Good day, ladies and gentlemen, and welcome to the Q1 2015 Employers Holdings Inc. earnings conference call. My name is Kate 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 towards 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 conference is being recorded for replay purposes. I would like to now turn the call over to Vicki Mills, Vice President, Investor Relations. Please proceed, ma'am.
Thank you, Kate. Good morning and welcome everyone to the first quarter 2015 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 Douglas Dirks, our Chief Executive Officer, Stephen Festa, our Chief Operating Officer, and our Chief Financial Officer, Terry Eleftheriou. 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.
Hello, Doug, we can't hear you into the call.
We're making a change to the mic.
Are we back? Can you hear me now?
I can hear you now. Please proceed, sir.
Thank you. Thank you, Vicki, and thank you all for joining us on the call today. We just had a minor technical issue. I will start my comments over again. Our first quarter results compared to the first quarter in 2014 indicate a strong start to this year. Our net income before the LPT increased $0.14 per diluted share relative to last year's first quarter. Our operating return on equity, adjusted for the LPT, increased 2.6 percentage points to 5.1%. Our combined ratio before the LPT improved six percentage points, and our book value per outstanding common share increased 1% since December 31st of last year and 8% year-over-year. These solid results reflect a number of continuing favorable trends in our business. First, our net rate was 12.4% higher in California and 3.1% higher overall in the past 12 months.
Second, our year-over-year payroll exposure was 13.9% lower in California and 3.6% lower overall. Third, as rate increases continued to outpace increases in loss costs, we again lowered our provision rate for current accident year losses. This, in turn, is driving the ongoing improvements in our loss ratio and the combined ratio. An advisory rate filing in April by the Rating Bureau in California indicates that loss emergence for accident years 2014 and prior was better than expected. The Bureau proposed an average pure premium rate decrease, which is 5% lower than the industry average filed pure premium rate and 10% less than the approved average advisory pure premium rate as of January 1st, 2015.
In our book of business, our indemnity claims frequency decreased year-over-year, and our loss experience indicates a slight upward movement in medical indemnity cost per claim that is reflected in our current accident year loss estimate. These favorable trends in our net rate, exposure, and losses are in large part results of our pricing and underwriting initiatives that we implemented last year. These include the use of the three-company pricing with territorial multipliers in California, non-renewing or increasing prices for underperforming business, and slowing policy count growth in California while targeting attractive classes of business in and outside of California. The decline in our top line this quarter was also the direct result of these initiatives and was largely linked to our Southern California business. We expect that premium in 2015 will reflect moderating net rate increases, modest growth in policy count and increasing competition.
We have filed adjustments to territorial multipliers in California effective June of this year. This rate action will result in price increases in the Los Angeles Basin and more competitive pricing in targeted areas of the rest of California. We are observing a more competitive operating environment this year as multi-line carriers are targeting workers' compensation in California and all of our states, particularly for accounts with annual premium greater than $25,000. Our growth plan for 2015 is focused on increasing policy count and premium in our states outside of California. This plan includes expanding our distribution channel of partners focused on small business. In addition, we plan to enter new states in the second half of this year. Our longer-term goal is to be writing business in all of the continental U.S., with the exception of the monopolistic states.
The expansion of our footprint will help us attain our goal of reducing our geographic concentration in California, which at the end of the first quarter, declined 2.5% of our total in-force premium and 5% as a percent of our policies. Additionally, we will continue our focus on technology, which includes the further development of predictive analytics and a multi-year replacement of our policy administration system. With that, I'll turn the call over to Terry. Terry?
Thank you, Doug. Our pricing and underwriting initiatives over the past year continue to drive improved operating results. Our operating income increased $0.17 per diluted share, or 121% in the first quarter, due largely to decreases in losses and loss adjustment expenses. You will note that we are now reporting our operating return on equity, which increased by 2.6 percentage points to 5.1% for the current quarter. Our reported operating return excludes amounts related to the LPT and both realized and unrealized gains net of taxes. These items are excluded because they are impacted by economic and other factors that are not necessarily indicative of trends in our operating performance. Operating income and operating return are important measures that reflect multiple disciplines that are critical to creating long-term shareholder value. We believe that tracking and reporting these measures will better align the interests of management and shareholders.
