Palomar Holdings, Inc. (NASDAQ:PLMR) Q3 2022 Earnings Conference Call November 3, 2022 12:00 PM ET
Company Participants
Mac Armstrong – Chairman and Chief Executive Officer
Chris Uchida – Chief Financial Officer
Conference Call Participants
Mark Hughes – Truist
David Motemaden – Evercore ISI
Pablo Singzon – JPMorgan
Tracy Benguigui – Barclays
Operator
Good morning and welcome to Palomar Holdings, Inc. Third Quarter 2022 Earnings Conference Call. During today’s presentation, all parties will be in a listen-only mode. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the call over to Mr. Chris Uchida, Chief Financial Officer. Please go ahead, sir.
Chris Uchida
Thank you, operator and good morning everyone. We appreciate your participation in our third quarter 2022 earnings call. With me here today is Mac Armstrong, our Chairman and Chief Executive Officer. As a reminder, a telephonic replay of this call will be available on the Investor Relations section of our website through 11:59 p.m. Eastern Time on November 10, 2022.
Before we begin, let me remind everyone that this call may contain certain statements that constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These include remarks about management’s future expectations, beliefs, estimates, plans and prospects. Such statements are subject to a variety of risks, uncertainties and other factors that could cause actual results to differ materially from those indicated or implied by such statements, including, but not limited to, risks and uncertainties related to the COVID-19 pandemic.
Such risks and other factors are set forth in our quarterly report on Form 10-Q filed with the Securities and Exchange Commission. We do not undertake any duty to update such forward-looking statements. Additionally, during today’s call, we will discuss certain non-GAAP measures, which we believe are useful in evaluating our performance. The presentation of this additional information should not be considered in isolation or as a substitute for results prepared in accordance with U.S. GAAP. A reconciliation of these non-GAAP measures to their most comparable GAAP measure can be found in our earnings release.
At this point, I will turn the call over to Mac.
Mac Armstrong
Thank you, Chris and good morning everyone. I am very proud of our third quarter results as they are further testament to our commitment to profitable growth and our execution of Palomar 2X, our intermediate term strategic plan of doubling our adjusted underwriting income while keeping a 20% adjusted return on equity. We grew the gross written premium of the business 66%, highlighted by sustained earthquake growth and incremental progress on newer lines of business such as Inland Marine and Casualty.
We made incremental traction in our nascent PLMR-FRONT and Excess property franchises amongst others. We added new talent throughout the organization in the underwriting, actuarial and technology departments, perhaps most significant, even with the full retention loss from Hurricane Ian, a major catastrophe that severely impacted our entire industry, we generated an adjusted combined ratio of approximately 90% as well as an adjusted ROE of 10% when adding back realized and unrealized gains and losses from our investment portfolio.
We further validated the resilience in our model as adjusted net income grew over 328% year-over-year, again with the full event retention loss. Taken together, our continued strong momentum through the third quarter provides a clear line of sight to doubling our adjusted underwriting income in an intermediate fashion and at a pace that has accelerated from where the concept was first introduced in June of this year.
Turning to our financial results and strategic priorities in more detail, during the quarter, we made strong progress executing on all four components of our 2022 strategic plan. Our first priority is focused on generating strong and profitable premium growth, which we accomplished once again this quarter having increased gross written premium 66% to $253.1 million. Our earthquake business grew 19%, led by strength in our residential earthquake product, which continues to benefit from our marketing and product development efforts, combined with the dislocation in the California homeowners market. This healthy dynamic is best exemplified by the fact that third quarter of 2022, like the first and second quarters of the year saw record quarterly new business sales.
Importantly, the market opportunities related to the proposed changes to the California earthquake Authority, whether it be coverage offerings or reduction in claims paying capacity have yet to come to fruition and as such, have not provided a meaningful growth catalyst for Palomar’s products. We remain excited at the prospects for the residential earthquake market in the year ahead.
Outside California, we continue to broaden our residential earthquake partnerships slate, whether it be through the addition of 3 new states to our travelers partnership or the addition of a new relationship that will increase our presence in Utah at the start of 2023. While these are smaller market opportunities, these partnerships will be additive to growth in the year ahead. Our commercial earthquake business continued to grow through a combination of exposure growth and rate increase while improving its underlying metrics through enhanced terms and conditions. Importantly, it saw inter-quarter rate increase acceleration to levels above 10%, which more than offset loss cost increases tied to our June 1 reinsurance renewal. We believe the impact of Hurricane Ian, most notably capacity constraints in the broader U.S. property insurance market will impact the commercial earthquake market, and therefore, provide the opportunity for further rate increases in portfolio optimization in the fourth quarter of 2022 and into 2023.
Beyond our earthquake franchise, we achieved strong growth across our entire portfolio of products, highlighted by our inland marine products, which grew 58% year-over-year and our commercial all-risk product, which grew 34% year-over-year, with nearly all of the growth due to rate increases in portfolio optimization as opposed to exposure. The Inland marine department continues to perform very well across its multiple segments, including both commercial and residential builders risk in motor truck cargo. Additionally, our newly launched Casualty franchise grew 350% year-over-year. Our real estate E&O and miscellaneous professional liability segments are standout performance as they continue to add conservatively underwritten low volatility risk to the portfolio.
Overall, we are encouraged with the launch and ramp of our casualty business and the traction that our team is achieving. PLMR-FRONT was also a significant contributor, generating 32% of our premium this quarter. I’ll discuss PLMR-FRONT in a bit more detail when reviewing some of our new initiatives later in the call. Combination of our growth in commercial lines, whether it be earthquake, Builder’s Risk or Select Casualty segments and PLMR-FRONT, helped drive considerable growth in Palomar Excess and Surplus Insurance Company, our E&S business. PESIC increased its gross written premiums 181% year-over-year to $163 million as compared to the third quarter of 2022.
The accelerating growth in our non-catastrophe exposed lines of business, whether it be casualty or PLMR-FRONT, provide diversification and business mix and business model through fee income across our portfolio and ultimately will lead to further predictability in our earnings base. As such, the success and our execution towards their success are key elements of our second strategic priority. Monetizing the capital investments we made in 2021. During the third quarter, PLMR-FRONT recorded $82.2 million of gross written premium, which I previously stated was 33% of total gross written premium in the quarter. We have ramped our PLMR-FRONT business very quickly since launching it in the fourth quarter of 2021. The business line has already generated a premium of $154 million year-to-date, which is at the high end of our previously updated guidance range of $130 million to $160 million of managed premiums for the full year.
