Palomar Holdings Inc

NASDAQ:PLMR

Earnings Call Transcript 2021-Q2

[Operator]

Good morning, and welcome to the Palomar Holdings, Inc. Second Quarter 2021 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded.

I would now like to turn the call over to Mr. Chris Uchida, Chief Financial Officer. Please go ahead, sir.

[T. Uchida, executive]

Thank you, operator, and good morning, everyone. We appreciate your participation in our Second Quarter 2021 Earnings Call. With me here today is Mac Armstrong, our Chairman, Chief Executive Officer and Founder. 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 August 12, 2021.

Before we begin, let me remind everyone that this call may contain certain statements that constitute forward-looking statements within the meanings 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 actuals to differ materially from those indicated or implied by such statements, including, but not limited to, the risks and uncertainties relating to 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 these -- 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'll turn the call over to Mac.

[D. Armstrong, executive]

Thank you, Chris, and good morning, everyone. Today, I will speak to our second quarter results at a high level and then discuss our strategic initiatives and efforts to drive profitable growth. From there, I'll turn the call back to Chris to review our financial results in more detail. The second quarter was a very good one and one in which we generated a record written premium, solid profitability and position Palomar for further execution on key strategic initiatives underway or identified.

As such, I'm eager to speak to several of Q2's highlights. First, our premium growth not only maintained the first quarter in 2020 levels, but actually strengthened this quarter as we grew broadly across our product portfolio suite. We grew gross written premiums by 54% compared to the first quarter growth rate of 45%. Premium growth was driven by a combination of new product launches, sustained performance in existing products, rate increases, new and existing partnerships and the extension of our distribution network.

Strong premium growth products included, but were not limited to residential commercial earthquake, specialty homeowners, Hawaii Hurricane and Inland Marine. Additionally, we saw very strong traction in Palomar Excess and Surplus Insurance Company, PESIC, our newly launched E&S carrier, which grew 42% sequentially from the first quarter of 2021. Second, we look to build on our success as we continue to broaden our product suite and partnership slate.

During the quarter, we launched several new products and partnerships via PESIC and continue to harvest existing products and partnerships, most notably those in the residential earthquake sector. These efforts allow us to grow new and existing lines of business, capitalize on conducive market conditions and dislocations and diversify our overall portfolio.

New products in the quarter included casualty offerings like layered and shared excess liability and small contractors general liability. Our newest partners with pure programs announced in June is another prime example as it allowed us to enter into the high-value builders risk segment and complements our commercial builders risk product offering. Third, our successful June 1 reinsurance renewal further demonstrated our commitment to profitable and predictable growth.

We secured incremental earthquake and hurricane limit to support our growth trajectory, enhance our already were robust panel of reinsurers and kept our retention at a level below that of 2020 when factoring in the elimination of co-participations. We believe the incremental limit, manageable retention and the aggregate limit procured in the first quarter ensures earnings stability and puts the floor in our results of approximately 11% for adjusted return on equity and $41 million for adjusted net income for the year.

Fourth, we may focus on continuous improvement as we constantly assess our products and markets to ensure we are earning adequate risk-adjusted returns. We are optimizing every aspect of our business and developing tools that provide insights into the complex markets we serve as we strive to deliver predictable returns and steady growth. For instance, we continue to take rate on our commercial business, run off unprofitable segments like admitted All Risk or Louisiana homeowners, utilize quota share reinsurance for attritional loss exposed casualty products and drive terms, conditions or risk attachment point.

Market conditions have been favorable on a portfolio basis, and we remain optimistic on the outlook through the balance of the year. Lastly, we opportunistically bought back 239,000 shares for $15.8 million during the second quarter. We know that we have the capital to execute our strategy for the foreseeable future and believe this action underscores our confidence in the business, our results to date, our strategy and our ability to create value.

Turning to our results in more detail, we delivered strong premium growth of 54% during the second quarter. Overall earthquake premium grew 29%, while non-earthquake premium increased 85%. Our commercial earthquake products were up 47% driven primarily by a rate in new business from distribution partners accessing testing.

Other primary distributers were Inland Marine and Hawaii Hurricane with 239% and 140% year-over-year growth, respectively. Specialty Homeowners showed a healthy increase of 65% year-over-year. Our commercial lines premium grew 70% during the quarter and it is worth highlighting, we are delivering this growth despite the continued runoff of our admitted All Risk policies, which impacted our second quarter premium growth by nearly 14 percentage points. As we speak here today, our mid All Risk business, which contributed 64% of the hurricane loss in 2020 has been 68% runoff.

As I previously mentioned, PESIC continued to experience strong growth as we expanded our product offerings and distribution relationships. We believe that our E&S business, which delivered $34.1 million in gross written premium grew 4% sequentially and from the first quarter of the year is in the very early innings of its development and can approach the size of our admitted carrier over time.

The second quarter's considerable growth was due to strength in existing property lines of business, such as commercial earthquake and layered and shared national property and further footing within our new lines like excess liability and Inland Marine. We are excited by PESIC's long-term prospects, and I look forward to updating you on our continued progress in future quarters.

