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MERCURY GENERAL CORP - 10-K - Management's Discussion and Analysis of Financial Condition and Results of Operations
(Edgar Glimpses Via Acquire Media NewsEdge) Cautionary Statements
Certain statements in this Annual Report on Form 10-K or in other materials the
Company has filed or will file with the SEC (as well as information included in
oral statements or other written statements made or to be made by the Company)
contain or may contain "forward-looking statements" within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. These forward-looking statements
may address, among other things, the Company's strategy for growth, business
development, regulatory approvals, market position, expenditures, financial
results, and reserves. Forward-looking statements are not guarantees of
performance and are subject to important factors and events that could cause the
Company's actual business, prospects and results of operations to differ
materially from the historical information contained in this Annual Report on
Form 10-K and from those that may be expressed or implied by the forward-looking
statements contained in this Annual Report on Form 10-K and in other reports or
public statements made by the Company.
Factors that could cause or contribute to such differences include, among
others: the competition currently existing in the automobile insurance markets
in California and the other states in which the Company operates; the cyclical
and general competitive nature of the property and casualty insurance industry
and general uncertainties regarding loss reserves or other estimates; the
accuracy and adequacy of the Company's pricing methodologies; the Company's
success in managing its business in states outside of California; the impact of
potential third party "bad-faith" legislation, changes in laws, regulations or
new interpretations of existing laws and regulations, tax position challenges by
the California Franchise Tax Board ("FTB"), and decisions of courts, regulators
and governmental bodies, particularly in California; the Company's ability to
obtain and the timing of the approval of premium rate changes for insurance
policies issued in states where the Company operates; the Company's reliance on
independent agents to market and distribute its policies; the investment yields
the Company is able to obtain with its investments in comparison to recent
yields and the market risks associated with the Company's investment portfolio;
the effect government policies may have on market interest rates; uncertainties
related to assumptions and projections generally, inflation and changes in
economic conditions; changes in driving patterns and loss trends; acts of war
and terrorist activities; court decisions, trends in litigation, and health care
and auto repair costs; adverse weather conditions or natural disasters,
including those which may be related to climate change, in the markets served by
the Company; the stability of the Company's information technology systems and
the ability of the Company to execute on its information technology initiatives;
the Company's ability to realize current deferred tax assets or to hold certain
securities with current loss positions to recovery or maturity; and other
uncertainties, all of which are difficult to predict and many of which are
beyond the Company's control. GAAP prescribes when a Company may reserve for
particular risks including litigation exposures. Accordingly, results for a
given reporting period could be significantly affected if and when a reserve is
established for a major contingency. Reported results may therefore appear to be
volatile in certain periods.
From time to time, forward-looking statements are also included in the Company's
quarterly reports on Form 10-Q and current reports on Form 8-K, in press
releases, in presentations, on its web site, and in other materials released to
the public. The Company undertakes no obligation to publicly update any
forward-looking statements, whether as a result of new information or future
events or otherwise. Investors are cautioned not to place undue reliance on any
forward-looking statements, which speak only as of the date of this Annual
Report on Form 10-K or, in the case of any document the Company incorporates by
reference, any other report filed with the SEC or any other public statement
made by the Company, the date of the document, report or statement. Investors
should also understand that it is not possible to predict or identify all
factors and should not consider the risks set forth above to be a complete
statement of all potential risks and uncertainties. If the expectations or
assumptions underlying the Company's forward-looking statements prove inaccurate
or if risks or uncertainties arise, actual results could differ materially from
those predicted in any forward-looking statements. The factors identified above
are believed to be some, but not all, of the important factors that could cause
actual events and results to be significantly different from those that may be
expressed or implied in any forward-looking statements.
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OVERVIEW
A. General
The operating results of property and casualty insurance companies are subject
to significant quarter-to-quarter and year-to-year fluctuations due to the
effect of competition on pricing, the frequency and severity of losses, the
effect of weather and natural disasters on losses, general economic conditions,
the general regulatory environment in states in which an insurer operates, state
regulation of premium rates, changes in fair value of investments, and other
factors such as changes in tax laws. The property and casualty industry has been
highly cyclical, with periods of high premium rates and shortages of
underwriting capacity followed by periods of severe price competition and excess
capacity. These cycles can have a large impact on the Company's ability to grow
and retain business.
The Company is headquartered in Los Angeles, California and operates primarily
as a personal automobile insurer selling policies through a network of
independent agents in thirteen states. The Company also offers homeowners,
commercial automobile and property, mechanical breakdown, fire, and umbrella
insurance. Private passenger automobile lines of insurance accounted for 81.6%
of the $2.6 billion of the Company's direct premiums written in 2011. 76.7% of
the private passenger automobile premiums were written in California. The
Company operates primarily in California, the only state in which it operated
prior to 1990. The Company has since expanded its operations into the following
states: Georgia and Illinois (1990), Oklahoma and Texas (1996), Florida (1998),
Virginia and New York (2001), New Jersey (2003), and Arizona, Pennsylvania,
Michigan, and Nevada (2004).
The Company expects to continue its growth by expanding into new states in
future years with the objective of achieving greater geographic diversification.
There are challenges and risks involved in entering each new state, including
establishing adequate rates without any operating history in the state, working
with a new regulatory regime, hiring and training competent personnel, building
adequate systems, and finding qualified agents to represent the Company. The
Company does not expect to enter into any new states during 2012.
This section discusses some of the relevant factors that management considers in
evaluating the Company's performance, prospects, and risks. It is not
all-inclusive and is meant to be read in conjunction with the entirety of
management's discussion and analysis, the Company's consolidated financial
statements and notes thereto, and all other items contained within this Annual
Report on Form 10-K.
2011 Financial Performance Summary
The Company's net income for the year ended December 31, 2011 increased to
$191.2 million, or $3.49 per diluted share, from $152.2 million, or $2.78 per
diluted share, for the same period in 2010. Approximately $141 million in
pre-tax investment income was generated during 2011 on a portfolio of
approximately $3.1 billion at fair value at December 31, 2011, compared to $144
million pre-tax investment income during 2010 on a portfolio of approximately
$3.2 billion at fair value at December 31, 2010. Included in net income are net
realized investment gains of $58.4 million and $57.1 million in 2011 and 2010,
respectively. Net realized investment gains include gains of $31.3 million and
$46.6 million in 2011 and 2010, respectively, due to changes in the fair value
of total investments pursuant to application of the fair value accounting
option.
During 2011, the Company continued its marketing efforts to enhance name
recognition and lead generation. The Company believes that its marketing
efforts, combined with its ability to maintain relatively low prices and a
strong reputation, make the Company very competitive in California and in other
states.
The Company believes its thorough underwriting process gives it an advantage
over competitors. The Company views its agent relationships and underwriting
process as one of its primary competitive advantages because it allows the
Company to charge lower rates yet realize better margins than many competitors.
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The Company's operating results and growth have allowed it to consistently
generate positive cash flow from operations, which was approximately $159
million and $92 million in 2011 and 2010, respectively. Cash flow from
operations has been used to pay shareholder dividends, retire debt, and help
support growth.
Economic and Industry Wide Factors
• Regulatory Uncertainty-The insurance industry is subject to strict state
regulation and oversight and is governed by the laws of each state in
which each insurance company operates. State regulators generally have substantial power and authority over insurance companies including, in
some states, approving rate changes and rating factors, and establishing
minimum capital and surplus requirements. In many states, insurance
commissioners may emphasize different agendas or interpret existing
regulations differently than previous commissioners. The Company has a
successful track record of working with difficult regulations and new insurance commissioners. However, there is no certainty that current or
future regulations and the interpretation of those regulations by
insurance commissioners and the courts will not have an adverse impact on
the Company.
• Cost Uncertainty-Because insurance companies pay claims after premiums are
collected, the ultimate cost of an insurance policy is not known until
well after the policy revenues are earned. Consequently, significant
assumptions are made when establishing insurance rates and loss
reserves. While insurance companies use sophisticated models and
experienced actuaries to assist in setting rates and establishing loss
reserves, there can be no assurance that current rates or current reserve
estimates will be adequate. Furthermore, there can be no assurance that insurance regulators will approve rate increases when the Company's
actuarial analysis shows that they are needed.
• Economic Conditions-Though many businesses are still experiencing the slow
recovery from the severe economic recession, the recent sovereign debt
crisis in Europe is leading to weaker global economic growth, heightened
financial vulnerabilities and some negative rating actions. The Company is
unable to predict the duration and severity of the current disruption in
the financial markets and its impact on the United States, and California,
where the majority of the Company's business is produced. If economic
conditions do not show improvement, there could be an adverse impact on
the Company's financial condition, results of operations, and liquidity.
