Ladies and gentlemen, thank you for standing by and welcome to the James River third quarter 2019 results conference call. At this time, all participants are in a listen-only mode. After the speakers' presentation, there will be a question and answer session. To ask a question during the session, you will need to press star one on your telephone. Please be advised that today's conference is being recorded. If you require any further assistance, please press star zero. I would now like to hand the conference over to your speaker today, Kevin Copeland, Head of Investor Relations. Please go ahead.
Thank you, Danielle. Good morning, everyone, and welcome to the James River Group third quarter 2019 earnings conference call. During the call, we will be making forward-looking statements. These statements are based on current beliefs, intentions, expectations, and assumptions that are subject to various risks and uncertainties, which may cause actual results to differ materially. For a discussion of such risks and uncertainties, please see the cautionary language regarding forward-looking statements in yesterday's earnings release and the risk factors section of our most recent Form 10-K, Form 10-Qs, and other reports and filings we make with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statements. I will now turn the call over to Adam Abram, Chief Executive Officer of James River Group.
Thanks so much, Kevin, and good morning, everybody. Sarah Doran, Bob Myren, and I are all here together, and before I turn the call to Sarah, I have a few comments about the loss we reported this quarter and our decision to walk away from our largest account. I think those of you who have followed us for a while know that we pride ourselves in our underwriting standards. This loss, which is driven by the lack of profitability on the Uber account, is not acceptable to us. We decided that it is not in the long-term interest of our company and our stakeholders to continue our contract with Uber. In 17 years since we founded James River, we've made underwriting profits in all but two years, and we've never reported a loss of this magnitude before.
We've canceled the account, and after taking a reserve charge, we expect to resume producing low double-digit annual returns on tangible equity in 2020. In Uber, we wrote a new type of risk that initially seemed to be highly profitable based on the data available to us. But Uber's business and the underlying risk evolved very quickly. Our underwriting assumptions and the related pricing did not keep pace with changes in Uber's business. Uber created a new transportation model that altered the American transport system and presented new challenges and opportunities for the insurance industry. The risk associated with this model shifted as the company expanded into new regions, added tens of thousands of drivers, and evolved beyond just ride-hailing. All of these factors created a situation where the risk became too large in absolute terms, given the size of our company.
Candidly, in some years, we mispriced the risk. Having said that, we're comfortable with our pricing for the 2018 and 2019 years. In response to poor results in 2016 and 2017, we negotiated substantial pricing increase for the contract on the 2018 renewal and renewed at similar rates for the 2019 renewal. We also purchased a quota share reinsurance contract for a third of the account for the first time in 2019. Profits we anticipate earning in these last two years will not fully offset losses from prior years. We decided to cancel this year, even though we believe the risk is well priced because of further complications related to the passage of Assembly Bill 5, or AB5, as it's known in the state of California. We believe AB5 will adversely alter the claims profile for rideshare companies.
In 2019, our pricing had not anticipated AB5, hence our concern. The legislation becomes effective two months before our policies would've naturally expired. When we canceled the account, we also drew upon the collateral established to pay the portion of claims costs retained by our client. The $1.2 billion in that trust account is now on our balance sheet and may be used to pay our former client's share of any claims as they arise. The funds are invested in short-term treasuries, and the interest earned will accrue to our benefit. While that does not reduce our loss ratio, the investment earnings will somewhat mitigate the effect of the losses we have reported. Last night, after we released earnings, Uber sent a note asking the collateral be redeposited within the trust. We're confident that we've handled the trust appropriately and do not intend to redeposit the funds.
We expect to process approximately 18,500 claims during the runoff of this book of business. We're well-staffed to handle these claims and are committed to handling them expeditiously and properly. In the end, I'd say the Uber account was a diversion from the steady engine that has always propelled our company: highly profitable underwriting of small and middle-market risk. That business is performing very well, in line with or ahead of our expectations. We decided to reset our focus on the many positives in our core E&S business and attractive growth opportunities we continue to see there and in our specialty admitted segment, and to start the new year focused on those opportunities. During the past quarter, our core E&S, our Excess and Surplus Lines business, meaning our James River E&S business other than commercial auto, grew by 72%, compared to the same period a year ago.
