Good day, ladies and gentlemen, welcome to the Employers Holdings, Inc. Quarter 3 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 follow at that time. If anyone should require assistance during the conference, please press star then zero on your touch-tone telephone. As a reminder, this call is being recorded. I would now like to introduce you for your host for today's conference, Vicki Erickson-Mills, Vice President Investor Relations. Ma'am, you may now begin.
Thank you, Donovan. Good morning, welcome everyone to the third quarter 2016 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 Terry Eleftheriou, our Chief Financial 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. We use non-GAAP metrics that exclude the impact of the 1999 Loss Portfolio Transfer, or LPT. These metrics are defined in our earnings press release available on our website. I will turn the call over to Doug.
Thank you, Vicki, thank you all for joining us on our call today. We are pleased with our strong
Ladies and gentlemen, your conference call will begin momentarily. Again, please stand by. Your conference call will begin again momentarily.
Donovan, can you hear us?
Yes.
Okay. Doug, do you want to continue?
I'm sorry. We've had an audio problem. I'm going to restart my commentary. We achieved the lowest accident year loss ratio in our history as a public company. For the third quarter, our operating earnings of $0.57 per diluted share declined $0.06 relative to last year's third quarter, primarily due to a higher effective tax rate. Our operating return on equity in the quarter was 8.2%, or 1.7 percentage points lower than the same period last year. Our combined ratio before the LPT was 95.2%, which represents an improvement of 40 basis points and is one of the most favorable combined ratios in the company's history. In the first nine months of this year, our operating earnings of $1.57 per diluted share increased $0.12 or 8% year-over-year.
Our operating return on equity was 7.8% or 10 basis points higher year-over-year due to improved underwriting performance. In the first nine months of the year, our combined ratio before the LPT improved to 96.9% or by 1.6 percentage points compared to the same period last year. Our third quarter and our year-to-date results reflect continuing positive trends, largely driven by our strategic initiatives to target profitable classes of business in all of our markets, to diversify our risk exposure, and to emphasize the early settlement of claims.
These positive trends include lower payroll exposure in the Los Angeles Basin, favorable shifts in business mix by state and territory, growth in in-force policies and premium outside the Los Angeles Basin, high renewal rates despite a robustly competitive marketplace. Strong reserve salvage from accelerated claims settlements, most prominently in Southern California. Other trends observed throughout the year have been stable or improving loss costs in the industry, which have been accompanied by generally lower rates in largely rational but competitive markets. These trends, along with our shift in business mix, are reflected in a 2.1% decline in our net rate year-over-year. Our net written premium in the third quarter declined 2% as final audit premium decreased $5 million relative to last year's third quarter, despite continuing strong final audit pickups. As you may recall, last year's third quarter final audit premium was substantially higher than expected.
Outside the L.A. Basin, we have had success in growing revenue, particularly in classes of business with historically low loss ratios. Despite a declining rate environment in many states year-over-year, in states outside of California, we have increased policy count by 6.2%, in-force premium by 2.3%, and payroll exposure by 2.2%. Our in-force premiums and policy count in the Los Angeles Basin of California declined 13.2% and 13.9%, respectively, year-over-year. While our in-force premiums and policy count in California outside of L.A. increased 10.3% and 4.1%, respectively. Overall, renewal premiums were down slightly in the third quarter year-over-year. Average policy count retention remained high, and average policy size declined nine-tenths of a percent year-over-year, with premium and policy declines in Southern California. Total revenues declined 3.4% in the third quarter, and net premium earned declined 3.2%.
Largely driven by a year-over-year decrease in final audit premiums. Our calendar year loss ratio, excluding impacts related to the LPT, improved 1.6 percentage points year-over-year due to the lower provision rate for losses compared with the third quarter of 2015. Our third quarter loss trends continued to be favorable and in line with the industry as we observed a slight decline in frequency and a slight upward movement in medical and indemnity cost per claim that is reflected in our current accident year loss estimate of 64.1%. This is a decline of 4.5 percentage points relative to the second quarter and 2.2 points relative to last year's third quarter. Net investment income declined $600,000 in the third quarter due to a slight decline in the average book yield on our portfolio assets.
Pre-tax book and tax-equivalent yields were 3.1% and 3.7%, respectively, each declining 10 basis points relative to the third quarter of 2015. Net realized gains of $1.6 million resulted primarily from the sale of equity securities as part of our regular rebalancing of our high-dividend equity investment portfolio. Our underwriting and other operating expenses for the quarter were $31.7 million, generally flat relative to the third quarter of 2015. Our underwriting expense ratio of 18.3% was 60 basis points higher than the same period last year, largely due to lower net premiums earned. Income tax expense increased $1.9 million in the quarter. Our effective tax rate for the quarter was 25.7%, an increase of 6.3 percentage points year-over-year due to increases in projected annual net income before taxes. We continue to actively manage our capital, and our balance sheet remains strong.
