Good morning. My name is Jamaria, and I will be your conference operator for today. At this time, I would like to welcome everyone to the Mercury General third 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 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 risk and uncertainties which cannot be predicted or quantified, 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 third 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. I am pleased to report our third quarter operating earnings were $1.11 per share, compared to $0.60 per share in the third quarter of 2017. The improvement in operating earnings was primarily due to an improvement in the combined ratio, an increase in after-tax investment income, and a lower corporate tax rate. The combined ratio was 95.6% in the third quarter of 2018, compared to 99.3% in the third quarter of 2017.
The combined ratio in the quarter was aided by premium rate increases, lower catastrophe losses, and a lower expense ratio. To improve our combined ratio, we have been increasing rates in most states. In California, a 5% personal auto rate increase in Mercury Insurance Company went into effect in March. A 6.9% personal auto rate increase for Mercury Insurance Company and California Automobile Insurance Company are pending approval with the California Department of Insurance. In addition, a 6.9% rate increase in our California homeowners line was filed in May. California personal auto and homeowners premiums represent about 77% of our direct company-wide premiums earned. Net catastrophe losses were $13 million in the quarter, primarily the result of the Carr Fire in Redding, California.
This compares to $19 million of net catastrophe losses in the third quarter of 2017, primarily from Hurricane Harvey in Texas and Hurricane Irma in Florida and Georgia. During the quarter, we recorded $6 million of unfavorable prior year reserve development, down from both the first and second quarter of 2018. The development in the quarter came primarily from our auto line of business. The expense ratio was 24% in the third quarter, compared to 25% in the third quarter of 2017. The lower expense ratio was primarily due to lower average commissions and a slight reduction in other operating expenses, coupled with a large increase in earned premiums. Advertising expense was $12 million in both the current and third quarter of 2017.
Excluding the impact of catastrophe losses, unfavorable reserve development, and ceded reinsured premiums earned, the combined ratio was 94.5% for the nine-month period ending September 30th, 2018, compared to 96.8% for the nine-month period ending September 30, 2017. After-tax investment income increased 24% to $33.5 million. The increase in after-tax investment income was primarily due to higher short-term interest rates, an increase in invested assets, a lower corporate tax rate, and higher yields obtained on certain classes of investments. Company-wide private passenger auto new business applications submitted to the company increased approximately 8% in the quarter, and company-wide homeowners applications increased 16% in the quarter. Earlier this month, Hurricane Michael caused significant damage in Florida, as well as in Georgia and Virginia.
At this time, based on the information currently available, we believe our ultimate losses from Hurricane Michael will be in a range between $4 million-$8 million, which will be recorded as losses in the fourth quarter. Our catastrophe reinsurance treaty provides for $205 million of coverage in excess of our $10 million retention. Lastly, we generally expect our combined ratio in the fourth quarter, excluding catastrophes, to be higher than the rest of the year due to increased loss frequency and higher severities caused by seasonal driving and weather. That said, it is hard to predict with certainty whether the underlying combined ratio will be higher, as there are many factors currently unknown or beyond our control. With that brief background, we will now take questions.
At this time, I would like to remind everyone, in order to ask a question, press star, then the number one on your telephone keypad. We'll pause for a moment to compile the Q&A roster. Your first question will come from Greg Peters with Raymond James. Please go ahead with your question.
Good morning. Based on what I see here, it looks like this third quarter result is the lowest combined ratio that you guys have produced in something like the last 10 years. Is that a right read?
Yeah, I believe that's right, Greg.
Congratulations.
Thank you.
I know it's been a hard-fought battle. I know you mentioned in your opening comments about some pending rate increases, two are in the auto and one's in the homeowners line, I believe. Given that the underlying and reported results are trending favorably, do you believe there's less possibility that those rates are going to be approved?
No, we still think that they will be approved. I think the indications show that we need the rates. In Cal Auto, I think in the last quarter, we talked about the fact that we were expecting approval. Additional questions came in from the department, not necessarily really based on whether or not we needed the rate, but just some additional questions, and I believe we've answered those questions in Cal Auto, and we do expect to have approval sometime in the near future in Cal Auto. In MIC, again, the rate templates from the Department of Insurance suggest that we do need the rate based on the trend. Although we don't expect that rate to go into effect until 2019, probably spring or mid of 2019 is our best guess right now. Same really with the homeowners rate filing that we followed earlier this year.
When you take a look at the rate templates that we followed, it clearly shows that based on the trends that we need the rate. I don't know, Robert, you want to add anything?
No, I really don't have much to add to that commentary.
Okay.
