Good day, ladies and gentlemen, welcome to the Q4 2010 Employers Holdings, Inc. earnings conference call. My name is Keith, I'll be your operator for today. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session. 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, today's conference is being recorded for replay purposes. I would now like to turn the conference over to your host for today, Ms. Vicki Erickson, Vice President of Investor Relations. Please proceed, ma'am.
Thank you, Keith, and welcome everyone to the fourth quarter 2010 earnings call for Employers Holdings, Inc. 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 Rick Yockey, 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 provisions 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, Fourth Quarter Earnings Call. Additionally, I would like to update a number included in the earnings press release and 8-K filed yesterday. In the year 2010, tax-exempt income as a percentage of pre-tax income was 50.6%, not 53.5%. I will turn the call over to Doug.
Thank you, Vicki. Welcome everyone, and thank you for joining us as we review our fourth quarter results. In the fourth quarter of 2010, we generated improved results despite an operating environment marked by competitive pricing, historically low investment yields, and high levels of unemployment and underemployment that has reduced both our premium in the workers' compensation line nationally. While signs of stability and growth are returning to some areas of our geographic footprint, unemployment rates in our three largest states, California, Florida, and Nevada, are at or near their highest levels in the past 35 years. Given these complex operating conditions, we are pleased to report a $0.24 per share increase in net income before the LPT in the fourth quarter year-over-year.
This increase is attributable to cost control actions that we implemented over the past two years, realized gains from equity sales in the fourth quarter of 2010, and increased written premium resulting largely from a favorable adjustment to the final audit accrual rate. That adjustment was a favorable adjustment of $2.8 million in the fourth quarter of 2010, relative to a negative adjustment of $2.8 million in the fourth quarter of 2009. Fourth quarter net income was negatively impacted by an absence of favorable reserve development, non-recurring restructuring charges, and a charge related to the renegotiation of a reinsurance agreement with Clarendon National Insurance Company that Rick will discuss in further detail. Our in-force premiums declined 16.6% since December 31st, 2009, but just 2.2% since September 30th, 2010, which may indicate that we are seeing the bottom of this market cycle.
Our average policy size decreased 17% to $7,200 from $8,700 at December 31st, 2009. Our insured payrolls continued to decline, but less so in the fourth quarter. Year-over-year, payroll exposure declined approximately 12% at December 31st, 2010, compared with 15% for the year-over-year period ended September 30th, 2010. In our larger states, Illinois was the only state where payrolls increased in 2010, while the largest percentage declines were in Florida, Nevada, and Wisconsin. We believe payroll declines in the year were the result of the loss, both voluntarily and involuntarily, of some larger account business in Wisconsin and Florida, the continuing high levels of unemployment in Nevada and Florida, a decline in hours worked, and a change in business mix. Our total net rate declined 7% in 2009 and 5% in 2010, a modest improvement. The net rate in California was positive in 2010.
California continues to be our largest state, representing just over half of our total in-force premium at the end of the year. Since 2008, we have increased filed pure premium rates in California in excess of 28%, including our most recent filing to increase rates 2.5% effective March 15th of 2011. In Florida, which represented approximately 5% of our in-force premium at the end of the year, the commissioner approved an average rate increase of 7.8% effective January 1st, 2011. In the 30 states in which we operate, effective in 2011, NCCI has received approval for pure premium rate increases in 11 states and for decreases in nine states. Our return on average equity with both components of that measure adjusted for the LPT was 5% for the full year. Our capital position remains strong, as demonstrated by our return of capital to shareholders through stock repurchases and dividends.
In fact, we returned over $74 million to shareholders through repurchases and dividends in 2010. At the same time, in the full year, we grew book value $1.41 per share, or by 6.8%, through net income and accretive share repurchases. Through December 31st, 2010, we repurchased over four million shares of common stock at an average price of $15.48 per share for a total of $64.4 million, completing our 2010 authorized share repurchase program, and we executed 14% of our current 100 million authorization. Yesterday, our board of directors declared a quarterly dividend of $0.06 per share with a record date of March 9th and payable on March 23rd. I'll turn the call over to Rick for further discussion of our financial results.
Thank you, Doug. Underwriting margin in the fourth quarter was pressured by loss trends, the lack of favorable reserve development for prior periods, and net rate. Our underwriting margins for the quarter, while still negative, were improved from the third quarter. On a GAAP basis, we had an underwriting loss of $6.4 million in the fourth quarter with a combined ratio of 107.6, representing an improvement of four points compared to the third quarter. Excluding the impact of the LPT, our underwriting loss was $11.1 million with a combined ratio of 111.7, an improvement of 5.8 points compared to the third quarter. Both GAAP and LPT adjusted combined ratios were nearly flat in the fourth quarter year-over-year. Our fourth quarter loss ratio increased 14.7 points year-over-year, largely due to the difference in favorable prior period reserve development.
