Good afternoon. My name is Mo, I will be your conference operator today. At this time, I would like to welcome everyone to the Mercury General Fourth Quarter Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' 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, 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, you may begin your conference.
Thank you very much. I would like to welcome everyone to Mercury's Fourth Quarter conference call. I'm Gabe Tirador, President and CEO. In the room with me is Mr. George Joseph, Chairman, Ted Stalick, Vice President and CFO, Robert Houlihan, Vice President and Chief Product Officer, John Sutton, Senior Vice President Customer Service, and Christopher Graves, Vice President and Chief Investment Officer. Before we take questions, we will make a few comments regarding the quarter. Our Fourth Quarter 2012 operating results were disappointing. Our combined ratio was 109.8% in the Fourth Quarter of 2012, compared to 99.4% in the Fourth Quarter of 2011. Our Fourth Quarter results were negatively impacted during the quarter by Hurricane Sandy, higher recorded frequency and severity, and adverse loss reserve development. Hurricane Sandy losses in the quarter were $28 million, of which approximately $22 million came from our homeowners business and $6 million from auto.
In California, our Fourth Quarter has historically been our highest frequency quarter due to weather and increased driving. This quarter was no exception, in fact, Fourth Quarter 2012 California personal auto loss frequency was higher than in the Fourth Quarter of 2011 and was 6% higher than the frequency recorded in the Third Quarter of 2012. In addition, as we evaluated our 2012 accident year results, we felt it was appropriate to increase our bodily injury severity picks for the entire 2012 accident year. We believe the increase in severity we are seeing is in part due to more severe accidents. Overall, we have experienced an increase in medical bills and medical procedures such as epidural injections. The $9 million of adverse prior year reserve development in the quarter came primarily from a class of commercial auto that the company stopped writing in 2011.
In California, we increased our private passenger auto rates approximately 4% effective October 26, 2012. This rate increase had a minimal impact on fourth quarter results as very little of the rate increase was earned. Although the 4% rate increase is going to aid our results in 2013, we believe the 4% is sufficient enough in order for us to reach our profitability target. Accordingly, we recently filed for a 6.9% rate increase in our non-standard California company and are in the process of finalizing a rate filing for our preferred auto California company. We believe the rates requested are supported by the underlying data. In our California homeowners line, we received a decision from the administrative law judge on our pending rate filing. The judge recommended a rate reduction of approximately 5.5%.
The commissioner rejected the administrative law judge's proposed decision and referred the matter back to the administrative law judge to gather more evidence. The commissioner recently issued a ruling to disregard his order to gather more evidence. We expect a final ruling from the commissioner in the near future. We strongly disagree with the administrative law judge's proposed decision. In fact, our actual results clearly demonstrate that the judge's trend selections were significantly too low for our largest homeowners form. Accordingly, we recently filed for a 6.9% rate increase that reflects our actual results. We will continue to pursue rates that allow a fair rate of return in our homeowners line. On a more positive note, our results outside of California continue to improve. Excluding the impact of Hurricane Sandy, our operations outside of California posted a combined ratio under 100%.
Over the past three years, we have taken significant rate action in most states outside of California, the impact of those rate actions is having a positive impact on our results. We believe our underlying results outside of California will continue to improve as more rate increases are taken where necessary and rate increases taken in 2012 continue to earn in during 2013. As we previously announced, we are consolidating our claims and underwriting operations located outside of California into hub locations in Florida, New Jersey, and Texas. Although we expect a one-time charge of approximately $8 million-$13 million in the first quarter of 2013, the new structure will improve our long-term profitability and allow us to scale more efficiently as we grow our business outside of California.
Lastly, premiums written continue to grow due to the combination of rate increases and increases in policies in force. Premiums written grew by 5.9% in the quarter, the largest quarterly increase since the first quarter of 2006. With that brief background, we will now take questions.
Once again, ladies and gentlemen, at this time, I would like to remind everyone, in order to ask a question, please press star, then the 1 on your telephone keypad. Again, that is star 1 to ask a question. We will pause for a brief moment to compile the Q&A roster. Your first question comes from the line of Alison Jakubowicz with Bank of America.