• Inflation-The largest cost component for automobile insurers is losses,
which include medical costs, replacement automobile parts, and labor
costs. There can be significant variation in the overall increases in
medical cost inflation, and it is often a year or more after the respective fiscal period ends before sufficient claims have closed for the
inflation rate to be known with a reasonable degree of
certainty. Therefore, it can be difficult to establish reserves and set
premium rates, particularly when actual inflation rates may be higher or
lower than anticipated.
• Loss Frequency-Another component of overall loss costs is loss frequency,
which is the number of claims per risk insured. There has been a long-term
trend of declining loss frequency in the personal automobile insurance
industry. In recent years, the trend has shown increasing loss frequency;
however, the Company is unable to predict the trend of loss frequency in
the future.
• Underwriting Cycle and Competition-The property and casualty insurance industry is highly cyclical, with alternating hard and soft market
conditions. The Company has historically seen significant premium growth
during hard markets. Premium growth rates in soft markets have ranged from
slightly positive to negative and were consistent in 2011.
Technology
In 2011, the Company continued to enhance its internet agency portal, Mercury
First. Mercury First is a single entry point for agents providing a broad suite
of capabilities. One of its most powerful tools is a point of sale (POS) system
that allows agents to easily obtain and compare quotes and write new
business. Mercury First
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is designed as an easy-to-use agency portal that provides a customized work
queue for each agency user showing new business leads, underwriting requests and
other pertinent customer information in real time. Agents can also assist
customers with processing payments, reporting claims or updating their
records. The system enables quick access to documents and forms and empowers the
agents with several self-service capabilities.
The NextGen system is designed to be a multi-state, multi-line system. NextGen
serves as the primary platform for all underwriting, billing, claims, and
commission functions supporting the private passenger auto line in seven states
(Virginia, New York, Florida, California, Georgia, Illinois, and Texas).
During 2010, the Company launched Guidewire, a commercially available software
solution, to replace legacy platforms and implemented it for the Nevada
homeowners line. In 2011, the Company expanded the Guidewire implementation to
Texas, Georgia, Illinois, Pennsylvania, and Oklahoma for the homeowners line of
business and for the Texas commercial auto line of business. The Company plans
to expand Guidewire to other states and lines of business during 2012.
In 2011, as part of its continuing commitment to service excellence, the Company
piloted in Georgia a new web capability for customers to bind and pay for new
policies online. These policies will be serviced by the Company's independent
agents. The Company plans to expand this capability to other states in the
future.
B. Regulatory and Legal Matters
The process for implementing rate changes varies by state, with California,
Georgia, New York, New Jersey, Pennsylvania, and Nevada requiring prior approval
from the respective DOI before a rate may be implemented. Illinois, Texas,
Virginia, Arizona, and Michigan only require that rates be filed with the DOI.
Oklahoma and Florida have a modified version of prior approval laws. In all
states, the insurance code provides that rates must not be excessive,
inadequate, or unfairly discriminatory. For the Company's two largest lines of
business, personal automobile and homeowners, the Company filed rate changes
that were neutral in seven states and increases in thirteen states during 2011.
The California DOI uses rating factor regulations requiring automobile insurance
rates to be determined in decreasing order of importance by (1) driving safety
record, (2) miles driven per year, (3) years of driving experience, and
(4) other factors as determined by the California DOI to have a substantial
relationship to the risk of loss and adopted by regulation.
During 2011, the Company received approval from the California DOI to implement
a revenue neutral personal automobile class plan filing. The Company expects the
plan will improve the pricing structure to better align premium rates charged
with risks insured. The new plan will lead to decreased rates for some risks and
increased rates for others. As a result, the Company may experience a short-term
decrease in the number of policies renewed. Preliminary indications are that
policy renewals have only decreased slightly; however, it is currently unknown
what the full extent, if any, of the possible decrease will be. The plan was
implemented in December 2011 and is expected to make the Company more
competitive in attracting new personal automobile insurance business.
On April 9, 2010, the California DOI issued a Notice of Non-Compliance ("2010
NNC") to MIC, MCC, and CAIC based on a Report of Examination of the Rating and
Underwriting Practices of these companies issued by the California DOI on
February 18, 2010. The 2010 NNC includes allegations of 35 instances of
noncompliance with applicable California insurance law and seeks to require that
each of MIC, MCC, and CAIC change its rating and underwriting practices to
rectify the alleged noncompliance and may also seek monetary penalties. On
April 30, 2010, the Company submitted a Statement of Compliance and Notice of
Defense to the 2010 NNC, in which it denied the allegations contained in the
2010 NNC and provided specific defenses to each allegation. The Company also
requested a hearing in the event that the Statement of Compliance and Notice of
Defense does not establish to the satisfaction of the California DOI that the
alleged noncompliance does not exist, and the matters
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described in the 2010 NNC are not otherwise able to be resolved informally with
the California DOI. The California DOI has recently advised the Company that it
is continuing to review this matter and it continues to question certain past
practices. No final determination has been made by the California DOI on how it
will proceed going forward. The Company anticipates that it will be advised by
the California DOI in the near future as to how the California DOI intends to
proceed. The Company denies the allegations in the 2010 NNC and believes that it
has done nothing to warrant the penalties cited in the 2010 NNC.
In March 2006, the California DOI issued an Amended Notice of Non-Compliance to
a Notice of Non-Compliance originally issued in February 2004 (as amended, "2004
NNC") alleging that the Company charged rates in violation of the California
Insurance Code, willfully permitted its agents to charge broker fees in
violation of California law, and willfully misrepresented the actual price
insurance consumers could expect to pay for insurance by the amount of a fee
charged by the consumer's insurance broker. The California DOI seeks to impose a
fine for each policy in which the Company allegedly permitted an agent to charge
a broker fee, which the California DOI contends is the use of an unapproved
rate, rating plan or rating system. Further, the California DOI seeks to impose
a penalty for each and every date on which the Company allegedly used a
misleading advertisement alleged in the 2004 NNC. Finally, based upon the
conduct alleged, the California DOI also contends that the Company acted
fraudulently in violation of Section 704(a) of the California Insurance Code,
which permits the California Commissioner of Insurance to suspend certificates
of authority for a period of one year. The Company filed a Notice of Defense in
response to the 2004 NNC. The Company does not believe that it has done anything
to warrant a monetary penalty from the California DOI. The San Francisco
Superior Court, in Robert Krumme, On Behalf Of The General Public v. Mercury
Insurance Company, Mercury Casualty Company, and California Automobile Insurance
Company, denied plaintiff's requests for restitution or any other form of
retrospective monetary relief based on the same facts and legal theory. While
this matter has been the subject of multiple continuations since the original
Notice of Non-Compliance was issued in 2004, the Company believes it has
received some favorable evidentiary related rulings from the administrative law
judge that may impact the outcome of this matter. On June 7, 2011, the Company
filed a number of motions, including motions designed to dispose of the 2004 NNC
or to substantially pare it down. Briefing on the motions is complete and the
Company has requested oral argument, but no hearing has been set. On January 31,
2012, the administrative law judge issued a bifurcation order which ordered a
separate hearing on the California DOI's order to show cause and accusation,
concerning the California DOI's false advertising allegations, to be scheduled
after the Commissioner's disposition of the proposed decision on the notice of
noncompliance, which concern the California DOI's allegations that Mercury used
unlawful rates.
In the 2004 and 2010 NNC matters, the Company believes that no monetary
penalties are warranted and intends to defend the issues vigorously. The Company
has been subject to fines and penalties by the California DOI in the past due to
alleged violations of the California Insurance Code. The largest and most recent
of these was settled in 2008 for $300,000. However, prior settlement amounts are
not necessarily indicative of the potential results in the current Notice of
Non-Compliance matters. Based upon its understanding of the facts and the
California Insurance Code, the Company does not expect that the ultimate
resolution of the 2004 and 2010 NNC matters will be material to the Company's
financial position. The Company has accrued a liability for the estimated cost
to defend itself in the regulatory matters described above.
The Company is, from time to time, named as a defendant in various lawsuits or
regulatory actions incidental to its insurance business. The majority of
lawsuits brought against the Company relate to insurance claims that arise in
the normal course of business and are reserved for through the reserving
process. For a discussion of the Company's reserving methods, see "Critical
Accounting Estimates" and Note 1 of Notes to Consolidated Financial Statements.
The Company also establishes reserves for non-insurance claims related lawsuits,
regulatory actions, and other contingencies for which the Company is able to
estimate its potential exposure and when the Company believes a loss is
probable. For loss contingencies believed to be reasonably possible, the Company
also discloses the nature of the loss contingency and an estimate of the
possible loss, range of loss, or a statement that such an
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estimate cannot be made. While actual losses may differ from the amounts
recorded and the ultimate outcome of the Company's pending actions is generally
not yet determinable, the Company does not believe that the ultimate resolution
of currently pending legal or regulatory proceedings, either individually or in
the aggregate, will have a material adverse effect on its financial condition,
results of operations, or cash flows.
