The Company is headquartered in Los Angeles, California and operates primarily as a personal automobile insurer selling policies through a network of independent agents, 100% owned insurance agents and direct channels, in thirteen states: Arizona, California, Florida, Georgia, Illinois, Michigan, Nevada, New Jersey, New York, Oklahoma, Pennsylvania, Texas, and Virginia. The Company also offers homeowners, commercial automobile, commercial property, mechanical breakdown, fire, and umbrella insurance. Private passenger automobile lines of insurance business accounted for 77.9% of the $3.0 billion of the Company’s direct premiums written in 2015 and 83% of the private passenger automobile premiums were written in California.
During 2015, 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 competitive in California and in other states.
The Company’s operating results and growth have allowed it to consistently generate positive cash flow from operations, which was approximately $190 million and $247 million in 2015 and 2014, respectively. Cash flow from operations has been used to pay shareholder dividends and help support growth.
Loss Frequency-Another component of overall loss costs is loss frequency, which is the number of claims per risk insured. Loss frequency trends are affected by many factors such as fuel prices, the economy, the prevalence of distracted driving and collision avoidance technology in vehicles. Loss frequency generally increased in 2015.
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 market conditions. The Company believes that the market is hardening with carriers generally raising rates, although this also depends on individual state profitability and the carriers’ growth appetite.
A new agent incentive management system was introduced in 2014 and enhanced in 2015 to better manage agency information, to continue to improve the agent experience and to provide for more flexible ways to compensate agents.
In 2015, the Company continued to invest in Guidewire, a commercial software solution that was launched in 2010 to replace legacy platforms, by adding new capabilities and enhanced features, including paperless workflow, to meet evolving business needs and regulatory changes. For private passenger automobile insurance, the Guidewire policy, billings and claims modules had been implemented in all states outside of California. California private passenger automobile claims processing was converted to the Guidewire claims module in 2015 and the Company expects to implement the policy and billings modules within the next two years.
During 2015, the Company implemented rate changes in thirteen states. In California, the following rate increases were implemented:
In May, a 6.4% rate increase on its preferred private passenger automobile line of insurance business, which represented approximately 50% of the total Company net premiums earned.
In August, a 6.9% rate increase on its standard private passenger automobile line of insurance business, which represented approximately 15% of the total Company net premiums earned.
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 Policies and Estimates" below and Note 1. Summary of Significant Accounting Policies, of the Notes to Consolidated Financial Statements in "Item 8. Financial Statements and Supplementary Data."
Preparation of the Company’s consolidated financial statements requires management’s 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 loss reserve that is required. A key assumption in estimating loss reserves is the degree to which the historical data used to analyze reserves will be predictive of ultimate claim costs on incurred claims. Changes in the regulatory and legal environments, results of litigation, medical costs, the cost of repair materials, and labor rates, among other factors, can impact this assumption. 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 liability claims, such as property damage claims, tend to be more reasonably predictable than long-tail liability claims.
The Company also engages independent actuarial consultants to review the Company’s loss reserves and to provide the annual actuarial opinions required under state statutory accounting requirements. The Company analyzes loss reserves quarterly primarily using the incurred loss, paid loss, claim count development, and average severity methods described below. When deciding among methods to use, 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 insurance business or coverage within a line of insurance business. The Company may also evaluate qualitative factors such as known changes in laws or legal rulings that could affect claims handling or other external environmental factors or internal factors that could affect the settlement of claims. When establishing the loss reserve, the Company will generally analyze the results from all of the methods used rather than relying on a single 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.
Loss development on MD reserves is generally insignificant because MD claims are generally settled in a shorter period than BI claims. 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 claims closed in the accident year reported are generally the smaller and less complex claims that settle for approximately $3,000 to $3,500, on average, whereas the total average settlement, once all claims are closed in a particular accident year, is approximately $10,000 to $11,000. 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 loss 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 loss reserves established for that accident year. Consequently, there is a decreasing likelihood of loss reserve development on any particular accident year, as those periods age. At December 31, 2015, the accident years that are most likely to develop are the 2013 through 2015 accident years; however, it is possible that older accident years could develop as well.