Hi. Thanks. Two questions. One, I was wondering if you could talk about your investment income results. It looks like the yield has been improving for the past several quarters. I just want to know what's going into that and what we might see as we go forward. The second one is, if I got it correct, you mentioned that in this quarter you trued up your loss picks for the year for, I think you said BI severity. I'm just wondering what the dollar amount impact was for the losses for that, just so I can get to a true underlying accident year loss ratio ex the CATs and the reserve changes for prior periods.
Chris, want to go ahead and take that?
Sure. Yeah. Hi, Alison. Good morning.
Hi.
On the income aspects, we've been getting a little more aggressive with our common stocks, more dividend plays. I didn't look at the exact amount, but we probably picked up some of the special dividends that came through at year-end as well. We're trying to get more fully invested with some of our cash, pushing a lot of that not just into stocks but also into more fixed income. Just on the whole, that's where you're getting that incremental pickup.
With respect to the second question, if I understood your question correctly, Alison, we don't evaluate our accident year results on a quarterly basis. We kind of take a look at the whole year. My suggestion to you would be to take a look at our year-to-date results and back out the development that we provided in the release. If you do that, and I think if you back out that, if you back out the CAT, I think you're right around 99.5, somewhere in that neighborhood as far as the underlying results. Going forward, we expect our underlying results outside of California to improve because we believe that the rates that we've taken are going to offset the trend. We expect margin improvement with respect to our operations outside of California.
In California, the 4% is probably close to offsetting potential expected loss trends, but clearly not enough to reach our profitability target. That's why we've made these additional filings in Cal Auto of 6.9, and we expect to make another filing in Mercury Insurance here probably within the next few weeks.
Okay. Thank you.
Okay.
Your next question comes from the line of Vincent D'Agostino with Stifel Nicolaus.
Hi, good afternoon.
Afternoon.
Just a follow-up from Alison's question. In regards to the higher BI picks, would it be safe to say that if loss cost trends remain mostly stable or where they're at now, would you expect adverse reserve development in 2013 to subside? Is there anything else in terms of those puzzle pieces that need to fall together for that to taper off?
We wouldn't expect adverse development in 2013 if the trends that we're selecting continue into next year.
Okay. Perfect. A California Auto question mostly again. In terms of the recently passed auto parts regulation, is there any chance that you'd be able to estimate if there'd be any loss impact from those regulations? Maybe if we could just do the math ourselves, if you happen to know what % of auto parts from repairs come from aftermarket versus newer recycled OEM, and if there's any price differential between the two?
Well, this new regulation goes into effect on March 30th. It's really difficult to estimate the impact at this point. Obviously, the potential impact of the regulation is a reduction in the number of aftermarket parts used in the repair of vehicles. Aftermarket parts are generally more cost-effective than original equipment manufactured parts. In addition, there's a potential of less competition from aftermarket part manufacturers that can lead to an increase in OEM part prices. Just to give you a little bit of an idea, about half the cost associated with the repair of vehicles are parts costs, about half. Now, at Mercury, most of the dollars that we spend in repair vehicles are OEM. The majority of the dollars that we spend are on OEM. However, we do use some aftermarket parts in some instances. This regulation has the potential to increase our costs.
All I can tell you right now is that we're going to monitor the results very closely.
Okay. I'm just going to go on a limb and assume that the 6.9% increase doesn't yet include any sort of estimate for the increased auto loss cost from the parts side.
That is correct.
Perfect. That's actually really helpful. The last one for me. I was wondering if we could get any sort of update on the Buy Button program in California and how that's working out in terms of new business how agents are kind of working with that.
Well, it's pretty new. We launched the Buy Button in late October. All that I can really tell you right now is that we're closely monitoring the results. We're making changes. We've made quite a few changes already in the last couple of months as we learn more about the online customer experience. It's just really too early for us to comment on the program in general, other than to say it's going as we expected. Generally, it's going as we expected. We're just adjusting as we learn more. I think we'll probably have more to be able to say on the Buy Button probably in the next maybe 6 months or so as we gather more evidence with respect to the Buy Button. It's going generally as we expected.
All right, great. Thanks for all your answers.
Okay.
Your next question comes from the line of Ray Iardella with Macquarie.
