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 the number 1 on your telephone keypad. If you would like to withdraw your question, please press 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. 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. The company posted operating earnings of $0.81 per share compared to $0.53 in the third quarter of 2013. The combined ratio was 96.7% compared to 99.2% in the third quarter of 2013. Higher average premiums per policy were a major contributor to the improved results.
Also adding to the positive results was a 5.5% improvement in investment income due to higher invested asset balances, favorable reserve development of $2 million and a low level of catastrophe losses totaling just $1 million for the quarter. Written premiums continue to grow, although the 2.2% growth rate posted this quarter is the lowest quarterly growth rate this year. Rate increases have had a positive effect on premiums written, but policies written and policy in force counts have declined. During 2014, the company took the following rate actions. A 6% rate increase was implemented in January for our Mercury Insurance Company California personal auto book of business, which represents about half of our company-wide premiums written.
An eight and a quarter percent rate increase was implemented in January for our California homeowners book of business, which represents about 10% of our company-wide premiums written. A 6.9% rate increase was approved and went into effect in October 2014 for our Cal Auto California personal auto book, which represents about 15% of our total written premiums. We have taken rate increases in several states outside of California during the first half of 2014, which has led to significant increases in new business volumes in those states. We have a 6.9% rate increase pending DOI approval in our Mercury Insurance Company personal auto book of business. California continues to experience positive premium growth. States outside California have experienced negative growth.
The company continually balances growth and profitability objectives and addresses these through many means, including rates, underwriting, expense initiatives, advertising, and distribution. For 2015, we expect to improve our growth prospects outside of California through the rate changes taken this year, coupled with increased advertising spend and distribution. As we have previously reported, we have adjusted our combined ratio targets outside of California to be above a 95% combined ratio as we have priced our products to expense targets we have not yet achieved but expect to achieve over the next several years. Loss costs for California personal auto are in line with our expectations. Both frequency and severity trends are in the low single-digit range. They are slightly elevated compared to the first half of the year.
In other states, loss trends vary a lot by state but are generally moderate, with the exception of New York, where trends have been running high. For California homeowners, we are experiencing increased loss severity trends. Because the eight and a quarter percent rate increase in January was preceded by a five and a half percent rate decrease, the results for California homeowners have not improved yet this year. We have taken additional steps to improve our California homeowners business, including the rollout of a new aligned homeowners product in the third quarter. The new product has led to an increase in policy applications. We recently announced the planned acquisition of Workmen's Auto Insurance Company for $8 million, which is expected to close in the first quarter of 2015, pending regulatory approval.
Workmen's is a L.A.-based non-standard auto writer that is expected to produce about $30 million in premiums in 2014. This acquisition fills a strategic niche for Mercury, as Workmen's non-standard auto product will complement Mercury's more preferred product offerings. Mercury's product offerings, including its policy provisions, are more preferred and mid-market and are not catered to the true non-standard market. We believe Workmen's auto product will allow Mercury to better penetrate the non-standard market in California. Year-to-date, the company posted a combined ratio of 96.4%. Looking forward, our fourth quarter results tend to be the worst of the year. We generally expect our fourth quarter combined ratio to be higher than the rest of the year by several points 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 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.
As a reminder, if anybody would like to ask a question, please press star one on your telephone keypad. Again, that is star one on your telephone keypad. Your first question comes from Vincent D'Agostino from KBW. Your line is open.
Hi. Good morning, guys.
Morning.
Just to start, so on Workmen's, so I can appreciate the comments you guys had made about filling the non-standard kind of slot for you guys. What I was kind of curious about is as that closes and you kind of bring that in-house, what type of changes, if any, that you'd be making to their filings, and then how, just because from looking at it's been kind of challenged from a profitability standpoint on their end, but I assume that you guys would be taking some of your expertise and leveraging that on a go-forward basis. I'd be kind of just curious what you guys would be looking to do with that going forward.
Well, with respect to the profitability, Workmen's just recently implemented a 6.9% rate increase in California. We'll be taking a look at whether or not we need additional rate increases in 2015. We also believe, Vincent, that increasing their production is going to provide them with some needed efficiencies. Their LAE and expense ratios are just much too high. Just to clarify something, in order for us to offer a third non-standard price point in California, the Department of Insurance and California statutes require us to qualify for what's called a super group exemption, which means that certain operations, including sales, marketing, pricing, and underwriting, have to be separated from our other operations. The Workmen's purchase is going to allow us to qualify for this super group exemption. Their operations will be managed separately from our other operations.
It's a way for us to better compete in this non-standard market. Now, there's certain back-office operations that we are allowed to combine, that includes, for example, claims, finance, human capital. Certain other operations do have to be maintained separately. We're going to take a look. Our Workmen's, I should say, is going to take a look at their overall rate adequacy. They're going to take a look at their segmentation. We're going to take a look at their distribution. Workmen's, I'm pretty sure, are going to be making some changes to all those aspects of the business.
