Larissa and I will be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we'll conduct a question and answer session. Please note that this conference is being recorded. I'll now turn the call over to Oksana Lukasheva. Please go ahead.
Thank you, Larissa. Good morning. Thank you for joining us for our second 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. Also in the room and available to answer your questions after our prepared remarks are Marita Zuraitis, President, Property and Casualty Companies, Andrew Robinson, President of Specialty Lines, and Bob Stachura, 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, statistical supplement, and a complete slide presentation for today's call are available in the investors section of our website at www.hanover.com. After the presentation, we will answer questions in the Q&A session.
Our prepared remarks in responses to your questions today, other than statements of historical fact, include forward-looking statements such as our guidance for segment income per share for 2012 and commentary on 2013 and 2014. 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. Today's discussion will also reference certain non-GAAP financial measures, such as total segment income, after-tax earnings per share, segment results excluding the impact of catastrophes and development, among others.
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 statistical 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, good morning, everyone, and thank you for joining our call today. The results released yesterday were in line with the early information we provided two weeks ago. Net income per share for the quarter was $0.46, and operating EPS was $0.22, which translates to an annualized operating ROE of 5% through the first six months of the year. Our book value per share, which is now $58.81, increased 8% over the last 12 months and 2% during the quarter. Though our earnings for the quarter were disappointing due to some specific challenges we faced, we continue to see favorable trends in our businesses and progress on our strategic priorities that positions us well for continued earnings improvement. Weather once again affected our domestic results. Our catastrophe losses in the U.S. were $71 million or nine points of the combined ratio.
Additionally, in response to some emerging loss trends in auto lines, we increased our loss estimates, most notably for 2011. We also increased loss estimates on our contract surety book. However, despite these challenges, we produced a profitable quarter given our diversified and improved portfolio. Importantly, we made progress on our key strategic priorities. We continue to improve the quality of our business mix through targeted pricing and underwriting activities and increased share of the higher margin business in the mix. We further strengthened our position and alignment with winning agents while maintaining a disciplined focus on pricing. We have also gained expense leverage through operating model efficiency. Finally, July 1 marked one full year since we completed the acquisition of Chaucer. Over the past year, Chaucer has delivered strong pre-tax segment earnings of $88 million.
Before I go into these areas in more detail and offer some thoughts on the market, the trends we are seeing in our business, and the impact they should have on our 2012 and longer-term outlook, I would like to have David review our second quarter results and provide you a better context.
Thank you, Fred, good morning, everyone. Net income for the second quarter was $20.8 million or $0.46 per diluted share, compared to a net loss of $32.2 million or $0.71 per diluted share in the prior year quarter. Our segment income this quarter was $10 million or $0.22 per diluted share, a substantial improvement over the loss of $38.4 million or $0.85 per diluted share in the prior year quarter. The difference between net income and segment income is due to a realized gain from CMI, a small workers' compensation third-party administrator business we sold. This business was not a strategic part of our core operations, and the sale allowed us to free up a modest amount of capital. This transaction resulted in an after-tax gain of $11 million or $0.24 per share, which is included in discontinued operations.
Catastrophe losses this quarter were $74 million compared to $157 million in the second quarter last year. While losses in the quarter were much lower than the record-high cats we experienced a year ago, they still represented nine points of the domestic combined ratio, which is about three to four points higher than our longer-term expectations for this business. The quarter was also impacted by unfavorable prior year reserve development. Overall for the company, we recorded net unfavorable prior year development of $17.2 million, or 1.6 points of the combined ratio. Compared to net favorable development of $15.3 million, or two points in the second quarter of last year. The unfavorable development was primarily attributable to a $13 million increase to the contract portion of our surety book, which is included in our other commercial lines business, as well as $8.3 million related to auto lines.
As you know, we significantly refocused and re-underwrote our surety business beginning in 2009. Given the financial crisis and subsequent weaker economic conditions, certain issues in our book became apparent. As a result of our actions, premiums in the contract surety book was reduced from a high of $80 million in 2008, 2009 to only about $40 million this year. Over the last two years, we've dramatically tightened our risk and financial metrics, upgraded our credit rating criteria, as well as brought in a new leadership team. As we mentioned in earlier calls, our contract surety book is currently divided into accounts we intend to support, which present the majority of the book, and accounts that were put in runoff, which includes accounts already in claims or are otherwise closely monitored so that any potential loss can be managed to the best outcome.
During the quarter, we completed a comprehensive account-by-account review and applied further stress testing for persisting economic pressures on our book. As a result, we identified some issues, primarily in the runoff portion of the contract surety portfolio, which led us to record increased prior year losses of $13 million this quarter. By way of background, we've been in this business for a very long time. Our contract surety book focuses on general construction with an average bond value of less than $2 million. The average duration of a project is less than two years, although projects frequently begin subsequent to the date the bond is written, so there is an extended exposure period that runs from the date the bond is written to the date the project is fully completed.
