Good day, everyone. Welcome to the Selective Insurance Group second quarter 2015 earnings call. At this time, for opening remarks and introductions, I'd like to turn the call over to Senior Vice President, Investor Relations and Treasurer, Ms. Jennifer DiBiase.
Good morning. Welcome to Selective Insurance Group's second quarter 2015 conference call. This call is being simulcast on our website, and the replay will be available through September 1st, 2015. A supplemental investor package, which includes GAAP reconciliations of non-GAAP financial measures referred to on this call, is available on the Investors page of our website, www.selective.com. Selective uses operating income, a non-GAAP measure, to analyze trends in operations. Operating income is net income excluding the after-tax impact of net realized investment gains or losses, as well as the after-tax results of discontinued operations. We believe that providing this non-GAAP measure makes it easier for investors to evaluate our insurance business. As a reminder, some of the statements and projections that we've made during this call are forward-looking statements as defined by the Private Securities Litigation Reform Act of 1995.
Forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties. We refer you to Selective's annual report on Form 10-K and any subsequent Form 10-Qs filed with the U.S. Securities and Exchange Commission for a detailed discussion of these risks and uncertainties. Please note that Selective undertakes no obligation to update or revise any forward-looking statements. Joining me today on the call are the following members of Selective's executive management team: Greg Murphy, CEO; John Marchioni , President and Chief Operating Officer; Dale Thatcher, CFO; and Ron Zalesky, Chief Actuary. Now I'll turn the call over to Dale to review the quarter's results.
Thanks, Jen, and good morning. We're very pleased with the results posted this quarter, which reflect the benefits of the strategic underwriting and claims initiatives we've implemented in our insurance operations. For the quarter, we reported operating income for diluted share of $0.62, up from $0.46 a year ago. Our statutory combined ratio for the quarter was 93.5%, improving from 97.5% a year ago. The underlying combined ratio, excluding catastrophes and prior year casualty development, improved by 2.7 points to 92.7%. Cat losses for the quarter were 4.9 points, in line with our second quarter expectations and lower than the 5.9 points reported a year ago. Non-cat property losses were one point above expectations in the quarter, but 1.3 points lower than second quarter 2014.
Favorable prior year casualty reserve development in the quarter was $20 million, or 4.1 statutory combined ratio points, compared to $17.5 million or 3.8 points a year ago. The favorable development is related to the benefits of our underwriting and claims initiatives of the past several years, while our overall reserve position continues to be very strong. For the quarter, overall statutory net premiums written grew by 11%, driven by steady retention levels, higher new business written, and renewal pure price increases. Standard Commercial Lines premiums were up 13%, benefiting from renewal pure price of 3%, steady retention of 83%, and a new business increase of 39%. For the quarter, this segment generated a statutory combined ratio of 90.1% compared to 95.5% a year ago. The improvement was driven by earned rate exceeding expected loss inflation, favorable reserve development, and lower non-cat property losses.
Including 11.3 points of favorable development, Workers' Compensation reported an 89.2% statutory combined ratio in the quarter, improving approximately 23 points from a year ago. The favorable development is largely attributable to continued lower-than-expected frequencies. We also continue to see a decrease in severity resulting from the claims initiatives we have instituted to address Workers' Comp results. General Liability also reported strong profitability with a 77.6% statutory combined ratio. This line benefited from 13.4 points of reserve releases, also largely driven by favorable claim frequencies. Earned renewal pure price increases exceeding expected loss inflation have also contributed to the improvement. Standard Personal Lines statutory premiums declined 3% in the quarter as targeted non-renewals and lower new business impacted production. Retention remained at 82%, while renewal pure price continued to be strong at 6.7%. The Personal Lines statutory combined ratio was 105.4% for the quarter, including 11.5 points of catastrophe losses.
