Qualitas Controladora SAB de CV

BMV:Q

Earnings Call Transcript 2022-Q4

[Operator]

Good morning, and welcome to Qualitas Fourth Quarter and Full Year 2022 Earnings Results Webcast. The conference will now begin. It is my pleasure to turn the call over to Mr. Santiago Monroy, Qualitas IRO. Please go ahead.

[Santiago Monroy, executive]

Thank you. Good morning and thank you for joining Qualitas Fourth Quarter and Full Year 2022 Earnings Call. I'm Santiago Monroy, Qualitas IRO. Joining us today are our CEO, Jose Antonio Correa; and our CFO and International CEO, Bernardo Risoul. As a reminder, information discussed on today's call may include forward-looking statements regarding Qualitas' results and prospects, which are subject to risks and uncertainty. Actual results may differ materially from what is discussed here today, and the company cautions you not to place undue reliance on these forward-looking statements. Qualitas undertakes no obligation to publicly update or revise any forward-looking statements, whether because of new information, future events or otherwise.

Let's turn it over to Jose Antonio, our CEO, for his remarks.

[Jose Correa Etchegaray, executive]

Thank you, Santiago. Good morning everyone. Great to be with you all again wishing you all the best for you and your families during this year. 2022 was a year of major challenges across most industries worldwide. We witness inflation levels unseen in decades, supply chains restrictions, geopolitical tension, financial markets corrections combined with hawkish monetary policies, and, above all, we all have experienced a new normality after coming out of 2 years of pandemic.

In the auto insurance industry, particularly in Mexico, we faced in addition new mobility trends with changes in driving and consumption behaviors; supply chain constraints on both, new cars and spare parts, technology and digitalization disruptions, hybrid and electric vehicles accelerated growth, among many others. While every year has its challenges and particularities, I must say this one was quite unique. In Qualitas, we embrace change, we acknowledge that challenging circumstances are always an opportunity to learn and keep on growing.

Auto insurance is a cyclical business and in 2022 we anticipated the cycle, taking actions early while staying agile to adjust and take advantage of the opportunities. Throughout 2022, we executed on our strategy, which enabled us to strengthen our market-leading position. Despite we will never be fully satisfied, and we will never stand still, there are many reasons to be proud of. Let me say a few of them. The number of Qualitas' insured units reached a record high, ending the year at 4.8 million, which represents more than 330,000 units during full year.

Top-line for the year came above expectations growing 10% during 2022. It has been reassuring that sequential growth in every single quarter for the year showed improvement with the fourth quarter being the best in several years. Growth was driven by our unique business, where we continue highlighting our closeness and relationship with our agents, reaching 20,000 agents, up 7%, and our unique commercial footprint, reaching 551 offices representing 29 new offices during the year. Qualitas Development Offices, those that reach 100,000 people localities, continue to be an engine of growth.

Written premiums coming from our -- what we call our ODQ's have shown a 13.5% compounded annual growth rate in the past 5 years. If they were a standalone insurance company, Mexico, they would take the position #14 in the insurance industry. Also profit continues to be challenging as the combined index continues to increase. Important to note, we continue to outperform our competitors by being the only one of the top 5 with a combined index below 100% in Mexico, and better than many global peers. Our vertical integration continues to expand and by doing so, strengthening competitive advantages, improving cost and service.

We are pleased on how our vertical subsidiaries serve new customers, consolidating themselves as an engine of profitable growth. Our business diversification journey took important steps. First, geographically, where we continue to consolidate our specialized business model in other countries, replicating what has made us the best auto insurance company in Mexico. Operations outside Mexico are still young, and while there are still adjustments to be made, especially in the U.S., we are encouraged by the confirmed potential.

Many opportunities have been identified in our U.S. business and we are in the midst of addressing them, as Bernardo will elaborate later on. Secondly, our expansion into Health. Qualitas Salud launch sets a cornerstone becoming our first entry in non-related auto business. Health is the sector with the largest growth and potential, where prevention and our excellence in service coupled with a value proposition, will seek to satisfy an unmet need of the 92% of the Mexican population without private insurance.

As a reminder, we decided to enter organically, to learn and adjust our model. We expect Qualitas Salud subsidiary to start being relevant in 3 to 5 years and an important part of our business in 10 years. 2022 was also key year for our commitment towards sustainability. As part of our ESG efforts, we committed to a Net Zero Emissions' scheme towards 2050 that will be reached through currently analyzed measures and processes that will compose our corporate carbon portfolio. These are just some highlights.

We continue to set the foundations for a bright future, entering 2023 with strong momentum and initiatives. Moving forward, we will continue executing on our 3 pillar strategy. We will first, focus on strengthening our leadership in the Mexican insurance market. Second, prioritize profitability in our international operations for them to be accretive at around 20% ROE objective. And third, execute our corporate development plan, using our strong capital position, diversification and the right engines of growth within the insurance ecosystem, will be crucial for the sustainability of our results.