We had $11.8 million of prior period reserve releases in the fourth quarter of 2009 and none in the fourth quarter of 2010. This difference contributed 14.1 points of the 14.7 points of increase in the fourth quarter loss ratio. Our loss provision rate increased in the fourth quarter to 73% from 69.4% in the third quarter of 2010 as a result of increasing severity trends, particularly in California. In terms of claims results in the fourth quarter and for the full year of 2010, reported claim counts for indemnity and medical decreased compared to 2009. We also continued to see a slight increase in average claim severity, driven by the increasing cost of medical and indemnity in California. Overall, incurred losses were lower in 2010 compared to 2009.
As you recall, in July of 2010, we reduced our total staff by approximately 160 positions in our regional operating units from five to three. We consolidated our underwriting activities and our offices. Final restructuring charges related to these actions were $900,000 in the fourth quarter of 2010, compared with $700,000 related to the consolidation activities in the fourth quarter of 2009. As a result of these actions, our underwriting and other operating expense ratio improved 12.7 points compared to the fourth quarter of 2009. Underwriting and other operating expenses, including restructuring charges, declined $13.2 million, or 36.5%, in the fourth quarter compared to the same period in 2009.
The commission expense ratio was flat in the quarter year-over-year, while the underlying commission expense declined largely due to lower premiums earned and a $3 million reduction in our estimate of certain administrative fees due Anthem Blue Cross under our joint marketing agreements. This decline was partially offset by a $1.8 million commission to renegotiate the terms of a reinsurance agreement with Clarendon National Insurance Company. The renegotiation resulted in the release of $74.6 million by Clarendon, of which $47.1 million was placed in a trust for the benefit of Clarendon to support liabilities under the reinsurance agreement. We invested the remaining $27.5 million. Our effective tax rate in the fourth quarter declined to 10.5% as a percentage of tax-exempt income to pre-tax income increased compared to the fourth quarter of last year.
Our fourth quarter pre-tax net investment income declined to $20.4 million from $21.8 million in the fourth quarter of 2009 due to a decrease in invested assets. The decline in invested assets resulted from the return of over $74 million to shareholders through stock repurchases and dividends in 2010. Our $2.1 billion portfolio was comprised primarily of fixed income maturities, which were rated on average double A or better. The average yield on our portfolio was 4.2% pre-tax and 5.3% on a tax equivalent basis with a duration of 4.9. This duration in the portfolio served us well in the fourth quarter in relative terms, given the increase in interest rates. Our investment portfolio is made up largely of fixed income securities, which remain short in duration and high in credit quality.
Municipals made up nearly half of our total portfolio with no undue geographic concentrations in these securities at the end of the fourth quarter. We increased our equity holdings slightly to 3.9% of total invested assets and shifted $20 million of equity securities to a high yield dividend portfolio, which resulted in realized gains of $9.2 million in the fourth quarter. This new portfolio is comprised of high quality, large cap equities that combined have a higher dividend rate than the equities previously held. We believe these investments will yield additional income while further diversifying our equity holdings across industries and issuers. At December 31st of 2010, we had approximately $375 million in cash and securities at the holding company. We are well-positioned from a capital and management standpoint to take advantage of opportunities as they arise. In their absence, we remain prepared to return capital to shareholders.
With that, I'll turn the call back to Doug.
Thank you, Rick. We remain focused on retention of our quality business, prudent pricing on new and renewal business, underwriting discipline, and adequate and timely recognition of changes in loss cost trends. We continue to execute the growth initiatives implemented in July of 2010. Specifically, we are targeting the addition of 20,000 policies and over 900 producer appointments by July of 2012. Overall, we are making progress in meeting our goals. Since July 1st and through December of 2010, we added over 340 producers and approximately two-thirds of these appointments are in our newer states. We also continue to deploy our rapid quote technology, which is now available in 22 of our 30 states. As a result of these actions, new business submittals have increased and total company submissions, quotes, and written policies are up year-over-year at December 31st.