Our focus on existing and new partner relationships continue to provide increased distribution, geographic expansion and product diversification. This concentration helped expand our distribution footprint, 5.4% sequentially and 21% year-over-year.

Our aforementioned new partnership with PURE Programs enables PESIC enter another focused market that of high-value residential builders risk insurance. We will continue to develop and seek new partnerships like PURE that enabled Palomar to aggressively grow our market share within profitable market segments.

In addition to our overall top line momentum, we delivered strong earnings and grew adjusted net income of $13.2 million in spite of $3.9 million of previously disclosed nonrecurring reinsurance charges incurred as a result of winter storm Uri. Our adherence to conservative levels of reinsurance coverage is exemplified by the successful completion of our reinsurance placement at June 1, where we procured an approximately $180 million of incremental limit for earthquakes and $100 million of incremental limit for wind storms. Our reinsurance coverage now exhausts at $1.65 billion for earthquake events and $700 million for hurricane events, providing ample capacity for our sustained growth.

We also increased our event retention from $10 million to $12.5 million for all perils, but actually reduced our true retention when factoring in co-participations. Successful 6/1 placement is emblematic of the strength and collaborative nature of our reinsurance relationships and moreover, positions us to take advantage of compelling market conditions.

The underlying cost of reinsurance continues to be subsidized by the favorable pricing and overall dislocation in the specialty insurance marketplace. The average rate increase on renewals during the second quarter for commercial earthquake policies was 14% versus 18% in the first quarter of 2021. Our Builder's Risk products saw new business come on at a blended rate increase of approximately 21%, with large accounts increasing as much as 25%. As it pertains to All Risk, our new business policies are being written at an average risk-adjusted rate, 25% higher than our expiring All Risk business, with rates increasing between 12% and 25% depending on the geography and size of the account. It is worth highlighting that it's not just in our commercial business where we are increasing rates.

In Coastal North Carolina, the State Department of Insurance improved a 14.3% rate increase on our Specialty Homeowners book. We remain confident that we will be able to sustain material rate increases throughout the remainder of the year. Separately, our premium retention in the second quarter was 86% for the total portfolio, excluding the runoff of our admitted All Risk business.

Turning to corporate sustainability and responsibility. I'm happy to report that we are continuing to make progress on the development and execution of Palomar's ESG initiatives. We recognize that strong ESG management better serves our employees, our business partners, our environment, our communities and all our stakeholders. We are building our ESG team and are continuing to strategize and formalize our policies. I look forward to updating you on the progress of our ESG initiatives going forward.

Additionally, we announced last week the addition of Daina Middleton to our Board. Daina has nearly 30 years of experience in operational leadership, customer relationship development, branding, marketing and the use of technology and analytics to grow businesses and will add significant value to Palomar as we continue on our strategic mission.

Overall, I'm delighted with our results. The execution of our growth strategy and the opportunity that I see ahead. It is important to emphasize that we have the capital to fully execute our growth strategy and repurchase shares in an opportunistic fashion. As a result, we bought back approximately 239,000 shares or $15.8 million of our $40 million share repurchase authorization in the second quarter. We will be invested as we capitalize on opportunity to maximize our growth and drive long-term value creation for our shareholders.

For the full year 2021, we continue to believe that our adjusted net income will be between $64 million and $69 million. This range considers additional investments in talent, systems, infrastructure and reinsurance, both excessive loss and quota share we have made or expect to make in the second half of '21 that we ultimately feel will generate strong returns over the next several years. Additionally, the aggregate cover put into place establishes a flow of approximately 11% for adjusted return on equity and $41 million for adjusted net income for the year.

With that, I'll turn the call over to Chris to discuss our results in more detail.

[T. Uchida, executive]

Thank you, Mac. Please note that during my portion, referring to any per share figure, I'm 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 reach the net loss. We have adjusted the calculations accordingly.

For the second quarter of 2020 was $12.3 million or $0.47 per share compared to net income of $12 million or $0.48 per share for the same quarter in 2020. Our adjusted net income was $13.2 million or $0.51 per share compared to adjusted net income of $13 million or $0.52 per share for the same quarter of 2020. With the interplay between the first 2 quarters losses and reinsurance premium, we believe the first half of the year is a better representation of our steady-state business. For the first half of 2021, our adjusted net income was $32.5 million or $1.24 per share compared to $25.4 million or $1.02 per share for the same period last year.

Additionally, we are pleased to report that our first half of 2021 adjusted net income was above the midpoint of the guidance provided with the first quarter results. Gross written premiums for the second quarter were $129.4 million, representing an increase of 54.4% compared to the prior year's second quarter.

As Mac indicated, this growth was driven by a combination of growth within our product portfolio, sustained rate increases, expansion of our E&S footprint and extension of our distribution networks.

Ceded written premiums for the second quarter were $51.6 million, representing an increase of 70.8% compared to the prior year second quarter. The increase was primarily due to increased catastrophe XOL reinsurance expense related to our exposure growth and additional nonrecurring charges resulting from winter storm Uri.

Secondly, we had increased quota share sessions due to growth in the volume of written premiums subject to quota shares. Ceded written premiums as a percentage of gross written premium increased to 39.9% for the 3 months ended June 30, 2021, from 36% for the 3 months ended June 30, 2020. This increase was primarily due to catastrophe XOL charges and a higher proportion of our written premiums being subject to quota shares.

