Good morning, ladies and gentlemen. Welcome to the fourth quarter results teleconference for Travelers. We ask that you hold all questions until the completion of formal remarks, at which time you will be given instructions for the question and answer session. As a reminder, this conference is being recorded on January 24th, 2017. At this time, I would like to turn the conference over to Ms. Gabriella Nawi, Senior Vice President of Investor Relations. Ms. Nawi, you may begin.
Thank you. Good morning. Welcome to Travelers' discussion of our 2016 fourth quarter and full year results. Hopefully, all of you have seen our press release, financial supplement, and webcast presentation released earlier this morning. All of these materials can be found on our website at www.travelers.com under the investor section. Speaking today will be Alan Schnitzer, Chief Executive Officer, Jay Benet, Vice Chairman and Chief Financial Officer, and Brian MacLean, President and Chief Operating Officer. They will discuss the financial results of our business and the current market environment. They will refer to the webcast presentation as they go through prepared remarks. We will take questions.
In addition, other members of senior management are in the room, including Michael Klein, Executive Vice President and President, Personal Insurance, Thomas Kunkel, Executive Vice President and President, Bond & Specialty Insurance, and Greg Toczydlowski, Executive Vice President and President of Business Insurance. Before I turn it over to Alan, I would like to draw your attention to the explanatory note included at the end of the webcast. Our presentation today includes forward-looking statements. The company cautions investors that any forward-looking statement involves risks and uncertainties and is not a guarantee of future performance. Actual results may differ materially from those projected in the forward-looking statements due to a variety of factors. These factors are described in our earnings press release and in our most recent 10-Q and 10-K filed with the SEC. We do not undertake any obligation to update forward-looking statements.
Also, in our remarks or responses to questions, we may mention some non-GAAP financial measures. Reconciliations are included in our recent earnings press release, financial supplement, and other materials that are available in the investor section on our website, travelers.com. Now, Alan Schnitzer.
Thank you, Gabby. Good morning, everyone, and thank you for joining us today. This morning, we released solid underwriting and investment results with record net and operating earnings per share for the quarter. Operating income was $919 million, generating an operating return on equity of 16.4%. This brings our full-year operating income to nearly $3 billion and operating return on equity to 13.3%. That's in line with the 13.5% average annual operating ROE we've delivered over the last 10 years. During the year, we grew adjusted book value per share by 7% after returning more than $3.2 billion of excess capital to our shareholders. Overall, our underwriting results for the year were strong, as evidenced by our consolidated combined ratio of 92%. Underwriting results in Business Insurance and international insurance were solid, and once again, we posted impressive underwriting results in Bond and Specialty Insurance.
Despite the disappointing impact of higher-than-expected personal auto bodily injury losses, our Personal Insurance combined ratio for the year was 95.1%, demonstrating the value of having a balanced homeowners and auto personal lines business. In our commercial business, we continue to be successful in the execution of our marketplace strategies. That resulted in continued historically high levels of retention and positive renewal premium change in the quarter, all of which reflects a stable environment. In our core middle market business, pure renewal rate change improved by a full point from the third quarter as we continue to execute at a very granular level to achieve our written return objectives. As you'll hear from Brian, in terms of new business, we continue to be quite active in terms of submission and quote activity, but also thoughtful in terms of underwriting discipline.
Turning to Personal Insurance, as you've seen, the results by line were mixed. Our homeowners business once again produced excellent results and grew net written premium for the first time since 2011. In our auto business, we're clearly disappointed by the underwriting result. During the fourth quarter, bodily injury losses were higher than expected. They developed unfavorably for the first three accident quarters of 2016 and the back half of 2015. Our claim data, the public chatter we hear from others in the marketplace, and other third-party data all cause us to continue to believe that our experience is principally environmental as opposed to specific to us or our Quantum Auto product. Loss trends change in our business, and as I've said before, our objective is to recognize it and react to the data we have as quickly as possible.
We're taking actions to improve the personal auto profitability. Brian will address this in more detail. Before I pass the mic to Jay Benet, let me conclude with this. 2016 was another strong year, adding to our long-term track record of delivering superior results. We enter 2017 with a great deal of momentum, and we're well-positioned for continued success. With that, I'll turn it over to Jay Benet.
Thanks, Alan. As Alan mentioned, we are very pleased with our results this quarter. A record net and operating income per diluted share of $3.28 and $3.20 respectively, operating income of $919 million, up 4% from the prior year quarter, an operating ROE of 16.4%. These results were driven by the continued solid underwriting performance, as evidenced by our consolidated combined ratio of 90%, which included the favorable impact of prior year reserve development, which I will discuss shortly, as well as the unfavorable impacts of CAT losses of $137 million pre-tax that related to Hurricane Matthew and the fires in Tennessee, and higher-than-expected auto BI losses in Personal Insurance. The quarter also benefited from the settlement of a reinsurance dispute and higher after-tax net investment income, which, after increasing sequentially quarter-by-quarter this year, increased 12% this quarter over the prior year quarter, all due to higher non-fixed income returns.
Fixed income NII of $405 million after tax was down $17 million from the prior year quarter due to the continuing impact of the low interest rate environment. Looking forward into 2017, based on the current interest rate environment and the specific securities that are scheduled to mature in 2017, we expect approximately $15 million to $20 million of lower after-tax NII on a quarterly basis in 2017 when compared to the corresponding periods of 2016. This is a $5 million per quarter improvement from what we communicated last quarter due to the recent rise in interest rates. Of course, if interest rates were to continue to rise from their current levels, this expected decrease in fixed income NII would be reduced even further.