In all cases, the Company vigorously defends itself unless a reasonable
settlement appears appropriate. For a discussion of legal matters, see Note 17
of Notes to Consolidated Financial Statements-Commitments and
Contingencies-Litigation.
C. Critical Accounting Estimates
Reserves
Preparation of the Company's consolidated financial statements requires judgment
and estimates. The most significant is the estimate of loss reserves. Estimating
loss reserves is a difficult process as many factors can ultimately affect the
final settlement of a claim and, therefore, the reserve that is
required. Changes in the regulatory and legal environment, results of
litigation, medical costs, the cost of repair materials, and labor rates, among
other factors, can impact ultimate claim costs. In addition, time can be a
critical part of reserving determinations since the longer the span between the
incidence of a loss and the payment or settlement of a claim, the more variable
the ultimate settlement amount could be. Accordingly, short-tail claims, such as
property damage claims, tend to be more reasonably predictable than long-tail
liability claims.
The Company calculates a point estimate rather than a range of loss reserve
estimate. There is inherent uncertainty with estimates and this is particularly
true with estimates for loss reserves. This uncertainty comes from many factors
which may include changes in claims reporting and settlement patterns, changes
in the regulatory or legal environment, uncertainty over inflation rates and
uncertainty for unknown items. The Company does not make specific provisions for
these uncertainties, rather it considers them in establishing its reserve by
looking at historical patterns and trends and projecting these out to current
reserves. The underlying factors and assumptions that serve as the basis for
preparing the reserve estimate include paid and incurred loss development
factors, expected average costs per claim, inflation trends, expected loss
ratios, industry data, and other relevant information.
The Company also engages independent actuarial consultants to review the
Company's reserves and to provide the annual actuarial opinions required under
state statutory accounting requirements. The Company does not rely on actuarial
consultants for GAAP reporting or periodic report disclosure purposes. The
Company analyzes loss reserves quarterly primarily using the incurred loss,
claim count, and average severity methods described below. The Company also uses
the paid loss development method to analyze loss adjustment expenses reserves as
part of its reserve analysis. When deciding which method to use in estimating
its reserves, the Company evaluates the credibility of each method based on the
maturity of the data available and the claims settlement practices for each
particular line of business or coverage within a line of business. When
establishing the reserve, the Company will generally analyze the results from
all of the methods used rather than relying on one method. While these methods
are designed to determine the ultimate losses on claims under the Company's
policies, there is inherent uncertainty in all actuarial models since they use
historical data to project outcomes. The Company believes that the techniques it
uses provide a reasonable basis in estimating loss reserves.
• The incurred loss development method analyzes historical incurred case
loss (case reserves plus paid losses) development to estimate ultimate
losses. The Company applies development factors against current case
incurred losses by accident period to calculate ultimate expected losses.
The Company believes that the incurred loss development method provides a
reasonable basis for evaluating ultimate losses, particularly in the
Company's larger, more established lines of business which have a long
operating history.
• The average severity method analyzes historical loss payments and/or
incurred losses divided by closed claims and/or total claims to calculate
an estimated average cost per claim. From this, the expected
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ultimate average cost per claim can be estimated. The average severity
method coupled with the claim count development method provide meaningful
information regarding inflation and frequency trends that the Company
believes is useful in establishing reserves. The claim count development
method analyzes historical claim count development to estimate future
incurred claim count development for current claims. The Company applies
these development factors against current claim counts by accident period
to calculate ultimate expected claim counts.
• The paid loss development method analyzes historical payment patterns to
estimate the amount of losses yet to be paid. The Company uses this method
for losses and loss adjustment expenses.
The Company analyzes catastrophe losses separately from non-catastrophe
losses. For catastrophe losses, the Company determines claim counts based on
claims reported and development expectations from previous catastrophes and
applies an average expected loss per claim based on reserves established by
adjusters and average losses on previous similar catastrophes.
There are many factors that can cause variability between the ultimate expected
loss and the actual developed loss. While there are certainly other factors, the
Company believes that the following three items tend to create the most
variability between expected losses and actual losses.
(1) Inflation
For the Company's California automobile lines of business, total reserves are
comprised of the following:
• BI reserves-approximately 60% of total reserves
• Material damage (MD) reserves, including collision and comprehensive property damage-approximately 20% of total reserves
• Loss adjustment expenses reserves-approximately 20% of total reserves.
Loss development on MD reserves is generally insignificant because MD claims are
generally settled in a shorter period than BI reserves. The majority of the loss
adjustment expenses reserves are estimated costs to defend BI claims, which tend
to require longer periods of time to settle as compared to MD claims.
BI loss reserves are generally the most difficult to estimate because they take
longer to close than other coverages. BI coverage in the Company's policies
includes injuries sustained by any person other than the insured, except in the
case of uninsured or underinsured motorist BI coverage, which covers damages to
the insured for BI caused by uninsured or underinsured motorists. BI payments
are primarily for medical costs and general damages.
The following table presents the typical closure patterns of BI claims in the
California automobile insurance coverage:
% of Total
Claims Closed Dollars Paid
BI claims closed in the accident year reported 35% to 41% 14%
BI claims closed one year after the accident year
reported 75% to 80% 55%
BI claims closed two years after the accident
year reported 93% to 95% 83%
BI claims closed three years after the accident
year reported 99% 96%
BI claims closed in the accident year reported are generally the smaller and
less complex claims that settle for approximately $2,500 to $3,000, on average,
whereas the total average settlement, once all claims are closed in a particular
accident year, is approximately $7,500 to $9,000. The Company creates incurred
and paid loss triangles to estimate ultimate losses utilizing historical payment
and reserving patterns and evaluates the results of this analysis against its
frequency and severity analysis to establish BI reserves. The Company adjusts
development factors to account for inflation trends it sees in loss severity. As
a larger proportion of claims from an accident year are settled, there becomes a
higher degree of certainty for the reserves established for that
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accident year. Consequently, there is a decreasing likelihood of reserve
development on any particular accident year, as those periods age. At
December 31, 2011, the Company believes that the accident years that are most
likely to develop are the 2009 through 2011 accident years; however, it is
possible that older accident years could develop as well.
In general, the Company expects that historical claims trends will continue with
costs tending to increase, which is generally consistent with historical data,
and therefore the Company believes that it is more reasonable to expect
inflation than deflation. Many potential factors can affect the BI inflation
rate, including changes in: claims handling process, statutes and regulations,
the number of litigated files, general economic factors, timeliness of claims
adjudication, vehicle safety, weather patterns, and gasoline prices, among other
factors; however, the magnitude of such impact on the inflation rate is unknown.
It is a common practice in the insurance industry for companies to provide small
settlement offers at the inception of a claim to BI claimants who have minor
injuries. These claims are settled quickly, reducing the likelihood that BI
claimants require larger settlements later on. It also results in some claimants
receiving payments that would not have received any payments if an extended
adjudication of the claim had occurred. When a large percentage of the total
claims are small dollar value claims resulting from this practice, it has the
effect of lowering the total average cost for all claims (severity) but
increasing the total number of claims (frequency). Mercury has historically used
this approach to handle its BI claims.
Beginning late in 2008 and continuing through the end of 2009, the Company
changed its claims handling procedures and discontinued the practice of
providing small settlement offers to BI claimants at the inception of the claim.
This had the effect of increasing loss severity and decreasing loss frequency
for the 2009 accident year. The prior practice was reinstated in 2010, which
resulted in decreased loss severity and increased loss frequency in 2010
compared to 2009. In 2011, the practice continued with even greater emphasis on
settling small claims quickly. As a result, the loss severity comparisons from
2008 through 2011 are impacted, with 2009 showing much higher severities than
had been the trend and 2011 and 2010 showing negative inflation trends when
compared to 2010 and 2009. Consequently, the Company believes that inflation
trend comparison between 2011 and 2008, when the same claims handling process
was practiced, is more indicative of the actual severity trend. This comparison
indicates an annualized inflation trend of 2.4%.
The Company believes that it is reasonably possible that the California
automobile BI severity could vary from recorded amounts by as much as 10%, 7%,
and 5% for 2011, 2010, and 2009, respectively. For example, at December 31,
2011, the loss severity for the amounts recorded at December 31, 2010 increased
by 5.2%, 6.8% and 3.8% for the 2010, 2009, and 2008 accident years,
respectively. Comparatively, at December 31, 2010, the loss severity decreased
for the amount recorded at December 31, 2009 by 2.6%, 0.8% and 0.1% for the
2009, 2008, and 2007 accident years, respectively. The following table presents
the effects on the 2011, 2010, and 2009 accident year California BI loss
reserves based on possible variations in the severity recorded; however, the
variation could be more or less than these amounts.
