Good afternoon. My name is Laurel, and I will be your conference operator today. At this time, I would like to welcome everyone to the Mercury General 2014 first quarter earnings 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. At that time, if you would like to ask a question, 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 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.
Thank you. I'll now turn the call over to Gabriel Tirador, President and CEO. Please go ahead.
I would like to welcome everyone to Mercury's first quarter conference call. I'm Gabe Tirador, President and CEO. In the room with me is Ted Stalick, Senior Vice President and CFO, Robert Houlihan, Vice President and Chief Product Officer, and Christopher Graves, Vice President and Chief Investment Officer. Before we take questions, we will make a few comments regarding the quarter. Company-wide, we experienced our 13th consecutive quarter of positive premium growth. Premiums written grew 5% in the first quarter of 2014 and were driven primarily by higher average premiums from various rate increases in California. Premiums written outside of California declined 4.7% in the quarter. Our first quarter operating earnings were $0.77 per share compared to $0.69 per share in the first quarter of 2013.
The improvement in operating earnings was primarily due to improved results in our California private passenger auto business and the absence of restructuring charges as compared to the prior year. The improvement in our California private passenger auto business was partially offset by worse results in our California homeowners business and in our operations outside of California. Excluding the impact of catastrophes, restructuring charges and favorable reserve development, the combined ratio was 96.6% in the quarter, compared to 96.7% in the first quarter of 2013. Favorable loss frequency during the quarter contributed to the improvement in our California private passenger auto results. Higher average premiums aided the results this quarter.
In our non-standard California company, a 6.9% rate increase that went into effect in July of 2013 is now being fully earned. In addition, a 6% rate increase in our preferred auto company went into effect in January 2014. However, the effect of this rate change had a minimal effect on earned premiums this quarter but will have a greater effect next quarter and will be fully effective in the third quarter of 2014. Our California homeowners combined ratio was over 100% in the quarter. Both frequency and severity were up in the quarter. In addition, a 5.5% rate decrease mandated by an administrative law judge that went into effect in May 2013 negatively impacted the results this quarter. However, as we previously reported, we implemented an 8.25% rate increase in our California homeowners business on January 25, 2014, which should improve results going forward.
Excluding catastrophes, our operations outside of California posted a combined ratio slightly under 100% for the quarter. As we have previously reported, we have taken various actions to improve our cost structure outside of California. These changes, coupled with our review of loss indications, allowed us to reduce private passenger auto rates in five of our markets in the first quarter of 2014. The rate reductions had an immediate positive impact on new business sales in all of these markets. Although we expect our new business sales outside of California to improve as a result of our rate reductions, we don't expect premiums written to grow in the near term as it will take some time for new business sales to impact premiums written and offset the lower average premiums from the rate reductions.
Our historical targeted combined ratio for private passenger auto is 95%, and we generally price our private passenger auto product to that target. However, in states outside of California, we are pricing our product to expense targets that we have not yet achieved but expect to achieve over the next several years. This pricing strategy will allow us to be more competitive than we otherwise would be, but it means that our margins will be lower than our long-term target for the next few years. With that brief background, we will now take questions.
Once again, ladies and gentlemen, if you would like to ask a question, please press star then the number one on your telephone keypad. We'll pause for just a moment to compile the Q&A roster. Your first question comes from the line of Vincent D'Agostino with KBW. Your line is open.
Hi. Good morning, everyone.
Good morning, Vincent.
Just to go back to last quarter, I wanted to try to make sure I understood some of the comments on auto frequency. Last quarter, there was a little bit of drag from increased driving in California, and then some of the VMT data we track might suggest that that kind of played out again. Just from a frequency standpoint, it seemed like maybe people were driving more, but because there was less dangerous road conditions, that even though more mileage, there were fewer accidents, and that's what drove your comment on the frequency in California being favorable.
Are you talking about the fourth quarter or the current quarter?
Trends in fourth quarter kind of carrying over into first quarter with increased driving. In first quarter, maybe even though there was increased mileage, if, say, there wasn't wet roads and that kind of thing, maybe more mileage here didn't translate into more accidents.
That's what we attributed it to, Vincent. That's correct.
Okay, good. Just to, obviously, you're here on the East Coast, I don't get to experience the good weather in California. It seems like maybe the weather was favorable. There was some drag on homeowners this quarter. I was just hoping to reconcile what maybe any sort of impacts from non-cat weather would be if we thought about trying to look at an apples comparison with homeowners clearly here being an issue, or not an issue, but something to try to normalize.