As a reminder, our updated guidance range includes our Texas homeowners business, which adds approximately $45 million of fee-generating premium to the base. Based on the year-to-date results and the overall strong performance of PLMR-FRONT, we believe we can achieve $180 million to $200 million for the full year. The growth in managed premium from PLMR-FRONT offers an attractive run rate of fee income as we moved into 2023 as well as a modicum of underwriting income for the two programs where we retain a small amount of risk.
Importantly, as we continue to expand to PLMR-FRONT, we remain disciplined through our conservative underwriting and collateral requirements to mitigate risk. I have already mentioned the solid performance of our new casualty lines in the quarter, but I’d also like to acknowledge the success of our excess property division. This line of business is led by a terrific experienced underwriter in Joel Esri, and it concentrates on writing excess property business risk in non-catastrophe exposed regions. While it’s off a small base, we are pleased to see the premium triple sequentially.
As the North American property market remains dislocated, we expect this line of business to do quite well. Progress and outperformance of our new initiatives has put us in a position where we believe we are meaningfully ahead of our Palomar 2X intermediate plan. Even if the growth may push our attritional loss ratio slightly up. The fee income generated by our fronting business is a meaningful level of stability that we have created in our portfolio to generate predictable earnings, which is not only a corporate full Palomar 2X, but also our third strategic priority, delivering consistent and predictable earnings.
Over the last 2 years, we have put into place multiple underwriting, portfolio management and risk transfer program to reduce volatility and enhance our risk-adjusted returns. I think these efforts were most pronounced without an impacted our results relative to the insurance industry broadly. Over the last few years, we have considerably reduced our Continental hurricane exposure. As such, our gross and ultimate loss from Hurricane Ian should under-index the industry due to the underwriting portfolio management actions taken since 2020.
Our exposure was limited to our commercial property products that are national in scope with an emphasis on layered and shared accounts with limited geographic concentration. While a full retention loss of $12.5 million is not ideal, can find some sales that we have an adjusted ROE when including the impact of unrealized gains and losses of 10% for the quarter and approximately 17% year-to-date.
Diversification and profitable growth from lines of business without cardinal hurricane risk is now providing a considerable earnings base that enables us to have an adjusted combined ratio of 90% and an adjusted ROE, excluding unrealized and realized gains and losses of 10% in a quarter where we incur a full retention loss. This favorably compares to the third quarter of 2021 on catastrophe losses led to an adjusted combined ratio of 100% and adjusted ROE, excluding realized and unrealized gains and losses of 2%. Additionally, we are continually improving our underwriting and risk management controls to ensure that we are in an appropriate risk-adjusted return for the higher volatility businesses that we continue to write. This approach will result in further adjustments as the market, the reinsurance market, especially absorbs the impact of Hurricane Ian.
Our core strategic priority is scaling our organization where we have invested in technology and infrastructure that provide a dynamic platform for product innovation as well as new business development. This is very attractive to experienced underwriters who would like to build a new business as can be seen in our newer lines of business-like builders risk in the marine, professional liability and excess property. During the quarter, we bolstered our underwriting ranks each of these product lines with the hiring of several industry veterans have proven track records. We will also continue to attract analytics, technology and actuarial professionals to the team. Before we dive into the financials, I’d like to offer a bit of commentary on the market, in particular, the property segment, which has entered a new stage of dislocation due to Hurricane Ian. The hard reinsurance market persists, continued rate increases, combined with improved terms and conditions will require renewals to cover any increase in loss costs at a minimum.
As it relates to our current cotton hurricane exposure, we have already reduced our PML by more than 60% over the last 2 years and still have some exposure in runoff. What we are left with is a national focused portfolio of property risk with wind exposure that saw an average rate in excess of 30% in the third quarter, and that was prior to an making landfall. The storm, along with other factors such as inflation, bond portfolio losses and other industry losses will result in significant capacity reduction for not just Florida, but throughout the Southeast. The magnitude of the capacity pullback will be difficult to assess until the January 1 reinsurance renewal is complete, but our expectation is that rates for Southeast and Florida wind will move up commensurately for inflation reinsurance cost and supply.
The capacity we commit to our E&S commercial all risk business will take advantage of the market in a disciplined fashion with a refreshed risk-adjusted return target. If accounts don’t hit those thresholds, we’re fine falling back as we have numerous growth vectors. As I mentioned earlier, we believe the commercial earthquake market will also see a level of dislocation, albeit not like that a Florida and the rest of the Southeast. The 10% rate increase we saw at the end of the third quarter will increase in the fourth quarter and into 2023. Terms and conditions whether it be deductibles or attachments should also improve.
Property capacity is going to be a scarce commodity in 2023, and we will judiciously use it in the primary market. As it pertains to reinsurance, we renewed our program at June 1, with pricing higher by 9% on a risk-adjusted basis, and we do not have excess of loss readings renewed at January 1. Our expectation is that post Ian, the hard reinsurance market will indeed persist and that backdrop informs our approach to maintain our growth and profitability targets in the year ahead. It is imperative for all of our property products, E&S and admitted commercial and residential to cover their loss costs through a combination of rate increase, inflation guards or terms and conditions. Importantly, it is worth reiterating that we were already reducing our exposure to cardinal U.S. hurricane and other secondary perils before the storm, and our core earthquake business is a unique line of business for reinsurers given its non-correlated risk. We think the confluence of those factors, along with the large profit bank we have built up with our reinsurance panel will help us navigate this cycle.
Turning to capital allocation, despite the cat losses that impacted our results this quarter, remained well capitalized and in a healthy position to fund future growth as well as opportunistically repurchase shares. During the quarter, we bought over 52,000 shares at a total cost of $3 million. To conclude, this quarter demonstrated further execution of the Palomar 2X strategic plan. We meaningfully grew written premium. We saw considerable progress and new products that add diversion to the earnings base and portfolio, and we demonstrated the resilience in our model as the full event retention did not preclude us from generating a compelling return on equity.
