Good morning. My name is Kelly. 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 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 1 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, 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, sir, 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 Robert Houlihan, Vice President and Chief Product Officer. On the phone is 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 second quarter operating earnings were $0.88 per share compared to $0.68 per share in the second 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 96.9% in the second quarter of 2018 compared to 97.8% in the second quarter of 2017. The combined ratio in the quarter was aided by premium rate increases and lower catastrophe losses, negatively impacted by an increase in unfavorable reserve development, $4.7 million of reinsurance reinstatement premiums earned, and a higher 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.
Personal auto and homeowners premiums in Mercury Insurance Company and California Automobile Insurance Company represent about 77% of our direct company-wide premiums earned. Catastrophe losses were $2 million in the quarter compared to $10 million in Q2 2017. $21 million of unfavorable reserve development in the quarter came primarily from our commercial lines of business and a reevaluation of ultimate loss adjustment expenses on our California personal auto line of business in light of increasing defense costs in an increasingly litigious environment. The expense ratio was 24.3% in Q2 compared to 24% in Q2 2017. The higher expense ratio was primarily due to an increase in advertising and profitably related accruals, partially offset by lower average commissions and cost efficiency savings.
Advertising expense was $9 million in the quarter compared to $6 million in Q2 2017. Excluding the impact of catastrophe losses, unfavorable reserve development, and ceded reinstatement premiums earned, the combined ratio was 95.2% for the six-month period ending June 30, 2018, compared to 97% for the six-month period ending June 30, 2017. After-tax investment income increased 11% to $31 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 20% in the quarter, and company-wide homeowners applications increased 14% in the quarter. The Carr wildfire in Northern California has been burning since last week.
At last report, the fire has destroyed over 800 structures and is approximately 20% contained. As of this morning, 11 total loss claims, one partial loss claim, 16 evacuation claims, and two renter claims have been reported to the company. Our catastrophe reinsurance treaty provides for $205 million of coverage in excess of our $10 million retention. With that brief background, we will now take questions.
At this time, if you would like to ask a question, please press star followed by the number one on your telephone keypad. Your first question comes from the line of Greg Peters from Raymond James. Your line is open.
Good morning, everyone. I had just a couple quick questions for you. First, around the pending 6.9% rate increases. Have you outlined an expectation around timing on when the insurance commissioner might provide you the green light on that?
On the Cal Auto one, I believe that was filed sometime last September or so.
Mid-September.
Mid-September. That one is closer, I would say, to getting approved. The Mercury Insurance Company one That was just filed in April, I believe. That's a more recent one. The Cal Auto, our expectation is it should get approved within the next few months, would you say, Robert?
Yeah, certainly.
Historically, at least.
We've received questions, we've corresponded with the Department. There's no outstanding issues, we're still working through additional questions are coming in from the Department. We think there'll be progress on that in the very near future.
Robert, is it true that it seems like, from the time you make the initial filing to the time there's resolution one way or the other, takes about a year. Is that an accurate read on it, or am I missing something?
That's accurate, although we kind of break it down as to whether there's an intervener in the process or not. Generally, if there's no intervener, it's been a little bit shorter timeframe than that.
the intervener only gets involved if the rate increase is in excess of 6.9%, correct?
No, interveners can be on any filing. The rule around the 6.9% is if the increase is above that amount and the intervener requests a hearing, they must be granted the hearing. If it's less than that, it's at the commissioner's discretion as to whether to grant a hearing. there can still be interveners on filings below the 6.9% and below.
Now, we don't have one in the Cal Auto one, the 6.9%, we don't have one on that, and we don't have one on the Mercury Insurance Company one.
Correct.
Okay.
As well.
The second question is just around the combined ratio. Obviously, showed a nice improvement in the second quarter. Congratulations. With the 95.2%, I'm going to call it an underlying combined ratio. Is it your expectation that 95.2 should hold through the balance of the year, should get better? Again, the 95.2, as I understand it, excluded catastrophes, reserve development, and reinsurance reinstatement premium, to clarify.
I think it'll depend on trends, really, on what happens with loss trends and whether or not the rate increases that we have that are still earning in, by the way, because the Mercury Insurance one went into effect, I think the 6.9 went into effect in March. We're going to still benefit from that going forward. It'll depend on the trends, whether or not the trends have stabilized or will stabilize. The Fast Track numbers do indicate that the first quarter severity came down a little bit for Ted, do you want to take that?
The Fast Track BI for California came down to 5.6% in the quarter. Overall paid severities are trended down for other coverages in the quarter. That may be an indication that the inflationary pressures are moderating somewhat in California.
If they stabilize at these levels, the 95.2 could hold or get even better, right? If the rate increases continue to roll through earned premium.
I guess it's possible either way.
Yeah, right. Okay. I'm not trying to put you in a box. Sorry about that.
No. We don't like to forecast combined ratios or operating earnings.
Yeah.
We never have.
You do have a combined ratio target for the company, correct?
We do. That's 95. That's correct.
Is that 95 including all in, including catastrophes-
Yes
prior period reserve development?
