Good day, ladies and gentlemen. Welcome to the Q2 2016 Employers Holdings, Inc. earnings conference call. At this time, all participants are on a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. If you require operator assistance during the program, please press star then zero on your touch-tone telephone. As a reminder, today's conference is being recorded. I would now like to introduce to you this conference call, Ms. Vicki Mills, Vice President, Investor Relations. You may begin, ma'am.
Thank you, Kevin. Good morning and welcome everyone to the second quarter 2016 earnings call for Employers. 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 facts 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, and thank you all for joining us on our call today. In the second quarter, our operating earnings of $0.45 per diluted share declined $0.06 relative to last year's second quarter. Our operating return on equity in the quarter was 6.7%, and our combined ratio before the LPT was 98.8%. In the first six months of this year, our operating earnings of $0.96 per diluted share increased $0.14 or 17% year-over-year as a result of higher earned premiums, coupled with incurred loss and expense ratio improvement over the prior period. Our operating return on equity was six tenths of a point higher than the comparable period last year due to improved underwriting performance.
In the first six months of the year, our combined ratio before the LPT improved to 97.8%, or 2.4 percentage points compared to the same period last year. Our second quarter and our year-to-date results reflect continuing strong underlying trends in our business. These include favorable shifts in business mix by state and territory, continued high renewal rates despite a robustly competitive marketplace, continued decreasing exposure in the Los Angeles area due to disciplined pricing objectives, continuing strong reserve salvage from accelerated claim settlements, most prominently in Southern California, and growth in in-force policies and premium in attractive classes outside of California and more recently in California markets other than the Los Angeles Basin.
As reported in our earnings announcement yesterday, in the second quarter of this year, we experienced four large random losses, which in excess of expected large losses totaled approximately $6.5 million pre-tax, $4.2 million after tax, or $0.13 per diluted share. The large losses raised our loss provision rate 3.7 percentage points in the second quarter. Additionally, residual market losses added an additional 0.8 of a point. Collectively, these losses resulted in a current accident year loss provision rate of 68.6%, compared with 66.5% in last year's second quarter. Excluding large losses and assigned risk, the current accident year loss estimate would have been 64.1%, equal to our provision rate in the first quarter, and 2.4 percentage points lower than last year's second quarter.
Our second quarter loss trends continued to be favorable with a slight decline in frequency and with increased severity related to the large loss activity. We do not believe these large losses are the result of underwriting errors, nor are they indicative of an underlying trend. At July 1st, reflecting the confidence we have in our book of business, we renewed our reinsurance treaty and raised our retention rate from $7 million to $10 million. This increased retention rate may lead to volatility in quarterly results. Despite this, we believe a higher retention rate is in the long-term economic interest of the company. Total revenues were up 5.7% in the second quarter, with increases in net premium earned. Net income before the LPT increased $0.03 or $0.06 per diluted share in the second quarter year-over-year.
Underwriting income of $9.7 million declined $4 million in the quarter, while underwriting income before the LPT was flat year-over-year at $2.1 million. Excluding impacts related to the LPT, our loss ratio increased 1.1 percentage points year-over-year due to the higher provision rate for losses compared with the second quarter of 2015. Our net written premium in the second quarter was flat as we recorded a $10.3 million increase in final audit premium year-over-year, which was offset by a slight decline in new and renewal premiums. Average policy size declined 2.1% year-over-year. In-force policy count was flat due to a decline in California of 5.6%. Policy count increased 6.5% in states outside of California. Net investment income in the second quarter was flat. Pre-tax book and tax equivalent yields were 3.2% and 3.7% respectively.
Net realized gains of $6 million resulted primarily from the sale of equity securities as a part of our regular rebalancing of our high-dividend equity investment portfolio and to meet cash needs at the holding company. Our underwriting and other operating expenses for the quarter were $33.6 million, an increase of $1.1 million or 3.4% relative to the second quarter of 2015. This increase was driven by increased premium taxes and compensation expenses. Our underwriting expense ratio of 19% was one tenth of 1% lower than the same period last year. Income tax expense increased $3.8 million in the quarter, largely due to a year-over-year increase in projected annual net income before taxes. Our effective tax rate for the quarter was 23.1%. We continue to actively manage our capital, and our balance sheet remains strong.