Okay. Good to know. I think the structure now makes a lot more sense to me, that's definitely good. As far as looking at the policy in force changes, it looks like we've started the inflection point for both homeowners and auto. It also looks like the commercial auto growth has been pretty strong. Just as we think about those mix changes going into our model, I know you guys don't give us the sort of by-line loss performance anymore. As far as just thinking conceptually about how each of those products rank, growth outside of California, commercial auto, homeowners growth, how would each of those rank in profitability versus, say, just the core California auto product? The question is really getting at, as you grow in each of those buckets, should we anticipate margin expansion to the overall aggregate book?
Well, I think compared to California auto is I think what your question, Vincent. I think homeowners is running hotter right now. California homeowners is running hotter, although we have that rate increase that's still earning in, we have a new product. It is running hotter than our California private passenger auto. Outside of California, as I've mentioned before, we expect to run hotter outside of California than in California for the next several years as we're pricing our product to expense targets we haven't achieved yet. We have a goal to achieve certain expense targets by 2017, we're putting plans in place to achieve that. In the interim, we can expect that the profitability outside of California is not going to be where California's at. I don't know if that answers your question or not.
On commercial auto, sorry if I missed it, that would be a little bit better, I would assume?
Yes. No, commercial auto is an exception. Our targets in commercial auto are better.
Okay. Got you. Just a modeling question. As far as other expenses running a little bit higher, just wanted to see relative over the last few quarters, the tick up there, just to make sure from, again, from a modeling standpoint, I'm understanding the drivers.
On the expense run rate, we had some savings from last year's restructuring, a large portion of that was in claims and affected the LAE ratio. We did have some cost savings from our commission changes outside of California that didn't go into effect until the second quarter, those will take a few quarters to fully impact in the policy acquisition costs. In addition, although we reduced some costs outside of California, our premium volume is down
You have some fixed costs spread over declining premium volume outside of California. Finally, the expense ratio was higher this quarter due to some higher profitability related accruals that we've booked.
Okay.
With that, we're still kind of projecting a normal run rate as expense ratio around 27% this year.
Got you. The $58.5 million this quarter in other operating expenses versus, say, the $53.8 million last quarter, that's going to be roughly mostly the costs outside of California spread over fixed costs spread over kind of a shrinking premium base?
Partially, also some of the profitability related accruals.
Got you. Okay.
Our margins are better this year than they were last year, the profitability related accruals are up.
It's always a good thing. Just, I guess one or two last ones. On the litigation issues with the Notice of Non-Compliance, I'm always just eager to get an update there if there is one.
There was actually a call on the 2004 non-compliance. There was a call with a judge last Friday to get an update on where the judge was at. Basically, the judge says that they expect to issue a ruling in mid-November, is what the judge told the parties. That ruling then goes to the commissioner. It may or may not become public for another 30 days. It goes directly to the commissioner. We're probably looking, if the judge does send out his ruling in mid-November, and if the commissioner waits the full 30 days, we're probably looking mid-December, late December before we find out the ruling, Vincent. You get that, Vincent?
Your next question comes from Gary Ransom, from Dowling & Partners. Your line is open.
Yes. On Workmen's, is there any overlap with the agency force that they operate through, or is there any new agents that you're bringing in in that acquisition?
I'm sure there's going to be some overlap. As an example, in the L.A. Orange County area they don't have that many agents right now. Very, very few agents relative to the size of the market. They probably have, I don't know, something like 30, 50 agents in the L.A. Orange County area. There's a lot of opportunity from our standpoint to increase distribution.
Okay. On the homeowners product, can you tell us a little bit more about what the features of the new product are that make it attractive?
Sure. I'll let Robert Houlihan handle that one.
With the new product, there's three areas where we've improved significantly. We've moved to our Guidewire platform, that provides much better technology than we had for our previous product. We've also added a lot of new feature to the program. Before, some of our coverages fell short of what the competition offered. Now we sort of match those coverage and expand and have some coverage features above and beyond what's offered by many of our competitors. Lastly, we've moved to by-peril rating, which we think gives us a much more accurate rating going forward. We've seen we off-balanced to zero relative to the pricing on our old product. We've seen about a 25% increase in new business applications with the new program. About 5% or so of those are rewrites. The net 20% we see is sort of incremental new business.
Can you give an example of what the new coverage features were?
Yes. Some of the new features, we have water backup coverage, service line coverage. We have a Home Systems Protection program, that covers breakdown in any mechanical features in the household. We have Identity Fraud Expense and resolution coverages with the new product.
Okay. Thank you. Just one broader question on capital adequacy. Could you talk a little bit about where you stand or what your view is of your capital base at this time, being mindful that you're adding on the $30 million of premium next year and your payout ratio is relatively high. Where do you stand right now?
We believe we stand, we're in a good position with respect to our capital position. We're riding at about 1.9 to one. Obviously, the acquisition of Workmen's is not really going to move the needle, at least in the short run. We have always maintained a dividend policy backdating, I believe back to 1985, when the company went public. The board of directors has continually maintained that dividend policy for all these years. That's how we distribute back our capital. The capital position that we do have today
The strong capital position allows us to maintain this dividend in times where maybe the earnings aren't as we would like. Overall, I think that we're comfortable with the capital position that we have today.
