Good day, ladies and gentlemen, and welcome to the third quarter 2015 Employers Holdings earnings conference call. My name is Matthew, and I will be your operator for today. At this time, all participants are in listen-only mode. We will conduct a question-and-answer session toward the end of this conference. If at any time during the call you require assistance, please press star zero and an operator will be happy to assist you. As a reminder, this call is being recorded for replay purposes. Now I'd like to turn the call over to Vicki Mills, vice president of investor relations. Please proceed, ma'am.
Thank you, Matthew. Good morning and welcome everyone to the third quarter 2015 earnings call for Employers. Yesterday, we announced our earnings results, and 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, and Terry Eleftheriou, our Chief Financial Officer. Due to a family medical situation, Steve Festa, our Chief Operating Officer, is unable to join us today. 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. Now I will turn the call over to Doug.
Thank you, Vicki, and thank you everyone for joining us today. Employers had another strong quarter. Our third quarter annualized operating return on equity was 9.9%. That is an increase of 5 percentage points, or 102% year-over-year, and 1.7 points, or 21%, over the second quarter of 2015. We recognized underwriting income before the LPT of $7.9 million, compared with an underwriting loss in the third quarter of last year. We will continue to price our coverage to properly reflect loss probabilities, and we have consistently demonstrated our willingness to forego business to competitors who price business at rates we consider insufficient. Our combined ratio before the LPT of 95.6 improved 8.8 points year-over-year and 3.2 points over the second quarter of this year.
Our adjusted book value per share, excluding unrealized gains, was $26.23 at the end of the quarter, an increase of 5% since the end of last year. Our strong third quarter results were in line with our loss and expense expectations. Revenues were below expectations due to lower than expected new and renewal business in Southern California, as well as lower than expected new business production in most parts of the country. Outside of Southern California, renewals in the quarter exceeded expectations. Since June of 2014, we non-renewed 11.8% of our premium available to renew in Southern California. In addition, 16.6% of the business we offered to renew in Southern California was written by competitors, presumably at a lower rate. In the third quarter, year-over-year, our in-force premium declined 2% overall and 6% in California. Our overall in-force premium count declined 1% overall and 7% in California.
In-force payroll exposure was less than 1% lower overall, but 10% lower in California. This means that we are generating more underwriting margin on less risk. Outside California, 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%, in-force premium by 4%, and payroll exposure by 6%. This growth, coupled with our results in California, has reduced our percentage of in-force premium in California to 57% of our total book in September 30th, 2015. This is almost a three percentage point decline since year-end. We have spoken previously about our diversification strategy of growing revenue outside of California and lessening our dependence on the Southern California market.
These results speak to the success of the actions we have taken to accomplish this strategy. Despite the impacts our initiatives are having on retention rates within the Southern California market, we are recognizing improved retention rates overall. Our policy retention rate nationally has improved five points year-over-year. Throughout this year, we have experienced an increasingly competitive operating environment in all of our states as multi-line and regional carriers target workers' compensation. Our net rate in California increased 4% as a result of the application of territorial multipliers, the effect of which has been to decrease new and renewal business in Southern California, and to increase new and renewal business in other parts of California, where losses are less volatile and margins are more attractive. Nationwide, net rates climbed 2%, in line with industry trends. With that, I'll turn the call over to Terry.
Thank you, Doug. Good morning, everyone. We again delivered solid operating earnings in the current quarter, in line with our expectations. Net premium written increased 1.4%, and net premium earned increased 4% year-over-year in the quarter. These increases were largely driven by higher final audit premium compared to the third quarter of 2014. The increase in final audit premium resulted from the following items. First, revised payrolls on expired policies upon final audit for the quarter were at levels significantly higher than estimates and were higher than what we have seen year to date. Second, we implemented a new audit process that drove a much higher level of compliance among our policyholders, particularly for our California business. These factors led to an 88% increase in final audit premium in the third quarter relative to the same period in the prior year.
This impacted net written premium and net earned premium by $10.1 million in the current quarter, which resulted in a 0.8 percentage point improvement in our quarterly expense ratio compared to the prior year. While this final audit premium impacted our expense ratio for the quarter, it only increases our operating earnings per share by $0.04 per diluted share for the quarter. We continued to prudently manage our expenses. Our underwriting and other operating expenses for the quarter were $31.6 million, or approximately 1% lower than in the same period last year. Our underwriting expense ratio declined almost one percentage point year-over-year, with the largest contributor being the increased final audit premiums that I just mentioned. Our third quarter loss ratio before the LPT improved 7.7 percentage points over the prior year, driven largely by a lower current accident year loss provision rate of 66.3%.