Our first quarter combined ratio before the LPT improved six percentage points year-over-year to 101.6%. We lowered our provision rate for current accident year losses by 6.9 percentage points year-over-year as rate increases continue to outpace increases in loss costs. The provision rate for the current accident year was 67.7%. 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 is reflected in the current accident year loss estimate. Excluding impacts related to the LPT, our loss ratio declined seven percentage points year-over-year, largely due to the low provision rate for losses compared with the first quarter of 2014. Our $9 million increase in paid losses in the quarter was driven by an internal initiative that is focusing on settling claims.
Settlement payments were up 40% in the first quarter year-over-year. This resulted in savings in case reserves, while overall loss reserves remained constant. The 4.9% decline in net earned premium, which was a direct result of our underwriting actions in Southern California, caused a 1% increase in our expense ratio to 21.1%. In absolute terms, our expenses remained flat year-over-year, reflecting our continued focus on expense management. At the same time, we have been able to make important investments in our operations that will drive longer-term benefits to our business. Net investment income in the first quarter declined $1.1 million relative to the first quarter of 2014. Both pre-tax book and tax equivalent yields declined 20 basis points year-over-year to 3.1% and 3.8%, respectively.
Income tax expense increased $2.8 million in the quarter, primarily due to a year-over-year increase in projected annual net income before taxes. Our effective tax rate for the quarter of 22.5% reflects the improvement in our combined ratio. We continue to actively manage our capital, and our balance sheet remains strong. There were no changes to prior accident year reserves this quarter for our voluntary business. Once again, there was no adverse development in our prior period reserves. The market value of our investment portfolio was $2.5 billion at the end of the quarter, an increase of 3.8% since December the 31st of 2014. During the quarter, purchase activity was concentrated in the municipal, corporate, and structured sectors. Portfolio exposure to municipals held steady at approximately 30%. Equity portfolio rebalancing generated $1.2 million in net realized gains. Portfolio duration lengthened slightly to 4.1.
At the holding company at the end of the first quarter, we had $84.5 million in cash and securities, net of restricted cash and securities. Now I will turn the call over to Steve Festa, our Chief Operating Officer.
Good morning. As Terry mentioned, our results in the first quarter continue the trends exhibited in the second half of 2014. On a year-over-year basis, we have increased net income and improved our operating results, more specifically our combined ratio as well as operating return on shareholders' equity. In prior calls, we have spoken often about several strategic initiatives that were launched during the second quarter of 2014. The ultimate objective of these initiatives has been and will continue to be improved operating results. We have also spoken previously about the impact these initiatives could have on our top line in the short term as we have identified and targeted classes of business, specifically in the Southern California market, that have underperformed relative to our expectations.
We previously have indicated that we were raising rates in these classes and expressed a willingness to walk away if the appropriate price was not accepted. We have adhered to that commitment, and as a result, we have observed a decline in premium in the first quarter. We expect this decline to be temporary as we work through our renewal book of business in California, a process which started in June of 2014. We also indicated that the trade-off would be improved profitability, a result we have achieved again this quarter. It is important to note that outside of California, we have increased policy count by 5.8% on a year-over-year basis and in-force premium in excess of 3%. Those increases have come despite highly competitive markets with declining rates in many states.
Much of the improvement in our bottom line can be attributed to reducing our exposure in certain classes, specifically in the Southern California market. Additionally, since June of 2014, we have non-renewed 13.5% of our premium available to renew in this market because of poor individual risk characteristics. As indicated earlier, this reduced exposure has been offset by growth in other parts of the state, as well as outside of California. As mentioned on prior calls, we are committed to the California market, but our commitment extends only to those risks and classes of business that meet our profit expectations. We have also identified and targeted other classes of business with historically low ultimate loss ratios outside of California as well as in specific regions within California. Within these classes of business, we have seen growth in new business of more than 18% since the second quarter of 2014.
We expect that growth trend to continue as we expand our targeted classes of business that generate these profitable results. Our diversification strategy of growing revenue outside of California and lessening our dependence on the Southern California market has helped to improve our operating results. Earlier, Doug mentioned two technology initiatives we are working on this year. I want to comment further on these projects. In 2014, we began the development of a predictive modeling underwriting platform. With this platform, we will leverage our historical data with algorithms which will drive improved results in the selection and pricing of accounts. The implementation of this model will begin later this year. We plan to stage the implementation in several phases over a 12-month period, implementing a few states at a time.