Net earned premiums for the second quarter were $54.2 million, an increase of 37.9% compared to the prior year's second quarter due to the growth in earning of higher gross written premiums offset by the growth in earning of higher ceded written premiums under reinsurance agreements. For the second quarter of 2021, net earned premiums as a percentage of gross earned premiums were 52.9% compared to 55.5% in the second quarter of 2020. As previously mentioned, with the additional reinsurance expense impacting the first and second quarters, we expected pressure on this ratio in the second quarter. This ratio would have been above 56%, excluding the additional nonrecurring reinsurance premium.

We believe the ratio of net earned premiums to gross earned premiums is a better metric for assessing our business versus the ratio of net written premiums to gross written premiums. As part of our recent reinsurance renewal, we adjusted our participation in our attritional quota share arrangements. With these changes, we expect this ratio to be around 53% to 55% on an annual basis, lower at the beginning of a new reinsurance placement and higher at the end with our expected growth written premium.

The expected net earned premium ratio contemplates our new aggregate cover that will provide improved earnings visibility and increased protection should be faced with multiple catastrophic events going forward. Losses and loss adjustment expenses, or LAE, incurred for the second quarter were $7.2 million due to attritional losses of $8.4 million, offset by $1.1 million of favorable development on current and prior year catastrophe losses. The loss ratio for the quarter was 13.3%, including an attritional loss ratio of 15.4% compared to a loss ratio of 10.1% during the same period last year comprised entirely of attritional losses. Non-catastrophe losses increased due to an active tornado and hail season and growth of lines of business subject to attritional losses such as specialty homeowners, flood, Inland Marine and our newer lines of business with conservative loss estimates as we continue to grow the premium base.

Our expense ratio for the second quarter of 2021 was 62.6% compared to 58.3% in the second quarter of 2020. On an adjusted basis, our expense ratio was 60.5% for the quarter compared to 54.9% in the second quarter of 2021. The increased expense ratio was driven by additional reinsurance placements with increased written premiums, including the aforementioned additional nonrecurring ceded premium and continued investment in the PESIC talent, systems and other infrastructure.

Similar to our net earned premium ratio, we feel is a better representation of our business to look at our expense ratio as a percentage of earned premium. Our acquisition expense as a percentage of gross earned premiums for the second quarter of 2021 was 21.9%, up slightly from 21% in the second quarter of 2020. This increase was influenced by the change in business mix and growth of our E&S business. The ratio of our other underwriting expenses, excluding adjustments to gross earned premiums for the second quarter of 2021 was 11.1%, improved sequentially from 11.9% in the first quarter of 2021.

Our combined ratio for the second quarter was 76% compared to 68.4% in the second quarter of 2020. Our adjusted combined ratio, which we believe is a better assessment of our efforts was 73.8% during the second quarter compared to 65.1% in the prior year second quarter. Excluding the additional nonrecurring fee reinsurance premium in the quarter, our adjusted combined ratio would have been approximately 69% for the quarter, made up of a loss ratio and an expense ratio of approximately 13% and 56%, respectively. We believe these ratios showed a more accurate picture of our business.

Net investment income for the second quarter was $2.2 million, an increase of 3.8% compared to the prior year second quarter. The year-over-year increase was primarily due to higher average balance of investments held during the 3 months ended June 30, 2021, offset slightly by lower yield on invested assets. Our fixed income investment portfolio yield during the second quarter was 2.25% compared to 2.83% for the second quarter of 2020.

The weighted average duration of our fixed maturity investment portfolio, including cash equivalents, was 3.84 years at the end of the quarter. Cash and invested assets totaled $427.8 million as compared to $430.4 million at June 30, 2020. For the second quarter, we recognized gains on investments in the consolidated statement of income of $300,000 compared to $778,000 gain in the prior year second quarter. Our effective tax rate for the second quarter was 20.5% compared to 21.5% for 3 months ended June 30, 2020.

For the current quarter, our income tax rate differed from the statutory rate due to tax impact of the permanent component of employee stock option exercises. Our stockholders' equity was $376.7 million at June 30, 2021, compared to $363.7 million at December 31, 2020, and $376.4 million at March 31, 2021. Importantly, the June 30, 2021 balance reflects our $15.8 million of stock repurchases. For the second quarter of 2021, annualized return on equity was 13.1% compared to 15.1% for the same period last year. Our annualized adjusted return on equity was 14.1% compared to 16.4% for the same period last year. Again, we believe the first half of the year is a better representation of our steady-state business.

For the first half of 2021, our annualized adjusted return on equity was 17.6% compared to 17.1% for the same period last year, which included the capital release in June of 2020. As Mac indicated, looking ahead to the remainder of 2021, we are maintaining our adjusted net income guidance of between $64 million and $69 million. As of June 30, we had 25,992,585 diluted shares outstanding as calculated using the treasury stock method. We do not anticipate a material increase in this number during the year-end.

With that, I'd like to ask the operator to open the line for any questions. Operator?

[Operator]

[Operator Instructions] Our first question is from Paul Newsome with Piper Sandler.

