Good day, ladies and gentlemen, and welcome to the third quarter 2013 The Hanover Insurance Group, Inc. earnings conference call. My name is Annette, and I'll be your coordinator for today. At this time, all participants are in a listen-only mode. Following the company's remarks, we will conduct a question-and-answer session, and instructions will be provided at that time for you to queue up for questions. If at any time during the call you require audio assistance, please press star zero and a coordinator will be happy to assist you. Please be advised this conference is being recorded for replay purposes. I will now turn the conference over to Oksana Lukasheva, AVP, Investor Relations. Please proceed.
Thank you, Annette. Good morning, and thank you for joining us for our third quarter conference call. We will begin today's call with prepared remarks from Fred Eppinger, our President and Chief Executive Officer, and David Greenfield, our Executive Vice President and CFO. Available to answer your questions after our prepared remarks are Jack Roche, President of Business Insurance, Andrew Robinson, President of Specialty Lines, Mark DesRosiers, President of Personal Lines, and Bob Stachury, President of International Operations and Chief Executive Officer of Chaucer. Before I turn the call over to Fred, let me note that our earnings press release, financial supplement, and a complete slide presentation for today's call are available in the investor section of our website at www.hanover.com. After the presentation, we will answer questions in the Q&A session.
Our prepared remarks and responses to your questions today, other than statements of historical fact, include forward-looking statements, including our earnings guidance for 2013. There are certain factors that could cause actual results to differ materially from those anticipated by this press release, slide two of the presentation deck, and our filings with the SEC. We caution you with respect to reliance on forward-looking statements, and in this respect, refer you to the forward-looking statements section in our press release, slide two of the presentation deck, and our filings with the SEC. Today's discussion will also reference certain non-GAAP financial measures such as operating income, operating income per share, operating results excluding the impact of catastrophes and developments, ex-CAT loss and combined ratio, and accident year loss and combined ratios, among others.
A reconciliation of these non-GAAP financial measures to the closest GAAP measure on a historical basis can be found in the press release or the financial supplement, which are posted on our website, as I mentioned earlier. With those comments, I will turn the call over to Fred.
Thank you, Oksana, and good morning, everyone. Thank you for joining our third quarter earnings call. We are reporting strong results this quarter. I am pleased to say that each of our business segments performed well and contributed to the overall improvement in our returns. Operating income for the quarter was $1.36 per diluted share, which translates to an annualized operating ROE of 10%. Our combined ratio for the period was 96%, compared to 100% in the third quarter of 2012. Certainly, a lower level of catastrophe activity this quarter accounts for some of the earnings lift. More importantly, our results also improved on an ex-CAT basis. We made solid progress on all our strategic priorities. We positioned ourselves well to continue the improvement through the remainder of the year and into next.
On an ex-CAT basis, we produced the highest nine-month operating earnings of our 10-year journey, demonstrating increasing earnings power and momentum for our franchise. We are pleased to see that the work we have been doing to improve our business mix and achieve margin expansion is now flowing through our results. With that said, we remain focused on our financial return goals. We have every expectation that our actions will continue to drive higher profitability in 2014 and beyond. I'll discuss progress on our priorities, our view of the prevailing market conditions, and our updated outlook following David's remarks on our financial results.
Thank you, Fred. Good morning, everyone. We had a very strong quarter with net income of $61 million or $1.37 per diluted share, compared to $40 million or $0.89 per diluted share in the prior year quarter. Operating income was $61 million or $1.36 per diluted share, almost twice the $33 million or $0.72 per diluted share we earned in the third quarter of last year. Our combined ratio of 96% in the quarter compared to 100% in the prior year quarter. This four-point improvement was driven by three main factors. Most importantly, our accident year underwriting operations, excluding CAT losses, provided the real substance of our improvement. In particular, with our domestic operations delivering a 61% ex-CAT accident year loss ratio, we're moving closer to our long-term targets. Second, we benefited from lower catastrophe losses.
Our actions have helped here, the industry overall has seen a very favorable quarter. Third, we saw a modestly higher benefit of net favorable loss reserve development in the current quarter. Each of these deserves further comment, starting with the ex-CAT accident year loss ratios. As I mentioned, the underlying loss ratio in our domestic businesses was 61% in the current quarter, four points better than the 65% we reported in the third quarter of 2012. As I've discussed on previous earnings calls, we did increase loss ratios in certain lines during the second half of last year. I continue to suggest that you also review our current quarter performance against full year 2012 loss ratios.