In the prior year period, the statutory combined ratio was 106.1%, including 17.1 points of cat losses. Homeowners reported a combined ratio of 114.3% in the quarter, compared to 124.5% a year ago due to lower cat activity. On an ex-cat basis, the combined ratio at 90.7% was essentially flat compared to 90.5% from the second quarter of 2014. Renewal pure price in this line remained strong at 9.2%. The Personal Auto combined ratio in the quarter was 106.4%, up from 100.2% a year ago. This quarter, no development was recorded in this line, compared to over five points of favorable prior year casualty development in the second quarter of 2014. Renewal pure price for the quarter was 4.4%. Excess and Surplus Lines continued to generate strong growth with a 20% increase in statutory net premiums written.
The E&S statutory combined ratio in the quarter was 102.7%, compared to 99.9% in the second quarter of last year. Adverse prior year casualty reserve development of $1 million added 2.4 points to the combined ratio this quarter. We successfully completed placement of our July 1, 2015 excess of loss reinsurance treaties, which now include coverage for our E&S business. We renewed both the casualty excess of loss and property excess of loss treaties with some enhancements in terms and conditions in the same structure as expiring. Casualty excess of loss treaty provides $88 million of coverage in excess of $2 million retention, while our property excess of loss treaty provides $38 million of coverage in excess of $2 million retention. Rates on the program were reflective of the soft conditions in the reinsurance market. Moving to the investment portfolio.
After-tax net investment income declined to $25 million for the quarter from $27 million in the second quarter of 2014. The decline was largely driven by lower interest income from the fixed income portfolio and lower returns from the alternative portfolio. The alternative portfolio continues to be impacted by the portfolio's exposure to energy-exposed limited partnerships, which report on a one-quarter lag. As a result of lower alternative investment income and the continued low interest rate environment, our after-tax portfolio yields declined to approximately 1.9% from 2.3% a year ago. Year to date, the after-tax new money yields have averaged 1.6% as we continue to invest in high-quality fixed income product. Operating cash flow has increased this year, while new money yields remain below our 2% expectation for full year 2015.
Our fixed income portfolio continues to be highly rated, with an average credit quality of double A minus and a duration of 3.7 years, including short-term investments. Within the overall portfolio, the pre-tax unrealized gain position decreased to $71 million from $128 million at the end of the first quarter. The pre-tax unrecognized gains position in the fixed income held the maturity portfolio was $11.8 million or $0.13 per share on an after-tax basis. Equities are 5% on invested assets, and the portfolio continues to be limited to U.S.-listed securities, which generate after-tax dividend yields of 3.4% on average. Surplus and shareholders' equity each ended the quarter at $1.3 billion, while book value per share increased 2% from year-end 2014 to $22.95. Annualized operating ROE was 11% in the quarter, which is above our weighted average cost of capital of 8.6%.
I'll turn the call over to John Marchioni to review insurance operations.
Thanks, Dale. For the quarter and for the first half of 2015, our insurance operations have performed extremely well. For the first six months, we had an overall statutory combined ratio of 93.2, an ex-catastrophe combined ratio of 88.1, and net premiums written growth of 10% as we leverage our strong position in the marketplace to profitably grow our business. New Commercial Lines business growth has been very robust year to date, increasing 34% as both submission and quote activity increased compared to last year. In fact, $90 million of new business production in the second quarter was an all-time company record for new business booked in a single quarter. We attribute this success to strong distribution partners working with our empowered Agency Management Specialists or AMSs as we continued to benefit from the ramp-up of 12 new AMS territories added at the end of 2014.
We closely monitor the quality and pricing levels of new business and remain very comfortable with both. On the renewal portfolio, we continue to balance rate and retention by providing our underwriters the tools they need to make informed decisions. For the first half of the year, Standard Commercial Lines retention remained strong at 83%, and renewal pure price was 3.3% on a written basis. For our highest quality Standard Commercial Lines accounts, which represent 55% of our premium, we achieved a renewal pure rate of 2.1% and point of renewal retention of 91%. On our lower quality accounts, which represent 9% of premium, we achieved a pure rate of 7.8% and point of renewal retention of 80%, which offers an opportunity moving forward to push for additional rate even if retention levels decline on that segment.