Yes.
the actual underlying combined ratio would be lower. The 95.2, if you were to apples-to-apples, should actually be below that because you're going to assume there's going to be some catastrophe losses in any given year. Is that?
That's a reasonable assumption that that's our goal.
Okay. That something below 95 as your underlying is your goal.
As you're defining it, yes.
Okay, perfect.
Correct. Yes.
I don't mean to parse words here.
Yeah. No, that's accurate. Well, our goal is to have a 95% combined ratio company-wide, all in. That's our goal.
Got it. Thank you for the clarity on that.
Sure.
I guess, I know there's other people that are going to ask questions. I like to ask Chris a question whenever I get a chance. It looks like the yield's up in the quarter. You did a real nice job of improving investment income, and I'm just curious if the current run rate is sustainable or are there some puts and takes that might moderate as we work through the balance of the year?
Chris, you want to handle that?
Yeah. Can you hear me okay?
Yeah.
Yes.
Yeah. Okay, good. I'm calling in on a cell phone. There's some give and take going on in the portfolio. For example, on the municipal bonds, we've still got some pretty nice book yields in the portfolio, and current rates still aren't quite, in most cases, at levels that can be accretive as bonds roll off. On the flip side, we've got.
Short rates rising with the Fed. We've got the portfolio more sensitive to short rates through CLOs, bank loans, the cash balances themselves. In fact, with those three together, it's about 10% of the portfolio. That makes us pretty sensitive each time the Fed moves rates up. We've got the benefit.
Chris, did you say CLOs as part of that 10%?
Yeah.
Okay.
CLOs are, I think they're about 3% of the portfolio right now, that's an increasing exposure that we're going to continue to build.
With the benefit also of the company's, with this quarter's good results and everything, that also adds wind to my back. I can't say, yeah, is this a sustainable rate just yet? I certainly feel good about the numbers that I'm turning in right now.
Okay, fair enough. Thank you, everyone, for your answers.
Thank you, Greg.
Your next question comes from the line of Ron Bobman from Capital Returns. Your line is open.
Hi. Thanks a lot. I had two topics I wanted to ask you about. When you mentioned, Gabe, the adverse development, I think I heard you say, I just wonder if you would repeat it and maybe expand on it a little bit. You started out saying that there was an element that was the commercial book, but then you also referenced the personal auto. Could you correct me if I heard it wrong and maybe expand on it a little bit?
It was a combination of both commercial lines of business loss side and also on the personal auto loss adjustment expenses.
Litigation
Our defense costs are going up as we're defending more of these claims with bodily injury.
Should we think of the $20 million being half and half? Commercial being half
Yeah
The defense cost element on personal auto, is that mainly the ballpark?
That's pretty close.
Okay. Separate and apart from that, the app count growth was pretty significant on both auto and home. What's going on there? What's driving that?
Well, I think it's a combination of factors. I think there's been rate increase activity going on in the market.
As a result of that, our close ratio has improved. In addition to that, there's been more quoting. A combination of increased quoting activity and close ratio improvement as a result of, I believe, rate increases. Although it appeared to me, and Robert, I don't know if you want to mention anything here, that the most recent month rate increases, it looks like it's starting to slow down. The number of rate increases and the magnitude of rate increases.
I would say the rate increases have induced more shopping.
Yeah.
We've also shifted our advertising spend more towards California.
Yeah.
We've generated more business in California because of the shift in ad spend. I think it's a combination of more shoppers from more rate increases in the marketplace and a slightly bigger ad spend in California.
Yeah.
Driving growth in our auto and homeowners in California.
Our rates being competitive, I think the close ratio improved as well.
Yeah.
Is the legal representation back to my sort of the adverse development and the LAE burden, is that geographically weighted? Are you seeing it more in a certain part of the state or not clear?
Well, I think I mentioned last quarter, I've seen it either throughout the whole state, but Southern California, I would say is worse.
Okay. History repeats itself, I guess.
Yeah.
Okay. Thanks, gentlemen.
Okay.
A good quarter. Hope it continues.
Thank you.
Your next question comes from the line of Christopher Campbell from KBW. Your line is open.
Yes. Hi, good morning.
Morning.
Morning.
Hey. I guess my first question is the reserve additions. If I'm just looking at the last few quarters, you guys have had about $100 million in the last three quarters. Look, at what point do you decide that this California BI issue might be bigger and that you need to take maybe a larger reserve charge to kind of put it behind you once and for all?
We essentially evaluate the reserves every quarter, and we take our best estimate based on the data that's available and our view of what's going to happen in the future. What you're talking about is putting a bias into our estimate, biasing it higher or low. We don't bake bias into our reserve analysis. What we do do is we have the company create its own internal analysis, and we have external actuaries create their own analysis independently, and then we sort of compare those analyses. Typically, the differences are not significant. We come up with our point estimate from that process. As far as taking sort of a big bath or a big charge to put it behind us, that's just not something that we do.
I'd also like to point out that I think the last couple of years, the environment has changed. There's no question about it, especially here in California from a BI perspective. The historical loss development factors that were chosen, they've been changing because of the environment changing. I think once that stabilizes and those factors become more stable, the accuracy of reserves are going to be much more stable as well. I think we're getting closer to that. It's not an exact science, as you know, reserving. We basically try to make our best estimate of the numbers. We use outside actuaries, we have internal actuaries, and we try to get to that best estimate. There's no question that the change in the environment here in California has caused us to be off from historical trends.