Thanks, good morning to you guys, I guess, out there on the West Coast. Couple of questions from me. First, I guess sort of more strategic. Maybe talk about the decision, the PIF growth that you're experiencing over in the California business, compare that against, I guess, perhaps results that are in the high 90s in terms of combined ratio or not. I guess, use your words, Gabe, towards your profitability targets.
Well, we implemented a rate increase of 4% last, I guess October 26th it was in California. It had, I would say, a very slight impact on our new business applications and very slight impact on our retention. The rate increase that we took in late October did not have a real big impact on our production levels. We believe that in order for us to hit our historical profitability target of 95%, we need more rate based on the trends that we're seeing. At this point, if your question is, are we doing anything to slow down business? At this point, the answer is no. I will say that I expect that the new business year-over-year growth that we expect in 2013 in California, new business sales growth, is going to moderate as compared to last year.
The comparisons are going to be more difficult, because we grew so much as far as new business counts in 2012. I think the comparison's going to be much more difficult, although I still expect to see some new business sales growth. We're not at a point, and I think that's where you're going, I'm not sure. We're not at a point that we're doing anything to try to limit the amount of business that we're getting at this point. We're filing for our six-nine in Cal Auto, we're filing for our rate increase in our preferred company as well.
Okay. No, that's certainly helpful. It's just, to me, it seems like you guys seem pretty upbeat on sort of the prospects outside of California, and I'd say a little more subdued in California. It seems like, to me, sort of just mathematically, it seemed to be growing outside of California and kind of where to be focused on. I think that's definitely the case.
Yeah, we're focused on definitely on growing our business outside of California. That's one of our strategic objectives is to continue to grow outside of California. The regulatory environment here in California is challenging right now, but we've been able to weather these types of environments in the past, and we're working through the system to try and get the amount of rate that we believe that we need to get a fair rate of return here in California.
Okay. That's helpful. Just want to make sure I heard the commentary right on the development in the fourth quarter. That wasn't personal auto related. That was commercial auto, and that class of business is no longer being written. Did I hear that correctly?
That's correct. Year to date for the 12 months, most of the development was from personal auto BI severity change in estimates. Most of that really came in the first half of the year. In the fourth quarter, we had a runoff of a discontinued commercial auto line that we stopped writing in 2011, and there was some readjustment of the reserves for that. That's a large chunk of the development we saw that came through in the fourth quarter.
No, that's helpful. Just trying to get a sense of whether or not those reserves have held up in California personal auto, and it seems to be the case. The other two questions, I guess, kind of more on the portfolio side. The realized gains and losses. I know you guys classify your portfolio as trading, so it's fair value. Maybe can you give us an idea, are those sort of true gains on sales or is that just fair value changes flowing through the income statement?
It's really both, but generally, most of it is mark to market and stuff that we haven't sold. Although I think there was some realized gains this year on actual sales.
Was that in the quarter as well, or do you not have that in front of you?
Yes. Most of it's going to just be mark to market changes.
Okay. Sticking sort of on the portfolio. The duration, I know it includes short term. It looks like it ticked down to 2.8 years, I believe, from 3.3 years. Anything in particular? Are you guys going shorter in the duration of the portfolio, or is that a sort of a movement away from munis or anything going on that you could provide any additional color?
It's just more cash related. In fact, on the munis, I've been actually looking a little further on the curve.
Okay.
Not much. Most of the duration impact is just going to be from the heavy cash we're sitting on.
Okay. You guys plan to invest that. I think that was sort of the commentary for you too.
Yeah. We are getting more aggressive at pushing that into the market.
Okay. Lastly, can you just talk about net premium surplus, kind of where you guys feel comfortable operating at sort of in this environment and given the growth you guys are seeing?
From a capital position, you're saying?
Yes.
I think we're running at 1.8 times right now. This company has been as high, I don't know, as three or more. Mr. Joseph is pointing at me. It's been even higher than that. I think I would feel comfortable in the neighborhood of two and a half times, somewhere in that neighborhood, Ted.
That's probably the limit.
Yeah.
Okay. That's very helpful. Thanks again.
Okay.
Your next question comes from the line of Meyer Shields with Stifel Nicolaus.
Thanks. My questions have all been answered.
ladies and gentlemen, as a reminder, if you'd like to ask a question, that is star one. Your next question comes from the line of Ronald Bobman with Capital Returns.
