Good day. My name is Ian, and I will be your conference operator today. At this time, I would like to welcome everyone to the Mercury General second quarter conference call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question and answer session. If you'd like to ask a question during that time, simply press star followed by 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 invoke 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 second 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, and Chris Graves, Vice President and Chief Investment Officer. Before we take questions, we will make a few comments regarding the quarter. Our second quarter operating earnings were $0.74 per share, compared to $0.88 per share in the second quarter of 2018. The deterioration in operating earnings was primarily due to an increase in the combined ratio. The combined ratio was 98.3% in the second quarter of 2019, compared to 96.9% in the second quarter of 2018.
The combined ratio in the quarter was negatively impacted by $9 million of unfavorable reserve development, $9 million of catastrophe losses, primarily from Midwestern storms, and a $3.4 million increase in accrued expenses as a result of an adverse appeals court ruling related to a California Department of Insurance non-compliance matter. The $9 million of unfavorable reserve development in the quarter was primarily due to an increase in our loss adjustment expense estimates for defense and cost containment expenses in our auto California lines of business, and also includes $3 million of unfavorable reserve development from prior years' catastrophe losses. Excluding the impact of unfavorable prior year reserve development, catastrophe losses, ceded reinstatement premiums earned, and increased accrued expenses related to the adverse appeals court ruling, the adjusted combined ratio was 95.5% in the second quarter of 2019, compared to 93.6% in the second quarter of 2018.
For states outside of California, the combined ratio deteriorated, which contributed to the increase in the company-wide combined ratio for the quarter. For all lines of business outside of California, we posted a combined ratio of approximately 108% in the second quarter of 2019, compared to 92% in the second quarter of 2018. Earned premium for both periods was approximately $130 million for states outside of California. Our homeowners combined ratio was 102% in the second quarter of 2019, compared to 95.3% in the second quarter of 2018, and contributed to the company-wide deterioration in the combined ratio. The California homeowners combined ratio was negatively impacted by an increase in loss estimates related to the significant California rainstorms that occurred during the first quarter of 2019. Our year-to-date accident year combined ratio for California personal auto is approximately 95%.
For California personal auto, we recorded a low single-digit reduction in frequency trend and a mid-single digit increase in the severity trend. In California, a 6.9% personal auto rate increase in California Automobile Insurance Company was implemented in March 2019, and a 6.9% personal auto rate increase for Mercury Insurance Company was implemented in May of 2019. Collectively, these represent two-thirds of company-wide direct premiums earned. Approximately 32% of the California Automobile Insurance Company rate increase was earned during the quarter, and only 10% of the Mercury Insurance Company rate increase was earned during the quarter. In addition, a 6.9% rate increase in our California homeowners line was approved by the California Department of Insurance with an implementation date of August 2019. We also recently filed for another 6.9% rate increase in our California homeowners lines of business. The California homeowners' premiums represent about 12% of direct company-wide premiums earned.
The expense ratio was 24.4% in the second quarter compared to 24.3% in the second quarter of 2018. The slightly higher expense ratio was primarily due to the $3.4 million increase in accrued expense related to the adverse appeals court ruling, partially offset by a decrease in acquisition costs, primarily from lower average commissions and cost efficiency savings. Premiums written grew 6.6% in the quarter, primarily due to higher average premiums per policy and an increase in homeowners policies written. We recently completed our catastrophe reinsurance treaty renewal effective July 1, 2019. The total reinsurance limit purchased increased from $205 million in the prior period to $589 million for the July 2019 through June 2020 period. Our retention increased from $10 million to $40 million. Total annual premiums on the new reinsurance program are approximately $38 million.
For the prior reinsurance treaty, total premiums were $40 million, including $18 million of reinstatement premiums. More details of the catastrophe reinsurance treaty renewal will be included in our second quarter 10-Q filing. With that brief background, we will now take questions.
Ladies and gentlemen, at this time, if you'd like to ask an audio question, you may do so by pressing star followed by the number one on your telephone keypad. Again, that's star one to ask an audio question. Our first question is the line of Greg Peters from Raymond James. Greg?
Hi, good morning.
Good morning.
I had a couple questions for you. First around the reserve development. I was going through my record of your results over the last 20 years, and it seems like if we narrow it down to last 10 years, you've had unfavorable development in eight of the last 10 years. With all the rate increases and all the changes, that sort of stands out because most companies tend to report favorable development. Can you give us some perspective? Obviously, you talked about severity issues, but can you give us some perspective of how that might change in the future?
Well, I think we've said before that, we feel, especially in the bodily injury line, that there's been a changing environment. How that might change in the future is we're being more conservative with respect to selecting more recent factors as opposed to averaging factors for a longer period of time. That should help with any adverse reserve development going forward. I will say that for California PPA, the loss reserve development this quarter was pretty much nonexistent. It was really on the defense and cost containment line or expenses where we're seeing increased litigation, and we decided to increase our reserves for defending bodily injury claims.
