Vicki Erickson Mills - Vice President of Investor Relations Douglas D. Dirks - Chief Executive Officer, President, Director, Member of Executive Committee and Member of Finance Committee William E. Yocke - Chief Financial Officer, Principal Accounting Officer, Executive Vice President and Treasurer Stephen V.

Festa - Chief Operating Officer and Executive Vice President.

Mark D. Hughes - SunTrust Robinson Humphrey, Inc., Research Division Amit Kumar - Macquarie Research Matthew J. Carletti - JMP Securities LLC, Research Division.

Good day, ladies and gentlemen, and welcome to the Quarter 3 2014 Employers Holdings, Inc. Earnings Conference Call. My name is Darren, and I will be your operator for today. [Operator Instructions] As a reminder, this call is being recorded for replay purposes. And now I'd like to turn the call over to Vicki Mills, Vice President, Investor Relations.

Please proceed, ma'am..

Thank you, Darren. Good morning, and welcome, everyone, to the third quarter 2014 earnings call for Employers. Yesterday, we announced our earnings results, and today, we expect to file our Form 10-Q with the Securities and Exchange Commission.

These materials may be accessed on the company's website at employers.com and are accessible through the Investors link. Today's call is being recorded and webcast from the Investor Relations section of our website, where a replay will be available following the call.

With me today on the call are Doug Dirks, our Chief Executive Officer; Steve Festa, our Chief Operating Officer; and Rick Yocke, our Chief Financial Officer. Statements made during this conference call that are not based on historical fact are considered forward-looking statements.

These statements are made in reliance on the Safe Harbor provision of the Private Securities Litigation Reform Act of 1995.

Although we believe the expectations expressed in our forward-looking statements are reasonable, risks and uncertainties could cause actual results to be materially different from our expectations, including the risks set forth in our filings with the Securities and Exchange Commission.

All remarks made during the call are current at the time of the call and will not be updated to reflect subsequent developments. We use non-GAAP metrics that exclude the impact of the 1999 Loss Portfolio Transfer, or LPT. These metrics are defined in our earnings press release available on our website. Now I will turn the call over to Doug..

Thank you, Vicki. And thank you, all, for joining us today. The third quarter showed continuing improvement in our loss ratio, excluding the impact of the LPT, and our expense ratio compared to the first and second quarters of this year.

Year-to-date, rate increases continued to outpace increases in loss cost, and we lowered our provision rate for losses in the quarter to 73.5%. This is a reduction of 3.5 percentage points from the annual provision rate for 2013.

Net income before the LPT was $0.10 lower than in last year's third quarter, driven largely by a current accident year provision rate that was 0.7 percentage points higher than in the third quarter of 2013 and an income tax benefit in the third quarter of last year from the reallocation of nontaxable reserves to taxable periods.

Underwriting expenses declined 2% compared to the same quarter last year. Our net investment income increased 2.1% as the investment portfolio continued to grow as a result of strong operating cash flows, somewhat offset by lower reinvestment yields. Company-wide, our payroll exposure is down 0.9 of a percent, while net rate is up 4.9%.

This means that we are getting $1.05 relative to $1 dollar of last year's premium with less exposure. Our underwriting actions, primarily focused on Southern California, have impacted our accounts over $25,000 in annual premium, which in part drove the modest 1% decline in net written premium and a policy size which was flat year-over-year.

Compared to 1 year ago, our company-wide policy count grew 2.4%, and our in-force premium grew 4%. In California, our policy count increased just 0.4 of a percent, and our in-force premium grew 5.1%. As expected, policy count retention in our Western states declined slightly, 2 percentage points to 81% in the last 12 months.

Policy retention in our Eastern states increased 4 percentage points since September 30 of last year. Our adjusted book value per diluted share increased 5.9% since December 31. With that, I'll turn the call over to Steve Festa, our Chief Financial Officer [Technical Difficulty] results.

We have purposely reduced our exposure in these underperforming classes predominantly in Southern California. As a result of these actions as well as others, we have reduced our in-force payroll in California year-over-year by 5.1% while increasing our net rate over the same period of time by 10.7%.

We remained committed to the California market, but it is important to note that our commitment extends to those classes of business that will generate the profit expectations that we have. Our payoff for these actions in the long term will be improved profitability. The trade-off in California in the near term is decreasing premium and policy count.

In states outside of California, our emphasis has been and will continue to be on growth. Our initiatives will gain traction in 2015, although we are already starting to see early positive returns.

In the third quarter of this year, in our states outside of California, we have increased in-force policies by 1.8% and increased premium by 0.7% quarter-over-quarter. Now Rick will discuss our financial results in more detail.