To try to put this in perspective as to how this business impacts our financials, our overall surety book of business performance over the past two and a half years has averaged a combined ratio of 138%. Nonetheless, the attractive core of our contract surety business continues to perform well, and we continue to realize good performance in the commercial portion of the surety book. Finally, as it relates to our recent quarter loss experience, we've seen improvement in the underlying loss patterns. While we are still seeing claim activity, the average size of losses has moderated as the average project completion ratio improved compared to only a year ago. All in, we are confident we've taken all the appropriate actions to improve the financial performance of this business.
While we anticipate a moderation of loss activity from the runoff portion of the surety business, we have incorporated in our financial outlook a higher expectation of losses for the second half of the year than we originally planned. At the same time, we believe we'll continue to see positive earnings contribution from commercial surety and the go-forward contract surety books. We believe this issue will have little to no impact on our 2013 earnings. Besides the contract surety impact, we also recorded unfavorable loss reserve development of $5.1 million and $3.2 million in our commercial and personal auto lines, respectively. The increase in net ultimate loss estimates was primarily in the 2011 accident year, driven by higher severity trends in liability lines, which began to materialize in the first quarter this year, including the impact of a small number of large losses in commercial auto.
That covers the more significant loss development items this quarter. We had some pluses and minuses in other areas. In homeowners, we recorded unfavorable development of $3.5 million that related to late-reported hail claims on non-cat storm losses in the latter half of 2011. We continued to see favorable development in the multi-peril line and workers' compensation line in the U.S. as well as at Chaucer overall. While unfavorable development recorded this quarter is clearly a focus for us, it represents less than a half a percent of our total net carried reserves, and we believe we've reacted relatively quickly through regular underwriting and pricing actions, which have been underway and will continue. Moving on to a discussion of our accident year underwriting results, excluding catastrophe losses. In commercial lines, the accident year combined ratio was 98% for the current quarter, compared to 97.9% last year.
Underlying the stable margins, our expense ratio continued to improve. The improvement comes from fixed cost leverage driven by earned premium growth, a more normal pace of business investments, as well as the improving efficiencies in our operating model. The quarter's expense ratio of 36.4% was impacted by the timing of certain performance-based expenses. The six-month 2012 expense ratio of approximately 38% is more in line with our expectation for the full year. The reported commercial lines current accident year loss ratio indicates deterioration in auto and other commercial lines. On a fully developed 2011 basis, results are more consistent as we are seeing relatively stable loss trends as favorable frequency trends are offset by emerging severity trends. In personal lines, the accident year combined ratio, excluding catastrophe losses, was 91% in the current quarter, compared to 91.8% in the second quarter of 2011.
The improvement is attributable to more favorable non-catastrophe weather losses in the current quarter, notably in our homeowners line. In auto, through six months, the accident year loss ratio is flat. Like the industry, we watch this line closely and analyze the liability as we continue to react with appropriate rate actions. Chaucer delivered its highest quarterly profit since the acquisition closed a year ago, generating $30 million of segment income before taxes. Chaucer's combined ratio of 91.9% included a low level of catastrophe losses of $3 million and favorable reserve development of $5 million, primarily within the 2010 and 2011 accident years. Chaucer's expense ratio was 37.2% this quarter, which is in line with our long-term expectations for this business. We continue to be pleased with Chaucer's business portfolio, disciplined underwriting practices, as well as the more favorable market trends evident in its business segments.
Moving on to a discussion of our investment results. Net investment income was $68.5 million for the quarter, up about 12% compared to the $61 million earned in the prior year quarter. The Chaucer invested assets acquired last year are the main driver of the increase, offset by lower yields on reinvested assets. For the second quarter, our overall earned yield on the fixed maturity portfolio was 4.3%. The Hanover's fixed maturities yielded 5.1% compared to 5.3% in the prior year quarter, and Chaucer investments yielded 2.3%. As you can see, on a sequential basis, we continue to generate a strong level of net investment income. Our yields are relatively unchanged as we continue to find favorable investment grade opportunities in the fixed income space. At June 30th, 2012, we held $7.7 billion in cash and invested assets, with fixed income securities representing 85% of the total.
Roughly 94% of our fixed income securities are investment grade, and the average duration in the portfolio is four years. Our balance sheet remains strong. We ended the quarter with $2.6 billion in shareholders' equity. Our book value per share at June 30th, 2012, reached an all-time high at $58.81, up 8% from the $54.44 at June 30th, 2011, and 2% from $57.65 at March 31st. Our capital management approach balances rating agency and regulatory capital requirements with plans for reinvestment in our business and opportunistic capital uses. We will continue to be diligent balancing all of our capital requirements and opportunities going forward. During the quarter, we repurchased 259,000 shares of common stock for $10 million in open market transactions. We have $125 million remaining in our share repurchase program, which we can deploy opportunistically based on market conditions.
