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 incorporated 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.
The Company is headquartered in Los Angeles, California and operates primarily as a personal automobile insurer selling policies through a network of independent agents and brokers in thirteen states. The Company also offers homeowners, mechanical breakdown, fire, umbrella, and commercial automobile and property insurance. Private passenger automobile lines of insurance accounted for 82.7% of the $2.6 billion of the Company’s direct premiums written in 2010. 76.9% of the private passenger automobile premiums were written in California. The Company operates primarily in the state of 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’s net income for the year ended December 31, 2010 decreased to $152.2 million, or $2.78 per diluted share, from $403.1 million, or $7.32 per diluted share, for the same period in 2009. Approximately $144 million in pre-tax investment income was generated during 2010 on a portfolio of approximately $3.2 billion at fair value at December 31, 2010, compared to $145 million pre-tax investment income during 2009 on a portfolio of approximately $3.1 billion at fair value at December 31, 2009. 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 Company’s net income for the year ended December 31, 2010 was negatively impacted by catastrophic rainstorms in California and homeowners losses in Florida as a result of sinkhole claims. The Company estimates that losses resulting from the California rainstorms were approximately $25 million. The Florida homeowners line of business incurred an underwriting loss of approximately $19 million in the fourth quarter, which includes a premium deficiency reserve of $6 million. The Company is in the process of withdrawing from the Florida homeowners market and expects to complete the withdrawal in 2012.
During 2010, 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 that it has a thorough underwriting process that gives the Company an advantage over its competitors. The Company views its agent and broker 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.
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.
Economic Conditions-While many economists believe that the severe economic recession is over compared to 2008 and 2009, they expect the recovery to be slow with many businesses experiencing the effects of the downturn for years to come. The Company is unable to predict the duration and severity of the continued disruption in the financial markets in the United States, and in California, where the majority of the Company’s business is produced. If economic conditions do not show significant improvement, the adverse impact on the Company’s financial condition, results of operations, and liquidity may continue.
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.
In 2010, 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 is also 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.
In 2010, as part of the Company’s continuing commitment to service excellence, the Company broadened its Astonishing Customers Everyday program, a streamlined loss application system which enhances the personal auto claims process including automated rental car reservations, repair services, and a new roadside assistance program. The Company also enhanced consumer web quoting capabilities and launched a new web page for tracking vehicle repairs.
During January 2011, the Company announced a workforce reduction of approximately 165 employees, primarily located in California. Approximately $4 million of severance related expense will be recognized during the first quarter of 2011. The Company anticipates annualized savings from the workforce reduction of approximately $11 million.
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. During 2010, the Company implemented rate increases in ten states and decreases in four states.
insurance rates. The agreement reached with the DOI includes a 4.96% rate reduction in MIC and a 4.44% rate reduction in MCC and CAIC. In addition, the rate filing improves the Company’s risk segmentation and introduces new discounts and road side assistance coverage. The rate filing became effective on December 15, 2010, and the Company expects that the new rates will make the Company more competitive in attracting new customers. The change in the actual average premiums collected per policy will differ from the change in the approved rates as a result of product enhancements, which command a higher rate, and any changes made to individual insurance policies relating to coverage amounts, vehicles insured, miles driven, or other rating factors that determine the rates charged for an insurance policy.
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 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.
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 accident year. Consequently, there is a decreasing likelihood of reserve development on any particular accident year, as those periods age. At December 31, 2010, the Company believes that the accident years that are most likely to develop are the 2008 through 2010 accident years; however, it is also possible that older accident years could develop as well.
During 2010 and 2009, the Company experienced meaningful increases in homeowners losses related to sinkhole claims in Florida. These claims have historically been very infrequent, but the cost per claim is high, averaging approximately $150,000 to $170,000 plus the cost to adjust the claim. The Company estimates that the total sinkhole related loss and loss adjustment expenses were approximately $20 million, $9 million, and $4 million for accident years 2010, 2009, and 2008, respectively. During this time period, the Company’s Florida homeowners policies in-force decreased by approximately 10% per year. In addition, the Company recorded a related premium deficiency reserve of approximately $6 million as of December 31, 2010. The reserve provides for a loss in 2010 of the estimated portion of losses to be incurred in 2011 that are in excess of the related unearned premium balance as of December 31, 2010.