The following table presents the effects of the California automobile BI loss reserves on the 2015, 2014, and 2013 accident years based on possible variations in the severity recorded; however, the variation could be more or less than these amounts.
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 3% to 5% 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.
At December 31, 2015, there were 28,255 BI claims reported for the 2015 accident year and the Company estimates that these are expected to ultimately grow by approximately 4.5%. The Company believes that while actual development in recent years has ranged between approximately 3% to 5%, 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.
At December 31, 2015 and 2014, the Company recorded its point estimate of approximately $1.15 billion and $1.09 billion, respectively, in losses and loss adjustment expense liabilities, which include approximately $440.7 million and $440.8 million, respectively, of IBNR. IBNR includes estimates, based upon past experience, of ultimate developed costs, which may differ from case estimates, unreported claims that occurred on or prior to December 31, 2015 and 2014, 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.
The Company evaluates its loss 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 2015, the Company reported unfavorable development of approximately $13 million on the 2014 and prior accident years’ losses and loss adjustment expense reserves, which at December 31, 2014 totaled approximately $1.09 billion. The unfavorable development in 2015 was primarily from the California homeowners and automobile lines of insurance business outside of California, which was partially offset by favorable development in the California personal automobile line of insurance business.
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, equity securities, and exchange traded funds. 99.7% of the fair value of financial instruments held at December 31, 2015 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 by financial instrument. 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 because they are less actively traded currently or in future periods. The fair value of such instruments is determined using techniques appropriate for each particular financial instrument. These techniques may 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 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 financial instruments may be reduced 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 are not actively quoted. For a further discussion, see Note 4. Fair Value Measurement, of the Notes to Consolidated Financial Statements in Item 8. "Financial Statements and Supplementary Data."
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 "Regulatory and
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 consolidated balance sheets and are computed monthly on a 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 to related unearned premiums. To the extent that any of the Company’s lines of insurance business become unprofitable, a premium deficiency reserve may be required.
(1) Combined ratio for 2014 does not sum due to rounding.
Expense ratio is calculated by dividing the sum of policy acquisition costs plus other operating expenses by net premiums earned. Excluding the $27.6 million penalty assessed by the California DOI and accrued by the Company in 2014, the expense ratio would have been 26.8% in 2014 comparable to the expense ratio in 2015. The 2015 expense ratio also included higher advertising expenses and lower average commissions paid to agents.
In 2015, the decreases in the fair value of equity securities were primarily due to a decline in the value of the Company's holdings in industrial stocks. Prior to the fourth quarter of 2014, the Company realized gains by selling equity securities. During the fourth quarter of 2014, decreases in the fair value of equity securities were primarily due to a decline in the value of the Company's holdings in energy stocks.
The increase in the 2014 expense ratio was affected by the $27.6 million penalty assessed by the California DOI as a result of the California Insurance Commissioner's adoption of a decision by the ALJ in the 2004 NNC. Excluding the effect of the California DOI penalty assessment, the expense ratio was 26.8% for the year ended December 31, 2014.
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 $164 million in 2016 to Mercury General. The Insurance Companies paid Mercury General ordinary dividends of $133 million during 2015. As of December 31, 2015, Mercury General had approximately $149 million in investments and cash that could be utilized to satisfy its direct holding company obligations.
The Company has generated positive cash flow from operations since the public offering of its common stock in November 1985, and 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 $449.5 million at December 31, 2015 as well as $100 million of credit available on a $250 million revolving credit facility, the Company believes its cash flow from operations is adequate to satisfy its liquidity requirements without the forced sale of investments. Investment maturities are also available to meet the Company’s liquidity needs. 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.
The following table presents the estimated fair value of fixed maturity securities at December 31, 2015 by contractual maturity in the next five years.
