Feb 7, 2018
Executives
Gabriel Tirador - President and Chief Executive Officer George Joseph - Chairman Ted Stalick - Senior Vice President and Chief Financial Officer Robert Houlihan - Vice President and Chief Product Officer Chris Graves - Vice President and Chief Investment Officer
Analysts
Greg Peters - Raymond James Alison Jacobowitz - Bank of America Gary Ransom - Dowling & Partners Samir Khare - Capital Returns Management Jay Cohen - Bank of America/Merrill Lynch
Operator
Good afternoon. My name is James and I will be your conference operator today.
At this time, I would like to welcome everyone to the Mercury General Fourth Quarter Conference Call. All lines have been placed on mute to prevent any background noise.
[Operator Instructions] This conference call may contain comments and forward-looking statements based on current plans, expectations, events, and financial and industry trends, which may affect Mercury General’s future operating results and financial position. Such statements involve risks and uncertainties, which cannot be predicted or quantified and which may cause future activities and results of operations to differ materially from those discussed here today.
I would now like to turn the call over to Mr. Gabriel Tirador.
Sir, please go ahead.
Gabriel Tirador
Thank you very much. I would like to welcome everyone to Mercury’s fourth quarter conference call.
I am Gabe Tirador, President and CEO. In the room with me is Mr.
George Joseph, Chairman; Ted Stalick, Senior Vice President and CFO; Robert Houlihan, Vice President and Chief Product Officer; and Chris Graves, Vice President and Chief Investment Officer. Before we take questions, we will make a few comments regarding the quarter.
Our fourth quarter operating earnings were $0.15 per share compared to $0.58 per share in the fourth quarter of 2016. The deterioration in operating earnings was primarily due to an increase in catastrophe losses and unfavorable reserve development partially offset by a $0.13 benefit from tax adjustments due to the new federal tax law.
The combined ratio in the quarter was 104.5% in the fourth quarter of 2017 compared to 99.2% in the fourth quarter of 2016. The combined ratio was negatively impacted by $20 million of net catastrophe losses due to California wildfires plus $3 million of reinsurance reinstatement premiums earned.
This compares to only $4 million of catastrophe losses in the fourth quarter of 2016. In addition, we recorded $36 million of unfavorable prior accident year reserve development in the fourth quarter of 2017 compared to $16 million of unfavorable prior accident year reserve development in the fourth quarter of 2016.
Adverse legal outcomes from two large claims from accident periods prior to 2013 accounted for $10 million of the $36 million of unfavorable reserve development in the quarter. Excluding the impact of catastrophe losses, unfavorable reserve development and ceded reinstatement premiums earned, the combined ratio was 97.2% in the fourth quarter of 2017 compared to 96.6% in the fourth quarter of 2016.
The unfavorable reserve development in the quarter came primarily from the bodily injury line of coverage on our California Auto lines of business. The company uses historical loss development patterns for estimating ultimate losses.
Over the past few years, actual case reserve and paid loss development have tended to exceed the company’s historical loss development patterns. At year end 2017, the company has factored this tendency into the company’s ultimate loss selections.
During 2017, our gross loss and loss adjustment expense reserves for current and prior accident years, excluding reserves for catastrophes increased by $162 million to $1.45 billion at December 31, 2017. The reserves established by the company represent our best estimate of the ultimate cost of losses and loss adjustment expenses incurred to-date.
However, since the provisions are necessarily based upon estimates, the ultimate liability maybe more or less than such provisions. The expense ratio was 23.4% in the fourth quarter compared to 24.9% in the fourth quarter of 2016.
The lower expense ratio was primarily due to a decrease in acquisition costs, cost efficiency savings and lower profitability-related accruals. To help offset increasing loss trends, we have been increasing rates in most states.
In California, a 5% personal auto rate increase in Mercury Insurance Company is going into effect in March. In addition, a 6.9% rate increase for California Automobile Insurance Company is pending approval with the Department of Insurance.
Personal auto premiums in Mercury Insurance Company represents about half of our direct companywide premiums earned and California Automobile Insurance Company represents about 14% of our direct companywide premiums earned. Premiums written excluding ceded reinstatement premiums grew 3% in the quarter primarily due to higher average premiums per policy.
Companywide private passenger auto new business applications submitted to the company decreased approximately 1% in the quarter. Companywide homeowners’ applications increased 10% in the quarter.
With that brief background, we will now take questions.
Operator
[Operator Instructions] Your first question comes from the line of Greg Peters from Raymond James. Go ahead please.
Your line is open.