I want to make something very clear. We acknowledge our competitive advantages and what has led to us to be the best auto insurance company, and we humbly recognize that we have opportunities. Therefore we have identified actions to further strengthen our operation not only in Mexico but in the rest of the countries in which we operate. All management members are focused in our 2023 game plan along with defined KPIs. We are also working hard on our organization, especially on the development of our top employees, which will continue to be our most important asset.

And with that, let's move to the financial details and a deeper dive on the quarter and year results. Bernardo, could you please?

[Bernardo Salas, executive]

Good morning, everyone. As Jose Antonio mentioned Qualitas has navigated a defiant year coming out stronger by staying true to our core competitive strengths and our service commitment to policyholders and agents. We are, however, conscious that near term will not be easy as we continue to manage inflation and focus on fixing some identified opportunities. Going deep into our financials, top line closed ahead of expectations, up 17% for the quarter and 10% for the year, setting a record high.

Excluding the pandemic, this is the highest quarterly growth in 6 years. When dissecting growth, strong performance was seen across all Mexico sub-segments and international markets, except for the U.S. in which I will shortly expand. Also, important to note around half of the growth is explained by tariff increases during last year while the rest is organic, coming from incremental volume and mix. Worth to highlight is our traditional segment, up 18% for the year, and a consistent driver of growth with a compounded annual growth rate of 7.5% over the past 5 years.

As a reminder, new car sales are the biggest source of growth for the insurance industry and posted a 7% recovery versus 2021 but is still 18% below 2019 levels. This performance drove our financial institution segment up 23% in the quarter, confirming signs of recovery, but still only 2% up for the year. Our portfolio composition closed with 78% annual policies and the remaining 22% in multiannual. For 2023 as new car sales continued to recover, we may see an increase in multiannual policies. Earned premiums is up 17% and 11% for the quarter and the full year respectively, reflecting the company's underwriting growth pace.

Reserves behavior came in line with what we have seen historically where in the fourth quarter we have a higher reserves constitution reflecting top line volume and mix of businesses. This quarter we constituted MXN 1.6 billion of reserves which is basically the same amount constituted in the year. Now, going into our international operation, we closed the year with them representing 8% of the total holding company underwriting. Let me break international into LatAm and U.S. providing more visibility from now on.

On the former, El Salvador, Costa Rica and Peru are doing well. They are steady growth above 20%. They are profitable and already yielding ROE in the high single digit and improving. On the other hand, our U.S. operation has been facing challenges that, as mentioned in prior calls, have resulted in the decision to shift strategy, where we will no longer focus on accelerated growth but rather on profitability. Since I am already on it, let me expand on our U.S. business that had a large impact on this fourth quarter and in the total year results.

Fixing our U.S. operation has now become a top priority for the company. As background, we launched this business back in 2014 to satisfy the unmet need of Mexican customers needing coverage in the U.S. border states and vice versa. Due to demand and opportunity, it started expanding into domestic U.S. market as well. Over the past quarters and given the long-tail litigation processes and legal particularities, mainly in Texas, we have been impacted by some older claims up to 6 years that have closed at a much higher cost than initially reserved.

This also forced us to relook at all historic claims' reserves, adjusting them to the upside. This quarter, and as anticipated, we finalized the actuarial assessment in partnership with an external firm, which confirmed the need to increase reserves, specifically the IBNR, which stands for incurred but not reported to comply with regulatory requirements. Total amount was $22 million during this fourth quarter, impacting loss cost and consequently a direct hit to profits. Important to note, this is not yet an expense nor an outflow of cash.

The amount will continue to be part of our portfolio and hopefully, we can release back some of those funds as we continue to see the business turning around. We know there is a large market potential in the U.S. Incentives for nearshoring in Mexico are high for companies serving the U.S. market and being the one insurance company that can provide unique service on both sides of the border is a competitive advantage we want to continue exploiting. Our revised strategy considers 4 main changes. First and foremost, a major refocus on the cross-border business, while importantly reducing appetite for domestic trucking, where legal environment is complex and has been the largest impact for us and for the industry overall.

Second, we have strengthened our organization. We have a new CEO in place, and a stronger claims and internal actuarial team. Third, we have and will continue to adjust tariffs. Some businesses are up more than 50% versus 2021 and more than 150% versus pre-pandemic levels. Lastly, we have also reengineered our claims processes which will now include mandatory use of telematics, selective law firms and specific KPIs. While it has been a negative year for the U.S. subsidiary, we reiterate there is potential and therefore, we have made this a priority.