The market value of our investment portfolio was $2.5 billion at the end of the quarter, an increase of approximately 1% since December 31st of 2015. The average credit quality of the fixed income portfolio was unchanged at double A minus, with a duration of 4.1. Equity securities represented 7.2% of our investment portfolio. At the holding company at the end of the second quarter, we had approximately $79.4 million in cash and securities. We hit a major milestone as our shareholders' equity, including the LPT deferred reinsurance gain, exceeded $1 billion. Our book value per share increased 7% since December 31st and 11% year-over-year. Our adjusted book value per share, which excludes unrealized gains, increased 3% since the end of last year and 9% year-over-year. We are executing upon our previously announced and authorized two-year share repurchase program.
In the quarter, we repurchased 204,954 of our common shares at an average price of $28.71, totaling $5.9 million. Our Board of Directors declared a dividend on our common stock of $0.09 per share for the third quarter. With that overview, I'll turn the call over to Steve Festa, our Chief Operating Officer.
Thank you, Doug, and good morning. As was referenced earlier in the call, net premiums written of $188.7 million were flat year-over-year for the quarter, reflecting a $10.3 million increase in final audit premium and a decline in new and renewal premiums. With respect to the slight decline in new and renewal premiums, this was driven by results in the Southern California market. Outside of Southern California, specifically the rest of the state, as well as the other states that we write business in, our new and renewal premium increased year-over-year for the quarter, and policy count outside of California grew 6.5%. Several of our larger targeted states exhibited double-digit new premium growth over the second quarter of 2015. In addition, policy unit retention rates on existing business continued to be higher than traditional norms.
This trend, which started in the second half of last year, has continued through the first two quarters of this year. This has occurred despite a very competitive environment in the states we do business in, as well as declining rates in the majority of those states. In Southern California, we experienced a decline in new and renewal business for the quarter. In prior calls, we discussed our disciplined focus on our pricing actions in this market. We have made it clear that if we are unable to achieve the appropriate price based on our profit expectations, we would walk away from the respective opportunity. This applies to both new as well as renewal business. We have executed on this strategy and will do so in the future as well. This will allow us to preserve the gains we have made in our profitability over the past two years.
We do know that there are, and will continue to be, profitable opportunities in this market, and we will continue to right these opportunities in the future. With respect to the increases in final audit premium, these increases have occurred mainly due to increased payroll through the policy period and noted at final audit. These payroll increases are driven by an increase in hours from existing employees, as well as the addition of new employees at the businesses we insure. We have seen this trend over the past several quarters. We are unable to forecast how long we expect this trend to continue, however. Finally, as Doug mentioned, our results in the quarter were impacted by four large losses totaling $6.5 million in excess of expected losses. Excluding the impact of these four losses, our current accident year loss estimate declined in the second quarter, year-over-year.
These losses were random, and it is important to note that they originated from insureds that are in classes of business that are aligned with our strategy of writing small business and low hazard risks. Although infrequent, these types of losses do occasionally occur even in the most profitable classes of business. Now I will turn the call back to Doug.
Thanks, Steve. Our second quarter and year-to-date results continue to be favorably impacted by successful execution of our strategic underwriting, pricing, and claims initiatives. Our business plan for 2016 continues our focus on expanding our distribution channel of partners and agents focused on small business with an ultimate goal of writing business nationwide. In addition, we are implementing our Predictive Analytics initiative as well as the multi-year replacement of our policy administration system. As we mentioned last quarter, we continue to expect flat to slight declines in net rate, modest growth in policy count, and markets that are competitive. With that, operator, we'll now turn the call over for questions.
Ladies and gentlemen, if you have a question or a comment at this time, please press the star then the one key on your touch-tone telephone. If your question has been answered and you wish to remove yourself from the queue, please press the pound key. Our first question comes from Mark Hughes with SunTrust.
Hi. Thank you very much. Good morning.
Good morning.
The current accident year losses, you say, other than the large items, would've been consistent with Q1. Assuming there's no recurrence of these large losses, would we think about the Q3 loss being like the $64.1?