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California Bodily Injury Inflation Reserve Sensitivity Analysis
(A) Pro-forma (B) Pro-forma
severity if actual severity if actual Favorable loss Unfavorable loss
Actual severity is lower by severity is higher by development if development if
Number of Recorded Implied 10% for 2011, 10% for 2011, actual severity is actual severity is
Accident Claims Severity at Inflation Rate 7% for 2010, and 7% for 2010, and less than recorded more than recorded
Year Expected 12/31/11 Recorded (1) 5% for 2009 5% for 2009 (Column A) (Column B)
2011 26,634 $ 8,450 -2.1 % $ 7,605 $ 9,295 $ 22,506,000 $ (22,506,000 )
2010 26,946 $ 8,632 -3.4 % $ 8,028 $ 9,236 $ 16,275,000 $ (16,275,000 )
2009 25,526 $ 8,933 13.2 % $ 8,486 $ 9,380 $ 11,410,000 $ (11,410,000 )
2008 N/A $ 7,891 - - - - -
Total Loss Development-Favorable (Unfavorable) $ 50,191,000 $ (50,191,000 )
(1) The change in the implied inflation rate in 2010 and 2009 is skewed by the
change in claims handling process noted above. The Company believes the
comparison between 2011 and 2008 is more indicative of the actual severity
trend. This results in an annualized implied inflation rate of 2.4%.
(2) Claim Count Development
The Company generally estimates ultimate claim counts for an accident period
based on development of claim counts in prior accident periods. For California
automobile BI claims, the Company has experienced that approximately 2% to 4%
additional claims will be reported in the year subsequent to an accident year.
However, such late reported claims could be more or less than the Company's
expectations. Typically, almost every claim is reported within one year
following the end of an accident year and at that point the Company has a high
degree of certainty as to what the ultimate claim count will be. The following
table presents the number of BI claims reported at the end of the accident
period and one year later:
California Bodily Injury Claim Count Development Table
Number of claims Number of claims Percentage increase in
reported at December 31 reported at December 31 number of claims
Accident year of each accident year one year later reported
2008 29,647 30,229 2.0 %
2009 25,684 26,555 3.4 %
2010 28,182 29,090 3.2 %
There are many other potential factors that can affect the number of claims
reported after a period end. These factors include changes in weather patterns,
a change in the number of litigated files, the number of automobiles insured,
and whether the last day of the year falls on a weekday or a weekend. However,
the Company is unable to determine which, if any, of the factors actually impact
the number of claims reported and, if so, by what magnitude.
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At December 31, 2011, there were 27,977 BI claims reported for the 2011 accident
year and the Company estimates that these are expected to ultimately grow by
2.6%. The Company believes that while actual development in recent years has
ranged between approximately 2% and 4%, it is reasonable to expect that the
range could be as great as between 0% and 10%. Actual development may be more or
less than the expected range. The following table presents the effect on loss
development based on different claim count within the broader possible range at
December 31, 2011:
California Bodily Injury Claim Count Reserve Sensitivity Analysis
Amount Recorded Total Expected Total Expected
at 12/31/11 at 2.6% Amount If Claim Amount If Claim
Claim Count Count Development is Count Development is
2011 Accident Year Claims Reported Development 0% 10%
Claim Count 27,977 28,711 27,977 30,775
Approximate average cost per
claim Not meaningful $ 8,450 $ 8,450 $ 8,450
Total dollars Not meaningful $ 242,608,000 $ 236,406,000 $ 260,049,000
Total Loss Development-Favorable (Unfavorable)
$ 6,202,000 $ (17,441,000 )
(3) Unexpected Large Losses From Older Accident Periods
Unexpected large losses are generally not provided for in the current reserve
because they are not known or expected and tend to be unquantifiable. Once
known, the Company establishes a provision for the losses, but it is not
possible to provide any meaningful sensitivity analysis as to the potential size
of any unexpected losses. These losses can be caused by many factors, including
unexpected legal interpretations of coverage, ineffective claims handling,
regulation extending claims reporting periods, assumption of unexpected or
unknown risks, adverse court decisions as well as many unknown factors.
Unexpected large losses are fairly infrequent but can have a large impact on the
Company's losses. To mitigate this risk, the Company has established claims
handling and review procedures. However, it is still possible that these
procedures will not prove entirely effective, and the Company may have material
unexpected large losses in future periods. It is also possible that the Company
has not identified and established a sufficient reserve for all unexpected large
losses occurring in the older accident years, even though a comprehensive claims
file review was undertaken. The Company may experience additional development on
these reserves.
Discussion of losses and loss reserves and prior period loss development at
December 31, 2011
At December 31, 2011 and 2010, the Company recorded its point estimate of
approximately $985 million and $1,034 million, respectively, in losses and loss
adjustment expenses liabilities which include approximately $344 million and
$308 million, respectively, of IBNR loss reserves. IBNR includes estimates,
based upon past experience, of ultimate developed costs which may differ from
case estimates, unreported claims which occurred on or prior to December 31,
2011 and estimated future payments for reopened claims. Management believes that
the liability for losses and loss adjustment expenses is adequate to cover the
ultimate net cost of losses and loss adjustment expenses incurred to date;
however, since the provisions are necessarily based upon estimates, the ultimate
liability may be more or less than such provisions.
During 2011, the Company experienced severe losses due to Georgia tornadoes,
Hurricane Irene, and California winter storms occurring between November 30 and
December 3, which resulted in increased homeowners and automobile claims. The
Company estimates that total losses from these storms are approximately $18
million.
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The Company evaluates its reserves quarterly. When management determines that
the estimated ultimate claim cost requires a decrease for previously reported
accident years, favorable development occurs and a reduction in losses and loss
adjustment expenses is reported in the current period. If the estimated ultimate
claim cost requires an increase for previously reported accident years,
unfavorable development occurs and an increase in losses and loss adjustment
expenses is reported in the current period. For 2011, the Company reported
unfavorable development of approximately $18 million on the 2010 and prior
accident years' losses and loss adjustment expenses reserves which at
December 31, 2010 totaled approximately $1.0 billion. The unfavorable
development in 2011 is largely the result of re-estimates of accident years 2008
through 2010 California BI losses which have experienced higher average
severities than were originally estimated at December 31, 2010.
Premiums
The Company's insurance premiums are recognized as income ratably over the term
of the policies and in proportion to the amount of insurance protection
provided. Unearned premiums are carried as a liability on the balance sheet and
are computed on a monthly pro-rata basis. The Company evaluates its unearned
premiums periodically for premium deficiencies by comparing the sum of expected
claim costs, unamortized acquisition costs, and maintenance costs partially
offset by investment income related to unearned premiums. To the extent that any
of the Company's lines of business become substantially unprofitable, a premium
deficiency reserve may be required. The Company established a premium deficiency
reserve of $6.0 million for its Florida homeowners operations in 2010. The
remaining reserve at December 31, 2011 was $2.5 million. The Company expects to
complete its withdrawal from the Florida homeowners market by September 2012.
Investments
The Company's fixed maturity and equity investments are classified as "trading"
and carried at fair value as required when applying the fair value option, with
changes in fair value reflected in net realized investment gains or losses in
the consolidated statements of operations. The majority of equity holdings,
including non-redeemable fund preferred stocks, are actively traded on national
exchanges or trading markets, and are valued at the last transaction price on
the balance sheet dates.
Fair Value of Financial Instruments
The financial instruments recorded in the consolidated balance sheets include
investments, receivables, interest rate swap agreements, accounts payable,
equity contracts, and secured and unsecured notes payable. The fair value of a
financial instrument is the price that would be received to sell an asset or
paid to transfer a liability in an orderly transaction between market
participants at the measurement date. Due to their short-term maturity, the
carrying values of receivables and accounts payable approximate their fair
market values. All investments are carried on the consolidated balance sheets at
fair value, as disclosed in Note 1 of Notes to Consolidated Financial
Statements.
The Company's financial instruments include securities issued by the U.S.
government and its agencies, securities issued by states and municipal
governments and agencies, certain corporate and other debt securities, corporate
equity securities, and exchange traded funds. Approximately 98% of the fair
value of the financial instruments held at December 31, 2011 is based on
observable market prices, observable market parameters, or is derived from such
prices or parameters. The availability of observable market prices and pricing
parameters can vary across different financial instruments. Observable market
prices and pricing parameters of a financial instrument, or a related financial
instrument, are used to derive a price without requiring significant judgment.