The market value of our investment portfolio was $2.6 billion at the end of the quarter, representing the highest level of invested assets in the company's history. The average credit quality of the fixed income portfolio was unchanged at AA- with a duration of 4.2. Equity securities represented 7.1% of the investment portfolio. At the holding company at the end of the third quarter, we had approximately $65.1 million in cash and securities. Our shareholders' equity, including the LPT deferred reinsurance gain, exceeded $1 billion. Our book value per share increased 9% since December 31st and 12% year-over-year. Our adjusted book value per share, which excludes unrealized gains net of tax, increased 5% since the end of last year and 8% year-over-year. We are executing upon our previously announced and authorized two-year share repurchase program.
In the quarter, we repurchased 399,739 of our common shares at an average price of $29.10, totaling $11.6 million. The board of directors declared a dividend on our common stock of $0.09 per share for the fourth quarter, with a record date of November 9th and payable on November 23rd. Now I'll turn the call over to Steve.
Thank you, Doug, and good morning. Net written premiums of $163 million were down $3.5 million, or 2.1%, year-over-year for the quarter. This decrease was driven by a $5 million decrease in final audit premiums. During the quarter, new business premium increased 12.9% year-over-year for the quarter. This new business growth has occurred despite declining rates in the majority of states we do business in, as well as a very competitive market environment. Several of the initiatives we have discussed on earlier calls are driving this increase in new business. In addition to our new business growth, we have increased our renewal premium outside of the Los Angeles basin. On a year-over-year basis, renewal premium outside of this market has increased 2.5% for the quarter. This growth, despite declining rates, can be attributed to policy unit retention rates on existing business, which continue to be higher than traditional norms.
Both our third quarter and year-to-date results reflect other continuing strong trends, driven largely by our strategic initiatives to target profitable classes of business in all of our markets, to diversify our risk exposure, and to emphasize the early settlement of claims. These positive trends include favorable shifts in business mix by state and territory, as well as sustained growth in new business submissions. In addition, excluding the Southern California basin, we have increased both in-force policies as well as premium. From a claims standpoint, we have had strong reserve salvage from accelerated claims settlements, most prominently in Southern California, as well as a reduction in claim frequency. As mentioned earlier, all of these trends, and specifically those related to revenue growth, have occurred despite continuing rate decreases in most states, along with strong competition from both regional and national competitors. We expect these headwinds to continue in the future.
Finally, during the third quarter, we entered the state of Massachusetts. We are leveraging long-standing national distribution partnerships as we write business in this state because we know these partners have a clear understanding of our risk appetite. This follows our movement to New York in the first quarter of this year and is in line with our vision for the future to be writing business in all of the continental United States, with the exception of the monopolistic states. Now I will turn the call back to Doug.
Thanks, Steve. Again, we are pleased with our strong results in the third quarter, which reflect the continued successful execution of our strategic underwriting pricing and claims initiatives. We will work to retain our best business and seek new business opportunities that meet our desired return objectives by continuing to focus on disciplined, data-driven risk selection and pricing across all of our markets. With that, operator, we'll now open up the call to questions.
Ladies and gentlemen, if you'd like to ask a question at this time, please press star and one on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. So one moment for questions. Our first question comes from Mark Hughes of SunTrust. Sir, your line is now open.
Thank you very much. Good morning.
Good morning.
On the competitive front, I think you had referenced competitive but largely rational. My reading of your commentary is you're a little less pessimistic, perhaps, compared to prior quarters. Am I overreading it, or is the competition steadier, let's say?
Yeah, I wouldn't say that we're seeing much change in the competitive environment. It continues to be competitive everywhere we do business. We tend to see the pricing to be largely rational. It's not consistently rational in our view. We do see competitors in the market that are willing to write business at prices that we can't and won't. Again, largely, we're finding the markets to be rational. There's not a lot of what you might characterize as crazy pricing occurring in the markets.
You talked about the new business premium up 13% year-over-year. That sounds pretty strong. I think your retention has been quite good. When we think about your top-line gross premiums written, excluding the audit pressure this quarter, largely steady the last six months. Do you think that's a good starting point as we think about the next few quarters? Are the new business trends enough to drive the top line ahead?