In December 2010, the Florida Senate issued a 47-page report entitled “Issues Relating to Sinkhole Insurance.” The report states that the “Florida Insurance Commissioner has identified sinkhole claims as a major cost driver and has expressed concern that such claims could threaten the solvency of domestic insurers and have a destabilizing effect on an already fragile market.” While the Company, with approximately 8,000 homeowners policies in-force in Florida, does not believe that the sinkhole issue creates solvency concerns, it does impair profitability. The Company is in the process of withdrawing from the Florida homeowners market and expects to complete the withdrawal in 2012.
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 2010, the Company reported favorable development of approximately $13 million on the 2009 and prior accident years’ losses and loss adjustment expenses reserves which at December 31, 2009 totaled approximately $1.1 billion. The favorable development in 2010 is largely the result of re-estimates of accident 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. The Company also experienced favorable development on New Jersey personal auto reserves, primarily resulting from more aggressive handling of litigated claims which include a high percentage of favorable results in cases brought to trial. In addition, the Company experienced unfavorable development of approximately $8 million on Florida reserves, which included approximately $3 million of unfavorable development on homeowners policies, primarily related to sinkhole claims.
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 value of receivables and accounts payable approximate their fair market values. All investments are carried on the 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 state and municipal governments and agencies, certain corporate and other debt securities, corporate equity securities, and exchange traded funds. Over 98% of the fair value of the financial instruments held at December 31, 2010 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 for a financial instrument, or a related financial instrument, are used to derive a price without requiring significant judgment.
Management’s recoverability assessment with regards 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 the majority of these debt securities are not subject to default risk. Thus, the principal amounts are believed to be 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
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 will enable management to use its discretion 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.
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. While it is not possible to know with certainty the ultimate outcome of contingent liabilities, an unfavorable result may have a material impact on the Company’s quarterly results of operations in the period of such determination; however, it is not expected to be material to the Company’s financial condition. See also “Regulatory and Legal Matters” and Note 17 of Notes to Consolidated Financial Statements.
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
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 increased primarily due to the decreased net premiums earned, the Company’s financial contributions of $12.1 million related to Proposition 17, and a premium deficiency reserve of $6.0 million recorded in the Florida homeowners line of business.
The Company’s loss ratio decreased primarily due to favorable development of approximately $58 million in 2009 compared to unfavorable development of approximately $89 million in 2008 coupled with lower loss frequency in 2009. Partially offsetting this are higher loss severities recorded in 2009, as well as lower average premiums earned per policy.
The Company’s expense ratio was affected by the impact of the amortization of AIS deferred commissions paid prior to the acquisition and severance payments related to a reduction in workforce during 2009, offset by other cost reduction programs. Prior to the acquisition of AIS, the Company deferred the recognition of commissions paid to AIS to match the earnings of the related premiums. Now that AIS is a wholly-owned subsidiary, commissions are no longer paid or deferred, and direct expenses are reflected in the expense ratio. Further, to improve profitability, the Company implemented several cost reduction programs including a salary freeze, a suspension of the employee 401(k) matching program, and a workforce reduction primarily located in California.
Included in net income (loss) are net realized investment gains of $346.4 million in 2009 compared with net realized investment losses of $550.5 million in 2008. Net realized investment gains include gains of $395.5 million in 2009 due to changes in the fair value of total investments pursuant to application of the fair value accounting option compared with losses of $525.7 million in 2008. The net gains during 2009 arise from the market value improvements on the Company’s fixed maturity ($261.9 million) and equity securities ($133.6 million). The primary cause of the significant gains in the Company’s portfolio was the overall improvement in the bond and equity markets. The Company’s municipal bond holdings represent the majority of the fixed maturity portfolio, which was positively affected by the overall municipal market improvement during 2009. The Company’s large holdings of energy related stocks also experienced growth in value during 2009, in excess of the 23.5% growth in the S&P 500 Index.
The following table presents the estimated fair value of fixed maturity securities held by the Company at December 31, 2010 by contractual maturity in the next five years.
The following table presents the credit quality ratings of the Company’s fixed maturity portfolio by security type at December 31, 2010 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 71.7% of fixed maturity securities at fair value experiencing no change in their overall rating. 11.2% of fixed maturity securities at fair value experienced downgrades during the period, offset by 17.1% 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 still within the investment grade portfolio, although $8.4 million, at fair value, was downgraded to below investment grade.