I can't forecast what the actual provision rate will be for the quarter. If you look at the underlying trends, as we indicated, we've continued to see a decline in frequency and absent the large losses, severity has been flat to just slightly up. Absent the large losses, I don't see anything that likely changes the trend.
Right. Having had these large losses, is that something you take a more conservative view, or you just treat it as completely random, the approach would be to go back to the former state of affairs?
The way we look at our provision rate is we build in some expectation for larger losses. In our comments this morning, you'll note that we referred to the $6.5 million pre-tax in excess of expected large losses. We do expect that there will be some. Again, they tend to be unpredictable, but given the size of the book of business, we build them into our plan. If there aren't large losses in excess of expectation, the underlying loss ratio should be in line with current trends.
Anything you can say, have you had any large losses so far this quarter? Would the trend be still elevated so far this quarter?
You're talking July?
That's right. Just in terms of large losses.
We haven't had any reported in July.
Okay.
That would be in excess of expectation.
Gotcha. The last couple of years, third quarter underwriting and other expense on an absolute basis was down sequentially. I think you've maybe discussed some of those dynamics. Is the same sort of situation in place this year? I know you don't give that sort of guidance precisely, but same sort of factors driving the absolute level of underwriting and other operating costs?
That number quarter to quarter can have some volatility because of the timing of typically some larger activities that might be related to professional fees or consulting. There's nothing unique about the third quarter in terms of run rate expenses that would make it different.
Okay.
Yeah.
This is Terry. Just to add a little bit of color to that. I think you should probably focus on the trend that we're seeing for the six months to date as being something more in line. I think the second quarter probably benefited slightly from the timing of these projects that we're undertaking. We would expect those expenses to flow through in the second half. I think the half-year trend is probably more in line with where we're headed.
Right. How about the new business trends? New and renewal down a little bit. Your retention has been good. Your audit premium has been good. Are we in kind of a steady state environment because of competition, or can we expect a little better or worse?
Mark, this is Steve. I'll answer it. As was said earlier on the call, if you exclude the Southern California market quarter-over-quarter, we actually grew from a new and renewal premium standpoint. Let me talk briefly about some of the headwinds and tailwinds that we've seen and our expectations for them in the second half of the year. From a headwind standpoint, we've talked about this multiple times. We're seeing declining rates in the large majority of the states that we write business in. The market is very competitive in the comp arena, and in particular, in the type of classes that we like to write. Those are some of the headwinds that we've seen, and I expect to see them in the second half of the year as well.
From a tailwind standpoint, some of the things that we've seen as we've entered into some new states in the past year and our plans to enter into new states in the future, along with increased production from some of our new and existing partners. We've seen an increase in our submissions year-over-year, which is offsetting some of those headwinds that I alluded to earlier, definitely outside of the Southern California market. Although we can't predict premium with certainty, I would expect that written premium, absent the audit premium, to be in a relatively tight range, potentially slightly up, essentially flat or slightly down in the second half of the year, given current conditions.
Okay. Thank you. The Southern California, I guess your response there incorporates the Southern California, but you've been kind of re-underwriting that book, and I think you're on round 2 or round 3, perhaps. Where do we stand? When is that going to be stabilizing?
When we first started talking about our initiatives in Southern California, they predominantly dealt with getting off of our worst-performing risks, we've gone through that. That took us a year to cycle through all of those policies. We're past that stage. We're at the stage right now where the market is competitive in Southern California, we see competitors that are putting pricing out there, both on new and renewal business that we're not willing to match because we don't want to relax the underwriting gains that we've made over the past couple of years. We're going to continue to apply that disciplined pricing, in particular in that Southern California market. However, having said that, as I said earlier on the call, there are opportunities in that market, in particular in certain classes of business that, A, we're competitive in, and B, it's profitable for us.
Our objective here is not to shrink in the Southern California market, but that might be the outcome based upon some of the competitive pressures and our desire to maintain the underwriting improvements that we've seen over the past couple of years.
Thank you.
Yeah.
Again, ladies and gentlemen, if you have a question or a comment at this time, please press the star then the one key on your touch-tone telephone. Our next question comes from Matthew Carletti with JMP Securities.