Mark, this is Steve. I'll take that question. Some of the initiatives that we've talked about on the last several earnings calls continue to gain momentum. I think those are some of the tailwinds that clearly have led to the increase in new premium in this quarter over the prior quarter of 2015. However, in particular, when we look at the NCCI states and we look at 2017, one of the headwinds that we are facing is there are more states in 2017 that will be taking rate decreases than we saw in 2016, and the rate decreases are deeper than what we saw in 2016. I think, despite some of the initiatives that we put in place, and they'll continue to gain momentum, there are those strong headwinds that won't subside in 2017 and some cases will be even stronger.
We're going to have to see how that plays out.
On the current accident year losses, very nice improvement. Is there any way to characterize how much of that was from the mix shift out of California versus just better underlying loss experience?
Mark, clearly the shift of our business out of L.A., where we see higher rates of litigation than we do in other states or other territories, has had a positive impact. You're also aware of the fact that we've had a strong emphasis in the last couple of years of focusing our sales efforts on pursue classes of business, and those are classes that have lower loss ratio results and are more profitable for us than other classes of business. I think it's a combination of some of our shifting of our business mix from certain territories within California, as well as an emphasis outside of California on more profitable classes of business. Both of those are large contributors to the success that we're having.
Actually one quick question. The audit premium down $5 million. What was it in this quarter last year? The absolute number.
Mark, this is Terry. Let me give you the numbers. In 2015, the third quarter final audit premium was $21.8 million. This quarter was $16.8 million, down by five.
Still quite strong. The settlement activity in California, is this all related to the uptick in severity that you saw, say, 2013, 2014, more lawyers being attached to claims? Are those settling more quickly or better than you would've expected, or is this a separate issue?
No, we've had a concerted effort within the organization to close out. We targeted certain types of claims at certain points in the life cycle of those claims. We've had that initiative in place now for about two years, and we've had a lot of success with that. It's not limited to that timeline. We've actually had higher closing ratios this year compared to prior years. A large percentage of those closures are in that Southern California market. Most of those claims were in litigation. There's clearly some correlation there between the improvement that we're seeing and the closure of those claims with the reserve salvage that's occurring as well.
I'll ask one more. I apologize. The underwriting expense, you were up a little bit year-over-year, but you've had this pattern of kind of declining expense through the first three quarters of the last couple of years. Last year in the fourth quarter, you had a step up in terms of underwriting expense. The year prior to that, it was another step down in the fourth quarter. Any hints as to what we might expect this year?
Mark, this is Terry. Our underwriting expense, if we look at essentially the last two years, tends to range between 18%-21% of our earned premium. The higher end of that range typically occurs in the first quarter historically because of certain employee benefit costs that are incurred. I can't really tell you what I think the fourth quarter's going to be, but it's going to be within that range, is my expectation.
No reason to think it's going to take a meaningful step up, though, is that fair?
From what level?
From the 3Q level, if we think about it in absolute terms, the 317.
Let me give you a little bit more insight into the third quarter. There are certain things that are fairly volatile in the expense number, and in particular, premium taxes and assessments. In the third quarter, we had a lower level of expected premium tax and assessments, in part because there were rate changes in certain states, and in particular one particular state, we had a refund on amounts that we previously paid. Those types of things, the volatility of that does occur quarter-on-quarter. If you look at the year-to-date, we're probably in line, but it does produce some level of volatility, as much as about $1 million in any given quarter. Those are things that are difficult to predict.
That's helpful. Thank you.
Our next question is from Amit Kumar of Macquarie. Your line is now open.
Thanks. Congrats on the quarter. Just a few quick follow-ups. First of all, just going back to the discussion we had in last quarter on the large losses, has there been any update on that front?
A couple of things. This is Steve. Amit, the large losses that we experienced in the second quarter, to be concise in responding to your question, they've developed as we've expected them to. There's really no more color on that.
Okay. Nothing more on that front, right? In terms of other things developing, because I think you had mentioned at that time, I think it was, I'm trying to think what the losses were exactly, but you haven't seen any change on that side, right? Anything new or any change in trend line?
We've said before, we said it on the last earnings call that, the type of business that we're in, we're occasionally going to have large losses. We'll have a large loss in most quarters. This quarter was no exception. None that exceeded the retention built into our third quarter planning assumptions.
Good. That's good to know. The other question I had, maybe tied to the NCCI comment you made in terms of the business. When you look at the underlying trends, the underlying loss ratio, do you get the sense that based on where the market is, there is room for additional improvement going forward? Based on the pluses and minuses, is it more static from here? How should we think about that?
What we continue to see nationally in our book, I think what's underlying the NCCI data as well as the independent bureaus, is a declining frequency. That's been a long-term trend. We don't believe that there's any reason to think that that's going to change. As long as you've got declining frequency and what has been a relatively and somewhat remarkably benign severity trend.
