Good afternoon. My name is Cherylee, and I will be your conference operator today. At this time, I would like to welcome everyone to the Mercury General Corporation 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 would 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. Please go ahead, sir.
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 loss was $0.13 per share compared to operating income of $0.33 per share in the fourth quarter of 2013. Premiums written grew 4.4% in the quarter, primarily due to higher average premiums per policy as a result of rate increases.
Our fourth quarter operating results were negatively impacted by a $27.6 million fine imposed by the California Insurance Commissioner related to a 2004 notice of noncompliance matter, $7 million of adverse loss reserve development, and $4 million of catastrophe losses. Excluding the impact of the fine, operating earnings were $0.37 per share in the quarter, compared to $0.33 per share in 2013, and the combined ratio was 101.7%, compared to 102.5% in 2013. We are very disappointed and strongly disagree with the insurance commissioner's determination that Mercury violated California's rate laws and with his decision to impose a penalty. This notice of noncompliance matter is related to the Krumme v. Mercury lawsuit that was decided in 2003.
In the Krumme v. Mercury Insurance Co. decision, the judge ruled that based on the mountain of evidence reviewed by the court, that no financial restitution was warranted in light of the Department of Insurance's loose practices, including the lack of guidance provided as to what constitutes a broker or an agent. It is our strong belief that this decision is contrary to California's rate laws, due process, and basic notions of fairness. We intend to vigorously litigate this matter of law, and we expect to ultimately prevail on the merits in a court of law. As we mentioned on our third quarter conference call, our fourth quarter has historically been our highest frequency and severity quarter due to weather and increased driving. In California, our combined ratio, excluding the fine, was 100.2% in the quarter, compared to 100.9% in the fourth quarter of 2013.
personal auto loss frequency and severity increased in the low to mid-single-digit range as compared to prior year. The year-over-year increase in frequency and severity is attributable to more bad weather in 2014 as compared to 2013, and possibly to increased driving as a result of lower gasoline prices. In 2013, we had unusually good weather during the fourth quarter. Our results were good in our two largest states outside of California. In both Florida and Texas, we posted combined ratios under 100%, and we are growing the top line. Our results in other states outside of California were mixed, and overall profitability outside of California has been negatively impacted by our New York and New Jersey operations. In New York and New Jersey, we instituted claims practices and procedures that sped up the setup of bodily injury case reserves and the payment of claims.
These new practices have made it more difficult to estimate ultimate losses as historical incurred and paid loss patterns may no longer apply. As case reserves and payments were sped up, our expectation was to have less loss development as the claims matured. However, the expected lower development has not yet materialized in the data, consequently, we used historical patterns to estimate our ultimate losses in these states. As a result, we recorded $6 million of adverse development in New York and New Jersey in the quarter, which also had the effect of increasing our 2014 accident year loss estimates. California continued to experience positive premium growth in the quarter as rate increases more than offset lower policy sales. Outside of California and excluding our Mechanical Breakdown Protection, our growth was flat in the quarter. This compares to negative growth of 3.9% and 7.6% for 2014 and 2013 respectively.
The improvement in growth outside of California is attributable to increased policy sales as a result of rate reductions taken in many states early in 2014 and increased distribution. For 2015, we expect to continue to improve our growth prospects outside of California from our improved competitive position, coupled with increased advertising spend and distribution. In California, a 6.9% personal auto rate increase went into effect in October 2014 for California Automobile Insurance Company, representing 15% of our total company-wide premiums. In addition, we have a 6.9% rate increase pending Department of Insurance approval in Mercury Insurance Company, representing about half of our company-wide premiums written, and an additional 6.9% rate increase was recently filed in California Automobile Insurance Company. In January, we launched our first-ever national advertising campaign. We currently operate in 13 states, representing approximately 56% of the U.S. population.
The economics made it more cost-effective to advertise on a national basis rather than on a local basis. The national advertising campaign should bring more awareness to Mercury's brand outside of California. Lastly, we closed on the Workmen's Auto Insurance Company acquisition in early January. This acquisition fills a strategic niche for Mercury, as Workmen's non-standard auto product will complement Mercury's more preferred product offerings. We believe Workmen's Auto product will allow Mercury to better penetrate the non-standard market in California. With that brief background, we will now take questions.
As a reminder, if you do have a question, please press star, then the number 1 on your telephone keypad. Our first question comes from the line of Vincent D'Agostino from KBW. Your line is open.
Hi, good morning, gentlemen. How are you?
Morning, Vincent.
