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Good morning. My name is Samaria [ph], and I will be your conference operator for today. At this time, I would like to welcome everyone to the Mercury General Third Quarter 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 everyone to Mercury's third 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. I am pleased to report our third quarter operating earnings were $1.11 per share, compared to $0.60 per share in the third quarter of 2017. The improvement in operating earnings was primarily due to an improvement in the combined ratio, an increase in after-tax investment income, and a lower corporate tax rate.
The combined ratio was 95.6% in the third quarter of 2018, compared to 99.3% in the third quarter of 2017. The combined ratio in the quarter was aided by premium rate increases, lower catastrophe losses, and a lower expense ratio.
To improve our combined ratio, we have an increasing rate in most states. In California, a 5% Personal auto rate increase in Mercury Insurance Company waiting to affect in March. A 6.9% Personal auto rate increase for Mercury Insurance Company and California Automobile Insurance Company are pending approval with the California Department of Insurance.
In addition, a 6.9% rate increase in our California Homeowners line was filed in May. California Personal auto and Homeowners premiums represent about 77% of our direct company-wide premiums earned.
Net Catastrophe losses were $13 million in the quarter, primarily the result of the Car fire in Redding, California. This compares to $19 million of net catastrophe losses in the third quarter of 2017 primarily from Hurricane Harvey in Texas, and Hurricane Irma in Florida and Georgia.
During the quarter, we recorded $6 million of unfavorable prior year reserve development, down from both the first and second quarter of 2018. The development in the quarter came primarily from our auto line of business.
The expense ratio was 24% in the third quarter compared to 25% in the third quarter of 2017. The lower expense ratio was primarily due to lower average commissions and a slight reduction in other operating expenses coupled with a large increase in earned premiums.
Advertising expense was $12 million in both the current and third quarter of 2017. Excluding the impact of catastrophe losses, unfavorable reserve development and ceded reinstatement premiums earned, the combined ratio was 94.5% for the nine-month period ending September 30, 2018, compared to 96.8% for the nine-month period ending September 30, 2017.
After-tax investment income increased 24% to $33.5 million. The increase in after-tax investment income was primarily due to higher short-term interest rates, an increase in invested assets, a lower corporate tax rate, and higher yields obtained on certain classes of investments.
Companywide private passenger auto new business applications submitted to the company increased approximately 8% in the quarter, and companywide homeowners' applications increased 16% in the quarter.
Earlier this month, hurricane Michael caused significant damage in Florida, as well as in Georgia and Virginia. At this time, based on the information currently available, we believe our ultimate losses from hurricane Michael will be in a range between $4 million and $8 million which will be recorded as losses in the fourth quarter.
Our catastrophe reinsurance treaty provides for $205 million of coverage in excess of our $10 million retention. Lastly, we generally expect our combined ratio in the fourth quarter excluding catastrophes to be higher than the rest of the year due to increased loss frequency and higher severities caused by seasonal driving in weather.
That said, it is hard to predict with certainty whether the underlying combined ratio will be higher as there are many factors currently unknown or beyond our control. With that brief background, we will now take questions.
[Operator Instructions] And your first question will come from Greg Peters with Raymond James. Please go ahead with your question.
Good morning. Based on what I see here, it looks like, this third quarter result is the lowest combined ratio that you guys have produced in something like the last 10 years. Is that a right, read?
Yes, I believe, that's right, Greg.
Congratulations.
Thank you.
I know it's been a hard fought battle. So I know you mentioned in your opening comments about some pending rate increases that are – two are in the auto and one is in the Homeowners line. I believe, given that the underlying and reported results are trending favorably, do you believe there's less possibility that those rate rates are going to be approved?
No, we still think that they will be approved. I think the indications show that we need the rates. In Cal Auto, I think in the last quarter, we talked about the fact that we were expecting approval. Additional questions came in from the department. Not necessarily really based on whether or not we needed the rate, but just some additional questions, and I believe we've answered those questions in Cal Auto, and we do expect to have approval sometime in the near future in Cal Auto.
In MIC, again the rates have -- that’s from the Department of Insurance, suggests that we do need the rate based on the trend. And although we don't expect that rate to go into effect until 2019 probably spring or mid of 2019 is our best guess right now.
And that’s same really with the Homeowners rate filing that we filed earlier this year, when you take a look at the – rate templates that we filed, it clearly shows that based on the trends that we need the rate. I don’t know, Robert you want to add anything?
No, I really don't have much to add to that commentary, Greg.