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 enables 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, 2015:
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 12.6 years and 12.6 years (12.2 years and 11.4 years when including short-term instruments) at December 31, 2015 and 2014, respectively. 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 further reduce the duration of the asset as interest rates decline. The call-adjusted average maturities of the overall bond portfolio were 3.4 years and 3.4 years (3.3 years and 3.1 years when including short-term instruments) at December 31, 2015 and 2014, 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 3.2 years and 2.8 years, (3.1 years and 2.6 years when including short-term instruments) at December 31, 2015 and 2014, respectively, including collateralized mortgage obligations with a modified duration of 1.9 years and 1.8 years at December 31, 2015 and 2014, 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.
Taxable holdings consist principally of investment grade issues. At December 31, 2015, fixed maturity holdings rated below investment grade and non-rated bonds totaled $37.5 million and $6.2 million, respectively, at fair value, and represented 1.3% and 0.2%, respectively, of total fixed maturity securities. At December 31, 2014, fixed maturity holdings rated below investment grade and non-rated bonds totaled $37.2 million and $10.8 million, respectively, at fair value, and represented 1.4% and 0.4%, respectively, of total fixed maturity securities.
Credit ratings for the Company's fixed maturity portfolio were stable in 2015, with 91.2% of fixed maturity securities at fair value experiencing no change in their overall rating. 2.7% and 6.1% of fixed maturity securities at fair value experienced upgrades and downgrades, respectively, in 2015. The downgrades were slight and still within the investment grade portfolio in 2015.
Included in fixed maturity securities are $243.3 million and $256.9 million of corporate securities, which had durations of 2.8 and 2.3 years, at December 31, 2015 and 2014, respectively. The weighted-average rating was BBB as of December 31, 2015 and 2014.
The Company’s common stock allocation is intended to enhance the return of and provide diversification for the total portfolio. At December 31, 2015, 9.3% of the total investment portfolio at fair value was held in equity securities, compared to 12.1% at December 31, 2014.
On July 2, 2013, the Company entered into an unsecured $200 million five-year revolving credit facility. The interest rate on borrowings under the credit facility is based on the Company’s debt to total capital ratio and ranges from LIBOR plus 112.5 basis points when the ratio is under 15% to LIBOR plus 162.5 basis points when the ratio is above 25%. Commitment fees for the undrawn portions of the credit facility range from 12.5 basis points when the ratio is under 15% to 22.5 basis points when the ratio is above 25%. Debt to capital ratio is expressed as a percentage of (a) consolidated debt to (b) consolidated shareholders' equity plus consolidated debt. In 2015, the interest rate was LIBOR plus 112.5 basis points on the $150 million of borrowings and 12.5 basis points on the undrawn portion of the credit facility. The interest rate was approximately 1.53% at December 31, 2015.
The bank loan and credit facilities contain financial covenants pertaining to minimum statutory surplus, debt to capital ratio, and RBC ratio. The Company was in compliance with all of its loan covenants at December 31, 2015.
In 2015, the Company made capital expenditures, including capitalized software, of approximately $20.1 million primarily related to Information Technology.
The table excludes liabilities of $10.9 million related to uncertainty in tax settlements as the Company is unable to reasonably estimate the timing and amount of related future payments.
Consolidated Statements of Operations for the Years Ended December 31, 2015, 2014, and 2013
Consolidated Statements of Cash Flows for the Years Ended December 31, 2015, 2014, and 2013
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Mercury General Corporation and subsidiaries as of December 31, 2015 and 2014, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2015, in conformity with U.S. generally accepted accounting principles.
We have audited Mercury General Corporation’s internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control-Integrated Framework (2013) 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.
In our opinion, Mercury General Corporation maintained, in all material respects, effective internal control over financial reporting as of December 31, 2015, based on criteria established in Internal Control-Integrated Framework (2013) issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Mercury General Corporation and subsidiaries as of December 31, 2015 and 2014, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2015, and our report dated February 9, 2016 expressed an unqualified opinion on those consolidated financial statements.