(1) Insured municipal bonds based on underlying ratings: AAA: $17,818, AA: $526,536, A: $655,150, BBB: $101,056, Non-rated/Other: $150,822
The Company had $2.4 billion at fair value and at amortized cost in municipal bonds at December 31, 2010, with a net unrealized gain of $10.5 million. Over half of the municipal bond positions are insured by bond insurers. For insured municipal bonds that have underlying ratings, the average underlying rating was A+ at December 31, 2010.
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, avoiding 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.
The weighted-average rating of the Company’s Alt-A mortgage-backed securities is A- and the weighted-average rating of the entire mortgage backed securities portfolio is AA as of December 31, 2010.
The Company’s common stock allocation is intended to enhance the return of and provide diversification for the total portfolio. At December 31, 2010, 11.4% of the total investment portfolio at fair value was held in equity securities, compared to 9.1% at December 31, 2009. The following table presents the equity security portfolio by sector for 2010 and 2009:
At December 31, 2010, short-term investments include money market accounts, options, and short-term bonds which are highly rated short duration securities and redeemable within one year.
The NextGen software project began in 2002 and the total capital investment is approximately $40 million as of December 31, 2010. The Mercury First software project began in 2006 and the total capital investment is approximately $40 million as of December 31, 2010. In accordance with applicable accounting standards, capitalization ceases no later than the point at which computer software project development is substantially complete and ready for its intended use. NextGen is substantially complete and all remaining expenditures will be recorded as other operating expenses. Although the majority of the related software development costs have been expended, additional Mercury First development and implementation costs are expected to be incurred in the future. The Guidewire software project began in 2009, and the total capital investment is approximately $8 million as of December 31, 2010.
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, 2010, the Insurance Companies had sufficient capital to exceed the highest level of minimum required capital.
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 $1.3 billion at December 31, 2010, and net premiums written of $2.6 billion, the ratio of premiums written to surplus was 1.9 to 1.
Consolidated Statements of Operations for Each of the Years in the Three-Year Period Ended December 31, 2010
Consolidated Statements of Comprehensive Income (Loss) for Each of the Years in the Three-Year Period Ended December 31,
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Mercury General Corporation’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated February 14, 2011 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
We have audited Mercury General Corporation’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Mercury General Corporation’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the Company’s internal control over financial reporting based on our audit.
(2) Mercury County Mutual Insurance Company is not owned but is controlled by the Company through a management contract.
The consolidated financial statements have been prepared in conformity with GAAP, which differ in some respects from those filed in reports to insurance regulatory authorities. All intercompany transactions have been eliminated.
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. These estimates require the Company to apply complex assumptions and judgments, and often the Company must make estimates about effects of matters that are inherently uncertain and will likely change in subsequent periods. The most significant assumptions in the preparation of these consolidated financial statements relate to reserves for losses and loss adjustment expenses. Actual results could differ from those estimates.
Equity securities consist of non-redeemable preferred stocks and common stocks on which dividend income is partially tax-sheltered by the 70% corporate dividend received deduction.
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. As discussed above, all investments are carried at fair value on the consolidated balance sheets, including $55.7 million of fixed maturities which are valued based on broker quotes for underlying debt instruments and an estimated benchmark spread for similar assets in active markets. Management determined fair value estimates for ARS amounting to $1.6 million using discounted cash flow models. The fair value of the Company’s $120 million and $18 million secured notes is estimated based on assumptions and inputs, such as reset rates, for similar termed notes that are observable in the market. The fair value of the Company’s publicly traded $125 million unsecured notes is based on the unadjusted quoted price for similar notes in active markets. Further, see Note 3 for methods and assumptions used in estimating fair values of interest rate swap agreements, and equity contracts. Due to their short-term maturity, the carrying value of receivables and accounts payable approximate their fair market values. The following table presents estimated fair values of financial instruments at December 31, 2010 and 2009.
Deferred policy acquisition costs primarily consist of commissions paid to outside agents or brokers, premium taxes, salaries, and certain other underwriting costs that vary with and are primarily related to the acquisition of new and renewal insurance contracts and are amortized over the life of the related policy in relation to the amount of premiums earned. Deferred acquisition costs are limited to the amount which will remain after deducting from unearned premiums and anticipated investment income the estimated losses and loss adjustment expenses and the servicing costs that will be incurred as the premiums are earned. The Company does not defer advertising expenses but expenses them as incurred. The Company recorded net advertising expenses of $30 million, $27 million, and $26 million during the years ended December 31, 2010, 2009, and 2008, respectively.