Okay, just a couple of quick ones here. We're starting to see some directional improvement in the personal lines, PIF growth. It seems like the growth outside of California is gaining traction. You guys had some comments this morning in the prepared remarks. Just wanted to double-check and see from the growth outside of California, both in terms of the actual premium production and then margin, all of that so far to date has kind of been coming in line with expectations?
I would say with the exception of the two states that I mentioned early in my prepared remarks, New York and New Jersey, certainly not coming in from a margin perspective in line with our expectations. It's mixed with the other states, but our two biggest states, Florida and Texas, certainly in line with our expectations. We're going the top line as well. Keep in mind that, as we have mentioned in prior calls, that we are pricing our product outside of California and many of these states to combined ratios that we don't expect from a cost standpoint. We're pricing our expenses at expense ratios that we're not there yet. We anticipate to have higher combined ratios in some of these states outside of California because of that. Probably closer to the 100% range as compared to a 95% target in some of these states.
In Florida and Texas year-to-date, on a year-to-date basis, we're well below 100% combined ratio. Those two states are our two biggest states.
Okay. All right, perfect. On New Jersey and New York, maybe I just kind of was assuming here, but I guess with the reserve kind of movements, I would've figured that would've been on some of the older accident years, maybe 2, 3 years older, not so much when you guys would've started growing that business. Is it more recent accident years where that growth has come in and expectations kind of haven't played out, or is it kind of the older stuff where I was assuming that might be the case?
Hi, Vincent. It's Ted. It's really been on the last couple accident years. As you know, as we bring up estimates on the most recent accident years, it also causes us to reevaluate what we're doing for the most current 2014 period.
Okay. Thank you. Then I guess two quick ones if I could squeeze them in. On ad spend, do you guys have anything specifically budgeted for the 2015 ad spend?
Yeah. We're planning on spending about double the amount that we spent last year. I think last year we spent in the neighborhood of about $23 million.
Okay.
In the neighborhood of $46 million-$47 million.
Perfect. Just one last one. Thanks for all the comments on the NC, just with the fine. Looking forward, I guess the way I understood it is that this California had previously bifurcated that issue into two. You'd just gotten kind of the state's ruling of that and understand that you guys are going to continue to defend that. Does that open kind of the road forward on the second part of that, which I think was more around cause, not so much the rate side of it? Am I understanding that correctly?
Yeah. There was two sides of it. One of them was on the rate side, and the second one was on the advertising, a false advertising claim. Both basically claimed that customers paid broker fees at the end of the day. The rate side was just adjudicated by the administrative law judge, which the Commissioner accepted his proposed decision. That one, on Thursday, we just filed a writ of mandate challenging it in court. As far as the other case, the other part of the bifurcated case, that's technically still out there. Haven't heard anything from the Department on that with respect to that case. From my perspective, I will say that at the end of the day, both cases led to the fact that someone paid, at least from the Department standpoint, alleging unapproved broker fees.
They both end up at the same result, but technically, that case is still out there. That is correct, Vincent.
Okay. All right. Thank you for that. Best of luck in 2015.
Okay.
Once again, if you do have a question, please press star, then the number 1 on your telephone keypad. Once again, Vincent D'Agostino from KBW, your line is open.
Didn't expect to get back in so quick. Just one quick one. Gabe, you had mentioned just with the gas prices, then you said this was a, I think the word was possibly a factor. You guys with the new company will be kind of getting into non-standard. Probably a little bit earlier to ask this question on the non-standard side, between, I guess, the preferred and standard books, we tend to think that frequency might react differently based off of the affluence of the drivers. I'm wondering if between the two existing California subsidiaries, if you're seeing any difference in frequency that might help explain the elasticity to gas prices, if you will.
I'm trying to think, Robert, from a frequency standpoint between, if I understood your question correctly, Vincent, between our Mercury Insurance Company and our Cal Auto Company, the difference between the frequency in those two companies. Obviously, Cal Auto has a higher frequency rate, a higher absolute frequency rate. I think the rate of change in Cal Auto was slightly higher than it was in Mercury Insurance Company. Call it the standard/non-standard at a higher frequency rate. Not only absolute, but also as far as an increase on the margin year-over-year than it did in our preferred book.
Okay, that would seem to support the premise that lower affluent drivers would be reacting a little bit, the reaction's a little bit larger in response to cheap gas.
I think it's early to tell. It's one quarter. You have more employment. There's more people on the roads with employment being better than it has been. At this point, we know that our fourth quarter frequency is always higher. It was higher than typical this quarter. We're not ready to say that that's a trend at this point. That's one quarter. It's something that we'll continue to monitor closely. Until we have more data, I think it's early for us to call that.