In contrast to the decrease in fixed income NII, non-fixed income NII of $96 million after tax was up $71 million from the prior year quarter, driven by significantly higher private equity returns. We continue to experience net favorable prior year reserve development on a consolidated basis, which totaled $264 million pre-tax this quarter, down a bit from the $292 million pre-tax in the prior year quarter. In Business Insurance and international, net favorable development of $234 million pre-tax was driven by better-than-expected loss experience in workers' comp and general liability, while in Bond & Specialty Insurance, net favorable development of $75 million pre-tax resulted from better-than-expected loss experience in fidelity and surety and general liability. Reserve development was unfavorable this quarter in Personal Insurance, $45 million pre-tax, driven by higher-than-expected auto BI injury losses related to the latter part of the 2015 accident year.
This corresponds with the increase in auto BI loss estimates that we made for the current accident year, which Brian will be discussing. In total, for the full year, we had consolidated net favorable reserve development of $771 million pre-tax, with approximately $665 million coming from our U.S. operations and $106 million coming from international. As I have done in the past, I am also providing you with some insight into what our combined 2016 Schedule P is expected to show when we file it on May 1. On a combined stat basis for all of our U.S. subs, all accident years across all product lines in the aggregate will have developed favorably. On a Schedule P product line basis, all of our commercial products will show favorable development or very modest amounts of unfavorable development.
For Personal Insurance, homeowners will show a modest amount of unfavorable development, primarily resulting from the higher-than-expected loss experience that I discussed in the third quarter webcast that related to a small number of liability claims from accident years 2013 and 2014, and private passenger auto liability will show the unfavorable development that I just referred to. There are two topics I'd like to cover relating to reinsurance. First, we were very pleased this quarter to have settled with one of our reinsurers in the U.S. USF&G versus Amerisure et al. case, a reinsurance dispute that's been pending for many years. As a result of the settlement, we recognized a $126 million pre-tax or $82 million after-tax gain in our fourth quarter earnings. I refer you to the Form 10-K that we filed on November 8th for more information related to this settlement.
Second, as shown on page 21 of the webcast, effective January 1, we renewed our corporate CAT aggregate XOL treaty that provides coverage for both single CAT events and an accumulation of losses from multiple CAT events with similar terms as in the prior year and at a slightly lower cost. The treaty continues to provide $1.5 billion of coverage, part of $2 billion excess of $3 billion after $100 million deductible per occurrence. It keeps the same broad peril and geographic coverage and the same positioning of the coverage layer, providing a significant buffer between earnings and capital. The treaty has a single limit with no reinstatement provisions, and please note that the total cost of this treaty, and therefore the reduction in cost, are quite small in relation to our operating income.
Operating cash flows were very strong this quarter, $1.14 billion, including the proceeds from the settlement of the reinsurance dispute I just mentioned, and after making a $200 million discretionary contribution to our now fully funded U.S. qualified pension plan, bringing total operating cash flows for the year to over $4.2 billion. We continue to generate much more capital than is needed to support our businesses and consistent with our ongoing capital management strategy, we returned $942 million of excess capital to our shareholders this quarter through dividends of $191 million in common share repurchases of $751 million. For the full year, we returned over $3.2 billion of excess capital to shareholders through dividends of $762 million and common share repurchases of over $2.4 billion.
Holding company liquidity ended the year at $1.68 billion, well above our target level, and our debt-to-total capital ratio, excluding the impact of net unrealized investment gains, ended the year at 22.3%, well within its target range. Net unrealized investment gains were $1.1 billion pre-tax or $0.7 billion after tax, down from almost $2 billion and $1.3 billion respectively at the beginning of the year due to the recent run-up in interest rates and spreads. As you may recall, we generally use a buy and hold approach for fixed income investing, so any change in unrealized that relates to a change in the general level of interest rates is something we do not pay much attention to. Cash flows from the portfolio are what matter to us.
Book value per share of $83.05 grew 4% from the beginning of the year. Importantly, adjusted book value per share of $80.44, which eliminates the after-tax impact of net unrealized investment gains, grew by 7% this year. With that, let me give the microphone over to Brian.
Thanks, Jay. I'll start with business and international insurance, where we are pleased with our full year financial and production results. We continued to generate excellent returns, achieving a combined ratio of 94.3. Retention for our domestic businesses remained at historically high levels. We successfully achieved positive rate change with renewal premium increases of over 2%. As Alan mentioned, retention for the industry remains very strong, reflecting a stable marketplace. In that light, we were quite pleased that we were able to generate nearly $2 billion of new business premiums, up slightly from 2015. Looking at the quarter's financial results, operating income of $722 million was higher than the prior year quarter by $156 million, with a very strong combined ratio of 89%. Operating income included the $82 million after-tax gain related to the settlement of a reinsurance dispute that Jay mentioned earlier.