We have good financial flexibility with a debt to capital ratio of 26% and total capital that is in excess of rating agency requirements for our ratings. Our holding company cash and investments were $185 million at June 30th, representing two times our external interest and dividend requirements. We also maintain a $200 million credit facility that provides additional flexibility. As a confirmation of our overall financial strength and the health of our company, all rating agencies affirmed our current ratings in this year's review cycle, which for us typically runs April through June. In their reports, they noted improvement in our market position and business diversification, lowered integration risks associated with Chaucer, and strong enterprise risk management culture and processes. Overall, despite the environment and some of the specific challenges we've discussed, we are pleased with the underlying trends in our business and our financial position.
With that, I'll turn the call back to Fred.
Thank you, David. As I mentioned earlier, and as David just reiterated, we feel very good about the fundamentals of our business, our position in the market, and our prospects for the future. When we evaluate the progress on our strategic priorities, we are pleased with the headway we've made, particularly given the ongoing pressures in the economy and the current marketplace. At this critical time for the industry, we remain fully committed to underwrite the best business. This means a heightened focus on pricing actions, continued exposure management practices, effective measures in the runoff portion of our surety book, and continued efforts on realizing the value of operating model efficiencies. Through these lenses, I'd like to review the business initiatives we continue to implement this quarter, as well as discuss the market environment in each of our business segments, beginning with Commercial Lines.
We achieved growth of 9% in core commercial in the second quarter of 2012, primarily driven by pricing, continuing strong retention levels, and increased new business with our partner agents. Overall price increases in the core businesses were just over 6%, demonstrating the continued success we were having in driving rate improvement. Our price increases in the middle market were 7% in the second quarter of 2011. In commercial auto, where we experienced some increase in severity, our pricing increased 5% compared to 1% a year ago. We are planning and expect to receive higher rate increases through the end of the year. We approach price increases in a thoughtful, targeted manner, so as to minimize disruption and improve the overall quality of our book. We believe our results this quarter demonstrate that this strategy is working.
Retention continues to be strong. We are confident our distribution strategy will enable us to achieve additional rate increases in the coming quarters. We continue to increase new business production and further strengthen our position with winning agents who understand and are aligned with our focus on the importance of writing profitable business. New business is coming from our targeted industry classes with lower property component, and we believe the quality of this business has never been better. The growth momentum in all our business provides us the flexibility to be more aggressive in our profit improvement initiatives. Our exposure management actions are on course, and while we curtailed some growth primarily in the CMP lines in certain states, we believe this is the right trade-off to make considering recent weather patterns and trends.
As a result of the price earnings through our book, mix changes, and given our current view of loss trends, we continue to be confident in improving results going forward. In our specialty lines, we grew 20% this quarter, driven by ex-healthcare, management liability, and especially industrial segments. Rate increases across specialty businesses averaged over 8%. Importantly, as our newer businesses mature and as we gain efficiency in our core commercial segment, our expense ratio continues to move down from its high water mark of 43.5 in the first quarter of 2010, when we were making our most substantial investments in commercial lines. Our normalized expense ratio run rate this year has decreased by over a full point from last year.
In line with our aspirations to be a top quartile insurer, we had to go through a period of very significant investments to build our competitive advantage in commercial lines. We've always been attentive to our expense base, and we remain focused on our goal and continue to execute on our promises as we build a strong and profitable insurance franchise. In personal lines, our focus on improving profitability translates into continued rate increases and managing pockets of exposure concentration in certain areas. In terms of pricing, the momentum we saw in the first quarter improved during the second quarter as our applied rate increased to 5% in auto and 9% in homeowners, compared to 4% and 7% respectively. We expect continued pricing opportunities going forward. It's important to note that the steps we are taking are not limited to rate.
We are working on a number of levers as we target improved underwriting margins. They include underwriting actions, particularly changing underwriting standards with respect to actual cash value of roofs, wind deductibles, as well as risk selection and location. We continue to actively mitigate property exposure in the second quarter as we did in the first. While these efforts are ongoing, they affected growth during the second quarter more than in recent quarters and reflected in the premium decline of 1%. During the quarter, we executed a renewal rights transaction with another party affecting approximately $30 million in annual net written premium and eliminating roughly 80 legacy agents in New York, New Jersey, and Connecticut. This transaction included a 100% coinsurance agreement running from May until this agreement is expected to be fully executed, a period of approximately 18 months.
As we discussed in Investor Day, we believe reducing micro-concentration in some geographic areas enables us to improve long-term margin in our business and provide additional profitable capacity for our partner agents. Adjusting for this transaction, we would have reported a net written premium growth of 4% in personal lines. This growth rate is more in line with the premium increases expected for the rest of the year. We will continue our pricing and underwriting efforts to achieve further margin improvement. We believe that we will be successful given our strong relationships with our agents and the unique value proposition we bring to our customers. Finally, we couldn't be more pleased with the way Chaucer has performed in the years since we completed our acquisition, and we are very excited about the opportunities that lie ahead.
