Good morning, ladies and gentlemen, and welcome to Kemper's fourth quarter 2015 earnings conference call. My name is Abigail, and I will be your coordinator for today. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. If anyone should require assistance during the conference, please press star and then zero on your telephone keypad. As a reminder, this conference is being recorded for replay purposes. I would now like to introduce your host for today's conference, Ms. Diana Hickert-Hill, Vice President, Investor Relations and Corporate Identity. Ms. Hickert-Hill, you may begin.
Thank you, operator. Good morning, everyone, and thank you for joining us. This morning, you will hear from three of our business executives, starting with Joe Lacher, Kemper's President and Chief Executive Officer, followed by Denise Lynch, Kemper's Property and Casualty Group Executive, and Frank Sodaro, Kemper's Senior Vice President and Chief Financial Officer. We will make a few opening remarks to provide context around our fourth quarter results. We will then open up the call for a question-and-answer session. John Boschelli, Kemper's Senior Vice President and Chief Investment Officer, will join our presenters during the interactive portion of the call. After the markets closed yesterday, we issued our press release and financial supplement. You can find these documents on the investor section of our website, kemper.com. Please note that our discussion today may contain forward-looking statements. Our actual results may differ materially from these statements.
For information on potential risks associated with relying on forward-looking statements, please refer to our Form 10-K and 10-Q reports filed with the SEC, as well as our earnings release. We plan to file our 2015 Form 10-K on or about February 12th. This morning's discussion includes non-GAAP financial measures that we believe are meaningful to investors. Finally, all comparative references will be to the fourth quarter of 2014 unless we state otherwise. Now I will turn the call over to Joe.
Thank you, Diana. Good morning, everyone, and thank you for joining us today. Before I comment on our performance in the quarter and the year, I want to let you know how honored I am to be here leading Kemper. I also want to acknowledge the hard work and many contributions of my predecessor, Don Southwell. He assembled a talented team who's been instrumental in helping me come up to speed quickly on the many aspects of our diverse business. Since joining Kemper just 2 months ago, I've been doing a deep dive on many fronts, and I'm learning a lot about our strengths, our opportunities, and our challenges. Overall, I'd say we're not happy with our financial performance in the past couple of years. It's going to take a couple of years for us to get it fixed.
While we do have areas that are going well, clearly we have issues we need to address, including some that drove results this quarter. For the near term, I'm focused on the critical few points that need my immediate attention while the team and I analyze our longer-term needs and plans. I commit to give you a strategic update this summer. We'll withhold strategy comments for now while that assessment is still underway. Given that context, I'll now shift to discussing our fourth quarter results and full-year performance. In short, it was a disappointing quarter overall. We'll detail the drivers for you. Underneath those issues, we did have some positives as well. We'll explore those too. Non-standard auto was our main problem area this quarter, especially the Alliance United business. This acquisition will not be accretive in its first full year.
However, we do expect it will be in its second year. We think the issues in non-standard auto overall and Alliance United specifically are fixable. We still feel good about the acquisition. We're seeing positives from the changes we made to our preferred auto book despite the headwinds and loss trends that the industry is experiencing. The fundamentals in our life and health segment are stable. Once again, our investments portfolio performed well. In total, Kemper's net operating income in the quarter was $5 million here. A significant driver was lower per quarter from Alliance United. Other factors include increased catastrophe losses, a higher underlying loss ratio in our P&C legacy lines, lower levels of favorable reserve development, and an increase in life insurance expenses. Additionally, in the prior year, we received a large special dividend from one of our alternative investments.
Similar to other companies in the non-standard auto industry, Alliance United's loss trends were pressured in the quarter. It was not a good time to be growing the line so quickly given the uptick in frequency and severity. As you may surmise, this is a key area for my immediate focus. Denise will cover Alliance United in more detail when she discusses the P&C segment's performance shortly. In total, Kemper's revenues were up $57 million in the quarter and ended the year at more than $2.3 billion, up $144 million as the Alliance United acquisition contributed to the top line more than offsetting reductions in the legacy businesses. Turning now to the life and health segment, the underlying results were stable. We earned $18 million in the quarter, down $16 million. You can see in our press release we had two main drivers for the decline.
The largest driver was related to the fourth quarter of 2014 when we benefited from a $14 million after-tax special dividend from the recovery of one investment in our alternative investments portfolio. The second driver was from an increase of $5 million after tax for legal fees in our life insurance line. On a full-year basis, we earned $72 million compared to $92 million last year. Excluding the impact of these two items, underlying earnings actually improved. Life & Health revenues were $205 million in the quarter, down $18 million with $16 million of the decline driven by lower net investment income. On a full-year basis, revenues were $811 million, down $21 million from 2014. These declines were driven by the 2014 special dividend I just mentioned.
