Earnings Call Transcript - MCY Q2 2020

Operator, Operator

Good morning. My name is Michele, 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. This conference call may contain comments and forward-looking statements based upon 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. Please go ahead.

Gabriel Tirador, President and CEO

Thank you very much. I would like to welcome everyone to Mercury’s second quarter conference call. I am Gab Tirador, President and CEO. On the phone, we have Mr. George Joseph, Chairman; Ted Stalick, Senior Vice President and CFO; Jeff Schroeder, 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. Net income in the second quarter was $228.2 million or $4.12 per share, which includes $125.2 million of after-tax gains on our investment portfolio. The rebound in the market in the second quarter helped to partially offset first quarter after-tax losses of $198.5 million on our investment portfolio. Year-to-date, net income was $89 million or $1.61 per share, which includes $73.4 million of after-tax losses on our investment portfolio. Most of the year-to-date investment losses are mark-to-market adjustments on securities that continue to be held by the company. Our second quarter operating earnings were $1.86 per share, compared to $0.74 per share in the second quarter of 2019. The improvement in operating earnings was primarily due to a reduction in the combined ratio from 98.3% in the second quarter of 2019 to 88.2% in the second quarter of 2020. Catastrophe losses in the quarter were $12 million, compared to $9 million in the second quarter of 2019. The company recorded $12 million in unfavorable reserve development in the quarter, compared to $9 million in the second quarter of 2019. The improvement in the combined ratio was primarily due to improved results in our private passenger auto line of business. Lower frequency in the quarter as a result of less driving from the COVID-19 pandemic was the primary reason for the improved results. The lower frequency in the quarter was partially offset by an increase in severity and a giveback of $100.3 million of premiums to personal auto customers as a result of less driving from the COVID-19 pandemic. Partially offsetting improved results in our private passenger auto line of business were worse results in our commercial auto, homeowners, and commercial multi-peril lines of business. Although, our commercial auto line of business also saw a decline in frequency in the quarter, increases in severity, unfavorable reserve development of $7 million, and a giveback of $5.5 million of premiums to commercial auto customers negatively impacted our commercial auto results in the quarter. In our homeowners line, both frequency and severity increased in the quarter. In addition, $3 million of unfavorable reserve development negatively impacted our homeowners results this quarter. To improve our homeowners results, a 6.99% rate increase in our California homeowners line went into effect in April. In addition, a 6.99% rate increase was recently approved by the California Department of Insurance. We expect to implement the recently approved rate increase in October. California homeowners premiums earned represent about 87% of company-wide direct homeowners premiums earned and 15% of direct company-wide premiums earned. Our commercial multi-peril results in the quarter were negatively impacted by a large $5 million fire loss net of reinsurance. In the second quarter, we launched two new programs. In June, we introduced our new personal auto usage-based insurance product MercuryGO in Texas. Early adoption rates are encouraging and above our expectations. We also introduced Phase 1 of our new commercial multi-peril product and system in California in the second quarter. The new product and system have been well received by our agents. We recently completed our catastrophe reinsurance treaty renewal effective July 1, 2020. The total reinsurance limit purchased increased from $600 million in the prior period to $717 million for the July 2020 through June 2021 period. In addition, the new reinsurance program has wildfire coverage in all layers. Our retention remains the same at $40 million. Total annual premiums on the new reinsurance program are approximately $50 million. For the prior reinsurance treaty, total premiums were $38 million. More details of the catastrophe reinsurance treaty renewal will be included in our second quarter 10-Q filing. The expense ratio was 27.2% in the second quarter of 2020, compared to 24.4% in the second quarter of 2019. The higher expense ratio in the quarter was primarily due to the reduction of premiums earned of $106 million due to premium refunds and credits to eligible policyholders for reduced driving and business activity as a result of the COVID-19 pandemic. Excluding the premium refunds and credits, the expense ratio would have been 24.1%. Premiums written declined 12.5% in the quarter, primarily due to the $106 million in premium refunds and credits. Excluding the $106 million in premium refunds and credits, premiums written declined by 1.2%. In addition, we plan on returning $22 million of July 2020 monthly premiums to eligible policyholders in August. Accordingly, we expect third quarter premiums written and earned to be reduced by approximately $22 million. We will continue to monitor the extent and duration of the economic impact related to COVID-19 and make further adjustments as necessary. We expect our underwriting and loss adjustment expense ratios to remain elevated in the third quarter, as premiums declined from givebacks without a proportionate reduction in expenses. With that brief background, we will now take questions.

Operator, Operator

Our first question comes from Greg Peters from Raymond James. Your line is open.