While the quarter’s losses were elevated, we were encouraged by two factors: one, 29% of the loss in the quarter were from lines that earned runoff for being restructured and two, a good portion of the quarterly loss was driven by product written premium outperformance and in line target rate loss ratios. Chris will provide more detail on both these items. For the full year, we now expect to generate adjusted net income between $82 million and $85 million, a 48% increase from 2021. This range includes additional reinsurance expense resulting from Hurricane Ian incurred in the fourth quarter and excludes catastrophes and unrealized gains and losses.
With that, I will turn the call over to Chris to discuss our results in more detail.
Chris Uchida
Thank you, Mac. Please note that during my portion, when referring to any per share figure, I am referring to per diluted common share as calculated using the treasury stock method. This methodology requires us to include common share equivalents such as outstanding stock options during profitable periods and exclude them in periods when we incur a net loss. We have adjusted the calculations accordingly.
For the third quarter of 2022, our net income was $4.3 million or $0.17 per share compared to net income of $0.2 million or $0.01 per share for the same quarter in 2021. Our adjusted net income was $7.4 million or $0.29 per share compared to adjusted net income of $1.7 million or $0.07 per share for the same quarter of 2021. Our adjusted net income, excluding net realized and unrealized losses was $9.2 million or $0.36 per share compared to $2 million or $0.08 per share last year.
Gross written premiums for the third quarter were $253.1 million, an increase of 66.2% compared to the prior year’s third quarter. Our consistent strong growth was driven by a combination of favorable rate acceleration and increases in volume across our products. Ceded written premiums for the third quarter were $161.9 million, representing an increase of 178.8% compared to the prior year’s third quarter. This increase was primarily due to quarter share reinsurance driven by the growth of our fronting business, lines of business subject to attritional losses and additional excess of loss reinsurance to facilitate growth and the impact from Hurricane Ian. Ceded written premiums as a percentage of gross written premiums increased to 64% for the 3 months ended September 30, 2022, from 38.1% for the 3 months ended September 30, 2021. As anticipated, our fronting business was the primary catalyst of this increase, slightly offset by a decrease in the XOL percentage compared to last year.
Net earned premiums for the third quarter were $77.9 million, an increase of 20.4% compared to the prior year’s third quarter. This increase is due to the growth and earning of higher gross written premiums offset by the growth and earning of higher ceded written premiums under reinsurance agreements. For the third quarter of 2022, net earned premiums as a percentage of gross earned premiums were 41.7% compared to 55.2% in the third quarter of 2021 and compared sequentially to 50.8% in the second quarter of 2022.
As a reminder, we have indicated that the expected growth of our fronting business would push this ratio over 50% on an annual basis, especially with the transition of our Texas Specialty Homeowners book to our fronting model, though it will add consistent fee income that will enhance our ROE and bottom line. Year-to-date, our net earned premiums as a percentage of gross earned premiums ratio was 48.4% and in line with our expectations based on the strong performance of our fee-based printing business.
Losses and loss adjustment expenses incurred for the third quarter were $30.9 million, made up of attritional losses of $18.4 million and $12.5 million of catastrophe losses from Hurricane Ian. The loss ratio for the quarter was 39.6%, comprised of an attritional loss ratio of 23.6% and a catastrophe loss ratio of 16%. Approximately $5.3 million or 29% of the attritional losses for the quarter were from lines of business in runoff or restructured.
Additionally, these lines of business exceeded their planned losses for the quarter by about $2 million. That, in conjunction with the success of lines of business key to Palomar 2X were the primary contributors to the elevated losses and loss ratio for the quarter. The results for the quarter affirm our decision to exit or restructure certain lines and focus on business essential to Palomar 2X. Considering those factors, we believe the loss ratio for the year will be between 20% and 21%. Our expense ratio for the third quarter of 2022 was 55.1% compared to 58.8% in the third quarter of 2021.
On an adjusted basis, our expense ratio was 50.7% for the quarter compared to 56.3% in the third quarter of 2021 and compared to 51.2% sequentially in the second quarter of 2022. Our acquisition expense as a percentage of gross earned premiums for the third quarter of 2022, was 14.6% compared to 22.5% in the third quarter of 2021 and compared to 18.1% sequentially in the second quarter of 2022. The improvement was driven by additional ceding commission or fronting fees from our new fronting business that are netted within acquisition expense and overall changes in our mix of business. The ratio of our other underwriting expenses, excluding adjustments to gross earned premiums for the third quarter of 2022 was 7.3% compared to 9.4% in the third quarter of 2021 and compared to 8.5% in the second quarter of 2022. Our combined ratio for the third quarter was 94.8% compared to 102.8% in the third quarter of 2021. Our adjusted combined ratio was 90.3% for the third quarter compared to 100.2% in the third quarter of 2021.
As a brief reminder, in concert with our Palomar 2X strategy, we introduced the metric of adjusted underwriting income. We calculate adjusted underwriting income similarly to adjusted combined ratio. We start with underwriting income and back out the adjustments that may not be indicative of our underlying business trends, operating results or future outlook. We believe that the adjusted underwriting income is the most comparable financial metric for evaluating Palomar 2X.
Our third quarter adjusted underwriting income was $7.5 million compared to a loss of $0.2 million last year. Our year-to-date adjusted underwriting income was $53.6 million compared to $36 million last year, growth of 48.7%. Net investment income for the third quarter was $3.7 million, an increase of 67.4% compared to the prior year’s third quarter. The year-over-year increase was primarily due to higher average balance of investments held during the 3 months ended September 30, 2022, due to cash generated from operations and by slightly higher yields on investments. Our fixed income investment portfolio book yield during the third quarter was 2.83% compared to 2.19% in the third quarter of 2021.
Our book yield on investments made during the third quarter was above 4.5%, trending higher at the end of the quarter. The weighted average duration of our fixed maturity investment portfolio, including cash equivalents, was 4.03 years at the end of the quarter. Cash and invested assets totaled $541.8 million as compared to $467 million at September 30, 2021. For the quarter, we recognized realized and unrealized losses on investments of $2.4 million as compared to realized and unrealized losses of $0.3 million in the prior year’s third quarter losses, we do expect our investment portfolio yield to improve in the foreseeable quarters based on the current market conditions. Our effective tax rate for the third quarter was 17.5% compared to negative 101.6% for the third quarter of 2021.