Greg Peters
From the East Coast, I will say good morning to you all. Thank you for the call and taking our questions.
So, let’s just go through a couple of the points in your press release, in your comments on the reserve development. I appreciate your prepared remarks.
And I was looking for more color specifically talk to me about the process for the year end reserve charge and should we presume that you changed the factor so therefore what’s affected you in the last couple of years shouldn’t affect you in future years or just sort of walk me through the methodology there, please?
Ted Stalick
Hey, Greg, this is Ted. We have a quarterly methodology and that incorporates trends that are developing based on the historical data.
And as we look at the data, we start to see more emergence coming through than was expected and you incorporate that into your current analysis and so what we have been doing over the past couple of years is factoring that into our analysis each quarter. At year end, we took the position that our trends have – our development trends have consistently been exceeding our expected incurreds and therefore we expect that to continue.
So, we factored that into our ultimate fix for year end.
Greg Peters
So, just to clarify on that one point, should we presume that you have sort of raised the bar, if you will, for future expectations or recast...
Gabriel Tirador
I would characterize it as we have taken the more recent development factors and weighted those more heavily. That doesn’t mean that it can’t – they can’t be larger than the most recent development factors.
Greg Peters
Right.
Gabriel Tirador
But all we are saying is that look we are not taking an average of longer period of time. We have weighted much more the more recent development factors to project our loss reserves this time.
That doesn’t mean that those factors can’t be even higher than the more recent development factors.
Greg Peters
Right. Did the tax considerations of looking at your reserves come into play?
I would assume this is a more cautious posture you have adopted and was that – was tax part of your calculus there?
Ted Stalick
We don’t consider tax in our analysis. We try to make the best estimate based on the data we have available.
And as Gabe mentioned as we have seen expected development exceed – or I am sorry actual development exceed expected development, we felt like we are putting more weight in the recent factors was the prudent thing to do.
Greg Peters
Right, right. Okay, great.
So number of other questions, but let’s segue into 2017 was a busy catastrophe year for the industry and for Mercury and obviously you highlighted the reinstatement premium that flowed through your fourth quarter results. And I am curious what your perspective is about reinsurance costs for 2018 in the context of the 2017 performance.
And if there is going to be any change in your catastrophe retention on a quarterly basis, etcetera?
Gabriel Tirador
Well, first of all, our cat reinsurance treaty expires on July 1, that’s when it renews. We think that even after the large cat loss season, there still remains a lot of capacity in the reinsurance market.
We are expecting pricing to go up on July 1 as we know, but we do believe at this time that the increases are going to be muted based on the abundance of capacity in the market. So, it’s early to tell.
As I mentioned July 1 the closer we get to July 1, we will know. We have built into our estimates a slight increase in our reinsurance cost, but we are going to have to wait till we are getting closer to our July 1 date.
Greg Peters
I appreciate that color. And at this point, you don’t want to have any comment about what the retention might be for events either or it’s the...
Gabriel Tirador
I anticipate our retention to remain the same that our retention as you know was at $100 million prior to July 1 of ‘17. And we have lowered that retention to $10 million on July 1.
And my expectation right now as we sit here today is for that retention to remain at $10 million.
Greg Peters
So, the $10 million retention is a per event retention?
Gabriel Tirador
Yes.
Greg Peters
Okay, thank you for that clarification. That was helpful.
I guess you commented a little bit about business or production statistics in the fourth quarter and I know some of your new business trends have been challenging in 2017 versus 2016. Do you think new business counts will be up in 2017 and can you – I guess you got to go through, it looks like homeowners is doing fine, but go through both California and non-California business?
Gabriel Tirador
Well, our California business growth in the fourth quarter was like 4%. And outside of California – and this is for private passenger auto and we had 13% growth in application counts in homeowners in California.
Now, outside of California, the app count for private passenger auto was down like 17% and homeowners down about 8%, so that resulted in overall PPA applications relatively flat down 1% for PPA, private passenger auto and up about 10% for our homeowner lines of business, but I will say that it’s improving from the previous quarter. If you take a look at our year-to-date numbers in California, they grew 2% for the year, but they were – as I mentioned, up 4% in the fourth quarter.
Outside of California, they were down the whole year 28% and are down 17% in the fourth quarter. So, the application count continues to improve as other competitors take rate increases.
My anticipation right now is that when you take a look at our top line growth, you will – we are expecting low single-digit top line growth in both California and outside California.
Greg Peters
Okay. So another area that you have commented on the past is advertising spend.
And I know you go through your year end budgeting process. And maybe you could talk about what the total advertising spend was in ‘17 versus your original intentions and how it compared to ‘16 and what you are thinking for 2018?