With Chaucer, we now have a more diversified, balanced company with greater scale, higher earnings resiliency, broader product capabilities, and greater earnings power. The financial benefits of Chaucer have exceeded our initial expectations. As part of the handover for four quarters, Chaucer has proven to be accretive to our organization. This said, we are only beginning to unlock the strategic value and distribution synergies that Chaucer brings to our company. While we intend to proceed methodically, we expect these synergies should further help build long-term shareholder value by improving the distinctiveness of our company for our best and largest agents and brokers and enhancing our long-term returns and book value. In the meantime, the market environment for us continues to improve. Rates and terms and conditions strengthen in the majority of the property lines, and especially in those areas affected by last year's cat.
Additionally, as the market responds to recent losses in energy and marine sectors, we are seeing pricing in these accounts improve as well. This said, in UK Motor, rates have moderated on the back of substantial increases over the last two years. The current underlying loss trends in Chaucer's business continue to be favorable. The quarter benefited from low frequency and severity of large losses, and this was complemented by benign catastrophe activity. Top-line growth also continues to track our expectations. We are confident Chaucer will continue to add to our earnings power and strengthen our market position with the best distributors going forward. Based on the trends we just discussed and incorporating the first six months of operating results, we currently expect our segment earnings for the full year 2012 to be in the range of $2.70-$2.90 per share.
The major drivers for the change from our original outlook are the following. We now expect catastrophe losses for the year to be six points of the combined ratio, reflecting the first six months of actuals, as well as a higher provision for July catastrophes in the U.S., which puts our third quarter catastrophe loss ratio expectation at around 7% of earned premium. Our updated outlook also incorporates a more conservative view of our auto margins. No material impact from prior years of reserve development, either favorable or unfavorable, and a more conservative view on our contract surety book. Overall, despite the challenges this quarter, we are excited about the capabilities we've built at The Hanover, the progress we've made, and the momentum we have in the marketplace. We have a very strong and balanced book of business.
As we've mentioned in the past, because of the recent weather patterns and economic trends, we believe it's important to remain focused on our underwriting, pricing, and mix management to ensure we can continue to improve our financial position. Given our strong position with agents and brokers, our improved mix and maturing businesses, as well as the additions we have made to our team, including Chaucer, we are strongly positioned to fully capitalize on the changing market and achieve our financial goals. We are in a good position to significantly improve our financial position in 2013 and reach our financial goals in 2014. Thank you. We are now ready for questions.
Thank you. We'll now begin the question-and-answer session. If you have a question, please press star then one on your touch-tone phone. If you wish to be removed from the queue, please press the pound sign or hash key. If you're using a speakerphone, you may need to pick up the handset first before pressing the numbers. Once again, if you have a question, please press star then one on your touch-tone phone. Our first question comes from Dan Farrell from Stifel Nicolaus. Dan, please go ahead.
Morning, Dan.
A couple questions. First, on your new cat guidance, you said to the back half of the year, I think you said it was points of cats. How do we think about that for maybe next year? Should we think about that as the run rate? Because you are engaged in ongoing catastrophe management. I'm also surprised that you bumped the third quarter more. I realize we're in hurricane season, but you've also done a lot to address coastal exposure. Is it because of some of the events that have taken place thus far?
Dan, I'm sorry. It was very hard to hear you. If you can talk a little bit louder.
Sure. Sorry. Let me try again there.
I think we got some of it, Dan. Maybe you can come back around. Let me start with the second point on the cats. We bumped the cats in the outlook because of obviously what happened in the second quarter. Also, you will recall there was a lot of activity around the end of June and into early July. We already have an indication of some activity in July. I realize it is early in the quarter. We are taking a view that we think the quarter will be a little higher than our original expectations as a result of what we have already seen for the first month of the quarter. We just thought it was prudent. You can do the math that we gave you. Say it is $10 million-$12 million more in the second quarter because of what we saw.
It was that significant storm that it was the last few days of June. It was the first three or so days of July that drove it. The other question you had is about our cat picks. As you know, last year, a couple of things. We felt that it was very important, we said at Investor Day, to assume that some of the weather patterns that we are seeing are real. We took our non-cat estimates up three points this year. That is why some of the rate activity and kind of transitioning through this year. We also took our cat percentages up. We have not yet determined exactly what our cat percentage would be next year. As you know, we have thinned out a lot of business. At the Investor Day, I talked about $200 million worth of business because it is not really hurricanes.
It is this notion of having some micro concentrations with all these kitty cats that we are experiencing that are quite different. We have taken a lot of action to reduce. We mentioned about $200 million of the business, which we are about two-thirds of the way down, finished. I am not necessarily sure we will take up our cat estimates next year at all or if that much, because again, we believe that our mix, all our strategy towards a more balanced geography and a more balanced casualty property, I think offsets some of the trends in the industry. Again, I think that we are likely to be close to where we are today at the end of next year. We have not really fully kind of assessed that.
