Good morning or afternoon. My name is Michelle, and I will be your conference operator today. At this time, I would like to welcome everyone to the Mercury General quarterly 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 number 1 on your telephone keypad. If you would like to withdraw your question, please 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 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, Chris Graves, Vice President and Chief Investment Officer, and Robert Houlihan, Vice President and Chief Product Officer. Before we take questions, we will make a few comments regarding the quarter. Our third quarter operating earnings were $0.67 per share compared to $0.59 per share in the third quarter of 2015. The improvement in operating earnings was primarily due to an improvement in the combined ratio from 99.2% in the third quarter of 2015 to 98.1% in the third quarter of 2016.
In California, we recorded an increase in Personal Auto severity in the mid-single-digit range for the 2016 accident year and an increase in frequency in the low single digits. Industry trends reflect frequency in California increased about 3% and severity about 6% for the 12-month period ending June 2016. To help offset the increase in loss trends, we have been increasing rates in California. This year, for our Personal Auto business in California, we implemented a 5% rate increase in late March 2016 for Mercury Insurance Company and a 6.9% rate increase in June 2016 for California Automobile Insurance Company. Personal Auto premiums in Mercury Insurance Company represents about half of our company-wide premiums earned, and California Automobile Insurance Company represents about 15% of our company-wide premiums earned. We have observed a significant number of our competitors also file for rate increases in California.
Outside of California, increasing loss cost trends and higher loss ratios that come with an increase in new business have negatively impacted our results. To address profitability outside of California, we have been increasing rates and tightening our underwriting. The expense ratio in the quarter declined to 25.2% from 26% in the third quarter of 2015. The decrease in the expense ratio was primarily due to lower profitability-related accruals. Net advertising expense in the quarter was $10 million, compared to $11 million in the third quarter of 2015. Premiums written grew 3.8% 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 15% in the third quarter of 2016 as we focus on improving profitability in our private passenger auto line. Company-wide Homeowners applications increased about 1% in the third quarter of 2016.
In California, we posted premiums written growth of 5.7%. Outside of California, premiums written decreased by 4.4% in the quarter. We are pleased to report the Superior Court of California ruled in our favor, vacating the commissioner's 2015 order that had imposed a penalty of $27.6 million against the company. The principal findings of the Superior Court order were that the broker fees at issue were not premium and the charging of such fees did not result in any violation of insurance code rate regulation provisions. The $27.6 million penalty imposed violated Mercury's right to fair notice and due process, and there was unreasonable delay by the department in issuing the notice of non-compliance in 2004, which resulted in a manifest injustice to the company.
The financial statement recognition of the reversal of the $27.6 million penalty, plus any related interest, is yet to be determined as the Superior Court's order is subject to appeal. We generally expect our accident quarter combined ratio for the fourth quarter to be higher than the rest of the year due to increased loss frequency and higher severity caused by seasonal driving and weather. That said, it is hard to predict with certainty whether the 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.
If anybody would like to ask a question, please press star one on your telephone keypad. Again, that would be star one on your telephone keypad. Your first question comes from Greg Peters from Raymond James. Your line is open.
Good morning, and congratulations on your results this quarter.
Morning, Greg.
Just a couple questions for you. On the severity commentary I think last quarter you said it was high single digits, so now we're reverting back to mid single digit. Is there anything sequentially in the trend that looks a little bit better in the third quarter versus the second quarter or the first half of the year?
Really here we're talking about maybe a one point difference. It's all.
Okay
semantics. Do you want to elaborate?
Yeah, Greg, the difference between mid and high maybe is the matter of instead of a seven or eight, it's a six or a seven. That may just have to do a little bit with our kicks more than anything.
That's perfectly understandable. Can you just step back for a second? I note your commentary on the expense ratio and the profitability accruals. Maybe you can sort of walk us through the logistics behind that, especially considering the possibility that going forward, your results may begin to improve a little bit as all the rate increases continue to flow through your book of business.
It's primarily related to bonus accruals, and because of the poor underwriting results this year, we're not really accruing for a bonus accrual this year. That amounts to maybe six tenths of a point. Half of that, or maybe a little bit more than half of that, is loss adjustment expenses, the other half is underwriting expense.
I see. If the underwriting results improve next year at this time, we could expect a reversal where the bonus accrual trend might move against the company. Is that correct?
That is correct. I think a full bonus accrual may be in the neighborhood of $20 million.
For the full year, that is, right? For the quarter?
For the full year, Greg. For the full year.
Where do you think it's going to come out this year?
Zero.
Zero. Wow. Okay. Just reverting back to the severity commentary around the current quarter and frequency. I know I've asked you this on previous calls, and it always is worth asking again. Where do you think you are in the possibility of filing for additional rate increases as both severity and frequency trends continue to march forward, in the context of your California book of business?