Mercury General Corporation ("Mercury General") and its subsidiaries (referred to herein collectively as the "Company") are primarily engaged in writing personal automobile insurance through 14 Insurance Companies in 13 states, principally California. The Company also writes homeowners, commercial automobile, commercial property, mechanical breakdown, fire, and umbrella insurance. The private passenger automobile line of insurance business was more than 77% of the Company’s direct premiums written in 2015, 2014, and 2013, of which approximately 83%, 83%, and 81% of the private passenger automobile premiums were written in California during 2015, 2014, and 2013, respectively. Premiums written represents the premiums charged on policies issued during a fiscal period, which is a statutory measure designed to determine production levels.
The Company did not have other comprehensive income (loss) in 2015, 2014 and 2013.
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, 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
The Company applies the fair value option to all fixed maturity and equity securities and short-term investments at the time an eligible items is first recognized. The primary reasons for electing the fair value option were simplification and cost benefit considerations as well as the expansion of the use of fair value measurement by the Company consistent with the long-term measurement objectives of the Financial Accounting Standards Board (the "FASB") for accounting for financial instruments. See Note 2. Fair Value of Financial Instruments for additional information on the fair value option.
As required by statute, the Company’s insurance subsidiaries have securities deposited with the Departments of Insurance or similar governmental agencies in the states in which they are licensed to operate with fair values totaling $21 million and $18 million at December 31, 2015 and 2014, respectively.
Deferred policy acquisition costs consist of commissions paid to outside agents, premium taxes, salaries, and certain other underwriting costs that are incremental or directly related to the successful acquisition of new and renewal insurance contracts and are amortized over the life of the related policy in proportion to premiums earned. Deferred policy acquisition costs are limited to the amount that 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 premiums are earned. The Company’s deferred policy acquisition costs are further limited by excluding those costs not directly related to the successful acquisition of insurance contracts. Deferred policy acquisition cost amortization was $539.2 million, $526.2 million, and $505.5 million during the years ended December 31, 2015, 2014, and 2013, respectively. The Company does not defer advertising expenditures but expenses them as incurred. The Company recorded net advertising expense of approximately $44 million, $23 million, and $20 million during the years ended December 31, 2015, 2014, and 2013, respectively.
The Company periodically assesses long-lived assets or asset groups including building and equipment, for recoverability when events or changes in circumstances indicate that their carrying amounts may not be recoverable. If the Company identifies an indicator of impairment, the Company assesses recoverability by comparing the carrying amount of the asset to the sum of the undiscounted cash flows expected to result from the use and the eventual disposal of the asset. An impairment loss is recognized when the carrying amount is not recoverable and is measured as the excess of carrying value over fair value. There were no impairment charges during 2015, 2014, and 2013.
The Company evaluates goodwill and other intangible assets for impairment annually or 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 their implied fair values. The Company qualitatively determines whether, more likely than not, the fair value exceeds the carrying amount of a reporting unit. There are numerous assumptions and estimates underlying the qualitative assessments including future earnings, long-term strategies, and the Company’s annual planning and forecasting process. If these planned initiatives do not accomplish the targeted objectives, the assumptions and estimates underlying the qualitative assessments could be adversely affected and have a material effect upon the Company’s financial condition and results of operations. In addition, the Company evaluates other intangible assets using methods similar to those used for goodwill described above. As of December 31, 2015 and 2014, goodwill and other intangible impairment assessments indicated that there was no impairment.
used rather than relying on a single 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.
At December 31, 2015, the Company’s deferred income taxes were in a net asset position, which included a combination of ordinary and capital deferred tax benefits. In assessing the Company's ability to realize 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 character within the carryback and carryforward periods available under the tax law. Management considers the 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.