In the Kemper Home Service Companies business, premium revenue was nearly flat at $116 million in the quarter, expenses benefited from the field consolidation. In Reserve National, premiums remained stable despite the transition away from hospitalization products and toward life, home health care, critical illness, and accident expense insurance. I'll turn now to investments. I'm pleased to report our investment portfolio performance remains an area of strength for us. Excluding last year's special dividend, our net investment income increased $8 million for the quarter and $15 million for the year. Our pretax equivalent yield is holding up well at 5.5% annualized for the quarter, slightly better than the full year. Our alternative investment portfolio, which primarily consists of LPs and LLCs, yielded 9% annualized for the quarter and 8% for the year.
Total return was a positive 0.4% for the quarter and 2.2% for the year, primarily from net investment income offset by rising yields. We're very pleased with our alternative investments performance, both for the quarter and year to date, in light of the equity and high yield markets volatility. Now I'll turn the call over to Denise to discuss our property and casualty segment results.
Thank you, Joe. I'll start with the segment overview in total and then go through the performance of each of our lines of business. The property and casualty segment lost five premium deficiency, resulting in a partial write-off of deferred policy acquisition costs. For the full year, we earned $27 million, up from $25 million last year. Our property and casualty revenues were $414 million in the quarter, up $97 million, driven by Alliance United, which more than offset a decline in our legacy lines. On a full year basis, revenues were $1.5 billion, up from $1.3 billion in 2014, primarily from having the eight months of revenues this year from Alliance United. Our policies in force increased sequentially, ending the year at 1.2 million, up from 823,000 last year, getting a lift from our acquisition. Net earned premiums were $392 million in the quarter, up $92 million.
Excluding Alliance United, premium retention improved two percentage points and new policies in force were up 15%, yet legacy earned premiums were $281 million, down $19 million. For the full year, segment net earned premiums were $1.4 billion, up $166 million versus 2014. The impact of Alliance United makes year-over-year comparisons difficult, as Alliance United runs at a higher underlying loss in LAE ratio, but a lower expense ratio than our legacy business. I'll provide more detail on profitability by line of business. On expenses, we had a $9 million charge to write down a portion of Alliance United's deferred policy acquisition cost. The legacy P&C expense ratio was up about a half point in the quarter. Now I'll provide a fourth quarter update on each of our lines of business. I'll start with the non-standard personal auto line.
In the quarter, net premiums written were $186 million, an increase of $117 million. Net earned premiums were $188 million, an increase of $113 million. While Alliance United drove the majority of the increase, the legacy non-standard auto net premium written were up 5% and marked the fourth straight quarter of period-over-period increase. The total loss in LAE ratio was 95.6%, with the underlying loss in LAE ratio at 92.7%. I will address the underlying performance at Alliance United separately from the legacy non-standard book. The Alliance United loss in LAE ratio of 105% includes an underlying loss in LAE ratio of 100.9% and 4.1 points from adverse pre-acquisition loss reserve development. Additionally, we saw significant current year adverse development that increased the fourth quarter underlying loss in LAE ratio by 6.7 percentage points. Obviously, this was a very disappointing performance.
The drivers of the underlying performance include, one, broadly, the industry saw loss trends nearly double in California over the last year to the mid-teens. Frequency and severity in bodily injury and property damage liability were the drivers, as well as collision severity. Alliance United was subject to the same environmental factors that impacted the industry, such as increased miles driven and more expensive repair costs. Two, Alliance United's claims department was somewhat understaffed at acquisition. The staffing gap grew with the increased frequency trends, increased new business, and some disruption to hiring during the integration. Three, we filed a class plan change and rate increase for a product representing about half of the business mid-year. This approval process is taking longer than typically expected. In response to these developments, we have implemented a few very important operational actions.
First, we continue to work with the Department of Insurance on this filing and are accelerating the filing to increase rates on the remaining business. Second, we hired and onboarded a significant number of new claim professionals in 2015 and expect to add more over this year to address the claim staffing issue. Third, we have taken actions to improve risk selection, price adequacy, and agency management. Collectively, these are now slowing new sales to more desired levels. While Alliance United is not meeting our expectations, the long-term strategic value of this business remains compelling. We do expect the acquisition to be accretive in its second year. It will take a few years before this business will meet our profit objectives. To our legacy non-standard auto book, this business did not meet our target profitability last year.