In Cal Auto, we have a 6.9% rate pending with the Department of Insurance, that's already in there. That's California Auto Insurance Company. Mercury Insurance Company, I believe there's a pretty good likelihood that within the next, I would say 90 days, that we will file a class plan that will include some sort of rate increase.
For California Automobile, the 6.9%, it's pending. That's on top of the 6.9% that was effective in June?
That is correct.
Yeah. Okay. Thanks for that color. On the non-California business, is there any one state of the remaining states that are in that business that are more problematic than others? Or perhaps you could just provide some additional color around what's going on in your business outside of California.
Well, our biggest two states outside of California are Florida and Texas, and the results have been poor in those states as a result of what I mentioned earlier. In addition to that, the trends were high in those two states. We feel that with the rate changes that we've made, some other procedural changes, that we're going to be much better positioned going into 2017. Some of the smaller states in the Northeast with respect to New York and New Jersey, we've made improvements in those two states, and we continue to make improvements in those two states. The two biggest states outside of California, Florida and Texas, we feel that we have made the changes and are continuing to make the changes to basically get us well-positioned for 2017.
By well-positioned, do you mean positioned to start growing again or positioned for profitability to hit your hurdles? Or both?
Profitability.
Right.
I think next year, the growth is going to be outside of California down as a result of the rate changes and other remedies that we've taken to improve profitability.
Okay.
I think it's more of a profitability play outside of California right now.
Just to clarify your last comment, is it policy count that's going to be down outside of California or premium, total premium, or both?
I anticipate that both will probably be down next year.
Okay. Thanks for that color.
Sure.
Probably one final cleanup area. Perhaps Chris could comment on the investment portfolio. I was looking at both pre-tax and after-tax income is down year-over-year. The average invested assets is up. Perhaps you could give us some commentary on how he thinks that's going to look going forward.
Yeah. Hey, Greg. A lot of that, I think, as you'd understand, is interest rate related. We've got bonds on the books with much higher book yields than current market rate. They're being reinvested perhaps a point or more less than what they were on the book. Even with increased cash flows coming into the portfolio, current rates don't allow for us to fully offset what we're losing. It's a bit of a battle, but I think in the past two years, we've provided some reasonable growth. This year is a bigger challenge, but I think that we should be able to at least maintain where we currently are, especially with rates at these levels. Then we'll just see what the company does with these rate increases and what they allow me to reinvest.
Just to close the loop on that commentary. If the interest rate environment stabilizes at this point or is stable from this point going forward, when would the yield on your total portfolio sort of bottom out? Does that happen next year, or is it happening right now, or do we still have some more runway?
No, it would still take a little bit more for rates to move higher before I think we'd see what you can call a bottoming, but it could easily be eclipsed with reasonable cash flows coming into the portfolio.
Right. Yeah. No, that makes sense. Perfect. Thank you, everyone, for your answers.
Thanks, Greg.
Your next question comes from Ken Billingsley from Compass Point. Your line is open.
Yes. I guess good morning out there. Question for you on just following up on your commentary earlier. I think, Greg, you answered some accrual questions for him, but maybe I just wrote this down wrong. You said the lower expense ratio, and I wrote down lower property-related accruals. Did I hear that wrong?
Profitability.
Profitability. Okay.
They're basically bonus.
Yeah. Okay. That makes a lot more sense. Thank you.
Yeah.
I got the commentary that you answered for Greg here. Let me just move on to this, just a 2 of follow fill-in questions. The mix of the business for what I guess in the market generally considered standard versus non-standard mix of business, could you give me what your percentage is today, and maybe how that's changed over the last year?
Well, I think that's hard to measure nowadays. Those lines have blurred. Let's talk about our biggest state in California, where we consider Mercury Insurance our biggest state, obviously, and our biggest company here in California. We consider that our preferred company. That represents about, I said earlier, about 50% of our company-wide premiums. We have Cal Auto, which is what we refer to as kind of mid-market non-standard, and that represents about 15%. That's about 65% of the business. Outside of California, we are more towards the non-standard arena as far as risk classifications go. Robert, would you have any other comments on that?
Certainly in terms of new business, in terms of our portfolio, I think it starts to skew more, renewal book skews more towards standard even outside of California.
The renewal book in general is shifting more towards standard, you said?
I'm just saying the new business probably skews more non-standard, but because of the lower policy life expectancy, when you look at the renewal book, it actually skews more standard.
Renewals by definition, if they renew long enough, they're more standard generally is the point.
Okay.
As far as new business goes, I would say we skew more non-standard outside of California.
Within California, obviously, that's a big state, but is there any specific geographic concentration? Of the, I guess 65% of your premium that's in the state, is it concentrated 50% in a certain county or two?
Southern California represents the majority. I would have to say off the top of my head, Robert, maybe 70% of the business down here in Southern California versus Northern California. That's an off the top of my head answer.
Where the cars are.
Yeah, that's where all the people are at.
