Good afternoon. My name is James, and I will be your conference operator today. At this time, I would like to welcome everyone to the Mercury General fourth quarter conference call. All lines have been placed on mute to prevent any background noise. After the speaker's remarks, there will be a question and answer session. If you would like to ask a question during this time, simply press star, then the number one on your telephone keypad. If you'd like to withdraw your question, press the pound key. This conference call may contain comments and forward-looking statements based on current plans, expectations, events and financial and industry trends, which may affect Mercury General's future operating results and financial position. Such statements involve risks and uncertainties, which cannot be predicted or quantified, and which may cause future activities and results of operations to differ materially from those discussed here today.
I would now like to turn the call over to Mr. Gabriel Tirador. Sir, please go ahead.
Thank you very much. I would like to welcome everyone to Mercury's fourth quarter conference call. I'm Gabe Tirador, President and CEO. In the room with me is Mr. George Joseph, Chairman, Ted Stalick, Senior Vice President and CFO, Robert Houlihan, Vice President and Chief Product Officer, and Chris Graves, Vice President and Chief Investment Officer. Before we take questions, we will make a few comments regarding the quarter. Our fourth quarter operating earnings were $0.15 per share compared to $0.58 per share in the fourth quarter of 2016. The deterioration in operating earnings was primarily due to an increase in catastrophe losses and unfavorable reserve development, partially offset by a $0.13 benefit from tax adjustments due to the new federal tax law. The combined ratio in the quarter was 104.5% in the fourth quarter of 2017, compared to 99.2% in the fourth quarter of 2016.
The combined ratio was negatively impacted by $20 million of net catastrophe losses due to California wildfires, plus $3 million of reinsurance reinstatement premiums earned. This compares to only $4 million of catastrophe losses in the fourth quarter of 2016. In addition, we recorded $36 million of unfavorable prior accident year reserve development in the fourth quarter of 2017, compared to $16 million of unfavorable prior accident year reserve development in the fourth quarter of 2016. Adverse legal outcomes from two large claims from accident periods prior to 2013 accounted for $10 million of the $36 million of unfavorable reserve development in the quarter. Excluding the impact of catastrophe losses, unfavorable reserve development, and ceded reinstatement premiums earned, the combined ratio was 97.2% in the fourth quarter of 2017, compared to 96.6% in the fourth quarter of 2016.
The unfavorable reserve development in the quarter came primarily from the bodily injury line of coverage on our California auto lines of business. The company uses historical loss development patterns for estimating ultimate losses. Over the past few years, actual case reserve and paid loss development have tended to exceed the company's historical loss development patterns. At year-end 2017, the company factored this tendency into the company's ultimate loss selections. During 2017, our gross loss and loss adjustment expense reserves for current and prior accident years, excluding reserves for catastrophes, increased by $162 million to $1.45 billion at December 31, 2017. The reserves established by the company represent our best estimate of the ultimate cost of losses and loss adjustment expenses incurred to date. However, since the provisions are necessarily based upon estimates, the ultimate liability may be more or less than such provisions.
The expense ratio was 23.4% in the fourth quarter, compared to 24.9% in the fourth quarter of 2016. The lower expense ratio was primarily due to a decrease in acquisition costs, cost efficiency savings, and lower profitability-related accruals. To help offset increasing loss trends, we have been increasing rates in most states. In California, a 5% personal auto rate increase in Mercury Insurance Company is going into effect in March. In addition, a 6.9% rate increase for California Automobile Insurance Company is pending approval with the Department of Insurance. Personal auto premiums in Mercury Insurance Company represents about half of our direct company-wide premiums earned, and California Automobile Insurance Company represents about 14% of our direct company-wide premiums earned. Premiums written, excluding ceded reinstatement premiums, grew 3% in the quarter, primarily due to higher average premiums per policy.
Company-wide private passenger auto new business applications submitted to the company decreased approximately 1% in the quarter. Company-wide homeowners applications increased 10% in the quarter. With that brief background, we will now take questions.