Gabriel Tirador
In ‘17, our total advertising expense was about $37 million that compares to about $40 million that it was in ‘16 and our anticipation for ‘18 right around $40 million.
Greg Peters
Okay. I have a number of other questions.
I am just going to requeue and let others have a chance.
Gabriel Tirador
Okay. Thanks, Greg.
Greg Peters
Alright.
Operator
[Operator Instructions] Your next question comes from the line of Alison Jacobowitz from Bank of America. Go ahead please.
Your line is open.
Alison Jacobowitz
Hi. Sorry if I missed it.
Was there any current year development in the fourth quarter in the reserve change or in the losses rather?
Ted Stalick
Yes, hi, Alison. We really look at our reserves on a year-to-date basis.
So, we don’t disclose or consider current year development within current accident quarter.
Alison Jacobowitz
Okay, thank you.
Operator
And your next question comes from the line of Gary Ransom from Dowling & Partners. Go ahead please.
Your line is open.
Gary Ransom
Thank you. I wanted to ask about taxes a little bit.
And I was wondering in the first of all the approval that you just got for the rates in California for 5%, did you have to refile with the 21% tax rate for that approval?
Gabriel Tirador
No.
Gary Ransom
No. So you got to sit with the 35%.
Is it – is the pending one that’s for the 6.9%? Do you have to re-file that one with the 21%?
Gabriel Tirador
That filing has been made. When was that filing made Robert?
Robert Houlihan
Months back.
Gabriel Tirador
Yes. We don’t anticipate having to make any changes to it.
Gary Ransom
Okay. Well, obviously Commissioner Jones has made a lot of noise on this point.
So I just wondered what your overall opinion or thinking about that is. Does it matter?
Is it important to you in the long run?
Gabriel Tirador
Yes. Robert, why don’t you address that?
Robert Houlihan
Sure. Well, in California, the rates are determined by return on surplus formula and the formula is based on an after-tax return, but it’s important to note, the formula doesn’t yield one number it yields a minimum, a max or a range.
So, the range will be shifted downward slightly by the change in tax laws. But we have gone back and we have looked at all of our filings both in MIC and Cal Auto over the last several years and both the requested rate and our approved rates on all those filings would still be within that range even after adjusting for the lower tax rates.
Gary Ransom
Great. Do you have a rough estimate of what that shift is at the top and bottom?
How much does it shift at the top and bottom of that range?
Robert Houlihan
It varies depending on circumstances. As we looked at direct filings, it was – it can alter from filing to filing.
Gary Ransom
Right, okay. And then another one on the tax theme, you have a lot of munis, under a 21% rate, the corporates maybe more attractive.
I wondered if you could tell us anything you have about your thinking on change in investment strategy with the new tax law?
Chris Graves
Sure. Yes, hey, Gary, this is Chris.
So, one of the main drivers to my investment decision process has always been after-tax income yield, that calculation levels the playing field. So, the new tax law would apply to investment income for its winners, no real losers at least to my universe and then there is net-neutral recipients and net neutral is applied to tax exempt income.
Insurance companies are taxed on tax exempt income albeit at a low rate. So, new tax law does change – excuse me, does not change our after-tax investment income there.
Consequently, we still retain about $0.95 of every $1. The winners from the new tax law are taxable income sources like corporate bonds and dividends.
Holders of taxable income sources now enjoy earning higher after-tax and income yields from the reduction from 35% to 21%. So, that means to us that we pickup about $0.14 more in taxable income.
Dividends net us about $0.01 more. So, our investment mix will clearly change due to the new tax law.
Municipal bonds still makes sense however though many more taxable asset classes are attractive, because of the new tax rate. So I am adding more taxable income, but I will have more to share on that at the next conference call.
Gary Ransom
Okay. Is it a reasonable assumption that if you are making changes, it would be more related to cash flows of new money as opposed to making any wholesale turnover or sales of current investments?
Chris Graves
I would say, in general, it’s going to be new money. But certainly, swaps within the portfolio say from, I mean, I guess the natural expectation would be to shift from tax exempt to taxable.
That really depends on what I am looking at once I do the after-tax yield calculations and take for example, rating and duration and other factors into account.
Gary Ransom
Okay, thank you. Just changing gears a little bit, I wanted to go a little bit more into the loss trends.
You are talking about BI severity being an issue. I mean, we see it in the adverse development, but is there something you are seeing currently that’s causing those trends to move higher?