A decline of 7.1 percentage points year-over-year, and 20 basis points lower than the end of the second quarter. As I discussed during our second quarter earnings call, the year-over-year decline in our loss provision rate has been driven by a number of factors, including rate changes, loss trends, changes in business mix by territory and by class, our strategic underwriting initiatives, and the non-renewal of higher loss ratio business, particularly in Southern California. The reduction in our third quarter loss pick was the result of three factors in roughly equal parts. These include the year-to-date shift in business mix by state and territory, improved pricing in California, and the non-renewal of poorly performing business in Southern California.
While our indemnity claims frequency decreased year-over-year, our loss experience indicated a slight upward movement in medical and indemnity cost per claim, which are reflected in the current accident year loss estimate. There were no changes to prior accident year reserves for our voluntary business. Once again, in the third quarter, there was no adverse development in our prior period reserves. Third quarter net investment income of $18.5 million increased 1.6% year-over-year, attributable to an increase in invested assets. The average pre-tax book yield on invested assets was unchanged at 3.2%. The tax equivalent yield on invested assets decreased to 3.8% at September 30th, 2015, compared to 3.9% at September 30th, 2014. Income tax expense increased $4.6 million in the quarter, primarily due to a year-over-year increase in projected annual net income before taxes. Our effective tax rate was 19.4% in the quarter.
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 3.6% since December 31st of 2014. The average quality of the fixed income portfolio was unchanged at AA- with a duration of 4.2. Equity securities represented 7.8% of our investment portfolio. High dividend equity portfolio rebalancing generated $1.7 million in gains, accounting for nearly all of the realized investment gains in the quarter. At the holding company, at the end of the third quarter, we had $76 million in cash and securities net of restricted cash and securities. Now I'll turn the call back over to Doug.
Thanks, Terry. Our results for the quarter reflect the continuation of actions that we initiated over a year ago. We have again made good progress in reducing underwriting risk while improving profitability. We continue to remain focused on creating value for our customers and for our shareholders. With that operator, we're ready to open the call up for questions.
Thank you very much. Ladies and gentlemen, if you wish to ask a question, please press star followed by 1 on your touch-tone telephone. If your question has been answered or you wish to withdraw your question, press star followed by 2. Press star 1 to begin. Please stand by for your first question. Your first question comes from Mark Hughes of SunTrust. Please go ahead.
Thank you very much. Good morning.
Good morning.
The audit premium, you've got a new process in place that obviously was very helpful in Q3. Should we anticipate more potential gains as other policies expire and are audited?
Hi, Mark. This is Terry. In terms of the final audit premium pickup in the third quarter, I think there's a number of factors that I tried to reference in my comments that have driven that. This new audit process that we've implemented that's driving a greater compliance. The other piece of it is the fact that the revised payrolls that are reported have increased as well. There are two elements to that. One is the extent to which payrolls were underreported when the policy was first issued, and the extent to which payrolls that are reported really reflect true sort of economic growth in our policyholders' businesses. I think it's really difficult to sort of assess the split of that between the two elements. if I was to-
How about the sustainability of that? I guess I assume if it's both of those factors should be just as true this quarter as they were last quarter.
yeah, I was just about to get onto that. in terms of-
Yep
Looking forward, I think I would say that it's very difficult from largely the last two months of the quarter where this really manifested itself to really draw a trend from that. I would be hesitant to draw a trend. The final audit premium, I think it historically, if you look at it, has fluctuated quarter on quarter. I think if we look at the year-to-date results, we're probably in line with where we were last year for the same period. I don't know if I can really say there's any trend here that I think we just need to see what the subsequent months show us.
Any early sense on 4Q?
In terms of final audit premium?
Yep.
No, I can't give you any guidance there.
Okay. The benefit to the expense line, the 1.8 points, there's no benefit to commission or losses in a case with this audit premium. Is that correct?
Correct.
The commissions were a little lower sequentially this quarter. Was that a function of the lower production? I guess, as a % of earned, it was down sequentially. Should it stay at this lower level, or will it maybe move back up a little bit?
I think we cited in the last call that we had for the second quarter that there were factors that drove the commission ratio higher for the second quarter. We talked about some temporary sales incentive programs that we had that have sort of ceased. I think if you look at the year-to-date, we gave guidance that we would expect our commission ratio to be in the 12%-12.5% range. If you look at the year-to-date, we're at 12.3%. I think that's probably in the ballpark of what we would expect.