Considering the nature of our business, we believe this is a 2-year turnaround, but it should post a significant improvement in 2023 as several of the above-mentioned changes are already in place. Moving back to Qualitas Controladora performance and costs, starting with the most important one, our loss costs and ratio continue to expand the expected trend given the business cycle, the effects of the mentioned industry inflation, mobility trends, and supply chain constraints. Loss ratio for the quarter was 76% and 70.5% for the full year; an important but expected increase versus year ago and above our desired technical objective of 62% to 65%.

For further reference, our loss ratio performance in the Mexican subsidiary stood at 70.5% for the quarter and 68.5% for the full year. To cope with cost increases trend, we have and will continue to be disciplined on both tariff increases and cost control. On the former, we have leveraged on specialization to make tailored adjustments where needed every 4 months. We have increased our tariffs 14% on average since its lowest point in 2020, recognizing important differences by business. We will continue adjusting, next one happening in this first quarter as we rather maintain smaller and constant increases than big steep changes.

Supporting our cost discipline, we continue relying on our vertical integrated structure to have advantages on spare parts and claims repairments, which are part of our material damages and make up for 55% of our claims cost. We are also improving specialization on claims with a full and comprehensive scan of conditions, and professionally trained team, and computerized diagnostics procedures to prevent fraud and to support our service for customers. In addition to our risk and fraud prevention, technology plays a key role on our operation.

Example of it is our already known Express Adjustment Tool, representing better service to the policyholder at lower costs since remote or desk claim officer has a 3 to one productivity versus the traditional claim officers. During the entire year, 25% of our claims were attended through this tools. Finally, as shown in the past year a stable and resilient Mexican peso should also help our operation through this economic cycle. Moving to other metrics, our quarterly and full year acquisition ratio stood at 22% and 23% respectively, in line with the historical average.

Commissions paid to agents remained unchanged and bonuses are always aligned with the growth, health and profitability levels of their portfolios. Operating ratio for the quarter was 0.8%, benefited by the strong underwriting performance which represented higher income from underwriting fees, as well as adjustment of some provisions. Year-end ratio stood at 3.1%. In a high inflation environment, it is also important to address productivity. Our written premiums versus operational staff ratio increased 7.6% versus 2021, becoming our highest ever.

Organization and payroll will grow accordingly to our cost control without leaving behind excellence in service. Qualitas has always seeked to align compensation to productivity. All of the above, resulted in a combined ratio of 98.5% for the quarter, ending the year at 96.4%, being north of our 90% to 94% target. In a year where global auto insurance players in the U.S., Europe and Mexico are posting combined indexes well above 100%, we are proud of our ability to create value and being true to our commitment to stay profitable at an operational level even in a deep-seated context.

Moving forward to our financial performance, we delivered $794 million during the quarter for a cumulative financial income of $1,423 million, implying a 3.1% annual ROI. As anticipated, we are starting to turn the corner on what was a sub optimal performance of our portfolio up to the third quarter, and we are well positioned to benefit from the high rates environment, especially in Mexico, which currently stands at 10.5%. For reference, our ROI for the quarter was 7.7%. It was a tough year for the markets and our annual performance reflects that.

We have adjusted, we expect financial income to play a key positive role in the next years, and it will certainly be a tailwind in 2023 as we continue to navigate the inflationary environment. Let me further give you some color on our portfolio specifics and why we are so confident in its near future performance. We have 89% on fixed income and 11% in equities. This overexposure to fixed income seeks to benefit from the mentioned high interest rates, especially considering the duration of our portfolio which now stands at 0.6 years, a great place to be and start taking longer term positions.

Important to note, by Dec 31, yield to maturity of our entire portfolio, including geographical distribution, stands at 8.5%, 350 basis points above year end 2021. On the equity side, despite tough performance, we have kept most of our positions as we believe their fundamentals pose them for recovery, yet we have not increased exposure nor plan to do so aggressively in the next months. Qualitas posted $607 million net income for the quarter, $2,209 million for the year, representing a 5.3% net margin. Tax rate was benefited especially during 4Q, and for the full year as well, due to the reported loss in our U.S. subsidiary and in our equity positions, as well as the annual inflation adjustments.

Moving forward, we could expect tax rate to be much closer to our historical average of 30%. Regarding our financial ratios, our 12 month ROE stood at 11.1%, reflecting the impact in our performance but also our strong capital position. Price to book value stands at 1.7. And just as reference, if we were to exclude one-timers, ROI would have been around 16%. Net, we closed the year with a higher-than-expected top line growth and a great momentum. We delivered positive operational profit that outstands in the industry and an investment portfolio that, while under-delivering in 2022, is well poised for the future.

