Good morning. My name is Karen, 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 the number one on your telephone keypad. If you would like to withdraw your question at any time, 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 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, 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 second quarter operating earnings were $0.64 per share compared to $0.83 per share in the second quarter of 2014. The deterioration in operating earnings was primarily due to higher catastrophe losses, increased advertising expenses, the results of the recently acquired Workman's Auto, and less favorable reserve development as compared to prior year.
Excluding the impact of catastrophes and favorable reserve development, the combined ratio was 97.9% in the second quarter, compared to 96.3% in the second quarter of 2014. Workman's Auto added 0.2 points to the second quarter combined ratio. Premiums written grew 5% in the quarter, primarily due to higher average premiums per policy, the acquisition of Workman's Auto, and an increase in new business policy sales. Workman's Auto premiums written of $5.3 million added 0.8 points to the quarter's premium growth. In the second quarter of 2015, California private passenger auto frequency and severity increased in the low single digits. On a sequential basis, frequency and severity was relatively flat from the first quarter. Higher average premiums from rate increases taken in 2014 partially offset the year-over-year increase in the frequency and severity in the quarter.
To further address the increase in loss cost, a 6.4% rate increase was implemented in late May for Mercury Insurance Company, representing about half of our company-wide premiums written. In addition, a 6.9% rate increase for California Automobile Insurance Company, representing about 15% of our company-wide premiums, was implemented on August second. Results outside of California were negatively impacted by $7 million of catastrophe losses, primarily in Texas and Oklahoma and our private passenger auto business in N.Y. Excluding catastrophe losses, the combined ratio was about 100% outside of California. In N.Y., we continue to evaluate reserves as the impact of changes in claims procedures, which includes the speeding up of claims settlement and case reserving, have added an element of uncertainty to the estimates.
In N.Y., we implemented a 3% rate increase in January of 2015 and a 9% rate increase in July of 2015. Our expense ratio in the quarter increased to 27.3% from 26.8% in the second quarter of 2014. The increase in expense ratio was primarily due to higher advertising expenses, partially offset by lower average commissions. Net advertising expense in the quarter was $12.1 million, compared to $5.5 million in the second quarter of 2014. Our 2015 advertising budget is heavily weighted toward a first-half spend. The advertising spend will be lower for the remaining 2 quarters of 2015. Company-wide, private passenger auto new business applications submitted to the company increased 11% in the second quarter of 2015, and homeowners new business submissions were up 32%.
In California, we posted premiums written growth of 5.6%. Outside of California and excluding our Mechanical Breakdown Protection, premiums written increased 5.5% in the quarter. This compares to negative growth of 3.9% and 7.6% for the years 2014 and 2013 respectively. With that brief background, we will now take questions. First, I think we're back up. Hello? You give us details back
Good. Are there any questions?
As a reminder, if any participant has a question, please press star then the number 1 on your telephone keypad. We will pause for just a moment to compile a Q&A roster. One moment, please. Your first question comes from the line of Ken Billingsley from Compass Point.
Hi, can you hear me?
Yes, Ken.
Very good. Thank you for taking these questions. Just a few questions. One on tax expense. Was the operating tax expense, was there a benefit during the quarter, or is it just naturally lower in general? Was there anything unique in the quarter?
No, there's nothing unique. We get a tax benefit on our realized losses on our investment portfolio, which is primarily due to mark-to-market adjustments as we flow all our investment changes through the P&L. As you can know from the P&L, we had an investment loss for the quarter, so that would've positively impacted the income tax accruals.
After adjusting for backing out the realized loss portion, there was no other-
No
movement?
No.
Okay. On the underwriting leverage side, it looks like it's just moving up slightly. I think I've asked this question before, just to clarify. Given your movement and mix of business a little bit, where do you feel comfortable taking underwriting leverage to?
I would say about two and a half times.
That's with the addition of commercial business and the Workman's group as well?
Yes.
Okay. Essentially, if you close in on that level, depending on profitability, at what point on the dividend payout ratio do you guys have to maybe slow down on the dividend?