The Company may hold or acquire financial instruments that lack observable
market prices or market parameters currently or in future periods because they
are less actively traded. The fair value of such instruments is determined using
techniques appropriate for each particular financial instrument. These
techniques may
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involve some degree of judgment. The price transparency of the particular
financial instrument will determine the degree of judgment involved in
determining the fair value of the Company's financial instruments. Price
transparency is affected by a wide variety of factors, including, for example,
the type of financial instrument, whether it is a new financial instrument and
not yet established in the marketplace, and the characteristics particular to
the transaction. Financial instruments for which actively quoted prices or
pricing parameters are available or for which fair value is derived from
actively quoted prices or pricing parameters will generally have a higher degree
of price transparency. By contrast, financial instruments that are thinly traded
or not quoted will generally have diminished price transparency. Even in
normally active markets, the price transparency for actively quoted instruments
may be reduced from time to time during periods of market
dislocation. Alternatively, in thinly quoted markets, the participation of
market makers willing to purchase and sell a financial instrument provides a
source of transparency for products that otherwise is not actively quoted. For a
further discussion, see Note 3 of Notes to Consolidated Financial Statements.
Income Taxes
At December 31, 2011, the Company's deferred income taxes were in a net asset
position materially due to unearned premiums, expense accruals, loss reserve
discounting, and tax credit carryforward. The Company assesses the likelihood
that its deferred tax assets will be realized and, to the extent management does
not believe these assets are more likely than not to be realized, a valuation
allowance is established.
Management's recoverability assessment of its deferred tax assets which are
ordinary in character takes into consideration the Company's strong history of
generating ordinary taxable income and a reasonable expectation that it will
continue to generate ordinary taxable income in the future. Further, the Company
has the capacity to recoup its ordinary deferred tax assets through tax loss
carryback claims for taxes paid in prior years. Finally, the Company has various
deferred tax liabilities which represent sources of future ordinary taxable
income.
Management's recoverability assessment with regard to its capital deferred tax
assets is based on estimates of anticipated capital gains and tax-planning
strategies available to generate future taxable capital gains, both of which
would contribute to the realization of deferred tax benefits. The Company
expects to hold certain quantities of debt securities, which are currently in
loss positions, to recovery or maturity. Management believes unrealized losses
related to a significant amount of these debt securities, which represent a
portion of the unrealized loss positions at period end, are fully realizable at
maturity. The Company has a long-term horizon for holding these securities,
which management believes will allow avoidance of forced sales prior to
maturity. The Company also has unrealized gains in its investment portfolio
which could be realized through asset dispositions, at management's discretion.
Further, the Company has the capability to generate additional realized capital
gains by entering into a sale-leaseback transaction using one or more of its
appreciated real estate holdings. Finally, the Company has an established
history of generating capital gain premiums earned through its common stock call
option program. Based on the continued existence of the options market, the
substantial amount of capital committed to supporting the call option program,
and the Company's favorable track record in generating net capital gains from
this program in both upward and downward markets, management believes it will be
able to generate sufficient amounts of capital gains from this program, if
necessary, to recover recorded capital deferred tax assets.
The Company has the capability to implement tax planning strategies as it has a
steady history of generating positive cash flow from operations, as well as the
reasonable expectation that its cash flow needs can be met in future periods
without the forced sale of its investments. This capability assists management
in controlling the timing and amount of realized losses it generates during
future periods. By prudent utilization of some or all of these actions,
management believes that it has the ability and intent to generate capital
gains, and minimize tax losses, in a manner sufficient to avoid losing the
benefits of its deferred tax assets. Management will continue to assess the need
for a valuation allowance on a quarterly basis. Although realization is not
assured, management believes it is more likely than not that the Company's
deferred tax assets will be realized.
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The Company's effective income tax rate can be affected by several factors.
These generally include tax exempt investment income, non-deductible expenses,
investment gains and losses, and periodically, non-routine tax items such as
adjustments to unrecognized tax benefits related to tax uncertainties. The
effective tax rate for 2011 was 22.0%, compared to 16.6% for 2010. The increase
in the effective tax rate is mainly due to an increase in taxable income
relative to tax exempt investment income. The Company's effective tax rate for
the year ended December 31, 2011 was lower than the statutory tax rate primarily
as a result of tax exempt investment income earned.
Goodwill and Other Intangible Assets
Goodwill and other intangible assets arise as a result of business acquisitions
and consist of the excess of the cost of the acquisitions over the tangible and
intangible assets acquired and liabilities assumed and identifiable intangible
assets acquired. The Company annually evaluates goodwill and other intangible
assets for impairment. The Company also reviews its goodwill and other
intangible assets for impairment whenever events or changes in circumstances
indicate that it is more likely than not that the carrying amount of goodwill
and other intangible assets may exceed the implied fair value. As of
December 31, 2011, the fair value of the Company's reporting units exceeded
their carrying value.
Contingent Liabilities
The Company has known, and may have unknown, potential liabilities which include
claims, assessments, lawsuits, or regulatory fines and penalties relating to the
Company's business. The Company continually evaluates these potential
liabilities and accrues for them and/or discloses them in the notes to the
consolidated financial statements where required. The Company does not believe
that the ultimate resolution of currently pending legal or regulatory
proceedings, either individually or in the aggregate, will have a material
adverse effect on its financial condition, results of operations, or cash flows.
See also "Regulatory and Legal Matters" and Note 17 of Notes to Consolidated
Financial Statements.
For a discussion of recently issued accounting standards, see Note 1 of Notes to
Consolidated Financial Statements.
RESULTS OF OPERATIONSYear Ended December 31, 2011 Compared to Year Ended December 31, 2010
Revenues
Net premiums earned in 2011 were essentially the same as 2010 while net premiums
written in 2011 increased by approximately $20 million from 2010. Net premiums
written by the Company's California operations were approximately $2 billion in
2011, a 0.4% decrease from 2010. Net premiums written by the Company's
non-California operations were approximately $632 million in 2011, a 4.5%
increase from 2010. Growth outside of California has come as a result of
expanded and improved product offerings and higher average premiums per policy.
Net premiums written is a non-GAAP financial measure which represents the
premiums charged on policies issued during a fiscal period less any applicable
reinsurance. Net premiums written is a statutory measure designed to determine
production levels. Net premiums earned, the most directly comparable GAAP
measure, represents the portion of net premiums written that is recognized as
revenue in the financial statements for the period presented and earned on a
pro-rata basis over the term of the policies. The following is a reconciliation
of total net premiums written to net premiums earned:
2011 2010
(Amounts in thousands)
Net premiums written $ 2,575,383 $ 2,555,481
Change in unearned premium (9,326 ) 11,204
Net premiums earned $ 2,566,057 $ 2,566,685
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Expenses
Loss and expense ratios are used to interpret the underwriting experience of
property and casualty insurance companies. The following table presents the
Company's consolidated loss, expense, and combined ratios determined in
accordance with GAAP:
2011 2010
Loss ratio 71.3 % 71.1 %
Expense ratio 27.2 % 29.6 %
Combined ratio 98.5 % 100.7 %
Loss ratio is calculated by dividing losses and loss adjustment expenses by net
premiums earned. The Company's loss ratio for 2011 was generally consistent with
the 2010 loss ratio. The loss ratio was affected by unfavorable development of
approximately $18 million and favorable development of approximately $13 million
on prior accident years' losses and loss adjustment expense reserves for the
years ended December 31, 2011 and 2010, respectively. The unfavorable
development in 2011 is largely the result of re-estimates of California BI
losses which have experienced higher average severities than originally
estimated at December 31, 2010. The 2011 loss ratio was also negatively impacted
by severe losses due to California winter storms, Hurricane Irene, and Georgia
tornadoes during 2011. The 2010 loss ratio was impacted by severe rainstorms in
California and homeowner's losses in Florida as a result of sinkhole claims
during 2010.
Expense ratio is calculated by dividing the sum of policy acquisition costs plus
other operating expenses by net premiums earned. The Company's expense ratio for
2010 was impacted by contributions made in support of a California legislative
initiative totaling $12.1 million and would have been 29.1% without those
financial contributions. The 2011 expense ratio decreased as a result of
decreased agent contingent commissions, consulting, advertising, and information
technology expenditures.
Combined ratio is the key measure of underwriting performance traditionally used
in the property and casualty insurance industry. A combined ratio under 100%
generally reflects profitable underwriting results; and a combined ratio over
100% generally reflects unprofitable underwriting results.
Income tax expenses were $53.9 million and $30.2 million for the years ended
December 31, 2011 and 2010, respectively. The increase in income tax expense
resulted from increased taxable income in 2011.
Investments
The following table presents the investment results of the Company:
2011 2010
(Amounts in thousands) Average invested assets at cost(1) $ 3,004,588 $ 3,121,366
Net investment income:
Before income taxes $ 140,947 $ 143,814
After income taxes $ 124,708 $ 128,888
Average annual yield on investments:
Before income taxes 4.7 % 4.6 %
After income taxes 4.2 % 4.1 %
Net realized investment gains $ 58,397 $ 57,089
(1) Fixed maturities and short-term bonds at amortized cost and equities and
other short-term investments at cost.
