Mercury General Corporation (MCY) Q1 2016 Earnings Report, Transcript and Summary

Good morning. My name is Heidi 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] 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.

Thank you very much. I would like to welcome ever to Mercury's first quarter conference call. I'm Gabe Tirador, President and CEO. In the room with me is 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 first quarter operating earnings were $0.13 per share, compared to $0.59 per share in the first quarter of 2015. The deterioration in operating earnings was primarily due to an increase in the combined ratio from 99.1% in the first quarter of 2015 to 103.9% in the first quarter of 2016. Our results in the quarter were negatively impacted by $40 million of unfavorable reserve development and $8 million of catastrophe losses. The majority of the unfavorable reserve development in the quarter came from our California and Florida auto bodily injury coverage. The development occurred across multiple accident years with about $6 million relating to accident year 2015 and the remainder to older years. Catastrophe losses in quarter were primarily from rain storms in California and hail storms in Texas. Excluding the impact of unfavorable reserve development and catastrophe losses, the combined ratio was 97.6% in the quarter compared to 99.1% in the first quarter of 2015. In California, we recorded an increase in severity in the mid single digits during the quarter as compared to the first quarter of 2015. California private passenger auto frequency was up slightly in the quarter, as compared to the first quarter of 2015. In California last year, we implemented several rate increases. In May 2015, we implemented a 6.4% rate increase in Mercury Insurance Company and in August 2015 we implemented a 6.9% rate increase in California Automobile Insurance Company. Mercury Insurance Company represents about half of our companywide premiums earned and California Automobile Insurance Company represents about 17% of our companywide premiums earned. This year in California, we implemented a 5% rate increase in late March 2016 for Mercury Insurance Company and a 6.9% rate increase was recently approved by the California Department of Insurance for California Automobile Insurance Company. We expect to implement the California Automobile Insurance Company rate increase in June 2016. Our rate activity is consistent with what we are seeing in the market. Outside of California, our results were negatively impacted during the quarter by unfavorable reserve development and catastrophe losses. Increasing loss cost trends and higher loss ratios that come with an increase in new business also negatively impacted our results during quarter. To address profitability outside of California, we are increasing rates and tightening our underwriting. Excluding the impact of unfavorable reserve development and catastrophe losses, the combined ratio outside of California was about 106% in the quarter compared to 101% in the first quarter of 2015. The expense ratio in the quarter declined to 26.4% from 27.7% in the first quarter of 2015. The decrease in the expense ratio was primarily due to moderately lower total operating expenses, which decreased by approximately $4.5 million, coupled with a 6.4% increase in net earned premiums. The operating expenses in the quarter included a slight reduction in net advertising expense from $16 million in 2015 to $15 million in 2016 and a reduction in profitability related accruals. Premiums written grew 7.7% in the quarter, primarily due to higher average premiums per policy and an increase in new business policy sales. Companywide private passenger auto new business applications submitted to the company increased 7% in the first quarter of 2016 and homeowners new business admissions were down 3%. In California, we posted premiums written growth of 6.9%. Outside of California, premiums grew 11.4% in the quarter. Outside of California, our loss adjustment expense ratio was too high. Accordingly, we are implementing various changes to improve our loss adjustment expense ratio, including a reduction in force we recently implemented that eliminated approximately 100 claims positions, primarily in our New Jersey and Florida hubs. The net annual savings from this change is approximately $7 million per year. We will record approximately $2 million in severance related costs in the second quarter of 2016. Lastly, we have not been able to profitably penetrate the Michigan and Pennsylvania market and believe our resources are better spent focusing on our other states. Accordingly, we recently made the decision to exit the states of Michigan and Pennsylvania and have filed our exit plans with each respective Department of Insurance. The company expects that once our exit plans are finalized, it will take about a year for the bulk of the policies to be off the books. In 2015, Michigan and Pennsylvania together produced 14.4 million of written premiums with a combined ratio of 137%. For these two states in 2015, the written premiums represented less than half of a percent of the company’s total written premiums and contributed an underwriting loss of approximately $0.07 per share. In 2014, Michigan and Pennsylvania produced $18.4 million of written premiums with a combined ratio of 130%. With that brief background, we will now take questions.

[Operator Instructions] Your first question comes from the line of Greg Peters from Raymond James. Go ahead, your line is open.