Okay. Well that’s good color. On the prior year development, obviously it's been you talked in the earlier conference calls about some of the trends that were popping up, that were causing this year's adverse development to at least through the nine months to be worse than last year's result through the nine months. But the trend is improving, there's less unfavorable development. Can you talk about where we are with that?
And I know that the fourth quarter has some volatility around it but you know should we look at this improving trend and think that maybe you've got the reserve issues resolved?
Well, we definitely are baking the trends into our selections, our ultimate selections. We’ve gone through a period over the last several quarters maybe four to six quarters where the underlying development was more than expected and that did moderate in the third quarter, which gives us some hope that this will be the end of adverse development going forward. But it's hard to tell, because I think things change and we look at it fast track data and it looks like the industry in California was moderating a bit in the last quarter or two. So that's also a good sign.
It was definitely better this quarter. But I think as we mentioned last quarter, our historical trends when we we're forecasting forward they're coming in higher. There's some actions on the link factors that we were selecting, we're coming in higher, but it appears to me at least that, that's starting to stabilize, which is why you saw in the third quarter less development, whether or not that continues in the future, you know we don't know.
Well I know, Gabe, you've talked for several years about your stated objective of the 95 combined ratio, and I assume as part of that stated objective you assume that there's not going to be negative or adverse reserve development. You assume that reserves are going to be adequately set. Is that the right read?
So we don't know any development over the other.
So -- we're some -- if you're catching up on the reported side, maybe you're catching up on me, on the reserve side too. Or maybe that would be you know what I would refer from your results. Can I can -- can you spend a little bit talking about the operating expenses and you know they were down a little bit in the third quarter. Were there some discretionary items that you just -- withheld held back on, or just talk to us a little bit about what the ebb and flow of the underwriting expenses in the quarter?
Our operating expenses were fairly I think they were flat compared to last year's third quarter. One of the things that I think is really helping the ratio is really our growth in earned premium. We're growing now at a lot faster rate than we are in operating expenses. Our ad spend I think was the same in the third quarter this year compared to last year.
And our effective commission rate is down, that, that's helped and that's variable. So the affected commission rate is down. That's going to help. And we've been monitoring our expenses, making sure, our from an expense standpoint that we're tight with the budget. So I think it's a combination of all those factors that are helping the expense ratio.
And can, can you just expand that for a second on the commission rates being down, I’m surprised by that comment. Usually agents are reluctant to give up commission.
Well, we’re talking about maybe I think and overall, maybe two or three-tens of a point, down year-over-year is my recollection. And our commissions in California are variable and they’re base on the possibility of the book of business and it's a three-year trading number that we use. So, that has been trending down a little bit. We’ve also made some change to our commission structure where we’re paying for certain type of business more and other types of business less, so a combination of all those factors have driven down the expense ratio or the commission rate here in California a little bit. I’m not talking about a lot. I think its two or three-tens of a point here in California.
We think our annual commission rate adjustment is effective with the July 1st for all our agents. So the commission rates just typically go down and you would expect to see that in the second half of the year.
Right. One more underwriting question and then I have a question for Chris. On the non-California business it -- can you comment about is Florida still shrinking auto market for you? Or is that stabilized in a position to start growing again and talk about the other states as well?
Florida was down in a quarter. It was still down in a quarter. Posted a very good combined ratio in Florida in the quarter, but the topline was down. Overall outside of California, our premiums were up about 2% for private passenger auto and about 5% up in the homeowners outside of California on the topline. And I think as I mentioned earlier from an application account standpoint, in the third quarter we were up at 7.9% in applications for private passenger auto for the entire quarter, about 8% up in California and about 7.2% up outside of California in a quarter. So, some of the states that are growing; Texas is growing on the top line and the ad count, New York, Oklahoma. The states that are down are the two primary states are down are Florida and Virginia.
Great. Thanks for that color. And I know you in your prepared remarks talked a little bit about investment income, but it really was a whopper of a quarter for you. And maybe you could give us more details about that? Is the 38 million a new run rate to expect going forward et cetera, Chris this would be good opportunity for you to chime in as well?
Hi, Greg. Going back several years we’ve sort of positioning the portfolio to be more sensitive to LIBOR rates. We’re definitely seeing benefits of those positions particularly through our CLO investment. We’ve been putting more capital towards investment grades CLOs. And so that helps. And then obviously, just tighter rates. In general, we’ve seen quite a big move this year which is allowing us to see more and more opportunities to buy fixed income that’s accretive to our book yield, which has not been the case for some time.