This gain was in other income. Accordingly, did not benefit the combined ratio. The underlying combined ratio, which excludes the impact of CATs and prior year reserve development, was 93.1. The underlying loss ratio was 1.4 points lower than the prior year, due to lower large losses and non-catastrophe weather-related losses, partially offset by a modest amount of margin compression. Turning to production, given the returns that we are generating in the segment, our focus continues to be on retention. We are very pleased that retention for our domestic business remained at 85% for the quarter. Renewal premium change of 2.5 points included renewal rate change of 0.7 points, which was higher than recent quarters, while new business came in at $439 million for the quarter.
Turning to the individual businesses, in select, retention continued its improving trend. Came in at a strong 83%. Renewal premium change was nearly 6 points. We generated new business premiums of $92 million, up 7% versus the prior year. In middle market, retention of 87% remained at a historically high level, while renewal premium change was over 2 points, including 1.4 points of renewal rate change, a full point higher than the third quarter. New business activity, as measured in submissions and quotes, has been up for the year. In the quarter remained consistent with the prior year. However, as 2016 progressed, fewer of these opportunities met our underwriting standards and/or return objectives. Accordingly, new business premiums of $226 million in the quarter were down 9% year over year.
In other Business Insurance, renewal premium change was down slightly with a relatively flat rate environment compared to the third quarter of 2016. While retention remained strong at 80% and new business premiums of $121 million. New business volumes for other Business Insurance were impacted by the same market dynamics I discussed in middle market. In international, production results were very strong in the quarter. Retention remained at 82%, while renewal premium change of over two points was higher than recent quarters, with the biggest single driver of the increase being Lloyd's, which due to the transactional nature of that market, is subject to variability. New business volume of $91 million was up 14% year-over-year, driven by Lloyd's, including the results of our new Global Construction and Renewable Energy groups.
All in for the segment, it was a very good quarter, capping off a year with strong production and profitability. Before turning to Bond & Specialty Insurance, I want to comment on our outlook for operating margins, which we include in our quarterly filings. Since our 10-K won't be filed for a few weeks, I would note that we expect underlying underwriting margins and the underlying combined ratio during 2017 will be broadly consistent with those in 2016. This is subject to the usual caveats and forward-looking statement disclaimers. I'll now turn to Bond & Specialty Insurance, which continues to perform exceptionally well. Operating income for the quarter of $161 million remains strong and was in line with the prior year quarter, as an improved underlying underwriting margin was offset by a slightly lower level of net favorable prior year reserve development.
The underlying combined ratio of 79.7 for both the quarter and year, with the full year result being an all-time best for the segment. On top line, net written premiums for the quarter were consistent with the prior year for both surety and management liability. In our management liability business, we continue to execute our strategy of retaining our best performing accounts while writing new business in return adequate product segments. We couldn't be more pleased that retention for the quarter was a record 88%, while we added $41 million of new business. Renewal premium change of 2.3 points is down about a point from recent quarters, reflecting a mix change impacting average policy duration. The other components of renewal premium change that drive profitability were essentially unchanged.
Bond & Specialty results remain terrific, and we continue to feel great about the segment's performance and execution in the market. In terms of outlook, as with Business Insurance, for 2017, we expect both the underlying underwriting margin and underlying combined ratio will be broadly consistent with 2016. Turning to Personal Insurance, net written premiums for the segment grew 12% in the quarter, with a combined ratio of 98.2 and an underlying combined ratio of 93.2. For the full year, net written premiums grew 10% with a combined ratio of 95.1 and an underlying combined ratio of 90.1. Overall, strong results for the segment, but results by line were mixed. In auto, as Alan mentioned, we booked further upward revisions in our loss estimates for 2016 and for the second half of 2015.
The auto combined ratio for the quarter was 116.7 and includes both the full year impact of the bodily injury related adjustments that I just mentioned and seasonably higher fourth quarter loss levels. Instead of taking you through a detailed reconciliation of the quarter, it would be more productive to focus on the full year ratios. For the full year combined ratio, we had a 104.0, and the underlying combined ratio was 101.8. These were both higher than we expected and at a level that does not meet our target returns. The full year 2016 underlying combined ratio included about two points from the tenure effect that we discussed last quarter. As we said then, when you're growing your book of business, the higher levels of new business will temporarily increase the combined ratio and the impact of tenure in the year was as we expected.
In addition to the impact of tenure, the full year 2016 underlying combined ratio is elevated by three and a half points due to the recognition of the increased bodily injury liability losses. This result represents a gap that we are working to close. You will recall that we reacted to signs of adverse bodily injury loss development with a reserve adjustment in the third quarter. Unfortunately, since then, we saw further development in excess of even those increased expectations, which drove our actions this quarter. The deterioration is primarily driven by an increase in the trend towards more severe accidents. Some of the factors that lead us to this observation are a higher percentage of claims involving distracted driving, more accidents involving higher speeds, and more accidents on highways and at intersections. This is also consistent with recent industry data.
For example, the National Safety Council report of significantly higher traffic fatalities in 2015 and 2016, a two-year trend that we haven't seen in decades. In response to these developments, we are taking action in the marketplace. Our primary response is to file for increased base rate, and in November and December of 2016, rate increases were implemented in 16 states, which cover about 60% of our quote volume. More rate changes at higher aggregate levels are planned for 2017, along with other ongoing actions to refine and optimize our underwriting process. The combined impact of these actions should be to both reduce the rate of growth and improve profitability. While it will take 18 to 24 months for the actions we're implementing to fully earn into the portfolio, we do expect that the auto combined ratio will improve in 2017.
