Good day, ladies and gentlemen, and welcome to the second quarter 2011 Employers Holdings earnings conference call. My name is Keisha, and I'll 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 the operator will be happy to assist you. As a reminder, this conference is being recorded for replay purposes. Now I'd like to hand the conference over to Vicki Erickson, Vice President of Investor Relations. Please proceed.
Thank you, Keisha, welcome everyone to the second quarter 2011 earnings call for Employers Holdings, Inc. Yesterday we announced our earnings results. Today we will file our Form 10-Q with the Securities and Exchange Commission. Our press release and Form 10-Q may be accessed on the company's website at employers.com, and these materials 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 are Doug Dirks, our Chief Executive Officer, and Ric Yocke, 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 a non-GAAP metric that excludes the impact of the deferred gain from the 1999 loss portfolio transfer, or LPT. This metric is defined in our earnings press release available on our website. As has been our practice, a list of our portfolio securities by CUSIP is available in the investors section of our website under calendar of events second quarter earnings call. Now I will turn the call over to Doug.
Thank you, Vicki. Welcome. Thank you for joining us as we review our second quarter results. Let's start with some highlights. Year-over-year, gross written premium increased 41%, net earned premium increased nearly 13%, and policy count increased 20%. These results are explained by several factors. First, the growth initiatives that we put in place a year ago are yielding the results we expected. Second, final audits increased our net earned premium by $4.5 million in the second quarter, accounting for approximately six points of the increase in earned premium. Third, total payroll exposure increased 5.6% year-over-year and 9.3% in the first six months of this year. Finally, while net rate declined 4% year-over-year, it declined by just over 1% in the first six months of 2011 and increased by more than 10% year-over-year in California, our largest market.
Now let's look at some of the details. As we expected, loss cost trends were stable relative to the first quarter. In terms of our loss provision rate, whereas in the first quarter, our provision rate increased because of changing loss trends in California, the increase in the second quarter is due to two factors, and I want to make this very clear. Half of the change is related to our assigned risk business. The remaining half is due to a change in the allocation of premium by state. None of the increase reflects any change in our view of loss cost trends. The lack of favorable prior period development in this year's second quarter decreased net income by $0.13 per diluted share relative to last year's second quarter and represented most of the $0.18 per share decline in net income.
Our policy count at June 30, 2011, grew by approximately 8,700 policies since June 30th of 2010. This increased our total in-force policies to over 52,000 at June 30th, 2011. In the past year, our average policy size has declined 16% to approximately $6,700 at quarter end. We have added over 700 producer appointments over the last 12 months. As we add new policies and agencies, our underwriting remains selective, focused on small businesses and those hazard groups and classes that have historically produced favorable loss ratios. During the second quarter, we grew in-force premium 1.4% year-over-year and 8.1% since the beginning of this year. Our strategic partners generated 23% of our in-force premiums as of June 30th, 2011, compared to 21% at the end of last year's second quarter. Retention of strategic partner policies in the second quarter was 89%, compared to overall retention of 87%.
Overall retention rates improved 3 percentage points quarter-over-quarter and 10 percentage points year-over-year. In California, which represented approximately 55% of our in-force premium at the end of the second quarter, payroll dropped over 1% in the past 12 months. Grew just over 5% year-to-date. Illinois continues to be our second largest state in terms of both payroll and premium. Payroll increased in Georgia over 30% year-over-year and year-to-date, making it one of our top five states in terms of payroll as well as in-force premium. In July, we filed for an average pure premium rate increase of 3.9% in California, and that filing was recently approved. The new rates will be effective September 15th. In Illinois, NCCI expects that the reforms enacted under House Bill 1698 will lower system costs by 8.8%.
As to our book of business, we disagree and believe that the reforms will have no meaningful impact on our loss costs, and we will file not to adopt the rate decrease that was recommended by NCCI. Given this changed environment, we will exercise caution related to growth in Illinois. Book value grew 3% since December 31st of last year. During the quarter, we repurchased 763,300 shares of common stock at an average price of $16.34 for a total of $12.5 million, with approximately $65 million of the authorized share repurchase remaining through June of 2012. Going forward, this program will be executed based on a number of factors, including stock price, corporate and regulatory requirements, and other market and economic conditions. Now I'll turn the call over to Ric for a further discussion of our financial results.