[Jon Paul Newsome, analyst]

Congratulations on the quarter. I was wondering if you could talk a little bit more about operating leverage, particularly with the other underwriting expenses. And just give us a sense of how these may or may not grow in proportion to the clearly rapid revenues you're building?

[T. Uchida, executive]

Paul, it's Chris. Thanks for the question. Yes. So when we look at operating leverage and especially, like you pointed out, the other underwriting expenses, we do think about that, and we talked about it really over the last couple of quarters that we expected that to kind of be flat but potentially up from where it was before. So we do feel that we have established what's called a good base as we've kind of built and invested.

We do plan on continuing to invest, but I do expect that ratio to improve over the second half of the year and kind of into 2022. Like I said, we will still invest in new talent, new systems and making sure that we are building scale in the organization over the long term. But even with those investments, I do expect that ratio to continue to improve, like you saw sequentially, especially compared to gross earned premium between the first quarter and the second quarter. In the second quarter, it was about 11.1% versus the first quarter of about 11.9%. So you're starting to see that scale kind of build-up, and I would expect that to continue.

[D. Armstrong, executive]

And Paul, this is Mac. Chris describes that well. And I think just putting -- looking at it long term, I think the other thing that will drive operating leverage is when we launch a new product, as you know, we are very conservative in how we use reinsurance whether it's quota share or per risk. As the products get more traction, our risk appetite likely increases, which will obviously allow us to retain more and therefore, drive some more further scale. So if you really think about it long term, '22, '23, that's when you can see even more leverage coming into play.

[Jon Paul Newsome, analyst]

And I wanted to ask a similar question about net investment income because I -- assuming that there's a little bit of leverage in there, as you move to E&S out of earthquake, which is I'd assume a longer tail lines of business, but you also have investment income going with these low interest rates, probably go in the direction. Maybe you can give us a sense of sort of how that should develop not necessarily for the next quarter, but over time, given the product mix change that you're working?

[D. Armstrong, executive]

Yes. Paul, it's a great point you raised. The history of Palomar and the specialty property focus has led us to have a rather short duration in the investment portfolio and frankly, a rather conservative investment portfolio. Ultimately, we drive the majority, if not the totality of our income through underwriting. But as the complexion of the book changes, I think it will to potentially extend our duration to change the complexion of the investment portfolio, some unless we hold no equities.

So that will develop over time, especially also as we have the ability with longer tail business to extend how long we might go out on the yield curve. So that really is a longer-term phenomenon. I don't expect a material bump up in investment income over the next 2 quarters. But you're absolutely right. It will afford us the luxury of potentially taking on a bit more -- I don't want to say risk in the investment portfolio, but just make it more commensurate with the exposure pattern.

[T. Uchida, executive]

You probably see a little more duration and yield in, but still a very conservative overall portfolio.

[Operator]

Our next question is from Jeff Schmitt with William Blair.

[Jeffrey Schmitt, analyst]

Just looking at the attritional loss ratio of 15% in the quarter versus 10% last year, how much of that was driven just by kind of above normal noncat weather versus the change in business mix? And could you provide any detail on how much you increased participation in the various quarter shares?

[T. Uchida, executive]

Yes, Jeff, a lot to in-box there, but a very good question. So when we think about that and we think about just the pure attritional loss ratio of about 15 points for the quarter, some of that was influenced by the additional reinsurance expense. As I mentioned on the prepared remarks, if you take out that reinsurance expense, that probably drops closer to about 14%. So still a little bit elevated than what we've guided to you before, but I think a little bit closer in line with expectations when you think about the second quarter of the year is a little more seasonal from a loss standpoint for us on the attritional side. We do have a total hail exposure in Texas and then some of the other Gulf states. So that was -- impacted the industry this quarter. So looking at those 2 things, it was a little bit elevated.

The other thing I would like to add to that is, when we think about the new lines of business, those lines of business, we do feel that we are being conservative in our loss estimates and that can be influenced by some of the inflation that we are seeing. But also on those newer lines, we don't have a lot of earned premium yet and don't have a lot of history. I think we're also being conservative in the loss picks we're using to try and estimate those lines. So those are some of the things influencing the quarter as we look at it. When I've talked about kind of our range of loss ratio looking at it on a long-term perspective.

Generally, I'm giving that on an annual basis, not necessarily a quarter-to-quarter basis, so it can move up and down. But I do expect that to normalize a little bit. You got to a good point on the other part, the quota shares. With the 6/1 renewal, we did change our quota share participation so that will increase the loss ratio a little bit over time basis to the guidepost I've given before. I wouldn't expect it to jump again. And I think that's probably going to go up let's call it, 1 to 2 points over time from what the guide post I gave before, which was kind of call it 2 to 3 points on the 8.5% for the year.

So now we're probably talking 4 to 5 points over the -- compared to last year as that continues to grow. You don't see a lot of that in Q2 yet because quota shares just changed at 6/1. You'll probably see a little more of that in Q3 and Q4.

The other thing I'd add to that is with that additional loss ratio, the 1 thing you're going to get, and we always talk about this is you're going to get a little more net earned premium. So that net earned premium now is going to be between 53% to 55%. I'd even mention to say over a 12-month period, that 55% might actually get to 56%.