In January 2016, the FASB issued Accounting Standards Update ("ASU") 2016-01, "Financial Instruments-Overall (Subtopic 825-10), Recognition and Measurement of Financial Assets and Financial Liabilities." The amendments in this ASU update address certain aspects of recognition, measurement, presentation and disclosure of financial instruments. ASU 2016-01: (1) requires equity investments (except those accounted for under the equity method or those that result in the consolidation of the investee) to be measured at fair value with changes in the fair value recognized in net income; (2) simplifies the impairment assessment of equity investments without readily determinable fair values by requiring a qualitative assessment to identify impairment; (3) requires the use of the exit price notion when measuring the fair value of financial instruments for disclosure purposes; and (4) requires separate presentation of financial assets and financial liabilities by measurement category and form of financial asset on the balance sheet or the notes to the financial statements. These amendments are effective for fiscal years beginning after December 15, 2017, including interim periods within those fiscal years. The Company does not anticipate that ASU 2016-01 will have a material impact on its consolidated financial statements and related disclosures.
In May 2014, the FASB issued ASU 2014-09, "Revenue Recognition (Topic 606): Revenue from Contracts with Customers." ASU 2014-09 requires entities to apply a five-step model to determine the amount and timing of revenue recognition. The model specifies, among other criteria, that revenue should be recognized when an entity transfers control of goods or services to a customer at the amount at which the entity expects to be entitled. In August 2015, the FASB issued an update which defers the effective
date of this standard to annual reporting periods beginning after December 15, 2017, including interim reporting periods within that annual reporting period. Early adoption is now permitted only as of annual reporting periods beginning after December 15, 2016, including interim reporting periods within that annual reporting period. The Company is evaluating the impact of this standard on its consolidated financial statements and related disclosures.
The Company applies the fair value option to all fixed maturity and equity securities and short-term investments at the time an eligible item is first recognized. The cost of investments sold is determined on a first-in and first-out method and realized gains and losses are included in net realized investment (losses) gains. See Note 3. Investments for additional information.
The fair value of the Company's $120 million secured note and $20 million secured note, classified as Level 2 in the fair value hierarchy described in Note 4. Fair Value Measurement, is estimated based on assumptions and inputs, such as the market value of underlying collateral and reset rates, for similarly termed notes that are observable in the market. The fair values of the secured notes approximated their carrying values.
The fair value of the Company's $150.0 million unsecured note, classified as Level 2 in the fair value hierarchy described in Note 4. Fair Value Measurement, is based on the unadjusted quoted price for similar notes in active markets. The fair value of the unsecured note approximated its carrying value.
The following table presents gross gains (losses) realized on the sales of investments:
The Company obtained unadjusted fair values on 99.7% of its portfolio from an independent pricing service. For 0.3% of its portfolio, classified as Level 3, the Company obtained specific unadjusted broker quotes based on net fund value and, to a lesser extent, unobservable inputs from at least one knowledgeable outside security broker to determine the fair value as of December 31, 2015. At December 31, 2015 and 2014, $10.4 million and $11.7 million, respectively, of equity securities were valued based on broker quotes for underlying debt and credit instruments and an estimated benchmark spread for similar assets in active markets.
Mortgage-backed securities: Comprised of securities that are collateralized by residential and commercial 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. The Company had holdings of $37.3 million and $32.5 million at December 31, 2015 and 2014, respectively, in commercial mortgage-backed securities.
Collateralized loan obligations: Valued based on underlying debt instruments and the appropriate benchmark spread for similar assets in active markets.
Secured notes payable: Valued based on underlying collateral and reset rates for similarly termed notes that are observable in the market.
Unsecured notes payable: Valued based on the unadjusted quoted price for similar notes in active markets.
Collateralized debt obligations/Private equity funds: Valued based on underlying debt/credit instruments and the appropriate benchmark spread for similar assets in active markets; taking into consideration unobservable inputs related to liquidity assumptions.
There were no transfers between Levels 1, 2, and 3 of financial assets and financial liabilities that were fair valued on a recurring basis in 2015 and 2014.
At December 31, 2015, the Company did not have any nonrecurring fair value measurements of nonfinancial assets or nonfinancial liabilities.
The $120 million credit facility is secured by municipal bonds held as collateral. The collateral requirement is calculated as the fair market value of the municipal bonds held as collateral multiplied by the advance rates, which vary based on the credit quality and duration of the assets held and range between 75% and 100% of the fair value of each bond. Effective December 3, 2014, the Company extended the maturity date of the $120 million credit facility from July 31, 2016 to December 3, 2017.