Rates in this segment have gone up for 10 quarters in a row and increased 3.2% in the third quarter and were up 6.5% if we exclude one large renewal of a profitable account. We wrote $133 million in core E&S this quarter and are on a pace to write approximately $500 million in core E&S this year. The growth in our core E&S business is very strong. Submissions through the first three quarters of this year are up by 22% compared to the first three quarters of last 2018. The pace is accelerating. Submissions in the third quarter were up 29%. We're continuing to book the current year at or above a 70% loss in LAE ratio. Long-term observers of our company know our E&S book has historically developed at significantly lower loss ratios than 70%. Pricing is excellent.
A couple of anecdotes will give you a flavor for parts of our market. Liability for habitational risks have seen very large rate increases. We recently wrote an E&S excess liability policy on a California apartment complex, where we reduced the limit by 50% from the expiring limit and increased the rate by over 500%. A similar example from the East Coast, but where we write the primary layer. Our premium was almost 400% of expiring premium, with substantial supplements for assault and battery, water damage, and even an absolute dog bite exclusion. This illustrates that right now, in truing the E&S business, there is an opportunity for improved pricing and more favorable terms and conditions. Because these are new accounts to us and not in the renewal, these increases aren't incorporated in our rate increase information that I was quoting to you before.
In our Allied Health division, we're seeing real strength in the smaller nursing home-assisted living area. Larger facilities have not yet seen rate increases. In September, we wrote multiple smaller accounts at increases exceeding 50%. We have not yet seen significant increases in construction-related accounts. Our specialty admitted business, turning to that, also had a very good quarter, growing slightly compared to a year ago and reporting a 94.1% combined ratio. We believe our fronting business in this segment has great potential to deliver high returns on equity while taking only moderate underwriting risk. Underwriting profits from the specialty admitted unit were $837,000 for the quarter. We're just starting there. New leadership at our specialty admitted segment has signed four new fronting deals we anticipate will bring in over $50 million in gross premiums annually.
Because of the fundamental strength of our company, I expect going forward that we will deliver a low double-digit return on average tangible equity. Before we get into your questions, I know we'd benefit from having additional insight from Sarah Doran, our chief financial officer. Sarah?
Thanks, Adam. Let me highlight a few of the financial points from the quarter. Net earned premium grew over 16% in our E&S segment this quarter and 30% in our core E&S business alone. Year-to-date, core E&S earned premium is up 20%. This quarter, the E&S segment represented over 77% of our total group net earned premiums. Starting in January of 2020, core E&S will be the majority of our group's earned premium as the large commercial auto account will roll off by the end of this year. Thinking about core E&S on its own, as Adam mentioned, we're booking loss ratios at above a 70% loss in LAE ratio. The expense and commission ratio for this business is in the mid to high 20s. As we've mentioned previously, we are getting strong rate in our core E&S lines.
Given our strong pricing and our historical results in core E&S, we expect that this business will generate very attractive returns. Let me take a moment to provide some additional color on the adverse development we experienced this quarter. We had adverse development of $57 million overall. We had $50 million of adverse development in the Uber book, most of which was focused on the 2017 underwriting year with the balance in the 2016 underwriting year. This recent quarter, we had losses in excess of expected for the 2016 and 2017 years, but we did not see this for the more recent 2018 and 2019 years, so we took no action there. As Adam mentioned earlier, and we've mentioned before, in 2018, we raised rates on this account significantly.