Okay. We'll stay tuned. Thanks again, guys. Take care.
Okay, thanks.
Our next question comes from the line of Ken Billingsley from Compass Point. Your line is open.
Good morning. I wanted to just follow up on one of the questions that was asked about the expense ratio. Your answer said that you're booking it below where I believe you said you're booking it currently below where it will actually run, and maybe I misinterpreted that. Does that mean that essentially you're booking the expense ratio lower than what you're actually seeing right now? Or do I have that reversed?
No, we're pricing our product so that we can be more competitive at expense ratios that we have not yet achieved. It's a pricing-
Got it.
Basically means that if we, let's say we're targeting a 95%, if we hit our target expense ratio, but we're not there yet, that means that we're going to run it a little hotter than that. We're going to run at about 100 or so until we hit those expense and LAE ratios. It's a pricing strategy.
You're pricing it below where the combined ratio would imply where the expense ratio needs to be based on.
Exactly
The ultimate volume. I may have missed if you gave this answer, about how much more growth do you need outside of California to get those expense ratios where they need to be? I understand you're into multiple states now, so that may be harder to answer, but are we talking that we need to grow 20%-30% from current levels or?
Well, it varies by state. It really does. In some states like Florida where we have a lot of volume, our expense ratio's already there. Our LAE ratio isn't there in that state, so it's going to vary pretty much by volume, and by state, I should say, outside of California. Texas, another state that we're pretty much at. You have some other states where the volumes are low that we have a long way to go.
Okay. The underwriting leverage just been ticking up. Where is your comfort level? How high do you feel you can take that, especially with the addition of the non-standard business, and I know it may be a smaller piece right now, but where are you comfortable taking statutory underwriting leverage to?
2.5 is something that we would be easily comfortable with, 2.5 times. I think we're at what, 1.9, two times right now?
Right around there, yes.
In our history, I can recall years in our history where we've hit way above three, right? Anyway, 2.5 time is probably a decent target.
One of the benefits we have is we have some additional capital up in the holding company. If the margins, the underwriting leverage gets too high, we always have the ability to contribute the capital down to the insurance subs.
If you needed to do that, which it looks like you still have some room, does that impact maybe the future dividend payout ratio assumptions going forward? Is that holding company cash allowing you to maintain that high dividend currently?
Well-
Oh, go ahead.
Not really. Obviously, that's some additional cash that you can use to pay out dividends, but most of the dividends are upstreamed out of current income from the insurance subs. To the extent that your insurance subs are writing profitably, higher underwriting leverage actually gives you a higher capacity to pay out upstream dividends to the holding company, which then can be paid out to the shareholders.
I will just say from a dividend standpoint, our strong capital position does allow us to pay a dividend in years where maybe the dividend payout ratio is above 100, in years maybe like this year, where we had a tough fourth quarter. We obviously recognize that we cannot, on a long-term basis, have a payout ratio above 100. I think our very strong capital position that we have today allows us to continue to pay the dividend in years such as this one.
Talking about the kind of tough fourth quarter, can you talk about any of the cat exposure in the Northeast so far? I realize you said that it wasn't all East Coast storms, that some of it was rainstorms in California. Can you maybe separate that and tell us maybe how the storms that we're seeing in the Northeast may be impacting results going forward?
Are you talking about the storms in January or the storms from the fourth quarter?
More about how maybe the January storms may be shaping up versus what you saw in the fourth quarter. Are they going to be just as big?
I don't think we really have a read on that yet.
Okay. Last question is, the old case, the adverse review that's come from California for the $27 million. If I read correctly, I believe you had said that, or at least there was no, or maybe it was from California, that there were no penalties or interest added to that $27 million. If you take this to court and you lose, do you run the risk of the penalties and interest being added back in?
Well, first of all, this is a fine. This is a penalty. Really the question has to do with interest, if interest is due. We're going to be filing for a stay with the court as well to stay the decision. The underlying question is, interest is due. In our opinion, this is not like a regular judgment where, in a regular judgment, interest would be due. That's our view. I suppose that the other side may take an opposing view, but our reading of the code of the law suggests that a penalty is different than a judgment.
Great. Thank you for taking my questions.
Okay.
As a reminder, if you do have a question, please press star then the number one on your telephone keypad. Our next question comes from the line of Arash Goshayeshi from KBW. Your line is open.