Thank you, Doug. Underwriting margin in the second quarter continued to be pressured by current accident year loss trends and a lack of favorable reserve development for prior periods. We recorded a non-adjusted underwriting loss of $14.3 million in the second quarter, with a combined ratio of 116.2. Excluding the impact of the LPT, our underwriting loss was $18.5 million with a combined ratio of 121. Our second quarter loss ratio increased 15.1 points year-over-year, largely due to the difference in prior period reserve development and second quarter provision rate for current accident year losses. We had $5.5 million of prior period reserve releases in the second quarter of 2010, and none related to voluntary business in the second quarter of 2011. This difference contributed six of the 15-point increase in the second quarter loss ratio.
The remainder was attributable to the provision rate for current year losses resulting from increasing medical and indemnity cost trends, particularly in California. We believe our reserves for prior accident years remain adequate. As we have noted before, while we evaluate prior accident year reserves collectively, we have seen some deficiencies in more recent periods, 2007 through 2009, offset by redundancies in earlier accident years, roughly 2003 through 2006. These accident year carry deficiencies and redundancies have remained largely unchanged since our last review. In fact, the 2010 accident year for our California operating company actually improved by $2.5 million. Our recent rate increases in California are intended to respond to the increasing loss costs that we have observed, and they will improve rate adequacy as they become effective in September and roll through our book of business.
Our intent is to keep pace with the development we are reserving, and we will continue to adjust rate levels in line with those observations in order to provide for ultimate claim costs. The increase in our loss ratio was partially offset by a 2.3-point improvement in our underwriting and other operating expense ratio year-over-year, driven largely by the 13% increase in net premiums earned. Underwriting and other operating expenses increased approximately $1 million in this year's second quarter compared to the same period last year. This increase was driven primarily by a $2.6 million increase in premium taxes and assessments. In the first six months of this year, underwriting and other operating expense decreased $5.5 million, or 9.6%, compared to the first six months of 2010.
Throughout the year, we expect quarterly operating expenses, other than commissions and premium taxes, to be relatively flat compared to those recorded in the first and second quarters. As we grow the top line, the expense ratio should continue to fall. Second quarter pre-tax net investment income declined to $20.3 million from $20.6 million in the second quarter of 2010 due to a slight decrease in yield. The tax benefit recognized in the second quarter was primarily attributable to the carry-forward of tax-exempt investment income and tax impacts related to the LPT agreement. Our $2 billion portfolio remained largely unchanged in the second quarter. The portfolio is comprised primarily of fixed income maturities, which are rated, on average, double A or better. Our portfolio is weighted towards short-term and intermediate-term bonds. At June 30th, 2011, equity securities represented 4.2% of our total portfolio.
The average yield of our portfolio was 5.2% on a tax-equivalent basis with a duration of 4.85. We protect our balance sheet with a comprehensive reinsurance program that was renewed on July 1st, and we retained our coverage at previous levels. At June 30th of 2011, we had approximately $425 million in cash and securities at the holding company. Our uses of capital remain the same. First, we invest in the organic growth of our operations. Second, we look for opportunistic strategic acquisitions. Third, we return capital to shareholders through stock repurchases and dividends. With that, I'll turn the call back to Doug.
Thanks, Ric. Our initiatives to grow our business through the addition of agents and policies resulted in increases in written and earned premium in the second quarter. As I've said in past quarters, our current market is characterized by a unique set of challenges, a slow economy, historically low yields on invested assets, and continuing price competition. Given these operating conditions, we have successfully reduced underwriting and other operating costs. We have improved and expanded service delivery through technology, increased our number of agents, and expanded unique strategic alliances and programs. We have responded to increasing loss cost trends in California nationally by providing for current accident year losses at rates higher than historic norms. Our growth initiatives are yielding the results we anticipated. Looking forward, we see opportunities to continue to expand our presence in the 30 states in which we operate. That operator will now take questions.
Ladies and gentlemen, if you wish to ask a question, please press star one. If your question has been answered or you would like to withdraw from the queue, simply press star two. Questions will be taken in the order received. Please press star one to begin. Your first question comes from the line of Mark Hughes with SunTrust. Please proceed.