Greg Peters, Analyst

Well, good morning to you. Good afternoon to those listening on the East Coast. I first wanted to just give everyone a heads up had some trouble getting access in the call this morning or this afternoon, depending on your time zone. We are asking for a conference ID. I don’t know if that’s normal or not. But let’s pivot back to the results and your announcement around the $22 million of giveback. Can you talk about the mechanics around that number? And if you are having favorable frequency continue in July and maybe it extends in August to September. Is it reasonable to assume that this giveback or refund is going to continue for the near-term?

Gabriel Tirador, President and CEO

Let me go ahead and have Jeff talk about the givebacks. Jeff?

Jeff Schroeder, Vice President and Chief Product Officer

Yeah. We saw continued frequency, obviously, declines through the month of June and into the month of July hence the giveback that Gabe just talked about for July. As far as that continuing into subsequent months, we are going to continuously evaluate that. And depending on how frequency moves over the next couple of months, we will potentially make adjustments to giveback and extend that for those particular months. But it’s a little early for us to tell at this point.

Gabriel Tirador, President and CEO

I will add that we did see an increase upwards slope in frequency as compared to where April and May and June and July. So, as Jeff mentioned, we will just continue to monitor every month, and we will adjust based on the information that’s coming in, and severity is rising as well, so offsetting some of the frequency benefits, but no question that there was an upward slope in frequency in the month of June and July as compared to April and May.

Greg Peters, Analyst

I want to continue discussing that idea. How has your interaction been with the California Department of Insurance? I noticed that your second quarter combined ratio is significantly below their mandated targets, so I'm curious about the involvement of regulatory authorities in your process at this time.

Gabriel Tirador, President and CEO

Well, I am not sure what you mean by, it's well below our mandated target. I don’t think I agree with that statement.

Greg Peters, Analyst

I am sorry. I thought there was a 96 combined ratio sort of threshold, maybe I am miss…

Gabriel Tirador, President and CEO

No. No.

Greg Peters, Analyst

Okay.

Gabriel Tirador, President and CEO

There is no threshold of 96 that I am aware of. They have a template that you have to file and that template has a maximum that you can take based on the template. And I will remind you that before COVID, we had rate pending in both companies something, I think, one to five and another one to four, something like that, pending because of severity increases. And I will add that the template allows for quite a bit more rate increase. So prior to COVID, there was no question that we needed rate and the template allows for quite a bit more rate than we were asking for.

Greg Peters, Analyst

Thank you for the clarification. Can you share how your interaction with the California Department has been as you announce these programs? Are they accepting your proposals or getting involved, or have they mainly been asking you to take action and then leaving the details to you?

Gabriel Tirador, President and CEO

Yeah. That’s basically how it’s been. They are allowing companies to do whatever giveback that they see fit, and they are not ordering any kind of specific giveback.

Greg Peters, Analyst

Got it. Thanks for…

Gabriel Tirador, President and CEO

Sure. Sure. No problem.

Greg Peters, Analyst

Can we discuss reinsurance? The retention remains at $40 million; is that per event or an aggregate for the quarter? Also, could you provide your insights on what the fire season might look like in the third and fourth quarters?

Gabriel Tirador, President and CEO

Well, that’s always hard to predict. But I will give Ted. Ted, do you want to talk about the reinsurance?

Ted Stalick, Senior Vice President and CFO

Yeah. Hi, Greg. So it’s $40 million per event. We did buy more limit. I would like to mention that, PG&E came out of bankruptcy on July 1st. And that put into place the utility industry subrogation fund, which will cover 40% of future losses caused by their equipment. So we see that as favorable towards cat losses in the third quarter and fourth quarter. We have already started having some fires here. There’s a big one out in Riverside County. But so far, I don’t know if any structures have been burned, and it seems to be going up into the mountains. So we will see what happens the rest of the year. Normally the wildfires are the worst when the Santa Ana winds come in, which is generally later in the fall.

Greg Peters, Analyst

Can you explain how the 40% works? For example, if an event costs $100 million, is 40% of that covered by subrogated claims to PG&E? Please clarify how this operates, considering there must be some accountability on their part.

Ted Stalick, Senior Vice President and CFO

Well, if the loss was caused by their equipment and that it’s shown to be caused by their equipment, my understanding is, yes, and this fund has been set up where the insurers can submit their claims and get the 40% reimbursement back from the fund.

Greg Peters, Analyst

Is that done before or after reinsurance?

Ted Stalick, Senior Vice President and CFO

In that example, $100 million would reduce to 60%, and according to our treaty, our retention is at 40%. Therefore, you would deduct the amount beyond 40% up to the 60% in that case.

Greg Peters, Analyst

Which is under 20%. Thank you for that clarification. How many events are covered in your treaty, including the first and second events?

