Mercury General Corporation (MCY) Q3 2015 Earnings Report, Transcript and Summary

Good afternoon. My name is Laurie and I will be your conference operator today. At this time, I would like to welcome everyone to the Mercury General Quarterly Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions]. Gabriel Tirador, you may begin your conference.

Thank you very much. I would like to welcome everyone to Mercury's Third Quarter Conference Call. I am Gabe Tirador, President and CEO. In the room with me is Ted Stalick, Senior Vice President and CFO; and Robert Houlihan, Vice President and Chief Product Officer. Before we take questions, we will make a few comments regarding the quarter. Our third quarter operating earnings were $0.59 per share compared to $0.81 per share in the third quarter of 2014. The deterioration in operating earnings was primarily due to an increase in the loss ratio from 69.8% in the third quarter of 2014 to 73.2% in the third quarter of 2015. The primary contributors to the elevated loss ratio were from our California private passenger auto and homeowners lines of business. Our California private passenger auto loss ratio increased to 71.2% in the quarter from 68.5% in the third quarter of 2014, and was up slightly from the second quarter 2015 loss ratio of 70.1%. Our California homeowners' loss ratio increased to 85.4% in the quarter from 76.7% in the third quarter of 2014. In the third quarter of 2015, California private passenger auto frequency was relatively flat and severity increased in the low single digits as compared to prior year. Higher average premiums from rate increases taken in 2014 and 2015, offset the year-over-year increase in severity in the quarter. However, the California private passenger auto loss ratio increased, as there was less favorable development in the quarter from prior and current accident year reserves as compared to prior year. To address the higher than targeted loss ratio, a 6.4% rate increase was implemented in late May for Mercury Insurance Company, representing about half of our company-wide claims revenue and a 6.9% rate increase for California Automobile Insurance Company, representing about 15% of our company-wide premiums, was implemented on August 2. In addition, the 5% and 6.9% rate increase is pending approval for Mercury Insurance Company and California Automobile Insurance Company respectively. Our California homeowners loss ratio was negatively affected by an increase in frequency in severity in the quarter. We believe the hotter than typical summer in California this year may have been a contributing factor to the increase in frequency and severity in the quarter. During the quarter, we experienced more than our historical number of large water and fire claims, which negatively impacted our severity. Partially offsetting the increase in loss ratio during the quarter, was a reduction in our expense ratio. Our expense ratio was 26% in the quarter compared to 26.9% in the quarter of 2014. The reduction in the expense ratio was primarily due to lower average commissions and profitability related accruals, partially offset by increased advertising expenses. Net advertising expense in the quarter was $10.9 million compared to $5.3 million in the third quarter of 2014. Outside of California, the combined ratio was about 101% in the quarter, compared to about 103% in the third quarter of 2014. Premiums rating grew 8.2% in the quarter, primarily due to higher average premiums per policy, the acquisition of Workmen's Auto, and an increase in new business policy sales. Workmen's Auto premiums were in the [ph] $5.2 million, added 7 cents points to the quarter's premium growth. Company-wide private passenger auto new business applications submitted to the company, increased 15% in the third quarter of 2015 and homeowners new business submissions were up 9%. In California, we posted premiums written growth of 7.5%. Outside of California and excluding our mechanical breakdown product, premiums written increased 9.1% in the quarter. We generally expect our fourth quarter combined ratio to be higher than the rest of the year than several points, due to increased loss frequency and higher severities, caused by seasonal driving [ph] and weather. This year, we expect that California personal auto rate increases implemented earlier in the year and earning into our results in the fourth quarter, will offset some or all of the seasonal loss effect. That said, it is hard to predict with certainty, as there are many factors currently unknown or beyond our control, including the severity of the elevated precipitation levels predicted from this year's El Niño event. With that brief background, we will now take questions.

[Operator Instructions]. Your first question is from Ken Billingsley of Compass Point. Your line is open.

Good afternoon -- I guess, good morning where you are at. One of the questions that I have is, specifically -- I know you gave some detail on the loss ratios in and outside of California and in the state. From a bucket standpoint, how much of it is primary business versus maybe what you would consider non-standard auto business, and where is that growth coming at from, as a percentage of overall book of business?