That is helpful. Just on the surety line, you said you put some provisions for higher losses through the rest of this year. Will we see that through prior year development or higher accident year loss pick? It is unclear to me if some of the contracts obviously started in 2008. It seems like some gets recognized in the reserve development. Obviously, you are taking some higher picks as well. The 57.1 accident year loss ratio ex cat in that other commercial line, is that a run rate, or should we think of that as having a little extra or sort of catch up from the previous quarter?
Let me try to first cover that first point, Dan. When you look at surety, it's a little bit different than the more traditional insurance lines in terms of current year versus prior year determination, because as you point out, the projects span multiple years, the premium is written in a particular year, and then the point at which a project fails is sometimes debatable in the process. Obviously, the date we get a notice or the date we determine is one thing, but the actual date in which we might choose to determine a loss could be different. I don't want to bog you down in all the details of that, if you will. I do think we will see some prior year development and potentially some also current accident year, as we talked about in the outlook.
I couldn't predict for you at this point without knowing explicitly what projects fail or what projects we're seeing losses come through, whether it's going to show up in prior year or current year. It's one of the reasons why I made the comment about just trying to look at the ratios in this business more on a longer term basis than on a period to period or a quarter-over-quarter basis, or a year-over-year basis.
All right.
In terms of the run rate, I don't have that in front of me. I think in terms of the other commercial line run rate, where we are now is similar to where we'll be in the second half of the year, maybe within a point or two. I don't expect to be much different from a comparative standpoint. I think if you compare year-over-year, we were a little higher last year in the third quarter in the other commercial lines. We think that that'll also sort of work its way out as we go into the second half of this year.
All right. Just one additional follow-up. You talked about obviously still maybe working through some of it this year, but you don't think there's much of any impact in 2013. Can you talk broadly about what gives you that confidence that-
Yeah. Dan, that's a good point. This book, again, we were in this business, The Hanover's in the business for 100 years, surety. There was a portion of this book that we inherited that was small contractors and had certain characteristics. That portion of the book grew a little bit but that's the book we really attacked in 2009. It has very specific credit characteristics. If you look at the losses we've experienced, that's where the vast majority of all the losses are coming from. That is basically going away. That book of business and those projects are finishing. You can look at the kind of result and all the different ways we look at losses and experience from those particular projects. That business is pretty much done, right? By the end of the year, that's a lot going away.
That's why we look going forward, and the business we've actually kept in our core business is running very well. The credit characteristics are outstanding. It's got more mix towards a more sophisticated contractor. It's more commercial surety, it's more flow commercial surety. The core of our book, both contract and commercial, that remains, is quite attractive, and the rest of the business and the projects are essentially getting finished. That's why it's pretty clear what's going to happen by the end of this year.
Chris Gallant from KBW is online with a question.
Good morning. Sort of back of the envelope math, I figure if three or four points of the bad weather in the second quarter and the third quarter were to be pulled out, that would indicate that your sort of underlying or normalized earnings power is in the $4 range, which means an average ROE, I think it's a little less than 7%. Is that the way we should be thinking about the profitability, the ROE potential of the company today? Is that the right math?
Yeah, I think if you look at the components, right? The three components we talked about. The weather, you could do the 12 and see what that change. The other is probably a point in auto that comes from these trends, where we think it's conservative and appropriate, given what other people are seeing in the industry to take a different outlook, a little bit more conservative outlook, particularly on the severity side of the auto business going forward. To much less extent, the surety adjustments. The upside, obviously, the reason why we think there's going to be so much upside in 2013 is our price almost across the board is above our loss cost pretty significantly now. Even in commercial auto and in personal auto, where we're making adjustments, our current rate level is better than our loss cost trends.
What you're going to see is increasing earning power in the business in 2013. That's why we're so confident. Obviously the drag, to your point, as surety ends, there's an upside to that. That's why I think between through 2013, the improvement of mix, the pricing earning its way in. We also will have additional leverage on the expense side. We think that earnings power increases in 2013, and as I said, I think by 2014, we're in our target range.
Okay. All right. Thank you.
Thanks, Chris.
Meyer Shields is okay with a question from Stifel Nicolaus.
Yeah, thanks. Good morning, everyone.
Morning, Meyer.
A couple of quick ones, then maybe a bigger picture question. With the renewal rights transaction, should the offset to written premium growth, I guess, is that pretty evenly spread over the next three quarters?
No, actually, a lot of it affected us this quarter because of the way the transaction came through. We expect we'll be back on a growth pattern, to the comments that Fred made, when we get into the next two quarters. Really, overall, the amounts involved here are not that significant that I think it would affect your spreading, if you will.
Okay. The fact that it was actually negative growth, you're saying is an anomaly.
Yeah. A lot of it has really more or less come through now. That's right.