We’ve been challenged to maintain where we where and that’s no longer the case. We can actually add some pretty bonds now and see a pickup in yield. And we’re not have to stretch for anything either. We can get pretty good credits and not have to take a lot of risk. And then dividends, we’re seeing more dividend bumps come through. The equity investments have helped, so all that combines has put some good wins to our back this year. I really can’t speak towards the run rate. It’s hard to say, buy certainly feeling pretty good about where we are right now.
The other thing I would add to that is, our investment balances have also grown which has helped us well.
Yes. That’s something else. That’s a good point, Gab. Mercury business when that does well, it doesn’t put any strain on me. And as you can see our list of balances have really picked up and have translated into investment income pickup. And if you go back over the history, we are approaching investment, annualized investment income numbers that we haven’t seen in 10 years but on our much higher balance. So I think you can – as rates normalized I think you can to speculate that the investment income kind of continue to do better.
Well, it’s certainly, the last two quarters have been particularly noteworthy so -- and the third quarter was a blockbuster no doubt. Well, listen I ensure those other analysts that want to ask questions. Congratulations on your quarter.
Thank you, Greg.
[Operator Instructions] Your next question is from Christopher Campbell with KBW. Please go ahead with your question.
Yes. Hi, good morning, gentlemen.
Good morning.
Hi, Chris
Hi. I guess my first question is on the premium growth. So looks like it maybe like 250 bps was from the other growth this quarter. Year-over-year was from the 12-month policy reintroduction. But if you back that out, you're still seeing 7% growth, so I guess like if you're decomposing that, how much of that would be exposure versus rate? Because I noticed the auto and the home were picking up this quarter?
It’s about 2% o on the policy growth for the rest of the rate.
Okay. So 2% exposure and then the other 5% excluding the policy introduction would be rate?
Yes, in that ballpark.
Okay. That’s really helpful. And I guess just kind of another question on reserves I think Greg asked a few. So, just looking at the reserves the last few years, it looks like the adverse reserve development seems to be the lowest in the third quarter and kind of heavier in the other three quarters of the year. Is there anything seasonal in terms of your review process that would kind of bias the third quarter to be lower than the other quarter of the year?
We follow the same process every quarter, so that’s an interesting observation, but I don’t think there’s anything bias in one way or the other?
Okay. And there’s no like different like data that you use for a quarter or depending or you have just you have a same input every quarter?
Same input, same process.
Okay. Got it. And then just kind of finally like a high level one on the regulatory environment in California. So I guess as Mercury gets more profitable, does this kind of create a heightened risk that regulators might order the rate rollbacks that that I think were like -- there were rumored a few months ago? And then just secondary one on that like how could the November election kind of shape California’s regulatory environment going forward?
Well, let Robert talk about the prescribed formula that we have here in California with respect to rates and then I can chime in on the election.
Yes. On the REIT filing it’s subject to return on surplus formula, so only to the extent of that formula would yield the decrease – can the department force reduction in rates. And right now, we discussed early we have two pending increases which we think are supported. The department if company hasn't filed in a period of time, the department has a right to come in and request a filing, but other than that, there’s no mechanisms for rate rollback.
Okay, guys. I thought like the Commissioner was like ordering like his staff to review all of the rates. Now like when would that be a risk like I guess? Or does that vary by line? So I think those are catching up on homeowners. But if auto is becoming more profitable, does it become more of a risk for auto versus homeowners?
I was going to say, you have the department can request a filing to be reviewed for potential decrease, but we already have pending filings going through the process right now. So there’s nothing above and beyond that.
The only think I can thing of is, there were some kind of – a notice went out, maybe what you’re referring to is when the taxes went down?
Yes. That’s it.
That’s what I think you’re referring to, but we’ve already incorporated the lower tax rate into our filing. So I think that’s what you’re referring to is that the Commissioner came out and said, hey, we’re going to look at rates, lower tax rate, but those lower tax rates are in the formula that we have for our filings.
Okay. So that’s all baked into the 6.9 [ph] you have going in Mercury and then in Cal Auto, so that’s already got the lower tax rate? And you’re still asking for 6.9, Correct?
Those filings already reflect the lower tax.
Okay. Got it.
And as far as the election, I’ll just make the comment that, we don’t think whoever gets elected will be any more adverse than we have today. That’ my feeling.
Okay. That’s very helpful. Thanks for all the answers. And best of luck in rest of the year in 2019.
Thank you.
And at that time there are no further questions. I would now like to turn it back over to the panel for any closing remarks at this time.
We’d like to thank you for joining us for the third quarter and we hope to bring you some good news as well in the fourth quarter. Thank you very much.
This concludes today’s conference call. You may now disconnect.