Okay. Then the lower than anticipated new business. I hear what you're saying, a little more competitive environment. Would you anticipate, are there steps you can take? What's your feeling about how that is going to shake out over the next few quarters?
Mark, this is Doug. We're still putting final touches on our plan for 2016. Just to describe what that process is, we go class by class, state by state, and build it from the ground up. We've not finished that. We've not come to a final view for 2016. We think there will be opportunities for us to pursue growth by expanding into additional states and identifying additional pursue classes of business in the states we're currently in. That's the opportunity for growth. The impact we've had on our book as a result of actions taken in Southern California will begin to moderate as we go through the balance of this year and into next year, both in terms of an impact on policy counts as well as an impact on premium. You saw that in last quarter's numbers.
Although we're still getting more rate in Southern California, we are seeing a fall off in policies continuing, but at a slower rate. Those are kind of the forces that will impact going forward. Clearly our objective remains the same. We want to continue to grow at a faster rate outside of California and change the business mix within California so that we have less dependence on the L.A. basin.
That Southern California steps, you did kind of a round, then I think you're on your second round of pricing adjustments. How many points headwind do you think that was this quarter, and when does that drop off?
Well, we did the last rate filing that is having an impact on that Southern California book back in June. We still have eight more months for that to work its way through the book. We will have a headwind there. How big of a headwind is somewhat dependent on what the competition does in that marketplace. We're putting up a price. We're not adjusting our price so that we can retain more of it or lose more of it. How much stays on the books is a function of what our competitors do. We're setting our pricing independent of what we think they're going to do. There's still another eight months or so for that to work its way through the book.
Just one final one. Terry, getting back to the audit process, I guess I have to assume if you've got a new audit process in place, it was very successful for the last couple of months of the third quarter. You'll be applying that audit process to an incremental group of new policies that are being audited this quarter. Is there any reason not to think that you ought to have, maybe not the same magnitude of benefit, but some still meaningful benefit?
Yeah, the process that we've implemented and began in large part during the latter part of the second quarter, that process will continue. We would expect that it will continue to drive high levels of compliance.
Okay. Thank you.
Thank you for your question. Your next question comes from the line of Amit Kumar of Macquarie. Please go ahead.
Thanks. Good morning, and congrats on another strong quarter. Maybe just a few quick questions. I apologize if you answered these because I had to jump from another call. If you look at the underlying loss ratio, obviously it was very strong this quarter. We've seen, I guess, you guys on a streak here in terms of the improvement in the loss ratio. Can you talk about the sustainability as the prior rate increases are earned? At what point does this flatten, or do you think we continue on this improving arc, if you will?
This is Doug. I'll take that question, Amit. A couple of things I'd point to. The first is we're not seeing significant changes in loss trends. That's been true through the year. As I just referenced to Mark's last question, rate increases are moderating in California. We're continuing to see them in Southern California. We are continuing to see a reduction in our higher loss business in L.A. That's a positive in terms of the loss trend. If you look nationwide, rates are flat to declining outside of California. If you look at the NCCI states, the projections, either the filed or approved rates for 2016 are down in almost all of the states where we're doing business. There is less than a handful that are seeing modest increases, less than 2%.
That would suggest that we are going to be reaching a point that's going to be more normal in terms of loss ratio. I can't project whether or not it's going to go down more, go up. I think it is going to flatten. I would be surprised to see another eight-point decline next year, given all of the items I've just discussed. Those are the factors that we expect will impact it going forward. Again, I can't put a number on any one of them individually. Everything would suggest that there will be a slowing to a flattening going forward.
That's helpful. The only other question I have is just based on, I guess, the backdrop of strong results. We're also talking about, I guess, pricing overall slipping nationwide. There was some discussion in the past of more competitors showing up over the past few years. Did you address the competition? Is it steady state, or do you think based on where we are in the market cycle, they are beginning to pull back, too?
I would say the competition continues nationwide. It is a competitive market, but I would stress that for the most part, what we're seeing in the market is rationality in terms of pricing. It's not universal. It never is. It never will be. But for the most part, the market is pricing business, in our view, rationally. It's competitive. You've got to be in the market. When you look at the declining rate levels, it's not just a function of pricing. It's loss experience. The industry is experiencing favorable loss trends in most of the country. The declining revenue stream, the top line is not just a function of competitive pricing, but it's a function of improving loss fundamentals. Yeah, I think you have to break those two up.
Again, it's pretty hard to assign a number to one or the other, but the decline in revenue is not solely related to a more competitive market.
Got it. That's all I have. Thanks for the answers.
Thank you for your question. Your next question comes from the line of Matthew Carletti of JMP Securities. Please proceed.