Keeping this in mind, our commercial lines quarter accident year loss ratio, excluding CAT losses, was 60%. Compared to 64% in the third quarter of 2012 and 62% for the full year of 2012. We are generating improved margins in commercial multi-peril and workers' compensation. In CMP, increased pricing, disciplined risk selection, and a lower incidence of large losses supported the underlying improvement this quarter. Stable workers' compensation results continued to benefit from our focus on smaller accounts, lower risk classes, and rate increases. In commercial auto, our accident year loss ratio for the third quarter was consistent with the prior year quarter, and although still higher than the full year 2012 ratio, this is within our expectations. We continue to price and manage profitability in this line aggressively to drive improvement over time.
As expected, our accident year loss ratio in other commercial lines, which includes surety and other program business, has improved from the full year 2012, given our previous and ongoing underwriting and pricing actions. However, this improvement was somewhat offset by two large property losses in our special property line, which accounted for a couple of points increase in the loss ratio this quarter. Losses in this line can be lumpy, but overall, this business has been historically profitable, and despite these two losses, still managed to deliver an underwriting profit this quarter. In Personal Lines, we generated a 63% accident year loss ratio excluding CAT losses, compared to 66% in both the third quarter and full year of 2012. We continue to earn in strong pricing increases and make meaningful improvements to the underlying quality of our Personal Lines book of business.
The homeowners' margin improved this quarter compared to the full year 2012, despite a higher incidence of large fire losses that we experience occasionally in this line. Chaucer's accident year loss ratio was 61% and also reflected some notable large loss events in the quarter. In particular, the Nairobi Mall loss in September and a large jewelry theft in July added about six points to the ratio. These types of losses are well within our risk appetite, and while they drove a higher loss ratio this quarter, Chaucer continues to outperform our expectations for the year. Overall, net favorable prior year reserve development in the period was $24 million, or two points of the combined ratio. Chaucer's favorable development was $28 million. We had favorable experience in property and to a lesser extent, in casualty lines. Additionally, Chaucer development also reflected positive foreign currency movements in the quarter.
In our domestic lines, prior year loss estimates overall proved to be solid. We had modest reserve additions related to auto bodily injury coverages. We also recorded modest unfavorable development in other commercial, primarily in surety, as we continue to bring a handful of runoff claims to resolution. This was partially offset by favorable development in workers' compensation, where the benefit of the changing business mix towards smaller accounts is prevalent. Catastrophe losses in the quarter were $31 million, or about three points on the combined ratio, compared to $52 million, or five points in the prior year quarter. Chaucer's catastrophe losses were $12 million this quarter, modestly higher than a year ago. Losses were primarily driven by two September storms in Mexico and a more modest impact from floods in Colorado. Domestically, catastrophe losses of $19 million for the quarter were lower than the $45 million reported last year.
Midwest hail and flood events in July and August, and to a much lesser extent, Colorado floods in September, were the main events this quarter. Moving on to a discussion of expenses. Our current quarter and year-to-date overall expense ratio of 34% is in line with our target for the year. We continue to make meaningful progress in gaining operating efficiencies and growth leverage, in particular in commercial lines, where the expense ratio is still somewhat higher than our longer-term targets. Although the overall expense ratio was in line with the prior year quarter, the current quarter included higher performance-based compensation expenses by nearly one point as compared to last year, which reflects improved results so far this year.
The net written premium growth of 5% in the quarter reflected premium increases in Chaucer of 23%, a 6% growth in commercial lines, and a 5% decline in Personal Lines, as we continue to execute on our strategy of exposure management and profitability improvement actions in the domestic businesses. Overall, each of our business segments performed well this quarter, and we're pleased with the improving underwriting trends. Our focus on a prudent pricing strategy, along with targeted underwriting initiatives, is evident in our results thus far this year. Moving on to investment results. We continue to maintain a high-quality, well-laddered investment portfolio. At September 30th, 2013, cash and invested assets were $8 billion, with fixed income securities and cash representing 92% of the total. Roughly 94% of our fixed income securities are investment grade, and the average duration of the portfolio is 4.1 years.
Net investment income this quarter was $65.7 million, compared to $69.2 million in the prior year quarter, and $67.9 million sequentially. The decline is a result of low new money yields. The earned yield on our fixed maturity portfolio was 3.99% in the quarter, compared to 4.23% in the prior year quarter, and 3.98% sequentially. I'll just finish up with a few comments on the balance sheet and capital. We ended the quarter with a strong total capital position of $3.5 billion. At September 30th, book value per share was $58.43, up 2% in the quarter, and generally in line with the December 2012 level. We opportunistically repurchased approximately 115,000 common shares for $6 million. On a year-to-date basis, we repurchased 1.6 million shares at a cost of $78 million or $48.26 per share, which represents approximately 4% of our outstanding shares at year-end 2012.
