Good morning. Welcome to the Primerica, Inc. second quarter 2016 financial results webcast. All participants will be in listen-only mode. Should you need assistance, please signal a conference specialist by pressing the star key followed by zero. After today's presentation, there will be an opportunity to ask questions. To ask a question, you may press star then one on your telephone keypad. Please note this event is being recorded. I would now like to turn the conference over to Kathryn Kieser, Executive Vice President, Investor Relations. Please go ahead.
Thank you, Chad. Good morning, everyone. Welcome to Primerica's second quarter earnings call. A copy of our earnings release, financial supplement, presentation, and webcast of today's call are available on our website at investors.primerica.com. Glenn Williams, our Chief Executive Officer, and Alison Rand, our Chief Financial Officer, will deliver prepared remarks. We'll open it up for questions. We reference certain non-GAAP financial measures in our press release and on this call. These non-GAAP measures have limitations, and reconciliations between non-GAAP and GAAP financial measures are attached to our press release. We will also make forward-looking statements in accordance with the safe harbor provisions of the Securities Litigation Reform Act. The company will not revise or update these statements to reflect new information, subsequent events, or changes in strategy.
Risks and uncertainties that could cause actual results to differ material from those exposed or implied are discussed in the company's 2015 annual report on Form 10-K, as reported quarterly by our reports on Form 10-Q. I'll turn the call over to Glenn.
Thank you, Kathryn. Good morning, everyone. I'll give you my perspective on our second quarter performance, as well as update you on our implementation progress for the Department of Labor's final fiduciary rule. Beginning on slide three, you can see in the second quarter of 2016, operating revenues increased 7% to $375.8 million, and net operating income increased 17% to $57.1 million from the prior year period. Results were driven by continued momentum in the term life business, as well as the seasonally strong trends historically experienced in the second quarter. Ongoing growth in term life issued policies, combined with strong second quarter persistency, led to a 14% increase in adjusted direct premiums year-over-year. Claims experience was below both historical levels and the modestly unfavorable level experienced in the prior year period.
The 30% increase in Term Life income before income taxes more than offset the modest headwinds experienced in our Investment and Savings Products sales and client asset values, which led to a 4% decline in ISP operating income before income taxes year-over-year. During the second quarter, we repurchased $40.6 million, or 800,000 shares of our common stock, for a total of $90.5 million or 2 million shares repurchased year-to-date through June. We expect to repurchase approximately $60 million of shares in the second half of 2016 and around another $125 million in 2017, in addition to paying stockholder dividends. Solid earnings as well as ongoing share repurchases in the second quarter drove a 27% increase in diluted net operating income per share to $1.19, and ROAE expanded to 20.2% from the year-ago period.
We expect ROAE to be in the 18%-19% range for the full year 2016. In addition to robust financial performance, we also experienced very positive distribution results in the second quarter. Our underlying business fundamentals continue to be very strong due to the enhancements made over the past several years, including changes to the licensing process. Building on this solid foundation, we've executed initiatives in the first half of 2016 to drive organic growth, including the launch of innovative mobile sales technology that appeals to a broad spectrum of representatives, and we have used effective competitions and incentives. As you can see on page four, our life license sales force grew 11% to 112,365 at the end of the second quarter versus a year ago and was up 4% from the end of the first quarter.
Year-over-year recruiting of new representatives increased 8%, and new life insurance licenses were 17% higher, indicative of continued strong recruiting levels and licensing focus. On a sequential quarter basis, recruiting increased 3%, and new life insurance licenses increased 26%. As we head into the second half of 2016, we're going up against strong distribution results following our convention last year. Our focused messaging and incentive programs have been very effective year-to-date, and we look to leverage this success to generate continued distribution growth as we head toward 2017. So far in the third quarter, we've seen year-over-year growth continue, including the addition of over 27,000 recruits in July and the life insurance sales force topping 113,000 at the end of the month.