Yeah, thank you. Good morning. Good afternoon. The loss ratio with the prices in California, you describe up 10%, you've filed for another 4%. Is that going to be enough that we should start to see the loss ratio in California start to come down?
Mark, I think it's a combination of factors. If you'll recall how we approach rate levels in California, the base rate or the filed rate is one component. The scheduled credit is another component. The individual account loss modifier is applied, and it's a combination of those three things that ultimately drive the net rate. I think the largest factor is going to be what happens on a competitive front. To the extent that the market starts to harden, we've got available both the rate filing and the scheduled credits to try to achieve more rate going forward. I think the rate filing itself has less to do with it and the competitive market pressures will have more to do with it.
With the competitive situation you're in today, is the pricing that you're seeing, effective pricing, is it adequate to start to bring the losses down?
Yeah, we are providing at rates that we believe are adequate to cover the loss cost trends in California. If you think about where we are and where the market is relative to what the Bureau is suggesting, the Bureau indicated that about a 40% rate increase was required. Our cumulative rate increase is now at about 30%, and we have always indicated that in the competitive market, we're not getting all of that. We expect that as the market hardens, we will have an ability to get more rates through a combination of the filed pure premium as well as the scheduled credit.
Fair to say that the market is hardening with your, I guess, prices rising as fast as they are?
Yeah, I think if you look at the market, the fact that we're getting more rate would suggest that maybe the market has made that turn, but it continues to be a very competitive marketplace.
How about the new business that you're bringing on? Obviously, you're getting a tremendous growth in written premium. What kind of loss ratio are you bringing that business on at as more of that is earned through? Should that help drop the loss ratio?
Yeah, typically, you'll see a higher net rate on new business than you do on renewal business. The reasoning for that is that on the renewal business, you have more experience on the risk, and also, if it's been a good risk, it's eligible for some renewal credits. We do see more rate on the newer business, which if it performs the same as on the new business, gets more rate. If it performs the same as renewal business, yeah, you would have a wider margin.
Do you have enough experience yet with the policies you've signed up post this growth initiative to say how they're doing in terms of loss performance? Obviously, this is a very good growth. Do you feel like you're pricing it appropriately?
Yeah, it's early, the data we have is green. That being said, what we're observing is that the new business is performing consistent with the existing business.
Great. Thank you.
Your next question comes from the line of Amit Kumar with Macquarie. Please proceed.
Thanks. Good afternoon. Just going back to the discussion on your top-line growth and new agents. Several other workers' comp companies are, in fact, shrinking their books right now, and they're not growing in many states. Why do you think that other companies are somewhat unable to replicate your strategy of just hiring new agents and growing? And I guess related to that, why do you think this strategy is right in these times and in these markets, as opposed to shrinking the core book?
I'll cite some data that you may want to follow up on. If you look at the AM Best data for 2010, in fact, in 2010, we gave up market share relative to 2009, and that can't be said for a majority of the top 50 writers of workers' compensation. If companies are saying they're shrinking, of course, they're shrinking. Exposures were down nationwide. It's more important to go and look at what companies are doing in terms of their share in individual states. I think that would give you a different story. As to why we're looking to grow and how we're doing it, go back to the core of our business. It's a very focused underwriting strategy. It's in a niche that's well-defined and where we have a great deal of experience.
We've been able to bring to the marketplace technology that has been adopted very quickly and surprisingly on our part, very quickly by a lot of agents. They like what they see. They like the quality of our brand, they like the quality of our operation, and they're bringing us business.
Okay. Just, I guess, related to that, in terms of this new business coming in, what specific changes have you incorporated in writing this new business, which was based on, I guess, lessons learned from the uptick, and extending the loss payment in your core book?
I'm sorry, Amit. I'm not sure I understand your question.
I guess what I'm saying is, how did you change the current business, the way you write the current business based on the loss picks ticking up in your previous business?
Well, the new business as well as the renewal business is reflecting the rates as we see them being required for the current period. In terms of the underwriting, we've not changed our underwriting approach. The pricing approach changes based on market conditions.
You're still applying the same underwriting standards.
Yes
to the new business and new agents.
Yes. What we've done is automated a lot of the process, but the underwriting strategy, the underwriting discipline remains unchanged.