Although we continue to favor capital deployment options that profitably grow our business, we will continue to be opportunistic as to stock repurchases. With that, I'll turn the call back to Fred.
Thank you, David. Most importantly, our efforts translate into higher underwriting margins. The measurable improvement in our loss trends that David just reviewed give me continued confidence in our ability to meet our goals for the remainder of the year and to generate even stronger results in 2014. I would like to comment on three of the priorities we set at the beginning of the year to drive us toward top quartile financial performance. Those priorities are continuing to improve our portfolio mix and property concentrations, improving pricing in our domestic businesses, and realizing the benefits of our Chaucer franchise.
As we discussed previously, we are assuming the increased frequency and severity of the weather that we and in the industry experienced over the last several years is here to stay. For that reason, we continue to pursue targeted actions to reduce our property concentrations that will reduce our volatility and improve our profitability over time. In addition, we targeted some small parts of our portfolio we believe could not reach target returns over the cycle. For example, some parts of our auto book. The impact of our ongoing actions on written premiums has peaked this quarter, resulting in only a modest growth within domestic lines. In the quarter, our various exposure management initiatives resulted in approximately $30 million reduction in Personal Lines premium, or eight points of quarterly growth.
We continued to shrink the monoline property book, as well as reduce exposure in targeted areas in the Northeast and Midwest, where we had significant concentration. In commercial lines, our exposure management actions led to a reduction in written premiums of $11 million in core commercial and $20 million in Specialty Lines, impacting our growth for the quarter by three points and 10 points respectively. The implementation of our initiatives will continue for the rest of the year. We expect deduction of approximately $50 million in all domestic lines in the fourth quarter, which will put us at about $200 million of deliberate premium reductions for the year. Even with these targeted actions, we maintain significant momentum in the market. Given our improved portfolio and partner strategy, there is no shortage of growth opportunities for us in the current marketplace.
Excluding our purposeful actions, our overall domestic growth rate was 8% in the third quarter and year to date. In core commercial, our new business production is the strongest it's been in several quarters, and our reported retention improved this quarter compared to last, despite these actions. With our mix adjustment actions trailing off, we think we are well positioned for solid growth in commercial lines next year. The same is true with Specialty Lines, where we continue to have a number of opportunities in our target segments to continue to profitably grow this business moving forward. In Personal Lines, we continue to aggressively promote our whole account strategy, becoming the market of choice for home and auto owners with more complex insurance needs. Given the timing of our various exposure reduction initiatives, the resulting pressure on the top line was the highest this quarter.
We expect this to subside over the next three quarters and believe our overall growth will resume in the second half of 2014. To summarize, we are satisfied that the completion of these targeted portfolio actions will improve our margins and create a strong foundation for future profitable growth given an improved and distinctive portfolio, as well as a strong position with our partners. A second priority for us is to execute meaningful targeted rate actions to improve our underwriting margins. We are satisfied with the level of pricing increases we achieved this quarter. In the third quarter, we realized pricing gains of 10% in Personal Lines, 9% in core commercial, and continued low teen increases in Specialty Lines, essentially continuing the trends we achieved during the first half of the year.
In core commercial, middle market workers' comp showed the most strength, where pricing increased by almost 12%, with most of the other lines hovering around 9%. We always approach our pricing strategy in a very targeted way with the objective of improving our overall quality of our book. As importantly, we believe we will continue to see solid price increases going into 2014. We remain convinced that positive rate is needed broadly in the market, given the persistency of low investment yields and active weather. With that said, rate increases in our personal auto book will likely moderate from a current high water mark of 9% as we are beginning to clearly see the cumulative benefit of past pricing actions on loss trends. Now, moving on to Chaucer, which delivered another quarter of strong performance.
This segment produced $32 million of pre-tax operating earnings in the third quarter and $110 million year to date, resulting in a combined ratio of 90% through the first nine months of 2013. The 23% net written premium growth in the quarter reflected our non-renewal of the Flagstone quota share this year and increased new business opportunities with improved rates in a number of classes, particularly in our marine division. We continue to tactically position the Chaucer business for softening market conditions, focusing our efforts on areas of business where we have strong and distinctive underwriting capabilities, including marine, political risk, casualty, and energy. Given the team's strong expertise in risk selection, pricing, and portfolio management, we are confident in our ability to continue to deliver on our plan, and we are excited about our future opportunities. However, we will remain cautious about growth in the near term.