For the third quarter of 2022, the tax rate differed from the statutory rate due to the impact of the permanent component of employee stock option exercises. During the quarter, we purchased 52,185 [Technical Difficulty] previously announced 2-year $100 million share repurchase program. We have approximately $76.7 million remaining under the authorized program. We will continue to take an opportunistic approach to share repurchases under this program when we view our stock trading at a discounted valuation. We remain focused on investing in and supporting the of our business lines as we strive to progress and execute on the framework provided to deliver Palomar 2X. Our stockholders’ equity was $367.8 million at September 30, 2022, inclusive of the share buyback and realized and unrealized changes to our investment portfolio compared to $394.2 million at December 31, 2021. For the third quarter of 2022, annualized return on equity was 4.6% compared to 0.3% for the same period last year.
Our annualized adjusted return on equity was 7.9% compared to 1.8% for the same period last year. We remain confident in our strategy to achieve long-term growth with sustainable and predictable earnings even [Technical Difficulty] was 15.3% and approximately 17%, excluding net realized and unrealized losses for the year. For the full year of 2022, we are providing adjusted net income guidance range of $82 million to $85 million, including additional reinsurance expenses resulting from Hurricane Ian and excluding catastrophes and unrealized and realized gains and losses.
With that, I’d like to ask the operator to open the line for any questions. Operator?
Question-and-Answer Session
Operator
Thank you. [Operator Instructions] Our first question today is from Mark Hughes of Truist. Please proceed with your question.
Mark Hughes
Yes. Thank you. Good morning. Good afternoon. Chris, the Specialty Homeowners business, you wrote $14 million in 2Q and zero in 3Q. What impact did that have on earned.
Chris Uchida
Yes. So Mark, that’s a great question. When you think about it from a gross earned standpoint, obviously, the impact was minimal, right? Let’s talk about the Specialty Homeowners book just a little bit. There is two pieces of that. There is the Texas portion that we have put into a full fronting model effective six of this year. There is the non-Texas Specialty Homeowners that is in runoff. Obviously, we did not write any more business in Q3. The Texas business is now in the fronting model already is our funding model, so it’s generating consistent fee income. But that move obviously has moved the written premium out of the Specialty Homeowners line, and we’ve now included it in the fronting line. From a net earned standpoint, obviously, there is an impact, there was some of that impact we felt in Q2, but there was only 1 month of that impact. The third quarter is the first full quarter where you see the full impact of that net earned, especially for the Texas Specialty Homeowners book being moved to the printing model. When you think about that from a headwind standpoint, that’s probably $3 million to $4 million of ceded earned premium that has now moved out of the net earned premium because that is in the fronting model. Obviously, we do receive a little bit of benefit of that in the losses, but also you see that in the acquisition expense. But when you’re thinking about from the top line, the revenue line or the net earned premium, yes, there is a little headwind from that, but that’s as expected, moving that and also, obviously, to get that fee income.
Mark Hughes
Thanks for that. I think your guidance for the non-cat loss ratio for the full year was 20% to 21%. How do you see the trajectory of that as we think about the emergence or development of the 2.0, what is – what should we think about next year specifically?
Chris Uchida
No, it’s a good question. Obviously, the loss ratio for the quarter was higher than we would like to see it. Some of that is due to the strong growth of the lines of business are key to Palomar 2X, whether it be Inland marine or casualty bills grew faster than we expected, definitely faster than we expected when we presented Palomar 2X at Investor Day. So we’re happy about that, and that was taken into the thesis when we’ve said all along that the loss ratio was going to continue to tick up because of the growth in some of these lines and the overall change in the mix of business. It’s also relevant when we talk about the lines of business that we’re running off. Those lines of business obviously contributed a little bit more than we would have liked this quarter, and those lines will mostly be run off in the first half of next year, but let’s call it mostly fully run off by the end of next year. So there is still some of that going to be running through there. We still expect from a mix standpoint that the loss ratio will continue to tick up. But when you think about it a little bit longer-term or intermediate term and you think about it in 2024 or 2025, when you think about the Palomar 2X bottle and what we presented, also assuming quota shares that are the same mix of business is the same as we presented.
We expect that loss ratio to continue to go down from where it was. So yes, it could go up to 23%, 24% in the more near-term. But I do expect over the more intermediate term of, let’s call it, 2 to 3 years that, that loss ratio will continue to tick down as the mix of business improves – some of those lines of business are fully run off and we get a little more consistent earnings and predictable earnings from some of the casualty clients, but also some of the lines subject to attritional quota share. So overall, I expect it to improve, but there is going to be a little bit of an increase and then a decrease, let’s call it, hopefully, we will see that starting to come up near the end of next year but early in 2024.
Mac Armstrong
Mark, this is Mac. What I would add is that the lines, whether it’s Casualty or Inland Marine did outpace the growth. And that’s a positive thing for us. But like Chris said, that means that you pull forward a little bit the timing on the attritional loss ratio ticking up. So net-net, we are accelerating the pace of Palomar 2X because of the performance of both fee generative business and PLMR-FRONT and those lines that are expected to grow at a quicker rate than historical binary lines like Hawaii and earthquake. So that is a positive in the sense that I think that it will allow us to get to the inflection point where the loss ratio does start to tick down at a quicker pace than initially forecast. So that is something that I’m actually encouraged by.
Mark Hughes
Mac, you say proposed changes that the California Earthquake Authority has not yet been a catalyst to the quake business. Can you elaborate on that? Why not and when if they are going to be a catalyst.
Mac Armstrong
Yes. Sure, Mark. And that’s a good question as well. I think ultimately, this California Earthquake Authority has not come to a conclusive decision on the majority of the changes that they are wrestling with. They have another governing body meeting in December. And the topics on the table include a reduction in coverages, especially the non-structure limits. There is also a discussion of them potentially going back to the traditional mini policy. So the changes in coverage there continues to be a little bit of a kicking of the can down the line. It creates agita and it allows us to market against us, but it doesn’t drive something conclusive whether it be from the participating insurers that are members of the CEA or some of our distribution partners that still have business that they send off there, especially something that’s a more full coverage policy.