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Included in net income are net realized investment gains of $58.4 million and
$57.1 million in 2011 and 2010, respectively. Net realized investment gains
include gains of $31.3 million and $46.6 million in 2011 and 2010, respectively,
due to changes in the fair value of total investments pursuant to application of
the fair value accounting option. The net gains during 2011 arise from a $62.1
million increase in the market value of the Company's fixed maturity securities
offset by a $30.9 million decline in the market value of the Company's equity
securities. The Company's municipal bond holdings represent the majority of the
fixed maturity portfolio, which was positively affected by the overall municipal
market improvement for 2011. The primary cause of the losses on the Company's
equity securities was the overall decline in the equity markets occurring
primarily in the third quarter of 2011.
Net Income
Net income was $191.2 million or $3.49 per diluted share and $152.2 million or
$2.78 per diluted share in 2011 and 2010, respectively. Diluted per share
results were based on a weighted average of 54.8 million shares in 2011 and
2010. Basic per share results were $3.49 and $2.78 in 2011 and 2010,
respectively. Included in net income per share were net realized investment
gains, net of income taxes, of $0.69 and $0.68 per share (basic and diluted) in
2011 and 2010, respectively.
Year Ended December 31, 2010 Compared to Year Ended December 31, 2009
Revenues
Net premiums earned and net premiums written in 2010 decreased 2.2% and 1.3%,
respectively, from 2009. Net premiums written by the Company's California
operations were approximately $2 billion in 2010, a 3.0% decrease from 2009. Net
premiums written by the Company's non-California operations were approximately
$605 million in 2010, a 4.6% increase from 2009. The decrease in net premiums
written in California is primarily due to a decrease in the number of policies
written and slightly lower average premiums per policy. Growth outside of
California has come as a result of expanded and improved product offerings and
higher average premiums per policy.
The following is a reconciliation of total net premiums written to net premiums
earned:
2010 2009
(Amounts in thousands)
Net premiums written $ 2,555,481 $ 2,589,972
Change in unearned premium 11,204 35,161
Net premiums earned $ 2,566,685 $ 2,625,133
Expenses
Loss and expense ratios are used to interpret the underwriting experience of
property and casualty insurance companies. The following table presents the
Insurance Companies' loss ratio, expense ratio, and combined ratio determined in
accordance with GAAP:
2010 2009
Loss ratio 71.1 % 67.9 %
Expense ratio 29.6 % 29.0 %
Combined ratio 100.7 % 96.9 %
The Company's loss ratio was affected by favorable development of approximately
$13 million and $58 million on prior accident years' losses and loss adjustment
expenses reserves for the year ended December 31, 2010 and 2009, respectively.
The favorable development in 2010 is largely the result of re-estimates of
accident
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year 2009 California BI losses which have experienced both lower average
severities and fewer late reported claims (claim count development) than were
originally estimated at December 31, 2009. Excluding the effect of prior
accident years' loss development, the loss ratios were 71.6% and 70.0% in 2010
and 2009, respectively. The increase is primarily due to severe losses in
California from heavy rainstorms in December 2010, and to sinkhole claims in
Florida.
The Company's expense ratio increased primarily due to the decreased net
premiums earned, the Company's financial contributions of $12.1 million related
to its support of the Continuous Auto Insurance Discount Act in California, and
a premium deficiency reserve of $6.0 million recorded in the Florida homeowners
line of business.
Income tax expenses were $30.2 million and $168.5 million for the years ended
December 31, 2010 and 2009, respectively. The decrease in income tax expense
resulted primarily from decreased net premium earned, decreased gains on the
fair value of the investment portfolio, and increased losses and loss adjustment
expenses.
Investments
The following table presents the investment results of the Company:
2010 2009
(Amounts in thousands) Average invested assets at cost(1) $ 3,121,366 $ 3,196,944
Net investment income:
Before income taxes $ 143,814 $ 144,949
After income taxes $ 128,888 $ 130,070
Average annual yield on investments:
Before income taxes 4.6 % 4.5 %
After income taxes 4.1 % 4.1 %
Net realized investment gains $ 57,089 $ 346,444
(1) Fixed maturities and short-term bonds at amortized cost and equities and
other short-term investments at cost.
Included in net income are net realized investment gains of $57.1 million and
$346.4 million in 2010 and 2009, respectively. Net realized investment gains
include gains of $46.6 million and $395.5 million in 2010 and 2009,
respectively, due to changes in the fair value of total investments pursuant to
application of the fair value accounting option. The net gains during 2010 arise
from $1.0 million and $45.7 million increases in the market value of the
Company's fixed maturity and equity securities, respectively. The primary cause
of the gains on the Company's equity securities was the overall improvement in
the equity markets.
Net Income
Net income was $152.2 million or $2.78 per diluted share and $403.1 million or
$7.32 per diluted share in 2010 and 2009, respectively. Diluted per share
results were based on a weighted average of 54.8 million shares and 55.1 million
shares in 2010 and 2009, respectively. Basic per share results were $2.78 and
$7.36 in 2010 and 2009, respectively. Included in net income per share were net
realized investment gains, net of income taxes, of $0.68 and $4.11 per basic
share, and $0.68 and $4.09 per diluted share in 2010 and 2009, respectively.
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LIQUIDITY AND CAPITAL RESOURCES
A. General
The Company is largely dependent upon dividends received from its insurance
subsidiaries to pay debt service costs and to make distributions to its
shareholders. Under current insurance law, the Insurance Companies are entitled
to pay ordinary dividends of approximately $179 million in 2012 to Mercury
General. The Insurance Companies paid Mercury General extraordinary dividends of
$270 million and no ordinary dividends during 2011. As of December 31, 2011,
Mercury General had approximately $76 million in investments and cash that could
be utilized to satisfy its direct holding company obligations.
The principal sources of funds for the Insurance Companies are premiums, sales
and maturity of invested assets, and dividend and interest income from invested
assets. The principal uses of funds for the Insurance Companies are the payment
of claims and related expenses, operating expenses, dividends to Mercury
General, payment of debt, and the purchase of investments.
B. Cash Flows
The Company has generated positive cash flow from operations for over twenty
consecutive years. Because of the Company's long track record of positive
operating cash flows, it does not attempt to match the duration and timing of
asset maturities with those of liabilities. Rather, the Company manages its
portfolio with a view towards maximizing total return with an emphasis on
after-tax income. With combined cash and short-term investments of $447.8
million at December 31, 2011, the Company believes its cash flow from operations
is adequate to satisfy its liquidity requirements without the forced sale of
investments. However, the Company operates in a rapidly evolving and often
unpredictable business environment that may change the timing or amount of
expected future cash receipts and expenditures. Accordingly, there can be no
assurance that the Company's sources of funds will be sufficient to meet its
liquidity needs or that the Company will not be required to raise additional
funds to meet those needs or for future business expansion, through the sale of
equity or debt securities or from credit facilities with lending institutions.
Net cash provided by operating activities in 2011 was $158.5 million, an
increase of $66.7 million over 2010. The increase was primarily due to the
decreased payment of tax and operating expenses. The Company reduced agent
contingent commissions, consulting, advertising, and information technology
expenditures in 2011. The Company utilized the cash provided by operating
activities primarily for the payment of dividends to its shareholders, the
purchase and development of information technology, and the retirement of debt.
Funds derived from the sale, redemption or maturity of fixed maturity
investments of $636.2 million were primarily reinvested by the Company in high
grade fixed maturity securities.
The following table presents the estimated fair value of fixed maturity
securities at December 31, 2011 by contractual maturity in the next five years.
Fixed Maturities
(Amounts in thousands)
Due in one year or less $ 30,758
Due after one year through two years 81,386
Due after two years through three years 110,199
Due after three years through four years 65,407
Due after four years through five years 114,193
$ 401,943
See "D. Debt" for cash flow related to outstanding debts.
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C. Invested Assets
Portfolio Composition
An important component of the Company's financial results is the return on its
investment portfolio. The Company's investment strategy emphasizes safety of
principal and consistent income generation, within a total return framework. The
investment strategy has historically focused on maximizing after-tax yield with
a primary emphasis on maintaining a well diversified, investment grade, fixed
income portfolio to support the underlying liabilities and achieve return on
capital and profitable growth. The Company believes that investment yield is
maximized by selecting assets that perform favorably on a long-term basis and by
disposing of certain assets to enhance after-tax yield and minimize the
potential effect of downgrades and defaults. The Company continues to believe
that this strategy maintains the optimal investment performance necessary to
sustain investment income over time. The Company's portfolio management approach
utilizes a market risk and consistent asset allocation strategy as the primary
basis for the allocation of interest sensitive, liquid and credit assets as well
as for determining overall below investment grade exposure and diversification
requirements. Within the ranges set by the asset allocation strategy, tactical
investment decisions are made in consideration of prevailing market conditions.