We, along with the industry, saw elevated loss trends over the course of 2015. Year-over-year profitability deteriorated every quarter, and that trend continued in the fourth quarter. We are in the process of rolling out a new product and rating plan. It's currently being used on about 45% of our book. Over the course of 2015, we increased our filed rate levels to about 10 points. These efforts have yet to yield a significant impact on results. In the quarter, we completed an overall review of our legacy non-standard business and identified a number of initiatives to improve profitability. We are in the process of executing those initiatives, we are going to reopen and expand the scope and urgency of that review to include every function and operating lever to drive improved financial performance in this business.
We're planning to file rate increases of nearly seven points with the majority in the first half of the year of our entire legacy book. Unfortunately, given the current results and the current industry loss trends, it will take some time before we achieve acceptable returns. In commercial auto, net premiums written were flat at $12 million in the quarter and down 3% at $54 million for the year. Earned premiums were stable in the quarter and for 2015 at $14 million and $55 million respectively. For the quarter, the loss and LAE ratio deteriorated to 92%, driven by $1 million of adverse development and a 9.7% increase in the underlying loss and LAE ratio due to increased frequency and severity. We continue various agency management, underwriting, and rate actions.
Moving to preferred auto, net premium written were $102 million in the quarter, down $8 million, and were $435 million for the year, down $52 million from 2014. Net earned premiums were $109 million in the quarter, down $14 million, and were $450 million for the year, down $76 million. New business written premiums grew by 8.5% as new policies in force increased for the sixth consecutive quarter to the highest level since the third quarter of 2013. Premium retention at 84% improved both year-over-year and sequentially. The loss in LAE ratio was 75.7%, up 6.6 points, primarily from lower levels of favorable prior year development. The underlying loss in LAE ratio increased to 76.2% for the quarter. When you look at quarterly results, there are periodic changes that occur from prior periods within the year.
When we remove the current year development, we're seeing a modest improvement in the quarterly underlying loss in LAE ratio. Over the past several years, we've executed a number of profit improvement actions which have been resulting in steady improvement in profitability. The underlying loss in LAE ratio was 70.9% for the year and improved about one point. We still have a ways to go, but continue to make progress. Turning to the homeowners line. Net premiums written in the quarter were $64 million, down $3 million, and total $276 million in the year, down 7%. Net earned premiums were $70 million in the quarter, a $6 million decrease. For the full year, net earned premiums totaled $286 million, an 8% decrease from last year. New business production grew 9% from last year. Premium retention improved four points to 84% and was up sequentially for the fourth straight quarter.
Catastrophes in the homeowners line finished at 18% of earned premiums in the quarter, up 13 points from last year and above our expectations. The quarter had been relatively mild until the last week of the year when tornadoes struck in North Texas. The loss in LAE ratio was 61.6% as the underlying loss in LAE ratio increased 4.9 points to 46.4%, primarily from increased severity from large fire losses. Average earned premium decreased slightly as mix changes offset 4% filed rate increases. Looking at the Property and Casualty segment in total, it was obviously a disappointing quarter. While the Alliance United acquisition failed to meet expectations, the long-term strategic value of the business remains compelling. However, it will take a few years before this business will meet our profit objectives. Our legacy non-standard auto business continues to underperform against a backdrop of deteriorating industry loss trends.
We are going to take a fresh look with an increased sense of urgency to significantly change the trajectory of this business. Efforts to stabilize preferred auto and home premiums show continued progress, and we expect this progress to continue. Now I will turn the call over to Frank.
Thanks, Denise, and good morning, everyone. Today, I'll cover Kemper's consolidated performance, capital, and parent company liquidity. For the fourth quarter, net income and net operating income were both $5 million, or $0.09 per share, compared to net income last year of $65 million, or $1.24 per share, and net operating income last year of $54 million, or $1.02. For the year, our net income was $86 million or $1.65 per share, compared to $115 million or $2.12. Net operating income was $70 million or $1.35 compared to $97 million or $1.79 per share last year. For the full year results for 2015, both net income and net operating income included a software write-off of $7 million after tax, or $0.14 per share. Similarly, the prior year's results included a software write-off of $35 million after tax, or $0.66 per share.
Total revenues were $617 million for the quarter, an increase of $57 million or 10%, as roughly $110 million of earned premiums from the Alliance United acquisition were partially offset by lower earned premiums from our legacy P&C. On a full year basis, our total revenues increased 7% to more than $2.3 billion, driven by over $270 million of earned premiums from Alliance United, offset by lower earned premiums from our legacy P&C business. Earned premiums in the life and health segment decreased about $20 million, primarily from lower life insurance premiums, which included an $8 million deferred premium adjustment in the first quarter of 2015. Net investment income decreased $14 million for the quarter and $7 million for the year due to the $22 million special dividend we received in 2014.