Rick?.

Thank you, Steve. Our third quarter combined ratio before the LPT improved 30 basis points year-over-year. Our underwriting expense ratio improved 1 percentage point compared to the same period last year as we contained costs and increased net earned premium.

Compensation expense was $1.3 million lower than in the third quarter of 2013, which decreased underwriting and other operating costs by 2 percentage points.

Comparison of the GAAP loss ratio for the third quarter year-over-year is not meaningful as the third quarter of 2013 includes a $10 million adjustment to LPT reserves, which flowed through losses.

Excluding impacts related to the LPT, our third quarter loss ratio increased 1 percentage point, largely due to the higher provision rate for losses in the third quarter of 2014 compared with the same period in 2013.

We lowered the loss provision rate throughout 2013 until the fourth quarter, when we raised the annual rate to 77% as a result of our reaction to litigated cumulative trauma claims in Southern California.

The sharp increase in open litigated indemnity claims that we experienced in the fourth quarter of 2013 in Southern California has not continued in the first, second or third quarters of this year.

Subsequently, with continued increases in net rate through the third quarter of 2014, we have decreased our loss provision rate to 73.5%, which is 0.6 of a percentage point lower than the prior quarter and 3.5 percentage points lower than the 2013 annual rate.

Our average paid claims in California at the end of 2013 continued to be well below industry averages, reported by the California Workers' Compensation Institute. In California, our average paid claim, litigated or not, was 27% better than the reported industry average for paid claims.

According to the CWCI, our average paid litigated claim was 40% lower than the statewide average at year-end 2013. There were no increases to overall reserves in this quarter for our voluntary business. The slight adverse development in the accident year loss ratio was related to assigned risk. Our indemnity claims frequency decreased year-over-year.

Our loss experience indicates an upward trend in medical and indemnity cost per claim this year, which is partially due to a year-over-year increase in cumulative trauma claims, particularly in California. While net rate continues to increase, loss ranges -- rates or trends have not changed materially from last quarter.

These trends are reflected in our current accident year loss estimates that I described a moment ago. Our balance sheet remain strong. The market value of our investment portfolio was $2.5 billion at the end of the quarter, an increase of 4.7% since the end of last year, with only a slight drop in yield.

During the quarter, $20 million of municipal securities matured or were subject to call, which allowed selective replacement. Purchase activity was concentrated in the taxable sectors, with a bias towards high-quality, short-term and intermediate term issues.

Sector allocations based on market value shifted slightly towards taxable securities, while duration declined slightly to 4.1%. The weighted average of the portfolio was AA at September 30. Rebalancing of the high-dividend equity portfolio resulted in realized gains of $1.8 million.

Equities represent 6.7% of the total market value of our investment portfolio. At the holding company, we have $85 million in cash and securities, net of restricted cash and securities. And now I'll turn the call back to Doug..

Thanks, Rick. Proceeding into next year, we will emphasize profitability by continuing to target lower asset classes of business that are consistently attractive from a loss ratio perspective, while gaining presence in states where our market share is low relative to our strategic share.

Based upon our current reserve position, our investment portfolio and our underwriting prospects, we believe we will be well capitalized heading into 2015. And with that, operator, we're ready to take questions..

[Operator Instructions] Question is from the line of Mark Hughes from SunTrust..

The underwriting expense ratio was a little lower this quarter.

Is that sustainable at that lower level?.

What we would expect on the underwriting expense ratio is that it will flatten. There's a couple of things happening there. One, we've taken very aggressive actions over the last several years.

The other is, with the underwriting actions we're taking and the slowing of growth in written premium, it will start to put pressure on that underwriting expense ratio. So are we looking for opportunities to continue to improve it? Absolutely. Will it continue to improve at the rate it has recently? Likely not..

Right.

But perhaps steady a little bit of a deleveraging offset by further cost savings, perhaps? So the ratio would be steady?.

Yes, I would expect the ratio it will be relatively steady..

And how are you looking at the -- you're actually thinking about the -- a written premium outlook? You were down 1% this quarter. You've got a number of initiatives to improve your -- or derisk in California, let's say. Your retention is better in the east.

Is -- would you anticipate the next quarter or 2 are going to look kind of like this one in terms of the top line flat, down slightly?.

Let me deconstruct that into a few pieces. We have very explicit plans as to what we will be doing in states outside of California in terms of where rates are likely to be next year. And by the way, most of the states outside of California will be having filed rate decreases for 2015.