Well, let's talk about California first. In California, Mercury Insurance Company, which is our largest subsidiary here in California, and you have Cal Auto, which is our mid-market company; we are primarily seeing more new business growth here in Mercury Insurance Company. And as far as the loss ratio, the loss ratio is much better in Mercury Insurance than it is Cal Auto. So there is a discrepancy between the preferred and the non-standard market. Outside of California, we tried to have a product that basically covers a broad range of risks, and we usually have one company outside of California, and we are able to [indiscernible], like I said, a broad range of risks. With respect to the loss ratio, there are certain states outside of California, where the loss ratio on non-standard has been hotter. But I can tell you in general, outside of California, we have been able to price that pretty well, and in many of our states outside of California, that non-standard piece, is actually behaving very well.

So outside of California, non-standard is performing better than expected?

I wouldn't say better than expected, but in general, it's performing like we are expecting.

Okay. And is this -- some of it is a mix of business, its interesting, I saw your lower expense ratio; some of it I believe is -- I consider it is driven by lower average commissions. Is that driven in California, or are you seeing improvements outside of California, if I recall correctly, you guys were paying higher commissions initially, as you were growing that business?

Well outside of California, we made some changes to our commission structure. You may recall Ken, back, I think it was in January of 2014, where we reduced rates but we also reduced commissions, back in 2014. And in California, we have also made some changes to our commission structure as well, where we reduced base commissions as well as possibility related commissions.

Is this potentially creating any adverse selection?

No, we don't believe so. Our commission levels are still well above the industry average in California for example. Our average commission rate in California covers about 17% or so, when you include contingent commissions. And now we are seeing the competition, probably is in the neighborhood of 13.

Okay. Moving on just -- on the equity side, on the balance sheet side, it seems like we have had five quarters now, but you have been selling equities and taking a real life loss. Can you talk about what the strategy is and what's going on there? I mean, is there a need from a cash standpoint, or what is the strategy using that cash for?

Ken, first of all, I just wanted to clarify that our entire portfolio is classified as trading. So the realized gains and losses are primarily mark-to-market adjustments and not securities that we have actually sold. So you can't really look at our P&L realized gains and losses and tease out the portion that was sold. But if you look at our 10-Q, it will be disclosed definitely there.

Okay.

That said, we have been shifting a portion of the portfolio out of equity securities and -- or towards fixed maturity securities. We started doing that earlier in the year, and that was primarily -- because Chris Graves, our Chief Investment Officer, became less and less comfortable with the equities and the markets and -- it felt like there was more opportunities in the fixed income space.

All right. Last question I have is, just on the dividend and the payout ratio; where do you think you can take the leverage of the business on a statutory basis, given your mix of auto and home and I am assuming the home is going to continue to grow. Where can you take the leverage ratio and how long can you support a dividend payout ratio that exceeds 100%? Before you feel that you need to adjust somewhere?

Well I think we have answered this in previous quarters. Ken, I think we feel comfortable -- [indiscernible] signs, and we are close to about 1.9 to 2 times now. We feel comfortable at about 2.5 times. And as far as the 100% payout, we anticipate -- I think you got to keep in mind, is we don't anticipate running at a 99% combined ratio in the long term. Our target ratio historically has been a 95% combined ratio, I think with the rate increases that we have taken here in California, that's going to help us get closer to that in California. Outside of California, we are willing to write a little bit higher than the 95% at this time, just trying to grow the business. But that said, we don't expect the 99% combined ratio in a dividend pay out ratio above 100% long term. But, I will say this, we do have the luxury that we have enough capital that, we feel very comfortable, with paying at 100 or slightly above 100% payout, because we have a pretty darn strong balance sheet.

Very good. Thank you for taking the questions.

Sure.

Your next question comes from the line of Greg Peters of Raymond James. Your line is open.

Good morning. Thank you for sponsoring the call and taking our questions. I wanted to talk about two areas or ask about two areas. First of all, marketing relationships you have both in California, outside of California, outside of the traditional independent agency channel. Can you talk about relationships you might have with CoverHound or your use of comparative raters outside of California?

Sure, I will let Robert Houlihan talk a little bit about that.

Sure. Outside of California, aside from our traditional, call it [indiscernible] earning, our business through national accounts. So it adds a financial [indiscernible] CoverHound, we also have been growing our business direct-to-consumer and we get that business generated from our advertising. We get some business buying leads and leads generator, and then we get a fair amount of business from comparison sites like Google Compare and Compare.com.

Can you possibly -- are you having different type of loss experience with these sources of business versus your traditional channel?