Okay. Well, that's good color. On the prior year development, obviously, you talked in earlier conference calls about some of the trends that were popping up that were causing this year's adverse development to, at least through the nine months, to be worse than last year's result through the nine months. The trend is improving. There's less unfavorable development. Can you talk about where we are with that? I know the fourth quarter has some volatility around it, but should we look at this improving trend and think that maybe you got the reserve issues resolved?
Well, we definitely are baking the trends into our selections, our ultimate selections. We've gone through a period of the last several quarters, maybe four to six quarters, where the underlying development was more than expected, and that did moderate in the third quarter, which gives us some hope that this will be the end of adverse development going forward. It's hard to tell because things change, and we look at FastTrack data, and it looked like the industry in California was moderating a bit the last quarter or two. That's also a good sign.
Yeah, it was definitely better this quarter. As I think we mentioned last quarter, our historical trends, when we were forecasting forward, they were coming in higher. The selections on the link factors that we were selecting were coming in higher. It appears to me, at least, that that's starting to stabilize, which is why you saw in the third quarter less development. Whether or not that continues in the future, we don't know.
Right. Well, I know, Gabe, you've talked for several years about your stated objective of a 95 combined ratio, and I assume as part of that stated objective, you assume that there's not going to be negative or adverse reserve development. You assume that reserves are going to be adequately set.
Yeah. That is correct.
Is that the right read?
That is correct. We do not assume any development one way or the other.
If you're catching up on the reported side, maybe you're catching up on the reserve side, too. Maybe that would be what I would infer from your results. Can we spend a little bit talking about the operating expenses? They were down a little bit in the third quarter. Were there some discretionary items that you just withheld back on, or just talk to us a little bit about what the ebb and flow of the underwriting expenses in the quarter.
Our operating expenses were fairly, I think they were flat compared to last year's third quarter. One of the things I think is really helping the ratio is really our growth in earned premium. We're growing that at a lot faster rate than we are the operating expenses. Our ad spend, I think, was the same third quarter this year compared to last year.
Yeah. Our effective commission rate is down. That's helped, and that's variable. If the effective commission rate is down, that's going to help. We've been monitoring our expenses, making sure from an expense standpoint that we're tight with the budget. I think it's a combination of all those factors that are helping the expense ratio.
Can you just expand for a second on the commission rates being down? I'm surprised by that comment. Usually, agents are reluctant to give up commission.
Well, we're talking about maybe, I think, in overall maybe two or three tenths of a point down year-over-year, is my recollection. Our commissions in California are variable, and they're based on the possibility of the book of business, and it's a three-year trading number that we use. That has been trending down a little bit. We've also made some changes to our commission structure, where we're paying for a certain type of business more and other types of business less. A combination of all those factors have driven down the expense ratio or the commission rate here in California a little bit. I'm not talking about a lot. I think it's two or three tenths of a point, here in California.
We make our annual commission rate adjustments as effective with the July 1st.
Right
for all of our agents. If the commission rates typically go down, you would expect to see that in the second half of the year.
Right. One more underwriting question, then I have a question for Chris. On the non-California business, can you comment about, is Florida still a shrinking auto market for you, or is that stabilized and in a position to start growing again? Talk about the other states as well.
Florida was down in the quarter, was still down in the quarter. Posted a very good combined ratio in Florida in the quarter, but the top line was down. Overall, outside of California, our premiums were up about 2% for private passenger auto and about 5% up in homeowners outside of California on the top line. I think as I mentioned earlier, from an application count standpoint, in the third quarter, we were up 7.9% in applications for private passenger auto for the entire quarter. About 8% up in California and about 7.2% up outside of California in the quarter. Some of the states that are growing, Texas is growing on the top line in the app count, New York, Oklahoma. The two primary states that are down are Florida and Virginia.
Great. Thanks for that color. I know you, in your prepared remarks, talked a little bit about investment income, but it really was a whopper of a quarter for you. Maybe you could give us more details about that. Is the $38 million a new run rate to expect going forward, et cetera? Chris, this would be a good opportunity for you to chime in as well.
Hi, Greg. Going back several years, we started positioning the portfolio to be more sensitive to LIBOR rates. We're definitely seeing the benefits of those positions, particularly through our CLO investments. We've been putting more capital towards investment-grade CLOs. That helps, and then obviously just higher rates in general. We've seen quite a big move this year, which is allowing us to see more and more opportunities to buy fixed income that's accretive to our book yield, which has not been the case for some time. We've been challenged to maintain where we were, and that's no longer the case. We can actually add some pretty good bonds now and see a pickup in yield. We're not having to stretch for anything either. We can get pretty good credits, and not have to take a lot of risk. Dividends.