The credit facilities and bank loan contain financial covenants pertaining to minimum statutory surplus, debt to capital ratio, and risk-based capital ("RBC") ratio. The Company was in compliance with all of its loan covenants at December 31, 2015.
On August 9, 2013, Animas Funding LLC ("AFL"), a special purpose investment vehicle, formed by and consolidated into the Company, entered into a three-year total return swap agreement with Citibank. Under the total return swap agreement, AFL receives the income equivalent on underlying obligations due to Citibank and pays to Citibank interest equal to LIBOR plus 120 basis points on the outstanding notional amount of the underlying obligations, which was approximately $124 million as of December 31, 2015. The total return swap is secured by approximately $40 million of U.S. Treasuries as collateral, which are included in short-term investments on the consolidated balance sheets.
Most options sold consist of covered calls. The Company writes covered calls on underlying equity positions held as an enhanced income strategy that is permitted for the Company’s insurance subsidiaries under statutory regulations. The Company manages the risk associated with covered calls through strict capital limitations and asset diversification throughout various industries. For additional disclosures regarding equity contracts, see Note 4. Fair Value Measurement.
The Company recognized $1.4 million of other intangible assets for a state insurance license related to the acquisition of Workmen's Auto Insurance Company. See Note 20. Acquisition for the acquisition's cost allocation.
Other intangible assets are reviewed annually for impairment and more frequently if potential impairment indicators exist. No impairment indicators were identified during any of the periods presented.
The Company and its subsidiaries file a consolidated federal income tax return. The income tax (benefit) expense consisted of the following components:
The Company and its subsidiaries file income tax returns with the Internal Revenue Service and the taxing authorities of various states. Tax years that remain subject to examination by major taxing jurisdictions are 2012 through 2014 for federal taxes and 2003 through 2014 for California state taxes. The Company is currently under examination by the California Franchise Tax Board ("FTB") for tax years 2003 through 2013. The FTB issued Notices of Proposed Assessments to the Company for tax years 2003 through 2010, which the Company formally protested. The proposed adjustments for tax years 2003 through 2006 were affirmed following an administrative protest process with the FTB examination. The Company is in settlement discussions with the FTB. If a reasonable settlement is not reached, the Company intends to pursue other options, including a formal hearing with the State Board of Equalization or litigation in superior court. Management believes that the resolution of these examinations and assessments will not have a material impact on the consolidated financial statements.
Management does not expect the Company's total amount of unrecognized tax benefits to materially increase within the next twelve months.
The Company recognizes interest and penalties related to unrecognized tax benefits as a part of income taxes. During the years ended December 31, 2015, 2014, and 2013, the Company recognized net interest and penalty expense, excluding refunds, of $112,000, $739,000, and $1,119,000, respectively. The Company carried an accrued interest and penalty balance of $2,915,000 and $2,803,000 at December 31, 2015 and 2014, respectively.
The following table presents the activity in the reserves for losses and loss adjustment expenses:
The increase in the provision for insured events of prior years in 2015 of approximately $12.7 million primarily resulted from the California homeowners and automobile lines of business outside of California, which was partially offset by favorable development in the California automobile line of business.
The increase in the provision for insured events of prior years in 2013 of approximately $3.0 million primarily resulted from Florida claims that were re-opened from prior years due to a state supreme court ruling that was adverse to the insurance industry.
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 2015, the insurance subsidiaries of the Company are permitted to pay approximately $164 million in dividends to Mercury General without the prior approval of the DOI of domiciliary states. The above statutory regulations may have the effect of indirectly limiting the ability of the Company to pay shareholder dividends. During 2015, 2014, and 2013, the Insurance Companies paid the Mercury General ordinary dividends of $133 million, $225 million, and $120 million, respectively.