But we have initiatives where we have identified what we expect to be able to produce in terms of growth in those states. So that's one element. If you look at California, we are about halfway through our original initiative of nonrenewing poor business in Southern California. That will continue exactly as expected.

The unknowing component is what will happen on the business that we have offered to renew but the renewables are not being taken because of our pricing expectations.

And just to give you a little flavor as to what's happened there and why it's so difficult to project is that if you look at the third quarter relative to the second quarter, the amount of renewals not taken, where we were willing to renew the account but only at a higher price, nearly doubled, which I think gives you -- should give you some comfort around Steve's statement that if we don't have our price we're walking away from this business.

Now if the market catches up -- catches back up to our pricing, we might start having more success there. If the market continues to price below what we think is the appropriate price, we're going to continue to see a drag on the renewal book..

Right.

So when you taken into account those various forces, is anything putting more headwind on written premium in 4Q versus the 3Q? Understanding that you've been undertaking these initiatives through 2014, do the initiatives mean -- does it say more of a headwind in the fourth quarter or about the same?.

I would see the fourth quarter being fundamentally different from the third quarter. It really, as I indicated in my earlier comment, it's really more a function of what the competitive marketplace does in the fourth quarter. But in terms of what we're doing, fundamentally unchanged. [Technical Difficulty].

Hello?.

Operator, are you able to hear us yet?.

Doug, this is Mark Hughes.

Can you hear me?.

We can hear you, Mark..

Okay, good. Let's go ahead. We missed your last question, Mark..

Yes, and I apologize for that. There had been a period of sort of garbled transmission earlier in the call that cleared up, so I'm not sure what happened whether it's you or me. The -- so my question had been the expanded distribution, the very nice growth you saw at the top line in 2011 and 2012.

I think you had originally suggested you were putting some higher loss picks on that business given the uncertainty.

Can you talk about how those losses have been trending?.

Yes, we've had stability now for several quarters in those prior years, so we're not seeing development there. Now if you look at what the adjustment we made the end of last year, it was really a function of what was happening specifically in Southern California.

And that was not simply a matter of new business written but existing business as well in an environment that turned negative fairly quickly..

Right. The numbers that you provided regarding your lower cost per claim on the various categories, I think, paid litigation, where you do is substantially better than the industry, can you talk about conceptually why that may not translate? I think your overall combined ratio was superior to the California market as a whole, but not by 30% or 40%.

So I'm sort of curious how those results translate into your P&L.

And if not now, kind of when would they translate into your P&L?.

So let me start with one element of that. Given our underwriting strategy, which is small account business that is lower hazard. We would expect that we would compare favorably to the industry averages year in, year out. That's a function of the type of business we write. However, that doesn't explain all of it.

We think we not only are writing a less hazardous book that produces better results over time but that are outperforming the industry even absent of that. And maybe I'll look to Steve and see if he wants to add anything on what he's seeing in that data relative to balance of the industry..

Yes. We have probably, Mark, for the last 6 years outperformed the industry. And we undertook in California 2 years ago an initiative to retrofit our provider network with respect to a focus on outcomes.

And the gap between our results and the industry in the last couple of years has widened, and we attribute most of that positive trending to the initiatives we undertook with respect to our provider network. But that's only been in the last couple of years.

So that -- those data points -- those paid data points need to work their way through the rest of the financial system for us to be in a position to really reflect them in our financials going forward..

And what is that time period where you would start to begin to see that show up in the P&L?.

Mark, what we've said before is we've seen this very marked change in the differential. As Doug alluded to at the outset of this conversation, we've always seen a difference historically, and that's been in the range of 10% or so. There's a widening of that gap has occurred in the last 18 months or so.

And that's really very coincidental with the outcome-based initiative that Steve's been describing. Ordinarily, our actuaries will want to see that repeat itself before we begin to push that into loss projections. I mean it's considered, but it is not, if you would say it, baked in at this point.

I would expect another couple of periods to make sure that we continue to see it and that we're sure that it relates to the outcome-based initiative as we believe it is..

Right.

Periods, as in quarters?.

Yes..

Your next question is from the line of Amit Kumar from Macquarie..

Just very quickly a few follow-ups, and I apologize if I missed to follow on the comments. The discussion on expanding market share in some of the non-California, I guess, states.

Can you talk about what would be the long term earned ROE hurdle for that business?.

Well, if you look just broadly, we've said for years in normal times that you'd expect about a 12% to 13% ROE in this business. I would argue we're not in normal times when we have a treasury that's paying 2.25%. And so that lowers what the thresholds might be at a particular point in time.

But I would suggest that over a longer period of time in a normal cycle you would expect to see something in the 12% to 13% range..