At this time, I'd like to remind everyone, in order to ask a question, please press star followed by one on your telephone keypad. I will pause for just a moment to compile the Q&A roster. Your first question comes from the line of Greg Peters from Raymond James. Go ahead, please. Your line is open.
From the East Coast, I'll say good morning to you all. Thank you for the call and taking our questions. Let's just go through a couple of the points in your press release and your comments on the reserve development. I appreciate your prepared remarks, and I was looking for more color, specifically, talk to me about the process for the year-end reserve charge, and should we presume that you've changed the factors, so therefore, what's affected you in the last couple of years shouldn't affect you in future years? Just sort of walk me through the methodology there, please.
Hey, Greg, this is Ken. We have a quarterly methodology, that incorporates trends that are developing based on the historical data. As we look at the data, you start to see more emergence coming through than was expected, and you incorporate that into your current analysis. What we have been doing over the past couple of years is factoring that into our analysis each quarter. At year-end, we took the position that our development trends have consistently been exceeding our expected incurred, and therefore, we expect that to continue, so we factored that into our ultimate fix for year-end.
Just to clarify on that one point, should we presume that you've sort of raised the bar, if you will, for future expectations or recast?
I would characterize it as we've taken the more recent development factors and weighted those more heavily.
Okay.
That doesn't mean that they can't be larger than the most recent development factors.
Right.
All we're saying is that, look, we're not taking an average of a longer period of time. We've weighted much more the more recent development factors to project our loss reserves this time. That doesn't mean that those factors can't even be higher than the more recent development factors.
Right. Did the tax considerations of looking at your reserves come into play? I would assume this is a more cautious posture you've adopted, and was tax part of your calculus there?
We don't consider tax in our analysis. We try to make the best estimate based on the data we have available. As Gabe mentioned, as we've seen actual development exceed expected development, we felt like putting more weight in the more recent factors was the prudent thing to do.
Right. Okay. Great. A number of other questions. Let's segue into 2017 was a busy catastrophe year for the industry and for Mercury. Obviously you highlighted the reinstatement premium that flowed through your fourth quarter results. I'm curious what your perspective is about reinsurance costs for 2018 in the context of the 2017 performance, and if there's going to be any change in your catastrophe retention on a quarterly basis, et cetera.
First of all, our cat reinsurance treaty expires on July 1. That's when it renews. We think that even after the large cat loss season, there still remains a lot of capacity in the reinsurance market. We are expecting pricing to go up on July 1 at renewal. We do believe at this time that the increases are going to be muted based on the abundance of capacity in the market. It's early to tell. As I mentioned, July 1, the closer we get to July 1, we'll know. We have built into our estimates a slight increase in our reinsurance costs. We're going to have to wait till we get closer to our July 1 date.
I appreciate that color. At this point, you don't want to have any comment about what the retention might be for events either, or-
I anticipate our retention to remain the same.
Okay.
Our retention, as you know, was at $100 million prior to July 1 of 2017, we've lowered that retention to $10 million on July 1. My expectation right now as we sit here today is for that retention to remain at $10 million.
The $10 million retention is a per event retention?
Yes.
Okay. Thank you for that clarification. That was helpful. I guess you commented a little bit about business or production statistics in the fourth quarter, and I know some of your new business trends have been challenging in 2017 versus 2016. Do you think new business counts will be up in 2017? I guess you got to go through, it looks like homeowners is doing fine. Go through both California and non-California business.
Well, our California business growth in the fourth quarter was 4%, and this was for private passenger auto. We had about 13% growth in application counts in homeowners in California. Outside of California, the app count for private passenger auto was down 17%, and homeowners down about 8%. That resulted in overall PPA applications, relatively flat, down 1% for PPA, private passenger auto, and up about 10% for our homeowner lines of business. I will say that it's improving from the previous quarter. If you take a look at our year-to-date numbers, in California, they grew 2% for the year, they, as I mentioned, up 4% in the fourth quarter. Outside of California, they were down the whole year, 28%, and they were down 17% in the fourth quarter. The application count continues to improve as other competitors take rate increases.