We're not going to give too much color on that. But obviously, it's always lower at the beginning when we set new reinsurance treaties and then kind of higher at the end and that kind of compares to what I mentioned on the prepared remarks is that our adjusted net earned premium would have been closer to 56% this quarter versus the 52.9% with the additional reinsurance expense associated with the backup things related to Uri. So a lot of different pieces there. But I think overall, with that additional quota share or our participation in the quota share, it's going to be positive to the bottom line because this is additional participation in lines of business that are doing well in the lines of business that we're very comfortable with.

[D. Armstrong, executive]

Jeff, this is Mac. Chris did a great job answering that. I'll just provide a couple more anecdotes around the loss ratio. So I think one thing to point out was around 12% of the loss ratio, call it, a point or so was from our admitted All Risk business is running off. So that was relatively a disproportionate contributor. So if you kind of normalize it, again, I think that 13%, 14%, Chris was alluding to is a good number.

And then secondarily, with those quota shares, they -- our increased participation, it's taking -- it's line-specific. Some lines we're taking another 5% or 10%, but it kind of blends out around 5% to 7.5% of increased participation. The balance sheet supports it, the underwriting results support it, the history and the programs support it. So it's a logical progression as we grow our balance sheet, and we grow our familiarity and frankly, our underwriting results history.

[Jeffrey Schmitt, analyst]

Okay. Great. That's great color. And then regarding the growth in Florida, I believe in the past, you mentioned that, that was builders risk or, I guess, motor truck cargo and then assumed reinsurance. Does that continue to be the case? Or are you starting to write other products there? And what's your appetite to grow in that market?

[D. Armstrong, executive]

You got 3 of the 4. So the fourth product is the National layered and share property, the All Risk property. So we have been writing that since August of last year in the state of Florida. But so the majority of it is going to be back line with this -- with some smattering of builders' risk and then it's motor to cargo and assumed reinsurance in those last 2 are non-cat exposed.

[Operator]

Next question is from Matt Carletti with JMP Securities.

[Matthew Carletti, analyst]

Couple of questions. First one, I wanted to ask you a question on capital. I mean, obviously, you feel comfortable and you're buying back stock, so there's excess. But the question is, as we look forward with the changing mix of business, more growth in specialty lines, and obviously, some changes in quota share. How should we think about kind of the leverage ratio or some other metric that kind of is the appropriate capital level for the company going forward versus you might have been a little higher in the past given more earthquake exposure?

[D. Armstrong, executive]

Matt, this is Mac. Great question. Great to hear from you. So the foundry that we have used historically is 1x our net premiums written to surplus. And as we sit here today, we are at 0.64x. And hence, that is why we -- 1 of the reasons why we've opportunistically bought back stock. Basically, the stock that we bought back was financed by free cash flow in the quarter or surplus that would have been built in accrued to the balance sheet. But since we are still relatively overcapitalized to those guide folks, we feel very good about our ability to execute the long-term growth strategy and maintain the premium growth that we've kind of discussed.

We said 40%, similar to last year. We're ahead of that, over 50% year-to-date. But your point is well taken that as the complexion of the book changes, much like the investment portfolio, that can shift out a little bit in duration, so can the targets. Now that being said, shifting it out, is it 1.1x -- is it 1.2x, I think that's feasible and conceivable, but it's not a material change, especially when you look at how the book is coming together, earthquake and Hawaiian Hurricane still grew 36% for the first part of the year in totality. So there still is a meaningful contributor from those capital-intensive non-loss or non-attritional loss bearing lines.

[Matthew Carletti, analyst]

Great. And then my other question relates to specifically the earthquake book, both commercial and residential. Just is it -- as it continued to grow, has the kind of geographic footprint where we think about the peak exposures and things like that, changed much over the past couple of years? Or is it largely unchanged, just growing kind of with the same mix?

[D. Armstrong, executive]

So there's a couple of ways to answer that question, Matt. And we're -- obviously, we grew just under 30% on the earthquake book. Commercial 47%, residential 24% for the first 6 months of the year. Inherent in that is improved spread of risk. And that's something we look at and something that we monitor very closely. We don't want all of our growth to come from one specific crest zone, Los Angeles or San Francisco, we want to come from across the State of California, we want to come from across the State of California, plus the Pacific Northwest as well as the Midwest if we can get that as well. That spread of risk drives down our unit-level economics and the cost of our reinsurance. And I'm pleased to report that we do continue to see that spread of risk, and I think it best exemplifies in our underlying metrics like average annual loss to premium, which is continuing to improve on the commercial side and driving to a level that's close to low 20s in totality in the portfolio. And on the residential side, it's in the high teens.

So we are getting good spread of risk. It's going to continue to be that which should continue to develop that way as we expand our distribution footprint, monetize partnerships and drive terms, especially on the commercial side.

[Operator]

Our next question is from Mark Hughes with Truist Securities.

[Mark Hughes, analyst]

You talked a lot about the losses in other expenses, but how about acquisition expenses? Any particular trajectory there? Or is this a good run rate?