Gabriel Tirador
I would just say medical inflation in my view is just seeing a lot more aggressive plaintiffs bar, a lot more referrals to doctors, lot more people willing to go under the knife and take and get MRIs and just the environment and it’s been like that for a little bit, but just a more aggressive plaintiff bar in my opinion at least from what I see in the claims that I see and you have medical inflation as well.
Gary Ransom
I maybe doing this from memory, but I feel like the California Fast Track numbers showed the BI severity was the only trend that wasn’t getting any better. It looked like frequency was getting better, even in property damage that things were generally either leveling off or getting better.
Is that consistent with what you are seeing in your book of business?
Gabriel Tirador
Well, I think in Fast Track, the latest quarter actually was a little bit better than it had been. There was a time there where it was double-digit increases in severity is my recollection in Fast Track.
In this latest quarter, which there is a lag in Fast Track, was a little bit better. We are recording in the – I think in the mid single-digit pure premium increase, Ted, is that about right?
Ted Stalick
6ish.
Gabriel Tirador
6ish and that includes the development that we basically booked this quarter. So, we take a look at it from an ultimate accident year basis and we are booking about mid single-digit severity increases.
Gary Ransom
Okay, that’s helpful. One last subject just on reinsurance, just a follow-up on that, do you have a full third limit available now after the two events penetrated the cover?
Gabriel Tirador
So, we have reinstated after the major Northern Cal fires, we reinstated about full limit. On the second event, which was the Southern California fires, we used up – it was a $25 million event and we used up $15 million of that limit.
There is not a reinstatement available for that $15 million. So, if there is a third event, our retention will be at the $25 million and then we will have coverage above the $25 million.
Gary Ransom
Right, okay, although hopefully the wildfire season is over by now.
Gabriel Tirador
Yes.
Gary Ransom
Okay, that’s it for me. Thank you very much.
Gabriel Tirador
Thank you.
Operator
Your next question comes from the line of Samir Khare from Capital Returns Management. Go ahead please.
Your line is open.
Samir Khare
Hi. I just wanted to ask about your reserves, you currently booked loss reserve estimate, how does that compare to your others actuarial midpoint of the reserves and what was that metric last year?
Ted Stalick
Our actuaries don’t come up with the range. We come up with the point estimate and we book our point estimate.
Samir Khare
Okay. And that was same as last year?
Ted Stalick
Yes. We came up with a point estimate last year, which we booked and a point estimate this year, which we booked.
Samir Khare
Okay. And then just on auto, when considering loss trend, how many compounded rate increases you think you need to get to rate adequacy and if you can speak to I guess the dynamic at the Department of Insurance, is there still a backlog?
Is that backlog – is the length of time before filings get approved, is that shortening?
Gabriel Tirador
Yes. I think some of that depends on what the loss trends end up being our most recent filing that we just got approved 5% for MIC.
I think we believe gets us in pretty good shape, Robert, for Mercury Insurance Company?
Robert Houlihan
That’s correct.
Gabriel Tirador
In Cal Auto, which had a 6, 9 pending, gets us close as well. We may need 1 more Cal Auto possibly.
As far as the timeline for rate approvals, Robert, do you want to comment on that?
Robert Houlihan
It’s taking about the same amount of time in the past. I mean, it’s just a slow process in California.
We don’t see any delays from a backlog certainly at this point.
Gabriel Tirador
Yes. I mean, I think our MIC filing maybe took, I don’t know, 9 months ballparkish.
Is that about right?
Robert Houlihan
Yes.
Samir Khare
Okay, great. Thank you.
Operator
Your next question comes from the line of Greg Peters from Raymond James. Go ahead please.
Your line is open.
Greg Peters
Great. Thank you allowing me to ask a couple of follow-ups.
Just two points of clarification or actually one. For what you report in your GAAP financials for the tax expense, is that just the federal component or do you include premium – state and premium taxes, state income tax and premium tax in that GAAP tax expense?
Gabriel Tirador
It includes state income tax, but premium taxes are in our acquisition cost.
Greg Peters
Okay, I am glad I asked that question then. And then another question was regarding – and I know Chris you started to talk a little bit about changing pieces of the puzzle for investment portfolio.
But I did notice that you have – the company harvested a lot of realized gains in 2017 and a big chunk of that was done prior to the tax law being passed. So I am just curious what was the perspective the mindset going into that and is that something that we should expect in 2018?
Chris Graves
So, Greg, we mark-to-market the whole portfolio so as it’s FASB 157, correct me, if I’m wrong?
Gabriel Tirador
159.