Secondly, as it relates to the reduction in claims paying capacity, they have stated that they are buying less reinsurance. It’s to the tune of $1 billion to $1.3 billion. That’s just going to come up as it renews. And so that’s a dynamic that we actually look opportunistically upon and there might be a limit that can be redeployed to our program that allows us to grow efficiently from a reinsurance standpoint and support the growth in the premium base. And frankly, it will allow reinsurers to get a participation in a more attractive and a better returning book of business. So what I would say is the coverages, it’s fluid. I would expect something will shake out over the course of ‘23. The reinsurance and claims paying capacity, which is a catalyst for the participating insurers as well as us as a buyer of reinsurance, that will take course over the course of the year as their program renews and they have got a lot of different treaty dates.
Mark Hughes
Appreciate it. Thank you.
Operator
The next question is from David Motemaden of Evercore ISI. Please proceed with your question.
David Motemaden
Hi, thanks. Good afternoon or good morning for you, guys. Just a question on how we should think about the reinsurance costs? I know you guys renew a lot of your – well, I think the aggregate renews on 4.1 and the rest of the program are news on 6.1 next year. Obviously, hearing about the dislocation, I think you guys had a 9% increase last year in your reinsurance costs. So I guess I’m wondering, it’s a two-part question. What are you guys expecting for your reinsurance cost increase this year just given everything that’s happened in the market? And second part, do you think you’ll be able to increase your pricing on a consolidated basis considering the residential earthquake book as well, will you be able to increase your price by enough to offset the cost of reinsurance?
Mac Armstrong
Dave, yes, this is Mac. That’s a good question, and it’s something that we are very focused on in taking stock of this reinsurance market. We’ve actually been in Bermuda, and we get down to remitting get to lending kind of on an off-cycle basis just to catch up and give people a holistic view of all the Palomar is doing. And it’s afforded us the chance to get a sense of this market. I mean it is a dislocated market and there is pullback from reinsurers or retrenching of their property cat appetite. I think it’s important, though, for us to reiterate a few kind of key themes. One is the property cat perils that are in the crosshairs for the majority of rate increase is going to be Southeast Wind, which obviously, we have some exposure to, but I’ll come back to that because it’s a very decreasing book of business. And then those that have secondary payrolls think about tornado hail, deracho [ph] or Midwest wind and then have delivered kind of unexpected losses. So for us, and even if you look at Ian, that was not an unexpected loss, but as it relates to us, we feel that we’re in a very solid position.
We have meaningfully reduced our SCS and cardinal hurricane exposure. It’s more than 60% since 2020. We actually, just with the runoff of this book that we have in place that we put into place at the start of this year, there is another 20% reduction in our PML. And so as we think about what comes up for renewal at 6.1, it’s really going to be a single peril or single uncorrelated peril renewal. And if you talk to reinsurers, that’s what they are focused on from a property cat standpoint. So they are focused on trying to confine their losses to what they are – what they have historically been in business for, and that’s earthquake, that could be Hawaiian Hurricane. It’s the unexpected loss, a winter storm or again, a deracho in the Midwest that puts the burden on the market and put a burden on the cost of capital. So what that means for us is as it becomes increasingly more single peril and uncorrelated with the market’s peak zone, I think we feel very good about the prospects for our renewal at 6:1. And with the aggregate because the same logic applies to the aggregate as the aggregate has really mostly Hawaiian Hurricane and earthquake in it. It’s easier to model and get their hands around and there is less of the 1000 cut scenario.
So what does that mean? We’re going to take stock of the renewals at 1/1. We have always – we haven’t put out guidance for 2023 yet, but we’ve all of our internal models for over the last several years have baked in increases in this market because we thought that the hard market would persist. So we feel very good that we can continue to operate, grow profitably and add a good combination of earthquake into electrician wine hurricane to the book next year. As it relates to your second question, I mean, I think we can get the rate that’s needed. We got in the third quarter on the Southeast Wind, a 30% rate up. That is going to accelerate. It’s got to accelerate to keep up with potential loss costs and inflation.
On the quake side, we were seeing double-digit rate increases now. And as I sit here in the fourth quarter, that’s picking up. And moreover, as capacity pulled back, whether it be MGA-driven capacity or multinational insurers that are putting more of their historical binding authority capacity back into reinsurance, we will be able to drive terms and conditions as well as rate. So overarchingly, I think we can get the rate to keep up with Lasko as it relates to the admitted side of the book, the one thing that we do have in particularly in high net worth segments, and we can change the cutoff and the parameters for high net worth. In residential earthquake, we can use our E&S company more. And we’ve been doing that, and we can continue to do so. And that’s where you can recover the rates that’s beyond the 8% inflation guard that we put in place on the residential quake. And I think the other thing that I would add on Hawaii, we have not only an 8% inflation guard, but we did get a 9% rate increase. So we can – and frankly, we can get more rates and potentially could get more rate next year there. So I think the combination of having a balance of commercial and residential business affords us the ability to pass on the cost. I think, the overall quality of our book makes us feel like that we will be able to grow and maintain certainly – directionally maintain our margins.
David Motemaden
Got it. Thanks. I appreciate that answer. And maybe just a follow-up there, I mean, are you hearing from reinsurer, we’ve been hearing just a broader retrenchment away from property lines, which I don’t know if that includes earthquake or not. Are you seeing just less capacity just full stop across property perils, just on the reinsurance side?
Mac Armstrong
We’re not hearing full stop. So again, we don’t have anything renewing at 1/1, but obviously, we’re talking to reinsurers back probably 30 reinsurers over the last month or so of a marketing trip that was actually established before Ian. But nonetheless, no, I mean I think it’s a matter of what their cost of capital is and what they are targeting. I think every reinsurer is looking as earthquake as, a, a bit of a safe haven. It’s not climate change impacted. It’s uncorrelated from their peak zone. So, Southeastern wind is a little bit of a different story. And so that’s why we feel good about the actions that we’ve taken over the last 2 years and that we will have probably when it’s all said and done, less than $200 million of Southeastern wind PML that we’re buying limit for, which is less than 10% of our total program. So when you can bundle southeastern wind with earthquake and then the other thing, too, is as we’ve grown and diversified, we can bring more casualty opportunities to reinsure. So there is more that we can trade with from our broad relationship standpoint, we feel that we are uniquely positioned in that regard. And the other thing I’d add is, Dave, we have built up a very significant book with our reinsurers. They made money with us, a lot of money with us. So I think that accounts for something, too.