So on buy button, on the direct-to-consumer business, our loss ratio has actually been favorable. Not by much, but slightly favorable to our core business. Some of the national accounts has been running a little bit higher, and we have been evaluating different underwriting approaches to bring that back into light.

It varies by state. I will say, it varies by state, but national accounts do vary a little bit by state, as far as the possibility by state. It does vary.

And you are segmenting Google; your relationship with Google into the direct channel, is that correct?

Correct.

And can you just talk about just the growth of those different channels? Maybe I am obviously focused on Google, just seeing how successful it is. There has been a lot of noise in the marketplace and I think CoverHound just recently completed another capital raise. So any perspective on that emerging market would be interesting?

Well at this point, it's immaterial irrespective of the number of sales that we are getting in Google per week. It's really immaterial, it's something that we are watching and working with Google on. But right now, the sales, when you consider our weekly sales company-wide, it’s a very small fraction.

That makes sense. Okay. And just piggybacking on the production side, can you just remind us how your advertising and marketing programs go? I know there has been increased expense this year. Can you sort of lay the groundwork of what we should be thinking about, in terms of not only the expense for the full year 2015, but how it might look for 2016?

Sure. I mean, I think based on the first nine months of the year, we are covering the vast majority of our advertising costs. In other words, our cost of sale is close to where it needs to be. And when we take a look at our advertising, we validate the effectiveness of our advertising. We take a look at it, by comparing the lifetime acquisition costs -- things we are pricing through the actual acquisition cost. So we are very close to where we'd like to be. We are a little bit off. I think looking at the budget this year, we are somewhere in the neighborhood of $48 million company-wide, for advertising. I think we are coming a little less than that this year. Maybe I don't know, 45-ish would be my best estimate at this time. And as we look forward into 2016, I think you can see similar amounts of advertising, because we think that the economics are working for us -- in general for us right now. So when we validate the economics, we are pretty close to where we need to be. So we are going to continue to do it. So I anticipate that our budget next year for advertising, its going to be similar. It might be a little lower, but its going to be similar.

Okay. Thank you for that clarification. One other minor technical question, just in the press release in the financials the reconciliation of the operating measures; I notice there is a big jump up in the change in net unearned premium quarter-over-quarter, but its flat year-to-date. Is there something going on there, or is it just a timing difference?

That's pretty much a timing difference, the third quarter. We have a seasonality to our premiums written and the first and third quarters, we write more premium than in the second and fourth. So its more of a seasonal -- there is six and 12 month policies, you will see fluctuations.

Right, right. Okay. Thank you very much for your answers.

Thank you.

[Operator Instructions]. Your next question is from Alison Jacobowitz of Bank of America Merrill Lynch.

Thanks. Really answered most of my questions, but if I could just look at it and then -- well first of all on the claims frequency, if I can ask you to just maybe repeat a little what you said on the auto claims frequency inside of California. I believe you said it was flat, quarter-over-quarter and severity was up in low single digits. But if you could repeat that, and if you could add any more color on what you're seeing in frequency? And then as far as the expenses, just even taking a step back, if you look at the way the expense ratio was in the quarter and you have talked before about -- maybe a range. I don't think I heard you say this time, how you are looking at your own expense ratio, given everything you said about advertising and rate increases etcetera going forward?

Okay. To answer the first part of your question, as I mentioned earlier, our frequency was relatively flat in the quarter, in our auto line, year-over-year in California Auto, and our severity was up in the low single digits. Now year-to-date, our frequency is up, year-over-year, and it was up the most -- to my recollection, was in the first quarter it was up the most, and then in the second and third quarter, it was relatively stable as compared to the first quarter, and year-over-year as I mentioned in the third quarter, relatively flat with severity up. As far as the expense ratio, we were in about a 26% expense ratio. On a year-to-date basis, we are running about 27% year-to-date with the increase of ad expense. Going forward -- as far as the fourth quarter is concerned first, in the fourth quarter, our advertising spend goes down quite a bit. So I anticipate the fourth quarter expense ratio to be 26-ish in the fourth quarter -- 26 to 26.5 maybe let's call it. And then as far as next year, probably similar to what its running this year.

Thanks.

You have no further questions at this time.

We'd like to thank everyone for joining us this quarter, and we look forward to speaking with you again next quarter. Thank you very much.

Ladies and gentlemen, this concludes today's conference call. You may now disconnect.