In conclusion, we are pleased with the progress our team has made, and we are encouraged that initiatives we put in place are translating into improved results this year and position us well for continued improvement in 2014. With our broad and distinctive portfolio and preferred shelf space with our agent partners, we have great momentum in the marketplace. We're experiencing solid growth where we desire, effectively rebalancing our business towards a more profitable mix. We remain on target to deliver our financial goals for 2013. With only a few months remaining and a year-to-date ex-CAT ratio of 93.4%, we remain confident in our original ex-CAT ratio guidance of 93%-94% for the full year. Given that our year-to-date EPS is $3.73, we are increasing our full-year guidance range to $4.70-$4.80 per share, assuming a CAT ratio in the quarter of approximately 4%.
With that, I would like to open the line for questions.
Thank you. Ladies and gentlemen, we will now conduct the question and answer session. If you have a question, please press the star key followed by the one on your touchtone phone. You will hear a tone acknowledging your request. If your question has been answered, please press star two. Your questions will be polled in the order they are received. Please stand by for your first question. The first question comes from the line of Vincent D'Agostino of KBW. Please proceed.
Good morning, David.
Good morning. Just when we look at your auto results, we're starting to see the core loss ratio improvement come through on Personal Lines. This quarter, we had seen a flat core commercial lines loss ratio. Really, if we look to what some of your competitors are doing this quarter, that's really quite solid. What I'm curious about is if you're seeing perhaps different trends or if really what you're really seeing here is just you taking a more conservative stance last year when we think about the year-over-year comparisons there.
Yeah, I think that's right. I think we feel good about how we reacted very quickly. As you know, we talked about this a year ago, and we're a little bit fortunate, right? Because our commercial auto tends to be small fleets and similar to our personal line. We have a pretty good insight into some of those severity trends, and so we reacted relatively quick. Our view is, given the noise in the marketplace, that it's prudent for us to make the picks where they are this quarter, which is consistent with last quarter. We believe we're right on where we expect it to be. There's no surprises. We feel good about what we did, and we feel good about the trends for us. I think that for us, we don't see any surprises or any change in our perspective on it.
Okay, good. Just jumping to Chaucer real quick. When we see headlines for what people are calling these blind underwriting schemes impacting the Lloyd's market and Berkshire's the obvious one, those are taking out considerable slices of premium. I'm just curious if there's any impact to Chaucer based off of the business mix there. Longer term, what you think the implications might be to the overall Lloyd's market if this type of activity continues.
Yeah. I'll comment and have Bob comment too. Obviously, when we acquired Chaucer, and we thought about Chaucer. A lot of the folks in Lloyd's or some of the people in Lloyd's are more focused, I would say, in kind of a reinsurance portfolio. Chaucer is a very specialty-oriented business. It leads a lot of its business. We have very good distinctive underwriting and real leadership position in things like energy, marine, et cetera. For us, we don't believe that it's going to have a material impact on us. I do think the smaller syndicates, some of those that aren't as distinctive, that just tag along, could see some meaningful impact. For us, we feel very good about it.
Matter of fact, we have been, since the transaction, we've acquired and attracted additional teams in some of our areas of focus and feel that we'll be leading more of the business going forward. I feel pretty good about where we're positioned. Bob, is there anything you want to comment on? I want to make sure.
You've really touched on those points. I think you're right. You might see over a period of time some of the smaller players in the Lloyd's market consolidating. From our position, we're quite strong in leadership, and we haven't really seen any effect to date.
Okay, great. Just keeping on Chaucer, David, you mentioned that there was an FX impact on the reserve development. Would you be able to quantify that?
Yeah. It's in the low millions of dollars. It spread. It wasn't any particular currency, just a number of currencies moved that when we revalue our reserves, obviously that has an impact on some of the foreign claim reserves that we have. It was pretty modest this quarter compared to previous quarters when I've talked about it. I'd tell you it's sort of in the $5 million, $6 million range.
If I could sneak one more in before I queue. Would it be safe to say with the year-to-date results so far coming through this quarter that you'd be incrementally more confident in your ability to reach a 10% or better ROE kind of over the near to medium-term horizon?
Yeah. Okay. That's a great point. As you know, we've worked really hard on the last few years to really get our portfolio and our position in a place where we believe that we can sustain our target returns through the cycle, that 11-13 that we talk about. We believe we're right on track for doing that, and we think 2014 is going to be a meaningful step in that direction, another improvement from this year. Obviously, the yields coming down put a little bit of stretch on that as far as making it difficult to get all the way there. We feel very good about where we are.