David Motemaden
Got it. Thanks. And then I guess just on the attritional loss ratio. I guess now we’re thinking 23%, 24%, I think, you were originally taking about a 21% to 22%, if I recall, for next year. Is that really, is that all driven by mix where you’re having just a greater portion of your net earned premiums that are just coming from these other lines, which I think you guys had outlined have a 57% attritional loss ratio, and it’s just purely mixed or is that 57% loss ratio that you guys laid out in the Palomar 2X? Has that changed at all?
Chris Uchida
That’s good question. Obviously, that has not changed, our view it is talked about it, our view on the lines of business that are fundamental to Palomar 2X into marine, casualty and the like, those loss picks haven’t changed. Those lines performed as expected this quarter. So we’re very happy with that. But the written premium and the earned premium associated with it have accelerated. And so from where we were at in June, we are in a different spot than it has accelerated. So I brought some of that loss ratio, call it, forward a little bit. And so when we look at it, and we think about 2023, yes, that does push the loss ratio up. But the one thing I’d also say is that we’ve always had this runoff in our expectations. And so we knew that, that part of the mix was in there when we’ve talked about this ticking up. If we can fast forward and get this out of our book, I still expect the loss ratio in total, same thing, all those caveats this with the same quota share, say mix to be below 20%. And so if we can do things faster and get that mix of the right spot by the end of 2023, maybe that happens faster, maybe something – one of those lines decelerates a little bit and other line goes faster, and so maybe it stays a little higher, a little bit longer, but that’s a little bit harder to predict. But overall, this mix is – or this new business that we’re writing is performing as expected it’s what we like to see. We’re very happy with it. We’re very happy with the growth trajectory. And I think when you look at it on a long-term basis and when it’s call it the mix is a little more mature, we still expect that loss ratio to be below 20%. But there is still going to be some increases in a little more of a short-term. So the one thing I would say is I don’t want people to front-run the comment where we say that $5.3 million or 29% of the loss ratio for the quarter is from these lines of business. These lines aren’t necessarily gone in Q4. They are going to take a little bit of time, but most of it – the majority of it will be gone by the first half of next year.
David Motemaden
Got it. Thanks. And is there like – because you guys obviously disclosed on the gross basis, gross written basis, the mix. Back of the envelope, I’m calculating like roughly 40% of your mix will be from these, I guess, attritional loss lines. Is that the right like level of the mix to think about? And is that sort of a stable level or would you – I guess it sounds like you would think it would stay at a 40% mix and it’s sort of going to be tapped out there?
Chris Uchida
Yes. I think are you doing that ex-fronting. I think if you are thinking about ex-fronting and we go in with, let’s call it, comparing to earthquake in Hawaii kind of the binary line. And yes, I think 40% is probably the right mix there. We have said for a while, excluding fronting that at some point in time, there is probably going to be a 50-50 mix between earthquake and other lines, I would say, in that commentary, that Hawaii is probably in there a little bit as well. But no, I think if those lines are, let’s call it, 40% to 50% of the non-fronting mix, and I think that’s a good mix for us. But obviously, everything still has to continue to grow, which we are watching as well and making sure that we are fundamentally strong on earthquake growth will continue and is a key fundamental to how we are operating the business. And earthquake has seen good growth as we sit here today.
David Motemaden
Great. Thank you.
Operator
The next question is from Pablo Singzon of JPMorgan. Please proceed with your question.
Pablo Singzon
Hi. Good afternoon. The first question I had is, could you speak to the slowdown in gross premium growth or binary alliance in the quarter? I think based on my math, you grew about 33% in the first half. And in the third quarter, your grading percent. It seems like from your comments, you expect growth to accelerate once disruption from the CA begins to play out. Also, can you comment on any impact you are seeing from each riders pulling out of California, I think all states announced stop filing new business?
Mac Armstrong
Hey Pablo, this is Mac. Yes, it’s a good question and happy you brought it up. The growth did slow down sequentially from the second quarter to the third quarter for Earthquake and Hawaiian Hurricane lines. I would point out that the third quarter is our largest and so it’s a tougher comp. But what I would tell you is that as we sit here today, the growth year-over-year in the early part of the fourth quarter has accelerated. Some of that’s a function of the residential side, E&S opportunities that we are seeing and the ability to get rate there. Some of that is some partnerships that are getting more and more traction. On the commercial side, it’s rate and dislocation or better said capacity pullback. So, while it was – earthquake did grow just under 20% in the third quarter, we expect that to sustain, if not grow faster for the remainder of the year. On Hawaii, we were waiting in the third quarter. We were not actively looking to grow our exposure there. We were waiting on the approval of a rate increase and an inflation guard. So, we did get both those approved in August. And you typically are quoting 45 days, if not 60 days out ahead. So, what we are seeing there is, again, a reacceleration of growth in those – in that binary segment. So, we feel very good about the growth prospects for residential earthquake and then even Hawaii. Hawaii, we are not going to be growing exposure, we are going to be growing more just from a pure rate. But I would expect a sustained level of growth in those lines that will be a nice anchor going forward.
Pablo Singzon
Got it. And then just a follow-up on the reinsurance discussion, how much of your residential risk book is admitted versus E&S? And how fast do you think you can shift your mix there? I guess the context of the question is that recognizing all these pricing levers you have, at the end of the day, your biggest exposure is still California earthquake, right, which is mostly admitted and a subject that regulator that’s not granting any pricing pieces?
Mac Armstrong
Yes. No, I mean we do have an inflation guard, right. So, that’s ticking up 8% a year on the admitted side. But the E&S book is around 10% right now plus or minus. And I think probably closer to 8% right now. But nonetheless, we do have the ability to increase that channel, in particular, as we look at high-value thresholds and which eligible for the traditional admitted versus the E&S from a high-value standpoint. We can look at certain producer channels. We can also look at geographic concentrations to manage that. So, the admitted side does not afford the latitude. We can use the E&S company. The inflation guard gives us a decent cushion as well. The inflation guard is frankly keeping up just with the risk-adjusted increase on the 6.1 renewal. So, the rest of it will be subsidized by the commercial.