The following table presents the composition of the total investment portfolio
of the Company at December 31, 2011:
Cost(1) Fair Value
(Amounts in thousands) Fixed maturity securities:
U.S. government bonds and agencies $ 14,097 $ 14,298
States, municipalities and political subdivisions 2,186,259 2,271,275
Mortgage-backed securities 33,008 37,371
Corporate securities 73,009 75,142
Collateralized debt obligations 39,247 47,503
2,345,620 2,445,589
Equity securities:
Common stock:
Public utilities 22,969 26,342
Banks, trusts and insurance companies 17,495 16,027
Industrial and other 326,135 316,592
Non-redeemable preferred stock 11,818 11,419
Partnership interest in a private credit fund 10,000 10,008
388,417 380,388
Short-term investments 236,433 236,444
Total investments $ 2,970,470 $ 3,062,421
(1) Fixed maturities and short-term bonds at amortized cost and equities and
other short-term investments at cost.
At December 31, 2011, 74.0% of the Company's total investment portfolio at fair
value and 92.6% of its total fixed maturity investments at fair value were
invested in tax-exempt state and municipal bonds. Equity holdings consist of
non-redeemable preferred stocks, dividend-bearing common stocks on which
dividend income is partially tax-sheltered by the 70% corporate dividend
received deduction, and a partnership interest in a private credit fund. At
December 31, 2011, 96.2% of short-term investments consisted of highly rated
short-duration securities redeemable on a daily or weekly basis. The Company
does not have any direct investment in subprime lenders.
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During 2011, the Company recognized $58.4 million in net realized investment
gains, which include gains of $54.1 million related to fixed maturity securities
and losses of $4.9 million related to equity securities. Included in the gains
and losses were $62.1 million in gains due to changes in the fair value of the
Company's fixed maturity portfolio and $30.9 million in losses due to changes in
the fair value of the Company's equity security portfolio, as a result of
applying the fair value option.
During 2010, the Company recognized $57.1 million in net realized investment
gains, which include gains of $5.9 million and $46.5 million related to fixed
maturity securities and equity securities, respectively. Included in the gains
were $1.0 million and $45.7 million in gains due to changes in the fair value of
the Company's fixed maturity portfolio and equity security portfolio,
respectively, as a result of applying the fair value option.
Fixed Maturity Securities
Fixed maturity securities include debt securities, which may have fixed or
variable principal payment schedules, may be held for indefinite periods of
time, and may be used as a part of the Company's asset/liability strategy or
sold in response to changes in interest rates, anticipated prepayments,
risk/reward characteristics, liquidity needs, tax planning considerations or
other economic factors. A primary exposure for the fixed maturity securities is
interest rate risk. The longer the duration, the more sensitive the asset is to
market interest rate fluctuations. As assets with longer maturity dates tend to
produce higher current yields, the Company's historical investment philosophy
has resulted in a portfolio with a moderate duration. The nominal average
maturities of the overall bond portfolio were 11.8 years at both December 31,
2011 and 2010 (10.8 years and 11.3 years, respectively, including all short-term
instruments). The portfolio is heavily weighted in investment grade tax-exempt
municipal bonds. Fixed maturity investments purchased by the Company typically
have call options attached, which reduce the duration of the asset as interest
rates decline. The call-adjusted average maturities of the overall bond
portfolio were 4.5 years and 6.3 years (4.1 years and 6.0 years including all
short-term instruments) at December 31, 2011 and 2010, respectively, related to
holdings which are heavily weighted with high coupon issues that are expected to
be called prior to maturity. The modified durations of the overall bond
portfolio reflecting anticipated early calls were 3.7 years and 4.7 years, (3.3
years and 4.5 years including all short-term instruments), including
collateralized mortgage obligations with a modified duration of 2.4 years and
2.2 years at December 31, 2011 and 2010, respectively, and short-term bonds that
carry no duration. Modified duration measures the length of time it takes, on
average, to receive the present value of all the cash flows produced by a bond,
including reinvestment of interest. As it measures four factors (maturity,
coupon rate, yield, and call terms) which determine sensitivity to changes in
interest rates, modified duration is considered a better indicator of price
volatility than simple maturity alone.
Another exposure related to the fixed maturity securities is credit risk, which
is managed by maintaining a weighted-average portfolio credit quality rating of
AA-, at fair value, consistent with the average rating at December 31, 2010. To
calculate the weighted-average credit quality ratings as disclosed throughout
this Annual Report on Form 10-K, individual securities were weighted based on
fair value and a credit quality numeric score that was assigned to each rating
grade. Tax-exempt bond holdings are broadly diversified geographically. Taxable
holdings consist principally of investment grade issues. At December 31, 2011,
fixed maturity holdings rated below investment grade and non-rated bonds totaled
$95.8 million and $17.2 million, respectively, at fair value, and represented
3.9% and 0.7%, respectively, of total fixed maturity securities. At December 31,
2010, below investment grade and non-rated fixed maturity holdings totaled
$139.4 million and $34.9 million, respectively, at fair value, and represented
5.3% and 1.3%, respectively, of total fixed maturity securities.
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The following table presents the credit quality ratings of the Company's fixed
maturity portfolio by security type at December 31, 2011 at fair value. The
Company's estimated credit quality ratings are based on the average of ratings
assigned by nationally recognized securities rating organizations. Credit
ratings for the Company's fixed maturity portfolio were stable as compared to
the prior year, with 77.6% of fixed maturity securities at fair value
experiencing no change in their overall rating. 15.9% of fixed maturity
securities at fair value experienced downgrades during the period, partially
offset by 6.5% in credit upgrades. The majority of the downgrades were due to
continued downgrading of the monoline insurance carried on much of the municipal
holdings. The majority of the downgrades were slight and the affected securities
remain in the investment grade portfolio, except for $3.8 million of fixed
maturity securities, at fair value, that were downgraded to below investment
grade during 2011.
December 31, 2011
AAA AA(1) A(1) BBB(1) Non-Rated/Other Total
(Amounts in thousands)
U.S. government bonds and agencies:
Treasuries $ 6,851 $ - $ - $ - $ - $ 6,851
Government Agency 7,447 - - - - 7,447
Total 14,298 - - - - 14,298
100.0 % 100.0 %
Municipal securities:
Insured 4,940 541,878 580,653 141,123 29,908 1,298,502
Uninsured 190,554 313,966 314,549 141,718 11,986 972,773
Total 195,494 855,844 895,202 282,841 41,894 2,271,275
8.6 % 37.7 % 39.4 % 12.5 % 1.8 % 100.0 %
Mortgage-backed securities:
Agencies 17,734 - - - - 17,734
Non-agencies:
Prime 3,686 660 1,196 395 3,942 9,879
Alt-A 30 1,816 1,223 1,545 5,144 9,758
Total 21,450 2,476 2,419 1,940 9,086 37,371
57.4 % 6.6 % 6.5 % 5.2 % 24.3 % 100.0 %
Corporate securities:
Communications - - - 6,681 - 6,681
Consumer-cyclical - - - - 103 103
Energy - - - 4,874 2,735 7,609
Basic materials - - - 4,222 - 4,222
Financial - 19,269 15,552 6,893 11,245 52,959
Utilities - - - 3,134 434 3,568
Total - 19,269 15,552 25,804 14,517 75,142
0.0 % 25.7 % 20.7 % 34.3 % 19.3 % 100.0 %
Collateralized debt obligations:
Corporate - - - - 47,503 47,503
Total - - - - 47,503 47,503
100.0 % 100.0 %
Total $ 231,242 $ 877,589 $ 913,173 $ 310,585 $ 113,000 $ 2,445,589
9.5 % 35.9 % 37.3 % 12.7 % 4.6 % 100.0 %
(1) Intermediate ratings are offered at each level (e.g., AA includes AA+, AA and
AA-).
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The Company had $32.0 million, 1.3% of its fixed maturity portfolio, at fair
value in U.S. government bonds and agencies and mortgage-backed securities
(agencies). In August 2011, Standard and Poor's downgraded the U.S. government's
long-term sovereign credit rating from AAA to AA+. This downgrade has triggered
significant volatility in prices for a variety of investments. While Moody's and
Fitch affirmed their AAA ratings, they placed a negative outlook in November
2011 and warned of a potential downgrade if no long-term deficit agreement was
reached over the next two years. The negative outlook reflects these rating
agencies' declining confidence that timely fiscal measures will be forthcoming
to place U.S. public finances on a sustainable path and secure the AAA ratings.
Standard and Poor's affirmed the U.S. Treasury's short-term credit rating of AAA
indicating that the short-term capacity of the U.S. to meet its financial
commitment on its outstanding obligations is strong. The Company understands
that market participants continue to use rates of return on U.S. government debt
as a risk-free rate. In addition, in the period after the downgrade, market
participants continued to invest in U.S. Treasury securities and push the yield
on U.S. Treasury securities even lower than before the downgrade.