Well, we had the 5.5% rate reduction that we had to take in May of 2013, a year ago, almost a year ago. That impacted, obviously, our average premiums, which impacted the combined ratio this quarter more so. Although, as I mentioned earlier, we have an 8.25% rate increase that went into effect in January. These are annual policies, so it does take a little bit of time to be reflected in earned premiums. In addition to that, although we had very little rainfall in the first quarter in California, although we did have about five inches of rain over, I don't know, a three or four-day period in California over a weekend. We estimate that impacted our California results, I think, by a couple million dollars. Those were the two major highlights for California.
We also booked a little bit of adverse development in California. For homeowners.
For homeowners. I'm talking about homeowners, yes.
Okay.
Just on the outside California growth as far as just the rate revisions and kind of pricing that to a longer-term pricing goal. As far as the next year or two, would you have any ballpark figures on what we might expect from an impact to the margin?
I think that outside of California, it'll vary by state. The larger states are probably going to be closer to where we need to be because of the scale. Overall, I think it'll be pushing closer to 100% combined ratio than the 95.
The 100 is outside of California.
Outside. We're talking about outside of California, yeah.
Okay, great. I have a few others, but I'll requeue. Thank you.
Okay.
Once again, ladies and gentlemen, that's star one on your telephone keypad to queue up for questions. Your next question comes from the line of Alison Jacobowitz with Bank of America.
Thanks. I was just wondering if you could talk a little bit about the expense ratio. It seems despite the restructuring charges and everything you've done, the overhead ratio doesn't look like it's coming down too much. How are you thinking about that going forward?
We're expecting, Alison, that that's going to run at around 27%, hopefully a little under 27% the rest of this year. We have a longer-term goal to get that down lower, but that's kind of what we're looking at it for the near term.
Okay. Thank you.
Your next question comes from the line of Vincent D'Agostino with KBW. Your line is open.
Yep. Thanks for taking the follow-ups. Just a few quick ones. Following up on Alison's question on the expense ratio. Looking at the acquisition ratio, I was a little surprised that it year-over-year was up, I just think with some of the changes you guys are putting in place on the cost structure outside of California that I maybe would have expected to see that being a little more stable. With the nice loss ratio in California, I was just kind of curious if there might have been some performance commission impact there this quarter.
Well, one of the reasons is the mix is a little higher mix in California as compared to prior years. Our California business has grown, outside of California has not grown. We tend to pay higher commissions here in California as compared to outside of California, as an example. You also have the impact of the fact that even though we've taken some cost reduction measures outside of California, I mentioned earlier that our premium volume is down outside of California. You have some fixed costs that we have reduced, you also have a situation where outside of California, our volume has declined somewhat. In addition to that, some of the expense measures that we're taking, including commissions, have not really taken effect in this first quarter.
You'll see some of those changes to commissions outside of California be effective probably starting in the second and the third quarter of this year. Those are three, I would say, major reasons.
Okay. Good color. Just looking at the balance sheet, looks like the debt maybe went up a little. I think in the 10-K, there was mention of a $20 million draw on the credit facility. I just want to check in and see if it has gone up. Second, would just be if that's the case, just sort of what would the plans for the proceeds be?
We've increased our financial leverage by taking some draws on our credit facility. I think we're up to almost 13% debt to total capital. We wouldn't expect that to go much north of 15%, if it does. I'll let Chris talk to where we're investing the funds. In general, we're looking at really favorable lending terms from the bank on our credit facilities, and it's provided us with financial flexibility in our holding company and the opportunity to increase our level of investments to enhance our investment income.
Yeah. This is Chris. The objective with the proceeds there is to find income opportunities up in the holding company. We are also looking at total return for the capital appreciation. It is somewhat of, I guess, an arbitrage opportunity from what the lending costs are versus what the market opportunities are currently available for us.
Okay. That's good. Just one quick one, and then I'll wrap up. Just going back to some of the pending issue before the ALJ. I was just kind of curious, just thinking about that as far as the timeline. It is my understanding that we'd probably get an update from the ALJ sometime in June, then the commissioner would have until September or October to make a final decision. I guess, does that timeline seem correct?
Are you referring to the 2004 Notice of Non-Compliance-
Yes
issue? The record has technically not closed, Vincent, although it's my understanding that it's ready to close. All administrative issues have been resolved by both sides, and I think the record is about ready to close. Once that record is closed, I believe the judge has something between 60 and 90 days to make a decision and send that decision up to the commissioner, which then he has, I believe, something in the same neighborhood, 30 to 60 days, for him to render his opinion.
Okay. Good to know. We'll stay tuned. Thanks for the answers, guys.
All right. Thanks, Vincent.
There are no further questions at this time. I turn the call back to the presenters.
I'd like to thank everyone for joining us this quarter, we look to speaking to you again next quarter. Thank you very much.
This concludes today's call.