All this confirms Qualitas' resilience and efficient adapting capacity. So with that said, let me now shift gears and talk about 2023, a year in which we expect to keep navigating complex dynamics. As anticipated by Jose Antonio, we will continue executing against our 3 pillar strategy and all actions will intend to deliver sustainable value creation to stakeholders. Considering the uncertainties on key variables, we believe best not to share a quantitative detailed guidance but rather give you some color on expectations for this New Year. Starting with the top line, we will aim high single to low double-digit growth, and the recovery in new car sales. We expect pricing competition to continue, and we will continue to adjust tariffs, ensuring our value equation supported by excellence in service, remains unmatched.

In line with our strategy, top line will be led by the LatAm markets including Mexico as they continue with a consistent growth pace, while the U.S. is expected to decline. Now moving to our loss ratio, as inflation continues to pressure costs, we first need to see industry inflation stabilize. In addition, spare parts supply and the industry evolution on robberies will be important factors. Robberies for Qualitas continue to be 21% below 2019 levels. At this point, our base assumptions would lead to another year above our long-term target of 62% to 65% but with sequential progress along the year and a better performance than 2022.

As we continue to experience improvement in financial institutions underwriting, acquisition costs should increase accordingly on the high end of our historical range, given they imply a higher acquisition cost. As mentioned, financial performance for the year should have a significant recovery, mainly driven by the rates environment. We should expect an annual 2023 ROI to be in line or slightly ahead to average references rates. All-in-all, we expect 2023 will bring a significant recovery, returning to steady growth top and bottom line with an ROE much closer to our long-term objective of 20%. As we start 2023, let me also give you some perspective on capital allocation.

At the end of the year, regulatory capital for the holding company stood at 4,040 million, with a solvency margin of MXN 14 billion, equivalent to 446% solvency ratio. We are also incorporating another metric for capital, broadly used in the industry, which relates to the earned premiums divided by equity ratio. We currently stand at 2.05 versus what we consider a normalized ratio of 3. Either way we look at it, our discipline and performance allows us to be in a strong capital position, ready for future projects of growth while providing value to shareholders.

As Jose Antonio mentioned, we have a defined corporate strategy, a clear path from which a sustainable growth for the parent company will come from; all of them within the insurance ecosystem and where there's an opportunity to replicate our unique business model and create value. As anticipated in our last earnings call, we currently have 2 open due diligence processes, one to strengthening our data analysis and our risk and fraud prevention competitive advantage in Mexico, and the other to strengthening our vertical operation.

If both projects are approved accordingly to Qualitas terms and conditions, first half 2023 would be a conclusive date for them. Both M&A's would represent no more than $50 million combined and in both of them. We truly believe that our DNA and business model will provide significant upside. Additionally, and related to our geographical expansion, we have set eyes in the fourth largest economy in LatAm, with 51 million people and vehicle fleet of 17 million units. I am talking about Colombia, a country without any specialized automobile insurance company and neither a risk prevention focused one.

The size of the market and insurance penetration of only 40% insurance would enable to replicate Qualitas' business model and closeness with future agents in that country. As always, we are planning for an organic entry, in a slow and gradual pace. We are starting the approval and legal processes with the local authorities, and we would like to start operations by the end of this year, although we will provide more details -- we have more perspective given some items that are outside of our control. Finally, we have proved that we consistent policy and appetite for cash dividend payments as we have done so over the past 7 years. We will continue to comply with our revised dividend policy that establishes a dividend payment between 40% and 90% of the previous year's net profit.

While it is still early to say, and there is a process to follow, we expect to be on the high end of the stated range. On top of that, we have an active share buyback fund with the main objective of improving liquidity. As of December 2022, we have held position 16 in the Mexican Marketability Index, trading above $5 million on average per day, which is a record high and well above other relevant public companies in Mexico. By year end, we had 6 million shares in Treasury, so we will assess implication of another share cancellation to create value without affecting the long term free float.

Qualitas continues to provide best-in-class service to our policyholders and agents and a solid performance in a dynamic environment. The positive outcome of 2022 is backed by the dedication, professionalism, and hard work of Qualitas more than 5,000 employees, as well as the seniority of our Board of Directors and experienced management team. Qualitas people continue to lead the way. Our well-defined 2023 game plan to robust top and bottom-line growth reaffirms our commitment to create and increase long-term value for all our stakeholders. I am confident and excited for the future ahead.

So, with that, I will be more than happy to address your questions. Operator, can you please open the line for Q&A.

[Operator]

[Operator Instructions] Our first question comes from Ernesto Gabilondo of Bank of America.

[Ernesto María Gabilondo Márquez, analyst]

My first question is on premiums growth. I would appreciate if you can elaborate what will be the expectations per segment? How much growth do you expect in the traditional business in financial institutions? What will be the growth in each of the subsidiaries? You mentioned that probably U.S. could be contracting, but what about Mexico, Central America, Peru and potentially in Colombia?