Excluding the special dividend, both the quarter and year increased from higher returns on our equity method investments, while the year was also driven by higher yields on fixed maturities. The investment portfolio in total generated a pre-tax equivalent annualized book yield of 5.5% for the fourth quarter of 2015 and 5.3% for the year, compared to 6.5% and 5.5% for the quarter and year in 2014. The Property and Casualty segment reported net operating loss of $5 million for the quarter compared to net income of $25 million last year. This decline was due to Alliance United's results, which included adverse development and the resulting DPAC write-off, as well as poor results from our legacy P&C book. For the year, the Property and Casualty segment reported net operating income of $27 million, compared to $25 million in 2014.
Given Alliance United's fourth quarter, results did not meet our expectations and were a drag on the full year. Net operating income for the life & health segment was $18 million for the quarter, compared to $34 million last year, and $72 million for the year, compared to $92 million last year. Last year, the life & health segment's net operating income benefited $14 million from the special dividend it received in the fourth quarter. Excluding that dividend, net operating income decreased for the current quarter and year by $2 million and $6 million respectively, due to higher legal expense and a deferred premium adjustment booked in the first quarter of 2015, offset by higher investment income.
Net operating loss from corporate and other increased $3 million and $9 million for the quarter and year respectively, primarily from higher pension costs driven by assumption changes at the end of 2014 and lower net investment income. Looking ahead to 2016 pension expense, we increased our discount rate by about 40 basis points and adopted the most recently published mortality tables at the end of 2015. We are reducing our expected long-term returns on pension investments and adopting the full yield curve approach for estimating interest and service costs. As a result of these assumption changes, we expect our pension expense to decrease about $11 million after tax for 2016. To put that in perspective, pension expense increased by about that same amount in 2015 compared to 2014, largely due to the adverse effects of assumption changes. I will now cover book value, capital, and parent company liquidity.
Book value per share was $38.82 at the end of the year, down 3% from last year, largely from the impact of higher market yields on our fixed maturity portfolio and dividends paid, partially offset by net operating income. Book value per share excluding unrealized gains on fixed maturities was $35.13, up 2% from the prior year, primarily from net operating income, partially offset by dividends. Statutory surplus levels in our insurance companies remain strong, and we estimate that we ended the year with risk-based capital ratios of approximately 390% for our life and health group and 325% for our legacy property and casualty group. We estimate that our insurance companies will have a maximum ordinary dividend capacity in excess of $170 million in 2016. During 2015, we repurchased more than 1.2 million shares of common stock for a total cost of $44 million or $35.57 per share.
In total, we returned $93 million of capital to shareholders. We estimate that we ended the year with more than $225 million of excess capital. From a liquidity perspective, the parent company held cash and investments of about $340 million while our $225 million revolver remained undrawn. I'll now turn the call back over to Joe.
Thanks, Frank. Capital allocation is a key part of the overall business assessment process that I've been conducting. As I look at the sources and uses of capital, I'm mindful to address both our short-term needs and long-term return objectives. We work for our shareholders who expect and deserve production of attractive returns. The good news is that our current capital position is strong. Historically, we've described our strategic capital allocation priorities as funding growth for new business that delivers appropriate returns, acquisitions that are accretive to our business, and returning capital to shareholders through dividends and share repurchases. We'll share with you more about our capital allocation priorities during our strategic update in the summer. My commitment to you is that we will be prudent stewards of your capital. I'll turn the call over to the operator to take questions. Operator?
Thank you. Ladies and gentlemen, if you have a question at this time, please press star and then one on your telephone keypad. If your question has been answered or you'd like to remove yourself from the queue, please press the pound key. Again, that's star one if you have a question at this time. Our first question comes from the line of Christine Worley with JMP Securities. Your line is open.
Thank you very much. Couple of questions on Alliance United and the non-standard book legacy. Can you sort of give us an idea over the past year, how much of the growth in those separate pieces has come from rate, how much has been just growth of expansion?
Sure, Christine. I'll take that question. The majority of the growth at Alliance United this year has come from new policy growth, although there is some additional rate flowing into the book from primarily mix shift changes that we are experiencing in that book. The majority of that growth is in fact coming from policies in force growth.
Can you quantify what the rate increases you have achieved on that book have been?
The average written premium is up mid-single digits on an exposure basis.