We also had adverse development of about $8 million in our casualty reinsurance book, driven by much higher than average claims volumes in the quarter related to several accident years. We had $1 million of favorable development from our individual risk workers' compensation book. Turning back to cash flow, we continue to enjoy strong cash flow from our businesses as operating cash flow was $145.7 million in the quarter alone and $213.8 million year to date. Third quarter cash flow is up materially over that of the first two quarters of this year, given the strong growth in core E&S gross written premium, which is up 51% year to date on its own. The investment portfolio performed as we expected this quarter as we earned $17.9 million in net investment income, an increase of 9% from the prior year quarter, largely in line with the growth of our portfolio.
More notably, as Adam mentioned, subsequent to delivering the early cancellation to our client on October 9th, we brought approximately $1.2 billion of assets onto our balance sheet from a collateralized trust, which Uber had posted for our benefit. These funds are invested in short-term government securities and now will earn additional net investment income for us. The collateral secured claims payments for the portion of the risk that we effectively fronted for our now former client, not for our own booked reserves. We are entitled to ask for additional collateral should that prove necessary. Through the first six months of the year, we've grown our book value by about $82 million or over 16%.
While the loss this quarter is a setback, we've still increased tangible equity over 12% year to date, despite paying almost $30 million in dividends through the first three quarters of the year, given our healthy 3.6% yield. Our balance sheet and capital position are well able to support the attractive growth we continue to see in our core E&S business and additional opportunities for growth we are realizing in the specialty admitted segment. We expect that our casualty reinsurance business will largely remain at similar premium volumes to what it has over the last year or so. While it's too early for us to provide guidance on 2020, I will echo what Adam said in that our opportunities to put capital to work at attractive returns for our shareholders are plentiful.
While our top line will likely be down modestly in 2020 from where we end 2019, our core E&S business has typically produced a lower developed combined ratio than has our commercial auto book, building a case for a compelling group-wide combined ratio. We will actively and carefully manage expenses over the next few quarters as we work to run off the bulk of the commercial auto book. With that, I'll turn the call back to Adam.
Thank you, Sarah. Operator, do we have questions?
As a reminder, to ask a question, you will need to press star one on your telephone. To withdraw your question, press the pound key. Please stand by while we compile a Q&A roster. Our first question comes from Matthew Carletti from JMP Securities. Your line is now open. Please go ahead.
Hey, thanks. Good morning.
Good morning.
Good morning. Maybe just a couple questions to start on the commercial auto reserve charge. For starters, can you give us a little bit of color behind the scenes in terms of what changed with the reserve charge this quarter? Are you at a different point in terms of confidence level in the reserving numbers? Have you gone higher towards the top end of the actuarial range? Has the percentage of IBNR increased? Can you help us understand how the reserve picture sits today versus a quarter or two ago?
Sure. Matt, this is Sarah. I think I would say, first of all, we have fairly standard practices and procedures around this, and we follow the same that we do every quarter in that we're looking at this book with monthly actuarial data, then we're doing a deep dive every single quarter. What we reacted to was losses in excess of expected in this quarter. We put up the number that I think was demanding of that. We are certainly watching it very carefully and very closely, especially around claims and further development and behavior of that. We feel that we have put up a number that is well in response to the data that we saw, that we were presented with. That's where we got to this quarter.
As I mentioned, more of that was concentrated on the 2017 year than on the 2016 year. We're clearly closer to the end of the 2016 year, just from a timing perspective, than we would've been at the beginning of the year.
Okay. Maybe can you remind us a little bit of some of the either the broad pricing changes or underlying exposure, state footprint changes that how 2017 might be different than 2016 on an underlying basis?
Sure. I think, and that's a great question. A big piece of moving from 2016 to 2017 was that we took a smaller share, I think we've mentioned this publicly before, of Florida, and we've mentioned Florida as being an outsized contributor from an under-insured and uninsured motorist perspective, and that causing some issues with regard to 2016. Now, clearly, we, in retrospect, have underpriced 2017 from the reserve additions that we're making this quarter, but we have less exposure to that state in 2017 than we did in 2016. We did have a pricing increase from 2016 to 2017, but as Adam mentioned, much more material pricing increased from 2017 into 2018. I think that really provides a significant amount of the basis for our comfort in 2018 and then 2019.