Yes, good morning. Hi. My question is concerning more of the future, I guess. I was wondering, we've had losses in New Jersey and New York, and I was wondering what the aggregate results have been there, and at what point would you say enough is enough from an operating standpoint, if it's just not working for you?
I don't have the aggregate numbers. If we felt that we could not get an adequate return in those states, at that point, if we felt that we just could not make it work and get an adequate return, that's the point that we would do it. I will say that New Jersey, for the whole year actually, posted combined ratio, let me see here.
Around 100.
Around 100% for the whole year. The quarter was bad. It's a good question. Obviously, it's a very good question. At some point, if we didn't feel that we could get an adequate return, and make the operations allow for that return, make the changes necessary, either from a pricing, operational standpoint, then at that point, we would have to take a look at that.
Okay. My next question, I see enormous amount of advertising from the direct writers. Actually, I saw an advertisement for Mercury Insurance in Iowa on TBS or something like that. I thought it was a nice commercial. I was wondering what kind of impact can you make given the huge budgets that these guys have? It's almost like you're Daniel in the Lion's Den or something. They've got these huge ad budgets, and you're running your ads. Have you had any sort of feedback yet around the effectiveness of these?
It's early. It just started in January. Our leads in the 13 states that we're in are up significantly, I would say. When we made this investment, which is a $46 million-odd investment, we made certain assumptions on how many leads we were going to get based on the advertising that we were going to be doing, and the lifetime value of the business we would sell. We made assumptions over close ratios. We put together an investment analysis for this $46 million that we're investing. I will say that's new to us though, so we had to make assumptions based on not ever advertising in some of these states. California, the assumptions we made, we've been here a long time. We understand what the ads do here. We did go in with the advertising with a plan, and an expected return.
We're going to have to see if that pans out or not. It is, as you point out, we have competitors that spend a lot more money than we do. That is an accurate statement.
Yeah. My last question is, where do you see the business in five years? Obviously, there's been this big swing. I think back in the early '90s, I once asked George about Progressive doing both the direct model and the agency model, and he said, "Well, we'll see how that works out." I was just wondering, where do you see personalized insurance? I see your policies in force have declined on the personal line side, and when does that rate of decline start to bother you? That'll be my last one. Thank you.
It's bothering me now. There's no question that this business has changed, and it's become more commoditized than it has in the past. There's a lot more quoting, a lot more aggregators out there. Agents use comparative raters. It's just become a lot more transparent and commoditized. Our goal is to try to adapt to that environment. We do allow now online sales. We have the buy button. It's a small percentage of our overall sales, but it's still a strategy of ours to be able to offer that to consumers. We have national aggregators that we've partnered with, national accounts. A recent release with respect to Google that we're going to be coming out with, or Google is coming out with. We're trying to do everything we can to try to reach the customer.
To try to get quoted. There's no question in my mind that the last 10 years have brought a lot of change. There's going to be more change in the future, and we just have to be able to adapt. You got autonomous cars that may be in the road 10 years from now. One of our strategies is obviously to continue to grow our homeowners market. We want to try to ramp more commercial business. To diversify in that area as well. The business has changed the past five, 10 years.
Yeah. Well, good luck to you. Thank you very much for taking my questions.
Thank you.
Our next question comes from the line of Vincent D'Agostino from KBW. Your line is open. Excuse me, Vincent D'Agostino from KBW, your line is open.
Oh, sorry about that. Thanks for your patience with me guys today with all the questions. I think this is a record for me. Gabe, you had mentioned the Google aspect, I just wanted to make sure I understood how that is all going to play out with any involvement of Mercury and kind of the Google platform, if you could?
Well, Google's launching a new insurance marketplace called Google Compare, and consumers will answer rating questions and be able to view rates from a number of carriers. Very similar to a comparative rater. If the consumer likes the particular rate, the consumers can then link to that carrier and complete the purchase. We believe it's going to provide access to many customers that might not otherwise be exposed to the Mercury product. I'm not sure when that's launching. As of yet, Google has not announced when that's going out officially. There have been some articles out there, and some blogs that talk about it, but we don't have any kind of dates or anything like that.
Okay. Just to make sure I understand that. The end consumer will be able to go, and we've come kind of in tune with the Google side of it, but from a Mercury standpoint, the customer will be able to buy a Mercury policy through that Google platform?
That is correct.
Okay. Excellent. Thanks, guys. Take care.
There are no further questions in queue at this time. I turn the call back over to our presenters.
Okay. I'd like to thank everyone for joining us this quarter. I look forward to talking to you in the first quarter of 2015.
This concludes today's conference call. You may now disconnect.