Okay. Then same question for the legacy book. Are you getting any growth there outside of rate?
In the legacy non-standard business, our policies in force are actually down. We are not adding policies to our portfolio at this time. What we're seeing is rate coming through from our actions in the book.
Okay. From an actuarial perspective, I know you filed the 7%, how much additional rate do you think you need to sort of get in line with what you're seeing from a loss cost perspective?
There's a ways to go on this book of business, as I said. This is going to take a few years to get this book, you're talking about Alliance United-
Correct
turned around. We will take the rate that we need on our portfolio as we work with the Department of Insurance on the product that we've got filed right now. We'll continue to take the additional rate on the rest of the book. We'll continue to take other underwriting agency management risk selection issues to be able to improve our price adequacy and our overall risk selection in the book. It will take a period of time to get it to our target returns.
Okay.
Christine, this is Joe. I'll just add on top of that. Obviously, we're dealing with California, which is a more challenging environment to get rates. We won't rely solely on the rate lever to respond to this, as Denise was saying. We'll be more aggressive with all of the tools at our disposal.
Okay. What's your average policy length on the Alliance United book?
The vast majority is well under 12 months.
Okay. Well under, more in the three to six-month range then, is that fair to say?
Yes, under six months.
Okay, under six months. Great. Just sort of one last question. How should we think about sort of the moving pieces from a combined ratio standpoint? If we look at the addition of people on the claims side, how quickly do you expect the losses to come down due to that sort of offsetting what additional expense spend you may have there?
Let me see if I can answer the question around Alliance United and the combined ratio there. What we are seeing is a significant deterioration in industry loss trends, and those same deterioration in industry loss trends affected Alliance United. We saw that come through in our prior year development and in our current year development. We're addressing that with rate and underwriting and other actions, but it is going to take a period of time to restore that book of business to our profit objectives. The key issue on this book of business really is the loss trend, recognizing the loss trend, and then acting upon it. With respect to the claims, we are already working on the claims to address that staffing issue. We've added several claims professionals throughout the year, and we'll continue to do so to address the staffing need that we have.
If your question, Christine, was narrow, because I think Denise is trying to answer the full impact on the combined ratio. If it's really a narrow question on are we going to drive up LAE by adding claims adjusters before they have an ability to impact loss costs-
Right
On that one in particular trade, we're very confident that adding the adjusters will more than pay for itself in loss cost management.
Okay, great. Thank you very much for the answers.
Thank you. Our next question comes from the line of Paul Newsome with Sandler O'Neill. Your line is open.
Good morning. Thank you for the call. I have a broad question and then a couple of narrow ones. Broadly, we're referencing a lot of trying to get profitability up to our targets. We have a bit of a change in management. What are those targets now?
Paul, I'm going to defer giving you a real specific answer on that one. What I want to do is spend a little more time digging into all of our businesses and really get a sense of where we want to take all of them broadly. It's a fairly easy statement when you look at our non-standard businesses, our Legacy and Alliance United, to say that they're not close to a reasonable target. We need to provide very reasonable returns for our shareholders on a consistent going-forward basis and do it by delivering consistent and replicable competitive advantages in the marketplace. Particularly in these two businesses, we're not delivering that right now. At a minimum, we've got to be in the double-digit ROE range. We'll give you a more specific answer by the summer as we dig more into these businesses.
That's fair. Specific question, the $5 million in after-tax legal fees on the life side, is that related to the lawsuit with the Illinois treasurer? Should we expect that those be, at least in the near term, recurring type costs?
The $5 million is related to our unclaimed property litigation and issues on a number of fronts. We will continue to pursue our legal options in that arena, hopefully until we have an appropriate conclusion. I don't anticipate you will see charges of that size on a regular basis, it would be somewhat surprising to me if this ends quickly. Our hope is that this is an adequate view of what should cover the issues we know that are out there over a reasonable period of time, things may change on that. The crisp answer is you shouldn't expect this kind of number every quarter.
Okay. Thank you. Back to the property casualty business. When you filed the rate plan, could you talk about the timing of when you filed the class plan for Alliance, how long it took, if there's any way to think about how quickly it can go through? I realize it's California, that's a hard question to ask, any more details about when it was originally filed and how long it lasted would be great.
Okay, Paul. For Alliance United, we filed a new class plan with a rate increase in the summer of this year, we have been working back and forth with the department to get that filing approved. We are still working with the department to get that filing approved. We expect to very soon after file another rate increase on the remaining product in the Alliance United portfolio.
Great. Thank you very much.