Fixed assets are stated at historical cost less accumulated depreciation and amortization. The useful life for buildings is 30 to 40 years. Furniture, equipment, and purchased software are depreciated on a combination of straight-line and accelerated methods over 3 to 7 years. The Company has capitalized certain consulting costs, payroll, and payroll-related costs for employees related to computer software developed for internal use, which are amortized on a straight-line method over the estimated useful life of the software, generally not exceeding 5 years. In accordance with applicable accounting standards, capitalization ceases no later than the point at which a computer software project is substantially complete and ready for its intended use. Leasehold improvements are amortized over the life of the associated lease.
The Company annually evaluates goodwill for impairment using widely accepted valuation techniques to estimate the fair value of its reporting units. The Company also reviews its goodwill for impairment whenever events or changes in circumstances indicate that it is more likely than not that the carrying amount of goodwill may exceed its implied fair value. There are numerous assumptions and estimates underlying the determination of the estimated fair value of the Company’s reporting units, including certain assumptions and estimates related to future earnings, long-term strategies, and its annual planning and forecasting process. If these planned initiatives do not accomplish the targeted objectives, the assumptions and estimates underlying the goodwill impairment tests could be adversely affected and have a material effect upon the Company’s financial condition and results of operations. As of December 31, 2010 and 2009, goodwill impairment evaluation indicated that there was no impairment.
Premium revenue is recognized on a pro-rata basis over the term of the policies in proportion to the amount of insurance protection provided. Premium revenue includes installment and other fees for services which are recognized in the periods the services are rendered. Unearned premiums represent the portion of the premium related to the unexpired policy term. Unearned premiums are predominantly computed on a monthly pro rata basis and are stated gross of reinsurance deductions, with the reinsurance deduction recorded in other receivables. Net premiums written were $2.56 billion, $2.59 billion, $2.75 billion in 2010, 2009, and 2008, respectively.
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, or labor rates, among other factors, can all 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 can be. Accordingly, short-tail 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 for loss reserves are necessarily based upon estimates, the ultimate liability may be more or less than such provisions.
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.
Basic earnings per share excludes dilution and reflects net income divided by the weighted average shares of common stock outstanding during the period presented. Diluted earnings per share is based on the weighted average shares of common stock and potential dilutive common stock outstanding during the period presented. At December 31, 2010 and 2009, potential dilutive common stocks consist of outstanding stock options. Note 16 contains the required disclosures relating to the calculation of basic and diluted earnings per share.
At December 31, 2010, the Company’s deferred income taxes were in a net asset position partly due to a combination of ordinary and capital deferred tax benefits. In assessing the realization of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. The ultimate realization of deferred tax assets is dependent upon generating sufficient taxable income of the appropriate nature within the carryback and carryforward periods available under the tax law. Management considers the scheduled reversal of deferred tax liabilities, projected future taxable income of an appropriate nature, and tax-planning strategies in making this assessment. The Company believes that through the use of prudent tax planning strategies and the generation of capital gains, sufficient income will be realized in order to maximize the full benefits of its deferred tax assets. Although realization is not assured, management believes that it is more likely than not that the Company’s deferred tax assets will be realized.
Under its 2005 Incentive Award Plan (the “ 2005 Plan”), the Compensation Committee of the Company’s Board of Directors granted to Gabriel Tirador, the Company’s Chief Executive Officer, 10,000 shares of restricted stock on March 23, 2010. On October 1, 2010, the Compensation Committee granted 45,000 restricted stock units to the Company’s senior management and key employees under the 2005 Plan. The restricted stock and restricted stock units will vest at the end of a three-year performance period, and then only if, and to the extent that, the Company’s cumulative underwriting income during such three-year performance period ending December 31, 2012 achieves the threshold performance levels established by the Compensation Committee.
In October 2010, the FASB issued a new standard to address diversity in practice regarding the interpretation of which costs relating to the acquisition of new or renewal insurance contracts qualify for deferral. Costs that meet the definition defined in the new standard are recognized as assets and referred to as deferred acquisition costs. Deferred acquisition costs are amortized over time using amortization methods dependent upon the nature of the underlying insurance product. Other costs that do not vary with and are not primarily related to the acquisition of new and renewal insurance contracts are charged to expense as incurred. The new standard will be effective for fiscal years and interim periods within those fiscal years, beginning after December 15, 2011. The Company is in the process of evaluating the impact of adoption on the Company’s consolidated financial statements.