And also how should we think about the growth of the medical product and also well related to the same topic, how much do you expect subsidiaries and the medical products to represent to premiums in 2024? Yes, a lot of questions that are better related to my first one. And then the second one is on your claims cost ratio. I don't know if you can break down the ratio on how much is related to weather impact, how much is related to inflation, how much related to FX and how much to accidents?

And when do you think that the claims ratio could be normalized into the historical leverage of 62%, 65%? And finally, my last question is in the respected ROE for this year. I don't know if it will be reasonable to expect a 90% dividend payout ratio this year, a solvency ratio of 400%. And I don't know if that sits at 18% ROE? Just wanted to hear if that sounds reasonable.

[Jose Correa Etchegaray, executive]

I'm glad that you joined us for a good morning question. Well, let me take the first one. Let me try to see -- what you showed me are not -- we do not show too much detail on premiums growth going forward. Having said that, let me tell you that my view is that it will depend a lot on how the economy goes to because, as you know, the expectation for -- in our biggest business, which is one, the GDP growth is expected to cool off a little bit to around 1%. Now the nice thing is that our insurance business is a bit countercyclical and that should be helping you.

So to give you an answer on this question that you have, I think that we are having a good base because we have been very disciplined to increase our tariffs according to the cost that we have been seeing, the inflation that we have seen in spare parts, et cetera. But I can say I expect that we have some -- I should say tailwind in helping us in the high single digits growth. It is not unlikely that we will see around 10% sorry about in terms of our growth. I am very pleased and I was discussing this with my team earlier this week in terms of how we have seen the behavior for the quarter for each of the 4 quarters that we have in 2022 and have a strong momentum.

So I see that there is a likelihood, strong likelihood that we will be double digit in that one in the terms of the Mexican subsidiary. Fortunately, in the LatAm, we are also double digit. I mean, we have a very good result for 2022. And this has been something that we -- as we [indiscernible] with our teams in LatAm, that continues to be the case for 2023. Now if we look to the U.S. subsidiary, as [indiscernible] words to all the analysts. What we are seeing in the U.S. that we are reshaping strategy, making sure that we go back to basics and go back to where we started.

So we see that, we are not envisioning growth in the U.S. Rather the U.S., we want really to improve profitability this way and go back to order products that we believe are the right thing to do and that would help us get back on track in that business. So also, I would say that our premium growth, I think it's going to be -- we have a good hands down area to improve both in our major markets in Mexico and also in Latin America. It relates to [indiscernible] it's kind of visible where we still need to see how the insurance -- I mean, sorry, the auto insurance -- the auto business are going to go, the new auto sales will be.

I've been talking to some of the largest manufacturers in Mexico, and they are all a little bit optimistic on that one. So we should be seeing the middle single-digit growth in the industry. There are some that are -- even anticipate closer [indiscernible] to 10%. So that will depend on that. We will be focusing a lot on the one that we really want. We will continue focusing [indiscernible] going to be a little more complicated because there has been some big competitive pressure in there. But I believe that as [indiscernible] now they are going to be getting the impact of new tariffs in the Fleet segment. And in the regional one, we perform well and we will see that double-digit growing there. But that will give you some part of the color I expect for the premium growth going forward. Bernardo, I don't know if you?

[Bernardo Salas, executive]

Let me address your second -- answer your question. So first of [indiscernible] cost, reduction at loss ratio is the biggest concern [indiscernible] Qualitas and the auto industry [indiscernible]. Most of the cost increases come from the auto spare parts. We've seen them increase 10%. So that's a couple above inflation this year. We're expecting to do -- we're starting to see some signs of stabilization. So we're hoping that, that peaks somewhere in the first half. Related to frequency because you well mention there's 2 elements. You can have the cost increases, but you can also have a frequency increase.

It is the frequency going up. Frequency was 26.1% this year. That compares to 24%. So there are indeed not only more expensive claims but also more claims [indiscernible]. Traffic is certainly higher as we see opening of business and schools and vacations. And we're hoping that frequency remains stable in the future. Biggest challenge from frequency remains on trucks, which are heavier [indiscernible] and through our prevention program comes into play, and we are expecting that to help [indiscernible]. There are no FX impact this year. We've seen opportunities, there is no benefit.

We saw the peso appreciated. We're not seeing prices going down in that same line, but at least that hasn't been and we're not expecting that to become an impact. So just to wrap up the second question, when are we expecting to be back in the 62% to 65% range? It's not -- it's unlikely it's going to be in 2023. We are expecting to be slightly above, certainly below in 2022. And the most important piece would be how we close the 2023, so Q4 of 2023. That's what we're expecting to stabilize the business, and we see it closer to that 65%, which will give us a true indicator on 2024.