Okay. That's very helpful. Where were the CMI results reported up until now? Is that in commercial?
Yeah. It was. It's pretty small on a performance basis, so I won't go through the actual numbers, but it really will have a very tiny effect on our, really almost no effect on our earnings going forward. It was a pure servicing business, so there was no underwriting aspect to it.
Right. No, I understand that. bigger picture-
Sorry?
I'm sorry. Can you hear me?
We can now, yeah.
Okay. Sorry. Having problems with my headset. Fred, you talked about how rate increases are exceeding current trend, and I think that's consistent with what we're hearing across the board. What leading indicators do you look at to sort of see where trend will be when these rate increases are being earned?
What's our indicators for trend, you're saying?
Right.
Go ahead.
Could trend get worse now and then ultimately keep up with or even exceed the earned premium increases stemming from higher rate levels?
Yeah. I guess we look hard at the trends and what the timing of the trends are. As I said, we haven't seen anything in the trends. If you look at frequency, because our mix of business is getting better in most of our businesses, we're seeing continued decrease in frequency. As we said in a couple of the auto lines, we're seeing severity tick up a little bit. The loss cost trends, in total, have not changed that much for us across the board so far. We don't see that changing right now. We see the pricing trends maintaining and going up a little bit in our businesses.
Okay, great. Thank you very much.
Matthew Carletti from JMP Securities Online.
Thank you.
Matt.
Good morning.
Morning.
Fred, I just had a question on. I wanted to just talk about UK Motor for a second. In recent conversations, I've noted some people are a little more concerned about the line. I wouldn't say alarmed in any way, but it comes up in conversation a lot more these days.
Yeah.
You mentioned the kind of the rate environment easing a bit. Is that your only concern right now, or are you seeing kind of underlying core trends deteriorating as well? As an add-on to that, is that a line that longer term is core to Hanover or might at some point you look for options if it were to deteriorate?
Good. Bob is here, I'm going to let Bob answer the question, and I can follow up, Bob, if there's anything else.
Yeah, sure. First of all, going to the rate expectations we've got. Obviously, you've had a situation where there needed to be some quite severe adjustment over the last couple of years, which we managed to get through and the market did as well. We've seen a moderation of those rate increases in 2012 as we got that book back on track. The book hadn't changed at all. The core portfolio we've got has remained pretty static. We're very selective about what we do right, and we have a very low market share in the U.K. Some of the industry dynamics that are being talked about probably aren't as apparent to us and aren't significant to us. I'd really say from our point of view, we're comfortable with the rating levels we're seeing at the moment, performance of that book.
Really, there's no indications that it's anything other than we expected from market conditions.
Yeah. If you recall from our earlier conversations, to Bob's point, I don't want to describe it as a non-standard, but we have a very interesting mix-
Yes
of program business and some specialty auto business, it's not that big. We got good rate increases, very significant rate increase the last couple of years, we've had very stable earnings right now. I think we're-
Yeah.
We feel that we're in a pretty good place right now, we don't see a big change in our ability to earn the margins we expect this year.
That's good.
Okay. That's helpful. Then just kind of a follow-up on the ROE and kind of accident year improvement discussion. Just to kind of refresh my memory, is it a 12%-
Yeah
ROE or 11-13 range is the target? Going on the math that was gone over before, pointed to kind of normalizing things, I think is what I'd call it, rough numbers if you were to normalize this year, let's say, a 7%-
Right
ROE. I guess you feel confident that given the rate increases you're seeing and the loss cost environment you're seeing, that over, say, two years, 2013 and 2014, there's 500 basis points of ROE improvement to be had?
Yeah. Again, one of the things that's unique about us, you guys know this, but in 2009, when we got the rate increases, we had made the company better. My view was that our portfolio wasn't distinctive enough and wasn't diversified enough to have sustainable ROEs in the range that we believe we need to do to be one of the better companies. A lot of our investment from 2009 forward was to change that portfolio, whether it was the Chaucer acquisition or the OneBeacon renewal rights deal, the investment we made in some of the specialty lines. Our portfolio now is dramatically different. It's got a nice geographic spread. It's 50/50 casualty property. It is much more distinctive in its mix as far as industry solutions. When we look at it, we're a little bit different than others.
We get really three things that are helping us. One is what I would call the traditional pricing that people are getting, that we are getting as well, that is really quite helpful. I would add to that pricing is that we're doing really good work right now on portfolio improvement, particularly around property. We've gotten off of, as I said, we focused on about $200 million worth of business that were property centric in places we didn't think we could get excess returns or adequate returns. We've gotten rid of those, and we've gotten rid of a lot of this micro concentration. About two-thirds of this is behind us. We've been pretty creative with renewal rights and other ways. Some transition costs to that, obviously. The combination of just core pricing and that has been very helpful.