This incremental rollout, initially in some of our smaller states, will enable us to make adjustments to the model as needed. Also in 2015, we began a multi-year project to replace our existing policy administration system. We believe that the new system will enable us to become more flexible and efficient as an organization and improve our customer-facing processes as well. We expect to fully deploy our new system in 2017. Now I will turn the call back to Doug.
Thanks, Steve. We're pleased with our continued improved profitability in the first quarter. Though top-line premium fell short of our expectations because of our profitability demands, we exceeded our targets in terms of losses, commissions, and underwriting expenses. With that operator, we'll turn the call over for questions.
Thank you. Ladies and gentlemen, if you wish to ask a question, please press star followed by one on your touch tone telephone. If your question has been answered or you wish to withdraw your question, press star followed by two. Press star one to begin, and please stand by for your first question. Your first question comes from the line of Amit Kumar, Macquarie Capital. Please go ahead.
From Macquarie. Congrats on the improvement in loss ratio. Just a few questions. Maybe just going back to the discussion on the Southern California markets and the non-renewal of the poorly performing business. You gave some numbers. Can you just sort of broadly talk about how far are you in that process? Are we getting closer? Is it just starting, or are we halfway there? Maybe just give us some sense on that.
Let me start with that question, Amit. We started that process June of last year, so we are most of the way through the non-renewal activity. It is a continuous process, but in terms of that first year, what we expected to do, we've been following that plan very closely. We just, at this point now, have a couple of months to go before we'll have gone through the whole cycle. The other piece of that plan had to do with repricing business that was acceptable to keep on the books, but only in the event we were able to get the price we needed. As I indicated earlier in my comments, with the adjustment to our territorial multiplier in Southern California, we will continue that push going forward.
I guess related to that is the discussion on the geographic concentration in California at, I think it's 58%, is what's in the press release. Broadly, if we step back, what would be a range where you might be comfortable at?
Our objective over the next three years is to not only decrease the percentage of business we have in California, but also decrease the percentage within California of Southern California to the rest of the state. We have an aggressive plan to accomplish that. I don't want to get into too much detail with respect to the long-term plan, but our expectation is by the end of this year that there will be a noticeable drop in that percentage in both Southern California compared to the rest of the state and California relative to our entire book.
Let me take a longer view on that, Amit. Ultimately, our objective is to be conducting business in all of the continental states, excluding the monopolies.
If this is a business strategy that suggests that we should have 2%-3% market share in all of those states, California represents 20% of the total U.S. comp market. We'll probably always have a heavier exposure to California because it's our most mature book of business. As Steve indicates, that number is certainly going to materially be falling over multiple years.
That's good to know. The other question I had, in your opening remarks, you briefly touched upon the rate decrease from the Bureau. Maybe just talk about how should we anticipate what the trajectory for your net rate might be for 2015, maybe just in broader terms.
There are a couple of considerations there. I'll point to the filing that we made that will be effective in June. We expect to push rate harder in Southern California.
If the market allows us to get that rate, our net rate in California will rise. If competitive market pressures prevent us from achieving that rate, well, it's not likely to rise by as much. We are conceding margin in other parts of the state where the book of business is performing very well.
We wish to remain competitive. I really can't give you a pick for that number because there are so many considerations. Broadly, we are continuing to push rate in the South and concede rate everywhere else.
Got it. Last question on, you mentioned briefly multi-line companies operating in the market. I'm curious, this is somewhat related, is the discussion on consolidation. Obviously, there's been a lot of discussion. We have seen a lot of consolidation on the Bermuda side. I'm wondering how do you feel about that in terms of Bermuda looking at specialty, in terms of broadening their portfolios. What sort of role do you expect to play? Has there been any sort of change in tone in terms of approaches, et cetera, what you may or may not have seen over the past few months or quarters? Thanks.
I can't comment on what's in the minds of people in Bermuda. Certainly, our markets don't lack for competition, and the returns are relatively attractive and improving. To what extent that influences M&A activity for those looking for specialty platforms, I can't comment. I also would say that I'm not noting any substantial change in trends.
Got it. Okay. That's all I have. Thanks for all the answers.
Thank you for your question. The next question comes from the line of Mark Hughes, SunTrust. Please proceed.
Thank you. Good morning. When we think about the second quarter, you've given a lot of puts and takes in terms of the growth initiatives, but you're still doing the repricing in Southern California, at least through June. Do you think you would see stability at the top line in terms of new business, perhaps, in the second quarter, or is that a second half event?