Ted Stalick, Senior Vice President and CFO

Our limits include one reinstatement.

Greg Peters, Analyst

Got it.

Ted Stalick, Senior Vice President and CFO

So and then once you exhaust the second reinstatement, you don’t have any coverage. So you could have theoretically a dozen events that fall within the layer, but haven’t exhausted the layer.

Greg Peters, Analyst

Thank you. I have a question regarding operations. You mentioned your focus in California, but also pointed out some initiatives happening outside of California, particularly the one in Texas. By the end of the year, do you anticipate that your non-California premium will be higher, the same, or lower than it was last year?

Gabriel Tirador, President and CEO

No, I am not going to make a prediction about that. There's just too much uncertainty at the moment. What I can share is that we are focused on enhancing our segmentation beyond California. We recently launched a new product called Mercury Advantage in several states, and this launch has significantly boosted new business in those areas. We intend to continue expanding this product across most of the country later this year and into next year. Additionally, our Mercury Gold program and the base program are performing well. However, the uncertainty makes it difficult to predict where premiums will settle. I can assure you that we are maintaining our underwriting discipline and taking a long-term perspective across all our states. While I won't make any predictions, there are several positive developments related to our products in progress.

Greg Peters, Analyst

Great. Thank you for the answers. The final question just would be to Chris regarding investments, just looking at the year-over-year and six months both on the quarter and the six-month basis, the average yield is down. Can you give us some perspective on how the new money rates compare with the existing portfolio yield and given what’s going on in the interest environment there, where the new level will normalize at?

Chris Graves, Vice President and Chief Investment Officer

I believe you already have much of the answer, which is that new rates are significantly lower than my average rates and where we were just six months ago. Cash rates are nearing zero, with new money rates at 55 basis points for the 10-year Treasury and about 65 basis points for AAA municipal bonds. When I account for that, we're looking at 1% to 1.5% out on the curve, which carries considerable duration risk. The question is how long we will remain in this environment. With a significant election on the horizon, I think that influences the situation. I expect we will be at these low rates for a while. Therefore, the comparisons will be difficult. We are exploring various options, including taking on more risk, such as equity investments. However, we have a very conservative investment policy, and we are nearing the limits of those restrictions. Dividend yields are appealing compared to fixed income, but the associated risks are ones we prefer not to breach. We will continue to strive for the best outcomes, and it’s clear that we are facing one of the most challenging environments we have ever experienced.

Greg Peters, Analyst

Right. It certainly looks like that. Listen, thank you, everyone for your answers. Appreciate the time.

Gabriel Tirador, President and CEO

Thank you, Greg.

Operator, Operator

Our next question comes from Ron Bobman of Capital Returns. Your line is open.

Ron Bobman, Analyst

Hi. Thank you very much. I hope everyone is doing well. I have a question regarding agent compensation. My understanding is that the carriers are handling this in a uniform manner, even considering the reductions in consumer premiums, meaning the agent commissions remain unchanged. I assume that is still the case. I would appreciate your confirmation on that. Additionally, I am curious about any incentive compensation that some agents may receive, particularly if it's tied to profitability. Have there been any changes to the profit-based compensation programs to account for the effects of COVID and the givebacks? Thank you.

Gabriel Tirador, President and CEO

Well, to answer your first question on base commissions, you are correct, base commissions have not been adjusted for the givebacks, as far as contingent commissions, we haven’t made a determination on that yet.

Ron Bobman, Analyst

Got you. Okay. Would you say that your peer group is largely in the same situation, which is still to be determined?

Gabriel Tirador, President and CEO

I don’t know about all our competitors. I don’t know.

Ron Bobman, Analyst

Okay.

Gabriel Tirador, President and CEO

I am not sure.

Ron Bobman, Analyst

Okay. I recall that shortly after the fires, you sold your subrogation rights to a third party for some of the fire losses. I'm curious if you have any remaining fire losses that are subject to subrogation from the utilities or if any could potentially be sold. Have all prior year fire losses been settled, meaning there isn't much uncertainty or variability regarding subrogation opportunities? Thanks.

Gabriel Tirador, President and CEO

Ted, do you want to handle that?

Ted Stalick, Senior Vice President and CFO

Yes, you are correct that we sold the subrogation rights to a third party. However, we retained our subrogation rights for the 2017 fires, commonly referred to as the Tubbs fire, and received an initial payment from the PG&E Trust just last week. This subrogation, along with any future claims, pertains to fully reinsured losses, meaning that the funds will go back to our reinsurance partners, resulting in no net loss reduction for Mercury from that subrogation. There was a minor benefit to the company due to a reduction in reinstatement premiums previously paid for those losses, amounting to just under $2 million, which we recorded in the second quarter. Regarding subrogation, we also have wildfires from the fourth quarter of 2019, specifically the Saddleridge Fire in Southern California and the Kincade Fire in Northern California. Both events occurred under our reinsurance retention, and it has not yet been determined if they were caused by utility equipment, although there is some evidence suggesting they might be. Therefore, there is potential for subrogation related to these two incidents, but currently, that remains uncertain.