Turning to homeowners and other, our results for the quarter and the full year remain strong and reinforce the value of a portfolio underwriter. The underlying combined ratio of 70.4 for the quarter and 75.7 for the year demonstrate consistent performance relative to 2015. In terms of top line, 2016 saw growth in net written premiums of 2%, and we look to continue the momentum in 2017. As I said, mixed results by line in the segment with challenges in auto mitigated by strong results in home, resulting in a segment combined ratio of 95.1 for the full year. We are fully aware that our recent auto results need to improve. The pricing and underwriting actions we're implementing should put us on track to deliver a more profitable portfolio in the years ahead.
Finally, as it relates to our outlook for Personal Insurance, we expect underlying underwriting margins during 2017 will be slightly higher than in 2016, and the underlying combined ratio during 2017 will be broadly consistent with 2016. In agency automobile, we expect underlying underwriting margins and the underlying combined ratio will improve in 2017 compared to 2016. In agency homeowners and other, we expect that underlying underwriting margins will be slightly lower, and the underlying combined ratio will be slightly higher in 2017 than in 2016, reflecting higher and more normalized levels of loss activity. With that, let me turn it over to Gabby.
Thank you. We are now ready to start the Q&A portion. Before we start, if I could just ask you to limit yourself to one question and one follow-up. Thank you.
Thank you. Ladies and gentlemen, if you would like to register a question, please press the one followed by the four on your telephone. You will hear a three-tone prompt to acknowledge your request. If your question has been answered and you would like to withdraw your registration, please press the one followed by the three. If you are using a speakerphone, please lift your handset before entering your request. One moment, please, for the first question. Our first question comes from the line of Michael Phillips with Goldman Sachs. Please proceed with your question.
Thanks so much. Brian, maybe a little bit on auto. If you could just give us some indication of how we should be thinking about sort of the starting point for 2017 and given the adjustments you made through the year, when should we start to see the rate increases
Flow through and should we expect the starting point to be closer to the developed loss ratio picks that you have set now for 2016?
Michael, this is Michael Klein from Personal Insurance. I'll take a crack at that. I think you will see the rate increases start to flow through in the first quarter. As Brian said, we began making rate filings in the fourth quarter, really in response to what we saw in the third quarter. The rate filings that we're now making as we look ahead to the first half of the year reflect the increased loss of content that we saw in the fourth quarter. Importantly, you don't see a lot of the fourth quarter rate filing activity in the production statistics just because of the timing of those rate increases. They went in in November and December, largely impacted renewals not until December. It's really a timing issue in terms of not seeing it show up in the fourth quarter of this year.
We would expect that you'll see the rate momentum start to build in the first quarter of 2017 and continue from there. In terms of the starting point for 2017, I would say two things. First of all, as Brian mentioned, that three and a half points that you see on the webcast slide, he mentioned that represents a gap that we're looking to close. In other words, that three and a half points is built into our baseline expectation as we start 2017. Then we're taking trend and forecasting that forward from that point. The starting point does include that three and a half points of additional losses and the gap that we're looking to close.
Got it.
Michael, just let me.
Yep, sure.
This is Brian. I would also just emphasize, obviously, thinking through the written versus earned dynamic with the rate. As we obviously get it on a written basis, it has to earn in over time, hence my comment of 18 to 24 months to work through the three and a half points.
Got it. Okay. That's helpful. Thanks. Most of your policies are 50/50 annual versus six-month policies, is that right? Or somewhere in that range?
It's a little bit more tilted towards annual, so it's about 60/40 annual versus six months.
Okay, got it. Brian, when you mentioned sort of the margin outlook for 2017 versus 2016, does that contemplate that whatever trend you're seeing is sort of the nadir, that we're not going to see more deterioration? Does that contemplate that you're going to see that the loss trend continue to increase at maybe some pace, not at the same level as we've seen? If you give some context there. Thanks.
Yeah, I think as Michael just said, the 3.5 elevation is built into our expectation. Above that, we're expecting kind of normal 3.5% loss trend, which includes a more normal inflation of severity, but we don't expect another spike. Michael?
Yeah, I would say, and just to clarify, Brian mentioned the 3.5-point loss trend. That is an elevated loss trend relative to where we've been. The forecast, importantly, I think it's important to take away that it includes both the increased baseline and a higher trend estimate going forward than we had in the past. It's modestly higher, but it is a bit of an increase in trend.
Got it. Great. Thank you very much.
Next question, please.
Our next question comes from the line of Kai Pan with Morgan Stanley. Please proceed with your question.
Thank you. Good morning. First question is just on these sort of deterioration of fourth quarter. If you're looking back on third quarter, what exactly sort of like accelerating term loss cost trend from the third quarter? Just want to get a confidence level that what you book in the fourth quarter, do you think that's it and it probably not be much matured like a deterioration from that levels?
The first thing I'd say, Kai, it's all the normal stuff. We're talking about very recent accident periods for a very long tail line of business. Just as a perspective. At the end of 2016, we have paid less than 15% of what we believe the ultimate losses will be for auto bodily injury. It's by nature a long tail line of business. It takes a while to play out. We're looking at all of the activity that we see both in frequency and severity of loss cut every which way you can think of. Looking at frequency activity, incurred losses, paid losses.
Importantly, we're also as we went into 2016, we're looking at that coming off of 2013, 2014, and early 2015 where we actually had slightly favorable development in the 2013 and 2014 years and consistent experience in the early part of the 2015 year. We're looking at the history that we have coming into the year. As we went into 2016, we started to see a little bit of movement in the fourth quarter 2015 and early 2016, but still within our range of expectations. We got to the third quarter and those periods, again, fourth quarter 2015, first two quarters of 2016 started to elevate above the expectations, hence we took the activity and the actions that we did last quarter.
This quarter, as we look at all of those periods again, we're looking at the end of 2015, early first three quarters of 2016, and obviously another quarter of data, we saw a continuation in that trend that was accelerating. We took what we think was the appropriate management's best estimate given all of those factors. We feel good about it, but there's certainly no guarantees that we can see what's going to happen next quarter. I mean, Michael, if you want to-
I think that's exactly right. I think it's a combination of additional development on the periods that we saw before an additional quarter's worth of data that again reflects the fact that that adverse development continued through the end of the year, we've made our best estimate based on the information Brian just described.
Okay. Thanks. Very comprehensive. My follow-up on the auto side again, is that if you look at PIF growth, 13% year-over-year is actually accelerated from the last few quarters. As you increase price, do you think that one coming down, and do you think the two points on the sort of new business penalty impact will be smaller in 2017?
Thanks, Kai. This is Michael. I would say a couple of things, and let me give you a little bit of the moving parts underneath the PIF growth, in the fourth quarter. We do expect, as we put rate into the marketplace and put additional rate into the marketplace, that our win rates will decline. On the business that we quote, do we convert it? We've actually seen in the 16 states that Brian mentioned, our win rates have come down as we put that rate into the marketplace. Think of that as our batting average, right? Our batting average is dropping as we put rate into the marketplace. The reason PIF growth is up in the fourth quarter is actually largely driven by the fact that we ended up with more at bats than we expected in the quarter.
Quote growth is actually elevated, so we've got more plate appearances, if you will, but the batting average, the win rate, has actually come down in response to the rate. Again, we think some of that is timing, some of that, as we mentioned last quarter, the ultimate impact of the actions we take depends somewhat on the fact that we're in a competitive environment, and the impact on growth depends a little bit on what happens in the marketplace. Our perception of what happened in the fourth quarter is we took rate, so did the market. The rate impacted our batting average, but the rate also drove business into the market, which drove that quote growth. The PIF growth is really a quote growth story, not a conversion rate story.
In terms of your question about expectation as we look ahead, our actions are focused on two things, improving profitability and managing growth. We expect, I gave you a little bit of an outlook for 2017 rate looking ahead into the first quarter. We would expect rate will rise and growth will drop as we look into the first quarter. What ultimately happens will depend on how those actions play out in the marketplace.
Thank you so much.
Next question, please.
Our next question comes from the line of Paul Newsome with Sandler O'Neill. Please proceed with your question.
I wanted to switch the question on to the commercial business a little bit. I was wondering if you could give just a little bit more color on the pricing environment in the domestic insurance business. It's a little bit tough to read the tea leaves. Is it better? Is it worse? Is there really any change from a competitive perspective in that business?
Paul, this is Brian. I'll start. I'm sure there'll be follow-ups to this, broadly speaking, we feel good about the trends that we see. When you look across the data on the renewal book, we continue to see some, albeit modest, but pretty consistent improvement in what we're seeing. We're encouraged by that. We think that might be somewhat a reflection of the market, fundamentally, I think it's a reflection of our execution. Our strategy on our portfolio remains incredibly consistent, that is to look at it on a very granular account-by-account or class-by-class basis, simplistically, for the really well-performing businesses, keep it at the best price that we can keep it at and the appropriate price, then work hard at improving the rest of the portfolio.
When we look at that granular level, we feel really good about the momentum and also feel good about the aggregate statistics. Directionally, we feel positive.
Paul, it's Alan. I would add to that it's not just a market dynamic, it's an our execution dynamic. It's a very granular, as Brian said, account by account, class by class. I think in some respects, importantly, it's the franchise value we bring to the marketplace. We look at an account, we figure out what we need to do to achieve the written return objectives that we have, I would say broadly speaking, we've been successful.
How closely does the commercial auto business, or has the commercial auto business tracked the results of the private passenger auto?
Paul, I'd say that we see a lot of the same trends in the businesses. They're different businesses. They have different starting points. The coverages aren't exactly the same. For example, on the Personal Insurance side, you've got uninsured and underinsured motorists. That's not such a factor on the Business Insurance side. I would say broadly speaking, the trends are consistent. We see consistency across them, but the results don't actually come out the same for a whole host of reasons.
We haven't seen the severity issue even at a lower level in the commercial auto?
No, I wouldn't say we haven't seen it. We have seen it. It has impacted recent years. We see a lot of the same trends. On the auto side, it's largely private passenger. On the Business Insurance side, you've got a lot of trucking, you've got different dynamics there. Also, it just manifests itself differently. On the Personal Insurance side, auto is obviously a bigger contributor to the segment, more in terms of volume. It just manifests itself more prominently. On the BI side, obviously commercial auto is a smaller piece of the whole, it manifests itself differently. We do see very consistent trends across both books.
Great. Thank you very much.
Thank you.
Next question, please.
Our next question comes from the line of Larry Greenberg with Janney Montgomery Scott. Please proceed with your question.
Thank you. I want to go back to the auto, I appreciate that you think it's mostly environmental on top of the tenure issue. I guess I just want to challenge you a bit on this and just question whether you think it's fair to say that maybe you picked up on some of these environmental factors later than some of the others did. If you agree with that, why do you think that's the case? I kind of say this in the context of when you were growing rapidly in auto and before you picked up on the BI trends. I know you talked about being keenly focused on what was driving that growth. I'm just curious on your thoughts on all that.
Larry, this is Brian, I'll start with, there's a lot in your question. We do believe it's a fundamentally environmental issue. We would never say it is definitively, exclusively an environmental issue. As I think I said last quarter, as I'm sure I said last quarter, Quantum 2 is a relatively new product that we're working out, and accordingly, we are very attuned to looking at how it is performing and always looking to improve it. I would not agree with your statement that we are late to seeing the fundamental trend of what's going on in bodily injury severity. Without doing a long history, you can go back 2011, 2012, 2013, we were talking about this a lot. Distracted driving and speeds are not brand-new things, and we were talking about it then.
We got to 2013 and talked about an elevated level of bodily injury, and we were hoping that that would remain pretty constant. We went through about a two-year period, 2013, 2014 into 2015, where we saw very constant, again, elevated levels, but constant with our expectations of what we were getting in bodily injury. In fact, 2014 has developed favorably, and we continue to see that. What we are talking about now is another increase in that trend. We're talking about very recent accident periods and looking at the data and responding, I think, pretty quickly. I think there's a bunch of things.
Further on the comment of, "You sure it's not Quantum 2?" We're sure it's not exclusively Quantum 2 because when we look across our business, the same fundamental trends are in the legacy book of business, are in the Quantum 1 book of business, are in the Quantum 2 book of business, are in the Business Insurance business. It's in industry data. It's with other carriers. It's not exclusively a Quantum issue. With that said, we are very granularly looking at how that product is performing state by state, cell by cell, and reacting. I know that's probably sounding way more defensive than I should.
The one thing I would add to that, Larry, it's Alan. The profile of the business that we're attracting, we actually like it. We look at the profile of all the business coming in, and if we didn't like that profile, we would have a different answer for you. Fundamentally, we like it. We just like it at a higher base rate.
Great. Thanks.
I guess that was your question. Next question, please.
Our next question comes from the line of Meyer Shields with Keefe, Bruyette & Woods. Please proceed with your question.
Thanks. One, I guess, question on the actual quarter. There was a slowdown in exposure unit growth within the middle market. I was hoping you could talk to that a little bit.
Meyer, there's nothing fundamental in terms of trends changing there. There's always going to be some normal volatility from quarter to quarter and things that drive the exposure, there's really nothing fundamental that we would identify as a trend.
Okay. Not related to the improving renewal rate changes?
No.
No.
No.
No.
Okay. More broadly speaking, when you look at the targeted after-tax returns, would a change in tax rate change what you're targeting?
Yeah. It's an interesting question, I guess instead of answering that specific question, Meyer, let me just back up. My guess is there's a lot of questions on the call in terms of change in administration, macro environment, how it's going to change a lot of different things, maybe I'll just back up.
We are very return-focused in the way we think about this business. It is the lens through which we evaluate just about every decision that we make. We calibrate our return expectation to our cost of capital. There are a couple of things going on that could impact our cost of capital. For example, if the risk-free rate goes up, cost of equity goes up. If the tax rate goes down, our after-tax cost of borrowing theoretically goes up. There could be other things in a change in tax policy.
If you just started with those two simple assumptions, you'd look at that and say, "Gee, if the risk-free rate goes up and if the tax rate goes down, you'd speculate that our overall cost of capital would go up." If our overall cost of capital went up, our return objectives would go up with it.
Okay, that's very helpful. Thank you.
Next question.
Our next question comes from the line of Brian Meredith with UBS. Please proceed with your question.
Yes, thanks. A couple questions here. Just first, on the Personal Insurance, do you think that the rate actions you're taking on auto insurance will have any impact on homeowners growth here going forward?
I think that's possible. We've certainly talked about the fact that one of the benefits of our auto growth has been growth in home.
Yep.
That said, we're doing what we can to mitigate that impact. We've got specific actions we're taking from an agency management and a distribution standpoint, and in other areas to try to make sure that any impact from the rate actions in auto don't have an impact on our ability to grow home. We're trying to continue the momentum that we have in the home line into 2017. In other words, they definitely correlate, we're hopeful there are things we can do to offset that and try to lever up the home growth.
Got you. The second question, on the domestic Business Insurance. We've seen your rate activity modestly increase the last several quarters. Is that a trend we should continue, or are you getting to a point now where you're saying, "All right, can't let the underlying loss ratios deteriorate anymore on an underwriting year basis?
I know this won't be totally satisfying, I think we're going to go back to the answer we give, which is we look at the accounts that are up for renewal every quarter, we try to figure out what we need to do to achieve our written return objectives. It's every single one of those transactions or every portfolio on the flow stuff really evaluated one at a time that rises up to that number. We don't paint with a broad brush. We don't go out to the market and say, "Get 1.4 points of rate in middle market." We say, "This is our overall return objective," and go out and execute one account or class at a time to get there. We will, when we get to the 10-K, give you an outlook on RPC. We haven't shared that yet.
It'll be in the 10-K when it comes out, we never forecast uniquely on pure rate.
Right. You are forecasting for a flat underlying combined ratio, right? For the next year, if I remember correctly, part of it was there's going to be better non-CAT weather lease normalization and then deterioration from rate below trend, right?
Yeah. The margin compression that we've had this quarter and the last few quarters has been relatively modest, and this quarter and in past quarters, it's been within other things that caused volatility in the period-over-period comparison. Most notably this quarter and probably recent quarters, weather and large losses. When we give you that outlook, and yes, we did say broadly consistent, and we're certainly not measuring it to the basis point, but broadly consistent within a relatively narrow range. That takes into account lots of things. Rate, loss trend, mix, claims handling initiatives, other strategic objectives. It really is sort of an all-in assessment, and we try not to focus too narrowly on that narrow rate loss trend. You've got exposure in there, too, contributing to margin. It really is a broader perspective when it comes to our outlook on margin.
Great. Thanks, Alan.
Thank you.
Next question, please.
Our next question comes from the line of Jay Cohen with Bank of America Merrill Lynch. Please proceed with your question.
Yeah. One more question, I guess about the new administration. Obviously, something that's been talked about relative to taxes is a border adjustment tax, and I'm wondering if you could share your thoughts on how that may affect your purchase of reinsurance from non-U.S. companies.
Jay, good morning. It's Alan. Let me start. It's really hard to answer that question without knowing what the border adjustment's going to look like. We've all read it depends on whether it gets characterized as an export or an import and whether the dialogue sort of defaults to the Neal bill, and we'll see where that comes out. I think broadly speaking, as it relates to us and reinsurance, I think our answer would be we're by and large a gross line underwriter. We like our underwriting, we like to keep it, and we buy reinsurance in pretty modest amounts. So if there were a tax adjustment that changed the cost of reinsurance, obviously we could look for alternative providers of reinsurance. We could buy a little bit less, buy a little bit more. It would come down to evaluating the individual transaction.
I think the broader point for us is reinsurance just isn't that big a deal for us.
Got it. Thanks for the thoughts.
Thank you.
Next question, please.
Our next question comes from the line of Amit Kumar with Macquarie. Please proceed with your question.
Thanks, and good morning. Two quick follow-ups on personal auto. The first question I have is, if I go back and look at the rates that were put in place for 2016, I guess average rate filings were in the range of, let's say, 3% or so. When you talk about the rate filings in November, December, and going forward, how should we think about that number compared to the historical 3% average number?
Good morning, Amit. It's Alan. I would say it's a pretty broad range. It depends on the state, and even there, it depends on two things. One, our experience in that state and the rate need, also recent rate filings in that state, right? Because there's a cumulative nature to it. Certainly, it's getting bigger than what you'd seen earlier in 2016, and we expect more of the same during 2017 to try to close that gap of the three and a half points.
Okay. Probably more than that. Is that a fair way to look at it?
Yes, definitely.
Okay. The second question, the final question I have is, you talked about 60% of your book, 16 states. You said more filings were in the pipeline. Is that immediate? Is that like a Jan, Feb thing, or is that more spread out versus the actions taken in the past?
Amit, this is Michael. I would say just to first clarify the comment. The comment was 60% of our quote volume. Again, think of that as a new business statistic, right? The 16 states that we filed in so far, those represent roughly 60% of our new business quote volume. Not exactly the same as 60% of the book, just a point of clarification. I would say the majority of the rest of the states have rate filings planned for the first quarter. Broadly speaking, we will have made rate filings in the majority of the states where we have the auto product by the end of the first quarter. We also have additional rate actions planned for later in the year, that obviously is all subject to regulatory approval and regulatory constraints as to the timing and the amount.
I would say the first round ought to be in market by late in the first quarter, we've got follow-up actions on the drawing board as we look into the remainder of 2017.
Got it. That's very helpful. Thanks for the answers, good luck for the future.
Thank you.
Thank you. Next question, please.
Our next question comes from the line of Ryan Tunis with Credit Suisse. Please proceed with your question.
Hey, thanks. My first question, I guess, is for Brian, and it's on the new business penalty. It doesn't sound like the thinking has really changed on the impact of the new business penalty. I guess even though the environment's revealed itself to be a bit more of an issue maybe than we thought a couple of quarters ago. Just what gives you confidence, I guess, to continue to compartmentalize the BI severity versus the new business drag, especially when we think about the fact that a pretty good size of the book is new business. I guess along those lines, if there still is a big tenure impact, why wouldn't we assume that a lot of that strain alleviates itself in 2017 with the growth pullback?
Yeah. A couple things. I think of the tenure impact as being discrete from the bodily injury trend. The tenure impact is just the math of the maturing of the book of business. In fact, where it goes in 2017 is a function somewhat of what growth rates do. It will likely increase in 2017 slightly as the growth that we've seen in the back half of 2016 earns through the business. I think of the tenure impact as more of just the arithmetic of, I don't think of it as a new business penalty as in, a BI where you're pricing differently.
Yeah. Again, this is Michael Klein. I would say, just to reinforce what Brian MacLean said, when we talk about the tenure effect, what we're really trying to do is just isolate the impact on the loss ratio from the relative age of the business, if you will, right? How tenured it is, what renewal it is at. As Brian MacLean said, it's essentially a mathematical exercise to estimate what that component is worth. The rest of it, the environmental trend that we talked about, the 3.5 points that's in the full-year loss ratio is absolutely the gap that we're actively working to close. What we do in the meantime is we monitor the performance of the tenuring-
Yeah
Try to isolate that and make sure that that is developing as we expected. That analysis has remained relatively consistent and is why we continue to have that same 2% estimate a quarter later.
Okay. That's helpful. A couple quick ones for Jay Benet. First, on the workers' comp and general liability, just curious the accident years on those reserve releases. Also just any color on how new money yields have changed, I guess, today versus the end of the third quarter. Thanks.
As it relates to the accident year question, it's really spread amongst a number of accident years. We, in the past, in our disclosures have said at times it's related to accident year X and Y. When we were preparing the disclosures this time, the laundry list of accident years was exceptionally long, and we just said, "Well, why don't we just say what it relates to?" There isn't any particular accident year for either one of them. It's just spread amongst various ones. As it relates to the new money yield, just looking up some stats. Let's see. We generally tend to focus on the 10-year Treasury. If you look at where the 10-year Treasury was at the end of September, it was 1.6, and end of December at 2.45. Spreads moved in that timeframe as well.
I think you could look at the public data as to what took place, but a considerable rise in interest rates from one period to the next. Bill, do you want to add something to that?
Yes, I thought I might add a little. Obviously, the question goes to at what point will new money yields exceed maturing yields. Obviously, the action of the fourth quarter gets us closer to that point, but we're not yet where we need to be. We've done a fair amount of work on it in the last few weeks, using a whole bunch of assumptions which would take a long time to relate. We think that for taxables being replaced by taxables, we reach that point sometime in the first half of 2017. For municipals replacing municipals closer to the first half of 2019. Obviously, a lot is going to be determined by the shape of any tax legislation. At the very extreme, if you needed a revenue-neutral bill and the municipal exemption itself were affected, that would be non-trivial.
If corporate rates and individual rates were simply lowered and the relative value of municipals were affected, they've already cheapened. That would be less important to us. The bottom line is what I think you're getting at, we're not quite there yet.
Okay. That's really helpful. Thanks, guys.
This is Jay Benet again. If I could just add one thing, not relating to your questions, but during my remarks, one of my colleagues tapped me on the shoulder indicating that instead of referring back to November's filing of a Form 8-K, I inadvertently said 10-K. We don't file a 10-K in November. We did file an 8-K about the settlement. I just wanted to correct the record.
Okay. Next question, please.
Our next question comes from the line of Elyse Greenspan with Wells Fargo. Please proceed with your question.
Hi. Thank you. Good morning. One question first on the Personal Auto book. As you pointed to your margin outlook for 2017, can you talk about, I guess, the components of the expense ratio and the underlying loss ratio? The expense ratio did tick down into Q4, so as part of helping to get to your margin goal for next year, some kind of improvement in the expense ratio to offset potentially a continued deterioration on the loss side. Can you just take us through the components a little bit?
Elyse, good morning. It's Alan. I would say that we go about as far as we want to go in giving outlook, and we're pretty hesitant to start breaking it down into the component pieces. Part of our strategy, at least on the auto side, was obviously reducing expenses, and you've seen that come through to some extent already. Going forward, we prefer not to break out the pieces.
Okay. Thank you. One other question. The Business Insurance reserve releases picked up materially year-over-year as well as sequentially. I know you referenced it spanned numerous accident years in the workers' comp and GL lines. As we think about potentially an environment where we'll see higher inflation levels going forward, just wondering if you can just provide some commentary kind of surrounding the picks that you're using on some of your longer tail lines and what gave you confidence for such a high level of reserve releases given the uncertainty surrounding forward inflation levels. Thank you.
As it relates to reserving as well as pricing and loss picks for a particular year, we're not assuming in any of the work we do this year or in any previous years that whatever the inflation environment that currently exists, and I'd have to say it's an inflation environment related to the specific drivers of losses in our product as opposed to the general level of inflation. We never assume that things are going to stay stagnant. There's an underlying assumption that things will, over time, revert back to the mean. As you can well imagine, there's a great deal of actuarial judgment and management judgment as to what that means.
In looking at the reserves as they exist today, looking at how the development patterns have manifested themselves in the loss triangles, we come up with what our best estimate is of the future payments that we will be making. If those best estimates are lower than what the carried reserves are, we'll make adjustments for it. It is factoring in a long-term view as to what levels of inflation might be.
Okay, thank you very much.
Next, this will be our last question, please. Thank you.
That's from the line of Jay Gelb with Barclays. Please proceed with your question.
Thank you. I had a question on your asbestos exposure. Earlier this month, The Hartford announced an economically favorable transaction with Berkshire Hathaway to buy a retroactive reinsurance contract. The size of Hartford's exposure is very similar to Travelers at $1.8 billion for asbestos environmental, and there's been a $300 million annual pre-tax drag on Travelers' earnings for the past two years. I'm wondering what your thoughts are now that other companies are taking steps to address these legacy exposures.
Yeah, thanks for asking, Jay. There's nothing fundamentally novel about those transactions, and as you can imagine, we look at them from time to time. So far, we haven't seen terms on one of those deals that we found attractive enough to do. I'm not sure what else to say about it.
Thanks very much.
Thank you.
Great. Thank you very much for joining us today. Have a great day.
Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect your lines.