Okay, great. Then I'll stop beating the reserve question here. Just one more. Have you considered, would you consider, are you considering an ADC on that book or some other form of reinsurance protection or transaction that would put it out of investors' minds for good?
We certainly realize the value that something like that could provide for exactly as you said it, for putting it to the side from an investor and certainly from our perspective. Those are options that we look at every day in our business with regard to this business, with regard to other options, soft capital options that could make sense. I think they need to make sense economically for us, and they're not simple transactions, but they're absolutely things that we would and should be considering, for sure.
Great. One last one if I can, not on the reserves. Can you help us understand how that E&S segment maybe will look different in, I know 2020 will be a bit of a transition year and then longer term in terms of loss ratio, expense ratio mix. I heard you mention mid to high 20s expense ratio is historically where the core E&S has run. I would imagine maybe it runs a little higher initially as you still have the commercial auto TPA business, all the 18,500 claims kind of in runoff. Can you help us at least directionally understand how that split will look as we move forward?
That's a great question, we are still working through. I'll maybe take a stab at it and then let Adam come in at the end. We are still working through kind of the fine point on our 2020 plan. What I would say is that we'll probably carry a little bit of additional expense into the beginning of the year, but we'll have worked our way out of that certainly by the end of the year. I'm comfortable with that mid to high 20s expense ratio on the core E&S business for all of 2020.
I would say it would be at the low end of that once we work our way out of all of the additional expense related to the business and managing those runoff claims, because just to reinforce, we do not expect to have any premiums coming in from that large account in 2020. I think what's most important there is that we work our way out of the claims and we come to a good reserve result. We're okay to carry a little bit of additional expense in the beginning with the big picture to come to a good landing. Adam, is there more you'd add to that?
It's just that I think you can get a good feel for how this book will look if you go back and look prior to our taking on the Uber account at our E&S business. For years, that business has run at a loss in LAE ratio hovering around 60. We've been able to run that business, and as Sarah said, well below 30, in the mid 25% to 28% expense ratio. That's where I would expect this book to settle out once we move through all the other, what I will now call noise, because it's stuff we're rolling off.
Great. Well, thank you for the answers and best of luck going forward.
Thank you.
Thank you. Your next question comes from Mark Hughes from SunTrust. Your line is now open. Please go ahead.
Yeah, thank you very much. Good morning.
Good morning, Mark.
Hey, Adam. The underwriting expenses in E&S, kind of the mid to high 20s, what sort of corporate expense would you have on top of that? I think you break that out in your earnings report. If I'm looking at it properly, the other operating expenses of corporate, another $7 million last quarter. Do we have the kind of mid to high 20s E&S expense load and then the corporate on top of that?
Yes. Excuse me, Matt. When I cite mid to high 20s, that's just the core E&S expense ratio. We do have the ongoing corporate expense, which is roughly $7 million and change a quarter. Then we've got the expense ratios in the other segments that we wouldn't expect to change materially.
Very good. Then when you think about the core E&S, Adam, you point out how you usually book it at 70 and then it develops favorably over time. As we think about 2020, the pace of development, I think it's all been kind of caught up in the issues with Uber these last year or two, so it's been harder to get a look at what's going on in the core E&S. Can you say anything about either the pace of development in the core E&S as it's been recently or as it's likely to be, at least in the near term? I know that's something that's difficult to predict or provide guidance on, just sort of trying to think how the model looks, at least in the near term, with respect to those moving pieces.