My anticipation right now is that when you take a look at our top-line growth, we're expecting low single-digit top-line growth in both California and outside California.
Okay. Another area that you've commented on the past is advertising spend. I know you go through your budgeting process. Maybe you could talk about what the total advertising spend was in 2017 versus your original intentions, and how it compared to 2016, and what you're thinking for 2018.
In 2017, our total advertising expense was about $37 million. That compares to about $40 million that it was in 2016, and our anticipation for 2018, right around $40 million.
Okay. I have a number of other questions. I'm just going to re-queue, let others have a chance.
Okay. Hey, thanks, Greg.
All right.
As a reminder, if you'd like to ask a question, please press star then one on your telephone keypad. Your next question comes from the line of Alison Jacobowitz from Bank of America. Go ahead, please. Your line is open.
Hi. Sorry if I missed it. Was there any current year development in the fourth quarter, in the reserve change, or in the losses, rather?
Yeah. Hi, Alison. We really look at our reserves on a year-to-date basis, so we don't disclose or consider current year development within the current accident quarter.
Okay. Thank you.
Your next question comes from the line of Gary Ransom from Dowling & Partners. Go ahead, please. Your line is open.
Thank you. I wanted to ask about taxes a little bit. First of all, the approval that you just got for the rates in California for 5%. Did you have to refile with the 21% tax rate for that approval?
No.
No. You got to sit with the 35. Is the pending one that's for the 6.9, do you have to refile that one with the 21?
That filing's been made. When was that filing made, Robert?
Months back.
Yeah. We don't anticipate having to make any changes to it.
Okay. Well, obviously, Commissioner Jones has made a lot of noise on this point. I just wondered what your overall opinion or thinking about that is. Does it matter? Is it important to you in the long run?
Yeah. Robert, why don't you address that?
Sure. Well, in California, the rates are determined by a return on surplus formula. The formula is based on an after-tax return. It's important to note, the formula doesn't yield one number. It yields a min and a max or a range. The range will be shifted downward slightly by the change in tax laws. We've gone back, and we've looked at all of our filings, both in MIC and Cal Auto over the last several years. Both the requested rate and our approved rate on all those filings would still be within that range, even after adjusting for the lower tax rates.
Great. Do you have a rough estimate of what that shift is at the top and bottom? How much does it shift at the top and bottom of that range?
It varies depending on circumstances. As we've looked at different filings, it can alter from filing to filing.
Right. Okay. Then another one on the tax theme. You have a lot of munis under a 21% rate. The corporates may be more attractive. I wondered if you could tell us anything you have about your thinking on a change in investment strategy with the new tax law.
Sure. Yeah. Hey, Gary, this is Chris. One of the main drivers to my investment decision process has always been after-tax income yield. That calculation levels the playing field. The new tax law, when applied to investment income, affords winners, no real losers, at least to my universe.
Then there's net neutral recipients. Net neutral is applied to tax-exempt income. Insurance companies are taxed on tax-exempt income, albeit at a low rate. The new tax law does not change our after-tax investment income there. Consequently, we still retain about $0.95 of every dollar. The winners from the new tax law are taxable income sources like corporate bonds and dividends. Holders of taxable income sources now enjoy earning higher after-tax income yields from the reduction from 35% to 21%. That means to us that we pick up about $0.14 more in taxable income. Dividends net us about $0.01 more. Our investment mix will clearly change due to the new tax law. Municipal bonds still make sense, however, though many more taxable asset classes are attractive because of the new tax rate.
I'm adding more taxable income, but I'll have more to share on that at the next conference call.
Okay. Is it a reasonable assumption that if you're making changes, it would be more related to cash flows or new money as opposed to making any wholesale turnover or sales of current investments?
I would say in general, it's going to be new money. Certainly swaps within the portfolio, say from, I guess the natural expectation would be to shift from tax-exempt to taxable. That really depends on what I'm looking at once I do the after-tax yield calculations and take, for example, rating and duration and other factors into account.