Okay, just one other question. I might requeue . On capital management, you talked about the buyback. Obviously, you mentioned a $425 million number at the Holdco. That is a meaningful number. What are your go-forward plans with the capital in the current times?
They remain unchanged from what we've been saying in the past, which is first objective is to invest in the operation, second is to pursue strategic opportunities, and the third is to return capital through share repurchases and dividends. It's always been a combination of the three and continues to be.
Okay. That's helpful. I will requeue . Thanks.
As a reminder, press star one if you have a question. Your next question comes from the line of Matt Carletti with JMP Securities. Please proceed.
Hey, thank you. I have a few questions. First one, you mentioned the renewal of your reinsurance treaty and that the coverage was unchanged. Can you tell us what happened with the pricing?
Matt, prices were flat.
Okay.
Actually, there was a slight decimal point downtick, for all intents and purposes, the pricing was flat.
Doug, could you comment on, you mentioned Georgia's now in the top five and you saw pretty good growth there. Can you comment on, just give us a little color on the dynamics of that state and what makes it attractive to employers?
Yeah. What we're finding in Georgia is that ADP, one of our key strategic partners, is driving a lot of that growth, and we're able to put on the type of business and the classes that we like, and we've had a great deal of success with it. That's the primary driver in Georgia.
Okay. Last question is, I saw earlier this week that there's some index of a small business borrowing got to such a high not seen since kind of 2008, and that the kind of delinquencies among small businesses are at a low. Can we interpret anything from that? Do you view that as a positive kind of foreshadowing for your core small business activity? Historically, have you not seen that correlation?
If that were a trend, I think it would be beneficial going forward. We're seeing a number of different reports that are suggestive of things starting to improve and even amongst small businesses. Just to look at some of our data, two of the states where we were hit the hardest and where the recession was the deepest were Nevada and Florida. We saw a leveling or a stabilizing of the loss of business near the end of the second quarter. I believe we're getting to the bottom of that. Those states are probably pretty good barometers for what's happening in small business environments.
Are you seeing any change in the mix of kind of the change in payroll coming from, say, new businesses opening doors versus existing customers in your book adding employees, or does that kind of remain stable?
I can't point to specific data there, Matt. The payrolls are going up. We're seeing a decline in average policy size. I think part of that is as we've increased our growth rate, we've been producing a larger number of smaller accounts. They're all mostly in hazard group A to D. They're within the 85 classes of business that we've rolled out our technology to. I think that's an indication of some turn in the small business market, but I think it's a little too early yet from our data to call that.
Okay, great. Thanks a lot.
Your next question is a follow-up from the line of Mark Hughes with SunTrust. Please proceed.
Thank you. I think that, Doug, you had suggested that of the change in losses in 2Q, half of that was from the assigned risk business, another half was a change in the premium mix by state. Were you referring to the sequential change there?
Yeah. What that means is that the provision rate is a composite. We establish an expected or a provided rate in all of the states where we do business. To the extent that premium grows in one state that might have a higher provision rate and it shrinks in a state with a lower provision rate, that would have the effect of increasing the composite rate or the provision rate we carry it at. That's really what was happening. There's enough precision to the number that a movement in the allocation of premium by state can have an impact on it.
In those terms, you're talking about the Q2 compared to Q1. Is that right?
Yes.
Right. No real deterioration. Steady.
Correct.
you talked about Illinois, that you disagree with the NCCI. Is that because your class codes are different than whatever aggregate they're calculating, or you just don't think that whatever changes are really going to make a difference overall?
Well, let me pull out one specifically. The 8.8% decrease provided by NCCI took into account expected loss cost savings from the use of medical provider networks.
We already use medical provider networks in Illinois.
Oh.
if you don't use them, you might get some benefit. If you are already using them, it has no impact on you whatsoever. That would be an example of why we view it differently as to our book of business than does NCCI to the total market.
Right. It wasn't that you questioned their methodology, it's just the applicability to you.
Yes.
That it's not applicable. Okay. Thank you.
There are no further questions in queue at this time. I would now like to hand the conference back over to management for any closing remarks.
Thank you very much. Thank you everyone for joining us today. We look forward to speaking with you again on our third quarter earnings call in November. Thank you.
Thank you for your participation in today's conference. This concludes the presentation. You may now disconnect your lines. Good day.