There doesn't seem to be a lot of pressure on the loss side right now. Obviously, that creates scale problems for the industry because as losses fall, subject premium will fall with it. That's not the worst problem to have to deal with.
Yeah. No, that makes sense. That's all I have for now. Thanks for the answers, and good luck for the future.
Thank you.
Ladies and gentlemen, if you'd like to ask a question at this time, please press star then one on your touchtone telephone. If your question has already been answered or you'd like to remove yourself from the queue, please press the pound key. Our next question comes from Cliff Gallant from Philadelphia Financial. Your line is now open.
Good morning. Thank you. I just wanted to get a better handle on your sort of the trends on your profit margins in L.A. County. It sounded like there were a few things that were happening at once. I know you guys are raising prices in that area. [Gift count is down double digit. I also think you mentioned something like a drop in frequency, and I know that you've been speeding up your claims payments there. I'm just wondering directionally, what kind of improvements are you seeing in that part of your business?
Let me talk generally about Los Angeles. A couple of years ago, we initiated some underwriting activities that were designed to remove from our book the most problematic risks we were writing in L.A. That was a 12-month initiative where we non-renewed approximately $20 million worth of business. The actions we've taken since then have really been aimed at pricing. We've defined return targets and have set our prices accordingly. To the extent that we're able to achieve that pricing in Los Angeles, we continue to actively write business. If we cannot achieve the desired returns in Los Angeles, we are and have shown a willingness to walk away from the business. At this point, the re-underwriting efforts are complete, and now we're using pricing to determine how much business we write in L.A.
At this point, that's no different than the way we approach it anywhere else in the country. The issues in L.A. from our standpoint have been dealt with, and now we are operating just as we do everywhere else in the country.
That's great. On the policy count in that area, I think I saw was down something like 13.9%, I think, in the L.A. area. Are you seeing that bottom, or any sense of trend on that?
Let me start, and then I'll turn this over to Steve. The policy count in L.A. continues to fall. We have seen that taper off perhaps a bit again as we completed our underwriting activities and have now moved to pricing objectives in L.A. It seems to be having less impact.
Yeah. Cliff, this is Steve. Just following up on Doug's comment. It is starting to stabilize, and one of the points that we clearly want to emphasize is there is good business to be written in L.A., and we are writing good business in L.A. It is just that, as Doug alluded to earlier, a couple of years ago, we had some legacy issues with our book that we cleaned up. We have taken a very hard stance on making sure that we get the right price. But we are stabilizing in L.A. compared to where we were a couple of years ago. We are seeking out profitable business in that territory, like any other part of the country that we do business in. We have shifted around some of our partnerships in Southern California, eliminated some partners that were not aligned with our objectives, and added some new ones.
I expect those trends to have a positive impact on our results in L.A. in the future.
Sounds great. I'm sorry, I have one other question. This is embarrassingly simple, but when you guys make an announcement that you've entered a new state like Massachusetts, you did this. What exactly does that entail?
Let me start with the most current news, Massachusetts. We are now writing business in the state of Massachusetts. Generally, and Massachusetts is no exception to this, we start off writing business with existing partnerships. For example, as you know, we've had longstanding partnerships with several payroll partners. The business we've written so far in Massachusetts has really been limited with those partners, but we are adding independent agents domiciled in the state and as well as border state agents that do business with us. But we are very careful to make sure that we start off when we enter a new state with existing partnerships that understand our risk appetite, have been partners with us for quite some time. Then we appoint, as we are doing in Massachusetts and other states in the future, we appoint new agents after a careful screening process.
All right. That's great. Thank you very much.
Our next question is from Matthew Carletti of JMP Securities. Your line is now open.
Hey, thanks. Good morning. Let's see, we've covered a lot of ground already, but I think I got one left. On capital, I know you've been buying back some stock, but as I look at premium to equity leverage, it's a very crude measure of kind of operating leverage, but it's kind of what we have to go on. It's kind of been going the other way. The earnings have picked up. The equity balance has grown. The market has kind of stabilized, so the top line's been a little more stable, and we've seen that ratio come back a little bit. It's in the 0.7 range. Two questions are, one, what's your long-term target to where you'd like to see that? Where do you think you could comfortably run the business, whether that be through profitable growth or giving capital back to shareholders?
Two is, how much of a handcuff or a hindrance is AM Best's continued negative outlook on the ability to get there?