Chris Graves
159. So what you see is net of market change and of realized gains and losses.
We actually took tax losses in the year, because we had capital gains to offset from prior periods. We have now from a tax perspective positioned ourselves where it’s more advantageous to take gains in 2018.
So, if this market holds up, I will be able to do that, but everything you are seeing for the most part is just portfolio market value changes.
Greg Peters
Thanks for that color. I appreciate it.
And then I just wanted to close out with just an opportunity for you guys to talk a little bit about – and I know you answered this in pieces, parts of some of the earlier questions. But just about your non-California approach to growing your footprint, growing your business, what states do you think in 2018 will be the biggest growth opportunities for you and conversely, which states outside of California will probably be shrinking the most and any sort of color around your posture outside of California, additional color is appreciated?
Gabriel Tirador
Well, I mean, I think I mentioned earlier that our anticipation is that outside of California, we are going to probably grow in the low single-digit range. As far individual states go, Robert, do you have any color on that that you want to share?
Robert Houlihan
I think one state we are starting to see some turnaround which is applications taxes. We clearly took a lot of rate there.
We took it earlier than other competitors and over the course of the last 3 to 6 months, we have seen a lot of large rate increases by other carriers, which has helped boost our new business production in that state.
Gabriel Tirador
Yes. And I think Florida, we are anticipating a little bit of growth in Florida.
I don’t think that there is any state really that we are anticipating significant growth in and other states that we are anticipating significant declines in. Our two biggest states, which is Florida and Texas, I think we are anticipating some small growth in those states.
Greg Peters
Perfect. Thanks again for taking my questions.
Gabriel Tirador
Sure.
Operator
Your next question comes from the line of Alison Jacobowitz from Bank of America/Merrill Lynch. Go ahead please.
Your line is open.
Jay Cohen
Hey, you can tell by the voice it’s not Alison, it’s actually Jay Cohen. I have just got a couple of follow-up questions.
When you talk about these price increases relative to claims trends they don’t seem to be exceeding that much in other words kind of mid single-digit increases, chasing mid single-digit severity increases. I know that’s simplistic.
Are you taking other underwriting actions to try to improve that loss ratio?
Gabriel Tirador
Well, yes, we have a lot of internal initiatives to try to improve our claims adjustment process to try to mitigate any leakage. Yes, I mean, there is quite a few initiatives in the claims area that the company has ongoing to try to mitigate leakage from that standpoint.
You are right that depending on what happens with future claims inflation, if we are taking a 5% rate increase and you have 5% increase in severity, you are going to pretty much hold the water. If the claims inflation comes in lower, you are going to do a little bit better.
For the year, when you back out our large catastrophe losses and also the development, we are running at about 97% or so combined ratio companywide. Robert, do you have any other color you want to add to that?
Robert Houlihan
Yes, I think there has also been some tightening at point of sale underwriting from an agency management as well that helped to offset some losses.
Gabriel Tirador
Yes, that’s a good point. We also have some other underwriting actions that we have been taking to help the loss ratio.
Jay Cohen
Got it. That’s helpful.
The other question on the fourth quarter overhead you suggested that essentially bonus accruals were down, not surprisingly given the profitability. Can you quantify that how much that helped your expenses in the quarter?
Gabriel Tirador
Well, I think maybe we are better off just talking about where we think the expense ratio will be in 2018. Ted, why don’t you?
Ted Stalick
Sure. So you know that we have seasonality in our expense ratio.
Our ad spend is heavily weighted to Q1 and Q3 and then Q4 is our lowest ad spend. For next year, we think the expense ratio will be slightly higher than the 24.7 that we posted for all of 2017.
Part of that is we are expecting to be able to accrue a higher amount for employee incentive plans next year.
Gabriel Tirador
And keep in mind too the employee incentive plans hit both the LAE ratio and the expense ratio. Half of our employees are claims.
So, when we are talking about bonus accruals and the expense ratio, we are just talking about the portion that hits the expense ratio. The majority of it probably hits the LAE ratio or a big chunk of it, I should say.
Ted Stalick
Half of it.
Gabriel Tirador
Half of it, probably.
Jay Cohen
So your loss ratio was aided a little bit by lower bonus accruals as well?
Gabriel Tirador
Yes.
Jay Cohen
Got it. Very helpful.
Thanks for the answer.
Gabriel Tirador
Sure.
Operator
And there are no further questions at this time. I turn the callback over to our presenters.
Gabriel Tirador
Well, I would like to thank everyone for joining us this quarter and we look forward to talking to you next quarter. Thank you very much.
Operator
This concludes today’s conference. You may now disconnect.