Having this level of pricing sophistication is critical to be successful in a competitive market. Competitive pressures are increasing, but the market seems to be rational as a low interest rate environment dampens overall returns and pressures companies to generate better underwriting margins. No P&C company is immune from declining yields, making disciplined pricing in the marketplace more important than ever. As a case in point, the CIAB Survey for the first quarter of 2015 showed commercial renewal pure pricing remained positive at 2% versus a 3.5% Selective reported in the first quarter, and we achieved second quarter renewal pure pricing in line with expected loss inflation. We are earning renewal price increases about 140 basis points above expected loss inflation. In addition to rate, our underwriting and claims initiatives also contributed significantly to our profitability improvement as the benefits of these initiatives work their way through underwriting results.
In particular, we are very pleased with the progress we have made on our Workers' Compensation line of business. In Workers' Comp, we are targeting specific classes of business for re-underwriting and increasing our mix of lower hazard grade business. We are seeing significant improvements in claims outcomes as a result of our strategic case management unit, Workers' Comp escalation model, and fraud detection and recovery models. Our results are ahead of our expectations, we are revising our 2015 guidance to now achieve a combined ratio in Workers' Comp of under 97%. Growth in our Excess and Surplus Lines business has been very robust year to date, with a 23% increase in net premiums written, which is largely attributable to new business growth of 39%. The recent implementation of a new rater is a key factor in driving new business.
We are comfortable with new business pricing levels, while there are targeted segments in the renewal inventory where we would like to drive more rate. As we roll out the pricing analytic capabilities for E&S that we have successfully implemented in our Standard Lines, we expect renewal pricing to move closer to targeted rate levels and E&S profitability to be more in line with Standard Commercial Lines. Growth in Personal Lines year to date has been negatively impacted by the ongoing strategic non-renewal of underperforming business and a decrease in new business. While dwelling fire non-renewal started at the beginning of 2014, New Jersey, which represents the biggest part of our dwelling fire book, began non-renewing policies in July. The positive news is that we are experiencing a stabilization in Personal Lines retention.
We are optimistic about the improving take-up rate in the Selective Edge product and believe that this business will ultimately perform and retain better than the non-Edge business. In the second quarter, 17% of our automobile new business was in the Edge product. For homeowners, 23% of new business was issued with Edge. Effective July 1st, we rolled out enhancements to the Edge for auto, including diminishing deductible, accident forgiveness, newer car replacement, and selected choice replacement cost. These enhancements to the Edge product line up nicely against our key competitors. We are very pleased with our overall insurance operations performance and believe we have the momentum for further improvement. Now I'll turn the call over to Greg Murphy.
Thanks, John, and good morning. The strong results delivered to date demonstrate the hard work accomplished by our employees and distribution partners to achieve profitable growth. Year to date, top line growth of 10% reflects the additional Commercial Lines production capacity we've created to grow our middle-market business through the expansion of our small business teams and increasing the number of AMSs. These measures provide us with Commercial Lines new business capacity exceeding $400 million. We are confident that we can leverage our business model to achieve this level of high-quality premium production while maintaining profitability through the use of our sophisticated underwriting tools that drive pricing discipline. Selective's organic Commercial Lines growth opportunity is significant by increasing our market share through the expansion of distribution partner market share and share of wallet.
As we increase our distribution force over time to represent 25% of the market share in each state, a $2 billion premium opportunity will be created. Increasing share of wallet within our distribution force to about 12% will generate another $1 billion of premium opportunity. Year to date, E&S net premium written growth of 23% was driven by new business, which increased 39% to $47 million. The growth is coming primarily from contracting, habitational, and mercantile service sectors. At a recent E&S producer council meeting, our distribution partners told us that the new rating system implemented earlier this year is very easy to use and helps facilitate the flow of business. Our renewal pure price increases year to date were 3.8%, which was above our expected loss inflation of 3%.