At the end of the third quarter, we expect the overall size of the life license sales force to continue to grow on a sequential quarter basis. As we turn to segment results, it's important to note that a strength of our franchise is the balance provided by having two complementary businesses that have proven track records of delivering positive results for our sales force and for the bottom line. Recently, you've seen this as we've been able to generate significant growth in Term Life, even as uncertainty in the markets has been a headwind to ISP. The growth in adjusted direct premiums and Term Life earnings has more than offset the retraction in the Investment and Savings Products segment revenue in recent quarters. This flexibility in our business model should enable us to continue to deliver growth and long-term stockholder value through environmental changes.
On page five, you can see Term Life issued policies grew 14% in the second quarter and continue to significantly outperform the industry, which reported a 2% increase in life insurance applications year-over-year, according to the Medical Information Bureau Life Index. Growth in our life insurance licensed sales force, as well as productivity in the high end of our historical range, drove the strong growth in issued policies in the second quarter. Productivity in the quarter of 0.23 policies issued per life licensed representative per month was consistent with the second quarter a year ago. On a sequential quarter basis, Term Life insurance policies issued were 17% higher than the first quarter, largely reflecting the higher productivity typical of the second quarter. Turning to Investment and Savings Products, lack of clear direction in the market pressured ISP results.
While net flows in the second quarter were positive, $247 million, ISP sales declined 6% to $1.47 billion, and average client asset values were relatively consistent with the prior year period at $48.9 billion. Our larger size sales, which are often in Variable Annuities and Managed Accounts, were more impacted than smaller sales by recent market uncertainty. Sales of Managed Accounts may also have been impacted by the anticipated launch of our new advisory platform later this year. On a comparative basis, both Canadian Segregated Funds and retail Mutual Funds declined year-over-year due to the decline in the Canadian exchange rate and strong sales following the new product rollout in the second quarter a year ago. Our redemption rate as a percentage of assets remained in line with historical trends. Sequentially, investment and saving product sales grew 7% during IRA season from the first quarter of 2016.
Sales and investment products in the U.S. increased 16% from the first quarter, while Canadian Mutual Funds and Segregated Fund sales declined from the typically higher sales during the Canadian retirement savings season in the first quarter. Total average client asset values increased 5% from the first quarter, reflecting market performance. Let's close with the Department of Labor's fiduciary rule. After extensive analysis of the various alternatives, we have concluded that we will use the Best Interest Contract Exemption in our brokerage business. The changes made in the final rule to the disclosure, administrative, and grandfathering provisions have made this exemption more workable than the previous proposal. Our talented management team, along with the help of industry-leading consultants and service providers, is currently working through a disciplined process to develop a detailed matrix of the various points in our clients' investment decision process.
This matrix will be used to develop operational processes and sales force training materials, as well as point-of-sale technology added to the front end of our investment execution process to capture a client's decision points during the sales process and support necessary disclosures. We continue to analyze this highly complex rule in order to determine other enhancements that may need to be made to the ISP business. Alison will provide more color on the cost of building these capabilities to meet the requirements of the rule in a moment. Throughout this rulemaking process, we've kept our top ISP licensed representatives informed about the DOL developments. Our ongoing communications about the rule, including the potential changes to our U.S. retirement business, have been well received by our representatives. We intend to make thoughtful judgments and are using a host of available resources to help us make good decisions.
We're also looking for the opportunities that may emerge with industry disruption throughout this review process. Our mission remains the same. We are committed to serving middle-income families, and we are confident that our simple business model will give us the flexibility to adapt to the new rule. Now let me turn the call over to Alison to discuss financial results in more detail.
Thank you, Glenn, and good morning, everyone. Today, I will cover the earnings results for each of our segments and a company-wide review of insurance and operating expenses, including some insights into potential DOL rule-related expenses. Starting on slide six, in our term life segment, we continued to experience strong performance with margins expanding to 20.6% this quarter. The seasonally strong persistency we normally experience in the second quarter was coupled with favorable performance across all aspects of the term life business. Operating revenues and adjusted direct premiums both increased 14% year-over-year. As we've discussed in the past, adjusted direct premiums should naturally grow over the next several years by a minimum of 10% annually as a result of the co-insurance transactions we entered into at the time of the IPO.