Hey, thanks. Good morning. Just have a few questions. Mark covered most of them. If I could just follow up on the four large losses you called out. Steve, I appreciate your comments that they're kind of all within your targeted lower hazard classes. Were they distinctly different kind of subclasses of business, one's a restaurant, one plumber, so on and so forth, or were they related in that sense? Also, any color you could give on what sort of injuries? It's something that you view as consistent with that class of business.
Sure, Matt. I'd be happy to answer those questions. Just a couple of color on the risks first, then I'll talk about the accidents themselves. With one exception of the four, all of these policies, the other three are policies that we have had for multiple years, including one policy that we have insured for 15 years. We have a good track record with these risks specifically. When we talked earlier about these losses being random, they definitely are. We haven't seen these kind of losses with these specific risks over the years since we've insured them. I think that's an important point to note. The other thing is that these are businesses that fit very nicely into our strategy of small business, low hazard. These risks were restaurant risks and other service industry risks.
They weren't, A, new policies for us, with one exception, and B, they were clearly within our sweet spot in terms of the type of business that we have written historically and will continue to write in the future. In terms of the accidents themselves, they were very random. They involved a motor vehicle accident, a fall, and burns. Those are the type of claims that we're occasionally going to get, even in the best managed risks. A little bit of color on the insureds themselves and the claims as well.
That's very helpful. Thank you. Just a couple of numbers questions for Terry. Two items. One just on investment income, roughly $18.5 million in the quarter. Is that a reasonable run rate number? Was there anything in there that was more one time that would skew it up or down? Second question, just any guidance you can provide on the tax rate? Is there any reason to believe that kind of the six-month run rate should look materially different going forward?
Yeah. Good questions, Matt. First of all, in terms of investment income, I think we are experiencing the same pressures that pretty much every insurance company is with regards to reinvestment yields. Reinvestment yields because of the movement in the 10-year treasury rate, which has come down, let's see, almost 70 or 80 basis points since the year-end, have been very challenging. As a result of that, we have deliberately taken the decision to accumulate cash, and presently we don't see compelling opportunities to deploy that cash. If that situation doesn't correct itself over the near term, then we may continue to see some continuing pressure on investment income. Our expectation, though, is that what we've seen in the most recent quarter is probably in line with where we will continue.
I would emphasize that we may choose to hold higher levels of cash balances than we've typically held to really identify compelling opportunities to put that cash to work.
Okay, great. Tax rate?
The tax rate. I think the tax rate is in line with our overall expectation. The effective tax rate fell slightly in the current quarter by virtue of the LPT reserve adjustment, the $5 million adjustment. It impacted-
Right
the effective tax rate by 2.7 percentage points. Our best estimate right now, notwithstanding any of these adjustments in the second half of the year, is that we should remain in line with what we reported.
Okay, great. Thank you very much for the answers.
Thanks.
Our next question is a follow-up question from Mark Hughes with SunTrust.
Yeah, you had a little bit of a favorable development in the quarter. Any thoughts on the outlook there?
Let me deal with what we booked for the current quarter. Doug may choose to add some color in terms of our prior year reserves. The 1.2 percentage point favorable development in the loss ratio is driven by a release of assigned risk or residual business reserves from 2015. It does not relate to our voluntary book of business. I will speak with regards to prior year reserves.
Yeah, I'll take that one, Mark. I guess I'd just summarize it very generally as we're not experiencing any pressure on prior period reserves. Years will flutter up and down. Sometimes it might be related to an individual claim in some of the more mature years. But there's no pressure on prior period reserves.
When you say no pressure, is that no pressure to release the reserves?
No, there's no pressure to take them up. The concern for some time has been the adequacy of our reserves, frankly, that's not been a real issue for us. As we're looking at it, in the more current periods, somewhat more favorable. Again, that can be offset by individual claims in some of the older years. Overall, a very stable reserve picture.
Thank you.
I'm not showing any further questions at this time. I'd like to turn the call back over to Douglas Dirks.
Very good. Thank you, everyone, for joining us today. We appreciate your questions and your interest, and we look forward to speaking to you again in the fall with our third quarter results. Thank you.
Ladies and gentlemen, this concludes today's presentation. You may now disconnect, and have a wonderful day.