Hi, good afternoon and morning for you all out there. I have a couple of questions. The Sandy losses, I was curious how many homeowners and auto claims you received from Sandy.
I don't have the exact numbers. It was over 2,000 claims in total. I don't have the breakout at hand, Ron.
Okay.
We can get that to you.
I'm sorry, did I cut you off?
Over 2,000 claims.
Total. Okay. What was the rough split unit-wise? Do you have like, was it that way much more?
I want to say we had something like 1,500, 1,600 homeowner claims, something in that neighborhood.
Thanks. The commercial auto program, whether it's $9 million or a meaningful portion of the $9 million, how did that number compare to sort of the reserve base for that commercial auto program?
Oh, it's big. I don't know. Do you have the percentage, Ted?
No. It's a commercial auto liability, so it does have quite a bit of reserves on it to begin with, but it was a reasonable percentage of the total reserve.
The increase that you took. I'm sorry, gentlemen. Sorry, I didn't mean to cut you off.
Oh, no. I was just going to mention that this kind of business too has higher limits usually, combined single limits of $1 million. That has an impact on the ability for some of these claims to develop higher. I'm sorry, what was your question?
Well, I'm trying to understand. Well, having stopped writing it in 2011, it's not all that mature. I was trying to understand how large the reserve base is for the commercial auto line. It doesn't sound like you have it at your fingertips.
Yeah.
I didn't realize that you wrote in N.Y. I knew that New Jersey was a target state, Florida as well, obviously California. I recognize that N.Y. produced some portion of your Hurricane Sandy loss because it's mentioned in here. How big is the N.Y. business that you do in auto and/or home?
For the year in N.Y., let me see here. In N.Y., we wrote something like close to $40 million in auto and about $20 million or so in homeowners.
Okay. Do you have any sort of underwriting action that you're going to do in the wake of Sandy, or are you generally happy with where you were relative to the coast or the type of vehicles or the production sources?
Well, we've been taking some action. Do you want to talk about that, Robert, in the New York, the Long Island area?
Yeah. We've been taking some targeted rate action on homeowners geographically on Long Island, particularly the South Shore of Long Island recently.
Post Sandy or even before Sandy?
It was before.
Before.
Before Sandy.
Okay. Okay, thanks, gentlemen. Appreciate the help.
Okay, thank you.
Thanks.
You have a follow-up question from the line of Ray Yerdella with Macquarie.
Yeah, thanks for taking the follow-ups. I have two. Just one, maybe if I can dig a little bit deeper into the consolidation of your claims and underwriting operations outside California. Just kind of curious, what do you guys think strategically in terms of being close to the customers? Is that very important in the personal lines business, or is that something you feel like maybe you can give up to get sort of a scale advantage or expense side advantage?
We don't really think it's as important anymore as it was maybe 10, 20 years ago. With the automation, you can pretty much underwrite a business from pretty much anywhere in the country in our view. We're going to have some local people from claims, as an example, that look at the cars, as an example. Our marketing people are going to be on the field as well, working with our agents. We are going to have some local people in each of these states. As far as the back-end stuff, where you're talking about the underwriting of the policies and the claims adjusting, we really don't feel that you're required to have a physical location in that state in order to be able to run that state successfully.
We think that this is going to provide us with the scalability that we really need outside of California going forward as we expand our operations outside of California.
Okay. Sort of last question, just sort of more strategic once again. When you guys think about potential consolidation with the industry, how do you think Mercury fits in as an organization, either as sort of a consolidator or consolidatee? Thanks again.
Well, historically, we've made maybe I think two purchases, I think, over the course of the 50 years of the company. We're not out there seeking any kind of acquisitions. From time to time, we get presented with opportunities. I think our last acquisition was a few years ago where we purchased our largest agent here in California because it was up for sale from Aon. It's not something that we're seeking. As far as being acquired, we're not looking to be acquired as well.
Okay, thanks again for all your answers.
Okay.
There are no further questions at this time.
Well, I'd like to thank everyone for joining us this quarter, and I hope to bring some better results for you in the first quarter of 2013. Thank you very much.
Ladies and gentlemen, with this, we conclude today's presentation.