In February 2010, the FASB issued a new accounting standard related to subsequent events, which amends the earlier FASB standard to address certain implementation issues related to an entity’s requirement to perform and disclose subsequent events procedures. The new standard requires SEC filers to evaluate subsequent events through the date the financial statements are issued and exempts SEC filers from disclosing the date through which subsequent events have been evaluated. The Company adopted the new standard which became effective for the interim reporting period ended March 31, 2010. The adoption of the new standard did not have a material impact on the Company’s consolidated financial statements.
In January 2010, the FASB issued a new standard related to fair value measurements and disclosures, which amends the earlier FASB standard to add new requirements for disclosures about transfers into and out of Levels 1 and 2 fair value measurements and separate disclosures about purchases, sales, issuances, and settlements related to Level 3 fair value measurements. The new standard also clarifies existing fair value disclosures about the level of disaggregation and about inputs and valuation techniques used to measure the fair value. The Company adopted the new accounting standard which became effective for the interim reporting period ended March 31, 2010, except for the requirement to provide the Level 3 activity of purchases, sales, issuances, and settlements on a gross basis, which will be effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. The adoption of the new standard did not have a material impact on the Company’s consolidated financial statements.
The following table presents gains and losses due to changes in fair value for items measured at fair value pursuant to application of the fair value option:
Net realized gains (losses) from investments included gains of $52.5 million and $338.7 million, and losses of $566.0 million related to trading securities which were still held at December 31, 2010, 2009, and 2008, respectively.
Level 1 Unadjusted quoted prices are available in active markets for identical assets or liabilities as of the reporting date.
Level 2 Pricing inputs are other than quoted prices in active markets, which are based on the following:
In certain cases, the inputs used to measure fair value may fall into different levels of the fair value hierarchy. In such cases, the level in the fair value hierarchy within which the fair value measurement in its entirety falls has been determined based on the lowest level input that is significant to the fair value measurement in its entirety. The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and consideration of factors specific to the asset or liability.
Municipal securities: Valued based on models or matrices using inputs including quoted prices for identical or similar assets in active markets.
Mortgage-backed securities: Comprised of securities that are collateralized by residential mortgage loans and valued based on models or matrices using multiple observable inputs, such as benchmark yields, reported trades and broker/dealer quotes, for identical or similar assets in active markets. At December 31, 2010 and December 31, 2009, the Company had no holdings in commercial mortgage-backed securities.
The Company’s total financial instruments at fair value are reflected in the consolidated balance sheets on a trade-date basis. Related unrealized gains or losses are recognized in net realized investment gains (losses) in the consolidated statements of operations. Fair value measurements are not adjusted for transaction costs.
The following tables present information about the Company’s assets and liabilities measured at fair value on a recurring basis as of December 31, 2010 and 2009, and indicate the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value:
Depreciation expense including amortization of leasehold improvements was $33.9 million, $28.9 million, and $27.0 million during 2010, 2009, and 2008, respectively.
(2) Includes an establishment of a premium deficiency reserve of $6 million for the Florida homeowners line of business during 2010.
On December 16, 2010, the California DOI notified the Company that MCC was authorized to pay a $270 million extraordinary dividend to Mercury General in 2011. Mercury General intends to use a portion of the proceeds from the dividend to repay the $125 million senior notes that mature on August 15, 2011.
For additional disclosures regarding methods and assumptions used in estimating fair values of interest rate swap agreements associated with the Company’s loans listed above, see Note 7.
Effective January 2, 2002, the Company entered into an interest rate swap on the $125 million senior notes for a floating rate of LIBOR plus 107 basis points. The swap agreement terminates on August 15, 2011. The swap is designated as a fair value hedge and qualifies for the shortcut method as the hedge is deemed to have no ineffectiveness. The fair market value of the interest rate swap was $4.2 million and $8.5 million as of December 31, 2010 and 2009, respectively, and has been recorded in other assets in the consolidated balance sheets with a corresponding increase in notes payable. The Company includes the gain or loss on the hedged item in the same line item, other revenue, as the offsetting loss or gain on the related interest rate swaps as follows:
On March 3, 2008, the Company entered into an interest rate swap of its floating LIBOR rate on the $18 million bank loan for a fixed rate of 4.25%. The swap agreement terminates on March 1, 2013. The swap is designated as a cash flow hedge. The fair market value of the interest rate swap was $1.1 million and $0.9 million as of December 31, 2010 and 2009, respectively, and has been reported as a component of other comprehensive income (loss) and amortized into earnings over the term of the hedged transaction. The interest rate swap was determined to be highly effective, and no amount of ineffectiveness was recorded in earnings during 2010, 2009, or 2008.