Our policy count at December 31st, 2010 grew by 1% or by approximately 400 policies in the full year. In the fourth quarter, we grew policy count by over 1,000 policies or by 2.4%. In January of this year, we increased unit count by an additional 1,325 policies, significantly more than in the full year of 2010. This increased our total in-force policies to 45,886 at January 31st, 2011. As we add new agencies and policies, our underwriting remains selective, focused on small businesses in those hazard groups and classes that have historically produced for us favorable loss ratios. We continue expanding our strategic partnerships and alliances. Our new business flow with ADP increased in 2010, particularly in California and Georgia. With Anthem Blue Cross, we have launched our integrated health product in Colorado. We believe this will generate integrated health business in a previously untapped market.
We also announced in the fourth quarter that we have joined forces with Hiscox to provide workers' compensation coverage as a part of their insurance offerings to small businesses in knowledge-based industries. We also continue to expand our relationships with industry-focused associations. We are the provider of choice for members of the National Federation of Independent Business in California and Florida. Additionally, in January of this year, the Nevada Restaurant Association named Employers its preferred provider. We will continue to pursue the membership recommendations with NFIB in additional states as well as other industry-focused associations representing small businesses in our core underwriting appetite. Our strategic partners generated 22.1% of our in-force premiums as of December 31st, 2010, compared to 18.8% at the end of the previous year.
The percentage increase can be attributed to higher retention rates for this business than for our independent agent-produced business, and a significant increase in strategic partner business activity, particularly ADP. Retention of strategic partner policies in the fourth quarter was 88%, compared to overall retention of 80%. In the full year, policy retention for strategic partner business was 82%, with 73% overall. In closing, our small business markets reflect persistent competition, particularly from some of the larger multi-line carriers. Yields are at historically low levels, and the economic recovery is sluggish, especially in terms of job creation. Our top three states are experiencing their highest unemployment rates in 35 years. Despite these challenges, we successfully reduced our operating expenses and have improved our ability to service our existing and produce new business. With that, Operator, we'll now take questions.
Okay, ladies and gentlemen, if you have a question, you can ask it by pressing *1 on your phone's keypad. If your question has been answered or you wish to withdraw your question, you can do so by pressing *2. Please press *1 now to begin. Your first question comes from the line of Amit Kumar with Macquarie. Please proceed.
Thanks. Good afternoon. Just quickly going back to the discussion on rates. You mentioned that you filed for a 2.5% rate increase in March. I know you've talked about scheduled credits and other offsets. How should we think about net rates going forward? Do they turn positive, or do they still net out to be flat for 2011? Maybe just refresh us on that discussion.
Well, if you think about what comprises the net rate, an increase in the filed rate would have the effect of increasing the overall rate we receive. That will be moderated and potentially could be offset based on the competitive conditions. As I indicated in my comments, our focus is on retaining the quality business that's produced very sound results for us in the past, while seeking to get the best rate we can on new business going forward.
Got it. It remains modestly positive going forward.
The filed rate would have the effect of increasing it. Ultimately, you have to see what the competitive landscape is. The other thing that I might touch on that has an impact on the net rate is there is some change of business mix. Less so in California than we're experiencing in other parts of the country. If you think about what's happened in the recession with a declining payroll in construction and manufacturing, those have typically been higher rate classes, and a change in the mix of business could drive down the net rate.
Okay. I'll follow up offline. Secondly, just quickly on new business from new agents. I know in the opening as well as in the press release, you mentioned that we will not buy new business. Maybe just refresh us as to what sort of gives you comfort on the quality of the new business, the classes, and who's losing this business, which is coming to you from these agents.
Well, let's address how we decide class of business. If you look at our results, we've always had in recent years, in excess of 40% of our total business is in 10 classes, and that focus continues. That gives us some assurance that as we're appointing new agents, they're underwriting for us or producing for us business that we have a great deal of familiarity with. I started at that point. We do try to find agents that have a focus similar to ours in terms of small businesses, and try to make sure that we're not appointing agents that have appetites or books of business that are different from what we seek to write.
Okay. Just finally, on capital management. Based on our commentary, is it fair to assume that perhaps the go-forward repurchase rate would be lower than sort of the run rate we have seen in the past instead of the new buyback?
Well, let me refresh for everybody. We have a $100 million share repurchase authorization that expires at June 30th of 2012. That was our open market purchases. The timing and number of shares we will purchase are dependent on a number of factors, one of which would be share price.
Okay. Thanks for the answers.
Your next question comes from the line of Mark Hughes with SunTrust. Please proceed.
Thank you. The good success in January in terms of new policies, obviously your distribution is ramping up there. Any help from other players pulling back from the market. I guess we see the headlines about AIG, but are others following suit? Is it a little bit easier to pick up business these days?