Thank you. Our next question comes from the line of Ron Bobman with Capital Returns. Your line is open.
Hi, good morning. I had a couple of questions, I guess largely focused on Alliance United. Could you describe the, and I assume following, Joe, your arrival, what sort of claims review's been done on both case and IBNR levels, whether you engaged any outside providers or whether you relied upon solely in-house staff? For starters, could you describe that?
Sure. What we've done in, I'll comment again as you requested, largely during my tenure. We've dug into case reserves, how those are put up, how the process is managed. We've done that ourselves. We've had our outside auditors doing it, and we've had at least one, maybe two third-party groups, depending on how you think of their review, gone through and take detailed reviews for us on those case reserves and claim practices, AU's claim practices compared to ours, compared to the industry. We've taken a broad and deep review of all of those elements, and all of those are informing both the numbers that we've booked this quarter and the actions that we are currently executing.
Do you consider, I understand you can get more information through the continued passage of time, do you consider the headquarters review, this work that you've done, complete or is there still broader additional case files to be looked at, broader production areas to look at? In essence, is your claims audit, your reserve audit on this acquired enterprise and the book they're producing for you today and that you inherited, is it complete or is it fair to say that there's really some more work to be done?
Ron, while there's always the potential for something else to be found, I would say this is a largely complete review. We've been very deep and thorough. This is a book that turns over. It's a relatively short tenure. We've been looking at the data since we've been owners for more than eight months. We've been deep inside of those items. There were a number of issues that made it somewhat challenging to read when we first acquired it. Alliance United, as companies do from time to time, had undergone a claim process where they were closing some claim files near the back end of last year and the early part of this year, and in a different way than they had in the past. That causes data to be a little more challenging to read. I think it was challenging for the folks that were booking their numbers.
It was certainly a challenge for us reviewing that information in the first 90 days that we had the book. We have cleared all of the clutter out of that and understand how that impacts the numbers and have a clear view on it. Again, our outside auditors and the outside expert we had look at it, have all been through it, understand it, and when you get 12 actuaries, you'll get 15 opinions. Even with them as a group, they are largely honed in on a consistent view of this, and believe we've got a thorough view and a thorough understanding, and have taken the appropriate action based on that.
Thanks. I assume that all claims are handled in-house, that they don't and Kemper doesn't rely upon third parties.
We do periodically use independent adjusters or appraisers, TPAs for parts of the item. We don't have the scale that we want in all spots. It's largely in a case where we don't have the geographic presence or the geographic spread. It's not a case where we're wholesale taking a state or taking a whole section of a state. It's more covering the edges. We typically drive that only on the simplest claims. Anything that's got what you might describe as hair on it, regardless of where it is, we pull those in. The group has a much tighter, narrower authority. You can almost think of it as a minor use of supplemental staffing rather than a broad outsourcing.
Okay. In the same area, I know non-standard retention levels are much, much lower than standard lines. I am curious about sort of what I would like to understand is, rate isn't where you want it to be, where it needs to be. It sounds like it's materially lower, it's going to take a couple of renewals, firstly, an approval by the state to get rate on this book where it needs to be. Are retention levels higher than they might otherwise be desirable? I mean, are we continuing to write business that effectively is underpriced? It's got a deficient margin. Is that not the case?
Ron, are you asking about Alliance United?
Yes. Yeah. Alliance United, sorry.
Alliance United's retention persistency is actually pretty consistent over time. Really with the policies being six months and under policies, we have the opportunity to get the rate into the book for new business as we write it, then the renewals as we renew them. We have that opportunity. Yes, as soon as we get that rate filing approved.
My last question. Thanks for your patience, because I know it's been a few. You said that you expect Alliance United to be accretive calendar 2016. I assume that's sort of on a total income basis, the investment income off of the cash flow and added to underwriting income. Can you give us a statement on what you think the combined is actually going to be for calendar 2016? Or what you hope it to be?
Well, let me adjust first a little bit on your question. What we said, I'm not trying to parse words, make sure we understand it. What we said is it was not going to be accretive in its first full year of ownership, which is not a calendar year of ownership.
Okay, great.
It's the 12-month period from acquisition, that we believed it would be accretive in the second year. That's a little bit of a time spread there. We don't typically do forward-looking views of combined ratios, I'm going to defer for giving you that much detail. We do recognize for this book that they are largely six-month policies, that we do have a number of levers that we can pull, that we have not been pulling as hard as they can be pulled. We'll actively engage in those. The analysis to the other part of your question on how we're defining accretive, we're looking at it on an independent basis to say, what did it add to the organization by being here? That takes into account all of the different components of that.