We were booking, and Sarah, you will correct me I hope here, but we started booking the E&S business at a 70 in 2018. We have the benefit of the 2018 year, which is already developing some maturity, and we get more insight into that as it goes on. Typically, we do not have a script here about how we bring down reserves. We look at the actual case reserves, and we look at our IBNR and measure the pace of claims and make a judgment that is a historically well-informed judgment, and it starts a couple years after we write the business. You will start to see those reserves roll into earnings as appropriate.
Very good. Then just two others, if I may. The $1.2 billion, why, if it was available, and you could begin generating investment income, just economically speaking, why would not you have done it sooner than you did here? What was the kind of the dynamic on the timing on the decision process?
It is a standard trust, Mark, and we felt that we were making a change, and by canceling the account, we felt like we wanted to be as secure as we could be in the moment. We made the decision to draw on the funds commensurate with the early cancellation of the account, just out of an abundance of caution.
Is that what triggers it? There is some sort of you have to make a case that there is a reason to take the assets, and then it becomes.
Mark?
Yeah, go ahead.
Mark. No, there's no case that needs to be made. Listen, I don't really want to get us into a lot of specifics.
Sure
About the account. This is a very standard arrangement across the industry. Any insurer who enters into one of these standard agreements can, at any time, typically draw down that trust. Our policy was we had canceled the policy. We're putting this book into runoff. We thought carefully about our situation and made the choice that we thought was the appropriate choice.
Thank you for that. The AB5, you say that you think that may adversely alter the claims profile for ride sharing. Could you expand on that a little bit?
Well, look, there's been an awful lot written about that by a lot of experts, but obviously, it's something that we did not price for. We didn't price for AB5, and it was a change, and we think it's a material change. Having experienced many different changes in the course of this relationship that affected losses, we thought this was the right thing for us to do. Just was not incorporated in our pricing.
Thank you.
Thank you. Your next question comes from Meyer Shields from KBW. Your line is now open. Please go ahead.
Great. Thanks so much. Just a few, hopefully, quick questions. I'm trying to understand, or let me ask this as a question. Given the significant rate increases embedded in both new and renewal core E&S, should we assume that 2020 could be booked at something below 70% initially, or is that roughly a good initial guide with favorable experience to be reported later?
We're not far along Meyer, to have a materially different view on the market. In the absence of new data in the beginning of November, I do think about that loss ratio, that 70% accident year as being a reasonable assumption.
Okay. That is perfect. Can you give us a sense of the timeline for paying down the $1.2 billion of claims-related collateral? In other words, how long that will be augmenting investment income?
Yeah, that's very hard to tell because there are a lot of assumptions around claims payments and kind of future, I guess, interaction as well. I think in the absence of that, I would just assume that it is $1.2 billion over the next year.
Okay, perfect. Does the fronting arrangement in casualty reinsurance provide ceding commissions to be earned in coming quarters, or was that all booked in the third quarter?
No, that will come over the next few quarters. Good question .
Okay, one last question, if I can, on the Uber reserves. I guess the one question that I'm hearing is that since you've had sort of late adverse experience on accident year 2016 and 2017, how do you have comfort that that won't materialize later on in the more recent accident years, even in the context of the current improved underwriting performance?
I think the biggest buffer against that is a very substantial price increase that we got in the 2018, 2019 year.
Does that preclude later development of claims for later emerging information?
No, it doesn't preclude later emergence of claims, but we just aren't seeing that right now. We're not seeing that kind of emergence right now.
Whereas I think we were at earlier points of prior years.
Yes.
Okay, understood. Okay, thank you so much.
Thank you. As a reminder to ask a question, please press star one. Your next question comes from Brian Meredith from UBS. Your line is now open. Please go ahead.
Yeah, thanks. One quick one and one maybe a little bit longer. The first one, Sarah, what kind of yield should we assume on those short-term funds?
It's a money market, treasury T-bill type yield there, Brian.
Okay. like a three-month.