This is Ted. One of the biggest issues we've had in the past has been with the California bodily injury coverages as far as the development goes. I'll just say, for the first half of this year, our actual versus expected incurred loss development has essentially been in line. It's developed pretty much how we expected it to when we set reserves at year-end. I know it's just two quarters, but this is something that we haven't experienced the last couple of years, where the actual has been higher than the expected. It does give us some indication that the increasing loss development factors that we've seen over the years have now sort of become more stable, and we're going to see better stability in those reserves.
Having said all that, Greg, we're obviously not happy with the reserve development that we've had eight out of the last 10 years. The rationale is what we just gave you.
I certainly appreciate that things around litigation are a moving target, it just stands out as unique because most of your peers have a tendency to go through shorter periods of adverse development, then they find neutrality or favorable development. Hey, in your opening comments, you called out the unfavorable reserve development. What I was trying to understand is, did that include the piece that you mentioned for catastrophe losses from prior years?
Yeah. The $9 million, within it had $3 million from catastrophe losses from prior years, which was primarily from the Woolsey Fire. The partial losses have developed more than we expected. The one thing I'll point out is the Woolsey event. We had exhausted our reinsurance limit within that layer, any development on the Woolsey was not covered. With this additional $3 million, we're now into the next layer, if there's any future development on prior cat, those will be fully covered by reinsurance.
Thank you for the clarification. Can I pivot for another line of questioning around the disclosure around your new catastrophe, your property cat program? I think in your comments on your limit, your total limit is up, what, substantially, like twice as much as what you purchased before. I'm just curious, obviously, your experience last year colored your perspective there, but this is all going to come at a cost, too. The quarterly retention is moving from 10 to 40. If we were to replay the quarterly results last year, how many quarters would we hit that $40 million retention?
If we were to replay.
The Camp Fire, obviously, was well in excess of $100 million, that would've hit that. The Woolsey Fire is in the low 40s.
Yeah.
a piece of that would've hit it. The Camp Fire was about $20 million.
Greg, we just felt that the pricing for the 10 to 40 was just too high.
Right.
It did not make economic sense from our standpoint to purchase that layer.
I totally understand what you're saying. It seems like going forward, the exposure on a net basis to cat losses will go up. If I'm to read through your comments, the cost of the reinsurance, the new program relative to last year is only up modestly or is there a different perspective on cost?
Well, it's up modestly if you consider the reinstatement premiums, the reality is that the rate increase, there was sizable rate increases in each layer. Pretty sizable rate increases in each layer. When you compare what we actually ended up paying last treaty period, it was about $40 million, and I think the new treaty's about $38 million.
That $40 from last year includes $18 million of reinstated limits.
Right.
The $18 million of what?
Reinstated limits.
Yeah.
Without that, it's 38 compared to 22.
That's hard to analyze though, because the retention changed.
Yeah
We obviously bought a lot more limit on the higher end.
Right. You mentioned in your comments that you'll have more detail around this in your 10-Q.
Yes.
We'll be able to pull out the costs, et cetera, that will be easy for us to identify?
Well, the total cost will be in there.
Yeah, I think the more detail's going to be around how the layers work and the exclusions within those layers.
Okay. Well, I don't want to hog up your conference call time, but it would be great to have a follow-on conversation offline on this topic.
Sure
just to make sure I have everything set up right. The last line of questions, I realize there's other analysts that probably want to ask questions. It seems like the California business is doing well, but the non-California business is not. Is your perspective changing on business outside of California now, or do you still have the same strategy going forward?
We have the same strategy going forward. Outside of California, current year-to-date results have been disappointing. In the quarter, we had quite a few large losses in the quarter that contributed to the results. We had increased severity. We had some Midwestern storms. On an accident year basis, through June of this year, the 2018 accident year is running 97, but the 2019 is running like at a 102.5. A lot of that is being driven right now by Florida and Georgia.
We're continuing to analyze what's going on there from a severity standpoint. We also have some changes that we're going to be implementing in Florida and Georgia, I think Florida in September and in November for Georgia, that from a segmentation standpoint, that we think will help both on the growth side and also on the profitability side. Last year we had a really good year outside of California. For PPA, I think we recorded the calendar year combined in the 93, 94 range, if my recollection is right. In an accident year, as I mentioned, for 2018, is about a 97. We have some work to do though outside of California, and especially in some of these states, to improve the results.
Great. Thank you for your answers.
Sure.
Our next question is from the line of Christopher Campbell from KBW. Christopher?
Yes. Hi, good morning, gentlemen.
Hey, Chris.
Chris.
Hey. First question's on the core loss ratios. It sounds like that you were having some issues in Florida and Georgia and some of the other states. If you're looking at the core loss ratio, that was up 200 basis points year-over-year. I mean, was any of that like one-time events, or is that more attritional? How should we think about modeling that going forward?
Well, I think from my perspective, at least for PPA outside of California, like I mentioned earlier, we think we're running at about 102 right now. We have some changes. There's a lot of volatility outside of California sometimes from quarter to quarter. I will say that. I think in California PPA, we think we're running at about a 95% on a year-to-date basis. We have a lot of the 6.9% that we haven't earned. Most of that has not been earned. We see frequency going down a couple points and severity going up mid-single digits. There should be some margin expansion in our California PPA line going forward, absent any kind of reserve development. That's how I would view it.