Mark, this is Steve. That realistically is a second half event. We're still working through that renewal cycle that started at the tail end of the second quarter of last year, and we're going to still see the impact from that first-year initiative, which will offset to some degree the growth that we will continue to see in states outside of California. Realistically, that's a second half, not a second quarter impact.
On the expense ratio, Terry, you had mentioned a one-point impact. What was that? Was that from a little lower premium that had a point impact, or was that some other factor?
Yes. A couple of comments there. Yes, you're indeed correct. The increase in the expense ratio is largely driven by the reduction in our net earned premium. As Doug mentioned in his closing remarks, we have exceeded expectations on expenses in aggregate terms. Quarter-on-quarter, or year-on-year, should I say, we are in line with what we incurred last year. I would also make one other observation. Our expenses on a quarterly basis have an uneven profile throughout the year. You will notice that historically, because of a variety of factors, largely driven by employee compensation and benefit, professional services, costs, those types of things. The first quarter and the second quarter tend to be at a higher level than the third and the fourth. We are very focused on expense management.
The current quarter in absolute terms came in lower than what we expected in terms of expenses. We are continuing to manage that closely as we move forward.
You say perhaps a similar seasonality this year to what you had last year?
Yes, I think that would be fair, that if you looked at 2014, we would expect a similar pattern.
Likewise, the tax rate, should we assume at this level through the balance of the year? I know that depends on overall levels of profitability, but I think you've made some judgments about that when you set the tax rate for this quarter. Should we assume a steady tax rate?
A couple of comments on tax. Our effective tax rate has risen this quarter to 22.5%. I believe the same quarter last year was around 10.5%. We determine our effective tax rate on a quarterly basis by projecting annual taxable income. If you were to look at note four in our consolidated financial statements for the quarter, which will be included in our 10-Q to be filed with the SEC later today, you'll see that there's a reconciliation of our tax expense between the federal statutory rate of 35% and our net effective rate. The reconciling items are what you would typically expect to see. There are dividends received deduction, our untaxed investment income, and the amortization on the deferred gain on the LPT.
The other items that have featured historically in our effective tax rate have been releases from pre-privatization reserves, which are nontaxable, and adjustments to the deferred gain because of changes in our expectation of loss reserves for that book of business. Those two items are very difficult to predict. I really couldn't give you any guidance on that.
Right. If you had to shade it, difficult to predict, I understand, would it be more likely to be kind of back to the lower level, or it could go either way?
I think it's fair to say that we would expect our tax rate to be in the low twenties as we continue our current strategy.
Right. If there is some volatility, would it be more likely to be on the downside?
The volatility, I think, would be driven by those two items that I just mentioned.
All right.
I really can't predict them.
Okay. The competition from the state fund, Doug, I think you had mentioned at AIFA perhaps that the state fund raising rates was a good thing. How are you viewing their competitive posture now?
Mark, this is Steve. It's a little premature at this point. Those rate changes went into effect April one. We're getting some information in. I would consider it more anecdotal at this point. I will be in a much better position to answer that question at the end of this quarter, next quarter.
What are the anecdotes telling you?
There's more of a movement towards in their tier 1 pricing, which is their preferred pricing to be much more selective in terms of the risks that get the benefit of that tier 1 pricing. That's clearly a theme that we're hearing at this point.
Right, which would be a positive, I presume?
Correct.
Okay. Thank you very much.
You're welcome.
Thank you for your question. Ladies and gentlemen, if you wish to ask a question, please press star one. Your next question comes from Matthew Carletti, JMP Securities. Please proceed.
Hey, thanks. Good morning. Just had a few questions. The first one on the accident year loss ratio, really nice movement over the last several quarters. I was hoping, Doug, maybe you could put it in perspective. Five quarters ago, when you were talking on the Q4 call in early 2014, after the events in Southern California, you made a comment that you'd be very cautious or very slow in recognizing improvement going forward. So we've seen 10 points of accident year loss ratio improvement since then. So I guess if you could provide some color just on, has the improvement been, in the numbers you're seeing, even quite a bit greater than what you're showing and there is a lot of caution there still? What are you assuming in terms of frequency and severity trends in setting the loss pick where you are for this year?
Are you assuming what you're seeing in the market or are you assuming things get worse as the year goes on? I think any color you could provide there would be great.