Investment income, the fact that as we do that analysis, if we hadn't bought the business, we wouldn't have made the $71 million payment. We would have had those dollars in-house. It's a view of with and without.
Okay. Thanks for the help. I appreciate your complete answers.
Thank you. Ladies and gentlemen, as a reminder, if you have a question or a follow-up, please press star and then one on your telephone keypad. Our next question comes from the line of Brian Roman with Boston Partners. Your line is open.
Good morning. Thanks for taking the question. Bunch of questions. Excuse me. You talked about doing a comprehensive claims review for Alliance United. Are you doing that for the other property casualty lines?
We have expanded that review for all of our non-standard, where it's the principal issue. It does run across, and use similar claim resources. We are looking and exploring that. We haven't made a call on whether we do it in our preferred area. What I'd tell you is a lot of what we're learning out of those two non-standard reviews will lift and update where appropriate and use it across.
I'm sorry, two non-standard reviews? What, Alliance United?
Alliance United, our legacy non-standard business.
Got it. Okay.
There's some element, Brian, that those needed to be fully insightful to look at them differently because we'd start with what was Alliance United doing before the acquisition, what were we doing as we integrated it, and then what was our legacy non-standard business doing?
Got it.
You could think of it as one with three parts. You could think of it as a couple. I'm trying to be fulsome in the answer.
I'm interested in Alliance United as well as the other non-standard businesses. You bought Alliance United, you closed on April 30th of last year. Between April 30th and basically the beginning of the fourth quarter of fiscal 2015, October 1st, you saw a need for rate increase. You saw a need for comprehensive review. Is there something that changed precipitously during that, what's that, about a six-month period? Is it just things that have been mounting for a while?
There were a handful of issues, Brian, that sort of hit simultaneously. The loss trend in the non-standard business in general had been relatively benign across the industry for a number of years. It has spiked during that time period you described, and California has spiked more significantly. That spike probably started just before the business was acquired, you get that as an environmental factor. Alliance United has had a long history of significant growth, and it would have been our expectation that that would have generally continued, it did, going into the wrong time to be growing with that loss trend. Given their growth, they had been, for some period of time, somewhat behind on claim staffing and were at acquisition.
That was known to us earlier, they were sort of constantly running to hire folks as fast as they could to keep up with their growth. We probably got a little delayed in that claim staffing on integration. We're behind on that staffing level, so have been aggressively working to catch that up, which is not ideal from a timing perspective as well. They had made those claim actions where they altered their behavior on some claim closing items near the end of last year and the early part of this year, which made the data that we look at to determine loss trends and determine where we are, harder to read. It was hard for us to read. It was hard for our outside expert to read. It was hard for our auditor to read. Everybody had the same challenge.
It wasn't a brain cramp on our side of having a problem reading it. All of those things were simultaneous. The normal ordinary course rate process that they would have gone through, they probably were a little delayed from what they normally would have been. My guess is, with a relatively small set of staffing, their side was distracted and was a little behind on that because they were dealing with an acquisition. We diligently moved on that after closing, got it filed, and it's gotten hung up in the department longer than any of us would have expected. There's a lot of things that happened simultaneously. We wouldn't describe those as excuses, but it's an explanation.
All of them happening at the same time with that industry rising loss trend made it hard to see the pace that this was deteriorating, and that's what's, I think, driving the issues and where we are now.
Whoever you bought Alliance United from, is there any sort of earn-out?
There is a couple of indemnification provisions. Frank, you want to help describe what the numbers are on that? Because I'll get them off.
Yeah. From a holdback perspective, there was a $12.5 million holdback that was a general indemnification bucket and then a $5 million holdback that was related to some legal matters.
Have those been paid or are they still being held back?
They're still being held back at this point.
What's the trigger that says that?
The first part of it, Brian, I think I know where you're going with the question. The first part of it, the 12 and a half, will not be paid out.
Okay
On where the results have been. I'm fairly certain that the $5 million for legal expense accrual, there will be some piece of that or all of that which will not be paid out as well.
What will that do? Lower your cost basis? How does that work? Is that just a cost that you will not incur in the future?
Well, the amount that we paid, or we published that we paid for this was the $71 million in that range. That included this holdback, so effectively that amount would be reduced by whatever ultimately comes back to us.
As stockholders, how do we get that back? That'll be through what, some sort of reversal or of the purchase price or?
Are you asking how it runs through the financial statements?
Yeah.
The economics?
A little of both, but also the financial statements. This doesn't happen very often.
The holdback is effectively already booked as a receivable.