In that regard, and my final comment would be, we're expecting that Q1 [indiscernible] will still be challenging from a claims standpoint, and we're expecting that first half to be the peak of [indiscernible]. And moving to the third question on dividend yield; let me just reiterate once that confirms and reiterate our commitment to pay dividends. We've done so for the past years, and we like our shareholders to continue getting that dividend. I think it would be fair to expect dividend on the high end of that 40% to 90% range. I wouldn't commit to a 90%, but it's always an option. So I think we'll have more as we approach the general assembly, which is the official time which we will create dividends.

[Ernesto María Gabilondo Márquez, analyst]

Perfect. Just a follow-up on the last point. And anything related to the solvency ratio, would it be reasonable to have a level of 400% in '23?

[Bernardo Salas, executive]

We do not have a target of solvency ratio. We do so for the insurance in-shop insurance company. We always want to make sure Qualitas stands out as a company that is solvent. So the excess capital will remain at the Controladora level and on that, we will be funding and fueling the growth in line with our strategy and the projects that we laid out. We do not have, at this point, any indications for extraordinary dividend payment. But as we said, no, that's always something that we have in the table. And once we lock a structured plan for ongoing growth, we can always put that again for discussion with both the Board and the general assembly.

[Ernesto María Gabilondo Márquez, analyst]

Perfect. And just on Colombia, I know that you're entering the business and likely to initiate operations by the end of the year. Any color on how much you pay to enter that country? Because I think it's the first time that you were -- have to mentioning this. So any color on that would be very helpful.

[Bernardo Salas, executive]

Well, we started -- yes, we want to start giving more transparency on Colombia, the one market, and only market where we're looking for geographic expansion. The size of Colombia, the conversations that we have with agents there have indicated that there is a space for a company with Qualitas DNA to come and create value. We're not banking for any growth happening in 2023, although we're aiming to issue our first policy late in the year. And regarding capital, we believe we have somewhere in the $5 million to $10 million that would include the capital that we are required to have as part of the consolidation of the insurance company.

[Jose Correa Etchegaray, executive]

Let me tell you just a little bit on the Colombia Part 2, Ernesto. And you know after all you know about the market in Colombia, about -- its similar in Mexico in terms of that the top 5 companies are almost 70% of the insurance market. And it is important for us to know that we have some risk management practices we mentioned before that we haven't seen in Colombia, and we have some advantages that we believe we can put it there. So that's why we are targeting that market. And well, the numbers that Bernardo said in terms of the capital we are very happy.

[Operator]

Our next question comes from Juan Ponce of Bradesco.

[Juan Ponce, analyst]

My question is more on the labor cost side, especially in Mexico, given the impact on minimum wage hikes, 20% this year, more vacation days and the gradual increase of employer pension contribution. So what are your expectations on these pressures this year? And I mean, you mentioned in your initial remarks that you will be increasing prices. But do you think this will be enough to offset this part or is this just a catch-up with the higher costs on the auto service side?

[Jose Correa Etchegaray, executive]

Excuse me, Juan, can you please ask the second part of your question to be clear?

[Juan Ponce, analyst]

Yes. So the second part would be how will you be able to mitigate these cost pressures if you see any?

[Jose Correa Etchegaray, executive]

Let me take just some of it. Clearly, inflation is a hot topic, I would say, because I personally I believe that to a high patient [indiscernible] in Mexico, and I know that one patient start is difficult to -- so that's something that is of some concern clearly for me because generally speaking, insurance companies as long as rates are high as we have in Mexico, that is not that bad. Now going back to your question in terms of patients and summary minimum wage increases, et cetera, clearly, we have a general impact on inflation in the specific case of Qualitas. What I can say is that our operating costs are very well under control. We have the lowest as a percent of premiums of the industry. And while we expect them to have some impact we are touching that in our calculations in '24. And so it will be some impact but not very major, and we are hearing [indiscernible] Bernardo you have anything to say on that.

[Bernardo Salas, executive]

No, only that [indiscernible], we never rely only on pricing to adjust for or compensate for price increases. We always look at productivity, we will look at automatization. So things that will help us compensate. So it is not a straightforward link between cost increases and inflation with tariff increases.

[Jose Correa Etchegaray, executive]

Let me add just to that, that we are -- we have a significant investment in systems. We have had over the past years and 2023 will be no different. And a number of those things are going to be near to productivity improvements as well.

[Juan Ponce, analyst]

Okay. So it's safe to say that there is basically no -- not much of an impact from these labor cost pressures in 2023?

[Jose Correa Etchegaray, executive]

Yes, I would prefer to say that even with those impacts, we will [indiscernible] with an operating target between 3% and 4%.

[Operator]

Our next question comes from Gilberto Garcia of Barclays.

[Gilberto Garcia, analyst]

I had a couple of specific questions and then a more general one. Firstly, on the financial income, did you recognize any impact from your UNIFIN stake in the fourth quarter? And can you provide us the current book value that you carry on that?