Pursuant to the terms of the Purchase Agreement, the Company was required to pay the former owner of AIS up to an undiscounted maximum amount of an additional $34.7 million as contingent consideration. Based on the actual performance of the AIS business as of December 31, 2010, the Company is not required to pay any of the contingent consideration.
The changes in the carrying amount of goodwill for the year ended December 31, 2009 are as follows (amounts in thousands):
The income tax provision reflected in the consolidated statements of operations is reconciled to the federal income tax on income (loss) before income taxes based on a statutory rate of 35% as shown in the table below:
The Company has a capital loss carryforward of $42.1 million which, if unused, will begin expiring in 2015.
There was a $2.8 million net decrease to the total amount of unrecognized tax benefits related to tax uncertainties during 2010. The decrease was the result of a change in management’s assessment of the technical merits of tax positions taken in an earlier period based on management’s best judgment given the facts, circumstances, and information available at the reporting date. The Company does not expect any further changes in unrecognized tax benefits to have a significant impact on its consolidated financial statements within the next 12 months.
As presented above, the balances of unrecognized tax benefits were $3.8 million and $6.7 million at December 31, 2010 and 2009, respectively. Of these totals, $3.0 million and $5.5 million represent unrecognized tax benefits, net of federal tax benefit and accrued interest expense which, if recognized, would impact the Company’s effective tax rate.
The Company recognizes interest and penalties related to unrecognized tax benefits as a part of income taxes. During the years ended December 31, 2010, 2009, and 2008, the Company recognized net interest and penalty (benefit) or expense, excluding refunds, of ($872,000), $266,000, and $623,000, respectively. The Company carried an accrued interest and penalty balance of $728,000 and $1,600,000 at December 31, 2010 and 2009, respectively.
The increase in the provision for insured events of prior years in 2008 of approximately $89 million resulted primarily from two sources. The estimates for California Bodily Injury Severities and California Defense and Cost Containment reserves established at December 31, 2007 were too low and accounted for approximately $45 million of the adverse development. The New Jersey reserves established at December 31, 2007 were too low and accounted for approximately $30 million of the adverse development. In California, the Company experienced a lengthening of the pay-out period for claims that are settled after the first year and a large increase in the average amounts paid on closed claims. The Company believes that the lengthening of the pay-out periods may be attributable to a law passed in California several years ago that extended the statute for filing claims from one year to two years. Initial indications, when the law was passed, were that this would have little impact on development patterns and therefore it was not fully factored into the reserve estimates. In hindsight, claims payouts two to four years after the period-end have increased thereby affecting the loss reserve estimates at December 31, 2007. In New Jersey, due to a short operating history and rapid growth in that state, the Company had limited internal historical claims information to estimate BI, PIP and related loss adjustment expense reserves as of December 31, 2007. Consequently, the Company relied substantially on industry data to help set these reserves. During 2008, the reserve indications using the Company’s own historical data rather than industry data led to increases in its estimates for both PIP losses and loss adjustment expenses. In particular, loss severities using Company data for the PIP coverage developed into larger amounts than the industry data suggested. In 2008, the Company started using its own historical data, rather than industry data to set New Jersey loss reserves.
The Insurance Companies are subject to the financial capacity guidelines established by their domiciliary states. The payment of dividends from statutory unassigned surplus of the Insurance Companies is restricted, subject to certain statutory limitations. For 2011, the direct insurance subsidiaries of the Company are permitted to pay approximately $31.9 million in dividends to Mercury General without the prior approval of the DOI of the states of domicile. The above statutory regulations may have the effect of indirectly limiting the ability of the Company to pay shareholder dividends. During 2010 and 2009, the Insurance Companies paid ordinary dividends to the Company of $128.0 million and $110.0 million, respectively.
The statutory capital and surplus of each of the Insurance Companies exceeded the highest level of minimum regulatory required capital.