The second point, though, is the maturity of our businesses. What we have now is probably $1 billion worth of business that either because of its geography or because it's a relatively new business where we built the operating model and specialty, or we invested in it, that those businesses are maturing. Not only do I have an operating leverage point, we have a loss ratio points, because there's no question we minimize new business penalty when we did that, and we did renewal rights and all these other creative reasons to avoid new business penalty. Obviously, when your business matures and you get the kind of rate increases we're getting, 8.5%, 9% in specialty and rate increase in margin improvement and mix improvement across the board in some of these new businesses, all those maturing businesses have huge leverage for us.
If you add the operating expense leverage, it's very material. You're seeing it. It's over 5 points since our peak when we started investing. The final point that I would tell you is that our retentions, given the market dynamics and because we focus on smaller average policy size and because of the disruption and the percentage of our business with partner agents, what we're seeing is we're getting better retention and better stability in a lot of the high margin pockets, which again, helps the overall performance of the business. When you look at our leverage, yep, you get the pricing, we have a lot more other levers because of where we are and what we've done. That gives us a lot of confidence in how we're kind of getting it. The other day, I talked about the big components.
The rate, the mix, and the maturing of these new businesses. If you look at the portfolio, we have so much more higher margin, more stable business. Now, I'd add another one today, after today's conversation. We obviously are also putting behind some of the last legacy issues that we had, and one is this, obviously, the surety business that was not as good as it should have been, and we probably made some mistakes on not getting rid of that business quicker. That's going to be behind us, too. That's why we're confident in increasing earnings power for the company. We've got to prove it. We've got to keep delivering it. If you look at our underlying mix and the momentum we have with agents, it's tremendous right now.
We're getting best looks at best business, and we're allowed to kind of take the mix changes because of our partnership position with the agents we have. It feels pretty good, but it's a little bit different than the traditional guys that are saying, "My mix is exactly the same, and I'm just getting rate." I mean, we have other levers because of the investments we made that we control, if you will. That's why I feel quite good about it.
That's very helpful. Last question is a numbers question. You're kind of following on the rate increases, which clearly have been very nice. Can you give us any sort of guidance on where you at least think your loss cost inflation numbers are now so we can kind of get an idea of what, or if you think yours are any different than, say, kind of the numbers that are thrown around in the industry, whether on personal lines or commercial lines or otherwise?
We don't normally talk about the numbers per se, Matt. I would say we're not dissimilar to where the industry is. We're definitely a few points below where we're getting on rate. We're very comfortable about the trend, if you will, that Fred was talking about in terms of pricing above our loss cost trends. I would say the other point to be made here is we still have very strong retentions, which also gives us the opportunity to drive more rate. We're not worried at all about the loss cost point at this moment in the juncture. Again, I won't go into the actual numbers there, but we're not dissimilar to what we're seeing in trends. Again, one of the things about us is that we have probably the lowest percentage of middle market workers' comp in the top 20 companies, too.
That is the one line, obviously, where the loss costs have continued to be pretty significant trends.
Right.
We just don't experience it. We're mostly a small workers' compensation writer, and we have a small percentage of workers' compensation. Most of ours, if you look at it's more contained. Even this severity thing we're talking about in commercial auto is a very contained thing. It's pretty obvious to see, and you can address it pretty quickly with rates. We don't have a lot of the long tail. We don't have public company D&O, which is another place where I think people look at that and say they're a little bit harder. Ours are much more short tail, more manageable, more clear, and with a GAAP to us is pretty stable.
To your point in commercial auto, Fred, when you think about the second quarter of last year, where we were only getting one point of auto price on a very profitable book, in this quarter, getting five points of price on that auto book, as you mentioned in your script, and only a slight increase in the severity trend, plus with what the industry is seeing, it bodes well to what we'll be able to build into price in the auto line going forward. I think that's a very good example of that.
All right. Thank you for all the answers, and best of luck.
Thank you.
Thank you, Matt.
Ray Iardella from Macquarie is online.
Thanks, good morning.
Good morning.
Good morning, Ray.
Good morning. A couple quick questions. I guess first, maybe David, on the stress test that you outlined on the surety reserves. Just curious, can you give us a high level of what are the parameters you're assuming in worst case scenario? I mean, is it a drastic downturn in the economy? Just give us some thoughts if possible.
Yeah. I'm going to ask Andrew Robinson, who leads our specialty business, I'm going to ask him to comment on that for you, Ray.
Ray, obviously we went through, coming out of 2008, a pretty severe downturn in the economy, and the construction economy was largely maintained by big infrastructure projects, which really isn't where most of our contract book is. What we're able to do very directly is back test against sort of a prolonged period that looks like 2008. What we were able to do is just get, when Fred talked about sort of the go forward book, or David talked about it, what we're able to do is just get to the segment of the market that we feel has credit quality well in excess of where the market is today, that we would feel comfortable in allowing us certainly some comfort if there was a further downturn in the construction economy.