[Bernardo Salas, executive]

So most of the UNIFIN impact was already reflected in Q3. There are no significant -- actually, I doubt there's any impact on UNIFIN since the equity has been on hold. That was something that we discussed at length on Q3. What we still have remains a small piece on the P&L, which is around MXN 35 million valuation. And then we still have like MXN 90 million at the balance sheet -- the way they're structured. So at this point, if it were go to zero, the value, the impact would be around MXN 120 million. On the other side, there's we believe there's upside and recovery. We're not banking on that. Our financial income does not consider it, but I think there's still dialogue that could put UNIFIN back on the table and hopefully be a nicer price on 2023.

[Gilberto Garcia, analyst]

Okay. That's very clear. And then second, on operating cost, they have been rather stable throughout the year at around $400 million per quarter. This quarter, it was substantially lower, similar to the fourth quarter of last year or 2021 rather. But we don't really see that seasonality in previous years. You mentioned that there were some provision releases that help that line this quarter. But I guess what should be the -- and you mentioned 3% to 4% in the previous question, is that the run rate? So I guess what I'm trying to ask is the extent of the one-off that benefited the operating expenses line this quarter.

[Bernardo Salas, executive]

So let me just provide on the fourth quarter, we usually do see a lower operating cost. If you look at last year, it was 0.9%. This year, it's 0.8%. Third, there is one main factor that benefits the operating costs, which relates to premium rights. So every premium we write, there's an extra charge that is intended that, that market practice that is intended to cover part of the cost. So as we see more number of premiums being written, we will see a higher benefit and it reflects on the operating expense. So that's one of the things that benefits on -- especially in the fourth quarter that we have a higher number of premiums [indiscernible].

The other thing, the ongoing range, it is 3% to 4%. We were at 3.1%. That's on the low end of that range. And a lot of that has to do with the [indiscernible] or employee profit sharing. For regulatory reasons, we reflect that expense, not on taxes but a part of the cost. So this year, we adjusted because we recognize that it wasn't going to be as high. So that's just a percentage of the projections. And that was the adjustment that we did. And there's also some minor returns related to compensation. And as the year did not turn out to be as good as we all have hoped for we also adjusted and that adjustment always happened in the fourth quarter.

[Jose Correa Etchegaray, executive]

Just let me add on that Gilberto and [indiscernible] that you are with us today. Let me tell you that, obviously, as we expect our profits to pick up in 2023. Obviously, we would be seeing part of the [indiscernible] profit share effect of that would increase and probably move it closer to 3.5% or 3.5% or 4%. We are also going to be -- get the benefit of the improvement that we see in the premiums -- that are in the premiums that we will be writing in 2023. So we are confident that we will remain within those ranges that Bernardo mentioned.

[Gilberto Garcia, analyst]

Okay. Very clear. And a final one on the increase in the frequency, I don't know if you could provide more color on what the potential reasons for that. In addition, obviously, there being more traffic. But I guess the question is, is this increase in frequency structural or more temporary in your view at this point?

[Jose Correa Etchegaray, executive]

That's one thing that is happening Gilberto. Obviously, there has been an increase in frequency versus 2021 and 2020. However, the frequency that we have goes back to the frequencies that we have seen in fact in 2018 and 2019. So there's no worry in that part, and it's more of a sustainable level of the frequency. But the change versus the 2021 is something that obviously goes back to explaining the results.

[Operator]

Our next question comes from Andres Soto of Santander.

[Andres Soto, analyst]

Congratulations on the recovery this quarter. I have a few questions. The first is related to the U.S. operations. I would like to understand at this point, how much of that is onshore business versus the cross-border business? And to what extent we can expect additional reserves being created this year. And if you are planning to reflect those reserves directly as loss ratio as it happened in the fourth quarter or is part of the reserves in the top line, and this is going to be another big factor from your top line improvement this year?

[Bernardo Salas, executive]

Let me take that question, and then we'll go on with any remaining ones that you have. So the U.S. operation, tough year for it. Yet, overall, we lost $35 million in the year. A part of that comes from the mentioned IBNR increase of $22 million this quarter. And a lot of the impact both in the IBNR and claims cost would come from claims that trades back to prior years, 2021 and before even 2016. So this is not a one-year effect. We're reflecting it, but it comes from the operation that has been in place for several years. The domestic market, which is the one that we started accelerating back 4 years ago, came up to represent 70% of the operation.

We're now pulling back. We expect that it represents around 30% to 35% in very niche categories or accounts customers that have been consistently proving to be good and healthy customers. On the opposite, our cross-border, which again, the niche where we have a right to win, also we believe we have more control and better chance of being profitable. That is yet to become the main part of our business, hoping to reach between 60% and 65% this year. So that is an important ship that speaks for the strategy change we have alluded broadly in the conversation. Not sure with that we cover what you wanted to?

