I think the ideal situation for us would be to see that type of inflation, just not see unexpected inflation on the medical side. I would say at the moment it's not a major concern, but it's an inherent concern in our line of business given the duration of our liabilities.
Finally, share buybacks. You've got a very clean balance sheet. Seems like you'd have plenty of capacity for that sort of thing. Where do you stand on that now?
I'll take that, Mark. Our favorite and number one use of capital is organic growth. When that is exhausted, we'll look down the ladder and share repurchases become attractive as an alternative. There are some things on the horizon that could lead to some greater organic growth that we don't really want to get into on this call. We've got a wait and see approach. Certainly buying shares back is an attractive option for us. Again, for some opportunities that we don't really want to get into right now, that may or may not transpire. We're in a wait and see mode.
When you say opportunities, are you talking expanded distribution, M&A, new classes? Can you give us a general sense of what you're alluding to there?
I would say we consider all of those to be potentials as well as potential market disruption.
Potential market. Okay. Thank you.
Our next question comes from Matthew Carletti at JMP Securities. Your line is open.
All right. Thanks. Good morning. I just had a question on kind of looking at the loss cost trends you're observing today, and the pricing off a little bit. What's your view of accident year profitability? Do you feel we're at peak? Do you feel there's more to go? And I guess as a follow on to that, aside from kind of just the actual trends being observed in the line book. Can you talk a little bit about some of your efforts around kind of the outcomes-based medical networks and your little more data-driven approach to account selection? Are you seeing evidence in those two items that's kind of allowing you to book the underlying trend and maybe do a little bit better? Thanks.
Matt, this is Doug. I'll take that question. When you look at the industry as a whole, I suspect we may be at a point where the results don't improve significantly. Certainly, seeing continuing falling frequency and modest severity increases, that probably suggests we're at a fairly stable point. To the second part of your question, and I think it's really the more important part of it is, if in fact that's what the broader workers' comp environment is, it doesn't mean that has to be our fate. Certainly, we're focused on a lot of initiatives that are designed to improve our efficiency on an underwriting expense side, as well as to drive improved loss cost results.
As you indicate, the outcomes-based network, the accelerated claim settlement activity, a variety of initiatives we have, one of which we just started rolling out in the pilot form, to identify large losses earlier in the life cycle. There are a number of things that we are able to do that hopefully will continue to drive down our loss costs, even though the industry as a whole may be at a flat patch.
Okay, great. Appreciate the color and congrats on a nice quarter.
Thank you.
As a reminder, if you have a question at this time, please press the star, then the number 1 key on your touchtone telephone. We have a question from Cliff Gallant of Philadelphia Financial. Your line is open.
Good morning.
Good morning.
Quarter. I wanted to just dig down a little bit more, I guess, in terms of thinking about how conservative you might be in booking your combined ratios. I realize your combined ratio ex the LPT, it's a 95.1, compared to a 98.8 the prior year quarter. Of course, the prior year quarter had the unusual losses. I think it's sort of flattish. Beneath that, when I look at the change in your PIF between California and not California, I assume there's a pretty material difference there in terms of your net premiums earned, in terms of how much is coming from Southern California and not. Is that a fair assumption?
I'm sorry. I'm afraid we're not quite following the logic there. Could you?
I guess what I'm saying is that. Maybe I should just say it more generally. Year-over-year, there's been some pretty material changes in your net premiums earned, in terms of where they're coming from, the profitability of those geographies.
There's been a slight shift out of California. I think we're talking a percentage or so.
Okay.
There has been a shift in California, more of a shift from the north to the south that does have the impact of improving the loss result. Most of that has probably made its way through the book. The shift from more premium being written in Northern California, less in Southern California.
Okay. Another question. In terms of investment income, the last couple of quarters, we've seen sort of a sequential decline in the reported investment income. Over that time, we've seen Treasury yields improve slightly. I'm just curious as to, do we get to a point where we start to see that sort of grow again? Where do we need yields to get before we start to see growth?
I'll take that, Cliff. We really don't churn the portfolio. We have maturities that we reinvest, and as a result, we're not going to be able to react to those change in the treasury yields in an abrupt manner. We've got some good legacy stuff that has not come off yet. We're at a bit of an inflection point where the new yield opportunities are no worse than the current yield. With continued increases in market interest rates, you'll see that shift. It'll be a slow shift for us because we really don't churn the portfolio from a net investment income standpoint.
Okay. I guess one more question. In terms of some of the infrastructure spending that you've been doing in 2017, in terms of technology and all, how far along have you come with that? To what degree is that pressuring your expense ratio here?
At this point, it's not having a material effect on the expense ratio. Because of the nature of those activities, they tend to be more capitalized, they'll start impacting the financial statement at the point where from an accounting standpoint, they have to move from capital to expense. I can't project that date for you, but that's the nature of how that rolls out.
Okay. Thank you. It's a good quarter.
Thank you.
I'm showing no further questions at this time. I would now like to turn the call back to Douglas Dirks for any further remarks.
Very good. Thank you. We appreciate your participation today and your support. We look forward to talking to you again in October as we report the third quarter results. Thank you all and have a great day.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program, and you may all disconnect. Everyone have a great day.