The 18% growth in policies issued in 2015 and 16% year-to-date growth in 2016 has propelled adjusted direct premium growth even further. We've provided guidance that, in general, operating income before income taxes should grow consistently with adjusted direct premiums, subject to quarterly volatility in claims persistency and expenses. In the second quarter, we saw a 30% increase in operating income year-over-year, far outpacing growth in adjusted direct premiums, driven by several factors. The benefits and claims ratio was 58.8% in the second quarter, reflecting incurred claims that were approximately $2 million below historical levels, a portion of which comes from the implementation of a new claims adjudication system for disabled lives. The ratio is also benefiting from YRT reinsurance rate reductions that we negotiated on 2014 and later issue years.
Favorable persistency experience in the second quarter led to DAC amortization and insurance commissions as a percentage of direct premiums decreasing to 13.4%, contributing about $1 million to the segment's income before income taxes. The insurance expense ratio for the period was 7.8%, down from the prior year as fixed costs are spread over a wider in-force premium base. On an annualized basis, we expect the term life operating margin to be in the 19% range in 2016, up from previous guidance due to strong first half results and improved benefits and claims ratio. Adjusted direct premiums are expected to show attractive growth rates in the low to mid-teens for the remainder of the year, and we expect these trends to continue for 2017.
On a sequential quarter basis, Term Life revenue increased 2%, income before income taxes increased 26%, and the Term Life margin increased 340 basis points from the first quarter of 2016. The DAC amortization ratio declined significantly from the prior quarter due to seasonally strong persistency in the second quarter, and the insurance expense ratio declined due to seasonally higher employee-related expenses for equity awards in the first quarter. The benefit ratio also declined due to favorable claims experience versus the prior quarter. Moving now to our Investment & Savings Products segment. On slide seven, you'll see our ISP operating revenues declined 2%, while ISP operating income before income taxes was 4% lower than the second quarter a year ago, with margins compressing slightly. Market uncertainty drove lower product sales, while average client asset values were flat with the prior year period.
Revenue-generating product sales and sales-based revenues declined 4% and 6% respectively from the second quarter a year ago. The sales-based net revenue ratio was lower than the prior year period, primarily due to the mix of product sales, including a 20% decline in Variable Annuity sales consistent with industry trends. Asset-based revenues and average client asset values were relatively consistent year over year. The Canadian asset-based net revenue ratio increased year over year, reflecting positive Canadian Segregated Funds market performance in the second quarter of 2016, which decelerated DAC amortization and led to $1.2 million of lower DAC amortization compared to the year ago period. Account-based revenues grew 6% year over year, largely reflecting the addition of a Mutual Fund provider to our record-keeping platform in 2015, as well as growth in our Managed and retail Mutual Fund account positions.
On slide eight, you can see the Corporate and Other Distributed Products segment's operating revenues were $32.4 million, and operating losses before income taxes were $5.6 million in the second quarter of 2016. The modest year-over-year increase in insurance and other operating expenses was primarily due to higher employee-related expenses and was partially offset by a $1.5 million lower interest expense from a negotiated reduction in the annual fees on an IPO-related reinsurance agreement from 3% to 0.5% earlier this year. Allocated net investment income increased 5% year over year as a slightly lower yield on the invested asset portfolio was more than offset by an approximate $1 million positive mark-to-market adjustment on the deposit assets backing the IPO-related reinsurance agreement.
Given the continued environment of extremely low interest rates and available yields around the world, I wanted to take a moment to remind everybody of a few points regarding our relative exposure to interest rates and credit spreads. The reserves we hold on our Term Life business, by product design, only cover anticipated mortality costs. These reserves are lower than those required for policy types that incorporate cash value. At 2.2 times, our invested asset leverage is significantly lower than that of most life insurance companies. This reduces both our reliance on net investment income for earnings, as well as our exposure to corrections in the credit market. In fact, net investment income represented less than 6% of operating revenues through the first half of 2016.