I would say that also, what we are thinking very seriously about is where our business is placed. For example, looking at the upper Midwest is very different than looking at Texas or even looking down in parts of the Gulf where there's a good deal of land reclamation work. Some of that is very geographic centric about how we look at our portfolio. It was those combination of things. Through the course of the process, I wouldn't say that we were surprised by what we concluded and what accounts we're going to support and what accounts were not. We're just more comfortable that what we have is a view that does look at this sort of stress test of the economy, that looks like sort of a period of 2008 prolonged into the future. All right.
Yeah, that's helpful. I guess my question was kind of more focused on the accounts where you guys have reserves right now. Is there any sort of stress testing you're doing around that and kind of put some parameters around what's sort of the worst case scenario, maybe what are the reserves currently held on that discontinued book, and then perhaps sort of give us an idea of maybe worst case scenario in your mind as it stands right now?
I think that's exactly what we did and what you saw us do.
Okay.
That's why we put the money up.
Yeah.
The vast majority of that was about this, which just says, what could happen? What's the worst outlook? To David's point, most of it, we adjusted in the reserves, we also are saying on a go forward, we did some also adjustment in our outlook to really capture in a pretty bad scenario what it would be, because we thought it was the right thing to do to be conservative and just kind of really do this and put it behind us this year. That's what you're seeing, is that kind of assessment and the impact of it on this quarter.
Ray, I would add one other item, which is, whenever we see a claim situation or a prospective claim situation, we're looking at the principal across all bonded exposure and non-bonded exposure. If you think about our point of view is really looking at the entire financial characteristics of the principal so that we can understand how activities, as it relates to some contract that we have or multiple contracts that we have, might be affected by some other non-bonded exposure, et cetera. For us, we're pretty comprehensive in understanding how some of these things relate and what really could be sort of the ultimate loss associated with maybe just a single claim that we're getting.
Okay. No, that's helpful, and I appreciate the color. Just putting it in all sort of big picture, I guess, the majority of the change was IBNR as opposed to any specific case reserves. Is that the right way to think about it?
No, again, it was both because these would be, again, because they're runoff business. If we could specifically identify it to the account, then we put it into the case, right? We literally did every single account left in our book and did this and assessed it. Again, to Andrew's point, this was a business we were in for a very long time. It was geographically centric to where we used to be big. It had characteristics. It was mostly small contractors. As you know, when the credit crisis came, they were the most affected by this. We believe we have a good handle on it.
As I said, with the stress tests on our go forward book, I want to echo how good we feel about our go forward book, because even with all these stress tests and assessments, our go forward book in all our scenarios performs very, very well. We feel very good about where we are right now in the go forward.
Okay. No, that's helpful. Then maybe moving on sort of ex surety and maybe some of the auto lines, was there any movement in the loss picks for the current year?
Yeah. Again, in our outlook, obviously we've tried to adjust, looking at the past and then looking at our book, what I was saying about our outlook, a big portion of our outlook change is just taking a more conservative point of view on the current accident year pick in auto. Particularly personal auto. We're not as big in commercial auto, and we don't write heavy trucks or anything. Most of our activity is really personal auto. I would tell you also that we're not just looking at our book, we're also listening to the industry dialogue about what the industry is saying and what's unfolding in the industry, which makes us want to take the conservative point of view on this because we're not the only person talking about what's happening with severity in the auto book.
We thought it was appropriate for us to, on a go forward basis, affect our picks. Again, most of this is 2011 and forward, right? Really that's what it is. That's how we addressed it.
Yeah. Besides those points, I think, Ray, there's very little movement in our other picks for the year.
Okay. Second quarter, no movement really up or down year to date?
Sorry, you have to expand on that.
During the second quarter, did you adjust any of the loss picks for the current accident year?
Just in the lines we've talked about we have.
Okay.
Across the other lines, we might have tweaked some things, but really marginally.
Marginally.
Okay. That's what I was looking for. Lastly, I'll requeue. Sorry to take up so much time. Buybacks, what is your thought on that going forward? I know there was marginally some buybacks in the second quarter, but just any color would be helpful. Thanks for all your answers.
Yeah, sure. I made some references in my remarks, but we saw the opportunity to deploy some capital in buybacks. There was a lot of volatility in the market. We saw there was some good value in putting some money to work here, and we did do some buybacks. As I said in my remarks, we're open to potentially doing some more, but I would tell you it'd be very modest amounts through the rest of the year. We have a lot of authorization left. No way are we going to be spending that entire authorization. I think as we see where our share price is today, and as we look at the volatility in the marketplace, we are going to opportunistically look at putting some money against more buybacks.
Okay, thanks for all the answers.
Ray, we don't have anyone else on the line, so we will take your last question. You mentioned you'll requeue.
No, that was all I had.
Okay.
Great. Thank you, Ray.
Thank you everyone for your participation today, and we are looking forward to talk to you next quarter.
Great. Thank you.
Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.