The Insurance Companies must comply with minimum capital requirements under applicable state laws and regulations. The RBC formula is used by insurance regulators to monitor capital and surplus levels. It was designed to capture the widely varying elements of risks undertaken by writers of different lines of insurance business 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. The Company periodically monitors the RBC level of each of the Insurance Companies. As of December 31, 2015, 2014, and 2013, each of the Insurance Companies exceeded the minimum required RBC levels, as determined by the NAIC and adopted by the state insurance regulators. None of the Insurance Companies’ RBC ratios was less
than 375% of the authorized control level RBC as of December 31, 2015, 2014 and 2013 . Generally, an RBC ratio of 200% or less would require some form of regulatory or company action.
The Plan includes an option for employees to make salary deferrals under Section 401(k) of the Internal Revenue Code. The matching contributions, at a rate set by the Board of Directors, totaled $8.5 million, $8.0 million, and $8.1 million for 2015, 2014, and 2013, respectively.
No stock options were awarded in 2015 and 2014 under the 2015 Plan and 2005 Plan, respectively. The fair values of stock options awarded in 2013 under the 2005 Plan were estimated on the dates of grant using a closed-form option valuation model (Black-Scholes). The following table provides the assumptions used in the calculation of grant-date fair values of stock options awarded during 2013 based on the Black-Scholes option pricing model.
The following table presents a summary of the stock option activity under the Company’s plans for the year ended December 31, 2015:
The following table presents the restricted stock unit grants summary at December 31, 2015:
The following table presents a summary of restricted stock unit awards activity during the years indicated:
The restricted stock units vest at the end of a three-year performance period beginning with the year of the grant, and then only if, and to the extent that, the Company’s performance during the performance period achieves the threshold established by the Compensation Committee of the Company’s Board of Directors. For 2013, 2014 and 2015 grants, vesting is based on the Company’s cumulative underwriting income, annual underwriting income, and net earned premium growth. As of December 31, 2015, 1,000, 8,000, and 6,000 target restricted stock units granted in 2015, 2014 and 2013, respectively, have been forfeited because the recipients were no longer employed by the Company. Expired shares represent shares that did not meet the vesting requirements.
The following table presents a reconciliation of the numerators and denominators of the basic and diluted earnings per share calculations:
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 2021. 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 $3.6 million and $4.4 million at December 31, 2015 and 2014, respectively. Total rent expense under these lease agreements was $16.0 million, $14.6 million, and $19.3 million for 2015, 2014, and 2013, respectively.
In March 2006, the CDI 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 CDI sought to impose a fine for each policy on which the Company allegedly permitted an agent to charge a broker fee, to impose a penalty for each policy on which the Company allegedly used a misleading advertisement, and to suspend certificates of authority for a period of one year. In January 2012, the administrative law judge (the "ALJ") bifurcated the 2004 NNC between (a) the CDI’s order to show cause (the "OSC"), in which the CDI asserts the false advertising allegations and accusation, and (b) the CDI’s notice of noncompliance, in which the CDI asserts the unlawful rate allegations. In February 2012, the ALJ submitted a proposed decision dismissing the NNC, based on conduct by the CDI and the Commissioner in violation of the Company's due process rights. Specifically, the ALJ found that the CDI's attorneys and the Commissioner engaged in improper ex parte
communication, and commenced a rule making in order to supersede unfavorable evidentiary rulings by the ALJ. The Commissioner rejected the ALJ's proposed decision. The Company challenged the rejection in Los Angeles Superior Court in April 2012, but the challenge was unsuccessful. The Court did not rule on the merits of the ALJ's due process concerns, but merely held that the Company was required to exhaust its administrative remedies before seeking relief in the Superior Court. The case was referred back to the ALJ, and the due process issues raised by the ALJ's dismissal were preserved for later appeal. Following an evidentiary hearing in April 2013, post-hearing briefs and an unsuccessful mediation, the ALJ closed the evidentiary record on April 30, 2014. Although a proposed decision was to be submitted to the Commissioner on or before June 30, 2014, after which the Commissioner would have 100 days to accept, reject or modify the proposed decision, or required further evidence, the proposed decision