In our Term Life business, DAC amortization and reserve requirements on in-force business are not impacted by changes in interest rates since assumptions are locked in at the time of issue, and we believe our DAC will remain fully recoverable. While we would generally like to see interest rates increase and provide better yielding investment opportunities, we do not see a prolonged low interest rate environment as a major headwind for our business. During the quarter, we did see a substantial improvement in fixed income prices as a result of the decreasing interest rates and slightly tighter credit spreads, and the net unrealized gains on our invested asset portfolio increased from 74.9% at March 31st to $105.2 million at quarter end.
We continue to demonstrate a strong capital position with Primerica Life Insurance Company's statutory risk-based capital ratio estimated to be around 430% and holding company liquidity of $99.7 million at the end of the second quarter. We will continue to take out ordinary dividends to the extent available, and we expect our RBC ratio to remain in excess of 400%. I'll move to a discussion of the company's insurance and other operating expenses. On slide nine, you can see our second quarter expenses of $77.9 million were $7.4 million higher than the second quarter of last year. The year-over-year change primarily reflects a $2.2 million increase in employee-related expenses, a $2 million increase in premium and growth-related expenses, as well as $1.8 million higher spend on technology infrastructure and mobile initiatives.
On a sequential quarter basis, expenses decreased by $2.8 million from the first quarter. Employee-related expenses declined about $5 million from the absence of the equity award expense that occurred at the time of grant in the first quarter. This was partially offset by increased technology infrastructure and mobile initiative expenses, higher growth-related expenses, and higher meeting and incentive costs, largely attributable to our biannual Women in Primerica conference in the second quarter. As Glenn discussed, we are in the process of determining the best means of providing investment advice to middle-income families under the Best Interest Contract Exemption. While we plan to leverage our already robust compliance and administrative infrastructures to comply with the DOL rule, we expect to incur substantial implementation costs for consulting, legal guidance, sales force training, and technology platforms over the course of the implementation period.
Our current estimate of one-time cash outlay is around $8 million between now and the end of 2017, with the timing of expense recognition and aggregate costs heavily dependent on whether we decide to develop, purchase, or lease technology solutions. We also expect ongoing costs of around $4 million to $5 million per year, which will begin to emerge towards the end of 2016 as we hire staff and so forth. In comparison to our 2015 expense run rate, there was about $1 million of expenses in 2015 that were largely associated with the comment letter process that will not be incurred in 2016 or future years. As a rough estimate, we expect to incur about $2 million per quarter through the end of 2017 for one-time and ongoing costs combined.
As we work through the implementation process, we will further refine both the amount and timing expectations for these expenses. Let's open it up for questions.
Thank you. We will now begin the question and answer session. To ask a question, you may press star then 1 on your telephone keypad. If you are using a speakerphone, please pick up your handset before pressing the keys. To withdraw your question, please press star then 2. At this time, we will pause momentarily to assemble our roster. The first question comes from Mark Hughes with SunTrust. Please go ahead.
Hi, this is actually Kevin on for Mark today. Thanks for taking my question. First question, just with the general market strength in Q3 so far, how is the ISP segment looking? Within that, I guess, how are our Variable Annuity sales looking?
Yeah. Hey, Kevin. Good morning. Yeah, we had a good start to the third quarter throughout our business. We don't provide specific guidance on that, but we're continuing to see the kind of trending that you've seen throughout our business. Some headwinds in the ISP section, more strength in everything else. That's kind of what our expectation is. Looks like things are trending about the same way as we've seen them in the past.
Okay, great. Thank you.
Again, if you'd like to ask a question, please press star then one. The next question is from Ryan Krueger with KBW. Please go ahead.
Hey, good morning. First question, the 19% term life margin guidance for 2016, is that something you expect to continue at a similar level in 2017 and beyond?