(1) Municipal Securities
The Company had $2.3 billion at fair value ($2.2 billion at amortized cost) in
municipal bonds at December 31, 2011, of which $1.3 billion were insured by bond
insurers. For insured municipal bonds that have underlying ratings, the average
underlying rating was A+ at December 31, 2011.
At December 31, 2011, the bond insurers providing credit enhancement were
Assured Guaranty Corporation and National Public Finance Guarantee Corporation,
which covered approximately 10% of the insured municipal securities. The average
rating of the Company's insured municipal bonds by these bond insurers was A+,
with an underlying rating of A-. The remaining bond insurers' credit ratings,
which covered approximately 90% of the insured municipal securities, are
non-rated or below investment grade, and the Company does not believe that these
insurers provide credit enhancement to the municipal bonds that they insure.
The Company considers the strength of the underlying credit as a buffer against
potential market value declines which may result from future rating downgrades
of the bond insurers. In addition, the Company has a long-term time horizon for
its municipal bond holdings which generally allows it to recover the full
principal amounts upon maturity and avoid forced sales prior to maturity of
bonds that have declined in market value due to the bond insurers' rating
downgrades. Based on the uncertainty surrounding the financial condition of
these insurers, it is possible that there will be additional downgrades to below
investment grade ratings by the rating agencies in the future, and such
downgrades could impact the estimated fair value of municipal bonds.
Municipal securities included auction rate securities ("ARS"). The Company owned
$0 and $1.6 million at fair value of ARS at December 31, 2011 and 2010,
respectively. ARS are valued based on a discounted cash flow model with certain
inputs that are not observable in the market and are considered Level 3 inputs.
(2) Mortgage-Backed Securities
The mortgage-backed securities portfolio is categorized as loans to "prime"
borrowers except for $9.8 million and $11.5 million ($8.3 million and $10.7
million at amortized cost) of Alt-A mortgages at December 31, 2011 and 2010,
respectively. Alt-A mortgage backed securities are at fixed or variable rates
and include certain securities that are collateralized by residential mortgage
loans issued to borrowers with stronger credit profiles than sub-prime
borrowers, but do not qualify for prime financing terms due to high
loan-to-value ratios or limited supporting documentation. At December 31, 2011,
the Company had no holdings in commercial mortgage-backed securities.
The weighted-average rating of the Company's Alt-A mortgage-backed securities
was BB+ and the weighted-average rating of the entire mortgage backed securities
portfolio was A+ as of December 31, 2011.
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(3) Corporate Securities
Included in fixed maturity securities are $75.1 million and $95.2 million of
fixed rate corporate securities, which had durations of 3.6 and 4.1 years, at
December 31, 2011 and 2010, respectively. The weighted-average rating was BBB+
as of December 31, 2011 and 2010.
(4) Collateralized Debt Obligations
Included in fixed maturities securities are collateralized debt obligations of
$47.5 million and $55.7 million, which represent 1.6% and 1.8% of the total
investment portfolio and had durations of 1.1 years and 2.0 years, at
December 31, 2011 and 2010, respectively.
Equity Securities
Equity holdings consist of non-redeemable preferred stocks, common stocks on
which dividend income is partially tax-sheltered by the 70% corporate dividend
received deduction, and a partnership interest in a private credit fund. The net
losses in 2011 due to changes in fair value of the Company's equity portfolio
were $30.9 million. The primary cause of the losses on the Company's equity
securities was the overall decline in the equity markets.
The Company's common stock allocation is intended to enhance the return of and
provide diversification for the total portfolio. At December 31, 2011, 12.4% of
the total investment portfolio at fair value was held in equity securities,
compared to 11.4% at December 31, 2010. The following table presents the equity
security portfolio by industry sector for 2011 and 2010:
December 31,
2011 2010
Cost Fair Value Cost Fair Value
(Amounts in thousands)
Equity securities:
Basic materials $ 32,719 $ 27,139 $ 11,755 $ 12,781
Communications 7,692 7,347 8,495 8,473
Consumer-cyclical 12,985 11,986 19,287 20,183
Consumer-non-cyclical 4,310 4,197 5,629 5,657
Energy 227,183 233,225 199,822 215,796
Financial 26,156 23,887 25,339 26,419
Funds 11,190 10,621 4,160 3,572
Industrial 34,622 28,728 35,040 34,915
Technology 8,548 6,875 4,611 4,555
Utilities 23,012 26,383 22,619 27,255
$ 388,417 $ 380,388 $ 336,757 $ 359,606
Short-Term Investments
At December 31, 2011, short-term investments include money market accounts,
options, and short-term bonds which are highly rated short duration securities
and redeemable within one year.
D. Debt
The Company retired all of its $125 million 7.25% senior notes on the August 15,
2011 maturity date by using a portion of the proceeds from the extraordinary
dividend paid by MCC to Mercury General.
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Effective August 4, 2011, the Company extended the maturity date of the $120
million Bank of America credit facility from January 1, 2012 to January 2, 2015
with interest payable at a floating rate of LIBOR rate plus 40 basis points.
On October 4, 2011, the Company refinanced its Bank of America $18 million LIBOR
plus 50 basis points loan that was scheduled to mature on March 1, 2013 with a
Union Bank $20 million LIBOR plus 40 basis points loan that matures on
January 2, 2015.
Both the $120 million credit facility and the $20 million bank loan contain
financial covenants pertaining to minimum statutory surplus, debt to capital
ratio, and risk based capital ratio. The Company is in compliance with all of
its financial covenants.
For a further discussion, see Notes 6 and 7 of Notes to Consolidated Financial
Statements.
E. Capital Expenditures
In 2011, the Company made capital expenditures of approximately $18 million
primarily related to Information Technology.
F. Regulatory Capital Requirement
The Insurance Companies must comply with minimum capital requirements under
applicable state laws and regulations, and must have adequate reserves for
claims. The minimum statutory capital requirements differ by state and are
generally based on balances established by statute, a percentage of annualized
premiums, a percentage of annualized loss, or RBC requirements. The RBC
requirements are based on guidelines established by the NAIC. The RBC formula
was designed to capture the widely varying elements of risks undertaken by
writers of different lines of insurance having differing risk characteristics,
as well as writers of similar lines where differences in risk may be related to
corporate structure, investment policies, reinsurance arrangements, and a number
of other factors. At December 31, 2011, the Insurance Companies had sufficient
capital to exceed the highest level of minimum required capital.
Among other considerations, industry and regulatory guidelines suggest that the
ratio of a property and casualty insurer's annual net premiums written to
statutory policyholders' surplus should not exceed 3.0 to 1. Based on the
combined surplus of all the Insurance Companies of $1.5 billion at December 31,
2011, and net premiums written of $2.6 billion, the ratio of premiums written to
surplus was 1.7 to 1.
OFF-BALANCE SHEET ARRANGEMENTSAs of December 31, 2011, the Company had no off-balance sheet arrangements as
defined under Regulation S-K 303(a)(4) and the instructions thereto.
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CONTRACTUAL OBLIGATIONS
The Company's significant contractual obligations at December 31, 2011 are
summarized as follows:
Contractual Obligations Total 2012 2013 2014 2015 2016 Thereafter
(Amounts in thousands)
Debt (including interest)(1) $ 143,547 $ 1,651 $ 1,010 $ 886 $ 140,000 $ - $ -
Lease obligations(2) 39,027 15,821 10,551 5,410 3,185 2,436 1,624
Losses and loss adjustment
expenses(3) 985,279 577,669 238,197 106,036 38,187 25,190 -
Total Contractual Obligations $ 1,167,853 $ 595,141 $ 249,758 $ 112,332 $ 181,372 $ 27,626 $ 1,624
(1) The Company's debt contains various terms, conditions and covenants which, if
violated by the Company, would result in a default and could result in the
acceleration of the Company's payment obligations. Amounts differ from the
balance presented on the consolidated balance sheets as of December 31, 2011
because the debt amounts above include interest.
(2) The Company is obligated under various non-cancellable lease agreements
providing for office space, automobiles, and office equipment that expire at
various dates through the year 2019.
(3) Reserve for losses and loss adjustment expenses is an estimate of amounts
necessary to settle all outstanding claims, including IBNR as of December 31,
2011. The Company has estimated the timing of these payments based on its
historical experience and expectation of future payment patterns. However,
the timing of these payments may vary significantly from the amounts shown
above. The ultimate cost of losses may vary materially from recorded amounts
which are the Company's best estimates.
(4) The table excludes liabilities of $3.6 million related to uncertainty in tax
settlements as the Company is unable to reasonably estimate the timing and
amount of related future payments.
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