Ron Bobman, Analyst

Okay. Thanks for the color. If there is deemed to be sort of culpability from the equipment, the earlier mentioned about the California reimbursement fund and the 40% that you mentioned, would these Q4 ‘19 fires and your losses potentially be eligible for reimbursement from that fund that you mentioned earlier?

Ted Stalick, Senior Vice President and CFO

I am not exactly sure, but I believe that’s correct and I also think that the 40% kind of sets the benchmark for where those claims would be paid out of anyway. So that’s all I really know on that. I think our ultimate losses on those two claims were in the $25 million to $30 million range right now.

Ron Bobman, Analyst

What do you mean by the benchmark of 40%? Why you chose the word benchmark? What’s that mean?

Ted Stalick, Senior Vice President and CFO

Well, all I mean by that is that, as all these fire claims have come in over the years, there’s been different varying levels of subrogation as a percentage of incurred losses that have been paid out. And now you have this fund that’s essentially saying we are going to guarantee you a 40% payout. So what I meant by benchmark is, if there’s prior claims that are not eligible under the fund, they will probably look towards this 40% rate as kind of the standard of what you pay.

Ron Bobman, Analyst

Okay. I can follow up if I still have quite a bit.

Ted Stalick, Senior Vice President and CFO

Yeah.

Ron Bobman, Analyst

Thanks and be well.

Gabriel Tirador, President and CEO

Thank you.

Operator, Operator

Our next question comes from Corey Wrenn of Pecaut & Company. Your line is open.

Corey Wrenn, Analyst

Good morning and good afternoon from the West. I have a couple of questions. My first question is regarding the low interest rates and the corresponding low returns on investments you are experiencing. Have you reconsidered your dividend or stock repurchase policy? It seems that the dividend yield is significantly higher than the returns on investments. My second question pertains to the shift towards a more technology-driven environment. You are witnessing online sales increase from 18% to 28%. Additionally, there are emerging companies like Lemonade that claim to capture vast amounts of data when users access their site. Have you considered how to leverage technology more effectively in your business, and how does your agency-based model function in today’s landscape? Thank you.

Gabriel Tirador, President and CEO

Let me first, I guess, answer the first question. As far as the dividend, this is something that the Board reviews on a quarterly basis and makes determination on a quarterly basis. And based on our prospects, our earnings, the coverage, and a lot of factors, and so it’s something that we just review every quarter. So I am going to leave that at that. We just, as you know, announced a dividend this quarter as well, a $0.63 dividend. As far as online, Lemonade, yeah, I mean, I know of them, I mean, 100,000 data points, which I think you are referring to is potentially the segmentation. We, obviously, have data warehouse and we segment our business as well. We are continuing and trying to update our segmentation. I mentioned earlier that we launched our Mercury Advantage program outside of California, which significantly improves our segmentation and we have seen very positive results with respect to Mercury Advantage. In the State of California, which is our biggest market, you are limited to what you can use. So there’s more limitations in California because of the regulatory constraints as far as what you can price on and what you can’t price on, including homeowners, which is what Lemonade sells. As far as technology goes, we continue to advance our technology. I mean, I can’t tell you how many bots that we are using right now. We have improved our agency-facing system. We are improving our online portal. We are using technology to settle claims to underwrite our risks. So we continue to try to improve our technology to streamline our operations without sacrificing our underwriting or claims accuracy and that’s the key. I mean, I don’t think it’s very difficult in this business to write a lot of business and maybe Lemonade will write a lot of business and we will see how they end up on the profitability end of it, but writing business is not difficult.

Corey Wrenn, Analyst

Do you believe that having agents handle the upfront underwriting gives you an advantage in selecting quality business?

Gabriel Tirador, President and CEO

We believe that our agency partnerships are extremely important.

Corey Wrenn, Analyst

Okay. Okay. Well, thank you and stay safe. Thank you.

Gabriel Tirador, President and CEO

Okay. Thank you.

Operator, Operator

There are no further questions at this time.

Gabriel Tirador, President and CEO

Well, thank you for joining us today. Thank you very much.

Operator, Operator

Ladies and gentlemen, this concludes today’s conference call. Thank you for participating. You may now disconnect. Everyone have a great day.