Yeah. Specifically with AIG, they've not been a competitor in our market space for the most part. We rarely, almost never see them in our market. I wouldn't characterize the market as now being less competitive, therefore providing us greater opportunities to grow. I think the success for us, and particularly as we've observed it in January, is increasing the number of appointments, expanding the pipeline, and doing a better job of establishing our brand in newer markets. We've seen an impact of that into the fourth quarter and through January this year.
Right. On the expense front, you've done a tremendous job, looking year-over-year at the operating expenses down substantially. With business here seeming to flatten out at the top line, how much more opportunity is there for cost savings, or will it be more leverage from growth going forward?
The focus is definitely on leverage from growth going forward. Our goal is to achieve growth without having to add additional staff, that's how we see an improvement in both our expense ratio and our combined ratio going forward.
Then you talked about claims counts being down. Is that reflective of frequency given the covered lives you've got? Are you also still seeing a frequency on a per head basis decline?
We're seeing two things. On a frequency per policy count, we're seeing that flatten. Overall, because business has been down, counts are down overall.
Frequency flattening. Again, is that a function of the change in policy counts or head counts, or is it?
No, that's just on a true level of computation. Frequency has been flat. We were seeing over prior periods, talking about prior to this quarter, we had seen some decreases in frequency over a period of years. That's kind of leveled out, but we're not seeing any ongoing increases in frequency.
All right. At least a stabilization this quarter, which would be a distinction from prior quarters.
Right.
Okay. Very good. Thank you.
Your next question is from the line of Matthew Carletti with JMP. Please proceed.
Hey, good afternoon. I just had a quick numbers question, Doug, I apologize if I missed it in your comments. In the release, you give the overall company net rate change minus 5% for the year. What was the year-over-year net rate change for the company at September 30?
7% at September 30.
Okay, great. Thanks a lot, congrats on a nice quarter.
Thank you.
Once again, ladies and gentlemen, if anyone has a question, please press *1 now. Your next question is from the line of Robert Royal with Path Capital. Please proceed.
Hi there. Just a follow-up question on some of the loss trend conversation. I've got your frequency comment, and I'm assuming that was a broad-based comment. If it's not, please add some more detail to that on a state-by-state basis. The other part of the question is the severity side, and I was hoping you could maybe expand upon those comments.
We have seen California medical continue to grow. We have not seen signs that that is abating. My comments earlier were, in fact, general. I don't know that I have any particular comment to make about states outside of California at this point. We do see similar increases in medical, California certainly is the one we're most keenly focused on and has been kind of the leader in that focus.
What would you say medical inflation is? What is it running at right now?
When we're talking about severity trends in California, we're not expressing it in terms of an inflation rate. A lot of what's driving increases in medical severity in California is increases in utilization and broadening definitions of compensability, things like sleep disorders, things we've talked about in the past. That's probably the greater concern of increasing severity than just an outright medical inflation assumption.
Okay. When you add that together with medical inflation, can you comment on what the trend implication is?
If you look back at the most recent work that California Bureau has done, they were seeing a declining rate in the trend, but it's still a positive number.
We'll be waiting for their next analysis. It's not been out yet, it should be out shortly. Again, a slight flattening of the trend line, but still an increase. I don't recall the number off the top of my head.
Okay. Second question on net rates. When you say net rate, what do you mean by that? Is that rate net of scheduled credits, or is that gross rate and it's not taking into account credits, or what do you exactly mean by that?
It's a filed rate, which is adjusted for an experience modification factor, which is unique to the individual insured based on their own loss experience, as well as a scheduled credit, which allows us to adjust our pricing based on competitive market conditions.
Okay, so it's rate less deductions. It's actually a pure premium.
The rate out the door is the way I would describe it.
Like a pure premium type rate.
No, I wouldn't call it that. It's a rate net of. You start with a standard rate, a filed rate, you adjust for individual experience and schedule credits for competitive conditions. It's not just competitive. We may actually look at a rate and say, we believe that particular risk is better than the class average, and consequently, it's deserving of a scheduled credit because we're expecting better results than the class as a whole.
Okay. Just a couple of numbers, technical questions. Audit premiums, do you expect them to come in once a year or every quarter?
The audit process is a continuous one, and we review that periodically through the year in establishing our accrual based on our actual experience with the individual policies as they come up for audit.
Okay. Do you have a paid loss figure in the quarter?
We'll dig for that one. We'll have it.
Okay. Thank you.
I want to go back and correct a statement I made following the question from Matthew Carletti. The number I gave of 7% at September 30th was 6%. It was 5% at December 31st. I said seven, it was six. Seven related to the prior year.
