The Company did business only in the state of California until 1990, when it began operations in Georgia and Illinois. In December 1996, the American Fidelity Insurance Group (AFI), now American Mercury Insurance Group (AMI), was acquired for cash. The 1996 results of operations of AMI for the month of December only are included in the Company's 1996 consolidated statement of income. The full year results of AMI for 1997 are included in the Company's 1997 consolidated statement of income. AMI writes automobile (approximately 57% of AMI's direct premiums) and other casualty lines of insurance principally in Oklahoma, Texas and Kansas, and is headquartered in Oklahoma City, Oklahoma. Total direct premiums written by AMI in 1997 were $87.3 million. Total direct premiums written by AMI in 1996 were $90.4 million; of that amount $5.5 million of premiums were written in December and included in the results of operations of the Company in 1996. AMI is licensed in 36 states. In early 1998, the Company also commenced operations in Florida.
During 1997, approximately 90% of the Company's direct premiums written, including AMI, were derived from California.
In February 1994, the California Insurance Commissioner approved new rates which were designed to improve the Company's competitive position for new insureds. These rate changes, which became effective on May 1, 1994, provided for decreases in premium rates for new insureds. Further rate modifications were approved and made effective on October 15, 1995, April 15, 1996 and October 1, 1997. The rate changes made over the last several years have been substantially revenue-neutral overall, with physical damage rates being increased and bodily injury liability rates decreased. The rate changes have resulted in a substantial increase in new business being submitted to the Company. Since March 31, 1994, Private Passenger Automobile ("PPA") policies in force in California have increased by approximately 350,000 to 650,000 at December 31, 1997, an annual rate of increase of over 20%.
of driving experience, (3) miles driven per year and (4) whatever optional factors are determined by the Insurance Commissioner to have a substantial relationship to the risk of loss and adopted by regulation. The law further requires that each of the four factors be applied in decreasing order of importance.
The Company's plan, and the new plans of most other California automobile insurers, were approved by the California DOI in October 1997. The Company's plan became effective November 1, 1997. Although the rate changes produced some minor dislocations, implementation of the new plan has not thus far had a material effect on the Company's overall competitive position or its profitability.
Investment income in 1997, including a contribution from AMI of $6.3 million, was $86.8 million, compared with $70.2 million in 1996. The after-tax yield on average investments of $1,262.9 million, including AMI, (fixed maturities at cost, equities at market) was 6.17%, compared with 6.50% on average investments of $975.1 million in 1996. The effective tax rate on investment income was 10.3% in 1997, compared with 9.7% in 1996. The effective tax rate was increased, and the effective after-tax yield was reduced slightly, by the inclusion of AMI for the full year 1997. The slightly higher tax rate on investment income in 1997 reflects an increase in the proportion of investment income derived from taxable bonds held by AMI and dividends on equities, principally perpetual preferred stocks. The redemption of bonds acquired during higher interest periods has been a negative influence on realized yields in each of the last several years and will continue in 1998. Bonds matured and called in 1997 totaled $54.0 million, compared with $72.9 million in 1996. Approximately $65.3 million of bonds are expected to mature or be called in 1998. Average yields being obtained during the first quarter of 1998 on new investments are 50 to 75 basis points lower than the average yield realized in 1997.
Premiums earned in 1996 of $754.7 million (including $5.2 million contributed by AMI in December 1996) increased 22.5% over premiums earned in 1995, primarily reflecting unit growth. Average premium per policy for the year was substantially unchanged. Net premiums written in 1996 of $795.9 million (including $4.5 million contributed by AMI) increased 25.0% over a year earlier, continuing a growth trend which began in the second quarter of 1993.
The loss ratio in 1996 was 66.5%, compared with 67.6% in 1995. The 1996 and 1995 loss ratios reflect small contributions from favorable loss reserve development from prior periods.
The expense ratio was 24.4% in 1996 and 1995. The consolidation of one month of operating results of AMI in 1996 had no material effect on either the loss or expense ratios.
Investment income in 1996, including a contribution from AMI of $400,000 for the final month of the year, was $70.2 million, compared with $63.0 million in 1995. The after-tax yield on average investments of $975.1 million, including AMI, was 6.50%, compared with 6.89% on average investments of $827.9 million in 1995. The effective tax rate on investment income was 9.7% in 1996, compared with 9.4% in 1995. The effective tax rate was increased and the effective after- tax yield was reduced slightly by the inclusion of AMI for the month of December 1996. The effective tax rate on investment income in 1996, excluding AMI, was 9.6%, and the after-tax yield was 6.56%. The slightly higher tax rate on investment income in 1996 reflects an increase in the proportion of investment income derived from dividends on equities, principally perpetual preferred stocks. Bonds matured and called in 1996 totaled $72.9 million, compared with $71.0 million in 1995. Average yields obtained during 1997 on new investments were approximately some 50 basis points lower than the average yield realized in 1996.
The Company's cash and short term investments totaled $62.8 million at December 31, 1997. Together with funds generated internally, such liquid assets are more than adequate to pay claims without the sale of long term investments.