Okay. Thank you. Just changing gears a little bit. I wanted to go a little bit more into the loss trends. You were talking about BI severity being an issue. We see it in the adverse development, but is there something you're seeing currently that's causing those trends to move higher?
I would just say medical inflation. In my view is just seeing a lot more aggressive plaintiffs bar, a lot more referrals to doctors, a lot more people willing to go under the knife and get MRIs and just the environment. It's been like that for a little bit, but just a more aggressive plaintiff bar, in my opinion, at least from what I see in the claims that I see. You have medical inflation as well.
I may be doing this from memory. I feel like the California Fast Track numbers showed the BI severity was the only trend that wasn't getting any better. It looked like frequency was getting better. Even in property damage, things were generally either leveling off or getting better. Is that consistent with what you're seeing in your book of business?
Well, I think in Fast Track, the latest quarter actually was a little bit better than it had been.
It's a third. Yeah.
There was a time there where it was double-digit increases in severity is my recollection.
Yes.
In Fast Track. In this latest quarter, which there is a lag in Fast Track, was a little bit better. We are recording in the, I think, in the mid-single digit pure premium increase. Ted, is that about right?
Six-ish.
Six-ish. That includes the development that we basically book this quarter. We take a look at it from an ultimate accident year basis, and we are booking about mid-single digit severity increases.
Okay. That is helpful. One last subject just on reinsurance, just a follow-up on that. Do you have a full third limit available now after the two events penetrated the cover?
We reinstated after the major Northern Cal fires, we reinstated about full limit. On the second event, which was the Southern California fires, it was a $25 million event, and we used up $15 of that limit. There's not a reinstatement available for that $15. If there's a third event, our retention will be at the $25.
Right.
We'll have coverage above the $25.
Right. Okay. Although, hopefully, the wildfire season is over by now.
Yeah.
Okay. That's it for me. Thank you very much.
Thank you.
Your next question comes from the line of Samir Tar from Capital Returns Management. Go ahead, please. Your line is open.
Hi. I just wanted to ask about your reserves. You currently booked loss reserve estimate. How does that compare to your others actuarial midpoint of the reserves? What was that metric last year?
Our actuaries don't come up with the range. We come up with point estimate, and we book our point estimate.
Okay. That was the same as last year?
Yeah. We came up with a point estimate last year, which we booked, and a point estimate this year, which we booked.
Okay. Just in auto, when considering a loss trend, how many compounded rate increases do you think you need to get to rate adequacy? If you can speak to, I guess, the dynamic at the Department of Insurance. Is there still a backlog? Is the length of time before filings get approved, is that shortening?
I think some of that depends on what the loss trends end up being. Our most recent filing that we just got approved, 5% for MIC, I think we believe gets us in pretty good shape, Robert, for Mercury Insurance Company.
That's correct.
Cal Auto, which has a 69 pending, gets us close as well. We may need one more in Cal Auto, possibly. As far as the timeline for rate approvals, Robert, do you want to comment on that?
It's been taking about the same amount of time in the past. It's just a slow process in California. We don't see any delays from a backlog, certainly at this point.
Yeah. I think our MIC filing maybe took, I don't know, nine months, ballpark-ish. Is that about right?
Probably.
Yeah.
Okay, great. Thank you.
Yeah.
Your next question comes from the line of Greg Peters from Raymond James. Go ahead, please. Your line is open.
Greg, thank you for allowing me to ask a couple of follow-ups. Just two points of clarification. Well, actually, one. What you report in your GAAP financials for the tax expense, is that just the federal component, or do you include state income tax and premium tax in that GAAP tax expense?
It includes state income tax, but premium taxes are in our acquisition costs.
Okay. I'm glad I asked that question then. Another question was regarding, and I know, Chris, you started to talk a little bit about changing pieces of the puzzle for the investment portfolio. I did notice that the company harvested a lot of realized gains in 2017, and a big chunk of that was done prior to the tax law being passed. I'm just curious, what was the perspective, the mindset going into that, and is that something we should expect in 2018?
Yeah. Greg, we mark to market the whole portfolio. Is it 157, Greg? Am I wrong?
159.