Pablo Singzon
Got it. And then just switching to the results of this quarter, maybe for Chris, how much earned premiums were associated with the runoff book in the third quarter? I am just trying to get a sense of the AOI loss ratio ex those losses. And I guess can you talk about the drivers of claims here? I think the main reason for your decision to exit certain lines and to switch it to cap risk, but it seems like attritional factors drove the losses this quarter?
Chris Uchida
Yes. No, that’s a fair statement, right. Obviously, if you look at this quarter, I mean some of these lines, mostly the lines don’t have a ton of cat. They do have a little bit of cat in there. So, some of that was felt. But no, the attritional losses were the reason in that call it – if they were cat, we look at the cat payback. But the attritional loss was the main reason we made the decision to exit these lines. When you look back in Q2, obviously, we had these lines and they were performing better, but there is some reading of the tea leaves, and we thought that this may be in there. And so this definitely affirms our decision to exit those lines. These lines in total, obviously, we haven’t given out the breakout of the earned premium, but in total, it’s probably good to think about these lines, even with this loss ratio operating in the 90% to 95% combined range. So, that’s probably a good way to think about it. But no, they drove some of the results this quarter. It’s something that we thought could happen and really did drive the reasoning behind we wanted to exit these lines. And so that’s what we started doing earlier this year. And that’s why the majority of it will be out by the middle of next year. So, we are happy with that decision. And we would just wish like some other people that it was out sooner. But it doesn’t take away from the good results we are having on the other lines of business and the growth that we are seeing in the binary lines, the growth that we are seeing in the lines are key to the Palomar 2X and the fee income that we are seeing on fronting as well. So, we feel good about all those things also.
Pablo Singzon
Are these lines non-tax specialty owners, or are they something else?
Mac Armstrong
There is specialty homeowners. There is also an assumed reinsurance relationship, which is, it’s a homeowner/renters product. And then there is one commercial property program that we are, again, restructuring running off.
Pablo Singzon
Okay. And then last for me, just given your cat experience this year, do you think the $6 million average annual loss estimate you offered before for cat still stands? And I guess, just given what happened, you talk about your appetite providing risk in Florida, given that you weren’t in that market in any meaningful way a couple of years ago. Thanks.
Mac Armstrong
Sure. So, I think there is a couple of things in there. The $6 million is the average annual loss and was not an average storm. This was, I don’t know if it’s a one in 40-year or one in 50-year or one in 30-year event. But so that’s – so it’s going to – an event like that will over-index the average annual loss. That all said, as I mentioned earlier, we still have line of sight on an incremental 20%-plus reduction to our exposure in continental hurricane, which will push down that AAL and also the runoff, which is a function of the runoff of that continental hurricane exposure, plus then one of the things that a hard market affords you is the ability to look at your book and drive further optimization. So, we have rate targets. We have the ability to contract our line sizes. We have the ability to look at occupancy eligibility and age of construction. So, all of those will also help the AAL our ability to – our retentions, whatever it might be. So, the AAL will actually come down if you roll forward in next year’s wind season through previously identified initiatives and then ongoing initiatives that we have right now on managing our wind exposure and taking advantage of rate and the like, we will push it down further. And then again, just to reiterate, and that was not an average event. That was a cat 4, cat 5 that hit Southwestern Florida, I think we feel very good about our losses only being 3% on a pretax basis of our surplus.
Pablo Singzon
Fair enough. Thanks Mac.
Operator
The next question is from Jen Lee [ph] of KBW. Please proceed with your question.
Unidentified Analyst
This is Jen Lee on for Meyer Shields. Thank you for taking my questions. My first question is on inflation. So, is there any kind of changes on the current inflation costs, are you comfortable with the current level?
Mac Armstrong
Yes. So, on the inflation guards, we did increase them from 5% to 8% on our admitted residential book, so residential earthquake and emitted Hawaiian hurricane. I think we continue to look at not just the inflation guards, but the underlying insurance to value and the ITV for all of our portfolio. So, we use that to look at when a policy is submitted for new business or renewal to make sure that the estimate on the replacement cost does factor in a true sense of inflation right now. We also have the ability to leverage our builders risk business, which has what’s called auditable policies that you can see once a project is completed, what was the ultimate cost and how did that compare to the original estimate. And so if that was 10% or 12% higher, not only is the premium adjusted, but we can use that on a regional basis to inform what we think the replacement cost should be across all of our portfolio on a state-by-state basis. So, right now, we think it’s adequate. That doesn’t mean that we won’t potentially bump them up. And hopefully, as the Fed gets inflation under control, there will start to be a cushion that would be below the 8%.
Unidentified Analyst
Got it. Thank you. And my second question is on the fronting premiums. Fronting premiums for this quarter continue to be strong. So, is there any updated thoughts for 2020 – this year and going forward in 2023?
Mac Armstrong
Yes. So, you are right. Fronting was strong this quarter, and it has exceeded our expectations this year, and I think that gives us great visibility on a nice fee income stream into 2023. We did take up the range from $180 million to $200 million this quarter from $160 million on the high end that we gave at the end of Q2. So, that gives us good momentum into ‘23. We have not given a target for ‘23. What I will say is that we have a nice pipeline of prospects for the fronting business. The existing clients are performing well. We have been able to bring incremental capacity to support their growth. through our reinsurance relationships. We have been able to help them execute on a host of ways. So, that gives us a very nice eviction on the fronting opportunity in ‘23 and beyond.
Unidentified Analyst
Got it. Thank you for the color.
Mac Armstrong
Thank you.
Operator
The next question is from Tracy Benguigui of Barclays. Please proceed with your question.
Tracy Benguigui
Thank you. As you have mentioned that you exhausted $12.5 million catastrophe retention and you are also paying a reinsurance reinstatement premium. Can you highlight what the reinsurance recoveries were your gross losses around trying to get at is I am just trying to figure out how far in your program, you might have had some losses and then just tagging back to that discussion with reinsurance capacity, if you had a view of how those reinsurers would feel about renewing with you since they have had some losses.