Okay, thank you. That's it for me.
Your next question comes from Allison Jacobowitz from Bank of America. Your line is open.
It's Allison Jacobowitz. Most of my questions have been answered, but I was just wondering if looking at the policies in force and the pressure in the auto business, if there's just any more color or details you can provide as to the environment inside and outside of California.
Inside California, the environment is competitive, we have taken rate increases in California that have impacted our new business sales. That has had a negative impact on our policies in force here in California. Outside of California, we reduced rates, Allison, as I mentioned earlier in the year, that's had a very significant impact on new business sales outside of California. Albeit average premiums are down when you take a rate reduction, we believe that in 2015, our new competitive rates, coupled with some increased advertising spend that we plan on doing, will allow us to grow outside of California in 2015. In California, it's going to remain a challenging environment to grow significantly in California, excluding our acquisition of Workmen's and what we may be able to do with the Workmen's acquisition in a non-standard area.
Great. Thank you.
Sure.
Your next question comes from Ron Bobman from Capital Returns. Your line is open.
Hi, good afternoon here. I guess good morning there. I had a question. You made a comment, Gabe, I think regarding the Workmen's and the non-standard concentration, in essence, that Workmen's complemented your non-standard book. I guess maybe it's weak in certain areas. Could you elaborate on sort of the elements of your existing non-standard book and where it's strong and where Workmen's sort of fills the void? Thanks.
Sure. Let me just first start by saying that our preferred company in California, that's where our statutory good drivers go into, in Mercury Insurance Company, and the non-statutory good drivers go into Cal Auto. That doesn't necessarily mean it's a true non-standard company. That's just by statute that we have risks that are by statute good drivers go into a preferred company, and by statute that are non-good drivers go in Cal Auto. Now, we don't have, for example, the policy provisions of typical non-standard riders are much more restrictive than what we have as an example. Workmen's has those types of restrictions. We don't have agents that are appointed in many areas that are appointed by really true non-standard carriers. It's a different market. We think it's a sizable market here in California.
It's probably over a billion-dollar size market here in California for what I'm labeling true non-standard versus our historical non-standard here in California for Cal Auto, which is our non-standard carrier here. There are differences between the two.
Gabe, thanks. Could you just elaborate what you mean by on that restrictions with my first follow-up?
Policy restrictions. What's afforded in the policy. What kind of coverages are afforded in the policy. There are more restrictions in non-standard type of policies where, as an example, there may not be any coverage for a permissive use driver in a non-standard policy. Where in our policy, we provide the coverage for that.
Okay. That helps. Thanks a lot, gentlemen.
Sure.
Again, if anybody has a question, please press star one on your telephone keypad. Your next question comes from Ken Billingsley from Compass Point. Your line is open.
Thank you. I just had a couple questions on the non-standard business, I understand you're talking about the Cal Auto as what's a little different than Workman's you just bought. What % of your business would you consider not prime? I guess maybe historically you would have considered your non-standard business prior to Workman's acquisition.
Well, I think Cal Auto represents about, what, 15% of our auto book. Is that?
Of our.
The total book. No.
Total book.
I would say it's closer to 25%, probably of our auto book, of our California auto book, something in that neighborhood.
Was there anything that prevented you from putting in some of those restrictions and building out the Cal Auto book, or did you specifically need or desire to create that third bucket to essentially target customers depending on their risk profile?
We needed that third bucket. As I mentioned earlier, we needed that third non-standard price point. To get that done I mentioned earlier, we need that super group exemption, which I described earlier in the call.
You needed the super group exemption and that stimulated the Workmen's acquisition?
I'm sorry?
I guess my question is it something that you could not have developed in-house, or was the Workmen's just attractive to maybe accelerate the pace of creating that group?
Much more difficult to do in-house from approval and regulatory standpoint.
Okay. The last question I have is regarding comments for outside of California, and I apologize if I've misinterpreted earlier statements from calls. Did I understand that your expense ratio outside of California, the agent commissions that you pay are a little bit higher than what you pay in California? First off, is that true? If so, can you talk about how much more it is and maybe how that has helped develop business?
No, it's not accurate. It's actually less than it is in California, by quite a few points.
Outside of California, you are paying smaller agent commission.
Yeah
will that change as you're looking to grow to be competitive or as you mix your advertising or will you expect that to stay the same?
We expect that to stay the same. We made some changes earlier in the year with respect to compensation commissions, but we expect that to stay the same going forward.
Great. Thank you for taking my questions.
Sure.
At this time, I have no further questions. I turn the call back over to the speakers for closing remarks.
We'd like to thank everyone for joining us this quarter, and we look forward to speaking with you in the fourth quarter. Thank you very much.
Thank you, everyone. This concludes today's conference call. You may now disconnect.