159. What you see is a net of market change and of realized gains and losses. We actually took tax losses in the year because we had capital gains to offset from prior periods. We've now from a tax perspective, positioned ourself where it's more advantageous to take gains in 2018. If this market holds up, I'll be able to do that. Everything you're seeing, for the most part, is just portfolio market value changes.
Thanks for that color. I appreciate it. I just wanted to close out with just an opportunity for you guys to talk a little bit about, and I know you answered this in pieces, parts of some of the earlier questions, but just about your non-California approach to growing your footprint and growing your business. What states do you think, in 2018, will be the biggest growth opportunities for you? Conversely, which states outside of California will probably be shrinking the most? Any sort of color around your posture outside of California, additional color is appreciated.
Well, I think I mentioned earlier that our anticipation is that outside of California, we're going to probably grow in the low single digit range. As far as individual states go, Robert, do you have any color on that that you want to share?
No, I think one state we're starting to see some turnaround in new business applications, Texas. We clearly took a lot of rate there. We took it earlier than other competitors, over the course of the last three to six months, we've seen a lot of large rate increases by other carriers, which has helped boost our new business production in that state.
Yeah, I think Florida, we're anticipating a little bit of growth in Florida. I don't think that there's any state really that we're anticipating significant growth in and other states that we're anticipating significant declines in. Our two biggest states, which is Florida and Texas, I think that we're anticipating some small growth in those states.
Perfect. Thanks again for taking my questions.
Sure.
Your next question comes from the line of Alison Jacobowitz from Bank of America Merrill Lynch. Go ahead, please. Your line is open.
Hey, you can tell by the voice, it's not Alison. It's actually Jay Cohen. Just a couple follow-up questions. When you talk about these price increases relative to claims trends, they don't seem to be exceeding them much. In other words, kind of mid-single digit increases chasing mid-single digit severity increases. I know that's simplistic. Are you taking other underwriting actions to try to improve that loss ratio?
Well, yeah, we have a lot of internal initiatives to try to improve our claims adjusting process to try to mitigate any leakage. Yes. There's quite a few initiatives in the claims area that the company has ongoing to try to mitigate leakage from that standpoint. You're right that, depending on what happens with future claims inflation, if we're taking a 5% rate increase, and you have 5% increase in severity, you're going to pretty much hold the water. If the claims inflation comes in lower, you're going to do a little bit better. For the year, when you back out our large catastrophe losses and also the development, we're running at about a 97% or so combined ratio company-wide. Robert, do you have any other color you want to add to that?
No, I think there's also been some tightening at point of sale underwriting.
Yeah
agency management as well that has helped to offset some losses.
Yeah. That's a good point. We also have some other underwriting actions that we've been taking to help the loss ratio.
Got it. That's helpful. The other question, on the fourth quarter overhead, you suggested that essentially bonus accruals were down, not surprisingly, given the profitability. Can you quantify that? How much that helped your expenses in the quarter?
Well, I think maybe we're better off just talking about where we think the expense ratio will be in 2018. Ted, why don't you.
Sure. You know that we have seasonality in our expense ratio. Our ad spend is heavily weighted to Q1 and Q3, and in Q4 is our lowest ad spend. For next year, we think the expense ratio will be slightly higher than the 24.7% that we posted for all of 2017. Part of that is we're expecting to be able to accrue a higher amount for employee incentive plans next year.
Keep in mind, too, that employee incentive plans hit both the LAE ratio and the expense ratio. Half of our employees are claims.
Yeah.
When we talk about bonus accruals and the expense ratio, we're just talking about the portion that hits the expense ratio. The majority of it probably hits the LAE ratio, or a big chunk of it, I should say. Half of it, probably.
Your loss ratio was aided a little bit by lower bonus accruals as well?
Yes.
Got it. Very helpful. Thanks for the answer. That was good.
Sure.
There are no further questions at this time. I turn the call back over to our presenters.
Well, I'd like to thank everyone for joining us this quarter, and we look forward to talking to you next quarter. Thank you very much.
This concludes today's conference. You may now disconnect.