was submitted on December 8, 2014. On January 7, 2015, the Commissioner adopted the ALJ's proposed decision, which became the Commissioner's adopted Order. The Company received notice of this Order on January 10, 2015. The decision and Order found that from the period July 1, 1996 through 2006, the Company's "brokers" were actually operating as "de facto agents" and that the charging of "broker fees" by these producers constituted the charging of "premium" in excess of the Company’s approved rates. The Order assessed a civil penalty in the amount of $27.6 million against the Company. The Company denies the allegations and/or findings in the Order, and believes that no monetary penalties are warranted. On February 9, 2015, the Company filed a Writ of Administrative Mandamus and Complaint for Declaratory Relief (the "Writ") in the Orange County Superior Court seeking, among other things, to require the Commissioner to vacate the Order, to stay the Order while the Superior Court action is pending, and to judicially declare as invalid the Commissioner’s interpretation of certain provisions of the California Insurance Code. Subsequent to the filing of the Writ, a consumer group petitioned and was granted the right to intervene in the Superior Court action. The court did not order a stay, and the $27.6 million assessed penalty was accrued in 2014 and paid in March 2015. The Company filed an amended Writ on September 11, 2015, adding an explicit request for a refund of the penalty, with interest. The court initially scheduled the matter for hearing on March 14, 2016, with the opening brief due October 19, 2015. The Company filed its opening brief, but the Commissioner then requested an extension of time to file an opposing brief and for the hearing on the Writ. The extension was granted, and the hearing is now scheduled for June 13, 2016. The Company intends to vigorously defend itself against the allegations, and seeks reversal of the $27.6 million assessed fine, unless a reasonable settlement can be reached.
The Company also establishes reserves for non-insurance claims related lawsuits, regulatory actions, and other contingencies when the Company believes a loss is probable and is able to estimate its potential exposure. 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 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.
Many businesses are still experiencing the effects of uncertain conditions in the global economy and capital markets, reduced consumer spending and confidence, and continued volatility, which could adversely impact the Company’s financial condition, results of operations, and liquidity. Further, the volatility and disruptions in global capital markets could adversely affect the Company’s investment portfolio. Although the disruption in the global financial markets has moderated, not all global financial
The following table presents summarized quarterly financial data for 2015 and 2014:
Net income during 2014 was primarily affected by the $27.6 million penalty assessed by California DOI, higher net premiums earned and increases in the fair value of the Company’s investment portfolio offset by catastrophe related losses. See Note 17. Commitments and Contingencies for "2004 NNC" discussion. The primary causes of the net loss during the fourth quarter of 2014 were the $27.6 million penalty described above, the declines in the fair value of the Company’s equity securities due to the overall decline in the equity market, and the severe rainstorms in California.
Net income during 2013 was primarily affected by higher net premiums earned offset by catastrophe related losses, and declines in the fair value of the Company’s investment portfolio due to the overall decline in the municipal bond markets. Net income during 2013 was also affected by the consolidation of claims and underwriting operations located outside of California into hub locations, which resulted in approximately $10 million of pre-tax office closure costs and severance related expense during the first quarter of 2013. The primary causes of the net loss during the second quarter of 2013 were increased losses resulting
The Company paid $8 million in cash for the shares of WAIC, of which $2 million has been withheld in escrow for up to three years as security for any loss development on claims incurred on or prior to June 30, 2014. Based on the evaluation performed at the acquisition date and at December 31, 2015, of the claims reserves for WAIC for losses and loss adjustment expenses incurred on or prior to June 30, 2014, the Company estimates that it will recover the $2 million held in escrow and, therefore, the Company has deducted it from cash consideration to arrive at the fair value of total consideration transferred. In accordance with regulatory approval requirements, the Company made a $15 million cash capital contribution to WAIC on January 12, 2015.
The Company is primarily engaged in writing personal automobile insurance and provides related property and casualty insurance products to its customers through 14 subsidiaries in 13 states, principally in California.