Use of our dynamic portfolio manager tool to balance rate and retention on an account level resulted in Commercial Lines renewal pure price increases of 3.3% for the first six months. Personal Lines rate was strong at 6.8%, with homeowners achieving 9.5% rate increases. Our E&S price increases were below expectations of 1.5%. We anticipate driving more rate in the next two quarters. With our ongoing success in increasing rate in Commercial and Personal Lines, we expect to achieve overall renewal pure price increases of just below 4% in 2015. The Commercial Lines marketplace is in transition as P&C carriers with profitability are aggressively pursuing new business opportunities while less profitable companies are trying to improve their combined ratios.
Many of these companies do not have sophisticated underwriting and pricing tools necessary to granularly price and identify underperforming business, which makes the renewal inventory vulnerable as they attempt to socialize rate changes. The industry pressure on underwriting performance is intense due to the low interest rate environment. The industry expected ROE from its investment portfolio is approximately six points, and we believe the industry-wide book yield will continue to be under pressure for the next three-year period. To compensate for lower ROE contribution from the investment income, companies will need to be forced to generate profitable combined ratio
We feel we have an advantage in this environment with our underwriting and investment leverage, as well as the superior underwriting and pricing tools we use to manage and monitor profitability at a very granular level. As we reflect on the strong first half results and our expectations for the second half of the year, we offer the following 2015 guidance. Statutory combined ratio of 90, an improvement from the previous guidance of 91, excluding catastrophes and any further prior year casualty reserve development. Catastrophe losses of four points. After-tax investment income revised from $100 million to a range of $95 million-$100 million. Weighted average shares of 58 million. I'll turn the call over to the operator for your questions.
Thank you. At this time, if you would like to ask a question, please press star one on your touch-tone phone. Please be sure your phone is unmuted in order to ask your question. Once again, please press star one if you would like to ask a question. One moment, please, for our first question. Your first question today comes from Scott Heleniak of RBC Capital Markets. Please go ahead with your question.
Yeah, good morning.
Morning.
Just wondering if you could touch a little bit more on the Commercial Lines growth is up double digits, which was nice. You talked last quarter and this quarter again about the new AMSs and the new agents. Wondering how much of the growth is actually coming from just getting more business, gaining share with your existing agency base as well, and if you could touch on that a little bit.
Yeah, Scott, this is John. I could start, Greg could certainly jump in. We don't disclose the growth between new storefronts and existing storefronts. We monitor that internally and our regions plan in that regard, and you would attribute, in most part, but not entirely, the growth from existing storefronts to track with growth with existing AMSs. The new AMS territories we've created aren't entirely new agency appointments. They've got some of the existing agents being moved. There's clearly the combination of those two factors, the addition of AMSs, the ramp-up of new agencies, as well as better penetration of existing agencies, which we track between business they control and business that's new to the agency, are all driving that increase in new business.
As Greg indicated when he referenced the capacity number, we think we have additional capacity with the resources, the agents, and the appetite and product portfolio we've got deployed. We continue, again, assuming the market continues to be rational, think that there's more upside for us in each of those areas.
I would say, Scott, again, when you look at our production, obviously, John went through it in his prepared comments, the addition of and the strength of the small business team and the staffing levels that we focused on that are creating more throughput from our agency base on a more consistent basis. Adding another 12 AMSs is just providing more middle market opportunity. The immediate focus is around share of wallet, we will follow that through market share expansion through additional distribution. That takes a little bit longer. That's a little bit slower developing as you add new agents on, and we've done that. We've increased our agency count now to we're now sitting at 1,130, and that's up a few.
I think it's like John said, more of it's coming from share of wallet at this time. I believe that's where you'll continue to see it. Over time, you'll see more migration and more addition of new business coming from new agency distribution.
Okay. I know you mentioned, I think this is just E&S, about the contractors class. Are you seeing growth ramp up in there as well in Commercial Lines? I know that had been a big line for you guys in the past. Is that something that's starting to come back as well?