[T. Uchida, executive]

Mark, it's Chris. Good to hear from you. Yes. I think right now, obviously, the acquisition expense did go up a little bit when you look at it over a quarter-over-quarter basis. I think right now, it's a pretty good. This will probably be a pretty good run rate. It may trickle up a little bit as one -- the quota shares that we talked about a little bit before. The -- by participating a little bit more, we are going to lose a little bit of that CD commission, so that we'll push the acquisition of a little -- acquisition expense up a little bit.

And then also with that, we are still expanding our lines of business. A lot of the commercial lines and the E&S lines are going to be driven through wholesaler channels, which is a little higher than retail. So that might push this up slightly, but where you saw it this quarter, I think, at least on a gross basis, around 21.9%, I think it's probably a good run rate. It can 22%, 22.5% or 21.5%, it's going to a little bit around there based on quarter-to-quarter mix. But overall, I wouldn't expect it to jump. We're not changing new ventures or anything like that, a lot of wholesale for commercial. There's no giant retail player or something like that, that's going to push the swing of the acquisition expense, I think it should hold pretty steady.

[Mark Hughes, analyst]

Yes. On the quake business, thinking about both commercial and residential. Where do we sit in terms of the growth trajectory, growth cycle there? The Ridge Crest quake was a nice catalyst, but you've maintained a lot of momentum even as that's kind of faded into the background of wildfires, I think it were a catalyst. Where do we sit now in terms of the growth outlook?

[D. Armstrong, executive]

Mark, this is Mac. It's a good question. I think we feel very good about the growth that we've had year-to-date for both those products. Residential place, our largest line of business, it's the bellwether line, if you would. It grew 24%, the dynamic that you're talking about around dislocation in the California homeowners' market driven by wildfire remains a catalyst for the intermediate future.

So what I would offer you is that I think we feel very good about the growth prospects for that line commercial quake. We have rates that we're still getting, and we're continuing to the distribution footprint. We are pleased with the growth there. Obviously, 47% in the second quarter was terrific. As I said earlier, earthquakes and Hawaii Hurricane on a blended basis grew 36%. So I don't know if that's sustainable indefinitely, but I think there's a lot of momentum in those lines of business that gives us great conviction around the next few years.

[Operator]

Our next question is from David Motemaden with Evercore ISI.

[David Motemaden, analyst]

I had another question just on the attritional loss ratio. And really sort of thinking about if we sort of hit a threshold here in terms of the impact of the mix shift and what that's having on the attritional loss ratio. I don't know, I may have misheard you, Chris, but it sounded like you had said that after we get through the, call it, 4 to 5 points of year-over-year increase this year. I guess as we think about 2022 and beyond, should we think about the impact of the mix shift on the loss ratio as being lower than I think it was like 2 to 3 points that you had spoken about previously?

[T. Uchida, executive]

Yes. I'm just making sure I understand your question and still free to jump in if I'm answering it the wrong way. So the way I think about it, first, Mac talked about the growth in the earthquake in Hawaii line. So those are very binary lines and still growing at a strong rate of 36%. So those do provide a very good anchor for the loss ratio. And those will continue to provide a good, call it anchor for the loss ratio and a 0% as we go forward and kind of grow and earn this premium over the next 12 months.

The mix obviously is very important to the overall loss ratio as we do look at different lines that you have attritional losses, whether it be the real estate E&O program, the in the marine, some of our other casualty lines, those do have losses associated with them. And I think, as I said before, we are trying to be very conservative on how we picked those lines because they do have -- some of them do have a little bit longer tail.

So I do expect as those lines and as we take a little more participation in the quota share, I do expect it to, I guess, continue to move up incrementally. I don't expect it. There's not going to be an overnight shift where it jumps from, let's say, 14% to 28%. It's expect as that mix or as some of those lines become a greater percentage of, let's call it, Palomar's overall book, that there will be more loss ratio as it goes on.

And thinking about, let's call it, I think is your question, past '22, right? So I think call it a couple of more points into the second half of the year based on where we were based on more of the quota share participation. But when you think long term, I do think it will still continue to trickle up. So with that, we are also going to probably long term increase our net earned premium. Those lines don't have cat XOL exposed to them -- or cat loss exposed to them, so we do not have to spend as much on XOL.

So what I would say is you're still going to be getting a good profit margin or net income delivery from those lines of business as you may continue to grow, and you're losing a lot of that volatility by not having cat exposure and is getting rid of some of that reinsurance spend on those. Aside from quota shares, I'm just saying that pure XOL spend on those lines, obviously, a lot less if nonexistent than on some of our other lines.

[D. Armstrong, executive]

And Dave, just to kind of put a bow around it. Those 0 loss or 0 attritional loss lines of quake in Hawaii are 51% of the business right now. So it's a 0 loss ratio. The loss pick varies by certainly each line, but it's not a circumstance where every single line is going to be 40%. Flood is in the low single digits. So this is not going to run away from us. And even if there was 40% for every other line, but quake in Hawaii gives a 20% loss ratio. So that is how that evolves, that's kind of an outer bound at least the next few years. So we think it's something that we can absolutely manage. And we also think that there's great prospects for the lower loss lines. So it's -- this is very manageable.