Thanks. Good morning. Just had a couple questions that haven't been covered. One, Terry Eleftheriou, just want to follow up on kind of where we left the audit premium discussion with Mark Hughes. You mentioned how the new process, I think the way you put it was, drives better compliance. I guess my question is just in trying to understand the new process, is it that these are premiums that maybe in the past might have gone uncollected by the company at some point, so net-net, it's better compliance in that sense in terms of you're auditing more accounts or however you might go about it? Or is it more of a timing issue in that you're either more quickly auditing the accounts and just accelerating the recognition of that final audit premium?
Matt Carletti, as you probably understand, the process of estimating final audit premiums is a fairly complex one. We set accruals on a monthly and quarterly basis in terms of what we expect to be able to bill. That accrual process looks at historical data. It looks at the level of pickup in final audit premiums. It looks at a variety of factors. A big driver, as I pointed out in my comments in terms of the pickup in the current quarter is the fact that, yes, this new audit process has driven a much higher level of compliance. It's sort of accelerated the reporting of final payrolls that we perhaps didn't get as quickly as we'd received in the past. There's been a much higher percentage of compliance for the audits that we have undertaken. We saw a significant pickup there.
The other piece of it is this piece around the actual final reported payrolls that our clients submit. Yes, they're much quicker to provide us with the final audit payrolls. They're also the payrolls that they submit or the locations that they operate under have increased. Those two things drive it. To be able to sort of assign how much applies to each of those is very sort of subjective. I don't really have that level of data analysis, but I think the second part of it is probably more significant than the former.
Okay, thanks. That's quite helpful. Just last one, just a numbers question. We saw and you mentioned that there was an aggregate, essentially no development, prior period development in the quarter. I'm just curious, were there any large movements year by year, whether it's favorable in a few years offsetting adverse in others, or was it just pretty quiet across the board?
No significant. I think the only thing we show in our earnings release is a 10-basis point improvement. That relates to our involuntary business, no significant change.
All right. Thanks very much. Congrats on a nice result in the quarter.
Thank you.
Thank you. Your next question comes from the line of Brian Rohman of Boston Partners. Please go ahead.
Good morning. Good quarter, guys.
Thanks, Brian.
Thank you, Brian.
Couple of questions. Following up on something that Mark asked earlier, you said a slowing or a flattening of the combined ratio. Are you suggesting that Nobody expected to continue to improve eight percentage points year-over-year forever. You're suggesting where it is right now based on the stability in loss costs that 94 or so, I think that was the number for the quarter, is sustainable for some period going forward?
I'm not going to take debate on that one, Brian.
I'm not trying to project.
I know. I'm happy to address that question. We continue to see improvement in the line because loss cost frequency's coming back down again. Severity is relatively modest. That provides an opportunity for some continuing improvement in the loss ratio. The actions we're taking in California, we're still getting rate on the business we want to keep in Southern California. In terms of the more aggressive action of non-renewing business in Southern California, that's essentially done. It never ends, but the initiative was a 12-month initiative. We've taken care of that. There are other parts of the country, frankly, where the business is performing extremely well, and we're going to have to concede some margin to keep that business. That's why when we suggest that it's moderating, potentially flattening, there are offsets there. Depending on what state you're in, or even within parts of a particular state.
That's what will happen as we go through 2016. Again, we've not finalized those plans yet, but certainly, we would hope that we can continue to show improvement in loss ratio.
Okay. That's fair. I got to ask you some questions about capital here. AM Best, you're still A- with negative outlook? Whatever they call it.
Yes. Thank you for asking that. I'll just give you an update on that. We did have our annual meeting with AM Best several weeks ago. We are in our normal rating cycle. Typically, in that normal rating cycle, we would expect an action from Best sometime near the end of the year. We don't control that, they do. If it were to follow past process, that's what we would expect.
Sometime before year-end?
Typically, that would be the case, yes. I have no reason to think it would be different from that this year. Again, we don't control the timing on that.
I always ask questions about what are you going to do with all your capital. When you sit down with AM Best, do they ask you what are your potential plans for uses of excess capital or capital generation, or do they just review the business at hand?
As a part of that process, we do provide a multi-year projection. The multi-year projection addresses both operating results and capital.
Let's just say that, for argument's sake, they take the negative watch off. However you slice it, you've got a lot of capital, and the business isn't growing. In fact, it's getting a little bit smaller, and you're generating capital. Absent an acquisition of some size, maybe you could talk through what are the potential options for use of capital, because it's going to get increasingly hard to generate a decent return on equity if the capital builds.