Got it. Are your loss development factors, are they materially different if you look at that versus California and non-California?
I think the way you would look at it is that they're changing more as you progress through the triangle. Whereas you look at some of the other states, we have favorable development in more than half of our states outside of California, and those have very stable development patterns. California has had progressively increasing development patterns as you go across the triangle, and that's what Gabe was describing earlier, which makes it much more challenging to get ahead of the reserves.
Got it. That's very helpful. I know, I was reading in the press release that you started introducing or reintroducing 12-month policies. Any difference, any changes you're doing in your pricing reserve amount, loss picks to kind of factor in that you might not be able to reprice those as quickly? If, knock on wood, that you get the estimate, you get like the first pass at that incorrect.
Well.
Certainly, in the indication process, we consider how long the next rate level will be in effect, and that certainly affects our calculations, the higher percentage of annual policy. In that respect, we take it into consideration.
Okay, great. I saw the strong premium growth. Part of that was the reintroduction of the 12-month policies. Are you seeing any benefit from the Access bankruptcy?
Yes, we did. In our non-standard auto company, Workmen's, there was significant growth there.
Okay. What are the quarters rates on that versus what that book looked like before the Access bankruptcy? Are they up? Are they down? Kind of, is there any indication how much higher your prices are than Access's were?
Based on some samples that we took, looking at their previous policy, substantially higher.
Okay. Got it. That's very helpful. Just one-
Which may be the reason that they're no longer in business.
Right. Yeah. I know there's been some other non-standard carriers that have been picking up business from that as well.
Yeah.
Just one final numbers one. Tax rate was a little lower. Is that just the more of that investment income versus underwriting income? Is that kind of a mixed thing this quarter or anything special?
Well, if you look at our effective tax rate in 2018, now we're under the benefit of the lower federal tax rate. Our investment income effective tax rate is around 10%, and underwriting income, other income, and capital gains and losses are around 21%. That's sort of how the math works out, and it just depends on the relative weight of those components of income.
Okay. Great, Ted. Thanks for all the answers. Best of luck in that third quarter.
Thank you.
Thanks.
If you would like to ask a question, it is star one on your telephone keypad. Your next question comes from the line of Greg Peters of Raymond James. Your line is open.
Thank you. Thanks for letting me ask a follow-up. Actually, two follow-ups. First of all, on the unfavorable development in the auto, not the commercial auto, the auto side. You said a portion of it's skewing from Southern California. I know you're pretty thoughtful in how you segment your customers, and I'm curious if there's been any predisposition to one segment being more at risk for these reserve adjustments than another segment.
When we take a look at our reserves in total, we don't segment or calculate our total reserves based on segment. Pricing is a different matter. Obviously, we do consider territory from a pricing standpoint. We take that into account. When we take a look at our reserves and calculate our total reserves, we're not taking Southern California and calculating a reserve for Southern California and one for Northern California. We take a look at our whole book of business. First of all, you have more credibility. Second of all, from a pricing standpoint, though, there's no question that we take territory into account.
Got it. Then I think you mentioned that there's favorable development outside of California, I know that's been a business that hasn't been growing for you. I'm curious now that you seemingly turned a corner around development, at least favorable development. I'm wondering if your growth profile is going to change for states outside of California.
Actually, in this quarter, outside of California, we actually saw a slight increase in our new business applications in private passenger auto. They grew about 2.3% outside of California. We've got a lot of initiatives going on, trying to make it easier for our agents. We have new software that we're implementing in the next couple of weeks. We have improvements in segmentation that we've been working on the underwriting side as well. We're hopeful that all the things that we're working on are going to improve not only the top line, but also our bottom line.
Would you like to call any of the states that are working, you're seeing some sense of optimism, or you just like to leave it with that?
I would just say that most of the states right now are well below 100, Ted. Some of our bigger states, Florida, Texas actually, I think grew a little bit.
Okay.
Florida was down a little bit, is my recollection, the two biggest states. Overall, like I said, from an application count standpoint, which is something that we monitor.
Yeah
Our application count this quarter was up slightly.
That's the first time in a while, correct?
Yeah. If you take a look at the year-to-date application count, they're down like 10%.
Right. Going back over for an extended period of time, that's been a shrinking market for you.
Yeah.
Do you feel like
It was a decent quarter. We're hoping that we can continue that trend.
Yeah. It sounds like you may have turned a corner there. The last question around advertising, you talked about moving around some of the pieces within the company. I'm wondering if the overall budget has changed for the full year, and how it compares with the previous year.
It's up slightly. I think our budget this year is up $2 million or $3 million, and we expect to spend around $40 million, Ted.
Mm-hmm. Yeah. Great. Thank you again for your answers.
Thank you.
There are no further questions at this time.
Well, great. Thank you for joining us this quarter, and we look forward to talking to you in the third quarter. Thank you very much.
This does conclude today's conference call. You may now disconnect.