Okay, your next question is from the line of Mark Hughes with SunTrust. Please proceed.
Yeah, on that amount, I think you had made a point about maybe mix shift contributing to the rate decline, moving away from manufacturing into more service occupations or service policyholders. Any way to gauge how much that influenced the pricing of a down five? How much of that is mix shift versus pure rate for like policies?
That's very difficult to estimate. In suggesting that, you have to consider mixes because we think that's having an impact on it, but we wouldn't have an ability to qualify it at that level of detail. I think if we're going to say where is it coming from, it's more likely to be coming from our newer states in the East, where there's been a shift in the book of business to our smaller, lower severity business. Less so in California. That book has been more stable over time.
Right. Some of the newer policies are lower severity, let's say.
Yes.
Right.
More hazard group A to D and less in E and F.
Right. That mix shift issue, it sounds like it's important, but you couldn't really measure it. Okay. Thank you.
In response to one of the earlier questions about paid losses, I would note that in 2010, loss payments were approximately $262 million. That's comparing with $289 million in 2009. Out of that $262 million that we paid this year, approximately $56 million related to current year losses.
Your next question is from the line of Robert Farnam with KBW. Please proceed.
Yeah, hi there. Just an overall question on your reserves. How would you characterize the overall reserve adequacy at the end of this year relative to the prior few years?
Well, we've always maintained our reserves conservatively. We continue to do so. We do note that rising costs have caused that to erode slightly. We believe that our adequacy, our conservatism is still acceptable and consistent with what we've done in the past. If that's what you're getting to, Bob.
Yes. That's what I'm getting to. Thanks, Rick.
Your next question is from the line of Ken Billingsley with EGB Securities. Please proceed.
Hi, good afternoon.
Hello.
Wanted to just follow up on some questions, maybe just to fine tune on the comments that you made. Regarding the net rates that you said since September 30th, you clarified that to be it's down 6%?
Correct.
Okay. The other question on the audit premiums, as you're doing those rolling audits, has that remained positive, or have they turned negative? Where is the expectation that you're building for 2011?
What we've seen is they never did turn in any way significantly negative. They've stabilized. They're very flat. We wouldn't want to prognosticate as to what the future brings, there's nothing that causes us to believe that anything's going to cause it to go negative. We'd certainly look forward to increasing employment, which would, of course, tend to drive them up. It's been flat, pretty much plus or minus zero.
That's what you've built that into your business plan, that audit premiums will be 0% to 1%?
Our planning is conservative when it comes to anticipating something like that and in terms of a positive development.
On the share repurchase authorization of $100 million that expires in 2012, I didn't quite catch the comment you said. Is it 14% has been repurchased so far?
Through the end of the year, correct.
Okay, through the end of 2010, you utilized 14% of the $100 million.
Correct.
Okay. Last question I have is, this is a very small number, just curious. We talked about a write-off on reinsurance recoverables. It was less than $1 million. Could you just comment on where that was from?
That was some older reinsurance related to AmCOMP. It was related to Reliance. It had been fully reserved as a, quote, "bad debt" in prior years.
Okay.
The unwinding caused it to run through that schedule and reflect as a negative development.
It was already on the balance sheet as a bad debt?
Yes.
Okay. Very good. Thank you. Congratulations on the quarter.
Thank you.
You have a follow-up from the line of Amit Kumar with Macquarie. Please proceed.
Thanks. Just two quick follow-ups based on the previous answers. On the loss reserve movement, was there an adverse offset by a positive development, or was there absolutely no shift in the results?
Amit, when you say a-
I mean like releases, offsets.
Let me say it this way, Amit. It wasn't the net of two big numbers that somehow happened to meet in the middle.
Okay. That's very helpful. The other question is just a discussion on the business mix shift. We do appreciate the color. Goods and services is half of your book. Just remind me, maybe just expand on that. The shift is from goods and services into what subsegment? I didn't quite catch that.
It's really shifting out of what were hazard groups E and F, more into A, B, C, and D. It's lower hazard business, typically that has lower payroll levels, lower rate. Consequently, that shift will result in a decrease in the net rate.
Got it. Okay, that's helpful. Thanks so much.
There are no other questions at this time, so I'd like to turn the call back over to Mr. Doug Dirks for closing remarks.
Very good. Thank you, everyone. Thank you for your participation today, and we look forward to reviewing our first quarter 2011 results with you. Thank you.
Ladies and gentlemen, that concludes the conference. Thank you for participating in. You may now disconnect . Have a great day.