[Andres Soto, analyst]

Just a follow-up on that point. So this $22 million adjustment that you made this quarter should we anticipate more of this in 2023?

[Bernardo Salas, executive]

So we believe we have reflected what we needed, and it's not what we believe is what the technical models show. We're at the low end of the technical range of reserve. So we're hoping that there is no adverse development. We could expect some, but it's certainly going to be at a much, much lower level than we had in 2022. This is, as I mentioned, a 3-year turnaround, and we're happy to provide quarterly updates on the U.S. business since again, this is one of the priorities for the company.

[Andres Soto, analyst]

Got it. So you say, 3 years from now, you basically will be focused basically on the cross-border business, rather the onshore one.

[Bernardo Salas, executive]

Yes. Probably, it's a cross-border and borderless business focus.

[Andres Soto, analyst]

Perfect. My second question is regarding capital -- your capital position. You mentioned the order was really bad. So I didn't fully get it. But you are mentioning a new metric of earned premiums to equity, I believe. What is the target that you look for this new metric? And based on this, what is your assessment of the excess capital of Qualitas at this point?

[Bernardo Salas, executive]

So again, we come back and look whether being 50% above the capital requirement was the single measure that we needed to address or that will -- is another one. So in the auto insurance, there is another one that relates to the investments and the capital or earned premiums and capital ratio. And on that one, it took earned premiums divided by capital ratio. What the market -- the industry expects is to be healthy is to be around 3x. We're now at 2x.

That that means that the excess cash is not as much as the $600 million that you would see laid out, it would be more in the $320 million. So we will be talking about what metrics we're considering that is not that we are walking away from -- or that we're solely looking at one. But we wanted to be transparent and say, actually comes from some analysts and investors that have called out the opportunity to use this metric as well for capital, excess capital or capital [indiscernible].

[Andres Soto, analyst]

Understood. So you say the excess capital actually is $320 million, we get it right?

[Bernardo Salas, executive]

Yes. We believe that $320 million or so it's a better and more educated reasonable number of excess capital that we totally look at the $600 million Yes.

[Andres Soto, analyst]

Got it. And from that, you are earmarking $60 million for the acquisitions and transit to new markets.

[Bernardo Salas, executive]

Yes. Both of the due diligence that we have in progress will total $50 million, that's 5-0 at most.

[Andres Soto, analyst]

The $10 million that you are going to allocate to Colombia, right?

[Bernardo Salas, executive]

Yes.

[Andres Soto, analyst]

Perfect. And my final question is very specific on taxes. We saw a very low tax rate. I would like to understand what is driving your tax burden? And how we should think about this looking into 2023?

[Bernardo Salas, executive]

Yes. Let me take it again. Let me just state that there are absolutely no planning strategies as part of this low tax. I think this is not only an internal commitment, but it also gets audited by internally and our external auditors. The reason to see such a low effective tax rate in the fourth quarter relates to the losses that we reported in the U.S. operation. The losses that we also reflect in our equity investment portfolio and the inflationary adjustment, which is a tax deductible item for every company in Mexico and we see higher inflation, we're also able to deduct at a higher percentage. Total year tax rate was also lower than the average. And I think, as I mentioned, our tax rate to be considered moving forward should be more closer to the 30% that we have historically had.

So for the sake of time, I think we have some written questions, but we are not going to be able to address all of them. So I will just speak one. So we have one from Thiago Paura from BTG that says congrats on the results. Just one question from my side on the financial results. So that treated guidance of 100 basis points and 150 basis points over the Mexican ratio now be understood at zero basis points over the Mexican reference rate for 2023. I mean just in line with the average rate of the year, is it fair to assume.

[Jose Correa Etchegaray, executive]

Thank you very much, Thiago. Let me tell you that with the financial markets [indiscernible] that we have had in 2022 and now the beginning of 2023, with inflation impacts across the world and some undefined things in terms of the growth of the economy. For us, yes, the guidance is going to be closer to be -- to the reference rate. Now at this point in time, as you know, the Mexican rate is around 10.5%, which is good. We are in a short-term position.

So we are really getting ourselves in a way that we can somehow capitalize that part, and we are going to start moving over to these rates. We are still expecting as you know that the Mexican rate have been following the set increases. We don't know what's going to happen with that said. There's still a number of analysts that say that the asset will continue increasing. You know the headline inflation in Mexico recently went a little bit up versus the prior latest numbers. So chances are that we will continue with that. So it is fair to assume that we will be closer to the reference rate in the case of Mexico for 2023.

[Bernardo Salas, executive]

And I think we're already at 10. So thank you, everyone, for joining.

[Operator]

This concludes today's conference call. You may disconnect your lines. Thank you for participating, and have a pleasant day.