Traditionally, it has been the Company's policy not to invest in high yield or "junk" bonds. In 1995, the Company adopted a policy to place a small proportion of its investments in the taxable sector in bonds rated lower than investment grade, but not lower than Ba by Moody's or BB by Standard & Poor's. At December 31, 1997 bond holdings rated below investment grade totaled $15.0 million at market (cost $14.0 million), or 1% of total investments. The average rating of the $1,071.4 million bond portfolio (at amortized cost) was AA-, while the average effective maturity, giving effect to anticipated early call, approximates 7.5 years. The modified duration of the bond portfolio at year-end was 6.1 years, reflecting the heavy weighting of high coupon issues, including housing issues subject to sinking funds, and other issues which are pre-refunded or are expected to be called prior to their maturity. Duration measures the length of time it takes to receive all the cash flows produced by a bond, including reinvestment of interest. Because it measures four factors (maturity, coupon rate, yield and call terms) which determine sensitivity to changes in interest rates, modified duration is a much better indicator of price volatility than simple maturity alone. Bond holdings are broadly diversified geographically, and, within the tax-exempt sector, consist largely of high coupon revenue issues, many of which have been pre-refunded and escrowed with U.S. Treasuries. General obligation bonds of the large eastern cities have generally been avoided.
Equity holdings of $173.5 million at market (cost $169.9 million), including perpetual preferred issues, are largely confined to the public utility and banking sectors and represent about 21.7% of total shareholders' equity.
The Company is nearing completion of the modifications to its computer programs and systems to resolve the problems created by the impending year 2000. The conversion of the most critical systems should be completed within the first quarter of 1998. The cost of this conversion has been charged to current operations and will not have a material effect on the financial condition of the Company.
in expanding generally in states outside of California, the impact of the permanent rating factor regulations recently adopted by the California Insurance Commissioner for private passenger automobile policies issued in California and the level of investment yields obtainable in the Company's investment portfolio in comparison to recent yields, as well as the cyclical and competitive nature of the property and casualty insurance industry and general uncertainties regarding loss reserve estimates and legislative and regulatory changes. Such risks and uncertainties and other factors are discussed above and in periodic filings with the Securities and Exchange Commission.
Summarized quarterly financial data for 1997 and 1996 is as follows (in thousands except per share data):
We have audited the accompanying consolidated balance sheets of Mercury General Corporation and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of income, shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
In most cases, the market valuations were drawn from standard trade data sources. In no case were any valuations made by the Company's management. Equity holdings, including non sinking fund preferred stocks, are, with minor exceptions, actively traded on national exchanges, and were valued at the last transaction price.
Net premiums written during 1997, 1996 and 1995 were $1,086,241,000, $795,873,000 and $636,590,000, respectively.
One agent produced direct premiums written of approximately 14%, 17% and 15% of the Company's total direct premiums written during 1997, 1996 and 1995, respectively.
settlement of the claim, the more variable the ultimate settlement amount can be. Accordingly, short-tail claims, such as property damage claims, tend to be more reasonably predictable than long-tail liability 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. Since the provisions are necessarily based upon estimates, the ultimate liability may be more or less than such provisions.
Interest paid during 1997, 1996, and 1995 was $5,077,000, $1,882,000, and $1,970,000, respectively. Income taxes paid were $52,611,000 in 1997, $30,550,000 in 1996, and $18,954,000 in 1995.
A summary of net investment income is shown in the following table:
At December 31, 1997 bond holdings rated below investment grade totaled approximately 1.0% of total investments. The average Standard and Poor's rating of the bond portfolio is AA-.
The amortized cost and estimated market value of fixed maturities available for sale at December 31, 1997, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Notes payable at December 31, 1997 consists of three unsecured notes payable under a credit agreement dated November 21, 1996. The combined principal amount on the notes of $75,000,000 is payable on November 21, 2000. The loan agreement may be extended annually for additional periods of one year each to maintain the three year maturity date. The interest rate is variable and is optionally related to the Federal Funds rate, Bank of New York prime rate or the Eurodollar London Interbank rate (LIBOR). Based on the rates effective through November 23, 1998, the net interest cost on the loan at December 31, 1997 is approximately 6.125%.
The provision for income tax expense (benefit) consists of the following components:
Increases in incurred losses in 1997 relating to prior years reflects increases in the Company's estimates for loss adjustment expenses.
approval of the Commissioner of Insurance of the state of domicile. The above statutory regulations may have the effect of indirectly limiting the ability of the Company to pay dividends.
The Company has estimated the Risk-Based Capital Requirements of each of its insurance subsidiaries as of December 31, 1997 according to the formula issued by the NAIC. Each of the companies' policyholders' surplus exceeded the highest level of recommended capital requirements.
Effective March 11, 1994 the Profit Sharing Plan also includes a leveraged employee stock ownership plan (ESOP) that covers substantially all employees. The Company makes annual contributions to the ESOP equal to the ESOP's debt
In September 1997, the common stock of the Company was split two-for-one. All share information has been adjusted accordingly.
As explained in Note 1, the Company applies APB Opinion No. 25 in accounting for its stock option plan. Accordingly, no compensation cost has been recognized in the Statements of Income. Had compensation cost for the Company's Plans been determined based on the fair value at the grant dates consistent with the method of SFAS No. 123, the Company's net income would have been reduced by $363,000, $295,000 and $116,000 in 1997, 1996 and 1995, respectively, and earnings per share (basic and diluted) would have remained the same in 1997, been reduced by .01 (basic and diluted) in 1996 and diluted would have been reduced by .01 in 1995 and basic would have remained the same in 1995. Calculations of the fair value under the method prescribed by SFAS No. 123 were made using the Black-Scholes option-pricing model with the following weighted- average assumptions used for grants in 1997, 1996 and 1995: dividend yield of 2.0 percent for all years, expected volatility of 30 percent for all years and expected lives of 7 years for all years. The risk-free interest rates used were 6.4 percent for the options granted during 1997, 5.5 and 6.4 percent for the options granted during 1996, and 7.4 and 6.4 percent for the options granted during 1995.