I'll respond to the second part of that first. As to AM Best, there is no handcuff there relative to capital. We continue to run very strong and improving capital ratios. The negative outlook is not influencing our capital decisions. Where do we see it going forward? Well, I think the challenge we have, along with the rest of the industry, is with economic growth below 2%, declining frequency in our line of business, there's not a lot of demand on capital, particularly given our profitability and the profitability of the line generally. It does force us to rethink what the opportunities are for deployment of capital. What have we done? Well, we increased our quarterly dividend at the beginning of this year, and we've authorized and are executing a share repurchase agreement.
Certainly, we will reevaluate the adequacy of those actions as we move into year-end and into next year. It is a challenge. There's just not a lot of attractive growth opportunities at the moment, and the business continues to generate very high levels of profitability.
Is there, maybe I'm looking at the wrong metric and help me if I can, but I kind of look at net premiums to equity or stat surplus, however you want to look at it. We're hovering in the ±0.7 range. Could you write it 1 to 1 in the current environment? If so, what are the steps to get there with kind of the backdrop that you're giving, which is, I agree, a tougher economic backdrop that's not going to provide a lot of easy growth opportunities.
Well, certainly talking specifically to the premiums to surplus or to capital ratio. Given where the combined ratios are, it would be attractive to be writing at a higher amount of leverage than 0.7 to 1. I think the issue there is we've indicated it's a very competitive marketplace where pricing is rational, and we're not at a point where we think it makes any sense to put business on the books solely to improve the leverage ratio, particularly given the yield on the portfolio right now. I don't happen to think cash flow underwriting ever makes much sense. It certainly doesn't make any sense in the current market conditions.
Yeah, I agree. I'm asking it more from the other side of that equation that, you know, is there an opportunity to increase the capital return and reduce the denominator more quickly? I recognize that you're in the middle of a share repurchase and you've upped the dividend. The good high-class problem to have, you've grown the equity faster and through good results. While the top lines remain stagnant. I guess that's more the angle I was coming at it, not suggesting that you grow in a market that wouldn't be appropriate, but that is there the opportunity to ramp up the share repurchase more quickly or up the dividend more quickly? Any thoughts on that would be appreciated.
Look at, from a share purchase standpoint, we've always viewed that as opportunistic. We are price sensitive to when
How much stock we're willing to repurchase, and that will always be the case. Yes, if the current trends continue, we expect that we will be generating capital that doesn't have an immediate need in the business.
Okay, great. Thank you for the answers and congrats on a nice quarter.
Thank you.
Our next question is from Sameer Khair of Capital Returns Management. Your line is now open.
Hi, good morning. I was just wondering and, pardon me if you've already addressed this, but if there was some reserve impact or if you anticipate some impact on your Florida reserves owing to the judgments that have just kind of come out.
We've evaluated that, and we don't see the need to adjust our reserves in Florida. We're comfortable with where they're at, even after the recent Supreme Court decisions.
Okay. Just help me understand, is it that your book is less susceptible because smaller insureds ? Is it because you guys have been quicker payers in claim settling?
Exactly. That's exactly the point. Based on the market that we write business in, we just don't see the trends that the entire state sees with respect to litigation rates. Also some where our business is concentrated within the state tends to be in areas with lower litigation rates than other counties within the state. All of those play into how our book of business can be different than the industry as a whole.
All right. Understood. Just looking at competition for a second, are you seeing a change in the way the national insurers are competing on workers' comp, perhaps expanding the classes of business they play in or increasing their commissions?
Well, yes, on both fronts. We've seen some of the national players increase commissions in several states. That trend continues. The other thing that we've seen, and we've talked about this before, is in particular in the last year and a half, we've seen more of a focus with some of the national competitors in the small business space. They're becoming more aggressive in that space than they have historically been. Both of the points that you referenced are trends that we're seeing with our national competitors.
Should we expect that Employers will actually, your company will increase the commissions as well to compete on the business that they like? Do you guys have a-
No, we have not been doing that, if you look at our third quarter results, when you see the increase in our new business premium, it hasn't really hampered our efforts. We're focused on other initiatives that we've talked about before to help drive our business. Increasing commissions is not something that we feel is necessary.
Okay. Just competitively, how's the State Fund, California State Fund, how are they behaving? Are they increasing their appetite? Are they decreasing it?
We don't compete with them very often. Even if there was competition in the past, it's not as much as it had been. I don't really have a good handle on that because When we compete, it's not the State Fund that we're usually bumping up against.
All right. Thanks for the answers.
Our next question's from Mark Hughes of SunTrust. Your line is now open.
Thank you. My questions were answered.
I'm showing no further questions at this time. I'd like to turn the call back over to Doug Dirks for any closing remarks.
Very good. Thank you all for joining us today and participating in the Q&A. We very much appreciate that. We look forward to talking to you again in February with our year-end results. Thank you all, and have a good 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.