At least through 2017, yes. There's some things that will emerge over time. We want to continue to keep a close watch on that. We believe for the next, let's say, three, four, five quarters, that's a good rate to look at. Again, there is some seasonality with it, as you saw this particular quarter. Second quarter is usually a little bit stronger than the others.
Okay, thanks. On ISP, appreciate the updated expense guidance. Was hoping to talk more about the types of changes you're contemplating more from a product standpoint, and specifically on how you're thinking about the types of commission structures you currently have and revenue-sharing agreements and things like that, and if material changes will need to be made to operate under the BIC.
Yeah. Hey, Ryan, it's Glenn. Those details are emerging a little more slowly than our expense details are. Obviously, as it's an industry moving, not just Primerica moving. A lot of discussions. As we've said before, we anticipate there'll be some standardization of products and to a certain extent, even compensation off of those products. Early on, I think the good news is the industry is being very thoughtful about this process. I know it's frustrating that that means it's somewhat slow, but the industry is being thoughtful, and that means there's no knee-jerk reactions or jumping to conclusions. We're not seeing radical proposals of changes that would cause us a great deal of concern, and I think we're traveling in the pack with most of the rest of the industry that shares characteristics of our business model.
While we don't have the details yet that I know everyone would like to hear, I think the standardization concept is something we keep in mind, and we see kind of a slow, methodical movement as it goes, and we're encouraged by both of those.
Maybe just one more specific follow-up. Do you believe that you'll still be able to sell the Class A shares on Mutual Funds that you've typically sold in the past under this structure?
Yes, we do, Ryan. There's been a lot of discussion about that, and quite frankly, some misinformation that I've seen in the media discussion of that. Class A shares are an important part of the brokerage platform and will continue to be, and based on my understanding, will continue to be for the entire industry, not just for Primerica. Where we see other companies and where we are no longer using Class A shares is in the managed account platforms going forward. Make sure that everyone focuses on the difference between those two pieces of the business. I think Class A shares are being replaced by institutional shares throughout the industry on managed account platforms, but will continue to be sold on brokerage platforms, including ours, going forward. We believe that is accommodated under BICE.
Thank you.
Once again, if you have a question, please press star then one. The next question is from Adam Klauber with William Blair. Please go ahead.
Good morning. A couple different questions. The conversion of sales reps has been going up. Could you talk about what are the one or two factors really helping that?
Adam. Good morning. Most of the time at Primerica, it's never one or two factors. It's a host of factors. We're continuing to see a high level of confidence in the middle market on Main Street. We're getting great response to our recruiting messages. We're seeing our recruiting numbers continue to be strong. We've also focused our sales force and a tremendous amount of the credit for what we see on the distribution side of our business obviously goes to our field leadership. We have strong alignment with them at this point. We're communicating with them effectively. They're communicating with us effectively, and that's how we come to the best answers and best conclusions on what we need to do.
If there was a standout characteristic as you've asked for, I think it's that alignment with our field leadership and the fact that we are on the same page like we've never been before. Of course, they are leading that process. They are also focused, like we are, on growth of the size of the licensed sales force. That, with improvements to how we get people licensed, which is something we've worked on a lot over the last couple of years and continue to work on, all of that kind of adds up to the kind of success that you're seeing. It's several different factors. The strongest ones, I think, are the field leadership and alignment at this point, but we are getting some tailwinds from continued confidence in the middle market. We're very effective in our messaging to prospective recruits and clients right now.
I think we've improved that. Those are some of the secondary characteristics I would add to the list.
Okay. Thanks. Reps are selling more in greater value Term, and obviously, second quarter is a better quarter. Do you see that as a continuing trend?
Yeah. As I mentioned in my prepared comments, over our history of almost 40 years now, we see our business kind of swing back and forth between focus on insurance, focus on investments appropriately, and that's part of one of the strengths of our franchise. We have generated a tremendous amount of excitement around our term insurance business in the last few quarters. We believe that can continue. There's a lot of strength there. There's a lot of focus. We would expect to continue to see that strength going forward. The uncertainty that we continue to discuss about the investment business, whether it be uncertainty in the market or uncertainty in regulations, is a bit of a headwind there, but we're continuing to see good performance in that area at the same time.