The dividend payout ratio, probably this quarter was, what, close to about 100% or just a little bit under 100%. There's a lot of factors that go into the dividend payout ratio. We take a look at our earnings, our prospects. It's something that the board decides every quarter. We feel that today, we have a pretty good capital position, where in years that we haven't really earned the dividend, we've been able to pay out a dividend. It's something for the board to evaluate every quarter. At this point, with the amount of capital position that we have, we feel pretty comfortable where we're at. To your question, if we get up to 2.5 times leverage, and we're using more of our capital to write more business. I think your question is, what happens to the dividend at that point?
We obviously don't expect, though, to have earnings at this level for long periods of time. Our combined ratio was 98.5% in this quarter. We don't expect that 98.5% to continue for a long period of time. We do anticipate that our margins are going to improve.
Okay. On the realized loss side, I know you're talking about the payout ratio on the operating side. In the first half of 2014, you had more realized gains than the last 4 quarter losses. You have had 4 quarters of realized losses. Is there something that you're invested in, or is there some change that you're making that there's been these linked losses on the realized investment portfolio?
I'll let Chris talk. As we mark our securities to market, they're sensitive to changes in market interest rates. Because as you know, most of our portfolio is primarily fixed income. We flow those changes through the P&L, so we get the negatives when interest rates go up, but the positive when interest rates go back down as far as our P&L adjustments.
I apologize. The bulk of your portfolio held for trading?
The entire portfolio is trading.
I'm assuming obviously you've put some thought into that. What is the reason for doing that versus available for sale?
When the new pronouncement came out, I think it was FAS 159 a few years ago. We evaluated the accounting, we felt that the true measure of our earnings is really our core operating earnings. We had found that when you were having to write down securities due to temporary market durations, you weren't able to get the benefit of when the market bounced back. We just felt like it was better for the company to flow all the changes through the P&L and mark everything to market as a trading portfolio.
Okay.
There was always discussion with the auditors every quarter with respect to what was permanently impaired, what was other than temporary. The fact of the matter is, whether you run it through your balance sheet or your income statement, the numbers are there. To us, it's simpler, and if you back out the realized gains or losses, you get to your operating earnings.
The last question I have is just on policy in force connected to the advertising. It looks like you did have another uptick in personal auto policy in force, flat year-over-year. I would imagine that maybe year-over-year comparison probably isn't most reflective, given the fact that you've implemented a bunch of rate increases. How are you viewing that flat year-over-year but up on a sequential quarter?
In California, we have a very large book. The new business probably represents about 10% of our premiums written, and you have 90% coming in from renewals. New business, although it has an impact, it's obviously not as big an impact as renewal business. Our California private passenger auto new business sales were up something like 9%, and they were up 11% company-wide. We are seeing some nice new business sales growth, which should help our renewals in future years. In 2014, my recollection is that in 2014, our new business sales were down quite a bit over 2013, which had an impact this year on renewals. We feel relatively comfortable in our Mercury Insurance Company, where we just implemented the 6.4% rate increase. Our retention did go down slightly, but that actually went down less than we had anticipated.
That was good news so far. It's only been one month into that rate increase, but we were anticipating a larger reduction in retention than we have seen so far.
On the advertising side, I believe most of your advertising has been more of on a national plan as opposed to focused. How has that turned out in states outside of California?
Most of the advertising obviously is coming in in California. The TV advertising, it's a national cable ad, and it's national. In addition to that, we get leads from lead aggregators. We buy leads. We do online advertising as well. It encompasses a whole lot of avenues for us to try to get new business. Outside of California, I think our PPA count new business was up something like 15%. It's having a positive impact. When we take a look at how effective our advertising is overall, we take a look at the lifetime value of the premium that we expect from all these new business sales from the advertising, and we deduct the cost of the advertising, obviously.
We deduct the cost of the commissions, which are lower, much lower than our stated commissions, because we pay much less commission on this type of business that we get through our advertising. We deduct lead fees that we get from our agents. We take a look at the lifetime value of that premium, deducting all the expenses, including the advertising. Right now, we're not recovering quite all the dollars. We're recovering pretty much most of the dollars. I will say, when you add back the anticipated underwriting income from the sales generator or the premium sales, we're definitely in the black. We need to improve. Overall, I would say it's been a decent investment in the advertising.
Great. Thank you for taking my questions.
Sure.
There are no further questions at this time.
I'd like to thank everyone for joining us this quarter, and we'll talk again next quarter.
Thank you. Appreciate it so much.
This concludes today's conference call. All participants may now disconnect.