Frankly, a lot of the actions in the marketplace that we're seeing confirms that our strategy of what we focus on, the breadth of our portfolio, the balance of our portfolio, and this notion of a balanced and kind of preferred agent strategy that allows us to have preferred shelf space, is really working out very nicely. We're pretty confident that we're moving in the right direction. Clearly, we've got to continue to improve, but we're set up nicely to have a material step of improvement in 2014, and frankly, even more after that. I think we're in a pretty good spot right now as far as momentum.
Okay. Great. Thanks for the answers, and talk to you soon.
Thanks, Vincent.
Ladies and gentlemen, just a quick reminder, if you wish to ask a question, please press star one. Thank you. The next line of question comes from Robert Horne from Sidoti & Company. Please proceed.
Hey, Robert. Good morning.
Hey, good morning. Can you talk more broadly about the Personal Lines segment and what drove the improvement on the accident year combined ratio? Is it mostly rate and some non-renewals, or has there been any changes to the terms and conditions of policies?
Obviously, for Personal Lines for us, that started a couple of years ago where we recognized this non-CAT weather phenomenon, where we wanted to get more rate into the system. We also have been moving for multiple years into this full account approach to the business, which helps create stability and a more attractive portfolio. What you're seeing is that just playing out. That is really playing into the results. What's interesting is a lot of the reductions that we're taking, while it helps us in our concentration of volatility in the future, frankly, a lot of the Personal Lines business we're getting out of marginally contributes today. It's not bad business, but it does, in the future, take off the volatility.
Most of our improvement, frankly, comparison improvement, is really this rate that's going into the book and this movement to an account approach, which gives us a lot of stability in the book. Mark, is there anything you want to add?
I mean, the only thing I would add to that, you alluded to non-renewals, I would describe it more as non-rate actions that we're taking around either agency management actions because of profitability or some rate pursuit type of activities that are not pure rate, that also drive some improvement to the bottom line as well.
Yeah.
Just to add one last point on that, Robert. When you're looking at our quarters, you obviously were more cautious about the fourth quarter, given we have a weather impact in that book of business.
That's true. I mean, we've had nice improvement. We'll have nice improvement comparisons in the fourth quarter from the previous year. David's right. Sequentially, we have a little bit of winter storm kind of thing that's going to happen in the fourth quarter, which is normal, which we have every year.
Right.
Okay. As far as the commercial lines pricing environment, can you just talk about what you're seeing and experiencing in that business? Contrary to some recent industry discussions, it seems like your renewal rates continue to show sizable increases.
Yeah.
Just wanted to get your thoughts on that.
Yeah, I'll make sure Jack comments on it too. Remember, our portfolio, I think our middle market average policy size is $75,000. We are a small commercial writer. What you see is, a lot of the comments are, in my view, about large accounts, if there's any softening. We don't see it, and we see good, stable rate increases across our book. Again, small doesn't tend to go up as much or go down as much, but we feel like we're in a really good position to have some stability. We would also say that in casualty lines, there's some people that have had some issues recently here. For our kind of business, that also helps a little bit. I think that you'll continue to see some casualty rate in our business.
So far, we feel pretty good about what we see and what our outlook is for the fourth quarter. Jack, is there any?
I guess the only thing I would add is that like all good companies, we have gotten better and better at segmenting our business and making sure that while we pursue market available rate, that we also improve our portfolio along the way. So we continue to drive a good portion of our increases through the segment of the business that needs it the most. As Fred said, because we concentrate on the small and the first and second tier middle market business, I think we get a better average price on the good business. We're not playing up in the upper middle market where it tends to be a little bit more volatile.
Okay, thanks. Just one more question. I wanted to get your overall view on the reinsurance market. It appears as though pricing is becoming more attractive from a buyer's standpoint. Does this rate environment change your thinking on purchasing reinsurance?
It's clear that particularly in the property CAT market, I do think there is some softness. I mean, I think we've seen the actions and frankly, the lack of losses that are also going to contribute to that and the new capital from outside the industry. From our perspective, that's helpful, obviously, at some level to us. Our CAT purchase in particular, where most of the sensitivity is in that market, is really about the Northeast, which is kind of an infrequent event, really. Therefore, we retain up to that $200 million. It has some impact, I would say it's not tremendous. There is a lot of flexibility in the reinsurance market now and an ability to partner more effectively on multiple years and things like that. We will be very thoughtful about that and think about that to enhance our position.
It's clearly available, but it's not huge for us. It's something, and it's important, and we should kind of manage it, but I don't see it as overwhelming in any way.
Okay, thank you. That's all I have.
Great. Thanks so much, Robert.
Thank you for your question.
I think we don't have any more questions. Thank you everyone for your participation today. We look forward to speaking to you next quarter.
Thank you. Thank you for your participation in today's conference. This concludes the presentation.