Okay. On the Department of Labor ruling, I think you sort of laid out that this could impact, or you have exposure to really more like 10% of earnings. Now after full review, I guess, how do you feel about that 10% number?
The 10% was really when we were using that pie chart we've used in the past just to say what pieces could be subject to the change.
Right.
As Glenn mentioned earlier, that was really looking at which components of our business. At this point, we now have to peel the onion down a little further and say, step one, as we said, we're going to use BICE. Theoretically, there's a construct for us to retain all of the business. The question then becomes the things that Glenn was talking about earlier, is what industry-wide changes might there be to product sets or compensation structures and the like. Fortunately, unfortunately, that's a very slow process. We want to make sure we're in step with what we're hearing throughout the industry, throughout product providers, et cetera. A little bit more detail on that will hopefully be able to be provided towards the end of the year, but we continue to work towards minimizing that as much as possible.
Okay. Thank you. The last, and sorry, this was sort of an outside question, certain people draw attention that you are similar to Herbalife. Can you say why you're not similar to Herbalife and why some of the issues that impacted that franchise won't impact Primerica?
Sure. I'd be happy to do that. There has been a lot of media coverage of the Herbalife settlement, quite frankly, as is often the case, a lot of poor media coverage. The Herbalife settlement was particular and specific to Herbalife and their dynamics. There's been no rule change at the FTC since that settlement. However, it's obviously wise of us to monitor what's going on in that part of the world and make sure we're seeing the changes in wind direction and so forth. We're very close to that. We keep our finger on the pulse. Specifically to your question on differentiation points, Primerica, we're a financial services company that is a model based on the traditional insurance agency model. That's what we grew up from over the last 40 years. We began as an insurance agency.
An insurance agency model has different levels of compensation between branch managers and area managers and representatives. There's some similarities in the compensation structures of the traditional agency model, and some of direct selling, quite frankly, some with franchising. Over time, we've evolved to adopt different characteristics of several business models. One is our history. We come from a different history than that company does. The second thing, obviously, is we operate in a highly regulated set of industries, insurance and securities being the two biggest ones. We've got a set of regulations dictating how we do business that's unique to the financial services industry. Our sales are to end consumer by the nature of our products. We don't have an inventory.
A lot of the Herbalife controversy was around inventory loading and representatives buying inventory, of course, we have no inventory in our products. We have intangible services, there's no way to load anyone with inventory in our model. Of course, our reps are not required to purchase our products. The vast majority of our sales are to clients with absolutely no affiliation to Primerica in any way other than being clients. 78% of our life insurance sales are to end clients that have no affiliation with Primerica at all. They're not our reps. They're not our recruits. Other things, we don't pay to recruit, okay? Our recruiting mechanism is something that's not a profit center for the company or for a representative. There's no money made on that.
We think that we've got a very strong case of how we differ from Herbalife, and stand apart from the kinds of issues that were addressed in their settlement.
Great. Thank you very much.
Glad to help.
The next question is a follow-up from Ryan Krueger with KBW. Please go ahead.
Hey, thanks. Sorry, just one more DOL follow-up. I guess, there's been some discussion around revenue sharing from asset management providers. Just hoping to get an update as you think about the revenue sharing agreements you have with your asset management providers, if you feel like those can continue in the current form as well under the BIC.
Well, revenue sharing is clearly contemplated under BICE. I do think, however, that you'll see a standardization. Revenue sharing agreements, I think, are very unique to each distributor in today's world. My guess is over time you'll see standardization of those agreements, we do anticipate that they will continue going forward on our brokerage business under the BICE agreement.
Okay, great. Thank you.
At this time, I'm showing no further questions.
Hey, well, thank you everyone for joining us. If there are other questions we can help with, just let us know. Everybody have a great day.
Thank you, sir. The conference is now concluded. Thank you for attending today's presentation. You may now disconnect.