Yeah. We're seeing strong growth across the board in all of our strategic business units, industry verticals, in Standard Commercial. Clearly contractors has rebounded a fair amount across our footprint. We continue to focus on being more diversified in our new business than we have in the past. We're seeing strong growth for up in contractors in both standard and Excess and Surplus Lines. We view that as a class that we've been very successful in terms of growth and profitability in the past. We also view that as a class that helps diversify our catastrophe exposure because it's a very casualty-driven class of business. That has certainly come back.
There's also an embedded growth capability just within our existing contractors in that as the economy got worse, the contractors shrank and eliminated employees. Now as the economy has begun to show a little bit of a spark, you do see some addition of employees. You're seeing positive audit and endorsement premium. There's some definite growth out there across the board.
Right. Exposure growth. Gotcha. On the expense ratio, I noticed that that ticked up a little bit, most of those mostly in E&S. I was just wondering if there's any kind of one-timers in there, just what sort of drove that? Would've thought there'd be some leverage and that would probably start to improve.
Yeah. In the E&S, you see a little bit of an uptick because we reevaluated some of the longer term agents' bonus compensation there and had to book some additional dollars into that.
Remember, E&S traditionally runs at a little bit higher rate anyway. If you look at our peer group, they're running at about the 34.7 kind of range. We're not too far off of what is expected within the E&S realm. Yeah, there is a little bit more in this particular quarter.
The only other thing I would add to this is, Greg, obviously we saw an elevation in the pension costs in 2015 over 2014, which will add approximately $8 million to our overall expense level. That's split in between both LAE and underwriting, most of it being in the underwriting side. I view that as just a reflection of the low discount rate that we got this year. There was a big pop this year. I would say, just to dovetail into Dale's comments, we are, as a result of higher level of profitability and the way we compensate our agencies on profit sharing, there's a one-year and three-year component. The one-year is obviously a solid year, and then the three-year performance continues to improve as well.
Again, our goal is to compensate our best performing agents for the relationship and the profitable business that they share with us. Remember, when we demonstrated our 2015 plan with you, we actually showed expense ratio in that plan going higher as a result of the pension, higher compensation to employees and agents, as well as some of the ongoing IT investments we continue to make.
Okay. That's fair. I think, John, you made a comment about the E&S combined ratio over time getting better and sort of getting toward the standard, closer to standard market combined ratio. Is that something that you expect to see signs of that in 2016? Is there anything left, any initiatives you have left to sort of get where you need to be profitability wise there?
We haven't put out guidance overall for 2016 or by individual segments. What you have in that line is about 2.5 points in the current year of prior year adverse development. As we indicated, we see the opportunity that you're referencing coming in some targeted areas on the renewal portfolio that need to be addressed through more aggressive rate and/or non-renewal action. That's where that management team is focused. We expect that to start to move through their performance relatively quickly. Our expectation is in all 3 of our segments, in the relatively near term, deliver to our target ROE.
The only other thing I would add to that too, obviously, that how we process our claim activity in there is an entire section that's being visited by our corporate claim group, and that's now folded under that operation. Just like you saw us manage, whether it's comp or how we're looking at our GL and what we've done in GL and Commercial Auto, we're going to provide that same level of discipline. I think there's opportunity on the claims side regarding lowering our cost of goods sold, and that's both on the LAE side as well as the loss side.
Jeff, if I could just add as well, remember that that business has a much lower retention level typically than standard business.
Right.
New business pricing levels are equally important, and we measure that closely as well. That mix will continue to improve based on where we're seeing new pricing levels on that segment.
Okay. Finally, surprised to not hear any commentary about M&A. Thought I'd just throw it out there. You guys entered E&S a couple of years ago through M&A. Just if you could give an update on how you're viewing M&A and what kind of impact you might experience from some of the M&A that's going out there.
I'd say clearly it is a frothy marketplace right now in terms of M&A. We are always looking at opportunities, but obviously with the full prices that are occurring out there in the environment, it probably somewhat lowers the likelihood that we would be a successful bidder, since we're not inclined to overpay for any enterprise. We are watching with great interest as everybody who is a student of the insurance marketplace. It's quite fascinating.