Good morning and thank you for the call. I had just a couple of questions. First, could you step back and update us on the consolidated financial position of the company and remind us why the first quarter disappointment doesn't really affect management or the Boards perspective on the dividend outlook?

So, I think we have a very strong capital position right now. We're writing above two-to-one in writings and …

Hello.

Yes, can you hear us?

I can hear you, there's someone else talking in the background. Is that coming from your end?

No.

Okay.

Sorry about that. Not sure who that is. I was saying that we have a pretty strong capital position that has allowed us to pay dividend in situations like this where the dividend payout ratio is above a hundred and we know that on a long term basis we can't have that. And at current investment income levels, we need to get to about a 98.3% combined ratio to be able to fund a dividend, but our target is a 95% combined ratio and our results are going to improve. We have the rate increases that we have in California that are going to start to earn in. Third and fourth quarter probably the most, you're going to see those rate increases fully earn, especially in the fourth quarter on the MIC rate increase. So, we certainly recognize that we can't continue to have a combined ratio at this level, but long term we really do not expect to have that target combined ratio. Again we expect our combined ratio to be about 95% on a long term basis. Having said all of that, it's up to the Board to evaluate the factors and make a decision on a quarterly basis that we think in our prospects going forward are going to be much better and that we also believe that the results are going to improve quite a bit going forward.

Thank you for the color on that question. I appreciate it and then just as a follow-up, you spoke of the 98.3 to earn the dividend, the target of 95 and then we're sitting back processing this $40 million adverse reserve development. So, 6 million of it apparently is for the 2015 accident year. Could you provide us some color on the sense of allocation of the remaining $34 million by accident year and I guess ultimately, with the rate increases coming online in the third and fourth quarter, is it reasonable to assume that that's going to result in improvement in the loss ratio or because of the higher accident year results that it's just going to sort of you're going to sort of be treading water for a period of time until you can get another round of rate increases approved?

Hi, this is Ted. I'll handle the development question. It spread primarily across 2014, 2013 and 2012 with 2014 being of the 34 million being the highest amount. I don't have the exact numbers, but essentially 2014 was the highest and I believe it gets progressively lower, and then actually 2013 and 2012 are about the same amount, so that's how they spread across those accident periods.

And then looking forward with respect to the possibility, if you take a look at the accident quarter, California combined ratio, I think we're right around 97% combined ratio, based on what we brought with the reserve development, so if that continues and we have no further development in subsequent quarters, and you have loss cost trends that hopefully stabilize, I think that you should see an improvement in the combined ratio with the 5%, 6% that we're earning here in California and the third or fourth quarter you have an accident year combined ratio of 97 or so you is should see improved results.

Okay just one follow-up to that and then I'll requeue. I guess when I look at the first quarter results and granted a lot of it as you point out is coming from 2014, 2013 and 2012 as it relates to the adverse reserve development, does this give you ammunition to go back to the California regulators and ask for yet another rate increase on top of the rate increase that you have implemented or will be implementing over the next couple of quarters?

Well I guess the short answer any time you have results that are not favorable, yes that does give you more support to raise rates is the short answer to that. We do think that in California Automobile Insurance Company we will probably be asking for more rates. That's coming and Mercury Insurance Company, we think depending on what happens in loss trends we think that we're pretty much where we need to be right now, but in California Automobile Insurance Company, which represents I think I said 17% of the year premium, strong likelihood that we're going to be filing for more rates.

And does that happen on an annual basis or how often are you allowed to do that?

You can file - there's no timetable with respect to when you have to file as long as there's not one pending, which there's not one pending now because it just got approved you can file tomorrow if you wanted to. Now whether - it’s not going to get approved in the next 30-60 days, it does take time in California.

I understand, completely understand. Thank you for those answers.

Sure.

[Operator Instructions] Your next question comes from the line of Alison Jacobowitz from Banc of America Merill Lynch. Go ahead, your line is open.

Hi. Thanks. So a couple questions. First, can you just repeat the combined ratio outside of California, it just went by me too quick I want to make sure I heard it right? And also if you could remind me of the mix of six months and one year premiums and then I guess the last policy mix for your business. And then the last question I had is with all of the rate increases in all of your efforts and everything you're doing to control the improvement in the loss ratio, could you go into more detail on thought about how it might impact growth going forward?