Yeah, I would say the one time, Gabe mentioned there was this $3.5 million expense charge that was a result of this Appellate court ruling. That's clearly not going to happen every quarter. Then the California homeowners was elevated in the first quarter. In California, we had a significant amount of stormy weather. There was about $4 million of additional reserves from the first quarter that we put up in the second quarter, just related to that kind of stormy weather event. Those are pretty much closed out. You could probably figure there's a little bit there, too.
Okay. Got it. That's very helpful. Just looking at California lines. I think, Gabe, you had said in the script, low single-digit increases in frequency, mid-single-digit increases in severity. Is that right?
Well, no-
California Auto.
Yeah. Reduction in frequency. Reduction. I think you said increase. Reduction.
Oh, okay. Got it.
Yeah. Mid-single-digit increase in severity, yeah.
Okay, perfect. All in, so should we be thinking low to mid-single digit loss cost inflation in that line?
That's what we're thinking.
Okay. Then you have the 6.9%, basically, you said only 10% of that earned in the second quarter. We have like 90% of that to come?
Yeah. For Mercury Insurance Company, which is our biggest sub, and then Cal Auto had about 32% of it earned.
Okay, got it. Are you guys planning on taking any more auto increases in California, or you guys think you're done for the time being?
I think we're done for the time being.
You are taking another 6.9%. You just filed for another 6.9% in California homeowners, correct?
Yes. The 6.9% goes into effect in August, and we filed for another 6.9% in California homeowners, yes.
Okay, great. Just pivoting to net investment income. Any pre-tax net investment income growth was a little bit weaker than I expected. It was only up like 70 basis points versus kind of that mid to high single-digit premium we've seen over the last year. I guess just why was the growth so soft this quarter? How should we think about projecting the net investment income going forward, especially as rates are starting to come down?
Yeah. Hey, Chris. It's Chris Graves. Well, I thought the growth was actually pretty good, especially year-over-year. We've seen the last year, we've positioned ourselves to be much more sensitive, and actually the prior year as well, to be much more sensitive to the rising low interest rates from the Fed. That really goosed investment income. Of course, that's come to an end. The curve has flattened on us, inverted in parts, leaving us with very few real interesting fixed income opportunities. In light of the structure of the yield curve, I've brought in our duration quite a lot. I think there's considerable more risk out on the yield curve. Going forward, it's going to be a tough environment, and I think it's going to last well through the rest of this year and a good part of 2020 as well.
I don't know if I mean, the company's growing. The underlying growth is good. I'm seeing growth in the investment portfolio. That's going to continue to push investment income higher if everything else stays the same. It's hard for me to tell you exactly where we're headed now.
Okay, got it. That's very helpful. Thanks, Chris. Maybe one for Ted. Operating tax rate was a little bit lower than we'd expected. Any color on anything special that was happening, and how should we think about modeling this going forward?
Well, I think it was lower because underwriting income was lower than you modeled. Underwriting income is taxed at roughly 21%, and investment income's taxed at roughly 10% or 11%. When the mix of those changes, it changes the overall effective tax rate.
Okay. Got it. Well, Thanks for all the answers. Best of luck in the second half of 2019.
Thanks, Chris.
Thanks, Chris.
Once again, ladies and gentlemen, that is star one if you would like to ask an audio question. Our next question is one of Jay Cohen from Bank of America. Jay?
Yeah, just a couple questions. During the call, you had suggested a more conservative loss pick. I think it was for auto BI. Is this something you have already put in place or something you have to contemplate going forward? Maybe I misheard it.
No, what I was referring to is, when we select link ratio factors, generally we would select maybe an average of going back four quarters, eight quarters, as an example. We are weighting more the more recent link ratio factors, which produces a higher amount. That is what I was referring to, Jay.
I guess looking forward over the next four quarters, that by itself, all else being equal, puts a little bit of upward pressure on the loss ratio? Not necessarily.
We've already done that, so I'm not sure why it would put upward, unless it's worse than we've picked.
Well, I guess because you've had some of this adverse development, that's why I thought. I guess it came from other areas, so it's not such a big factor. I guess the other question, with the price increases, how are you finding the reaction in the market? It feels as if you're being a bit more aggressive than others in raising price. Is there some competitive blowback because of these increases?
Yeah. I would say that our new business applications are down quite a bit, actually. In California for the quarter, they were down about 20%. What's happening too is the quoting volume is down quite a bit. Our quote volume is down about 16% year-over-year for the quarter. As a result, our new business is down as a result of both the 6.9% increase that we took and the quoting volume. Now, if you take away the quoting volume, our forecast was pretty much in line, a little bit better than in line with respect to what we thought the new business and our retention would end up at. The quote volume has really had an impact.
Got it. Makes sense. Thanks, Gabe.
Sure. Thanks, Jay.
At this time, I'm showing that we have no further questions on the line. I'd like to turn the call back to the presenters for any closing remarks.
I'd like to thank you all for joining us this quarter, and we look forward to speaking with all of you next quarter. Thank you very much.
Ladies and gentlemen, this does conclude today's conference call. We thank you greatly for your participation. You may now disconnect.