Sure. I'll answer that question. I stand by my original comments. When we see things happening, we'll be quick to sync it up and slower to take it down. As we've been able to bring it down, it's been a result of the actions that we took specifically in Southern California. I'll quote myself again. We knew what it was, we knew where it was, and we knew what we were going to do about it. That's exactly what's happened, and things have gone at the pace we expected them to go. When you think about 2015, we continue to take those actions. We're nearly through the first year now. That is on target.
I think as we continue to expand at a more rapid rate outside of California and adhere to our demands on profitability in Southern California, that absent some other external event, we should be able to show continued improvement.
Okay. Great. In saying that, when you're setting or making the pick for 2015 here in Q1, I think the comments before that frequency was down and severity was up slightly, both medical and indemnity. Are you assuming, not looking for numbers, but are you assuming down severity, flat severity, up severity as you think about the year? Likewise, what are you thinking about in terms of, I'm sorry, frequency? What do you think about in terms of severity as well?
As we put our plan together, we do it state by state, quarter by quarter. What I can tell you is at the end of the first quarter, we saw that our rate expectations were in line with the plan and our loss expectations were in line with our plan. We have a plan that takes us through the balance of this year. Incorporated within that are expectations around trend, which would include both frequency and severity. Again, that's done on a state-by-state basis. Clearly, we're seeing lift in the loss ratio because of improvements in frequency and severity as well as lift from the rate side. It's a combination of everything. It's not only one or several. At this point, everything is contributing to an improved result.
Okay, great. Thanks. One quick one for Terry, if I can. Back to the expense ratio or more so the, I'm thinking about in dollars. Would it be fair to assume roughly flat expense dollars? Forget about quarters, we just say annually, 2015 versus 2014. Is there a reason to think that there should be some savings or some addition? I can work out what the ratio is based on growth assumptions.
Well, I think we tried to answer this in the last quarter where we said we were on a run rate in terms of expenses. From a ratio perspective, we would expect that to continue going forward. Part of the challenge that we have is that we obviously are looking to manage our expense profile very closely, but at the same time, we're seeking to make fairly significant investments in our operating business model that's going to drive longer term benefits for this business and for our shareholders in terms of an overall return. Part of the challenge that we and others often have is trying to balance short term versus long term. That's part of the process. I think it would be fair to say that we're trying as best as we can to keep our expense profile level.
Great. Thanks very much for the answers.
Thank you for your question. The next question comes from Vladislav Yeliseyev from Goldman. Please go ahead.
Good afternoon, gentlemen. I had a quick question on the capital structure. Over the past, obviously a few years, you guys have been dealing with Southern California and changing the profile of the geographic distribution, et cetera. There's not been a buyback in place for quite a while. The dividend kind of stayed stable. At some point, as you guys are clearly stabilizing the numbers, which look a lot better, by the way. You guys seem to have done a lot of progress. A lot of great things happened there. At what point you guys will start getting back to the mode of returning some of that capital? Obviously, ROE is not yet at the levels that are probably most shareholders would find acceptable.
We would expect that some of that capital structure will start changing back to their historical profile with a little higher dividend and maybe some share buyback embedded in it.
This is Terry Eleftheriou. We obviously periodically reevaluate our capital plan to assess the most optimal use of capital, consistent with our overall strategy to deliver increases in shareholder value over the longer term. Our current capital plan, its focus is to continue to invest in our operating subsidiaries, obviously preserve our A- rating, maintain our dividend, and provide a level of financial flexibility for our business that we need to maintain to take advantage of opportunities as and when they arise. We are presently reevaluating that plan. We do not have any plan to undertake a stock repurchase program. If that was to occur, we'd obviously make the appropriate announcement.
Okay. From the standpoint of shareholders, wouldn't you agree that you guys are over the last two or three years, you needed some money to contribute down to the subsidiaries. At some point as shareholders, a lot of the guys that asked questions were analysts, and they have a different kind of question profile. From the standpoint of us as shareholders, obviously, we're looking for not only improvement in short-term results, but more of an alignment of and understanding what the long-term capital structure will look like and when the returns on equity will get back to more historical values. Good quarter, and I appreciate you guys taking my question.
Thank you.
Thank you for your question. We have no further questions, I would now like to turn the call over to Doug Dirks for closing remarks.
Thanks very much. Thank you for joining us all today. Again, we see a very strong start to the beginning of 2015. We've got a very detailed plan. We will continue to execute against it. We look forward to speaking to you again next quarter. Thank you all very much.
Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect. Good day.