106% on an accident year basis, Allison was the combined ratio outside of California. As far as the mix between six months and one year, Robert, most of it is six months I don't know if we have a percentage?

Heavily weighted towards six months. I don't have the exact percentage at my finger tips.

Okay. Heavily weighted towards six months though, and your question regarding growth going forward, any time you raise rates Allison your growth is going to be impacted. We're also taking some action with respect to some national accounts outside of California, national agencies that have been running high and we've curtailed some of their business. So, my expectation is that growth is going to slowdown from a policy unit standpoint, you'll see that new business sales will start to slow.

Thank you that's very helpful.

Okay.

Your text question comes from the line of Greg Peters from Raymond James. Go ahead, your line is open.

Thank you for allowing me to ask a couple of follow-ups. I'd like to just step back for a moment and have you go back and talk about frequency and severity trends, particularly in California and I know you made some opening comments, but perhaps you could give us some additional color just so we have a sense of what the conditions look like, a better sense of what the conditions look like in that State?

Well one of the things we look at, Greg is industry trends and I believe and physical damage and bodily injury. The trends we're showing in the 5% to 7% range on severity and somewhere in the low single digits on frequency and that's pretty consistent with what we're seeing in our 2006 trend, we're very close to the industry trends on frequency and severity.

Have you seen any moderation in frequency as it relates to say last year or is it consistent, are you still seeing the same consistent trend from last year? It seems the latter, but I just want to confirm that.

It was interesting because in the first quarter of 2015, we saw a fairly large increase in frequency compared to the first quarter of 2014, but when we looked at that closer, it looked like the first quarter of 2014 actually was sort of unusually low and then what we thought throughout 2015 is frequency sort of moderated and I think we ended the year around 2% or low single digits and that's kind of continued into 2016 kind of the same frequency trend.

Okay, I guess just to close out one other question, considering the growth in the top line and I was struck by the change in investment income in the first quarter versus the first quarter last year, I'm just curious if there's been any change in perspective in the way you're allocating assets in your investment portfolio? Perhaps you could just talk about what's going on there?

Sure, how are you doing Greg, it's Chris.

Hi, Chris.

The past two years as you probably have noticed we were able to grow investment income. It is probably with a bit of irony now that I'm facing more challenging comps despite the fact that the Fed only gotten off the fence and started raising short-term rates, but the mix, the mix last year was much more aggressively shifted towards municipal bonds from common stocks and that was more of a market decision. I've just not had a lot of confidence in market valuations on stocks and felt municipals were a better place to be and that actually turned out to be a pretty good call in hindsight for last year, so the mix currently is still weighted heavily towards municipal bonds. Unfortunately, everyone else's identified value in municipal bonds and with the negative rates abroad, we're seeing actually demand from Asia from Munis, from some of the folks that I talk to tell me, and anything with a positive rate is worth buying. So the yields in the market right now that I'm looking at, I'm right around the belly of the curve is something in the neighborhood of 2% to 2.5% and for a number of years we've been buying bonds with the expectations that the economy was going to grow, rates moved higher, and once we got to about this point in time we would be able to reinvest at a much higher rate environment. Obviously that's not the case. So we’ve got bonds currently rolling off this year that have book yields 4.5% or higher. So it makes the reinvestment much more challenging and that’s simply it and so we’re doing what we can to reinvest and try to make up as much income as we can and try to find opportunities around the edges but I’m less optimistic that we are going to be able to grow investment income as we did the past two years and I think it’s going to be a bit of an uphill battle for this calendar year.

Right. Chris, just I’m pretty sure I know the answer to the following question but you can just confirm it. Exposure to things like the energy complex and/or Puerto Rico or other municipalities or debt instruments that may be having some problems, I’m sure is pretty minimal if not existent, but could you confirm that?

No, I always have to knock on wood with this answer. We’ve been fortunate on the Muni side that we’ve avoided many of the problems out there. We don’t have exposure to Puerto Rico. We didn’t have any exposure to Detroit or San Bernardino or Mammoth any of the others that have fallen out of bed. On the equity side, back in 2014, we had much higher energy exposure on stocks and rolling into 2015 we certainly had some and we’ve rolled that exposure down considerably. So at this point, that exposure is minimal only on the equity side. We really don’t have any debt exposure on energy.

Okay, thank you very much for your answers again.

Thank you.