Mac Armstrong
Yes. Hey Tracy, this is Mac. That’s a good question. So, just as a reminder, we do have prepaid reinstatements. So, we have a $12.5 million retention loss from this event. And then whatever is impacted in those lower layers of our reinsurance program are reinstated and so come back online. Now, we have not disclosed our gross right now as of yet. We are seeing claims come in. What I will tell you is this is immaterially up our program. Now, that being said, for those reinsurers that are in our first layer of the program, and if it’s in the first layer and ticks up into the second, we want to be mindful of their losses, and there will need to be payback there. But this is well within the first two layers of our reinsurance program and hopefully really just closer to the first layer.
Tracy Benguigui
Okay. No, that’s definitely helpful. And I totally get your commentary earlier that some of the perils that you are in might be attracted to some reinsurers. But just thinking like a stress scenario like where in the danger zone could you be in terms of raising retention, coinsurance, maybe reducing top layers, I mean how do you think about if you had a stretch what would be the minimum you could think about in terms of reinsurance protection.
Mac Armstrong
Hey Tracy, we are looking at the market closely. And I think we look at our retention because that is, frankly, where there will be losses into that first layer because of Ian. And so will we have to take our retention up $3 million, $5 million, we will see how that goes. Maybe we will do it vertically through a co-participation in that first layer. We obviously don’t want to get to a point where we are trading dollars. So, the rate online is 100%. That doesn’t make a whole lot of sense for us. I think there is a couple of themes that I want to impress upon you, though, as you think about stress scenarios. Again, I made the point around earthquake being a nice diversifier. I will make the point again that we have a substantial bank built with those reinsurers, so we have made them money. But the one thing that you are hearing from reinsurers is they want to see retentions go up. They also are moving up programs. And so for us, as you get above I will forecast it, $175 million of limit, you go into really only binary exposures or single payroll exposures. And that’s where property reinsurers are looking to go. They want to go to a single peril, so if they take a loss from an earthquake, that’s what they are in business for. It’s not a circumstance where they are taking a loss in the layer that they thought was only Earthquake exposed and then there was a winter storm that hit it. So, what you are seeing is reinsurers moving up in the mid working levels of programs and there is actually a scenario. I mean this is my roasted view that we are going to have excess demand in the middle of our program because it will have an attractive rate online, and it will be single peril. So, I think that’s the dynamic that will play itself out, whether it’s excess demand or what the price is, it will be manageable for us. But I do think that it’s not a circumstance where we have Midwestern to hail exposure, Florida exposure all the way through our program, so we are scratching and cling for a limit. We are actually going to be bringing something to them that’s involved with the property reinsurance market. I think the other thing that I need to reiterate is we have a $2.1 billion program, $675 million of that is in cat bonds that is multiyear. So, they are not renewing right now. So, they are locked-in in 2024 or 2025. So, I think that’s also like you think about those stress scenarios. We don’t have the totality of the program renewing the majority of the program is single peril, and the strong majority of the program doesn’t have any secondary peril exposure.
Tracy Benguigui
Thank you.
Operator
We have a follow-up question from Mark Hughes of Truist. Please proceed with your question.
Mark Hughes
Yes. Chris, what would you say is a good ratio we should be thinking about in terms of earned premium relative to written, I think this quarter was a little lower because of the new reinsurance and new quota share. When we think about Q4 or maybe and go forward a few quarters, what should that ratio look like?
Chris Uchida
Yes. I think the best way to think about it is it’s going to continue to decrease, right. And I think as we transition some of our business over to fee-based business like fronting or even some of the newer clients that have attritional exposure where we use a heavy amount of quota share to protect our risk and to help deliver more consistent earnings that the net earned premium is going – the net earned premium ratio is going to continue to go down. So, at the end of this quarter, it was, let’s call 42%, sorry 48% for the full year. I think I have said all along that I expected it to be below 50% for the full year. That trend is happening, right. And so could that full year number be 45%, 46% or potentially even lower maybe, but I think that trend when you think out to ‘23 is going to continue. Fronting has been strong. We expect that trend to continue. Mac obviously didn’t really take up the range on where we performed there. The growth in the lines of business, key to Palomar 2X, casualty, Inland Marine have been strong. Those have quota shares with them. That’s going to increase. And you can actually see that even on the net written side, right, we did see a significant portion of our written premium this quarter to reinsure. Some of that, obviously, is XOL, Mac talked about. We did have some cost increases there. Also, if you will remember, XOL, the first quarter that you have a full quarter of excess of loss is your heaviest quarter as the percentage goes because you are paying the same rate for the next 12 months, even though we are planning on growing our book and we buy to be able to facilitate that growth. So, XOL is a little bit higher. But the quota shares is going to drive the largest amount of that differential into future quarters when you think about the net earned. So, I expect it to continue to decrease on the other side of that, the fees side of that. I expect the acquisition expense, especially as a percentage of gross earned to continue to decrease as well. And you saw that trend continue Q2 to Q3 of this year. So, it’s down to 14.6%. That trend is what we expected as well. So, it’s still going in the right direction. And so I think that’s what I continue to expect with net earn. I am not going to give out a specific target for next year at this stage. But no, I do expect it to keep going down. And I think there is going to be more consistent fee income from that, but also just strong performance in those lines of business is what you are seeing and what you are seeing go through our net earned premium ratio right now.
Mark Hughes
Thank you for that. Appreciate it.
Chris Uchida
You’re welcome.
Operator
There are no additional questions at this time. I would like to turn the call back to Mac Armstrong for closing remarks.
End of Q&A
Mac Armstrong
Great. Thanks operator and thanks to all who were able to join. We appreciate your participation questions and your support. I would also be remiss if I didn’t thank all of our team at Palomar for their dedication to the business and as well as all of our customers and partners for what they do and they are critical to our success. To conclude, we do think that this quarter really was a demonstration of the meaningful strides we are making on our path to Palomar 2X. We have reached record growth in gross written premium. We monetize and continue to monetize our capital investments made over last year and the early part of this year, and we really did demonstrate the increasing resilience in our business model. Overall, we have line of sight in our ability to execute Palomar 2X, and we look forward to delivering considerable value to our shareholders as we do indeed achieve those milestones. So, thank you very much. Enjoy the rest of your day. And we will talk to you next quarter.
Operator
This concludes today’s conference. You may disconnect your lines at this time. Thank you for your participation.
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