Yeah. I would add to all this, consolidation inside our distribution plan, I think, provides Selective with some unique opportunities because we've got a lot of agents that want to up their market share or their share of wallet, as we like to refer to it with Selective. Consolidation in the market, I think, provides or puts a lot of agents into a highly concentrated market situation. I think agents generally try to avoid being concentrated positions, obviously, unless they're with us.
Sure.
That's you. Our opportunity I think for expansion capability, whether it's something that we're looking at for a team of people in either our E&S division or maybe in some of our commercial lines capability or just the fact on the agency side, ability to get a bigger agency commitment to place more of their best business with us, I think provides us with opportunity. I think all the noise is good for Selective.
Okay. Thanks a lot.
As a reminder, if you would like to ask a question, please press star one on your touch-tone phone. Next question comes from Mike Zaremski of Balyasny Asset Management. Please go ahead with your question.
Hey, good morning, gentlemen.
Morning.
Question on the four points of cat load guidance. If I look year-to-date, it's running above 4%. Obviously, wind season just started. I hadn't thought that there were a lot of, if I look at PCS data, a lot of activity in some of your states this past quarter. I guess also, if I just look at last year, it ran close to four points as well. I didn't think last year was a particularly active year. I guess, how do you get comfort four points is the right level?
Obviously, we spend a lot of time every year in trying to budget the right number, but clearly, that is the one number within our guidance that always has greater volatility around it since it's so dependent on not only the events themselves, but also the way PCS may code them. I would say that although last year and this year you think of as having lower activity only because there aren't a lot of big named occurrences, but there is a great frequency of catastrophe losses that you see in both of those years. You do have a lot of particular events that have occurred. If you look at how we arrive at our budget number, quite frankly, if you go back a few years, we very rarely had greater than an average of one and a half points on the combined ratio.
Over the last few years, we've averaged between the four and the six kind of a range. You're either double a historic average or you're somewhat slightly less than the current average. We think that four makes sense. We closed the year last year with 3.2 points on the combined ratio for the full year. Four points felt like a reasonable number for this year. Clearly, we're just starting wind season. Hurricane season, on occasion, has a big impact on us if something large hits us in one of our particular states, but also, that's an uncertainty too. In years where they all hit Florida and the Gulf Coast, we have very little in the way of losses. We still feel pretty good about our overall cat estimate.
Clearly, if a hurricane hits South Carolina or New Jersey, we'll have to revisit that estimate.
Got it. That's helpful. Lastly, regarding alternative investments, if I look at the absolute level of alternatives, it looks like it's been decreasing over time. Should we expect you guys to continue lowering your allocations to alternatives?
Basically what's happening right now is the existing alternatives are returning cash quicker than we're able to find new alternative investments that we find attractive. There's not a distinct desire to shrink our commitment to the class. It's really more a matter of opportunity compared with return of cash from those. It's really dependent on us identifying new opportunities that we feel good about, that we are able to provide appropriate returns and also appropriate volatility. I.e., not too much volatility in the overall scheme of things. That's kind of the overall view of that.
Got it. Thanks for the color.
Sure.
Your next question comes from Alison Jacobowitz of Bank of America Merrill Lynch. Please go ahead with your question.
Thanks so much. I was wondering if you could talk a little bit about the growth in Commercial Property and what you're seeing from pricing there. I think we've been, some of our esteem declined, we just wanted to hear your color on that.
Yeah. We don't view property as necessarily an outlier. We're an account underwriter, and we write business on a package basis. We write very little of any monoline property on a Commercial Lines side, and certainly don't write any large property on the monoline side. The pricing that we've seen has been relatively in line with the other major lines of business, and that has been the case throughout this cycle. The style of business we write and the manner in which we write it, there's really nothing that would make property an outlier in either direction from a pricing perspective or from a competitive perspective.
Thanks.
At this time, we have no additional questions.
All right. Well, if you have any follow-up items, please contact Dale and Jennifer. Thank you very much for participating in the call this morning.
Once again, this does conclude today's conference. All parties may disconnect at this time.