Yeah
three-month T-bill. Okay, great. My second question, Adam, I'm just curious, with the substantial growth you're putting on your E&S, core E&S business, do you have kind of the platform and infrastructure to absorb that type of growth right now? I want to tie that in with what's going on right now with Uber and just how integrated with that and the rest of your platform, and just to avoid disruptions that could potentially cause some issues as far as claims management, underwriting, all sorts of other things.
Absolutely. We've got the infrastructure to manage the growth in the E&S business. Our throughput right now is growing because of good hard work and very capable management and organization by our teams in the E&S unit. Our throughput has grown, that is the number of quotes that we've been able to put out, and we've put some technology behind that assist us in quoting faster and better. We're not strained at all in terms of our ability to handle this growth. We've added new people in the underwriting division. Right now, the Uber account is really strictly, obviously a claims operation, and we have sufficient people to handle those claims easily, efficiently, consistently, and within the four corners of the contract. We'll engage in an orderly runoff of that book. The Uber claims segment is separated from our E&S claims segment.
They're under a common management, but the people handling Uber claims are different than the people handling the liability claims in our E&S segment. As Uber runs off, by the way, there may be opportunities for us to move some people over from Uber claims into the liability group as that grows. In fact, that's kind of an advantage that we have right now in terms of this expanding book. As you think about the growth in claims, just in numerical claims that will inevitably come, we've got a lot of talented people handling Uber claims who may eventually come over and be part of the E&S claims handling. It's actually a fortuitous and good arrangement.
Great. Thank you.
Thank you. You have a follow-up question from Mark Hughes from SunTrust. Your line is now open. Please go ahead.
Yes. On claims development, there's been some commentary, obviously, around the commercial auto that the development pattern has been lengthening or you're seeing, not you, but others are seeing higher losses in the tail. Even on non-commercial auto risks or losses there perhaps have been developing less favorably than expected. Have you seen that? The whole point about social inflation, just kind of broadening up the conversation, and one of your notable competitors that talked about it. Are you seeing anything like that in your core E&S business where some of the development patterns are a little different?
We're not. We're looking hard at it. We certainly are aware of all the commentary around that. We've not seen what people are referring to as the social inflation in our core E&S book, middle market, basically small and middle market E&S book to date, but we are alert to it. I will say, we've enjoyed 10 quarters in a row of significant rate increases. As I was pointing out before, the renewal book, those rate increases that we report to you, I think they're part of the story. There's another part of the story where you can't quite capture the flavor except to explain to you what the expiring premium from another insurer was compared to the premium we got. I gave you a couple of examples of several hundred percent here. I didn't just cherry-pick those examples.
That's a phenomena that's going on in parts of the E&S market. At the same time, I'm not seeing yet the social inflation that people are talking about. If you look at our long-term history in this business, which is, as I pointed out earlier, 17 years, we've got a long history through many cycles of looking at fully developed loss and LAE ratios. Those typically have been hovering right around 60% over time. I think the price increases that we're getting are really good, and I think that this book will perform in line with our long-term history in good years, because I think we're really in good position in these years in the current environment.
Understood. One final quick question. Do you happen to have the written and earned for the commercial auto piece in the third quarter? I think historically that maybe gets broken out later, but I wonder if you have them there in front of you. Again, the written and earned in commercial auto within E&S.
Yeah. It was about $80 million there.
That was the earned-
Yeah. The net written and the net earned, they're about the same, right? Because we basically earn the premium as we write it.
Yeah. net written would be the same.
Yeah.
Do you have gross written by any chance?
Well, gross would be the additional amount given the large reinsurance contract. It's a little over $100 million.
Yeah. Okay. Very good. Thank you.
Thank you.
Thank you. I'm showing no further questions in queue at this time. I would like to turn the call back to Adam Abram for closing remarks.
Well, thank you everybody for your interest in our company, and we look forward to reporting to you next quarter and to visiting with you from time to time. We deeply appreciate your interest, and speak to you soon. Thank you.
Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect.