Good morning, ladies and gentlemen. Welcome to the second 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 July 21st, 2016. 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, Tina. Good morning and welcome to Travelers' discussion of our 2016 second quarter 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 businesses and the current market environment. They will refer to the webcast presentation as they go through prepared remarks. Then we will take questions.
In addition, other members of senior management are in the room, including Bill Heyman, Vice Chairman and Chief Investment Officer, 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. 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. Now, Alan Schnitzer.
Thank you, Gabby. Good morning, everyone, and thank you for joining us today. This morning, we reported second quarter operating income of $649 million, or $2.20 per share, and an operating return on equity of 11.6%. Our underwriting results remain strong, as reflected in our 93.1% combined ratio for the quarter, despite the impacts of higher catastrophe and non-cat weather-related losses year-over-year. For the six months, we reported operating income of $1.35 billion, or $4.52 per share, and an operating return on equity of 12%. Given the cumulative impact of eight or so years of declining interest rates on our investment portfolio, also relative to the fresh lows in the risk-free rate, we feel terrific about the returns we continue to generate.
Our expertise in risk selection and pricing, our thoughtful and consistent investment strategy, our active approach to capital management all come together to enable us to achieve our objectives of delivering superior returns and creating shareholder value. Turning to production, the second quarter was another example of the successful execution of our marketplace strategies. We're very pleased with the record volume of premium that we wrote in the quarter, we continue to be very pleased with the modeled returns on the business we're writing. In our commercial businesses, retentions remained high and renewal premium change was positive. Underneath that, consistent with our very granular approach to execution, in middle market, we retained 90% of the premium from our best-performing accounts, with only a modest decline in renewal rate change on that business. On our poor-performing accounts, we achieved renewal rate change in excess of loss trend.
You might have noticed that renewal rate change in domestic business insurance was slightly positive as compared to slightly negative in the first quarter, renewal rate change in middle market improved by a full point. We don't forecast rate, we're not calling a bottom, but the significance of this to us is that the market remains remarkably stable, we're generally successful in achieving our written return objectives. In terms of new business, we are actively seeking and finding opportunities that meet our return thresholds. We delivered strong new business growth in our commercial businesses, including 10% growth in new business and domestic business insurance. In personal insurance, net written premiums grew 9% to a record of over $2.1 billion, with accelerating momentum in both auto and homeowners. New business was up 21% year-over-year, driven by the success of the Quantum product.
Quantum Auto 2.0 continues to meet our financial expectations, is successfully enhancing our market position. Our success in the marketplace across all our businesses really speaks to the value of the talent that we have in the home office and in the field, their ability to leverage our data and analytics and work with our distribution partners to deliver great products and services at fair prices to our customers. Franchise value matters. Before I turn the call over to Jay Benet, I'd like to acknowledge and thank all of our colleagues in the claim organization for their extraordinary efforts in handling the claims of our customers affected by severe weather and fires so far this year.
These experts are on the front line for us, delivering on the promise we extend with every policy that we write, it has been a very active year so far for them. Their responsiveness and expertise are great for our customers and an important competitive advantage for us. In Canada, where we saw significant wildfires in the Fort McMurray area, both our customers and we benefited from the work we've done to replicate our U.S. claim model, which enables us to respond to large-scale events with our own highly trained professionals and resources without resorting to independent adjusters. All in all, solid results for the quarter in the first half, particularly in light of the weather and wildfires, and continued excellent execution in the marketplace. With that, I'll turn it over to Jay Benet.
Thanks, Alan.
As I did in the first quarter, I'd like to start by saying that we were pleased with our results, operating income of $649 million and operating return on equity of 11.6%, despite there being lower than in the prior year quarter. These reductions did not result from significant changes in underlying business trends. Notably, as indicated on page four of the webcast, the quarter-over-quarter decrease in operating income was impacted by, among other things, PCS cat events and lower fixed income net investment income. Losses from PCS cat events that met or exceeded our threshold for recording as cats were $79 million higher after tax than in the prior year quarter. While losses from PCS cat events that fell below our cat thresholds, which we recorded as part of non-cat weather related losses within underlying underwriting results, were $56 million higher after tax than in the prior year quarter.
In fixed income, NII was $21 million lower after tax, primarily due to the continuing low interest rate environment, as we had anticipated in the outlook section of our first quarter 2016 10-Q. Everything else was pretty much a wash. We continued to experience net favorable prior year reserve development, which totaled $288 million pre-tax, or $192 million after tax this quarter, up from $207 million pre-tax, or $133 million after tax in the prior year quarter. In business and international insurance, net favorable development of $138 million pre-tax, or $94 million after tax, primarily resulted from better than expected loss in domestic workers' comp for accident years 2006 and prior, and accident year 2015.
Better than expected loss experience in domestic general liability for accident years 2011 and 2015, and better than expected loss experience in our European operations, partially offset by an $82 million pre-tax or $53 million after-tax increase to environmental reserves. In Bond & Specialty Insurance, net favorable development of $150 million pre-tax, or $98 million after tax, primarily resulted from better than expected loss experience in fidelity and surety for accident years 2010, 2013, and 2014, and better than expected loss experience in GL for accident years 2007 through 2011. Year to date, on a combined stat basis for all of our U.S. subs, all accident years have developed favorably or had de minimis unfavorable development. In addition, other than commercial multi-peril, all product lines have developed favorably year to date.
While CMP has developed unfavorably by $42 million year to date, you may recall my telling you in the first quarter that there was an offsetting favorable development in the property product line as middle market property losses that had been recorded in the property line at year-end 2015 were subsequently determined to be CMP related. Operating cash flows of $443 million were very strong, particularly recognizing that they were net of the $524 million payment we made this quarter as final settlement of the PPG asbestos litigation. We ended the quarter with holding company liquidity of $1.75 billion. All of our capital ratios were at or better than their target levels. Net unrealized investment gains increased to approximately $3.6 billion pre-tax, or $2.3 billion after tax, up from $2 billion and $1.3 billion respectively at the beginning of the year.
While book value per share of $85.73 and adjusted book value per share of $77.61 increased 7% and 3% respectively, also from the beginning of the year. We continue to generate much more capital than we need to support our business. Consistent with our ongoing capital management strategy, we returned $747 million of excess capital to our shareholders this quarter through dividends of $197 million and share repurchases of $550 million. Year to date, we've returned over $1.5 billion to our shareholders through dividends and share repurchases. Before turning the microphone over to Brian, there's one additional topic I'd like to cover, our cat reinsurance coverage. In addition to our corporate cat aggregate XOL treaty, which had renewed at the beginning of the year, our cat reinsurance includes cat bonds that are specific to the Northeast U.S., along with a Northeast gen cat treaty.
With respect to the cat bonds, one that had provided up to $300 million of coverage for certain losses expired as scheduled in May 2016. Given our current risk profile, we decided not to replace it. With respect to the remaining cat bond, which will not expire until May 2018, the attachment point and maximum limit were reset as required annually to adjust the modeled expected loss of the layer within a predetermined range. For the year beginning May 16th, 2016, we will begin recovering amounts under this cat bond if losses in the covered area for a single occurrence reach an additional attachment amount of $1.968 billion. The full $300 million coverage amount is available on a proportional basis until such covered losses reach a maximum $2.468 billion. Finally, our Northeast gen cat treaty was renewed on July 1.
This treaty provides up to $800 million, part of $850 million of coverage subject to a $2.25 billion retention for certain losses arising from hurricanes, tornadoes, hailstorms, earthquakes, and winter storm or freeze losses from Virginia to Maine. A more complete description of our cat reinsurance coverage, including a description of earthquake and international coverage, is included in our second quarter 10-Q, which we filed earlier today, as well as in our 2015 10-K.
While the total cost of these treaties is small in relation to our operating income, we were able to save some money by not replacing the expiring cat bonds. With that, let me turn the microphone over to Brian.
Thanks, Jay. In Business Insurance and international insurance, we're pleased with the results this quarter. In domestic Business Insurance, we achieved very strong retention, along with a modest increase in renewal rate change versus the first quarter and higher levels of new business. Our strategy has not changed as we strive to retain our best-performing accounts, get rate where needed, and write new business when it meets our target returns. This has been our strategy for some time, and as a result, we continue to be viewed as a stable and financially strong market by our distributors and customers. Along with the meaningful competitive advantages that we deliver, this consistent leadership position is resulting in additional growth opportunities for us. Turning to the financial results for the segment, operating income was $393 million, with a combined ratio of 97.5%.
Cat losses for the quarter were $143 million net after tax, which included $61 million from the Canadian wildfires. Excluding the Canadian fires, cat losses were slightly higher than the prior year quarter. The underlying combined ratio, which excludes the impact of cats and prior year reserve development, was 95.5%, up 2.4 points compared to the second quarter of 2015. The loss ratio increased by 1.7 points, driven primarily by non-cat weather, which was higher than both the prior year quarter and our expectation. The expense ratio was up seven-tenths of a point over last year, driven primarily by commissions as the second quarter of 2015 benefited from a one-time favorable adjustment. Net written premiums for the quarter were in line with the prior year quarter, with domestic Business Insurance premiums up about 2%.
Given the returns that we are generating in this business, our focus continues to be on retention. We were very pleased that retention remained at 85% for the quarter. Renewal premium change was just over two points, including renewal rate change that was slightly positive. New business of $525 million was up 10% versus the second quarter of 2015. Turning to the individual businesses within Business Insurance, beginning with Select, we achieved retention of 82% and renewal premium change of nearly 6%. Rate change was down slightly versus the first quarter of 2016, while exposure was in line with recent periods and new business was up slightly year-over-year. In middle market, retention remained very strong at 87%, with renewal premium change of about a point and a half, in line with recent quarters.
In terms of new business opportunities, given our leadership position in the market, submissions were up year-over-year. Accordingly, we had more opportunities to quote on the types and classes of business we find attractive and to grow our new business while maintaining our return thresholds. In other Business Insurance, retention of 82% was up a point year-over-year, while renewal premium change was a half a point and new business of $154 million was consistent with the second quarter of 2015. As we've mentioned in the past, other Business Insurance includes our national property business. While there continues to be some rate pressure in this business, returns remain attractive, and as a result, retention is our priority. As you can see on page 13 of the webcast, excluding national property, renewal rate change for other Business Insurance remains positive and was relatively consistent with recent quarters.
In international, net written premiums for the second quarter were down about 12% quarter-over-quarter. Excluding the impact of foreign exchange, net written premiums were down about 9%, driven by disciplined underwriting actions in our U.K. business, along with lower economic activity impacting the marine and energy lines of our Lloyd's business. New business of $107 million was up 67% year-over-year, driven primarily by Optima, our new strategic personal lines auto product in Canada, which was modeled after our U.S.-based Quantum Auto 2.0 product. All in a good quarter for the segment with strong production and profitability. I'll turn now to Bond & Specialty Insurance, where we had another terrific quarter. Operating income of $202 million was up significantly from the prior year quarter, driven by a higher level of net favorable prior year reserve development. The underlying combined ratio of 80.9% remains exceptionally strong.
As for top line, net written premiums for the quarter were in line with the prior year, as growth in management liability was offset by lower surety premium. The lower surety volume was due almost entirely to favorable one-time reinsurance impacts in the prior year quarter. Across our management liability business, retention remained at historically high levels and new business volumes were up as we continue to execute our strategy of retaining our best accounts and writing more business in our return adequate product segments. We continue to feel great about this segment's performance. In Personal Insurance, results were again strong, and we remain particularly pleased with our ability to add top line growth at appropriate financial returns. Net written premiums for the quarter of $2.1 billion were an all-time high, with double-digit growth in agency auto, while growth also accelerated in agency homeowners and other.
In both products, we continue to produce strong retention and new business levels. Agent and consumer receptivity to Quantum Auto 2.0 remains exceptional, and importantly, as significant amounts of Quantum Auto 2.0 business are now coming through their renewal cycles, we're pleased with the retention rates we're seeing on those policies. In homeowners, our growth momentum is building due to crossover benefits from Quantum Auto 2.0, as well as pricing changes and improvements to agent and customer experience. Turning to profitability, operating income for the segment was down compared to the prior year quarter, due primarily to lower net favorable prior year reserve development. The underlying combined ratio of 89.5% was in line with our expectations, but up about a point from the prior year, driven by the impact of the significant new business volume in recent years and normal quarterly volatility in weather and other loss activity.
In agency auto, the 101.3 combined ratio included 2.7 points in CATs, primarily resulting from hailstorms. Weather also impacted the underlying combined ratio with 1.7 points of non-CAT weather related losses, which is approximately one point higher than both our expectations and the second quarter of 2015. The remaining increase in the underlying combined ratio was driven by the high levels of new business that I just mentioned. As we've noted before, the Quantum Auto 2.0 business is priced to our long-term target returns, and loss experience is performing in line with our expectations. Turning to agency homeowners and other, underlying financial results remain strong. The second quarter underlying combined ratio of 78.2% is well within our target return levels as we continue to execute our disciplined underwriting and pricing strategies.
Overall, for Personal Insurance, we feel great about the growth and the financial returns that the business is generating. Before I turn it back to Gabby, I would like to take a moment to recognize Doreen Spadorcia, who announced her retirement from Travelers effective September 1st of this year. Over the past 30 years, Doreen has played an important role on our management team, and we wish her well as she enjoys a new chapter of her life. With that, let me turn it over to Gabby.
Thank you, Brian. Tina, we are now ready to start the Q&A portion of the call. If I could ask the participants to limit yourself to one question and one follow-up, please. Thank you.
Thank you. Ladies and gentlemen, if you would like to register a question or comment, 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're using a speakerphone, please lift your handset before entering your request. One moment please for our first question. Our first question comes from Randy Binner of FBR & Co. Please go ahead.
Hey, good morning. Thank you. I wanted to talk about the underlying combined ratio in business and international. I think in the comments and in the press release, you attributed the increase of 2.4% to non-CAT weather, as well as loss costs not being covered by earned pricing. I think, can we get more granular on that? Because we're at a point in the cycle where not covering loss costs with earned trend is potentially an issue, and just wanted to get a better detail on that.
Sure, Randy, it's Alan. I'll take that. The underlying combined ratio in that segment, you're right, was down 2.4 points. Part of that was commission, and that was a year-over-year comparison thing. Nothing going on there. The other piece of that was in the loss ratio. The majority of that does come from non-CAT weather. There is a relatively small piece of earned rate versus loss trend coming through. One of the reasons we showed you page four in the webcast was to try to put that in a little bit of context. Really what's impacting year-over-year is the weather. As we said before, we've tried to make clear that rate and loss trend is one small piece of what goes on, but there's also taxes, expenses, base year mix, the impact of changes in claims handling, things like that.
Everything else, as we would've expected, was a wash. There's nothing in that earned rate versus loss trend that was surprising to us or that we think shouldn't have been evident from the written information we've provided over the last year or so.
Is the piece of it, though, that's the loss trend versus earned pricing, I think you're saying that it's not surprising you, but it does seem to be changing. Is it a bigger piece of the equation than it has been in the last few quarters?
It's the earned impact of what we've been disclosing as written over the past year. It's earning in as we would've expected, and we called it out just in the interest of transparency. Again, nothing that surprises us, and given where our written and earned returns are, nothing that we're not comfortable with.
Just finally, oh, sorry. Go ahead.
I was just going to say is, as I said in my prepared remarks, Randy, we're very comfortable with the model returns on the business we're writing and.
Just to give you a little bit more context.
With non-cat weather, this would be truly episodic. Nothing trend-wise you're seeing in that?
That's correct. Nothing trend-wise from that. It's a normal volatility in non-cat weather.
All right, great. Thank you.
Thank you.
Thank you. Our next question comes from Kai Pan, Morgan Stanley. Please go ahead.
Good morning. First question is on the pricing slight uptick in the second quarter. Could you give a little bit more granularity in term by lines or by account size? What do you see underlying sort of trends there, in term of both from supply and demand side? What do you see could potentially be the upside pricing as well as downside to that pricing?
Kai, this is Brian. I'll start. A couple of broad dynamics. I think not surprisingly, auto is the line where we're seeing the most positive pricing movement. Comp is, I think, the line with the most pressure, and that's I think, really consistent with workers' comp, if you see what's coming out of NCCI and other competitors, that's not surprising. From an account size perspective, larger accounts under more pressure. We've talked a lot and others have talked about a large property business. We think that's somewhat consistent with the returns that have been in that business, but some pressures there. I think even larger casualty business is under a little more pressure than the middle and small type of business. I don't think from an industry perspective there's anything appreciable, that would be the broad strokes.
Okay. A follow-up on the reserve side. Looks like reserve continued to be strong. I just want to focus on sort of three areas. One is that the workers' comp release in 2015, is that too early for a long tail line of business? Secondly, the $82 million environmental charges looks like we are having those amounts at least for the last 5 to 6 years. Just wondering why wouldn't you book, if you know the pattern is there, why wouldn't you book a big charge up front? The third piece is on a pretty strong, like Bond & Specialty continued release at any underlying loss cost trend there would be appreciated. Thank you so much.
Thanks, Kai. This is Jay Benet. Let's try to take them in order. As far as the workers' comp, you're absolutely right. When you have a very long tail line of business you look very carefully at things that happen in the short term and don't necessarily react to them. In the case of the workers' comp, what you're seeing here is favorable development in 2015 that related to a relatively short component of it relating to medical, where medical bills come in quickly, they get resolved quickly, and the assumption that we had put in there for medical inflation was just too high. While the line itself is a long tail line, there are components of it that are more short tail, and that's primarily what we reacted to there.
As far as the environmental piece is concerned, I think if you look at us as well as the industry, you'll see a similar pattern, if you will, of people trying to, at various points in time, estimate what the ultimate is going to be for environmental losses. Recognizing that you're dealing with something that is a very difficult kind of reserve to truly evaluate. In doing so, you have to make various assumptions as to what the future's going to look like in terms of new claims to policyholders, what the average frequency and severity might be associated with things that have been reported or not reported. It's those assumptions that you're constantly updating as time goes on.
What we disclosed, and I'll point you to the 10-Q, what we disclosed this year is actually very similar to what we've disclosed in prior periods and what you've seen other companies disclose, that there really hasn't been a change in the environment, per se. Things have gotten a little better. The rate of them getting better has just been less than what was previously assumed or hoped for. That's a chunk of the reserve addition. In addition to that we're always subject to judicial rulings or other things that take place episodically in various jurisdictions. There was one that came out of the Northwest that increased modestly some of our claim costs there that we also recognized. Finally on the Bond & Specialty, this was a quarter for a fairly large prior year reserve development benefit.
I wouldn't say there was anything unusual about it. This is, as you know, it's a high severity, low frequency business. It's one where information emerges slowly. As it emerges, you're always evaluating whether or not it's blossomed to a level where you really feel action is appropriate. There are things that have been taking place, whether it's in items related to the financial crisis or whatever that we've been watching. Things got to a point this quarter where we recognized that it was appropriate to take some reserve action. It wasn't any one product line. It wasn't any one particular claim or things like that.
It was pretty much spread across the whole management liability and surety book of business.
Thank you so much.
Thank you. Our next question comes from Michael Nannizzi of Goldman Sachs. Please go ahead.
Thanks so much. We talked about non-cat weather in BI and personal auto. Can you talk about non-cat weather in the homeowners book and how that has looked recently?
Yeah. Michael, this is Brian MacLean again. In this quarter, similarly, there was some, but not to the same degree. Just to quantify it, because I said about a point on the auto side, it was probably about a half a point on the personal property side of some impact there. Some, but not as dramatic of that, again, that's specifically the PCS event.
Got it. I guess I'm just curious because it looks like in the last few quarters, especially in BI, we've talked about non-cat weather impacting the underlying and sort of a driver for the year-over-year comps being negative. In auto, looks like it was a factor this quarter as well. When I look at my estimates and your results over the last several quarters, homeowners has been consistently better, and I think better even relative to your outlook as you've disclosed in your 10-Qs. I'm just trying to understand why the impact is potentially disproportionate in these areas. Is it because the nature of the risk is different or reinsurance or something else that's causing non-cat weather to be, looks like a tailwind in one potentially and a headwind in the others?
Yeah, Michael, this is Michael Klein. I think what you're seeing is a combination of factors in the home product, and weather is one of them. In the case of this quarter, I think what you see is, to Brian MacLean's point on the net impact, it's a couple moving parts underneath. You've got the weather impact, but we also have sort of underlying experience on fire, non-weather water losses that again, also fluctuate quarter-to-quarter. When Brian MacLean talks about weather and other normal quarterly fluctuations, that's really what he's talking about, and this quarter was an example of that, where we had some other non-cat weather, again, non-weather water, fire experience that came in better than expected.
Importantly, for the year-over-year comparison this quarter, there actually was a significant individual risk fire loss in the second quarter of last year that helps the quarter-over-quarter comparison, just to give you a little bit of color on that.
Got it. That's very helpful. Thanks. Then maybe Brian, on BI, it sounded like from Alan's comments that the lift in the expense ratio was commission related. I'm guessing that means that that should continue, because I'm also just sort of trying to square that because at 33-
No.
No, it's not. Okay.
The commission, last year in the second quarter, we had a takedown in our contingent commission accrual that reduced the number. That created a year-over-year kind of difference.
Yeah, the delta's not really in the base commissions. The delta's in these other things.
Yeah
Cause quarter-to-quarter variances.
Yeah.
Got it. I guess my point is, the 33.3 expense ratio in this quarter, forget the comps, just the absolute number this quarter, is that how we should be thinking about it? It sounds like there was some one-offs last year, this quarter, is that how we should be thinking about the expense ratio from here?
It's Alan, Michael. I guess I would say that we try not to forecast on these individual pieces, what I'd suggest is maybe you go back over the last, I don't know, somewhere between two and four quarters and average the number and maybe use that as sort of a proxy for a go-forward number. There's always going to be some volatility quarter to quarter.
Okay, got it. Just because it does screen relatively high when I go back.
Yeah
It sounds like maybe there's some volatility. I was just trying to understand what drove just some episode of a higher expense ratio that should cause that to normalize as you're sort of suggesting it should. Maybe I can follow up afterwards. Thanks.
Okay. Next question, please.
Thank you. Thank you. Our next question comes from Ryan Tunis of Credit Suisse. Please go ahead.
Hey, thanks. My first question, I guess, is for Brian. I was just hoping for a little bit more color on what's been driving the solid new business growth in middle market. I think you mentioned submissions are up, but I guess sort of like over the past couple quarters, it has been pretty strong and just sort of what you're seeing on the new business front.
Yeah, I think it's a couple of factors. We believe, as I tried to say in my comments, driven by the fact that I think we're in a pretty strong position in the marketplace. We've been executing in a very stable and effective way, I think, for a long period of time. We've got some real competitive advantages. The overall market is pretty stable, but there has been some pretty well-publicized dislocations, and at least a couple of very large carriers have been very open about taking profit improvement actions. That's created some specific opportunities. I think we think more broadly has also created a little bit of a mood in the marketplace of flight to quality.
Like I said, we've seen our submission activity up a decent amount, and we've also, consistent with that, been driving a message to our organization, not strategically to do anything different with returns, but to be more active and to be out there quoting more. Just to be blunt about it, we're pushing our place pretty hard right now to
To be real active in the marketplace and get out the quotes and not compromise on returns, but try to meet the opportunity of the submission activity. That's been paying off in specifically our core middle market commercial accounts business and the construction areas.
Ryan, I would add to that part of our motivation behind pushing a little bit more activity is just where returns are, product returns in the marketplace after five or so years of price increases. There's a lot out there that's potentially attractive to us, and this is really important, consistent with our return objectives. We're not making any compromises on that.
Okay. That makes a lot of sense. I guess my other question was just on looking at the margin trajectory in agency auto and how to think about that on a go-forward basis. I guess year-to-date, there have been a couple of things that seem to have been weighing on the accident and loss ratio some. There's the new business drag, then there's the elevated non-CAT weather. Something that we thought was interesting was looking in the 10-Q, it looks like the language looking into 2017 was that margins would remain where they've been. I'm just curious, as you lap the elevated new business and you get rid of the lower non-CAT weather, why would margins not be improving as you look out into 2017?
I think just a couple quick comments, then I'll toss it to Michael. Certainly, we view the non-CAT weather as episodic, we think that should absolutely return to normal levels. On the new business dynamic, the good news is that we continue to write some significant levels of new business through that product. We feel great that we are building real embedded value in that portfolio, but it is going to take longer. The stronger the production top line is, the longer it is going to take for that to really work through the loss ratio. The other point I'd make is the Quantum 2.0 product also was designed to have a lower expense ratio and a little bit higher on the loss side. You have to look at the combined end total to get that product.
Ryan, if I could just clarify something. One of the things we actually added to the Q this quarter was in the outlook section, we had previously spoken to underlying underwriting margins, and we thought it was important to add combined ratio because people often use those terms interchangeably. As you know, the combined ratio is a function of the premium volume, whereas the margins are just dollars. Just to clarify, what we're saying here in the Q is for auto, which I think is what we're talking about, for the early part of 2017, the company expects underlying underwriting margins, the dollars, to be slightly higher because of what's taking place with writing higher volumes of business that's profitable. Writing a higher percentage of new business relative to the base is also causing a slight uptick in the underlying combined ratio.
You have this feature here where the dollars are going up at the same time that the combined ratio is going up. I just wanted to clarify that.
Yeah, that's helpful. I think I was a little bit confused by that. Thanks, guys. Appreciate it.
Ryan, the other factor just to note, it's not all this new business impact from what we're writing. As Michael explained a second ago, we have had this in the last quarter or so, this favorable non-weather loss activity. As we also highlight in the 10-Q, we expect that to return to a more normal level. That's also having, on a go-forward basis, a slight adverse impact.
Thanks.
Underneath it, this is Michael Klein. The only thing I would add is underneath it, just to reiterate, Quantum Auto 2.0 is priced to the same return level as the book of business has been priced to. It really is the dynamic of a preponderance of newer, think of it as younger business. The portfolio is getting younger because of the outsized growth that we've seen over the last couple of years. The long-term return targets for the product remain consistent with where they've been.
Thank you. Our next question comes from Amit Kumar of Macquarie. Please go ahead.
Thanks, and good morning. Two quick questions. Probably these are follow-ups, and I apologize if I'm still not clear. Just going back to the discussion on BI and what Randy was asking. If you X out all the moving parts and just focus on the underlying discussion on the negative loss cost trends versus on pricing, is it episodic, is what you're saying? Or is this the usual sort of trend line, i.e., you have talked about this in the past that over time, this equation will get flipped, and now we are at the point where it has flipped? I'm just trying to understand that.
Yeah, it's not episodic. There is a trend there. I think what we've told you in the past is there is some danger to looking at that very narrow definition of rate versus loss trend.
Obviously anybody could look at rate, which is sort of around zero, and loss trend, which is something north of zero on a written basis, and it has been moving in that direction for some number of quarters. As anybody, as we would've expected, as that earns in over time, there will be some negative pressure on margin. What we said in the past is, you got to look at that in the context of all the other moving pieces that impact underlying underwriting margin. Things like, we had a tax impact year-over-year this quarter. There's expenses, there's base year, there's mix. All those other things go into that number, what we've shown you this quarter is all of that comes out to about a wash.
I guess I'd also point you to the outlook where we give you a sense of over the next 4 quarters or so that we would expect the underlying underwriting margins, obviously subject to the volatility of weather and whatnot, to continue to be broadly consistent.
The other thing I'd emphasize, this is Brian MacLean, is that there's a lot of things in there that we have to react to, there are other things in there that we are actively managing. You shouldn't have the impression that we're just sitting by, as Alan Schnitzer just said, pricing is at roughly 0 this quarter, rate and loss trend is something north of that we're just conceding that margins will recede. We're managing our mix. We're taking actions in underwriting selection. We're taking actions in claim execution, which are all impacting our loss trend. We're reacting to weather volatility, et cetera, that might be moving through the business. There's no denying that the sheer arithmetic of that narrow piece, the loss trend and the rate, right now is a negative.
We've said in the past that it's relatively modest, it continues to be relatively modest. There are all the other impacts that are going through.
Got it. That's a fair comment. The second question I had was just going back to the discussion on Quantum 2.0. In the past, when we've talked about loss cost trends, frequency was pegged at 0.5, severity was at 2.5. Has there been any evolution in that number, or is it still the same?
Nope. We didn't see anything different in the core underlying trends of what was going on in the auto book. We would be at exactly those numbers you just said, about a half a point of frequency, two and a half of severity.
Got it. All right.
As we've said in the Quantum Auto 2.0 specifically, still running consistent with our loss expectations.
Got it. That's all I have. Thanks for the answers.
Thank you. Our next question comes from Charles Sebaski of BMO Capital Markets. Please go ahead.
Good morning. Thanks for getting me in. I guess I'd like to follow up again on following Amit on Quantum 2.0 and the agency auto book, and the clarity. I realize there's additional disclosure in the Q, but how you guys expect the auto book to evolve out? I guess the commentary of early 2017 being ±16%, which is ±15%, and you say that you're underwriting to the same return dynamic. I guess this has been a book in flux that, coming out of 2011 and 2012 where it's been underperforming and the introduction of Quantum 2.0, just where is a run rate on what we should expect?
There's so many moving parts, but it seemed like this should be a story that was improving, and I guess the commentary seems to be that it's maybe gotten as good as it's going to get. Is that right?
The message absolutely is not, "This is as good as it's going to get." The core from a profitability perspective-- well, let me start with a top-line perspective, because what's the story on Quantum 2.0? We have been pleasantly surprised with the traction the product has gotten in the business and in the marketplace. We clearly went in with an expectation that this would enhance growth, and we've done better than our original expectations there, and you can see the numbers. We feel good about that. We're not sure where that's going to go exactly in the future, but we think that we're going to be able to sustain some pretty decent amount of growth going forward. From the profitability perspective, just as is true of all business that we've ever written in this product, it matures over the years, and so there's a tenure impact.
As Michael just said, the younger tenured business is typically not as profitable. As we write the business, we're targeting a tenured longer-term return, and we're on track to do that. As this portfolio matures and as Quantum 2.0, as we get more and more of the aging of the book, we believe the trend should absolutely be improving profitability on this business.
Okay. I guess on that, could you give us some additional insight on the tenure, the curing of the auto book on what is the average policy life for you guys on this? I guess, when I think of some commercial accounts that might be longer, it seems that auto still is a quicker turn product. This introduction of new growth, which really been strong, what's the timeline for curing on an auto book, and how long do you on average keep auto policies?
Charles, I don't know that I'll get into the specifics of the
Policy life expectancy, et cetera. To give you a little bit more color, this is Michael, on the aging of the auto book. You have to really think about both components of what's going on here. First, you need to think about a vintage and think about a book of business we write in a given policy year, and that new business that we write in that term, that comes on at a higher loss ratio early, and then as we renew it improves. If you look at the production statistics that we've been disclosing and the high levels of new business, what's happening inside the portfolio then, which is the second piece, is on average, the portfolio is getting younger. If younger business carries a higher loss ratio, that's what we describe as the increase in the combined.
When you look at the outlook for the second half of 2016, we say the combined ratio will be higher due to the impact of the higher new business levels we've been writing. That is the underlying dynamic that's flowing through the book. That does continue into the first half of 2017. It just gets offset by an expectation of return to normalized non-cat weather levels. The underlying dynamic of the book getting younger, meaning less tenured, we've had the accounts not as long, continues into 2017. Recognize also, though, that as we write more Quantum Auto 2.0 business, there is a benefit to the combined ratio from an offsetting improvement in the expense ratio because it carries a commission. That underlying aging of the book or reducing average tenure of the book does continue into 2017.
It just gets offset by, again, an expectation of return to more normalized weather. That's why the outlook reads the way it does.
It's an assumption, not an expectation.
Sorry, it's an assumption. Yep. Sorry, Jay. Yep.
One other point on that. Again, as Michael said, we're not going to give you explicitly the target we have for life expectancy on policies. We think that's part of our competitive kind of conversation. We clearly accept that hitting the expectations of retaining the business is important, which is why in my comments I emphasized that as we're going into year two and in some cases year three for the Quantum Auto 2.0 product, we feel really good that we are hitting the retention rates we expected. Whatever our expectation was for life expectancy, along with our statement about losses are progressing, so is the retention of the business. You can look at our long-term retention and begin to deduce some kind of policy life expectancy by just doing the arithmetic.
Thank you very much for the answers.
Thank you. Our next question comes from Jay Gelb of Barclays. Please go ahead.
Thank you. I was hoping to get a bit more insight on the pace of share buybacks. It's slowed over the past few quarters on a linked quarter basis. The slowdown in share buybacks was actually a little greater than the reduction in earnings from the first half of 2015 to the first half of 2016. Can you give us a bit more insight on that?
Yeah. Jay, this is Jay. I think you're looking back at a period of time where, as we've said in the past, over time, share buybacks are going to be enabled by earnings. While there's pension contributions and whatever, it's the earnings of the place over time that will drive what the total share buybacks and dividends are. What you saw, and I think you even asked the question in the past, can we continue to buy back at levels that are higher than our earnings? Well, this is the flip side of it. This is just an indication of the timing element of when we look and see what the future quarter projections are.
They obviously come out to be whatever they'll be, and we're just picking numbers in the particular quarter that we're doing the share buybacks over a longer-term view to say, in this particular quarter, $550 sounds like the right number. I wouldn't read anything into it in terms of a change in philosophy or a change in execution. It's just going to be what we'd refer to as the normal quarterly variation in a policy and a discipline that's been set for a long period of time.
I see. Okay. Thank you for that. Second one. Excuse me. What was the overall impact in the combined ratio in 2Q from non-cat weather on a combined ratio basis?
We're looking.
Okay. If you have that number, I also wanted to ask about, I know the U.K. leave vote is not significant relative to Travelers in its overall business, but if you have any thoughts on that, I think that'd be real helpful for us.
Sure. In terms of Brexit, the most significant impact to us will be whatever it means for overall economic activity. The amount of premium that we write out of the U.K. that relies on passporting is very small. It's something like 5% of our overall international premium, and about half of that's through Lloyd's, and we assume that one way or another, Lloyd's will address the passporting issue, as will we, by the way. Long way to go to see how that's going to work out and what the ultimate arrangements are going to be. Other than the overall macro impact, we don't expect any significant impact to us.
Appreciate that, Alan.
Thank you.
Thank you. Our next question comes from Paul Newsome of Sandler O'Neill. Please go ahead.
Good morning, congratulations on the quarter. I wanted to ask about the competitive landscape in the personal lines business. We've had a few management changes of recent note, like Progressive and State Farm. I'm wondering if the components of who is being competitive out there have changed in the last year.
Yeah, Paul, this is Michael Klein. I would say, broadly speaking, the answer to that question is no. Competitive dynamics are very local in the business as well. While there have been changes in management at some national competitors, frankly some local regionals as well, the broad competitive dynamics in the business remain consistent. When we look at the rate filing monitoring that we do in the business to assess the rates that carriers are taking in particular states in auto or home, we don't see a lot of shift in behavior there. I would say the competitive dynamics are broadly consistent.
Is there a general idea that the agency folks keep losing share and the regionals and the direct people are the most competitive? Is that still fairly the case?
I think if you look at the latest AM Best data, you continue to see some incremental shift in share by channel. Interestingly, I think, consistent with the last couple of years, the majority of the gains you're seeing in the online direct channel are actually coming from captive and less and less from independent agency. Broadly, I think those trends continue.
Great. Thanks. Appreciate it.
This is Jay Benet. Somebody had asked the question about what was the impact on the combined ratio of non-cat weather. I'll give you the number, but I also have to give you a little bit of a preface to it. We are parsing things very thin here and talking strictly about that. If you ask the question, what's the impact of non-cat weather on the combined ratio on a consolidated basis, we would say it's 150 basis points. But I'd also point out that if you ask the question about, well, what about other losses, that goes in a different direction. What about mix? That goes in a different direction. We will answer your question, but there's lots and lots of things that are taking place here that make the one number not necessarily indicative of the trends or of what the expectation is.
I would just urge you to go back to the Q and the outlook to see what all of this, to us, actually translates into.
Thank you. Our next question comes from Jay Cohen of Bank of America Merrill Lynch. Please go ahead.
Yes. Thank you. Just to follow up, the language in the 10-Q on the Business Insurance segment where you extended your commentary on the margin into 2017, again, the broadly consistent language. I assume that's largely because the first half of 2016 had a high level of loss activity in non-cat weather. Is that fair?
That's right. There's some large losses in non-cat weather that in the outlook, we would expect would return to normal levels. We would assume.
Got it. Thanks. Then the second question may be for Bill Heyman because he hasn't had a chance to speak yet. Obviously, as we would expect, the non-fixed income returns are always going to be variable. Can you give us a sense of, given how the portfolio is constructed today, what is an expected return for that portfolio at this point?
Thanks, Jay. I think an expected return for non-fixed income ought to be in the high single digits pre-tax. If you look at this quarter, we made a bit more in real estate than we figured. Real estate has two components, rentals from properties we own and NII from real estate funds. Hedge funds were below what we expected, but positive, and the big variable was private equity, where the portfolio was almost flat, made a few million dollars, and we would have expected about $50 million pre-tax. What's interesting is the cash flow from that portfolio has remained at historic levels. It simply hasn't contained as much NII in the past. We would aim for a double-digit pre-tax return on these assets. If we didn't feel we could do that, we probably would reduce our allocation.
I think a fair expectation is high single digits pre-tax.
That's great. Thanks so much.
Great. The next question will be our last question. Thank you. Thank you. Our final question comes from Larry Greenberg of Janney. Please go ahead.
Hi, thanks. I apologize for going back to this, just listening to some of the chatter that's out there this morning, there's something of a view that you guys elaborating on the pricing loss trend relationship in Business Insurance suggests that you're seeing or thinking something new. If I hear what you're saying, it really doesn't appear to be the case. I just want to be sure that I've got that right.
Yeah, Larry, it's Alan. Let me be really clear about it. There's nothing that's changed. There's nothing that's surprising us, everything is consistent with what we've reported to you on a written basis over the last four quarters. The real reason we put it in there is we wanted to be completely transparent about it. It's a very small piece, but we thought, "Gee, if we didn't put it in there, you or somebody would've said to us, 'Gee, how can this not be happening? Because we're looking at your written numbers over the last three or four quarters.'" I'll just reiterate, it's small. It's within our expectations. It's wrapped up with all the other things that are typically moving around in a quarter. It's about a wash in terms of the year-over-year impact. No message intended in terms of anything out of the ordinary.
Completely expected, completely consistent with what we've seen on a written basis, we continue to be very pleased with the model of returns on the business that we're writing.
Great. Just my follow-up. Jay, in your discussion on non-renewing that cat bond, I think you said that the reason was due to your current risk profile. I'm just curious about that comment and if you could elaborate a little bit on that.
Primarily, our cat program is one that protects capital, not one that really deals with income protection. If you look at where the limits are and things of that sort, and where the attachment points are, it's pretty high up there. In any given period, we're looking at the entirety of it, where our property exposures are, and just given the way the book has evolved over the last few years, we just felt that this wasn't really adding much on a risk versus cost basis, so we decided not to renew it.
Okay, thank you.
Great. That's it. This concludes our call for today. As always, we in investor relations are available for follow-up questions. Have a great day. Thank you.
Thank you. Ladies and gentlemen, that does conclude the conference call for today. We thank you for your participation and ask that you please disconnect all lines. Thank you and have a good day.