I would agree with that. For purpose of that discussion, I'll take your points. Let's take M&A activity off the table. Let's take off dramatic demands on capital because of organic growth. I'm taking those off to be consistent with your question. That leaves us with a handful of actions, and those are all returning capital to shareholders.
Okay.
That could occur through the ordinary dividend, it could occur through an extraordinary dividend, it could occur through share purchases. Those are all options for us. I would agree that given our current results, if you were to project them forward, there would be a buildup of capital in the company. Clearly, generating the type of results we are now with almost a double-digit return in our operating return on equity, we are clearing our cost of capital, and we are able to build up capital in the organization. If we achieve our targets, I would expect that, as you described, we will need to define a capital strategy that would likely include some return of capital to shareholders through some mechanism.
Last question, what are your thoughts on acquisitions? Is there stuff in the marketplace? What sort of things would make sense?
We would certainly be interested in anything that allowed us to improve our footprint in the market. At this point, we are not actively pursuing an expansion of other lines of insurance. I've always described it as something that opportunistically we would be interested in. We're not out trying to make that occur. We are focused on the business we're in today, and I'm very pleased with the results we've been able to generate, not only in the last quarter, but over the last about seven quarters now. That is our focus, but we've always viewed M&A activity as opportunistic.
Great. Thank you for taking my questions.
You're welcome. Thank you.
Thank you. Just to remind you, ladies and gentlemen, to ask a question, please key star followed by one on your telephone. Your next question comes from line of Mark Hughes of SunTrust. Please proceed.
Could you talk about the loss development on the older accident years? You've talked in times past about how your loss performance on some of your claims in California, for instance, your losses were lower than peers. I'm just sort of curious, as time goes by and you get more credibility in your experience, how do you see the older accident years developing? You've been kind of flat in recent quarters in terms of development. What are the prospects for that, again, with more time and better information to come out differently? I guess the other point is you've been settling claims at an accelerated pace. You've commented on that as well. When does that start to show up in loss development?
I'll address that, Mark. Let's start with our performance relative to the industry. I had the opportunity to sit through a presentation within the last 30 days or so with updated data. This comes out of the CWCI, so it's a very good view of total claims experience in California. We continue to see an outperformance relative to the industry on a paid basis, really across the board. We've attributed some of that, probably a significant part of it, to our outcomes-based network. We are driving much better medical results in California today than we were previously. Previously, we were outperforming the industry. That continues. In terms of our accelerated claims settlement, that's happening nationwide. Clearly, California is the biggest part of the book, and it's having the largest impact there. We are starting to see that emerge in the actuarial data.
It takes a little bit longer to see it in the actuarial data than it does in the paid data, but we can observe it in real-time. It continues to be a favorable impact on our overall loss results. As that makes its way through the actuarial work, I would expect we'll start to see more benefit from that. That initiative is not finished. We are continuing to aggressively pursue claims and get them closed so that there's no exposure to development going forward. That's had a very favorable impact. That eventually will reach an end. That's not a forever process. We have changed our claims process. We'll be much more aggressive in trying to settle claims within, say, the first three years and get that risk off the books.
Your point about your superior performance in California, is that already reflected in your reserves? If it's sustained and you give it more credibility, then it will lead to potential favorable development?
We're starting to see it work its way through the actuarial data. It takes time, number 1, for it to get into the data, then work its way through, and then finally, for the actuaries to assign it higher levels of credibility. It's not something that happens overnight. It is a lengthier process as that experience emerges in the loss triangles. The actuaries are very much aware of what's happening in real-time, and it certainly influences their opinions in terms of loss picks, but they very much wait to see it emerge through the data.
You could have a situation where current accident year dynamics are slowing in terms of improvement, possibly flattening, at the same time, your development on prior accident years could begin to emerge in a more favorable way. Is that fair?
I'm not quite sure how I want to answer that one, Mark. I think that's a reasonable assumption. I'm not projecting that, but I think that's a reasonable assumption.
Right. Okay. Not to put words in your mouth. Thank you.
No, no.
Thank you. Just to remind you, ladies and gentlemen, to ask a question, please key star then one on your telephone. We have no more questions at this time. Now I would like to turn the call back over to Mr. Doug Dirks for the closing remarks.
Thank you very much. Thank you, everyone, for joining us on the call today. We appreciate your participation and your questions. We look forward to seeing you February next year to report our full 2015 results. Thank you, and have a good day.
Thank you for joining in today's conference, ladies and gentlemen. This concludes the presentation. You may now disconnect. Good day.