No stock options were awarded in 2010. In 2009 and 2008, the fair value of stock option awards was estimated on the date of grant using a closed-form option valuation model (Black-Scholes) based on the following table, which provides the weighted-average values of assumptions used in the calculation of grant-date fair values during the years ended December 31:
Expected volatilities are based on historical volatility of the Company’s stock over the term of the options. The Company estimated the expected term of options, which represents the period of time that options granted are expected to be outstanding, by using historical exercise patterns and post-vesting termination behavior. The risk free interest rate is determined based on U.S. Treasury yields with equivalent remaining terms in effect at the time of the grant.
A summary of the stock option activity under the Company’s plans as of December 31, 2010 and changes during the year then ended is presented below:
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Company’s closing stock price and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all options been exercised on December 31, 2010. The aggregate intrinsic value of stock options exercised was $431,000, $508,000, and $442,000 during 2010, 2009, and 2008, respectively. The total fair value of options vested was $498,000, $763,000, and $652,000 during 2010, 2009, and 2008, respectively.
The following table presents information regarding stock options outstanding at December 31, 2010:
As of December 31, 2010, $763,800 of total unrecognized compensation cost related to non-vested stock options is expected to be recognized over a weighted-average period of 1.9 years.
Under the 2005 Plan, the Compensation Committee of the Company’s Board of Directors granted to Gabriel Tirador, the Company’s Chief Executive Officer, 10,000 shares of restricted stock on March 23, 2010. On October 1, 2010, the Compensation Committee granted 45,000 restricted stock units to the Company’s senior management and key employees under the Plan. The restricted stock and restricted stock units will vest at the end of a three-year performance period, and then only if, and to the extent that, the Company’s cumulative underwriting income during such three-year performance period ending December 31, 2012 achieves the threshold performance levels established by the Compensation Committee.
The Company is obligated under various non-cancellable lease agreements providing for office space and equipment rental that expire at various dates through the year 2019. For leases that contain predetermined escalations of the minimum rentals, the Company recognizes the related rent expense on a straight-line basis and records the difference between the recognized rental expense and amounts payable under the leases as deferred rent in other liabilities. This liability amounted to approximately $1,159,000 and $1,452,000 at December 31, 2010 and 2009, respectively. Total rent expense under these lease agreements was $17,076,000, $17,529,000, and $12,002,000 for 2010, 2009, and 2008, respectively.
The following table presents future minimum commitments for operating leases as of December 31, 2010:
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 a hearing before the administrative law judge had been set to start on September 14, 2009, the hearing has been vacated. The evidentiary phase of the hearing has been rescheduled to begin May 9, 2011. On February 15, 2011, there will be a procedural hearing addressing evidentiary issues. The outcome of the procedural hearing on February 15 may impact the commencement of the hearing on May 9, 2011 and could have an impact on the outcome to the extent limitations on certain evidence is ordered by the administrative law judge. This matter has been the subject of five continuations since the original Notice of Non-Compliance was issued.
The Company is also involved in proceedings relating to assessments and rulings made by the FTB. See Note 10.
Many economists believe that the severe economic recession is over, but they expect the recovery to be slow with many businesses feeling the effects of the downturn for years to come. The Company is unable to predict the duration and severity of the current disruption in the financial markets in the United States. The recession, with continuing high unemployment rates, has contributed to declining premium revenues and could lead to further premium revenue declines in the future. If economic conditions in the United States, and in California, where the majority of the Company’s business is produced, do not show improvement, the adverse impact on the Company’s results of operations, financial position, and cash flows may continue.
Net income was mainly affected by lower net premiums earned and higher total losses incurred, slightly offset by favorable development on loss reserves, and lower gains due to changes in the fair value of the Company’s investment portfolio during 2010 compared to 2009. The favorable development of loss reserves is largely the result of re-estimates of California BI losses. Declines in income during the second quarter of 2010 were driven by declines in the fair value of the Company’s equity securities due to the overall decline in the equity markets, especially in the oil sector as a result of the oil spill in the Gulf of Mexico. The primary causes of the net loss during the fourth quarter of 2010 were declines in the fair value of the Company’s municipal securities due to the overall decline in the municipal markets, catastrophe losses in California from heavy rainstorms, and increased losses and a premium deficiency reserve recorded in the Florida homeowners line of business.