Okay. The other question I had was regarding the recent WCIRB filing and the discussion and the comment period, et cetera.

What is your pricing outlook for 2015 based on where we are?.

Are you talking specifically California or more broadly?.

California, and, obviously, broadly would also help..

Okay. So let's start with California. Our expectation is that there will be continuing pressure to rise rates -- for rates to rise through 2015 in California. There are still some issues around the impact of 863 that are yet to be more fully understood. I believe the actuarial committee has got a meeting next, I think, next Tuesday.

And one of the agenda items, we'll be talking about the impact of 863. So there is still some uncertainty there.

As we've indicated, we think the notion that 863 would be neutral, that the increases in permanent disability would be offset by system savings is not going to be the case in the end, that in fact the PD benefits will be -- will not be offset by system savings. What that number, ultimately, is I don't know. It's not been fully realized yet.

So I think that will keep pressure on rates going forward. As I indicated earlier through the balance of the country, loss costs are falling, frequency is down and the loss cost filings. So I think more generally of the nonbureau NCCI states, for the most part across the board you're seeing declining rates.

Now that's a good thing because the rates are declining because the loss cost environments are improving. But that clearly creates pressure on top-line growth.

Again, it's not bad pressure to have because the losses are coming down, but it will create some pressure on the top line; and consequently, it creates modest pressure on things like the expense ratio..

Got it., that's helpful. And lastly, can you remind us -- would 2015 be when you would meet A.M.

Best again? Or when is that happening?.

We meet with them annually. We've met with them, I guess, within probably the last about 6 -- 75 days or so. So we're just on a normal routine cycle..

Any change on sort of the review? I remember us having the discussion that generally it takes 3 to 4 years for them to go and revisit the view they might have had.

Any updates on that?.

We just, again, we had our routine annual meeting with them. As of this point, no actions have been taken by them. We expect that will occur in the normal course. There's nothing outside of the normal course that's occurred this year..

The next question is from the line of Matt Carletti from JMP Securities..

Just had a couple of questions. The first, Doug, is on your -- actually following up on Amit's question about kind of over the cycle ROE versus a ROE attainable in this kind of different interest rate environment.

Whether it's kind of absolute range or spread to kind of where interest rates are, however you want to look at it, do you have a view on what sort of ROE you think the Employers' model could attain if interest rates don't move much over, say, the next couple of years? Are we staying at 2.5%, 3% interest rate environment?.

Well, there are a variety of views on this one. I've heard expressed is that you should think about it as being normal would be -- for the industry would be something like 600 basis points over the treasury. So that would get you to about 8 and change. Obviously, we would like to see something in the double digits.

We'd like to be able to produce at least 10% ROE. To achieve that, we need to see a combined ratio down kind of in the range of 95% or so. So that's -- I think that's an achievable target. It's hard to imagine that the market moves as quickly going forward as it has in the recent past. But we think the trend will continue to be favorable..

Okay. And then, my next question relates to the spike in litigated claims that's on Q4. And obviously it's, thankfully, gone quiet for at least the 9 months since then.

And recognizing the fact that as we get to this Q4 your Southern California book will be a smaller piece of the business than it was last year, with the benefit of hindsight, I mean, it seems like that was a very moment in time kind of rushed to get claims represented. If I recall, it wasn't even a quarter really. It was kind of 6 to 8 weeks.

Any view on what exactly drove that rush before year end and if similar conditions exist that might see that sort of rush again this year as we approach year end?.

I've not heard a compelling explanation from anybody as to what it is. Our suspicion is that it was tied to the increase in the permanent disability award and the potential for a larger recovery for all parties as a result of that. But it's -- I don't think there's a definitive answer. I personally believe that, that's probably the best explanation..

Okay, that's helpful. And then one last just number's question probably for Rick. Just on the development in the quarter, it was -- it looks like 0 in the voluntary book. In some past quarters, it's been kind of almost nothing across all years. And in the other quarters, it's been a little more adverse in recent, offset by favorable and prior.

Did this quarter fall into any one of those two buckets in particular?.

It actually was very, very small movement or no movement between years, Matt. In the past, I've said it was single-digit millions between years. It didn't even achieve that this year -- this quarter..

This doesn't even qualify as noise..

There were no further questions at this time. [Operator Instructions].

All right. It looks like we're finished for today. Thank you, all, very much for joining us. We look forward to talking to you again early next year as we report out our full year 2014 results. Thank you, all, very much..

Thank you. Ladies and gentlemen, that concludes your conference call for today. You may now disconnect. Thanks for joining and have a very good day..