Right.
I mean, that's what's happened as the development and these other things that have led to filling up that bucket. From a financial statement perspective, it's essentially booked.
Okay.
As we book some of the incremental charges, we booked an offset from the income statement for a receivable. As it was being used, it was a buffer to the results.
Okay. Is Alliance United a standalone company from an AM Best standpoint?
It is. It's a standalone company. We did not bring it into our pool.
Right.
It's a non-standard company and writes on a more leveraged basis than the rest of our pool, so we have it separate.
Do you think it'll need a capital injection at this point? Obviously, that is to be determined, but is it something you could see them needing at some point?
Yes, Brian, we do anticipate with the fourth quarter results that it'll need a capital contribution. We're waiting on finalizing stat, because that's really what will drive it.
Okay. Joe, I just want to get back to something you said earlier. You don't do projections, but you talked about expecting double-digit returns on equity. When you review or go over your strategic plan with investors, as you said this summer, are you going to try and provide some sort of pathway to some higher level of return on equity?
I'm trying to see if I'm understanding your question and making sure I'm answering it correctly. We have to, from a reasonable perspective to deal with investors, tell you what we think our strategy is and what kind of reasonable returns we're going to get, and it will not be a pie in the sky hope strategy. We'll have a point of view about how we're going to operate and how we're going to get there.
Okay. Right now you got plenty of capital, right?
Correct.
All right.
That is one of the things we feel particularly good about.
All right. Those are my questions for now. Thank you very much.
Thank you. Our next question comes from the line of Adam Klauber with William Blair. Your line is open.
Good morning, everyone. Thanks. A lot of discussion on Alliance and non-standard. Also noticed that the loss ratio in the preferred book also jumped up a lot during the quarter. I guess a couple of questions there. One is that, is that a bit of an accident year catch up because it moved from 68 to 76, so a big jump. Two, could you talk about the trends that necessitated a higher loss ratio on the preferred side?
Sure, Adam. With the preferred auto, there really are a couple things going on here in the preferred auto in the fourth quarter. First of all, we have seasonality in our loss cost in the preferred book of business, and we have that in the fourth quarter. It's always our hottest, and in fact, continues to be our hottest in 2015. That is really just a seasonality in our book of business. I think the second thing going on here, it has to do with prior development. If we strip away the prior development from current year and prior year, what we actually find is that the underlying performance of this book of business continued to improve in the fourth quarter. We actually are continuing to make progress in the underlying when you strip away those pieces of information.
Okay. As we think about that book of business, are you still, I guess, pushing for more rate next year? At what point do you think that will start showing unit or PIF growth?
Yes. While we like the progress we've been making now for many quarters, it's still not sufficient to get us to where we need to be. We have more work to do to improve this portfolio, and it does mean increasing rates in the next year. We're looking at mid-single-digit rate increases next year across our portfolio, and continued efforts around improved segmentation and underwriting actions to drive continued progress on that line.
Okay. Thank you. One question on the equity method investments. With market stress, can we expect lower income out of that portfolio?
We had a background noise on our end. Can you just repeat that one more time, Adam? I'm sorry.
Oh, sure. Yeah, on the equity method investments, with having some stress in overall financial markets, does that suggest a tougher outlook for that portfolio?
This is John speaking. From the equity method, most of those assets or most of those investments are debt related. The underlying investments are in debt-related instruments. I kind of always go back to general economic trends. If we have a recession, those will probably be hurt, but if it continues to move along like we are right now, we hope it continues to perform like it has.
Okay. Thanks a lot.
Thank you. We have time for one final question, our question comes from the line of Ron Bobman with Capital Returns. Your line is open.
My questions were asked by others. Thanks.
Thank you. I'm showing no further questions. I'd like to turn the call back to management for closing remarks.
Thank you, operator. Thank you for all of you for joining the call today and your interest and questions. I'd like to leave you with just a couple of final thoughts. We do know this was a disappointing quarter, and we've had some tough financial results for the last couple of years. I don't believe that these results define our franchise or our potential. We have a strong brand. We've got a strong balance sheet with a strong capital position and a talented and committed team. We are fully engaged, and I'm committed to you to let you know that we're going to work tirelessly to address our near-term issues and to deliver a focused strategy, one that delivers attractive financial returns to our shareholders, serves our customers and agents well. I appreciate your patience as we evaluate every aspect of our business to refine our plans.
Our team is energized as we move to help Kemper realize our full potential. I look forward to updating you in future calls. Thank you for your time this morning and for your interest.
Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program. You may all disconnect. Everyone, have a great day.