Sure. Okay. Pretty broad. The last question I have is, could you just update on ad spending? If you're expecting to write any less outside of California, can you talk about your ad budget and ad spending plans and how that may be affecting the expense ratio now and going forward?
Well, we haven't decided yet for 2017. Our best expectation right now is that it would probably remain flat, but that has not been finalized yet for 2017.
I understand your answer here, but would you be considering staying with a national campaign as opposed to being focused, and does that cover California for you as well, or do you have a specific ad plan in California?
Well, we advertise locally in California as well besides the national, so we do that already.
That we still haven't evaluated whether or not we're going to still continue with the national. That's something still under evaluation. We have always advertised here locally as well, even though we have some national ad spend.
Okay. Do you have off the top of your head what the national ad campaign was on an annual basis, what the cost was?
Ted, do you have how much total advertising expense?
Our total is about $40-$42, I think.
In the region of $40 million, yeah.
Like Gabe mentioned, the national is one component of that. I think it's maybe even less than half of that. There's a lot of digital advertising, sports advertising.
He's talking just about the national substantial, yeah.
Yeah.
Robert, do you have any?
It's a little less than half.
Yeah.
Yeah.
Okay. Great. Well, thanks for taking my questions.
Thank you, Ken.
Your next question comes from Jay Cohen from Bank of America. Your line is open.
Yes. Thank you. A couple questions. For the fourth quarter, do you have any sense yet what Hurricane Matthew will do to the results?
We think at this point it's not going to be material, Jay. Maybe $1 million-$2 million is our best estimate right now from the data that we have.
Great. That's helpful. Secondly, I guess outside of California, as you shrink, obviously the goal is to improve the loss ratio. At some point, would you have a scale issue? It seems to be a lack of scale, whether it's with the agents or from a claims standpoint. How do you deal with that balance, guys?
Well, one of the things that we did, I guess, last year sometime where we centralized our hubs so that we can get more scale. Now we have basically some central hubs in Florida, in Texas, and in California, and we closed down a lot of the other hubs that we had so that we can get some more scale and efficiencies. We tried to deal with that so that we can basically centralize our operations and get more leverage. With the top line declining, it does put added pressure. There's no question about that. It's something that we'll have to take a look at to see how much added pressure it's going to be adding.
Got it. You've tried to build in, I guess, at least some flexibility to the system there.
Yeah, we did that. When did we do that? It was two years ago, I guess we did that, Jay, where we centralized our operations outside of California, and we have major hubs now.
Yeah. Okay.
They basically service many states.
Yeah, I do remember you guys doing that. That's helpful. Thanks, Gabe.
Good.
Again, if anybody would like to ask a question, please press star one on your telephone keypad. Your next question comes from Ron Bobman from Capital Returns. Your line is open.
Hi, gentlemen. I had a question on rates. Obviously, it sure seems like everybody in the business is pushing rate. I'm wondering if you could talk a little about retention, maybe regionally. Also, are you seeing less shopping and thus better retention? Maybe all companies are doing so by virtue of the common list in rates that all carriers are pushing. I'd be curious to get your thoughts and your view. Thanks.
I'll let Robert, why don't you talk about retention? Because this is better than we expected, actually.
Yeah, certainly, in California, as you say, it's sort of a rising tide. We're seeing rate increases and underwriting actions from all of our competitors. With the rate increases, our new business application counts have held steadier, perhaps moved up slightly. Our retention is only down a point or so despite all the rate that we've taken.
I mean, to give you an idea of some of the rate action, you have a lot of rate activity that has already occurred. In addition to that, you have a lot of rate filings that are pending. You got GEICO, Allstate, Farmers, Infinity, 21st Century, Safeco, La Luna, Progressive, State Farm, The Northern Club, all with pending 6.9% or thereabout rate increases pending.
Thanks. I'd be curious to know whether the state's taking any different approach, I guess timeline-wise, as far as approving the 6.9s. I think the 6.9% is sort of a typical threshold without having a hearing, but correct me if I'm wrong. Could you comment about other states and what's going on retention and rate-wise? Sort of the same question, but as you look at your other states. Thanks, guys.
Robert?
Yeah. A couple of questions there. Timelines for reviews with the department have actually been quicker than historical timelines. That hasn't been an issue. Outside of California, it's a little bit of a mixed bag. There are some states where the rate increases are moving us into a less competitive position. Thus, some of Gabe's comments about the slowdown in growth or actually decline in premium because we are becoming less competitive in a few states, and we have seen some decline in retention in a few states as our rates have become a little bit uncompetitive.
I would have thought it would be more common. We hear from so many auto companies that are pushing rate, I guess it varies by state. You're seeing the differential. Thanks, guys, and best of luck.
Thank you.
I have no further questions at this time. I turn the call back over to the presenters for closing remarks.
Well, thank you very much for joining us this quarter. We look forward to talking to you again next quarter. Thank you.
Thank you, everyone. This concludes today's conference call. You may disconnect.