[David Motemaden, analyst]

Got it. Okay. That's helpful. That explains it. I guess another question I have is just wondering, there is a lot of mix shift going on. I'm wondering if we could sort of peel back the onion a little bit. And if you could give us a sense for on some of the non-earthquake lines, how margins are trending there specifically on like the attritional loss ratios, are those -- are you seeing margin improvement that's being sort of masked by the mix shift?

[D. Armstrong, executive]

Yes. I mean I think it's line-specific. The builder's risk program and the flood program are 2 that I would highlight that are performing very well from a loss perspective. Builders risk is getting great in addition to producing consistent results. We do have certain lines that we could see some improvement in not to pick on one, but the motor truck cargo line has a loss ratio that's above its target. And we think as a result, we have kind of been going through an optimization and a portfolio optimization with respect to that. And premium retention is down, but the underlying loss ratio is sequentially improving.

So I think you're going to see a product by product, those that are hitting their target margin I think our specialty homeowners is hitting its target margin in states like Mississippi and Alabama, Texas is pretty close. When you back out Uri, it's better.

So we are seeing good performance in those lines and then some that we do need to like to ship a little bit. But nothing that's gotten out of whack and plus the way that we use quota share reinsurance. -- it really prevents us from running the temperature in the line, and that's something that something we've always adhered to.

We're going to seed off 20 -- we're going to retain 20%, 25%, 30% out of the gate, seed off through the residual amount. That affords us insulation from a shock-off. It affords us a major SCS event from disrupting the results. I think all of those tools we've used have allowed us to have a pretty consistent result outside of the cat season of last year.

[Operator]

Next question is from Tracy Benguigui with Barclays.

[Tracy Dolin-Benguigui, analyst]

Just going back to the op-lev question, as you ramp-up new products via PESIC, can you contextualize how many new underwriters you need to bring on board versus utilizing managing general underwriters? And are you seeing saturation amongst MGAs as a new entrant, predominantly, I'm thinking about recap or China do the same thing?

[D. Armstrong, executive]

Yes, Tracy, this is Mac. Thanks for the question. It's a good one. I would say is that we're doing both. We are working with MGAs, especially as we think about layered and shared business. And more often than that, they're going to complement what we do internally from an underwriting standpoint.

So you can certainly do get operating leverage when you work with an MGA. You not -- you are basically having an oversight either making sure that the underwriting guidelines are adhered to. You're hitting your target metrics, you're hitting your target return parameters. We are also, though, adding underwriting talent and internally for new lines of business or existing lines of business, and we have several initiatives underway this quarter that we look forward to introducing to you all after Q3. So it's a combination of the 2. But to your question, getting a new product up and running on the E&S company. We try to do it in a fairly investment-like fashion.

And what we have done is something that John Christenson, our COO, has spearheaded is an innovation lab. And it's what it's trying to do is do kind of a thin client approach from a systems development perspective to roll out a new line of business. It could be one that we don't write right now or could -- or are currently writing. So for instance, we are bringing on a new residential E&S blood program that's leveraging and existing underwriting talent, leveraging existing systems, but it's going to be delivered through a thin client front end that's a lower cost investment that allows us to prove the concept. Once it's proven itself, we can move it on to more of a Cadillac policy administration system or Pega platform that we already have for all of our other lines.

And in doing so, you reduce the execution or the sum cost. So I think what the long and short of it is we're going to use both approaches. We've done that historically. We want to have both internal underwriting and program underwriting for our property business. We're going to gen up new lines internally that hopefully don't take a ton of investment from a talent perspective and assistance perspective, but they will cost something. And that's why when we give our guidance, we feel very good about the guidance, and we also feel very good about the long-term process because we are investing growth not just in '21, but in '22 and '23, whether it's people, talent, people systems or other infrastructure.

[Tracy Dolin-Benguigui, analyst]

Great. That's really great. Maybe just a follow-up on that question about the saturation amongst these MGAs. I mean is it tougher these days to -- in turn to partnership given there's a lot of others that might be trying to do the same thing? Or you still have your Pega you think?

[D. Armstrong, executive]

Yes, it's a good question. No. I think we feel very good about: a, we have a terrific group of MGAs that we do work with long-standing history, terrific track records, many of them go back to prior to the relationships go back prior to the formation of Palomar. But no, we think we are seeing in the business that we want.

And I think ultimately, most -- again, most of the MGA business we are doing is layered and shared property where we take our pro rata participation. So it allows us to add incremental limit or replace limit in like a large tower of property exposure. So there's not saturation circumstance.

[Operator]

[Operator Instructions] Our next question is from Meyer Shields with KBW.

[Meyer Shields, analyst]

Great. Is there any room to adjust the inflation guard when we're seeing the sort of building materials cost inflations that we're seeing now?

[D. Armstrong, executive]

The inflation guard, depending on the state need to be approved by the Department of Insurance. And so we have an automatic 5% increase in residential earthquake in California. I mean, that is similar one for Hawaii. I will say for our more complicated risk and residential quake, we're writing them E&S. And by writing the E&S, so we can -- which we always do factor in the cost of inflation. And level in not only demand surge but a rising cost of goods and replacement cost of goods.