You're welcome.

Your next question comes from the line of Ken Billingsley from Compass Point. Go ahead, your line is open.

Good morning out there. Thank you for taking my call. I have three initial questions and I apologize I got on a little late so if you addressed this in the commentary I can read it in the transcript, but just on net premiums written growth, obviously that surprised us a little bit here and it was stronger than expected. Was there anything that you discussed, any items that maybe carryover going forward or anything in the quarter that were one time in nature?

Just basically rate, higher average premiums per policy was really the big driver, Ken. It’s just higher rates.

So it was almost all rate related and you were saying that the second half of 2016 could even see another bump in there related primarily to rates as well?

Yes, I would say yes. It’s primarily related to rate. As I mentioned in my prepared remarks, our new business policy sales were up but really the driving force is the higher average premiums per policy.

Okay, and on the expense ratio, striking out the acquisition cost, it’s just the other operating expense ratio continues to be trending down year-over-year. I know the second quarter is going to have a one-time adjustment, but anything that you are doing there maybe differently, were you reducing kind of the expenses in other states or is this a trend that we would likely see continuing obviously with the adjustment that you mentioned in the press release?

Well, we are actively managing our expenses and trying to keep those in line, but I think partially what is happening here, Ken is that our earned premiums are going up and we kind of been able to hold the line on the operating expenses, so that makes the ratios improve. That’s really what’s going on.

And would you say that and I know it was something you discussed in prior quarters is, are we there yet or is there still even more room for improvement on that portion of the expense ratio?

Our goal is to improve that and the loss adjustment expense ratio, so yes there is more room for improvement.

So there’s more earned premium coming through on the current base and you are not looking to necessarily having to hire in other parts and I know you have 100 people coming out in the second quarter but you are not looking to replace that in other pieces of the business?

Correct.

Okay. And then did you have any commentary on reinsurance expectations, costs, fundamentally kind of hearing a mixed bag from some reinsurers, so any discussions you’ve had with them regarding obviously expectations given recent storm activity or are you able to flow through any of those to help keep cost down and not have to raise rates as much so you don’t lose as much business? Can you give any color on that?

Well, we don't use a lot of reinsurance - very little reinsurance primarily on our property business and we have a cat, our biggest reinsurance is our catastrophe covered which I think renews on July 1. We still don’t have indications on where the pricing is going to be there but we really don’t rely a lot on reinsurance, Ken so it's not a significant factor for us.

And how much of the $40 million was net of reinsurance?

The $40 million?

On the reserve charge.

Probably the whole thing.

Okay so there was no reinsurance none of that had your cat layers it was all absorbed by you?

Oh, no we have $100 million retention on the cat. We also buy some facultative reinsurance on our homeowners business, but again it’s not material.

Okay. Great. Thank you for taking my questions.

Thanks, Ken.

Your next question comes from the line of Greg Peters from Raymond James. Go ahead, your line is open.

Sorry to keep pestering you. Just one follow-up question on the advertising campaign. I know that, that was something that you were hoping would help improve your penetration in other states and I’m just curious where you are with the national advertising campaign in terms of dollars spent last year and what you are planning to spend this year and how it foots with your withdrawal from a couple of the markets that you talked about before.

Well, I think our advertising budget this year, Greg is $42 million in 2016 and it was $44 million in 2015 so very comparable. And based on our 2015 results, we were recovering the vast majority of our advertising costs how we look at it and in the first quarter of 2016, we actually recovered all of our advertising costs. So we feel that it’s working. The impact of the Michigan and Pennsylvania is not going to be material because they were very small states. Obviously, the bulk of our advertising dollars get allocated to our California market, which is our biggest market. So again, spend is going to be very similar to last year at this point, $42 million as I think I mentioned versus $44 million a year ago and Michigan and Pennsylvania are not going to have a material impact on us.

Is the spend for this year skewed in one quarter more so than another or is it fairly evenly distributed across all four quarters?

Oh, no the first quarter by far we spent the most. I think we spent $15 million this quarter and that’s an annualized rate, $60 million right and we are only planning on spending $42 million.

Perfect and thank you again for the answers.

Thanks, Greg.

[Operator Instructions] And there are no further questions at this time. I’ll turn the call back over to the presenters.

Well, thank you very much for joining us this quarter and we hope to bring better results in future quarters. Thank you very much.