We're seeing more dividend bumps come through. The equity investments have helped. All of that combined has put some good winds to our back this year. I really can't speak towards the run rate. It's hard to say, but I'm certainly feeling pretty good about where we are right now.
The only thing I would add to that is our investment balances have also grown, which has helped as well.
That's something else. That's a good point, Gabe. Mercury's business, when it does well, doesn't put any strain on me. As you can see, our investment balances have really picked up, and that's translated into investment income pickup. If you go back over the history, we are approaching annualized investment income numbers that we haven't seen in 10 years, but on a much higher balance. As rates normalize, I think you can start to speculate that investment income's going to continue to do better.
Well, certainly the last two quarters have been particularly noteworthy. The third quarter was a blockbuster, no doubt. Well, listen, I'm sure there's other analysts that want to ask questions. Congratulations on your quarter.
Thank you, Greg.
Once again, as a reminder, if you would like to ask a question, press star then the number one on your telephone keypad. Your next question is from Christopher Campbell with KBW. Please go ahead with your question.
Yes. Hi. Good morning, gentlemen.
Morning.
Hi, Chris.
Hey. I guess my first question's on the premium growth. It looks like maybe like 250 basis points of the growth this quarter year-over-year was from the 12-month policy reintroduction. If you back that out, you're still seeing 7% growth. I guess, if you're decomposing that, how much of that would be exposure versus rate? I noticed the auto and the home PIF were picking up this quarter.
Yeah.
It's probably about 2% on the policy growth. The rest are rate.
2% would be exposure, the other 5%, excluding the policy introduction, would be rate?
Yeah, in that ballpark.
Yep.
Okay. Got it. That's really helpful. I guess just, kind of another question on the reserves. I think Greg asked a few. Just looking at the reserves the last few years, it looks like the adverse reserve development seems to be the lowest in the third quarter and kind of heavier in the other three quarters of the year. Is there anything seasonal in terms of your review process that would kind of bias the third quarter to be lower than the other quarters of the year?
We follow the same process every quarter. That's an interesting observation, but I don't think there's anything biasing it one way or the other.
Okay. There's no different data that you use per quarter depending, or is it just you have the same inputs every quarter?
Same input, same process.
Okay. Got it. Just kind of finally, like a high-level one on the regulatory environment in California. I guess as Mercury gets more profitable, does this kind of create a heightened risk that regulators might order the rate rollbacks that I think were rumored a few months ago? Just, a secondary one on that is, how could the November elections kind of shape California's regulatory environment going forward?
Well, I'll let Robert Houlihan talk about the prescribed formula that we have here in California with respect to rates, then I can chime in on the election.
Yeah, on the rate filings, it's subject to a return on surplus formula. Only to the extent that that formula would yield a decrease can the department force a reduction in rates. Right now, as we discussed earlier, we have two pending increases, which we think are supported. The department, if the company hasn't filed in a period of time, the department has the right to come in and request a filing. Other than that, there's no mechanisms for a rate rollback.
I thought the commissioner was ordering his staff to review all of the rates. When would that be a risk, I guess? Does that vary by line? I know you guys are catching up in homeowners, but if auto is becoming more profitable, does it become more of a risk for auto versus homeowners?
I don't-
Go ahead.
No, I was going to say, the department can request a filing to be reviewed for potential decrease. We already have pending filings going through the process right now. There's nothing above and beyond that.
The only thing I can think of is that there was some kind of notice went out. Maybe what you're referring to is when the taxes went down.
Yeah, that's it.
That's what I think you're referring to. We've already incorporated the lower tax rate into our filing.
Right
I think that's what you're referring to, is that the commissioner came out and said, "Hey, we're going to look at the rates, lower tax rate." Those lower tax rates are in the formula that we have for our filings.
Okay, that's already baked into the 6.9 you have going in Mercury General and then in California Automobile Insurance Company. That's already got the lower tax rate.
Yeah.
You're still asking for 6.9, correct?
Yeah, those filings already reflect the lower tax rate.
Yeah.
Okay, got it.
As far as the election, I'll just make the comment that we don't think whoever gets elected will be any more adverse than what we have today. That's my feeling.
Okay, got it. Well, that's very helpful. Thanks for all the answers and best of luck in the rest of the year in 2019.
Thank you.
Thanks.
At this time, there are no further questions. I would now like to turn it back over to the panel for any closing remarks at this time.
We'd like to thank you for joining us for the third quarter, and we hope to bring you some good news as well in the fourth quarter. Thank you very much.
This concludes today's conference call. You may now disconnect.