I think just overarchingly, as you think about inflation, it's all already been in our portfolio with the inflation guard that you talk about, but also how we use demand surge in setting the base level AAL for a risk. We price risk off of AAL by having demand surge and that reflects heightened cost of labor, heightened cost of material goods, when there is a catastrophe. So that lever, if you would, is factored into all of our unit level pricing.

So we think that we can adjust for it. I think the other thing that I would add to is just the short-tail nature of our business will allow us to cycle through inflationary increases probably quicker than others that may be exposed to social inflation or just a longer tail of loss cost development. I know that's more than you asked, but I thought I'd add that.

[Meyer Shields, analyst]

No, always welcome more than I asked, but just a limitation of my own questions. And just -- I know we touched on this earlier. I just want to make sure for modeling purposes. When we take out the nonrecurring charge, obviously, we get a lower operating expense ratio, is this charge not likely to occur even if we have multiple storms or other issues? And I'm taking into context the reduced exposure in Louisiana and so on?

[T. Uchida, executive]

Yes. So I think this nonrecurring charge that we're talking about is a lot of this or most if not all is really related to Uri. So those events can happen again. I think the way we have restructured our reinsurance program now is less likely. And I think there's a couple of factors we don't have any co pars right now, no reinstatement obviously coming into play.

And then also we have the aggregate later, more importantly, that will limit the downside impact of multiple events on our portfolio. So I think those 3 factors don't know, eliminating completely, but I think they basically provide that we don't feel that this is going to happen. It's definitely not something we're building into the models that we're using because it would take a unique set of events for something like that to occur again.

[D. Armstrong, executive]

Well, I think I don't foresee happening for the reasons Chris talked about, but also the loss came from the line of business that we're exiting. More than 80% of the loss came from the admitted All Risk business. So that's a line that we're out of. So it's not to say that we couldn't see E&S losses from a winter storm like that, but it's not going to be a similar type of exposure. So it is -- fundamentally, it is absolutely nonrecurring.

[Operator]

Our next question is from Pablo Singzon with JPMorgan.

[Pablo Singzon, analyst]

Another question on the attritional loss ratio this time more short term. I want to make sure I understood you correctly. So if you take 14%, 15% as a base, would it be reasonable to assume a step-up in the second half of this year just because of the reinsurance program kicking in? And I guess, should you also think about some elements of seasonality given that weather losses tend to be more concentrated in the second half of the year?

[T. Uchida, executive]

Well, so I would say that for our book of business, when we talk about it, the attritional losses are usually weighted more to the first half of the year. There is going to be a lot more total hail. Obviously, we do have a significant Texas exposure for our purposes. So if you're thinking about it from an attritional standpoint, we view it as more a first half of the year type of phenomenon.

So with that, I would say, generally speaking, we do see loss planning to improvement in our book for the second half of the year. Definitely, you see that in Q4. With that, I did indicate that we did change our participation in some of the quota shares. So I wouldn't expect our loss ratio to go up. But I would expect it to kind of be in that range of where we were before, let's call it, 11% to 13% to 14%, unexpected to blend out there, so there could be ups and downs, but I generally view the second half of our year from an attritional standpoint to be lower. Now obviously, we are in the midst of hurricane season. But like we said, we don't go blend into our own.

[D. Armstrong, executive]

Yes, Pablo, Again, just to add a little more color. Again, the nonrecurring reinsurance charge, that influenced the attritional loss ratio by 2 points or so. So if you back that out, the loss ratio is 13%. So you should -- sequentially, you can grow the loss ratio off a back base as opposed to a higher number. So that's why Chris feels good about that 11% to 14% range he's referring to.

[Pablo Singzon, analyst]

Okay. And then the second question, just on capital. So how should we think about the decent buybacks from here and new authorizations potentially, given that you've used up a good amount of the $40 million program that outstanding. And as you had mentioned that you still have a decent amount of capital flexibility?

[D. Armstrong, executive]

Yes. So overarchingly, I think we will continue to be opportunistic with the buyback, and also putting the opportunistic deployment of that capital vis-a-vis other investments that we're making in the business. As I said, and I'll reiterate, we feel that based on where we are from a net premiums written to surplus ratio that we have adequate capital to grow and execute the growth plans and grow 40%-plus for the rest of this year without incremental capital and beyond for that matter.

So I think it's really going to be opportunistic Pablo and it's going to be juxtaposed against new lines of business, new partnerships, new talent that we're bringing on and the greenfield opportunities we see. I think in the second quarter, we just saw that was disproportionately advantageous for us when we thought respective value, return on equity and just free cash flow generation.

[Operator]

Ladies and gentlemen, we have reached the end of the question-and-answer section. And I would like to turn the call back to management for closing remarks.

[D. Armstrong, executive]

Thanks very much, operator, and thank you, everyone, for your participation today. Hopefully, you walked away with the sense that Palomar is performing at a very high level. And that we have a considerable amount, if not a ton of conviction in all that we have in front of us. The growth is very strong. The profitable growth is equally strong. We are very focused on providing consistent earnings and look forward to sharing our results with you in the third quarter in the months to come. So be well, and thanks very much for your time.

[Operator]

This concludes today's conference. You may disconnect your lines at this time. Thank you very much for your participation, and have a great day.